Beta and cost of debt Flashcards
what is the formula for BETA
cov(I,M)/Var(M)
how is Beta usually estimated?
by regressing firm returns against market returns and taking the coefficient. the alpha of the regression should equate to rf(1-Beta) if the firm performed as expected during the regression period.
what is Blume’s adjustment?
Beta-ADJ= beta raw(2/3)+1(1/3)
what are problems with estimating beta through regression?
This approach presents the following shortcomings- High standard errors;- Firm’s business mix and leverage over the regression period, not current ones- Not available for private firms / not reliable for illiquid markets
what are the main 4 questions one must decide for when regressing for beta?
- Historical returns- Using a longer time period allows for a greater number of observations. Longer time
periods, though, might introduce biases due to structural changes in the firm/industry risk
profile. This is the main reason supporting using a shorter period, between 2 and 5 years - Return type- Both stock returns and market returns should be calculated considering both the capital
gains and the dividends received during the period under consideration- Some sources calculate returns only based on price changes without considering dividends - Frequency (Return Interval)- Using daily returns increases the number of observations in the regression.
Nevertheless, such an approach exposes the estimation process to a significant
bias in beta estimates caused by the lack of liquidity of certain stocks - The market index- Due to the emergence of internationally diversified investors who allocate their
assets in different markets, it is increasingly common to calculate β with respect to
international indices, (e.g. Morgan Stanley Capital Index)
what is an accounting beta? what are its problems?
it is calculated based on covariance between earnings, however it is affected by accounting policies and low frequency of earnings releases.
what is the effect of operating leverage on Beta? what about the discretionality of the product offered? which type of firms do these relationships affect?
high operating leverage (proportion of fixed costs) implies higher Beta, this results in smaller firms usually having higher beta.
high discretionality= higher BETA.–> cyclical firms, luxury firms and growth firms have higher BETA.
what are the steps when building up Beta from fundamentals?
identify all of the businesses your firm operates in.
find comparable firms in each business and delever their betas using their D/E ratios, then compute a weighted average beta for the business area.
estimate how much value your firm derives from each business area
compute a beta for the firm using a weighted average of the business betas and the weights computed in point 3
relever this beta by using your company’s own D/E ratio.
how is levered beta calculated if we assume that debt is subjected to market risk?
If debt carries market risk (i.e., βD!= 0 ) and you can estimate βD, then βL is
βL = βU· 1+((1−τC)· D/E) −βD·(1−τC)· D/E , or
βL = βU· (1+D/E)−βD· D/E
what are the advantages of calculing beta with the bottom up approach
Lower noise
The standard error in a bottom up β will be significantly lower than the standard error in a
single regression β. Roughly speaking, the standard error of a bottom up β estimate is:
Std Error of bottom up β = Average Std Error across βs / sqrt(# of firms in sample)
▶ Current Operating Structure
The bottom up β can be adjusted to reflect changes in the firm’s business mix and
▶ Financial Structure
The bottom up β can be adjusted to reflect recent or future changes (e.g. restructuring) in the firm’s financial structure
▶ Private Firms / Illiquid Stocks / Start-Ups
Stefano Rossi
you can estimate bottom up β even when you do not have historical stock prices
(e.g. IPO, Company’s divisions, Start-Ups, …)
what approaches can you use when calculating the business unit weights for the bottom up beta?
apply a multiple to revenue/income split (usually provided by the firm itself). use the customer base division.
what should i use as weights in the WACC
for E fully diluted market capitalization, for Debt the estimated market value of all interest bearing debt, including leases.
