Determinants of Beta Formally: Cyclicality of Revenues Not the same volatility of revenues Biotech vs. Steel Operating Leverage The mix of fixed and variable costs Financial Leverage The mix of debt and equity financing All three have an impact on the variability of the Net Income available to the stockholders

Cyclicality of Revenues Does the company make Consumer products βP&G = 0.52 Not very cyclical Office Products and Supplies βOffice Max = 2.68 Very cyclical

Degree of Operating Leverage Mix of Fixed and Variable costs DOL increases as fixed costs rise relative to variable costs DOL magnifies the effects of cyclicality on EBIT Formula: DOL = %D Sales %D EBIT

Half Fixed Half Variable Degree of Operating Leverage Three alternatives All Variable costs: DOL = 1.00 Half Fixed, Half Variable: DOL = 1.50 All Fixed: DOL = 2.00   All Variable Costs Half Fixed Half Variable All Fixed Costs Units 90 100 110 Price $20 Var Costs $10 $5 $0 Fixed Costs $500 $1,000 Sales $1,800 $2,000 $2,200 VC $900 $1,100 $450 $550 FC Total Costs $950 $1,050 EBIT $850 $1,150 $800 $1,200 %ΔSales -10% 10% %ΔEBIT -15% 15% -20% 20% DOL 1.00 1.50 2.00

Financial Leverage Mix of Debt and Equity financing Increases as fixed interest payments rise Financial Leverage magnifies the effects of cyclicality on NI (and EPS) Financial Leverage is measured by the usual leverage measures See Chapter 3 Debt/Equity is the most common financial leverage measure in this context

(These are the “All Variable Cost” example from before) Financial Leverage Three alternatives No Debt: Interest Expense = $0 Some Debt: Interest Expense = $500 High Debt: Interest Expense = $800 (These are the “All Variable Cost” example from before)   No Debt Some Debt High Debt EBIT $900 $1,000 $1,100 Int Exp $0 $500 $800 EBT $400 $600 $100 $200 $300 Taxes (35%) $315 $350 $385 $140 $175 $210 $35 $70 $105 NI $585 $650 $715 $260 $325 $390 $65 $130 $195 %ΔEBIT -10% 10% %Δ NI -20% 20% -50% 50%

More about Financial Leverage What is the effect on the firm’s Equity Beta from more debt? Recall a Portfolio’s Beta is the weighted average beta of the components So the Company’s Total Beta is the weighted average beta of the stocks and bonds issued to finance the company βPortfolio = E/V βEquity + D/V βDebt But the Total Beta is really Asset Beta βAssets = E/V βEquity + D/V βDebt

βEquity = βAssets [1 + D/E] βEquity = βAssets [1 + (1-T)D/E] Beta and Financial Leverage We have this relationship: βAssets = E/V βEquity + D/V βDebt But think about βDebt βDebt = Cov(RDebt,RMkt)/Var(RMkt) Covariance of debt and the market is close to zero βDebt ≈ 0 βAssets = E/V βEquity + 0 Since V = E + D: βAssets = E/(E + D) βEquity βEquity = βAssets (E + D)/E βEquity = βAssets (E/E + D/E) βEquity = βAssets [1 + D/E] βEquity = βAssets [1 + (1-T)D/E]

Example: CMG is financed only with equity (no debt) This referred to as an “unlevered firm” The beta of its stock is 1.02 What is the beta of its assets given that it has no debt? βEquity = βAssets (1 + D/E) = βAssets (1 + 0/E) = βAssets (1) βEquity = βAssets = 1.02 If CMG were to issue enough debt to buy back 20% of its outstanding stock, what would happen to the beta of the remaining stock? D/E = 0.20/0.80 = 0.25 βEquity = βAssets (1 + D/E) = 1.02 (1 + 0.25) = 1.275 The market risk of the stock increases by 25% Solely from a financing decision

RE = Rf + βEquity[E(RM) – Rf] Recap: Determinants of Equity Beta Cyclical nature of the product Degree of operating Leverage DOL = %ΔEBIT/%ΔSales Is this a business decision or nature of the product? Financial Leverage βEquity = βAssets (1 + D/E) We use βEquity to calculate RE RE = Rf + βEquity[E(RM) – Rf] We Use RE to calculate WACC WACC = WERE + WDRD(1 – TC)

Some Beta Terminology βE = βL and βA = βU Corporate Finance Question: Corporate Finance: Equity Beta βE and Asset Beta βA Investments: Levered Beta βL and Unlevered Beta βU βE = βL and βA = βU Corporate Finance Question: Given the Asset Beta (βA cyclicality and DOL), what do financing decisions do to equity risk (Equity Bata βE) and the cost of equity capital? βA  βE Investments Question: Given the Levered Beta (the CAPM beta, βL )what does the company’s risk look like without the leverage (βU)? βL  βU

Calculating Unlevered Beta Before (Corporate finance notation) Given βA what is βE? βE = βA [1 + (1-T)D/E] Now (Investments notation) Given βL what is βU? βL = βU [1 + (1-T)D/E] βU = βL/[1 + (1-T)D/E]

What Happens to Equity Return? Equity Risk: βE = βA [1 + (1 - T)D/E] βL = βU [1 + (1 - T)D/E] Equity Return: RE = RA + (RA – RD)(1 – T)D/E RL = RU + (RU – RD)(1 – T)D/E (This is MMII with taxes)