BETA - CONCEPT

• In finance, the beta (β) of a stock or portfolio is a number

describing the relation of its returns with that of the
financial market as a whole.
• The beta coefficient is a key parameter in the capital asset
pricing model (CAPM). It measures the part of the asset's
statistical variance that cannot be mitigated by the
diversification provided by the portfolio of many risky
assets, because of the correlation of its returns with the
returns of the other assets that are in the portfolio. Beta
can be estimated for individual companies using
regression analysis against a stock market index such as
S&P 500.
 BETA - CONCEPT
• The formula for the beta of an asset within a portfolio is

• where ra measures the rate of return of the asset, rp

measures the rate of return of the portfolio, and cov(ra,rp)
is the covariance between the rates of return.
• The portfolio of interest in the CAPM formulation is the
market portfolio that contains all risky assets, and so the
rp terms in the formula are replaced by rm, the rate of
return of the market.
 BETA - CONCEPT
• It Is non-diversifiable risk, its systematic risk, or market
risk.
• Beta is also referred to as financial elasticity or correlated
relative volatility, and can be referred to as a measure of
the sensitivity of the asset's returns to market returns.
• measuring beta can give clues to volatility and liquidity in
the marketplace
 BETA - CONCEPT
• The beta coefficient was born out of linear regression
analysis. It is linked to a regression analysis of the returns
of a portfolio (such as a stock index) (x-axis) in a specific
period versus the returns of an individual asset (y-axis) in
a specific year. The regression line is then called the
Security characteristic Line (SCL).

