The capital asset pricing model (part 2) - ACCA (AFM) lectures

[@blackm9063]

Thank you Sir... you made it easy..... amazing

[@chhavigoyal5781]

Thank you for your Lectures

[@Artho-k9u]

The gearing ratio provides an extra layer of risk because the debt may be higher than the equity so company is at a risk of not being able to pay back the debt. But immediately after that you say that debt is always assumed to be risk-free in the exam. Quite the contradiction isn't it?

[@opentuition]

No, that is not the case. The existence of debt in a company creates more risk for the shareholders. This is the case whatever the level of debt and whether the debt is risk free or not (although the level of debt and the riskiness of the debt will both affect the extra risk to the shareholders). Also, the risk from gearing is not primarily because of the risk of not being able to repay the debt (in fact Modigliani and Miller ignore this risk completely in arriving at their hypotheses) but is because of the fixed interest payable when there is gearing - this creates more risk to the expected dividends). The only time that we assume debt to be risk-free in the exam is when using the asset beta formula. The formula does include the risk of the debt (the debt beta) but in the exam we always assume the debt itself to be risk free (and therefore a debt beta of zero) but it is only when using this formula that we make this assumption. If you have more question then please ask in the Paper AFM Ask the Tutor Forum on our free website. The reason is that I am not able to always monitor questions posted here, but I always answer questions posted in our free Ask the Tutor Forum :-)

[@Artho-k9u]

@@opentuition Thank you so much for the clarification. I will keep this in mind.

[@deanhaigh7673]

Surely if the gearing ratio is 0.4 debt to equity, the ratio is Equity 0.6:Debt 0.4? Or have I missed something here?

[@Directlite664]

This is a ratio. Debt ÷ equity

[@Directlite664]

Debt=0.4 and equity =1

[@andre_tube..]

Not quite, the ratio is debt to equity. If the ratio was 0.4 debt to capital, then it would mean that debt is 40 percent of total capital, leaving equity to be 60 percent