Systematic risk or the market risk is a risk that is not company specific and is driven by macro-economic or general economic factors from external environment which affects all the companies but the level of this risk differs between different types of businesses (different sectors).
Apart from these risks; there are company specific risk known as unsystematic risk. The unsystematic risks are caused by factors that create extra risk in the company over and above the systematic risk of the industry; e.g., risk of underperformance of new CEO or poor labour relations resulting in unrest.
The portfolio theory suggests that investors in capital market are holding well-diversified portfolio whereby they have diversified away the unsystematic risk or company specific risk and therefore they are concerned about the level of systematic risk which will determine the required return.
Although the company cannot reduce the systematic risk further by diversification in the same system or market, but such reduction in level of systemic risk could be achieved by diversification into altogether different system or market.
Lastly, the beta is an indirect measure which compares the systematic risk associated with the company shares with the systematic risk of the capital market as a whole. In book-based definition it is an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole. The beta values are found through using regression analysis technique to compare the return on company shares with the return on capital market as a whole.
CAPM & Beta:
The expectation of equity holders changes with reference to gearing level in the company which needs to be appraised.
We never compute cost of debt using CAPM. The valuation of debt / cost of debt is completely different. We are not computing WACC here even. It is all about cost of equity to be measured using CAPM. Here a major factor is “beta” which is a measure of systematic risk presence in the business. The steps are:
Step-1
Locate suitable proxy company/companies. It may be like a listed company data in the same business or industry data etc.
Step-2
Determine the equity beta of proxy company/companies, their gearing and tax rates.
Step-3
Ungear the proxy equity betas to obtain asset betas.
Step-4
Calculate the average asset beta (in case we have taken data of multiple proxy companies)
Step-5
Regear the asset beta with our company capital mix
Step-6
Use the CAPM to compute project specific cost of equity
The asset beta is the beta relevant to the business risk in an ungeared company in the appropriate line of business. It can be useful to think of this as the “ungeared beta”.
The equity beta is the beta relevant to the risk experienced be an equity holder in a geared company, in the appropriate line of business with a given level of gearing. It can be useful to think of this as the “geared beta”.
Assuming the debt beta is zero, the asset beta formula becomes:
The equity beta (gearing effect) to compute company specific or project specific beta:
Lastly computing the require return or project specific return or cost of equity using CAPM:
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