Week 1

Question 1

What do all business decisions act to do? What are the main types?

Answer 1

All decisions act to maximise the value of the business, this could be via investment decisions(what assets to invest in), financing decisions(finding the right kind of debt for your firm and the right mix of debt and equity to fund your operations), and dividend decisions (whether to return cash to shareholders or invest it.)

Question 2

What is the hurdle rate? What should it reflect?

Answer 2

The hurdle rate is the minimum rate of return we will accept for a given level of risk.

The hurdle rate should reflect the riskiness of the investment and the mix of debt and equity used to fund it.

Question 3

What should our return reflect? What business decision does this relate to?

Answer 3

The magnitude and timing of the cash flows, as well as all side effects. This relates to investment decisions.

Question 4

How can we maximise firm value with debt and equity? What business decision does this relate to?

Answer 4

The optimal mix of debt and equity will maximise firm value. This relates to financial decisions

Question 5

How should our debt relate to the tenor of our assets? What kind of business decision is this?

Answer 5

The right kind of debt will match the tenor of our assets, this is a financial decision.

Question 6

What are two major business dividend decisions?

Answer 6

How much can be returned to shareholders depends on current and potential investment opportunities.

How we choose to return cash to the shareholders will depend on whether they prefer dividends or buybacks.

Question 7

What is cost of capital generally given by?

Answer 7

Cost of capital is generally given by the weighted average cost of capital.

Question 8

What is the expected return in the capital asset pricing model

Answer 8

In the capital asset pricing model the expected return is given by the risk-free rate + beta * (expected return on the market portfolio - risk-free rate).

Question 9

What is market risk premium? What does it generally change with?

Answer 9

Market risk premium is the difference between the market expected return and the risk-free rate. It is the premium that investors demand for investing in an average risk investment, relative to the risk free rate, generally, this should be greater than zero, increase with the risk aversion of the investors in that market, and increase with the riskiness of the “average” risk investment.

Question 10

What are the conditions for an investment to be risk-free

Answer 10

The two conditions for an investment to be risk free are: there has to be no default risk, generally this implies the security is issued by a reputable government. Also there must be no uncertainty about the reinvestment rates, which implies it is a zero coupon security with the same maturity as the cash flow being analyzed.

Question 11

Do we typically worry about the time horizon of our risk free investment?

Answer 11

In theory we need to use different risk-free rates for each cash flow, in practice however, this effect is small enough that it is not typically with it and we just use long term government bond rates.

However, for short term analysis it is entirely appropriate to use a short term government security rate as the risk-free rate.

Question 12

What is important with regards to the risk-free rate and currency?

Answer 12

We should use a riskfree rate in the same currency as our cashflow are estimated in.

Question 13

Why can there be a problem with using historic data to estimate risk premiums?

Answer 13

Risk premiums change over time, making it hard to estimate using historic data.

Question 14

What are the main ways we can estimate risk premiums?

Answer 14

To estimate risk premiums in practice we can:

1. Survey investors on their desired risk premiums and use the average premium from these surveys
2. Assume that the actual premium delivered over long time periods is equal to the expected premium.
3. Estimate the implied premium based on today’s asset prices.

Question 15

What are the limitations of the survey approach to finding risk premiums?

Answer 15

The survey approach is limited by:
There are no constraints on reasonability, meaning the risk premium could be negative or abnormally high.

The survey results are more reflective of the past than the future.

They tend to be short term, with even the longest surveys not going beyond one year.

Question 16

How do we estimate the risk premium using the historical approach? What does it assume?

Answer 16

To use the historical premium approach(the default method):

1. Define a time period for the estimation.
2. Calculate the average returns on a stock index during that period.
3. Calculate the average returns on a riskless security over the period.
4. Calculate the difference between the two and use it as a forward looking premium.

This approach assumes the risk aversion of investors has not changed in a systematic way across time, allowing it to change year to year, but reverting back to historical averages). It assumes the riskiness of the “risky” portfolio has not changed in a systematic way across time.

Question 17

How do we find the implied equity risk premium?

Answer 17

We find out what investors are willing to pay for stocks to find an expected return and hence an implied equity risk premium. We can do this by valuing the present value of future cash flows of the stock/index and finding the implied discount rate to get the expected return and hence risk premium.

Question 18

What is a common method for estimating the equity risk premium of a company based on its location?

Answer 18

Generally we estimate an equity risk premium for a company based on where a company is incorporated (using the equity risk premium for that country). However, it may be more sensible to estimate the equity risk premium based upon the countries a company operates in (a weighted average expected risk premium, based on the proportion of revenue from each country).

Question 19

What is the standard method for estimating betas? What are some important things to remember?

Answer 19

The standard method for estimating betas is to regress stock returns against market returns such that stock returns = intercept + beta * market returns. This is CAPM equation in disguise.
The slope corresponds to the beta of the stock, and measures systematic risk. The R^2 of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be attributed to market risk, with the remainder being the firm-specifc risk.

Question 20

What are the typical discount rates for business cash flows?

Answer 20

The potential discount rates for a business are typically the cost of equity, the cost of debt, or the cost of capital (WACC).

Question 21

What is the CAPM form of the regression beta equation?

Answer 21

The CAPM form of the regression beta equation is Return on stock = risk free rate * (1-beta) + beta * market return.

Question 22

What does the intercept of the regression model for beta suggest?

