Changes in a Stock’s Beta Coefficient
As we shall see later in the book, a firm can influence its market risk, hence its beta, through (1) changes in the composition of its assets and (2) changes in the amount of debt it uses. A company’s beta can also change as a result of external factors such as increased competition in its industry, the expiration of basic patents, and the like. When such changes occur, the firm’s required rate of return also changes, and, as we shall see in Chapter 9, this will affect the firm’s stock price. For example, consider Allied Food Products, with a beta of 1.48. Now suppose some action occurred that caused Allied’s beta to increase from 1.48 to 2.0. If the conditions depicted in Figure 8-10 held, Allied’s required rate of return would increase from 13.4 to 16 percent:
r1 rRF (r M rRF )bi
6% (11% 6%)1.48
13.4%
to
r2 6% (11% 6%)2.0
16%
As we shall see in Chapter 9, this change would have a negative effect on Allied’s stock price.
Differentiate among a stock’s expected rate of return (rˆ), required rate of return (r), and realized, after-the-fact, historical return (r-).
Which would have to be larger to induce you to buy the stock, rˆ or r? At a given point in time, would rˆ, r, and r– typically be the same or different? Explain.
What are the differences between the relative volatility graph (Figure 8-9), where “betas are made,” and the SML graph (Figure 8-10), where “betas are used”? Explain how both graphs are constructed and the information they convey.
What would happen to the SML graph in Figure 8-10 if inflation increased or decreased?
What happens to the SML graph when risk aversion increases or decreases?
What would the SML look like if investors were indifferent to risk, that is, if they had zero risk aversion?
How can a firm influence the size of its beta?
A stock has a beta of 1.2. Assume that the risk-free rate is 4.5 percent and the market risk premium is 5 percent. What is the stock’s required rate of return? (10.5%)
