Chapter 11-13 Flashcards
How is the standard deviation of returns for individual common stocks or for a stock portfolio calculated?
The spread of outcomes on different investments is commonly measured by the variance or standard deviation of the possible outcomes. The variance is the average of the squared deviations around the average outcome, and the standard deviation is the square root of the variance. The standard deviation of the returns on a market portfolio of common stocks has averaged around 20% a year.
Why does diversification reduce risk?
The standard deviation of returns is generally higher on individual stocks than it is on the market. Because individual stocks do not move in exact lockstep, much of their risk can be diversified away. By spreading your portfolio across many investments, you smooth out the risk of your overall position. The risk that can be eliminated through diversification is known as specific risk.
What is the difference between specific risk, which can be diversified away, and market risk, which cannot?
Even if you hold a well-diversified portfolio, you will not eliminate all risk. You will still be exposed to macroeconomic changes that affect most stocks and the overall stock market. These macro risks combine to create market risk—that is, the risk that the market as a whole will slump.
Stocks are not all equally risky. But what do we mean by a “high-risk stock”? We don’t mean a stock that is risky if held in isolation; we mean a stock that makes an above-average contribution to the risk of a diversified portfolio. In other words, investors don’t need to worry much about the risk that they can diversify away; they do need to worry about risk that can’t be diversified. This depends on the stock’s sensitivity to macroeconomic conditions.
How can you measure and interpret the market risk, or beta, of a security?
The contribution of a security to the risk of a diversified portfolio depends on its market risk. But not all securities are equally affected by fluctuations in the market. The sensitivity of a stock to market movements is known as beta. Stocks with a beta greater than 1.0 are particularly sensitive to market fluctuations. Those with a beta of less than 1.0 are not so sensitive to such movements. The average beta of all stocks is 1.0.
What is the relationship between the market risk of a security and the rate of return that investors demand of that security?
The extra return that investors require for taking risk is known as the risk premium. The market risk premium—that is, the risk premium on the market portfolio—averaged 7.6% between 1900 and 2015. The capital asset pricing model states that the expected risk premium of an investment should be proportional to both its beta and the market risk premium. The expected rate of return from any investment is equal to the risk-free interest rate plus the risk premium, so the CAPM boils down to
r=rf +β(rm −rf)
The security market line is the graphical representation of the CAPM equation. The security
market line shows how the return that investors demand is related to the security’s beta.
What determines the opportunity cost of capital for a project?
The opportunity cost of capital is the return that investors give up by investing in the project rather than in securities of equivalent risk. The CAPM implies that the opportunity cost of capital depends on the project’s beta. The company cost of capital is the expected rate of return demanded by investors in a company. It depends on the average risk of the company’s assets and operations.
The opportunity cost of capital is determined by the use to which the capital is put. Therefore, required rates of return depend on the risk of the project, not on the risk of the firm’s existing business. The project cost of capital is the minimum acceptable expected rate of return on a project given its risk.
Your cash-flow forecasts should already factor in the chances of pleasant and unpleas- ant surprises. Potential bad outcomes should be reflected in the discount rate only to the extent that they affect beta.
How do firms compute weighted-average costs of capital?
WACC formula one more time:
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The WACC is the expected rate of return on the portfolio of debt and equity securities issued by the firm. The required rate of return on each security is weighted by its propor- tion of the firm’s total market value (not book value). Because interest payments reduce the firm’s income tax bill, the required rate of return on debt is measured after tax, as rdebt × (1 − Tc).
Why do firms compute weighted-average costs of capital?
Firms need a standard discount rate for average-risk projects. An “average-risk” project is one that has the same risk as the firm’s existing operations and that supports the same relative amount of debt.
What about projects that are not average?
The weighted-average cost of capital can still be used as a benchmark. The benchmark may be adjusted up for unusually risky projects and down for unusually safe ones.
What happens when capital structure changes?
The rates of return on debt and equity will change. For example, increasing the debt ratio will increase the risk borne by both debt and equity investors and cause them to demand higher returns. However, this does not necessarily mean that the overall WACC will increase, because more weight is put on the cost of debt, which is less than the cost of equity. In fact, if we ignore taxes, the overall cost of capital will stay constant as the fractions of debt and equity change.
How do firms measure capital structure?
Capital structure is the proportion of each source of financing in total market value. The WACC formula is usually written assuming the firm’s capital structure includes just two classes of securities, debt and equity. If there is another class, say preferred stock, the formula expands to include it. In other words, we would estimate rpreferred, the rate of return demanded by preferred stockholders, determine P/V, the fraction of market value accounted for by preferred, and add rpreferred × P/V to the equation. Of course, the weights in the WACC formula always add up to 1. In this case D/V + P/V + E/V = 1.
How are the costs of debt and equity calculated?
The cost of debt (rdebt) is the market interest rate demanded by debtholders. In other words, it is the rate that the company would pay on new debt issued to finance its investment projects. The cost of preferred (rpreferred) is just the preferred dividend divided by the market price of a preferred share.
The tricky part is estimating the cost of equity (requity), the expected rate of return on the firm’s shares. Financial managers commonly use the capital asset pricing model to estimate expected return. But for mature, steady-growth companies, it can also make sense to use the constant-growth dividend discount model. Remember, estimates of expected return are less reliable for a single firm’s stock than for a sample of comparable-risk firms. Therefore, managers also consider WACCs calculated for industries.
Can WACC be used to value an entire business?
Just think of the business as a very large project. Forecast the business’s operating cash flows (after-tax profits plus depreciation), and subtract the future investments in plant and equipment and in net working capital. The resulting free cash flows can then be discounted back to the present at the weighted-average cost of capital. Of course, the cash flows from a company may stretch far into the future. Financial managers therefore typically produce detailed cash flows only up to some horizon date and then estimate the remaining value of the business at the horizon.
