Ch 6-Beta Estimation and Cost of Equity

BETA ESTIMATION AND THE COST OF EQUITYCHAPTER 6

Financial Management, Ninth Edition I M Pandey Vikas Publishing House Pvt. Ltd.

LEARNING OBJECTIVESDiscuss the methods of estimating beta.Explain the market model for calculating beta.Examine the difference between betas of individual firms and the industry beta.Highlight the beta instability.Explain the determinants of beta.Show the use of beta in determining the cost of equity.*


Beta Estimation*


Example *


Example-Steps to be followed*


Cont*


Example*


Market Model*


Beta Calculation: Example*


Beta Estimation in PracticeIn practice, the market portfolio is approximated by a well-diversified share price index. We have several price indices available in India.There is no theoretically determined time period and time intervals for calculating beta. The time period and the time interval may vary. 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.*


*Beta Estimation in PracticeThe return on a share and market index may be calculated as total return; that is, dividend yield plus capital gain:One may calculate the compounded rate of return as shown below:


Examples of Beta Estimation forCompanies in India*


*Characteristic Line and Beta for HUL


*Characteristic Line and Beta for Infy


*Characteristic Line and Beta for MahaTel


*Characteristic Line and Beta for Ranbaxy


Betas for the Sensex CompaniesThe BSEs sensitivity index includes 30 highly traded shares.The estimates are based on daily returns for one year.*Note that Jaiprakash Associates has the highest beta of 2.28 andGujarat Ambuja Cement the lowest beta of 0.37.


Does Beta Remain Stable Over Time?Betas may not remain stable for a company over time even if a company stays in the same industry. Over time, a company may witness changes in its product mix, technology, competition or market share. *


*


Nature of BusinessIf we regress a companys earnings with the aggregate earnings of all companies in the economy, we would obtain a sensitivity index, which we can call the companys accounting beta. The real or the market beta is based on share market returns rather than earnings. The accounting betas are significantly correlated with the market betas. This implies that if a firms earnings are more sensitive to business conditions, it is likely to have higher beta.We must distinguish between the earnings variability and the earnings cyclicality.*


Operating Leverage and Financial LeverageThe degree of operating leverage is defined as the change in a companys earnings before interest and tax due to change in sales. Operating leverage intensifies the effect of cyclicality on a companys earnings.Financial leverage refers to debt in a firms capital structure. Since financial leverage increases the firms (financial) risk, it will increase the equity beta of the firm.*


Asset Beta and Equity BetaFor an unlevered (all-equity) firm, the asset beta and the equity beta would be the same.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:*


CAPM and the Opportunity Cost of EquityFrom the firms point of view, the expected rate of return from a security of equivalent risk is the cost of equity. The expected rate of return or the cost of equity in CAPM is given by the following equation:*


Industry Vs. Company BetaThe 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.

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.

Beta estimation and selection is an art as well, which one learns with experience.*


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Ch 6-Beta Estimation and Cost of Equity

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