Unlevered betas and the cost of equity capital: An empirical

approach

Draft Copy

By
Mehdi Sadeghi* and Julio S. Sabogal
Unlevered betas and the cost of equity capital: An empirical approach
Abstract
Current paper investigates the significance of financial leverage in computation of
systematic risk within the context of CAPM model. First, we attempt to test whether
variables such as growth rate, target leverage, and the proper rate of discounting tax
shields affect Unlevered Betas (
u
). Second, investigate whether utilizing the basic idea
behind
u
would help to overcome the information shortfalls in calculating the cost of
capital for non-traded firms. We develop a model that allows us to empirically test these
assumptions. Our results suggest that the use of the Levered Proxy Betas in solving the
lack of market information problem for both non-traded firms and individual business units
is not misleading, even when we use book value of debt instead of market-values. We also
find more support in statistical performance term for Modigliani-Miller (1958, 1963)
assumptions in in calculating (
u
) compared with Miles and Ezzel (1985) model.


Corresponding author: Mehdi Sadeghi
Department of Applied Finance & Actuarial Studies,
Macquarie University,
Sydney, Australia, 2109,
Tel: (61) 2-98508527,
E-mail: msadeghi@efs.mq.edu.au.


2


1 Introduction

Since the publication of seminal paper by Hamada (1972) on the role of financial leverage
in the computation of systematic risk and development of unlevered Betas (
u
), this
concept has been the subject of investigation by the academic researchers and practitioners
in two different ways. While researchers have been more engaged in the discussion of how
variables such as growth rate, target leverage, or and an appropriate discount tax shields
may affect
u
. , practitioners have been concerned about how to utilise the basic idea
behind
u
to resolve the lack of information problem in calculation of the cost of capital
for non-traded firms. However, little effort has been made to empirically examine how
relevant or effective these approaches might be.

Current study is an attempt to fill this research gap and contribute to the literature in two
different ways. First, we empirically test a theoretical model for unlevered beta. However,
instead of checking the Unlevered Betas directly, we develop a theoretical target that
allows us to test their performance. Second, we evaluate the performance of unlevered
beta to confirm the robustness of practioners, methodology as we believe that the real
importance of the unlevered betas is its usefulness as a proxy method to calculate the cost
of equity for non-traded firms.
Need one or two more introductory sentence at the beginning to tell the reader what will
follow. Previous theoretical discussion has been mainly focussed on the impact of
corporate taxes () on
u
. Some studies
1
agree with two underlying assumptions in
u

calculation. First, the absolutevalue of debt does not change over the time as suggested
by Modigliani-Miller (1958, 1963) (MM hereafter). Second, the correct rate to discount
Tax Shields is CostofDebt(Ke). On the other hand, following Miles and Ezzell (1985) (ME

1
(Fernandez, 2004, 2005, 2007; Massari, Roncaglio & Zanetti, 2008)
3

hereafter), another group of authors
2
consider that the absolute value of debt changes
periodically to maintain a target LeverageRatio (D/E
L
) and the correct rate to discount Tax
Shields is CostofUnleveredEquity(Ku). Our results suggest that both definitions (MM and
ME) have a strong statistically significant relationship with the market beta (m).
Nevertheless, both tend to increase the average of the (re-calculated) proxy levered betas
above the expected value of one. Our empirical evidence doesnt support ME warning that
inclusion of taxes in u tends to overestimate the cost of capital. Instead, our results
suggest that MM approach has two advantages in our study: First, the mean of the
levered proxy betas using MM approach are closer to the predicted value of one in our
dataset. Second, estimated coefficients according to that approach are higher compared
with the ME approach. Our findings also diverge from the empirical results obtained by
Marston & Perry (1996). However, the immediate concern is about the capacity of
leverage to explain changes in m
,
rather than an attempt to show the direct relationship
between m

and

u
.

In testing the application of
u
to determine the cost of equity capital for unlisted
companies,, our paper is related to the empirical findings of Bowman (1980). Brown
relaxed the assumption on the requirement that D and E
L
should be as stated in their
respective market values and asserted that by using the accounting measure (book value
of debt) as a proxy for the market value of debt, the variations in the results should
become insignificant. We document a strong positive relationship between m and proxy
levered betas calculated with the book values of debt and equity. These results essentially
confirm the findings obtained by Bowman & Bush (2006), but differ in the sense that we
do not control for size as they did, because for us the theoretical foundation between size
and systematic risk of the firm in the CAPM context is not clear.

