STRATEGIC FINANCIAL MANAGEMENT
Hurdle Rate: Cost of Equity
KHURAM RAZA
ACMA, MS FINANCE
First Principle and Big Picture
Cost of Equity
 CAPM Approach
 Risk Free Rate
 Risk premium
 Risk Parameter: Beta
 Historical Market Betas
 Beta Fundamentals
 Business Risk
 Operating Leverage
 Financial Leverage
o Bottom Up Betas
 Accounting Betas
 Own bond yield –plus –judgmental Risk Premium Approach
 Discounted Cash Flow (DCF) Approach
Inputs required to use the CAPM
The Risk free Rate and Time Horizon
The Bottom Line on Risk free Rates
What if there is no default-free entity?
Risk Premium
The risk premium in the capital asset pricing model
measures the extra return that would be demanded by
investors for shifting their money from a riskless investment
to an average risk investment. It should be a function of two
variables
 Risk Aversion of Investors: As investors become more risk
averse, they should demand a larger premium for
shifting from the riskless asset.
 Riskiness of the Average Risk Investment: As the
riskiness of the average risk investment increases, so
should the premium. This will depend upon what firms
are actually traded in the market, their economic
fundamentals and how good they are at managing risk
Estimating Risk Premiums
Historical
Premiums
There are three
ways of estimating the risk premium in
1. It begins by defining a time period for the estimation
theIt then
capital
asset
pricing
model
2.
requires
the calculation
of the
average–returns on a stock index and average
returns on a riskless security over the period
Large
investors can be surveyed about their
3. it calculates the difference between the returns on stocks and the riskless return
and
uses it as a risk premium
looking
forward.
expectations
for the
future,
 The actual premiums earned over a past period can
Estimation
Issues
be obtained
from
historical data and
 There are no constraints on reasonability; individual money managers
 Time Period Used
could provide
expected returns
thatextracted
are lower thanfrom
the riskcurrent
free rate, for
The implied
premium
can be
Choice of Risk
free Security
instance.

Arithmetic
and Geometric Averages
market
data.
 Survey
premiums are extremely volatile; the survey premiums can change
dramatically, largely as a function of recent market movements.
 Survey premiums tend to be short term; even the longest surveys do not
go beyond one year.
Risk Parameter: Beta
Historical Market Betas
The standard procedure for estimating betas is to regress
stock returns (Rj) against market returns (Rm) –
Rj = a + b Rm
Rj-Rf= a + b (Rm-Rf)
Regression Interpretation:
Estimation Issues
Slope
 length of the estimation
Intercept
period
 return interval
R squared
 market index
Standard error
Fundamental Betas
 The beta for a firm may be estimated from a regression
but it is determined by fundamental decisions that the
firm has made
on what business to be in, how much
Operating
Leverage:
operating leverage to use in the business and the
The
degreeto
of operating
leverage
is auses
function
of the cost
structure of a
degree
which
the
firm
financial
leverage.
Financial Leverage
firm, and is usually defined in terms of the relationship between fixed
costs and total costs.
A firm
thatforhas
leverage
high of the
The beta
value
a high
firm operating
depends upon
the (i.e.,
sensitivity
Financial
leverage
the
risk
the have
stockholders
that
caused
an
fixed costs
relative
to total
costs)
willtoalso
higher
in to by
demand
forisits
products
and
services
andvariability
of itsis costs
macoperating
The beta
ofroeconomic
athan
isfactors
determined
by
variables
–
increase
infirm
debt
and
in three
aoverall
company's
capital
income
would
apreferred
firm producing
similar
product
with
lowstructure.
that equities
affecta the
market.
a company increases debt and preferred equities, interest payments
operatingAs
leverage
(1) the
type
of business
or
businesses
the firm
isis in
increase,
reducing
EPS.
As
a
result,
risk
to
stockholder
return
increased.
 Cyclical companies have higher betas than non‐cyclical
firms
(2)
Degree
Operatingof
Leverage
= % Change
in EBIT/ in
% Change
in Sales
theofdegree
operating
leverage
the firm
and
 Degree
of
financial
leverage
=
%
Change
in
EPS/
%
Change
EBIT
 Firms which sell more discretionary products will in
have
(3) The firm's
financial
leverage.
higher
betas than
firms that
sell less discretionary
Bottom Up Betas
Breaking down betas into their business, operating leverage and financial leverage
components provides us with an alternative way of estimating betas, where we do not
need past prices on an individual firm or asset to estimate its beta.
 The bottom up beta can be estimated by doing the following:
1.
2.
3.
4.
Find out the businesses that a firm operates in
Find the unlevered betas of other firms in these businesses
Take a weighted average of these unlevered betas
Lever up using the firm’s debt/equity ratio
 The bottom up beta is a better estimate than the top down beta for the follo
wing
reasons
a)
b)
The standard error of the beta estimate will be much lower
The betas can reflect the current (and even expected future) mix of businesses that
the firm is in rather than the historical
Asset Beta = ß equity (Equity/Debt + