ESTIMATING  HURDLE  RATES  I:  DEFINING  &  MEASURING  RISK  

Risk  =  Danger  +  Opportunity  

The Investment DecisionInvest in assets that earn a return

greater than the minimum acceptable hurdle rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and

equity to fund your operations

The Dividend DecisionIf you cannot find investments that make your minimum acceptable rate, return the

cash to owners of your business

Hurdle Rate4. Define & Measure Risk5. The Risk free Rate6. Equity Risk Premiums7. Country Risk Premiums8. Regression Betas9. Beta Fundamentals10. Bottom-up Betas11. The "Right" Beta12. Debt: Measure & Cost13. Financing Weights

Investment Return14. Earnings and Cash flows15. Time Weighting Cash flows16. Loose Ends

Financing Mix17. The Trade off18. Cost of Capital Approach19. Cost of Capital: Follow up20. Cost of Capital: Wrap up21. Alternative Approaches22. Moving to the optimal

Financing Type23. The Right Financing

Dividend Policy24. Trends & Measures25. The trade off26. Assessment27. Action & Follow up28. The End Game

Valuation29. First steps30. Cash flows31. Growth32. Terminal Value33. To value per share34. The value of control35. Relative Valuation

Set Up and Objective1: What is corporate finance2: The Objective: Utopia and Let Down3: The Objective: Reality and Reaction

36. Closing Thoughts

3

First  Principles  

The Investment DecisionInvest in assets that earn a

return greater than the minimum acceptable hurdle

rate

The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to

fund your operations

The Dividend DecisionIf you cannot find investments

that make your minimum acceptable rate, return the cash

to owners of your business

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used

to fund it.

The return should reflect the

magnitude and the timing of the

cashflows as welll as all side effects.

The optimal mix of debt and equity

maximizes firm value

The right kind of debt

matches the tenor of your

assets

How much cash you can

return depends upon

current & potential

investment opportunities

How you choose to return cash to the owners will

depend on whether they

prefer dividends or buybacks

Maximize the value of the business (firm)

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The  noGon  of  a  benchmark    

¨  Since  financial  resources  are  finite,  there  is  a  hurdle  that  projects  have  to  cross  before  being  deemed  acceptable.  

¨  This  hurdle  will  be  higher  for  riskier  projects  than  for  safer  projects.  

¨  A  simple  representaGon  of  the  hurdle  rate  is  as  follows:    Hurdle  rate        =    Riskless  Rate  +  Risk  Premium  

¨  The  two  basic  quesGons  that  every  risk  and  return  model  in  finance  tries  to  answer  are:  ¤  How  do  you  measure  risk?  ¤  How  do  you  translate  this  risk  measure  into  a  risk  premium?  

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What  is  Risk?  

¨  Risk,  in  tradiGonal  terms,  is  viewed  as  a  ‘negaGve’.  Webster’s  dicGonary,  for  instance,  defines  risk  as  “exposing  to  danger  or  hazard”.  The  Chinese  symbols  for  risk,  reproduced  below,  give  a  much  beXer  descripGon  of  risk:  

危机    ¨  The  first  symbol  is  the  symbol  for  “danger”,  while  the  second  

is  the  symbol  for  “opportunity”,  making  risk  a  mix  of  danger  and  opportunity.  You  cannot  have  one,  without  the  other.  

¨  Risk  is  therefore  neither  good  nor  bad.  It  is  just  a  fact  of  life.  The  quesGon  that  businesses  have  to  address  is  therefore  not  whether  to  avoid  risk  but  how  best  to  incorporate  it  into  their  decision  making.  

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AlternaGves  to  the  CAPM  

The risk in an investment can be measured by the variance in actual returns around an expected return

E(R)

Riskless Investment Low Risk Investment High Risk Investment

E(R) E(R)

Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.

The CAPM The APM Multi-Factor Models Proxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:

If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors

Beta of asset relative toMarket portfolio (froma regression)

Betas of asset relativeto unspecified marketfactors (from a factoranalysis)

Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.

Betas of assets relativeto specified macroeconomic factors (froma regression)

In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)

Equation relating returns to proxy variables (from aregression)

Step 1: Defining Risk

Step 2: Differentiating between Rewarded and Unrewarded Risk

Step 3: Measuring Market Risk

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LimitaGons  of  the  CAPM  

1.  The  model  makes  unrealisGc  assumpGons  2.  The  parameters  of  the  model  cannot  be  esGmated  precisely  

-­‐  DefiniGon  of  a  market  index  -­‐  Firm  may  have  changed  during  the  'esGmaGon'  period'  

3.  The  model  does  not  work  well  -­‐  If  the  model  is  right,  there  should  be      

 a  linear  relaGonship  between  returns  and  betas    the  only  variable  that  should  explain  returns  is  betas  

-­‐  The  reality  is  that    the  relaGonship  between  betas  and  returns  is  weak      Other  variables  (size,  price/book  value)  seem  to  explain  differences  in  returns  beXer.  

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Why  the  CAPM  persists…  

¨  The  CAPM,  notwithstanding  its  many  criGcs  and  limitaGons,  has  survived  as  the  default  model  for  risk  in  equity  valuaGon  and  corporate  finance.  The  alternaGve  models  that  have  been  presented  as  beXer  models  (APM,  MulGfactor  model..)  have  made  inroads  in  performance  evaluaGon  but  not  in  prospecGve  analysis  because:  ¤  The  alternaGve  models  (which  are  richer)  do  a  much  beXer  job  than  the  CAPM  in  

explaining  past  return,  but  their  effecGveness  drops  off  when  it  comes  to  esGmaGng  expected  future  returns  (because  the  models  tend  to  shid  and  change).  

¤  The  alternaGve  models  are  more  complicated  and  require  more  informaGon  than  the  CAPM.  

¤  For  most  companies,  the  expected  returns  you  get  with  the  the  alternaGve  models  is  not  different  enough  to  be  worth  the  extra  trouble  of  esGmaGng  four  addiGonal  betas.  

9

Gauging  the  marginal  investor:  Disney  in  2009  

10

Extending  the  assessment  of  the  investor  base  

¨  In  all  five  of  the  publicly  traded  companies  that  we  are  looking  at,  insGtuGons  are  big  holders  of  the  company’s  stock.  

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6ApplicaGon  Test:  Who  is  the  marginal  investor  in  your  firm?  

¨  Looking  at  the  breakdown  of  stockholders  in  your  firm,  consider  whether  the  marginal  investor  is  ¤  An  insGtuGonal  investor    ¤  An  individual  investor  ¤  An  insider  

B  DES  Page  3  PB  Page  13  

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Read  Chapter  3  

Task  Who  is  the  marginal  investor  in  your  firm?