Report on financial research paperDocument Transcript
REPORT ON FINANCIAL RESEARCH PAPER RESEARCH PAPERS ON:A) What is the riskfree rate? A Search for the Basic Building BlockB) Valuing Companies with intangible assetsC) Measuring Company Exposure to Country Risk: Theory and Practice Submitted To: Dr. Satinder Bhatia By: Nilesh A. Mashru Roll no. 28, Student id: S12MMMMM01593 PGDIBS, BKC - Mumbai
What is the riskfree rate? A Search for the Basic Building BlockRisk free rate is basically the rate of return of an investment with zero risk of financial loss. It isinterpreted as the return or interest that an investor would expect from an absolutely risk-freeinvestment. For instance the most commonly used benchmark for risk free rate is bank interest on fixeddeposits. As fixed deposits with bank have zero risk of financial loss, interest income expected out of thesame is interpreted as risk free income and the rate of such interest as risk free rate.Since the risk free rate can be obtained with no risk, it is implied that any additional risk taken by aninvestor should be rewarded with an interest rate higher than the risk-free rate.The risk free rate means different things to different people and there is no such consensus on how togo about a direct measurement of the same. However, perhaps the most common interpretation isaligned to Fishers concept of inflationary expectations, described in his treatise The Theory of Interest(1930) which is based on the theoretical costs and benefits of holding currency. In Fisher’s model theseare described by two potentially offsetting movements: i) Expected increases in the money supplyshould result in investors preferring current consumption to future income. ii) Expected increases inproductivity should result in investors preferring future income to current consumption.The correct interpretation is that the risk free rate could be either positive or negative and in practicethe sign of the expected risk free rate is an institutional convention - this is analogous to the argumentthat Tobin makes on page 17 of his book, Money, Credit and Capital. In a system with endogenousmoney creation and where production decisions and outcomes are decentralized and potentiallyintractable to forecasting, this analysis provides support to the concept that the risk free rate may notbe directly observable.However, it is commonly observed that for people applying this interpretation, the value of holdingcurrency is normally perceived as being positive. It is not clear what is the true basis for this perception,but it may be related to the practical necessity of some form of currency to support the specialization oflabour, the perceived benefits of which were detailed by Adam Smith in The Wealth of Nations.However it should be observed that Adam Smith did not provide an upper limit to the desirable level ofthe specialization of labour and did not fully address issues of how this should be organised at thenational or international level.An alternative (less well developed) interpretation is that the risk free rate represents the timepreference of a representative worker for a representative basket of consumption. Again, there arereasons to believe that in this situation the risk free rate may not be directly observable.Usually the return on domestically held short-dated government bonds is normally perceived as a goodproxy to the risk free rate provided there is no perceived risk of default associated with the bond (e.g.Eurozone crisis).The risk-free interest rate is highly significant in the context of the general application of ModernPortfolio Theory which is based on the Capital Asset Pricing Model. There are numerous issues with this
model, the most basic of which is the reduction of the description of utility of stock holding to theexpected mean and variance of the returns of the portfolio. The risk free rate is also a required input infinancial calculations, such as the Black–Scholes formula for pricing stock options and the Sharpe Ratio.Note that some finance and economic theories assume that market participants can borrow at the riskfree rate; in practice, of course, very few (if any) borrowers have access to finance at the risk free rate.In corporate finance and valuation, we start off with the presumption that the riskfree rate is given andeasy to obtain and focus the bulk of our attention on estimating the risk parameters of individuals firmsand risk premiums. But is the riskfree rate that simple to obtain? Both academics and practitioners havelong used government security rates as riskfree rates, though there have been differences on whetherto use short term or long term rates.In this paper by Aswath Damodaran from Stern school of Business, New York University, not only doeshe provide a framework for deciding whether to use short or long term rates in analysis but also aroadmap for what to do when there is no government bond rate available or when there is default riskin the government bond.What is a risk free asset?To understand what makes an asset risk free, let us go back to how risk is measured in investments.Investors who buy assets have returns that they expect to make over the time horizon that they willhold the asset. The actual returns that they make over this holding period may by very different fromthe expected returns, and this is where the risk comes in. Risk in finance is viewed in terms of thevariance in actual returns around the expected return. For an investment to be risk free in thisenvironment, then, the actual returns should always be equal to the expected return.Hence it can be concluded that when there is no variance between the expected & the actual rate ofreturns on a particular investment, it is a risk free rate.Why do riskfree rates matter?The riskfree rate is the building block for estimating both the cost of equity and capital. The cost ofequity is computed by adding a risk premium to the riskfree rate, with the magnitude of the premiumbeing determined by the risk in an investment and the overall equity risk premium (for investing in theaverage risk investment). The cost of debt is estimated by adding a default spread to the riskfree rate,with the magnitude of the spread depending upon the credit risk in the company. Thus, using a higherriskfree rate, holding all else constant, will increase discount rates and reduce present value in adiscounted cash flow valuation.The level of the riskfree rate matters for other reasons as well. As the riskfree rate rises, and thediscount rates rise with it, the breakdown of a firm’s value into growth assets and assets in place willalso shift. Since growth assets deliver cash flows further into the future, the value of growth assets willdecrease more than the value of assets in place, as riskfree rates rise.