• αa is called the asset's alpha and βa is called the asset's

beta coefficient. Both coefficients have an important role
in Modern portfolio theory (APT).
 BETA - CONCEPT
• The SML graphs the results from the capital asset pricing
model (CAPM) formula. The x-axis represents the risk
(beta), and the y-axis represents the expected return. The
market risk premium is determined from the slope of the
SML.
• The relationship between β and required return is plotted
on the security market line (SML) which shows expected
return as a function of β. The intercept is the nominal
risk-free rate available for the market, while the slope is
E(Rm)− Rf.
BETA - CONCEPT
 BETA - CONCEPT
• It is a useful tool in determining if an asset being
considered for a portfolio offers a reasonable
expected return for risk. Individual securities are
plotted on the SML graph. If the security's risk versus
expected return is plotted above the SML, it is
undervalued because the investor can expect a greater
return for the inherent risk. A security plotted below
the SML is overvalued because the investor would be
accepting a lower return for the amount of risk
assumed.
 BETA - CONCEPT
• A misconception about beta is that it measures the
volatility of a security relative to the volatility of the
market. If this were true, then a security with a beta of
1 would have the same volatility of returns as the
volatility of market returns. In fact, this is not the
case, because beta also incorporates the correlation of
returns between the security and the market. The
formula relating beta, relative volatility (sigma) and
correlation of returns is:
 BETA - CONCEPT
• if one stock has low volatility and high correlation,
and the other stock has low correlation and high
volatility, beta cannot decide which is more "risky".
• This also leads to an inequality (because |r| is not
greater than one): explain ->
• In other words, beta sets a floor on volatility. For
example, if market volatility is 10%, any stock (or
fund) with a beta of 1 must have volatility of at least
10%.
 BETA - CONCEPT
• Another way of distinguishing between beta and
correlation is to think about direction and magnitude.
If the market is always up 10% and a stock is always
up 20%, the correlation is one (correlation measures
direction, not magnitude). However, beta takes into
account both direction and magnitude, so in the same
example the beta would be 2 (the stock is up twice as
much as the market).
 BETA - CONCEPT
• a stock's beta shows its relation to market shifts, it is
also an indicator for required returns on investment
(ROI) or [E(R)]
• highly rational investors should consider correlated
volatility (beta) instead of simple volatility (sigma).
• Beta has no upper or lower bound, and betas as large
as 3 or 4 will occur with highly volatile stocks.
 BETA VALUES
• Beta can be zero. Some zero-beta assets are risk-free,
such as treasury bonds and cash.
• However, simply because a beta is zero does not
mean that it is risk-free. A beta can be zero simply
because the correlation between that item's returns
and the market's returns is zero.
• An example would be betting on horse racing. The
correlation with the market will be zero, but it is
certainly not a risk-free endeavor.
 BETA VALUES
• A negative beta simply means that the stock is inversely
correlated with the market.
• Example : Many precious metals and precious-metal-
related stocks are beta-negative as their value tends to
increase when the general market is down and vice versa.
• A negative beta might occur even when both the
benchmark index and the stock under consideration have
positive returns. It is possible that lower positive returns
of the index coincide with higher positive returns of the
stock, or vice versa. The slope of the regression line (i.e.,
beta) in such a case will be negative.
 BETA VALUES
• If beta is a result of regression of one stock against
the market where it is quoted, betas from different
countries are not comparable.
• Staple stocks are thought to be less affected by cycles
and usually have lower beta. Procter & Gamble,
which makes soap, is a classic example. Other similar
ones are Philip Morris (tobacco) and Johnson &
Johnson(Health & Consumer Goods). Utility stocks
are thought to be less cyclical and have lower beta as
well.
 BETA VALUES
• 'Tech' stocks typically have higher beta.
• An example is the dot-com bubble. Although tech
did very well in the late 1990s, it also fell sharply in
the early 2000s, much worse than the decline of the
overall market.
• Beta has no upper or lower bound, and betas as large
as 3 or 4 will occur with highly volatile stocks.
Analysis of Common Stock Betas
• Negative Beta Shows an inverse relation to the stock market and is
highly unlikely. Gold Stocks though fall into this category.
• Beta of 0 Value of current cash (with no inflation) has a Beta of 0. No
matter how the market performs, idle cash sitting always remains the
same (with no inflation).
• Beta 0 - 1 These stocks are less volatile than the stock market in
general. Commonly includes utility company stocks.
• Beta of 1 A Beta of 1 means the stock market is moving in the same
direction as the Market Index such as S&P 500.
• Beta >1 Stocks with a Beta of >1 are more volatile than the stock
market. This commonly includes high-tech stocks. Why? This is
because as technology becomes rapidly advanced, outdated technology
is useless. Many companies are thus wiped out due to out-dated
technology. Beta >100 This is impossible. A stock can never be 100
times more riskier than the stock market in general. This is because a
small change in the returns of the stock will make the stock price go to
$0.
 CRITICISM OF BETA
• Beta views risk solely from the perspective of market prices,
failing to take into consideration specific business
fundamentals or economic developments.
• Beta fails to allow for the influence that investors themselves
can exert on the riskiness of their holdings through such
efforts as proxy contests, shareholder resolutions,
communications with management, or the ultimate purchase of
sufficient stock to gain corporate control and with it direct
access to underlying value.(qualitative things)
• Beta also assumes that the upside potential and downside risk
of any investment are essentially equal, being simply a
function of that investment's volatility compared with that of
the market as a whole.
 BETA ESTIMATION
• DIRECT METHOD: RATIO OF COV. B/W
MARKET RETURN AND SECURITY’S RETURN TO
THE MARKET RETURN VARIANCE.
• β = COV(S,M)/ VAR(M) ; S=SECURITY, M=MKT.
 STEPS
1. CALCULATE AVERAGE RETURN ON MARKET
AND THE SECURITY.
2. CALCULATE DEVIATIONS ON RETURN ON
MARKET FROM AVG RETURN.
3. CALCULATE DEVIATIONS ON RETURN ON
SECURITY FROM AVG RETURN.
4. MULTIPLY DEVIATIONS OF MARKRT RETURN
AND DEVIATION OF SECURITY’S [Link]
SUM AND DIVIDE BY NO. OF OBSERVATIONS.
 STEPS CONTD..
5. CALCULATE SQUARED DEVIATIONS OF
MARKET RETURNS. NOW DIVIDE THE SUM OF
SQUARED DEVIATIONS BY NO. OF
OBSERVATIONS (AVG) TO GET VARIANCE OF
MARKET RETURN.
6. DIVIDE THE COV OF MARKET AND SECURITY
WITH THE VARIANCE OF THE MARKET. THIS IS
BETA.
 BETA ESTIMATION
• MARKET(INDEX) MODEL: REGRESS
RETURNS ON A SECURITY AGAINST
RETURNS OF MARKET INDEX
• R j= α + β J R m + e J

