The Full-Information Approach for

Estimating Divisional Betas:

Implementation Issues and Tests
Jess Chua, Philip C. Chang, and Zhenyu Wu

We discuss implementation problems and test approaches for using the full-information approach for
estimating divisional betas. For both full-information and pure-play estimates, variations using capital
structure adjusted betas perform better than those with raw betas, and those with betas estimated using
the M&M no-tax type capital structure adjustment are better than those using the Hamada type adjustment.
The choice of divisional weights does not make any statistically significant difference. We find that
estimates from the pure-play approach are better than those from the full-information approach. [G31]

„Despite its well-known theoretical limitations, the
cost of capital of the firm is a basic, important tool in
corporate finance. Theory stipulates that for a
multidivisional firm, if the risk of divisional cash flows
is different from the firm’s cash flows, then the
appropriate discount rate for an investment decision at
the division level should reflect the riskiness of the
divisional cash flows rather than that of the firm’s cash
flows. But because there is no way to know the market
values of divisions, estimating divisional costs of
capital has been a challenge.
The first published study (Fuller and Kerr, 1981)
related to estimating divisional cost of capital, of which
we are aware, utilized a pure-play approach to estimate
divisional betas. Inability to find pure-plays for the
different lines of businesses in which multi-divisional
firms are engaged led to the development of the full-
information approach (Ehrhardt and Bhagwat, 1991).
The pure-play approach restricts its information set to
firms engaged in only one line of business and ignores
the information contained in multidivisional firms.
Including the information from all firms engaged in the
relevant lines of business, both pure-play and
multidivisional, is the reason the full-information
approach is referred to as such.
The full-information approach has several
Jess Chua is a Professor of Finance, Philip C. Chang is an
Associate Professor of Finance, and Zhenyu Wu is a PhD
candidate at the University of Calgary in Calgary, Alberta,
Canada T2N 1N4.
implementation issues that previous studies have not
discussed. The most important conceptual issue is
that the procedure, as described in previous studies
and as recommended by consultants, assumes
implicitly that all multidivisional firms finance their
divisions in exactly the same way. In this study, we
test whether eliminating this unrealistic assumption
by using capital structure adjusted betas improves
the divisional betas estimated. We also test 24 different
ways of applying the full-information approach. Other
implementation issues include the possibility that
firms use missing values or missing variables,
assignment of divisional capital structure, and
variations in the capital-structure adjustment formulas.
Our empirical results show that eliminating this
unrealistic assumption improves the divisional beta
estimates. We also provide evidence for a theoretically
more correct and empirically more accurate method of
applying the full-information approach. We illustrate
many different ways of applying the full information
approach; this has not been done before. Further, we
provide results suggesting that the M&M no-tax type
of capital structure adjusted betas are better than the
Hamada type adjusted betas in this particular
application. Earlier studies compare the M&M and the
Hamada adjustments on a theoretical basis, but to our
knowledge the two approaches have not previously
been compared empirically.
The article is organized as follows: Section I

