Estimating the Assets-in-Place Beta: A Feedback Algorithm

Abstract

Based on the linear decomposition of a firm's beta on the betas of its growth options and its Assets in Place, we propose a feedback algorithm to estimate the latter. Our proposal is founded on the existence of risk classes defined by a specific level of systematic risk for current business and growth opportunities. We test our model on a sample of US firms over the period 1994-2007, by identifying risk classes with industry groups as defined by Fama-French's 48-segment classification (Fama and French, 1997). Our results confirm rapid convergence of estimated parameters, and values which are quite consistent with the real option approach predictions. Our model addresses a practical problem which is yet to be resolved and is crucial for valuing firms and capital budgeting decisions. Empirical results are encouraging and shed new light on the problem of estimating the cost of capital.

Keywords: real options, growth opportunities, beta estimation, cost of capital, valuation

JEL Classification: G12, G31