The remainder of this paper is as follows: In Section 2 we present the unlevered betas and
the method to calculate a proxy of the Market-based Beta using such metrics. In Section 3

2
See for example: (Arzac & Glosten, 2005; Cooper & Nyborg, 2006; Fieten et al., 2005; Harris & Pringle,
1985; Myers, 1974; Ruback, 2002; Taggart, 1991; Tham & Vlez-Pareja, 2004)
4

we develop our testing model. In section 4.1 we describe our dataset and methodology.
Section 5 presents the empirical results. Section 6 examines the robustness of our results,
and Section 7 concludes.
2 Unlevered betas and proxy methods
According to the MM theory, the Firm Value (V
L
) (in absence of Bankruptcy costs) is a
function of its own hypothetical value when is non-debt financing (V
U
) and the present
value of the effect of tax shields (VTS) produced by the financial debt. Thus,

L U
V V VTS = + (0)
As an implication of the MM theory, Hamada (1972) define the relationship between the
systematic risk and leverage: ( ) | | = / / m u EL Eu . Where EL

is theMarketValueofLevered
Common Equity and Eu

is the Expected Market Value of the Unlevered Common Equity.
Rubinstein (1973) extended the Hamada model by incorporating the impacts of corporate
taxes () and themarketvalueofdebt(D) on beta according to the following model:

( ) ( ) 1 / 1
MM
L
u m D E | | t = + (

(0)
Miles and Ezzell (1985) argue that equation (0) implies constant D. Additionally, this
equation assumes that the correct discount rate for VTS in (0) is the Cost of Debt (Kd)
(Fieten et al., 2005; Tham & Vlez-Pareja, 2004). An alternative model by Bowman
suggests that
3
:
( ) 1
ME
L
u m D E | | = + (0)
Although the only difference between (0) and (0) is the use of tax shields, the extensive
discussion regarding which one is the correct model to calculate the Unlevered Beta is
inconclusive. On one hand, Fernandez (2004, 2005, 2007) and Massari, Roncaglio &
Zanetti (2008) among others, support the underlying assumptions in (0), while Arzac &
Glosten (2005); Cooper & Nyborg (2006); Fieten et al. (2005), Harris & Pringle (1985),
Myers (1974) Ruback (2002); Taggart (1991) and Tham & Vlez-Pareja (2004) argue that

3
The Bowman (1980) definition of
u
can be also derived from Miles and Ezzell (1985), assuming constant
growth.
5

(0) is the correct derivation of
u
. These studies have been largely limited to the
theoretical issues, with little reference to the empirical implications of this conundrum. A
couple of empirical research that is also available on this subject use either (2) [Bowman
(1980)] or (3) [Marston & Perry (1996)](0), giving little attention to the theoretical issues.

On the other hand, practitioners calculate the cost of equity capital (Ke) using either (0) or
(0) as a proxy method for non-traded firms or individual business units. It is a common
technique to calculate an average industry sector unlevered beta
( )
u | and recalculate a
new Proxy Levered Beta ( ) l | using the leverage of the private company.
| | 1 L u | | = + (0)
Where represents the correct relationship between the Leveraged Ratio (L) and the
Systematic Risk. Thus, = L for ME and =L*(1-) for MM.

3 Corporate taxes and Systematic risk
The tax rate has a diminishing effect in the decomposition of systematic risk. Without
corporate taxes there is not conflict between MM and ME approaches (equations (0) and
(0)). When tax rate is more than zero, the beta estimated according to MM model are
higher than the results from ME model (Miles & Ezzell, 1985). However, the argument
regarding which model is more accurate may not be solved through an empirical test due
to the absence of a theoretical target. Define the theoretical target in one sentence.
Therefore, differences between the two models are confined to the theoretical discussion
about their underlying assumptions. However, the use of the levered proxies allows us to
compare the performance of the two models by comparing empirical results with
predicted values. This predicted value (in the absence of disturbances) is the same as
Market-Based Beta, as the average of all Levered Proxies should be equal to one. To
discuss this idea, consider the average of the unlevered betas
( )
u | for a group of firms in
the same risk-class during a given period of time:
6


( )
1
(1/ ) *
1
n
i
i
i
m
u n
|
|

=
=
+

(0)
where = L for ME and =L*(1-) for MM. In the absence of any market imperfections, all
unlevered betas in the same risk-class group should be equal (Hamada, 1972), in such
case (0) becomes: ( ) 1
i i i
u m u | | | = + = for all i in the same risk-class. Certainly, an
industry sector might be considered as a proxy for a risk-class. However, it is not realistic
to assume that all unlevered betas in the same industry sector are equal. Let
i
be an error
term that encloses all market disturbances and risk-class misspecifications are defined as:

i i
u u | | = (0)
Using
i,
the relationship (0) can be redefined as:
( ) 1 *
U i i i
m | | = + (0)
Using the practitioners approach (equation (0)) we calculate a general expression for the
Proxy Levered Beta (
L
) of any firm in a specific industry sector in a given period of time:

( )
( ) ( )
* 1
1 * * 1
*
i i i
i i i i
i i
l u
m
m
| |
|
|
= +
= + +
=
(0)
From (0) we can establish that the expected value of the Proxy Levered Beta is the same
as the Market-Base Beta in absence of both market disturbances and risk-class
misspecifications (
i
=1). Add a concluding sentence before following to the next section

7

4 Data and Methodology

4.1 Dataset
In one sentence or so, define the nature of the panel data you are intending to use
For instance, In this section we discuss the details of the panel data set we used in our
study.
Our panel data contains the annual financial information from Compustat and market
prices and dividends from CRSP of 159 companies listed in US Markets in the period from
1972 to 2007. We exclude those firms that do not have all of the accounting information,
as well as those that are not traded at the beginning or at the end of the period under
scrutiny. We also exclude firms with market capitalization of less than 10 million.
Furthermore, we dropped potentially bankrupt companies with negative D/E ratios, or D/E
ratios over 10 from our sample
4
. Firms in the Global Industry Classification (GIC) sector #
50 are also excluded due to the small number of firms in the sample.

