Question

Which of the following companies should have the highest beta? Multiple Choice Orange Company that has low operating and financial leverage. Yellow Company that has highly cyclical revenues and uses high levels of fixed costs. Black Company that has highly cyclical business activity and low operating leverage Red Company that has low cyclical business activity and low fixed costs. Blue Company that has low cyclical business activity and high operating leverage.

Answer 1

Beta is a measure of riskiness of a firm. It measures the systematic risk. When risk is high, the beta will be high and according to capital asset pricing model (CAPM), the required return for investors would be high. The revenue cycle of a firm, along with operating and financial leverage are major determinants of beta of a company.

operatingleverage tells about the company's fixed and variable costs proportions in its total costs. When fixed costs are high, then operating leverage is also high. Companies with high degree of operating leverage can have huge fluctuations in profit when revenue changes.

a. incorrect. Low leverage firms are perceived to be less risky firms.

b. correct. When revenues are highly cyclical, the riskiness is high and beta of such companies are high. High level of fixed cost implies high operating leverage. Such companies have high beta. Thus, both factors lead to high beta and this is the answer.

c. incorrect. Low operating leverage causes its beta to be less than that of (b).

d. incorrect. Low cyclical business and low fixed cost would lead to low beta.

e. incorrect. Low cyclical business would cause beta to be lower than that of (b).

Thus, the correct option is b. Company Y should have highest beta.