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Chapters 8-10
 

Chapters 8-10

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    Chapters 8-10 Chapters 8-10 Presentation Transcript

    • Chapters 8, 9, 10 Financial Analysis and Decisions SCH-MGMT 640 Risk and Return Mila Getmansky Sherman Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved .
    • Capital Asset Pricing Model CAPM R = r f + B ( r m - r f )
    • Beta and Unique Risk 1. Total risk = diversifiable risk + market risk 2. Market risk is measured by beta, the sensitivity to market changes beta Expected return Expected market return 10% 10% - +
      • 10%
      +10% stock -10%
    • Beta and Unique Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio.
    • Beta and Unique Risk
    • Beta and Unique Risk Covariance with the market Variance of the market
    • Beta
    • Testing the CAPM Avg Risk Premium 1931-2005 Portfolio Beta 1.0 Security Market Line 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium
    • Testing the CAPM Avg Risk Premium 1931-65 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium
    • Testing the CAPM Avg Risk Premium 1966-2005 Portfolio Beta 1.0 SML 30 20 10 0 Investors Market Portfolio Beta vs. Average Risk Premium
    • CAPM Assumptions
      • Two benchmarks: Treasury bills and market portfolio
      • U.S. Treasury bills are risk-free (risk = 0)
      • Investors can borrow money at the same rate at which they lend
    • Arbitrage Pricing Theory
      • Alternative to CAPM
      • Expected Risk
      • Premium = r - r f
      • = B factor1 (r factor1 - r f ) + B f2 (r f2 - r f ) + …
      • Return = a + b factor1 (r factor1 ) + b f2 (r f2 ) + …
    • Arbitrage Pricing Theory
      • Estimated risk premiums for taking on risk factors
      • (1978-1990)
    • Three Factor Model
      • Steps to Identify Factors
      • Identify a reasonably short list of macroeconomic factors that could affect stock returns
      • Estimate the expected risk premium on each of these factors ( r factor 1 − r f , etc.);
      • Measure the sensitivity of each stock to the factors ( b 1 , b 2 , etc.).
    • Testing the CAPM High-minus low book-to-market Return vs. Book-to-Market Dollars (log scale) Small minus big http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
    • Three Factor Model
    • Topics Covered
      • Company and Project Costs of Capital
      • Measuring the Cost of Equity
      • WACC (Weighted Average Cost of Capital)
    • Company Cost of Capital
      • A company’s cost of capital can be compared to the CAPM required return
      Required return Project Beta 1.13 Company Cost of Capital 12.9 5.0 0 SML
    • Company Cost of Capital
    • Debt and WACC
      • r assets = WACC = r debt D/V + r equity E/V
      • After tax WACC = (1-T c )r debt D/V + r equity E/V
      IMPORTANT E, D, and V are all market values of Equity, Debt and Total Firm Value r equity = r f + B equity ( r m - r f ) V= D + E
    • Capital Structure & COC Expected return (%) B debt B assets B equity R rdebt =8 R assets =12.2 R equity =15 Expected Returns and Betas prior to refinancing
    • Measuring Betas
      • The SML shows the relationship between return and risk
      • CAPM uses Beta as a proxy for risk
      • Other methods can be employed to determine the slope of the SML and thus Beta
      • Regression analysis can be used to find Beta
    • Measuring Betas Intel Computer Slope determined from plotting the line of best fit. Price data: July 1996 – June 2001 R 2 = .29 B = 1.54
    • Measuring Betas Intel Computer Slope determined from plotting the line of best fit. Price data: July 2001 – June 2006 R 2 = .30 B = 2.22
    • Measuring Betas Heinz Slope determined from plotting the line of best fit. Price data: July 1996 – June 2001 R 2 = .18 B = .47
    • Measuring Betas Heinz Slope determined from plotting the line of best fit. Price data: July 2001 – June 2006 R 2 = .15 B = .36
    • Estimated Betas