WACC Flashcards
What is WACC?
It is the minimum rate of return that companies must obtain from their investments in order to meet the minimum returns required by its investors
Should we use market or book value when computing WACC?
Market value
What does Ke mean to investors?
Opportunity cost
In emerging markets, can we use gov bond rates as Rf?
No
What is the Beta of a company?
It is a measure of the volatility of a security/portfolio to the market as a whole
How is the Beta estimated?
By a linear regression of company’s historical return and market index performance
What is the Kd?
The rate at which a company can borrow or renegotiate its debt
What is Kd for investors?
Required returns
Does default spread increase or decrease as rating diminishes?
Increases
What interpretation can we give to Kd if the company has bonds outstanding?
Kd = interest rate (YTM)
What interpretation can we give to Kd if the company has recently borrowed long term from a bank?
We can use i as Kd
What is the SML?
A linear relationship from what I should expect on a stock and its systematic risk. It is what you expect to earn in the long-term
What happens to the expected return if B=0?
Expected return = risk free rate
What is the slope of the SML?
ERP
What happens to/on the SML line when Beta decreases?
There is a movement along the line and returns decrease
What happens to/on the SML line when Beta increases?
There is a movement along the line and returns increase
What happens to/on the SML line when Risk free increases?
There is a parallel upward shift on the line and returns increase
What happens to/on the SML line when Risk free decreases?
There is a parallel downward shift on the line and returns decrease
What happens to/on the SML line when ERP increases?
There is a pivotal upward shift and return increases
What happens to/on the SML line when ERP decreases?
There is a pivotal upward shift and return decreases
Does ERP increase or decreases with risk-aversion?
Increases
How can we compute ERP?
We look at historical data on the average of market and riskless assets over the same period and calculate the difference
Stocks - bonds
Mkt % - Rf %
When computing ERP from historical data what should we do?
Make it:
- Long term because of standard deviation
- Consistent with risk-free
- Compounded average
What is the ratio used to compute Beta?
Covariance of asset w market/ mkt variance:
Cov (Ri, Rm)/var(Rm)
What are the three Beta determinants?
Product type, Operating leverage and Financial leverage
How does product type influences on the Beta?
-It depends on the sensitivity of the demand for the firms G/S, thus:
- The more discretionary the product, the higher the B
- Cyclical companies have higher B
- Growth firms too
How does operating leverage influences on the Beta?
OP leverage is the proportion of FC a firm has, that is, how rigid is their cost structure:
- Depends on the sector
- Higher OP leverage = greater income variability = higher B
- Smaller and young firms have H B
How does financial leverage influences on the Beta?
As firms borrow, they create fixed payments (I) that make their E/Q more volatile, which increases income volatility = higher B
Does the beta increases with the targeted D/E?
Yes
What does the unlevered beta tells us?
The riskiness of being in the business/ the firm’s assets
What is the B of the company if it has zero debt
Where in the WACC do we see Fin leverage risk?
Levered beta
Where in the WACC do we see Business risk?
Unlevered beta
Where in the WACC do we see Country risk?
in ERP
Where in the WACC do we see the influence of the currency choice?
On the Rf
What is the variance of an investment?
The variance on any investment measures the disparity between actual and expected returns
What are the CAPM assumptions?
- Investors act rationally and have at their disposal
all relevant information on financial securities - There are homogeneous expectations among investors
- All the investors hold the same portfolio, called market portfolio
Which risk can be minimized by diversification?
Firm-specific
How does diversification minimizes firm-specific risk?
1- Each investment is a much smaller percentage of the portfolio, muting the effect (positive or negative) on the overall portfolio.
2- Firm-specific actions can be either positive or negative. In a large portfolio, it is argued, these effects will average out to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens.
How can we estimate ERP?
Historical ERP: Assume that the actual premium delivered over long time periods is equal to the expected premium - i.e., use historical data.
• Survey investors on their desired risk premiums and use the average premium from these surveys.
• Estimate the implied premium in today’s asset prices.
How does debt affects cost of equity?
By borrowing more, you increase your financial leverage, making equity riskier
How does debt affects cost of debt?
It will increase your DS pushing up Kd
