Notes on Asset Beta and Equity Beta Relationship

According to M-M theory, the total risk of a rm does not change with leverage, rather it is only
shared between shareholders and debt holders with leverage. This is captured in Proposition II
of the M-M theory, as below:
RA = RE

E
D
+ RD
V
V

(1)

where RA , RE and RD are the required rate of return on assets, rm's equity and debt respectively. D
V is the market value debt ratio.
If CAPM holds for all assets in the market, then, the required return on the asset, equity and
debt would be,
RA = RF + A [E(RM ) RF ]
RE = RF + E [E(RM ) RF ]
RD = RF + D [E(RM ) RF ]

(2)
(3)
(4)

where RF is the risk-free rate of return, A is the systematic risk of the rm's assets, E is the
beta of the rm's equity and D is the beta of the rm's debt. Substituting equations 2, 3 and
4) in 1 would imply:
A [E(RM ) RF ] = E [E(RM ) RF ]

Equation 5 would lead to:

A = E

E
D
+ D [E(RM ) RF ]
V
V

E
D
+ D
V
V

(5)
(6)

Equation 6 would suggest that the risk of the assets cannot be inuenced by the nancing choice.
With leverage it is only shared between shareholders and creditors.
However, when the rm pays taxes, it earns a corporate tax shelter, which is benecial to the
shareholders. Hence, it is able to eectively reduce the cost of capital through an optimal
leverage policy. This leads to the modication of Equation 1 to give W ACC , dened as:
W ACC = RE

E
D
+ RD (1 T )
V
V

(7)

The presence of corporate taxes as above has an impact on the relationship between A and
E as given in Equation 6. However, it depends on the debt policy of the rm, whether it
follows (a) constant D
V ratio or (b) constant debt, as you have discussed in capital structure.
The relationship under these two leverage policies are discussed in the following sections.

Prepared by Prof. Joshy Jacob for classroom discussion as part of Corporate Finance course for AY 2014-15.

Leverage policy: Maintain Constant D/V ratio

When a rm earns a positive tax shelter, the value of the rm increases by the present value of
the tax shelter. Let us dene the following:
VU = Value of the unlevered rm
VL = Value of the levered rm
VIT S = Present value of the interest tax shelter, and
(8)

VL = VU + VIT S

The value of the tax shelter VIT S increases the equity value of the levered rm as reected in
the market value balance sheet as below:
Market value securities Market value assets
Equity
Debt

Value of assets (VU )

Value of tax shelter (VIT S )

The presence of the VIT S in the balance sheet of the levered rm, would change Equation 6 to
the following, taking portfolio beta as the weighted average of the constituent betas:
A

VU
VIT S
E
D
+ IT S
= E + D
VL
VL
V
V

(9)

where IT S is the beta of the tax shelter, which is exposed to risk. However, when a rm follows
a leverage policy to maintain constant D
V ratio, IT S would be equal to A . This happens as
the rm retires (issues) debt as the market value of declines (increases) to maintain the leverage
target. For instance, given constant interest rate and tax rate, the interest tax shelter would
change along with with rm value as follows:
Firm value

1000 2000

D/V ratio
Debt
Interest rate
Interest
Tax
ITS

40%
400
10%
40
40%
16

40%
800
10%
80
40%
32

Substituting A = IT S leads to Equation 6. Hence, this relationship between A and E can

be reliably employed, even when the rm pays corporate taxes.
Further, in the case of investment grade debt, the debt holders do not face any signicant risk and
therefore, D would be negligible. Hence D in Equation 6 can be assumed as zero. Equation 6
then becomes,
A = E

E
V

(10)

E = A

V
E

(11)

or

Equation 11 implies that the beta of equity increases along with leverage. 10 and Equation 11
are used to estimate beta of equity of a rm from that of its comparable rms which dier only
in their leverage.
2

Leverage policy: Maintain Constant Debt

If the rm maintains a constant amount of debt irrespective of market value of the rm, instead
of a constant D
V target as discussed above, then the relationship between the beta of asset and
beta of equity would change. This relationship is known as the Hammada equation. Intuitively,
if a rm is able to maintain a constant amount of debt irrespective of its market value, it would
earn a greater tax shelter. This in turn, would be more valuable to the shareholders, than
borrowing according to a constant D
V target. Hence it would reduce their risk in the rm (E )
D
relative to the constant V case.
Let VL be the total value of a levered rm with perpetual debt D and tax rate T . Then,
according to M-M theory, you have learnt that:
VL = VU + T D

(12)

If the market value of the equity of the levered rm and its debt can be dened as EL and D,
then,
EL + D = VU + T D
(13)
which implies,
EL + D(1 T ) = VU

(14)

The above relationship implies that in a market where the required return on assets, equity and
debt are dictated by the CAPM, the total systematic risk of the assets should be shared by the
equity holders and debt holders, in their proportion of the holdings in the rm. Accordingly,
the systematic risks would be:
A = E

EL
D(1 T )
+ D
VU
VU

(15)

E = A

VU
D(1 T )
D
EL
EL

(16)

EL + D(1 T )
D(1 T )
D
EL
EL

(17)

which can be organised as,

substituting for VU in Equation 16,

E = A

which becomes,
E = A + (A D )

D(1 T )
EL

(18)

when D = 0 (investment grade debt), the relationship between E and A becomes



D
E = A 1 + (1 T )
EL

(19)

Comparison of Equation 11 and Equation 19 suggests that the equity beta is lower in the latter
case as suggested.
However, assuming that a rm is able to employ constant debt irrespective of its market conditions is somewhat far fetched and therefore often not employed in the estimation of cost of
capital. We would only employ Equation 11 to estimate the beta of equity in Corporate Finance
course. Part of above discussion is given in pages 508-509 in your textbook.