SSRN ID223797 Code000918140

Demystifying the Use of Beta in the Determination of the
Cost of Capital and an Illustration of Its Use in Lazard’s

Valuation of Conrail
Samuel C. Thompson, Jr. *
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
VI. SUMMARY OF BETA RESULTS AND INTRODUCTION TO A DJUSTED BETAS................283

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
A. Net Present Value

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).
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
C. Beta and the Capital Asset Pricing Model

One of the principal ways of determining the cost of equity is the capital asset
9. BREALEY & M YERS, supra note 1, at 120.

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.
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).
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.
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
D. Purpose of the Article

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
27. BRIGHAM & GAPENSKI , supra note 1, at 214.

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.
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.
II. INTRODUCTION TO BETA36
A. Systematic and Unsystematic Risk

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).
can be diversified away by investing in stocks of other companies, possibly in other

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
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).
eliminated and only the bedrock of market risk remains.”48 Thus, the market portfolio has
only systematic ris k.
B. Beta: A Measure of Systematic Risk

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

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).
50. Thompson, supra note 1, at 504 (citing ALAN C. SHAPIRO , MODERN CORPORATEFINANCE 118 (1990)
and GILSON & BLACK , supra note 37, at 94-98).
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>.
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%
57. RADCLIFFE , supra note 1, at 181.

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%
Table B
Frequency and Probability Distribution
for Stock 1 (AT&T)
[1] [2] [3]
Stock's Frequency of Probability
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]
8-Year Period
(1) 20% 3 40%
(2) 15% 2 20%
(3) -5% 3 40%
TOTALS 8 100%
Table D
Frequency and Probability

Distribution for Stock 3
(Utility Stock)
[1] [2] [3]
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
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).
III. DERIVATION OF BETA THROUGH THE USE OF COVARIANCE AND VARIANCE
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.
64. More generally, this equation can be written as:
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
(PDF)
(1) 15% 40% 6%
(2) 10% 20% 2%
(3) -0- 40% 0%
TOTAL
∑ ( 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.
Table G
(Growth Stock)
[1] [2] [3]
Stock's Probability Expected Return
(PDF)
(1) 20% 40% 8%
(2) 15% 20% 3%
(3) -5% 40% -2%
TOTAL
Table H
(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
Var(Y) = σy2 = Σ(Y - µy)2 Py(Y)

66. HILDEBRAND & OTT, supra note 1, at 118; see also GUJARATI , supra note 1, at 765.
67. HILDEBRAND & OTT, supra note 1, at 118.
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
Thus, there is a three-step process in computing variance that can be illustrated as

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
15% 8% 7
10% 8% 2
0% 8% -8
68. Id. at 119.

69. BREALEY & M YERS, supra note 1, at 149-51.
Table K
Actual Return for Expected Returns Deviation From
20% 9% 11
15% 9% 6
-5% 9% -14
Table L
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
11 x 11 = 121
6 x 6 = 36
-14 x -14 = 196
Table P
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
49 x .40 = 19.60
4 x .20 = 0.8
64 x .40 = 25.60
TOTAL 46 Variance
Table S
Stock 2's 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
6.76 x .40 = 2.70
.16 x .20 = .032
5.76 x .40 = 2.30
TOTAL 5.032 Variance
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:
Covariance Between Stock 1 and the Market = σ1µ = COR1µ σ1 σµ
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:
Standard Deviation (σm) of Variation (σm2 ) = VARIANCE (ó m 2 )
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.
75. Id.
76. A normal distribution will produce a bell-shaped curve. Although “the pattern of historical returns
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.
79. Id.
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
Comparison of Expected Returns and Standard Deviations

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

82. SPIEGEL , supra note 1, at 294.
83. Id.
84. Id.
85. Id.
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 )
This formula is also sometimes written as:90
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
86. See infra Part IV.F.

