beta estimation and the cost of equity

Chapter - 6

Beta Estimation and The Cost of Equity

2Financial Management, Ninth Edition © I M PandeyVikas Publishing House Pvt. Ltd.

Chapter Objectives Discuss 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 Direct Method—The ratio of covariance

between market return and the security’s return to the market return variance:

2

Covar =

σσ σ Cor σ

= = Corσ σ σ

j, mj

m

j m j, m jj, m

m m m


Beta Estimation The Market Model—In the market model, we

regress returns on a security against returns of the market index.

j jj mR R e


Beta Estimation in Practice In 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 Practice The 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: rj = log[Pt – Pt -1] = log[Pt /Pt -1


Summaries of Regression Parameters for HLL Vs. Market Returns

Alpha (intercept) 0.0061 Standard error of alpha 0.0038 Beta 0.7479 Standard error of beta 0.1107 Correlation 0.6635 Coefficient of determination 0.4402 F-statistic 45.6143

Significance 0.0000 Market HLL Average return 0.00046 0.00647 Variance of returns 0.00115 0.00149 Variance 0.00086


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. There could be several reasons for this. Over time, a company may witness changes in its product mix, technology, competition or market share.


Determinants of Beta Nature of Business Operating Leverage Financial Leverage


Nature of Business 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.

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 firm’s 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 Leverage 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.

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.


Asset Beta and Equity Beta For 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:

Debt1EquityE A


CAPM and the Opportunity Cost of Equity From the firm’s 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:

( )j e f m f jR k R R R


Industry Vs. Company Beta 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.

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.

beta estimation and the cost of equity

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