Slide strategic financial management l05

Strategic
Strategic Financial
Financial Management
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
o

 Business Risk
 Operating Leverage
 Financial Leverage

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
larger premium for shifting from the riskless asset.

demand a

 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 –

Historical Premiums
 ItLarge
investors
canperiod
be for
surveyed
about their expectatons for the future,
1.
begins by
defining a tme
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
 itThe
actual
premiums
earned
over
a past
period
can and
be uses
obtained
data and
3.
calculates
the difference

between
the returns
on stocks
and the
riskless return
it as a risk from
premiumhistorical
looking forward.

 The implied premium can be extracted from current market data.
Estimation Issues
 Time Period Used
 Choice of Risk free Security
 There are no constraints on reasonability; individual money managers could provide expected returns that are lower than the
 Arithmetc
and Geometric Averages
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.


Risk Parameter: Beta

Historical Market Betas
The standard procedure for estmatng betas is to regress stock returns (R j) against market returns
(Rm) –
Rj = a + b Rm
Rj-Rf= a + b (Rm-Rf)
Regression Interpretaton:

Slope
Intercept
R squared
Standard error

Estimation Issues





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 ofLeverage:
a firm is determined by three variables –
Operating
(1) the type of business or businesses the firm is in
Leverage
(2) theFinancial
degree of operatng
leverage in the firm and
(3) The firm's financial 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
The  beta
 value
 a  firm
 dependsthat
 upon
 the  sensitvity
 of  thein demand
 its  products
 and
Financial leverage
is the
risk for
to the
stockholders
is caused

by an increase
debt and for
preferred
equites
in a services
company's
leverage
 and  of
 costs  toincreases
 mac-roeconomic
 that
 affect interest
 the  overall
 market.
  
capital structure.
As its
a company
debt and factors
preferred
equites,
payments
increase,
reducing EPS. As a result,



risk to stockholder return is increased.
Degree of Operatng Leverage = % Change in EBIT/ % Change in Sales
Cyclical  companies  have  higher  betas  than  non ‐cyclical   firms  


Firms  which
 sell = more
 discretionary
 Degreeof financial
leverage
% Change
in EPS/ % products
Change in will
EBIT have higher  betas  than  firms  that  sell  less  
discretionary


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.
2.
3.
4.

Find  out  the  businesses  that  a  firm  operates  in  
Find  the  unlevered  betas  of  other  firms  in  these  businesses
Take  a  weighted average  of  these   unlevered  betas  
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  

a)
b)

reasons

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

inventory methods

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 = ???