Financiering

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Financiering

• Jeroen E. Ligterinkjeroenl_at_fee.uva.nl
• 2001

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BMM 10 Topics Covered

• Measuring Beta
• Portfolio Betas
• CAPM and Expected Return
• Security Market Line
• Capital Budgeting and Project Risk

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Measuring Market Risk

• Market Portfolio - Portfolio of all assets in the
  economy. In practice a broad stock market index,
  such as the SP Composite, is used to represent
  the market.
• Beta - Sensitivity of a stocks return to the
  return on the market portfolio.

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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.

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Measuring Market Risk

• Example - continued

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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.

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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.

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Measuring Market Risk

• Example - continued

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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 SP Composite Index
  stocks, you would have an average beta of 1.0

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Measuring Market Risk

• Market Risk Premium - Risk premium of market
  portfolio. Difference between market return and
  return on risk-free Treasury bills.

Market Portfolio
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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.

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Measuring Market Risk

• Security Market Line - The graphic representation
  of the CAPM.

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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.

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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 companys 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.. B2.0
• 1/3 Computer Hard Drive Mfr.. B1.3
• 1/3 Dog Food Production B0.6
• AVG. B of assets 1.3

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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 companys 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.

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BMM 11 Topics Covered

• Geothermals Cost of Capital
• Weighted Average Cost of Capital (WACC)
• Capital Structure
• Required Rates of Return
• Big Oils WACC
• Interpreting WACC
• Flotation Costs

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Cost of Capital

• Cost of Capital - The return the firms investors
  could expect to earn if they invested in
  securities with comparable degrees of risk.
• Capital Structure - The firms mix of long term
  financing and equity financing.

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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?

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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?

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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?

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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?

Interest is tax deductible. Given a 35 tax rate,
debt only costs us 5.2 (i.e. 8 x .65).
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WACC

• Weighted Average Cost of Capital (WACC) - The
  expected rate of return on a portfolio of all the
  firms securities.
• Company cost of capital Weighted average of
  debt and equity returns.

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WACC
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WACC

• Three Steps to Calculating Cost of Capital
• 1. Calculate the value of each security as a
  proportion of the firms market value.
• 2. Determine the required rate of return on each
  security.
• 3. Calculate a weighted average of these required
  returns.

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WACC

• Taxes are an important consideration in the
  company cost of capital because interest payments
  are deducted from income before tax is
  calculated.

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WACC

• Weighted -average cost of capital

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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.

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WACC

• Example - continued
• Step 1
• Firm Value 4 2 6 12 mil
• Step 2
• Required returns are given
• Step 3

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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
• Corporate taxes complicate the analysis and may
  change our decision

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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 firms securities.

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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.
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Measuring Capital Structure
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Measuring Capital Structure
If the long term bonds pay an 8 coupon and
mature in 12 years, what is their market value
assuming a 9 YTM?
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Measuring Capital Structure
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Required Rates of Return

• Bonds
• Common Stock

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Required Rates of Return

• Expected Return on Preferred Stock
• Price of Preferred Stock
• solve for preferred

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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.
• This is sometimes called Adjusted Present Value.