Requirements for an Investment to be called Risk-Free 1. There can be no default risk. 2. There is no re-investment risk.Risk free rate will vary with time if both the above conditions have to be fulfilled which is a puristsolution. Hence a one year cash flow will use a one year risk free rate and a five year cash flow will useda five year risk free rate.A practical compromise is to comeup with one common risk free rate to use on all the cash flows.Common use of this is by banks in terms of duration matching. In valuation and capital budgeting, wecould use a variation on this duration matching strategy, where we use one riskfree rate on all of thecash flows, but set the duration of the default-free security used as the risk free asset to the duration2of the cash flows in the analysis.The currency effect: Even if we accept the proposition that the ten-year default free bond rate is the riskfree rate, the number we obtain at any point in time can vary, depending upon the currency that youuse for your analysis.Risk free rate vary across currencies: Since the rates that we have specified as riskfree rates are all overthe same maturity (ten years) and are default-free, the only significant factor that can cause differencesis expected inflation. High inflation currencies will have higher riskfree rates than low inflationcurrencies. If higher riskfree rates lead to higher discount rates, and holding all else constant, reducepresent value, using a yen riskfree rate seemingly should give a company a higher value than using a USdollar riskfree rate.Summarizing, the risk free rate used to come up with expected returns should be measured consistentlywith the cash flows are measured. Thus, if cash flows are estimated in nominal US dollar terms, the riskfree rate will be the US Treasury bond rate.Real VS Nominal Risk free rate: Done consistently, the value of a company should be the same whetherwe discount real cash flows at a real discount rate or nominal cash flows, in any currency, at a nominaldiscount rate in the same currency.Issues in Estimating risk free rates: a. There are no long term traded government bonds b. In many countries (and their associated currencies), the biggest roadblock to finding a riskfree rate is that the government does not issue long term bonds in the local currency. c. When there are no long term government bonds in the local currency that are widely traded, analysts valuing companies in that market often take the path of least resistance when estimating both cash flows and discount rates, resulting in currency mismatches in their valuations.
d. Choosing valuation Currency – mature currency or local currency e. The government is not default free f. Local currency bond rate would include a default spread. g. Risk free rate may vary over time h. What is considered a more normal rate could have potential problems – Experience on normal rate would change with time period, using normal risk free rate against current risk free rate could have valuation consequences and interest rates vary from time to time.Conclusion:The risk free rate is the starting point for all expected return models. For an investment to be risk free, ithas to meet two conditions. The first is that there can be no risk of default associated with its cash flows.The second is that there can be no reinvestment risk in the investment. Using these criteria, theappropriate risk free rate to use to obtain expected returns should be a default-free (government) zerocoupon rate that is matched up to when the cash flow or flows that are being discounted occur. Inpractice, however, it is usually appropriate to match up the duration of the risk free asset to theduration of the cash flows being analyzed. In corporate finance and valuation, this will lead us towardslong-term government bond rates as risk free rates. In this paper, we considered three problemscenarios. The first is when there are no longterm, traded government bonds in a specific currency. Wesuggested either doing the valuation in a different currency or estimating the riskfree rate from forwardmarkets or fundamentals. The second is when the long-term government bond rate has potentialdefault risk embedded in it, in which case we argued that the riskfree rate in that currency has to be netof the default spread. The third is when the current long term riskfree rate seems too low or high,relative to historic norms. Without passing judgments on the efficacy of this view, we noted that it isbetter to separate our views about interest rates from our assessment of companies.
