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Managerial Finance

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Title: 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
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