1 / 13

Determinants of Beta Formally: Cyclicality of Revenues Not the same volatility of revenues Biotech vs. Steel Operati

Determinants of Beta Formally: Cyclicality of Revenues Not the same volatility of revenues Biotech vs. Steel Operating Leverage The mix of fixed and variable costs Financial Leverage The mix of debt and equity financing

herve
Download Presentation

Determinants of Beta Formally: Cyclicality of Revenues Not the same volatility of revenues Biotech vs. Steel Operati

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Determinants of Beta Formally: • Cyclicality of Revenues • Not the same volatility of revenues • Biotech vs. Steel • Operating Leverage • The mix of fixed and variable costs • Financial Leverage • The mix of debt and equity financing • All three have an impact on the variability of the Net Income available to the stockholders

  2. Cyclicality of Revenues Does the company make • Consumer products • βP&G = 0.52 • Not very cyclical • Office Products and Supplies • βOffice Max = 2.68 • Very cyclical

  3. %DEBIT DOL = %D Sales • Degree of Operating Leverage • Mix of Fixed and Variable costs • DOL increases as fixed costs rise relative to variable costs • DOL magnifies the effects of cyclicality on EBIT Formula:

  4. Degree of Operating Leverage Three alternatives • All Variable costs: DOL = 1.00 • Half Fixed, Half Variable: DOL = 1.50 • All Fixed: DOL = 2.00

  5. Financial Leverage • Mix of Debt and Equity financing • Increases as fixed interest payments rise • Financial Leverage magnifies the effects of cyclicality on NI (and EPS) • Financial Leverage is measured by the usual leverage measures • See Chapter 3 • Debt/Equity is the most common financial leverage measure in this context

  6. Financial Leverage Three alternatives • No Debt: Interest Expense = $0 • Some Debt: Interest Expense = $500 • High Debt: Interest Expense = $800 (These are the “All Variable Cost” example from before)

  7. More about Financial Leverage • What is the effect on the firm’s Equity Beta from more debt? • Recall a Portfolio’s Beta is the weighted average beta of the components • So the Company’s Total Beta is the weighted average beta of the stocks and bonds issued to finance the company βPortfolio = E/V βEquity + D/V βDebt • But the Total Beta is really Asset Beta βAssets= E/V βEquity + D/V βDebt

  8. Beta and Financial Leverage • We have this relationship: βAssets= E/V βEquity + D/V βDebt • But think about βDebt βDebt = Cov(RDebt,RMkt)/Var(RMkt) Covariance of debt and the market is close to zero βDebt≈ 0 βAssets= E/V βEquity + 0 • Since V = E + D: βAssets= E/(E + D) βEquity βEquity= βAssets (E + D)/E βEquity= βAssets (E/E + D/E) βEquity= βAssets [1 + D/E] βEquity = βAssets [1 + (1-T)D/E]

  9. Example: • CMG is financed only with equity (no debt) • This referred to as an “unlevered firm” • The beta of its stock is 1.02 • What is the beta of its assets given that it has no debt? βEquity= βAssets (1 + D/E)= βAssets (1 + 0/E)= βAssets (1) βEquity= βAssets = 1.02 • If CMG were to issue enough debt to buy back 20% of its outstanding stock, what would happen to the beta of the remaining stock? D/E = 0.20/0.80 = 0.25 βEquity = βAssets (1 + D/E) = 1.02(1 + 0.25) = 1.275 • The market risk of the stock increases by 25% • Solely from a financing decision

  10. Recap: Determinants of Equity Beta • Cyclical nature of the product • Degree of operating Leverage • DOL = %ΔEBIT/%ΔSales • Is this a business decision or nature of the product? • Financial Leverage • βEquity = βAssets (1 + D/E) • We use βEquity to calculate RE RE = Rf + βEquity[E(RM) – Rf] • We Use RE to calculate WACC WACC = WERE + WDRD(1 – TC)

  11. Some Beta Terminology • Corporate Finance: Equity Beta βE and Asset Beta βA • Investments: Levered Beta βL and Unlevered Beta βU βE= βL andβA= βU • Corporate Finance Question: • Given the Asset Beta (βA cyclicality and DOL), what do financing decisions do to equity risk (Equity Bata βE) and the cost of equity capital? • βA βE • Investments Question: • Given the Levered Beta (the CAPM beta, βL )what does the company’s risk look like without the leverage(βU)? • βL  βU

  12. Calculating Unlevered Beta Before (Corporate finance notation) • Given βAwhat is βE? βE= βA[1 + (1-T)D/E] Now (Investments notation) • Given βL what is βU? βL= βU[1 + (1-T)D/E] βU = βL/[1 + (1-T)D/E]

  13. What Happens to Equity Return? Equity Risk: βE= βA[1 + (1 - T)D/E] βL= βU[1 + (1 - T)D/E] Equity Return: RE= RA + (RA – RD)(1 – T)D/E RL= RU+ (RU– RD)(1 – T)D/E (This is MMII with taxes)

More Related