Determinants of Beta

Formally:
1. Cyclicality of Revenues
– Not the same volatility of revenues
– Biotech vs. Steel
2. Operating Leverage
– The mix of fixed and variable costs
3. 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
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1. 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

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2. 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: %D EBIT
DOL =
%D Sales

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Degree of Operating Leverage
Three alternatives
• All Variable costs: DOL = 1.00
• Half Fixed, Half Variable: DOL = 1.50
• All Fixed: DOL = 2.00
  All Variable Costs Half Fixed Half Variable All Fixed Costs
Units 90 100 110 90 100 110 90 100 110
Price $20 $20 $20 $20 $20 $20 $20 $20 $20
Var Costs $10 $10 $10 $5 $5 $5 $0 $0 $0
Fixed Costs $0 $0 $0 $500 $500 $500 $1,000 $1,000 $1,000

Sales $1,800 $2,000 $2,200 $1,800 $2,000 $2,200 $1,800 $2,000 $2,200
VC $900 $1,000 $1,100 $450 $500 $550 $0 $0 $0
FC $0 $0 $0 $500 $500 $500 $1,000 $1,000 $1,000
Total Costs $900 $1,000 $1,100 $950 $1,000 $1,050 $1,000 $1,000 $1,000
EBIT $900 $1,000 $1,100 $850 $1,000 $1,150 $800 $1,000 $1,200

%ΔSales -10% 10% -10% 10% -10% 10%

%ΔEBIT -10% 10% -15% 15% -20% 20%
DOL 1.00 1.00 1.50 1.50 2.00 2.00

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3. 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

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 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)

  No Debt Some Debt High Debt
EBIT $900 $1,000 $1,100 $900 $1,000 $1,100 $900 $1,000 $1,100
Int Exp $0 $0 $0 $500 $500 $500 $800 $800 $800
EBT $900 $1,000 $1,100 $400 $500 $600 $100 $200 $300
Taxes
(35%) $315 $350 $385 $140 $175 $210 $35 $70 $105
NI $585 $650 $715 $260 $325 $390 $65 $130 $195

%ΔEBIT -10% 10% -10% 10% -10% 10%

%Δ NI -10% 10% -20% 20% -50% 50%

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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 7

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]
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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
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Recap: Determinants of Equity Beta
1. Cyclical nature of the product
2. Degree of operating Leverage
• DOL = %ΔEBIT/%ΔSales
• Is this a business decision or nature of the product?
3. 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)
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Some Beta Terminology
• Corporate Finance: Equity Beta βE and Asset Beta βA
• Investments: Levered Beta βL and Unlevered Beta βU

βE = βL and βA = 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
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Calculating Unlevered Beta

Before (Corporate finance notation)

• Given βA what 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]

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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)

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