CH6 - CAPM, Betas, Debt CAPM

Question 1

Assumptions

Answer 1

Assumes investors are well diversified so have eliminated unsystematic (specific) risk. Beta factor includes the level of systematic (general, market risk).

Question 2

Betas

Answer 2

• Ba = Ungeared Beta – Ba reflects purely systematic risk of business area
• Be = Geared Beta – Be reflects systematic risk of business area and companies gearing ratio

Question 3

How to QUESTION:

Answer 3

1. We take a proxy equity Be beta from a firm in a similar industry (same systematic risk), and de-gear it to get the Asset beta Ba, which only has the systematic risk.
2. We then regear it with the Market values of debt and equity for OUR company in question, to then input the unsystematic risk and get an equity beta Be which includes the unsystematic risk

Question 4

Dividend Growth Formulas:

Answer 4

Past Dividends - (D0/Dn)^(1/n)-1

Gordon’s Growth model

G = rb
B= earnings retention rate
R = rate of return to equity. BUT now it’s Ke
G = keb
However, at AFM R becomes Ke!!!!

Question 5

Modigliani and Miller Proposition 2 Formula

Answer 5

Formula given, BUT REMEMBER:

KIE IS UNGEARED (EQUITY ONLY). IF GIVEN EQUITY AND DEBT, USE THE SECOND FORMULA TO DEGEAR IT.

12.7%=1Kei + 0.175Kei
Also t same as 12.7% = 1.175Kei

Question 6

Iredeemable debt

Answer 6

Debt Holder’s cost of Debt: Kd = I/MV
Company’s cost of Debt: Kd = I*(1-T)/MV

Question 7

Redeemable Debt:

Answer 7

T0 = (MV)
T1-T5 = Interest (1-T) - 100Interest*Net Tax
T5 = Repayment - 100 or premium

Use 5% and 10% DF and do IRR calc

Question 8

CAPM Debt

Answer 8

Kd(1-T) = Rf + credit spread

If spread is in between, start with the base and get 1 year as below and add on

Remember to weight based on $m amount by MV to get Market value of debt.
If given MV Multiple amount by that e.g. trading at 90% = $30
If given per nominal – Multiply by MV/Nominal e.g. 110/100
Or for shares = Share price/nominal value e.g. 1.22/0.5

Question 9

Estimating Yield Curves to input into redeemable debt

Answer 9

Per Year Formula
Year 1 R1 (100+Coup Whole Number)/MV -1

Year 2 R2 (100+Coup Whole Number)/MV-(Coupon rate whole number yr2/1+r1)^(1/2)-1

Year 3 R3 ((100+Coup Whole Number)/MV-(Coupon whole number yr3/1+r1)-(Coupon rate whole number yr3/1+R2^2))^(1/3)-1

Question 10

Valuing Bonds

Answer 10

Calculate govt yield curve % from above then add the spread

Take each of these values as Discount Factors per year
Int 1
Int 2
Int 3+ Repayment

Multiply all by the DF and add together to get the MV of the bond MV is the T0 in the redeemable situation.