Determinants of Beta: Cyclical Revenues, Operating Leverage, and Financial Leverage

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)