Interest Rates What we should know about the effects of change in various market interest rates over

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Interest RatesWhat we should know about the
effects of change in various market interest
rates over hospitality-related F/S

• Tad Hara, PhD
• Rosen College of Hospitality Management
• University of Central Florida

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Introduction

• Hospitality Tourism related businesses
• Capital intensive
• Large portion of fixed assets on the balance
  sheet.
• This structure necessitates students (future
  managers) to understand
• Operating Leverages related management
  techniques, such as yield management
• How the company obtained/secured the financing to
  match the capital requirements, and its
  implications
• How the change in market interest rates would
  affect business environment for his/her firm

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Some Examples of What We Teach

• Capital Asset Pricing Model (CAPM)
• Learn the concept of relationship between Risk
  Return
• Bond Pricing
• How change in market rates would affect the price
  of bonds (fixed income securities)
• Valuation of Stocks
• How the expected dividend, perceived growth rate,
  investors required rate of return would affect
  the theoretical price of stocks
• Feasibilities, and Valuation of Assets
• How the change in market rates would affect the
  value of the assets

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1. Capital Asset Pricing Model

• Students will learn the relationship between Risk
  and Expected Return
• Risk is defined as variance of the expected
  return. Then what is the risk free investment
  with which the variance is zero (risk free)?
• US Treasury by definition

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The Market Portfolio

• If we are very risk averse, can we hold an asset
  that has no risk?
• Risk-free asset has a guaranteed return.
• An example would be a security issued by the U.S.
  Government, such as a treasury bill.
• If the return is guaranteed, what is the standard
  deviation of the return for the risk-free asset?
• SD 0
• The Market Portfolio is the theoretical
  representation of all the portfolios in the
  market. (similar to market average)

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Risk and Return
Expected Return
Rm Rf
0 1 2
Standard Deviation (Risk)
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Risk and Its Components

• Systematic Risk Unsystematic Risk Total Risk
• Systematic risk relates to those factors that
  affect all assets in the market.
• Unsystematic risk relates to those factors that
  are specific to a particular asset.
• The market portfolio is so diversified that all
  unsystematic risk is removed as assets are added
  to it.
• Therefore, the only risk in the Market Portfolio
  is systematic.

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Beta

• Beta is the measure of an assets systematic risk
  relative to the Market Portfolio.
• Beta ?xm?x / ? m
• It is found by multiplying the correlation
  coefficient of any asset (asset x) and the market
  portfolio by the standard deviation of asset x.
  This product is divided by the standard deviation
  of the market portfolio.

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Beta (continued)

• Betas are compared to the overall market.
• The market portfolio has a beta of 1.
• If the stock of a company has a beta of 2, it is
  twice as risky as the market.
• Where can I find betas?
• Use linear regression
• Yahoo! Finance website
• Various brokerage firm websites

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Risk and Return
Expected Return Rf (Rm Rf) x ß
Expected Return
Exam Risk free rate 4, Return on Market
Portfolio Is 12. Given the ß of the Investment
is 1.5, what Would be expected return On your
investment?
SML
Rm Rf

• 4 (12 -4) x 1.5
• 16

0 1 2
Beta (ß)
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The Capital Asset Pricing Model

• The Security Market Line is an equation for a
  straight line.
• Beta is the slope of the line.
• If a project generates a return higher than the
  required rate of return as shown by the SML,
  value is created and the project is accepted. If
  not, then value is lost and the project should be
  rejected. (Exhibit 4-16 P80)

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Limitations and Future of CAPM

• The CAPM cannot always predict the returns of
  assets accurately and it has limitations.
• The market portfolio is a theoretical concept no
  consensus on which proxy for the market portfolio
  is best.
• Betas are calculated based upon historical
  returns and then used to predict future returns.
• Despite the limitations, CAPM is useful in
  getting investors to understand a fundamental
  relationship between risk and return.
• CAPM is accredited to Dr. William Sharpe,
  recipient of Nobel Prize in Economics (1990).
  http//nobelprize.org/economics/laureates/

