MONASH
BUSINESS
SCHOOL
Lecture 10
Risk analysis and cost of capital
Last week
– Prospective analysis (Application - II)
 Assumptions on forecast financial items
 Basis for assumptions
 Forecasting financial line items
 Segment information and forecasting
 Sensitivity analysis (scenarios)
 Using forecast spreadsheet
 Case analysis – JB Hi-Fi.
2
MONASH
BUSINESS
SCHOOL
2
Valuation flow chart
Capital market analysis
•Stock liquidity
•analysts’ coverage
•information environment
Business analysis
•Macroeconomic and other
external macro factor analysis
•Industry analysis
•Business strategy analysis
Communication and
governance analysis
•
•
•
•
Management quality
Disclosure quality
Internal corporate governance
External corporate governance
Financial
analysis
Earnings quality
and accounting
analysis
Prospective
analysis
(forecast)
Risk
analysis
&
discount
rate
Valuation
MONASH
BUSINESS
3
SCHOOL
This week
– Risk analysis and cost of capital
• Types of risks
• Measuring risks
• Types of capital
• Cost of equity
• Weighted average cost of capital
• Case analysis – JB Hi-Fi
MONASH
BUSINESS
4
SCHOOL
Risk, cost of capital and valuation
Source: http://people.stern.nyu.edu/adamodar/pdfiles/country/CostofCapitalCFA2015.pdf
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BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Risk analysis
Objectives of risks analysis
• Risk Analysis is like understanding the application of a brake in
the car
• For managers risk analysis is not for slowing down but to help
increase speed
• For investors risk analysis helps understand the investment risks
and identify opportunities
MONASH
BUSINESS
7
SCHOOL
Crisis impact on sectors: 2009 vs 2020
Source: World Steel
MONASH
BUSINESS
SCHOOL
Total Government and Central Bank Stimulus Estimates in Response to
Crisis (% of GDP)
Source: Morgan Stanley
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BUSINESS
SCHOOL
Risk chart
Risk
categories
1
2
3
4
Strategic
Industry
Market
Alignment
Decision
making
Operational
Production
Cost
inefficiency
Property
Health and
safety
Management
Image
Control
Reporting
quality
Project
management
Political
War
Instability
Institutional
Government
policy change
Financial
Commodity
price risk
Liquidity
Credit
Foreign
exchange
Exogenous
Earthquake
Flood
Volcanic
Fire
MONASH
BUSINESS
10
SCHOOL
Risk disclosure and risk mitigation
• Risk related disclosure in annual reports
• ASX Corporate Governance Council : Principles
of Good Corporate Governance
Principle 7: Companies should establish a sound system of risk oversight and
management and internal control.
• Recommendation 7.1: Companies should establish policies for the oversight and management of
material business risks and disclose a summary of those policies
• Recommendation 7.2: The board should require management to design and implement the risk
management and internal control system to manage the company’s material business risks and
report to it on whether those risks are being managed effectively. The board should disclose that
management has reported to it as to the effectiveness of the company’s management of its
material business risks.
• Recommendation 7.3: The board should disclose whether it has received assurance from the chief
executive officer (or equivalent) and the chief financial officer (or equivalent) that the declaration
provided in accordance with section 295A of the Corporations Act is founded on a sound system of
risk management and internal control and that the system is operating effectively in all material
respects in relation to financial reporting risks.
