BETA ESTIMATION AND

COST OF EQUITY
USING CAPM METHOD

SUBMITTED BY GROUP NUMBER 1

AMULYA MANTENA (11104)
ANURADHA.R (11105)
BINSHA SHAJAHAN (11109)
BHAVANIKANTH (11111)
SASI BHUSHAN (11114)

INTRODUCTION
The risk and return relationship is a fundamental concept in not only financial analysis, but in
every aspect of life. If decisions are to lead to benefit maximization, it is necessary that
individuals/institutions consider the combined influence on expected (future) return or benefit as
well as on risk/cost. The requirement that expected return/benefit be commensurate with risk/cost
is known as the "risk/return trade-off" in finance.

This discusses the trade-off and, using conventional statistical tools, provides a method for
quantifying risk. Two categories of risk borne by the firm's stockholders, business risk and
financial risk, are discussed and demonstrated, as is the concept of leverage. The session also
examines risk reduction via portfolio diversification and what requirements need to be met for
firms to experience the benefits of diversification. The Capital Asset Pricing Model (CAPM) is
used to demonstrate the risk/return trade-off by relating the required return on the firm's
investments to its beta (or market) risk.

WHAT IS RISK?
Whether it is investing, driving, or just walking down the street, everyone exposes themselves to
risk. Your personality and lifestyle play a big role in how much risk you are comfortably able to
take on. If you invest in stocks and have trouble sleeping at night, you are probably taking on too
much risk.
Risk is defined as the chance that an investment's actual return will be different than expected.
This includes the possibility of losing some or all of the original investment.
Those of us who work hard for every penny we earn have a harder time parting with money.
Therefore, people with less disposable income tend to be, by necessity, more risk averse. On the
other end of the spectrum, day traders feel if they aren't making dozens of trades a day there is a
problem. These people are risk lovers.
When investing in stocks, bonds, or any investment instrument, there is a lot more risk than
you'd think. In the next section, we'll take a look at the different kind of risk that often threatens
investors' returns.
Ex-post risk

A type of risk measurement technique that uses historic returns to predict the riskiness of a
certain investment in the future. This type of risk measure is the equivalent of the statistical
variance of an asset's returns relative to its mean.
Using historic returns as a measure of future risk has been a traditional method used by investors
to determine the riskiness of a given asset. Ex-post risk is often used in value at risk analysis - a
tool used to give investors a best estimate of the maximum amount of loss that they could expect
to incur on any given trading day.

Ex-ante risk
A term that refers to future events, such as future returns or prospects of a company. Using exante analysis helps to give an idea of future movements in price or the future impact of a newly
implemented policy.
An example of ex-ante analysis is when an investment company values a stock ex-ante and then
compares the predicted results to the actual movement of the stock's price.

RISK AND RETURN

Risk can be defined as the deviation between expectations and actuals. It can be either positive or
negative. The more the deviation from the expected value, the more is the risk.
Return expresses the amount which an investor actually earned on an investment during a certain
period. Return includes the interest, dividend and capital gains; while risk represents the
uncertainty associated with a particular task. In financial terms, risk is the chance
or probability that a certain investment may or may not deliver the actual/expected returns.
The risk and return trade off says that the potential return rises with an increase in risk. It is
important for an investor to decide on a balance between the desire for the lowest possible risk
and highest possible return.