87. MALKIEL , supra note 1, at 272-74.
89. Id. at 298.
91. Id. at 430-31, 458.
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.
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.
Table Y
[1] [2] [3] [4] [5] [6] [7]
2
x y x xy y2
x=x- x y=y- y
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
[1] [2] [3] [4] [5] [6] [7]
x y x2 xy y2
x=x- x y=y- y
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
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:
Covariance Between Stock 1 and the Market = Cov (1m)

= 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
Now it is possible to compute the beta.
E. The Determination of Beta

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
96. See BREALEY & M YERS, supra note 1, at 145.

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):
CORTm σTσm 0σT σm

= =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
(See Table BB) (See Table Q)

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.
IV. DERIVATION OF BETA THROUGH REGRESSION A NALYSIS
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.
99. Id. at 420.
100. Id. at 421.
101. Id.
GRAPH C
Scatter Diagram for

Market Return and Return on Stock 1
(See Table W)
Relationship
Market Stock 1
15% 15%
10% 10%
0% 0%
Obviously, the relationship is linear.
GRAPH D
Scatter Diagram for

(See Table W)
Relationship
Market Stock 2
15% 20%
10% 15%
0% -5%
The relationship is linear, but less so than for stock 1.

GRAPH E
Scatter Diagram for

(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.
C. The Method of Least-Squares

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
D. Normal Equations for Least-Squares Line

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:
103. HILDEBRAND & OTT, supra note 1, at 429-30.

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
Σxy = aΣx + bΣx 2

(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.
Solving the Equation Simulataneously
(-13)25 = (-13)3a + (-13)25b

= -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:
Finding the Slope

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%:
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:
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]
15% 20% 225 300
10% 15% 100 150
0% -5% 0 0
∑ x = 25% ∑ y = 30% ∑ x 2 = 325 ∑ xy = 450
Table FF
Least-Squares Table for Stock 3
[1] [2] [3] [4]
X Y X2 XY
Market's Return Stock's Return [1] squared [1] x [2]
15% 10% 225 150
10% 7% 100 70
0% 5% 0 0
∑ x = 25% ∑ y = 22% ∑ x 2 = 325 ∑ xy = 220
The least squares equations for stocks 2 and 3 are as follows:
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
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.
Solving the Equation Simultaneously

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
= 60 = -14a + ob = -66 = -14a + ob

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:
Finding the Slopes (the Beta)

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:
Regression Line Equations

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.
GRAPH G
Best Fit Line for Stock 2
Value of x Regression Line Equation

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%
GRAPH H
Best Fit Line for Stock 3
Value of x Regression Line Equation

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
E. Short-Cut Method For Computing Slope-Beta

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.
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
[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
[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:
Computing Betas with the Shortcut Method
Beta Stock 1 Beta Stock 2 Beta Stock 3

Σxy Σxy Σxy
b= b= b=
Σx 2
Σx 2
Σx 2
117 201 38 .2
b= b= b=
117 117 117
b=1 b = 1.71 b = .32
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
For the three stocks the intercepts are computed as follows:
Computing Intercepts of the Three Stocks
Stock 1 Stock 2 Stock 3

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:
Total Variation = Σ(Y - Y )2
107. GUJARATI , supra note 1, at 77.

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:
Explained Variation = Σ(Yest - Y )2
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:
Total Variation = Explained Variation + Unexplained Variation
Σ(Y - Y ) 2 = Σ(Yest - Y ) + (Y - Yest)
The coefficient of determination (r2 ) is the ratio of explained variation to total

variation, that is:111
Explained Variation Σ(Yest - Y ) 2

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.
Table JJ
(r2 ) Coefficient of Determination for Stock 1
[1] [2] [3] [4] [5] [6]
X Y Yest Total Variance Explained Variance

