Beta Problems

Beta and CAPM

 Learning Outcomes
• Appraise and interpret the systematic
risk through Beta.

• Calculate and interpret the Ke (Cost

of Equity through CAPM Model.

• Differentiate between Beta and

Standard Deviation.
What Is Beta?
• Beta (β) is a measure of the volatility—or systematic risk—of a
security or portfolio compared to the market as a whole (usually
the S&P 500).

• Beta measures a stock's volatility, the degree to which its price

fluctuates in relation to the overall stock market

• Stocks with betas higher than 1.0 can be interpreted as more

volatile than the S&P 500.
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 Beta Computation

N S X Y - (S X ) (S Y )
b= 2 2
N S X - (S X )
Problem (Beta)
Solution
 COST OF EQUITY – CAPITAL ASSET PRICING MODEL (CAPM)
CAPM quantifies the relationship between risk and required return in a well-functioning market.
Capital Asset Pricing Model
(CAPM)
• It describes the relationship between
systematic risk and expected return for assets,
particularly stocks.

• CAPM is widely used throughout finance for

pricing risky securities and generating
expected returns for assets given the risk of
those assets and cost of capital.

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Ke   = Rf   + b I  (Rm  - Rf )

where,           

CAPM
Ke  = Cost of equity capital

Rf   = Risk free rate of return

Rm = Market return of a diversified portfolio

b I  = Beta coefficient of the firm’s portfolio

Quiz
• To compute the required rate of return for equity in a company using the CAPM, it
is necessary to know all of the following EXCEPT:

a) the risk-free rate.

b) the beta for the firm.
c) the earnings for the next time period.
d) the market return expected for the time period.

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Calculate WACC

• Riviera unlevered cost of equity is 12 Percent.

• Riviera Debt-Equity ratio of 3:7

• The risk free rate of interest is 8 percent

• Cost of borrowing is 10 Percent

• Tax rate is 30 Percent

• Market risk Premium is 5.5 percent

 • An investor owns a stock portfolio equally invested in a risk
free asset and two stocks. If one of the stocks has a beta of
0.75 and the portfolio is as risky as the market, the beta of
the stock in portfolio is
• (A) 2.12
Problem • (B) 2.25
• (C) 2.56
• (D) 2.89
Problem

• Unlevered beta and effective tax rate of S Ltd is 0.8 and 35 percent respectively. The
company intends to undertake a project with 60 percent debt financing. Assuming risk
free rate of 7.5 % and market premium 8 %, calculate cost of equity (rounded up to two
decimal points)

• (A) 13.90%
• (B) 20.14%
• (C) 16.40%
• (D) None of (A), (B) or (C)
Quiz
• Which statement below is true regarding the APV model?

• Analysts can only determine the value effects created by leverage and taxes using the APV model.
• The APV and free cash flow models do not discount the identical cash flow stream.
• In most cases a firm's cost of capital does not reflect financial distress costs when the firm uses
leverage.
• When using the APV model, the unlevered cost of equity will be misstated when potential
financial distress costs are high.
Quiz
• The adjusted present value (APV) and free cash flow models give
equivalent results. An analyst may prefer to use the APV model
because the :

• APV uses the historical cost flow statement, which the free cash flow model does
not
• APV highlights the extent to which the value of the firm is enhanced by the use of
leverage in its capital structure
• APV focuses on the value of core operations whereas the free cash flow model
does not