A firm’s beta is used to estimate its required return on equity. Beta is a measure of risk; riskier firms will have higher betas, whereas less risker firms will have lower betas. Beta is estimated by regressing a stock’s returns with overall market returns.
At times, we need to estimate the beta for a project or a company that is not publicly traded. In this case we use the pure-play method.
This method has three steps:
Step 1: Shortlist comparable publicly traded companies.
Step 2: Derive unlevered beta or comparable asset beta for the project using comparable company’s D/E and tax rates:
Step3: Get the equity levered beta for the project using project specific D/E and tax rate:
AA Corp. is a large conglomerate and wants to determine the equity beta of its food division. This division has a D/E ratio of 0.7. The tax rate is 40%. A comparable publicly traded food company has an equity beta of 1.2 and a D/E ratio of 0.5. What is the equity beta of AA’s food division?
Using the pure play method, we can calculate the equity beta of AA’s food division as:
Inference: Since AA’s food division has more debt than the publicly traded company, it is riskier and has a higher beta value.
The general assumption so far has been that an investor is investing in a developed country. But what happens when an investor invests in emerging economies? Here the CAPM is modified to adjust for additional risk in a developing market by adding country risk premium (CRP) to market risk premium.
The country risk premium is computed as:
Country ERP = Sovereign yield spread *
Annualized standard deviation of equity index
= Annualized standard deviation of the sovereign bond market in terms of the developed market currency
For example, assume you are a U.S. based investor investing in Indian securities. The risk-free rate is 3% and the beta for a stock is 1.5. The market risk premium is 6% and CRP for India is 3%. The cost of equity is 3 + 1.5[6+3] = 16.5%.