THE RELATIONSHIP BETWEEN RISK AND RETURN

Because risk and return are very important aspects in finance, it calls for concern to study the
relationship that exists between them. This notwithstanding, it has been brought to our notice that
there has been a debate on whether the relationship existing between risk and return is positive,
negative or curvilinear (Fiegenbaum et al, 1996). Bear this in mind that as far as issues in finance
are concerned, they will always be looked at from at least two different points of view because of
the difference between the classical school of thought and the behavioural school of thought.
Statistics has proven that most investors are risk averse. This idea serves as a backbone for
looking into the positive relationship existing between risk and return. This is judging from the
point that most low risks are mostly associated with low return and vice versa (Fisher and Hall,
1969) thereby leaving investors with the problem of choosing the option that best maximises
their abilities (Schoemaker, 1982).
Never the less, this positive relationship of risk and return has been supported by many classical
financial theories including CAPM, MPT and EMH. Haslem loc also supported the fact that
there is a positive relationship between risk and return, where he stated that the Capital Asset
Pricing Model (CAPM) posits that return and risk are positively related, higher return carries
higher risk and this was as well strongly supported by Vaitilingam et al 2006. Using the
portfolio theory as a guide for investment decisions, it was suggested that the greater the risk the
greater the expected return. This is because, according to Lumby 1988, the basis of the
relationship between risk and return has always been justified on grounds that investors are
generally risk-averse.
According to Bowman (1980 and 1982), and after carrying out exclusive research and sampling
from different industries, Bowman resulted in suggesting the existence of considerable variance
with the classical finance theories in relation to risk and return in what became known as the
Bowman paradox or the risk and return paradox. It has been evident from his findings that most
of the time, when there happen to be a negative relationship between risk and return, that implies
investors must have swapped from being risk-averse to risk-seekers and this can be experienced
in any institution whether the institutions are performing well or not. This therefore implies there
really do exist a negative relationship between risk and return.

IMPORTANCE OF RISK-RETURN RELATIONSHIP

The relationship between risk and return is a fundamental financial relationship that affects
expected rates of return on every existing asset investment. The Risk-Return relationship is
characterized as being a "positive" or "direct" relationship meaning that if there are expectations
of higher levels of risk associated with a particular investment then greater returns are required
as compensation for that higher expected risk. Alternatively, if an investment has relatively
lower levels of expected risk then investors are satisfied with relatively lower returns.
This risk-return relationship holds for individual investors and business managers. Greater
degrees of risk must be compensated for with greater returns on investment. Since investment
returns reflects the degree of risk involved with the investment, investors need to be able to
determine how much of a return is appropriate for a given level of risk. This process is referred
to as "pricing the risk". In order to price the risk, we must first be able to measure the risk (or
quantify the risk) and then we must be able to decide an appropriate price for the risk we are
being asked to bear.

RISK ANALYSIS

Risk in investment exists because of the inability to make perfect or accurate forecasts. Risk in
investment is defined as the variability that is likely to occur in future cash flows from an
investment. The greater variability of these cash flows indicates greater risk.
Variance or standard deviation measures the deviation about expected cash flows of each of the
possible cash flows and is known as the absolute measure of risk; while co-efficient of variation
is a relative measure of risk.

SOURCES OF RISKS

Inflation
Business cycle
Interest rates
Management
Business risk
Financial risk

TYPES OF RISKS

Systematic risk
Systematic risk influences a large number of assets. A significant political event, for example,
could affect several of the assets in your portfolio. It is virtually impossible to protect yourself
against this type of risk.
It is also called as Uncontrollable Risk. A risk which an individual cannot able to control is
Systematic Risk or unavoidable risk.

Risk caused by factors that affect the prices of virtually all securities, although in different
proportions. Examples include changes in interest rates and consumer prices. Although it is not
possible to eliminate systematic risk through diversification, it is possible to reduce it by
acquiring securities (for example, those of utilities and many blue chips) that have histories of
relatively slowly changing prices. Also called market risk, no diversifiable risk.

Credit or Default Risk - Credit risk is the risk that a company or individual will be unable to
pay the contractual interest or principal on its debt obligations. This type of risk is of
particular concern to investors who hold bonds in their portfolios. Government bonds,
especially those issued by the federal government, have the least amount of default risk and
the lowest returns, while corporate bonds tend to have the highest amount of default risk but
also higher interest rates. Bonds with a lower chance of default are considered to
be investment grade, while bonds with higher chances are considered to be junk bonds. Bond
rating services, such as Moody's, allows investors to determine which bonds are investmentgrade, and which bonds are junk.

Operational Risk: During the 1990s, financial institutions started to focus attention on the
risks associated with their back office operations what came to be called operational risks.
Having already focused on managing market and credit risks, a number of institutions
broadly defined operational risk as all risks other than market or credit risks. Others have
defined operational risk more narrowly as risk associated with human or technology failure.

Interest Rate Risk - Interest rate risk is the risk that an investment's value will change as a
result of a change in interest rates. This risk affects the value of bonds more directly than
stocks.
Market Risk - This is the most familiar of all risks. Also referred to as volatility, market risk
are the day-to-day fluctuations in a stock's price. Market risk applies mainly to stocks and
options. As a whole, stocks tend to perform well during a bull market and poorly during a
bear market - volatility is not so much a cause but an effect of certain market forces.
Volatility is a measure of risk because it refers to the behavior, or "temperament", of your
investment rather than the reason for this behavior. Because market movement is the reason
why people can make money from stocks, volatility is essential for returns, and the more
unstable the investment the more chance there is that it will experience a dramatic change in
either direction.

Systematic risk is comprised of the unknown unknowns that occur as a result of everyday life.
It can only be avoided by staying away from all risky investments.

Why It Matters:
Because of market efficiency, you will not be compensated for the additional risks that arise from
failure to diversify your portfolio. This is extremely important for those who may have a large
holding of one stock as part of an employer-sponsored incentive plan. Unsystematic risk exposes
you to adverse events on a company or industry level in addition to adverse events on a global
level.

Unsystematic risk
Unsystematic risk is sometimes referred to as "specific risk". This kind of risk affects a very
small number of assets. An example is news that affects a specific stock such as a sudden strike
by employees. Diversification is the only way to protect yourself from unsystematic risk. It is
also called as controllable Risk. A risk which an individual can control through his ability and
knowledge is Systematic Risk or avoidable risk.
The risk that is specific to an industry or firm. Examples of unsystematic risk include losses
caused by labor problems, nationalization of assets, or weather conditions. This type of risk
can be reduced by assembling a portfolio with significant diversification so that a single event
affects only a limited number of the assets. Also called diversifiable risk
Business Risk: By changing the proportion of the variables and taking as leverage either in
product or service the person can take risk in his organisation as trial and error method, if it
doesnt work out he can try in another object. It will be purely on the interest of the
individual, so he can have full control on his own decisions.
Financial Risk: By changing the proportion of the Debt and Equity mix, the person can take
risk in his organisation the overall objective of any enterprise is to minimize cost and
maximize profit, the person can try this leverage if the Earnings Per share (EPS) gets
increased the leverage can be accepted. So he can take the full advantage of risk.

Dealing With Nonsystematic and Systematic Risk

For passive investors (i.e. investors of financial instruments), minimizing nonsystematic risk
factors is not difficult. By adequately diversifying your investment portfolio, you can effectively
manage nonsystematic risks.
Some academics believe that by holding between 12 and 18 stocks (or bonds), one can achieve
adequate diversification to eliminate nonsystematic risk. Yes, but they need to be the correct mix
of assets. When we discuss portfolio creation later on, I will consider how to properly diversify
an investment portfolio.
For those managing a business, it is impossible to diversify one company. However, by being
able to identify the nonsystematic risks, you can take steps to reduce their potential impact. We
will look at the specific risks and how to deal with them in my next post.
As some of the alternate names suggest, systematic risk is more difficult to manage. Although
sometimes called non-diversifiable or non-controllable risk, you can actual take measures to
reduce this risk. Diversification, insurance, and hedging are examples of ways to address
systematic risk. When we look at portfolio construction, I will make suggestions on dealing with
systematic risk issues.

Difference between Systematic and Unsystematic Risk

While investing in a stock market one need to take into account two types of risks one is
systematic and other is unsystematic risk. Lets look at the difference between the two of them
Systematic risk refers to the risk which affects the whole stock market and therefore it cannot be
reduced or diversified away. For example any global turmoil will affect the whole stock market
and not any single stock, similarly any change in the interest rates affect the whole market
though some sectors are more affected then others. This type of risk is called non diversifiable
risk because no amount of diversification can reduce this risk.;
Unsystematic risk is the extent of variability in the stock or securitys return on account of
factors which are unique to a company. For example it may be possible that management of a
company may be poor, or there may be strike of workers which leads to losses. Since these
factors affect only one company, this type of risk can be diversified away by investing in more
than one company because each company is different and therefore this risk is also called
diversifiable risk.

RETURN ANALYSIS
An investment is the current commitment of funds done in the expectation of earning greater
amount in future. Returns are subject to uncertainty or variance Longer the period of investment,
greater will be the returns sought. An investor will also like to ensure that the returns are greater
than the rate of inflation.
An investor will look forward to getting compensated by way of an expected return based on 3
factors

Risk involved

Duration of investment [Time value of money]

Expected price levels [Inflation]

The basic rate or time value of money is the real risk free rate [RRFR] which is free of any risk
premium and inflation. This rate generally remains stable; but in the long run there could be
gradual changes in the RRFR depending upon factors such as consumption trends, economic
growth and openness of the economy.
If we include the component of inflation into the RRFR without the risk premium, such a return
will be known as nominal risk free rate [NRFR]

NRFR = ( 1 + RRFR ) * ( 1 + expected rate of inflation ) - 1

Third component is the risk premium that represents all kinds of uncertainties and is calculated
as follows Expected return = NRFR + Risk premium

RISK AND RETURN TRADE OFF

Investors make investment with the objective of earning some tangible benefit. This benefit in
financial terminology is termed as return and is a reward for taking a specified amount of risk.
Risk is defined as the possibility of the actual return being different from the expected return on
an investment over the period of investment. Low risk leads to low returns. For instance, incase
of government securities, while the rate of return is low, the risk of defaulting is also low. High
risks lead to higher potential returns, but may also lead to higher losses. Long-term returns on
stocks are much higher than the returns on Government securities, but the risk of losing money is
also higher.
Rate of return on an investment can be calculated using the following formulaReturn = (Amount received - Amount invested) / Amount invested
He risk and return trade off says that the potential rises with an increase in risk. An investor must
decide a balance between the desire for the lowest possible risk and highest possible return.

WHAT IS BETA?

A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the

market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that
calculates the expected return of an asset based on its beta and expected market returns

A beta of 1 indicates that the security's price will move with the market.
A beta of less than 1 means that the security will be less volatile than the market.
A beta of greater than 1 indicates that the security's price will be more volatile than the
market.

COST OF EQUITY
The annual rate of return that an investor expects to earn when investing in shares of a
company is known as the cost of common equity. That return is composed of the dividends paid
on the shares and any increase (or decrease) in the market value of the shares.
The return expected of any risky common stock should be composed of at least three different
return components: (1) a return commensurate with a risk-free security (Rf); (2) a return that
incorporates the market risk associated with common stocks as a whole (Rm); and (3) a return
that incorporates the business and financial risks specific to the stock of the company itself,
known as the company's beta.

The first measure of return (Rf) relates to what market rate of return is currently available from a
risk-free security, like the yield associated with a long-term Treasury Bond. So if the yield on
Treasury Bonds is 5%, an investor should expect a return greater than 5% for a common stock.

The second measure of return (Rm) relates to what market returns are currently available from
and what risks are associated with stocks in general. There is a general risk premium (the equity
risk premium) associated with the stock market as a whole. That risk premium should be priced
into any equity investment. For example, if you expect to earn 8% on average (from a diversified
portfolio) in the stock market and the risk-free rate is 5%, the Equity Risk Premium (Rerp)
would be (Rerp) = (8% - 5%)= 3%.

Equity Risk Premium(Rerp) = Exp. Return on Market(Rm) - Risk Free Rate(Rf)

The third measure of return versus risk (beta) should be related to the specific stock being
purchasedhow risky is the type of business the firm does and how risky is the financial
structure or leverage of the firm. Beta measures the risk of the company relative to the risk of the
stock market in general. With greater risk, as measured by a larger variability of returns (business
or operating risk), the company's should have a larger beta. And with greater leverage (higher
debt to value ratio) increasing financial risk, the company's stock should also have a larger beta.
And with a larger beta, an investor should expect a greater return. The beta of an average risk
firm in the stock market is 1.00.

The financial risk model that uses beta as its sole measure of risk ( a single factor model) is
called the Capital Asset Pricing Model (CAPM) and is used by many market analysts in their
valuation process. The relationship between risk and return that comes out of that model and the
one that is incorporated into our FCFF analysis and spreadsheet software is:

Exp.(Rs) = (Rf) + beta(Rerp)

FACTORS AFFECTING EQUITY RETURNS

There are 5 economic factors that affect equity returns:
1. Unanticipated changes in default risk;
2. Unanticipated changes in the term structure of interest rates;
3. Unanticipated changes in the inflation rate;
4. Unanticipated changes in the long-run growth rate of profits for the economy; and
5. Residual market risk.

OBJECTIVE OF THE STUDY

To estimate beta of the stocks of selected companies using CAPM

To estimate the cost of equity of the selected companies, based on beta values obtained
above.

METHODOLOGY ADOPTED

The study considers the share price information of 5 listed companies namely Tata
motors, Bharti Airtel, Hindustan Unilever, Infosys Ltd and ONGC.
The time period considered is 52 weeks starting from 1 st January 2011 to 1st
January 2012. Accordingly, the number of data points is 52.
The market benchmark selected is NSE Nifty.
Since data is on weekly basis, the closing price of every Friday is taken into
consideration. If Friday happens to be a holiday, the closing price of Thursday is
taken into account.
Beta is estimated using Regression analysis, where, returns of stocks under
consideration are dependent variable and Nifty returns are independent variable.
Basic principle behind this methodology is the concept of CAPM ( Capital Asset
Pricing Model)
Risk free proxy is taken as treasury bill return and assumed to be 6% per annum.

CAPM
A model that describes the relationship between risk and expected return and that is used
in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value
of money and risk. The time value of money is represented by the risk-free (rf) rate in the
formula and compensates the investors for placing money in any investment over a period of
time. The other half of the formula represents risk and calculates the amount of compensation the
investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that
compares the returns of the asset to the market over a period of time and to the market premium

(Rm-rf). The relation between risk and return that usually holds, in which one must be willing to
accept greater risk if one wants to pursue greater returns. also called risk/reward trade-off.
The concept that every rational investor, at a given level of risk, will accept only the largest
expected return. That is, given two investments at the exact same level of risk, all other things
being equal, every rational investor will invest in the one that offers the higher return. The riskreturn tradeoff is pervasive throughout economics and finance. It is the reason that riskier bonds
pay higher coupons than other bonds. It is also the reason that bonds pay lower returns than most
stocks because they are a less risky investment. The Markowitz Portfolio Theory attempts to
mathematically identify the portfolio with the highest return at each level of risk.

RESULTS AND ANALYSIS

TATA
MOTORS
0.643

BETA
VALUE
COST OF -0.54342
EQUITY

BHARTI
AIRTEL
0.6646

HUL

INFOSYS

ONGC

0.5795

0.8889

0.643

-0.2484

-0.2018

-0.3711

-0.2366

Interpretation
It can be interpreted that the stocks of the companies considered in the study are defensive, as
indicated by their respective beta values. However, among all, HUL is least risky. Interestingly, it
is observed that the cost of equity for the stocks under consideration turned out to be negative,
which is not practical. The reason behind that is that average return on Nifty for the period of
study itself is negative. This can be attributed to the limited period that we considered in our
study. Furthermore, the period of study is witnessing extraordinary macro-economic disturbances
like Euro crisis, Euro crisis, downtrend in US, relative under performance of Indian economy,
unexpected rupee depreciation.
Thus, the results of the study may not reliable.

LIMITATIONS OF THE STUDY

Study is conducted only for a period of 2 years and 1 month, which may not be a reliable
period. Because, market performance during this time period is mainly influenced extra
ordinary events like Euro crisis, downtrend in US, relative under performance of Indian
economy, unexpected rupee depreciation. As a result, findings of the study may not be
reliable.
No trace of primary data is considered for study and is completely dependent on the
secondary sources of data.
An exact trend cannot be made because the period considered for the study is very small.
Moreover the time taken for doing the study is just one month within which a detailed
understanding about the topic is not possible.
The study is limited to secondary data. However, there is possibility of error in collecting,
tabulating and analyzing the data

REFERENCES
1. Financial Management by Rajiv S. & Anil Misra
2. www.nseindia.com
3. www.bseindia.com