Cost of Common Stock Using the Capital Asset Pricing Model The investor’s required rate of return is compensation for both the time
Cost of Common Stock Using the Capital Asset Pricing Model The investor’s required rate of return is compensation for both the time
value of money and risk. To figure out how much compensation there should be for risk, we first have to understand what risk we are talking about.
As we saw in Chapter 10, the capital asset pricing model (CAPM) assumes an investor holds a diversified portfolio—a collection of invest- ments whose returns do not move in the same direction nor at the same time nor by the same amount. The result is that the only risk left in the portfolio as a whole is the risk related to movements in the market as a whole—market risk.
If we assume all shareholders’ hold diversified portfolios, the risk that is relevant in valuing a particular investment is the market risk of that investment. The greater the market risk, the greater the compensa- tion—meaning a higher yield—for bearing this risk. And the greater the yield, the lower the present value of the asset because expected future cash flows are discounted at a higher rate that reflects the higher risk.
The cost of common stock is the sum of the investor’s compensation for the time value of money and the investor’s compensation for the market risk of the stock:
Cost of common stock = Compensation for the time value of money
+ Compensation for market risk Let’s represent the compensation for the time value of money as the
expected risk-free rate of interest, r f . The risk-free rate of interest is the rate that is earned on an asset that has no risk. If a particular common
The Cost of Capital
stock has market risk that is the same as the risk of the market as a whole, then the compensation for that stock’s market risk is the market risk premium. The market’s risk premium is the difference between the
expected return on the market, r m , and the expected risk-free rate, r f :
Market risk premium = r m – r f
If the expected risk-free rate is 3% and the expected return on the mar- ket is 11%, the market risk premium is 8%.
But if a particular common stock has market risk that is different from the risk of the market as a whole, we need to adjust that stock’s market risk premium to reflect its different risk. Suppose the market risk premium is 8%. If a stock’s market risk is twice the whole market’s risk, the stock’s premium for its market risk is 2 × 8%, or 16%. If a stock’s market risk is half the risk of the market as a whole, the stock’s pre- mium for market risk is 0.5 × 8%, or 4%. What we are doing here is fine tuning the compensation investors will need to accept that stock’s market risk. We fine tune by starting with our benchmark of the risk of the market as a whole and adjust it to reflect the market’s premium for the stock’s relative market risk to come up with the stock’s premium.
Let β represent the adjustment factor. Then the compensation for market risk is:
Compensation for market risk = βr ( m – r f ) Because we know the compensation for the time value of money, r f ,
and now we know the compensation for market risk, we see that the
cost of common stock, r e , is:
(11-6) ■ The term ( r m – r f ) represents the risk premium required by investors for
r e = r f + βr ( m – r f )
bearing the risk of owning the market portfolio. ■ The multiplier, β, fine tunes this market risk premium to compensate for the market portfolio associated with the individual firm. β, com- monly referred to as beta, is a measure of the sensitivity of the returns on a particular security (or group of securities) to changes in the returns on the market—a measure of market risk.
A common stock having a β greater than 1.0 has more risk than the average security in the market. A common stock having a β less than 1.0 has less risk than the average security in the market.
THE FUNDAMENTALS OF VALUATION
Suppose a firm’s stock has a β of 2.0. This means its market risk is twice the risk of the average security in the market. If the expected risk- free rate of interest is 6% and the expected return on the market is
10%, the cost of common stock, r e , is:
r e = 0.06 + 2.0(0.10 – 0.06) = 0.14 or 14% In this example, the market risk premium is (10% – 6%) = 4%. A
market risk premium of 4% means that if you own a portfolio with the same risk as the market as a whole (that is, with a beta of 1.0), you would expect to receive a 10% return comprising: 6% to compensate you for the price of time and 4% to compensate you for the price of market risk. If you invest in a security with a β of 2.0, you would expect
a return of 14% comprising: 6% to compensate you for the price of time and 2.0 times 4% = 8% to compensate you for the price of that security’s particular risk.
The CAPM is based on two ideas that make sense: Investors are risk averse and they hold diversified portfolios. But the CAPM is not with- out its drawbacks. First, the estimates rely heavily on historical values— returns on the stock and returns on the market. These historical values may not be representative of the future, which is what we are trying to gauge. Also, the sensitivity of a firm’s stock returns may change over time; for example, when the firm changes its capital structure. Second, if the firm’s stock is not publicly-traded, there are no data sources even for historical values.
