Asset beta is a measure of systematic risk or volatility of a portfolio or a security compared with the whole market. Unlevered firms operating in the same industry and facing the same risk need to calculate the asset betas. When calculating the asset beta, the following steps are followed:
First, a firm’s beta coefficient is determined. For a public company, beta can be found on the finance websites. Second, the company’s debt to equity quotient is determined. This refers to the relative weight of assets funded using debt versus the weight of those funded using equity. This figure can be found from the statement of financial position. The third step is to determine the tax rate charged to the company. This can be calculated from the income statement since it will vary depending on the company’s earnings and locality. The last step is to calculate the company’s asset beta using the following formula:
D/E = debt/equity ratio.
BL = leveraged firm's beta.
Tc. = corporate tax rate.
Capital asset pricing model operates under several assumptions. First, it assumes that investors are rational in decision making and risk averse. Their goal is utility maximization. Secondly, that all assets are perfectly liquid and infinitely divisible. Thirdly, that returns of assets are normally distributed. The fourth assumption is that the lending and borrowing interest rates are the same. Lastly, individuals can not affect security prices because the market is at equilibrium.
In spite of these assumptions, capital asset pricing model has more strong holds that make it a reliable risk analysis tool. As a result, it is modified to mitigate these assumptions but still retains the strong holds. For instance, it is modified to generate the arbitrage pricing model which has significant characteristics to the CAMP.
Brealey, R. A., Myers, S. C., & Allen, F. (2011). In P. T. Model, Principles of Corporate Finance (pp. 185-233). Columbus: McGraw-Hill/Irwin.
Titman, S. (1997). Designing Capital Structure to Create Shareholder Value. Journal of Applied Corporate Finance, 3-28.