53
54
discusses the issues in applying the full-information
approach. Section II describes the research method
while Section III presents the results and discussion.
Conclusions are made in Section IV.
I. Issues in Applying the Full-
information Approach
Like earlier studies on the divisional cost of capital,
we focus on estimating the betas for the divisions,
rather than the cost of capital for the division. In the
pure-play approach, the beta for a division is estimated
by the average of the betas of firms deemed to be
engaged in only a single line of business that is similar
to that of the division. On the other hand, the full-
information approach is based on the theoretical
observation that, according to the capital asset pricing
model (CAPM), the beta of a firm is equal to the market-
value weighted average of the betas for the different
lines of business in which the firm is engaged.
(1)
where , wij is the market-value weight of
division j of company i, and βij is the beta of division j
of company i.
Theoretically, if we know the market values of the
divisions, we can use them as a ratio to the total market
value of the firm as weights, wij, and treat them as the
independent variables. With the multidivisional firm
betas as the dependent variable, we can then use this
relation as the basis of a cross-sectional regression
model to estimate the βij’s as the coefficients.1 This is
the approach applied by researchers (Ehrhardt and
Bhagwat, 1991; Krueger and Linke, 1994; Kaplan and
Peterson, 1998) and recommended by consultants (e.g.,
Copeland, Koller, and Nurrin, 1990; Ehrhardt 1994). 2
A. Capital Structure and the Estimated
Divisional Betas
The above relation holds theoretically regardless of
1
Boquist and Moore (1983) proposed using goal programming
to estimate the divisional betas. As Crum and Bi (1988) pointed
out, the approach does not yield a unique solution if there are
more firms than lines of business.
2
Harris, O’Brien, and Wakeman (1989) applied the full-
information approach to estimate divisional WACC directly.
This assumes that WACC is not affected by capital structure
and can be perceived as in conformance with theory as long as
one accepts the M&M original hypothesis that capital structure
does not affect WACC. Even accepting the M&M original
hypothesis, however, the WACC for a multi-divisional firm is
equal to the weighted average of the divisional WACC only
under very restrictive risk, cash flow, and constant capital
structure assumptions.
JOURNAL OF APPLIED FINANCE — SPRING/SUMMER 2006
whether we measure the firm beta (the dependent
variable in the regression) on a leveraged or
unleveraged basis, but we estimate the divisional
betas on the same basis. Thus, if the firm beta we use
is the firm’s asset beta, then the coefficients of the
regression model are the divisional asset betas. On
the other hand, if the firm beta in the regression is the
firm’s leveraged beta, then the divisional betas
estimated are also leveraged.
This introduces two questions. The first is, what
capital structure can we implicitly assume from these
leveraged betas? It must be some kind of average
capital structure for the divisions of the multidivisional
firms in the sample. The second question is, what can
we implicitly assume from the estimated divisional
betas about the capital structure for the different
multidivisional firms in the sample? Since we estimate
a single beta for each line of business in which a
division may be engaged, we must implicitly assume
that the same capital structure is embedded in the
estimated divisional beta for all the multidivisional
firms in the sample. But if capital structure affects beta,
this can be true only if all multidivisional firms finance
their divisions exactly the same way. Actually, our
method also assumes implicitly that two multidivisional
firms operating in the same combination of lines of
business will have the same firm-level capital structure.
Clearly, neither of these implicit assumptions is likely
to be true in practice.
Estimating the divisional asset betas avoids this
conceptual problem, so using the firm-asset beta as
the dependent variable and estimating the divisional-
asset betas is conceptually superior. However, if there
is much noise in the data, whether or not estimating
divisional-asset betas instead of divisional-leveraged
betas provides significantly better results is an
empirical question. This is the primary purpose of the
empirical part of our study.
B. Missing Values and Missing Variables
By definition, the weights we use as independent
variables must add to one for each multidivisional firm.
In practice, the weights will sum to less than one in the
majority of cases, because firms typically do not report
asset size, revenue, or profit for minor lines of business.
This can create missing value or missing variable
problems for the estimation procedure.
If we include all sectors of the economy in the cross-
sectional regression, then this is a missing values
problem, because the weights will be missing for
certain sectors in which some of the multidivisional
firms are engaged. But most studies do not, and
numerically cannot, include all the sectors of the
economy and still preserve the sectors as meaningful
CHUA, CHANG, & WU — FULL-INFORMATION APPROACH FOR ESTIMATING DIVISIONAL BETAS
