Managerial Finance

1
Managerial Finance

• FINA 6335
• The CAPM and Cost of Capital
• Lecture 9

2
Simplifying Assumptions

• Individuals can trade securities without regard
  to fees, taxes, and other frictions.
• Individuals get any relevant information about
  the firms they are interested in costlessly.
• Individual investors can borrow or save at the
  same riskless rate equal the the riskfree rate
  

3
Market Equilibrium
CML
return
Optimal Risky Porfolio
rf
?

• All investors have the same CML because they all
  have the same optimal risky portfolio given the
  risk-free rate.

4
Market Equilibrium
CML
return
Optimal Risky Porfolio
rf
?

• The CML
• Rp Rf (sp /sM )(RM- Rf )

5
Definition of Risk When Investors Hold the Market
Portfolio

• Researchers have shown that the best measure of
  the risk of a security in a large portfolio is
  the beta (b)of the security.
• Beta measures the responsiveness of a security to
  movements in the market portfolio.

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Estimates of b for Selected Stocks
Stock Beta
Bank of America 1.55
Borland International 2.35
Travelers, Inc. 1.65
Du Pont 1.00
Kimberly-Clark Corp. 0.90
Microsoft 1.05



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The Formula for Beta
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Relationship between Risk and Expected Return
(CAPM)

• Expected Return on the Market

• Expected return on an individual security

Market Risk Premium
This applies to individual securities held within
well-diversified portfolios.
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Expected Return on an Individual Security

• This formula is called the Capital Asset Pricing
  Model (CAPM)

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Relationship Between Risk Expected Return
Expected return
b
1.0
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Relationship Between Risk Expected Return
Expected return
b
1.5
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Summary and Conclusions

• This chapter sets forth the principles of modern
  portfolio theory.
• The expected return and variance on a portfolio
  of two securities A and B are given by

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Summary and Conclusions

• The efficient set of risky assets can be combined
  with riskless borrowing and lending. In this
  case, a rational investor will always choose to
  hold the portfolio of risky securities
  represented by the market portfolio.

?P
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Summary and Conclusions

• The contribution of a security to the risk of a
  well-diversified portfolio is proportional to the
  covariance of the security's return with the
  markets return. This contribution is called the
  beta.

• The CAPM states that the expected return on a
  security is positively related to the securitys
  beta

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Estimating b with regression
Security Returns
Return on market
Ri a i biRm ei
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Security Market Line
Security Returns
Beta
Ri Rf bi(Rm Rf )
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Practical Issues in CAPM

• Forecasting Beta
• The problem is that you assume your estimate of
  Beta is the true value of Beta
• regression toward one
• Allow for extremes
• What Time Horizon
• 2 years of weekly, or 5 years of monthly

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The Security Market Line

• Risk free interest rate?
• The Market Risk Premium
• 5.7

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Firm valuation

• See Chapter 18, Section 1 and 2.
• We will want to value the firm using the
  Discounted Cash Flow (DCF) method.
• Three issues
• What do you want to discount?
• How do you project this over time?
• How do you discount it?

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Be Heroic!!!
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Basic Valuation

• What do you want to Discount?
• How do you project these?
• How do you discount these?

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Basic Valuation

• What do you want to Discount?
• Free Cash Flow
• How do you project these?
• How do you discount these?

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Basic Valuation

• What do you want to Discount?
• Free Cash Flow
• How do you project these?
• From Historical Data
• How do you discount these?

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Basic Valuation

• What do you want to Discount?
• Free Cash Flow
• How do you project these?
• From Historical Data
• How do you discount these?
• The Cost of Capital or (Weighted Average)

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Free Cash Flow

• Start with EBIT
• Subtract Taxes
• Leaves EBIT(1-t) Unlevered (Operating) Net
  Income
• Plus Depreciation
• Less Capital Expenditures
• Less Increases in Working Capital
• Bottom Line Free Cash Flow

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Example

• Current Sales
  60
• Cost of Goods Sold
  25
• Gross Profit
  35
• Less Operating Expenses
  9
• Less Depreciation
  6
• EBIT
  20
• Less Income Tax Rate (_at_ 35)
  7
• Operating (Unlevered) NI
  13
• Plus Depreciation 6
• Less Capital Expenditures
  2
• Less Increases in Working Capital
  1
• Free Cash Flow
  16
• 
  

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How do we make estimates?

• 1. Income tax should be the statutory rate.
• Depreciation You need to project depreciation
  into the future. Will increase as Capital
  Expenditures increase. How do you estimate?
• Capital Expenditures Note, to propel growth,
  you need to invest How do you determine Cap Ex
  ???
• Finally, Changes in Working Capital?

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Projections of Growth

• Recall growth depends on 2 variables
• Retention rate (1 Payout ratio)
• Return on Investments Operating Income as a
  percentage of Book Value of Assets
• Consider Historical Rates as well

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Discount Rate

• Conceptually
• V Present Value of the firms Cash flows,
  discounted by a number called the cost of
  capital
• Basically it is the IRR of the Firm.
• Conceptually, you want to discount by a rate that
  reflects the risk of the firms operating Cash
  Flow.

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How do you estimate this

• Weighted Average Cost of Capital
• Once you have the stream of operating Cash Flows
  generated by the firm, the next problem is to
  determine how to discount it.
• The discount rate that makes the Value of the
  firm equal the firms cash flow is what we call
  the Cost of Capital.
• As a practical matter this can be approximated by
  the Weighted Average Cost of Capital (WACC)

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WACC

• The WACC is defined as
• rWACC rE X (E/(ED)) rD(1-t) X (D/(ED))
• The weighted average of the (after tax) cost of
  the component securities issued by the firm,
  weighted by the proportion of those securities
  issued by the firm.
• rE is the required return to the equity of the
  firm
• rD is the required return to the debt of the firm
  
• D is the (market value) of the debt issued by the
  firm
• E is the market value of the equity.
• t is the firms tax rate.

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WACC Estimation

• Some of these variables are not easily estimated
  so we make some assumptions
• To estimate D use the Book value of the debt.
• To estimate rD use the ratio of Total Interest
  payments to the total book value of the debt
• To estimate rE use the Capital Asset Pricing
  Model