Hi Question 22.10 in chapter 22 give an expression for a Co. WACC in terms of the cost of equity and debt. Both R(equity) and R(debt) are then expressed in CAPM formulae where it is the risk-free rate plus a Beta x Risk premium. For both R(equity) and R(debt) the Risk premium parts are given as (Rm-Rf). Is this the same risk premium in both cases or is there an Equity risk premium and a Debt risk premium? Thanks. danie
In my opinion the risk premium should be the same for both equity and debt. It is the beta factor that transforms the 'standard' risk premium into a debt or equity risk premium in the formula. If you have only a single beta factor for the company as a whole, you can either: i. Use the same beta for both equity and debt and argue that they are influenced by the same factors in a single company (not sure this would float very well in an exam); or ii. Use a pragmatic adjustment and continue answering the question from there, for example: beta (equity) = beta (debt) * 1.2 ... arguing that an equity stake in a particular company will be more risky than debt in the (same) company. Any thoughts from a tutor?
Hi Beta (Rm -Rf) is something that can be applied to any risky asset, whether it is debt or equity. Most people refer to (Rm -Rf) as the "equity risk premium" which is confusing, but in some cases it is referred to as the "market risk premium" which is better. Most debt in the real world has a beta of around 0.2, but some junk debt can behave as equity. So in summary, if it is not a risk free asset, you can measure its beta and use Rf +beta(Rm -Rf)
