Required Rate of Return Flashcards
What are the 3 elements for the Required rate of return?
- Time preference rate
- Element for expected inflation
- Risk premium
What are the elements for the required rate of return for debt?
What elements are required for a rate of return for share?
What investment can be referred as risk free rate?
- Treasury Bills
- Long term government bonds
What is Equity risk premium?
- 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
What are risks related to Shares?
- 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
What are the assumptions for the Portfolio Theory?
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
What is Portfolio Theory?
- 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
What is the Capital Asset Pricing Model (CAPM)?
- 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
What are CAPM assumptions?
- 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
What is a Beta?
- 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
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)
E(Ri) = 0.04 + 0.824 x 0.065
E(Ri) = 0.04 + 0.0536
E(Ri) = 0.0936 or 9.36%
What does the Dividend Valuation Model(DVM) or Gordon’s Growth Model?
- Alternative method to estimate cost of equity of a particular company
- Alternative method to estimate the cost of equity to CAPM
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?
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%
Pro’s and Con’s of CAPM and DVM
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