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
The value of ? and ? in the regression equation are given by the following equations:
N S X Y - (S X ) (S Y ) b= N S X 2 - (S X ) 2 (5) (4,774.49) - (27.42) (19.73) bj = (5) (5, 438.58) - (27.42) 2 23,872.45 - 541.00 23,331.45 = = = 0.88 27,192.90 - 751.86 26, 441.04
Alpha = a = Y - bX Alpha = a j = 3.95 - (0.88) (5.48) = - 0.89
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 Parameters for HUL vs. Market Returns in India Summaries of Regression
15
Characteristic Line and Beta for HUL
16
Characteristic Line and Beta for Infy
17
Characteristic Line and Beta for MahaTel
18
Characteristic Line and Beta for Ranbaxy
19
Betas for the Sensex Companies
BSE’s sensitivity index includes 30 highly traded shares. ? The estimates are based on daily returns for one year.
? The
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
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.
? If
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:
? E ? ? A ?1 ?
? ? Debt ? Equity ? ?
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. 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. estimation and selection is an art as well, which one learns with experience.
? Those
? Beta
doc_160254913.ppt
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
The value of ? and ? in the regression equation are given by the following equations:
N S X Y - (S X ) (S Y ) b= N S X 2 - (S X ) 2 (5) (4,774.49) - (27.42) (19.73) bj = (5) (5, 438.58) - (27.42) 2 23,872.45 - 541.00 23,331.45 = = = 0.88 27,192.90 - 751.86 26, 441.04
Alpha = a = Y - bX Alpha = a j = 3.95 - (0.88) (5.48) = - 0.89
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 Parameters for HUL vs. Market Returns in India Summaries of Regression
15
Characteristic Line and Beta for HUL
16
Characteristic Line and Beta for Infy
17
Characteristic Line and Beta for MahaTel
18
Characteristic Line and Beta for Ranbaxy
19
Betas for the Sensex Companies
BSE’s sensitivity index includes 30 highly traded shares. ? The estimates are based on daily returns for one year.
? The
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
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.
? If
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:
? E ? ? A ?1 ?
? ? Debt ? Equity ? ?
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. 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. estimation and selection is an art as well, which one learns with experience.
? Those
? Beta
doc_160254913.ppt