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Correlation Coefficient and Portfolio
Standard Deviation of the two assets portfolio
can be expressed as follows
Calculate SD of the portfolio when (1) ?1 (2)
?0, (3) ? -1 (1)5.33, (2) 3.77, (3) 0.00
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2. Bond Pricing

• Students will learn what the bond is, how it is
  used to finance the capital needs, and how its
  market value fluctuates as interest rates
  changes.
• Thorough understanding of Time Value of Money
  concept is the very essential part of the
  processes.

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Valuing Corporate Bonds

• Suppose a 15-year corporate bond has a 10 coupon
  rate and a 1,000 par value. For simplicity
  assume the coupon is paid once a year. What is
  the value of this bond today if an investor
  requires a 10 rate of return?
• The value will be the present value of the coupon
  payment (an annuity) plus the present value of
  the par value (a lump sum).
• Buying a cow for milk and eventually for meat.

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Valuing Corporate Bonds

• The general equation for the value of a bond is
• Computing the bond value in this example

C Coupon payment Coupon Rate x par value
10 x 1,000 n of payments to maturity ib
investors required rate of return. Vb value
of the corporate bond
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Valuing Corporate Bonds

• In the last example the rate of return and the
  coupon rate were the same. What happens to a
  bonds value when the market rate of interest is
  less than the coupon rate?
• Ex ib 8, while coupon rate is still 10?

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Valuing Corporate Bonds

• In the last example the rate of return was less
  than the coupon rate. What happens to a bonds
  value when the market rate of interest is greater
  than the coupon rate?
• Ex ib 12, while coupon rate is still 10?

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Valuing Corporate Bonds

• Relationship between market rate of return,
  coupon rate, and bond value.
• Market rate Coupon rate Bond value value
• Market rate Coupon rate Bond value Par
  value
• Market rate Par
  value
• This is extremely important to understand, and
  memorizing this will not help. UNDERSTAND IT!

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3. Valuation of Stocks

• Unlike bonds, stocks have varying dividends and
  the future sales value at the end of holding
  period is not fixed
• Bond ? equal coupon payments, at maturity you get
  the face value back
• Stock ???

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3. Valuation of Stocks
At maturity you get 1,000 back (face value)
Bond Equal amount of coupon payments
You do not know how much you get back at future
sales
Stock Less predictable stream of cash flows
Its a dividend!
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3. Valuation of Stocks

• There are several methods that we teach but I
  pick up one of them today.

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Constant-Growth Dividend Valuation Model

• A company with a constant dividend payout ratio
  and constant return on equity will have a
  constant growth rate.
• For example, what is the growth rate for a
  company earning 12 on equity and a 40 dividend
  payout ratio?
• Growth (1 40) x 12 60 x 12 7.2

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Constant-Growth Dividend Valuation Model

• If we expect this company to have earnings of 5
  per share in the coming year and the 7.2 growth
  rate is constant, we can compute the common stock
  value to an investor requiring a 10 return with
  the following constant growth model

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Constant-Growth Dividend Valuation Model

• The companys dividend in the coming year must be
  2.00 per share
• d1 5.00 x 40 2.00
• And thus the value of the stock is

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Value, Rate of Return, and Growth

• What happens to a common stocks value if the
  investors required rate of return increases but
  the future expected cash flows remain constant?
• With the same expected future cash flows, the
  only way an investor can receive a higher rate of
  return is to pay less for the stock! Thus,
  higher rates of return cause stock values to
  decline!

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Value, Rate of Return, and Growth

• Lets use the constant-growth example to
  illustrate this inverse relation between rates of
  return and common stock value. Previously we
  assumed a 2 dividend in 1 year, a 7.2 growth
  rate, and a 10 rate of return, and obtained a
  value of 71.43 as follows

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Value, Rate of Return, and Growth

• What if the general level of interest rates rises
  and as a result investors now require a 12
  return on this common stock?
• The stock value declines to 41.67. This same
  relationship would hold for any of the common
  stock valuation models we have presented in this
  chapter.

