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, begins by defining a tme the estmaton 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 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 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 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: 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) + 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 = ke = ??? ... 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... 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... 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,