Course notes MGT339 - Class 1.doc

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University of Toronto Mississauga
Louis Florence

Class 1 • Calculating beta in practice… (to be done in class) note that this method only works for publicly traded firms! • Determinants of beta • Cyclicality of revenues Is that the same as variability? We can find the expected return on the financial asset (a stock) using the CAPM. We need to know the risk free rate, the market risk premium and the beta of the stock. If a risky project has the same risk profile as the all-equity company undertaking the project, and the company is publicly traded, we can use the company beta and CAPM to calculate the cost of equity capital for the company and for the project. Suppose the firm is considering undertaking a project whose risk level is different from the firm overall, and we wish to estimate the project beta, so that we can calculate the project cost of equity capital. We can try to find a (traded) financial asset with the same level of risk as the project, and use the financial asset’s beta to calculate its cost of capital, which would be the right discount rate to discount the expected cash flows from the project the firm is considering. The same approach would work to determine the cost of capital of an all- equity financed private firm. The presence of debt will make the story more complicated, as we shall see later. What is operating leverage? Does operating leverage affect beta? What is financial leverage? Does financial leverage affect beta? Operating Leverage example - in class exercise! Imagine two identical companies, A and B, with expected monthly sales of $200,000, except that A has monthly fixed costs of $80,000 and variable expenses equal 50% of revenue while B has monthly fixed costs of $20,000 and variable expenses equal to 80% of revenue. Find the profit for A and B if revenue is i) $200,000, ii) $260,000, iii) $140,000. Monthly Profit for A Profit for B Revenue $200,000 20,000 20,000 $260,000 50,000 32,000 $140,000 -10,000 8,000 Conclusion: Clearly A is more risky than B – gives more uncertain profits. 1 Financial leverage example Consider buying a house for $600,000, which you expect to be worth either 10% more, or 10% less in 1 year. Imagine 2 scenarios. In the first scenario, you pay for the house with $600,000 of your own $$. In the second scenario you borrow $500,000 from the bank and use only $100,000 of your own SS. In which case is your own equity more risky. Conclusion: leveraged equity is more risky than unleveraged equity. We want to distinguish between asset beta and equity beta. If a firm is entirely equity financed, β = β asset equity If a firm is partly f
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