Corporate Finance

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Corporate Finance

This adjustment equation reflects the theory that, over time, company betas will tend toward their industry
average beta. For example, the betas of public utility companies tend to be less than one. Therefore, when
adjusting the beta of a public utility company, it is appropriate to adjust its beta towards the average beta of
the other companies that make up its industry group.
The formula for weight is based on the formula suggested by Vasicek. The greater the statistical confidence
in the regression beta, the closer that weight is to one.
The peer group beta calculated by Ibbotson Associates takes into consideration the industry betas of all
industries in which a company is involved. It is the sales-weighted average of the betas for each industry in
which a company has sales.
Assume that Company A has a peer group beta of 0.71. It lists sales in four different segments. The peer
group beta is calculated in the following manner:

Sales in Percentage of Sales-weighted
Industry industry sales in OLS beta
Segment OLS beta ($ in millions) industry component

A 0.56 9.396 26.17 percent 0.15
B 1.05 5,698 15.87 percent 0.17
C 0.68 20,767 57.84 percent 0.39
D 0.38 44 0.12 percent 0.00
Total 35,905 100.00 percent 0.71

An estimate of beta for Procter and Gamble in 2003 is given here:

Levered Unlevered

Raw beta 0.0 (0.00)^6 0.0
Peer group beta 0.51
Ibbotson beta 0.02 0.01

Note:Raw beta is the Ordinary Least Squares estimate of levered and unlevered beta. Peer
group beta is the sales-weighted average of industry betas. Ibbotson beta is the weighted
average of regression beta and peer group beta.

Ibbotson Associates report cost of equity calculated using the Fama-French, three-factor model as well.
An estimate of the model’s factors for P&G is given below:

Fama-French beta (Coefficient on excess market return) = 0.02,

R-square = 0.01,

SMB premium = –0.17, and

HML premium = 0.46.

Cost of equity (Fama-French) = Risk-free rate + (FF beta × Equity risk premium) + SMB premium

+ HML premium.

Cost of Capital for Unlisted Divisions

The CAPM can be used to estimate the cost of equity for a listed firm. An unlisted division, by definition,
does not have stock market data. So CAPM cannot be applied directly. The accepted procedure is to follow

(^6) R-square in parenthesis.