THE SOURCES OF BETA
Where does Beta come from? What is the source? Definitely, not thin air! Well, we can identify three sources:
Source 1: Revenue Cycle of the firm
Some firms expand very well during the expansion phase of a business cycle; others do badly. Revenues and distributable income of many entities (example automobiles) exhibit a tendency to be cyclical. It is seen that such firms have a high beta.
Source 2: Operating Leverage
Operating leverage is linked to fixed costs. The existence of fixed costs in a company’s cost structure leads to disproportionate changes in EBIT for every percentage change in revenue. Two firms with identical levels of revenues may have differing operating leverages (one having higher fixed costs as compared to another). Operating leverage magnifies the effect of cyclicality in revenues. A firm with a higher operating leverage will tend to have a higher Beta than another with a relatively lower leverage.
Source 3: Financial Leverage
The existence of fixed cost bearing source of finance can magnify the change in earnings per share for every percentage increase in EBIT. This is referred to as financial leverage. A form having a sizable debt will have to meet interest and principal payments. Consequently, the risk level for its stockholders will be higher relative to another firm which is free from debts.
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