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RISK-RETURN MODEL
Risk-free rate: LT govt bond rate, same currency as cash
flows - If no default-free entity, deduct default spread by:
(1) Obtain default spread based on rating/risk score, (2)
Use alternate currency to do analysis, (3) Compare
government bond issued in USD with USD govt bond rate
to get default spread, (4) Use CDS as default spread
Risk premium:
(1) Survey approach
(2) Historical premium approach: Define time period for
estimation, calculate average returns on stock index during
period (geometric average), calculate average returns on
riskless security during period and find difference
- Standard error in estimate =
- For emerging markets with less historical data, add
country risk premium. Use countrys bond rating/default
spread and multiply by (SD of countrys equity/SD of
countrys bond). Add to US risk premium.
(3) Implied premium approach: Add dividends and
buybacks yield against index and find average yield over a
few years. Use average yield to estimate CF this year by
multiplying by index NPV. Estimate earnings growth and
calculate CF for next few years (grow at same rate). After a
few years, assume earnings grow at risk-free rate.
Solve for IRR (r) and obtain implied risk premium (E(r) = rf
+ RP)
- Choosing between historical/implied: Historical RP
assumes market is mispriced while implied RP assumes
market is fairly priced (on average) and is more forward
looking.
Beta (top-down): Regress stock returns against market
returns
- Decide on an estimation period (trade-off: accuracy vs
relevance) and decide on return interval (usually
weekly/monthly/quarterly since daily and yearly avoided
due to thin-trading and few data points)
- Estimate returns (including dividends for ex dividend
months)
- Choose market index (based on marginal investorsdiversify locally/globally) and estimate returns inclusive of
dividends
- Regression results:
- Beta (b) is gradient
- Standard error of beta estimate: Find confidence intervals
- y intercept (a): a > rf(1-b) means stock did better than
expected during regression period
- Jensens alpha: a = rf(1-b) Annualized excess return =
*RMB to correct rf to monthly if returns are monthly
- R-squared: Estimate of proportion of total risk attributed
to market risk
(Diversified investor look at beta, non-diversified look at R 2
and beta)
Beta (Bottom-up): Better estimate as standard error is
lower and can reflect current and expected future mix
rather than historical.
Determinants of beta: (1) Industry effects (sensitivity of dd
to macro factors), (2) Operating leverage (Higher OL,
higher proportion of fixed cost, greater earnings
variability), (3) Financial leverage (Hamada equation
)
*Regression beta is levered
*Betas of portfolios are MV weighted average of betas of
individual investments in portfolio
*Mergers beta calculation:
General method: (1) Find biz segments of firm, (2) Obtain
median beta for each segment in industry, (3) Find median
D/E in each segment, (4) Use hamada to find unlevered
beta for each segment, (5) Correct unlevered beta for cash
using median (cash/firm value)
(6) Find median enterprise value/sales for each segment
(EV is market cap+debt-cash), (7) Multiply firms biz
segment revenue to each EV/sales to get estimated value,
(8) Use proportions of estimated values and unlevered
betas for each segment to find firms unlevered beta, (9) If
finding overall levered beta, use hamada on firms
unlevered beta and actual D/E ratio, (10) If finding levered
beta for each segment, allocate firms debt across biz
segments by estimating each segments debt using
median D/E and estimated value of segments, (11) Use
proportion of estimated debt and multiply by actual total
debt to get allocated debt, (12) Take estimated value
allocated debt to find estimated equity, (13) Use (allocated
debt)/(estimated equity) to find levered beta for each
segment, (14) To get beta for assets (not just operating
assets, use
INVESTMENT RETURNS
(A) To all investors
(1a) Accounting view of return: Find return on
capital
- Estimate accounting earnings on project (operating
income after tax)
- Revenue direct expenses depreciation (inclusive of
pre-project) allocated G/A costs Taxes
*AKA
EBIT(1-T) before interest
- Find average book value of capital/beginning book value
of capital
- BV = BV of pre project investment + BV of fixed assets +
BV of working capital (non-cash and non-debt only)
*WC
= CA - CL
- Find ROC
*Always calculate implied tax rate!!!!
