Risk and Beta Flashcards
How can we estimate Beta?
Using historical real-world returns of the market and the security itself.
What are the determinants of beta?
Beta of a stock is determined by the inherent risk of firms:
1) Business Risk
2) Financial Risk
Break down business and financial risk
Cyclicality of revenues and operating/ finaical leverage
Cyclicality of revenues
Firms’ revenue also fluctuates in line with the business cycle thus highly cyclical industries have high betas.
Operating Leverage
Firms with higher fixed costs will experience larger fluctuations in operating income.
Financial leverage
Financial leverage is interested in the debt level of a firm, as debt creates fixed costs of finance.
M&M (1958) Prop 1
In a perfect capital market, the value of a firm is independent of its capital structure. This means the value of a leveraged firm is the same as an unleveraged firm.
Drawbacks of M&M (1958)
Assumes:
1) No taxes
2) No transaction costs
3) Individuals can borrow/lend money in the market at the same rate as corporations.
M&M (1958) Prop 2
The cost of equity rises with leverage because the risk to equity rises with leverage.
Why is (𝑅0- 𝑅𝐵) intuitively positive?
Debtholders have a priority claim on the firm’s earnings. Thus, the risk they face is generally less than the risk of the firm’s overall earnings.
Drawbacks of MM (1958) Prop 2
In a perfect capital market, total firm value depends only on the total risk of the firm’s assets, not capital structure. Realistically, this may not be the case.
M&M (1963) Prop 1 with tax
Interest payments are tax-deductible, while dividend payments are not. This creates an incentive for firms to use debt.
M&M (1963) Prop 2 with tax
The cost of equity rises with leverage because the risk to equity rises with leverage just not as much as M&M (1958)
Miller (1977) with personal tax
To be more realistic, we know that cash flows to investors are typically taxed twice. Firms pay corporate tax and individual investors pay income taxes when they receive their debt interest or equity dividends.
What are the types of income from a stock?
Dividend income- generally taxed as ordinary income.
Realised capital gain- the tax rate has been lower than ordinary income. Deferred tax payments are capital gains that are taxed when realised.
What are the types of income from a bond?
Taxable interest- interest income from government bonds and corporate bonds. It’s taxed as ordinary income.
