Download Corporate Finance

CORPORATE FINANCE
REVIEW FOR QUIZ 1A
Aswath Damodaran
Basic Skills Needed


What are the potential conflicts of interest that underlie a
business and how do they manifest themselves in practice?
Can you read a regression of stock returns against market
returns?
-

How would you use the intercept to measure stock price performance?
What does the slope of the regression measure?
What does the R squared of the regression tell you about risk?
.Can you use the beta to estimate an expected return on an
investment?
2
Corporate governance.. Use common sense…

Stockholder/ Managers: The essence of strong corporate governance is the
same as the essence of a good democracy. Stockholders (voters) get the right to
question managers, hold them accountable and change them, if they so desire.


Lenders/ firm: The peril that lenders face is that, if left unprotected,
stockholders will take advantage of them. If they feel unprotected, they will
have to incorporate that fear into their lending decisions.


Key question on any action: Will it increase the power of stockholders to hold managers
accountable or lessen it?
Key question on any action: Will this action protect lenders more from stockholder
expropriation or less? What are the consequences?
Markets/ firm: The key component of market efficiency is that market prices
reflect available information and will react appropriately to new information.

Key question on market efficiency: Can an investor or investors take advantage of a perceived
market reaction?
3
Manager/ Stockholder conflict: Example

The essence of corporate governance, as defined in
corporate finance, is that stockholders have the power to
choose/replace managers. Given this definition, which of
the following statements best characterizes a good
corporate governance system?
a.
b.
c.
d.
e.
Stockholders replace all managers every year
Stockholders replace only bad managers every year
Stockholders have the option to replace all managers every
year.
Stockholders have the option to replace only bad managers
every year
None of the above
4
Lender/ Stockholder Conflict: Example

One concern that banks have when they lend to
companies is that their interests are different from those
of the stockholders running these companies. If you
move to a system where lenders’ interests are
unprotected, which of the following would you expect to
observe on lending and interest rate?
a.
b.
c.
d.
e.
No effect on either borrowing or interest rates
Lenders will lend more money and charge lower interest rates
Lenders will lend less money and charge lower interest rates
Lenders will lend more money and charge lower interest rates
Lenders will lend less money and charge higher interest rates
5
Market Efficiency: Example

There is evidence that the stock price “pops” (jumps
about 10-15% from the offering price) on the
offering date for initial public offerings. Given the
definition of efficient markets (that the market price
reflects available information), this price jump is
incompatible with an efficient market.

True
 False
6
Society/ Firm: Example

Apple has come under pressure from activists for using
suppliers who pay low wages to their employees.
Assuming that you believe that this is not an ethical
practice for an extremely profitable company, which of
the following do you think is most likely to change
Apple’s behavior?
a.
b.
c.
d.
e.
Make Apple’s top managers take a Social Responsibility (CSR)
class.
Introduce a motion of disapproval at Apple’s next annual
meeting.
Buy Apple shares, with the intent of changing its managers.
Don’t buy Apple products (iPods, iPhones, iPads, Macbooks).
None of the above.
7
Risk and Return: The Risk free Rate

The first building block for an expected return is the risk free rate.
For an investment to be riskfree, it has to deliver a guaranteed
return, which then requires that two criteria be met:



You can have no default risk in the entity issuing the security
Your time horizon on the cash flow match up to the time horizon for the
risk for the “riskfree” investment. In corporate finance, we cheat and use
the long term default free rate as the risk free rate
To get to a long term default free rate, we usually start with the
government bond rate but have to stop and check to see, if it is in
fact default free.
If it is default free, that rate is the risk free rate
 If there is default risk, you have to capture that risk in a default spread
(over and above the risk free rate) that you net out
Risk free rate = Government bond rate – Default spread for the government

8
Risk and Return: The Equity Risk Premium


The equity risk premium is the premium you would
charge over and above the risk free rate to invest in
equities as a class or in the average equity risk
investment. It can be estimated using either historical
data or a forward looking estimate (based on how risky
assets are priced).
If you do use historical data, remember




To use the longest time period you can (since the standard error
in the estimate is huge)
To be consistent in the risk free rate that you use
To use the geometric average (since it will compound over time)
If you use a forward looking estimate, recognize that the
number will be volatile and change over time.
9
Risk free rate & ERP: Example

