BETA, MARKET MODEL,UNLEVERED

BETA, SECURITY MARKET LINE

LEVERED BETA , COST OF EQUITY
AND WACC (UNDER MM)
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 A SYNOPOSIS
BETA
IT IS A MEASUR OF MARKET RISK OF A STOCK
IN A PORTFOLIO OF DIVERSE INVESTMENTS
IT IS COMPUTED BY REGRESSING STOCK
RETURN (NOT PRICE) ON MARKET RETURN
(PROXY OF MARKET RETURN IS SENSEX&
NIFTY IN INDIA, S&P 500 IN USA OR BENCH
MARK MARKET INDEX IN OTHER COUNTRIES)
BETA CAN BE CALCULATED WITH REFERENCE
TO DIFFERENT TIME FRAME. THERE COULD BE
DAILY BETA, MONTHLY BETA, YEARLY BETA
ETC.

 Regression-Market Model for Determining
‘beta’
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 The regression model used above is called market model /

index model. For practical purpose the following can be used
as an alternative particularly when we use short period return
– daily or weekly-


 Ri= αi+βi Rm+ui------------------------------(2)


 If the company is an all equity company, in that case the
beta obtained by the above equation is called equity beta
 Security Market Line

The equation of the line (line of best fit) obtained
by using (1)is E(Ri ) - Rf = βi [E(Rm )- Rf ] is called
SML (Security Market Line) showing the excess
return of a stock over risk free rate is a function
of beta only. All the securities traded in the
market must fall on SML. Intercept α representing
excess/ sub-optimal return vanishes through
arbitrage and expected stochastic disturbance
term E(ui )=0 by definition. In the language of
econometrics ui ~iid (0,σ). Ultimately SML is a
regression line through origin. R2 Value of the
regression explains how variation of the stock
return is explained by the variation of the marker
return.
Variance of a stock
return
Variance of a portfolio
return

 In case of variance of stock return- the first
expression of the RHS is the measure of variance
attributable to market fluctuation and hence
represents the market risk or un-diversifiable risk
and the second expression represents the unique
risk of a stock that goes away in a well diversified
portfolio, thus variance of a portfolio is –
 σ2p= β2pσ2m
 Unique risk goes away but market risk remains
which is equivalent to mean covariance of two
stock of a divesified portfolio.

 MM Approach
Proposition 1 : The market value of any firm is
independent of capital structure.
Proposition 2 : The expected rate of on the
common stock of a levered firm increases in
proportion to Debt / Equity ratio. ( This follows
from proposition 1)
 Thus, WACC = RA= D/D +E * RD+ E/D+E *RE
 Simplifying, we get RE= RA+ (RA-RD) D/E
 Debt keeps the overall cost of capital
(WACC)unchanged
 but increases the cost of equity capital in
proportion to
 MM and Beta

As per MM, capital structure does not impact

value of a firm. Value of a firm (-a project or
combination of projects consisting of assets)is
obtained by discounting future cash flow (CF)
generated by the assets by required return of
the project dependent upon risk of the
project. The risk involved is measured by βA
= βE, if the project is all equity financed. βA
does not change if a part of project is
financed by debt.
If debt is used βA remaining same – βE
increases in proportion to debt used. Thus, βE
 Levered, Unlevered Beta and Re-levered
Beta

If the return of a levered firm is regressed against

the market return the slope of the regression line
what we get is levered beta, i.e.βL. The second
step un-levering is done in the following way –
(Note: unlevered beta :βu = βA )
βu =βL / (1 + D/E) = βL/(V/E) where V is the value
of the firm , V = D + E,
If tax adjusted, βu =βL / [1 + (1-tc) D/E]
Last step is re-levering as per target debt ratio –
βRL = βA + (βA – βD ) D (t)/E , where D(t) denotes
target debt
If tax adjusted, βRL = βA + (βA – βD ) (1 -tc )D (t)/E
WACC, COMPOSITE BETA AND SEGMENT
BETA
Cost of equity component of WACC is
computed by using levered beta based on
target debt ratio.
WACC = D/D +E * RD (1-tc )+ E/D+E *RE
Regression w,r.t. market return produces
composite beta. This is an adequate measure
(adjusted for leverage) if a firm is
substantially in a particular line of business. A
company having different operating
segments having different risk return profile,
beta is arrived at in respect of each segment
separately for project evaluation adjusted for
leverage if practically possible.
EXAMPLE -1
Beta ( composite) of a firm is 1.25. Risk-free
rate of loan is 8% . Market Return 12%.
Market value of the firm (all equity) = 100.
The firm borrows 50 at 10%. Assuming no
tax, compute –
Levered beta
Required rate of return on Equity(pre & post
borrowing)
WACC (Post-borrowing)
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PEAD - Example