4.2 Methodology
The methodology is applied in four steps: First, we compute the Market-based Beta using
an equally weighted portfolio conformed for all companies in the sample. Second, we
calculate the Unlevered Beta for each economic sector. Third, we compute the Levered
Proxy Beta of each firm using its unlevered sector beta. Finally, we run the panel
regressions between Market-based Betas and Levered Proxy Betas.
The descriptive statistics of the sample are presented in Table 1. Panel A shows Financial
Fundamentals and Panel B present Market Return.


See (Marston & Perry, 1996) for a further discussion.
8


Table1Descriptivestatisticsofthesampledata
Panel A. Descriptive statistics of Firmfinancial fundamentals

Global Industry Classification (GIC) Sector
(10) (15) (20) (25) (30) (35) (45) (55) Total
Firms
14 16 39 17 11 10 6 46 159
Years
31 31 31 31 31 31 31 31 31
Observations
434 496 1,209 527 341 310 186 1,426 4,929
Market Value
of Equity
Average 17,661 5,789 8,441 4,734 18,248 33,352 20,276 3,195 9,764
Stnd Dev 47,320 10,128 34,121 7,238 32,881 51,160 40,061 4,296 29,482
Min 78 33 10 12 16 119 46 36 10
Max 432,187 64,034 455,607 54,850 183,159 284,853 202,342 40,251 455,607
Book Value
of Equity
Average 8,202 2,618 2,951 1,769 3,349 5,904 5,756 2,253 3,371
Stnd Dev 17,013 3,704 8,212 2,215 5,460 9,945 9,852 2,496 7,809
Min 92 40 17 21 23 64 32 41 17
Max 121,762 19,389 115,559 15,458 39,619 71,217 42,832 26,102 121,762
Debt
Average 3,193 1,786 5,097 1,136 2,559 2,091 3,228 3,149 3,174
Stnd Dev 4,089 3,078 31,230 1,808 4,656 2,903 7,702 3,564 15,856
Min 15 0 0 0 0 4 0 54 0
Max 28,574 16,568 514,116 10,238 29,122 18,545 35,274 23,873 514,116
Debt over
Market Equity
Average 0.57 0.36 0.57 0.31 0.18 0.12 0.15 1.24 0.64
Stnd Dev 0.60 0.30 0.83 0.35 0.17 0.12 0.14 0.72 0.74
Min 0.02 0 0 0 0 0.01 0 0.14 0
Max 7.16 2.97 7.95 2.49 0.87 1.29 0.93 8.11 8.11
Debt over
Book Equity
Average 0.73 0.58 0.88 0.55 0.67 0.39 0.34 1.40 0.89
Stnd Dev 0.56 0.46 1.11 0.45 0.95 0.26 0.34 0.63 0.83
Min 0.03 0 0 0 0 0.03 0 0.48 0
Max 4.13 4.43 7.71 2.36 9.81 1.57 1.53 8.17 9.81
Taxes Average 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40 0.40
Panel B. Market return

Global Industry Classification (GIC) Sector
(10) (15) (20) (25) (30) (35) (45) (55) Total
Firms
14 16 39 17 11 10 6 46 159
Months
432 432 432 432 432 432 432 432 432
Observations
6,048 6,912 16,848 7,344 4,752 4,320 2,592 19,872 68,688
Market Return
Average 1.46 1.28 1.34 1.19 1.32 1.25 1.29 1.10 1.25
Stnd Dev 9.10 8.52 8.90 8.41 7.40 7.78 11.51 6.17 8.07
Table 1 presents the descriptive statistics of the sample. The sample is composed by nonfinancial and nontelecomunication firms listed in
US markets during 1972 to 2007. Accounting information is obtained from COMPUSTAT yearly file and market-based information comes
from CRSP monthly file. Market Value is calculated as the Closing Price at the end of the year (Compstat item#199) multiplied by the
number of outstanding shares (#25) at the end of each year. Book Value of Equity is Common Equity (#60). Debt is defined as Debt in
Current Liabilities (Compustat item # 34) plus Long-Term Debt (#9). Taxes are defined as the top statutory corporate taxes and are
available at Tax Policy Center. The firms are divided using Global Industry Classifications (GIC) sectors: Energy (10), Materials (15),
Industrials (20), Consumer discretionary (25), Consumer staples (30), Health Care (35), Information Technology (45) and Utilities (55).
Total column corresponds to the sum of all GIC sectors in rows Firms, Years, Months and Observations.