R j= E(R)ON SECURITY J
R m IS EXPECTED MKT RETURN
β J IS SLOPE OF REGRESSION
e J IS ERROR TERM
 BETA- DETERMINANTS
• Nature of business (cycles). Eg commodity
goods vs utility.
• Operating leverage – use of fixed costs
Dol = (∆ebit/ebit)/(∆sales/sales)
VC ά sales
FC const. so variability in ebit is due to FC
Higher the dol higher the risk, ie high beta.
 BETA- DETERMINANTS
• Financial leverage: refers to debt in a firjms cap.
Structure. Any firm with debt- levered firm. There are
fixed interests (financial FC) and cause ∆ in ebit
• Dfl = (∆ eps)/ (∆ ebit/ebit)
• As fl of a firm increases the βe of firm also increases.
 example
• Standard & Poor's 500 Index (S&P 500) has a
beta coefficient (or base) of 1. That means if
the S&P 500 moves 2% in either direction, a
stock with a beta of 1 would also move 2%.
• Under the same market conditions, however,
a stock with a beta of 1.5 would move 3% (2%
increase x 1.5 beta = 0.03, or 3%). But a stock
with a beta lower than 1 would be expected
to be more stable in price and move less
 PORTFOLIO BETA
• The beta of a portfolio is the weighted sum of the
individual asset betas, According to the proportions of the
investments in the portfolio.
• A measure of a portfolio's volatility. A beta of 1 means
that the portfolio is neither more nor less volatile or risky
than the wider market. A beta of more than 1 indicates
greater volatility while a beta of less than 1 indicates less.
Beta is an important component of the Capital Asset
Pricing Model, which attempts to use volatility and risk to
estimate expected returns.
• Example: if 50% of the money is in stock A with a beta
of 2.00, and 50% of the money is in stock B with a beta
of 1.00,the portfolio beta is 1.50.
 PORTFOLIO BETA
• Portfolio betas tend to be more stable than individual
security betas.
• βp = w1 β1 + ……+ wn βn
 PROJECT BETA
• For evaluation of the projects institutional discount rates are
established and applied to the analysis of all projects.

• Institutional discount rates are determined by calculating an

organization's weighted average cost of capital (WACC)
Often the weighted average of the cost of equity and the cost
of debt The weights are determined by the relative proportions
of equity and debt.

• It is determined by adding the weighted cost of debt to the

weighted cost of equity to determine the required rate of
return.
 PROJECT BETA
• For example, assume that the cost of debt is 5 percent and
that debt makes up 20 percent of your capital structure,
while the cost of equity is 15 percent and equity constitutes
80 percent of your capital structure.

The weighted average cost of capital (WACC) is then:

WACC= (5%)(20%) + (15%)(80%) = 1% + 12% = 13%.

• Therefore, your required rate of return (discount rate,
hurdle rate is 13%
 PROJECT BETA
• Cost of debt is determined by how much an
organization pays in interest on its debt
multiplied by one minus the tax rate.

For example, if your debt rate is 5 percent, and

your corporate tax rate is 22 percent, then your
cost of debt is:
Cost of Debt = I (1-t)
Cost of Debt = 5% x (1 - 22%) = 4%
 PROJECT BETA
• The cost of equity is more difficult to determine. The
most commonly accepted method in finance is the
capital asset pricing model (CAPM)
• An economic theory that describes the relationship
between risk and expected return, and serves as a
model for the pricing of risky securities.
• three major elements to the CAPM- risk free rate,
expected rate of return and beta, which represents
the measure of a company's risk relative to the
overall market.
 PROJECT BETA
• Taking a company's returns and plotting them
against the returns of the S & P 500
determines beta. 
• analysis is then used to determine the slope of
the "best fit" line through the plotted points.
Beta is the slope of the "best fit" line.
 PROJECT BETA
• The beta used to determine risk, and from that,
cost of equity, WACC, and the discount rate
for an institution is a reflection of the risk of
the entire organization's cash flow.
• It does not reflect the risk associated with the
Incremental cash flows associated with a new
project, new building, or new piece of
equipment.
 PROJECT BETA
• Estimating Beta
In risk analysis, estimating the beta of a
project is quite important. But like many
estimations, it can be difficult to determine.

The two most widely used methods of

estimating beta are:

[Link]-play method
[Link]-beta method
 PROJECT BETA
• Pure-Play Method
When using the pure-play method, a company seeks out companies
with a product line that is similar to the line for which the company
is trying to estimate the beta. Once these companies are found, the
company would then take an average of those betas to determine its
project beta.

Example : Newco would like to add beer to its existing product

line of soda. Newco is quite familiar with the beta of making soda
given its history. However, determining the beta for beer is not as
intuitive for Newco as it has never produced it.
Thus, to determine the beta of the new beer project, Newco can take
the average beta of other beer makers, such as Anheuser Busch and
Coors.
 PROJECT BETA
• When using the accounting-beta method, a
company would run a regression using the
company's return on assets (ROA) against the
ROA for market benchmark, such as the S&P
500.
The determination of cost of capital under the CAPM approach involves the
estimation of Beta, riskfree rate and market return. Beta is generally
determined by comparing the return of the firm or the project as the
case may be with the market return and ascertaining the relationship.

