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Valuation of Conrail

I. INTRODUCTION....................................................................................................................242

A. Net Present Value ........................................................................................................242

B. Cost of Capital .............................................................................................................243

C. Beta and the Capital Asset Pricing Model..............................................................244

D. Purpose of the Article.................................................................................................246

II. INTRODUCTION TO BETA ...................................................................................................247

A. Systematic and Unsystematic Risk............................................................................247

B. Beta: A Measure of Systematic Risk.........................................................................249

C. Background Information on Return on the Market and on Four Securities .....249

III. DERIVATION OF BETA THROUGH THE USE OF COVARIANCE AND VARIANCE ..........252

A. Introduction..................................................................................................................252

B. Expected Return ...........................................................................................................252

C. Variance........................................................................................................................254

D. Covariance...................................................................................................................258

1. Introduction ............................................................................................................258

2. Standard Deviation................................................................................................258

3. Correlation Coefficient.........................................................................................260

4. Computation of Covariance.................................................................................264

E. The Determination of Beta.........................................................................................264

IV. DERIVATION OF BETA THROUGH REGRESSION A NALYSIS ..........................................266

A. Introduction..................................................................................................................266

B. Scatter Diagrams .........................................................................................................266

C. The Method of Least Squares ....................................................................................268

D. Normal Equations for Least Squares Line..............................................................268

E. Shortcut Method for Computing Slope-Beta...........................................................275

F. Coefficient of Determination.....................................................................................277

V. DERIVATION OF BETA THROUGH THE USE OF EXCEL’S LINEAR REGRESSION

FUNCTON .............................................................................................................................282

* Professor and Director, Center for the Study of Mergers and Acquisitions, University of Miami School

of Law, and Tax Policy Advisor (on behalf of the United States Treasury Department), Ministry of Finance,

Republic of South Africa. The author would like to thank Tarek Sayed, a 1998 graduate of the University of

Miami School of Law and a student in the Graduate Program in Taxation at the University of Miami School of

Law, and Gheri Hicks, a third-year student at the University of Miami School of Law, for their assistance in the

preparation of this art icle.

242 The Journal of Corporation Law [Winter

A. Summary........................................................................................................................283

B. Adjusted Betas..............................................................................................................284

VII. A SSET AND EQUITY BETAS AND THE LEVERING AND UNLEVERING FORMULA ........284

A. Introduction..................................................................................................................284

B. The Levering and Unlevering Formula...................................................................288

VIII. RETURNING TO THE CAPITAL A SSET PRICING M ODEL .................................................290

IX. LAZARD’S USE OF BETA, CAPM, AND THE FORMULA FOR LEVERING AND

DELEVERING BETA IN COMPUTING CONTRAIL ’S WACC AND PRESENT VALUE.....293

A. Introduction..................................................................................................................293

B. Computation of Levered Beta....................................................................................294

C. Conversion of Levered Beta to Unlevered Beta.....................................................294

D. Recomputation of Levered Beta for Various Debt to Equity Ratios...................296

E. Use of CAPM to Compute Cost of Levered Equity................................................297

F. Computation of Conrail’s Weighted Average Cost of Capital.............................298

G. Use of WACC in Determining the Present Value of Conrail’s Free Cash

Flow...............................................................................................................................300

X. SUMMARY OF LAZARD’S DCF VALUATION APPROACH ..............................................302

XI. CONCLUSION .......................................................................................................................303

I. INTRODUCTION

One of the principal methods of valuation in mergers and acquisitions and other

capital budgeting contexts is the net present value (NPV) technique, which can be broken

down into four steps.1 First, this technique requires an estimate of the free cash flows and

the terminal value expected to be generated by the target firm (target) or other

investment.2 Free cash flow is the actual cash flow, not accounting earnings, that the

target can expect to generate. Thus, depreciation and other noncash deductions used in

1. See Samuel C. Thompson, Jr., A Lawyer’s Guide to Modern Valuation Techniques in Mergers and

Acquisitions, 21 J. CORP . L. 457, 528-30 (1996). The present article is an extension and elaboration on many of

the concepts discussed in Part VI of the earlier article. See id. at 501-20. See generally RICHARDA. BREALEY &

STEWART C. MYERS, P RINCIPLES OF CORPORATE FINANCE (5th ed. 1996); EUGENE F. BRIGHAM& LOUISC.

GAPENSKI , FINANCIAL MANAGEMENT: T HEORY AND P RACTICE (8th ed. 1997); JOHN Y. CAMPBELL ET AL., THE

ECONOMETRICS OF FINANCIAL MARKETS (1997); T OM COPELAND ET AL ., VALUATION: MEASURING AND

MANAGING THE VALUE OF COMPANIES (2d ed. 1994); DAMODAR N. GUJARATI , BASICECONOMETRICS (3d ed.

1995); BURTON G. MALKIEL , A RANDOM W ALK DOWN W ALL STREET (6th ed. 1996); ROBERTC. RADCLIFFE,

I NVESTMENT: CONCEPTS, ANALYSIS, AND STRATEGY (5th ed. 1997); ALFRED RAPPAPORT , CREATING

SHAREHOLDER VALUE (1986); MILTON L. ROCK ET AL., T HE MERGERS AND ACQUISITIONSHANDBOOK (2d ed.

1994); STEPHEN A. ROSS ET AL., FUNDAMENTALS OF CORPORATE FINANCE (2d ed. 1993); and J. FRED WESTON

ET AL., T AKEOVERS, RESTRUCTURING, AND CORPORATE GOVERNANCE (2d ed. 1997).

Several of the statistical concepts discussed here are explored in the following statistics books: DAVID

K. HILDEBRAND & R. LYMAN OTT, BASIC STATISTICAL I DEAS FOR MANAGERS (3d ed. 1996) and MURRAYR.

SPIEGEL , SCHAUM’ S OUTLINE OF T HEORY AND P ROBLEMS OF STATISTICS (2d ed. 1991).

2. See Thompson, supra note 1, at 481-500. The discussion here will focus on the acquisition of a target.

2000] Demystifying the Use of Beta 243

computing net income are added back, and capital expenditures and other nondeductible

cash expenditures are deducted in computing free cash flow. The terminal value is the

cash expected to be realized from the sale of the target after an assumed holding period,

such as five or ten years.

Second, the cost of capital, which is the return required for an investment in the

target, must be determined. Third, the estimated free cash flows and terminal value are

discounted to present value at the applicable cost of capital, or discounted rate, to arrive

at the aggregate present value of these cash flows.3 These first three steps are generally

referred to as the discounted cash flow (DCF) method.

Fourth, the NPV of the transaction is determined by subtracting the cost of the target

from the aggregate present value of the target’s cash flows and terminal value. If this

amount is positive, the investment has a positive NPV. In such a case, because the

investment will offer a return that exceeds the cost of capital of the investment, the

investment should generally be made.4 Thus, the key variables used in the NPV

technique are the estimate of the free cash flows and terminal value and the determination

of the cost of capital.

In an article entitled The Valuation of Cash Flow Forecasts: An Empirical Analysis,

Professors Steven Kaplan and Richard Ruback find that “discounted cash flow valuation

methods provide reliable estimates of market value [of management buyouts and

leveraged recapitalizations].”5 This analysis provides strong theoretical support for the

proposition that the DCF and related NPV techniques are important valuation tools in

merger and acquisition transactions.

B. Cost of Capital

Depending on the particular context, the cost of capital may be the weighted average

cost of capital (WACC) appropriate for the target firm, 6 the cost of equity assuming an

unleveraged target firm, or the cost of equity assuming a leveraged target firm. For

example, Professor Alfred Rappaport generally recommends the use of WACC in

determining the cost of capital.7 WACC automatically takes account of the financing

decision by placing the appropriate weight on the cost of equity and the after-tax cost of

the debt. Because the interest on debt is tax deductible for federal income tax purposes,8

the use of debt will cause the WACC to be lower than the cost of equity. This approach is

referred to here as the WACC DCF approach.

Richard A. Brealey and Stewart C. Myers, on the other hand, generally suggest that

the financing decision be separated from the investment decision by discounting the cash

3. Id. at 469-81.

4. Id. at 474-75. Even if an investment produces a negative NPV, the investment may be undertaken if,

for example, an option to make a follow-on investment that could result in an aggregate positive NPV is

embedded in the initial investment decision. The impact of “real options” like this are discussed in BREALEY &

MYERS, supra note 1, at 589-610. See also Keeping All Options Open, ECONOMIST, Aug. 14, 1999, at 62.

5. Steven N. Kaplan & Richard S. Ruback, The Valuation of Cash Flow Forecasts: An Empirical

Analysis, 50 J. FIN. 1054, 1091 (1995).

6. Thompson, supra note 1, at 522-25.

7. RAPPAPORT , supra note 1, at 55; see also Thompson, supra note 1, at 522-25.

8. I.R.C. § 163 (1986).

244 The Journal of Corporation Law [Winter

flows and terminal value at the cost of unlevered equity for the target.9 The impact of the

use of debt is separately accounted for by discounting the expected tax savings from any

interest deduction at the applicable cost of equity capital and adding the present value of

the tax saving to the NPV to determine the adjusted NPV or APV. 10 This is referred to

here as the APV DCF approach. Professors Kaplan and Ruback use what they refer to as

the “Compressed APV” technique in conducting their DCF valuation study.11

Under both the WACC and APV approaches, interest is not deducted when

computing the free cash flows, because the effect of the use of interest is accounted for

with a lower cost of capital with WACC or by separately discounting the tax savings

from the interest deduction with APV. This is referred to as the all equity method of

computing free cash flow, that is, unlevered free cash flow.12 The WACC and APV

methods produce a valuation of the target’s assets; the target’s outstanding debt is then

subtracted to determine the value of the target’s equity.

In following a third approach, Eugene F. Brigham and Louis C. Gapenski suggest

that a target’s free cash flows, after deducting interest, plus terminal value, be discounted

at the target’s leveraged cost of capital.13 Because this approach is valuing the equity,

debt is not subtracted from the valuation as is the case with WACC and APV. This

approach is referred to here as the equity DCF approach. Properly applied, these three

methods should produce similar estimates of the fair market value of the target’s equity.

All of these methods require an estimate of the cost of equity: the cost of levered equity

under WACC and the Brigham and Gapenski technique, and the cost of unlevered equity

under the Brealey and Myers APV technique.

Investment banking firms generally seem to use the WACC DCF approach and,

therefore, use the all equity assumption in creating a cash flow statement, thus focusing

on an unlevered free cash flow. This is illustrated in the cash flow statement used by the

investment banking firm of Lazard Frères & Co., LLC in its valuation of Conrail,14

which was the target of an acquisition by competing acquirors CSX and Norfolk

Southern.15 It is also illustrated in the 1989 acquisition of Warner Communications, Inc.

by Time, Inc. In that case, the investment bankers for both Time and Warner used

unlevered free cash flow statements in their DCF analyses.16

One of the principal ways of determining the cost of equity is the capital asset

10. Id. at 528-31; see also Thompson, supra note 1, at 521-22.

11. See Kaplan & Rubak, supra note 5, at 1062.

12. See generally BREALEY & M YERS, supra note 1, at 120.

13. BRIGHAM & GAPENSKI , supra note 1, at 1087-89. Brigham and Gapinski refer to the method as the

“equity residual method to valu[ing] the target firm, because the estimated net cash flows are a residual which

belongs solely to the acquiring firm’s shareholders.” Id. at 1089.

14. See infra Appendix B.

15. This transaction is discussed in Norfolk Southern Corp. v. Conrail Inc., Civ. Act. No. 96-7197 (E.D.

Pa. 1997) (Vanartsdalen, J., ruling from the bench), reproduced in SAMUEL C. T HOMPSON , JR., BUSINESS

P LANNING FOR MERGERS AND ACQUISITIONS (1997).

16. See Thompson, supra note 1, at apps. C-3, D-5.

2000] Demystifying the Use of Beta 245

pricing model (CAPM).17 CAPM provides that the cost of equity capital (re) for a target

is determined by a formula that takes into account the following variables: (1) the risk-

free rate of return (rf); (2) the market risk premium (rm-rf), which is the difference

between the expected return on the market (rm ) the risk-free rate of return (rf ); and (3) the

beta (β ) for the target’s stock. Beta measures the relationship between the movements of

the returns on a stock with the movements of the equity market.18 The formula is as

follows:19

Expected Rate of Return (re) = [Risk-free Rate of Return (rf)] + Beta (β)

x [Market Risk Premium (rm-rf)]

re = rf + β (rm - rf)

The risk-free rate of return is either the T-bill rate, as suggested by Brealey &

Myers 20 and John Y. Campbell, Andrew W. Lo, and A. Craig MacKinlay,21 or the T-

bond rate, as suggested by Brigham and Gapenski.22 The market risk premium is the

difference between the expected return on a market portfolio of common stocks (rm)

(such as the S&P 500)23 and the risk-free rate (rf). Brealey and Myers report that

historically the market risk premium when the T-bill rate is used as the risk-free rate has

been 8.4% per year,24 and Tom Copeland, Tim Koller, and Jack Murrin report that if the

ten year T-bond rate is taken as the risk-free rate, the market risk premium is 5 to 6%.25

Thus, if the T-bill rate is used as the risk-free rate, the market risk premium will be higher

than if the T-bond rate is used.26

While the risk-free rate and the market risk premium are determined by observing

market factors, the beta is specific to the target. As will be seen, the beta for the market

17. This model may be used for determining the cost of equity capital for purposes of applying the

economic valued added (EVA) concept. See, e.g., AL EHRBAR, EVA: T HE REAL KEY TO CREATINGWEALTH

178-79 (1998). “EVA . . . is a measure of corporate performance that . . . includ[es] a charge against profit for

the cost of all the capital a company employs.” Id. at 1.

18. BREALEY & M YERS, supra note 1, at 160-61. “Beta measures the amount that investors expect the

stock price to change for each additional 1 percent change in the market.” Id. at 166.

19. Thompson, supra note 1, at 502 (citing RICHARD A. BREALEY & STEWARTC. MYERS, PRINCIPLESOF

CORPORATE FINANCE 190-97 (4th ed. 1991)).

