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