Presentation title
MONASH
BUSINESS 1
28th February 2011
SCHOOL 1
SOX Risk Disclosure -20F filing of BHP
External risks
• Fluctuations in commodity prices and impacts of ongoing global economic volatility may
negatively affect our results, including cash flows and asset values
• Our financial results may be negatively affected by currency exchange rate fluctuations
• Reduction in Chinese demand may negatively impact our results
• Actions by governments or political events in the countries in which we operate could
have a negative impact on our business
Business risks
• Failure to discover new reserves, maintain or enhance existing reserves or develop new
operations could negatively affect our future results and financial condition
• Potential changes to our portfolio of assets through acquisitions and divestments may
have a material adverse effect on our future results and financial condition
• Increased costs and schedule delays may adversely affect our development projects
MONASH
BUSINESS
12
SCHOOL
SOX Risk Disclosure -20F filing of BHP (cont.1)
Financial risks
• If our liquidity and cash flow deteriorate significantly it could adversely affect our
ability to fund our major capital programs
• We may not recover our investments in mining, oil and gas assets, which may
require financial write-downs
• The commercial counterparties we transact with may not meet their obligations
which may negatively impact our results
Operational risks
• Cost pressures and reduced productivity could negatively impact our operating
margins and expansion plans
• Unexpected natural and operational catastrophes may adversely impact our
operations
• Our non-controlled assets may not comply with our standards
• Breaches in our information technology security processes may adversely impact
the conduct of our business activities
MONASH
BUSINESS
13
SCHOOL
United Nations Sustainable Development Goals
Page 14
Confidential
MONASH
BUSINESS
SCHOOL
Why should management bother about UNSDG?
• The world is watching and take keen interest in recent
developments
• Broader stakeholder groups question the approach of large
companies more than ever before
• Information on the actions of an organization is now publicly
available
• There are significant economic benefits of engaging with UNSDG
• Evidence of economic benefits of adopting and delivering on
UNSDGs for an organization
20/07/2022
Confidential
MONASH
BUSINESS
SCHOOL
What do investors know about large companies?
• Business Ethics
• Health and Safety
• Climate Change
• Land Use & Biodiversity
• Controversial Investments
• Product Safety
• Customer Relations
• Substantial Emissions
• Employee Relations
• Supply Chain
• Environment Concerns
• Union Relations
• Governance Structures
• Water Management
Page 16
20/07/2022
Confidential
MONASH
BUSINESS
SCHOOL
ESG score statistics – sample companies
Measures
Mean Lower Quartile
Median
Upper Quartile
Minimum Maximum
Overall Score
0.7903
0.7365
0.8981
0.9465
0.0323
0.9868
Economic Score
0.6876
0.5309
0.7826
0.9138
0.0201
0.9877
Environmental Score
0.7919
0.8171
0.9255
0.9435
0.0846
0.9732
Corporate Governance Score
0.7162
0.6362
0.7808
0.9051
0.0556
0.9841
Social Score
0.7312
0.6363
0.8317
0.9243
0.0430
0.9917
Page 17
20/07/2022
Confidential
MONASH
BUSINESS
SCHOOL
Sustainability disclosures – impact of PS2 and COVID-19
6,00
Sustainability dislosure index (mean values)
5,50
5,00
4,50
4,00
3,50
3,00
2011
2012
2013
SUSTAIN_INDEX
2014
2015
SUSTAIN_PRACTICE
2016
2017
2018
SUSTAIN_REPORT
2019
2020
2021
CLIMATE_RISK
MONASH
BUSINESS
SCHOOL
Pre COVID-19 and COVID-19 pandemic period
Two-sample t-test of firms in the pre COVID-19 and COVID-19 pandemic period
COVID-19 =0
COVID-19 = 1
N = 8,809
N = 985
Diff. in mean
t-statistics
Variables
TOBIN’SQ
2.542
2.483
0.059
0.10
ROA
-0.411
-0.233
-0.178
-1.90*
SUSTAIN_INDEX
5.097
5.710
-0.613
-6.27***
SUSTAIN_PRACTICE
5.140
5.751
-0.611
-6.29***
SUSTAIN_REPORT
4.378
4.822
-0.444
-9.36***
GUNNFOG_RANK
4.724
4.780
-0.056
-0.60
MONASH
BUSINESS
SCHOOL
Research questions
RQ1: Is there any significant association between a firm’s sustainability practices and its
valuation (accounting performance) in the year of the COVID-19 pandemic?
RQ2: Does the association between a firm’s sustainability practices and its valuation
(accounting performance) vary across COVID-19 pandemic years and non-pandemic years?
