Market Value

Outline 3: Risk, Return, and
Cost of Capital
3.1 Rates of Return
3.2 Measuring Risk
3.3 Risk & Diversification
3.4 Measuring Market Risk
3.5 Portfolio Betas
3.6 Risk and Return
3.7 CAPM and Expected Return
3.8 Security Market Line
3.9 Capital Budgeting and Project Risk
3.10 Cost of Capital
3.11 Weighted Average Cost of Capital (WACC)
3.12 Capital Structure
3.13 Required Rates of Return
3- 1
3- 2
Rates of Return
Percentage Return =
Capital Gain + Dividend
Initial Share Price
Percentage Return = 6 +430.56
= .153 or 15.3%
3- 3
Rates of Return
Dividend Yield =
Capital Gain Yield =
Dividend
Initial Share Price
Capital Gain
Initial Share Price
3- 4
Rates of Return
0.56
Dividend Yield =
43
 .013 or 1.3%
6
Capital Gain Yield =
43
 .140 or 14.0%
3- 5
Market Indexes
Dow Jones Industrial Average (The Dow)
Value of a portfolio holding one share in each of 30 large
industrial firms.
Standard & Poor’s Composite Index (The S&P 500)
Value of a portfolio holding shares in 500 firms. Holdings are
proportional to the number of shares in the issues.
3- 6
The Value of an Investment of $1 in 1900
1000
Index
Common Stocks
Long T-Bonds
T-Bills
10
0.1
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000
Source: Ibbotson Associates
Year End
-60
Year
1999
1992
1985
1978
1971
1964
1957
1950
1943
1936
1929
1922
1915
1908
1901
Return (%)
3- 7
Rates of Return
Common Stocks (1900-2001)
60
40
20
0
-20
-40
3- 8
Expected Return
Expected market
return
=
interest rate on
Treasury bills
+
normal risk
premium
(1981) 21.7%
=
14
+
7.7
(2002) 9.5%
=
1.8
+
9.3
3- 9
Measuring Risk
Variance - Average value of squared deviations
from mean. A measure of volatility.
Standard Deviation - Average value of squared
deviations from mean. A measure of volatility.
3- 10
Risk and Diversification
Diversification - Strategy designed to reduce risk
by spreading the portfolio across many
investments.
Unique Risk - Risk factors affecting only that firm.
Also called “diversifiable risk.”
Market Risk - Economy-wide sources of risk that
affect the overall stock market. Also called
“systematic risk.”
3- 11
Risk and Diversification
Deviation from
Average Return
20.01
12.15
12.28
-22.17
-22.25
Squared
Deviation
400.45
147.65
150.78
491.69
495.24
1685.81
Year
Rate of Return
1997
31.29
1998
23.43
1999
23.56
2000
-10.89
2001
-10.97
Total
56.41
Average rate of return = 56.41/5 = 11.28
Variance = average of squared deviations = 1685.81/5 = 337.16
Standard deviation = squared root of variance = 18.36%
3- 12
Risk and Diversification
Portfolio rate
of return
(
(
=
+
)(
)(
fraction of portfolio
in first asset
fraction of portfolio
in second asset
x
x
rate of return
on first asset
rate of return
)
)
on second asset
20
19
19
19
19
19
19
19
19
19
19
19
19
19
19
00
95
90
85
80
75
70
65
60
55
50
45
40
35
26
Std Dev
3- 13
Stock Market Volatility 1926-2001
60
50
40
30
20
10
0
3- 14
Portfolio standard deviation
Risk and Diversification
0
5
10
Number of Securities
15
3- 15
Portfolio standard deviation
Risk and Diversification
Unique
risk
Market risk
0
5
10
Number of Securities
15
3- 16
Measuring Market Risk
Market Portfolio - Portfolio of all assets in the
economy. In practice a broad stock market
index, such as the S&P Composite, is used
to represent the market.
Beta - Sensitivity of a stock’s return to the
return on the market portfolio.
3- 17
Measuring Market Risk
Example - Turbo Charged Seafood has the
following % returns on its stock, relative to
the listed changes in the % return on the
market portfolio. The beta of Turbo
Charged Seafood can be derived from this
information.
