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1 a General Introduction to Risk, Return, and the Cost of Capital

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Notes 1 A General Introduction to Risk, Return, and the Cost of Capital 1. The return on an investment can be expressed as an absolute amount, for example, $300, or as a percentage of the total amount invested, such as eight per cent. The formula used to calculate the percentage return of an investment is: (Selling price of the asset – Purchase price of the asset + Dividends or any other distributions which have been paid during the time the financial asset was held) / Purchase price of the asset. If the investor wants to know her return after taxes, these would have to be deducted. 2. A share is a certificate representing one unit of ownership in a corporation, mutual fund or limited partnership. A bond is a debt instrument issued for a period of more than one year with the purpose of raising capital by borrowing. 3. In order to determine whether an investment in a specific project should be made, firms first need to estimate if undertaking the said project increases the value of the company. That is, firms need to calculate whether by accepting the project the company is worth more than without it. For this purpose, all cash flows generated as a consequence of accepting the proposed project should be considered. These include the negative cash flows (for example, the investments required), and posi- tive cash flows (such as the monies generated by the project). Since these cash flows happen at different points in time, they must be adjusted for the ‘time value of money’, the fact that a dollar, pound, yen or euro today is worth more than in five years. This adjustment is done by discounting (dividing) the future cash flows by a rate which reflects the return desired by the firm if undertaking the project under scrutiny. 4. Equity is the capital raised from owners, such as common stock shareholders. 5. The overall general upward price movement of goods and services in an economy, usually measured by the Consumer Price Index and the Producer Price Index. As the cost of goods and services increases over time, the value of a currency falls, since the purchasing power of individuals decreases. That is, with the same amount of money a person cannot buy as much as she could previously. 6. A note is a short-term debt security, usually with a maturity of five years or less. 7. Liquidity refers to the possibility of converting the asset (house, painting, share of stock, etc.) into cash quickly and with no loss of value. For example, if cash is needed in a hurry, the homeowner might not have time to find the best possible buyer for her house and some value will be lost during the transaction. On the other hand, common stocks traded in big markets are very liquid as they can be converted into cash fast and without any loss. 8. http://nihoncassandra.blogspot.com 9. A statistical measure of volatility. More generally, it measures the extent to which a series of values are spread around their average. 10. We could rank women attending a conference by height. Most of the population would group between 5’ 2” to 5’ 7”, while those taller or shorter would only be a small percentage of the population. Hence the probability that any one attendee 230 Notes 231 would fall under this range is larger than the probability that anyone would be 6’ 3” or 4’ 8”, for example. 11. Preferred stock is a hybrid security which combines the characteristics of debt and equity. 2 The Components of the Cost of Capital and Alternative Models 1. For their work on this, William Sharpe, Harry Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economic Sciences. 2. Black, F. and Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81 (May/June 1973), 637–54. 3. Copeland, T. E. and Weston, J. F. (1988). Financial theory and corporate policy. (3rd edition) Reading, MA: Addison-Wesley, 468–71. 4. Hsia, C. (1991). Estimating a firm’s cost of capital: An option pricing approach. Journal of Business Finance and Accounting, 18(2), 281–7. 5. Stephen A. Ross (1976). The arbitrage theory of capital asset pricing. Journal of Economic Theory (December), 241–60. 6. Chen, N., Roll, R. and Ross, S. A. (1986). Economic forces and the stock market. Journal of Business (1986), 383–403. 7. Fama, F. and French, K. (1992). The cross-section of expected stock returns, Journal of Finance (1992), 427–86. 3 Problems in Using the Models 1. A more in-depth discussion on the CAPM is provided in the Appendix. 2. Robert C. Merton (2003). Continuous-Time Finance. (Revised edition) Blackwell Publishing, 97–119 and 446–520. 3. F. Macaulay (1938). Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856. New York: National Bu reau of E conom ic Resea rc h. Cite d i n B o d ie, Z . A . K a ne a nd Ma rc u s, A . J. Investments. (3rd edition) Irwin. 4. The right risk free rate to use in asset pricing models: A note. September 1998, www. stern.nyu.edu/~adamodar 5. The most widely used database, from Ibbotson Associates, has returns going back to 1926. Jeremy Siegel, at Wharton, recently presented data going back to the early 1800s. 6. Booth (1999) examines both nominal and real equity risk premiums from 1871 to 1997. While the nominal equity returns have clearly changed over time, he con- cludes that the real equity return average has been around 9 per cent over that period. He suggests adding the expected inflation rate to this number to estimate the expected return on equity. 7. Adapted from ‘Best Practices’ in Estimating the Cost of Capital: Survey and Synthesis’ (R. Bruner, K. Eades, R. Harris, and R. Higgins), Financial Practice and Education (Spring/Summer 1998). This reference was taken from the note prepared by Professor Robert Harris, and draws, in part, directly from ‘Best Practices’ in Estimating the Cost of Capital: Survey and Synthesis,’ and thanks go to the authors for their permission to reproduce these results. Copyright © 2004 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. 232 Notes 4 Caveats 1. Most flotation expenses are fixed, so the total cost of selling bonds and stocks is proportionally lower for large issues than for small ones. This may explain why firms prefer to raise large amounts of external funds infrequently rather than small amounts often. For issues of the same size, it has been shown that the cost of raising equity is higher than the cost of raising debt. 2. Fisher, I. (1930) The theory of interest. Library of Economics and Liberty. Retrieved March 21, 2010 from www.econlib.org/library/YPDBooks/Fisher/fshToI.html. 3. Amihud, Y. and Mendelson, H. (1989). Liquidity and cost of capital: Implications for corporate management. Journal of Applied Corporate Finance (Fall), 65–73. 4. The median is the numeric value splitting the upper and lower part of a distribution in half. To find this value we need to order all observations from the lowest value to the highest (or vice versa) and choose the one in the middle. 5. Kraus, A. and Litzenberger, R. (1976). Skewness preference and the valuation of risky assets. Journal of Finance (September), 1085–1100. 6. Black, F. and Scholes, M. (1973). The pricing of options and corporate liabilities. Journal of Political Economy, 81, 637–54. 7. Several academic studies show that option-based compensation leads to a greater likelihood of earnings restatements and outright fraud. See Agrawal, A. and Chadha, S.(2006). Corporate governance and accounting scandals. Journal of Law and Economics, 371–406; Burns, N. and Kedia, S. (2006). The impact of performance-based com- pensation on misreporting. Journal of Financial Economics, 35–67; and Denis, D. J., Hanouna, P. and Sarin, A. (2006). Is there a dark side to incentive compensation? Journal of Corporate Finance (June), 467–88. 5 Country Risk 1. http://www.standardandpoors.com, http://www.moodys.com, http://www.fitchrat- ings.com 2. This column follows Moody’s descriptions. 3. Moody’s adds numeric modifiers 1, 2 and 3 to each generic classification for ratings Aa to Caa. Modifier 1 indicates that the instrument is of the highest quality within its category, modifier 2 indicates an average qualification and modifier 3 positions the instrument in the bottom bracket of the generic category. 4. Godfrey, S. and Espinosa, R. (1996). A practical approach to calculating costs of equity for investment in emerging markets. Journal of Applied Corporate Finance, 9(3), 80–90. 5. Erb, C., Harvey, C. and Viskanta, T. (1995). Country risk and global equity selection. The Journal of Portfolio Management (Winter), 74–83. 6. See note 5. 7. Estrada, J. (2000). The cost of equity in emerging markets: A downside risk approach. Emerging Markets Quarterly, 4 (Fall), 19–30 and Estrada, J. (2001). The cost of equity in emerging markets: A downside risk approach, II. Emerging Markets Quarterly (Spring), 63–72. 6 The Optimal Capital Structure 1. Modigliani, F. and Miller, M. H. (1958). The cost of capital, corporation finance and the theory of investment. American Economic Review, 48(3), 261–97. Notes 233 2. Myers, S. C. (1984). The capital structure puzzle. Journal of Finance, 39(3), 575–92. 3. Williamson, O. (1983). Corporate finance and corporate governance. The Journal of Finance, 43(3), 567–91. 4. Jensen, M. and Meckling, W. (1976) Theory of the firm: Managerial behaviour, agency costs and capital structure.
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