Chapter 2.2 Capital Cost and Relative Risk Analysis
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Questions and Answers

What does the term 'unlevered beta' refer to?

  • The beta of a company's debt, unadjusted for the company's equity.
  • The beta of a company's assets, without considering the financial leverage. (correct)
  • The beta of a company's equity, adjusted for the company's debt.
  • The beta of a company's equity, unadjusted for the company's debt.

    • How does operating leverage affect a company's beta?

  • The relationship between operating leverage and beta is complex and unpredictable.
  • Operating leverage has no effect on beta.
  • Firms with high operating leverage tend to have lower betas.
  • Firms with high operating leverage tend to have higher betas. (correct)

    • Which of the following statements about the relationship between financial leverage and beta is true?

  • Higher financial leverage leads to a higher beta. (correct)
  • The relationship between financial leverage and beta depends on the industry.
  • Financial leverage has no impact on beta.
  • Higher financial leverage leads to a lower beta.

    • Why do cyclical companies tend to have higher betas than non-cyclical companies?

    <p>Cyclical companies are more sensitive to changes in the overall economy. (B)</p> Signup and view all the answers

    Which of the following companies would likely have the highest beta?

    <p>A software company developing cutting-edge technology. (B)</p> Signup and view all the answers

    How can a company's beta be adjusted to reflect the impact of financial leverage?

    <p>By using the company's unlevered beta and its current debt-to-equity ratio. (C)</p> Signup and view all the answers

    What is the relationship between a company's beta and its cost of equity?

    <p>A higher beta leads to a higher cost of equity. (D)</p> Signup and view all the answers

    How does the cost of debt differ from the cost of equity?

    <p>The cost of debt is typically lower than the cost of equity. (C)</p> Signup and view all the answers

    What is the primary reason why it is difficult to adjust for operational leverage when calculating a firm's unlevered beta?

    <p>It is difficult to gather information on fixed and variable costs for each firm in a sector. (C)</p> Signup and view all the answers

    What is the unlevered beta called when we use it as a starting point for calculating the beta of a specific company?

    <p>Pure business beta (B)</p> Signup and view all the answers

    Which statement accurately describes the relationship between operating leverage and unlevered beta?

    <p>A company with higher operating leverage will generally have a higher unlevered beta. (C)</p> Signup and view all the answers

    How does the financial leverage of a firm impact the equity beta (levered beta)?

    <p>Higher financial leverage increases the levered beta. (C)</p> Signup and view all the answers

    Why do we typically ignore the tax effect when estimating the beta of debt?

    <p>The beta of debt is very low and the tax effect is negligible in most cases. (C)</p> Signup and view all the answers

    A company has a high level of financial leverage and a low unlevered beta. What can we conclude about the company's overall risk profile?

    <p>The company has a high level of risk. (B)</p> Signup and view all the answers

    Why is it important to adjust the pure business beta for both operating leverage and financial leverage when estimating a company's equity beta?

    <p>Adjusting the pure business beta makes it more relevant to the specific company's financial structure and operations. (D)</p> Signup and view all the answers

    Which of the following statements accurately describes the significance of the debt-adjusted approach to beta calculation?

    <p>The debt-adjusted approach makes the calculation more realistic by incorporating the market risk of debt into the calculation. (A)</p> Signup and view all the answers

    When is the standard error of a bottom-up beta estimate likely to be lower?

    <p>When the number of firms in the sample is larger. (C)</p> Signup and view all the answers

    What is the primary advantage of using a bottom-up beta estimate over a single regression beta?

    <p>Bottom-up betas can be adjusted to reflect changes in the firm’s business mix and financial leverage, whereas regression betas reflect the past. (B)</p> Signup and view all the answers

    Why is it important to estimate the value of each business a firm operates in when computing a bottom-up beta?

    <p>To accurately determine the weightings used in the weighted average beta calculation. (A)</p> Signup and view all the answers

    In computing a bottom-up beta, what adjustment is made to the average beta of comparable firms?

    <p>The average beta is adjusted for differences in the firm's financial structure. (C)</p> Signup and view all the answers

    What is the primary difference between a levered beta and an unlevered beta?

    <p>A levered beta considers the firm's debt financing, while an unlevered beta does not. (B)</p> Signup and view all the answers

    If a firm expects its debt-to-equity ratio to change in the future, what impact will this have on its levered beta?

    <p>The levered beta will increase if the debt-to-equity ratio increases. (A)</p> Signup and view all the answers

    Why is it necessary to adjust a bottom-up beta for changes in a firm's business mix over time?

    <p>To reflect the changing risk profile of the firm due to its evolving business operations. (D)</p> Signup and view all the answers

    What is the relationship between the cost of equity and the levered beta?

    <p>A higher levered beta leads to a higher cost of equity. (A)</p> Signup and view all the answers

    Flashcards

    Business Beta

    The beta value reflecting the risk of a firm's business operations without considering financial leverage.

    Unlevered Beta

    The beta of a firm adjusted for its operating leverage, representing its risk independently of debt.

    Levered Beta

    The beta that considers financial leverage, representing the risk of a firm's equity including debt.

    Debt/Equity Ratio

    A financial ratio indicating the relative proportion of debt and equity used to finance a firm's assets.

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    Operating Leverage

    The proportion of fixed costs in a firm's cost structure, affecting its unlevered beta.

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    Fixed Costs

    Costs that do not change with the level of production or sales.

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    Financial Leverage

    The use of debt financing to increase the potential return to equity holders.

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    Bottom-Up Betas

    Method to estimate beta by analyzing the betas of publicly traded firms in the same business sector.

