Contents - AL-Tax

4.3 Required Return on Debt and Equity Capital 57divided by (ii) the variance of the market portfolio. 4 The measure of systematic riskfor an individual firm is referred to as its “beta.” A number of academics and privatesector firms regularly quantify and publicly report individual corporations’ betasand industry-wide betas.The least labor-intensive approach to determining betas for transfer pricing purposesis to utilize published industry betas. In general, different betas would applyto individual group members, because they operate both in different geographicmarkets and, often, at different market levels. Unlevered published betas should beused, rather than levered betas, because the former measure business risk alone. Asa separate step, published unlevered betas should be “relevered” to reflect individualaffiliated companies’ actual leverage.In principle, one could also estimate betas for individual tested parties. However,inasmuch as individual members of controlled groups are not publicly traded, somemodifications to the standard analysis are necessary in a transfer pricing context.4.3.1.1 Measurements of Firm-Specific BetasAn individual member of a publicly held multinational group will not have a directlymeasurable beta. Rather, betas can only be quantified by means of the standardregression analysis for the group as a whole, because its stock price reflects its operationsas a whole. Therefore, in applying the proposed required return methodologyto establish transfer prices, and assuming that industry betas are not satisfactoryapproximations, one must develop estimates of the relevant entity-specific betas. Ina valuation context, the following approaches have been proposed: 51. Management comparisons: Discuss with senior management the types of risksborne by the relevant legal entity in relation to a range of firms for which betasare published, and select a beta on this basis.2. Comparability analyses: Identify publicly traded competitors that are similarto the tested party in terms of systematic risk (a qualitative judgement), and usethese competitors’ betas.3. Multiple regression analysis: When good comparables cannot be identifiedbecause independent firms are diversified to a greater or lesser extent than theaffiliated company, or diversified in different, albeit overlapping, ways, regressunlevered betas for individual standalone firms against the proportion of assetsthat the companies devote to each of their lines of business. The coefficients ofthese weights constitute unbiased estimates of unlevered line-of-business betas. 64 Covariance is a measure of the way in which two random variables move in relation to each other.Variance is a measure of the dispersion of a distribution.5 See Copeland, Tom, Tim Koller and Jork Murrin, Valuation: Measuring and Managing the Valueof Companies, John Wiley & Sons, Inc.: New York, 2005.6 As discussed in Copeland et. al., the constant term in this regression equation must be suppressed.