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Class 12
Class 12
Today
Discount rates
Reading
Class 12
Review
The CAPM
Measuring risk
A stocks systematic risk is measured by beta, the slope when
the stock return is regressed on the market:
Ri = + RM +
Required returns
Investors should be compensated for bearing non-diversifiable,
beta risk. The required return on a stock is:
E[Ri] = rf + i E[RM rf]
Market risk premium
Class 12
Slope = E[RM] rf
20%
= 1.5
15%
Market portfolio ( = 1)
10%
= 0.5
5%
=0
0%
0
0.2
0.4
0.6
0.8
1
1.2
Stock's beta
1.4
1.6
1.8
Class 12
CF3
CF1
CF2
CF4
+
+
+
+ ...
2
3
4
(1 + r) (1 + r)
(1 + r)
(1 + r)
Discount rate
The rate of return that investors demand on investments with the
same level of risk.
CAPM
Class 12
Class 12
Example
Its 1979. Southwest Airlines, a growing start-up, has been profitable
as the low-cost airline in the Texas market. Southwest is thinking
about expanding to other U.S. cities. Management forecasts that the
expansion will cost $100 million over the next few years but will lead
to strong future growth ($ millions):
Year
1977
1978
1979
1980
1981
1982
Sales
NI
NWC
CAPX
49.0
7.5
5.1
41.5
81.1
17.0
9.7
45.1
136.1
16.7
10.7
54.5
213.1
28.4
12.4
56.7
270.4
34.2
11.1
79.4
331.2
34.0
19.3
140.2
Class 12
$ 30
25
20
15
10
5
0
Dec-72
Dec-73
Dec-74
Dec-75
Dec-76
Dec-77
Dec-78
Dec-79
Class 12
Issue 1
How can we estimate the projects beta?
What factors are important?
Two approaches
Estimate the firms beta
Estimate the industrys beta (comparables)
How much data?
5 10 years of monthly data
Class 12
Estimating beta
1: Estimate the firms beta
Advantage
If the project has the same risks as the firm (an expansion), this
approach measures exactly what we want
Disadvantages
Generally not very precise (high standard error)
diversified firms
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Class 12
Southwest
Is this approach useful for SW?
Is the risk (beta) of the expansion likely to be the same as the
beta of the firm?
Is Southwests past beta likely to be a useful guide for the future
beta of the project?
Class 12
SW return
40%
30%
20%
Slope = 1.25
10%
0%
-40%
-30%
-20%
-10%
0%
10%
20%
30%
40%
-10%
Mkt return
-20%
-30%
-40%
12
Class 12
0.50
SW return
1973-1977
= 1.20
0.40
0.30
-0.40
-0.30
-0.20
-0.10
0.10
0.10
0.10
0.20
-0.30
-0.20
0.30
0.40
-0.40
-0.20
-0.10
0.00
0.00
-0.10
-0.30
-0.30
-0.40
-0.40
0.10
0.10
-0.20
0.20
0.30
0.40
-0.40
Mkt return
-0.30
-0.20
-0.10
0.00
0.00
-0.10
-0.20
-0.30
-0.30
-0.40
-0.40
13
0.40
1988-1992
= 1.52
0.30
0.20
0.10
0.30
Mkt return
0.40
0.20
0.00
0.00
-0.10
0.20
0.50
SW return
1983-1987
= 1.06
0.40
0.10
-0.20
0.50
-0.10
-0.30
Mkt return
0.30
-0.40
0.30
0.20
0.00
0.00
-0.10
1978-1982
= 1.14
0.40
0.20
-0.20
SW return
0.50
SW return
0.10
0.20
0.30
0.40
Mkt return
Class 12
Estimating beta
2: Estimate the industrys beta*
Advantages
Beta estimated more precisely.
Disadvantages
Do the firms really have the same risk as the project?
Do they serve different markets? Do they have more debt? Do
they have the same cost stucture?
* Estimate the betas of individual firms and then average, or estimate the beta of an industry
portfolio.
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Class 12
Southwest
Is this approach useful for SW?
Is the risk (beta) of the expansion likely to be the same as the
beta of other airlines?
1.42
1.18
1.30
Airline
Northwest
United
USAir
15
1.35
1.55
1.37
Class 12
40%
Airline
industry return
30%
Slope = 1.36
20%
10%
Mkt return
0%
-30%
-20%
-10%
0%
-10%
-20%
-30%
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10%
20%
30%
Class 12
Issue 2
Riskfree rate?
rproject = rf + project E[RM rf]
Should the riskfree rate be the short-term Tbill rate or the longterm Tbond rate?
