Lecture 3

Question 1

What are the determinants of beta?

Answer 1

Determined by the inherent risks of firms:
* Business risk: cyclicality of revenues and operating leverage
* Financial risk: financial leverage

Question 2

How does business risk (cyclicality of revenues) affect beta?

Answer 2

• Some firms’ revenue fluctuates in line with the business cycle. Highly cyclical industries have high betas
• E.g retailers, technology, and automotive firms fluctuate with the business cycle
• Utilities and food sectos less dependent on busines cycle => lower beta

Question 3

How does business risk (operating leverage) affect beta?

Answer 3

• Higher operating leverage (more FC than. VC) → Higher earnings volatility → Higher business risk → Higher beta
• E.g pharmeceutical firms with high R&D costs

Question 4

How does financial risk (financial leverage) affect beta?

Answer 4

• Concerned with the debt level of a firm, as debt creates fixed costs such as interest payments.
• There are three different types of beta for financial risk.