Corporate Finance

Dr Angie Andrikogiannopoulou
 Course Overview

Primer
1. Time Value of Money 2. Analysis of Financial Statements

Financing Decisions
Investment Decisions
1. Bond Valuation Company Valuation
1. Capital Budgeting
2. Equity Valuation 1. Forecast CFs
2. NPV/IRR/Payback
3. Capital Structure 2. Find discount rate
Risk and Return

Source: http://imas.org.sg
 Capital Market History
The Value of an Investment of $100 in 1928, Real Returns

$1,000,000
Equities Bills Bonds
$100,000
Dollars (log scale)

$10,000

$1,000

$100

$10
1928
1932
1936
1940
1944
1948
1952
1956
1960
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
Year
 Capital Market History
S&P 500 Returns, 1928-2015
60.00%

40.00%
Percentage Return

20.00%

0.00%

-20.00%

-40.00%

-60.00%
1928
1933
1938
1943
1948
1953
1958
1963
1968
1973
1978
1983
1988
1993
1998
2003
2008
2013
Year
Capital Market History

Source: CRSP, Morgan Stanley Capital International

What about individual stocks?

Capital Market History

• Larger stocks tend to have lower volatility than smaller stocks.

• Even the largest stocks are more volatile than the S&P500.
Positive Equity Risk Premium

Investors are usually risk averse.

– What would happen if stocks paid on average the same returns as
T-bills?
– No one would want to buy stocks ⇒ stock prices would go down ⇒
stock returns would go up to pay premium

'()*+,*-,.
"# ↓ ⇒ % = ↑
,.

– So stock prices adjust to pay risk premium for holding risky stocks.
– On average, during 1928-2015, the equity risk premium in the U.S.
has been 7.92%.
Measuring Expected Return and Risk

Expected return of a stock between ! = 0 and ! = 1:

% ()*' % +' − +,
% &' = + = / 201 &'
+, +,
01

Using historical returns:

7
1 1
&3 = &' + &5 + ⋯ &7 = / &8
4 4
89'
 Measuring Expected Return and Risk

Variance/Standard deviation of the return of a stock:

!"# $% = ' $% − ' $% ) = * -+, $% − ' $% )

+,
./012! $% = !"# $%

Using historical returns:

%
!"# $ = 34% ∑367% $6 − $8 )

Covariance/Correlation between the returns of stocks A and B:

9:! $; , $= = ' $; − ' $; $= − ' $=

9:! $; , $=
9:## $; , $= =
./012! $; > ./012! $=
Portfolio Expected Return and Risk: 2 stocks

Expectation and variance of portfolio return:

! "# = ! %& "& + %( "( = %& ! "& + %( ! "(

)*" "# = )*" %& "& + %( "( = %&( )*" "& + %(( )*" "( + 2%& %( ,-) "& , "(

The formula for the variance can conveniently be rewritten in terms

of standard deviations and correlations:
/#( = %&( /&( + %(( /(( + 2%& %( /& /( 0&( ,

where /# = )*" "# , /& = )*" "& , /( = )*" "( , 0&( = ,-"" "& , "(
Portfolio Expected Return and Risk: ! stocks

When there are ! stocks, the expected portfolio return is given

by:

" #$ = ∑*
'() +' " #' ,

The variance of the portfolio return can be computed by summing

up the numbers in the following table.
Portfolio Risk: ! stocks
To compute the variance of !-stock portfolio, sum up numbers in this table:
"*) %*)
1
")) %)) "4"6%4%6&46
Stock number in portfolio

2
"() %()
3 "5"!%5%!&5!
4

1 2 3 4 5 6 N
Stock number in portfolio
Diversification
Diversification is a strategy designed to reduce risk by spreading the portfolio across
many investments.
Unique Risk: Risk factors affecting only a particular firm. Also called diversifiable risk ,
or “idiosyncratic risk”.
Market Risk: Economy-wide sources of risk that affect the overall stock market. Also
called systematic risk, and cannot be diversified away.
Portfolio Volatility
50%
corr = 100%
Standard Deviation

40%

30% Diversifiable
Risk
corr = 20%
20%

10% Systematic
Risk corr = 0%

0%
1 10 100 1000
Number of Stocks
Markowitz Portfolio Theory

• Portfolio Theory proposed by Harry Markowitz (1952).

• Combining stocks into portfolios can reduce standard deviation
below the level obtained from a simple weighted average
calculation.
• Correlations < 1 make this possible.
2-stock Portfolios
• Consider 2 stocks with the following characteristics:
Stock Expected Return Standard Deviation Correlation
Intel 26% 50%
Coca-Cola 6% 25% 0

• Consider all possible portfolios of these 2 stocks with weights 0 ≤ $% ≤ 1

and 0 ≤ $' ≤ 1 such that $( + $' = 1.
2-stock Portfolios

Coca-Cola is dominated by a combination of Intel and Coca-Cola that has

higher expected returns.
2-stock Portfolios

• Investors buy a combination of Coca-Cola and Intel because of

diversification benefits.
• However, investors do not hold portfolios on the downward
sloping part of return-volatility frontier.
• Investors only buy portfolios on the upward sloping part which
is called the efficient frontier because these portfolios offer
higher returns for a given level of risk.
• Investors choose portfolios on the efficient frontier according to
their risk preferences.
2-stock Portfolios
We can plot frontiers for different correlations
2-stock Portfolios
• Lower correlations allow for more efficient portfolios because a given
level of expected return can be achieved by bearing less risk.
• In the extreme case when stocks are perfectly negatively correlated
(! = −1) one can even achieve a riskless portfolio with zero standard
deviation of returns.
• Portfolios on the %-stock efficient frontier dominate the portfolios on
2-, 3-, … ,% − 1 stock frontiers.

Return (%)
Expected

Standard
Deviation
Measuring Systematic Risk
• For investors, only systematic risk matters, since that is the only
risk that cannot be diversified away.

• How can we measure the systematic risk of a stock?

• A common way to approach the measurement is to look at the

relation between the returns of one stock and the returns of the so-
called market portfolio.

• The market portfolio refers to a portfolio of all the stocks in the

market, with stocks weighted according to their market
capitalizations. In practice, a broad index such as the S&P 500 can
be used.
Measuring Systematic Risk

• The measure for systematic risk is called beta. The beta of stock ! with the
market portfolio " is defined as
,-./01 +$ ()1 +$ , +&
#$,& = ()** +$ , +& =
,-./01 +& 12* +&

• Beta is interpreted as the % change we expect in the stock for an 1%

change in the market.
• An asset whose returns move fully hand-in-hand with the market has a
beta of 1, and the beta of a risk-free asset is 0.

• Note that the beta of a portfolio of 6 stocks can be calculated as the

weighted average of the betas of its components:
;
#7,& = 8 <$ #$,&
$9:
Betas by Sector

Industry Name N Average Beta Market D/E Ratio Unlevered Beta

Natural Gas Utility 0.65 62.04% 0.44
Water Utility 0.7 77.89% 0.47
Tobacco 0.73 21.57% 0.63
Educational Services 0.79 8.89% 0.75
Food Processing 0.87 28.98% 0.71
Telecom. Utility 1.03 84.06% 0.63
Aerospace/Defense 1.15 23.64% 0.97
Precious Metals 1.18 6.76% 1.12
Financial Svcs. (Div.) 1.37 135.83% 0.65
Automotive 1.5 108.58% 0.8
Entertainment 1.72 37.99% 1.3
Steel (Integrated) 1.72 36.84% 1.32
Advertising 1.79 36.55% 1.36
Semiconductor Equip 1.79 5.84% 1.7
Heavy Truck/Equip Makers 1.94 46.41% 1.42
Public/Private Equity 2.18 104.42% 1.07

Source: http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/Betas.html
Data Used: Value Line database; Date of Analysis: Data used is as of 2011; see above link for updates
Betas over Time

Estimated Betas for Cisco Systems, 1999–2009

Example

Assume the risk-free return is 5% and the market portfolio has an

expected return of 12% and a standard deviation of 44%. Intel’s stock
return has a standard deviation of 68% and a correlation with the
market of 0.91.
1. What is Intel’s beta with the market?

456789 1, 0.68
+, = ./00 1, , 13 = 0.91 = 1.41
456789 13 0.44

If the market goes up by 1%, Intel will go up by 1.41%, on average.

