# Determinants of Beta and WACC

1774 WordsJan 13, 20118 Pages
Chapter 12 – Determinants of Beta and WACC [pic] Ct is not known for certain. It is a random variable. It has a probability distribution with a mean and standard deviation. Ct = E(Ct) = expected cash flow “r” is the appropriate cost of capital. It should have the same riskiness as Ct If Ct is a normal extension of the firm’s operations, and the firm is entirely equity financed, we use the stockholders’ required return as found through the CAPM for the appropriate value of ‘r’. E(Ri) = Rf + (i (Rm – Rf) Remember: the Beta of security i is the standardized covariance of its returns with the returns on the market portfolio. (i = Covi,Mkt (2Mkt Determinants of Beta 1. Cyclicality of revenues – How…show more content…
If we want to include the fact that interest payments are tax-deductable to the corporation, we need to modify the Hamada Equation as follows: (Equity = [pic] When we add taxes, the computations become a bit more complex, but the principles remain the same. Example: Reese’s Pieces Corp. has a capital structure of 80% equity and 20% debt. It is not taxed. If you do an analysis of its returns vs. the market’s returns for the past five years, you will find that its beta is 0.75. This is the observable (Equity Suppose the risk-free rate is currently 3% and the market risk-premium is 5.7%. What is the required return of investors? According to the CAPM: E(RRP) = 3% + 0.75 (5.7%) = 7.275% Now, suppose that Reese’s is considering taking on additional debt that will change its capital structure to 60% equity and 40% debt. How will that change investors’ required rate of return? For simplicity, let’s assume that the Beta of Reese’s debt is zero. First calculate Reese’s Pieces’ unlevered beta ((Asset ): (Equity = [pic] (Asset = ((Equity) / [pic] = (0.75) / (1 + .2/.8) = (0.6) Next, ‘relever’ the firm with the new level of debt. (Equity = [pic] = 0.6 (1 + .4/.6) = 0.6 (1.6667) = 1.0 With a new beta of 1.0, the CAPM says investors require a return of: E(RRP) = 3% + 1 (5.7%) = 8.7% Weighted-Average Cost of Capital - WACC - The expected return on a