9

4.2.1 Market Betas
We use the Firms Market Return (R
it
), calculated in the CRSP database as
( )

= +
it it it it
R P D P
1
/ , where P
it
is the stock price at month t, D
it
is the Cash Dividend Paid,
and P
it-1
is the stock price at the end of the previous month. The result was filtered to the
range (-50, 100) to avoid leverage caused by extreme observations (Campbell, Polk &
Vuolteenaho, 2010). We obtain the monthly Market Beta for each firm using both the
individual market returns from both the 60 ( )
60
m |

and 12 previous moths
( )
12
m | , using
the standard model:
( ) ( )
2
, i m m
m R R R | o o = . Where R
m
is the average return of an
equally weighted portfolio composed by all the firms contained in the dataset
5
,
( )
, i m
R R o
is the covariance of the stock return and market return and ( )
2
m
R o is the market
variance.

We have a number of reasons to justify the use of two different measures of m: First, the
estimation of
( )
60
m | is standard in the literature, so we need it to compare our results
with previous findings. Second, we are concerned about whether the use of shared
information can affect our results. This problem arises when we calculate our coefficients
with a month-firm base, using information from 60 previous months. For example, the
market return obtained in 1980/01 is an observation needed to compute the m from the
same period to 1984/12. Finally, the use of a m

based upon 60 months implies that we
have five different leverage ratios (using yearly financial statements), then, is not clear for
us whether the use of an average of such points can affect our results. Consequently, we
compute m

based upon 12 previous months
( )
12
m | as an alternative that does not
share information with the monthly betas calculated in overlapping periods.
4.2.2 Unleveraged process and levered proxy betas

5
Previous research (Beaver, Kettler & Scholes, 1970; Beaver & Manegold, 1975; Marston & Perry, 1996)
shows that using a value weighted portfolio rather than the equally weighted portfolio in the context of
comparing accounting and market based betas does not significantly alter the results.
10

We obtain a matrix with monthly m for each company in the sample between 1977 and
2007. Note that observations from 1972 to 1976 are needed to compute
60
m | . We match
the monthly market information with the annual financial information of each firm
dropping all months but December each year.

The unlevered betas are computed using the two calculated versions of market-based
betas
( )
12 60
and m m | |

for the corresponding periods, using also both relationships (0)
and (0) for each one of the two versions of the market-based betas. Although theory
advises for the use of the market price of debt and equity as the correct measure for the
leverage (D/E), we use the book value of debt as a proxy of its market value. The use of
Market Value of debt implies an enormous amount of additional work beyond the focus of
this paper and the book value is a good substitute at the firm level (Bowman, 1980;
Mulford, 1985). We define Debt (D) as Debt in Current Liabilities (Compustat item # 34)
plus Long-Term Debt (#9). Equity (E) is the market value of the firm at the end of the year
calculated as the Closing Price at the end of the year (#199) multiplied by the number of
outstanding shares (#25) it may be OK for your thesis to refer to Compustat numbers.
However, you have to remove them from a submitted copy to a journal for publication
Corporate taxes are defined as the top statutory corporate taxes for each year
6
. We use
two definitions of Leverage: D/E and D/BE. The latter corresponds to the use of the Book
Value of Equity (BE)
7
instead of its market value as used by practitioners for non-traded
firms. We average across the average firms leverage of the five previous years when we
compute
( )
E
u | and
( )
BE
u | based upon
60
m | .
We obtain four alternative definitions of the Levered Proxy Beta:
MM
E
l | and
MM
BE
l |
represent the unleveraged and leveraged process, according to MM approach (equation
(0), using the market-value and the book value of equity, respectively.
ME
E
l | and
ME
BE
|

6
US top statutory corporate taxes were 48% between 1972 and 1978; 46% from 1979 to 1986; 40% in 1987;
34% between 1988 and 1992 and 35% thereafter.
7
BE is Common Equity (Compustat item #60).
11

correspond to the unleveraged- if this is a minus sign, then use minus leveraged process
in equation (0), using again both market-value and book value of equity. We run the
process twice using our two market market-based betas
( )
12 60
and m m | | .

To summarize, we calculate two versions of market-base beta for each firm-year, then we
unleverage the beta using the specific leverage (D/E and D/BE) of the firm. We average
the unleveraged betas for each sector-year and finally we recalculate a Proxy Levered Beta
for each firm-year using the specific leverage of the firm. Therefore we obtain four
versions of the levered proxy beta for each version of the market-based beta:

( ) ( ) 1 / 1
MM MM
BE BE
l l u D BE | | | t = = + (

(0)

( ) ( ) 1 / 1
MM MM
E E
l l u D E | | | t = = + (

(0)

( ) 1 /
ME ME
BE BE
l l u D BE | | | = = + (

(0)

( ) 1 /
ME ME
BE B
l l u D E | | | = = + (

(0)
Where
( )
E
u | and
( )
BE
u | are the cross-sectional average of the industry sector unlevered
beta for each firm using the market and the book value of equity respectively. D/E and
D/BE corresponds to the average leverage using five previous years for
60
m | .



