Risk, Return, and Hurdle Rates
Do young/high-growth firms have higher or lower betas than well established firms?
higher
What happens to the Equity Risk Premium when risk aversion increases?
(Rm - Rf) increases
What happens to the Equity Risk Premium when the "average" risk investment increases?
(Rm - Rf) increases
Which debt should be included in WACC?
- All interest bearing long term debt - short term debt if the company uses it to finance long term projects
What are the 3 inputs you need to estimate the Cost of Equity using CAPM?
1- Current Risk Free Rate 2- Expected Market Risk Premium (E(Rm) - Rf) 3- Beta
What are the two ways to estimate the ERP for Emerging Markets?
1- Default Spread Approach 2- Melded Approach
What are Historical Risk Premiums sensitive to?
1- How far back in history you look 2- Whether you use Tbill v Tbond rates as rf asset 3- Whether you use geometric or aritmetic averages
What two conditions are neded for an asset to be Risk Free?
1- No default risk (issued by govt) 2- No Reinvestment Risk (zero coupon bond with matching maturities)
What are the fundamentals of deriving a firm's Beta?
1- Type of Business 2- Degree of Operating Leverage 3- Degree of Financial Leverage
For an asset to be risk free what should be equal?
Actual Return = Expected Return
How did a stock perform if Jensen's alpha is > 0?
Better than expected during regression period
What is Cost of Capital?
Cost to the firm of financing the funding of projects
You are valuing a Brazilian Company. Cash flows are in Brazilian Reals. Revenues split 20% Brazilian, 30% US, 50% German. How do you find the risk free rate to use?
Currency Dependent: Rf = Brazilian Rate - Default spread
What is the conventional practice for ERPs on a multinational firm?
Estimate ERP based on where country is INCORPORATED
True or False: If stock holders are not well diversified, CAPM will overestimate the expected return of an asset.
False, If investors are not well diversified CAPM will UNDERESTIMATE the expected return of an asset
What does higher operating leverage lead to?
Greater earnings volitility --> Higher Betas
Do discretionary products (luxury) have higher or lower betas than nondiscretionary products (grocery)
Higher
What give a firm higher operating leverage?
Higher fixed costs
Do cyclical firms (housing & automobiles) have higher or lower betas than non-cyclical firms (food processing & tobacco)?
Higher than non-cyclical
What ratio is used to compute a synthetic Rating for a company?
Interest Coverage Ratio
Which estimation period reflects less standard error when estimating Beta: Shorter or Longer?
Longer
Can you estimate regression beta for private firms?
No: there is no public historical data to use (it is backward looking)
What is the cost of tebt if the company does not have current bonds outstanding, and has a bond rating?
Risk free rate + default spread
What does the cost of equity tell you?
The % return for a firm's equity in order for investors to break even
What is the "hurdle rate" for firms when analyzing projects from an equity standpoint?
The Cost of Equity (Re = Rf + B(Rm - Rf)
What is the cost of preferred stock?
The Dividend Yield (Dividend Per Share/ Market Price Per Share)
What is the Equity Beta of a firm in the beta equations?
The Levered Beta
What is the cost of debt if the company does not have a rating, and has no bonds outstanding?
The interest rate previously charged by the bank ( or synthetic rating)
What is the Equity Risk Premium definition?
The premium that investors demand for investing in an average risk investment, relative to the risk-free-rate (Rm - Rf)
What is cost of capital in terms of math?
The weighted average between the cost of financing though debt, preferred stock (equity), and Common equity.
True or false: Firms with more equity financing have higher betas
True
How did a stock perform if Jensen's alpha is < 0?
Worse than expected during regression period