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
Explained Variation Σ (Yest - Y ) 2 = 117

r2 =
Total Variation Σ (Y - Y ) 2 = 117
117
r2 =
117
r2 = 1
Table KK
[1] [2] [3] [4] [5] [6]
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
Explained Variation Σ (Yest - Y ) 2 = 339.53

r2 =
Total Variation Σ (Y - Y ) 2 = 353
339.53
r2 =
353
r 2 = .96
TABLE LL
[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
Explained Variation 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
Explained Variation Σ (Yest - Y ) 2

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.
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
In computing r2 from these r’s one gets:
Stock r2 = r2
1 12 = 1
2 0.982 = 0.96
3 0.952 = 0.90
And the r2 s computed from the two formulas are as follows:
Stocks r2 Computed from Formula for r2 Computed by Squaring the r Determined

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
The difference in the computation of the r2 for stock 3 is presumably attributable to

rounding errors.
116. Id.
117. Id.
V. DERIVATION OF BETA THROUGH THE USE OF EXCEL’S LINEAR REGRESSION FUNCTION
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:
Table MM Table NN Table OO
Excel Linear Regression Excel Linear Regression Excel Linear Regression

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:
= INDEX(LINEST (known ys, known xs),1)
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)
As a result the beta of 1 appears in cell B10.

The intercept can be determined using the following formula:
=INDEX(LINEST(known ys, known xs),2)
The betas using the LINEST function are as follows:

Table PP
Betas Using LINEST Function
Stock Beta
1 1.00
2 1.71
3 0.31
VI. SUMMARY OF BETA RESULTS AND INTRODUCTION TO A DJUSTED BETAS
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
=INDEX(LINEST(known ys, known xs),1) 1 1.71 .31
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.
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:
Adjusted Beta = 0.33 (Historical Beta) + 0.67(1.0).
This concept is not examined further here.
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).
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)).
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).
129. Thompson, supra note 1, at 515 (citing BREALEY & M YERS, supra note 19, at 191-92 (providing the
basis for the illustration)).
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)
0.8 = 0.08 + (0.6)(x)
.8 - .08
=x
.6
.72
=x
.6
1.2 = x
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
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.
B. The Levering and Unlevering Formula132

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
Cost of Levered = Risk-free + Business Risk + Financial Risk

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):
rle = rf + âu(rm - rf) + β u(rm - rf)(1-T)(D/E)
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.
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)
Third: Eliminate the rf term from both sides of the equation:
β l(rm - rf) = β u(rm - rf) + β u(rm - rf)(1-T)(D/E)
Fourth: Divide both sides of the equation by (rm - rf):
β l = β u + β u(1-T)(D/E)
Fifth: Simplify the right-hand side of the equation:
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)]
Brigham and Gapenski sum up these principles as follows:

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 ],
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.
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).
GRAPH L
Security Market Line
The expected risk premium on a particular stock can, therefore, be written as:147
Expected Risk Premium = (β ) x (Expected Risk Premium Market)

= 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:
Expected Rate of Return = r = (Risk-Free Rate of Return) + (β ) x Market Risk Premium
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
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).
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.
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).
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)).
B. Computation of Levered Beta

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.
C. Conversion of Levered Beta to Unlevered Beta

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.
163. See supra Parts IV and V.
164. See supra Part III.
165. See supra Part II.C.
166. See infra Appendix A[4].
Table RR
Conversion of Levered Betas to Unlevered Betas
[1] [2] [3] [4]

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

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:
APPENDIX A[9][a] and [b]

[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:
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
E. Use of CAPM to Compute Cost of Levered Equity

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:
rle = rf + β l(rm - rf)
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
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
Capital Cost of Risk-Free Levered β x Cost of

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%
Thus, Table UU above demonstrates that the cost of equity, as determined by

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

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:
After-Tax Cost of Debt = Pre-Tax Cost of Debt x (1-T)

= 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:
167. See supra Part VII.

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)]
 D  x (Pre-tax Cost of Debt (r )) (1 – Tax Rate (T))

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%
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
168. BRIGHAM & GAPENSKI , supra note 1, at 639-40.

