Beta for a project?

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dejavu

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Since the Beta of a project is levered according to the debt-equity ratio of a company, what happens when a debenture holder or preference shareholder converts the securities he/she is holding into common stock? Will Beta have to be re-levered again?
Also, I understand that Beta of a stock gives an idea about its voltality with respect to a benchmark (index), but what exactly is beta for a project?
Also, it is written in this article: https://konvexity.wordpress.com/2013/01/11/importance-of-project-beta/

“Higher is the proportion of debt in the capital structure, the higher is the beta of the company”

How does more debt mean a higher beta?

Thanks in advance
 
dejavu wrote:Since the Beta of a project is levered according to the debt-equity ratio of a company, what happens when a debenture holder or preference shareholder converts the securities he/she is holding into common stock? Will Beta have to be re-levered again?
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Yes.
dejavu wrote:Also, I understand that Beta of a stock gives an idea about its voltality with respect to a benchmark (index), but what exactly is beta for a project?
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Beta’s not exactly volatility with respect to an index. (Look at this article I wrote on beta: http://financialexamhelp123.com/beta/)
The beta of a project is the same as the beta for a company’s stock: the expected change in the return of the project (i.e., the return to the equity holders of the project) given a change in the return of the market.
dejavu wrote:Also, it is written in this article: https://konvexity.wordpress.com/2013/01/11/importance-of-project-beta/
“Higher is the proportion of debt in the capital structure, the higher is the beta of the company”
How does more debt mean a higher beta?
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As I wrote above, beta measures the sensitivity of the returns to the project’s equity holders to a change in market returns. The greater the debt, the less the equity, so the greater the (percentage) change in equity return for a given change in asset return.
dejavu wrote:Thanks in advance
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You’re welcome in arrears.
 
Beta is not a volatility measure, it is a sensibility measure. Beta < 1 means equity returns less sensible changes than market returns changes (Note “changes” as a noun). Beta = 1 means exactly the same sensibility of returns (if market returns rise 5%, the stock returns rise 5%). Beta > 1, you can guess.
Higher debt ratio increases the risk of the project, so this scenario is reflected with a higher beta.
Beta is used in CAPM model, you can see there that the higher the beta, the higher the expected or required return on the stock / project.
 
Thanks for your reply. Nice and insightful article. A couple of more questions…
S2000magician wrote:
Beta’s not exactly volatility with respect to an index. (Look at this article I wrote on beta: http://financialexamhelp123.com/beta/)
The beta of a project is the same as the beta for a company’s stock: the expected change in the return of the project (i.e., the return to the equity holders of the project) given a change in the return of the market.
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When we look at a company’s stock, an Index represents (or acts as the proxy of) the market return (such as the S&P 500 in your article. But what is the market return with respect to a project? Surely we don’t compare the project’s returns to that of an index?
S2000magician wrote:
As I wrote above, beta measures the sensitivity of the returns to the project’s equity holders to a change in market returns. The greater the debt, the less the equity, so the greater the (percentage) change in equity return for a given change in asset return.
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Could you please illustrate this with a numerical example please? Also, what do you mean by a “project’s equity holders”? At any given time a company has multiple projects running simultaneously. In such a scenario, is the classification of equity shareholders on the basis of different projects possible? If so, how?
 
Also, in your article you have emphasized on the fact that Beta has to do with returns of the stock with respect to market returns and not the price of the stock.
Does this then, render this investopedia article inaccurate: http://www.investopedia.com/terms/b/beta.asp
 
You would compare a project to an index. Instead of taking a project a company could simply buy stocks (or more realistically return cash to shareholders and allow them to).
Unless a company can add some value by taking a project (positive NPV) they should simply take the cash they would have used for it and give it to shareholders.
All equity investors in a company are equity investors in a project.
simple numerical example (assume no taxes etc.). Asset value =200, debt= 100, equity=100
if the asset has a beta of 1, and the market increases by 50% the assets will be expected to be 300. With debt of 100 equity will be 200. Because of the debt the equity returns are greater than the asset returns
 
dejavu wrote:Also, in your article you have emphasized on the fact that Beta has to do with returns of the stock with respect to market returns and not the price of the stock.
Does this then, render this investopedia article inaccurate: http://www.investopedia.com/terms/b/beta.asp
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Yes; there is a lot in that article that is wrong.
DEFINITION of ‘Beta’
A measure of the volatility, or systematic risk, of the returns of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns.
Also known as “beta coefficient.”
INVESTOPEDIA EXPLAINS ‘Beta’
Beta is calculated using regression analysis, and you can think of beta as the tendency of a security’s returns to respond to swings in the market. A beta of 1 indicates that the security’s price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security’s price will be more volatile than the market. For example, if a stock’s beta is 1.2, it’s theoretically 20% more volatile than the market.
Many utilities stocks have a beta of less than 1. Conversely, most high-tech, Nasdaq-based stocks have a beta of greater than 1, offering the possibility of a higher rate of return, but also posing more risk.
 
