CHAPTER 6

BETA ESTIMATION AND THE COST OF EQUITY

Q.1.
A.1.

What is beta? How is it measured? What are the problems in beta estimation?
Beta is the measure of systematic risk and it is the ratio of covariance between
market return and the securitys return to the market return variance:
cov ar j, m
j =
2m

j m cor j, m
m m

j
m

cor j, m

Beta is also calculated by the market or index model. In the market model,
we regress returns on a security against returns of the market index. The market
model is given by the following regression equation:
R j = + jRm + ej
where Rj is the expected return on security j, Rm is the expected market
return, is intercept, j is slope of the regression and ej is the error term (with a
zero mean and constant standard deviation). The slope, j, of the regression
measures the variability of the securitys returns relative to the market returns and
it is the securitys beta
Problems in Beta Estimation: In practice, the market portfolio is
approximated by a well-diversified share price index. We have several price
indices available in India. Notice that these indices include only shares of
companies. In theory, the market portfolio should include all risky assets shares,
bonds, gold, silver, real estate, art objects
In computing beta by regression, we need data on returns on market index
and the security for which beta is estimated over a period of time. There is no
theoretically determined time period and time intervals for calculating beta. The
time period and the time interval may vary. The returns maybe measured on a
daily, weekly or monthly basis. One should have sufficient number of
observations over a reasonable length of time.
The return on a share and market index may be calculated as total return;
that is, dividend yield plus capital gain. In practice, one may use capital gains/loss
or price returns [i.e. Pt/Pt-1 1] rather total returns to estimate beta of a
companys share. A further modification may be made in calculating the return.
One may calculate the compounded rate of return.
Q.2.
A.2.

Do betas remain stable over time? What problem is posed by the instability of the
beta?
Betas may not remain stable for a company over time even if a company stays in
the same industry. There could be several reasons for this. Over time, a company
may witness changes in its product mix, technology, competition or market share.
In India, many industrial sectors are witnessing changes in competition and

market composition due to the government policy of reforms and deregulation.

This is expected to affect the betas of many companies.
Beta is an important component in the calculation of the cost of capital,
which is used as a discount rate in valuing assets and securities Instability of beta
will cause problem in determining a discount rate which is consistent over the life
of an asset.
Q.3.
A.3.

How do you calculate the cost of equity using the CAPM framework?
From the firms point of view, the expected rate of return from a security of
equivalent risk is the cost of equity. The expected rate of return or the cost of
equity in CAPM is given by the following equation:
R j = k e = R f + (R m R f ) j
We need the following information to estimate a firms cost of equity:
1. The risk-free rate,
2. The market premium and
3. The beta of the firms share

Q.4.
A.4.

What factors influence the beta of a share? Explain.

Beta depends on three fundamental factors:
1. The nature of business: If a firms earnings are more sensitive to business
conditions, it is likely to have higher beta.
2. The operating leverage: The degree of operating leverage is defined as the
change in a companys earnings before interest and tax due to change in
sales. Companies with higher degree of operating leverage have high
betas.
3. The financial leverage: Financial leverage refers to debt in a firms capital
structure. Since financial leverage increases the firms (financial) risk, it
will increase the equity beta of the firm.