Determinants of Beta
As we discussed above beta depend on three fundamental factors: the nature of business, the operating leverage and the financial leverage. About the nature of business we discussed earlier, fro this post we discussing about other two factors.
Operating Leverage
Operating leverage refers to the use of fixed costs. The degree of operating leverage is defined as the change in an economy’s earning before interest and tax due to change in sales. Since variable costs change in direct proportion of sales and fixed costs return constant, the variability in earning before interest and tax when sales change is caused by fixed costs.
Higher the fixed cost, higher the variability in earning before interest and tax for a given change in sales. Other things remaining the same, companies with higher operating leverage are more risky.
Operating leverage intensifies the effect of cyclically on a company’s earnings. As a consequence, companies with higher degree of operating leverage have high betas.
Financial Leverage
Financial leverage refers to debt in a firm’s capital structure. Firms with debt in the capital structure are called leverage firms.
The interest payments on debt are fixed irrespective of the firm’s earnings. Hence, interest changes are fixed costs of debt financing. The fixed costs of operations result in operating leverage and caused earnings before interest and tax to vary with changes in sales.
Similarly, the fixed financial costs result in financial leverage and cause profit after tax to vary with changes in earning before interest and tax. Hence, the degree of financial leverage is defined as the change in a company’s profit after tax due to change in its earnings before interest and tax. Since financial leverage increases the firm’s financial risk, it will increase the equity beta of then firm.
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