bml321 - wk 2 slides 012511
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Risk & Return (ch 8) Stocks (ch 9) Cost of Capital (ch 10)
8-1
BML 321 – Week 3
Financial Management
Risk and Rates of Return
Chapter 8
Stand-Alone Risk Portfolio Risk Risk and Return: CAPM/SML
8-2
Selected Realized Returns, 1926-2007
Average Standard
Return Deviation
Small-company stocks 17.1%32.6%
Large-company stocks 12.320.0
L-T corporate bonds 6.2 8.4
L-T government bonds 5.8 9.2
U.S. Treasury bills 3.8 3.1Source: Based on Stocks, Bonds, Bills, and Inflation: (Valuation Edition) 2008 Yearbook (Chicago: Morningstar, Inc., 2008), p28.
8-3
Comparing Standard Deviations
Corporate Bonds
Prob.
T-bill
Stocks
0 3.8 6.2 12.3 Rate of Return (%)
8-4
Probability Distributions
Coefficient of Variation (CV)
8-5
A standardized measure of dispersion about the expected value, that shows the risk per unit of return.
r̂
return Expecteddeviation Standard
CV
N
1iirr̂
return of rate xpected r̂
iP
E
Calculating Portfolio Expected Return
9.3% (6.2%) 0.5 (12.3%) 0.5 ˆ
rw r̂
:average weighteda is ˆ
p
N
1i
i
^
ip
p
r
r
8-6
Partial Correlation, ρ = +0.35
8-7
Illustrating Diversification Effects of a Stock Portfolio
8-8
Stand-alone risk =
Market risk + Diversifiable risk
Diversifiable risk – portion that can be eliminated through proper diversification.
Market risk – portion that cannot be eliminated through diversification. Measured by beta.
Capital Asset Pricing Model (CAPM)
Model linking risk and required returns.
ri = rRF + (rM – rRF)bi
8-9
If beta = 1.0, as risky as the average stock.
If beta > 1.0, riskier than average.
If beta < 1.0, less risky than average.
Most stock betas are between 0.5 to 1.5.
Illustrating the Security Market Line
.T-bills
SML
rM = 10.5
rRF = 5.5
SML: ri = 5.5% + (5.0%)bi
ri (%)
Risk, bi
8-10
-1 0 1 2
Stocks and Their Valuation
Chapter 9
Features of Common Stock Determining Common Stock
Values Preferred Stock
9-11
Discounted Dividend Model
Value of a stock is the present value of the future dividends expected to be generated by the stock.
)r(1D
... )r(1
D
)r(1D
)r(1
D P̂
s3
s
32
s
21
s
10
9-12
grD
grg)(1D
P̂s
1
s
00
Gordon Growth Model:
Where g = (1 – k) * ROEAnd r is derived from CAPM equation.
The dividend stream would be a perpetuity.
What would the expected price today be, if g = 0?
$15.38 0.13$2.00
r
PMT P̂0
2.00 2.002.00
0 1 2 3rs = 13%
9-13
Supernormal Growth: What if g = 30% for 3 years before achieving long-run growth of 6%?
rs = 13%
g = 30% g = 30% g = 30% g = 6%
2.301
2.647
3.045
46.114
54.107 =
0 1 2 3 4
D0 = 2.00 2.600 3.380 4.394 4.658
P̂0
$66.54 06.0 0.13
4.658 P̂3
9-14
Components of return
Dividend yield = D1/P0
Capital gains yield = (P1 – P0)/P0
Total return (rs)
= Dividend yield + Capital gains yield
9-15
Corporate Valuation Model(aka Free Cash Flow Model)
Value of the entire firm equals the present value of the firm’s free cash flows.
1.Find the market value (MV) of the firm, by finding the PV of the firm’s future FCFs.
2.Subtract MV of firm’s debt and preferred stock to get MV of common stock.
3.Divide MV of common stock by the number of shares outstanding to get intrinsic stock price (value). 9-16
Firm Multiples Method
Analysts often use the following multiples to value stocks. P/E
P/CF
P/Sales
9-17
Preferred Stock
Hybrid security.
Like bonds, fixed dividend that must be paid before common stock dividends are paid.
However, payments can be skipped or postponed in unprofitable years.
9-18
pr
D Vp
The Cost of Capital
Chapter 10
Sources of Capital Component Costs WACC Adjusting for Flotation Costs Adjusting for Risk
10-19
What sources of long-term capital do firms use?
Long-Term Capital
Long-Term Debt
Preferred Stock
Common Stock
Retained Earnings
New Common
Stock
10-20
Calculating the Weighted Average Cost of Capital
WACC = wdrd(1 – T) + wprp + wcrs
The w’s refer to the firm’s capital structure weights.
The r’s refer to the cost of each component.
10-21
Component Cost of Debt
WACC = wdrd(1 – T) + wprp + wcrs
10-22
rd is the marginal cost of debt capital.
Often estimated as YTM on long-term debt
Why tax-adjust; i.e., why rd(1 – T)?
Example: 15-yr, 12% bond selling for $1154.INPUTS
OUTPUT
N I/YR PMTPV FV
30
5
60 1000-1154
Component Cost of Preferred Stock
WACC = wdrd(1 – T) + wprp + wcrs
rp is the marginal cost of preferred stock, which is the return investors require on a firm’s preferred stock.
Preferred dividends are not tax-deductible, so no tax adjustments necessary. Just use nominal rp.
Our calculation ignores possible flotation costs.
10-23
Component Cost of Equity
WACC = wdrd(1 – T) + wprp + wcrs
10-24
rs is the marginal cost of common equity using retained earnings.
The rate of return investors require on the firm’s common equity using new equity is re.
What are flotation costs?
Three Ways to Determine the Cost of Common Equity, rs
CAPM: rs = rRF + (rM – rRF)b
DCF: rs = (D1/P0) + g
Own-Bond-Yield-Plus-Risk-Premium:
rs = rd + RP
10-25
Find the Cost of Common Equity Using the CAPM Approach
The rRF = 7%, RPM = 6%, and the firm’s beta is 1.2.
rs = rRF + (rM – rRF)b
= 7.0% + (6.0%)1.2 = 14.2%
10-26
D0 = $4.19, P0 = $50, and g = 5.
D1 = D0(1 + g)
= $4.19(1 + 0.05)
= $4.3995
rs = (D1/P0) + g
= ($4.3995/$50) + 0.05
= 13.8%10-27
Find the Cost of Common Equity Using the DCF Approach
rd = 10% and RP = 4.
This RP is not the same as the CAPM RPM.
This method produces a ballpark estimate of rs, and can serve as a useful check.
rs = rd + RP
rs = 10.0% + 4.0% = 14.0% 10-28
Find rs Using the Own-Bond-Yield-Plus-Risk-Premium Method
What is a reasonable final estimate of rs?
Method Estimate
CAPM 14.2%
DCF 13.8%
rd + RP 14.0%
Average 14.0%
10-29
Ignoring flotation costs, what is the firm’s WACC?
WACC = wdrd(1 – T) + wprp + wcrs
= 0.3(10%)(0.6) + 0.1(9%) + 0.6(14%)
= 1.8% + 0.9% + 8.4%
= 11.1%
10-30
What factors influence a company’s composite WACC?
Market conditions.
The firm’s capital structure and dividend policy.
The firm’s investment policy. Firms with riskier projects generally have a higher WACC.
Should the company use the composite WACC as the hurdle rate for each of its projects?
10-31