...UV0402 Rev. Apr. 8, 2014 APPLYING THE CAPITAL ASSET PRICING MODEL This note discusses how some of the most financially sophisticated companies and financial advisers estimate the cost of equity capital. We particularly focus on areas where finance theory is silent or ambiguous, and practitioners are left to their own devices. Conclusions are based on interviews with two groups: (1) well-regarded firms ranked by peer companies as industry leaders and (2) a sample of 11 of the most active financial advisers (investment banks). For context on academic advice, we also cite recommendations from topselling graduate-level textbooks and trade books in corporate finance.1 Findings The Capital Asset Pricing Model (CAPM) is the dominant model for estimating the cost of equity, with over 90% of firms and all the financial advisers employing this model. Moreover firms and advisers seldom mentioned other asset-pricing models. Yet disagreements exist on how to apply the CAPM. The CAPM states that the required return (R) on any asset can be expressed as Equation 1: R = R f + ( Rm - R f ) (1) 1 Survey evidence and much of the discussion is adapted from T. Brotherson, K. Eades, R. Harris, and R. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: An Update,” Journal of Applied Finance 23, no. 1 (2013), which is an update of an earlier article: R. Bruner, K. Eades, R. Harris, and R. Higgins, “‘Best Practices’ in Estimating the Cost of Capital: Survey and...
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...1. Primary objective of the corporation Management has one basic, overriding goal – to create value for stockholders. Stockholders own the firm - it legally belongs to them. That ownership position gives stockholders the right to elect the directors, who then hire the executives who actually run the company. The directors, as representatives of the stockholders, determine managers’ compensation, presumably rewarding them if performance is superior or replacing them if performance is poor. Of course, there are some constraints on what management can do when working to create value for stockholders. Management can’t engage in illegal employment practices, create monopolies to exploit consumers, violate anti-pollution laws, or engage in prohibited activities. For most companies and at most times, managers do focus on shareholder value maximization, because in the long run stockholders do remove directors and managers who fail in their fiduciary duty. There are events that refocus managers’ attention on the interests of stockholders. First, stock ownership has become increasingly concentrated in the hands of institutional investors, and their holdings are so large they would depress a stock’s price if they simply dumped it. Therefore, institutional investors are now using proxy fights and takeovers to force changes in poorly performing companies. Second, the penalties for executives who violate their responsibility to shareholders have increased. Good managers...
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...Midland’s divisions, Mortensen collected beta estimates from several businesses with operations similar to those of Midland’s divisions and used the average of these estimates to derive a beta estimate for divisional beta estimates (pg.6). 2. Calculate Midland’s corporate WACC. Be prepared to defend your specific assumptions about the various inputs to the calculations (risk-free rate, equity market risk premium (EMRP), beta). Is Midland’s choice of EMRP appropriate? If not, what recommendations would you make and why? Midland’s corporate WACC is 9.17%. Please see exhibit 1 for supporting calculations. The risk-free rate for 2006 came from the Department of Treasury’s website, which we added to Midland’s 2006 Equity Market Risk Premium of 5% (pg.6). We used the 10-year rate to approximate the duration of a corporate investment. Equity and debt are derived from figures in Luerhman and Heilprin’s exhibit 5, and reflect closing prices on December 31st, 2006 rather than an annual average (pg.11). Midland’s choice of EMRP is not appropriate because market risk premium...
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...interest rate into account, PPC’s actual cost of capital would be calculated as: [.08(1-.34)]= 5.28%. PPC has simply been using 10% (their equity growth rate) as their cost, but must instead either use the CAPM model to calculate their cost of equity, or the Dividend-growth model. If they use the CAPM model, which is the most accurate, their cost of equity will be: .078+.8(.1625-.078)=14.56%. Or they can use the Dividend-growth model and their cost of equity would be: (2.7/63)+.1=14.29%. Both are acceptable but, because the Dividend-growth model is subjective, and the coupon rate (that PPC was originally using is a sunk cost, they should use the market rate). Thus using the market rate to calculate CAPM you use the Beta and market risk premium which are both based on the market rate and more accurate. Finally, their company WACC of 9% that they have calculated is incorrect and given the above calculations, their WACC using CAPM would...
