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Interest Rates What we should know about the effects of change in various market interest rates over hospitality-related

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### Interest RatesWhat we should know about the effects of change in various market interest rates over hospitality-related F/S…

### In Feasibility Class, we will cover the essence of the whole thing in a hurry. (You get a taste)

Tad Hara, PhD

Rosen College of Hospitality Management

University of Central Florida

Introduction

- Hospitality & Tourism related businesses
- Capital intensive
- Large portion of fixed assets on the balance sheet.
- This structure necessitates students (=future managers) to understand
- Operating Leverages & related management techniques, such as yield management
- How the company obtained/secured the financing to match the capital requirements, and its implications
- How the change in market interest rates would affect business environment for his/her firm

Some Examples of What We Teach

- Capital Asset Pricing Model (CAPM)
- Learn the concept of relationship between “Risk & Return”
- Bond Pricing
- How change in market rates would affect the price of bonds (fixed income securities)
- Valuation of Stocks
- How the expected dividend, perceived growth rate, investor’s required rate of return would affect the theoretical price of stocks
- Feasibilities, and Valuation of Assets
- How the change in market rates would affect the value of the assets

1. Capital Asset Pricing Model

- Students will learn the relationship between Risk and Expected Return
- Risk is defined as “variance” of the expected return. Then what is the “risk free investment with which the variance is zero (=risk free)?
- “US Treasury” by definition

The Market Portfolio

- If we are very risk averse, can we hold an asset that has no risk?
- Risk-free asset has a guaranteed return.
- An example would be a security issued by the U.S. Government, such as a treasury bill.
- If the return is guaranteed, what is the standard deviation of the return for the risk-free asset?
- SD = 0
- The Market Portfolio is the theoretical representation of all the portfolios in the market. (=similar to “market average”)

Market Portfolio

US Treasury: Risk =0 with Guaranteed Return

Risk and ReturnExpected Return

Rm

Rf

0 1 2

Standard Deviation (=Risk)

Risk and Its Components

Systematic Risk + Unsystematic Risk = Total Risk

- Systematic risk relates to those factors that affect all assets in the market.
- Unsystematic risk relates to those factors that are specific to a particular asset.
- The market portfolio is so diversified that all unsystematic risk is removed as assets are added to it.
- Therefore, the only risk in the Market Portfolio is systematic.

Beta

- Beta is the measure of an asset’s systematic risk relative to the Market Portfolio.
- Beta = xmx/ m
- It is found by multiplying the correlation coefficient of any asset (asset x)and the market portfolio by the standard deviation of asset x. This product is divided by the standard deviation of the market portfolio.

Beta (continued)

- Betas are compared to the overall market.
- The market portfolio has a beta of 1.
- If the stock of a company has a beta of 2, it is twice as risky as the market.
- Where can I find betas?
- Use linear regression
- Yahoo! Finance website
- Various brokerage firm websites

Risk and Return

Expected Return = Rf + (Rm – Rf) x β

Expected Return

Exam: Risk free rate =4%,

Return on Market Portfolio

Is 12%. Given the β of the

Investment is 1.5, what

Would be expected return

On your investment?

SML

Rm

Rf

- 4% + (12% -4%) x 1.5 =
- 16%

0 1 2

Beta (β)

The Capital Asset Pricing Model

- The Security Market Line is an equation for a straight line.
- Beta is the slope of the line.
- If a project generates a return higher than the required rate of return as shown by the SML, value is created and the project is accepted. If not, then value is lost and the project should be rejected. (Exhibit 4-16 P80)

Limitations and Future of CAPM

- The CAPM cannot always predict the returns of assets accurately and it has limitations.
- The market portfolio is a theoretical concept; no consensus on which proxy for the market portfolio is best.
- Betas are calculated based upon historical returns and then used to predict future returns.
- Despite the limitations, CAPM is useful in getting investors to understand a fundamental relationship between risk and return.
- CAPM is accredited to Dr. William Sharpe, recipient of Nobel Prize in Economics (1990). http://nobelprize.org/economics/laureates/

Correlation Coefficient and Portfolio

Standard Deviation of the two assets portfolio can be expressed as follows:

Calculate SD of the portfolio when (1) ρ=1 (2) ρ=0, (3) ρ= -1

(1)=5.33%, (2) =3.77%, (3) = 0.00%

2. Bond Pricing

- Students will learn what the bond is, how it is used to finance the capital needs, and how its market value fluctuates as interest rates changes.
- Thorough understanding ofTime Value of Money conceptis the very essential part of the processes.

Valuing Corporate Bonds

- Suppose a 15-year corporate bond has a 10% coupon rate and a $1,000 par value. For simplicity assume the coupon is paid once a year. What is the value of this bond today if an investor requires a 10% rate of return?
- The value will be the present value of the coupon payment (an annuity) plus the present value of the par value (a lump sum).
- Buying a cow for milk and eventually for meat.

Valuing Corporate Bonds

C = Coupon payment = Coupon

Rate x par value = 10% x 1,000

n = # of payments to maturity

ib = investor’s required rate of

return.

Vb = value of the corporate bond

- The general equation for the value of a bond is:
- Computing the bond value in this example:

Valuing Corporate Bonds

- In the last example the rate of return and the coupon rate were the same. What happens to a bond’s value when the market rate of interest is less than the coupon rate?
- Ex: ib = 8%, while coupon rate is still 10%?

Valuing Corporate Bonds

- In the last example the rate of return was less than the coupon rate. What happens to a bond’s value when the market rate of interest is greater than the coupon rate?
- Ex: ib = 12%, while coupon rate is still 10%?

