Chapter 5 Flashcards
What is the definition of cost of capital?
The expected rate of return that the market requires in order to attract funds to a particular investment.
What is cost of capital also referred to as?
Discount rate
What common approaches are used for calculating the return on common equity?
Capital asset pricing model (CAPM)
Modified CAPM
Build-Up (BU) method
What is the WACC?
Weighted average cost of capital utilizes the required rate of return for debt and equity at the proportion of the relative percentages in the company’s capital structure.
What must the rate of return take into account?
The perceived risk of the investment
Cost of capital ______ looking _____ rate of return
Forward, expected/required
What economic principle is cost of capital based on?
Substitution (an investor will not invest in a particular investment if a more attractive substitute investment is available
What are the three types of economic risk components inherent in capital markets for equity?
Maturity risk (interest rate risk) Market risk (systematic risk) Company-specific risk (unsystematic risk)
What is the primary way that CAPM and BU method differs?
The way they treat market risk (systematic risk). CAPM utilizes a beta applicable to the subject stock and multiplies by the market risk premium (equity risk premium) whereas BU method makes a direct adjustment (subjective)
What is market risk?
Uncertainty of future returns due to factors that affect the stock market as a whole that cannot be eliminated by diversification
What are common benchmarks for market risk?
S&P 500, NYSE, and Russell 2000 indices
What is beta?
The tendency of a stock to correlate with changes in the broader market (total returns with dividends and not just change in price should be used)
Often thought of as industry-specific risk
Measures market risk volatility (relative return volatility or systematic risk)
When is a beta greater than 1?
When a stock’s returns change to a greater degree (either up or down) than the broader market
When is the beta less than 1?
When a stock’s returns change to a lower degree than the broader market
When is the beta less than zero?
When the stock’s returns move in the opposite direction of the market
How is beta measured for a public company?
Compare the company’s beta with the market over the same look-back period
How is beta measured for a private company?
Using guideline public companies
What types of risk are reflected in betas?
Operating risk and financial risk (level of debt carried)
How is debt handled when using guideline public companies to estimate beta?
Unlevering betas to remove the impact of debt which captures the operating risk as if it were financed with all equity capital and relevering using the company’s capital structure = levered beta
What risk do unlevered betas capture?
Operating risk
What are the 8 assumptions of CAPM?
1) Investors are risk-averse
2) Rational investors seek to hold efficient (well diversified) portfolios
3) All investors have identical investment time horizons (expected holding periods)
4) All investors have identical expectations about such variables as expected rates of return and how capitalization rates are generated
5) There are no investment-related taxes/transaction costs
6) Relative return volatility (risk) is a modifier of equity market risk and required return
7) The rate received from lending money is the same as the cost of borrowing money
8) The market has perfect divisibility and liquidity
What size of company is typically valued using the CAPM econometric model?
Large or medium-sized companies
How does CAPM measure the relative volatility in returns?
Comparing returns to public market benchmarks such as the S&P 500
How is market or systematic risk measured in CAPM?
Beta