,Corporate Finance: Summary of the book:
Chapter 12: Risk, cost of capital and capital budgeting:
The discount rate: the rate of return expected, given its risk. (Investor)
The discount rate for a manager is the cost of raising capital to fund the company’s
investments.
,12.2: The estimation of Beta:
Beta is the covariance of a security with the market, divided by the variance of the market.
, If you believe that the operations of a firm are similar to the operations of the rest of the
industry, you should use the industry beta simply to reduce estimation error. If executives
believe that the operations of the firm fundamentally differ from those in the rest of the
industry, the firm’s beta should be used.
12.3 Determinants of Beta:
There are 3 factors that influence the beta of the firm:
1. Cyclicality of revenues: Some firms are quite cyclical; they do well in the expansion
phase of the business cycle and poorly in the contraction phase. Hi-tech firms,
retailers and automotive firms are dependent on the business cycle. Beta is the
standardized covariance of a security’s return with the market’s return. Cyclicality is
not the same as variability!
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2. Operating leverage: The difference between variable and fixed costs allow us to
define operating leverage. Operating leverage refers to the firms fixed cost of
production. Operating leverage magnifies the effect of cyclicality on beta. Business
risk is the risk of the firm without financial leverage. Business risk depends on the
responsiveness of the firm’s revenue to the business cycle and on the firm’s
operating leverage.
3. Financial leverage and Beta: The extent to which a firm relies on debt. Because a
levered firm must make interest payments regardless of the firm’s sales, financial
leverage refers to the firm’s fixed cost of finance.
Asset beta: The beta the firm’s shares had if the firm been financed only with equity.
Beta equity: The beta of the equity of the leverages firm.
Beta asset< Beta equity for a levered firm.
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