Parts
» Financial Management and Analysis
» SECURITIES MARKETS The primary function of a securities market—whether or not it has a
» Stock Exchanges Stock exchanges are formal organizations, approved and regulated by
» Stock Market Indicators Stock market indicators have come to perform a variety of functions,
» Efficient Markets Investors do not like risk and they must be compensated for taking on
» THE FEDERAL RESERVE SYSTEM The United States has a central monetary authority known as the Fed-
» The Fed and the Money Supply Financial managers and investors are interested in the supply and
» Deposit Institutions Traditionally, the United States has had several types of deposit institu-
» Investment Banking The primary market involves the distribution to investors of newly
» Interest Rates and Yields Because bonds are traded in the secondary market, the price of the bond
» The Risk Premium Market participants talk of interest rates on non-Treasury securities as
» OPTIONS An option is a contract in which the writer of the option grants the
» Buying Call Options The purchase of a call option creates a position referred to as a long call
» Buying Put Options The buying of a put option creates a financial position referred to as a
» CAP AND FLOOR AGREEMENTS There are agreements available in the financial market whereby one
» I n assessing a company’s current and future cash flows, the financial
» Depreciation for Tax Purposes For accounting purposes, a firm can select a method of depreciation
» Capital Gains We tend to use the term “capital gain” loosely to mean an increase in the
» Current assets (also referred to as circulating capital and working
» Noncurrent Assets Noncurrent assets are assets that are not current assets; that is, it is not
» Deferred Taxes Along with long-term liabilities, the analyst may encounter another
» THE INCOME STATEMENT An income statement is a summary of the revenues and expenses of a
» THE STATEMENT OF CASH FLOWS The statement of cash flows is a summary over a period of time of a
» T he notion that money has a time value is one of the most basic con-
» DETERMINING THE PRESENT VALUE Now that we understand how to compute future values, let’s work the
» Shortcuts: Annuities There are valuation problems that require us to evaluate a series of level
» THE CALCULATION OF INTEREST RATES
» T here are a number of factors that affect a stock’s price and its value to
» Dividend Valuation Model If dividends are constant forever, the value of a share of stock is the
» Returns on Common Stock As we saw in the preceding section, the value of a stock is the present
» Straight Coupon Bond Suppose you are considering investing in a straight coupon bond that:
» Returns on Bonds If you invest in a bond, you realize a return from the interest it pays (if
» Coupon Bonds The present value of a bond is its current market price, which is the dis-
» Callable Bonds Some bonds have a feature, referred to as a call feature, that allows the
» RISK Whenever you make a financing or investment decision, there is some
» Financial Risk When we refer to the cash flow risk of a security, we expand our con-
» Reinvestment Rate Risk Another type of risk is the uncertainty associated with reinvesting cash
» Interest Rate Risk Interest rate risk is the sensitivity of the change in an asset’s value to
» Currency Risk In assessing the attractiveness of an investment, we estimated future cash
» 5 (Continued) Portfolio of Investment C and Investment D
» Portfolio Size and Risk What we have seen for a portfolio with two assets can be extended to
» I n Chapters 8 through 10, we discussed and practiced techniques for
» The Cost of Debt Because Congress allows you to deduct from your taxable income the
» The Cost of Common Stock The cost of common stock is the cost of raising one more dollar of com-
» INTEGRATIVE EXAMPLE: ESTIMATING THE COST OF CAPITAL FOR DUPONT
» CAPITAL BUDGETING Because a firm must continually evaluate possible investments, capital
» Investment Cash Flows When we consider the cash flows of an investment we must also consider
» Asset Disposition At the end of the useful life of an asset, the firm may be able to sell it or
» Change in Expenses When a firm takes on a new project, the costs associated with it will
» Putting It All Together Here’s what we need to put together to calculate the change in the firm’s
» The Analysis To determine the relevant cash flows to evaluate this expansion, let’s
» The Problem The new equipment costs $300,000 and is expected to have a useful life of
» T he value of a firm today is the present value of all its future cash
» Payback Period The payback period for a project is the length of time it takes to get your
» Discounted Payback Period The discounted payback period is the time needed to pay back the origi-
» Net Present Value If offered an investment that costs $5,000 today and promises to pay
» Net Present Value Decision Rule
» Profitability Index The profitability index (PI) is the ratio of the present value of change in
» Stand-Alone versus Market Risk If we have some idea of the uncertainty associated with a project’s
» Sensitivity Analysis Estimates of cash flows are based on assumptions about the economy,
» Simulation Analysis Sensitivity analysis becomes unmanageable if we change several factors
» Options on Real Assets The valuation of stock options is rather complex, but with the assis-
» OVERVIEW OF DEBT OBLIGATIONS In a debt obligation, the borrower receives money in exchange for a
» Repayment Schedule Term loans are usually repaid in installments either monthly, quarterly,
» Interest In the United States, interest is typically paid twice a year at six month
» Debt Retirement By the maturity date of the bond, the issuer must pay off the entire par
» Rating Systems In all systems the term high grade means low default risk, or conversely,
» S uppose you buy a new car that costs $20,000 and you pay cash for it.
