L3 Flashcards
How do you approximate the opportunity cost of capital?
WACC
How do you work out the cost of debt?
proxy benchmark with the same intrinsic charactersitics as the investment you are trying to make
based on risk free rate
In a wacc calculation what is the t rate range?
1-0
0 is not tax
1is 100% tax
What is the IRR and what does a high IRR mean?
IRR is the discount rate that gets the NPV to 0
if higher then there is a higher rate of return on the project
What are the three meain theories for calculating an expected rate of return on equity for a new investment project?
- capital asset pricing model and its many variants
- Arbitrage Pricing Theory
- Recovery Theorem
What is the CAPM equation?
rj = rf + Beta x (rm-rf)
the risk free rate
beta
the equity risk premium is the rm-rf
What does CAPM assume?
incomplete because you are reluing on market betas and assuming most assets will be moving in tandem with peers - not correct
does not capture idiosyncratic factors
it is market forces/factors thus doesn’t include costs
What does a beta of less than 1 and above 1 mean?
less than 1 = demand lower returns than market rate = low risk less volitle underlying market
greater than 1 = demands higher returns than market rate= higher volatility = more risky
What is the impact of leverage on returns?
the higher the leverage the higher the expected rate of returns
= taking on more risk if you leverage up so your returns should be higher
low leverage lower rate of return
What is the difference between a levered and unlevered beta?
Levered beta is the equity beta
unlevered is asset level returns
key to this is the issue that beta for projects all have different capital structures so need to recalculate the bet based on the cap structure
what is the levered beta correlated to?
is postively correlated to leverer - higher leverage, the higher the volatility of returns and hence higher expected rate of return
Can you tell me what the equational relationship between asset beta and equity beta?
BA= BE/ 1+(1-T) x D/E
What are some of the assumptions that CAPM make in comparison to the real world?
- assumes trivial transaction costs –> acc high transaction costs limit feasibility of arbitrage; irreversibility of investments
- assumes asset returns are normally distributed –> Acc asset returns distributions unknown - fattails and skewed distributions
- assumes there is a market portfolio available to all investors –> strategic goals and industry norms limit the scope of potential investments
- assumes investors have homogenous expectations about asset returns –> acc investors have heterogenous expectations driven by inherent diversity
What are the three approaches to understand international equity risk premiums?
- Assume that every company in the country is equally exposed to country risk
E(Return) = RF + Country ERP + Beeta (US premium) - Assume that a countries exposure to country risk is similar to its exposure to other market risk
E(R) = RF + B x (US Premium + Country ERP) - Treat country risk as a separate factor and allow firms to have different exposures to country risk - perhaps based upon the proportion of their revenues come from non-domesitc sales
E9R) = RF + b (US premium) + I (Country ERP)
Country ERP : additional country risk equity premium
How do you account for currency?
Does not relfect country risk premium
define underlying investment in hard currency and then account for this in your expected return and return on equity
or
do underlying investment in local dom currency then swap it back - account for fx difference, hedge it and then it incurs some kind of cost
When is real options useful in terms of management considerations?
help to estimate the value of flexibility and choice
- to delay investment
- to expand the investment
- to adjust or alter investment
- to abandon the investment at an early stage
What is real options?
method estimates a value for the flexibility and choice of management, which is present when managers are making a decision on whether or not to undertake a project
When is real options a good option?
when there is a lot of underlying volatility in future cash flows and uncertainty in what the outcomes will be
What are the six key inputs for real options?
- the underlying asset value - using DCF
- options exercise price
- risk free rate
- volatility - statistical information from historical data
- time
- type of option - when it can be exercised
What is relative valuation?
where the value of an asset is compared to the values assessed by the market for similar assets
How do you do a relative valuation?
- Identify comparable assets
- obtain market values for these assets
- convert these market values into standardised values. this process of standardizing creates price multiples
- compare the standardized values for comparable asset
- control for any difference between the firms that might affect the multiple, to judge whether the asset is under or over valued
Typically when is a multiples based valuation used?
in mature investments - acts like a sanity check where it is difficult to observe the expected return on equity
How is a relative valuation an advatange?
relative valuations are more likely to reflect market perceptions and moods then a DCF
Advantage when
- the objective is to sell a security at that price today - eg in an IPO
- investing on momentum-based strategies
- in understanding how the market is assessing future growth
what is revenue a function of?
price and volume
What is the gearing ratio?
debt/enterprise value
or
debt/capex
If the gearing ratio is high there is a high proportion of debt to equity and there is a higher risk - potential for financial distress
How do you work out the project FCF or CFADS?
EBITDA- tax - traingle CAPEX - trainge WC
How do you calculate the equity FCF
CFADs - debt service (principle +interest)
How do you work out the equity IRR?
DCF of the equity FCF
test if the leverage will be value creative or destructive