20. BREALEY & M YERS, supra note 1, at 147; see also Thompson, supra note 1, at 510-11.

21. CAMPBELL ET AL., supra note 1, at 184.

22. BRIGHAM & GAPENSKI , supra note 1, at 170. Brigham and Gapenski say that the risk -free rate in a

CAPM analysis can be proxied by either a long-term rate (the T -bond rate) or a short-term rate

(the T -bill rate). Traditionally the T -bill rate was used, but in recent years, there has been a

movement toward the use of the T -bond rate because there is a closer relationship between T-

bond yields and stocks than between T -bill yields and stocks.

Id. at 173 n.13.

23. CAMPBELL ET AL ., supra note 1, at 184 (suggesting use of the S&P 500 as the proxy for the market

portfolio).

24. BREALEY & M YERS, supra note 1, at 146.

25. COPELAND ET AL ., supra note 1, at 260.

26. For example, Ibbotson Associates found the average risk premium of stocks, which had an average

return of 12.5%, over T -bonds to be 7.4%, and the average risk premium of stocks over T -bills to be 8.8%.

BRIGHAM AND GAPENSKI , supra note 1, at 351.

246 The Journal of Corporation Law [Winter

portfolio is 1 and, consequently, if the target has a risk profile that is the same as the

market, the target will also have a beta of 1. In such case, the required cost of capital for

the target will be the same as the market’s rate of return. This can be seen as follows.

Assume that the market rate of return is 12%, the risk-free rate is 5%, and the target’s

beta is 1. Consequently, the required rate of return is 12%, computed as follows:

r = rf + β (rm - rf)

r = 5% + 1(12% - 5%)

r = 5% + 1(7%)

r = 12%

If the target is more risky than the market portfolio, the target’s beta will be higher

than 1, and the target’s required rate of return will be higher than the return on the

market. If the target is less risky than the market portfolio, the target’s beta will be lower

than 1, and the target’s required rate of return will be lower than the return on the market.

Brigham and Gapenski report that betas for a single stock may not be stable over time;27

that is, the beta for the period from 1985 to 1990 may differ from the beta for the period

1990 to 1995. They report that betas of a portfolio of ten or more randomly selected

stocks are reasonably stable.28 They go on to state: “The conclusion that follows from the

beta stability studies is that the CAPM is a better concept for structuring investment

portfolios than it is for estimating the cost of capital for individual securities.”29 This

conclusion could mean that in determining the beta for a particular company, it may be

prudent to consider the betas for similar companies. On this point, Copeland, Koller, and

Murrin say that “Because measurement errors tend to cancel out, industry averages are

more stable than company betas.”30

The purpose of this Article is to first discuss the derivation of beta and then to

illustrate how beta and CAPM were used by the investment banking firm of Lazard

Frères & Co., LLC (“Lazard”) in determining the cost of capital for Conrail and in

valuing Conrail’s free cash flows. Although the validity of beta and CAPM have been

challenged,31 Brigham and Gapenski say that CAPM and beta are “useful conceptual

tool[s].”32 Also, Brealey and Myers say that CAPM is the “best-known model of risk and

return,”33 and that CAPM is “widely used by large corporations to estimate the discount

28. Id.

29. Id.; see also BREALEY & M YERS, supra note 1, at 209 (“Potentially large estimate errors [can arise]

when you estimate betas of individual stocks from a limited sample of data. Fortunately these errors tend to

cancel when you estimate betas of portfolios.”).

30. COPELAND ET AL ., supra note 1, at 264.

31. See, e.g., Eugene F. Fama & Kenneth R. French, The Cross-Section of Expected Stock Returns, 47 J.

FIN. 427 (1992); Thompson, supra note 1, at 517-20; BRIGHAM & GAPENSKI , supra note 1, at 213-16;

CAMPBELL ET AL ., supra note 1, at 211-17.

32. BRIGHAM & GAPENSKI , supra note 1, at 216.

33. BREALEY & M YERS, supra note 1, at 194.

2000] Demystifying the Use of Beta 247

rate,” that is, the cost of capital.34 Further, in evaluating the utility of beta, Burton G.

Malkiel concludes that the “reports of beta’s total demise are, in my judgment,

premature.”35

CAPM and beta are used by investment bankers in preparing, inter alia, merger and

acquisition valuations. This is illustrated in Appendix A, which contains the computation

by Lazard of the cost of equity and WACC of Conrail, which, at the time, was the target

of both CSX and Norfolk Southern. This Appendix illustrates how Lazard first

determined Conrail’s beta and then used CAPM with both leveraged and unleveraged

betas to determine Conrail’s cost of equity under various debt-equity assumptions. Lazard

then used this range of costs of equities to determine a range of WACCs for Conrail. This

Appendix also illustrates the application of the formula for moving from levered to

unlevered betas and then back to levered betas. Appendix B shows how Lazard used

Conrail’s WACC as determined in Appendix A to determine the present value of

Conrail’s free cash flows and terminal value.

Parts II through VI address the derivation of beta, Part VII discusses the formula for

moving between unlevered and levered betas, and Part VIII elaborates on the use of beta

in CAPM. Part IX first analyzes Lazard’s use in Appendix A of CAPM and beta in

computing Conrail’s WACC and then discusses Lazard’s use in Appendix B of this cost

of capital in determining the value of Conrail’s cash flows. Finally, Part X provides a

brief summary of Lazard’s WACC DCF valuation of Conrail.

There are two types of risk inherent in investments: systematic risk and unsystematic

risk. Risk in either context means that future returns are uncertain.37 Systematic risk is a

function of broad macroeconomic conditions that affect the prices of all assets.38 Thus,

there is systematic risk in holding any asset. Conversely, unsystematic risk is a function

of the characteristics associated with a particular asset as opposed to broad market

factors.39 For example, risk factors such as the rate of growth of GNP or interest rate

levels have a systematic effect on all firms .40 Comparatively, risk factors such as possible

changes in consumer tastes, new product developments, and changes in prices of raw

materials affect particular firms and, therefore, are referred to as unsystematic risks.41

Diversification can reduce or eliminate unsystematic risk by balancing the losing

stocks with winning stocks; such risk is often referred to as diversifiable risk, unique risk,

residual risk, or specific risk.42 The specific risk of holding stock in a particular company

34. Id. at 206; see also W ESTON ET AL., supra note 1, at 189-90.

35. MALKIEL , supra note 1, at 271.

36. Part II.A-B is largely excerpted from the discussion in Thompson, supra note 1, at 502-04.

37. Id. at 502 (citing BREALEY & M YERS, supra note 19, at 149; RONALD J. GILSON & BERNARD S.

BLACK , T HE LAW AND FINANCE OF CORPORATE ACQUISITIONS 81-100 (2d ed. 1995)).

38. Thompson, supra note 1, at 502 (citing BREALEY & M YERS, supra note 19, at 137).

39. Thompson, supra note 1, at 502-03 (citing BREALEY & M YERS, supra note 19, at 137).

40. Thompson, supra note 1, at 503 (citing GILSON & BLACK , supra note 37, at 108).

41. Thompson, supra note 1, at 503 (citing GILSON & BLACK , supra note 37, at 107).

42. Thompson, supra note 1, at 503 (citing BREALEY & M YERS, supra note 19, at 137).

248 The Journal of Corporation Law [Winter

industries. Diversification cannot eliminate systematic risk, however. Systematic risk is

often referred to as undiversifiable risk or market risk.43 Because market risk results from

broad macroeconomic factors that threaten most businesses, stocks have a tendency to

move in the same direction.44

Brealey and Myers elaborate on the concepts of unique (or unsystematic) risk and

market (or systematic) risk:

If you only have a single stock, unique risk is very important, but once you

have a portfolio of 20 or more stocks, diversification has done the bulk of its

work. For a reasonably well-diversified portfolio, only market risk matters.

Therefore, the predominant source of uncertainty for a diversified investor is

that the market will rise or plummet, carrying the investor’s portfolio with it.45

The following graph illustrates total risk as a function of both systematic and

unsystematic risk and the reduction of unsystematic risk through diversification.46

This graph illustrates that the greater the diversification (represented on the

horizontal axis), the less the total risk (measured on the vertical axis). Unsystematic risk

is reduced by diversification; systematic risk is not. Diversification reduces unsystematic

risk because the prices of different stocks move differently, the price movements are less

than perfectly correlated, and the decline in the prices of some stocks are offset by

increases in the prices of others.47 Brealey and Myers explain that “With more securities,

and therefore better diversification, portfolio risk declines until all unique risk is

43. Thompson, supra note 1, at 503 (citing BREALEY & M YERS, supra note 19, at 137).

44. Thompson, supra note 1, at 503 (citing BREALEY & M YERS, supra note 19, at 139).

45. Thompson, supra note 1, at 503 (citing BREALEY & M YERS, supra note 19, at 139).

46. Thompson, supra note 1, at 503 (citing BREALEY & M YERS, supra note 19, at 139 and GILSON&

BLACK , supra note 37, at 89-93).

47. Thompson, supra note 1, at 504 (citing BREALEY & M YERS, supra note 19, at 137).

2000] Demystifying the Use of Beta 249

eliminated and only the bedrock of market risk remains.”48 Thus, the market portfolio has

only systematic ris k.

Beta is the measure of the sensitivity of a security’s return to market movements.49

Thus, it is a measure of the systematic risk of a security.50 Beta indicates what the likely

move for the particular stock will be for a given move in the market, that is, how

sensitive a particular stock is to a move in the market. For a stock with a beta of 1, a 10%

market rise would, on average, lead to a 10% rise in the price of the stock. For a stock

with a beta of 1.5, a market rise of 10% would lead on average to a 15% rise in the price

of the stock. Thus, beta “measures the marginal contribution of a stock to the risk of the

market portfolio.”51 Beta “gauges the tendency of the return on a security to move in

parallel with the return of the stock market as a whole.”52

The beta for a particular stock is calculated by running a linear regression between

past returns for that stock and past returns of a market index, such as the Standard and

Poor’s 500,53 or by dividing (1) the covariance between the returns on the particular

stock and the returns on the market index by (2) the variance of the market portfolio. Part

III shows how beta is derived through the use of the covariance and variance concepts,

Part IV derives beta through the use of regression analysis, and Part V shows how beta

can be derived through the use of the linear regression function in the Excel program.

Betas are generally computed on the basis of past data (i.e., ex post). Techniques

exist, however, for estimating ex ante, or future, betas.54 Although many financial

organizations, such as Merrill Lynch,55 publish beta estimates for many companies, and

beta estimates are provided through a service offered by Bloomberg,56 one of the

purposes of this Article is to give the reader an intuitive understanding of the statistical

concepts behind beta. This will be of particular assistance in those circumstances when

the analyst needs to construct his or her own beta estimate.

To illustrate the computation of beta, the following returns are assumed to have been

obtained for a particular period (which in this case is assumed to be eight years) for the

market portfolio and for three different stocks (stocks 1, 2, and 3). This data is shown

48. Thompson, supra note 1, at 504 (quoting BREALEY & M YERS, supra note 19, at 144).

49. Thompson, supra note 1, at 504 (citing BREALEY & M YERS, supra note 19, at 143).

50. Thompson, supra note 1, at 504 (citing ALAN C. SHAPIRO , MODERN CORPORATEFINANCE 118 (1990)

and GILSON & BLACK , supra note 37, at 94-98).

51. Thompson, supra note 1, at 504 (quoting BREALEY & M YERS, supra note 19, at 163).

52. Thompson, supra note 1, at 504 (quoting David W. Mullins, Jr., Does the Capital Asset Pricing Model

Work?, HARV. BUS. REV., Jan.-Feb. 1982, at 105, 108).

53. Thompson, supra note 1, at 504 (citing RAPPAPORT , supra note 1, at 58).

54. Thompson, supra note 1, at 504 (citing RAPPAPORT , supra note 1, at 58-59).

55. MERRILL LYNCH , SECURITY RISK EVALUATION (Jan. 2000). The use of the Merrill Lynch beta book is

discussed in BREALEY & M YERS, supra note 1, at 207-12.

56. Data provided by Bloomberg includes “complete descriptiv e information, volume, and output from

Bloomberg analytics such as beta . . .” The Bloomberg Service (visited Feb. 18, 2000) <http://www.bloomberg.

com/products/prod_terminal02.html>.

250 The Journal of Corporation Law [Winter

below in frequency distributions, which show the frequency with which each return

occurred. This is referred to as a discrete distribution, because there are a finite number of

possible returns.57 Also, Tables A, B, and C show the probability (i.e., a probability

distribution) of the particular outcome (i.e., return), which is determined by analyzing

historical data concerning the market’s or stock’s possible returns and the frequency of

those returns. To simplify matters, there are only three returns for each stock. It is

assumed that the highest, middle, and lowest returns for each stock are perfectly

correlated with the highest, middle, and lowest returns for the market; for example, when

the market produces its highest return, each stock produces its highest return, and so on.58

This assumption is important in computing the correlation coefficient in Part III.D.3 and

in performing the regression analysis in Part IV.

Table A

Frequency and Probability Distribution

for the Market Portfolio

[1] [2] [3]

Market's Frequency of Probability

Actual Returns Returns Over of Outcome

8-Year Period

(1) 15% 3 40%

(2) 10% 2 20%

(3) -0- 3 40%

TOTALS 8 100%

58. The data in Tables A through C were derived from the following chart:

RETURNS OF:

YEAR MARKET STOCK 1 STOCK 2 STOCK 3

AT&T GROWTH UTILITY

STOCK STOCK

1. 1991 15% 15% 20% 10%

2. 1992 0% 0% -5% 5%

3. 1993 15% 15% 20% 10%

4. 1994 10% 10% 15% 7%

5. 1995 0% 0% -5% 5%

6. 1996 10% 10% 15% 7%

7. 1997 0% 0% -5% 5%

8. 1998 15% 15% 20% 10%

2000] Demystifying the Use of Beta 251

Table B

Frequency and Probability Distribution

for Stock 1 (AT&T)

[1] [2] [3]

Stock's Frequency of Probability

Actual Returns Returns Over of Outcome

8-Year Period

(1) 15% 3 40%

(2) 10% 2 20%

(3) -0- 3 40%

TOTALS 8 100%

Table C

Frequency and Probability

Distribution for Stock 2

(Growth Stock)

[1] [2] [3]

Stock's Frequency of Probability

Actual Returns Returns Over of Outcome

8-Year Period

(1) 20% 3 40%

(2) 15% 2 20%

(3) -5% 3 40%

TOTALS 8 100%

Table D

Distribution for Stock 3

(Utility Stock)

[1] [2] [3]

Stock's Frequency of Probability

Actual Returns Returns Over of Outcome

8-Year Period

(1) 10% 3 40%

(2) 7% 2 20%

(3) 5% 3 40%

TOTALS 8 100%

The above data is dramatically simplified for illustrative purposes. Brigham and

Gapenski report that most analysts use five years of data in computing betas, and they

seem to suggest the use of weekly returns for a five-year period, which would produce a

252 The Journal of Corporation Law [Winter

sample size of 260 (e.g., 52 weeks x 5 years = 260).59 Campbell, Lo, and Mackinlay

suggest the use of five years of monthly returns,60 which would produce a sample size of

60 (e.g., 12 months x 5 years = 60).

A. Introduction

As indicated, the beta for a particular stock is determined by dividing: (1) the

covariance between (a) the returns on the particular stock, and (b) the returns on the

market portfolio, by (2) the variance of the market portfolio. Covariance here is a

measure of the “degree of parallelism” between the returns on a particular stock and the

returns on the market portfolio.61 The variance of the market portfolio indicates the

potential for deviation of the market’s actual return from the market’s expected return,

and the variance for a particular security indicates the potential for deviation of the

security’s actual return from the security’s expected return. Thus, variance and the

associated concept of standard deviation are measures of financial risk, that is, “the

chance that expected security returns will not materialize and, in particular, that the

securities you hold will fall in price.”62

B. Expected Return

The market’s expected return (i.e., more generally the expected value) is the profit

expected from the market as a rate of return for a specified period. A security’s expected

return is the return expected for the security for a specified period. The expected return is

computed by multiplying each of the actual returns by the probability that such return

would have occurred and summing the results. Thus, the starting point in computing the

expected return is to construct a probability distribution of returns as set forth in Part II.C.

Brigham and Gapenski explain, “If we multiply each possible outcome by its probability

of occurrence and then sum these products, . . . we have a weighted average of outcomes.

The weights are the probabilities, and the weighted average is the expected rate of

return. . . .”63

The expected rate of return E(R) is expressed in the following equation:

E(R) = P1 r1 + P2 r2 + P3 r3 . . . + Pn rn

n

= ∑ Pr i i

i =1

In the above equations, P1 through Pn are the probabilities associated with returns r1

through rn .64

60. CAMPBELL ET AL ., supra note 1, at 184.

61. MALKIEL , supra note 1, at 237.

62. Id. at 229.

63. BRIGHAM & GAPENSKI , supra note 1, at 148.

64. More generally, this equation can be written as:

2000] Demystifying the Use of Beta 253

The computations of the expected returns for the market portfolio and the three

stocks set forth in Part II.C are set forth below:

Table E

Market's Expected Return

[1] [2] [3]

Market's Probability Expected Return

Actual Returns of Outcome [1] x [2]

(PDF)

(1) 15% 40% 6%

(2) 10% 20% 2%

(3) -0- 40% 0%

TOTAL

Expected Return = 8%

Table F

Expected Return of Stock 1

(AT&T)

[1] [2] [3]

Stock's Probability Expected Return

Actual Returns of Outcome [1] x [2]

(PDF)

(1) 15% 40% 6%

(2) 10% 20% 2%

(3) -0- 40% 0%

TOTAL

Expected Return = 8%

∑ ( X ) = ∑ f ( xi)xi

i =1

Here Σ (X) is the expected value of the discrete random variable (X), f(xi) is the probability distribution function

(PDF) of X, and xi represents the possible values of X. GUJARATI , supra note 1, at 763. The PDF (e.g., the

probability that the discrete random variable X has the value xi) sums to 1, thus accounting for all possible

outcomes of X. Id. at 758. This is demonstrated on Tables E through H. The equation above for the expected

value of X is sometimes written in the following simple form:

∑ ( X ) = ∑ xf ( x) x

Id. at 763.

254 The Journal of Corporation Law [Winter

Table G

Expected Return of Stock 2

(Growth Stock)

[1] [2] [3]

Stock's Probability Expected Return

Actual Returns of Outcome [1] x [2]

(PDF)

(1) 20% 40% 8%

(2) 15% 20% 3%

(3) -5% 40% -2%

TOTAL

Expected Return = 9%

Table H

Expected Return of Stock 3

(Utility Stock)

[1] [2] [3]

Market's Probability Expected Return

Actual of Outcome [1] x [2]

Returns (PDF)

(1) 10% 40% 4%

(2) 7% 20% 1.4%

(3) 5% 40% 2%

TOTAL

Expected Return = 7.4%

In summary, the expected return is the weighted average return, which is found by

multiplying each possible return by the corresponding probability and summing the

results. Brigham and Gapenski explain that “The tighter, or more peaked, the probability

distribution, the more likely it is that the actual [return] will be close to the expected

[return] . . . .”65

C. Variance

The variance of a random variable such as the returns on the market or a security “is

the probability-weighted average of squared deviations from the mean (expected

value).”66 The formula for the variance of a random variable (Y) can be written as

follows:67

66. HILDEBRAND & OTT, supra note 1, at 118; see also GUJARATI , supra note 1, at 765.

67. HILDEBRAND & OTT, supra note 1, at 118.

2000] Demystifying the Use of Beta 255

In the formula, µy is the expected value of Y, which can be written E(Y), while Py(Y)

is the probability distribution for each value of y. David K. Hildebrand and R. Lyman Ott

explain that in calculating Var(Y), one takes “each value y, subtract[s] the expected value

µy = E(Y), square[s] the result, multipl[ies] by the probability Py(y), and sum[s].”68 In

computing variance, the expected return of the market or of a particular security is

subtracted from the actual return for a particular period or periods. This difference is then

multiplied by the probability of such an occurrence. The resulting amount is then squared

to get the variance. The formula for the variance of the market (σµ2 ) can be set out in

words as follows:69

n

σµ 2 = ∑ [ Ri − E ( R)] 2 Pi

i =1

follows. (Note that the measure of variance is stated in the same units as the expected

return, which in this case is a percentage.)70 The first step is to subtract the market’s or

security’s expected return from the actual return to compute the deviation from the mean

as follows:

Table I

Market’s Deviation from the Mean

Actual Return for Expected Returns Deviation from

Particular Periods Mean

15% 8% 7

10% 8% 2

0% 8% -8

Table J

Stock 1's Deviation from the Mean

Actual Return for Expected Returns Deviation from

Particular Periods Mean

15% 8% 7

10% 8% 2

0% 8% -8

69. BREALEY & M YERS, supra note 1, at 149-51.

70. RADCLIFFE , supra note 1, at 183.

256 The Journal of Corporation Law [Winter

Table K

Stock 2's Deviation from the Mean

Actual Return for Expected Returns Deviation From

Particular Periods Mean

20% 9% 11

15% 9% 6

-5% 9% -14

Table L

Stock 3's Deviation from the Mean

Actual Return for Expected Returns Deviation from

Particular Periods Mean

10% 7.4% 2.6

7% 7.4% -0.4

5% 7.4% -2.4

The second step is to square the deviations from the mean in order to obtain all

positive numbers, as follows:

Table M

Market’s Squared Deviation

7 x 7 = 49

2x2=4

-8 x -8 = 64

Table N

Stock 1’s Squared Deviation

7 x 7 = 49

2x2=4

-8 x -8 = 64

Table O

Stock 2’s Squared Deviation

11 x 11 = 121

6 x 6 = 36

-14 x -14 = 196

2000] Demystifying the Use of Beta 257

Table P

Stock 3’s Squared Deviation

2.6 x 2.6 = 6.76

-0.4 x -0.4 = 0.16

-2.4 x -2.4 = 5.76

The third step is to multiply the squared deviation by the probability of occurrence

of the particular actual return and sum to get the variance.

Table Q

Market’s Variance

Squared Deviation x Probability = Variance

49 x .40 = 19.60

4 x .20 = 0.8

64 x .40 = 25.60

TOTAL 46 Variance

Table R

Stock 1's Variance

Squared Deviation x Probability = Variance

49 x .40 = 19.60

4 x .20 = 0.8

64 x .40 = 25.60

TOTAL 46 Variance

Table S

Stock 2's Variance

Squared Deviation x Probability = Variance

121 x .40 = 48.40

36 x .20 = 7.20

196 x .40 = 78.40

TOTAL 134 Variance

Table T

Stock 3's Variance

Squared Deviation x Probability = Variance

6.76 x .40 = 2.70

.16 x .20 = .032

5.76 x .40 = 2.30

TOTAL 5.032 Variance

258 The Journal of Corporation Law [Winter

The market’s expected return and variance show the probability distribution

associated with the stocks constituting the market.

D. Covariance

1. Introduction

Covariance is a measure of the way two random variables, such as the returns in the

market and the returns on stock 1, move in relation to each other, that is, the way they

“covary.”71 It is a measure of the way the returns on a particular stock move in relation to

the returns on the market. The covariance between stock 1 and the market portfolio (µ) is

determined by multiplying (1) the correlation coefficient72 (COR1 µ) for stock 1 and the

market by (2) the standard deviations (σ) of stock 1 and the market. The correlation

coefficient measures the degree to which the movements of the prices of two variables

are correlated, that is, move together. The standard deviation is the square root of the

variance.

The covariance formula can be written as follows:

This formula posits that the covariance between stock 1 and the market (σ1 µ) is equal to

the correlation coefficient between stock 1 and the market (COR1 µ), multiplied by the

standard deviations for stock 1 and the market (σ1 σµ). The covariance, between the

returns on a particular stock and the returns on the market portfolio, measures the way the

expected returns on the stock move in relation to the expected returns of the market.

If the covariance is positive, the returns of stock 1 and the market move in the same

direction. If the covariance is negative, the returns of the stock and the market (the

variables) move in opposite directions.

2. Standard Deviation

The standard deviation is the positive square root of the variance of a variable.73 The

standard deviation expresses the dispersion of returns in units that can be more easily

understood.74 Radcliffe explains that “the term standard can be thought of as

standardizing squared return deviations back to a non squared value.”75

The standard deviation of the market is written as follows:

Continuing this illustration, the square root of the market’s variance of 46 is 6.78.

Thus, the standard deviation is 6.78. This means that for normal distributions,76 68.27%

72. Id.

73. Id.

74. RADCLIFFE , supra note 1, at 183.

75. Id.

76. A normal distribution will produce a bell-shaped curve. Although “the pattern of historical returns

2000] Demystifying the Use of Beta 259

of the actual returns on the market are within one standard deviation (i.e., 6.78) on either

side of the expected return; 95.45% of the actual returns are within two such standard

deviations, and 99.73% of the actual returns are within three such standard deviations.

The standard deviation for stocks 1, 2, and 3 are set out below:

Table U

Standard Deviation of Stocks 1, 2, and 3

STANDARD

STOCK VARIANCE VARIANCE = DEVIATION

1 46 46 = 6.78

2 134 134 = 11.57

3 5.036 5.036 = 2.24

Brigham and Gapenski explain that “The smaller the standard deviation, the tighter

the probability distribution, and, accordingly, the lower the riskiness of the stock.”77

Thus, two stocks could have the same expected returns but different standard

deviations.78 This can be illustrated as follows:

Although both stocks A and B have the same expected return, stock A has less risk as

indicated by its smaller deviation from the expected return. Thus, when stock A has a

smaller deviation from the expected return, it is said to dominate stock B.79

from individual securities has not usually been symmetric, the returns from well-diversified portfolios of stocks

do seem to be distributed approximately symmetrically.” MALKIEL , supra note 1, at 231.

77. BRIGHAM & GAPENSKI , supra note 1, at 150-51.

78. RADCLIFFE , supra note 1, at 218.

79. Id.

260 The Journal of Corporation Law [Winter

In general, a stock with a higher expected return will also have a higher standard

deviation. For example, as illustrated in the following table, stock 2 above has both a

higher expected return and a higher standard deviation than stocks 1 and 3.

Table V

Stock Expected Return Standard Deviation

1 8% 6.78%

2 9% 11.57%

3 7.4% 2.24%

Investors obviously would prefer a stock with the highest expected return and the lowest

standard deviation, that is, the lowest risk of a return that would vary substantially from

the expected return.

Brigham and Gapenski also report that in recent years “the standard deviation of a

one-stock portfolio [(σ1 )] (or an average stock), is approximately 35 percent. A portfolio

consisting of all stocks, which is called the market portfolio, would have a standard

deviation, σM, of about 18 percent . . . .”80 Thus, in Graph A in Part II.A, which illustrates

systematic and nonsystematic risk, the total of the systematic and nonsystematic risk

associated with the average one-stock portfolio has a standard deviation of about 35%,

and the market portfolio, which has only systematic risk, has a standard deviation of

18%. Consequently, total risk is approximately equally divided between systematic and

nonsystematic risk.

3. Correlation Coefficient

The correlation coefficient is a measure of the strength of the linear relationship

between two random variables such as the return on the market (x) and the return on

stock 1 (y). “The stronger the correlation, the better x [the independent or explanatory

variable] predicts y [the dependent variable].”81 Correlation is closely related to the

concept of regression, or estimation of a dependent variable (y) from an independent

variable (x).82 Correlation determines the “degree of relationship between variables,

which seeks to determine how well a linear or other equation describes or explains the

relationship between variables.”83 If the dependent variable y tends to increase as the

independent variable x increases the correlation is said to be positive or direct. On the

other hand, if y tends to decrease as x increases, the correlation is said to be negative.84

Simple correlation or simple regression involves only two variables; multiple correlation

and multiple regression involve more than two independent variables.85

81. HILDEBRAND & OTT, supra note 1, at 457.

82. SPIEGEL , supra note 1, at 294.

83. Id.

84. Id.

85. Id.

2000] Demystifying the Use of Beta 261

This Part focuses only on correlation, while Part IV addresses the determination of

beta from regression analysis and demonstrates how the correlation coefficient can be

determined from the coefficient of determination.86 Beta is determined from one

independent variable (i.e., market return) and, therefore, involves simple correlation or

simp le regression. Arbitrage Pricing Theory, which is an alternative to CAPM for

determining the cost of capital, involves the use of multiple independent variables.87

If all values of the independent and dependent variables satisfy the correlation or

regression equation exactly, the variables are said to be “perfectly correlated.” If there is

no correlation between two variables, the variables are said to be “uncorrelated.”88

Mathematically the correlation coefficient, which is generally denoted rxy , is written

as follows:

Σ xy

r xy =

(Σ x 2 )(Σ y 2 )

In this equation, x = X - X and y = Y - Y .89 Thus, the formula for the correlation

coefficient can be written more precisely as follows:

Σ( x − x ) 2 ( y − y ) 2

r xy =

( Σ ( x - x ) 2 )( Σy - y ) 2 )

Sxy

r xy =

Sxx Syy

Here S means summation, that is Σ . The terms can be further defined as follows:91

∑ xy = Sxy = ∑ (x − x )( y − y )

i i

i

∑ x = Sxx = ∑ (x − x )

2

i

2

∑ y = Syy = ∑ ( y − y )

2

i

2

87. MALKIEL , supra note 1, at 272-74.

88. SPIEGEL , supra note 1, at 294.

89. Id. at 298.

90. HILDEBRAND & OTT, supra note 1, at 457.

91. Id. at 430-31, 458.

262 The Journal of Corporation Law [Winter

Σ xy and Sxy are the sum of the x deviations times y deviations; Σ x2 and Sxx are the sum

of the x deviations times the x deviations, that is, the sum of the x deviations squared; and

Σ y2 or Syy are the sum of the y deviations squared.92 “This formula, which automatically

gives the proper sign of r, [positive or negative], is called the product-moment formula

and clearly shows the symmetry between x and y.”93

Using the formula, the correlation coefficients between the market and stocks 1, 2,

and 3 can be computed as follows.94 First, tables showing the relationship between the

independent variable, x (e.g., the return on the market), and the dependent variables, y

(e.g., the returns on stocks 1, 2, and 3), are first constructed as follows:95

Table W

Relationship Between Returns on Market and Returns on 3 Stocks

Relationship Between Relationship Between Relationship Between

Return on the Market Return on the Market (x) Return on the Market (x)

(x) and Return on Stock and Return on Stock 2 (y) and Return on Stock 3

1 (y) (y)

Market Stock Market Stock Market Stock

15% 15% 15% 20% 15% 10%

10% 10% 10% 15% 10% 7%

0% 0% 0% -5% 0% 5%

Second, a table showing each element of the formula for computing the correlation

coefficient is prepared as follows for each stock. The first two columns in this table

repeat the information from the above tables showing the relationship between the

market’s return and the return for each of stock 1, 2, and 3. The third step is to plug into

the formula for determining the correlation coefficient the information from the above

correlation coefficient tables:

Table X

Correlation Coefficient Table for Relationship Between Market and Stock 1

[1] [2] [3] [4] [5] [6] [7]

2

x y x xy y2

x=x- x y=y- y

Market Stock 1 Squaring the [3] x [4] Squaring the

Return Return x = 8% y = 8% amounts in [3] amounts in [4]

15% 15% 7 7 49 49 49

10% 10% 2 2 4 4 4

0% 0% -8 -8 64 64 64

Σ x2 = 117 Σ xy = 117 Σ y2 = 117

92. Id.

93. SPIEGEL , supra note 1, at 298.

94. Id. at 308.

95. Table W is constructed from the information on the returns for the eight-year period set out in note 58,

supra.

2000] Demystifying the Use of Beta 263

Table Y

Correlation Coefficient Table for Relationship Between Market and Stock 2

[1] [2] [3] [4] [5] [6] [7]

2

x y x xy y2

x=x- x y=y- y

Market Stock 2 Squaring the [3] x [4] Squaring the

Return Return x = 8% y = 9% amounts in [3] amounts in [4]

15% 20% 7 11 49 77 121

10% 15% 2 6 4 12 36

0 -5% -8 -14 64 112 196

Σ x2 = 117 Σ xy = 201 Σ y2 = 353

Table Z

Correlation Coefficient Table for Relationship Between Market and Stock 3

[1] [2] [3] [4] [5] [6] [7]

x y x2 xy y2

x=x- x y=y- y

Market Stock 3 Squaring the [3] x [4] Squaring the

Return Return x = 8% y = 7.4% amounts in [3] amounts in [4]

15% 10% 7 2.6 49 18.2 6.76

10% 7% 2 -0.4 4 -0.8 0.16

0% 5% -8 -2.4 64 19.2 5.76

Σ x = 117 Σ xy = 36.6 Σ y = 12.68

2 2

The third step is to plug into the formula for determining the correlation coefficient

the information from the above corellation coefficient tables:

Table AA

Correlation Coefficient Between Market and theThree Stocks

Correlation Coefficient Correlation Coefficient Correlation Coefficient

Between Market and Stock 1 Between Market and Stock 2 Between Market and Stock 3

Σ xy Σ xy Σ xy

r= r= r=

( Σx )( ΣY )

2 2

( Σx )( ΣY )

2 2

( Σx 2 )( ΣY 2 )

117 201 36.6

r= r= r=

(117 ) × (117) (117 ) × (353) (117) × (12.68)

117 201 36.6

r= r= r=

13689 41301 1483.56

117 201 36.6

r= r= r=

117 203.2 38.52

r=1 r = .99 r = .95

264 The Journal of Corporation Law [Winter

4. Computation of Covariance

Once the correlation coefficient is determined as above, it is possible to compute the

covariance between the market return and the return on each of stocks 1, 2, and 3

pursuant to the following formula:

= σ1m

= COR1mσ1 σm

This formula says that the covariance between stock 1 and the market can be computed

by multiplying the correlation coefficient between stock 1 and the market by the standard

deviation of stock 1 and the standard deviation of the market as follows:

Table BB

Covariance Between the Three Stocks and the Market

[1] [2] x [3] x [4] = [5]

Stock Correlation Standard Standard Covariance

Coefficient x Deviation of x Deviation of Between

Between Stock in Stock in [1] Market = Stock in [1]

[1] and the Market and the

Market

COR1m = r1m σ1,2 or 3 σm

Stock

1 1 x 6.68 x 6.78 = 46

Stock

2 .98 x 11.57 x 6.78 = 76.87

Stock

3 .95 x 2.24 x 6.78 = 14.42

The beta of stock 1 is derived by dividing (1) the covariance between (a) the returns

on stock 1, with (b) the returns on the market portfolio (COR1mσ1 σm), by (2) the variance

of the market portfolio (σm2 ). The formula can be written as follows:96

COR1mσ1σm

β of Stock 1 =

σm 2

This formula says that the beta of stock 1 is equal to (1) the product of (a) the correlation

coefficient between stock 1 and the market (COR1m), (b) the standard deviation of returns

2000] Demystifying the Use of Beta 265

on stock 1 (σ1 ), and (c) the standard deviation of returns on the market (σm), divided by

(2) the variance of the market (σm2 ).

Thus, the beta of the market portfolio is equal to one. This can be established as

follows:

COR1mσ1σm 1σmσm σm 2

= = 2 =1

σm 2 σm 2 σm

Comparatively, the beta of a risk-free asset, such as a T-bill, is equal to zero because

there is no correlation between the price of treasury bills and the price of the market. This

can be established as follows (T represents treasury bills):

= =0

σm σm 2

2

The beta of a particular stock, which can be negative, zero, or positive, is an indicator of

the degree to which the price of the stock changes in relation to changes in the market.

The betas for stocks 1, 2, and 3 can be determined by dividing the covariances of

these stocks as determined above by the variance of the market portfolio as determined

above:

Cov( x, y )

β=

σm 2

Table CC

Computation of Beta of the Three Stocks

[1] [2] [3] [4]

Covariance of Variance of Beta of Stock in

Stock Stock in [1] with ÷ Market = [1]

Market σ m

2

Stock 1 46 ÷ 46 = 1

Stock 2 76.87 ÷ 46 = 1.67

Stock 3 14.42 ÷ 46 = .31

This shows that if the market goes up or down by 10%, the price of stock 1 is expected to

go up or down by 10%, the price of stock 2 is expected to go up or down by 16.67%, and

the price of stock 3 is expected to go up or down by 3.1%. Beta is a much more sensitive

measure of the relationship between the returns on stocks and the market than the

correlation coefficient. Although the correlation coefficients for stocks 1, 2, and 3 are

very close at 1, 0.98, and 0.95, respectively, the betas for these stocks are dramatically

different at 1, 1.66, and 0.31, respectively.

266 The Journal of Corporation Law [Winter

A. Introduction

Beta can also be determined through the use of simple regression analysis.

Regression analysis uses past data on the relevant independent and dependent variables to

develop a predictive equation.97 The independent or explanatory variable, in this case the

market return, is used to make a prediction about the value of the dependent variable, in

this case the return on stocks 1, 2, and 3.

Like the correlation coefficient, regression analysis provides an estimate of the

degree of correlation between the dependent and independent variables, thereby

measuring the strength of the relationship.98 With simple regression analysis, which is

based on one independent variable, the equation for predicting the dependent variable (y)

is a linear function of a given independent variable (x). The prediction equation is the

familiar equation for a straight line:

yˆ = a + bx

The constant a is the intercept which is the predicted value of y (e.g., return on stock

1) if the predicted value of x (i.e., return on the market) is zero.99 Simple linear

regression uses past data to fit a prediction line that relates a dependent variable (y) (e.g.,

the returns in stocks 1, 2, and 3) to a single independent variable (i.e., the return on the

market).100 A fundamental assumption of simple regression analysis is that “the relation

is, in fact, linear. According to the linearity assumption, the slope of the equation [i.e., b]

does not change as x changes.”101

B. Scatter Diagrams

One way of making a judgement about whether a linear relationship exists between

the dependent variable Y and the independent variable X is to construct a scatter diagram

that shows the location of the points (X,Y) on a graph in which the horizontal axis

represents the independent variable X and the vertical axis indicates the dependent

variable Y. Murray R. Spiegel explains that “If all points in [the] scatter diagram seem to

lie near a line, . . . the correlation is called linear. In such cases, . . . a linear equation is

appropriate for purposes of regression (or estimation).”102 Scatter diagrams for stocks 1,

2, and 3 and the market are set out in the following graphs. These diagrams show the

relationship between the market’s return and the return for the particular stock.

97. HILDEBRAND & OTT, supra note 1, at 419; see also GUJARATI , supra note 1, at chs. 1-4.

98. HILDEBRAND & OTT, supra note 1, at 419.

99. Id. at 420.

100. Id. at 421.

101. Id.

102. SPIEGEL , supra note 1, at 294.

2000] Demystifying the Use of Beta 267

GRAPH C

Market Return and Return on Stock 1

(See Table W)

Relationship

Market Stock 1

15% 15%

10% 10%

0% 0%

GRAPH D

Market Return and Return on Stock 2

(See Table W)

Relationship

Market Stock 2

15% 20%

10% 15%

0% -5%

268 The Journal of Corporation Law [Winter

GRAPH E

Market Return and Return on Stock 3

(See Table V)

Relationship

Market Stock 3

15% 10%

10% 7%

0% 5%

The relationship is also linear. Thus, it would appear that regression analysis would be

appropriate for relating the return on the market to the returns on each of stocks 1, 2, and

3.

The least-squares method is used to determine a “best fitting line” that relates the

independent and dependent variables. As explained by Hildebrand and Ott:

The regression analysis problem is to find the best straight-line prediction. The

most common criterion for ‘best’ is based on squared prediction error [i.e., the

vertical deviations from the line] . . . . [T]he equation for the prediction line [is]

the slope [b] and intercept [a] that minimize the total squared prediction

error.103

As indicated, the equation for the least-squares line can be set out as follows:

y = a + bx

The constants, the intercept (a) and the slope (b), are determined by solving

simultaneously the equations:

2000] Demystifying the Use of Beta 269

Σy = aN + bΣx

Σxy = aΣx + bΣx 2

These are called the normal equations for the least-squares line.104

The values of the various terms of these equations can be determined by the use of a

table as set out below for stock 1 in Table DD.105

Table DD

Least-Squares Table

for Stock 1

[1] [2] [3] [4]

x y x2 xy

Market’s Return Stock’s Return [1] squared [1] x [2]

15% 15% 225 225

10% 10% 100 100

0% 0% 0 0

Σ x = 25% Σ y = 25% Σ x2 = 325 Σ xy = 325

Because there are just three pairs of values of x and y, N=3, the least-squares equation

becomes:

Least-Squares Equation

Σy = aN + bΣx

(25) = a(3) + b(25)

25 = 3a + 25b

and

(325) = a(25) + b(325)

325 = 25a + 325b

Next, the two equations must be solved simultaneously. First, the slope b is eliminated so

that the intercept can be computed. This is accomplished by multiplying the first equation

by -13 and then subtracting the second equation, thereby eliminating the slope.

104. SPIEGEL , supra note 1, at 297-98; see also GUJARATI , supra note 1, at 55.

105. SPIEGEL , supra note 1, at 275.

270 The Journal of Corporation Law [Winter

= -325 = -39a - 325b

[minus]

325 = 25a + 325b

= 0 = -14a = 0

a = 0/14

a = 0

Now that the intercept a is found, the slope can be found as follows:

25 = 3a + 25b

25 = 3(o) + 25b

25 = 25b

b = 25/25

b = 1

Thus, the equation for the least-squares line can be determined as follows:

Regression Line

Equation for Stock 1

y = a + bx

y = 0 + (1)x

y = x

This b = 1 is the beta for stock 1, and it can be graphed as follows, with x = 5%, 10%,

15%, and 20%:

2000] Demystifying the Use of Beta 271

GRAPH F

Beta for Stock 1

Regression

Value of x Line Equation

y=x

x = 5% 5% = 5%

x = 10% 10% = 10%

x = 15% 15% = 15%

x = 20% 20% = 20%

The least-squares tables for stocks 2 and 3 are set out below:

272 The Journal of Corporation Law [Winter

Table EE

Least-Squares Table for Stock 2

[1] [2] [3] [4]

X Y X2 XY

Market's Return Stock's Return [1] squared [1] x [2]

0% -5% 0 0

Table FF

Least-Squares Table for Stock 3

X Y X2 XY

Market's Return Stock's Return [1] squared [1] x [2]

10% 7% 100 70

0% 5% 0 0

Least-Squares Equations

Stock 2 Stock 3

∑ y = aN + b ∑ x ∑ y = aN + b ∑ x

1. 30 = a(3) + b(25) 22 = a(3) + b(25)

30 = 3a + 25b 22 = 3a + 25b

and

∑ xy = a ∑ x + b ∑ x 2 ∑ xy = a ∑ x + b ∑ x 2

2. 450 = a(25) + b(325) 220 = a(25) + b(325)

450 = 25a + 325b 220 = 25a + 325b

2000] Demystifying the Use of Beta 273

Next, the two equations must be solved simultaneously by first eliminating the slope

so that the intercept can be computed. For both equations, this is done by multiplying the

first equation by -13 so that when the second equation is subtracted from the first, slope

(b) is eliminated.

Stock 2 Stock 3

Determining the Intercept Determining the Intercept

(-13)30 = (-13)(3a) + (-13)25b (-13)22 = (-13)(3a) + (-13)25b

= -390 = -39a - 325b = -286 = -39a -325b

[minus] [minus]

450 = 25a + 325b 220 = 25a + 325b

a = 60 a = -66

-14 -14

a = -4.28 a = 4.71

Now that the intercepts for stocks 2 and 3 have been determined, the slopes (b) for

each of these stocks can be obtained as follows:

Stock 2 Stock 3

Determining the Slope Determining the Slope

30 = (3a) + 25b 22 = 3a + 25b

30 = 3(-4.28) + 25b 22 = 3(4.71) + 25b

30 = -12.84 + 25b 22 = 14.13 + 25b

42.84 = 25b 7.87 = 25b

b = 42.84 b = 7.87

25 25

b = 1.71 b = .314

It should be noted that this slope is the beta for stocks 2 and 3. The beta for stock 2 is

slightly over the 1.66 beta for stock 2, determined statistically through the use of

covariance, and the beta for stock 3 is the same as the .31 beta for stock 3, determined

statistically through the use of covariance.

The equations for the regression lines for stocks 2 and 3 are as set forth below:

Equation for Stock 2 Equation for Stock 3

y = -4.28 + 1.7x y = 4.71 + .31x

These two equations can be graphed as follows with, in both cases, x = 0%, 10%, and

15%. The actual returns are also shown.

274 The Journal of Corporation Law [Winter

GRAPH G

Best Fit Line for Stock 2

y = -4.28 + 1.7x

x=0 y = -4.28 + 1.7(0)

y = -4.28%

x = 10% y = -4.28 + 1.7(10)

y = -4.28 + 17.0

y = 12.72%

x = 15% y = -4.28 + 1.7(15)

y = -4.28 + 25.5

y = 21.22%

2000] Demystifying the Use of Beta 275

GRAPH H

Best Fit Line for Stock 3

y = 4.71 + .31x

x=0 y = 4.71 + .31(0)

y = 4.71

x = 10% y = 4.71 + .31(10)

y = 4.71 + 3.1

y = 17.81

x = 15% y = 4.71 + .31(15)

y = 4.71 + 4.65

y = 9.36

A short-cut way of computing the slope or beta is to use the following formula:106

Short-Cut Method

∑ xy Sxy

b= =

∑x 2 Sxx

106. HILDEBRAND & OTT, supra note 1, at 430; see also GUJARATI , supra note 1, at 55.

276 The Journal of Corporation Law [Winter

In this formula, x equals x minus the expected value of x(x - x ) and y equals y minus the

expected value of y(y - y ).

The following short-cut beta tables are set up to compute Σ xy and Σ x2 :

Table GG

Short-Cut Beta Table for Stock 1

[1] [2] [3] [4] [5] [6]

x y x-x y-y (x - x )(y - y ) (x - x )2

Market Stock x = 8% y = 8% [3] x [4] [3]squared

Return Return

15% 15% 7% 7% 49 49

10% 10% 2% 2% 4 4

0% 0% -8% -8% 64 64

Σ (x - x )(y - y ) = 117 Σ (x - x )2 = 117

Table HH

Short-Cut Beta Table for Stock 2

[1] [2] [3] [4] [5] [6]

x y (x - x )(y - y ) (x - x )2

Market Stock x - x = 8% y - y = 9%

Return Return

[3] x [4] [3]squared

15% 20% 7% 11% 77 49

10% 15% 2% 6% 12 4

0% -5% -8% -14% 112 64

Σ (x - x )(y - y ) = 201 Σ (x - x )2 = 117

Table II

Short-Cut Beta Table for Stock 3

[1] [2] [3] [4] [5] [6]

x y (x - x )(y - y ) (x - x )2

Market Stock x - x = 8% y = y = 7.4%

[3] x [4] [3]squared

Return Return

15% 10% 7% 2.6% 18.2 49

10% 7% 2% -.4% .6 4

0% 5% -8% -2.4% 19.2 64

Σ (x - x )(y - y ) = 201 Σ (x - x )2 = 117

Using the simplified formula for computing beta and the information from the above

beta tables, the results are as follows:

2000] Demystifying the Use of Beta 277

Σxy Σxy Σxy

b= b= b=

Σx 2

Σx 2

Σx 2

117 201 38 .2

b= b= b=

117 117 117

These are close to the betas obtained from the above calculation of the least-squares line.

Once the slope is determined using the short-cut formula above, the intercept can be

computed with the use of the following short-cut formula:

a= y -b x

a= y -b x a= y -b x a= y -b x

a = 8 - 1(8) a = 9 - 1.71(8) a = 7.4 - .31(8)

a=0 a = 9 - 13.68 a = 7.4 - 2.48

a = -4.68 a = 4.92

Using the normal equations for the least squares, the intercepts are 0, -4.28, and 4.71,

respectively. The intercept shows the expected return for the stock if the market's return

is zero.

F. Coefficient of Determination

The coefficient of determination (r2 ) is a measure of the strength of the correlation

between a dependent variable (Y) and an independent variable (X). It “measures the

proportion or percentage of the total variation in [the independent variable] Y explained

by the regression model.”107 The coefficient of determination is derived from an analysis

of (1) the variance of the actual values of Y from the expected value of the dependent

variable (Y ), and (2) the variance of the actual values of Y from the estimate

(determined from the equation of the regression line of Y on X) of the values of the

dependent variable (Yest).108 Specifically, the total variation of Y is defined as:

108. SPIEGEL , supra note 1, at 296.

278 The Journal of Corporation Law [Winter

This equation says that the total variation is the “sum of the squares of the deviations of

the values of Y from the mean Y .”109

The total variation is made up of the explained variation and the unexplained

variation. The explained variation is defined as the sum of the squares of the deviations of

(1) the estimated values of Y (Yest) determined from the regression line, from (2) the

mean of Y ( Y ). Thus, the explained variation can be written as follows:

On the other hand, the unexplained variation is defined as the sum of the squares of

the deviations of (1) the actual values of Y, from (2) the estimated values of Y (Yest)

determined from the regression line. Thus, the unexplained variation can be written as

follows:

Unexplained Variation = Σ(Y - Yest)2

The deviations of Y from Yest are referred to as unexplained variations because these

deviations “behave in a random or unpredictable manner.”110

To summarize, total variation, is the sum of the explained variation and the

unexplained variations, and is written as follows:

variation, that is:111

r=

Total Variation Σ (Y - Y ) 2

The ratio lies between 0 and 1. If r2 is zero, this means there is no explained

variation and the total variation is, therefore, all unexplained—that is, Y is not dependent

at all on X.112 Thus, an r2 of 1 means there is perfect correlation between the dependent

and independent variables. This is because each estimate of the value of Y (Yest), from

the regression line, is the same as the actual value of Y. Tables JJ, KK, and LL below

compute the r2 for each of stocks 1, 2, and 3.

109. Id.

110. Id.

111. Id.

112. Id.

2000] Demystifying the Use of Beta 279

Table JJ

(r2 ) Coefficient of Determination for Stock 1

[1] [2] [3] [4] [5] [6]

See Table (Estimate from (Y - Y )2 (Yest - Y )2

F Regression Line with (See Table N) ([4] - [3])2

X=0, 10%, 15%)

(See Graph F)

15% 15 8 15 49 (15 - 8)2 = (7)2 = 49

10% 10 8 10 4 (10 - 8)2 = (2)2 = 4

0% 0 8 0 64 (0 - 8)2 = (-8)2 = 64

Σ (Y - Y )2 = 117 Σ (Yest - Y )2 = 117

r2 =

Total Variation Σ (Y - Y ) 2 = 117

117

r2 =

117

r2 = 1

Table KK

(r2 ) Coefficient of Determination for Stock 2

[1] [2] [3] [4] [5] [6]

X Y Yest Total Variance Explained Variance

See (Estimate from

(Y - Y )2 (Yest - Y )2

Table G Regression Line with

(See Table O) ([4] - [3])2

X=0, 10%, 15%)

(See Graph G)

15% 20 9 21.22 121 (21.22 - 9)2 = (12.22)2 =

149.33

10% 15 9 12.72 36 (12.72 - 9)2 = (3.72)2 = 13.84

0% -5 9 -4.28 196 (-4.28 - 9)2 = (-13.28)2 =

176.36

Σ (Y - Y )2 = 353 Σ (Yest - Y )2 = 339.53

r2 =

Total Variation Σ (Y - Y ) 2 = 353

339.53

r2 =

353

r 2 = .96

280 The Journal of Corporation Law [Winter

TABLE LL

(r2 ) Coefficient of Determination for Stock 3

[1] [2] [3] [4] [5] [6]

See (Estimate from (Y - Y )2 (Yest - Y )2

Table Regression Line (See Table P) ([4] - [3])2

H with X=0, 10%,

15%)

(See Graph H)

15% 10 7.4 9.36 6.76 (9.36 - 7.4)2 = (1.96)2 = 3.84

10% 7 7.4 7.81 0.16 (7.81 - 7.4)2 = (0.41)2 = 0.17

0% 5 7.4 4.21 5.76 (4.71 - 7.4)2 = (-2.69)2 = 7.24

Σ (Y - Y )2 = 12.68 Σ (Yest - Y )2 = 11.25

r2 =

Total Variation Σ(Y - Y ) 2 = 12.68

11.25

r2 =

12.68

r 2 = .89

As demonstrated in Table JJ, the r2 for stock 1 is 1, meaning that all of the variance

for stock 1 is explained by the movements in the market. Table KK shows that the r2 for

stock 2 is 0.96, meaning that only 4% of the variance for stock 2 is not explained by

movements in the market, and Table LL shows that the r2 for stock 3 is 0.89, meaning

that 11% of the variance for stock 3 is not explained by movements in the market.

The coefficient of correlation (or correlation coefficient (r)) is simply the square

root of r2 , as follows:113

r=±

Total Variation Σ (Y - Y ) 2

The values of r vary from -1 and +1, with the minus sign indicating a negative linear

correlation and the positive sign indicating a positive linear correlation.114 It should be

noted that “r is a dimensionless quantity; that is, it does not depend on the units

employed.”115

114. Id.

115. Id.

2000] Demystifying the Use of Beta 281

If r has a value of zero, there is no linear correlation between the two variables. On

the other hand, if r is near 1 or -1 the correlation is said to be high.116 However, even if

the correlation is high, there may be no causation, because the correlations may be

nonsense or spurious.117 The correlation coefficient “measures the goodness of fit

between (1) the equation actually assumed and (2) the data.”118

As indicated in Part III.D.3 above, the correlation coefficient (r) can also be written

as follows:

Σ( x − x ) 2 ( y − y ) 2

r=

(Σ ( x - x ) 2 )( Σ ( y - y ) 2 )

Σxy

r=

(Σ x 2 )(Σ y 2 )

The computation of the correlation coefficients for the three stocks pursuant to this

formula are set out in Table AA. There we see that the r’s are as follows:

Stock r

1 1.00

2 0.98

3 0.95

Stock r2 = r2

1 12 = 1

2 0.982 = 0.96

3 0.952 = 0.90

Coefficient of Determination from the Formula in Section III.D.3.

1 1.00 1.00

2 0.96 0.96

3 0.89 0.90

rounding errors.

116. Id.

117. Id.

118. SPIEGEL , supra note 1, at 297.

282 The Journal of Corporation Law [Winter

Beta can be computed simply through the use of the linear regression function on a

computer program, such as the LINEST statistical function in the Microsoft Excel

program. The first step in using the function is to specify the relationship between the

returns on the market and the returns on three stocks. These relationships are set out

below in Tables MM through OO:

Stock 1 Stock 2 Stock 3

X Y X Y X Y

Market Stock 1 Market Stock 2 Market Stock 3

Return Return Return Return Return Return

15% 15% 15% 20% 15% 10%

10% 10% 10% 15% 10% 7%

0% 0% 0% -5% 0% 5%

Once the data is arrayed as above, beta for each stock can be determined by the insertion

of the following formula in the formula bar:

Thus, for example, assume that in Table MM the returns for stock 1, the y or

dependent variable, are set out in column and rows C6 through C8 on an Excel

worksheet, and the returns for the market, the x or independent variable, are set out in

column and rows B6 through B8. Beta could then be computed in, for example, cell B10

by putting the following formula in the formula bar for cell B10:

=INDEX(LINEST(C6:C8, B6:B8),1)

The intercept can be determined using the following formula:

2000] Demystifying the Use of Beta 283

Table PP

Betas Using LINEST Function

Stock Beta

1 1.00

2 1.71

3 0.31

A. Summary

In summary, the betas determined under the above four methods ((1) use of

covariance and variance, (2) use of the normal equations for the least-squares line, (3) use

of the shortcut regression method, and (4) use of Excel linear regression formula), result

in the following betas:

Table QQ

Summary of Computations of Beta

Estimated Beta

Method for Stocks

1 2 3

[1] Covariance Divided by Variance

COV ( x, y)

â= 1 1.67 .31

σm 2

[2] Normal Equations for the Least-Squares Line

Σ x = aN + b Σ x

Σ xy = aΣ x + b Σ x2 1 1.71 .31

[3] Short-Cut Formula

Σxy

b= 1 1.71 .32

Σx 2

[4] Excel: Linear Regression Function

The largest difference is in the computation of beta for stock 2. Using the covariance

divided by variance method provides a somewhat different result than any of the other

methods. The difference is presumably attributable to rounding differences. If the betas

are rounded to one decimal point, each method produces a beta of 1.7 for stock 2.

