Seminar 3

Question 1

What does Ke means to who?

Answer 1

1) To investors: expected rate of return today

2) To firm: cost of equity

Question 2

What kind of risk free rate should we use and why?

Answer 2

Normalised risk free rate (average 10 year bond rate over the last 30 years ~4%)
- no risk of being too high or low

Question 3

What does risk free rate mean and what implications does it have?

Answer 3

• no default and reinvestment risk
• actual return = expected return
• Implications: time horizon matters

Question 4

Issues with historical equity risk premium estimates

Answer 4

1) Time period
2) Choice of risk free rate: duration, definition
3) Survivorship bias
4) Geometric or Arithmetic mean
5) String of unusual events (current # cannot be used to forecast future #)

Question 5

Limitations of S&P 500

Answer 5

Survivorship bias – companies that cannot survive will drop and be kicked out of the list

Question 6

2 ways to determine ____ equity risk premium estimates

Answer 6

Forward looking ERP estimate

1) Gordon growth model
2) Macroeconomic model

Question 7

1) Gordon Growth Model (forward looking ERP)

Answer 7

ERP = DY + g - LT government bond yield

• suitable for mature markets
• div and earnings grow at a constant rate
• stock price grows as the same rate as earnings + assume that earnings growth determines capital gain

Question 8

2) Macroeconomic Model (forward looking ERP)

Answer 8

ERP = (1+expected inflation) x (1+expected real earnings growth per share//GDP economy real growth) x (1+expected P/E growth) - 1 + (expected income) - expected risk free rate
= [(1 + TIPs)/(1 + nonTIPs) - 1] x (1 + labour supply growth rate + labour productivity growth rate) x (1 + expected P/E growth) - 1 + (expected dividend yield + expected return from reinvestment of income) - yield on treasury bonds

Question 9

Methods to determine required return on equity + explain each method is suitable to determine return on what types of stocks

Answer 9

1) Bond yield plus risk premium
- commonly used for firms that are not publicly traded

2) CAPM
- suitable for predicting portfolio returns
- indosyncratic (firm specific) risks in the portfolio cancel each other out

3) Multifactor models
- suitable for predicting returns for individual stocks (R^2 increase which means that the factors in multifactor models explain variability of data better than old model)

4) Arbitrage pricing theory (macroeconomic model)

Question 10

Limitations with beta (CAPM model)

Answer 10

1) Assumes investors are risk adverse

2) Only accounts for systematic/market risk, but all risks should be accounted for

Question 11

Considerations/Limitations for beta

Answer 11

1) Thinly traded/private firms: use comparables and adjust
2) Choice of market index: use S&P 500
3) Adjusted beta = (1/3 x 1.0) + (2/3 x adjusted beta) – suitable for firms in mature stage of PLC and changes follow market portfolio
4) Length and frequency of data – Bloomberg uses 2 weeks

Question 12

Fama French Model (3-factor model)

Answer 12

Ke = risk free frate + market risk premium x beta(m) + size premium (SMB) x beta(s) + value premium (HML) x beta(v)

• small cap stocks have better returns than large cap stocks historically
• value stocks (high book-market) have better returns than growth stocks (low book-market)

Question 13

Dissect HML

Answer 13

1) Growth (low Book-Market)
2) Value (high Book-Market)

• book –> past ; market –> future
• high B/M means MV reflects BV –> low growth
• low B/M means investors expect high future growth and is willing to pay more today

Question 14

Pastor Stambaugh Model (4-factor model)

Answer 14

Ke = risk free frate + market risk premium x beta(m) + size premium (SMB) x beta(s) + value premium (HML) x beta(v) + liquidity premium x beta(l)

• factor in liquidity –> returns from illiquid stocks - returns from liquid stocks

Question 15

Fama French Carhart Model (4-factor model)

Answer 15

Ke = risk free frate + market risk premium x beta(m) + size premium (SMB) x beta(s) + value premium (HML) x beta(v) + prior 1-year return x beta(pr1yr)

Question 16

Arbitrage Pricing Theory

- disadvantage of APT

Answer 16

Ke = risk free rate + [(actual - expected)factor x beta(1) + …}

• disadvantage: can get negative return

Question 17

BYPRP Model

- advantages

Answer 17

Advantages:

• **specific to company
• recognise higher risk of equity – junior claim to debt
• reflects default risk, inflation and real inflation rates
• simple

Question 18

WACC formula

Answer 18

WACC = WdKd*(1 - Tax) + WpKp + WeKe

Question 19

Calculate cost of debt using interest expense method

Answer 19

1) Obtain interest coverage ratio = average EBIT / interest expense (most current?)
2) Identify default spread based on interest coverage ratio –> forward looking (use latest year)
3) Cost of debt = risk free rate + default spread