Reading 31: Return Concepts

Question 1

A. Distinguish among the following:holidng period return, expected holding peirod return, required return, return from convergance of price to intrinsic value, discount rate, and internal rate of return

Answer 1

A. Distinguish among the following:

1. ** Holidng period return:** get over pay minus one, also known as div yield plus price appreciation
2. Expected holding peirod return: expected dividend yield plus expected price appreciation
3. Required return: minimum level of expected return, opportunity cost, or highest return for given risk level.
4. Return from convergance of price to intrinsic value: ?
5. Discount rate: general term for any rate used in finding the present value of a future cash flow.
6. IRR: the discount rate that equates the PV of the asset’s expected future cash flow’s to the asset’s price.

Question 2

A. Calculate and interpret equity risk premium using historical and forward-looking estimation approaches

Answer 2

A. Defined: the incremental return (premium) that investors require for holding equities rather than a risk-free asset

B. Equation 1: CAPM

C. Equation 2: Rf + ERP + Other premium/discounts (build up method)

Question 3

A. Estimate the required return on an equity investment using the CAPM, Fama-French model, the Pastor-Stambaugh model, macroeconomic multifactor models, and the build-up method.

Answer 3

1. CAPM=Rf + Beta ( ERP ); Beta measures systematic risk
2. Fama-French = Rf + BmRMRF + BsSMG+BvHML (Risk free rate, plus ERP, plus size premium, plus value premium)
3. Pastor-Stambaugh = same as Fama-French, + BLIQ
4. Macro Multifactor
5. Build-Up = Rf + ERP +- Premia/discount

Question 4

A. Explain beta estimation for public companies, thinly traded public companies, and nonpublic companies

Answer 4

1. Public Companies: 5 years of monthly data
2. Thinly traded or nonpublic: use the comps method
   - Choose a benchmark company
   - Estimate the Beta
   - Unlever the benchmark company by taking the inverse of one plus the benchmark company debt to equity ratio
   - Relever using the subject company capital structure, taking one plus debt to equity multiplied by the unlevered beta

Question 5

A. Describe the strengths and weaknesses of methods used to estimate the required return on an equity investment.

Answer 5

1. CAPM

• Benefits: simple
• Weakness: beta can be a poor predictor of future average return as idosyncratic risk can overwhelm market risk

2. Fama-French

• Benefits: Uses a characteristic and valuation component together with an equity market compenent
• Weakness: Better than CAPM, but still only explains about 5%.

3. Pastor-Stambaugh
4. Macro Multifactor
5. Build-Up

Question 6

A. Explain international considerations in required return estimation

Answer 6

Considerations

1. Exchange Rates
2. Data and model isues in emerging markets

Method

Developed Market ERP + Country Premium

Question 7

A. Explain and calculate the WACC for a company

Answer 7

WACC = [MVD / (MVD + MVCE)]rd(1-t)+[MVcE / (MVD + MVCE)]r

Question 8

A. Evaluate the appropriateness of using a particular rate of return as a discount rate, given a description of the cash flow to be disocunted and other relevant factors

Answer 8

1. Cost of Equity (Req. Return on Equity) is appropriate for cash flow to equity (cash after senior claims have been paid)
2. WACC is appropriate for cash flows available to all of company’s capital providers.
3. Use nominal terms, given tax rates are given nominally