Valuing Companies with Intangilble AssetsAs we move from manufacturing to service based economies, an increasing large proportion of the firmsthat we value derive their value from intangible assets ranging from technological patents to humancapital. In this paper, we focus on a few variables that make valuing these service companies differentfrom conventional manufacturing firms. The first is that accountants routinely miscategorize operatingand capital expenses, when firms invest in intangible assets. Thus, R&D expenses, which are reallycapital expenses, are treated as operating expenses, thus skewing both reported profit and capitalvalues. The second is that firms with intangible assets are more likely to use options and restricted stockto compensate employees and the accounting treatment of this compensation can also affect earningsand cash flows. This paper looks at how best to correct for the accounting errors and the consequencesfor valuation. Looking at publicly traded firms, it is obvious that many firms derive the bulk of their value fromintangible assets. From consumer product companies, dependent upon brand names, to pharmaceuticalcompanies, with blockbuster drugs protected by patent, to technology companies that draw on theirskilled technicians and know-how, these firms range the spectrum.Characteristics of firms with intangible assets 1. Inconsistent accounting for investments made in intangible assets 2. Generally borrow less money 3. Equity optionsSuch companies have valuation consequences due to miscategorization of capital expenses, the sparinguse of debt and equity based compensation. 1. We generally draw on the current earnings and current book value of a firm to derive a value for existing assets. The flawed accounting treatment of intangible assets renders both numbers unreliable. 2. If growth is a function of how much firms reinvest and the quality of that reinvestment, the accounting treatment of expenditures on intangible assets makes it difficult to gauge either number. The reinvestment made by the firm is often buried in the operating expenses. 3. Additional risk as monitoring assets is difficult. 4. Intangible assets may or may not get steady in the short run.Issues with the valuation: 1. Capital expenses treated as operating expenses leads to loss of a potent tool to estimate growth & internal consistency.
2. Effect of accounting miscategorization can vary widely across firms in the same sector thus making it difficult to do a relative comparison. 3. Looking for simple alternative methods may lead to false sense of complacency.Consequences for Valuation:When we capitalize R&D, brand name advertising and training expenses, there are significantconsequences for both discounted cash flow and relative valuation. In discounted cash flow valuation,our estimates of cash flows and growth can be dramatically altered by the use of the adjusted numbers.In relative valuation, comparisons of firms within the same sector can be skewed by where they are inthe life cycle.Discounted Cashflow Valuation:When we capitalize the expenses associated with creating intangible assets, we are in effect redoing thefinancial statements of the firm and restating numbers that are fundamental inputs into valuation –earnings, reinvestment and measures of returns.a. Earnings: The operating and net income of a firm will change as a consequence. Since the adjustmentinvolves adding back the current year’s expense and subtracting out the amortization of past expenses,the effect on earnings will be non-existent if the expenses have been unchanged over time, and positive,if expenses have risen over time.b. Reinvestment: The effect on reinvestment is identical to the effect on earnings, with reinvestmentincreasing or decreasing by exactly the same amount as earnings.c. Free Cash flow to the equity(firm): Since free cash flow is computed by netting reinvestment fromearnings, and the two items change by the same magnitude, there will be no effect on free cash flows.d. Reinvestment Rate: While the free cash flow is unaffected by capitalization of these expenses, thereinvestment rate will change. In general, if earnings and reinvestment both increase as a consequenceof the capitalization of R&D or advertising expenses, the reinvestment rate will increase.e. Capital Invested: Since the unamortized portion of prior year’s expenses is treated as an asset, it addsto the estimated equity or capital invested in the firm. The effect will increase with the amortizable lifeand should thererfore be higher for pharmaceutical firms (where amortizable lives tend to be longer)than for software firms (where research pays off far more quickly as commercial products).f. Return on equity (capital): Since both earnings and capital invested are both affected bycapitalization, the net effects on return on equity and capital are unpredictable. If the return on equity(capital) increases after the recapitalization, it can be considered a rough indicator that the returnsearned by the firm on its R&D or advertising investments is greater than its returns on traditionalinvestments.