Valuing Corporate Bonds

- Relationship between market rate of return, coupon rate, and bond value.
- Market rate > Coupon rate Bond value < Par value
- Market rate = Coupon rate Bond value = Par value
- Market rate < Coupon rate Bond value > Par value
- This is extremely important to understand, and memorizing this will not help. UNDERSTAND IT!

3. Valuation of Stocks

- Unlike bonds, stocks have varying dividends and the future sales value at the end of holding period is not fixed
- Bond equal coupon payments, at maturity you get the face value back
- Stock ??

3. Valuation of Stocks

At maturity you get $1,000 back (face value)

Bond: Equal amount of

coupon payments

You do not know how much you get back at future sales

Stock: Less predictable stream of

cash flows: It’s a dividend!

3. Valuation of Stocks

- There are several methods that we teach but I pick up one of them today.

Constant-Growth Dividend Valuation Model

- A company with a constant dividend payout ratio and constant return on equity will have a constant growth rate.
- For example, what is the growth rate for a company earning 12% on equity and a 40% dividend payout ratio?
- Growth = (1 – 40%) x 12% = 60% x 12% = 7.2%

Constant-Growth Dividend Valuation Model

- If we expect this company to have earnings of $5 per share in the coming year and the 7.2% growth rate is constant, we can compute the common stock value to an investor requiring a 10% return with the following constant growth model:

Constant-Growth Dividend Valuation Model

- The company’s dividend in the coming year must be $2.00 per share:
- d1 = $5.00 x 40% = $2.00
- And thus the value of the stock is:

Value, Rate of Return, and Growth

- What happens to a common stock’s valueif the investor’s required rate of return increasesbut the future expected cash flows remain constant?
- With the same expected future cash flows, the only way an investor can receive a higher rate of return is to pay less for the stock!Thus, higher rates of return cause stock values to decline!

Value, Rate of Return, and Growth

- Let’s use the constant-growth example to illustrate this inverse relation between rates of return and common stock value. Previously we assumed a $2 dividend in 1 year, a 7.2% growth rate, and a 10% rate of return, and obtained a value of $71.43 as follows:

Value, Rate of Return, and Growth

- What if the general level of interest rates rises and as a result investors now require a 12% return on this common stock?
- The stock value declines to $41.67. This same relationship would hold for any of the common stock valuation models we have presented in this chapter.

Value, Rate of Return, and Growth

- What happens to a common stock’s value if the earnings and dividends growth rate increases but the rate of return remains the same?
- With a higher growth rate dividends are now expected to be greater. Of course with the same rate of return, the value of the common stock will increase to investors!

Value, Rate of Return, and Growth

- Let’s use the constant-growth example to illustrate this direct relation between dividends and earnings growth and common stock value. Using the same beginning assumptions as before:

Value, Rate of Return, and Growth

- What if the earnings and dividends growth rate rises from 7.2%to 8.0% and, as a result, future dividends are expected to be higher than before?
- The stock value increases to $100.00. This same relationship would hold for any of the common stock valuation models we have presented in this chapter.

4. Feasibilities, Valuation of Assets

- Sales comparison, cost, and income based-valuation approach are taught.
- What makes students competitive is the knowledge of several income based approaches, for which the knowledge of Time Value of Money is a prerequisite.

Income Capitalization Approach

- Valuation Technique 1
- Band of Investment
- Using WACC concept for “Debt” and “Equity”
- WACC of Mortgage Return & Equity Return

NOI in the case is given as $4,107,000

Divide NOI by the cap rate = Capitalized value of the Flow = Value

= $36,935,000

Valuation of Income Properties

- Note that the Value = NOI / Cap Rate
- Cap Rate = function of market interest rate
- From lenders’ view, what matters most is the borrower’s monthly debt service coverage ratio (Net Monthly Income / Monthly DS)
- DS = function of Principal amount, Terms (# months), Interest rate
- Interest rate = function of market rate (US Prime, LIBOR plus certain premium)
- Δ Interest rate = Δ DS Δ Value of the Asset?

One Mini-Case

- Assume a commercial investor has the following parameters
- Loan to Value (LTV) = 80% of acquisition cost
- Terms of Loan = US Prime + 50bp, 240 months
- Lender’s Requirement : Monthly NOI / DS > 1.2
- From a seller’s point of view, unless s/he is trained well in real estate finance, perception of appropriate value is driven by “sales comparison” “Last year, this had a value of $XX, because my neighbor sold comparable one at $YY…”

One Mini-Case

- Assume a commercial investor has the following parameters
- Loan to Value (LTV) = 80% of acquisition cost
- Terms of Loan = US Prime + 50bp, 240 months
- Lender’s Requirement : Monthly NOI / DS > 1.2

US Prime Rate

2004-11-10 5.00

2004-12-15 5.25

2005-02-02 5.50

2005-03-22 5.75

2005-05-03 6.00

2005-06-30 6.25

2005-08-09 6.50

2005-09-20 6.75

2005-11-01 7.00

2005-12-13 7.25

2006-01-31 7.50

Financial Training at Rosen College

- You are given MS-Excel sheet electronically, and work on the whole calculation in MS-Excel, and submit electronically. Graded and posted electronically
- In Finance class, weekly HW x 12, Cases x 3, plus one more =16 assignments per semester, all Excel-based, completely paperless
- Example: Correlation, NPV, IRR, Capital Budgeting, Financial Statement analysis, Income Property Valuation, Hotel Operational Analysis, Weighted Average Cost of Capital calculations, 10 year feasibility analysis, Quantitative analyses of Management Contracts, Franchise Agreements, Lease Contracts, Sensitivity Analysis

Tad Hara, PhD

Rosen College of Hospitality Management

Thara@mail.ucf.edu

http://www.hospitality.ucf.edu/thara.aspx

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