12


Table2Summarystatisticsofcalculatedvariables
Variable Mean Std. Dev. Min Max

Panel A.
Calculations based upon 60 previous months


60
m | 1.00 0.42 -0.29 3.48

MM
u |

0.78 0.39 -0.23 3.25
ME
u |

0.70 0.38 -0.23 3.16

MM
BE
u |

0.71 0.36 -0.23 2.91

ME
BE
u |

0.62 0.34 -0.23 2.69

MM
BE
l | 1.03 0.37 0.38 4.31

ME
BE
l | 1.05 0.47 0.33 6.30

MM
BE
l | 1.04 0.41 0.36 4.90

ME
BE
l | 1.07 0.52 0.33 7.18

MM
E

1.13 1.66 -74.05 45.62

ME
E

1.15 1.67 -72.42 46.91

MM
BE

1.15 1.79 -78.17 50.34

ME
BE

1.18 1.88 -80.00 54.01

Panel B.
Calculations based upon 12 previous months


12
m | 1.00 0.74 -2.28 5.30

MM
u |

0.79 0.64 -1.74 5.07

ME
u |

0.71 0.61 -1.56 4.99

MM
BE
u |

0.71 0.58 -1.62 4.99

ME
BE
u |

0.62 0.54 -1.46 4.99

MM
BE
l | 1.03 0.48 -0.13 6.22

ME
BE
l | 1.06 0.58 -0.14 9.40

MM
BE
l | 1.05 0.52 -0.10 5.32

ME
BE
l | 1.09 0.64 -0.09 7.78

MM
E

1.87 23.11 -171.05 934.04

ME
E

1.93 23.76 -177.25 928.84

MM
BE

2.00 26.21 -180.61 999.86

ME
BE

2.24 27.79 -199.86 1,022.40
13

Table 2 Shows the summary statistics of the calculated coefficients. The Market Beta (m) for each firm using both the individual
market returns from both the 60 and 12 previous moths (Panel A and Panel B respectively). u is Unlevered Beta calculated using
equations (0) or (0). l is proxy levered beta (equation (0)). is the error term in the unleveraged-leveraged process (equation
(0)). Subscript E indicates calculation using the market value of debt and subscript BE specify the Book Value of Equity.
Superscripts ME and MM correspond to the unleveraged-leveraged process suggested by ME.


Table 2 presents the summary statistics for two versions of Market-based Betas using 60
previous months (Panel A) and 12 previous months (Panel B) and the Levered Proxy Betas.
The averages of the proxy levered betas are higher than the theoretical expectation of 1 in
both panels. The results using Book Values are greater than those where the Market
Values are employed. This is not surprising since the average of the Market Value of the
equity is greater than the Book value of Equity (see Table 1). Therefore, the factor (1+ D/E)
in equations (0) and (0) tend to be greater than (1+ D/BE) in equations (0) and (0).
Although we obtained the result
MM
U
|
>
ME
U
|
predicted by ME, this relationship is contrary
in the case of Levered Proxy Betas. The reasons why those results are arisen will be
explained latter. The specification error not only exceeds the expected average of one in
all cases, but also contains a great amount of noise.
5 Empirical results

Our empirical model is extracted from equation (0). We report Generalized Least Squares
(GLS) panel regression estimates, robust to heteroskedasticity and cross-sectional
correlation. They are also adjusted for serial correlation in the time series dimension of
the panel using Prais-Winsten correction:

1 2 3 it it it it
L m | o o | o c = + + + (0)

, 1 it i t it
c c q

= +
| | 1 s

Table 3 summarizes our findings. Panel A reports the results using market-based beta,
estimated with data for 60 previous months. Panel B shows the estimates using market-
based beta calculated from 12 previous months data. For both panels the relationship
14

between all Levered Proxy Betas and he Market-Based Beta incomplete sentence. All
proxy beta definitions are related with the market beta at the one precent level sentence
is not clear. This is an interesting result due to the great amount of noise incorporated
during the unleveraged-leveraged process. The specification error are also related with
Market-Based Beta in seven out of eight specifications, indicating that encloses
information that is missing by Levered Proxy Beta. This result reiterates that industry
sector is just a proxy of a class risk and there are factors other than industry and leverage
that affect systematic risk.
Table 3 also let us making some interesting comparisons: First, contrasting both panels,
our results suggest that the relationship between m

and

u
is stronger when using 60
months to calculate betas. This is a symptom of the use of sharing information somehow
may alter the information dynamics and tend to artificially increase the results. Second,
Proxy Levered Betas using book-values of debt show weaker relationships than those
computing market-values, accordingly with previous results. Finally, the relationships
using MM definition present stronger relationship than ME counterparts. Perhaps this last
is our most important results because it adds an empirical light to the discussion regarding
which one of the theoretical models are most accurate.