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Value, Rate of Return, and Growth

• What happens to a common stocks value if the
  earnings and dividends growth rate increases but
  the rate of return remains the same?
• With a higher growth rate dividends are now
  expected to be greater. Of course with the same
  rate of return, the value of the common stock
  will increase to investors!

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Value, Rate of Return, and Growth

• Lets use the constant-growth example to
  illustrate this direct relation between dividends
  and earnings growth and common stock value.
  Using the same beginning assumptions as before

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Value, Rate of Return, and Growth

• What if the earnings and dividends growth rate
  rises from 7.2 to 8.0 and, as a result, future
  dividends are expected to be higher than before?
• The stock value increases to 100.00. This same
  relationship would hold for any of the common
  stock valuation models we have presented in this
  chapter.

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4. Feasibilities, Valuation of Assets

• Sales comparison, cost, and income
  based-valuation approach are taught.
• What makes students competitive is the knowledge
  of several income based approaches, for which the
  knowledge of Time Value of Money is a
  prerequisite.

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Income Capitalization Approach

• Valuation Technique 1
• Band of Investment
• Using WACC concept for Debt and Equity
• WACC of Mortgage Return Equity Return

NOI in the case is given as 4,107,000 Divide NOI
by the cap rate Capitalized value of the Flow
Value 36,935,000
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Valuation of Income Properties

• Note that the Value NOI / Cap Rate
• Cap Rate function of market interest rate
• From lenders view, what matters most is the
  borrowers monthly debt service coverage ratio
  (Net Monthly Income / Monthly DS)
• DS function of Principal amount, Terms (
  months), Interest rate
• Interest rate function of market rate (US
  Prime, LIBOR plus certain premium)
• ? Interest rate ? DS ? ? Value of the Asset?

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One Mini-Case

• Assume a commercial investor has the following
  parameters
• Loan to Value (LTV) 80 of acquisition cost
• Terms of Loan US Prime 50bp, 240 months
• Lenders Requirement Monthly NOI / DS 1.2
• From a sellers point of view, unless s/he is
  trained well in real estate finance, perception
  of appropriate value is driven by sales
  comparison ?Last year, this had a value of XX,
  because my neighbor sold comparable one at YY

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One Mini-Case
US Prime Rate 2004-11-10 5.00 2004-12-15
5.25 2005-02-02 5.50 2005-03-22
5.75 2005-05-03 6.00 2005-06-30
6.25 2005-08-09 6.50 2005-09-20
6.75 2005-11-01 7.00 2005-12-13
7.25 2006-01-31 7.50

• Assume a commercial investor has the following
  parameters
• Loan to Value (LTV) 80 of acquisition cost
• Terms of Loan US Prime 50bp, 240 months
• Lenders Requirement Monthly NOI / DS 1.2

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Financial Training at Rosen College

• You are given MS-Excel sheet electronically, and
  work on the whole calculation in MS-Excel, and
  submit electronically. Graded and posted
  electronically
• In Finance class, weekly HW x 12, Cases x 3, plus
  one more 16 assignments per semester, all
  Excel-based, completely paperless
• Example Correlation, NPV, IRR, Capital
  Budgeting, Financial Statement analysis, Income
  Property Valuation, Hotel Operational Analysis,
  Weighted Average Cost of Capital calculations, 10
  year feasibility analysis, Quantitative analyses
  of Management Contracts, Franchise Agreements,
  Lease Contracts, Sensitivity Analysis

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In Feasibility Class, we will cover the essence
of the whole thing in a hurry. (You get a taste)

• Tad Hara, PhD
• Rosen College of Hospitality Management
• Thara_at_mail.ucf.edu
• http//www.hospitality.ucf.edu/thara.aspx