ESTIMATING HURDLE RATES I: DEFINING & MEASURING RISK
Risk = Danger + Opportunity
The Investment DecisionInvest in assets that earn a return
greater than the minimum acceptable hurdle rate
The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and
equity to fund your operations
The Dividend DecisionIf you cannot find investments that make your minimum acceptable rate, return the
cash to owners of your business
Hurdle Rate4. Define & Measure Risk5. The Risk free Rate6. Equity Risk Premiums7. Country Risk Premiums8. Regression Betas9. Beta Fundamentals10. Bottom-up Betas11. The "Right" Beta12. Debt: Measure & Cost13. Financing Weights
Investment Return14. Earnings and Cash flows15. Time Weighting Cash flows16. Loose Ends
Financing Mix17. The Trade off18. Cost of Capital Approach19. Cost of Capital: Follow up20. Cost of Capital: Wrap up21. Alternative Approaches22. Moving to the optimal
Financing Type23. The Right Financing
Dividend Policy24. Trends & Measures25. The trade off26. Assessment27. Action & Follow up28. The End Game
Valuation29. First steps30. Cash flows31. Growth32. Terminal Value33. To value per share34. The value of control35. Relative Valuation
Set Up and Objective1: What is corporate finance2: The Objective: Utopia and Let Down3: The Objective: Reality and Reaction
36. Closing Thoughts
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First Principles
The Investment DecisionInvest in assets that earn a
return greater than the minimum acceptable hurdle
rate
The Financing DecisionFind the right kind of debt for your firm and the right mix of debt and equity to
fund your operations
The Dividend DecisionIf you cannot find investments
that make your minimum acceptable rate, return the cash
to owners of your business
The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used
to fund it.
The return should reflect the
magnitude and the timing of the
cashflows as welll as all side effects.
The optimal mix of debt and equity
maximizes firm value
The right kind of debt
matches the tenor of your
assets
How much cash you can
return depends upon
current & potential
investment opportunities
How you choose to return cash to the owners will
depend on whether they
prefer dividends or buybacks
Maximize the value of the business (firm)
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The noGon of a benchmark
¨ Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable.
¨ This hurdle will be higher for riskier projects than for safer projects.
¨ A simple representaGon of the hurdle rate is as follows: Hurdle rate = Riskless Rate + Risk Premium
¨ The two basic quesGons that every risk and return model in finance tries to answer are: ¤ How do you measure risk? ¤ How do you translate this risk measure into a risk premium?
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What is Risk?
¨ Risk, in tradiGonal terms, is viewed as a ‘negaGve’. Webster’s dicGonary, for instance, defines risk as “exposing to danger or hazard”. The Chinese symbols for risk, reproduced below, give a much beXer descripGon of risk:
危机 ¨ The first symbol is the symbol for “danger”, while the second
is the symbol for “opportunity”, making risk a mix of danger and opportunity. You cannot have one, without the other.
¨ Risk is therefore neither good nor bad. It is just a fact of life. The quesGon that businesses have to address is therefore not whether to avoid risk but how best to incorporate it into their decision making.
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AlternaGves to the CAPM
The risk in an investment can be measured by the variance in actual returns around an expected return
E(R)
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R)
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)Can be diversified away in a diversified portfolio Cannot be diversified away since most assets1. each investment is a small proportion of portfolio are affected by it.2. risk averages out across investments in portfolioThe marginal investor is assumed to hold a “diversified” portfolio. Thus, only market risk will be rewarded and priced.
The CAPM The APM Multi-Factor Models Proxy ModelsIf there is 1. no private information2. no transactions costthe optimal diversified portfolio includes everytraded asset. Everyonewill hold this market portfolioMarket Risk = Risk added by any investment to the market portfolio:
If there are no arbitrage opportunities then the market risk ofany asset must be captured by betas relative to factors that affect all investments.Market Risk = Risk exposures of any asset to market factors
Beta of asset relative toMarket portfolio (froma regression)
Betas of asset relativeto unspecified marketfactors (from a factoranalysis)
Since market risk affectsmost or all investments,it must come from macro economic factors.Market Risk = Risk exposures of any asset to macro economic factors.
Betas of assets relativeto specified macroeconomic factors (froma regression)
In an efficient market,differences in returnsacross long periods mustbe due to market riskdifferences. Looking forvariables correlated withreturns should then give us proxies for this risk.Market Risk = Captured by the Proxy Variable(s)
Equation relating returns to proxy variables (from aregression)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
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LimitaGons of the CAPM
1. The model makes unrealisGc assumpGons 2. The parameters of the model cannot be esGmated precisely
-‐ DefiniGon of a market index -‐ Firm may have changed during the 'esGmaGon' period'
3. The model does not work well -‐ If the model is right, there should be
a linear relaGonship between returns and betas the only variable that should explain returns is betas
-‐ The reality is that the relaGonship between betas and returns is weak Other variables (size, price/book value) seem to explain differences in returns beXer.
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Why the CAPM persists…
¨ The CAPM, notwithstanding its many criGcs and limitaGons, has survived as the default model for risk in equity valuaGon and corporate finance. The alternaGve models that have been presented as beXer models (APM, MulGfactor model..) have made inroads in performance evaluaGon but not in prospecGve analysis because: ¤ The alternaGve models (which are richer) do a much beXer job than the CAPM in
explaining past return, but their effecGveness drops off when it comes to esGmaGng expected future returns (because the models tend to shid and change).
¤ The alternaGve models are more complicated and require more informaGon than the CAPM.
¤ For most companies, the expected returns you get with the the alternaGve models is not different enough to be worth the extra trouble of esGmaGng four addiGonal betas.
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Gauging the marginal investor: Disney in 2009
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Extending the assessment of the investor base
¨ In all five of the publicly traded companies that we are looking at, insGtuGons are big holders of the company’s stock.
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6ApplicaGon Test: Who is the marginal investor in your firm?
¨ Looking at the breakdown of stockholders in your firm, consider whether the marginal investor is ¤ An insGtuGonal investor ¤ An individual investor ¤ An insider
B DES Page 3 PB Page 13
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Read Chapter 3
Task Who is the marginal investor in your firm?