Finance 3041 Final Study

Consider a two stock portfolio. Explain why a lower correlation coefficient for the two stocks leads to lower portfolio variance.

A lower correlation coefficient means that the two stocks move together less, leading to a greater diversification effect from holding them together in a portfolio. This greater diversification effect leads to more of the total risk being diversified away, leaving a lower overall portfolio variance.

What evidence is there that the stock market is efficient?

Answers here could be pretty wide-ranging. Event studies, long-run studies of mutual fund manager performance, the time-series properties of stock returns all point to an efficient market where investment in stocks is a zero-NPV investment.

What is our measure of systematic risk?

Beta. Beta is technically the slope coefficient from a regression of the stock's returns on the market's returns, so it measures how much the stock tends to move for a 1% move in the market.

Why would anyone want to buy international stocks or international mutual funds?

Buying international stocks and mutual funds gives the investor international diversification. Even if you build a well-diversified portfolio of US stocks, you are still exposed to US specific risk. By adding an international component to your portfolio, you can diversify away the US specific risk as well.

How does the financing decision (equity vs. debt) for a project affect NPV?

By creating a tax shield, choosing debt could increase the project NPV. If you said financing doesn't matter, you got some points, if you just stated the M&M list, you got half credit. If you specifically mentioned tax shields as part of the list or in the answer, you got full credit.

What is a good estimate of the equity value of CSH? Explain your reasoning.

CSH and EJH are both in the construction business, so your best bet is to use the way the market values EJH to value CSH. The background page shows that EJH has a total firm value of $100m and debt of $40m, meaning its equity is $60m. You also see that EJH's current cash flows for equity holders are $5m. Thus, EJH is trading at 12x cash flows (60m/5m = 12). Since CSH is also in the construction business, it would be reasonable to assume that the market will value it similarly, also pricing it at 12x cash flows. CSH's cash flows are $4m, so its equity value would be $48m.

Why do equity holders demand a different return than the return on the assets?

Equity holders take on two types of risk: asset risk and financial risk. The asset risk comes from the fundamental nature of the assets underlying the business. The financial risk comes from the fact that the more debt there is in the capital structure, the lower the probability that the equity holders (at the back of the line) will get paid. They demand some extra compensation for the risk of standing at the back of the line.

True or false: you cannot reduce the risk of your portfolio by adding a stock that is positively correlated with the other stocks in the portfolio.

False: unless it is perfectly correlated, it will add some diversity. You still get some diversification.

Example of unsystematic risk

Fire at the company's headquarters

How does holding stocks in a portfolio reduce your exposure to unsystematic risk?

Holding a large portfolio of stocks with a less than perfect correlation produces a diversification effect. This effect is due to the fact that unsystematic events do not strike all companies at the same time, so when some of your stocks have negative unsystematic events, others will have positive ones. Thus, the shocks will be offset and the unsystematic risk of the whole portfolio will be reduced.

Assume that TER has two divisions and one of them is in the same line of business as FOS. TER has total cash flows of $100 million, split equally between its two divisions. TER wants to know the discount rate it should use for making investment decisions in the division that competes with FOS? Explain. Part 2: What is the total value of that division?

If TER's division is just like FOS, then the risk of its projects should be the same as the asset risk of FOS, meaning that the discount rate should be the expected return on assets for FOS: 9.72% Part 2: Again, if TER's division is just like FOS, then if it were to be publicly traded, it should be valued similarly to FOS, meaning that growth expectations, etc. should be similar to those of FOS. Thus, its P/CF ratio should be about 15. Since it has cash flows of $50 million (half of $100 million), its total value should then be 15 x $50 million = $750 million.

Your company is worth $200m and is financed 100% with equity. You think it may be value-increasing to replace $80m of the equity with debt. How could this change the value of the company?

If a change in capital structure affects the value of a company, it must do so through one of these channels (M&M Proposition): Taxes, transaction costs, or changes in investment policy. Replacing some with debt would create a tax shield for the company.

Underpriced example:

If you go through and do the CAPM for this stock, you see that it should be priced to earn 14.7% expected return. Since it is priced to earn more than that, 15%, it is priced too low (its price needs to rise to lower the expected return to new purchasers of stock B). Thus, it is underpriced.