representatives of distinct lines of business.
Consequently, researchers do applications for sectors,
rather than for the entire economy. In these studies,
more finely defined subsectors more accurately
represent the different lines of business. This can then
cause either a missing data or a missing variables
problem. If the unreported line of business is in one of
the subsectors included in the regression, then there
is a missing data problem, but if the unreported line of
business is in a subsector not included in the
regression, then it is a missing variables problem.
Both missing values and missing variables problems
can cause estimation problems, although the former is
less serious. The missing values problem causes a loss
of efficiency but is less likely to create a bias because,
there is no reason to believe that multidivisional firms
systematically omit reporting their operations in the
same set of sectors. However, if the missing variables
are correlated with the error term, then they will
generate a bias.
We have no solution for these missing values and
variables problems except to minimize the exposure,
which we do by avoiding firms whose total weights
are significantly lower than one. We also deal with
these problems through a robustness test. First, we
conduct our tests by redistributing the missing weights
among the subsectors that have positive weights.
Second, we conduct the tests again, but this time we
ignore the missing values and variables.
C. Capital Structure for Divisions
If the cross-sectional regression yields divisional-
asset betas, these betas must still be converted to
divisional-leveraged betas before we can estimate the
divisional costs of equity. This requires information
about the capital structure of the divisions. But firms
do not finance their businesses division by division;
they finance the firm as a whole. Therefore, we must
assign the capital structure of a division in some fashion.
We do so by taking into account both the industry-
average debt ratios and the specific firm’s debt ratio.
II. Method
Our data comprises firms with complete
corresponding data in the Research Insight (formerly
Compustat) and CRSP databases from 1991 to 2001.
We note that there is nothing special about the sample
period. The data for the period was what was available
when we began the study. Eliminating firms with
incomplete data for the period does not cause a
survivability bias.
We assign lines of business according to their four-
digit SIC code. We exclude firms for which the sums
55
of weights are lower than 0.85. As discussed
previously, doing so minimizes exposure to the
missing values problem and to the effects of any
missing variables problem.
Also as discussed previously, using firm-asset betas
in the cross-sectional regression is conceptually
superior, because doing so avoids the assumption that
all multidivisional firms finance their divisions in
exactly the same manner. However, we cannot observe
the asset beta of a firm. Instead, what we obtain from
market values is the firm’s leveraged beta, which we
refer to here as the “raw firm betas.” This term
differentiates these betas from the predicted firm
leveraged betas that we use in later validation tests.
Therefore, we must convert the raw firm betas into the
firm-asset betas.
There are two ways of estimating the firm-leveraged
beta: using total returns based on the market model
and using excess returns based on the CAPM. There
are also two formulas for converting a leveraged beta
to the corresponding asset beta: Modigliani and Miller
(M&M) and Hamada. The Hamada formula assumes
riskless debt, but the M&M formula can accommodate
both riskless and risky debt. For the risky-debt version,
we assume that the beta for the debt is equal to 0.25.
This is based on Booth (1999), who observes that
although the beta for long-term debt has experienced
wide swings, the average for 1970-1995 is between 0.2
and 0.3. Incorporating these six variations (two raw
betas multiplied by three conversion formulas) gives
us six different firm asset betas. We define these betas,
plus the raw firm betas, in Exhibit 1.
Once we obtain the firm-asset betas we can use them
as the dependent variable in the cross-sectional
regression to obtain the divisional-asset betas. For
the independent variables, theory requires market
values of the divisions. But in practice, divisional
market values are unknown, so previous research uses
book values as proxies. We follow this precedent.
To test the robustness of the results, we use three
different proxies for the three sets of divisional
operating information typically reported by
multidivisional firms: the book value of divisional
operating assets, divisional sales, and divisional
operating income before depreciation (OIBD).
Each divisional-asset beta that we obtain as a
coefficient of the regression model represents the
asset beta for a particular line of business, but
because of differences in capital structure, the
divisional beta for this line of business in a particular
firm will differ from that in others. Thus, we must
then convert the divisional-asset betas to divisional
betas by adjusting for the effects of the division’s
capital structure, which requires that we assign capital
structures to the divisions.
56 JOURNAL OF APPLIED FINANCE — SPRING/SUMMER 2006

