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Lecture 9

FINC-212 Lecture Notes - Lecture 9: Operating Leverage, Weighted Arithmetic Mean, Fixed Cost

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Kate Waldock

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Determinants of Beta
- Product Type
o Industry Effects: The beta depends on the sensitivity of demand for its
products/services, and of its costs to macroeconomic factors
Cyclical companies have higher betas than non-cyclical firms
Firms that sell more discretionary products have higher betas
- Operating Leverage
o Higher operating leverage results in greater earnings variability, which results in
higher betas
o Fixed Costs Measure = Fixed Costs / Variable Costs
Measures the relationship between fixed and variable costs
The higher the proportion, the higher the operating leverage
o EBIT Variability Measure = % Change in EBIT / % Change in Revenues
Measures how quickly EBIT changes as revenue changes
The higher the number, the greater the operating leverage
- Financial Leverage
o More financial leverage means higher fixed costs, which makes their earnings to
equity investors more volatile increases earnings volatility, increasing beta
o 𝛽L = 𝛽U [1+ ((1-t)D/E)]
𝛽L = Levered or Equity Beta
𝛽U = Unlevered or Asset Beta
Qualities of Beta
- Beta of a Portfolio is always the market-value weighted average of the betas of the
individual investments in that portfolio
o The beta of a mutual fund is the weighted average of the betas of the stocks and
other investments in that portfolio
o The beta of a firm after a merger is the market-value weighted average of the
betas of the companies involved in the merger
- Firm Beta vs. Divisional Beta
o A firm’s beta is the weighted average of its division’s betas
o Divisional betas are weighted averages of its individual project’s betas
- Bottom-up vs. Top-down Beta
o Top-down beta for a firm comes from regression
o Bottom-up beta can be estimated by doing the following
Find out the businesses that a firm operates in
Find the unlevered betas of the other firms in these businesses
(remove the effects of cash on the beta)
Take the average (or median) beta
Lever up using the firm’s D/E ratio
o Bottom-up beta is more accurate because
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