...ESTIMATING RISK AND RETURN MARISOL ROSARIO MARCH 13, 2016 NANCY ODETT ESTIMATING RISK AND RETURN Question 1: * Proficient-level: "Why is expected return considered forward-looking? What are the challenges for practitioners to utilize expected return?" (Cornett, Adair, & Nofsinger, 2016, p. 258). * Distinguished-level: Explain the role of probability distribution in determining expected return. * Question 2: * Proficient-level: "Describe how different allocations between the risk-free security and the market portfolio can achieve any level of market risk desired" (Cornett, Adair, & Nofsinger, 2016. p. 258). * Distinguished-level: Provide examples of a portfolio for someone who is very risk averse and for someone who is less risk averse. * Question 3: * Proficient-level: Refer to the table below to complete this question. "Compute the expected return given these three economic states, their likelihoods, and the potential returns" (Cornett, Adair, & Nofsinger, 2016, p. 259). * Distinguished-level: Recalculate the expected return under a set of changed economic probabilities. * Question 4: * Proficient-level: "If the risk-free rate is 3 percent and the risk premium is 5 percent, what is the required return?" (Cornett, Adair, & Nofsinger, 2016, p. 259). * Distinguished-level: Identify which financial security's return is typically considered the risk-free rate. * Question 5: * Proficient-level:...
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...was "significantly lower than the expected return" of entering the new market, he fully expected the company to introduce its own brand of detergents, soaps, cleansers, and personal-care products by the end of 1990 --- What is your opinion on this statement? (Max. 50 words) * The CFO needed to be reasonably sure that the money invested will generate greater returns than the minimum level expected by investors/bondholders in order to go ahead with the plan Should P&G compute cost of retained earnings as part of the cost of capital? (Max. 50 words) * Yes. Since retained earnings form part of shareholder's capital (and consequently part of return expected from holding the share) it must be considered Why bond and stock markets are only reasonably effecient? (Max. 50 words) * Investors are subject to many biases such as confirmation, loss aversion, overconfidence biases and even the gambler's fallacy which may reduce the efficiency of the market. Should CORPOSTRAT try to reconcile the difference between its client and P&G or should it just report the findings and let the client interpret the result on its own? * https://docs.google.com/forms/d/12CbbCV-E6rEFBtAsVmVKGOh33wFJ9vsUS9-mol4YKoU/formResponse 1/7 1/9/2015 Procter & Gamble: Cost of Capital CORPSTRAT should directly report the findings as it is always good to have multiple estimates through different (wellsubstantiated) assumptions for cost of capital While estimating WACC for her client, Does looking at companies...
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...calculating the required return to the shareholder. This figure in turn has been used to calculate the economic value of the stock and the Weighted Average Cost of Capital (WACC) for capital budgeting. In recent years, the CAPM has been attacked as an incomplete model for explaining market pricing behavior, but academics and practitioners cannot agree on a good replacement. And so the CAPM remains an important model in practical investment and financial management decision making. Calculating Beta: The most important component in calculating the required return to shareholder (from the CAPM) is the company’s beta. The CAPM can be succinctly stated as: k s k RF k M k RF s k RF Market Risk Premium s [1] The original model was conceived of theoretically, and was expected to be forward looking. Careful reading of Sharpe’s original work show that the market assesses systematic risk looking at expected future covariance of the company’s returns with that of the overall market. It is assumed that these covariances are unbiased and efficient estimates of the observed relationships ex post facto. Traditionally the CAPM relationship is estimated using simple regression on historical outcomes, where ks is the y variable, and kM-kRF (or the market risk premium) is the only x variable. Care must be taken that the returns plugged into the regression are all for the same period. Calculated stock returns should be annualized if the risk-free rate is an annual...
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...Equity Risk Premium provides a much clearer way of understanding returns of equities as an asset class, leading to a better ability to forecast and manage risk, thus resulting in better portfolio construction. For example, if investors can objectively quantify the relative returns on stocks, bonds, and cash through risk premia, they can make better decisions on how to allocate their money across these three asset classes. If the equity premium is high, investors should allocate a larger portion of their assets to equities than if it is low. The idea that riskier investments should deliver higher expected returns than less risky ones in the basis for all risk-return models in finance, and thus central to all asset allocation decisions. Thus, the Equity Risk Premium, i.e. the premium demanded by investors for investing in the stock market, is an essential input in both the Capital Asset Pricing Model (CAPM) as well as in asset allocation decisions involving equities. In the CAPM, market risk is measured by beta which when multiplied with the ERP gives the total risk premium for an asset or portfolio. Risk premia are central to competing risk return market models as well. For example, competing multifactor models measure risk by a series of betas each corresponding to the risk premium for an individual market risk factor. The effects of estimating ERP are far reaching for investment managers as well as the global economy. Since assuming a high ERP of 7% will result in far greater...