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...Year Average) Risk-Free Rate of Return (Rf)(1) S&P 500 Index Market Return (Rm) - Yearly for Last 10 Years Size Premium AAPL D/(D+P+E) AAPL D/E AAPL P/E AAPL Cost of Debt (Rd) - Average of Last 5 Issued Bonds AAPL Cost of Preferred (Rp) AAPL Tax Rate Risk free rate Choose Then 25.4% 1.34% 7.2% 0.0% 7.9% 8.6% 0.0% 2.5% 0.0% 26.4% Levered Beta 1.560 1.547 1.489 0.508 1.522 0.899 Ticker Name NYSE:HPQ Hewlett-Packard Company NYSE:EMC EMC Corporation NasdaqGS:WDC Western Digital Corporation KOSE:A005930 Samsung Electronics Co. Ltd. NasdaqGS:NTAP NetApp, Inc. NasdaqGS:GOOGL Alphabet Inc. Average Total Debt 25,502.0 7,420.0 2,567.0 10,116.9 1,488.0 7,927.0 Mkt. Val. Equity 51,896.8 53,866.3 18,388.4 161,909.4 9,973.5 466,718.1 Pref Equity 0.0 0.0 0.0 0.0 0.0 0.0 Debt/ Equity 49.1% 13.8% 14.0% 6.2% 14.9% 1.7% Pref/ Equity 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% Unlevered Beta(2) 1.141 1.403 1.349 0.485 1.370 0.888 1.254 1.106 Average Unlevered Beta for Comps AAPL D/E AAPL P/E AAPL Tax Rate -3 AAPL Levered Beta United States United States Treasury Constant Maturity - 5 Year 1.106 8.6% 0.0% 26.4% 1.176 WACC Market Risk Premium (Rm - Rf) Multiplied by: AAPL Levered Beta Adjusted Market Risk Premium Add: Risk-Free Rate of Return (Rf)(1) Add: Size Premium Cost of Equity Multiplied by: AAPL E/(D+P+E) Cost of Equity Portion 5.9% 1.176 6.9% 1.3% 0.0% 8.3% ...
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... $100.00 RATE 12.48% Problem 5-6 RISK FREE 3% INFLATION 3% 6% TREASURY SECURITY 6.3% MRP 0.3% Problem 5-7 MATURITY 16 COUPON RATE 10% PMT 50.00 FV $1,000.00 YTM 4.25% PV $1,085.80 Problem 5-13 MATURITY 5 COUPON RATE 8% PMT $80.00 FV $1,000.00 PV -974.42 RATE 8.65% Question 6-6 Not necessarily. If a beta were to double, its expected return would not double. According to the SML equation, an increase in beta will increase a company’s return by an amount equal to the market risk premium times the change in beta. Problem 6-1 STOCK BETA $35,000.00 0.8% $40,000.00 1.4% $75,000.00 PORTFOLIO BETA 1.12% Problem 6-2 RISK FREE 6% MARKET RETURN 13% BETA 0.7% RATE OF RETURN 10.9% Problem 6-7 a. RISK FREE 9% MARKET RETURN 14% BETA 1.3% RATE OF RETURN 15.5% b. RISK FREE 10% RISK FREE 8% MARKET RETURN 13% MARKET RETURN...
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...Quiz2 Question 1 1 out of 1 points | | | Other things equal, an increase in the government budget deficit @An increase in the government budget deficit, other things equal, causes the government to increase its borrowing, which increases the demand for funds and drives interest rates upAnswer | | | | | Selected Answer: | drives the interest rate up. | Correct Answer: | drives the interest rate up. | | | | | * Question 2 1 out of 1 points | | | If a portfolio had a return of 10%, the risk free asset return was 4%, and the standard deviation of the portfolio's excess returns was 25%, the risk premium would be _____.Answer | | | | | Selected Answer: | 6% | Correct Answer: | 6% | | | | | * Question 3 1 out of 1 points | | | Over the past year you earned a nominal rate of interest of 14 percent on your money. The inflation rate was 2 percent over the same period. The exact actual growth rate of your purchasing power wasAnswer | | | | | Selected Answer: | 11.76%. | Correct Answer: | 11.76%. | | | | | * Question 4 1 out of 1 points | | | The holding-period return (HPR) on a share of stock is equal toAnswer | | | | | Selected Answer: | the capital gain yield during the period, plus the dividend yield. | Correct Answer: | the capital gain yield during the period, plus the dividend yield. | | | | | * Question 5 1 out of 1 points | | | An investment...