284 The Journal of Corporation Law [Winter

B. Adjusted Betas

True betas, as measured above, tend to move toward 1 over time.119 This has led to

the development of adjusted betas. Brigham and Gapenski explain, “One can begin with a

firm’s pure historical statistical beta, make an adjustment for the expected future

movement toward 1.0, and produce an adjusted beta which will, on average, be a better

predictor of the future beta than would the unadjusted historical beta.”120 They go on to

report that ValueLine’s adjusted betas are based on approximately this formula:

VII. A SSET AND EQUITY BETAS AND THE LEVERING AND UNLEVERING FORMULA

A. Introduction121

A firm’s cost of capital is a function of its business risk—the risk associated with the

firm’s investments or assets.122 In a firm with no debt, the common shareholders face

only this business risk. But if the firm carries debt (i.e., is leveraged), the common

shareholders also face financial risk: the risk that the firm will not be able to service the

debt and therefore will go into bankruptcy.123 Obviously, the more leverage, the greater

the risk to the common shareholders. Financial risk, however, does not affect business

risk; leverage does not affect the firm’s assets.124

In determining the beta of a firm’s equity, the beta must be adjusted to reflect the

financial risk (i.e., leverage) employed by the particular company. A firm’s leverage

controls its level of financial risk and its beta. As a firm’s leverage increases, its financial

risk and beta correspondingly increase.125 A firm’s asset beta would apply if the firm did

not employ any leverage. Therefore, the asset beta assumes a firm incurs business risk,

but not financial risk.

Brealey and Myers explain that because low risk is generally associated with debt of

large publicly-held firms with little debt, financial analysts generally assume that the beta

of the debt of such firms is zero. When the firm’s debt beta is zero, its debt is not

sensitive to moves in the equity market.126 This concept of stability is intuitively

appealing. Debt holders in firms that are not highly leveraged can be fairly certain that

they will be paid regardless of market shifts. Assuming Brealey and Myers are correct,

the value of the debt is not affected by market swings. Brealey and Myers explain,

however, that stability may not occur in periods of volatile interest rates such as the early

120. Id.

121. This Part is excerpted from Thompson, supra note 1, at 514-17.

122. Id. at 514 (citing BREALEY & M YERS, supra note 19, at 189).

123. Thompson, supra note 1, at 514 (citing BREALEY & M YERS, supra note 19, at 189).

124. Thompson, supra note 1, at 514 (citing BREALEY & M YERS, supra note 19, at 190).

125. T hompson, supra note 1, at 514 (citing BREALEY & M YERS, supra note 19, at 191-92 and THOMASE.

COPELAND & J. FRED W ESTON, FINANCIAL T HEORY AND CORPORATE P OLICY 455-60 (3d ed. 1988)).

126. Thompson, supra note 1, at 514 (citing BREALEY & M YERS, supra note 19, at 191).

2000] Demystifying the Use of Beta 285

1980s when betas on corporate bonds were as high as 0.3 to 0.4.127 In a highly leveraged

firm, it can be expected that the value of the debt will change with changes in the market.

However, regardless of whether the value of a firm’s debt fluctuates or remains constant,

investing in the firm’s debt will be less risky than holding equity in the same firm.

If the beta of a firm’s debt is zero, the beta of its stock will equal the firm’s asset

beta. The asset beta is equal to the sum of the weighted average of the beta of the firm’s

debt (D), and the beta of the firm’s equity (E).128 Thus, the firm’s asset beta can be

expressed algebraically as:

D E

β of assets = β of debt + β of equity

V V

D E

In this formula, is the portion of the firm’s value attributable to debt, and is the

V V

portion of the value attributable to equity.

If the beta of the firm’s debt is positive (meaning the debt is sensitive to market

moves), the beta for the firm’s equity will exceed the firm’s asset beta because of the

financial risk associated with the debt. The weighted averages of the firm’s debt beta and

equity beta will equal the firm’s asset beta (i.e., the beta of a nonleveraged or low

leveraged firm).

The following illustration helps conceptualize these ideas.129 Assume that a

nonleveraged firm has an asset beta of 0.8. This is also the firm’s equity beta as

illustrated on the following graph:

127. Thompson, supra note 1, at 514 (citing BREALEY & M YERS, supra note 19, at 191 n. 9).

128. Thompson, supra note 1, at 514 (citing BREALEY & M YERS, supra note 19, at 191).

129. Thompson, supra note 1, at 515 (citing BREALEY & M YERS, supra note 19, at 191-92 (providing the

basis for the illustration)).

286 The Journal of Corporation Law [Winter

GRAPH I

Asset Beta

This means that without any debt the stock is not very sensitive to market moves—the

price of the equity will move both up and down less than the market.

Now assume that the firm takes on such substantial debt that debt represents 40% of

the value of the firm and the debt has a beta of 0.2. The firm’s equity beta, which is now

1.2, can then be computed algebraically since the only unknown in the following formula

is the equity beta:

D E

â assets = â of debt + â of equity( x)

V V

0.8 = (0.4)(0.2) + (0.6)(x)

.8 - .08

=x

.6

.72

=x

.6

1.2 = x

2000] Demystifying the Use of Beta 287

This result is intuitively appealing because it can be expected that, as a firm becomes

more and more leveraged, the equity holders will demand a higher return to compensate

for the added financial risk.

The relationship between the debt and asset betas in the above case can be

diagramed as:

GRAPH J

Relationship Between Asset Beta and Equity Beta

The following principles can be derived by relating the previous diagram to the following

formula for determining the asset beta:

D E

β assets = β of debt + β of equity

V V

First, the lower the beta of debt, the lower the beta of equity. If debt has a beta of

zero, the beta of equity is equal to the asset beta. Second, the higher the beta for debt, the

higher the beta for equity. Third, the asset beta equals the weighted average of the firm’s

debt and equity betas. Fourth, the firm’s asset beta does not change with leverage, as

asset betas are not affected by financial risk. This, too, is intuitively appealing because

the income stream does not depend on whether the cash flow pays the firm’s debt holders

or equity holders.

Many industry-wide betas reflect asset betas after removing the effects of financial

leverage on beta. Thus, determining the equity beta of a particular firm in the industry

288 The Journal of Corporation Law [Winter

requires adjusting the asset beta upward for any leverage utilized.130 However, if an

equity beta is available, it may be necessary to convert the equity beta into an asset beta,

a process referred to as “unlevering.”131 The levering and unlevering formula is

discussed in next.

If a firm has no debt (i.e., leverage) and only one type of asset (e.g., railroad

operations) the firm’s equity beta will also be its asset beta, and the equity beta could be

expressed as the unlevered equity beta, β u . If, however, the firm has debt, the firm’s

equity beta will reflect this leverage and can be expressed as a leveraged equity beta, β l .

In a 1969 article, Robert Hamada set out a mathematical formula for moving

between levered and unlevered betas,133 and the formula is commonly used today.134 As

explained by Brigham and Gapenski, “Robert Hamada combined the Capital Asset

Pricing Model . . . with the MM [i.e., Modigliani-Miller] after-tax [capital structure]

model to obtain” the cost of equity capital for the levered firm (rle).135 Hamada’s formula

is as follows:136

Equity Rate Premium Premium

rle = rf + β u (rm - rf) + β u (rm - rf)(1-T)(D/E)

T is the combined federal and state corporate income tax rate (assume 40%), and D/E is

the firm’s debt to equity ratio. Thus, if the firm has no debt, the financial risk term

becomes zero and the firm’s cost of equity, rle, is determined by the standard form

CAPM, with beta being the unlevered beta, β u .

Hamada’s formula divides the required cost of equity capital for the levered firm

(rle) into three elements:137 (1) a risk-free rate, rf; (2) a premium for business risk, β u (rm -

rf); and (3) a premium for financial risk, β u (rm - rf)(1-T)(D/E).138 Hamada also derived

from the above formula a formula for determining the beta for a levered firm, β l , as

follows. The starting point is the basic formula for the cost of equity for the levered firm

(rle):

130. Thompson, supra note 1, at 517 (referring to BREALEY & M YERS, supra note 19, at 190-92).

131. Thompson, supra note 1, at 517 (citing SHAPIRO , supra note 50, at 263-65, which discussed the

unlevering process).

132. See BRIGHAM & GAPENSKI , supra note 1, at 488-91, 629-31.

133. Robert S. Hamada, Portfolio Analysis, Market Equilibrium, and Corporate Finance, 24 J. FIN. 13

(1969).

134. See BRIGHAM & GAPENSKI , supra note 1, at 488-91, 629-31.

135. Id. at 629.

136. Id.

137. Id.

138. Id.

2000] Demystifying the Use of Beta 289

This formula can be simplified as follows to arrive at levering and delevering formulas:

First: Set the required levered equity return into a form that is dependent

on a levered beta, β l:

rle = rf + β l(rm - rf)

Second: Set the right-hand term equal to the Hamada form of the cost of

levered equity reflecting separate premiums for business and

financial risk:

rf + β l(rm - rf) = rf + β u(rm - rf) + β u(rm - rf)(1-T)(D/E)

β l = β u + β u(1-T)(D/E)

β l = β u[1 + (1-T)(D/E)]

Thus, the levered equity beta for a firm (β l ) can be determined from the unlevered

equity beta for the firm (β u ), pursuant to the following formula:

Levering Formula

β l = β u[1 + (1-T)(D/E)]

and, correlatively, the unlevered equity beta for the firm (β u ) can be derived from the

levered equity beta (β l ) pursuant to the following formula:

Unlevering Formula

β1

βu =

[1 + (1 - T)(D/E)]

Thus, under the MM and CAPM assumptions, the beta for any firm is equal to

the beta the firm would have if it used zero debt, adjusted upward by a factor

that depends on (1) the corporate tax rate and (2) the amount of financial

leverage employed. Therefore, the firm’s market risk, which is measured by [β l ],

290 The Journal of Corporation Law [Winter

depends on both the firm’s business risk as measured by β u and its financial risk

as measured by [β l ] - β u = β u (1-T)(D/E).139

In many cases it will be possible to determine a firm’s equity levered beta (β l )

before determining a firm’s asset beta. The equity levered betas could then be delevered

to get the unlevered equity beta or asset beta pursuant to the following formula:

β1

βu =

[1 + (1 - T)(D/E)]

In other cases, the analyst may have an estimate of a firm’s asset beta (β u ) and will

have to lever up that beta to determine the firm’s equity levered beta (β l ), pursuant to the

following formula:

β l = β u[1 + (1-T)(D/E)]

One way of getting an estimate of the beta for an asset (e.g., a railroad operation) is

to use what Brigham and Gapenski call the “pure-play method.”140 Under this method,

several publicly traded firms that are only engaged in the railroad business are identified

and the average leverage equity beta for these firms is determined by regressing their

stock returns against the market. This estimate of the leverage equity beta is then

delevered using the average debt to equity ratio of those firms in the delevering formula:

β1

βu =

[1 + (1 - T)(D/E)]

As will be seen in Part IX, this pure play method was used by Lazard in determining

the cost of capital for Conrail. Lazard first estimated Conrail’s levered equity beta (β l )

by, for example, regressing the historical returns on the stock of Conrail and several other

railroad firms against the historical returns on the market.141 Lazard then delevered the

beta using the above delevering formula,142 and then relevered the beta for various

capital structure assumptions using the following levering formula:143

β l = β u[1 + (1-T)(D/E)]

VIII. RETURNING TO THE CAPITAL A SSET PRICING M ODEL144

Returning to the CAPM model, the elements of CAPM are (1) the beta for the

particular stock; (2) the risk-free rate (rf); and (3) the market risk premium (rm-rf). A

140. Id. at 490-91.

141. See infra Appendix A, Columns [1], [2], and [3].

142. See infra Appendix A, Column [4].

143. See infra Appendix A, Column [9].

144. This Part is excerpted from Thompson, supra note 1, at 511-13.

2000] Demystifying the Use of Beta 291

market portfolio of common stocks has a beta of 1 because the “covariance of the market

itself is identical to the variance of the market portfolio.”145 The expected risk premium

of holding a market portfolio is equal to the market risk premium (rm-rf), and the

expected return of holding the market portfolio is equal to the sum of the risk-free rate (rf)

and the market risk premium (rm– rf). Thus, there is a one-to-one relationship between the

beta of a portfolio of common stocks and the expected return of such a portfolio. The

following graph illustrates this one-to-one relationship:

GRAPH K

Beta of Portfolio of Common Stocks

This graph shows that the beta of a risk-free Treasury bill, which has an expected

return of rf, is zero, and the beta for the market portfolio, which has a return of rm, is 1.

The graph also illustrates that any security with a beta of less than 1 can expect a return

that is less than the market return because such a security is less risky than the market

portfolio. Furthermore, any security with a beta greater than 1 has an expected return that

is more volatile than that of the market because that security is more risky than the

market portfolio. Thus, the cost of capital for a low beta stock will be less than the cost of

capital for the market, and the cost of capital of a high beta stock will be higher than the

cost of capital for the market. For example, AT&T, which has a beta of less than 1, will

have a lower cost of capital than Tandem Computer, which has a beta greater than 1.

The line intersecting the risk-free rate on the vertical axis is known as the security

market line (SML). The SML illustrates the capital asset pricing model, which provides

that “the expected risk premium on each investment is proportional to its beta.”146

145. Id. at 511 (citing COPELAND & W ESTON, supra note 125, at 198).

146. Thompson, supra note 1, at 512 (quoting BREALEY & M YERS, supra note 19, at 162).

292 The Journal of Corporation Law [Winter

GRAPH L

Security Market Line

The expected risk premium on a particular stock can, therefore, be written as:147

= β x (rm - rf)

= β (rm - rf)

The expected rate of return (or the discount rate, hurdle rate, or cost of capital) can be

derived from the algebraic statement of the CAPM:

r = rf + β (rm - rf)

In a well functioning capital market, “a security cannot sell for an extended period at

prices low enough to yield more than the appropriate return indicated on the SML.”148

Such a security would become an attractive investment relative to other securities with

similar risk. The demand for the security would cause its price to rise until the expected

return fell to the appropriate point on the SML. Conversely, a stock with a price high

enough to put its expected return below the appropriate point on the SML would induce

investors to sell the stock, thereby driving down the price until the rate of return was

appropriately placed on the SML. 149

147. Thompson, supra note 1, at 512 (citing BREALEY & M YERS, supra note 19, at 138).

148. Thompson, supra note 1, at 513 (quoting Mullins, supra note 52, at 108).

149. Thompson, supra note 1, at 513 (citing Mullins, supra note 52, at 108).

2000] Demystifying the Use of Beta 293

Thus, in using CAPM to determine the appropriate discount rate for the acquisition

of a target corporation, it is necessary to identify: (1) the risk-free rate (i.e., the rate on

Treasury bills), (2) the market risk premium, which over time has been 8.4%, and (3) the

beta for the target corporation. Although there is an element of judgement in determining

beta, most estimates should be in the same ballpark.

If the target is involved in several lines of business, it is appropriate to determine,

using the CAPM, a discount rate for each segment150 and to discount to present value,

using the DCF model, the estimated free cash flows and terminal value of each line of

business. In the words of Brealey and Myers, “The true cost of capital depends on the use

to which the capital is put.”151

This is basically the method that was followed in valuing the different business

segments of Warner Brothers in the acquisition by Time of Warner Brothers to form

Time-Warner. The investment banking firms of Wasserstein/Shearson, in their opinion to

Time’s board,152 and Lazard in its opinion to Warner’s board,153 used a range of

discount rates for each of Warner’s business segments. Neither report indicates, however,

whether the discount rates were determined by using CAPM.

Some companies use different discount rates depending on the type of investment

being analyzed. For example, an investment that expands the firm’s core business may be

analyzed with a discount rate equal to the firm’s cost of capital, determined using

WACC. A more risky venture may be analyzed with a higher discount rate, and a less

risky venture may have a lower rate.154

CAPM was used by the Delaware Court of Chancery in the appraisal decision in

Cede & Co. v. Technicolor, Inc.,155 where the court said, “The CAPM methodology is

certainly one of the principal [sic] ‘techniques or methods . . . generally considered

acceptable [for estimating the cost of equity capital component of a discounted cash flow

modeling] in the financial community. . . .’” 156

IX. LAZARD’S USE OF BETA, CAPM, AND THE FORMULA FOR LEVERING AND

DELEVERING BETA IN COMPUTING CONTRAIL’S WACC AND PRESENT VALUE

A. Introduction

Lazard Frères & Co., LLC represented Conrail in the proposed acquisition of

Conrail by competing acquirors CSX and Norfolk Southern. Appendix A presents

Lazard’s use of levered and unlevered betas and CAPM in computing an estimate of

Conrail’s WACC, and Appendix B shows Lazard’s discounted cash flow valuation of

Conrail’s cash flows, with the discount rate determined by the use of WACC as indicated

in Appendix A. This Part examines these two appendices in detail.

150. Thompson, supra note 1, at 513 (citing BREALEY & M YERS, supra note 19, at 189).

151. Thompson, supra note 1, at 513 (citing BREALEY & M YERS, supra note 19, at 182).

152. Thompson, supra note 1, at 513 (directing the reader to Appendix C, at C-2 to C-3 of that article).

153. Thompson, supra note 1, at 513 (referencing Appendix D, at D-5 to D-6 of that article).

154. Thompson, supra note 1, at 513 (citing BREALEY & M YERS, supra note 19, at 189).

155. No. CIV.A. 7129, 1990 WL 161084 (Del. Ch. Oct. 19, 1990).

156. Thompson, supra note 1, at 513 (quoting Cede & Co., 1990 WL 161084, at *28, which cited

Weinberger v. UOP, Inc., 457 A.2d 701, 713 (Del. 1983), and referencing Northern Trust Co. v. C.I.R., 87 T.C.

349, 368 (1986)).

294 The Journal of Corporation Law [Winter

Lazard’s starting point was the computation of Conrail’s levered beta. Rather than

focusing only on Conrail, Lazard uses the levered betas of five railroad firms (Burlington

Northern, CSX, Conrail, Norfolk Southern, and Union Pacific)157 to compute an average

levered beta.158 This approach is consistent with the recommendation of Brigham and

Gapenski, Brealey and Myers, and Copeland, Koller, and Murrin, all of who say that a

single firm’s beta may be unstable and, therefore, recommend using a portfolio of firms

in a particular industry in estimating a firm’s beta.159 Here the average levered beta of

0.88 is close to Conrail’s levered beta of 0.85.160

Appendix A does not indicate how Lazard determined the levered betas for the

firms. The estimates could have come from a beta book,161 from a service like

Bloomberg,162 from regressing the returns on these stocks against the returns on the

market,163 or from use of the covariance statistical technique.164 If the regression or

covariance technique is used, weekly or daily returns for the market and the stocks should

be used for a period of at least five years.165 The result here is the levered beta because

the computation was done with respect to the equity of each firm, thereby automatically

taking into account the firm’s leverage.

The next step used by Lazard was to compute the unlevered betas for each firm and

to determine an average unlevered beta.166 Although Appendix A does not indicate what

method Lazard used in converting the levered betas in column [3] of Appendix A into

unlevered betas in column [4] of Appendix A, it is clear that it used the delevering

formula set out in Part VII:

β1

βu =

[1 + (1 - T)(D/E)]

Here β u is the unlevered beta; β l is the levered beta; T is the corporate income tax rate,

which, as indicated in chart [8] of Appendix A, is 40%; D is the debt set out in column

[6] of Appendix A; and E is the equity set out in column [7] of Appendix A.

The following table demonstrates that this formula converts the levered betas in

column [3] of Appendix A into the unlevered betas in column [4] of Appendix A:

157. See infra Appendix A[2] for Lazard’s examination of these five railroad firms.

158. See infra Appendix A[2], A[3].

159. See supra Part I.C.

160. See infra Appendix A[3].

161. See supra Part I.B.

162. See supra Part I.B.

163. See supra Parts IV and V.

164. See supra Part III.

165. See supra Part II.C.

166. See infra Appendix A[4].

2000] Demystifying the Use of Beta 295

Table RR

Conversion of Levered Betas to Unlevered Betas

(From Appendix (From (Compare

A[2]) Appendix Appendix

A[3]) A[4])

Comparable Levered ÷ Delevering Formula Unlevered

Company Beta Beta

1. Burlington 0.95 ÷ 1 + (1 -T)(D/E) *

Northern

0.95 ÷ 1 + (1 - .4)(4.2/12.8)

0.95 ÷ 1 + (.6)(.33)

0.95 ÷ 1 + .19

0.95 ÷ 1.19 = 0.79

2. CSX 0.98 ÷ 1 + (1-T)(D/E)

0.98 ÷ 1 + (1 - .4)(2.8/10.5)

0.98 ÷ 1 + .6 (.27)

0.98 ÷ 1 + .16

0.98 ÷ 1.16 = 0.84

3. Conrail 0.85 ÷ 1 + (1-T)(D/E)

0.85 ÷ 1 + (.6)(2.0/5.7)

0.85 ÷ 1 + (.6)(.35)

0.85 ÷ 1 + .21

0.85 ÷ 1.21 = 0.70

4. Norfolk Southern 0.82 ÷ 1 + (1+T)(D/E)

0.82 ÷ 1 + (.6)(1.8/11.6)

0.82 ÷ 1 + (.6)(.15)

0.82 ÷ 1 + .09

0.82 ÷ 1.09 = 0.75

5. Union Pacific 0.82 ÷ 1 + (1-T)(D/E)

0.82 ÷ 1 + (.6)(6.1/10.2)

0.82 ÷ 1 + (.6)(.59)

0.82 ÷ 1 + (.35)

0.82 ÷ 1.35 = 0.60

Avg. 0.74

*

The estimate of Debt (D) and Equity (E) comes from Appendix A[6] and A[7].

296 The Journal of Corporation Law [Winter

Lazard’s next step was to recompute a levered beta for Conrail under the various

debt to equity financing assumptions set out in columns [9] [a] and [b] of Appendix A, as

follows:

[a] [b]

Debt/Capital Debt/Equity

1. 0.0% 0.0%

2. 10.0% 11.1%

3. 20.0% 25.0%

4. 30.0% 42.7%

5. 40.0% 66.7%

6. 50.0% 100.0%

Thus, Lazard decided to determine a levered beta for Conrail under the assumption that

Conrail’s capital structure included from zero to 50% debt. Notice that the ratio of debt to

total capital (including debt and equity) in column [9][a] is less than the corresponding

debt to equity ratio in column [9][b].

Column [9][c] has an average unlevered beta of 0.74, which was computed in

column [4], as discussed above. Column [9][d] sets out a levering factor that is applied to

the average unlevered beta in column [9][c] to come up with a levered beta in column

9[e]. Although Appendix A does not indicate how Lazard came up with the levering

factor, it is clear that Lazard used the following formula for determining a levered beta,

which is set out in Part VII:

β l = β u[1 +(1-T)(D/E)]

The levering factor here is computed by the following formula: [1 +(1-T)(D/E)]. The

T in this formula is the 40% tax rate indicated in column [8][a], the D/E term is set out in

percentage form in column [9][b], which is derived from the debt to capital ratio in

column [9][a]. For example, if the debt in column [9][a] is 20%, the equity is 80%, and,

as indicated in column [9][b], the ratio of debt to equity expressed as a percentage in

column [9][b] is 25%. Thus, the levering factor set in column [9][d] is computed as

follows:

2000] Demystifying the Use of Beta 297

Table SS

Computation of Levering Factors

Debt:Equity Debt/Equity Levering Formula Levering Factor

as a % [1 +)1 - T)(D/E)] = (See column

(See column [9][b]) [9][d])

1. 0%:100% 0.0% [1 + (.60)(0.0)] = 1

2. 10.0%:90.0% 11.1% [1 + (.60)(.111)] = 1.07

3. 20.0%:80.0% 25.0% [1 + (.60)(.250)] = 1.15

4. 30.0%:70.0% 42.9% [1 + (.60)(.429)] = 1.26

5. 40.0%:60.0% 66.7% [1 + (.60)(.667)] = 1.40

6. 50.0%:50.0% 100% [1 + (.60)(1.00)] = 1.60

With the above levering factors, Lazard then computed the levered beta for the

various debt to equity ratios as follows:

Table TT

Computation of Levered Betas

Debt:Equity Debt/Equity Average Levering Levered

As a % Unlevered x Factor = Beta

(See column Beta (See (See column

[9][b]) (See column column [9][e])

[9][c]) [9][d])

1. 0%:100% 0.0% 0.74 x 1.00 = 0.74

2. 10.0%:90% 11.1% 0.74 x 1.07 = 0.79

3. 20.0%:80% 25.0% 0.74 x 1.15 = 0.85

4. 30.0%:70% 42.9% 0.74 x 1.26 = 0.93

5. 40.0%:60% 66.7% 0.74 x 1.40 = 1.03

6. 50.0%:50% 100% 0.74 x 1.60 = 1.18

Lazard’s next step was to use the estimate of the levered beta under these six

possible capital structures to compute a cost of levered equity under each structure.

Column [9][f] sets forth the cost of equity, which is the cost of levered equity, and this is

the result of the use of CAPM. CAPM provides that the cost of levered equity is equal to

the risk-free rate plus the beta multiplied by the market risk premium, which is set forth

as follows:

Here rle is the cost of levered equity, rf is the risk-free rate, β l is the beta for levered

equity, and (rm-rf) is the return on the market minus the risk-free return, or the market risk

premium.

Column [8][b] of Appendix A gives the risk-free rate (rf) as 6.64%. This is

presumably the T-bond rate. Column [8][c] gives the market risk premium (rm-rf) as

7.0%, and column [9][e] gives the levered beta under the six capital structures. Thus, the

298 The Journal of Corporation Law [Winter

cost of equity in column [9][f], which is the cost of levered equity (rle), was computed by

Lazard using CAPM as follows:

Table UU

Lazard’s Computation of Conrail’s Cost of Levered Equity Using CAPM

Structure Levered = Rate + Market Risk = Equity

Debt:Equity Equity (See Premium (See (See

rle column columns [9][e] column

[8][b]) & [8][c]) [9][f])

1. 0% 100% rle = 6.64% + [(0.74) x (7.0%] = 11.8%

2. 10.0% 90.0% rle = 6.64% + [(0.79) x (7.0%)] = 12.1%

3. 20.0% 80.0% rle = 6.64% + [(0.85) x (7.0%)] = 12.6%

4. 30.0% 70.0% rle = 6.64% + [(0.93) x (7.0%)] = 13.1%

5. 40.0% 60.0% rle = 6.64% + [(1.03) x (7.0%)] = 13.9%

6. 50.0% 50.0% rle = 6.64% + [(1.18) x (7.0%)] = 14.9%

CAPM, increases from 11.8% when zero debt is used in the capital structure (that is, the

cost of unlevered equity) to 14.9% when the capital structure contains 50% debt. This

illustrates that 11.8% is the cost of equity with only business risk and that this cost

increases as the financial risk to the firm increases.167

Column [11] of Appendix A shows the computation of Conrail’s weighted average

cost of capital (WACC) under the six different capital structures and under seven

different assumptions about the cost of debt, as set forth in column [10]. For illustrative

purposes we will assume that the pre-tax cost of debt for Conrail is 10% and the after-tax

cost is 6%, as indicated in column [10][g]. Since the tax rate is 40% as indicated in

column [8][a], the after-tax cost of debt must be 6.0% when the cost of pre-tax debt is

10%, computed as follows:

= 10% x (1-0.40)

= 10% x 0.60

= 6%

Lazard computed the WACCs under the six capital structures by applying the

applicable weight for the debt and equity under each of the cases pursuant to the

following formula:

2000] Demystifying the Use of Beta 299

WACC Formula

WACC = [(Percentage of Debt (D) in Capital Structure (D+E)) x

(After-tax Cost of Debt) + (Percentage of Equity (E) in

Capital Structure (D+E)) x (Cost of Levered Equity)]

WACC = D + E d

E

+ x (cost of Levered Equity (rle))

D+ E

D E x r

WACC = D + E x (rd)(1 – T) + le

D+ E

D

In Table VV below, is set out in column [2], (rd )(1 – T) is set out in column

D +E

D E

[3], the result of x (rd )(1-T) is set out in column [4], is set out in column

D +E D +E

E

[5], rle is set out in column [6], the result of × rle is set out in column [7], and the

D+E

WACC is set out in column [8].