A market that is semi-strong form efficient:

Incorporates all publicly-available information into prices Semi-strong form market efficiency is a level of market efficiency that requires that all publicly-available information be already incorporated in stock prices. Thus, in a semi-strong form efficient market, you can't read about something in the paper or hear about it on TV then go make a trade you know will be profitable — it's already too late, because the market quickly and efficiently impounds all public information into prices.

Why does only systematic risk matter to investors?

Investors only get rewarded for taking on systematic risk. Unsystematic risk can be diversified away, so the market does not offer higher return for taking it on.

What does it (semi-strong form market) imply about how easy it is to pick winners (stocks that will increase in value)?

It implies that it is really hard to consistently pick winners. Since you can't be assured of picking winners using publicly available information, you would have to be consistently lucky. The only way to consistently pick winners is to use information that is not already incorporated into stock prices (inside, or private information).

Why is portfolio diversification a good thing?

It reduces unsystematic risk, leaving only systematic risk. Since investors do not get rewarded for taking on unsystematic risk, they should avoid it. Portfolio diversification allows them to do this.

What can you conclude about Google's growth prospects relative to Apple's? Explain.

Let's compare their P/CF ratios: Google's is $486/$29 = 16.8, and Apple's is: $250/$14=17.9, so the market has built-in higher growth prospects for Apple than for Google. P/CF ratio compares the price to the current cash flows being generated by the company. A high P/CF ratio is difficult to justify unless the market expects those cash flows to grow substantially in the future.

Mutual funds:

Load funds do not outperform no-load funds. Even when a mutual fund manager picks stocks that outperform the market, their investors often don't do better than the market. Mutual funds allow individual investors to buy a piece of a well-diversified portfolio.

If the stock market is efficient, that means the expected NPV of investing in the market is zero. Does that mean you shouldn't invest?

No. A zero NPV simply means that you are getting a fair return for the amount of (systematic) risk you are taking on. There is nothing wrong with getting the fair return. In an efficient market, you should not expect to get an abnormally high return for the amount of risk you are taking — if such an opportunity were offered, everyone would want to buy it, and the price would rise until the return was just fair again. In the long run, simply earning the fair market return has compounded to a substantial growth in the initial investment.

Can you lower your pre-tax WACC by shifting more of your financing to debt? Explain why or why not.

No. While a quick look at the formula suggests that by putting more weight on the "cheaper" source of funding, you might lower your pre-tax WACC, this ignores two important facts. First, the WACC is the expected return of your assets, which does not change if you change the financing mix. Second, when you increase debt, you increase the riskiness of the equity, causing the cost of equity capital to increase to offset the extra weight on the lower cost of debt capital.

KMS has a higher standard deviation than CSH. What does this imply about CSH's equity beta compared to KSM's equity beta?

Nothing. Beta measures only SYSTEMATIC risk while standard deviation measures TOTAL risk. Beta and standard deviation are not quoted in the same units, so you cannot directly compare them. It is quite possible that even though KMS has a higher total risk (standard deviation) than CSH, less of that total risk is due to systematic risk than it is for CSH, so CSH could have a higher beta, meaning more systematic risk, but still have a lower standard deviation (just by having a small amount of unsystematic risk.)

Which type of risk generates higher expected return and why?

Only systematic risk generates a higher expected return. Total risk is comprised of systematic and unsystematic risk. The unsystematic risk will be diversified away in a portfolio, so there is no need to bear it. Consequently, since you don't have to bear it, you are not rewarded for doing so. The systematic risk will remain even in a well-diversified portfolio, so investors must be rewarded for bearing this risk in order for them to be willing to invest

What's the difference between closed-end and open-end mutual funds?

Open-end funds are sold by the fund company. Closed-end funds are traded on exchanges.

What happens to portfolio standard deviation as the correlation between the stocks in the portfolio goes down? Why does this happen?

Portfolio standard deviation will go down as the correlation between the stocks in the portfolio goes down. This happens because as the correlation between two stocks becomes lower, their movements offset each other more often, making the net movement (the portfolio's movement) less. As the portfolio's swings dampen, its standard deviation goes down.

What two things combine to equal equity risk?

Project risk and financial risk!

Why does risk matter in valuing projects, stocks, or any cash flows?

Risk matters because people are risk averse, so that they will only bear greater risk if you offer them a greater expected reward. All else equal, the less certain you are about the cash flows, the higher you must expect them to be in order for the project to be acceptable.

What types of projects would you use the WACC for?

Scale expanding projects

What is the difference between standard deviation and beta?

Standard deviation measures total risk and beta measures systematic risk.

