Chapter 12 Systematic Risk Beta CAPM Measuring Systematic Risk 1 The amount of a stock s risk that is removed by diversification depends on its correlation with 2 other stocks in the portfolio If you build a large enough portfolio you can remove all unsystematic risk by diversification but you will still be left with systematic risk Market Portfolio the portfolio of al risky investments held in proportion to their value Market Capitalization the total market value of a firm s equity equals the market price per share times the number of shares Market Capitalization shares outstanding price per share Value Weighted Portfolio a portfolio in which each security is held in proportion to its market capitalization Market Proxy a portfolio whose return is believed to closely track the true market portfolio Market Index the market value of a broad based portfolio of securities Beta the expected percentage change in the excess return of a security for a 1 change in the excess return of the market portfolio Capital Asset Pricing Model CAPM an equilibrium model of the relationship between risk and return that characterizes a security s expected return based on its beta with the market portfolio The expected return on any investment should come from two components 1 A baseline risk free rate of return that we would demand to compensate for inflation and the time value of money even if there were no risk of losing our money 2 A risk premium that varies with the amount of systematic risk in the investment Expected Return risk free rate risk premium for systematic risk Required return the expected return of an investment that is necessary to compensate for the risk of undertaking the investment Security Market Line SML the pricing implication of CAPM it specifies a linear relation between the risk premium of a security and its beta with the market portfolio Chapter 13 The Cost of Capital Capital A firm s sources of financing debt equity and other securities that it has outstanding Capital Structure the relative portions of debt equity and other securities that a firm has outstanding Cost of Capital When investors buy the stock or bonds of a company they forgo the opportunity to invest that money elsewhere expected return from alternative investments opportunity cost Firm must offer potential investors an expected return equal to what they could earn elsewhere at the same level of risk providing this return is the cost a company bears in exchange for obtaining capital from investors Weighted Average Cost of Capital WACC the average of a firm s equity and debt costs of capital weighted by the fractions of the firm s value that correspond to equity and debt respectively Weighted average of the return you earn holding all the stock of them firm and the return you earn holding all of the debt Market value Balance Sheet similar to an accounting balance sheet but all values are current market values rather than historical costs Market Value of Equity Market Value of Debt Market Value of Assets WACC Calculations holders Unlevered a firm that does not have debt outstanding o All the free cash flows generated by its assets are ultimately paid out to its equity o Valuation Principle market value risk and cost of capital for the firm s equity are equal to the corresponding amounts for its assets o Estimate the firm s equity cost of capital using the CAPM o Cost of capital for the firm s assets is the same as the firms costs of equity Levered a firm that has debt outstanding o Calculate the cost of capital of the firm s assets by computing the weighted average of the firm s equity and debt cost of capital o rWACC fraction of firm financed by equity equity cost of capital fraction of firm value financed by debt debt cost of capital asset cost of capital Leverage the relative amount of debt on a firm s balance sheet Yield to Maturity the Cost of Debt The market price of the firm s existing debt implies a yield to maturity the return that current purchasers of the debt would earn if they held the debt to maturity Use the yield to maturity to calculate the firm s current cost of debt Taxes and the Cost of Debt The return paid to the debt holders is not the same as the cost to the firm interest paid on debt is a tax deductible expense When a firm uses debt financing the cost of the interest it must pay is offset by the tax deduction Effective cost of debt a firm s net cost of interest on its debt after accounting for the interest tax deduction Holders of preferred stock are promised a fixed dividend paid before any common holders Cost of Preferred Stock Capital Cost of Preferred Capital Preferred Dividend Preferred Stock Price Cost of Common Capital A company cannot directly observe its cost of common stock must estimate it Capital Asset Pricing Model o Estimate the firm s beta of equity o Determine the risk free rate o Estimate the market risk premium by comparing historical returns on a market proxy to historical risk free rates o Apply the CAPM Cost of Equity risk free rate equity beta market risk premium Constant Dividend Growth Model o Cost of Equity dividend growth rate dividend 1 year current price WACC Equation rwacc rEE rpfd P rD 1 TC D For a company that does not have preferred stock the WACC condenses to rwacc rEE rD 1 TC D Net Debt total debt outstanding minus any cash balances net debt debt cash risk free securities Methods in Practice The Risk Free Interest Rate o Most firms use the yields on long term treasury bonds The Market Risk Premium o Since 1926 the S P 500 has produced an average return of 7 1 above the rate for one year Treasury securities o Since 1959 the S P 500 has shown an excess return of only 4 7 over the rate for one year Treasury securities Using the WACC to Value a Project A project s cost of capital depends on its risk Similar risk to the average market risk of the firm s investments the its cost of capital is equivalent to the cost of capital for a portfolio of all the firm s securities the project s cost of capital is equal to the firm s WACC Levered value the value of an investment including the benefit of the interest tax deduction given the firm s leverage policy WACC method discounting future incremental free cash flows using the firm s WACC produces the levered value of a project o The firm s WACC represents the average return the firm must pay to its investors both debt and equity holders on an after tax basis Key Assumptions o Average Risk We assume initially that the