Beta, Leverage and the Cost of Capital

This note briefly discusses the versatile and widely-used technique of levering and
unlevering beta, which has many and varied applications in finance. The note addresses the
intuition and relevant mathematical expressions of this technique, and illustrates its
usefulness with a practical application focusing on Starbucks.

1. Introduction
Consider a company in which the CFO is debating the convenience of adding debt to
its capital structure. The CFO obviously knows the companys current cost of equity and may
be able to foresee, perhaps with the help of a rating agency, the companys cost of debt at the
new level of debt. The problem is that once the company adds debt to its capital structure, its
cost of equity will change. How can the CFO estimate the companys new cost of equity?
Consider a company with several divisions that do business in very different sectors
(think General Electric or Berkshire Hathaway). Besides knowing the companys overall cost
of equity, its CFO may also want to know the cost of equity for each different division. The
problem is that none of these divisions trade separately in the stock market, hence their
individual stock returns are not observed, and therefore their betas cannot be estimated in the
usual way. How can the CFO estimate the cost of equity for each division?
Finally, consider a private company for which the CFO wants to estimate the cost of
equity. The problem is that this companys equity does not trade on a public exchange, hence
(as in the previous case) its stock returns are not observed, and therefore its beta cannot be
estimated in the usual way. How can the CFO estimate the cost of equity for this private
company?

Note that the three problems just described are frequently encountered in practice.
Very often, companies consider changes in their capital structure, evaluate projects for
divisions with different levels of risk, and need to estimate a discount rate even if they do not
publicly trade on organized exchanges. Thus, CFOs routinely face questions like the three
mentioned above. The ultimate goal of this note is to discuss a technique that makes it
possible to answer all three questions.

2. A Very Brief Overview of the CAPM and the Cost of Capital

The Capital Asset Pricing Model (CAPM), one of the most widely used models in
finance,posits that the required return on a companys equity is an increasing function of risk,
where risk is measured by the companys beta. More precisely, the CAPM is given by the
expression:
RE = Rf + MRPB , [1]
where RE denotes the required return on a companys equity (or cost of equity), Rf
the risk-free rate, MRP the market risk premium, and B the beta of the companys equity. In
words, the CAPM states that the required return on a companys equity is a function of the
risk-free rate plus a risk premium, the latter given by the product of the market risk premium
and the beta of the companys equity.

3. A Closer Look at Beta

Besides being a measure of systematic risk, beta is also a measure of relative
volatility, capturing the reaction of a companys stock to fluctuations in the market. In this
regard, a useful reference value for beta is 1, which indicates that if the market goes up or
down by 1%, a stock with a beta of 1 also goes up or down, on average, by 1%.

A stock with a beta larger than 1 tends to amplify the markets fluctuations; that is, on
average it goes up or down by more than 1% when the market goes up or down by 1%. A
stock with a beta lower than 1, on the other hand, tends to mitigate the markets fluctuations;
that is, on average it goes up or down by less than 1% when the market goes up or down by
1%. Although negative betas are possible in theory, they are hardly ever observed in practice.
An interesting question to ask, and central to our discussion in this note, is: What are the
factors that determine whether beta is high or low? The short answer is that beta is largely
determined by two factors: business risk and financial risk. Business risk is determined by the
risk of the sector in which the company sells its products or services; a pharmaceutical
company, a retailer, and a bank are obviously businesses with very different risk profiles.
Financial risk, on the other hand, is determined by the companys level of
indebtedness, which can be measured by its debt ratio (debt divided by total capital) or its
debt-equity ratio (debt divided by equity).
Given our purposes in this note, we will consider the sector in which the company
sells its products or services as given; this is simply because our aim is to explore the impact
of leverage on a companys beta, risk, and required return. In other words, in order to focus
on financial risk, we will take the companys business risk as given.