Ch 06

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Ch 06

  1. 1. Chapter - 6 Beta Estimation and The Cost of Equity
  2. 2. Chapter Objectives <ul><li>Discuss the methods of estimating beta. </li></ul><ul><li>Explain the market model for calculating beta. </li></ul><ul><li>Examine the difference between betas of individual firms and the industry beta. </li></ul><ul><li>Highlight the beta instability. </li></ul><ul><li>Explain the determinants of beta. </li></ul><ul><li>Show the use of beta in determining the cost of equity. </li></ul>
  3. 3. Beta Estimation <ul><li>Direct Method—The ratio of covariance between market return and the security’s return to the market return variance: </li></ul>
  4. 4. Beta Estimation <ul><li>The Market Model—In the market model, we regress returns on a security against returns of the market index. </li></ul>
  5. 5. Beta Estimation in Practice <ul><li>In practice, the market portfolio is approximated by a well-diversified share price index. We have several price indices available in India. </li></ul><ul><li>There is no theoretically determined time period and time intervals for calculating beta. The time period and the time interval may vary. </li></ul><ul><li>The returns may be measured on a daily, weekly or monthly basis. One should have sufficient number of observations over a reasonable length of time. </li></ul>
  6. 6. Beta Estimation in Practice <ul><li>The return on a share and market index may be calculated as total return ; that is, dividend yield plus capital gain. </li></ul><ul><li>One may calculate the compounded rate of return as shown below: </li></ul><ul><li> r j = log[P t – P t -1] = log[P t /P t -1 </li></ul>
  7. 7. Summaries of Regression Parameters for HLL Vs. Market Returns
  8. 8. Does Beta Remain Stable Over Time? <ul><li>Betas may not remain stable for a company over time even if a company stays in the same industry. There could be several reasons for this. Over time, a company may witness changes in its product mix, technology, competition or market share. </li></ul>
  9. 9. Determinants of Beta <ul><li>Nature of Business </li></ul><ul><li>Operating Leverage </li></ul><ul><li>Financial Leverage </li></ul>
  10. 10. Nature of Business <ul><li>If we regress a company’s earnings with the aggregate earnings of all companies in the economy, we would obtain a sensitivity index, which we can call the company’s accounting beta . </li></ul><ul><li>The real or the market beta is based on share market returns rather than earnings. </li></ul><ul><li>The accounting betas are significantly correlated with the market betas. This implies that if a firm’s earnings are more sensitive to business conditions , it is likely to have higher beta. </li></ul><ul><li>We must distinguish between the earnings variability and the earnings cyclicality. </li></ul>
  11. 11. Operating Leverage and Financial Leverage <ul><li>The degree of operating leverage is defined as the change in a company’s earnings before interest and tax due to change in sales. Operating leverage intensifies the effect of cyclicality on a company’s earnings. </li></ul><ul><li>Financial leverage refers to debt in a firm’s capital structure. Since financial leverage increases the firm’s (financial) risk, it will increase the equity beta of the firm. </li></ul>
  12. 12. Asset Beta and Equity Beta <ul><li>For an unlevered (all-equity) firm, the asset beta and the equity beta would be the same. </li></ul><ul><li>For a levered firm, the proportion of equity will be less than 1. Therefore, the beta of asset will be less than the beta of equity. The beta of equity for a levered firm is given as follows: </li></ul>
  13. 13. CAPM and the Opportunity Cost of Equity <ul><li>From the firm’s point of view, the expected rate of return from a security of equivalent risk is the cost of equity. </li></ul><ul><li>The expected rate of return or the cost of equity in CAPM is given by the following equation: </li></ul>
  14. 14. Industry Vs. Company Beta <ul><li>The use of the industry beta is preferable for those companies whose operations match up with the industry operations. The industry beta is less affected by random variations. </li></ul><ul><li>Those companies that have operations quite different from a large number of companies in the industry, may stick to the use of their own betas rather than the industry beta. </li></ul><ul><li>Beta estimation and selection is an art as well, which one learns with experience. </li></ul>

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