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    Beta of Equity

    The measure of a firm's equity volatility in relation to the overall market.

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    Cyclical Companies

    Firms whose revenues are affected by economic cycles, usually with higher betas.

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    Luxury Goods Firms

    Firms that sell non-essential high-priced items, typically with higher betas.

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    Young Firms

    Newer companies which usually experience higher volatility and higher betas.

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    Growth Firms

    Companies expected to grow at an above-average rate, usually have higher betas.

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    Average Beta

    The simple average of regression betas for comparable firms.

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    Debt to Equity Ratio

    A measure of a firm's financial leverage calculated by dividing total debt by total equity.

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    Weighted Average Unlevered Beta

    Average of unlevered betas adjusted with business value weights.

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    Standard Error of Bottom-Up Beta

    A measure of variability in the bottom-up beta, lower than single regression betas.

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    Historical vs Bottom-Up Betas

    Bottom-up betas are more current and reflect the present scenario, unlike historical regression betas.

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    Study Notes

    Capital Cost and Relative Risk

    • Measuring relative risk avoids using beta or modern portfolio theory if investors are diversified in their portfolio.
    • Options exist for estimating relative risk. -Relative standard deviation (captures all risk rather than just market risk) -Proxy models (evaluate historical returns using multiple regressions to identify variables explaining differences in returns) -CAPM Plus Models (modify the traditional CAPM to incorporate additional premiums)
    • Accounting risk measures analyze accounting earnings volatility or balance sheet ratios to identify risk.
    • Qualitative risk models prioritize qualitative factors (like management quality) in risk assessments.
    • Debt-based measures use observable debt costs to estimate equity costs.

    Determining Betas and Relative Risk

    • Firm Beta is linked to the nature of products or services offered by a company: more discretionary products suggest higher betas.
    • Operating Leverage is influenced by the fixed costs relative to total costs: higher fixed costs imply higher betas.
    • Financial Leverage increases equity betas. This is because raising capital from debt rather than equity usually increases risk.

    Bottom-Up Betas

    • Identifying the relevant businesses for the company is the first step.
    • Publicly traded firms in similar businesses are used to find corresponding beta values.
    • The average of these betas is determined.
    • This weighted average of unlevered betas gives the bottom-up unlevered beta.
    • Levered Beta is the adjusted value based on the firm's market debt to equity ratio.

    Why Bottom-up Betas

    • Bottom-up betas are less noisy estimations compared to traditional betas due to averaging across firms.
    • No historical stock prices are needed for bottom-up beta calculations.
    • The bottom-up approach can adapt to modifications of the firm's business mix or financial leverage.

    Estimating Bottom-up Beta and Cost of Equity: Valuing the Firm's Assets

    • Specific financial metrics (Sample Size, Sample, Unlevered Beta, Revenues, Peer Group EV/Sales, Value of Business, Proportion of Value) for an organization are provided for various categories, and relative or financial positions are described.

    Embraer's Bottom-up Beta

    • Levered beta is derived from the unlevered Beta.
    • Unlevered Beta is used to evaluate if using U.S. and European counterparts is appropriate for evaluating Brazilian Beta.
    • Specific concerns pertaining to this assumption are presented.

    Gross Debt vs Net Debt Approaches

    • Analysts in specific areas often use Gross debt or Net Debt, leading to differences in outcomes.
    • A specific example using Embraer and their debt ratio demonstrates the difference between evaluating on gross or net debt in cost of capital computations.

    Costs of Equity: Summary

    • Cost of equity is primarily computed using a bottom-up beta for the firms business type and in conjunction with a risk free rate and a measure of risk tolerance .
    • Historical premium and implied premium can be used in combination with a firm's risk free rate and beta computation to derive the cost of equity.
    • A variety of metrics pertaining to pricing and valuation, along with financial characteristics, are listed to compute a cost of equity.

    Estimating Cost of Debt

    • Cost of debt is based on the prevailing market rate of interest.
    • Utilizing yields to maturity on outstanding firm debt.
    • Calculating the default spread based on the credit rating of the company.
    • Estimating a synthetic rating when there is no rating data or inconsistent ratings.

    Estimating Synthetic Ratings

    • The interest coverage ratio (EBIT divided by Interest Expenses) provides a metric for estimating the risk and credit rating.
    • Using recent industry-specific (Embraer) metrics yields an interest coverage ratio.
    • The interest coverage ratio is used to derive a bond rating and its associated default spread.

    Cost of Debt Computations

    • Default spread, combined with a risk-free rate and the firm's specific default spread (based on other traded equities in the same industry) yields the overall cost of debt.

    Subsidiaries and Hybrids

    • Methods for dealing with hybrid financial instruments (e.g. convertible bonds) are described.
    • Breaking down hybrid instruments into their individual components (debt or equity) allows for appropriate weighting in a total capital computation.
    • Preference shares should be weighted independently of debt, only if they constitute less than 5% of overall capital value.

    Decomposing Convertible Bonds

    • Steps necessary to compute the value of a convertible bond when faced with debt or equity weighting concerns are presented, along with associated calculations.

    Cost of Capital Recap

    • The components of a cost of capital valuation, including cost of borrowing, marginal tax rates and market values are explained.
    • A summary diagram is provided.

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    Measuring Relative Risk (PDF)

    Description

    This quiz explores the concepts of capital cost and relative risk in investment portfolios. It covers different methods for measuring risk, such as relative standard deviation, proxy models, and qualitative risk assessments. Test your understanding of these key financial principles and how they impact investor decision-making.

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