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Chapter - 6

Beta Estimation and The


Cost of Equity
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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.
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Beta Estimation
Direct MethodThe ratio of covariance
between market return and the securitys return
to the market return variance:
2
Covar
=

Cor
= = Cor

j, m
j
m
j m j, m j
j, m
m m m
|

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Beta Estimation
The Market ModelIn the market model, we
regress returns on a security against returns of
the market index.
j j j m
R R e o | = + +
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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.
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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:
r
j
= log[P
t
P
t
-1] = log[P
t
/P
t
-1
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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


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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.
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Determinants of Beta
Nature of Business
Operating Leverage
Financial Leverage
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Nature of Business
If 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.
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Operating Leverage and Financial
Leverage
The 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.
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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:
Debt
1
Equity
E A
| |
(
= +
(

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CAPM and the Opportunity
Cost of Equity
From 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:
( )
j e f m f j
R k R R R | = = +
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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.