Slide strategic financial management l05

Risk PremiumThe risk premium in the capital asset pricing model measures the extra return that would be demanded by investors for shifting their money from a riskless investment to an

Strategic Financial Management

Hurdle Rate: Cost of Equity

Khuram Raza

ACMA, Ms Finance

First Principle and Big Picture

Cost of Equity

 CAPM Approach

 Risk Free Rate

 Risk premium

 Risk Parameter: Beta

 Historical Market Betas

 Beta Fundamentals

 Business Risk

 Operating Leverage

 Financial Leverage

o Bottom Up Betas

 Accounting Betas

 Own bond yield –plus –judgmental Risk Premium Approach

Discounted Cash Flow (DCF) Approach

Inputs required to use the CAPM      

The Risk free Rate and Time Horizon      

The Botom Line on Risk free Rates      

What if there is no default-free entty?      

Risk Premium

The risk premium in the capital asset pricing model measures the extra return that would be

demanded by investors for shifting their money from a riskless investment to an average risk investment It should be a function of two variables

 Risk Aversion of Investors: As investors become more risk averse, they should demand a

larger premium for shifting from the riskless asset.

 Riskiness of the Average Risk Investment: As the riskiness of the average risk investment

increases, so should the premium This will depend upon what firms are actually traded in

the market, their economic fundamentals and how good they are at managing risk

Estimating Risk Premiums

There are three ways of estmatng the risk premium in the capital asset pricing model –

 Large investors can be surveyed about their expectatons for the future,

 The actual premiums earned over a past period can be obtained from historical data and

 There are no constraints on reasonability; individual money managers could provide expected returns that are lower than the risk free rate, for instance

 Survey premiums are extremely volatle; the survey premiums can change dramatcally, largely as a functon of recent market movements

 Survey premiums tend to be short term; even the longest surveys do not go beyond one year

Historical Premiums

1. It begins by defining a tme period for the estmaton

2. It then requires the calculaton of the average returns on a stock index and average returns on a riskless security over the period

3. it calculates the difference between the returns on stocks and the riskless return and uses it as a risk premium looking forward

Estimation Issues

 Time Period Used

 Choice of Risk free Security

 Arithmetc and Geometric Averages

Risk Parameter: Beta

Historical Market Betas

The standard procedure for estmatng betas is to regress stock returns (R j ) against market returns (R m ) –

Rj = a + b Rm

Rj-Rf= a + b (Rm-Rf)

Regression Interpretaton:

 Slope

 Intercept

 R squared

 length of the estmaton period

 return interval

 market index

Fundamental Betas

 The beta for a firm may be estmated from a regression but it is determined by fundamental decisions that the firm has made on what business to be in, how much operatng leverage to use in the business and the degree to which the firm uses financial leverage.

 The beta of a firm is determined by three variables –

(1) the type of business or businesses the firm is in

(2) the degree of operatng leverage in the firm and

(3) The firm's financial leverage.

The beta value for a firm depends upon the sensitvity of the demand for its products and services       and of its costs to mac-roeconomic factors that affect the overall market

 Cyclical companies have higher betas than non cyclical firms       ‐    

 Firms which sell more discretionary products will have higher betas than firms that sell less         discretionary

Operating Leverage:

The degree of operatng leverage is a functon of the cost structure of a firm, and is usually defined in terms of the

relatonship between fixed costs and total costs A firm that has high operatng leverage (i.e., high fixed costs relatve to total

costs) will also have higher variability in operatng income than would a firm producing a similar product with low operatng

leverage

 Degree of Operatng Leverage = % Change in EBIT/ % Change in Sales

Financial Leverage

Financial leverage is the risk to the stockholders that is caused by an increase in debt and preferred equites in a company's capital structure As a company increases debt and preferred equites, interest payments increase, reducing EPS As a result, risk to stockholder return is increased.

 Degree of financial leverage = % Change in EPS/ % Change in EBIT

Bottom Up Betas

Breaking down betas into their business, operatng leverage and financial leverage components provides us with an alternatve way of estmatng betas, where we do not need past prices on an individual firm or asset to estmate its beta.

 The botom up beta can be estmated by doing the following:      

1 Find out the businesses that a firm operates in      

2 Find the unlevered betas of other firms in these businesses      

3 Take a weighted average of these unlevered betas      

4 Lever up using the firm’s debt/equity ratio      

 The botom up beta is a beter estmate than the top down beta for the following reasons      

a) The standard error of the beta estimate will be much lower      

b) The betas can refect the current (and even expected future) mix of businesses that the firm is in rather than      

the historical    

Asset Beta = ß equity (Equity/Debt + Equity) + ß Debt ( Debt/Debt + Equity)

ß unlevered = ß levered (1/1+Debt/Equity) (1-t) + 0

ß unlevered (1+Debt/Equity) (1-t) = ß levered

Accounting Betas

A third approach is to estmate the market risk parameters from accountng earnings rather than from traded prices Thus, changes in earnings at a division or a firm, on a quarterly or annual basis, can be regressed against changes in earnings for the market, in the same periods, to arrive at an estmate of a “market beta” to use in the CAPM.

 While the approach has some intuitve appeal, it suffers from three potental pitfalls.

a) accounting earnings tend to be smoothed out relative to the underlying value of the company

b) accounting earnings can be infuenced by non-operating factors, such as changes in depreciation or

inventory methods

c) accounting earnings are measured, at most, once every quarter, and often only once every year

Own bond yield –plus –judgmental Risk

Premium Approach

Some analysts use a subjectve, ad hoc procedure to estmate a firm’s cost of common equity: They simply add a judgmental risk premium of 3% to 5% to the interest rate on the firm’s own long-term debt

Discounted Cash Flow (DCF) Approach

Marginal investor expects dividends to grow at a constant rate and if the company makes all payouts

in the form of dividends (the company does not repurchase stock), then the price of a stock can be found as follows:

P0 = D1 / ( ke – growth )

Solving for ke such that

ke = ( D1 / P0 ) + growth Where g = ROE( Retention Ratio)

If g = 0

ke = ???