CHAPT

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

Cont
6

Cont
7

Example
8

Beta Calculation for Jaya Infotech Limited

Market Model
9

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Beta Calculation:
Example

Estimates for Regression Equation

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Beta Calculation:
Example

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Beta Estimation in
Practice
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.

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Beta Estimation in
Practice

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:

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

15

Characteristic Line and Beta for HUL

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Characteristic Line and Beta for Infy

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Characteristic Line and Beta for MahaTel

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Characteristic Line and Beta for Ranbaxy

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Betas for the Sensex

Companies

The BSEs 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.

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Does Beta Remain Stable

Over Time?
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.

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Determinants of
Beta
Nature of
Business

Operating
Leverage

Financial
Leverage

Nature of Business
22

If we regress a companys earnings with the aggregate

earnings of all companies in the economy, we would obtain a
sensitivity index, which we can call the companys
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 firms 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.

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Operating Leverage and

Financial Leverage
The

degree of operating leverage is defined as the

change in a companys earnings before interest and
tax due to change in sales. Operating leverage
intensifies the effect of cyclicality on a companys
earnings.
Financial leverage refers to debt in a firms capital
structure. Since financial leverage increases the
firms (financial) risk, it will increase the equity
beta of the firm.

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Asset Beta and Equity

Beta
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:

Debt
E A 1

Equity

25

CAPM and the

Opportunity Cost of
From the firms point of view, the expected rate of
Equity

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:

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Industry Vs. Company

Beta

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.