The management of Nelson plc wish to estimate their firm’s equity beta. Nelson has had a stock market quotation for only two months and the financial management feels that it would be inappropriate to estimate beta from the actual share price behavior over such a short period. Instead it is proposed to ascertain, and where necessary adjust, the observed equity betas of other companies operating in the same industry, and with the same operating characteristics as Nelson, as these should be based on similar levels of systematic risk and be capable of providing an accurate estimate of Nelson’s beta
Three companies have been identified as firms having operations in the same industry as Nelson with identical operating characteristics. However, only one company, Oak plc, operates exclusively in the same industry as Nelson. The other two companies have some dissimilar activities or opportunities in additional to those which are the same as those of Nelson.
Details of the three companies are as follows;
a. Oak plc has an observed equity beta of 1.12. The capital structure at market value is 60% equity, 40% debt.
b. Beech plc has an observed equity beta of 1.11. It is estimated that 30% of the current market value of Beech is caused by risky growth opportunities which have an estimated beta of 1.9. The growth opportunities are reflected in the observed beta. Beech’s other activities are the same as Nelson’s. Beech is financed entirely by equity.
c. Pine plc has an observed equity beta of 1.14. Pine has two divisions, East and West. East’s operating characteristics are considered to be identical to those of Nelson. The operating characteristics of West are considered to be 50% more risky than those of East. In terms of financial valuation East is estimated as being twice as valuable as west. The capital structure of Pine at market values is 75% equity, 25% debt.
Nelson is financed by equity. The tax rate is 40%.
Required
a. Assuming all debt is virtually risk-free, make three estimate of the equity beta of Nelson plc. The three estimates should be based, separately, on the information provided for Oak, Beech and Pine.
b. Explain why the estimated beta of Nelson, when eventually determined from observed share price movements, may differ from the value derived from the approach in (a) above.
c. State the reason why a company has a very volatile share price and is generally considered to be extremely risky can have a lower beta value, and therefore lower financial risk, than an equally geared firm whose share price is much less volatile.