Answer 16

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Read more on total beta

See industry averages for total betas

When you use conventional risk and return models (such as the CAPM, APM and multi-factor models) to estimate costs of equity for a private firm, you will tend to under estimate the risk in the firm. This is because these models look at only the portion of the risk that is not diversifiable and assume that the remaining risk will be diversified away. To the extent that private business owners or the investors in closely held firms are not diversified, they will be cognizant of all risk (and not just the market risk). In fact, if you know how much of the risk in the firm is market risk, you can compute a modified beta for the CAPM:

Total Beta = Market Beta/ Correlation between stock and the market

For a private business, both the market beta and the correlation will have to come from looking at publicly traded firms in the same business. For example, assume that you have to estimate the cost of equity for a private software firm. If the average market beta of software firms is 1.20 and only 25% of the risk in software firms is from the market (correlation with the market), the total beta for the software firm will be:

Total beta = 1.20/ .25 = 4.80

This total beta can be used to come up with a much higher cost of equity for a private business. As the owner of the private firm diversifies (either by taking his firm into other business or by withdrawing some of his or her wealth out of the business and investing in an index fund or a pension fund), the total beta will decrease.





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