higher betas. The tax factor in the equation captures the
benefit created by the tax deductibility of interest payments.
Theunleveredbetaofafirmisdeterminedbythetypesofthe
businessesin which itoperates and its operating leverage.
Thisunleveredbetaisoftenalsoreferredtoastheassetbeta
sinceits valueis determined by theassets (or businesses)
ownedby thefirm.Thus, theequitybetaof acompany is
determinedbyboththeriskinessofthebusinessitoperatesin
and theamount of financial leveragerisk ithas taken on.
Sincefinancial leverage multiplies theunderlying business
risk,itstandstoreasonthatfirmsthathavehighbusinessrisk
shouldbereluctanttotakeonfinancialleverage.Italsostands
to reason that firms which operate in relatively stable
businessesshouldbemuchmorewillingtotakeonfinancial
leverage.
Breaking risk down into business and financial leverage
componentsalsoprovidessomeinsightintowhycompanies
havehighbetas,sincetheycanendupwithhighbetasinone
oftwoways:Theycanoperateinriskybusinesses,orthey
can use very high financial leverage in a relatively stable
businesses.
Bottom-Up Betas
Breakingdownbetasintotheirbusiness,operatingleverage,
and financial leverage components provides us with an
alternativewayof estimatingbetas,where wedonot need
historicalreturnsonanassettoestimateitsbeta.Todevelop
thisalternativeapproach,weneedtointroduceanadditional
featurethatbetaspossessthatprovesinvaluable.Thebetaof
twoassetsputtogetherisaweightedaverageoftheindividual