Question

What is business risk? What is financial risk? Assume an all-equity firm starts to borrow with 25% debt ratio (debt/total assets). If the unlevered beta=1.2, what will be the leveled beta using Hamada’s equation if the tax rate = 40%?

Answer 1

> Business Risk

• Business risk refers to a threat to the company’s ability to achieve its financial goals.
• In business, risk means that a company’s or an organization’s plans may not turn out as originally planned or that it may not meet its target or achieve its goals.
• Such risks cannot always be blamed on the owner of the company, as risk can be influenced by various external factors, which may include rising prices of raw materials for production, growing competition, or changes or additions to existing government regulations.
• In simple words, we can say business risk means a chance of incurring losses or less profit than expected.

> Financial Risk

• Financial risk is the risk that a company won't be able to meet its obligations to pay back its debts. Which in turn could mean that potential investors will lose the money invested in the company.
• The more debt a company has, the higher the potential financial risk.
• Potential financial risk should be a factor to consider when deciding whether or not to invest in a particular company.

> Levered Beta Calculation

• Formula

• Calculation

- Debt Equity ratio = Debt / Equity

                              = 0.25 / 0.75

                              = 0.3333

- Beta (unlevered) = Beta (Levered) / [ 1 + 0.3333 (1 - 0.40) ]

                       1.2 = Beta (Levered) / [ 1 + 0.3333 (1 - 0.40) ]

         Beta (Levered) = 1.2 * [ 1 + 0.3333 (1 - 0.40) ]

                              = 1.2 * 1.19998

                              = 1.44 Answer

Hope you understand the solution.

Stay Safe!