Corporate Finance

100
Corporate Finance

25

20

15

A

10

0.25 0.5 1.5 2

Beta

Required rate of return

Average cost

of capital

B

B

A

1.0

Note:Line AB shows the required rate of return for projects with different betas. Project B, a low risk proposal, would be
incorrectly rejected since it is compared with the average cost of capital for the company. Project A, a high-risk
venture, will be incorrectly accepted.

Industry Beta

The beta of any individual asset is:

βi =

Var( )

Cov( – )

m

mi

R

RR

Now consider a portfolio with weights Wp. The beta of the portfolio is:

βp =

Var( )

Cov( – )

m

mp

R

RR

=∑

=

β

n

i

W ii

1

The betas of individual stocks tend to be fickle. They change quite rapidly. Portfolio betas, on the other
hand, are more stable. Their standard errors are generally lower than those of individual betas. The weighted
average of betas of stocks in the same industry group—say, pharmaceutical—is called industry beta; the
weights are market capitalization (number of shares outstanding multiplied by market-price) of individual
companies. What purpose does industry beta serve? Suppose Reliance is in the process of appraising a
banking project. So its executives are interested in estimating cost of equity for the project. They can use
either the Reliance beta or the banking industry beta. Common sense tells us that the banking industry beta
is more indicative of what investors expect from that project. In other words, cost of equity and cost of
capital are project-specific. The WACC for the company cannot be applied across the board to all projects.
The cost of equity estimated for the parent company can be applied only if the project has the same riskiness
as the parent company and financing mix. The industry beta for some major industry groups is shown in
Exhibit 4.9. Thus, RIL should use the banking beta of 1.84 for the banking project and not its own beta of
1.54. Given here is the cost of capital for several industry groups in the US: