and Rosenberg Rudd The Corporate Use of Beta
Introduction o The CAPM determines minimum required rates of return from investments in risky assets o CAPM- derived return can be used by corporate managers as the hurdle rates for evaluating corporate investments o Difficulty has been the reasonable judgement about the betas or projects prices of such non-trading assets are not readily observable and thus the standard statistical estimates of betas cannot be applied The reward for risk-bearing o Investors are concerned with the return on their entire portfolio of assets and the risk of any individual project is relevant insofar as it contributes to the risk of that portfolio o Risk should not be evaluated in isolation, but one must instead consider each project within the context of all other assets in the company, risk of one division should be compared with the risk of all other divisions o If implementing a project whose returns are very risky but the opposite of the normal cycle may provide a hedge against the risks of other businesses and reduces risk on an aggregate level o However, even the corporate-wide perspective is not broad enough for most corporations relevant context is the cumulative portfolio of stockholders o In this context, the appropriate criterion for evaluating risk shifts from the corporate portfolio is the market portfolio The Simple CAPM o Stockholders are assumed to be diversified across many assets and therefore the success or failure of one company is only one contributing factor to the performance of the portfolio o No the isolated equity risk of the individual corporation counts but the contribution to the diversified portfolio o Risk contribution is measured by beta since the higher the beta, the greater the contribution to the risk of investors portfolio (and higher return) o According to the CAPM required return increases in direct proportion to its beta (only concerned with systematic risk) o Individual risk is diversifiable and therefore not priced by the market o Beta is a measure of systematic risk and is also a relative risk measure expressing systematic risk exposure in relationship to all other securities o Market portfolio has a beta of 1; a beta of greater than 1 indicates above-average systematic risk o Required return is equal to the risk-free return and an increment that compensates the investor for accepting the assets risk (beta*risk premium) Determining required rates of return o To use the CAPM need the short-term rate, the market return and the after-tax cost of debt o The market return can be estimated by looking at historical returns or by surveying investor opinion to arrive at a consensus Extensions of the CAPM o Market portfolio definition is flawed since a narrow index like the SP500 does not include all risky assets like human capital, coin collections etc
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Rosenberg and Rudd The Corporate Use of Beta
o Existence of international capital markets adds further complications o Problems also arise from the unrealistic assumptions of the simple CAPM extensions o Question which particular definition of the market portfolio of common stocks to define beta should be used (wider the index the better Russell) Capital budgeting and the cost of capital o Steps for capital budgeting o Estimation of investments after-tax cash flows o Prediction of the risk o Estimation the of cost of capital o Calculation of the NPV of the investment by discounting the cash flows using the cost of capital o Calculated cost of equity capital must be adjusted by leverage to arrive at the WACC to discount to cash flows o If the investment differs from the norm then the investment should be evaluated to its own beta rather than the company beta o Method of similars estimates the risk of a division or project using the average beta of a sample of companies in the same line of business Measurement and prediction of beta o For publicly-traded companies, beta can be estimated by observing the relationship between the companys stock price and market movements o Beta is only an estimate of historical alignment of the stock price with the market value is sometimes a prediction of the future alignment o Historical alignment may have been strongly influenced by chance events estimation error historical alignment may misrepresent the underlying systematic relationship unreliable predictor of future risk o Furthermore, there is the chance than the beta may change over time due to major changes in lines of business Bringing fundamental information to bear o Fundamental approach to risk prediction offers the potential for considerable improvement o Fundamental betas have strong advantages over market-generated betas o Stronger intuitive appeal o Fundamental prediction rules are suited to the analysis of non-trading assets o Fundamental betas outperform predictions solely based on historical data The relation of beta to fundamentals o Beta measures the responsiveness of an individual companys market value to the general market movement o Also industry, EPS performance and balance-sheet characteristics provide a good indication of the companys exposure to economy-wide developments
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Rosenberg and Rudd The Corporate Use of Beta
Industry effects o Significant and persistent differences in betas between industries related to business risk Balance sheet and IS characteristics o Growth corporate growth is a highly significant and consistent predictor of beta o Growth-oriented strategy requires large capital investments and adds higher uncertainty risk +beta o Growth can be measured by the retention ratio or increase of total assets o Earnings variability earnings variation is a good and persistent indicator of business risk o Financial leverage the greater the leverage, the higher the beta o Size stocks of smaller companies are perceived to be riskier investments Predicting beta for a project or division of a corporation o Determine the industry or industries the company is in by looking at SICs if a company falls into many categories allocate the riskiness in proportion to the PV of its operations o Quantify the various characteristics with financial ratios o Make adjustments according to the descriptors The fundamental beta prediction compared with the method of similars o Both methods attempt to estimate future risk using comparative sources of information (market and accounting data) o (+) similars simplicity but arbitrariness of selection of similar, small-sample companies o (-) fundamental complex o (+) minimizes estimation error through the process of averaging improved accuracy o Use of explicit formulas o Descriptors can be used to identify unique characteristics of the project
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