Discount rates Flashcards
Today what are we going to look at calculating?
WACC and Return on assets ( unlevered cost of capital Ra/Ru)
We know the 2 main inputs of capital to a company is debt and equity but how do we derive the returns of these components?
Why is CAPM such an unrealistic model?
Assumes investors have perfect information, there are no transaction costs, investors are risk averse and also that investors also make their choices once in their lives ( make a choice today and collect returns in the next period)
What is a reason why the CAPM model was derived?
To quantify the risk premium of an asset ( which is the extra compensation for the asset’s risk over the risk free. In CAPM this risk premium is proportional to the assets covariance with the market portfolio.
So why do we say investors want to diversify their risk?
Investors want to diversify and generally have beta’s of assets less than 1 because remember beta is proportional to the assets covariance with the market portfolio ( so if the market goes up, so does the the asset and vice versa),
What is CAPM’S main takeway and why?
CAPM’s main takeaway: risk premium only depends on the asset’s non-diversifiable (a.k.a. “systematic”) risk, which is captured by the asset’s beta.
Why? Investors can fully diversify and eliminate the contribution of assets’ “idiosyncratic” risks to their portfolio/ firm specific.
Why cant systematic risk cant be diversified?
This type of risk cannot be eliminated through diversification because it affects the entire market or economy. Systematic risk is typically caused by factors such as economic cycles, political events, natural disasters, or changes in interest rates. I
Your firm is considering buying a license for oil exploration in Alaska. Immediately after paying for the license you will invest $50M in a drilling tower. There is a 10% chance that
there will be 10M barrels of oil in the ground and a 90% chance that there will be nothing.
The license specifies that you must sell all the oil you find to the government in one year from now for $95 per barrel.
The risk-free rate is 5%, the market risk premium is 6%, and the beta of oil is 0.5. What is the maximum amount you are willing to pay for the license?
Ri = 5% + 0.5%(6%) = 8% the expected return of oil is this, so you think you might wanna discount by this rate. However from an investors point of view all the risk is firm specific ( idisocraytic risk- no matter if the market is going up or down, the oil price will always be the same, so beta from our POV = 0. Also the amount of oil in the ground going to be the same no matter what state, so uncorrelated, so all we need to use is the risk free rate
so NPV = -50 + (10%*10M + 90% X 0 =1 mil barrels of oil x $95 per barrel = 95 mil.
So finally its NPV = -50 + 95/1.05 = 40.48. ( ANOTHER WAY TO EXPLAIN IT In simpler terms, the beta of oil (0.5) shows that oil investments are not as affected by changes in the overall market compared to other investments. In this problem, you sell oil to the government at a fixed price, so the usual market risks don’t apply. Therefore, you use the risk-free rate to calculate the value of the project, as it’s considered a safer investment without the typical risks of oil investments. The cashflows you will receive are not going to be exposed to market risk because its a fixed price. )
1) The CEO of Blade Runner Inc. argues that she does not use the CAPM for capital budgeting because the firm is not well diversified. Is she right?
2) You are considering taking all your money out of the stock market and investing it in a single biotech project. Should you use the CAPM to evaluate this investment?
1) No investors need to be diversified, not the firm
2) No, investor is not well diversified, CAPM doesn’t apply ( breaks CAPM main assumption that investors c
With the risk free rate what proxies do we use in the computation of CAPM?
Often proxied using the return on safe government securities in the currency of your CFs. The yields on these securities can be easily obtained from Bloombery or from newspapers.
Problem with government bonds is that they have different yields over time ( hence different returns) , what maturity do we use?
The 10 year government bond spread of the country you are investing in
What is a popular way to compute the market risk premium?
A popular way to compute the MRP is with the arithmetic average of the annual excess returns of stocks over bonds over a long time horizon. For example, the average annual difference between the return on the stocks and that on U.S. Treasury bonds between
1928 and 2016 is around 5-7%.
Problem though: US has been one of the best performing countries in the last decade, will it happen next decade.
Most of the time CAPM is used to estimate discount rates on equity securities, but how do we in practice get the equity beta of a publicly traded firm?
If we have a public data set of returns, we just need to run a regression in which we measure the excess return on my stock as a function of an intercept plus beta times the time series of returns of the market -rf.
To run regression we use daily data with 2 years of data ( as returns firms change vastly sometimes year on year.)
There is an assumption that for most debt securities their betas are assumed to be 0 ( returns don’t correlate with market)? why?
Corporate bonds don’t trade frequently
Lets look at companies with a good investment grade debt ( assigned a credit rating) why is beta low?
The probability of the company going bankrupt is so low that the expected rate of return on investors is pretty much the same as what the company is promising us at a certain point of time.
What is the formula for asset beta ( unlevered beta) and equity beta ( levered beta), interpret the equity beta?
Notice its the same for the unlevered cost of capital for asset beta and in fact all the betas can be changed to returns, as returns and betas are linearly combinations of each other.
Everytime a company changes there borrowing ratio, the more debt holders will be ahead of us in the queue to get the cash flows before shareholders can, so not only bearing risk of operations but the financial risk of borrowing to much, thus average expected return increases
How is the formula for equity beta ( levered) different from when a company assumes a constant leverage ratio to an equation where a company issues a constant level of debt ( e.g. issue 10 million of debt forever. )?
Constant leverage ratio = without (1-t)
Constant level of debt = with (1-t)
So what is the first step to realise ( A conglomerate is a large company made up of smaller, diverse businesses operating in different industries under one corporate umbrella, providing stability and risk diversification.) ?
Because the company is a conglomerate, we don’t know the risk, we don’t know what the risk of oil is going to be, so we can look at other publicly listed company. The projects risk is based on oil so we will only deal with General American oil, Louisiana Oil Exploration and Mesa Petroleum.
So actually do the calculation?Why is your equity beta what it is ?
So the 1.51 says if we invest in the oil project without using any leverage our beta should be 1.51.
Our equity beta is higher than those accompanies chosen because our D/E is higher than all other companies despite similar Asset beta.
What is the the formula for equity beta when the beta of debt is 0?
What is the formula of equity beta when a firm has a constant level of debt but beta of debt is 0 ?
1) Unlever both company
2) then work backwards to find car’s beta.
1.425 = 0.5 x 2 + 0.5 x Ba,C – Ba,C = 0.85.
Clue remember that Ba is ( measures systematic risk in relation to market so its used in CAPM).
Once we have estimates for a firm’s expected return on debt and equity securities, we can
estimate the firm’s WACC using the following formula (assuming the firm maintains a constant debt-to-equity ratio)?
Using this discount rate, we can compute the NPV of a firm’s cash flows which is?