Answer 22

The intercept of the regression model for beta suggests the stock did better than expected during the regression period if it is above the risk free rate * (1-beta). If equal the stock did as well as expected during the during the regression, if less then the stock did worse than expected during the regression period.

Question 23

What is Jensen’s alpha given by?

Answer 23

The difference between the regression intercept for beta and the risk free rate * (1-beta) is known as Jensen’s alpha.

Question 24

What is involved in setting up a beta estimation?

Answer 24

1. Decide on an estimation period, longer estimation periods provide more data, but firms change. Shorter periods can be affected more easily by significant firm specific events that occurred during the period. Services typically use periods ranging from 2 to 5 years for the regression.
2. Decide on a return interval(e.g daily, weekly, monthly), shorter intervals yield more observations, but suffer from more noise. Noise is created by stocks not trading and biases all betas to 1.
3. Estimate returns(including dividends) on stock, including dividends only on the ex-dividend month.
4. Choose a market index and estimate returns (and dividends) on the index for each interval for the period.

Question 25

How can the R^2 of our beta regression be useful for an undiversified and diversified investor?

Answer 25

By using our R^2 we can see how much of our risk is systematic and how much is firm-specific/diversifiable and will not be rewarded. if we are a diversified investor we do not need to care about the systematic risk and therefore do not have to care if beta is the same. If we are undiversified though we will want the stock with the highest R^2 as it has less risk in total.

Question 26

How can manager’s utilise the CAPM expected return? How does it apply to the hurdle rate?

Answer 26

Managers can use the expected return from CAPM as their investors need to make at least this expected return to break even for their equity investment, this is the hurdle rate for projects, when the investment if analyzed from an equity standpoint, as such the expected return from CAPM is the cost of equity. The expected return from CAPM is also the long term expected return of the stock, assuming the stock is priced correctly and CAPM is a reasonable risk modle.

Question 27

What occurs to company beta as size increases?

Answer 27

Typically as companies get bigger their beta gets smaller.

Question 28

What are the main determinants of beta?

Answer 28

Product type, operating leverage effects, and financial leverage.

Question 29

How does the product type determinant of beta work?

Answer 29

product type refers to industry effects, the beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market. Cyclical companies have higher betas than non-cyclical firms, firms which sell more discretionary products will have higher betas than firms that sell less discretionary products.

Question 30

How does the operating leverage effects determinant of beta work?

Answer 30

This refers to the proportion of the total costs of the firm that are fixed. With other things being equal, higher operating leverage results in greater earnings variability which in turn results in higher betas.

Question 31

What are some potential measures of operating leverage?

Answer 31

Potential measures of operating leverage could be fixed cost measure, the fixed costs divided by the variable costs.
Or it could be the EBIT variability measure, this is given by the percentage change in EBIT divided by the change in revenues, the higher this ratio the higher the beta typically.

Question 32

How does the financial leverage determinant of beta work? How does this relate to levered and unlevered beta?

Answer 32

Financial leverage: As firms borrow they create fixed costs that make their earnings to equity investors more volatile, increasing the equity beta. The beta of equity alone (levered beta) can be written as a function of the unlevered beta and the debt-equity ratio.
Beta levered should be higher than unlevered beta. The beta calculated with regression is typically levered beta.

Question 33

What is the equation relating equity beta to unlevered beta?

Answer 33

Beta leveraged(equity beta) = unlevered beta * (1+((1-marginal tax rate)*Debt/equity))

Question 34

What is the beta of a portfolio/merger given by?

Answer 34

The beta of a portfolio/merger is the market-value weighted average of the betas of the individual investments in that portfolio. The same goes for most things combining in a merget.

Question 35

What is the beta of a firm relative to its projects?

Answer 35

The beta of a firm is the weighted average of the betas of its individual projects. At a broader level of aggregation, the beta of a firm is the weighted average of the betas of its individual divisions.

Question 36

How do we get top-down beta for a firm? What about bottom up?

Answer 36

The top-down beta for a firm comes from a regression.

The bottom up beta can be estimated by:
Finding out the businesses that a firm operates in, finding the unlevered betas of other firms in these businesses, take a weighted (by sales or operating income( average of these unlevered betas, lever up using the firm’s debt/equity ratio.

Question 37

Is a top-down or bottom-up approach to calculating beta typically better? Why?

Answer 37

The bottom-up beta is typically better than top-down because the standard error of the beta estimate will be much lower, the betas can also reflect the current(and even expected future) mix of businesses that the firm is in rather than the historical mix.

Question 38

How do we find the unlevered betas for a firm’s businesses?

Answer 38

To find the unlevered betas for a firm’s businesses we should find comparable firms to find their median beta, then calculate the median company unlevered beta using the median Debt/equity ratio and the median tax rate. To get the business unlevered beta we take our company unlevered beta and divide it by (1- (median cash and cash equivalents/median firm value)).

Question 39

What should we check when deciding if a project is a good idea for a firm? What must we be careful of?

Answer 39

When deciding whether a project is a good idea for a firm we should check to see if the cost of equity for the particular business section is smaller than the expected return. If we instead base this decision on the whole company’s cost of equity then risky business sections will be more likely to get funded.

Question 40

What can we do to estimate betas from regressions if the assets are not traded?

Answer 40

The conventional approaches of estimating betas from regressions does not work for assets that are not traded. There are no stock prices or historical returns that can be used to compute the regression beta. In this case we can estimate beta by using comparable firms or using accounting earnings.