1. 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

2. 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

3. 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

4. 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

5. 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

6. (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%

7. 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

8. 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]

9. 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 ( ) = 1.275
The market risk of the stock increases by 25%
Solely from a financing decision

10. 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)

11. 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

12. 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]

13. 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)