MONASH
BUSINESS
SCHOOL
Results of regression estimates for test of company performance
Test of RQ1 using market measure TOBINS’ Q as dependent variable
2011 to 2021 (all years)
Intercept
SUSTAIN_INDEX
SUSTAIN_PRACTIC
E
SUSTAIN_REPORT
2011 to 2019 (pre COVID-19 years)
2020 and 2021 (COVID-19 years)
(1)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
3.777*
3.618*
1.964
2.947
2.745
1.524
5.674**
5.604**
4.100
(1.77)
(1.69)
(0.87)
(1.47)
(1.37)
(0.71)
(2.03)
(2.00)
(1.44)
0.466**
*
(4.85)
0.471***
0.251*
(4.46)
(1.74)
0.523***
0.531***
0.283*
(5.37)
(4.96)
(1.93)
0.773***
0.733***
0.709***
(3.89)
(3.19)
(3.08)
MONASH
BUSINESS
SCHOOL
Results of regression estimates for test of company performance
Test of RQ1 using accounting measure ROA as dependent variable
2011 to 2021 (all years)
(1)
Intercept
SUSTAIN_INDEX
SUSTAIN_PRACTIC
E
SUSTAIN_REPORT
2011 to 2019 (pre COVID-19 years)
2020 and 2021 (COVID-19 years)
(2)
(3)
(4)
(5)
(6)
(7)
(8)
(9)
0.978***
(-4.00)
(-3.94)
-0.520**
-1.108***
-1.088***
-0.665***
-0.094
-0.094
0.011
(-1.99)
(-4.74)
(-4.65)
(-2.66)
(-0.42)
(-0.42)
(0.05)
-0.992***
-0.073***
-0.076***
-0.016
(-6.50)
(-6.20)
(-1.35)
0.077***
(-6.77)
-0.081***
-0.015
(-6.48)
(-1.27)
-0.172***
-0.180***
-0.046**
(-7.45)
(-6.75)
(-2.52)
MONASH
BUSINESS
SCHOOL
Results of regression estimates for firm performance using climate risk disclosure
Panel A: Test of RQ1
Intercept
CLIMATE_RISK
TOBIN’SQ
ROA
1.945
(0.86)
0.673***
(3.79)
-0.639**
(-2.43)
-0.121***
(-5.86)
TOBIN’SQ
ROA
1.440
(0.74)
0.655***
(3.66)
0.465
(0.30)
0.031
(0.81)
Yes
Yes
Yes
9,794
0.113
-0.805***
(-3.55)
-0.118***
(-5.66)
0.173
(0.95)
-0.006
(-1.30)
Yes
Yes
Yes
9,794
0.109
Panel B: Test of RQ2
Intercept
CLIMATE_RISK
COVID-19YEAR
CLIMATE_RISK*COVID-19YEAR
Control variables
Industry fixed effect
Year fixed effect
N
Adjusted R2
MONASH
BUSINESS
SCHOOL
Important considerations for investors and analysts
Climate change risks
• Does the company face risks associated with climate change? Explain
• What is the company doing about climate change-induced risks?
• What is your assessment of the company’s strategy to address climate change risk?
COVID-19 risks
• Does the company face risks associated with the spread of COVID-19? Explain
• What is the company doing about COVID-19 induced risks?
• What is your assessment of the company’s strategy to address COVID-19 risk?
Ukraine-Russia conflict risks
• Does the company faces risks due to the conflict between Ukraine and Russia?
Explain
• What is the company doing about the potential risks due to the conflict?
• What is your assessment of the company’s strategy to address the risk?
MONASH
BUSINESS
24
SCHOOL
MONASH
BUSINESS
SCHOOL
Cost of capital overview
Short exercise
 Assume that there are two companies operating in the same country
and each earn $100 in free cash flows in the current year.
 Both companies have the same projected growth rate of 5 percent
annually in perpetuity.
 Analysis shows that the first company has a current value of $5,000
and the second company has a current value of $2,000.
 Also assume that the capital structures of the two companies is the
same and remain constant.
What do you think drives this difference in
26
value?
MONASH
BUSINESS
SCHOOL
Systematic and unsystematic risk
•
Systematic risk – systematic or unavoidable risk is risk arising from factors
which affect the whole market such as wars, financial crisis, national
economic changes etc.
•
Unsystematic risk – is avoidable risk unique to each separate investment
such as effect of strikes, emergence of new competitor, change in
management etc.
