Estimated Beta Coefficient, Essay Example

What is the estimated beta coefficient of your company? What does this beta mean in terms of your choice to include this company in your overall portfolio?

The target company in my portfolio is Macy’s, Inc. This is one of US biggest retailers, its merchandise, includes men’s, women’s, children’s apparel and accessories, and to some extent cosmetics, furnishing and other consumer goods. The company operates more than 800 department retail stores in 45 states and in the District of Columbia, Puerto Rico and Guam. Here an estimated overall amount of 167,000 employees work in these retail stores. The estimated beta coefficiency of Macy’s, Inc. equals 1.969. The beta of a company is the company’s risk compared to the overall market risk. Beta in a company, measures the company’s stock changeability in relation to the rest of the market. It is calculated through a regression analysis, the problem in this case is that beta is calculated from historical measurements, which is not always reliable when making predictions for the future. In this case Macy’s, Inc. has a beta coefficient of 1.969, which is by 0.969 greater than the overall market beta. This means that Macy’s stocks are 1.969 times more risky than the overall market activity, which is quite high, making our portfolio require diversification if it would includes Macy’s, Inc. However as we know with the use of the beta we can identify if the reward for investing into such stock would be worth while.

Given the beta of your company, the present yield to maturity on U.S. government bonds maturing in one year (currently about 4.5% annually) and an assessment that the market risk premium (that is – the difference between the expected rate of return on the ‘market portfolio’ and the risk-free rate of interest) is 6.5%, use the CAPM equation in order to find out what is the present ‘cost of equity’ of your company? Explain what is the meaning of the ‘cost of equity’.

After estimating the beta of Macy’s, Inc. we can get straight to estimating the CAPM equation in order to find out the present “cost of equity” of our target company. William F. Sharpe is one of the main founders of the Capital Asset Pricing Model, which is used for valuing stocks, securities, derivatives and/or assets with the use of relating risk and expected return. The Capital Asset Pricing Model is based on the idea that investors expect additional rewards for risky investments being made. The additional return expected by investors is called the risk premium. In the CAPM model, the expected return demanded by investors equals to the rate on a risk-free security plus the risk premium. If we find out that the expected risk does not beet, or at least meet the required return, investor will refuse this investment and the investment should not be at all undertaken due to being irrational and unprofitable. The CAPM formula is: Expected Security Return (Cost of Equity) = Riskless Return + Beta * (Expected Market Risk Premium), where Expected Market Risk Premium = Expected Market Risk – Riskless Return (cash; government bonds i.e.). Since the present yield to maturity on U.S. government bonds maturing (Riskless Return) in one year is about 4.5% annually and an assessment that the Expected Market Risk Premium is 6.5% we can easily identify the “cost of equity” of our company: Cost of Equity = 4.5% + 1.969 * 6.5% = 17.2985%. Cost of Equity is the minimum rate of return the company is obliged to offer its shareholders to compensate them for bearing some risk and waiting for their returns.

Choose two other companies (Dillards & JC Penney), look up their “Beta” and report the names of these companies and their betas. Suppose you invest one third of your money in each of the stocks of these companies. What will the beta of the portfolio be? Given the data in (b), what will the Expected Rate of Return on this portfolio be? Do you feel that the three-stock portfolio is sufficiently diversified or does it still have risk that can be diversified away? Explain.

The following two companies Dillard’s (DDS) and JC Penney (JCP) are of the same market sector as Macy’s, Inc., however their beta coefficients are 2.548 and 1.7411, correspondingly one more riskier and the other less. If I had invested a third of the overall money equally into each of these companies, my beta portfolio would turn out to be: Beta Portfolio = 1/3 * 1.969 + 1/3 * 2.548 + 1/3 * 1.7411 = 0.6563 + 0.8493 + 0.5804 = 2.086. Thereby we have estimated the Beta of the portfolio, and no we can estimate the Expected Rate of Return of the portfolio: Expected Rate of Portfolio Return = 4.5% + 2.086 * 6.5% = 18.059%. From the estimates made, we can confidently say that the three-stock portfolio did not at all diversify our portfolio, the three-stock beta is greater then of Macy’s alone, as a result the Expected Rate of Return is also greater. This portfolio has not changed the scale of risk for investing and needs to be more diversified in order to make it less risky. The retail segment is a risky segment by characteristic, it is relatively stable so during short-term investments it is less changeable.

References

William F. Sharpe,  2009. Capital Asset Pricing Model CAPM. Retrieved Nov. 14, 2009 from http://www.valuebasedmanagement.net/methods_capm.html/

Investopedia.com, 2009. Capital Asset Pricing Model – CAPM. Retrieved Nov. 14, 2009 from http://www.investopedia.com/terms/c/capm.asp/