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...Cost of Capital at Ameritrade 1 Objective j • This case provides the opportunity for you to p estimate the cost of capital. • To develop an understanding of how capital market data and the CAPM can be used to estimate the required rate of return for real investments 2 Background g • Ameritrade: formed in 1971, IPO in March , pioneer in the deep-discount p 1997, a p brokerage sector. – Helped create the deep discount market – The first to offer many new services that changed th way i di id l i h d the individual investors managed t d their portfolios. 3 • Ameritrade’s strategy: to grow its customer , q base, which required substantial investments in technology and advertising. • Needed an estimate of the project’s risk. risk 4 Q Question • How risky are these cash flows? • How are they related to the stock market? 5 To-do’s • Determining what firms can be considered comparable when estimating the cost of capital • Calculating returns from stock prices g q y • Estimating CAPM equity and asset betas from capital market data g g • Understanding the effect of leverage on equity betas g pp p • Evaluating how appropriate the estimated cost of capital is for different types of real investments 6 The Discount Brokerage Business g • What are the primary sources of revenue? – Transaction revenues • Brokerage commissions • Clearing fees • Payment for order flow – Interest revenues • Margin lending to customers • Interest on investment of...
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...interviews with two groups: (1) well-regarded firms ranked by peer companies as industry leaders and (2) a sample of 11 of the most active financial advisers (investment banks). For context on academic advice, we also cite recommendations from topselling graduate-level textbooks and trade books in corporate finance.1 Findings The Capital Asset Pricing Model (CAPM) is the dominant model for estimating the cost of equity, with over 90% of firms and all the financial advisers employing this model. Moreover firms and advisers seldom mentioned other asset-pricing models. Yet disagreements exist on how to apply the CAPM. The CAPM states that the required return (R) on any asset can be expressed as Equation 1: R = R f + ( Rm - R f ) (1) 1 Survey evidence and much of the discussion is adapted from T. Brotherson, K. Eades, R. Harris, and R. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: An Update,” Journal of Applied Finance 23, no. 1 (2013), which is an update of an earlier article: R. Bruner, K. Eades, R. Harris, and R. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: Survey and Synthesis,” Financial Practice and Education (Spring/Summer 1998). The 2013 study reports these results plus others on the weighted average cost of capital. The study chose leading firms using Fortune’s list of Most Admired Companies. Firms were selected based a survey of 698 companies that ranked other companies on a number of criteria including wise use of...
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...satisfactory rate of return. The case recounts the debate within the company over the use of a single hurdle rate to evaluate all segments of the company versus a riskadjusted hurdle-rate system. The tasks for the student are to resolve the debate, estimate weighted average costs of capital (WACCs) for the two business segments, and respond to the raider. Suggestions for complementary cases: “Nike Inc.” (case 13) gives an introductory exercise in the estimation of the cost of capital. “Coke vs. Pepsi, 2001” (case 14) offers the estimation of WACCs for two competitors and opportunities to reflect upon how business risk drives cost of capital. “Phon-Tech Corp.” (UVA-F-1161) is a simplified version of “Teletech Corporation, 1996” (case 15), excluding consideration of levered beta and segment capital structures. The case was prepared to serve as part of an introduction to estimating investors’ required rates of return. It would best follow one or two class sessions introducing techniques for estimating WACC. The numerical calculations required are light, though some of the subtleties about the use of risk-adjusted hurdle rates will require time for the novice to absorb. The case can be used to pursue a variety of teaching objectives, including the following: • • • • Extend risk-return (i.e., mean-variance) analysis to corporate finance Survey classic arguments for and against the use of risk-adjusted hurdle rate systems Assess the assumptions and limitations of risk-adjusted hurdle...
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...Question 1 (a) rc, t is the increase rate of real US private consumption. re, t is the real return of the share price index of the New York Stock Exchange after CPI adjustment. rf, t is the real return of the Long-term government bond yield after CPI adjustment. (b) The plotting graph indicated that there is no obvious trend of the increase rate of real US private consumption. The rate reached its lowest point in 1974. There is no clear trend of real return of the share price index of the New York Stock Exchange after CPI adjustment. It is worth to notice that it reached its lowest return in 1974 too, which is about -0.38. The graph of the real return of the Long-term government bond yield after CPI adjustment is different from the above two: before 1980, the return was mainly below 0.02 and reached its lowest return in 1974. After 1980 there was a dramatic rise of the return until 1985. Then it decreased a little and fluctuated around 0.04. Question 2 (a) From the above table we can obtain the Standard Deviation of rc, t equals 0.017232. This is the Std. Dev. estimation with degree of freedom adjustment. In order to get the variance without any degree of freedom adjustment, the equation below must be used to make the adjustment: Var (y without degree of freedom) = T-1T *S2y Thus the variance of rc, t can be calculated: δ2c =35-135 *0.0172322 =0.000288 The variance of the increase rate of real US private consumption is about 0.000288. It measures...
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...Case 12 “Best practices “in Estimating the Cost of Capital The Cost of Capital The purpose of this case is to present evidence on how some of the most financially sophisticated companies and financial advisers estimate capital costs. This evidence is valuable in several respects. First, it identifies the most important ambiguities in the application of cost-of-capital theory, setting the stage for productive debate and research on their resolution. Second, it helps interested companies benchmark their cost-of-capital estimation practices against best-practice peers. Third, the evidence sheds light on the accuracy with which capital costs can be reasonably estimated, enabling executives to use the estimates more wisely in their decision-making. Fourth, it enables teachers to answer the inevitable question, “How do companies really estimate their cost of capital?” Survey Findings The detailed survey results appear in Exhibit 2. The estimation approaches are broadly similar across the three samples in several dimensions. • Discounted Cash Flow (DCF) is the dominant investment-evaluation technique. • WACC is the dominant discount rate used in DCF analyses. • Weights are based on market not book value mixes of debt and equity.8 • The after-tax cost of debt is predominantly based on marginal pretax costs, and marginal or statutory tax rates. • The CAPM is the dominant model for estimating the cost of equity. Some firms mentioned other multi-factor asset-pricing models...
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...sales. Contingent claim valuation, uses option pricing models to measure the value of assets that share option characteristics. Aswath Damodaran 3 Valuation Models Asset Based Valuation Discounted Cashflow Models Relative Valuation Contingent Claim Models Liquidation Value Stable Replacement Cost Two-stage Three-stage or n-stage Current Equity Firm Sector Option to delay Option to expand Young firms Option to liquidate Equity in troubled firm Market Normalized Earnings Book Revenues Value Sector specific Undeveloped land Equity Valuation Models Dividends Firm Valuation Models Patent Undeveloped Reserves Free Cashflow to Firm Cost of capital approach APV approach Excess Return Models Aswath Damodaran 4 Discounted Cashflow Valuation: Basis for Approach CF1 CF2 CF3 CF4 CFn + + +...
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...Miller jointly received the 1990 Nobel Memorial Prize in Economics for this contribution to the field of financial economics. Fischer Black developed another version of CAPM, called Black CAPM or zero-beta CAPM that does not assume the existence of a riskless asset. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM (Fama & French, 1982). CAPM has become very attractive as a tool that measures risk to possible in relation to expected return, although it is still widely used for estimating the cost of capital for firms and evaluating the performance of managed portfolios. While CAPM is accepted academically, there is empirical evidence suggesting that the model is not as profound as it may have first appeared to be. CAPM’s empirical fallings arise theoretically from many over simplified assumptions made by the model. This has made it difficult to implement valid test for this model (Kristina Zucchi, 2015). For example according to the CAPM model the risk from an asset such as stock should be measured relative to a comprehensive, but this principle can include such as human capital not just financially traded assets. It is also unclear as to whether if we should narrow the scope of this to financially traded assets or expand this to include other financial instrument such as bonds, and...
