J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk and Investment Decisions April 23, 2007 (LA), or April 12, 2007 (OCC)

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk and Investments u All value in finance is present value of expected future cash flows discounted at the risk-adjusted discount rate u Estimating expected future cash flows as in Baldwin example (Chapter 7) or Sheet II of PVFIRM05 u CAPM is one way to choose a discount rate which we explored last week

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Expected versus Required Rate u Investors require compensation for systematic risk u If expected returns from a project or an asset is higher than the required rate, it has positive net present value u Equivalently, its internal rate of return is higher than the opportunity rate u Security market line is relation between systematic risk and required rates in CAPM

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Security Market Line (SML) Systematic Risk Expected Return 0 RFRF =1=1 RMRM SML        E(R) > Required Rate Accept Reject E(R) < Required Rate

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Estimating the Cost of Equity u The cost of equity is extremely important and all methods of estimating it may be biased or misleading u The only option is to estimate expected returns several ways u We explore three ways: –CAPM (by far the most common) –Reviewing past performance –The dividend-growth model

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Cost of Equity Capital (CAPM): 1 u Easily computed u Use risk-free rate and premium on average stock (in text Treasury bill rate and 8.5%) u For stock i with a given beta - u Need only know a stock’s beta

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Risk Premium Issues u Risk premium relative to Treasury bills as in text (p. 307) or long-term Treasury bonds as in Valuation by Copeland et al u Risk premium certainly varies through time and is difficult to estimate u Fama and French (1992) find that beta coefficients do not explain differences in returns across stocks but that BV/MVand market cap do

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Equity Betas and Asset Betas u An all-equity firm’s beta is determined by the assets the firm owns u Returns from an assets are from revenues, costs, and necessary investments in fixed and working capital (free cash flows) u Correlation of asset returns depend on correlation of revenues and market factors u Variance of returns depends on fixed versus variable costs, or operating leverage

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Estimating Asset CAPM Betas u Theoretical determinants –Revenue variability and covariability –Costs and operating leverage »Fixed costs »Variable costs »Operating leverage u Industry betas u “Divisional” and “pure play” betas

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Operating Leverage Volume $ 0 Revenues Firm 1 Costs Firm 2 Costs FC-2 FC-1 Initial Operating Income Initial Volume Breakeven Points B2B2 B1B1

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Leveraged Equity and Betas u Fixed financing costs cause financial leverage to increase variability of equity returns u Return on equity is riskier in the presence of fixed payments from operating income like interest u If interest or other financial claims are completely fixed, their ß = 0

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Leveraged Equity Betas u Portfolio beta is weighted average of betas u Firm’s asset beta is a portfolio of debt and equity claims on total market value of asset u Assuming β Debt = 0 we have

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Asset Betas with Taxes u Tax deductibility of interest modifies “leverage effect of debt” and reduces impact of debt-equity ratio on equity betas (see footnote page 351): u PVFIRM05 makes adjustments in beta to recalculate equity beta with changes in debt ratio

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Historical Returns & Cost of Equity: 2 u We seek the expected future rate of return on the firm’s equity u Historical experience may be useful in assessing a firm’s expected future performance, especially with established firms u In any case, any analysts should know how the firm analyzed has performed in the past u Can use Wharton Common Stock Return data

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Growth Model & Cost of Equity: 3 u In Chapter 5 (p. 142), we saw: This is often referred to as the Gordon growth model u The cost of equity can be estimated as the expected dividend yield and the expected growth rate of dividends using:

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Firm versus Project Risk u Some firms invest in projects with very different asset risks –General Motors, Boeing, General Electric –Firm can be viewed as a portfolio of investments, although value from diversification can be questioned u Appropriate risk adjustment is for the project u Firm-wide target rates are only appropriate if the project has the same risk as the firm in terms of asset risk and financing risk

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Returns: Debt and Equity u Each claimant on the income from the firm has expected returns based on the degree of risk associated with the income from the claims u Management of firms must satisfy expectations of providers of capital to maintain value of firm u If higher returns are earned, shareholders gain

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Weighted-Average Cost of Capital (WACC) u Overall cost of capital (debt and equity) is the weighted-average of expected returns on debt and equity u Interest on debt is a tax-deductible expense thus after-tax cost of debt is r B (1-T C ) where r B is expected return on debt and T C tax rate u The WACC is therefore

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Using WACC for Investments u WACC is widely used in corporations as the discount rate for projects or a cutoff rate of return u Discount rates should reflect the risk appropriate to the project being analyzed u WACC is appropriate only when –Project has same risk as the firm –Project will not change capital structure of the firm

J. K. Dietrich - GSBA 548 – MBA.PM Spring 2007 Class 13 u Read Chapter13 u Do assigned problems u Complete Part 3 of group project u Group should begin assignment of tasks in preparing Final Summary (due on date of final) to assure that the group project is complete and a finished product