CHAPTE R 6 BETA ESTIMATION AND THE COST

CHAPTE R 6 BETA ESTIMATION AND THE COST OF EQUITY

LEARNING OBJECTIVES 2 Discuss the methods of estimating beta. Explain the market model for calculating beta. Examine the difference between betas of individual firms and the industry beta. Highlight the beta instability. Explain the determinants of beta. Show the use of beta in determining the cost of equity.

Beta Estimation 3

Example 4 Returns on Sensex and Jaya Infotech

Example-Steps to be followed 5

Cont… 6

Cont… 7

Example 8 Beta Calculation for Jaya Infotech Limited

Market Model 9

Beta Calculation: Example 10 Estimates for Regression Equation

Beta Calculation: Example 11

Beta Estimation in Practice 12 In practice, the market portfolio is approximated by a well-diversified share price index. We have several price indices available in India. There is no theoretically determined time period and time intervals for calculating beta. The time period and the time interval may vary. The returns may be measured on a daily, weekly or monthly basis. One should have sufficient number of observations over a reasonable length of time.

Beta Estimation in Practice 13 The return on a share and market index may be calculated as total return; that is, dividend yield plus capital gain: One may calculate the compounded rate of return as shown below:

14 Examples of Beta Estimation for Companies in India Summaries of Regression Parameters for HUL vs. Market Returns

15 Characteristic Line and Beta for HUL

16 Characteristic Line and Beta for Infy

17 Characteristic Line and Beta for Maha. Tel

18 Characteristic Line and Beta for Ranbaxy

19 Betas for the Sensex Companies The BSE’s sensitivity index includes 30 highly traded shares. The estimates are based on daily returns for one year. Note that Jaiprakash Associates has the highest beta of 2. 28 and Gujarat Ambuja Cement the lowest beta of 0. 37.

Does Beta Remain Stable Over Time? 20 Betas may not remain stable for a company over time even if a company stays in the same industry. Over time, a company may witness changes in its product mix, technology, competition or market share.

21 Determinants of Beta Nature of Business Operating Leverage Financial Leverage

Nature of Business 22 If we regress a company’s earnings with the aggregate earnings of all companies in the economy, we would obtain a sensitivity index, which we can call the company’s accounting beta. The real or the market beta is based on share market returns rather than earnings. The accounting betas are significantly correlated with the market betas. This implies that if a firm’s earnings are more sensitive to business conditions, it is likely to have higher beta. We must distinguish between the earnings variability and the earnings cyclicality.

23 Operating Leverage and Financial Leverage The degree of operating leverage is defined as the change in a company’s earnings before interest and tax due to change in sales. Operating leverage intensifies the effect of cyclicality on a company’s earnings. Financial leverage refers to debt in a firm’s capital structure. Since financial leverage increases the firm’s (financial) risk, it will increase the equity beta of the firm.

Asset Beta and Equity Beta 24 For an unlevered (all-equity) firm, the asset beta and the equity beta would be the same. For a levered firm, the proportion of equity will be less than 1. Therefore, the beta of asset will be less than the beta of equity. The beta of equity for a levered firm is given as follows:

25 CAPM and the Opportunity Cost of Equity From the firm’s point of view, the expected rate of return from a security of equivalent risk is the cost of equity. The expected rate of return or the cost of equity in CAPM is given by the following equation:

Industry Vs. Company Beta 26 The use of the industry beta is preferable for those companies whose operations match up with the industry operations. The industry beta is less affected by random variations. Those companies that have operations quite different from a large number of companies in the industry, may stick to the use of their own betas rather than the industry beta. Beta estimation and selection is an art as well, which one learns with experience.