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.../ 29 Testing the CAPM: Background CAPM is a model It is useful because it tells us what expected returns should be. We want test whether it is a good model. Remember, whenever we test a model we are jointly testing market efficiency. Testable Implication of the CAPM The market portfolio is the tangency portfolio: E (ri ) = rf + βiM [E (rM ) − rf ], where βiM = cov(ri , rM ) σ 2 (rM ) Karl B. Diether (Fisher College of Business) Testing the CAPM 2 / 29 Testing the CAPM: The Approach Average Return vs CAPM Prediction The most common approach is two compare historical average returns to the CAPM’s prediction. We compute the CAPM’s estimated prediction by estimating beta (β), the market premium (E (rM ) − rf ), and the risk free rate (rf ). We want the estimated prediction error (called α): ˆ αi = ¯i − CAPM Prediction ˆ r ˆ r = ¯i − ¯f − βim (¯M − ¯f ) r r r The CAPM and α ˆ α will not always be zero even if the CAPM is true. Why? ˆ What can we say about prediction error if the CAPM holds? Karl B. Diether (Fisher College of Business) Testing the CAPM 3 / 29 A Good Strategy? Stock tip: Invest in mid-cap stocks. It is a good strategy because everyone ignores mid-cap stocks. Investor want blue chips, or they want to invest in small start-up companies with growth opportunities. Therefore, mid-cap stocks tend to be undervalued and have high returns on average. Testing Is this true? What do you think of this strategy? How can we test this empirically...
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...------------------------------------------------- Chapter 2 – ESTIMATING DISCOUNT RATES (starting at page 28) Cost of Equity * Can be measured with: * CAPM: risk measured relative to a single market factor * Arbitrage pricing model: cost of equity is determined by the sensitivity to multiple unspecified economic factors * Multiple factor model: sensitivity to macroeconomic variables is used to measure risk i. Estimate Risk-Free Rate ii. Estimate Risk Premium iii. Estimate Beta * Unlevered beta: the beta a company would have if it were all equity financed * CAPM: beta estimated relative to market portfolio * APM / Multi-factor: betas relative to each factor have to be measured. There are 3 estimation approaches: * Historical market betas (most used): regressing stock returns against market returns. Analysts often obtain these from estimation services. * Fundamental betas (bottom-up): betas determined by (i) type of businesses the firm in is, (ii) degree of operating leverage (fixed costs relative to total costs), (iii) firm’s financial leverage. * Accounting betas: look at changes in the firms’ earnings vs. changes in earnings for the market. * For private firms, may have to estimate betas using comparable publicly traded firms. * Estimating the cost of equity * Cost of equity is the return shareholders expect to make. If firms don’t deliver this, the SHs become restive and rebellious. * CAPM: Expected return = riskfree rate +...
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... Further Improvements (5) Efficiency Gains (3) User’s Perspective Your Grade Financial Modelling Joaquim Cadete 2 Risk Management: the main concern… Counterparty risk Credit risk Interest rate risk Capital risk and solvency Funding risk Risk Management Reputational risk Foreign exchange risk Off-balance sheet risk Operational risk Financial Modelling Market or trading risk Sovereign risk Regulatory risk Joaquim Cadete 3 Risk and Return Theories Diversification Standard deviation of portfolio return σ Unsystematic or diversifiable risk Systematic or Total risk market-related risk Number of holdings Financial Modelling Joaquim Cadete 4 Interest rate risk: the first layer of volatility… Operational Risk: Betas. Operational risk Systematic risk or nondiversifiable risk Unsystematic or diversifiable risk A Total Risk Shareholders’ risk A E E A E A= E Financial Modelling Joaquim Cadete 5 Interest rate risk: the first layer of volatility… Operational Risk: Betas. If A = E, then RA = Rf + βA (RM – Rf). And 1 = = − Assuming that the company is already at the stage of infinite stable growth. Financial Modelling Joaquim Cadete 6 Interest rate risk: the first layer of volatility… 200% 175% Market Value as % of the Initial Investment 1 150% 125% 100% 75% 50% 1: APV...
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...Marriott Case Study In this summary, we are going to discuss Marriott’s strategy points for maintaining its status as a premier growth company, weighted average cost of capital (WACC), divisional hurdle rates, and justification of numbers used in calculations. Marriott’s strategic plan to maintain its status as a premier growth company can be broken into four distinct areas: managing (as opposed to owning) hotel assets, choosing investments that increase shareholder value, optimizing the use of debt within the capital structure, and repurchasing undervalued shares. The choice to manage hotel assets has the benefit of freeing up capital to invest in other opportunities. This allows for more growth throughout the company. Investing in projects that increase shareholder value through the use of a discounted cash flow technique also enhances growth opportunities. Optimizing the debt portion of their capital structure allows them to focus on the ability to service their debt, instead of targeting a debt to equity ratio. This ensures that their capital is efficiently utilized. The final financial strategy to discuss here is Marriott’s repurchasing of undervalued shares. This allows for more retained earnings, which again speaks to their efforts to efficiently utilize capital. All four of these strategic decisions ensure that capital is efficiently utilized towards growth, which is clearly in line with the company’s goal of remaining a premier growth company. Marriott uses the weighted...
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