Exhibit 1. Alternative Firm-Leveraged and Asset Betas Used

Where: rm = market return using S&P500; rf = riskfree rate, 30-day T-bill; D = value of debt; E = value of equity; V = value of the firm
= E + D; ȕE = equity or levered beta; ȕD = debt beta; and t = corporate tax rate.

Raw firm beta: total return – Market model

Beta 1
E1 : r D  E1rm  H
Raw firm beta: excess return – CAPM model
Beta 2
E 2 : (r  r f ) E 2 (rm  r f )  H
Firm-asset beta: M&M type, total return, riskless debt (ȕD=0)

Beta 3 D E E
E3 ED  E1 E1
DE DE DE
Firm-asset beta: M&M type, total return, risky debt (ȕD =0.25)

Beta 4 D E D E
E4 ED  E1 * (0.25)  E1
DE DE DE DE
Firm-asset beta: M&M type, excess return, riskless debt (ȕD=0)

Beta 5 D E E
E5 ED  E2 E2
DE DE DE
Firm-asset beta: M&M type, excess return, risky debt (ȕD=0.25)

Beta 6 D E D E
E6 ED  E2 * (0.25)  E2
DE DE DE DE
Firm-asset beta: Hamada type, total return

Beta 7 ª D  E  tD º
E7 «¬ D  E »¼ E1 (Grinblatt and Titman, 2002)

Firm-asset beta: Hamada type, excess return

Beta 8 ª D  E  tD º
E8 «¬ D  E »¼ E 2

As a result of the riskiness of its line of business
and the firm’s particular inclination to finance with debt,
each division of a multidivisional firm will have a
different debt capacity. This means that our assignment
of divisional capital structures must take into account
both the division’s debt capacity and the firm’s
willingness to finance with debt. Thus, we assign the
divisional capital structures as follows:
First, we collect the total debt and total assets for
the individual firms in the sample. We use the total
liability as our proxy for total debt and assign preferred
shares to equity. More complex capital structures,
e.g., convertible debentures, require subjective
judgment on whether they are debt or equity. Since
we use the same capital structures for all the
variations, this should not bias the results against
any particular variation.
Next, we collect industry-average debt ratios and
match them as well as possible to the different
subsectors. For each firm, we add the industry-average
CHUA, CHANG, & WU — FULL-INFORMATION APPROACH FOR ESTIMATING DIVISIONAL BETAS
debt ratios for the subsectors in which the firm has
business operations. Doing so may sum to below or
above one. We then calculate what the debt would be
for each division if the division were financed according
to the industry average. If the multidivisional firm
finances itself according to divisional industry
averages, then adding these divisional debts will give
the total firm debt. This total is never equal to the
firm’s actual debt.
Next, we calculate the proportions of total firm debt
that would have been assumed by each division. To
arrive at the debt carried by the different divisions, we
multiply these proportions by the firm’s actual debt.
Dividing this divisional debt by the operating assets
of the division yields the divisional debt ratios. This
procedure assumes no synergy in debt financing and
is illustrated in Exhibit 2.
Column (1) in Exhibit 2 shows the industry average
debt ratios for the divisions. Column (2) shows the
divisional operating assets. If the sum of these
divisional operating assets does not sum to the total
assets of the firm, then we allocate the deficit or surplus
proportionally to the divisions. Column (3) is the
product of the first two columns and represents the
debt that each division would have if it were financed
according to industry average. The sum at the bottom
of the column represents the total debt that the firm
would have if it were financed according to industry
average. Column (4) is Column (3) divided by the total
debt at the bottom of the Column (3), and represents
the proportion of the firm’s total debt that each division
would be assigned to carry if the firm were financed
division by division, according to industry average.
Column (5) is Column (4) multiplied by the actual total
debt of the firm, and represents the dollar amounts of
the firm’s actual debt that each division is assigned to
carry. Dividing Column (5) by Column (2) yields the
assigned debt ratio for each division in Column (6).
This way, the total debt and the debt ratio of the firm
are equal to the actual ones and each division carries
more (less) debt than industry average if the firm, as a
whole, was more (less) inclined toward debt financing.
The divisional debt ratios also reflect each industry’s
average practice in debt financing.
We estimate 24 cross-sectional regression models
for the entire sample of companies for each year from
1991-2001. The regression models have R-squares in
the 0.2 to 0.25 range. This compares favorably with
the R-squares of the typical regression model for firm
raw betas. However, in the latter, the low R-squares do
not equate to poor fit. Instead, we interpret them as a
low proportion of systematic risk. But when we
estimate the divisional cost of capital, the R-squares
are strictly measures of goodness of fit.
To see whether the goodness-of-fit improves if we
57
use subsamples instead of the entire sample, we repeat
the procedure for three separate subsamples: chemicals
and allied products (SIC 2800); measurement, analyzing,
control instruments, and related Products (SIC 3800);
and electric, gas and sanitary services (SIC 4900). We
choose these subsamples on the basis of having a
sufficiently large number of firms in the sectors. We
find that the R-squares do not improve. Therefore,
results indicate that the fit is not encouraging.
Even more important than goodness-of-fit is the
ability of the full-information approach to predict the
divisional betas. Unfortunately, it is not possible to
test this directly, because the true divisional betas are
not available. Instead, we must compare the different
methods indirectly according to their abilities to predict
multidivisional firm betas.
The sample sizes are not large enough for us to have
a hold-out sample on which to conduct
contemporaneous prediction tests. Therefore, we
perform one-year-ahead prediction tests. By doing so,
we introduce the problem of beta instability. Thus, our
prediction test is simultaneously subject to both those
errors that arise from beta instability and those arising
from the estimation approach. The test is consistent
in the sense that we compare all approaches on the
same basis. In most applications, this will be the
prediction problem encountered, because financial
decisions are forward looking.
We are able to do the comparison tests only for the
SIC 49 sector, because only this sector has a sufficient
number of multidivisional and pure-play firms. The mix
of multidivisional and pure-play firms varies from year
to year. The range is one-third to one-half
multidivisional firms.
To illustrate the procedure for the first set of
predictions, we use return data from 1991 to estimate
the raw firm betas for the multidivisional and pure-
play firms.3 We then convert these 1991 raw firm betas
to firm-asset betas and use them in the 1991 cross-
sectional regression to obtain the 1991 divisional-asset
betas. After that, we convert the 1991 divisional-asset
betas to predicted 1992 divisional betas, using either
the M&M or the Hamada formula and the 1992 debt
ratios assigned, as illustrated in Exhibit 2. We then
multiply these 1992 divisional betas by the appropriate
1992 weights to generate the 1992 predicted
multidivisional-firm betas. Finally, we compare these
1992 predicted firm betas with the 1992 multidivisional-
firm raw firm betas, which we estimate by a regression
using 1992 return data.
We preserve consistency in terms of the raw beta,
the capital structure adjustment formula, and the
3
A longer period would have been better, but extending the
period further back would have significantly reduced the number
of firms.
58 JOURNAL OF APPLIED FINANCE — SPRING/SUMMER 2006

Exhibit 2. Example for Assignment of Divisional Debt Ratios

Sample firm total debt: 5,000

Sample firm total assets: 10,000
Proportion of
Industry Division Debt Firm Debt by Total Firm
Average Debt Division by Industry Industry Debt Assigned
Ratio Assets Average Average Allocated Debt Ratio
(4)=(3)/ (5)=(4) x
Line of Business (1) (2) (3)=(1)x(2) Sum of (3) Firm Debt (6)=(5)/(2)
1 0.30 3,000 900 0.295 1,475.41 0.492
2 0.40 2,000 800 0.262 1,311.48 0.656
3 0.25 4,000 1,000 0.328 1,639.34 0.410
4 0.35 1,000 350 0.115 573.77 0.574
Total 10,000 3,050 1.000 5,000.00

weight proxy. For example, if we estimate the 1991 raw
firm beta by using excess returns, then we also estimate
the 1992 raw firm beta for testing prediction accuracy
by using excess returns. When we convert the 1991
raw firm beta to firm-asset beta using the M&M
riskless debt formula, we also convert the divisional-
asset betas to divisional betas by using the M&M
riskless debt formula. And if the weight proxy we use
to generate the divisional-asset betas is Sales, then
the weight proxy we use to convert the divisional-
asset betas to the divisional betas is also Sales.
For further comparison, we obtain six sets of
divisional asset betas based on only the pure-play
firms. For each pure-play firm, we estimate two raw
firm betas by using the total returns and excess returns,
respectively. We convert each of the raw firm betas to
firm-asset betas by using the M&M adjustment for
capital structure assuming riskless debt, the M&M
adjustment assuming risky debt, or the Hamada
adjustment, resulting in six distinct asset betas for each
pure-play firm. We note that for these pure-play firms,
we do not have to assign the debt ratios. We then
estimate the divisional-asset beta for a particular line
of business (corresponding to a particular return and
particular capital structure adjustment) by using the
arithmetic average of the firm-asset betas estimated
for all the pure-play firms in the sample that are engaged
in that particular line of business. We convert these
divisional-asset betas to divisional betas for each
multidivisional firm by using the assigned debt ratios
for the different divisions in the subsequent year.
Finally, we multiply the division betas by the respective
weight proxies in the subsequent year to generate the
one-period-ahead, pure-play predicted multidivisional
firm beta, and compare it with the raw firm beta that we
obtain for the subsequent year.
To test whether there is any useful information in
the forecasting process, we also forecast the
multidivisional firm’s beta by using the market average
beta of one. If there is, the predictions we make using
the complicated process should be better than those
we make by using the market average. Thus, we
compare the actual multidivisional-firm betas with the
24 full-information predicted betas, six pure-play
predicted betas, and the market average of one.
We repeat the process with the second, third, etc.,
year as the estimation year. For the 11 years of data,
we obtain ten years of prediction tests for each
combination of approach, return data, and capital
structure adjustment formula.
To compare the prediction accuracies of the
different models, we rely on the mean-square error
measure (MSE). To test whether the differences in
prediction accuracies are statistically significant, we
use the nonparametric Wilcoxon rank sum test on a
pair-wise basis.
III. Results and Discussion
In presenting the results from comparing the different
approaches of estimating divisional betas, we note that
these results are for the case in which, when the weights
sum to less than one, we allocate the weights for
unreported lines of business in proportion to the
reported lines. The results for the case in which we
ignore the weights are not qualitatively different.
We summarize the results to answer the three main
questions related to our method: Is using capital-
structure-adjusted betas better than using raw betas,
which assume that the divisions of multidivisional firms
are all financed in the same way? Does it make any
difference which available proxy we use for the
division weight? Does the full-information approach
produce better divisional-beta estimates than the
CHUA, CHANG, & WU — FULL-INFORMATION APPROACH FOR ESTIMATING DIVISIONAL BETAS 59

Exhibit 3. Comparison of Multidivisional Beta Estimates Based on Eight Different Firm Betas

z-Statistics for Differences in MSE Rank Sums

Comparison Pairs Pure-Play Full Information
Beta1 vs. Beta2 -0.562 -0.857
Beta1 vs. Beta3 5.160** 5.722**
Beta1 vs. Beta4 5.722** 6.402**
Beta1 vs. Beta5 5.145** 5.736**
Beta1 vs. Beta6 5.692** 6.402**
Beta1 vs. Beta7 2.632** 3.947**
Beta1 vs. Beta8 2.484** 3.578**
Beta2 vs. Beta3 5.559** 6.165**
Beta2 vs. Beta4 6.180** 6.623**
Beta2 vs. Beta5 5.500** 6.165**
Beta2 vs. Beta6 6.165** 6.623**
Beta2 vs. Beta7 3.415** 4.672**
Beta2 vs. Beta8 3.341** 4.406**
Beta3 vs. Beta4 0.503 1.478
Beta3 vs. Beta5 -0.163 0.177
Beta3 vs. Beta6 0.503 1.360
Beta3 vs. Beta7 -4.332** -3.489**
Beta3 vs. Beta8 -4.258** -3.800**
Beta4 vs. Beta5 -0.340 -1.478
Beta4 vs. Beta6 -0.355 0.030
Beta4 vs. Beta7 -4.820** -4.982**
Beta4 vs. Beta8 -5.189** -5.618**
Beta5 vs. Beta6 0.444 1.419
Beta5 vs. Beta7 -4.199** -3.474*
Beta5 vs. Beta8 -4.140** -3.814**
Beta6 vs. Beta7 -4.716** -4.968**
Beta6 vs. Beta8 -5.115** -5.662**
Beta7 vs. Beta8 -0.621 -0.813

Beta1 and Beta2 are raw betas.

Beta3 to Beta8 are capital structure adjusted betas.
**Significant at the 0.01 level.
*Significant at the 0.05 level.

pure-play approach? information estimates. The results in the pair-wise

As we noted earlier, we use the nonparametric
Wilcoxon rank sum test. We apply it to both the R-
squares of the year-by-year cross-sectional
regressions and to the MSEs of the predicted
multidivisional-firm betas. Since none of the tests on
R-squares is statistically significant, the discussion
here focuses on the MSE results.
In Exhibit 3, we present the results of the Wilcoxon
rank-sum tests for the MSEs from predicting one-
period-ahead multidivisional-firm betas. The left
column named “Pure-Play” shows the z-statistics for
the differences in MSE rank sums on a pair-wise basis
for the pure-play estimates, while the column named
“Full Information” shows the z-statistics for the full-
comparisons show that estimates based on raw firm
betas (Beta1 and Beta2) have significantly higher rank
sums for both the pure-play and the full-information
approaches than do those based on capital-structure-
adjusted betas (Beta3 to Beta8). This suggests that
adjusting for capital structure improves the divisional
beta estimates.
Beta3, Beta4, Beta5, and Beta6 are all based on the
M&M no-tax formula. Beta7 and Beta8 are based on
the Hamada formula. The z-statistics for the differences
in rank sums indicate for the pair-wise comparisons
that those based on the M&M no-tax formula have
significantly lower prediction errors than do those
based on the Hamada formula, again for both the pure-
60 JOURNAL OF APPLIED FINANCE — SPRING/SUMMER 2006

