Session 8: Expected returns and Costs of Equity

In this class, we looked past regression betas at how the choices companies make about the businesses they enter can determine their betas.. Summarizing the class, here is what we listed as the three determinants of betas:
1. Betas are determined in large part by the nature of your business. While I am not an expert on strategy, marketing or productions, decisions that you make in those disciplines can affect your beta. Thus, your decision to go for a price leader as opposed to a cost leader (I hope I am getting my erminology right) or build up a brand name has implications for your beta. As some of you probably realized today, the discussion about whether your product or service is discretionary is tied to the elasticity of its demand (an Econ 101 concept that turns out to have value)... Products and services with elastic demand should have higher betas than products with inelastic demand. And if you do get a chance, try to make that walk down Fifth Avenue...
2. Your cost structure matters. The more fixed costs you have as a firm, the more sensitive your operating income becomes to changes in your revenues.
3. Financial leverage: When you borrow money, you create a fixed cost (interest expenses) that makes your equity earnings more volatile. Thus, the equity beta in a safe business can be outlandishly high if has lots of debt. The levered beta equation we went through is a staple for this class and we will revisit it again and again. So, start getting comfortable with it.

If you remember, we looked at the beta for Disney after its acquisition of Cap Cities in the class. The first step was assessing the beta for Disney after the merger. That value is obtained by taking a weighted average of the unlevered betas of the two firms using firm values (not equity) as the weights. The resulting number was 1.026. The second step is looking at how the acquisition is funded. We looked at an all equity and a $10 billion debt issue in class and I left you with the question of what would happen if the acquisition were entirely funded with debt. (If you have not tried it yet, you should perhaps hold off on reading the rest of this email right now)
Debt after the merger = 615+3186 + 18500 = $22,301 million ( Disney has to borrow $18.5 billion to buy Cap Cities Equity and it assumes the debt that Cap Cities used to have before the acquisition)
Equity after the merger = $31,100 (Disney's equity does not change)
D/E Ratio = 22,301/31,100= 0.7171
Levered beta = 1.026 (1+ (1-.36) (0.7171)) = 1.497
Note that I used a marginal tax rate of 36% for both companies, which was the case in 1996.

Slides: https://nyu.box.com/s/nfah5jjpih77ma50itxab18px2kvap45
https://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/postclass/session8atest.pdf
Post class test solution: https://www.stern.nyu.edu/~adamodar/pdfiles/cfovhds/postclass/session8asoln.pdf Receive SMS online on sms24.me

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