# «Australian Journal of Basic and Applied Sciences, 6(10): 180-188, 2012 ISSN 1991-8178 The Effect of Systematic Risk on Cost of Capital determinants ...»

Australian Journal of Basic and Applied Sciences, 6(10): 180-188, 2012

ISSN 1991-8178

**The Effect of Systematic Risk on Cost of Capital determinants Applying CAPM Model:**

Evidence from Tehran Stock Exchange (TSE)

1

Hosein Asgari Alouj, 2Nahid Maleki Nia, 3Seyed Masoud Sajjadian Amiri

1

Department of Accounting and Management, Bilesavar Branch, Islamic Azad University, Bilesavar,

Iran Municipal No. 8-2-603/11, Flat No. 201, second floor, road No.10, Zehra Nagar, Bnjarahills, Hyderabad, India 2 Department of Accounting and Management, Bilesavar Branch, Islamic Azad University, Bilesavar, Iran 3 College of Commerce and business management, Osmania University Abstract: A firm’s cost of capital should be determined by its exposures in respect of systematic risk, indicated by beta means how changes in systematic risk affect firm cost of capital and its determinants like cost of equity, cost of debt,debt and equity financing mix. The most difficult component of the weighted average cost of capital to calculate is the cost of equity. One approach to estimate the cost of equity is the Capital Asset Pricing Model approach where the financial manager estimates the firm’s beta. A time series regression was used to estimate the beta. After dividing the firms’ systematic risk into three groups with low, middle and high beta, our findings provide that the beta factor has strong impact on the relationship between weighted average cost of capital and its determinants which indicates firms with high beta have significantly higher cost of equity, higher cost of debt, higher equity financing and lower debt financing and lower effective tax rate benefits and finally higher cost of capital. Also there is indirectly and insignificantly relationship between systematic risk and debt financial leverage which indicates debt financing and also financial leverage decreases insignificantly by increasing the beta and finally the cost of capital increases insignificantly.

So Firms can benefit from improved systematic risk management through a reduction in their cost of equity capital, a shift from equity to debt financing, and higher effective tax benefits associated with the ability to add debt. The cost of capital that range from -17 to 100 basis points are followed by significant changes in the cost of equity that range from -20 to 130 basis points and significant changes in the cost of debt that range from 0 to 220 basis points.

**Key worsd:**

## INTRODUCTION

Finance perspectives have stated that the three primary decisions in financial management are investment decision, cash flows decision and capital structure decision. Among those three decisions, capital structure was adheres as one of strategy that can be used to deal with systematic risk. Capital structure is one of the most important strategic decisions that face financial managers. One popular technique of capital structure is an accurately estimated weighted-average-cost-of-capital (WACC) that is used to discount the future cash flows.To estimate the WACC, the financial manager must calculate the after-tax cost of debt, the cost of preferred stock, and the cost of equity. The most difficult component to calculate is the cost of equity. One method to calculate the cost of equity is the Capital Asset Pricing Model (CAPM), which is examined in this paper.

The fundamental premise of the CAPM is that the risk of a stock can be decomposed into two components.

The first component is systematic risk, which is related to the overall market. The second component is nonsystematic risk, which is specific to the individual stock. The CAPM approach further asserts that the expected return for a security is related only to the security’s beta, which is the measure of systematic risk.

Unfortunately, financial managers cannot directly observe beta, but must estimate it. To estimate the beta of a firm, a time-series regression is often used and requires the financial manager to select both a return interval and an estimation period.

Does cost of capital determinants affect the cost of capital related to systematic risk? Most theoretical and empirical cases in the finance and accounting literature predict that decreasing systematic risk reduces cost of equity based on CAPM model and thus leads to lower costs of capital. Since the existing empirical literature has largely focused on relationship between cost of capital determinants and cost of capital by P. Sharfman et al (2008) and others, negative relationship between beta and expected return of equity by Armstrong et al (2009), some positive relationship between level of leverage and beta by M. Bhatti et al (2010) and others. Armstrong et al (2009) demonstrated that negative beta behave differently from positive beta. H. Prasetyo (2011) categorized

the level of systematic risk in three groups; lower, middle and higher systematic risk,which was all positive beta ranging from 0 to up,to test relationship between financial leverage and capital intensity among those three categories and found that the tree groups of beta has different R- Pearson product moment and different significant levels. Another study were done in iran by Jamshidinavid et al (2012) and showed no significant relation between efficiency indicators as independent variables, in one hand, and systematic risk (Beta) as dependant variables and suggested according to the importance of systematic risk estimation to investigate the relation of other financial and accounting indicators and variables and the kind of systematic risk. In their study there was no focus on the beta level may be rang from negative beta to positive one. Previous studies give some insight into the choice of this study in order to test the effect of systematic risk on cost of capital determinants, Although most current empirical researches has its own area regarding the beta,level of leverage and cost of capital determinants and has recognized this problem in each area separately and has attempted to address it.

The premise of this paper is that if cost of capital determinants affects the cost of capital for a firm, it must be through systematic risk as mentioned by Armstrong et al (2009) and H. Prasetyo (2011) and others in Iranian capital market. Therefore, the effect of cost of capital determinants must depend on the risk-factor loading, or beta, of the firm. This paper examines do the firms with different level of systematic risk exposures, ranging from negative beta to positive one,behave differently to make an optimal trade-off financing and cost of capital reduction This body of research concludes that the beta factor has strong impact on the relationship between weighted average cost of capital and its determinants which indicates firms with lower beta have significantly lower cost of equity, lower cost of debt, lower equity financing and higher debt financing and higher effective tax rate benefits and finally lower cost of capital. So Firms can benefit from improved systematic risk management through a reduction in their cost of equity capital, a shift from equity to debt financing, and higher effective tax benefits associated with the ability to add debt.