» Limited Liability The corporate form of doing business is attractive to owners of a busi-
» Stock Ownership We can classify a corporation according to whether its shares of stock
» Voting Rights Common shareholders are generally granted rights to
» Corporate Democracy Corporate democracy gives owners of the corporation a say in how to
» Methods of Repurchasing Stock
» Dividends Although a firm’s board of directors declares a dividend on its preferred
» Sinking Funds Because there is no legal obligation to pay the preferred dividend and
» DEBT VERSUS EQUITY The combination of debt and equity used to finance a firm’s projects is
» CAPITAL STRUCTURE AND TAXES We’ve seen how the use of debt financing increases the risk to owners;
» Interest Tax Shield An interesting element introduced into the capital structure decision is
» Unused Tax Shields The value of a tax shield depends on whether the firm can use an interest
» PUTTING IT ALL TOGETHER As a firm increases the relative use of debt in the capital structure, its
» A s we saw in Part Three, managers base decisions about investing in
» CASH MANAGEMENT Cash flows out of a firm as it pays for the goods and services it pur-
» The Baumol Model The Baumol Model is based on the Economic Order Quantity (EOQ)
» The Miller-Orr Model The Baumol Model assumes that cash is used uniformly throughout the
» The Check Clearing Process The process of receiving cash from customers involves several time-
» RECEIVABLES MANAGEMENT When a firm allows customers to pay for goods and services at a later
» Captive Finance Subsidiaries Some firms choose to form a wholly-owned subsidiary—a corporation
» The Economic Order Quantity Model The Economic Order Quantity (EOQ) model helps us determine what
» Just-in-Time Inventory The goal of the just-in-time (JIT) inventory model is to cut down on the
» Monitoring Inventory Management We can monitor inventory by looking at financial ratios in much the
» Add-on-interest Another way of stating interest is with add-on interest, where the total
» Trade Credit Trade credit is granted by a supplier to a customer purchasing goods or
» Commercial Paper Commercial paper is an unsecured promissory note with a fixed matu-
» Types of Inventory Financing There are several different types of loan arrangements that involve
» SPECIALIZED COLLATERALIZED BORROWING ARRANGEMENT FOR FINANCIAL INSTITUTIONS
» RATIOS AND THEIR CLASSIFICATION
» RETURN-ON-INVESTMENT RATIOS Return-on-investment ratios compare measures of benefits, such as earn-
» The Du Pont System The returns on investment ratios give us a “bottom line” on the perfor-
» LIQUIDITY Liquidity reflects the ability of a firm to meet its short-term obligations
» PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its
» Using a Benchmark To interpret a firm’s financial ratios we need to compare them with the
» INTEGRATIVE EXAMPLE: FINANCIAL ANALYSIS OF WAL-MART STORES 6
» Dilutive Securities For a company having securities that are dilutive—meaning they could
» ANALYSTS’ FORECASTS There are many financial services firms offering projections on different
» PRICE-EARNINGS RATIO Many investors are interested in how the earnings are valued by the mar-
» FREE CASH FLOW Cash flows without any adjustment may be misleading because they do
» NET FREE CASH FLOW There are many variations in the calculation of cash flows that are used
» Using Cash Flow Information The analysis of cash flows provides information that can be used along
» THE GLOBAL ECONOMY Many countries export a substantial portion of the goods and services
» FOREIGN CURRENCY Doing business outside of one’s own country requires dealing with the cur-
» The Euro The European Union consists of 15 European member countries that
» Global Equity Market In 1985, Euromoney surveyed several firms that either listed stock on a
» Currency Swaps When issuing bonds in another country where the bonds are not denom-
» Currency Option Contracts In contrast to a forward or futures contract, an option gives the option
» A s an alternative to the issuance of a corporate bond, a corporation
» WHAT RATING AGENCIES LOOK AT IN RATING ASSET-BACKED SECURITIES
» Third-Party Guarantees Perhaps the easiest form of credit enhancement to understand is insur-
» EXAMPLE OF AN ACTUAL STRUCTURED FINANCE TRANSACTION
» Accounting for Capital Leases
» FEDERAL INCOME TAX REQUIREMENTS FOR TRUE LEASE TRANSACTIONS
» Direct Cash Flow from Leasing When a firm elects to lease an asset rather than borrow money to pur-
» S tructured financing is a debt obligation that is backed by the value of
» CREDIT IMPACT OBJECTIVE While the sponsor or sponsors of a project financing ideally would pre-
» A business that maximizes its owners’ wealth allocates its resources
» Budgeting In budgeting, we bring together analyses of cash flows, projected income
» Taxes and Transaction Costs The Black-Scholes option pricing model ignores taxes and transaction
Show more