rates of return, respectively, are 14% and 16%. Projects in the false acceptance zone should be made to pass their higher discount rates rather than the firm's overall required rate of return.
IV. The Determinants of Beta:
The determinants of beta are discussed in Chapter 12. The three major determinants covered are:
· The cyclicality of project revenues,
· The operating leverage of the project, and
· The financial leverage of the project.
Please review the first two of these determinants on your own. The text discussion is quite straightforward. Let me briefly discuss the third determinant as a preview.
When we relax our assumption of an all-equity firm, we find that debt has an impact on the equity (stock) beta. Since the beta of the real asset portfolio must equal the beta of the financial security portfolio, debt plus equity, we should observe the following familiar relationship:
p = Xii, or
βA = B/(B+S)*βB + S/(B+S)*βS.
In words, the beta of the real asset portfolio, βA, must equal the beta of the portfolio of financial securities. The portfolio weight of the bonds in the financial security portfolio is B/(B+S) and the portfolio weight of the stock in the financial security portfolio is S/(B+S) (S is the market value of equity and B the market value of debt as above). Obviously, the portfolio beta on the asset-side of the balance sheet must equal the portfolio beta on the financial security-side of the balance sheet.
The next thing to note is that βS must be greater than βB! Does this requirement make sense to you? It should! Stocks are riskier than bonds; their betas should reflect this fact. Bond payments have higher priority than stock payoffs. If the firm defaults on bond payments, it can be forced into bankruptcy. If the firm misses a dividend, tough luck equityholders!
Bond betas, βB, are usually quite small. Let's for a moment assume that the bonds are riskfree, i.e., their betas equal zero.
If we plug in a zero for the bond beta in the above equation, we have
βA = S/(B+S)*βS.