The remainder of the paper consists of five sections. The first section focuses on the breakdown of the measures into their contributing components and the expression some previous studies. The second section describes the research method. The third section contains the descriptive statistics of the measures and the final section contains the summary and the conclusions.

2. Literature Review:

Firms raise money from both equity investors and lenders to fund investments. If we consider all of the financing that the firm takes on, the composite cost of financing will be a weighted average of the costs of equity and debt, and this weighted cost is the cost of capital. Hirschey et al (2008) demonstrated how to estimate hurdle rates of the firm.

Estimating hurdle rates of the firm.

According to Hirschey et al (2008) we must estimate the costs of equity, debt, and capital for firm. The cost of equity is the rate of return investors require on an equity investment in a firm. The risk and return models need a riskless rate and a risk premium (in the CAPM model) or premium (in the APT and multifactor models).They also need to measure of a firm’s exposure to market risk in the form of beta. These inputs are used to arrive at an expected return on an equity investment.

(1) We must estimate the inputs to this model-riskless rate, the risk premium, and the beta of equity. We defined a riskless rate as one for which the investor knows the expected returns with certainty. The riskless rate is the rate on a zero-coupon government bond that matches the time horizon of the cash flow being analyzed.

The risk premium measures the extra return that would be demanded by investors for shifting their money from riskless investment to an average risk investment. There are two ways to estimate the risk premium in the capital asset pricing model.one is to estimate historical premium which is the difference between average return on stocks and average returns on riskless securities over an extended period of history. In calculating the average returns over past periods, since the CAPM is built on the premise of expected returns being averages and risk being measured with variance and the variance is estimated around the arithmetic average and not the geometric average, it may be seem logical to stay with arithmetic averages to estimate risk premium. The next is to estimate implied premium which is the required return on equity minus the riskless rate.

(2)

**We can estimate the required return on equity from the following growth rate:**

The slope of the regression corresponds to the beta of the stock and measures the riskiness of the stock. The intercept of the regression provides a simple measure of performance of the investment during the period of the regression, when returns are measured against the expected returns from the capital asset pricing model. It can

**be compared this regression formula with following rearrangement of the CAPM model:**

(5) Thus, a comparison of the intercept to should provide a measure of the stock’s performance.

Second is to estimate Fundamental betas which is determined with regard to the type of business, the degree of

**operating leverage and financial leverage of a firm may be estimated from a regression.(a) The type of business:**

the more sensitive a business is to market conditions, the higher is beta. Thus, cyclical firms (housing companies) have higher betas than noncyclical firms (food processing companies). (b) The degree of operating leverage: the degree of operating leverage is a function of firms cost structure and indicates the relationship between fixed costs and total costs. A firm that has high fixed costs relative to total costs has high operating leverage and higher beta. The operating leverage of a firm is average changes in operating income as a function

**of average changes in sales over the period of time:**

(c) The degree of financial leverage of the firm: An increase in financial leverage will increase the beta of the equity in a firm. The operating leverage of a firm is average changes in net income as a function of average changes in sales over the period of time. Higher leverage increases the variance in net income and higher beta makes equity investment in the firm riskier. If all the firms risk is produced by the stock holders (the beta of debt is zero) and debt has a tax benefit to the firm, then, The last one is to estimate Accounting betas which is determined in respect of the market risk parameters from accounting earnings rather than from traded price. Regressing the changes in earnings (net income) against changes in profits for the market index yields it can be calculated the beta.

The cost of debt measures the current cost to the firm of borrowing funds to finance project. As the interest rates increase, the cost of debt and the default risk of the company will also increase. But since interest is tax deductible, the after tax cost of debt is a function of the tax rate and makes it lower than the pre-tax cost of debt.

(8) The weights, assigned to equity and debt in calculating the weighted average cost of capital, have to be based on market value, not book value. The market value of equity is the number of shares outstanding times the current stock price and a simple way to convert book value debt into market value debt is to treat the entire debt on the book values.

Since a firm can raise its money from three sources – equity, debt, and preferred stock – the cost of capital is defined as the weighted average of each of these costs. The weights on each of these components should reflect their market value proportion.

**Thus, and are the market value of equity, debt, and preferred stock, respectively and, and are the cost of equity, the cost of debt and the cost of preferred stock,respectively, the cost of capital can be estimated as follows:**

** 182 Aust. J. Basic & Appl. Sci., 6(10): 180-188, 2012**

R. Daves et al (2000) demonstrated that financial managers can estimate the cost of equity via the CAPM approach and if the financial manager estimates the firm’s beta via regression analysis, then the financial manager must select both the return interval and the estimation period. Regarding return interval, this study finds that the financial manager should always select daily returns because daily returns result in the smallest standard error of beta or greatest precision of the beta estimate. However, regarding estimation period, the financial manager faces a dilemma. While a longer estimation period results in a tighter standard error for the estimate of beta, a longer estimation period also results in a higher likelihood that there will be a significant change in the beta. Thus, the beta estimated over longer estimation periods is more likely to be biased and of little use to the financial manager. The results show that an estimation period of three years captures most of the maximum reduction in the standard error of the estimated beta from a one-year estimation period to an eightyear estimation period. Additionally, less than fifty percent of the firms experience a significant shift in beta over a three-year period.