Question

An investor prefers to invest in companies that have high operating leverage. How can this be accomplished if the investor also requires a portfolio beta of 1.0?

Multiple Choice

Invest 50% in cyclical stocks and 50% in firms with high operating leverage

Invest 50% in a market index fund and 50% in firms with high operating leverage

Finance part of the portfolio with borrowing

Invest a portion of the portfolio in U.S. Treasury securities

Answer 1

The degree of operating leverage measures how sensitive a firm is to its fixed costs. It increases as fixed costs rise and variable costs fall.and it magnifies the effect of cyclicity on beta. A higher proportion of fixed costs in the production process means that the operating leverage is higher and the company has more business risk. The increased business risk leads to higher beta. Further, cyclical stocks tend to have high beta values, which are usually higher than 1 because of risk due to cyclical nature of business.

a. Investing equally in cyclical stocks and in firms with high operating leverage would lead to beta greater than 1 based on above explanation.

b. Investing 50% in a market index fund and 50% in firms with high operating leverage would also lead to beta greater than 1 because beta of market index funds will remain 1 but beta of firms with high operating leverage would be greater than 1 because of business risk. And since the portfolio beta is weighted average beta, investor's beta shall exceed 1 when invested equally

c. Borrowing funds will increase the investor's risk and therefore his portfolio beta will also increase and exceed 1.

d. By investing a portion of the portfolio in U.S. Treasury securities, the investor can reduce his portfolio beta because U.S. Treasury securities have beta less than 1 and do not move very much in relation to the overall market. So he can setoff higher beta on investment in firms with high operating leverage by investing in U.S. Treasury securities. He can maintain beta of 1 by giving appropriate weights to U.S. Treasury securities and firms with high operating leverage.

Hence the answer is d.