1. Determinants of Beta Formally: 1.Cyclicality of Revenues – Not the same volatility of revenues – Biotech vs. Steel 2.Operating Leverage – The mix of fixed and variable costs 3.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 1

2. 1.Cyclicality of Revenues Does the company make Consumer products – β P&G = 0.71 – Not very cyclical Office Products and Supplies – β Office Depot = 3.47 – Very cyclical 2

3. 2.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 =  Sales  EBIT 3

4. 3.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 Debt/Equity is the most common financial leverage measure in this context 4

5. Operating Leverage and Financial Leverage Three alternatives All Variable Costs, No Debt : DOL = 1.00 All Fixed, No Debt: DOL = 2.00 All VC with Debt: DOL = 2.00 5 All VC - No Debt All FC - No Debt All VC - Debt Sales $1,000$1,100 $1,000$1,100 $1,000$1,100 Variable Costs $500$550 $0 $500$550 Fixed Costs $0 $500 $0 EBIT $500$550 $500$600 $500$550 Interest Expense $0 $250 NI $500$550 $500$600 $250$300 %ΔSales 10% %ΔEBIT 10% 20% 10% %ΔNI 10% 20% Operating Leverage %EBIT = %ΔSales %EBIT > %ΔSales %EBIT = %ΔSales Financial Leverage %NI = %ΔEBIT %NI > %ΔEBIT Total Leverage %NI = %ΔSales %NI > %ΔSales

6. 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 β Portfolio = E/V β Equity + D/V β Debt But the Total Beta is really Asset Beta β Assets = E/V β Equity + D/V β Debt 6

7. Beta and Financial Leverage We have this relationship: β Assets = E/V β Equity + D/V β Debt But think about β Debt β Debt = Cov(R Debt,R Mkt )/Var(R Mkt ) Covariance of debt and the market is close to zero β Debt ≈ 0 β Assets = E/V β Equity + 0 Since V = E + D: β Assets = E/(E + D) β Equity β Equity = β Assets (E + D)/E β Equity = β Assets (E/E + D/E) β Equity = β Assets [1 + D/E] β Equity = β Assets [1 + (1-T)D/E] 7

8. 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? β Equity = β Assets (1 + D/E) = β Assets (1 + 0/E) = β Assets (1) β Equity = β Assets = 0.98 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 β Equity = β Assets (1 + D/E) = 0.98 (1 + 0.25) = 1.225 The market risk of the stock increases by 25% Solely from a financing decision 8

9. Recap: Determinants of Equity Beta 1.Cyclical nature of the product 2.Degree of operating Leverage DOL = %ΔEBIT/%ΔSales Is this a business decision or nature of the product? 3.Financial Leverage β Equity = β Assets (1 + D/E) We use β Equity to calculate R E R E = R f + β Equity [E(R M ) – R f ] We Use R E to calculate WACC WACC = W E R E + W D R D (1 – T C ) 9

10. Some Beta Terminology Corporate Finance: Equity Beta β E and Asset Beta β A Investments: Levered Beta β L and Unlevered Beta β U β E = β L and β A = β U Corporate Finance Question: – Given the Asset Beta (β A cyclicality and DOL), what do financing decisions do to equity risk (Equity Bata β E ) and the cost of equity capital? – β A  β E Investments Question: – Given the Levered Beta (the CAPM beta, β L )what does the company’s risk look like without the leverage (β U )? – β L  β U 10

11. Calculating Unlevered Beta Before (Corporate finance notation) Given β A what is β E ? β E = β A [1 + (1-T)D/E] Now (Investments notation) Given β L what is β U ? β L = β U [1 + (1-T)D/E] β U = β L /[1 + (1-T)D/E] 11

12. What Happens to Equity Return? Equity Risk: β E = β A [1 + (1 - T)D/E] β L = β U [1 + (1 - T)D/E] Equity Return: R E = R A + (R A – R D )(1 – T)D/E R L = R U + (R U – R D )(1 – T)D/E (This is MMII with taxes) 12