You are working with a Polish company on estimating its
hurdle rate, in Polish Zlotys. You are consequently trying to
estimate a riskfree rate and equity risk premium to use and
have collected the following information:



The Polish government has ten-year Zloty denominated bonds trading,
with a market interest rate of 5.5% and ten-year Euro-denominated
bonds trading, with a market interest rate of 3.25%. The ten-year
German government Euro-denominated bonds trade at an interest rate
of 1.75%. (Poland has the same local currency and foreign currency
rating).
The standard deviation in the Polish Government bond is 15% and the
standard deviation in the Polish equity index is 21%.
You have estimated a historical risk premium for Poland, using 5 years
of data, of 11.5% and a historical risk premium, using 100 years of data,
for the US, of 5%.
10
Part a: Estimating a risk free rate in Zlotys

Step 1: Get the government bond rate in Zlotys


Step 2. Estimate the default spread for the Polish
government. This can be done by comparing the rate
on a Euro denominated Polish bond and the German
Euro bond rate.


Government bond rate in Zlotys = 5.50%
Default spread = 3.25% - 1.75%
Step 3: Net out the default spread from the
government bond rate

Risk free rate = Govt bond rate – Default spread = 5.5% 1.5% = 4%
11
Part b: Estimating an Equity Risk Premium for
Poland


You have historical risk premiums for Poland but the time
period is too short to yield a meaningful value. The historical
risk premium for the US is over a longer time period, but it is
for a mature market.
To estimate the additional risk premium you would charge for
Poland, you can start with the default spread of 1.50% that
you estimated for Polish government debt. You would then
need to scale it up for the additional risk in Polish equities,
with the scaling factor obtained from the standard deviations
of the Polish equity and bond markets.



Historical premium for mature market =
Country risk premium for Poland = 1.5% (21/15) =
Total equity risk premium for Poland =
5.00%
2.10%
7.10%
12
Reading a Regression: The Intercept
Intercept – Rf (1- Beta) = Jensen’s alpha
This is what
the stock
actually did in
a month in
which the
market did
nothing
This is what the
stock was
expected to do
in a month in
which the
market did
nothing
Excess
Return
13
A Bloomberg regression page
14
Intercept to Jensen’s Alpha: Example

There are two key measurement issues to keep in mind:



It is the difference between the two (the intercept and the riskfree rate (1-beta)) that matters
The intercept and the riskfree rate have to be stated in the same terms – if one is monthly, the
other has to be monthly as well.
Estimate the Jensen’s alpha for Kraft Foods, given that
the average annualized T.Bill rate over the five years was
1.2%.
Intercept = 0.39% (Remember the Bloomberg number is already a
%)
Monthly risk free rate = 0.10% (Annual risk free rate/12 = 1.20%/12
= 0.1%)
Monthly riskfree rate (1- Beta)= 0.10% (1-0.532) = 0.0468%
Jensen's alpha = 0.39% - 0.0468% = 0.3432%
15
The Risk breakdown (R2): Example


The R squared is the proportion of the variance in the
stock that is explained by the market. It is the portion
that cannot be diversified away.
If you chose to invest all of your money in Kraft
Foods, what proportion of the risk would you not be
rewarded for?
The market risk is captured by the R-squared, which is
25.7%
 If you choose not to be diversified, you will not get
rewarded for 74.3% of the risk.

16
Using the beta: Example


The regression beta is the raw beta for the firm. The
adjusted beta is just that number moved towards one.
Use the regression beta on the page to estimate a dollar
cost of equity for Kraft Foods. The ten-year treasury
bond rate is 2% and Kraft Foods gets 50% of its revenues
in the United States, 20% in Europe and 30% in Asia.
The equity risk premium is 6% for the US, 6.5% for
Europe and 8% for Asia.
Riskfree rate = 2% (US government bond rate assumed to be
default free)
Beta = 0.532 (The raw beta)
Equity risk premium = 0.5 (6%) + 0.2(6.5%) + 0.3 (8%) = 6.70%
Cost of equity = 2% + 0.532 (6.70%) = 5.5644%
17