slides sesshhion 18

8/10/2019 Slides Sesshhion 18

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GMP 14-15: Financial ManagementSession 18

Uday Damodaran XLRI Jamshedpur

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Session 18

Beta: Fundamental Drivers;Leverage, Asset Beta and Equity Beta


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Analyzing Risk, Going Deeper


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Beta, and Risk Premium

We said that desired rate of return is a function of risk andthat an index of the relevant risk (systematic risk) is beta.And how did we go around measuring it?


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Beta

How did we go around measuring it?What about the beta for hundreds of businesses whosestocks are not listed?

Take betas of similar companies?

Instead let us try and look at the concept of risk (and beta)in a non-numerical, analytical manner


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Aswath Damodaran

There are three approaches available for estimating theseparameters. The first is to use historical data on market pricesfor individual investments . The second is to estimate thebetas from the fundamental characteristics of the investment.

The third is to use accounting data.


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Risk Analytics

Let us look at firm risk in a more analytical wayWhich, according to you, are the most risky sectors,companies?What are the major sources of risk?


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Risk: Sensitivity of Sales to Changes in the Economy

Economy

TOP LINE


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Ud D d


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Firm 1 Firm 2 Firm 1 Firm 2 Firm 1 Firm 2

Base Base ( I) (I) (II) (II)

SALES 100 100 200 200 50 50

VAR. COST 80 40 160 80 40 20FIXED COST 10 50 10 50 10 50

EBIT 10 10 30 70 0 -20

CASE (I): 100% increase in sales

CASE (II): 50% decrease in sales

Degree of Operating Leverage

Ud D d


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Which industries might be the..

Diciest?Sir Richard Charles Nicholas Branson, and..

A recession is when you have to tighten your belt;depression is when you have no belt to tighten. When you

have lost your trousers, youre in the airline business Sir Adam Thomson, founder and chairman of BritishCaledonian Airlines


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Uday Damodaran


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FIRM 1 FIRM 2

DOL 3 1.5

Sales Stable, Very Volatile, VeryPredictable Unpredictable

For which firm is EBIT more volatile?

Business Risk

Uday Damodaran


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Business Risk

Therefore:

Business Risk (Variability in EBIT):

Function of DOL, Variability in Q + Noise

Uday Damodaran


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Risk: 2. Matter of Choice

Economy

TOP LINE

EBIT

Variability in Q

DOL

+ Noise!!

Uday Damodaran


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Connecting things

EBIT

Function ofcyclicality, DOL

Function ofQ, Cost

Structure

Uday Damodaran


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Business Risk

Therefore:

Business Risk (Variability in EBIT):

Function of DOL, Variability in Q + Noise

So, how do you lower business risk?

Uday Damodaran


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Risk: 3. Capital Structure!

Economy

TOP LINE

EBIT

PAT

Uday Damodaran


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Firm 1 Firm 2 Firm 1 Firm 2 Firm 1 Firm 2

Base Base ( I) (I) (II) (II)

SALES 100 100 200 200 50 50

VAR. COST 70 70 140 140 35 35

FIXED COST 10 10 10 10 10 10EBIT 20 20 50 50 5 5

INTEREST 5 15 5 15 5 15

PBT 15 5 45 35 0 -10

Tax 7.5 2.5 22.5 17.5 0 -5

PAT 7.5 2.5 22.5 17.5 0 -5

EPS 0.5 0.5 1.5 3.5 0 -1

Degree of Financial Leverage

Uday Damodaran


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Structural Risk

Economy

TOP LINE

BOTTOM LINE

? EBIT

Proxy?

Proxy?

Uday Damodaran


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And thus.

(Aswath Damodaran)the levered beta , which is also the betafor an equity investment in a firm or the equity beta , isdetermined both by the riskiness of the business it operatesin and by the amount of financial leverage it has taken on

Uday Damodaran


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Capital Budgeting and Risk

Cost of equity f(Beta equity )

Beta equity f(Cyclicality, Operating Leverage, FinancialLeverage)

Cost of capital f(Betaasset

)

Beta assets f(Cyclicality, Operating Leverage)

Got it?


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Uday Damodaran


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y XLRI Jamshedpur

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Relationship between beta levered and beta unlevered

L = u (1 + D/E )

Got it?

Uday Damodaran


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y XLRI Jamshedpur

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Bottom Up Betas

Estimate betas for comparable firms; compute average betaand average leverageUn-lever the average beta by taking the average levered betaand using average financial leverage

Compute the bottom up unlevered beta for the firm by taking aweighted average of the unlevered betas for the businessesthat the firm operates inCompute the leveraged beta for the firm using its financialleverage

Lowers standard error [to s .e / sqrt(n)]!

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