3. 21.

Business and financial risk [LO 16.1] Assume a firm’s debt is riskfree, so that the cost of debt equals the risk-free rate, Rf. Define βA as the firm’s asset beta—that is, the systematic risk of the firm’s assets.

Define βE to be the beta of the firm’s equity. Use the capital asset pricing model (CAPM) along with M&M Proposition II to show that

βE = βA × (1 + D/E), where D/E is the debt-to-equity ratio. Assume the tax rate is zero.