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B831 Corporate Finance > Required Rate of Return > Flashcards

Required Rate of Return Flashcards

1
Q

What are the 3 elements for the Required rate of return?

A
  • Time preference rate
  • Element for expected inflation
  • Risk premium
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2
Q

What are the elements for the required rate of return for debt?

A
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3
Q

What elements are required for a rate of return for share?

A
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4
Q

What investment can be referred as risk free rate?

A
  • Treasury Bills
  • Long term government bonds
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5
Q

What is Equity risk premium?

A
  • Equity risk premium or market premium is difference between market return and risk free rate
  • Premium that investors require for taking on risk of buying shares rather than investing in risk free government bonds
  • Calculated using historical data
  • Is this a good predication of the future?
  • Typically between 5% and 8%
  • Equity risk premium = (E(Rm)-Rf) with E(Rm) expected return on market and Rf the risk free rate
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6
Q

What are risks related to Shares?

A
  • Previously quantified risk by measuring standard deviation of returns
  • Different shares have different risks
    • There is a systematic risk of investing in stock market
    • There is an unsystematic risk of investing in individual shares
  • Need some approach that allows us to model the specific risk of different shares
  • First need to look at combining shares into portfolios
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7
Q

What are the assumptions for the Portfolio Theory?

A

Assumptions

  • Investors make investment decisions in a single time period framework. This can be one week, one month, one year or longer
  • Investors prefer more money to less money
  • Investors are risk averse: they require extra return for extra risk
  • Investors measure return by expected return and measure risk by standard deviation of returns
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8
Q

What is Portfolio Theory?

A
  • How investors combine shares to give the best return for a given risk
  • Specific risk of individual shares can be diversified away
  • Core level of market risk cannot be diversified away
  • If you hold a large number of shares the value of your portfolio will go up when market goes up and down when market goes down
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9
Q

What is the Capital Asset Pricing Model (CAPM)?

A
  • Practical version of Portfolio Theory
  • Sharpe (1964) and Lintner (1965) showed that expected return of an individual share is linked to expected return on stock market by a linear equation
  • Model is based on market portfolio and estimates risk and return of an individual share relative to risk and return of the market
  • Alternative method to estimate cost of equity is DVM
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10
Q

What are CAPM assumptions?

A
  • A risk free asset exists which is risk free for all investors
  • Investors can invest or borrow at this risk free rate
  • All investors have the same expectations for share returns and risks – they accept consensus forecasts
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11
Q

What is a Beta?

A
  • Correlation of a share’s returns with those of the market
  • β of market = 1
  • If share is more cyclical than the market then β > 1
  • If share is less cyclical than the market then β < 1
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12
Q

Pearson β = 0.824. If risk free rate is 4.0% and equity risk premium is 6.5% what is expected return on Pearson shares?

E(Ri) = Rf + β(E(Rm)-Rf)

A

E(Ri) = 0.04 + 0.824 x 0.065
E(Ri) = 0.04 + 0.0536
E(Ri) = 0.0936 or 9.36%

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13
Q

What does the Dividend Valuation Model(DVM) or Gordon’s Growth Model?

A
  • Alternative method to estimate cost of equity of a particular company
  • Alternative method to estimate the cost of equity to CAPM
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14
Q

In November 2010 Pearson had a share price of 953p and a 2009 dividend of 35.5p. Average dividend growth rate over the last 5 years is 5.1%
Estimate the cost of equity for Pearson using Gordon growth model. How does this compare with earlier CAPM estimate?

A

E(Ri) = (D1/Pi) + g
E(Ri) = ((35.5 x 1.051)/953) + 0.051
E(Ri) = ((37.31)/953) + 0.051
E(Ri) = 0.03915 + 0.051
E(Ri) = ((35.5 x 1.051)/953) + 0.051
E(Ri) = 0.090 0r 9.0%

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15
Q

Pro’s and Con’s of CAPM and DVM

A

CAPM is

  • Simple to use
  • Requires estimates of risk free rate, equity risk premium and β for share
  • Relative model
  • Only single period model

DVM

  • Simple to use
  • Can be made more complex by using different dividend growth forecasts for different periods
  • Can estimate cost of equity without market level inputs
  • Only as good as forecasts of g
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16
Q

How to calculate the cost of debt?

A
  • Estimate cost of debt relative to risk free rate – credit risk premium

or

  • Estimate cost of debt by using historic debt and interest payments
17
Q

What is capital structure?

A
  • Measures proportion of debt and equity
  • Different definitions and terminology
    • Gearing
    • Net gearing
    • Leverage (gross)
  • Finance uses gearing ratio D/(D+E) as measure of capital structure
  • By definition D/(D+E) + E/(D+E) = 100%
18
Q

What is the impact of capital structure on company value?

A
  • Capital structure has no impact on overall company value when taxes are ignored
  • When taxes are introduced capital structure has impact on company valuation (Modigliani and Miller 1963)
  • Debt interest payments are tax deductible
  • Tax Shield reduces cost of debt
19
Q

What are Capital Structure Trade-off?

A
  • In practice choice of debt/equity ratio is more conservative than tax advantage would suggest
  • The more debt in a capital structure the more likely a company will default on its debt and be forced into bankruptcy
  • Think of costs associated with default and liquidation
20
Q

What are the elements of WACC?

21
Q

Company X has a capital structure of 25% debt and 75% equity. The corporate tax rate is 28%. The cost of debt is 6%. Company X’s shares have a beta of 0.8. The risk free rate is 5% and the equity risk premium is 6%. Calculate the company’s WACC.

A

E(Ri) = Rf + β(E)(Rm)-Rf)
E(Ri) = 0.05 + 0.8 x 0.06
E(Ri) = 0.098 or 9.8%

WACC = D/D+E x Rd x (1-T) + E/D+E x Re
WACC = 0.25x0.06x(1-0.28) + 0.75x0.098
WACC = 0.0108 + 0.0735
WACC = 0.0843 or 8.43%

22
Q

Company Z has a target debt to equity (debt/debt+equity) ratio of 40%. Corporate tax rate is 28%. Company Z pays 3.5% credit risk premium on its debt. The beta of the company’s shares is 1.1. The equity risk premium is 6% and the risk free rate is 3%. Calculate the company’s WACC.

A

E(Ri) = Rf + β(E)(Rm)-Rf)
E(Ri) = 0.03 + 1.1 x 0.06
E(Ri) = 0.096 or 9.6%

WACC = D/D+E x Rd x (1-T) + E/D+E x Re
WACC = 0.40x0.065x(1-0.28) + 0.60x0.096
WACC = 0.01872 + 0.0576
WACC = 0.0763 or 7.63%

23
Q

What is the ‘Bird in Hand Theory’?

A
  • A dividend today is worth more than a potential capital gain in the future (Gordon 1959)
  • Investors viewed future earnings as uncertain and were less uncertain about dividends
  • Higher the risk the higher the yield required
24
Q

Name Other Dividend Policy Issues?

A
  • Agency theory
  • Life cycle theory
  • Signalling Theory
  • Game Theory

B831 Corporate Finance (9 decks)

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