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ACCA Strategic Professional · Advanced Financial Management · Discounted cash flow techniques

Which statement about using CAPM-based project discount rates is correct?

Ungearing a proxy's equity beta removes financial risk and leaves the asset beta, which reflects only business risk. This can then be regeared to the financing structure of the project being appraised.

  1. AThe asset beta reflects both business risk and financial risk
  2. BThe equity beta of a geared firm is lower than its asset beta when debt is positive
  3. CUngearing a proxy's equity beta removes the effect of financial risk to leave business riskCorrect
  4. DRegearing the asset beta should use the proxy's gearing ratio rather than the project's financing

Explanation

Asset beta measures business risk alone because the effect of gearing has been removed. With positive debt the equity beta is higher than the asset beta, not lower. Regearing should use the investing firm's project financing, not the proxy's.

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