Hurdle rates for Firms. 04/09/07 Ch. 7. Investment decision. Firms should invest in projects that creates value for the firm’s shareholders These are projects that yield a return greater than the minimum acceptable hurdle rate with adjustments for project riskiness. Investment decision.
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Hurdle rates for Firms
04/09/07
Ch. 7
Hurdle rate = Risk-free Rate + Risk Premium
where re is the cost of equity for a particular stock, rf is the risk free rate, and rm is the return on the market (S&P 500 index for our purposes)
How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund?
Go back to the previous example. Assume now that you are making the same choice but that you are making it in the aftermath of losing your job. Would you change your answer?
Index value = Expected index dividends
(RR on the index – growth rate in dividends)
RR on index – current risk-free rate
where a is the regression intercept and b is the slope of the regression.
Forward-looking beta = Regression beta * 0.67 + 1 * 0.33
a > rf (1-β) ....Stock did better than expected during regression period
a = rf (1-β)....Stock did as well as expected during regression period
a < rf (1-β)....Stock did worse than expected during regression period
α = a - rf(1-β)
If this measure is greater (less) than 0, the company performed better (worse) than investors expected during the period from which the regression data was obtained.
where
L = Levered Beta
u = Unlevered Beta
t = Corporate marginal tax rate
D = Debt Value
E = Equity Value
BT rd * (1 – tax rate)
rd = YTM * (1-t)
www.standardandpoors.com
rd = (30-yr. T-bond yield + spread) * (1-t)
rd = (30-yr. T-bond yield + spread) * (1-t)
Interest Coverage Ratio = EBIT / Interest Expenses
Interest Coverage RatioS&P Rating
> 8.5AAA
6.50 - 8.50AA
5.50 – 6.50A+
4.25 – 5.50A
3.00 – 4.25A-
2.50 – 3.00BBB
2.25 – 2.50BB+
2.00 – 2.25BB
1.75 - 2.00B+
1.50 – 1.75B
1.25 – 1.50B-
0.80 – 1.25CCC
0.65 – 0.80CC
0.20 – 0.65C
< 0.20 D
where rps, Dps, and Pps are the cost of preferred stock, dividend on preferred stock and current price per share of preferred stock, respectively.
Shares outstanding * current stock price
Market value of bonds (D)
into 2 distinct components:
*rd represents an after-tax cost of debt