Pragmatic problems in using beta for managerial finance applications

Abstract

Any faculty member with experience in teaching managerial finance and investment courses can cite occasional awkward findings by students about required rates of returns. Unfortunately, many times the explanations for such unexpected findings are not as simple as outlier problems in the sample or an offer by a modified version of the model to correct the problem. Our purpose is to explore a broad sample to demonstrate the frequency of cases where Capital Asset Pricing Model (CAPM)-generated marginal costs of equity are less than zero; less than the risk-free rate and less than the company's marginal cost of debt capital. In addition to several robustness checks, the results are very similar with either Internet or calculated betas suggesting that the data used in the analysis does not present unusual characteristics. However, we do not offer further modifications to CAPM or other asset pricing models.

Notes

¹ We checked a recent COMPUSTAT version, finding that it lists 1600 rated corporations out of 8361. Thus, the size of our nonrated sample to the rated sample is in line with a much larger database.

² There are few AAA ratings, and, as we found, the issues we address do not apply to highly rated corporations.

³ Now the Quicken.com data is available through Yahoo ‘Finance’.

⁴ The yield curve was upward-sloping over most of its range. Some believe that T-bill or T-note rates apply in CAPM usage. Either of these assumptions would cause more k _e estimates to violate the constraint.

⁵ A late COMPUSTAT version has 8361 total companies with listed betas. Totally 925 of these are negative.

⁶ Given that the very high performance of many of these stocks, it is a mistake to any way correlate low or negative betas with a likelihood of financial distress.

⁷ Based on trading days.