In the above case the beta is calculated for four business groups in a computer

# In the above case the beta is calculated for four

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market portfolio. In the above case, the beta is calculated for four business groups in a computer segment and not a broad-based market portfolio. Hence, beta calculations will not be the same, as such. Beta of the Leveraged Firm B(L) =Beta of Unleveraged FirmB(U)×[(Equity+ Debt)÷Equity] = 1.275 × [(400 + 50) ÷ 400] = 1.434 Market Index Relationship : This leveraged Beta of 1.434 will be equal to the Beta estimated by regressing returns on ABC Computers stock against a market index. The reasoning is as under- 1. The Beta of a security is a measure of return for the systematic risk of that security, relative to the market i.e. its Systematic Risk. 2. A portfolio generally consists of a well - diversified set of securities. 3. The Systematic Risk cannot be diversified away, and hence, the Beta of a portfolio is the value - weighted beta of the securities constituting the portfolio. 4. The Beta of a portfolio depicts the systematic Risk (i.e. Non-Diversifiable Risk) of the portfolio itself. Fianancial Management & international finance 98 COST-VOLUME-PROFIT ANALYSIS Financial Management Decisions 3. Cost of Equity for ABC Computers = Return of Risk Free Securities + (Market Risk premium × Beta) = 7.50% + (8.50% × 1.434) = 19.69% 4. Cost of Equity for each Division Division Cost of Equity for each Division = Return of Risk Free Securities + (Market Risk premium × Beta) Mainframe = 7.50% + (8.50% × 1.10) = 16.85% Personal Computer = 7.50% + (8.50% × 1.50) = 20.25% Software = 7.50% + (8.50% × 1.10) = 24.50% Printers = 7.50% + (8.50% × 1.00) = 16.00% For valuing Printer Division, K e of 16% would be used. Illustration 22 : Leverage and Beta Analysis The following summarises the percentage changes in operating income, percentage changes in revenues and the betas fo four pharmaceutical firms. Firm Change in Revenue Change in Operating Income Beta PQR Ltd. 27% 25% 1.00 RST Ltd. 25% 32% 1.15 TUV Ltd. 23% 36% 1.30 WYZ Ltd. 21% 40% 1.40 Required : 1. Calculate the Degree of Operating Leverage for each of these firms. 2. Use the Operating Leverage to explain why these firms have different beta. Firm Change in Change in Degree of Operating Leveratge Beta Revenue Operating Income (1) (2) (3) (4) = (3) + (2) (5)(given) PQR Ltd. 27% 25% 0.926 1.00 RST Ltd. 25% 23% 1.28 1.15 TUV Ltd. 23% 36% 1.57 1.30 WXY Ltd. 21% 40% 1.905 1.40 Inference : 1. DOL of WXY Ltd. is the highest of all firms. High DOl reflects high operating risk, which means WXY Ltd. has the maximum operating risk. Also PQR Ltd. is exposed to minimum operating risk, when compared to other forms. 2. Beta is the measure of volatility of risk of a security against the market risk. Both Operating Leverage and Beta reveals the measure of risk. Since the Operating Leverage is different for each firm, the beta would also be different. Therefore, High DOL = High Risk = High Beta. 99 Fianancial Management & international finance Illustration 23 : Net Income Approach – Valuation of Firm The following data arelates to four Firms— Firm A B C D EBIT in Rs. 2,00,000 3,00,000 5,00,000 6,00,000 Interst in Rs. 20,000 60,000 2,00,000 2,40,000 Equity Capitalization Rate 12% 16% 15% 18% Assuming that there are no taxes and rate of debt is 10%, determine the value of each firm using the Net Income approach. Also determine the Overall Cost of Capital of each firm.  #### You've reached the end of your free preview.

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