Estimating Hurdle Rate for Firms

Aswath Damodaran
The Cost of Equity and Capital
 Firms raise money from both equity investors and lenders to fund investments.
 Both groups of investors make their investments expecting to make a return.
 The expected return for equity investors would include a premium for the equity risk
in the investment.
 This expected return is called the cost of equity.
 Similarly, the expected return that lenders hope to make on their investments
includes a premium for default risk, and we call that expected return the cost of
debt
 If we consider all of the financing that the firm takes on, the composite cost of
financing will be a weighted average of the costs of equity and debt, and this
weighted cost is the cost of capital.
Why do we need Hurdle Rates for Firms?

 Why do firms need to know their costs of equity and capital?

 One of the fundamental decisions that every business needs to make is to assess
where to invest its funds and to reevaluate, at regular intervals, the quality of its
existing investments.
 The investment principle specifies that firms should invest in assets only if they
expect them to earn more than their hurdle rates. The costs of equity and capital
for a firm represent what the firm needs to make collectively on all its
investments in order for them to be good investments.

For instance, if The Home Depot's cost of capital is 9.51%, it has to make at least 9.51% on the capital
it has invested in all its existing investments. Alternatively, considering the equity investors'
perspective alone, The Home Depot with a cost of equity of 9.78% has to earn at least 978% on the
equity it has invested in all its existing investments for these to be considered good investments.
Why do we need Hurdle Rates for firms?

 It is worth emphasizing, however, that this does not imply that every project The
Home Depot takes will be measured against these criteria, since projects within a
firm can have varying degrees of risk.
 Knowing a firm's cost of equity and capital also allows us to compare different ways
of financing its operations. We can change the mix of debt and equity at Boeing,
for instance, and examine the effects, if any, on the cost of capital for the firm.
 Increasing the proportion of debt at the firm may allow us to lower the cost of
capital from its existing level of 9.17%, letting the firm accept more investments
the value of a business is computed by discounting the expected cash flows to
equity investors at the cost of equity.
 Given that our objective in making decisions is to maximize the value of the
business, and by extension, the value of the stock (equity), the costs of equity and
capital become fundamental inputs into the decision process.
Cost of Equity
 Rate of return investors require on an equity investment in a firm.
 The risk and return models need a reckless rate and a risk premium (in the
CAPM) or premiums (in the APM and multifactor models).
 They also need measures of a firm's exposure to market risk in the form of
betas, These inputs are used to arrive at an expected return on an equity
investment:

Expected Return = Riskless rate + Beta (Risk Premium)

 The expected return to equity investors includes compensation for the market
risk in the investment, and it is the cost of equity.
Riskless Rate

 A riskless asset is one for which the investor knows the expected returns with
certainty. Consequently, for an investment to be riskless over a specified time
period (time horizon), two conditions have to be met:

1. There is no default risk, which generally implies that the government has to
issue the security. Not all governments are viewed as default free, and this does
create a practical problem in obtaining riskless rates in some markets.

2. There is no uncertainty about reinvestment rates, which implies that there are
no cash flows prior to the end of our time horizon, since these cash flows have
to be reinvested at rates that are unknown today
Riskless Rate and Time Horizon
 Should we use a short-term or a long-term government bond rate as a riskless
rate?

Assume, for instance, that we are analyzing a five-year project and that we need a
five-year riskless rate. A six-month treasury bill is not riskless for a five-year time
horizon because there is reinvestment risk at the end of each six-month period. In
fact, neither is a five-year government bond with coupons without risk since the
coupons have to be reinvested, at the rates prevailing at that time, every six
months for the next five years. Only a five-year zero-coupon government bond
fulfills our conditions: it has no default risk, and there are no cash flows prior to
the end of the fifth year. Thus, the riskless rate is the rate on a zero-coupon
government bond that matches the time horizon of the cash flow being analyzed.
Here, since the only cash flow is the principal on the bond coming due at maturity,
there is neither default nor reinvestment risk.
Riskless Rate and Time Horizon
In theory, this translates into using different riskless rates for each cash flow on an
investment the one-year zero-coupon rate for the cash flow in year 1, the two-year
zero-coupon rate for the cash flow in year 2, and so on. In practice, using a long-term
government rate (even on a coupon bond) as the riskless rate on all the cash flows in
a long-term analysis will yield a close approximation of the true value. For short-
term analysis, it is appropriate to use a short-term government security rate as the
riskless rate.
Riskless Rate When there is Sovereign Risk
 We assumed that Government never default on their obligation that they issue
long-term bonds, and that these bonds are traded to yield a market interest rate.
 In a number of economies, one or all of these assumptions may be violated. In
some developing countries where governments in the past have failed to meet
their promised obligations, investors do not view the government as default-free.
 In many other markets, the government might not issue long-term that one can
obtain is a short-term government rate. There are three ways for a long term
default free rate.
1. To bypass the question of a riskless rate entirely by doing the analysis in a different
currency (such as the U.S. dollar) where a riskless rate is easy to obtain.
2. The second is to find the rate at which the largest and safest corporations in that country
can borrow long term at the local currency and reduce that rate by a small default
premium (say, 1 to 2 %) to arrive at a long-term riskless rate.
3. The third solution applies when short-term government bond rates (which are default
free) are available but not long term rates.
Riskless Rate When there is sovereign risk
Assume, for instance, that there are one-year Malaysian government bonds
(denominated in Malaysian Ringgit) trading at 12%, that the one-year U.S. government
bond rate is 4%, but that there are no long-term Malaysian government bonds. An
approximate long-term Malaysian government bond rate (in Ringgit) can be estimated
by adding the spread of 8% between the one-year government bonds to the 10-year
or 30-year U.S. government bonds rate. For instance, with a 10-year U.S. government
bond rate of 6%, this would yield a 10-year Malaysian government bond rate of 14%.
Currency Choices and Real Rates
 In most analyses, other questions need to be answered about the riskless rate. If
we are working with a U.S. company, should the riskless rate always be a rate on a
U.S. government security?
 If the U.S. company plans an investment in South Africa, should we use the South
African Rand riskless rate instead? What if we were looking at a South African
company instead?
 The riskless rate has to be defined in the same terms as the cash flows on the
analysis. If the analysis is done in dollar terms, the riskless rate always has to be a
U.S. government security rate, whether the firm doing the analysis is a U.S. firm or
a non-U.S firm and whether the project is in the United States or any other
country.
 This should be the case even if the country in which the company is located has its
own dollar-denominated bonds,2 which carry a default risk premium. The country
default risk premium is best reflected in the risk premium component and not in
the riskless rate.
Currency Choices and Real Rates
 If the cash flows are in South African Rand, the riskless rate has to be a Rand
riskless rate. There is a second choice we might need to make in terms of the
riskless rate. Some analyses are based entirely on real cash flows; that is, the cash
flows are estimated, as if there were no inflation in the currency. If the analysis is
done in real terms, the riskless rate has to be a real riskless rate, which can be
obtained in one of two ways:
1. If there are default-free securities that guarantee a real rate, that real rate is a real
riskless rate. In the United States, for instance, there are inflation-protected
treasury bonds for which the holder receives a guaranteed real rate3 rather than a
guaranteed nominal rate
2. If no such securities exist in the market in which you are attempting to estimate a
real riskless rate, it can be approximated by the long-term real growth rate of the
economy. Thus, the real riskless rate in China may be set equal to 6% because that
is what you expect the long-term real growth rate in the Chinese economy to be It
will be much lower (2-3%) for more mature, slower growth economies
Risk Premium
 The risk premium is a significant input in all the asset pricing models.