3- 18
Measuring Market Risk
Example - continued
Month Market Return % Turbo Return %
1
+ 1
+ 0.8
2
+ 1
+ 1.8
3
+ 1
- 0.2
4
-1
- 1.8
5
-1
+ 0.2
6
-1
- 0.8
3- 19
Measuring Market Risk
Example - continued
 When the market was up 1%, Turbo average %
change was +0.8%
 When the market was down 1%, Turbo average %
change was -0.8%
 The average change of 1.6 % (-0.8 to 0.8) divided
by the 2% (-1.0 to 1.0) change in the market
produces a beta of 0.8.
 Perform a regression:
 Turbo’ return = alpha +beta (market return)
B=
1.6
2
= 0.8
3- 20
Measuring Market Risk
Example - continued
Turbo
return %
1
0.8
0.6
0.4
0.2
0
-0.2-0.8 -0.6 -0.4 -0.2
-0.4
-0.6
-0.8
Market Return %
0
0.2
0.4
0.6
0.8
1
3- 21
Portfolio Betas
Diversification decreases variability from
unique risk, but not from market risk.
The beta of your portfolio will be an
average of the betas of the securities in the
portfolio.
If you owned all of the S&P Composite
Index stocks, you would have an average
beta of 1.0
3- 22
Stock Betas
Stock
Beta
Amazon
3.30
DellComput er 2.14
GE
1.18
Ford
1.05
Delta Airlines
1.00
PepsiCo
.67
McDonald' s
.66
Pfizer
.57
ExxonMobil
.41
H.J.Heinz
.31
B
3- 23
Risk and Return
3- 24
Risk and Return
3- 25
Measuring Market Risk
Market Risk Premium - Risk premium of market
portfolio. Difference between market return and
return on risk-free Treasury bills.
14
Expected Return (%) .
12
Market
Portfolio
10
8
6
4
2
0
0
0.2
0.4
0.6
Beta
0.8
1
3- 26
Measuring Market Risk
CAPM - Theory of the relationship between risk and
return which states that the expected risk premium
on any security equals its beta times the market
risk premium.
Market risk premium = rm - rf
Risk premium on any asset = r - rf
Expected Return = rf + B(rm - rf )
3- 27
Measuring Market Risk
Expected Return (%) .
Security Market Line - The graphic representation
of the CAPM.
Security Market Line
Rm
Rf
Beta
1.0
3- 28
Capital Budgeting & Project Risk
The project cost of capital depends on the
use to which the capital is being put.
Therefore, it depends on the risk of the
project and not the risk of the company.
3- 29
Capital Budgeting & Project Risk
Example - Based on the CAPM, ABC Company has a cost
of capital of 17%. (4 + 1.3(10)). A breakdown of the
company’s investment projects is listed below. When
evaluating a new dog food production investment, which
cost of capital should be used?
1/3 Nuclear Parts Mfr.. B=2.0
1/3 Computer Hard Drive Mfr.. B=1.3
1/3 Dog Food Production B=0.6
AVG. B of assets = 1.3
3- 30
Capital Budgeting & Project Risk
Example - Based on the CAPM, ABC Company has a cost
of capital of 17%. (4 + 1.3(10)). A breakdown of the
company’s investment projects is listed below. When
evaluating a new dog food production investment, which
cost of capital should be used?
R = 4 + 0.6 (14 - 4 ) = 10%
10% reflects the opportunity cost of capital on an
investment given the unique risk of the project.
3- 31
Cost of Capital
Cost of Capital - The return the firm’s
investors expect to earn if they invested in
securities with comparable degrees of risk.
Capital Structure - The firm’s mix of long
term financing and equity financing.
3- 32
Cost of Capital
Example
Geothermal Inc. has
the following
structure. Given that
geothermal pays 8%
for debt and 14% for
equity, what is the
Company Cost of
Capital?
3- 33
Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
Market Value Debt $194
Market Value Equity
$453
30%
70%
Market Value Assets $647 100%
3- 34
Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital?
Portfolio Return = (.3x8%) + (.7x14%) = 12.2%
3- 35
Cost of Capital
Example - Geothermal Inc. has the following
structure. Given that geothermal pays 8% for debt
and 14% for equity, what is the Company Cost of
Capital? Portfolio Return = (.3x8%) + (.7x14%) = 12.2%
Interest is tax deductible. Given a 35% tax rate, debt only
costs us 5.2% (i.e. 8 % x .65).