If you created a portfolio of ZTC and Apple, is it possible for its standard deviation to be less than 40%? Explain

Sure. We know that ZTC is a conglomerate and Apple is a consumer electronics company, so they will not be perfectly correlated. As long as the two companies are not perfectly positively correlated, we can construct a portfolio using all positive weights that will still have a portfolio standard deviation less than the average of the stocks in it. In this case, both stocks have a standard deviation of 40%, so the average will also be 40% and the resulting portfolio will have less than 40% standard deviation.

What is the difference between systematic and unsystematic risk and what is an example of each?

Systematic risk is related to economy/market-wide events like interest rates, recessions, and wars. These types of events affect all stocks and cannot be diversified away. Unsystematic risk is related to events that don't affect all companies. Examples: your plant burns down, your product flops, your product is a huge hit, your CEO gets fired.

Which type of risk are you rewarded for bearing?

Systematic risk. Since you can avoid bearing unsystematic risk by simply holding a diversified portfolio, no one is going to reward you for not doing so. In order to entice you to bear systematic risk, you have to be offered ever-increasing rewards.

If a change in a firm's mix of debt and equity changes any one of three things, the firm's total value will change. What are these three things?

Taxes, Transaction Costs, Investment Policy

If a change in capital structure (shifting the proportion of debt and equity) changes the value of the company, it must be because it affects:

Taxes, transaction costs, real investment policy (M&M proposition tells us that if capital structure matters it matters because it affects these 3 things.)

If there were no covenants to restrict them, discuss two ways that equity holders might take actions that leave bondholders worse-off.

The 3 ways we discussed in class are: 1. Paying excessive (or even liquidating) dividends, that bleed down the cash cushion in the firm that could otherwise be used to pay the bondholders in a down year. 2. Asset substitution: switching from relatively safe to riskier assets after issuing the bonds. This way, you get a loan at a low rate reflecting your safe assets and then make a switch to a riskier business that would have required a higher interest rate. 3. Issuing bonds of higher priority: After you sell bonds, you turn around and sell new bonds with senior priority to those bonds, thus placing them in a riskier position.

Explain the Modigliani and Miller (M&M) proposition about capital structure. Make sure you explain why it is useful.

The M&M proposition says that with no taxes, no transaction or information costs and fixed real investment policy, capital structure choices do not affect the value of the firm. The real value of this comes in the fact that it narrows the list of things we have to consider when making capital structure choices. Once we consider how the choice will affect taxes, transaction costs or investment policy, we're done.

Imagine that Boeing decides that it wants to start making and selling sneakers. Where should they get the beta for making the capital budgeting decision for this project?

The best place to get the beta would be to look at a shoe company. Boeing would want to be careful not to use its own beta for this project because that would be an aircraft manufacturing beta and it is considering making shoes. Nike Adidas would be a good start for determining a shoe beta.

If a company increases its total value by creating an interest tax shield, who benefits — equity holders or bondholders? Why?

The equity holders benefit. The tax shield means that ATCF's will be higher. Since the equity holders are residual claimants, they care about the ATCF's. The bondholders are no better or worse off because their payment is fixed.

Write formula for portfolio variance and explain what each term does.

The formula says that the risk of a portfolio is made up of the weighted risks of the assets in the portfolio (the first 2 terms) plus an adjustment for how those assets move together (the last term). The first two terms are necessary because the portfolio risk must be affected by the risks of the individual assets. The last term is necessary because we are looking at the aggregate movements of the portfolio, which are going to be strongly affected by how the assets interact. Thus, if the assets tend to move in opposite directions then the last term will adjust the overall portfolio risk downward.

Between 2 stocks, how can you use the beta to know which is a riskier addition?

The higher beta means riskier. In a well-diversified portfolio, systematic risk is the only concern since unsystematic risk is diversified away. Standard deviation is not the measure of risk I look at since it measures total risk. Systematic risk is measured by beta. A beta of 1.5 tells that for every 1% move in the market, you can expect the stock to move 1.5%.

For preferred stock:

The price is just the PV of a perpetuity of its dividend, discounted at the cost of capital for that company's preferred stock: Price = (Div/Rp)

Using CAPM, how much of expected return is compensation for risk?

The risk free rate is the compensation given purely for giving up your money, so the remaining % is compensation for risk.

Why isn't the risk of a portfolio just a weighted average of the risks of assets in the portfolio?