Table 3 Parameters estimates of regressions of Levered Proxy Betas on MarketBased
Betas

MM
BE
l l | | =
ME
BE
l l | | =
MM
E
l l | | =
ME
E
l l | | =

PanelA.
1 2 3
(60)
it it it it
l m | o o | o c = + + +
m | 0.270*** 0.275*** 0.287*** 0.300***
(17.26)

(15.66)

(18.97)

(17.79)

it
0.00509**

0.008***

0.00350**

0.00591***

(2.84)

(3.30)

(3.00)

(4.27)

Observations 4,929 4,929 4,929 4,929

PanelB.
15

1 2 3
(12)
it it it it
l m | o o | o c = + + +
m | 0.187*** 0.185*** 0.193*** 0.193***
(15.17)

(14.32)

(15.85)

(14.91)
it
0.00026*

0.00026

0.00035*

0.00037*
(1.77)

(1.64)

(2.46)

(2.27)
Observations 4,929 4,929 4,929 4,929
Table 3 reports the results of the Generalized Least Squares panel regression model adjusted using Prais-Winsten correction.
Panel A reports the results using market-based beta (m) calculation using 60 previous months. Panel B shows the estimates
using results using market-based beta calculation using 12 previous months. l is the Levered Proxy Beta equations (0) to (0).
is the error term in the unleveraged-leveraged process (equation (0)). Subscript E indicates calculation using the market value of debt and
subscript BE specify the Book Value of Equity. Superscripts ME and MM correspond to the unleveraged-leveraged process suggested by
ME. First row of each panel reports the coefficients and second row in each panel reports the corresponding t statistics (in
parentheses).
* p<0.05, ** p<0.01, *** p<0.001.


5.1 Comparing the empirical performance of ME vs. MM model
We are interested in confirm whether the larger mean when we compute the proxy using
the ME model in Table 2 is a signal of larger results than those obtained using MM model.
If ME proposal tend to overestimate the risk, this may indicate that the cost of equity
capital using such method is also overestimated. We run Wilcoxon sign-rank test and
Somers D test on the pooled sample. These two tests are nonparametric test that allow
us testing the null hypothesis
MM ME
| | = . The results in Table 4 indicate that the null
hypothesis is soundly rejected in all possible interpretations of the accounting-based
betas. As signalled by ME, the unlevered betas using MM model are higher, however there
are not a theoretical predicted value to use as a target, therefore is not possible to reach
any conclusion regarding this finding. The results are contrary in all cases of the Levered
Proxy Betas. The sign of the z-statistic indicates that ME proxies tend to be higher and may
indicate that using ME tend to overestimate the systematic risk due to the results are
above the expected value of one.

Table4TestsofdifferencebetweentheresultsusingMMandMEmodels

Panel A. Calculations based upon 60
previous months


Panel B. Calculations based upon 12 previous
months

16

Pair
comparation
Wilcoxon
z-statistic
Somers D
z-statistic

Wilcoxon
z-statistic
Somers D
z-statistic
MM ME
u u | | = 60.80*** 9.31*** 58.08*** 16.69***
MM ME
E E
l l | | = -6.51*** -11.76*** -7.06*** -11.76***
MM ME
BE BE
l l | | = -11.60*** -11.34*** -12.99*** -11.34***
Table 4 presents the results (z-statistics) of sign-rank test and Somers D for paired observations on the pooled sample.
Panel A reports the results using market-based beta calculation using 60 previous months. Panel B shows the results
using market-based beta calculation using 12 previous months. The null hypothesis is
MM
=
ME
. u is Unlevered Beta
calculated using equations (0) or (0). l is the Levered Proxy Beta equations (0) to (0). Subscript E indicates calculation using the
market value of debt and subscript BE specify the Book Value of Equity. Superscripts ME and MM correspond to the unleveraged-
leveraged process suggested by ME.
* p<0.05, ** p<0.01, *** p<0.001.


6 Robustness checks
The results obtained from Table 3 allow us to make a general conclusion regarding the
empirical validity of the unleveraged-leveraged process for our sample. Nevertheless, the
performance of the process may be different for each economic sector and the general
result might be influenced by the model specification. We check the results in two ways:
Analysing the validity of unleveraged-leveraged process on each specific sector (section
6.1) and testing the regression in different periods of time (section 6.2).
6.1 Results by economic sector
The first concern we have is whether our results might be affected by unlevered betas
coming from some specific sectors. Especially for those that have fewer companies in our
sample, due to in those cases the specific weight of each firm in the sector average is high.
Table 5 reports the results regression model by sector. The results indicate that all
versions of the levered proxy betas are highly correlated with the market-based betas in
seven out of eight sectors. A striking result from Table 5 is that not for all specifications
the estimates the levered betas using market values are bigger than those using book
values. This finding contradicts the expected results.


