There’s just no stopping it. The capital amassed by private takeover firms is simply overwhelming. Any reasonable person could conclude that public utilities face wholesale changes in terms of...
Business & Money
the stock in question. If a company takes on additional leverage, then its standard deviation of returns is likely to increase, thus leading to an increase in the measured beta as a result of the additional leverage.
The second way to demonstrate the risk-increasing effect of leverage is by using Robert Hamada's well-known decomposition of beta, shown below:
BL = Bu + Bu (1-T) D
The above formula indicates that as the amount of debt (D) increases compared to the amount of equity (E), the levered beta (BL) that we measure in the market will increase. In this formulation, the unlevered beta (Bu) represents the operational risk of the company in the absence of leverage-i.e., it is the pure business risk of the company.
There is evidence that, over time, common stockholders have, in fact, earned a higher rate of return than have bondholders. Ibbotson Associates indicates that over a long period of time, common stocks have earned a market return more than 6 percentage points greater than long-term corporate bonds. Clearly, common stockholders have earned a significant premium as compared with bondholders.- R.G.R.
1. 1. See, for example, Standard & Poor's August 12, 2004 report entitled "Rising Coal Prices May Threaten U.S. Utility Credit Profiles."
2. This is of special concern given that The Value Line Investment Survey of May 14, 2004 indicates that a significant proportion of many utilities' long-term debt is variable rate.
3. Common stockholders absorb all of the earnings variability, even though they provide only some of the capital of a firm. For example, if a write-off is required, it is charged to the retained earnings component of common stockholders' equity. Common stockholder risk is exacerbated due to the effects of leverage. If a company is financed 50 percent with equity and 50 percent with debt, common stockholders would absorb all of the write-off-that related to their proportional share of capital and also that related to the debt share of capital. Using the above hypothetical company as an example, if such a company were required to write off 20 percent of its capital, 40 percent of its common equity would be lost. Thus, leverage magnifies the write-off that common stockholders have to absorb. The presence of leverage causes similar fluctuations in earnings levels flowing from cash flow variability unrelated to write-offs too.
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