Outline 3: Risk, Return, and Cost of Capital

1. Outline 3: Risk, Return, and Cost of Capital 3.1 Rates of Return 3.2 Measuring Risk 3.3 Risk & Diversification 3.4 Measuring Market Risk 3.5 Portfolio Betas 3.6 Risk and Return 3.7 CAPM and Expected Return 3.8 Security Market Line 3.9 Capital Budgeting and Project Risk 3.10 Cost of Capital 3.11 Weighted Average Cost of Capital (WACC) 3.12 Capital Structure 3.13 Required Rates of Return

2. Rates of Return

3. Rates of Return

4. Rates of Return

5. Market Indexes Dow Jones Industrial Average (The Dow) Value of a portfolio holding one share in each of 30 large industrial firms. Standard & Poor’s Composite Index (The S&P 500) Value of a portfolio holding shares in 500 firms. Holdings are proportional to the number of shares in the issues.

6. The Value of an Investment of $1 in 1900 Index Year End Source: Ibbotson Associates

7. Rates of Return Common Stocks (1900-2001)

8. Expected Return

9. Measuring Risk Variance - Average value of squared deviations from mean. A measure of volatility. Standard Deviation - Average value of squared deviations from mean. A measure of volatility.

10. Risk and Diversification Diversification - Strategy designed to reduce risk by spreading the portfolio across many investments. Unique Risk - Risk factors affecting only that firm. Also called “diversifiable risk.” Market Risk - Economy-wide sources of risk that affect the overall stock market. Also called “systematic risk.”

11. Risk and Diversification

12. Risk and Diversification

13. Stock Market Volatility 1926-2001 Std Dev

14. Risk and Diversification

15. Risk and Diversification

16. Measuring Market Risk Market Portfolio - Portfolio of all assets in the economy. In practice a broad stock market index, such as the S&P Composite, is used to represent the market. Beta - Sensitivity of a stock’s return to the return on the market portfolio.

17. Measuring Market Risk Example - Turbo Charged Seafood has the following % returns on its stock, relative to the listed changes in the % return on the market portfolio. The beta of Turbo Charged Seafood can be derived from this information.

18. Measuring Market Risk Example - continued

19. Measuring Market Risk Example - continued • When the market was up 1%, Turbo average % change was +0.8% • When the market was down 1%, Turbo average % change was -0.8% • The average change of 1.6 % (-0.8 to 0.8) divided by the 2% (-1.0 to 1.0) change in the market produces a beta of 0.8. • Perform a regression: • Turbo’ return = alpha +beta (market return)

20. Measuring Market Risk Example - continued

21. Portfolio Betas • Diversification decreases variability from unique risk, but not from market risk. • The beta of your portfolio will be an average of the betas of the securities in the portfolio. • If you owned all of the S&P Composite Index stocks, you would have an average beta of 1.0

22. Stock Betas

23. Risk and Return

24. Risk and Return

25. Market Portfolio Measuring Market Risk Market Risk Premium - Risk premium of market portfolio. Difference between market return and return on risk-free Treasury bills.

26. Measuring Market Risk CAPM - Theory of the relationship between risk and return which states that the expected risk premium on any security equals its beta times the market risk premium.

27. 1.0 Measuring Market Risk Security Market Line - The graphic representation of the CAPM.

28. Capital Budgeting & Project Risk • The project cost of capital depends on the use to which the capital is being put. Therefore, it depends on the risk of the project and not the risk of the company.

29. Capital Budgeting & Project Risk Example - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10)). A breakdown of the company’s investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used? 1/3 Nuclear Parts Mfr.. B=2.0 1/3 Computer Hard Drive Mfr.. B=1.3 1/3 Dog Food Production B=0.6 AVG. B of assets = 1.3

30. Capital Budgeting & Project Risk Example - Based on the CAPM, ABC Company has a cost of capital of 17%. (4 + 1.3(10)). A breakdown of the company’s investment projects is listed below. When evaluating a new dog food production investment, which cost of capital should be used? R = 4 + 0.6 (14 - 4 ) = 10% 10% reflects the opportunity cost of capital on an investment given the unique risk of the project.

31. Cost of Capital Cost of Capital - The return the firm’s investors expect to earn if they invested in securities with comparable degrees of risk. Capital Structure - The firm’s mix of long term financing and equity financing.

32. Cost of Capital Example Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?

33. Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?

34. Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital?

35. Cost of Capital Example - Geothermal Inc. has the following structure. Given that geothermal pays 8% for debt and 14% for equity, what is the Company Cost of Capital? Interest is tax deductible. Given a 35% tax rate, debt only costs us 5.2% (i.e. 8 % x .65).

36. WACC Weighted Average Cost of Capital (WACC) - The expected rate of return on a portfolio of all the firm’s securities. Company cost of capital = Weighted average of debt and equity returns.

37. WACC

38. WACC Three Steps to Calculating Cost of Capital 1. Calculate the value of each security as a proportion of the firm’s market value. 2. Determine the required rate of return on each security. 3. Calculate a weighted average of these required returns.

39. WACC • Taxes are an important consideration in the company cost of capital because interest payments are deducted from income before tax is calculated.

40. WACC Weighted -average cost of capital=

41. WACC Example - Executive Fruit has issued debt, preferred stock and common stock. The market value of these securities are $4mil, $2mil, and $6mil, respectively. The required returns are 6%, 12%, and 18%, respectively. Q: Determine the WACC for Executive Fruit, Inc.

42. WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil

43. WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given

44. WACC Example - continued Step 1 Firm Value = 4 + 2 + 6 = $12 mil Step 2 Required returns are given Step 3

45. WACC Issues in Using WACC Debt has two costs. 1)return on debt and 2)increased cost of equity demanded due to the increase in risk • Betas may change with capital structure(levered beta): • Corporate taxes complicate the analysis and may change our decision

46. Measuring Capital Structure • In estimating WACC, do not use the Book Value of securities. • In estimating WACC, use the Market Value of the securities. • Book Values often do not represent the true market value of a firm’s securities.

47. Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate.

48. Measuring Capital Structure Market Value of Bonds - PV of all coupons and par value discounted at the current interest rate. Market Value of Equity - Market price per share multiplied by the number of outstanding shares.

49. Measuring Capital Structure

50. Measuring Capital Structure If the long term bonds pay an 8% coupon and mature in 12 years, what is their market value assuming a 9% YTM?