Table VV (Part 1)

Computation of Conrail’s WACC

[1] [2] [3] [4]

Percentage After Tax Weighted

Debt: Debt in x Cost of Debt = Average Cost of

Equity Capital (rd (1-T)) Debt

Structure

D

D+E

1 0% : 100% 0% x 6.0% = 0%

2 10.0% : 90.0% 10% x 6.0% = 0.6%

3 20.0% : 80.0% 20% x 6.0% = 1.2%

4 30.0% : 70.0% 30% x 6.0% = 1.8%

5 40.0% : 60.0% 40% x 6.0% = 2.4%

6 50.0% : 50.0% 50% x 6.0% = 3.0%

300 The Journal of Corporation Law [Winter

Table VV (Part 2)

Computation of Conrail’s WACC

[5] [6] [7] [8]

[Percentage Cost of Weighted WACC

of Equity in x Equity = Average [Column [4] plus

Capital (See column Cost of column [7]]

Structure [9][f]) Equity (See Appendix A

E column [11][g])

D+E

1. 100% x 11.8% = 11.80% 11.8%

2. 90% x 12.1% = 10.89% 11.5%

3. 80% x 12.6% = 10.08% 11.3%

4. 70% x 13.1% = 9.17% 11.0%

5. 60% x 13.9% = 8.34% 10.7%

6. 50% x 14.9% = 7.45% 10.5%

As indicated in column [8] of Table VV above, the WACC goes down as the use of

debt in the capital structure increases. Brigham and Ga penski point out that, at some

point, the additional use of debt should cause the weighted average cost of capital to

begin to rise because “financial distress and agency costs become increasingly important,

offsetting some of the tax advantages [of using debt].”168

G. Use of WACC in Determining the Present Value of Conrail’s Free Cash Flow

The next step followed by Lazard was to use the estimate of Conrail’s WACC set

out in Appendix A as the discount rate in the Discounted Cash Flow analysis in Appendix

B. As seen in column [3] of Appendix B, Lazard used the following three estimates of

Conrail’s WACC as the discount rate: 11.0%, 11.5%, and 12.0%. It is standard practice to

use a range of discount rates as part of a sensitivity analysis.169 On this point Judson P.

Reis and Charles R. Cory in a chapter entitled the Fine Art of Valuation, in the Mergers

and Acquisitions Handbook write:

As a practical matter . . . the weighted average cost of capital never is used as a

point estimate of the ‘right’ discount rate. Instead, this calculation defines the

center of a range of discount rates (usually one or two percentage points on

either side of the estimate) that will be used to discount the cash flows.170

In this case, the 11.5% midpoint of the range in Appendix B[3] is the same as the

estimate of Conrail’s WACC with 10% debt in the capital structure and a 10% pre-tax

cost of debt, as demonstrated in Appendix A[11][g]. Because approximately 25% of

Conrail’s capital is in debt as demonstrated in Appendix A[6] and [7], the WACC with a

169. See Thompson, supra note 1, at 499-500.

170. Judson P. Reis & Charles R. Cory, The Fine Art of Valuation, in ROCK ET AL., supra note 1, at 184.

2000] Demystifying the Use of Beta 301

25% debt and a 10% pre-tax interest rate would have been 11.2%, determined by

extrapolation from Appendix A [11][g].

Although we do not know exactly how Lazard arrived at the 11.0%, 11.5%, and

12.0% estimates of the discount rate used in Appendix B[3], the assumptions appear to be

realistic given the estimates of WACCs computed in Appendix A[11].

These three discount rates were used to compute the present value of the free cash

flows computed in Table [1] of Appendix B. This table computes the free cash flows by

starting with an estimate of Conrail’s net income for each year from 1997 through 2003

as indicated in Table [1][a] of Appendix B and adding back the after-tax interest expense

shown in Table [1][b] to compute unlevered net income (Table [1][c]), that is, income

computed without any interest expense. In explaining the rationale for this adjustment,

Reis and Cory explain:

DCF valuations use a discount rate that reflects the firm’s weighted-average

cost of capital or the price it must pay to suppliers of both debt and equity.

Accordingly, the free cash flows to be discounted should be developed

independent of financing costs. In valuing a going concern with existing

liabilities, therefore, the after tax cost of interest is added back to [net income]

to create an unlevered free cash flow.171

Additionally, the following adjustments are made in computing free cash flow:

depreciation and amortization (Table [1][d]) are added back, capital expenditures (Table

[1][e]) are deducted and the adjustments relating to working capital (Table [1][f]),

deferred taxes (Table [1][g]), and other items (Table [1][h]) are made in computing the

free cash flow set out in Table [1][i]. The result here is consistent with the standard

method of computing the free cash flows.172 The present value of these free cash flows

under the three discount rates is set out in Column [4] of Appendix B, which is labeled

NPV of Cash Flows.173

The terminal value of Conrail for year 2004, the year after the last year for the cash

flow projections, is estimated by reference to Conrail’s earnings before interest, taxes,

depreciation, and amortization (EBITDA). Conrail’s EBITDA is set forth on Line[2] of

Appendix B, but the EBITDA for the year 2004 is not given. In any event, Table [5] of

Appendix B shows that a range of terminal values is estimated by multiplying the

EBITDA for year 2004 by 8, 8.5, and 9. These multiples were apparently determined by

considering multiples of comparable companies or comparable transactions. This is a

standard way for determining the terminal values,174 and it is also appropriate to use a

range of estimates of terminal value as part of a sensitivity analysis.175 Thus, Table [5]

shows the present value of the range of terminal values determined using the range of

discount rates.

172. See Thompson, supra note 1, at 481-89; Reis & Cory, supra note 170, at 182.

173. Technically, column [4] presents the present values of the free cash flows, not the net present value

(NPV). NPV is the difference between (1) the cost of an investment and (2) the present value of the free cash

flows and terminal value.

174. Thompson, supra note 1, at 489-98.

175. Id. at 499-500.

302 The Journal of Corporation Law [Winter

Conrail’s free cash flows and terminal values, thus giving the value of Conrail’s assets

(i.e., Conrail’s enterprise value). This table is a summation of the present values of the

cash flows in Table [4] and the present values of the terminal values in Table [5].

Table [8] shows the estimate of the range of Conrail’s equity value by subtracting

from the enterprise value in Table [6], Conrail’s net debt (i.e., debt minus cash) of $2.102

billion set out in Table [7]. Thus, for example, using the 11% discount rate, the range of

equity values of Conrail go from $7.271 billion, with a terminal value computed at 8

times the 2004 EBITDA, to $8.125 billion, with the terminal value computed at 9 times

the 2004 EBITDA.

Table [10] shows the equity value on a per share basis after taking account of certain

option proceeds, which were not valued using the discounted cash flow technique. Thus,

Table [10] shows that the value per share of Conrail ranged from a low of $74.68, with a

discount rate of 12% and the terminal value determined by using a multiple of 8 times the

2004 EBITDA, to a high of $89.51, with a discount rate of 11%, and the terminal value

determined by using a multiple of 9 times the 2004 EBITDA. This valuation turned out to

be significantly less than the $115 per share price finally paid by Norfolk Southern.176

Lazard used beta and CAPM to estimate Conrail’s cost of levered equity under

various capital structures, and then estimated Conrail’s WACC under various capital

structures with various costs of debt. Lazard then, exercising its judgement based on the

WACCs in Table [11] of Appendix A, used rates of 11%, 11.5%, and 12% as a range of

discount rates for determining the present value of Conrail’s free cash flows and terminal

value. By using WACC in determining the discount rate, Lazard automatically took into

account the financing effect and, therefore, it was appropriate for Lazard to discount

Conrail’s free cash flows without deducting any interest payments. The present value

determined by discounting the free cash flows and the terminal value is the estimated

value of Conrail’s assets. Lazard, therefore, deducted Conrail’s net debt in computing the

fair market value of Conrail’s equity.

As an alternative, Lazard could have used the adjusted net present value (APV)

method suggested by Brealey & Myers.177 With APV, Lazard first would have

discounted Conrail’s free cash flows (without interest deduction) and terminal value at

Conrail’s cost of unlevered equity, and then discounted the expected tax savings from the

interest deduction at the same cost of unlevered equity. The sum of the two present values

would have been the value of Conrail’s assets. Lazard would have then deducted

Conrail’s net debt in computing the fair market value of Conrail’s equity.

As another option, Lazard could have used the equity DCF approach suggested by

Brigham and Gapenski.178 Under this approach, Lazard would first have computed

Conrail’s WACC using the levered equity beta as it did in Appendix A. Lazard would

then have discounted Conrail’s free cash flows with interest deducted and its terminal

176. See Agis Salpukas, Conrail Chugs off into the Sunset, N.Y. T IMES, June 1, 1999, at C1.

177. See supra Part I.B.

178. Id.

2000] Demystifying the Use of Beta 303

value at the WACC. The interest is deducted in this approach, because the equity is being

valued.179 The result would be the fair market value of Conrail’s equity.

XI. CONCLUSION

whether to make an investment in a capital project, including in determining the valuation

of a target in a merger or acquisition transaction. The determination of the appropriate

cost of capital is a necessary element in the discounted cash flow model. The most

commonly used technique for determining the cost of equity capital is the CAPM, which

posits that the cost of equity capital is equal to the sum of (1) the risk-free rate and (2) the

beta for the investment times the market risk premium. Thus, beta is an essential element

in CAPM and, therefore, is often an essential element in the discounted cash flow model.

Beta, which is a measure of the sensitivity of the returns for a particular stock to the

returns on the market, can be derived through the use of the concepts of covariance and

variance, and through the use of regression analysis, including Excel’s linear regression

function. Betas for a target firm can be expressed either as levered or unlevered, and

depending on the circumstances, it may be necessary to move from a levered to an

unlevered beta, or vice versa. A formula developed by Robert Humada permits

movements between levered and unlevered betas.

The analysis in Parts VI and VII of Lazard’s valuation of Conrail, which was the

target of competing bids by CSX and Norfolk Southern, illustrates in a real life

acquisition context the computation of levered and unlevered betas and their use in a

discounted cash flow model.

304 The Journal of Corporation Law [Winter

APPENDIX A

Lazard’s Computation of Conrail’s Weighted Cost of Capital

Ticker Comparable Levered Unlevered Debt Cap. Debt Equity

Company Beta Beta Ratio Value

BNI Burlington Northern 0.95 0.79 24.8% $4,239.0 $12,834.6

CSX CSX 0.98 0.84 21.3% 2,848.0 10,522.7

CRR Conrail 0.85 0.70 26.5% 2,078.0 5,755.7

NSC Norfolk Southern 0.82 0.75 13.1% 1,765.0 11,658.7

UNP Union Pacific 0.82 0.60 37.6% 6,155.0 10,223.0

AVERAGES 0.88 0.74 24.7% $3,417.0 $10,199.0

[8]

Assumptions

[a] Marginal Tax Rate: 40.00%

[b] Risk Free Rate of Return: 6.64%

[c] Market Risk Premium: 7.00%

[9]

Computation of Cost of Equity

Average Levering Levered Cost of

Debt/Cap. Debt/Equity Unlevered Beta Factor Beta Equity

0.0% 0.0% 0.74 1.00 0.74 11.8%

10.0% 11.1% 0.74 1.07 0.79 12.1%

20.0% 25.0% 0.74 1.15 0.85 12.6%

30.0% 42.9% 0.74 1.26 0.93 13.1%

40.0% 66.7% 0.74 1.40 1.03 13.9%

50.0% 100.0% 0.74 1.60 1.18 14.9%

[10]

Pre-Tax/After-Tax Cost of Debt

[a] [b] [c] [d] [e] [f] [g] [h]

4.20% 4.50% 4.80% 5.10% 5.40% 5.70% 6.00% 6.30%

2000] Demystifying the Use of Beta 305

[11]

Weighted Average Cost of Capital

Debt/Cap. (See [10])

(See [9a])

[a] [b] [c] [d] [e] [f] [g] [h]

4.20% 4.50% 4.80% 5.10% 5.40% 5.70% 6.00% 6.30%

0.0% 11.8% 11.8% 11.8% 11.8% 11.8% 11.8% 11.8% 11.8%

10.0% 11.4% 11.4% 11.4% 11.4% 11.5% 11.5% 11.5% 11.6%

20.0% 10.9% 11.0% 11.0% 11.1% 11.1% 11.2% 11.3% 11.3%

30.0% 10.5% 10.5% 10.6% 10.7% 10.8% 10.9% 11.0% 11.1%

40.0% 10.1% 10.1% 10.2% 10.4% 10.5% 10.6% 10.7% 10.8%

50.0% 9.6% 9.7% 9.9% 10.0% 10.2% 10.3% 10.5% 10.6%

APPENDIX B

Lazard’s Discounted Cash Flow Analysis of Conrail

[1]

Projected for the Year Ended December 31 ($ in Millions)

[a] Net Income $ 488 $ 559 $ 630 $ 691 $ 739 $ 811 $ 885

[b] Plus: After-Tax Interest 96 85 72 56 56 34 11

[c] Unlevered Net Income 584 644 702 747 795 845 897

[d] Depreciation & Amortization 282 290 302 311 320 329 339

[e] Capital Expenditures (510) (550) (550) (562) (578) (595) (612)

[f] Changes in Working Capital 3 (5) 1 16 16 17 17

[g] Deferred Taxes 90 101 111 96 99 102 105

[h] Other (43) (43) (43) (43) (43) (30) (30)

[i] Free Cash Flow $ 406 $ 438 $ 523 $ 566 $ 609 $ 668 $ 715

Memo Items:

[2] EBITDA $ 1,217 $ 1,321 $ 1,425 $ 1,507 $ 1,592 $ 1,681 $ 1,774

306 The Journal of Corporation Law [Winter

Discount NPV of Terminal Value Enterprise Value

Rate Cash Flows 2004 EBITDA Multiple: 2004 EBITDA Multiple:

8.0x 8.5x 9.0x 8.0x 8.5x 9.0x

11.0% $ 2,539 + $ 6,834 $ 7,261 $ 7,688 = $ 9,373 $ 9,800 $ 10,227

11.5% 2,494 + 6,622 7,036 7,450 = 9,117 9,530 9,944

12.0% 2,451 + 6,418 6,819 7,220 = 8,869 9,270 9,671

Less Net Equity Value (b) Options Equity Value Per Share

Debt 2004 EBITDA Multiple: Proceeds 2004 EBITDA Multiple:

8.0x 8.5x 9.0x 8.0x 8.5x 9.0x

$ (2,102) $ 7,271 $ 7,696 $ 8,125 $ 76 $ 80.18 $ 84.84 $ 89.51

(2,102) 7,015 7,428 7,842 76 77.38 81.90 56.42

(2,102) 6,767 7,168 7,569 76 74.68 79.06 83.44

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