Betas and Leverage Suppose drug retailer CVS has an equity beta of 0.80 and a debt-equity ratio of

QUESTION

Betas and Leverage Suppose drug retailer CVS has an equity beta of 0.80 and a debt-equity ratio of 0.10. Estimate its asset beta assuming its debt beta is zero. Suppose CVS were to increase its leverage so that its debt-equity ratio was 0.50. Assuming its debt beta were still zero, what would you expect its equity beta to be after the increase in leverage?
Solution: Company has an equity beta of 0.80 Debt equity ratio of the company is 0.10 Tax rate is assumed here to be 40% So, Asset (beta) = Equity (beta) / [1+D/E (1-t)] Asset (beta) = 0.80 / [1+0.10*0.6] Asset (beta) = 0.80 / 1.06 = 0.755 Hence Asset (beta) of the company is 0.755 Again, if the debt equity ratio changes to 0.5, then its

ity beta would be (assuming that asset beta of the company remains at 0.755) Asset (beta) = Equity (beta) / [1+D/E (1-t)] 0.755= Equity (beta) / [1+0.5*0.6] Equity (beta) = 0.755 * 1.3 Hence Equity (beta) of the company is 0.9815

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