The Relevance of the Firm's Leverage as the Only Factor in the Estimation of Systematic Risk: An Empirical Analysis Using the Unlevered Betas for a Group of Firms in a Common Economic Sector

16 Pages Posted: 8 Feb 2006

See all articles by Julio Sarmiento-Sabogal

Julio Sarmiento-Sabogal

Pontificia Universidad Javeriana

Edgardo Cayon Fallon

Colegio de Estudios Superiores de Administracion

Date Written: September 1, 2005

Abstract

An extensive body of knowledge has been developed around the theoretical relationship between the assumption that support the theory of the cost of capital and those that support the Portfolio-Capital Asset Pricing Model. The main discussion concerning how these theories are related is focused in the use of beta as a measure of systematic risk for valuation purposes in corporate finance. The theory suggests that systematic risk is solely determined in function of the leverage (debt) used by a particular firm, under this premise various studies in corporate finance (especially those concerning firm's valuation methods) have suggested the use of proxy methods for the estimation of unlevered (debt-free) beta in order to calculate a more accurate estimate of the cost of capital of non-traded firms in an easy way. In this paper, we make an empirical test to see the validity of the theoretical assumptions concerning the premise that the unlevered betas of companies that are in the same economic sector, must be equal or at least they must have a similar variance around a grand mean throughout different periods in time. The dataset used for this analysis contains the quarterly financial information and daily closing stock prices of 1008 companies listed in the NYSE from 20 different economic sectors for the period comprehended between the 1st quarter of 1999 to the 4th quarter of 2004. By using ANOVA as our chosen statistical method, we found that in 15 of the 20 economic sectors under scrutiny, there is not sufficient empirical evidence to let us to confirm the premise about the equality and stability of the unlevered betas of a group of companies in the same economic sector. Therefore, this finding led us to conclude that by using a proxy method for estimating systematic debt-free risk, practitioners could be using an erroneous approach given the fact that there is not enough evidence that the unlevered betas for a group of firms in the same economic sector are equal.

Keywords: Cost of Capital, Firm Valuation, Betas, leveraged betas

JEL Classification: G32

Suggested Citation

Sarmiento-Sabogal, Julio and Cayon Fallon, Edgardo, The Relevance of the Firm's Leverage as the Only Factor in the Estimation of Systematic Risk: An Empirical Analysis Using the Unlevered Betas for a Group of Firms in a Common Economic Sector (September 1, 2005). Available at SSRN: https://ssrn.com/abstract=881743 or http://dx.doi.org/10.2139/ssrn.881743

Julio Sarmiento-Sabogal (Contact Author)

Pontificia Universidad Javeriana ( email )

Carrera 7 # 40-62 Piso 4
FCEA-Depto de Administración
Bogota, D.C. 00001
Colombia
(57-1)3208320 ext 3156 (Phone)
(57-1)3208320 ext 3169 (Fax)

HOME PAGE: http://www.javeriana.edu.co/decisiones/Julio

Edgardo Cayon Fallon

Colegio de Estudios Superiores de Administracion ( email )

Calle 35 No. 6-16
Bogota
Colombia

Here is the Coronavirus
related research on SSRN

Paper statistics

Downloads
330
Abstract Views
1,477
rank
101,936
PlumX Metrics