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.
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.
171. Id. at 187.

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.
Table [6] of Appendix B presents the range of discounted present values of

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
X. SUMMARY OF LAZARD’S DCF VALUATION A PPROACH
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.
178. Id.
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
The discounted cash flow technique is commonly utilized by firms in determining

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.

APPENDIX A
Lazard’s Computation of Conrail’s Weighted Cost of Capital
[1] [2] [3] [4] [5] [6] [7]

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
[a] [b] [c] [d] [e] [f]

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]
7.00% 7.50% 8.00% 8.50% 9.00% 9.50% 10.00% 10.50%

4.20% 4.50% 4.80% 5.10% 5.40% 5.70% 6.00% 6.30%
[11]
Weighted Average Cost of Capital
After-Tax Cost of Debt

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)
1997 1998 1999 2000 2001 2002 2003
[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
[3] [4] [5] [6]

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
[7] [8] [9] [10]

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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Demystifying the Use of Beta in the Determination of the

Cost of Capital and an Illustration of Its Use in Lazard’s

Samuel C. Thompson, Jr. *

VI. SUMMARY OF BETA RESULTS AND INTRODUCTION TO A DJUSTED BETAS................283

A. Net Present Value

C. Beta and the Capital Asset Pricing Model

9. BREALEY & M YERS, supra note 1, at 120.

D. Purpose of the Article

27. BRIGHAM & GAPENSKI , supra note 1, at 214.

II. INTRODUCTION TO BETA36

A. Systematic and Unsystematic Risk

can be diversified away by investing in stocks of other companies, possibly in other

B. Beta: A Measure of Systematic Risk

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

57. RADCLIFFE , supra note 1, at 181.

Frequency and Probability

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

59. BRIGHAM & GAPENSKI , supra note 1, at 354.

Var(Y) = σy2 = Σ(Y - µy)2 Py(Y)

65. BRIGHAM & GAPENSKI , supra note 1, at 149.

Thus, there is a three-step process in computing variance that can be illustrated as

68. Id. at 119.

Covariance Between Stock 1 and the Market = σ1µ = COR1µ σ1 σµ

Standard Deviation (σm) of Variation (σm2 ) = VARIANCE (ó m 2 )

71. BREALEY & M YERS, supra note 1, at 157.

Comparison of Expected Returns and Standard Deviations

80. BRIGHAM & GAPENSKI , supra note 1, at 163.

This formula is also sometimes written as:90

86. See infra Part IV.F.

Covariance Between Stock 1 and the Market = Cov (1m)

Now it is possible to compute the beta.

E. The Determination of Beta

96. See BREALEY & M YERS, supra note 1, at 145.

CORTm σTσm 0σT σm

(See Table BB) (See Table Q)

IV. DERIVATION OF BETA THROUGH REGRESSION A NALYSIS

Scatter Diagram for

Obviously, the relationship is linear.

Scatter Diagram for

The relationship is linear, but less so than for stock 1.

Scatter Diagram for

C. The Method of Least-Squares

D. Normal Equations for Least-Squares Line

103. HILDEBRAND & OTT, supra note 1, at 429-30.

Σxy = aΣx + bΣx 2

Solving the Equation Simulataneously

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

Finding the Slope

15% 20% 225 300

10% 15% 100 150

∑ x = 25% ∑ y = 30% ∑ x 2 = 325 ∑ xy = 450

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

15% 10% 225 150

∑ x = 25% ∑ y = 22% ∑ x 2 = 325 ∑ xy = 220

The least squares equations for stocks 2 and 3 are as follows:

Solving the Equation Simultaneously

= 60 = -14a + ob = -66 = -14a + ob

Finding the Slopes (the Beta)

Regression Line Equations

Value of x Regression Line Equation

Value of x Regression Line Equation

E. Short-Cut Method For Computing Slope-Beta