Managerial Finance

1
Managerial Finance

• FINA 4330
• The Capital Asset Pricing Model (CAPM)
• Lecture 15

2
Simplifying Assumptions

• Individuals can trade securities without regard
  to fees, taxes, and other frictions.
• Individuals get any relevant information about
  the firms they are interested in costlessly.
• Individual investors can borrow or save at the
  same riskless rate equal the the riskfree rate
  

3
Summary and Conclusions

• The contribution of a security to the risk of a
  well-diversified portfolio is proportional to the
  covariance of the security's return with the
  markets return. This contribution is called the
  beta.

• The CAPM states that the expected return on a
  security is positively related to the securitys
  beta

4
Estimating b with regression
Security Returns
Return on market
Ri a i biRm ei
5
Practical Issues in CAPM

• Forecasting Beta
• The problem is that you assume your estimate of
  Beta is the true value of Beta
• regression toward one
• Allow for extremes
• What Time Horizon
• 2 years of weekly, or 5 years of monthly

6
The Security Market Line

• Risk free interest rate?
• The Market Risk Premium
• 5.7

7
Firm valuation

• We will want to value the firm using the
  Discounted Cash Flow (DCF) method.
• Three issues
• What do you want to discount?
• How do you project this over time?
• How do you discount it?

8
Basic Valuation

• What do you want to Discount?
• How do you project these?
• How do you discount these?

9
Basic Valuation

• What do you want to Discount?
• Free Cash Flow
• How do you project these?
• How do you discount these?

10
Basic Valuation

• What do you want to Discount?
• Free Cash Flow
• How do you project these?
• From Historical Data
• How do you discount these?

11
Basic Valuation

• What do you want to Discount?
• Free Cash Flow
• How do you project these?
• From Historical Data
• How do you discount these?
• The Cost of Capital or (Weighted Average)

12
Free Cash Flow

• Start with EBIT
• Subtract Taxes
• Leaves EBIT(1-t) Unlevered (Operating) Net
  Income
• Plus Depreciation
• Less Capital Expenditures
• Less Increases in Working Capital
• Bottom Line Free Cash Flow

13
Example

• Current Sales
  60
• Cost of Goods Sold
  25
• Gross Profit
  35
• Less Operating Expenses
  9
• Less Depreciation
  6
• EBIT
  20
• Less Income Tax Rate (_at_ 35)
  7
• Operating (Unlevered) NI
  13
• Plus Depreciation 6
• Less Capital Expenditures
  2
• Less Increases in Working Capital
  1
• Free Cash Flow
  16
• 
  

14
Discount Rate

• Conceptually
• V Present Value of the firms Cash flows,
  discounted by a number called the cost of
  capital
• Basically it is the IRR of the Firm.
• Conceptually, you want to discount by a rate that
  reflects the risk of the firms operating Cash
  Flow.

15
How do you estimate this

• Weighted Average Cost of Capital
• Once you have the stream of Cash Flows generated
  by the firm, the next problem is to determine how
  to discount it.
• The discount rate that makes the Value of the
  firm equal the firms cash flow is what we call
  the Cost of Capital.
• As a practical matter this can be approximated by
  the Weighted Average Cost of Capital (WACC)

16
WACC

• The WACC is defined as
• rWACC rE X (E/(EDP)) rD(1-t) X (D/(EDP))
  rP X (P/(EDP))
• The weighted average of the (after tax) cost of
  the component securities issued by the firm,
  weighted by the proportion of those securities
  issued by the firm.
• rE is the required return to the equity of the
  firm
• rD is the required return to the debt of the firm
  
• D is the (market value) of the debt issued by the
  firm
• E is the market value of the equity.
• t is the statutory tax rate.
• rP is the required return to the preferred stock
  of the firm
• P is the (market value) of the preferred stock
  issued by the firm

17
WACC Estimation

• Some of these variables are not easily estimated
  so we make some assumptions
• To estimate D use the Book value of the debt.
• To estimate rD use the ratio of Total Interest
  payments to the total book value of the debt
• To estimate rE use the Capital Asset Pricing
  Model