Geneva Steel should look for an all-equity financed fast-food firm and calculate the beta of its equity. Armed with this beta, they then find the required discount rate, using the SML, to evaluate the investment. Ideally, Geneva would find the betas of several fast-food firms and average the betas to get a more accurate estimate of fast-food risk (eliminate sampling error).

For this and other potential investments outside of the steel business, Geneva should identify firms that are "pure play, or carbon-copy" firms, or firms doing business solely in the area of the contemplated investment. The betas of these firms should be used with the SML to evaluate the attractiveness of the investment.

Example:

Now, let's take another example. We have a firm with four major asset categories. Each of these asset categories has equal value; i.e., each amounts to 25% of the firm's portfolio of real assets. The firm is all-equity financed.

ASSETSEQUITY

A1

A2 S

A3

A4

Assume the betas of the four real asset categories are known and equal to 0.50, 0.75, 1.00, and 1.25, respectively. What is the beta of this portfolio of real assets?

N

βp = Σ XiβAi, where

i=1

N equals the number of real assets, Xi represents the weight of asset i, and βi is the beta of asset i. You've seen this equation before in Chapter 10. Since each of the above four asset categories have equal weight,

βp = (0.25)(βA1) + (0.25)(βA2) + (0.25)(βA3) + (0.25)(βA4) =

βp = (0.25)(0.50) + (0.25)(0.75) + (0.25)(1.00) + (0.25)(1.25) = 0.875.

0.875 represents the beta of the portfolio of the firm's real assets. Since the stock beta reflects the risk of the real asset portfolio, the stock's beta will also be 0.875. (However, as discussed above usually we would have to estimate the stock's beta and infer that the real assets' portfolio beta was equal to 0.875.)

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