MONASH
BUSINESS
SCHOOL
Cost of capital
Cost of Capital
Valuation
Corporate Finance
• Investment Analysis
• Capital Structure
• Dividend Policy
Hurdle Rate – invest if return on investment is at least as
much as the cost of capital of the investment
Optimising tool – choose the capital structure that
minimises the cost of capital
Used to determine whether the company should retain cash
or return it to investors
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BUSINESS
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How stocks compare with government bonds
Hist o r ic al S t o ck Ret u r n s an d 10-y ear Go v en men t
Bo n d Yield s
20
15
10
Dec-2018
Oct-2018
Aug-2018
Jun-2018
Apr-2018
Feb-2018
Dec-2017
Oct-2017
Aug-2017
Jun-2017
Apr-2017
Feb-2017
Dec-2016
Oct-2016
Aug-2016
Jun-2016
Apr-2016
Feb-2016
Dec-2015
Oct-2015
Aug-2015
Jun-2015
Apr-2015
-5
Feb-2015
0
Dec-2014
RETURN
5
-10
-15
-20
AGB 10 Year
^AORD
Data Source: Reserve Bank of Australia and Yahoo! Finance
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MONASH
BUSINESS
SCHOOL
Cost of capital and valuation
 The cost of capital is the discount rate used in valuation
– Note that for the purpose of valuation, the cost of capital is the opportunity
cost of investing in something of equivalent risk
 It must meet the following criteria:
– Include the opportunity cost of all investors
– Must weight the security’s required return by the target market-based weight
and not historical cost
– Any financing related benefits must be included
– Must be computed after tax
– Must be based on the same expectations of inflation as those in calculating
the free cash flow
– Duration of securities used should match the duration of cash flows
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BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Weighted average cost of capital (WACC)
Weighted average cost of capital (WACC)
 A simple expression for WACC:
D
E
WACC  rd (1  t )  re
V
V
 Where,
– D/V: Target debt to enterprise value based on market values
– E/V: Target equity to enterprise value based on market values
– rd: The cost of debt
– re: The cost of equity
– t: The marginal tax rate
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BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Cost of equity: CAPM
How good is CAPM for estimating cost of equity?
• CAPM just works okay (does not work if not in a CAPM
regime).
• Lacks perfection
• Simply a calculation based on risk and reward
• Has short comings though widely used
• Useful during CAPM regimes otherwise not (refer to ASX
AllOrd historical data)
• Way out is to use historical equity risk premium instead
of current market return
MONASH
BUSINESS
SCHOOL
Use of CAPM- KPMG Valuation Practices Survey
Presentation title
MONASH
BUSINESS 3
SCHOOL 5
Cost of equity: CAPM (capital asset pricing model)
𝑟𝐸 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 )
Risk-free rate beta Equity risk premium
• Based on CAPM
• CAPM has been questioned but
– It still works for long-term (yearly) returns
– It is intuitive
– Easier to implement than alternate models
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MONASH
BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Risk free rate
Risk-free rate
 Rate on long-term govt. bonds
– Should ideally match duration with that of firm’s cash flows
 Commonly used government bond
 2.75% (currently)
 Real or nominal?
– Nominal if inflation is built into the cash flows -- consistency
 Current or historical average?
 If govt. bonds have default risk, then subtract the default risk premium
– Example: The current 10-year government of India bonds have a YTM of 7.56%. These
bonds were rated BAA2 by Moody’s (translating into a default spread of 2.15%). Then the
true risk-free rate is 5.41%.
– The 10-year Australian Government Bonds have a AAA credit rating, which means that the
default spread is 0.
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MONASH
BUSINESS
SCHOOL
Impact or coronavirus: Stock versus bonds
Source: The Motley Fool
MONASH
BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Beta
Beta
• Beta is a risk measure comparing the volatility of a
stock's price movement to the general market.
• Beta provides a good idea of a stock's inherent risk or
sensitivity to general market fluctuations.
• High beta stocks react strongly to variations in the
market, and low beta stocks are less affected by market
variations.
41
MONASH
BUSINESS
SCHOOL
Beta estimation
 Daily, weekly, or monthly returns?
