Higher Beta: All-Equity or All-Debt Firm?
Couldn't find an answer to this in guides or anything -- what has a higher beta, an all-equity or an all-debt company? Is it an all-debt because they are more risky and hence more volatile?
What Determines Beta?
The key to answering this question in understanding what determines beta. Beta is a term used in trading to indicate volatility or systematic risk of an asset compared to that of the overall market. Higher values of beta indicate higher returns and more risk relative to the overall market.
As one WSO user points out:
There are essentially three variables (or risks) that affect beta:
- business risk (pricing power, product demand, staple vs. discretionary etc.)
- operating risk (fixed cost as a % of total operating costs)
- financial risk (amount of debt in capital structure)
More Debt = Higher Beta
Certified Hedge Fund Professional – Quant @IlliniProgrammer" explains how debt affects beta:
In a perfect world, if you've got two companies with identical assets but one has a lot more debt, the company with more debt is going to see the market's assessment of the value of its' equity (stock price) change faster than one that has less debt.
Another way of looking at it is that companies with a higher debt ratio are riskier and riskier debt starts to look more and more like equities in their sensitivity to the market.
In general, more debt financing means higher betas for both equities and debt.
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what beta are you looking at?
levered beta: you can't really look at levered beta for all debt, because it is N/A or approaching to infinite, but I guess it is bigger on a mathematical basis. unlevered beta: it's the same because it doesn't depend on the financing of the company.
for levered: since the levered Beta equation is unlevered * (1+(1-T)D/E) so as Debt increases so does Beta (approaching infinity for an all debt company)
well you can argue this from two angles, from mathematical basis, yes all debt is higher because of approaching to infinity. on a practical basis, levered beta is beta for equity, taking into consideration the amount of leverage. you don't have equity in an all debt scenario, not sure if levered beta will still be a relevant term in this case, I think it is more like N.M than infinite.
This is an unanswerable question, since an all debt company is not publicly traded and therefore has no returns to regress against market returns. Asking what's the Beta for 100% debt company is a little like asking what is the interest expense for an 100% equity company.
Instead, taking 99%/1% and 1%/99% obviously the 99% debt version of the company would have a MUCH higher levered beta (which is what we observe in the public equity markets) since the equity is levered to such a high degree. Regardless, unlevering both betas would yield the same number.
jhoratio, you're dead wrong. Theoretically, a beta does not depend on regressing market returns; that is just the method we all choose to do because it is simple. However, that does not mean that this is an "unanswerable question." Every asset (liquid or non-liquid) has a beta. The hard part is accurately determining it. In fact, simple regressions (stock X's return on market index returns) tend to have large standard of errors, which is why bottom-up betas are better to use.
OP, I think this is a good question because it requires you to know what determines beta. There are essentially three variables (or risks) that affect beta: business risk, operating risk, and financial risk. So in order to be able to answer if an all-equity company or an all-debt company has a higher beta, you need to know their relevant business risk (pricing power, product demand, staple vs. discretionary etc.), operating risk (fixed cost as a % of total operating costs), and financial risk (amount of debt in capital structure).
You CANNOT answer this question by simply stating that since an all-equity firm has no financial risk, its beta is lower. If an all-equity firm has much higher business risk and operating risk, its total beta can still be higher than a company that is all-debt financed but has much lower business and operating risk.
Lastly, remember that creditors to a firm that is 100% debt financed essentially also become its shareholders, which blurres the definition of equity risk and financial risk.
^^ how the hell do they become its shareholderes? in the case that it goes bankrupt sure but their upside is still limited ....
Well if its 100% financed with debt, that means that creditors have a 100% claim on the cash flows and assets of the company. There is no equity to buffer potential losses and the creditors fully bear all the risks of the business. While first lien and senior creditors are fairly safe, subordinate and unsecured creditors become equally exposed in the case of bankruptcy as shareholders.
In a perfect world, if you've got two companies with identical assets but one has a lot more debt, the company with more debt is going to see the market's assessment of the value of its' equity (stock price) change faster than one that has less debt.
Likewise, owning debt is a little like having cash and being short a put on the firm's assets, with the "strike price" at the dividing line between debt financing and equity financing. (I'm making a few HUGE assumptions here that don't usually play out in real life, including CAPM, that the company declares bankruptcy if it is insolvent when the debt must be repaid even if it otherwise has the legal ability to repay, and that there's only one class of debt.) Since the underlying are changing at the same rate and the debt/puts that are closer to the money will have a higher delta than ones that are way out of the money, the firm with more debt financing will see its' debt change more when the overall market changes. Another way of looking at it is that companies with a higher debt ratio are riskier and riskier debt starts to look more and more like equities in their sensitivity to the market.
Some good points have been raised about whether the situation is applicable for 100% debt financing or 100% equity financing, but in general, more debt financing means higher betas for both equities and debt; the underlying asset's beta is conserved under CAPM because there is more lower-beta debt and less higher-beta equity. Credit markets have their own measures of beta, as well.
as Huey Lewis would say, "There ain't no living in a perfect world"
What? Why? Faster, as in 'it takes the market 5 min to price in news about X, but only 3 min about Y - because Y has
Not just one class - there should only be one bond, if there is more you need to consider a whole set of options with different maturities and it gets way to complicated to discuss on an internet forum.
Apart form all that - how can a company be all debt? Who would decide how to use the companies property if there is no owner?
The proper question is what happens to beta as D/E approaches infinity.
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