*If given EBIT after operating lease expenses/debt, add
back interest expense (PV/debt value of lease payment x
cost of debt)
(1b) EVA and comparison
- To value the entire firm (existing investments), compare
ROC of firm with WACC of firm
- To value new investments, compare ROC of individual
project with WACC of biz segment/firm
*Adjust WACC
for EM risk etc
- EVA (Economic value added) = (ROC WACC) x BV of
capital invested
(Value spread x investment = excess returns)
(2a) Cash flow view of return: Find incremental cash
flows and NPV/IRR
- EBIT(1-T) (accounting earnings) + D/A (inclusive of preproject) Capex change in non-cash working capital
- In year 0, add back pre-project investment (previously
expensed off- since it would have existed anyway. Left with
normal investment and increase in working capital)
- In years 0-10, deduct pre-project depreciation x tax to
remove tax benefit from sunk depreciation (only have tax
benefit from normal dep)
- In years 0-10, add back after-tax fixed/non-variable G/A
costs since only variable costs will contribute to cash-flows
on project
*To know if variable/fixed, compare allocated expense and
increase in expense due to project. If increase in
expense>allocated so instead of adding back (allocatedincrease)(1-T), minus (increase-allocated)(1-T)
- Get incremental cash flows: Time-weighted
(compounding/discounting)
- Closure: For projects with short/finite life, find salvage
value (expected proceeds from selling investment in proj
which is fixed assets+WC). For projects with infinite life,
compute terminal value =
(2b) Measures of return
- NPV > 0 means add value to firm - Minus year 0
investment (BV of fixed assets and WC) from NPV of cash
flows. May have salvage/terminal value
- Annuity to compare NPV of proj with different span:
- IRR > Hurdle rate (IRR: Discount rate that sets NPV = 0)
- NPV vs IRR: (1) Project only has 1 NPV but may have >1
IRR, (2) NPV ($ value) will be larger for large-scale projects
while IRR (% value) will be larger for small-scale projects,
(3) NPV assumes CF reinvested at hurdle rate while IRR
assumes reinvested at IRR
*Overall NPV more reliable
(2c) Consistency rule: Project conclusions identical in
different currencies
(B) To shareholders only
(1a) Accounting view of return: Find return on
equity
- Estimate net income/year (EBIT Interest Taxes) *Get
tax rate
- Find debt payments per year:
Beg
debt
100,00
0
Intere
st
6,373
Principal
repaid
7,455
Total
paid
13,828
End
debt
92,545
i/r x
BD
)(change in non-cash
WC)
*Concept: Change in debt/capital (asset growth or
reinvestment). Assumes that net debt is always a stable
proportion of reinvestment
- Compare cash returned/FCFE ratio
3. How much do you trust the management with excess
cash?
- If cash returned/FCFE ratio < one, there is cash balance in
the company
- Performance measures: (a) Investment perf: Compare
ROE and re
(b) Stock performance: Jensens alpha (if negative,
underperformance)
- E.g. Disney could have afforded to pay more divid but
chose to invest in
High growth
Transition
ROC
9.91%
Reinvest
rate
53.72%
based on
acquisition
costs
ROC x
reinvest rate
26.7%
Beta =
0.9033
COD = 6%
Declines linearly
to 9%
Declines to
33.33%
(= g/ROC)
Expected
g
D/C ratio
Risk
paramet
ers
Stable
growth
Stable at 9%
33.33%
(= g/ROC)
Linear decline to
3%
stable g of 3%
Stays unchanged
Beta changes
Beta = 1
linearly to 1
No change in COD
Poor projects
Force managers to justify holding
cash or return cash to
shareholders
Defici
t
Good projects
Give managers
flexibility to keep
cash and set
dividends
Firm should cut
dividends and
reinvest more
ratio
(6) Optimal mix: Enhanced cost of capital approach
- Takes into account indirect cost of bankruptcy
- Use same steps as prev method but reduce EBIT
according to predicted rating accordingly
- When computing FCFF and FV, reduce EBIT too
(7) Optimal mix: Adjusted present value approach
(max firm value)
- FV = Value of firm w/o debt + effect of debt on FV
- FV = VU + Tax benefit Bankruptcy cost
(a) Estimate Vu
- Estimate unlevered beta, find re and FCFE/FCFF FV=
OR
- Estimate current MV firm Current tax benefit + current
expt bank cost
- Current tax benefit = Current debt x T
- Current bankruptcy cost = predicted probability of
bankruptcy x predicted cost of bankruptcy (%) x firm value
(b) Estimate tax benefit at different levels of debt
(c) Estimate bankruptcy cost at different levels of debt
- Probability of debt corresponding to synthetic rating of
debt (in first approach)
(d) Find debt level where VL is the highest
*VL=VU + dollar debt(% debt x VL)*T P(D)*cost of debt*VL
but difficult to solve so assume VL is same as current FV to
calculate dollar debt and COB
(8) Optimal mix: Relative analysis (industry avg w
subjective adjust)
- Choose variables (subjective adjustments- e.g. tax rate,
insider ownership, income stability, amount of intangible
assets)
- Run regression of debt ratios on these variables
E.g. Debt ratio = a + b*(tax rate) + C*(earnings volatility)
- Estimate proxies of firm and enter into cross sectional
ratio to get estimate of predicted debt ratio
- Compare actual to predicted debt ratio
- R-squared tells us how close data is to regression line
- Can do based on industry or whole market (extend
sample scope)
(9) Changing debt from actual to optimal
1. Timing: If there is bankruptcy/takeover threats
(a) Quickly increase debt ratio (takeover threat) Sell
operating assets and use cash to buy back stock, or pay
special dividend Borrow money to buy back stock
(b) Gradually increase debt ratio Take good projects with
debt
(c) Quickly reduce debt ratio (bankruptcy threat) Sell
operating assets and use cash to pay off debt Issue new
stock to retire debt or get debt holders to accept equity
(d) Gradually reduce debt ratio Take new good projects
with equity/RE (not debt) If no good projects, pay off debt
by issuing new equity Reduce dividends
2. Choosing right kind of debt: Ensure CF on debt matches
as closely to CF on firms assets Reduce default risk,
increase debt capacity and FV
(a) Intuitive approach
- Duration (ST/LT)
- Currency
- Effect of inflation uncertainty about future (market leader
use floating rate since less affected by i/f, just raise prices)
- Industry competition (competitive, use fixed)
- Growth patterns (growth firms, low current CF, high future
CF)
- Cyclicality (E.g. commodity bonds- i/r and principal
payments linked to commodity prices, catastrophe
bonds/notes issued by insurance companies- i/r and
principal payment linked to disasters)
(b) Quantitative approach- to confirm intuitive approach