17


Table5Parametersestimatesregressionsbysector
PanelA.
1 2 3
(60)
it it it it
l m | o o | o c = + + +

GIC Sector
(10) (15) (20) (25) (30) (35) (45) (55)
ME
E
l l | | =
0.8*** 0.22*** 0.25*** 0.14*** 0.23*** 0.3*** 0.37*** 0.37***
(21.42) (7.3) (5.95) (5.63) (7.03) (7.74) (9.41) (10.16)
ME
BE
l l | | =
0.83*** 0.24*** 0.33*** 0.19*** 0.19*** 0.31*** 0.41*** 0.35***
(22.55) (6.81) (8.18) (7.21) (5.45) (7.67) (8.99) (9.24)
MM
E
l l | | =
0.71*** 0.21*** 0.16*** 0.12*** 0.23*** 0.29*** 0.36*** 0.36***
(17.28) (7.16) (5.98) (6.01) (7.16) (7.69) (9.27) (10.09)
MM
BE
l l | | =
0.74*** 0.22*** 0.22*** 0.17*** 0.21*** 0.3*** 0.38*** 0.34***
(18.85) (6.8) (8.0) (8.06) (6.25) (7.55) (9.19) (9.3)

PanelB.
1 2 3
(12)
it it it it
l m | o o | o c = + + +
GIC Sector
(10) (15) (20) (25) (30) (35) (45) (55)
ME
E
l l | | =
0.31*** 0.17*** 0.05** 0.06*** 0.17*** 0.32*** 0.28*** 0.27***
(8.96) (6.71) (2.61) (4.24) (6.45) (9.51) (7.63) (9.62)
ME
BE
l l | | =
0.33*** 0.16*** 0.05** 0.07*** 0.15*** 0.31*** 0.28*** 0.21***
(9.27) (5.19) (3.04) (4.49) (4.79) (9.47) (6.72) (6.91)
MM
E
l l | | =
0.31*** 0.17*** 0.05*** 0.06*** 0.17*** 0.31*** 0.27*** 0.25***
(9.3) (7.02) (3.67) (5.29) (6.57) (9.48) (7.55) (9.33)
MM
BE
l l | | =
0.32*** 0.16*** 0.05*** 0.07*** 0.16*** 0.31*** 0.27*** 0.2***
(9.45) (5.79) (4.06) (5.34) (5.47) (9.59) (6.95) (7.03)
Firms 14 16 39 17 11 10 6 46
Years 31 31 31 31 31 31 31 31
Observations 434 496 1209 527 341 310 186 1426
Table 5 reports the results of the Generalized Least Squares panel regression model adjusted using Prais-Winsten correction.
Panel A reports the results using market-based beta (m) calculation using 60 previous months. Panel B shows the estimates
using results using market-based beta calculation using 12 previous months. The firms are divided using Global Industry
Classifications (GIC) sectors: Energy (10), Materials (15), Industrials (20), Consumer discretionary (25), Consumer staples (30),
Health Care (35), Information Technology (45) and Utilities (55). l is the Levered Proxy Beta equations (0) to (0). is the error
term in the unleveraged-leveraged process (estimates not reported). Subscript E indicates calculation using the market value of debt and
subscript BE specify the Book Value of Equity. Superscripts ME and MM correspond to the unleveraged-leveraged process suggested by ME.
18

First row of each panel reports the coefficients and second row in each panel reports the corresponding t statistics (in
parentheses).
* p<0.05, ** p<0.01, *** p<0.001.


6.2 Regression results in subsamples
Another concern is whether the selected period in our sample affects the results. Especially
because our results does not confirm the previous findings from Marston & Perry (1996). Table 6
presents the results when the sample is divided in two subsamples: From 1977 to 1991 and 1992
to 1997. Although the estimates are lower than those obtained from the full sample, the statistical
significance is very high for both sub periods.

Table6Parametersestimatesregressionsusingsubsamples

MM
BE
l l | | =
ME
BE
l l | | =
MM
E
l l | | =
ME
E
l l | | =

PanelA.
1 2 3
(60)
it it it it
l m | o o | o c = + + +
1977 1991
m |

0.822*** 0.907*** 0.835*** 0.952***
(24.58) (21.7) (24.39) (22.42)
N 2385 2385 2385 2385
1992 2007
m |

0.262*** 0.271*** 0.280*** 0.297***
(14.11) (13.23) (16.2) (16.35)
N
2544 2544 2544 2544

PanelB.
1 2 3
(12)
it it it it
l m | o o | o c = + + +
1977 1991
m |

0.184*** 0.182*** 0.189*** 0.189***
(9.39) (8.41) (9.2) (7.88)
N 2385 2385 2385 2385
1992 2007
m |


0.193*** 0.192*** 0.203*** 0.206***
(12.33) (11.73) (13.59) (13.43)
N
2544 2544 2544 2544
Table 6 reports the results of the Generalized Least Squares panel regression model adjusted using Prais-Winsten
correction. The sample is divided in two subsamples: 1977 to 1991 and 1992 to 2007. Panel A reports the results using
market-based beta (m) calculation using 60 previous months. Panel B shows the estimates using results using
market-based beta calculation using 12 previous months. l is the Levered Proxy Beta equations (0) to (0). is the error
term in the unleveraged-leveraged process (estimates not reported). Subscript E indicates calculation using the market value of debt
and subscript BE specify the Book Value of Equity. Superscripts ME and MM correspond to the unleveraged-leveraged process
suggested by ME. First row of each panel reports the coefficients and second row in each panel reports the
corresponding t statistics (in parentheses).
* p<0.05, ** p<0.01, *** p<0.001.