dejavu wrote:Thanks for your reply. Nice and insightful article. A couple of more questions…
S2000magician wrote:Beta’s not exactly volatility with respect to an index. (Look at this article I wrote on beta: http://financialexamhelp123.com/beta/)
The beta of a project is the same as the beta for a company’s stock: the expected change in the return of the project (i.e., the return to the equity holders of the project) given a change in the return of the market.
Click to expand...
When we look at a company’s stock, an Index represents (or acts as the proxy of) the market return (such as the S&P 500 in your article. But what is the market return with respect to a project? Surely we don’t compare the project’s returns to that of an index?
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Why not? You’re comparing the risk of this project to the risk of some other investment the shareholders could make; why not a broad market index?
dejavu wrote:
S2000magician wrote:As I wrote above, beta measures the sensitivity of the returns to the project’s equity holders to a change in market returns. The greater the debt, the less the equity, so the greater the (percentage) change in equity return for a given change in asset return.
Click to expand...
Could you please illustrate this with a numerical example please?
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ROE = ROA × A/E
ΔROE = ΔROA × A/E
As debt increases, A/E increases, increasing ROE and increasing the volatility of ROE.
dejavu]
S2000magician[/I said:
wrote:Also, what do you mean by a “project’s equity holders”?
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The owners of the company: the shareholders.
dejavu]
S2000magician[/I said:
wrote:At any given time a company has multiple projects running simultaneously. In such a scenario, is the classification of equity shareholders on the basis of different projects possible?
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At any given time an investor will own several stocks: a portfolio; they’re an equity holder in each.
At any given time a company will be engaged in several projects: a portfolio: the company’s shareholders are equity holders in each project.
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Thank you for your reply… So from what I understand, the debt-equity ratios of projects should be such that they complement the debt-equity ratio of the company as a whole? Please correct me if I’m wrong.
Another doubt I have is regarding the asset beta.
The curriculum says that beta is unlevered to remove the effects of financial leverage (namely debt). Why then, is Beta (asset) equal to Beta(debt)*weight of debt + Beta(equity)*weight of equity?
Why is the debt component even part of the equation when Beta(asset) is supposed to be an indicator free from financial risk?
 
But why isn’t it taken as 0 in the formula derivation for Beta (asset)? If it were taken as 0, the tax component (1-t) wouldn’t be there in the final formula?
 
dejavu wrote:But why isn’t it taken as 0 in the formula derivation for Beta (asset)? If it were taken as 0, the tax component (1-t) wouldn’t be there in the final formula?
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Beta is risk premium moment you say beta is zero you are talking about risk free assets.
 
Dejavu,
I believe you are going with a conception of Beta is the “risk”…here answer is NO.
Because Beta is a factor which rewards the investor for taking risk in account hence the SML or Security Market Line go upwards with change in higher beta and vice versa…Higher beta higher reward and vice versa.
 
anandmishra453 wrote:
Dejavu,
I believe you are going with a conception of Beta is the “risk”…here answer is NO.
Because Beta is a factor which rewards the investor for taking risk in account hence the SML or Security Market Line go upwards with change in higher beta and vice versa…Higher beta higher reward and vice versa.
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Total risk can be decomposed into systematic risk and non-systematic risk. The first one is related to the macroeconomic risk or the risk of the market, and the other one is referred to the individual or specific risk of an investment. When you build a diversified portfolio the non-systematic risk is diluted to aproximately zero so the remainning amount of risk the the systematic one. Beta reflects that systematic risk, so indeed it measures risk.
 
Harrogath wrote:
Total risk can be decomposed into systematic risk and non-systematic risk. The first one is related to the macroeconomic risk or the risk of the market, and the other one is referred to the individual or specific risk of an investment. When you build a diversified portfolio the non-systematic risk is diluted to aproximately zero so the remainning amount of risk the the systematic one. Beta reflects that systematic risk, so indeed it measures risk.
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I came across a question in which a company increases its debt-equity ratio from 0.5 to 0.6 and the changes in asset and equity betas are asked.
I know the correct answer is that asset beta is not affected by debt-equity ratio, and only the equity beta will undergo an increase.
But if asset beta is NOT affected by leverage or debt, why is it equal to the sum of Beta (Debt) and Beta (Equity), i.e. Beta (asset) = Beta (debt) + Beta (equity)?
 
anandmishra453 wrote:Beta is risk premium moment you say beta is zero you are talking about risk free assets.
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This isn’t true.
Beta measures only systematic risk, not total risk. An asset with a zero beta can still have unsystematic risk.
 
dejavu wrote:
I came across a question in which a company increases its debt-equity ratio from 0.5 to 0.6 and the changes in asset and equity betas are asked.
I know the correct answer is that asset beta is not affected by debt-equity ratio, and only the equity beta will undergo an increase.
But if asset beta is NOT affected by leverage or debt, why is it equal to the sum of Beta (Debt) and Beta (Equity), i.e. Beta (asset) = Beta (debt) + Beta (equity)?
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Please resolve this doubt of mine.
I also have a doubt with this question:
Quote:
Company A has a debt equity ratio of 2.0. A is evaluating the cost of equity for a project in the same line of business as Company B and will use the pure-play method with B as the comparable firm. B has a beta of 1.2 and a debt equity ratio of 1.6. The project beta most likely:
a) Will be less than A’s Beta
b) Will be greater than A’s Beta
c) Could be greater or less than A’s Company Beta
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I guessed the correct option (c) but I only did so because there is a possibility that A and B are in entirely different tax brackets. Is there any other reason you could think why (c) is the correct answer?
 
The taxes are added because we assume that debt+equity=the value of the firm + the value of the fax benefit of debt
it’s called Hamada’s equation if you want to look up more on it
we don’t know company A’s beta, so we can’t say if the project beta is higher or lower
 
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