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...The role of exogenous risk in structuring contracts Objectives: • To illustrate a kind of transaction cost driven by information asymmetry and differential preferences with respect to risk allocation • Logical sequence Information asymmetry impossible to contract on effort contract on results or performance Inefficient risk allocation emerges when: • Performance not fully under the control of agent • Agent more risk averse than principal need to • Importance of risk in economic life • Scarce in empirical studies: mainly, Allen and Lueck (evidence and refs.), but always proxies of risk and sectorial studies • Huge in economic theory of contracts—an issue of tractability? • Most likely overstated, hard to say for how much • Management: main failure of incentives seems to be ‘gaming’ not risk • Literature review: • Visit http://www.bris.ac.uk/cmpo/incentives/incentindex.html 1 1. Principal-agent model with moral hazard Data Agent utility: U(S, e) = S - e Employer profit: B = 0,20 V - S – 10 Relationship effort-results (e.g., sales): Effort (e) 2 1 Sales, m € (V) 100 0,25 0,75 200 0,75 0,25 sales ‘inform’ on effort Probability grows with effort Reservation utility = best alternative job U(S = 4, e = 1) = 4 -1=2-1=1 Observable effort Observability can contract on effort terms. ¿Low or high effort? Assumption: wage equal reservation utility: U(e=2) = S2 - 2 = 1 U(e=1) = S1 - 1 = 1 Profit will be 16 and 11 m: S2 = 9 S1 = 4 B(e=2) = 0,20...
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...October 10, 2012 i. Risk-Free Rate Risk-free rates will depend on when the cash flow is expected to occur and depend upon the period over which investors want the return to be guaranteed. Consequently, we need to take the time horizon into consideration to find out the most suitable risk-free rate. Midland Energy Resources is a well-established company with 120-year history. It is not a company which relies on seeking special opportunity to earn instant profit so that 1-Year T-bond rate is obviously not a proper option. Instead, a long-term development is expected through capital allocation. Here, we choose 30-Year over 10-Year T-bond rate. Someone may argue that 10-Year is suitable since long-term expected cash flow will be affected by political risk in the Exploration and Production division. This may be true but the company also plans to invest in sophisticated extraction method to extend the lives of older fields as well as developing undeveloped reserves. With such heavy investment the company could not expect a shorter return period and all of these methods may shield the company from those negative affects to some extent. The 30-Year T-bond rate is also preferred by examining the other two divisions. The Refining and Marketing, which is the company’s largest division in aspect of revenue, has long-lived productive assets resulting in a relatively long return period. Moreover, although the profit margin of R&M division is decreasing steadily with a long-term trend...
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...MIRRs. This is one reason some people favor the MIRR over the regular IRR. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. The percentage difference between the MIRR and the IRR is equal to the project’s WACC. 3. (TCO D) Church Inc. is presently enjoying relatively high growth because of a surge in the demand for its new product. Management expects earnings and dividends to grow at a rate of 25% for the next 4 years, after which competition will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company's last dividend, D 0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is...
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...Structured Finance Homework 3 Bond Valuation with Annual Payments Exercise 5.1 5-1 Bond Valuation with Annual Payments Data: M = Par Value = $1,000 C = Maturity value. We can assume that it is the same as the par Value = $1,000 r = Coupon rate = 0.08 i = Effective interest rate per coupon = 0.09 n =Number of coupon payments remaining = 12 Calculations In order to calculate the current market price of these bonds, I will use the formula for the bond price on the date of a coupon payment. The bond price on the date of a coupon payment is the PV of all coupons + the PV of the maturity value *. means multiplication The present value of all coupons = M * r* [1-(1+i)-n]/i The present value of the maturity date = C * [(1+i)-n] The current market price of these bonds is M * r* [1-(1+i)-n]/i + C * (1+i)-n] = = 1,000 * 0.08 * [1-(1+0.09)-12]/0.09 + 1,000 * (1+0.09)-12] = = 80 *(1-0.355)/0.09 + 1,000 * 0.355 = $572.858+ $355.534 = $928.3927 Answer: The current market price of these bonds is $ 928.39 Exercise 5.2 5-2 YTM for Annual Payments Data: M = Par Value = $1,000 Current Price (PV) = 850 r = Coupon Rate = 10% = 0.1 PMT = $100, because (0.1 * 1,000) N =Years to maturity = 12 Calculations In order to calculate the Yield to Maturity (YTM), I will use the following formula: |850 = |[pic] ...
