Chap 9 Flashcards
What is the company cost of capital?
- the expected return on a portfolio of all the company’s outstanding debt and equity securities
- It is the opportunity cost of capital for investment in all of the firm’s assets, and therefore the appropriate discount rate for the firm’s average-risk projects.
What is the CAPM and its formula?
-implies an expected return rate
r = rf + β(rm − rf)
Should a firm use the same opportunity cost of capital for all investments?
Each project should in principle be evaluated at its own opportunity cost of capital, like we see in the value additivity principle: each investment should be valued like a mini firm
According to the SML, what projects should be accepted?
any project lying above the upward-sloping SML that links expected return to risk
What can you say about the SML line in comparison to the C.O.C rule?
SML =upward sloping line, a function of beta
C.O.C = flat horizontal line at required return rate (on y -axis)
In general, the correct discount rate increases as project beta increases. We want to accept projects above the security market line, not just ones that offer a higher return than the company’s cost of capital
What may happen if a firm uses only the C.O.C rule?
They arent taking risk into account, and in return it would reject many good low-risk projects and accept many poor high-risk projects
What is a naked call option?
is an option purchased with no offsetting (hedging) position in the underlying stock or in other options.
Does the true C.O.C depend on project risk or the company undertaking it?
project risk
Why do company’s make a company C.O.C? Why did we learn about that?
they set a companywide cost of capital as a benchmark. This is not the right discount rate for everything the company does, but adjustments can be made for more or less risky ventures
The cost of capital is estimated as a blend of…
cost of debt (the interest rate) and the cost of equity (the expected rate of return demanded by investors in the firm’s common stock).
What do the values of debt and equity sum to?
D + E = V (where V is firm value and asset value)
Note that these figures are all market values
Is the market value of equity or book value of equity larger?
The market value of equity is often much larger than the book value
What is the order of riskiness for cost of equity, company and debt?
cost of debt
How do you calculate company cost of capital (WACC)? and after tax WACC?
Company cost of capital WACC = rD D/V + rE E/V
After Tax WACC = After-tax WACC = (1 − Tc)rDD/V + rEE/V
Do individual stock beta’s change over time?
Yes
What size portion of each stock’s total risk comes from movements in the market? What is the rest of the risk made up of?
a small portion is from market movement, and the rest is firm-specific, diversifiable risk
What does r^2 measure?
measures the proportion of the total variance in the stock’s returns that can be explained by market movements
If the observations are independent, what does this say about the standard error?
The standard error of the estimated mean beta declines in proportion to the square root of the number of stocks in the portfolio
Is industry beta or portfolio betas more reliable?
Industry beta’s
What is the formula for expected long-term return from bills?
Expected long-term return from bills = yield on long-term bonds − 1.5%
Does a flatter or more steep SML better reflect history?
Using a “flatter” SML is perhaps a better match to the historical evidence, which shows that the slope of average returns against beta is not as steeply upward-sloping as the CAPM predicts
Is the cost of debt always less than the cost of equity?
yes
Why is the WACC formula dangerous?
because it suggests that the average cost of capital could be reduced by substituting cheap debt for expensive equity
BUT THAT DOESNT WORK
As the debt ratio D/V increases, the cost of the remaining equity also increases, offsetting the apparent advantage of more cheap debt.
The after-tax WACC depends on….
the average risk of the company’s assets, but it also depends on taxes and financing
-b/c debt has a tax advantage
What is the definition of asset beta?
the direct measure of project risk
What is the formula of asset beta?
Asset beta = βA = βD(D/V) + βE(E/V)
where BD is beta of debt, and BE is beta of equity
Why is debt beta positive?
- debt investors worry about the risk of default. Corporate bond prices fall, relative to Treasury-bond prices, when the economy goes from expansion to recession. The risk of default is therefore partly a macroeconomic and market risk.
- all bonds are exposed to uncertainty about interest rates and inflation. Even Treasury bonds have positive betas when long-term interest rates and inflation are volatile and uncertain.
Are overall company C.O.C’s useful for conglomerates?
Overall company costs of capital are ALMOST USELESS for conglomerates. This is bc conglomerates diversify into several unrelated industries, so they have to consider industry-specific costs of capital
Sometimes good comparables are not available or not a good match to a particular project. What are the 3 things then a financial manager needs to consider?
- Think about the determinants of asset betas. Often the characteristics of high- and low- beta assets can be observed when the beta itself cannot be.
- Don’t be fooled by diversifiable risk.
- Avoid fudge factors. Don’t give in to the temptation to add fudge factors to the discount rate to offset things that could go wrong with the proposed investment. Adjust cash- flow forecasts first.
How does cyclicality determine asset beta’s?
Cyclical firms—firms whose revenues and earnings are strongly dependent on the state of the business cycle—tend to be high-beta firms. Thus you should demand a higher rate of return from investments whose performance is strongly tied to the performance of the economy ex. airlines, resorts
How does operating leverage determine asset betas?
High operating leverage means a high asset beta.
A firm with high fixed costs, relative to its variable costs, is said to have high operating leverage.
How can cash flows generated by an asset be broken down?
Cash flow = revenue − fixed cost − variable cost
How can we break down an assets PV?
PV(asset) = PV(revenue) − PV(fixed cost) − PV(variable cost)
Where is the cyclicality of revenues reflected in the asset beta formula? What does that say about the asset beta?
reflected in βrevenue
the asset beta is proportional to the ratio of the present value of fixed costs to the present value of the project.
What is the formula for DOL (degree of operating leverage) and what does it mean?
DOL = 1 + fixed costs/ profits
DOL measures the percentage change in profits for a 1% change in revenue.
Do diversifiable risks affect asset beta’s?
NO, do not affect asset betas and should not affect the discount rate for the projects
The most likely cash flow is the….
Unbiased one . Unbiased forecasts incorporate all risks, including diversifiable risks as well as market risks
Why are fudge factors dangerous?
Fudge factors in discount rates are dangerous because they displace clear thinking about future cash flows
The fudge factor overcorrects for bias and would penalize long-lived projects
What are certainty equivalents?
an
What are certainty equivalents?
an
What are certainty equivalents?
- converted cash flows
- adjusts for a change in risk that happens over the course of the investment
How do you calculate a certainty equivalent (CEQ)?
PV= C/(1+r)^t = CEQ/(1+ risk free rate)^t
What is the difference between discounting cash flows with the risk adjusted discount rate method VS using the CEQ method?
- the risk adjusted discount rate adjusts for time and risk together
- The certainty-equivalent method makes separate adjustments for risk and time
What does hair cut for risk mean?
financial slang referring to the reduction of the cash flow from its forecasted value to its certainty equivalent
Should distant cash flows (riskier cash flows) be discounted at a higher rate than earlier cash flows?
NO
- Using the same risk-adjusted discount rate for each year’s cash flow implies a larger deduction for risk from the later cash flows
- The reason is that the discount rate compensates for the risk borne per period.
- The more distant the cash flows, the greater the number of periods and the larger the total risk adjustment