The historical Beta is the first step in the determination of the ex-ante Beta. Either
the historical Beta can be accepted as the proxy for the future Beta or
modifications can be made to it to conform to the future. If we are thinking of a
new Company for a single project, we will have no historical records to go by.
We would then compute the Beta of companies of the same size and
about the same lines of business and after making necessary adjustments to it;
take it as the Beta for the firm. In case the Company has been existence for
some time, first taking the historical records of this as well as other similar
Companies and then by modifying the findings, we can determine Beta.
 PROJECT BETA
Typical procedure for developing a risk-adjusted discount rate
is as follows:
1. A company first begins with its cost of capital for the firm.
2. The cost of capital then must be adjusted for the riskiness of
the project, by adjusting the company's cost of capital either up or
down depending on the risk of the project relative to the firm.
• For projects that are riskier, the company's WACC would be
adjusted higher and if the project is less risky, the company's
WACC is adjusted lower ( because average cost of capital may
not always reflect the extreme cases)
The main issue in this procedure is that it is subjective.
 numerical
• An illustration
Let us assume that a Company has a Beta of 1.2. The
risk-free rate of interest is 5% and the expected return on
the market is 12%. The cost of capital of equity of the
Company under the CAPM model would work out to
13.4% as follows:
5%+(12-5)1.2=13.4%
Let us also assume that the Debt-Equity ratio is
60:40 and that the cost of debt post-tax is 10%. The
weighted average cost of capital would then be
(10*60/100)+(13.4*40/100)=11.36%
Now a new project is being considered for expansion
of activities. That project has a Beta of 3.6 and on
being taken up would require 25% of the total resources
of the Company.
We can thus gather that the Beta of the Company as
a whole after taking up the project would be
(1.2*75%)+(3.6*25%)=1.8
So, the new cost of equity would be
5%+(12-5)1.8=17.6%
Consequently the new WACC would be
10*60%+17.6*40%=13.04%
In order to meet the WACC of 13.04%, the new project
must generate 18.08% as follows:
Let the return from the new project be x
0.75*11.36+0.25*x=13.04%
Solving, we get x=18.08%
• An alternative approach
The required return of 18.08% can also be ascertained
by another method. Taking each project as a separate
entity, we can arrive at their respective costs of capital.
The equity component of the new project then will
have a cost of 5% +(12-5)3.6=30.2%. The weighted
average cost of capital of the new project alone will thus
be 30.2*40%+10*60%=18.08
The Hamada formula for adjusting the
Leverage factor
• The Beta that we impute to a project is likely to
undergo changes with the change in the capital structure
of the Company.
• If the Company is entirely equity based, its Beta is likely
to be lower than if it undertakes a borrowing. A number
of factors like default risk, bankruptcy risk and agency
costs contribute to this phenomenon.
• For the sake of convenience, let us call the Beta of a firm
which is levered as Levered Beta and that of a firm on an
all-equity structure as Unlevered Beta. Robert Hamada
brought out formulae for ascertaining Levered Beta given
the unlevered beta and also to find out unlevered Beta
given the levered Beta.
GEARED AND UNGEARED BETA
• Also called levered and unlevered beta.
• Levered Beta (or equity beta)= Risk of Equity
• Unlevered Beta (Asset beta) = Risk of Entire
Firm (Assets)
• Firm Value (V) = Debt Value (D) + Equity Value
(E)
GEARED AND UNGEARED BETA
Beta of a Unlevered Firm
Beta of an Unlevered Firm
BU=BL(1+(1-T)D/S), where
BU= Beta of an unlevered firm
BL=Beta of a levered firm
T=tax rate
D=component of Debt in capital structure
S=component of Equity in capital structure
GEARED AND UNGEARED BETA
Beta of a Levered Firm
BL=BU(1+(1-T)D/S), where
BL=Beta of a levered firm
BU= Beta of an unlevered firm
T=tax rate
D=component of Debt in capital structure
S=component of Equity in capital structure
GEARED AND UNGEARED BETA
Given the Beta of a firm which is already
levered, we can ascertain what its Beta would
be if it chooses on all-equity structure. This
also means that if the target firm has leverage
different from the structure assumed in
estimating the levered Beta, this can first be
converted into an unlevered Beta and then re-
converted into a levered Beta using the
leverage parameters relevant to the firm.
 example
Suppose there are three firms P, Q and R, which closely
resemble project X that is to be embarked upon. The
stock Betas of the three firms are taken and found to
be 2.73, 2.23 and 1.73 respectively for P, Q and R. The
Ratio of Debt to Equity for the three firms averages to
0.67. The marginal tax rate is 36%. The average stock
Beta works out to 2.23.
Translating these into the Hamada formula for
unlevered firms we get:
BU=BL/(1+(1-T)(D/S))
=2.23/(I+0.64)(0.67)=1.56
If the project is proposed to be financed by 50% equity
and 50% debt, we can modify the above Beta by
applying the Hamada formula for Levered firms:
BL=BU((I-T)D/S)
=1.56(1+0.60)(0.5/0.5)=2.5
So, on a 1:1 debt equity ratio, the Beta will be 2.5.
This Beta can be used now for determining the cost of
equity for the project and its weighted average cost of
capital, so that a more meaningful appraisal can be had.