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...and services to their customers, because customers have so many options in the same market place and it’s really tough job and banking sector is also the part of this competitive environment. Because banking sector have to become more towards customized their services and creates customer oriented atmosphere to meet the basic needs of their customers and to attract them. "Success of the baking organization starts from retention and loyalty of the...
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...American history there has always been a conflict between the federal government intervening in the banking business vs. the Federal government staying out of the banking business * In 1830 when Andrew Jackson (the founder of the Democrat Party) was elected president. He terminated the fed government sponsored US Bank, and resolved the conflict. * The fed government basically stayed out of the banking business until the ’30s, when FDR took office, and the fed government intervened deeply into the ‘banking business,’ which was defined by the IRS, FDIC, Comptroller of the Currency, SEC (if public-owned), and State Bank Supervisors etc. * By defining what the ‘business of banking’s was the statutes, regulations, and enforcement personnel administering these laws, bankers were boxed into doing business as defined by state and federal governments. * Still In present day Banks are financial institutions that hold too much control over the economy and if they fail there are enormous consequences hence the need for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. WHY THE NEED FOR REGULATORS * Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions and guidelines. * To create transparency between banking institutions and the individuals and corporations with whom they conduct business. * To reduce...
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...changes, in policy, employees and culture. I have witnessed banks with similar number of employees, start-up capital and management expertise perform very differently. This paper will search and comment on why performance of similar institutions can be result of management decisions. Lastly, we will attempt to identify those trends and comment to alternate decision making that could have had different results. A quick preview over the last 10 years indicates our nation has witnessed a tremendous increase in failed banks. As with the Great Depression of 1930, the 2008 demise caught even seasoned professionals by surprise! They seemed like smart, financial leaders who were well educated and fully integrated into the heartbeat of the banking system… boy were they wrong… Banks as old as 100 years, fell within months! Although the pace has slowed, they still are failing at levels that can decimate local economies. In 2005 and 2006 there were no bank failures in USA! Was it power bases that gave a false sense of security? Was it poor management? Was it more? THE CULTURE OF CIRCLE BANK With...
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...A PROJECT ON STUDY OF CASH MANAGEMENT AT STANDARD CHARTERED BANK SUBMITTED IN PARTIAL FULFILLMENT OF BACHELORS OF MANAGEMENT STUDIES L S RAHEJA COLLEGE OF ARTS AND COMMERCE UNIVERSITY OF MUMBAI ACADEMIC YEAR 2010-2011 SUBMITTED BY: BINAY ROY PROJECT GUIDE: PROF. NAVEEN ROHATGI DECLARATION This is to certify that the project report ‘Study of Cash management at Standard Chartered Bank’ is submitted by me in partial fulfillment of the requirement of Bachelors of Management Studies in the academic year 2010-2011. The information it comprises of is true and original as per my research and observation. ----------------------------- Signature of the Student (Name of the Student) CERTIFICATE This is to certify that Mr. Binay Roy has completed the project ‘Study of cash management at standered chartered bank’ under the guidance of Prof. Naveen Rohatgi in the academic year 2010-2011 and has submitted the same to the University of Mumbai in partial fulfillment of the requirement of the Bachelors of Management Studies courses. -------------------------------- ---------------------------------- Signature of the Principal Signature of the Project Guide (Dr. Ms. M.B.Madlani) (Prof. Naveen Rohatgi) ------------------------------------------ Signature of the External Examiner. ACKNOWLEDGEMENT I would...
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