 What Is the Risk Premium Supposed to Measure?

The risk premium measures the "extra return" that would be demanded by
investors for shifting their money from a riskless investment to an average
risk investment. It should be a function of how risk- averse investors are and
how risky they perceive stocks (and other risky investments) to be, relative
to a riskless investment.
 Because each investor in a market is likely to have a different assessment of
an acceptable premium, the premium will be a weight of these individual
premiums, where the weights will be based on the wealth brings to the
market. Investors with more wealth will therefore have their risk premiums
weighted more than investors with less ore wealth, like Warren Buffett, will
have therefore have their risk premiums weighted more than investors with
less wealth
Risk Premium

 Assume that stocks are the only risky assets and that you are offered two
investment options. One is a riskless investment on which you can make 6.7%,
and the other is a stock mutual fund. How much more than 6.7% would you
need to be offered, on an expected basis, to pick the latter? Would you ever
settle for less than 6.7%?
Estimating Risk Premiums
 Two ways to estimate the risk premium in the capital asset pricing model:
 One is to look at the past and estimate the premium earned by risky
investments (stocks) over riskless investments (government bonds); this is
called the historical premium.
 The other is to use the premium extracted by looking at how markets price
risky assets today; this is called an implied Premium
Historical Risk Premiums
 The most common approach to estimating the risk premium is to base it on historical data. In the
arbitrage pricing model and multifactor models, the raw data on which the premiums are based are
historical data on asset prices over very long time periods. In the CAPM, the premium is estimated by
looking at the difference between average returns on stocks and average returns on riskless securities
over an extended period of history.
 In most cases, we follow these steps to find historical risk premiums. First, we define a time period for
the estimation, which can range as far back as 1926 for U.S. data. Then, we calculate the average
returns on stocks and average returns on a riskless security over the period. Finally, we calculate the
difference between the return on stocks and the riskless return and use it as a risk premium to predict
future returns
 When we use historical premiums, we implicitly assume that the risk aversion of investors has not
changed across time and that the relative riskiness of the risky portfolio (stocks) has not changed
over time either. In calculating the average returns over past periods, a measurement question
arises: Should we use arithmetic or geometric averages to compute the risk premium? The
arithmetic mean is the average of the annual returns for the period under consideration, whereas
the geometric mean is the compounded annual return over the same period. The following example
demonstrates the difference
Historical Risk Premiums
 On stocks and the riskless return and use it as a risk premium to predict future
returns. When we use historical premiums, we implicitly assume that the risk
aversion of investors has not changed across time and that the relative riskiness
of the risky portfolio (stocks) has not changed over time either.
 In calculating the average returns over past periods, a measurement question
arises: Should we use arithmetic or geometric averages to compute the risk
premium ? The arithmetic mean is the average of the annual returns for the
period under consideration, whereas the geometric mean is the compounded
annual return over the same period. The following example demonstrates the
difference.
Year Price Return
0
1 100 100%
2 60 -40%
Historical Risk Premiums
 The arithmetic average return over the two years is 30% , while the geometric
average is only 9.54% (). Those who use the arithmetic average premium argue
that it is much more consistent with the of the CAPM and a better predictor of
the risk premium in the next period. The geometric mean is justified on the
grounds that it takes into account compounding and that it is a better predictor of
the average premium in the long term. There can be substantial differences in risk
premium based on the choices made at this stage, as illustrated in Table 7.1. The
data in the table are based on historical data on stock, treasury bill, and treasury
bond returns and provide estimates of historical risk premiums. As you can see,
the historical premiums can vary widely depending on whether we go back to
1926, 1962, or 1981, whether we use T. Bills or T. Bonds as the riskless rate, and
whether we use arithmetic or geometric average .
 Historical Risk Premiums for the U.S. Market

Stocks - T.Bills Stocks - T.Bonds

Arithmetic Geometric Arithmetic Geom etric
Historical Period Average Average Average Avera ge
1926 - 1998 9.31% 7.95% 7.52% 6.38%
1962 - 1998 6.81 6.03 5.68 5.29
1981 - 1998 12.96 10.72 12.22 10.09
Historical Risk Premiums
Although it is impossible to prove one premium right and the others wrong, we are
biased toward
Longer term premiums, since stock returns are volatile and shorter time periods
can provide premiums with large standard errors. For instance, the premium
extracted from 25 years of data will have a standard of about 4 to 4%.
Long-term bond rates as riskles rates, since our time horizons in corporate
financial analysis tend to be long term, and we use the treasury bond rate as our
riskless rate.
Geometric average premiums, since arithmetic average premiums overstate the
expected returns over long The geometric mean yields lower premium estimates
than does the arithmetic mean, and provides a more appropriate estimate for
longer time horizons. On this issue, however, there is significant disagreement.
Ibbotson Associates argues for the arithmetic average premium, noting that it is
the best estimate of the premium for the next period. Indro and Lee (1997)
compare arithmetic and geometric premium increasing with the time horizon.
Historical Risk Premiums

• These biases would lead us closer to the premium of 6.38% that is the geometric
average premium for stocks over T. bonds from 1926 to 1998. In this book we use
a premium of 5.50% in most of the examples involving U.S. companies.
• Although historical data on stock returns is most easily available and accessible in
the United States, the premiums for other countries can be obtained as well. The
problem, however, is that it is almost impossible to get reliable historical data for
as long a time period. Ibbotson and Brinson, for instance, report the risk
premiums, shown in Table 7.2 for major non-U.S. markets from 1970 through
1996.
Historical Risk Premiums
 The risk premium for stocks over long-term government bonds has typically been
much lower in the European markets (not counting Britain) than in either the
United States or Japan. We would argue that the changes in many European
markets and the economics underlying them have been so large that the
historical premiums are useless. This point can be made even more emphatically
when looking at the emerging markets. Knowing the premium that an investor
would have made in the Brazilian market from 1987 to 1998 would not be much
use for estimating the future premium, given the substantial shift in the Brazilian
economy from the hyperinflationary environment of the 1980s to the lower-
inflation economy of today.
Historical Risk Premiums
• If we cannot use historical premiums for other countries, how exactly can we get
a premium to use in calculating the cost of equity in the CAPM? Returning to
fundamentals , the risk premium should be a function of the volatility in the
underlying economy and the risk associated with that particular market. Other
things remaining equal, we would expert markets that are riskier than the United
States to have larger premiums than the United States does, looking forward. To
estimates how much larger, we will use a two-part approach.
Table: Risk Premiums across the World, 1970 - 1995
Annual Return
Annual on
Equity Risk
Return on Government
Premium
Country Equity Bonds
Australia 8.4 7% 6.99% 1.4 8%
Canada 8.98 8.30 0.68
France 11.51 9.17 2.34
Germany 11.30 12.10 - 0.80
Hong Kong 20.39 12.66 7.73
Italy 5.4 9 7.84 - 2.35
J apan 15.73 12.69 3.04
Mexico 11.88 10.71 1.17
Netherlands 15.4 8 10.83 4 .65
Singapore 15.4 8 6.4 5 9.03
Spain 8.22 7.91 0.31
Switzerland 13.4 9 10.11 3.38
UK 12.4 2 7.81 4.61
USA 10.90 7.90 3.00
Historical Risk Premiums
1. Use country ratings to estimate default risk and spreads: Ratings agencies such as
Standard and Poor's and Moody's rate countries, just as they rate companies,
based on the country's financial and political strengths and weaknesses. The
advantage of these ratings is that they are associated with default premiums that
allow us to quantify the effect on the risk premium. Thus, at the end of 1998,
Brazil with a BB- rating was viewed as a riskier country to invest in than Chile,
with an A rating. In addition, since both Brazil and Chile have long-term dollar-
denominated bonds outstanding, we can estimate the default spreads associated
with these ratings. For instance, at the end of 1998, Brazilian dollar bonds were
trading at interest rates about 5% higher than the U.S. treasury bond rate, while
Chilean dollar bonds were trading about 2% higher than the treasury bond rate.
2. Adjust the country default spread to reflect the relative volatility of the equity
market: Equity should generally be riskier than the debt issued by that same
country. To measure the relative risk of equity, we use a simple measure, based
on the standard deviations of the stock and bond markets in that country.
Historical Risk Premiums
•  Relative Volatility of Equity =

• For instance, the relative volatility of the Brazilian equity market for 1998 was
estimated from the standard deviation of Brazilian stocks (43.2%) and the
standard deviation in the Brazilian long-term bond price (23.6%).
Relative Volatility of = = 1.83
Historical Risk Premiums
• Relative Volatility of = = 1.83
• The standard deviations were estimated using two years of weekly returns from
1997 and 1998. The default spread estimated in the first part is then scaled up to
reflect the relative volatility of the equity market and yields a country equity risk
premium:
Country Equity Risk Premium = Default Spread × Relative Volatility of Equity
• For Brazil,
County Equity Risk Premium= 5% × 1.86 = 9.15%
• Note that this premium is purely for country risk . If we make the assumption that
the equity risk premium we have estimated for the United States(5.5%) is the equity
risk premium for a mature equity marker, the total risk premium for a country is the
sum of the mature equity risk premium and the country risk premium. Thus, the
total equity in U.S dollar terms:
Cost of Equity = U.S Treasury Bond rate + Beta (U.S. Equity Risk Premium + Country
Risk Premium)
Historical Risk Premiums
• We
  look at other ways in which we can incorporate the country risk premium in
the cost of equity in Damodaran(1999).
• Godfrey and Espinosa (1996) suggest a variant in which they add the country
default spread to the risk-free rate and multiply the U.S. equity risk premium by
the volatility of the country's equity market, relative to the U.S. market.
Cost of Equity = U.S. risk-free rate + Country default spread + Beta (U.S. Risk Premium)()
• Implied Equity Premiums: A second approach to estimating risk premiums does
not require surveys or historical data, but it does assume that the overall market
prices stocks correctly. Consider, for instance, a very simple valuation model for
stocks:
Value =
Historical Risk Premiums
• This is the present value of dividends growing at a constant rate forever,
developed in Chapter 5. Three of the four inputs in this model can be estimated
from publicly available information - the current level of the market (value), the
expected dividends next period, and the expected growth rate in earnings and
dividends in the long term. The only unknown is the required return on equity;
when we solve for it, we get an implied expected return on stocks. Subtracting
the riskless rate will yield an implied equity risk premium.
Historical Risk Premiums
• To
  illustrate the estimation of implied equity risk premiums, assume that the
current level of the S&P 500 Index in 900. Assume also that the expected
dividends on the index next year will be 2% of current stock prices (this is called
the dividend yield), and that the expected growth rate in earnings and dividends
in the long term is 7%. Solving for the required return on equity yields the
following:

 Solving for r,
r = =9%

• If the current riskless rate is 6%, the risk premium will be 3%.
Historical Risk Premiums
• The advantage of this approach is that it is market-driven and current and does
not require any historical data. It is, however, bounded by whether the valuation
model used is the right one and by whether the inputs to that model are available
and reliable. For instance, in the above example, the use of dividends as the cash
flow to equity investors and the assumption of constant growth might lead to an
implied risk premium that is too low. Finally, the implied risk premium is based on
the assumption that the market is correctly priced.
• The contrast between the implied risk premium and the historical premium is
best illustrated by graphing out the implied premiums in the S&P 500 going back
to 1960 in the following figure. Each year, we estimate expected dividends and
expected growth, and we use the level of the index at the end of the year to
estimate implied equity premiums. Note that implied equity risk premiums are
consistently lower than the historical premiums that we estimated in the table.
The implied premium has also decreased over time.
Historical Risk Premiums
• CC : Assume that the implied premium in the market is 3% and that you are using
a historical premium of 7.5% . If you valued stocks using this historical premium,
are you likely to find more under- or overvalued stocks? Why?
Betas
• Historical Market Betas The conventional approach to estimating the beta of
an investment is a regression of returns on the investment against returns on a
market index. For firms that have been publicly traded for a length of time, it is
relatively straightforward to estimate returns that an investor would have made
by investing in the firm's stock each interval (such as a week or a month) over
that period. I theory, these stock returns on the assets should be related to
returns on a market portfolio, that is, a portfolio that includes all traded assets, to
estimate the betas of the assets. In practice, we tend to use a stock index, such as
the S&P 500, as a proxy for the market portfolio, and we estimate betas for stocks
against the index.
Betas
•   standard procedure for estimating betas is to regress stock returns (Rj) against
The
market returns (Rm)
=a+b
where a = Intercept from the regression
b = Slope of the regression =

The slope of the regression corresponds to the beta of the stock and measures the
riskiness of the stock.
The intercept of the regression provides a simple measure of performance of the
investment during the period of the regression, when returns are measured against the
expected returns from the capital asset pricing model. To see why, consider the following
rearrangement of the capital asset pricing model:
= + β( - )
= (1 - β) + β
Betas

• 
Compare this formulation of the return on an investment to the return equation
from the regression:
=a+b
Thus, a comparison of the intercept (a) to (1 - β) should provided a measure of the
stock's performance, at least relative to the capital assets pricing model. In
summary then:
If a> (1 - β) Stock did better than expected during regression period
a = (1 - β) Stock did as well as expected during regression period.
a< (1 - β) Stock did worse than expected during regression period
Betas
• The difference between a and (1 - β) is called Jensen's alpha and provides a
measure of whether the investment in question earned a return greater than or
less than its required return, given both market performance and risk. For instance,
a firm that earned 15% during a period, when firms with similar betas earned 12% ,
will have earned an excess return of 3%; its intercept will also exceed (1 - β) by 3%.
• The third statistic that emerges from the regression is the R squared of the
regression. While the statistical explanation of the R squared is that it provides a
measure of the goodness of fit of the regression, the economic rational is that it
provides an estimate of the proportion of the risk of a firm that can be attributed
to market risk; the balance (1 - ) can then be attributed to firm specific risk.
• The final statistic worth nothing is the standard error of the beta estimate. The
slope of the regression, like any statistical, may be different from the true value,
and the standard error reveals just how much error there could be in the estimate.
The standard error can also be used to arrive at confidence intervals for the "true"
beta value from the slope estimate.
 In Practice: Estimating CAPM Risk Parameters For
Boeing
•  assessing risk parameters for Boeing, we compute the returns on the stock and
In
the market index as follows.
1. The returns to a stockholder in Boeing are computed month by month from
October 1993 to September 1998. These include both dividends and price
appreciation and are defined as follows:
=
where
= Returns to a stockholder in Boeing in month j
= Price of Boeing stock at the end of month j
= Dividends on Boeing stock in month j
• Dividends are added to the returns of the month in which stockholders are
entitled to the dividend.
 In Practice: Estimating CAPM Risk Parameters For
Boeing
•   The returns on the S&P 500 market index are computed for each month of the
2.
period using the level of the index at the end of each month and the monthly
dividend on stocks in the index:
=
• where is the level of the index at the end of month j and Dividend is the on the
index in month j. Although the S&P 500 and the NYSE Composite are the most
widely use indices for U.S. stocks, they are, at best, imperfect proxies for the
market portfolio in the CAPM, which is supposed to include all traded assets.
Betas
•   regression statistics for Boeing are as follows:
The
a. Slope of the regression = 0.96. This is Boeing's beta, based on monthly returns from 1993 to 1998.
Using a different time period for the regression for different return intervals (weekly or daily) for
the same period can result in a different beta.
b. Intercept of the regression = 0.09% . This is a measure of Boeing's performance, where it is
compared with (1 - β) . The monthly riskless rate (since the returns used in the regression are
monthly returns) between 1993 to 1998 averaged 0.4%, resulting in the following estimate for the
performance:
(1 - β) = 0.4% (1 - 0.96) = 0.02%
intercept - (1 - β) = -0.09% - (0.02%) = -0.11%
This analysis suggests that, when expectations are based on the CAPM, Boeing performed 0.11%
worse than expected on a monthly basis between October 1993 to September 1998. This results in an
annualized excess return of approximately -1.31%

Annualized Excess Return = -1

= = - 1.31%
Betas
• By this measure of performance , Boeing did slightly worse than expected
between October 1993 to September 1998. Note, however, that this does not
imply that Boeing would be a poor investment in the future. The performance
measure also does not provide a breakdown of how much of this excess return
can be attributed to the performance of the entire sector (aerospace and
defense), and how much is specific to the firm. To make that breakdown, we
would need to compute the excess over the same period for other firms in the
aerospace and defense industry and compare them with Boeing excess return.
The difference would then be attributable to firm-specific actions. In this case, for
instance, the average annualized excess return on other aerospace/defense firms
between 1993 and 1998 was - 2.16%, suggesting that the firm-specific
component of performance for Boeing is actually 0.85%. [Firm-specific Jensen's
alpha = - 1.31% - (-2.16%)]
Figure: Boeing versus S&P 500: October 1993-
September 1998
Betas

c. R squared of the regression = 29.56%. This statistic suggests that 29.56% of the
risk (variance) in expected return. Boeing's R squared is slightly higher than the
median R squared of companies listed on the New York Stock Exchange, which was
approximately 25% in 1998.
d. Standard Error of Beta Estimate = 0.20. This statistic implies that the true beta
for Boeing could range from 0.76 to 1.16 (subtracting and adding one standard
error to beta estimate of 0.96) with 67% confidence and form 0.56 to 1.36
(subtracting and adding two standard error to beta estimate of 0.96) with 95%
confidence! Although these ranges may seem large, they are not unusual for most
U.S. companies. We should therefore consider regression estimates of betas from
regressions with caution.
Betas

cc: Assume that after we have done the regression analysis, both Boeing and
Biogen, a biotechnology company, have betas of 0.96. Boeing, however, has an R
squared of 30% while Biogen has an R squared of only 10% . If you were a well
diversified investor, which of these two stocks would your prefer for your portfolio?
If you were not well diversified, which of these two stocks would you prefer?
Betas
• Using a Service Beta. Most of us who use betas obtain them from an estimation
service; Merrill Lynch, Barra, Value Line, Standard and Poor's , Morningstar, and
Bloomberg are some of the well-known services. All these services begin with the
regressing beta described above and adjust them to reflect what they feel are
better estimates of future risk. Although many of these services do not reveal
their estimation procedures, Bloomberg is an exception.
Betas

• Although the time period use is identical to the one used in our earlier
regression, there are subtle differences between this regression and the one in
Figure 7.2 . First, Bloomberg uses price appreciation in the stock and the market
index in estimating betas and ignore dividends. The fact that dividends are
ignored does not make much of a difference for a company like Boeing, but it
could make a difference for a company that either pays no dividends or pays
significantly higher dividends that the market.
Figure: Historical Beta Calculation for Boeing
 BETAS
• Ignoring dividends doesn’t make difference for a firm like Boeing
• But it can make difference for a firm that either doesn’t pay dividend at
all or pays significantly higher amount
Adjusted beta=Raw beta(.67) +1.00(.33)
• Betas over time tend to move towards average beta
• This may be explained by the fact that firm’s product mix and client base
become more diversified as they get larger

47
 BETAS
• 3 decisions for setting up the regression
• 1.Length of the estimation period
-Longer estimation period provide more data but firm’s risk characteristic
might change over the time period

2.Return Interval
-Using daily or intra-day returns will increase the number of observations
in the regression
-Using weekly or monthly return can reduce nontrading bias
 BETAS

• 3. Choice of a market Index

-standard practice is estimating betas relative to the index of the
stock market where its stocks trade
-may not be best approach for international investor
• Different beta estimates may be provided as a result of using
different estimation period and market indices
• Beta delivered by each of these services comes with a standard
error
 Historical Beta estimate for HOME DEPOT

• ReturnsHomeDepot=1.11%+.62Returns
• R squared=14.65%
• Beta =.62
• Standadrd error of the estimate=.20
• Market risk=14.65%
• Firm Specific 85.35%
 Historical Beta estimate for HOME DEPOT

• Jensen’s Alpha=1.11%-.4%(1-.62)=1.01% a month

• Annualized Jensen’s Alpha=(1.01)12-1=12.68%
• Between 1993 and 98 Home Depot earned 12.68% more than
expected
• Though Home Depot performed better than expected it doesn’t
imply Home Depot will be good investment in future
 Historical Beta estimate for InfoSoft

• Historical approach works only for assets that have been traded
and have market prices
• InfoSoft doesn’t have market price history
 Fundamental Betas

• Less reliant on historical betas and more cognizant of fundamental

determinants
• Determined by 3 variables
Type of business or businesses the firm is in
Degree of operating leverage of firm
Firm’s financial leverage
 Fundamental Betas
• Type of Business
More sensitive a business is to market conditions, the higher the
beta
• This view can extend to company’s products too
• Beta of P&G lower than beta of Gucci
 Fundamental Betas
• Degree of Operating Leverage
Function of a firm’s cost structure
Defined in terms of relationship between fixed cost and total
cost
High fixed cost relative to total cost is said to have high
operating leverage
High operating leverage will also have higher variability in
operating income compared to a company with low leverage
 Fundamental Betas
• Higher variance in operating income will lead to higher beta for
firm with high operating leverage
• Can firms change their operating leverage?
• Firms have made cost structure more flexible by
Negotiating labor contracts emphasizing flexibility
Entering into joint venture agreements where fixed costs are
borne by someone else
Subcontracting manufacturing and outsourcing which reduce
need for expensive plants and equipments
 Fundamental Betas

• Possible to get an approximate measure of the operating leverage

by looking at changes in operating income as a function of
changes in sale
Degree of opeating leverage= ( % change in opeating profit / %
change in sales)
 Operating Leverage for Home Depot
Year Net Sales Change in sales EBIT Change in EBIT
1988 1454 $98
1989 2000 37.55% 127 29.59%
1990 2759 37.95 185 45.67
1991 3815 38.27 265 43.24
1992 5317 34.65 382 44.15
1993 7148 39.15 549 43.72
1994 9239 29.25 744 35.52
1995 12477 35.05 1039 39.65
1996 15470 23.99 1232 18.58
1997 19536 26.28 1534 24.51
1998 24156 23.65 1914 24.77
AVERAGE 32.58 34.94
 Operating Leverage for Home Depot

Operating Leverage= ( % change in EBIT / % change in sales )

= ( 34.94% / 32.58%) = 1.07
• Operating leverage for other retail firms is 1.05
• Home Depot has an operating structure similar to its competitors
 Fundamental Betas
• Degree of Financial Leverage
Other thins remaining equal, increase in financial leverage will
increase the beta of the equity in a firm
Intuitively Fixed interest payments on debt to result in high net
income in good times
Negative net income in bad times
High leverage increases the variance in net income and makes
equity investment in firm riskier
 Fundamental Betas
•  If beta of debt is zero and debt has tax benefit to firm then
ßL = ßu(1+(1-t) () )
Where,
ßL =Levered beta for equity in firm
ßu =unlevered beta of the firm
t= Corporate Tax rate

=Debt/Equity ratio
 Fundamental Betas
• Unlevered Beta is determined by types of businesses in which it
operates and its operating leverage
• Often also called asset beta
• Levered Beta is determined by riskiness of business and amount
of financial leverage risk it has taken on
• Some financial leverage multiplies underlying risk
 Effects of Leverage on Betas
• Boeing had a historical beta of 0.96
• Estimating average debt/equity ratio between 1993 and 1998
using market values.
Average Debt/Equity Ratio=17.88%
• Beta over this period reflects this average leverage. To estimate
unlevered beta over this period using corporate tax rate of 35%
Unlevered Beta=(Current Beta/1+(1-tax rate)(average
debt/equity))
• Levered Beta=Unlevered Beta x [1+(1-tax rate)(debt/equity)]
 Effects of Leverage on Betas
• If Boering were to increase debt equity ratio to 10%
Levered beta(at 10% DIE)= 0.86[1+(1-.35)(.10)]=0.92

• Bottom Up Betas
• An alternative way of estimating betas without using past prices
• Weighted average of two betas, weight based on market value
• Beta for a firm is weighted average of betas of all the difference
businesses it is in
 Effects of Leverage on Betas
• 4 Steps of estimating the beta
Identify businesses in which firm operates
Estimate average unlevered betas of other publicly traded firms that
are primarily or only in each of these businesses
Take weighted average(also called bottom-up unlevered beta) of
unlevered betas, using proportion of firm values derived from each
businesses as the weights/operating income/revenues
Lastly estimate current market values of debt and equity of firm and
use it to equity ratio to estimate levered beta
 Estimating Bottom-up Beta
Company Name Beta Market Cap(mil) Debt due 1 yr out Long-term Debt D/E Ratio
Building Materials 1.05 136 1 113
Catalina Lightings 1 16 7 19
Contl Materials .55 32 2 7
Eagle Hardware .95 612 6 146
Emco Limited .65 187 39 119
Fastenal CO 1.25 1157 16
HomeBase Inc 1.1 227 116
Hughes Supply 1 610 1 335
Lowe’s Cos. 1.2 12554 111 1046
Waxman Ind. 1.25 18 6 121
Westburne Inc .65 607 9 34
Wolohan Lumber .55 76 2 20
16233 200 2075 14.01%
 Estimating Bottom-up Beta
• Unlevered Beta=[.93/1+(1-.35)(.1401)]=0.86
• Market Value of Equity= $51,739 millions
• Estimated market value of Debt=$1137 million
• Bottom-up Beta for The home Depot=0.86[1+(1-.35)(1137/51,739)]=0.87
Estimating Bottom-up Betas for Boeing
 Historical regression beta doesn’t fully reflect the effects of significant changes in
business mix and financial leverage
 To estimate Boeing’s beta, its business is divided into two areas:
• Commercial Aircraft, which is Boeing’s core business of manufacturing commercial jet
aircraft and providing related support services.
• Information, Space, and Defense Systems (ISDS) which include RnD, production &
support of military aaircraft, helicopters, and missile systems.

Table 7.6: Estimating Unlevered Betas for Boeing's Business Areas

Segment Revenues Estimated Value Unlevered Beta Segment Weight Weighted Beta
Commercial Aircraft $26,929 30,160.48 0.91 70.39% 0.6405
ISDS 18,125 12,687.50 0.80 29.61 0.2369
Firm 42,848 100.00 0.88
Estimating Bottom-up Betas for Boeing

The equity beta can be estimated using the current financial leverage for Boeing as a
firm. To determine equity beta, let’s combine the market value of equity of $32.60
billion & the value of debt of $8.2 billion, and use a 35% tax rate for the firm.
 
Equity Beta for Boeing = 0.88 [1 + (1-0.35)()] = 1.014

This is not that different from the historical beta of 0.96 obtained from regression, but
much truer reflection of the risk in Boeing.
Estimating Bottom-up Betas for InfoSoft
 Historical regression beta cannot be used since InfoSoft doesn’t have a history of
past prices
 To estimate Boeing’s beta, bottom-up approach is used by obtaining the betas and
debt/equity ratios for publicly traded software firms.
Table 7.7: Betas and Leverage of Publicly Traded Software Firms

Grouping Number of Firms Beta D/E Ratio Unlevered Beta

All Software Firms 264 1.45 3.70% 1.42
Small-cap Software Firms 125 1.54 10.12 1.45
Entertainment Software Firms 31 1.50 7.09 1.43

• The D/E ratios are market value D/E ratios

• The unlevered betas are similar for all three groups
• Since smaller firms tend to have higher operating leverage, firm size may have
indirect effect on betas
Estimating Bottom-up Betas for InfoSoft

 Unlevered Beta = 1.43, and Marginal tax-rate = 42%

Bottom-up Beta for InfoSoft = 1.43 [1 + (1-0.42)(0.0709)] = 1.49

Bottom-up betas are far more precise than simple regression betas because they’re
calculated by averaging across a large number of regression betas. The average
reduces standard error of the estimate. The bottom-up process of estimating betas
provides a solution when firms go through a major restructuring that changes both
their business mix and leverage. In these cases regression betas are misleading for
they don’t fully reflect the effect of these changes.
Beta of a Firm after an Acquisition:
Boeing and McDonnell Douglas
At time of acquisition, the two firms had following market values and betas:
Company Beta Debt Equity Firm Value
Boeing 0.95 $3,980 $32,438 $36,418
McDonnell Douglas 0.90 2,143 12,555 14,698

Considering tax rate = 35%,

 
Boeing’s unlevered beta = = 0.88

 
McDonnell Douglas unlevered beta = = 0.81

 
Unlevered beta for combined firm = 0.88 + 0.81 = 0.86
Beta of a Firm after an Acquisition:
Boeing and McDonnell Douglas
The acquisition was accomplished by issuing new stock in Boeing to cover the value
of McDonnell Douglas’ equity. No new debt was used to finance the deal.
Debt = McDonnell Douglas Old Debt + Boeing’s Old Debt
= $3,980 + $2,143 = $6,123 million
Equity = Boeing’s Old Equity + New Equity used for Acquisition
= $32,438 + $12,555 = $44,993 million
 
D/E Ratio = = 13.61%

The D/E ratio cumulated with the new unlevered beta for the combined firm yields

New beta = 0.86 [1 + 0.65(0.1361)] = 0.94

Estimating Accounting Betas – InfoSoft
Table 7.8: Earnings changes for InfoSoft and for S&P 500a

Period InfoSoft S&P 500 Period InfoSoft S&P 500

1992:Q1 7.50% -1.30% 1995:Q2 24.10% 8.50%
1992:Q2 8.30 2.20 1995:Q3 17.50 6.00
1992:Q3 8.80 2.50 1995:Q4 16.00 5.00
1992:Q4 7.90 3.00 1996:Q1 27.00 8.10
1993:Q1 14.30 3.60 1996:Q2 21.30 7.00
1993:Q2 16.50 5.10 1996:Q3 22.50 7.20
1993:Q3 17.10 5.50 1996:Q4 20.00 6.00
1993:Q4 13.50 6.20 1997:Q1 17.10 5.80
1994:Q1 11.50 4.30 1997:Q2 22.20 8.00
1994:Q2 12.30 4.70 1997:Q3 17.80 6.10
1994:Q3 13.00 4.50 1997:Q4 14.50 4.50
1994:Q4 11.10 4.20 1998:Q1 8.50 1.30
1995:Q1 18.60 7.10 1998:Q2 3.50 -0.50

Regressing the changes in earnings at InfoSoft against changes in profits for the S&P 500 yields:

InfoSoft Earnings Change = 0.05 + 2.15 (S&P 500 Earnings Change)

Based on this regression, the beta for InfoSoft is 2.15.
Market, Bottom-up, & Accounting Betas: which to use

 Almost never use accounting betas.

 Using historical market betas is discouraged; because of the failures of local indices,
standard errors in beta estimation, and inability of regressions to reflect the effects of major
changes in business mix and financial risk.
 Bottom-up provides the best beta estimates because:
•They allow us to consider changes in business and financial mix before they occur
•They use average betas across large numbers of firms- less noisy than individual firm
betas
•They allow us to calculate betas by area of business for a firm, useful both in the context of
investment analysis and valuation
Estimating the Cost of Equity
Either historical, fundamental, or accounting betas

Rate on a long-term govt. bond

Either historical or implied premium

Expected Return = Riskless Rate + Beta x Expected Risk Premium

In an arbitrage pricing and multifactor model,

Beta relative to factor j
 
Expected Return = Riskless Rate + (Risk Premium)

Risk premium relative to factor j

Estimating the Cost of Equity
Table 7.9: Cost of Equity Calculations

Boeing The Home Depot InfoSoft

Bottom-up Unlevered Beta 0.88 0.86 1.43
Bottom-up Beta 1.014 0.869 1.489
Riskless Rate 5.00% 5.00% 5.00%
Risk Premium 5.50% 5.50% 5.50%
Cost of Equity 10.58% 9.78% 13.19%

In estimating cost of equity using the CAPM, fundamental betas are used for they
best reflect the true riskiness of these firms.
Risk, Cost of Equity, and Private Firms
Three ways to estimate cost of equity for a private firm with undiversified owners:
1. Assume that the business is run with the near-term objective of selling to a large
publicly traded firm or making an initial public offering. Then it’s reasonable to use
the market beta to find cost of equity
2. Add a premium to the cost of equity to reflect the higher risk created by the
owner’s inability to diversify
3. Adjust the beta to reflect total risk rather than market risk
 
Total Beta =

R squared of the regression measures the market risk.

Calculating the Cost of Debt

Cost of Debt is determined by the following variables:

1. The current level of interest rates: As the level of interest rates increases, the cost of
debt for firms will also increase.
2. The default risk of the company: As the default risk of a firm increases, the cost of
borrowing money will also increase.
3. The tax advantage associated with debt: since interest is tax deductible, the after-tax
cost of debt is a function of the tax rate.

After-tax cost of debt = Pre-tax cost of debt (1 - tax rate)

Calculating the Cost of Debt

Many firms have bonds outstanding that don’t trade on a regular basis. Since these
firms are usually rated, their costs of debt can be estimated by using their ratings and
associated default spreads.
When no rating is available, there are two alternatives:
1. Evaluate Recent Borrowing History: By looking at the most recent borrowings
made by a firm, default spreads can be sensed & used to find cost of debt.
2. Estimate a synthetic rating: Synthetic rating is the rating assigned to a firm based
on its financial ratios.
Calculating the Cost of Debt
Table 7.10: Interest Coverage Ratios and Ratings

Interest Coverage Ratio Rating

>12.5 AAA
9.50 - 12.50 AA
7.50 - 9.50 A+
6.00 - 7.50 A
4.50 - 6.00 A-
3.50 - 4.50 BBB
3.00 - 3.50 BB
2.50 - 3.00 B+
2.00 - 2.50 B
1.50 - 2.00 B-
1.25 - 1.50 CCC
0.80 - 1.25 CC
0.50 - 0.80 C
<0.65 D

InfoSoft, which is a non-rated private firm, has an interest coverage ratio of 6.15 . So,
rating ‘A’ would be assessed for this firm.
Estimating The Cost of Debt
Let’s estimate the cost of debt for three firms- Boeing, The Home Depot & InfoSoft.
• For Boeing and The Home Depot, Current Bond Ratings approach is used, to
arrive at market interest rates at which they can borrow.
• For InfoSoft, a cost of debt is estimated based on a synthetic rating for the farm,
which will be employed to arrive at a cost of debt.
Table 7.11: Cost of Debt Calculations

Boeing The Home InfoSoft

Bond Rating AA A+ A
Default Spread Over 0.50% 0.80% 1.00%
Market Interest Rate 5.50% 5.80% 6.00%
Marginal Tax Rate 35% 35% 42%
Cost of Debt 3.58% 3.77% 3.48%

The after-tax cost of debt is significantly lower than the cost of equity for all the companies.
Calculating The Cost of Hybrid Securities
 

• Hybrid securities (preferred stock, convertible bonds) share characteristics

with both debt and equity.
Preferred Stock
– Characteristics of debt: the preferred dividend is prespecified at the time of the
issue and is paid out before common dividend
– Characteristics of equity: payments of preferred dividends aren’t tax deductible

Kp =

 Assumptions: Dividend is constant in $ terms forever, and preferred stock has no

special features.
 Preferred stock is safer than common equity.
Calculating The Cost of Preferred Stock: General Motors Co.
 

In March 1995, GM had preferred stock that paid a dividend of $2.28 annually &
traded at $26.38 per share.

Cost of Preferred Stock =

=
= 8.64%

GM’s cost of equity using the CAPM was 13% its pre-tax cost of debt was 8.25%, &
its after-tax cost of debt was 5.28%.
Calculating The Cost of Hybrid Securities

Convertible Bonds
‒ Can be converted into equities, at the option of the bondholder.
‒ Can be viewed as a combination of a straight bond (debt) & a
conversion option (equity).
 Breaking down a Convertible Bond into Debt & Equity Components:
Amazon Inc.
• Convertible bonds were issued with 4.75% coupon rate, and a 10-year maturity
• Would’ve had to pay 11% if issued straight bonds
• Bonds were issued at 98% of par
• Total par value of convertible bond issue $1.25 billion
Straight Bond Component = Value of a straight 4.75% coupon bond due in 10 years with a 11%
interest rate
= $636 (assuming semiannual coupons)
Conversion Option = $980-$636 = $344

• The straight bond component of $636 is treated as debt with the same cost as rest of
debt
• The conversion option of $344 is treated as equity with the same cost as other equity
issued by the firm
• For the entire bond issue of $1.25 billion, value of debt is $795 million, & value of
equity is $430 million
Calculating the Weights of Debt and Equity Components
Market Value versus Book Value Weights
Three standard arguments are made against using market value, none is convincing.
• “Book value is more reliable than market value because it isn’t as volatile”

Market value, with its volatility, is a much better reflection of true value than its
book value.
• “Using book value rather than market value is a more conservative approach to
estimating debt ratios”
Even if the market value debt ratios are lower than the book value ratios, the cost
of capital calculated using book value ratios will be lower than that of market value
ratios, making them less conservative estimates.
• “Lenders won’t lend on the basis of market value”
Lenders do lend on basis of market value. Like taking a second mortgage on a
house by its owner, that has appreciated in value.
Estimating The Market Values of Equity and Debt
 

The market value of equity is generally the number of shares outstanding times the
current stock price.

The market value of debt is difficult to obtain directly, since very few firms have all
their debt in the form of bonds outstanding trading in the market.

For example: The market value of $1 billion in debt, with interest expenses of $60
million and a maturity of six years, when the current cost of debt is 7.5%, can be
estimated as follows:

Estimated Market Value of Debt = 60 [] + = $930

Determining Estimated Market Value of Debt for Boeing
 

Book value of debt = $6972 million, interest expense on the debt = $453 million, average
maturity of the debt = 13.76 years, pre-tax cost of debt = 5.50%
Estimated MV of Boeing Debt = 453 [] + = $7,631
 Add present value of rental commitments over next five years, with the cost of debt of
5.50% used as discount rate.
Table 7.12: Debt Value of Operating Leases: Boeing

Year Commitment Present Value at 5.5%

1 $205 $194.31
2 167 150.04
3 120 102.19
4 86 69.42
5 61 46.67
$562.64

The cumulative market value of debt for Boeing is $8,194 million.

Determining Estimated Market Value of Debt for The Home Depot
 

Book value of debt = $1580 million, interest expense on the debt = $37 million, average
maturity of the debt = 3 years, pre-tax cost of debt = 5.80%
Estimated MV of Boeing Debt = 37 [] + = $1,433
 Add book value of debt and present value of operating lease commitments in the
financial statements. Pre-tax cost of debt of 5.80% is used as discount rate.

Table 7.13: Debt Value of Operating Leases: The Home Depot

Year Operating Lease Expense Present Value

1 $294 $277.88
2 291 259.97
3 264 222.92
4 245 195.53
5 236 178.03
Yr 6-15 2700 1513.37
PV of Operating Lease Expense $2,647.70
The cumulative market value of debt for The Home Depot is $4,081 million.
Determining Estimated Market Value of Debt for InfoSoft

InfoSoft’s book debt of $4.5 million has an estimated market value of $4583 million,
since the book cost of debt of 7% is higher than the market interest rate for the firm
of 6%; the debt is two-year debt.
Table 7.14: Comparison of Book Value and Market Value Debt Ratios

Boeing The Home Depot InfoSoft

(in millions) (in millions) (in '000s)
Book Value of Equity $12,953 $5,955 $3.5
Book Value of Debt $6,854 $1,311 $4.5
Book Value Debt/Equity 52.91% 20.97% 128.57%
Book Value Debt/(Debt + Equity) 34.60% 17.34% 56.25%
Market Value of Equity $32,595 $85,668 NA
Estimated Market Value of Debt $8,194 $4,081 $4,583
Debt/Equity 25.14% 4.76% 7.09%
Debt/(Debt + Equity) 20.09% 4.55% 6.62%
Estimating The Cost of Capital
 

 Cost of Capital is the weighted average of each of these three components:

• Cost of Equity (ke) reflects the riskiness of the equity investment in the firm
• After-tax Cost of Debt (kd) is a function of the default risk of the firm
• Cost of Preferred Stock (kps) is a function of its intermediate standing in terms of risk
between debt and equity.

If E, D, & PS are the market values of equity, debt, and preferred stock, respectively,
then

Cost of Capital = ke() + kd() + kps (

Table 7.15: Cost of Capital Calculation

Boeing The Home Depot InfoSoft

Cost of Equity 10.58% 9.78% 13.19%
Equity/(Debt + Equity) 79.91 95.45 93.38
Cost of Debt 3.58 3.77 3.48
Debt/(Debt + Equity) 20.09 4.55 6.62
Cost of Capital 9.17 9.51 12.55