FINA 4330 The Capital Asset Pricing Model (CAPM) Lecture 15 Managerial Finance FINA 4330 The Capital Asset Pricing Model (CAPM) Lecture 15

Simplifying Assumptions Individuals can trade securities without regard to fees, taxes, and other frictions. Individuals get any relevant information about the firms they are interested in costlessly. Individual investors can borrow or save at the same riskless rate equal the the “riskfree rate”

Summary and Conclusions The contribution of a security to the risk of a well-diversified portfolio is proportional to the covariance of the security's return with the market’s return. This contribution is called the beta. The CAPM states that the expected return on a security is positively related to the security’s beta:

Estimating b with regression Characteristic Line Security Returns Slope = bi Return on market % Ri = a i + biRm + ei

Practical Issues in CAPM Forecasting Beta The problem is that you assume your estimate of Beta is the true value of Beta “regression toward one” Allow for extremes What Time Horizon 2 years of weekly, or 5 years of monthly

The Security Market Line Risk free interest rate? The Market Risk Premium 5.7%

Firm valuation We will want to value the firm using the Discounted Cash Flow (DCF) method. Three issues: What do you want to discount? How do you project this over time? How do you discount it?

Basic Valuation What do you want to Discount? How do you project these? How do you discount these?

Basic Valuation What do you want to Discount? Free Cash Flow How do you project these? How do you discount these?

Basic Valuation What do you want to Discount? Free Cash Flow How do you project these? From Historical Data How do you discount these?

Basic Valuation What do you want to Discount? Free Cash Flow How do you project these? From Historical Data How do you discount these? The Cost of Capital or (Weighted Average)

Free Cash Flow Start with EBIT Subtract Taxes Leaves EBIT(1-t) = Unlevered (Operating) Net Income Plus Depreciation Less Capital Expenditures Less Increases in Working Capital Bottom Line: = Free Cash Flow

Example: Current Sales = $60 Cost of Goods Sold 25 Gross Profit 35 Less Operating Expenses 9 Less Depreciation 6 EBIT 20 Less Income Tax Rate (@ 35%) 7 Operating (Unlevered) NI 13 Plus Depreciation 6 Less Capital Expenditures 2 Less Increases in Working Capital 1 Free Cash Flow 16

Discount Rate Conceptually: V = Present Value of the firm’s Cash flows, discounted by a number called the “cost of capital” Basically it is the IRR of the Firm. Conceptually, you want to discount by a rate that reflects the risk of the firm’s operating Cash Flow.

How do you estimate this Weighted Average Cost of Capital Once you have the stream of Cash Flows generated by the firm, the next problem is to determine how to discount it. The discount rate that makes the Value of the firm equal the firm’s cash flow is what we call the Cost of Capital. As a practical matter this can be approximated by the Weighted Average Cost of Capital (WACC)

WACC The WACC is defined as: rWACC = rE X (E/(E+D+P)) + rD(1-t) X (D/(E+D+P)) + rP X (P/(E+D+P)) The weighted average of the (after tax) cost of the component securities issued by the firm, weighted by the proportion of those securities issued by the firm. rE is the required return to the equity of the firm rD is the required return to the debt of the firm D is the (market value) of the debt issued by the firm E is the market value of the equity. t is the statutory tax rate. rP is the required return to the preferred stock of the firm P is the (market value) of the preferred stock issued by the firm

WACC Estimation Some of these variables are not easily estimated so we make some assumptions: To estimate D use the Book value of the debt. To estimate rD use the ratio of Total Interest payments to the total book value of the debt To estimate rE use the Capital Asset Pricing Model