19


6.3 Panel Regression Issues
Recent literature has been concerned about possibility of biased regression estimates
in the panel data (due to the nature of this type of datasets which may present
dependence in both cross-sectional and time series dimensions.) Petersen (2009) and Gow
(2010) suggests using cluster regressions as a robust method. Nevertheless, we decide
using a GLS with Prais-Winsten correction regression that is also robust also for
heteroskedasticity. Is the later method as good or better? From table Table 7 we can
conclude that our results do not change using the commonly used Fama-MacBeth
regression or a cluster regression.
Table7ParametersestimatesofOLSregressions

MM
BE
l l | | =
ME
BE
l l | | =
MM
E
l l | | =
ME
E
l l | | =

PanelA.
1 2 3
(60)
it it it it
l m | o o | o c = + + +
m Fama-MacBeth

0.744*** 0.820*** 0.728*** 0.807***

(16.18)

(17.45)

(14.49)

(14.73)

m Cluster Regression
0.588***

0.521***

0.521***

0.595***

(10.25)

(9.00)

(10.47)

(8.69)

Observations 4,929 4,929 4,929 4,929

PanelB.
1 2 3
(12)
it it it it
l m | o o | o c = + + +
m Fama-MacBeth

0.299*** 0.327*** 0.308*** 0.338***
(10.69)

(10.25)

(11.6)

(11.04)
m Cluster Regression 0.273***

0.287***

0.282***

0.300***
(11.33)

(10.66)

(12.01)

(11.26)
Observations 4,929 4,929 4,929 4,929
Table 7 reports the results of Fama-MacBeth regression or a cluster regression. Panel A reports the results using market-
based beta (m) calculation using 60 previous months. Panel B shows the estimates using results using market-based beta
calculation using 12 previous months. l is the Levered Proxy Beta equations (0) to (0). is the error term in the unleveraged-
leveraged process (estimates not reported). Subscript E indicates calculation using the market value of debt and subscript BE specify the
Book Value of Equity. Superscripts ME and MM correspond to the unleveraged-leveraged process suggested by ME. First row of each
panel reports the coefficients and second row in each panel reports the corresponding t statistics (in parentheses).
* p<0.05, ** p<0.01, *** p<0.001.

20



6.4 Values of and endogeneity issues
Equation (0) allows us to compare the performance of all versions of the Proxy Levered
Beta. However, the same equation encloses a possible endogeneity in our estimations
when is equal to one. From Table 2 we can conclude that the large standard deviation in
all versions of as well as the huge difference between the minimum and maximum of the
same variable are indicators of its real value. Nevertheless, we conduct a formal test to
check if the median of is equal to one (Ho: =1). The results from Table 8 suggest that
we can reject the null hypothesis in all specifications of .

Table8Wilcoxontestonmedianofequaltoone

Calculations based upon 60 previous
months

Calculations based upon 12 previous
months

MM MM MM
BE BE BE
u | | = 10.602*** 3.935***
ME ME ME
BE BE BE
u u | | = 11.680*** 5.180***
MM MM MM
E E E
u u | | = 10.502*** 3.354***
ME ME ME
E E E
u u | | = 11.703*** 4.501***
Table 9 presents the results (z-statistics) of Somers D test on the pooled sample. Panel A reports the results using market-based
beta calculation using 60 previous months. Panel B shows the results using market-based beta calculation using 12 previous months.
The null hypothesis is =0. is Unlevered Beta calculated using equations (0) or (0). l is the Levered Proxy Beta equations (0) to
(0). Subscript E indicates calculation using the market value of debt and subscript BE specifying the Book Value of Equity.
Superscripts ME and MM correspond to the unleveraged-leveraged process suggested by ME.
* p<0.05, ** p<0.01, *** p<0.001.

7 Conclusions
Current paper investigates the significance of financial leverage in computation of
systematic risk within the context of CAPM model. Our results suggest that the use of
the Levered Proxy Betas in solving the lack of market information problem for both
nontraded firms and individual business units is not misleading, even when we use
book value of debt instead of marketvalues. We also find more support in statistical
21

performance term for ModiglianiMiller (1958, 1963) assumptions in in calculating
(
u
) compared with Miles and Ezzel (1985) model.


The strong correlation between the Market-based Beta and its levered proxy counterpart
we found in Table 3 is consistent with the empirical findings of the majority of previous
studies. This suggests that the use of the Levered Proxy Betas to solve the lack of market is
a sound procedure. Although the relation is stronger for market values, book values of
equity also show statistical significant relationship. This is good news for practitioners who
have been using the unleveraged approach for years without much empirical support
about the validity of their procedures.

Our results show that the MM assumption regarding the inclusion of tax effect in the
unlevered beta calculation has a more statistical performance than the Miles and Ezzel
(1985) with the market-based beta and also their results are closer to the theoretical
expected result of one.

22

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