In other words, this investment is more risky than investing in the
market portfolio.
Capital Asset Pricing Model (CAPM)

• We said that systematic, undiversifiable risk is measured with beta,

and other risks can be removed by holding a sufficiently broad
portfolio of assets.
• How is this related to the required returns on stocks?
• Investors will require a return that compensates them for the
systematic risk measured by beta.
• This is the foundation for the Capital Asset Pricing Model (CAPM)

! "# = %& + (#,* ! "* − %&

Risk Premium for stock ,

Security Market Line
Expected return is a linear function of beta. This function is called Security
Market Line. All possible portfolios will be somewhere on this line.
Example (cont’d)

Assume the risk-free return is 5% and the market portfolio has an

expected return of 12% and a standard deviation of 44%. Intel’s stock
return has a standard deviation of 68% and a correlation with the
market of 0.91.
1. What is Intel’s beta with the market?
2. Under the CAPM assumptions, what is its expected return?

456789 1, 0.68
+, = ./00 1, , 13 = 0.91 = 1.41
456789 13 0.44

: 1, = 5% + 1.41 < 12% − 5% = 14.87%

Applying the CAPM in practice

1. The Risk-Free Rate

– The yield on U.S. Treasury securities.
– Current or Historical? Long-term or short-term?
2. The Market Portfolio
– Most practitioners use the S&P 500 as the market proxy, even
though it is not actually the market portfolio.
3. The Market Risk Premium
– Historical or forward-looking estimates?
4. The Beta
– Look them up on Bloomberg. How does Bloomberg calculate these
betas?
The Risk-free Rate
Choosing the risk-free rate for the CAPM:

• Use the prevailing yields, not historical rates.

o Prevailing yields reflect current market conditions and hence

investors’ current opportunity set.

• Match to economic life of the project.

o Cash flows to equity arrive over a long horizon.

o For capital budgeting, project horizon is typically shorter.
Estimation of Beta
Monthly excess returns for Cisco vs the S&P 500 for 1996–2009. Beta can
be estimated as the slope of the line that fits our observations in the best
possible way.
Estimation of Beta

Bloomberg commands:
∙ BP/ LN Equity <GO> (type “bp/ ln” – press F8 – press Enter)
∙ BETA <GO> (type “beta” – press Enter)
CAPM as a Regression
Suppose we have observed !" − !$ and !% − !$ for stock & over a long
period of time, and we run the OLS regression

!%' − !$' = )% + +% !"' − !$' + ,%'

Systematic Risk Idiosyncratic Risk

• )& is the intercept term of the regression.

• +& (!3/ – !5/) represents the sensitivity of the stock to market risk.
• ,&/ is the error term and represents the deviation from the best-
fitting line and is zero on average.

Since -[,&/] = 0:
- !%' = !$' + +% - !"' − !$' + )%

Expected return from the SML Distance above/below the SML

Estimation of Beta

• You can also get Beta from comparable firms, i.e., firms that
have a similar risk profile of cash flows (e.g., firms in the same
industry).

• Advantages:
– Beta estimate will usually have a lower error because the
volatility of a portfolio of comparables is smaller than the
volatility of an individual company.
– For private companies comparables are the only way to
compute beta because there is no stock price data.

… but must be careful to choose good comparables…

Market Risk Premium
• For the market risk premium it is common to use the historical
average excess return of the market over the risk-free rate over as
long a period as possible.

• Historical Data
– Using 1928-2010: !(#$) – !(#' ) = 9.32% – 3.66% = 5.66%
– Using 1961-2010: !(#$) – !(#' ) = 9.67% – 5.23% = 4.44%
– Using 2001-2010: !(#$) – !(#' ) = 1.38% – 2.16% = −0.79%

• Using historical data has two drawbacks:

– Standard errors of the estimates are large.
– Backward looking, so may not represent current expectations.
– Some evidence of decline in market risk premiums in late years.
Market Risk Premium

Which risk premium do you use to predict future returns?

• McKinsey Corporate Consulting — 5% to 6%

• Social Security Admin — 4%

• Professors of Finance — 3.5% to 5.5%

Putting CAPM to work: MSFT

Let’s estimate equity cost of capital for Microsoft.

Data:

1. risk-free rate: 2.89% (current rate of 30-year treasury)

2. Beta: 1.48 (from Yahoo! Finance, Key Statistics)

3. Market risk premium: assume 4%

'( = 2.89% + 1.48 × 4% = 8.81%