equity Flashcards
When you need to estimate beta in order to compute the cost of capital for a company or project, there are 2 main methods available for you:
using a market model regression of stock returns, or
using the pure-play method.
when to use pure play over market model regression
Of course, the market model regression is well-suited for estimating betas of listed companies. The problem arises when you need to estimate the beta for a non-listed company or non-standard project. In the case of non-listed companies, you can use the so-called pure-play method.
what affects company’s beta
business risk, and
financial risk.
Business risk:
risk associated with operating earnings which, in turn, depend on revenues. Similar industry - similar business risk
financial risk
uncertainty of net income and cash flows. The greater the share of debt in the financing of the company, the greater the financial risk. In short, companies with a high financial leverage are characterized by high financial risk.
Algorithm of the pure-play method:
Select comparable companies listed on the stock exchange.
Estimate beta for comparable companies.
Unlever the beta from step 2 by removing the effect of financial leverage. The unlevered beta reflects the business risk of the assets and thus is called the asset beta.
Lever the beta by adjusting the asset beta to the financial risk of the company for which you want to calculate the beta. This beta is called the equity beta.
asset beta vs equity beta
The asset beta (unlevered beta) is the beta of a company on the assumption that the company uses only equity financing. In contrast, the equity beta (levered beta, project beta) takes into account different levels of the company’s debt. A company has one asset beta and, depending on its debt-to-equity ratio, it can have many different equity betas.
dividend payout =
1 - earnings retention rate
capm / cost of equity, Rs =
Rf + B(Rmkt - RFR)
g =
retention rate * roe
price =
e*(p/e)
p/e =
dividend payout / (k-g)
There are two important rules in the primary capital markets:
Rule 415 allows large firms to register security issues and sell them piecemeal over the following two years. Such issues are called shelf-registration. This rule allows a single registration document to be filed that permits the issuance of multiple securities.
Rule 144A allows corporations (including non-U.S. firms) to place securities privately with large, sophisticated investors. The issuer of a private placement reduces issuing costs because it does not have to complete the extensive registration documents. However, investors will require a higher return since no secondary market exists and thus the liquidity risk is high.
primary markets
those in which new issues of bonds, preferred stock, or common stock are sold by government units, municipalities, or companies to acquire new capital.
New issue.
Key factor: issuer receives the proceeds from the sale.
Initial public offerings
These are new shares that a firm offers to the public for the first time. They are typically underwritten by investment bankers through negotiated arrangements (the most common form), competitive bids, and best-effort arrangements (investment bankers act as brokers, not taking the price risk).