– Daily returns yield more observations, but betas based on daily returns could be
biased towards zero because of non-synchronous trading
– Monthly returns yield few observations and therefore high standard errors of
estimates
– Weekly returns may be a good compromise, although even weekly data has nonsynchronous trading for many securities
 Market index?
– Theoretically, returns on all possible assets including real estate and human
capital
– In practice, a readily available index such as S&P500, AORD, ASX200
– Usually local market index, because most investors do not diversify across
countries
– Does not make much difference
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BUSINESS
SCHOOL
Beta estimation time periods
 Is historical beta appropriate to use?
– Theoretically no
– Adjust, if you know that the firm is getting into another industry
 How long back to go?
– No more than 5 years
– Monthly for 5 years, monthly for 1 year
 Graph rolling betas to detect systematic changes in the stock’s risk
 Use a reasonably long time-series to measure beta
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MONASH
BUSINESS
SCHOOL
Predicted beta – Disney and Netflix
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MONASH
BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Equity risk premium (ERP)
Equity Risk Premium (ERP)
• ERP is forward-looking expectation of stocks less 10-year
government bonds
• ERP in Australia since 1958 and till 2005 was 6.3% calculated as an
geometric mean
• World average till 2001 was 5.9%
• During GFC and COVID-19 pandemic ERP increased slightly
• The Australian market has a larger representation of resourcebased companies, which have high levels of systematic risk.
• An incomplete list of factors that would support a higher MRP in
Australia include being a smaller market, with less liquidity,
smaller companies, less diversity and fewer risk management
opportunities.
MONASH
BUSINESS
SCHOOL
Equity risk premium comparison
Source: http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html
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BUSINESS
SCHOOL
Implied Market Risk Premia: Australia
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BUSINESS
SCHOOL
Historic equity risk premium
Source: KPMG Corporate Finance (Australia)
MONASH
BUSINESS
SCHOOL
Implied cost of equity
 Not very useful for valuation
– Guess why?
 Why use it then?
– Three reasons:
 Can be used as a benchmark to test the “margin of error”
– For instance, suppose CAPM produces an estimate of 10% and using
this rate, you determine that the stock is under-valued. However, if the
implied cost of equity is 10.2%, you may not want to invest in the
stock. If the implied cost of equity is 15%, it may be a different story
 Can be used to calculate an implied cost of equity for an entire sector
 Can use this approach to calculate an implied cost of equity for a company
in different time periods and then compute an average cost of equity from
those estimates
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MONASH
BUSINESS
SCHOOL
MONASH
BUSINESS
SCHOOL
Cost of Debt
The cost of debt
 For investment-grade debt, the cost of debt can be reasonably
approximated to the yield to maturity (YTM)
 Theoretically,
pd 
rc
rc
rc
FV


...


(1  YTM ) (1  YTM ) 2
(1  YTM )T (1  YTM )T
T

 (1  YTM )
n 1
rc
n

FV
(1  YTM )T
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MONASH
BUSINESS
SCHOOL
On the yield to maturity (YTM)
 The YTM should be calculated on liquid, option-free, long-term debt
 For US companies, the YTM can be obtained free of charge from
TRACE (data available from 2002)
 For Australian companies, the ASX website provides the information
for publicly traded debt
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MONASH
BUSINESS
SCHOOL
What if the company’s debt is not publicly traded?
 Two approaches:
– Look at the most recent borrowing history
 Cost of debt is the average cost of borrowing
– Calculate the synthetic spread
 Calculate the interest coverage ratio of the
company and compare with those of companies
that have publicly rated bonds
 Apply the average spread of companies with same
interest coverage ratio
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MONASH
BUSINESS
SCHOOL
Next week (Lecture 11)
• Lecture
– Valuation (theory and application – I)
• Aims and objectives of valuation
• Myths (truth) about valuation
• Valuation methods
• Terminal value calculation
• Case analysis – JB Hi-Fi
• Tutorial
– Discussion of lecture content of week 10 Risk analysis and cost of capital
– Discussion on assessment requirements – Assignment 2 (Section G)
– Applying risk analysis and calculating cost of equity capital of JB Hi-Fi
– Discussion of exam questions from the past
MONASH
BUSINESS 5
SCHOOL 5