g. Expected growth rates: Since the expected growth rate is a function of the reinvestment rate and thereturn on capital, and both change as a result of capitalization, the expected growth rate will alsochange. While the higher reinvestment rate will work in favor of higher growth, it may be more thanoffset by a drop in the return on equity or capital.In summary, the variables that are most noticeably affected by capitalization are the return onequity/capital and the reinvestment rate. Since the cost of equity/capital is unaffected by capitalization,any change in the return on capital will translate into a change in excess returns at the firm, a keyvariable determining the value of growth. In addition to providing us with more realistic estimates ofwhat these firms are investing in their growth assets and the quality of these assets, the capitalizationprocess also restores consistency to valuations by ensuring that growth rates are in line withreinvestment and return on capital assumptions. Thus, technology or pharmaceutical firms that want tocontinue to grow have to keep investing in R&D, while ensuring that these investments, at leastcollectively, generate high returns for the firm.ConclusionThis paper examines the two key issues that we face when valuing firms with substantial intangibleassets. The first is that the accounting treatment of what comprises capital expenditures at these firmsis inconsistent with the accounting treatment of capital expenditures at manufacturing firms. R&Dexpenses, brand name advertising and employee recruitment and training expenses are treated asoperating, rather than capital expenses. As a result, both the earnings and book value numbers at thesefirms are skewed and using them in valuation can lead to poor estimates of value. We examined ways ofcorrecting for this accounting inconsistency and the resulting effect on value. In general, firms that canconvert R&D expenditures more efficiently and profitably into commercial products will see theirestimated values increase, as a result of the correction, whereas firms that spend significant amounts onacquiring intangible assets with little to show for it in terms of higher earnings will see their estimatedvalues decrease. The second issue that we consider is the use of equity options to compensateemployees. We look at two traditional approaches for dealing with these options – the diluted stock andtreasury stock approaches – and discard them. Instead, we argue for valuing these options usingmodified option pricing models and adjusting the value of common shares today both for options thathave been granted in the past (the option overhang) and expected future option grants.
Measuring Company Exposure to Country Risk: Theory and PracticeThe growth of financial markets in Asia and Latin America and the allure of globalization has made theanalysis and assessment of country risk a critical component of valuation in recent years. In this paper,we consider two issues. The first is the whether country risk should be considered explicitly in valuation,and if the answer is yes, how to do it. Generically, there are two ways of incorporating country risk; wecan either adjust the cash flows or change the discount rate and we will consider both approaches. Thesecond and equally important issue is how to assess a company’s exposure to country risk. Firstly not allcompanies in an emerging market are equally exposed to country risk and that we need to differentiatebetween firms. Secondly, a company’s exposure to country risk comes not from where it incorporatesand trades but from where it does its business. In other words, assessing and dealing with country riskcan be important even for companies that trade in developed markets, if they get a significant portion oftheir revenues in emerging markets.While evaluating country risk, there are 2 basic questions: 1. Whether there should be an additional premium when valuing equities in these markets because of the country risk? Yes depending upon the country of investment, the premium may or may not be considered when valuing equities in these markets. While globally diversified investors are playing an increasing role in the pricing of equities around the world, the resulting increase in correlation across markets has resulted in a portion of country risk being nondiversifiable or market risk. 2. Estimation of such premium for emerging markets. a. Historical risk premium approach b. Implied Premium approachDeterminants of a company’s exposure to risk: 1. Revenue sources 2. Production facilities 3. Risk management 4. Data constraintsConclusion:As companies expand operations into emerging markets and investors search for investmentopportunities in Asia and Latin America, the assessment of country risk has become a centralcomponent of valuation. In this paper, we considered two key questions. The first is whether thereshould be an extra premium assessed for country risk, and if yes how to estimate it. While it is true that
globally diversified investors can eliminate some country risk by diversifying across equities in manycountries, the increasing correlation across markets suggests that country risk cannot be entirelydiversified away. To estimate the country risk premium, we consider three measures: the default spreadon a government bond issued by that country, a premium obtained by scaling up the equity riskpremium in the United States by the volatility of the country equity market relative to the US equitymarket and a melded premium where the default spread on the country bond is adjusted for the highervolatility of the equity market. We also estimated an implied equity premium from stock prices andexpected cashflows. The second question relates to how this country risk premium should be reflectedin the costs of equities of individual companies in that country. While the standard approaches add thecountry risk premium as a constant to the cost of equity of every company in that market, we argue fora more nuanced approach where a company’s exposure to country risk is measured with a lambda. Thislambda can be estimated either by looking at how much of a company’s revenues or earnings comefrom the country – the greater the percentage, the greater the lambda – or by regressing a company’sstock returns against country bond returns – the greater the sensitivity the higher the lambda. If weaccept this view of the world, the costs of equity for multinationals that have significant operations inemerging markets will have to be adjusted to reflect their exposure to risk in these markets.