The risk of a portfolio is highly dependent on how the returns of the assets in that portfolio co-vary. If the assets tend to move together, then the portfolio return will move around more than if the assets tend to move in opposite directions. We can combine two very risky assets and get a safe portfolio if the assets are negatively correlated, meaning that when one asset is up, the other tends to be down. These offsetting up and down swings will result in little movement in the overall portfolio.

What are the two measures of risk and what is the difference between the two?

The two measures of risk we talked about in class are variance (or its square root, standard deviation) and beta. Variance measures TOTAL risk: systematic plus unsystematic — all things that contribute to the movements in the price of a stock. Beta measures only systematic risk (or undiversifiable risk). Systematic risk is the risk that we are compensated for taking on.

Your company is considering adding more debt to its capital structure. It is your job o figure out how this might impact the value of the company. What information do you need to know to determine its impact?

Think about the M&M theorem: you would care about how the change will affect your company's taxes (through interest deductibility), any transaction costs that will be incurred, and whether the capital structure change will somehow change your investment policy.

If financing policy affects firm value, it does so through at least one of three channels. List them.

This is the M&M proposition: Taxes, Transaction/Information costs, Investment Policy

Assuming that a company has no debt and using equity beta to find a discount rate, if assumption is wrong, will the discount rate be too high, too low, or correct?

Too high. If the company has debt, the equity will be riskier than the underlying assets of the company. Since the Beta of the equity is higher than the beta of the assets in this case, and Dell's equity beta is 1.5, using 1.5 gives too high of a discount rate.

Which type of risk can a portfolio help you avoid?

Unsystematic risk. By holding a basket of stocks, the random unsystematic ups and downs of one stock will be tempered by offsetting unsystematic downs and ups of other stocks. You will be left with only systematic risk, exposure to events that move whole baskets of stocks.

What do we use Beta for in capital budgeting and why?

We use beta for the systematic risk of the project. We need a measure of systematic risk because our shareholders are only concerned about systematic risk. Since they can diversify away unsystematic risk, they are not rewarded for bearing it. They are rewarded for systematic risk, however. Thus, if we take on a project with high systematic risk, it must offer high return.

After calculating the standard deviation of your portfolio (q #9 on p. 98), is this standard deviation different from just the simple weighted average of he standard deviations for the two stocks?

Yes. The reason is because the two stocks are not perfectly positively correlated. You get some diversification benefit form holding them together (they sometimes move in different directions, dampening the overall movement of your portfolio). This diversification results in a lower portfolio variance than just the weighted average of the individual stock variances would produce. You can see in the formula that the third term includes the correlation coefficient, which is adjusting the risk of the portfolio to account for the co-movement of the stocks.

Is the US stock market semi-strong form efficient? What is our evidence?

Yes. We use a technique called the "event study" and examine price reactions to public announcements of value-relevant information. The reactions show that the previously private information was not already impounded into the prices (the market is not strong-form efficient), but that as soon as the information becomes public, the prices move to the new correct level (on average). This movement takes place quickly, within 15 minutes, and profitable trading strategies do not exist past 15 minutes.

You work for a company with many divisions. Would you reduce the value of the firm if you used the company's WACC as your discount rate for all projects in the company?

You would be using the wrong discount rate for most of your investment decisions. In particular, you would be using too low a discount rate in your riskier divisions and too high a discount rate in your safer divisions. This would lead you to accept too many risky division projects and reject too many safer division projects. In the first case, you are accepting negative NPV projects and in the second case, you are rejecting positive NPV projects.

Example of systematic risk

expansions/recessions

If we hold a portfolio of the debt and equity of a company in proportion to their weights in the capital structure, our portfolio will have an expected return equal to the firms:

pre-tax WACC. Also note that the pre-tax WACC is the firm's expected return on assets as a whole, which can be computed from the CAPM using its asset beta.

The US stock market is:

semi-strong form efficient. Corporate insiders can make money on their trades. The US stock market follows a random walk. All public information is incorporated into stock prices.

The beta that a company uses for a capital budgeting decision:

should reflect the systematic risk of the project. Only the project's risk is relevant. The risk of the company tells us about the risk of projects already taken, not projects that the company is considering. If the company is going to spend shareholders' money on a new project, it must expect to make a return commensurate with the risk of the project. Not relevant: beta reflecting total risk, beta reflecting company's cost of capital, beta that is a weighted average of company's and projects systematic risk.