Equity, Debt and Asset Betas

Equity, Debt and Asset Betas - Equity Debt and Asset Betas...

Info icon This preview shows pages 1–3. Sign up to view the full content.

View Full Document Right Arrow Icon
Equity, Debt and Asset Betas T t t t r C NPV 0 ) 1 ( C t is not known for certain. It is a random variable. It has a probability distribution with a mean and standard deviation. C t = E(C t ) = expected cash flow “r” is the appropriate cost of capital. It should have the same riskiness as C t If C t is a normal extension of the firm’s operations, and the firm is entirely equity financed, we use the stockholders’ required return as found through the CAPM for the appropriate value of ‘r’. E(R i ) = R f + i (R m – R f ) Remember: the Beta of security i is the standardized covariance of its returns with the returns on the market portfolio. i = Cov i,Mkt 2 Mkt Some Determinants of Beta 1. Cyclicality of revenues – How responsive are revenues to changes in the business cycle? Does the firm produce normal goods or inferior goods? Highly cyclical high covariance with the market higher beta. 2. Operating Leverage (Degree of Operating Leverage) – Degree to which costs are fixed. High FC relative to VC high operating leverage Contribution margin = Price – VC = incremental profit from an additional sale Low Contribution margin = low FC & high VC = low DOL – example is grocery store High Contribution margin = high FC & low VC = high DOL – example is airline High Operating Leverage profits are more responsive to changes in sales higher beta 1
Image of page 1

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
3. Financial Leverage – similar to operating leverage if we think of debt as a FC Equity = Equity beta = beta of a firm’s stock. This is what we have been measuring and looking at thus far. It is a measure of both the firm’s business risk and its financial risk.
Image of page 2
Image of page 3
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern