Levered Beta

3 Key excerpts on "Levered Beta"

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  Investment Valuation

  Tools and Techniques for Determining the Value of any Asset, University Edition

  • Aswath Damodaran(Author)
  • 2012(Publication Date)
  • Wiley

    (Publisher)

  Controlling for differences. In essence, when we use betas from comparable firms, we are assuming that all firms in the business are equally exposed to business risk and have similar operating leverage. Note that the process of levering and unlevering of betas allows us to control for differences in financial leverage. If there are significant differences in operating leverage—cost structure—across companies, the differences in operating leverage can be controlled for as well. This would require estimation of a business beta, where the effects of operating leverage are taken out from the unLevered Beta:

  Note the similarity to the adjustment for financial leverage; the only difference is that both fixed and variable costs are eligible for the tax deduction, and the tax rate is therefore no longer a factor. The business beta can then be relevered to reflect the differences in operating leverage across firms.

  CASH AND BETAS

  In the process for estimating bottom up betas, we suggested a two step process: getting a weighted average of the betas of the businesses that a firm is in, using the sector-average betas of other publicly traded firms in each business and then adjusting for the debt to equity ratio of the firm in question.

  In making these adjustments, though, we have to deal that a firm may have a significant portion of its assets as cash. Since cash is usually invested in close to riskless, liquid investments, it should have a beta of zero. So, how does cash enter the computation? It does so in two places. When we computed the sector-average beta, we suggesting unlevering the average regression beta for the sector, using the average debt to equity ratio and marginal tax rate for the sector. Thus, with an average Levered Beta of 1.30, an average debt to equity ratio of 50% and an average tax rate of 40%, we estimate a sector-average unLevered Beta of 1.00 for the entertainment business:

  However, this is the unLevered Beta for companies in this business and these companies will generally have some of these value in cash balances. Assume, for instance, that the average cash balance of entertainment firms in the sector is 10%. The unLevered Beta for the entertainment business alone can then be computed as follows:

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  eBook - ePub

  Risk-Based Investment Management in Practice

  • Frances Cowell(Author)
  • 2013(Publication Date)
  • Palgrave Macmillan

    (Publisher)

  A popular measure of leverage is to compare the face value of the investments with the underlying amount invested. This captures leverage due to borrowing, but ignores the effects of uncovered derivatives positions and investments in geared and high beta or high duration assets. Its measure is often used to compare the portfolio’s leverage to the limits defined by the investment mandate or applicable regulation. Limits expressed this way have the big disadvantage that they are easy to circumvent.

  Borrowing is relatively easy to measure, but derivative exposure often isn’t, especially if long and short positions offset only approximately (for example a five-year bond future versus a shorter two-year bond future); call versus put options, and so on. Capturing the underlying gearing in individual assets can be even trickier.

  A robust measure is to take direct account of the portfolio’s exposure to its market by measuring its beta to the risky asset in question, such as the equity market, for an equity portfolio; or duration relative to some comparator bond, such as a ten-year government issue, for a bond portfolio. This approach can capture all sources of leverage and can be measured using publicly available information such as past asset prices and bond terms and conditions. It cannot easily be circumvented.

  While beta to the market is the most robust means of gauging the leverage of an equity portfolio, it is not fool-proof. Betas are estimates that depend on the sample data from which they are computed. Yet, while an error is almost inevitable, it is usually small compared to the systematic error that often biases the face-value measure of leverage.

  Currency exposure

  Estimates of portfolio exposure to currency fluctuations are used to calculate the amount needed to hedge the portfolio back to its base currency. Currency exposure is usually given by the sum of the face value of assets denominated in each currency. But this confounds the sum of portfolio weights in assets denominated in a particular currency with the portfolio’s exposure to the currency. To see why, consider Toyota, a Japanese carmaker. The face value method tells us that Toyota has exposure to the Japanese Yen and to no other currency. Yet casual observation contradicts this, as the vast majority of its sales and a large proportion of its manufacturing takes place outside Japan. Nestlé, which is exposed to fluctuations in currencies other than the Swiss Franc, is a similar example, as are many other firms.

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  eBook - PDF

  Introduction to Finance

  Markets, Investments, and Financial Management

  • Ronald W. Melicher, Edgar A. Norton(Authors)
  • 2020(Publication Date)
  • Wiley

    (Publisher)

  How to estimate a stock’s beta is the topic of this chapter’s Learning Extension. DISCUSSION QUESTION 3 Do you think there might be a relationship between a stock’s total risk and its systematic risk? Why or why not? Select two firms from Table 12.8 and explain why you believe there is a difference (or similarity) between their beta values. • Institutions and Markets Banks, brokerages, pension funds, insurance companies, and financial institutions of all types evaluate expected return, risk, and portfolios for their own and their clients’ invest- ments. Markets transmit perceived changes in asset risk and expected return through changes in security prices. • Investments The trade-off between risk and expected return is a foundational concept in finance, cutting across markets, investments, and financial management. Knowing how to compute and evaluate return and risk and knowing the important role that correlations play can help investors put together well- diversified portfolios. • Financial Management Actions by investors affect a firm’s stock price and the market interest rates on its bonds. Price changes relative to competing firms and the overall market inform management how inves- tors view their actions. Financial risk and return concepts are among the most mathematical and confusing to the first-time finance student, but they are vital to understanding financial markets, institutions, and management. Much of mod- ern investment analysis, portfolio management, and corporate finance is based upon the topics introduced in this chapter. LO 12.1 Historical returns are computed from past income cash flows and price changes. We can use returns measured over periods of time to compute an average return. LO 12.2 Once we have determined the average return we can compute measures of risk, such as variance, standard deviation, and the coeffi- cient of variation.

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