Match horizons
If short-lived project, use Tbill rate
17
Class 12
1-yr Tbill
10-yr Tbond
12%
8%
4%
0%
Jun-53
Jan-63
Jun-72
Jan-82
18
Jun-91
Jan-01
Class 12
Issue 2
Market risk premium?
rproject = rf + project E[RM rf]
Historical estimates
1872 1999: 5.73% (std error = 1.63%)
1926 1999: 8.26% (std error = 2.24%)
1963 1999: 6.44% (std error = 2.51%)
r = DY + g
1872 1999: 3.64% (std error = 1.15%)
1872 1949: 3.79% (std error = 1.78%)
1950 1999: 3.40% (std error = 0.99%)
Going forward? My guess, 4 6%
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D
rg
Class 12
20
Class 12
Southwest
Cost of capital
Firms beta: SW = 1.25
1.30
Discount rate*
* If no debt
21
Class 12
Issue 3
Debt financing, part 1
If the firm has debt, the cost of capital (discount rate) is a weighted
average of the costs of debt and equity financing.
D
E
(1 - ) rD + rE
A
A
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Class 12
Balance sheet
Assets
Current Liabilities
Current
Assets
Long-Term Debt
Fixed Assets
1. Tangible fixed
assets
2. Intangible
fixed assets
Shareholders
Equity
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Class 12
Southwest
In 1979, Southwest was financed with 20% debt (debt / firm value).
The borrowing rate was 11.4% and the tax rate was 35%. What is
Southwests WACC?
Cost of equity
E = 1.30 rE = 10.39 + 1.30 5.00 = 16.89%
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Class 12
Issue 3
25
Class 12
Southwest
Airline industry
Equity betas
Airline
American
Continental
Delta
E
1.42
1.18
1.30
Airline
Northwest
United
USAir
E
1.35
1.55
1.37
Airline
Northwest
United
USAir
D/V
22%
37%
25%
Leverage ratios
Airline
American
Continental
Delta
D/V
42%
30%
53%
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Class 12
Southwest
The tax rate is 35%, rD = 11.4%, rf = 10.39%, and E[RM rf] = 5.0%.
rE = rf + E E[RM rf]
D
E
WACC = (1 - ) rD + rE
A
A
Airline
American
Continental
Delta
Northwest
United
USAir
Average
E
1.42
1.18
1.30
1.35
1.55
1.37
1.36
rE
17.5%
16.3
16.9
17.1
18.1
17.2
17.2%
27
D/A
42%
30
53
22
37
25
35%
WACC
13.3%
13.6
11.9
15.0
14.2
14.8
13.8%
Class 12
Issue 4
Multifactor models
Beta might not fully summarize all relevant risks. Additional risk
factors could be important.
Measuring risk
Regress Ri on macroeconomic risk factors, F1 FK
Ri = i + i1 F1 + i2 F2 + + iK FK + i
ik is firm is sensitivity to the factor.
Expected returns
Expected returns are linearly related to risk
E[Ri] = 0 + 1 i1 + 2 i2 + + N iN
k is the risk premium for factor k.
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Class 12
Multifactor models
Fama-French 3-factor model*
CAPM misses risk factors associated with size and B/M
What are the risks?
RM = Market portfolio return
SMB = Small stock return Big stock return
HML = High-B/M stock return Low-B/M stock return
Ri = i + i RM + si RSMB + hi RHML + i
E[RM rf] 5.0%, E[RSMB] 3.0%, E[RHML] 4.0%
*http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/
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Class 12
B/M portfolios
Decile
Low B/M
2
3
4
5
6
7
8
9
High B/M
1.10
1.08
1.05
0.99
0.91
0.86
0.93
1.04
1.16
1.29
Size portfolios
Decile
Smallest
2
3
4
5
6
7
8
9
Largest
R2
0.88
0.90
0.92
0.89
0.87
0.84
0.76
0.74
0.64
0.54
30
1.33
1.06
1.13
1.14
1.14
1.10
1.04
1.10
1.00
0.90
R2
0.56
0.73
0.79
0.84
0.86
0.88
0.91
0.93
0.96
0.97
Class 12
Southwest Airlines
Cost of capital
RSW = + SW RM + sSW RSMB + hSW RHML + i
SW = 1.123
s SW = 0.623
h SW = 0.442
Cost of equity
rE = 10.4 + 1.123 5.0 + 0.623 3.0 + 0.442 4.0 = 19.7%
WACC
WACC = 0.20 (1 0.35) 11.4% + 0.80 19.7% = 17.2%
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