RISK AND RETURN RELATIONSHIP AND COST OF CAPITAL Lesson 5 Castellanza, 19 th October, 2011 Corporate Finance

Executive Summary Risk and return relationship: the financial value of time The cost of capital Capital Asset Pricing Model (CAPM) Markovitz Portfolio Theory

Corporate Finance Return Risk Time FINANCIAL DECISIONS (i.e. capital budgeting/ investment decisions) Key factors influencing financial decisions

Corporate Finance 1.RETURN r = r f + Expected Risk Premium Where: “r f ” = Free Risk Return “Expected Risk Premium” = extra expected return required by adverse risk investors for taking on risk 2.RISK -Risk in investment means that future returns are UNPREDICTABLE -Risk states the possibility that Effective Return can “deviates” from Expected Return (the spread of possible returns is measured by standard deviation) Key factors influencing financial decisions

Corporate Finance 3.TIME Financial value of time is connected to: Risk (it is propotional to the probability that expected return will be effectively realized) Flexibility Temporal distribution of value Key factors influencing financial decisions

Corporate Finance DEFINITION: We define the company cost of capital as “the expected return on portfolio of all the company’s existing securities”. That portfolio usually includes DEBT as well as EQUITY. ASSUMPTIONS: Every company’s financial fonts have a cost The returns to investors vary according to the risk the have borne RISK = COST OF CAPITAL The cost of capital

Corporate Finance The cost of Equity capital (Ke) 1/2 In general terms, in order to estimate “Ke” it is necessary to consider the OPPORTUNITY COST, defined as “the expected return on other securities with the same degree of risk”. It means that: A potential shareholder will invest in a company’s capital only if the expected return is at least equal to the return that can be earned in the capital market on securities of comparable risk. Ke = r f + Risk Premium

Corporate Finance When it is possible to estimate the enterprise market value, the correct ratio to calculate “Ke” is: Ke = EPS / P* Where: EPS = Earning per Share P*= Market Value The cost of Equity capital (Ke) 2/2

Corporate Finance Kd = i (1-t) Where: i = Interest Rate on Debt (1-t) = Fiscal Effect due to interest tax deductibility The cost of Debt (Kd)

Corporate Finance The WACC is the average rate of return demanded by investors in the company’s debt and equity securities: WACC = [Ke E / (E + D)] + [Kd D / (E + D)] Where: E = Equity D = Debt Ke > WACC > Kd The Weighted-Average Cost of Capital (WACC)

Corporate Finance The Risk/Return relationship 1/4 r = r f + Expected Risk Premium Where: “r f ” = Free Risk Return “Expected Risk Premium” = extra expected return required by adverse risk investors for taking on risk From which: Expected Risk Premium = r – r f

Corporate Finance HOW TO ESTIMATE RETURN FREE RISK (r f ) AND EXPECTED RISK PREMIUM?  r f = the interest rate free risk is conventionally the return on Treasury bills: it is fixed and unaffected by what happens to the market.  Expected Risk Premium = r – r f = β · (r m – r f ) (Market Risk)(Market Risk Premium) The Risk/Return relationship 2/4

Corporate Finance The Risk/Return relationship 3/4 THE CAPITAL ASSET PRICING MODEL (CAPM) It states that in a competitive market the expected risk premium on each investment is proportional to its Beta. Expected Return on Investment Security market line Treasury Bills (β = 0) Market portfolio (β = 1) rfrf rmrm β …This means that each investment should lie on the sloping security market line connecting Treasury Bills and the Market Portfolio. 01

Corporate Finance THE CAPM CONCLUSION An investor can always obtain an Expected Risk Premium of β (r m –r f ) by holding a mixture of the Market Portfolio and a Risk Free loan The most efficient way to decrease risk is DIVERSIFICATION The Risk/Return relationship 4/4

Corporate Finance The Markovitz Portfolio Theory Markovitz Theory is based on the concept that DIVERSIFICATION REDUCES VARIABILITY (standard deviation = risk). The market portfolio is made up of individual stocks, but its variability doesn’t reflect the average variability of its components. Diversification works because prices of different stocks do not move exactly together. VARIABILITY = RISK =COST OF CAPITAL

Corporate Finance Unique Risk and Market Risk 1/3 The risk that potentially can be eliminated by diversification is called UNIQUE RISK (also called SPECIFIC RISK or UNSYSTEMATIC RISK). It stems from the fact that many of the perils that surround an individual company are peculiar to that company and perhaps its immediate competitors. It is impossible to totally eliminate risk, because it is impossible to have stock prices perfectly correlated. …That is why… … Diversification reduces risk rapidly at first, than more slowly, untill a point in which the effect on standard deviation (risk) is null.

Corporate Finance There is also some risk that it is impossible to avoid, regardless of how much a company diversify.This risk is generally known as MARKET RISK (also called SYSTEMATIC RISK). Market risk stems from the fact that there are other economywide perils that treaten all businesses. … That is why… … Stocks have a tendency to move together, and investors are exposed to market uncertainities, no matter how many stocks they hold. Unique Risk and Market Risk 2/3

Corporate Finance Unique Risk and Market Risk 3/3 Market Risk Unique Risk Number of securities Portfolio standard deviation

Corporate Finance How to estimate the Market Risk (β) From CAPM:  Expected Risk Premium = r – r f = β · (r m – r f ) MARKET RISK: the Beta of an individual security measures its SENSITIVITY to market movements. ß =  % r e /  % r m Where: “r e ” = Expected Return from security “r m “ = Expected Return on Market

Corporate Finance The meaning of “Beta” MARKET RISK: the Beta of an individual security measures its SENSITIVITY to market movements.  Stocks with β > 1 = tend to amplify the overall movements of the market;  Stocks with 0< β <1 = tend to move in the same direction as the market, but not as far.

Corporate Finance Return on Stock A (%) Return on Market (%) The Return on Stock A changes on average by 1.26% for each additional 1% change in the Market Return. Beta is therefore 1.26 β - When the market rises an extra 1%, stock A price will rise by 1.26% - When the market falls an extra 2%, stock A price falls an extra 2X1.26= 2.52% The meaning of “Beta”

Corporate Finance The risk of a well-diversified portfolio depends on the Market Risk of the securities included in the portfolio How do individual securities affect portfolio risk?