WACC = (.3x5.2%) + (.7x14%) = 11.4%
3- 36
WACC
Weighted Average Cost of Capital (WACC)
- The expected rate of return on a portfolio of
all the firm’s securities.
Company cost of capital = Weighted average of debt
and equity returns.
3- 37
WACC
rassets =
rassets 
total income
valueof investments
(D x rdebt ) + (E x requity)
V
rassets   x rdebt    x requity 
D
V
E
V
3- 38
WACC
Three Steps to Calculating Cost of Capital
1. Calculate the value of each security as a
proportion of the firm’s market value.
2. Determine the required rate of return on
each security.
3. Calculate a weighted average of these
required returns.
3- 39
WACC
Taxes are an important consideration in the
company cost of capital because interest payments
are deducted from income before tax is calculated.
3- 40
WACC
Weighted -average cost of capital=
WACC =
[
D
V
] [
x (1 - Tc)rdebt +
E
V
]
x requity
3- 41
WACC
Example - Executive Fruit has
issued debt, preferred stock and
common stock. The market
value of these securities are
$4mil, $2mil, and $6mil,
respectively. The required
returns are 6%, 12%, and 18%,
respectively.
Q: Determine the WACC for
Executive Fruit, Inc.
3- 42
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
3- 43
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
3- 44
WACC
Example - continued
Step 1
Firm Value = 4 + 2 + 6 = $12 mil
Step 2
Required returns are given
Step 3
WACC =
[
4
12
] (
x(1-.35).06 +
=.123 or 12.3%
2
12
) (
x.12 +
6
12
)
x.18
3- 45
WACC
Issues in Using WACC
Debt has two costs. 1)return on debt and 2)increased cost of
equity demanded due to the increase in risk
 Betas may change with capital structure(levered beta):
Bassets =
[
D
V
] [
x Bdebt +
E
V
]
x Bequity
 Corporate taxes complicate the analysis and may change
our decision
3- 46
Measuring Capital Structure
In estimating WACC, do not use the Book
Value of securities.
In estimating WACC, use the Market Value
of the securities.
Book Values often do not represent the true
market value of a firm’s securities.
3- 47
Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
3- 48
Measuring Capital Structure
Market Value of Bonds - PV of all coupons
and par value discounted at the current
interest rate.
Market Value of Equity - Market price per
share multiplied by the number of
outstanding shares.
3- 49
Measuring Capital Structure
Big Oil Book Value Balance Sheet (mil)
Bank Debt
$
200
25.0%
LT Bonds
$
200
25.0%
Common Stock
$
100
12.5%
Retained Earnings $
300
37.5%
Total
$
800
100%
3- 50
Measuring Capital Structure
Big Oil Book Value Balance Sheet (mil)
Bank Debt
$
200
25.0%
LT Bonds
$
200
25.0%
Common Stock
$
100
12.5%
Retained Earnings $
300
37.5%
Total
$
800
100%
If the long term bonds pay an
8% coupon and mature in 12
years, what is their market
value assuming a 9% YTM?
16
16
16
216
PV 


 .... 
2
3
12
1.09 1.09 1.09
1.09
 $185.70
3- 51
Measuring Capital Structure
Big Oil MARKET Value Balance Sheet (mil)
Bank Debt (mil)
$ 200.0
12.6%
LT Bonds
$ 185.7
11.7%
Total Debt
$ 385.7
24.3%
Common Stock
$ 1,200.0
75.7%
Total
$ 1,585.7
100.0%
3- 52
Required Rates of Return
Bonds
rd = YTM
Common Stock
re = CAPM
= rf + B(rm - rf )
3- 53
Required Rates of Return
Dividend Discount Model Cost of Equity
Perpetuity Growth Model =
Div1
P0 =
re - g
solve for re
Div1
re =
+ g
P0
3- 54
Required Rates of Return
Expected Return on Preferred Stock
Price of Preferred Stock =
P0 =
Div1
rpreferred
solve for rpreferred
rpreferred
Div1
=
P0
3- 55
Flotation Costs
The cost of implementing any financing
decision must be incorporated into the cash
flows of the project being evaluated.
Only the incremental costs of financing
should be included.

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