Two firms have the same operating structure and the same operating systematic risk, ß = .8. firm 1 has 20% debt in their capital structure while Firm 2 has four units of debt for every 7 units of equity. The tax rate faced by both firms is .4. The debt beta is assumed to zero. What is the difference in systematic risk between the riskier firm and the less risky firm?
A) .26 Firm 2 beta greater than Firm 1 beta.
B) .15 Firm 2 beta greater than Firm 1 beta.
C) .30 Firm 2 beta greater than Firm 1 beta.
D) .10 firm 2 beta greater than Firm 1 beta.

Question

Quizplus · Accepted Answer

The equity beta can be calculated using the formula: β_equity = β_asset * (1 + (1 - tax rate) * (D/E)). For Firm 1, D/E = 0.2/0.8 = 0.25. For Firm 2, D/E = 4/7. Calculating both, Firm 1's equity beta is 0.8 * (1 + 0.6 * 0.25) = 0.92, and Firm 2's equity beta is 0.8 * (1 + 0.6 * (4/7)) = 1.07. The difference is 1.07 - 0.92 = 0.15.

Two Firms Have the Same Operating Structure and the Same