Exhibit 4. Wilcoxon Rank-Sum Test Results for Comparison of the Three Divisional Weight Proxies

z-Statistics for Differences in MSE Rank Sums

Pure-Play FIT
Asset OIBD Asset OIBD
OIBD -1.324 -- -0.109 --
Sales -0.522 0.611 -0.362 -0.324

**Significant at the 0.01 level.

*Significant at the 0.05 level.

Exhibit 5. Results from Wilcoxon Rank-Sum Tests: Pure Play, Full information, and Market Average of One

z-Statistics for Differences in MSE Rank Sums

Full Information Pure Play
Pure Play 7.39** –
One -9.32** -12.53**

**Significant at the 0.01 level.

play and full-information approaches.
In terms of the choice between the market model and
the CAPM for estimating the raw firm beta, the results
show no statistically significant difference. In terms
of whether to assume riskless or risky debt when
applying the M&M no-tax formula, again, the results
show no statistically significant difference.
In summary, our results suggest that adjusting for
capital structure improves the divisional-beta estimates.
Furthermore, the results indicate that the M&M no-
tax formula is superior to the Hamada formula when
making the capital structure adjustments in this
particular application.
To find out which one of the three weight proxies, assets,
sales, or OIBD, yields better divisional-beta estimates,
we again apply the Wilcoxon rank-sum test to the MSEs
for the three groups of estimates. Exhibit 4 presents our
results. As the table shows, none of the differences in
rank sums is statistically significant. This is true for both
the pure-play and the full-information estimates.
Exhibit 5 shows the results when we compare the MSEs
for the pure-play divisional-beta estimates with those for
the corresponding full-information estimates. The
difference in rank sums is statistically significant in favor
of the pure-play estimates. This suggests that when they
are available, the pure-play estimates are better.
Finally, the results show that both the MSEs for the
pure-play estimates and the full-information estimates
are significantly smaller than are those that use the
market average of one. This suggests that both the
pure-play and the full-information approaches can
incorporate valuable information in estimating
divisional betas.
Due to data availability, we are able to make the
comparison tests for only one sector. Therefore, we
caution care in interpreting the results, especially with
respect to whether they can be generalized to all
sectors. In terms of whether to assume riskless or
risky debt when applying the M&M no-tax formula,
we do not test whether changing the assumed-debt
beta would make a statistically significant difference.
We are not aware of a parametric significance test for
differences in MSEs, therefore, we use a
nonparametric test. A parametric test might yield
different conclusions.
IV. Summary and Conclusion
Many academics and consultants advocate the full-
information approach as a better method than the pure-
play approach for estimating divisional beta. We
discuss some conceptual and statistical problems
endemic in this viewpoint.
We test approaches that eliminate or minimize the
conceptual and statistical problems. In the process,
we compare pure-play estimates against 24 different
variations of full-information estimates. Our results
show that adjusting the beta estimates for the effects
of capital structure improves the estimates and is at
the same time conceptually superior. Using the
M&M no-tax formula instead of the Hamada formula
to make the capital structure adjustments yielded
better estimates.
Comparing the full-information estimates against the
pure-play estimates shows that the latter are better.
Therefore, if pure-play estimates are available, they
should be preferred.
CHUA, CHANG, & WU — FULL-INFORMATION APPROACH FOR ESTIMATING DIVISIONAL BETAS
Finally, our results show that useful information is
incorporated in both the pure-play and full-information
approaches, both of which yield better divisional-beta
estimates than does the market average of one.
However, we caution that these results be interpreted
with care, because the observations made here about
prediction accuracy are based on only one sector (SIC
49), the only sector for which we find sufficient numbers
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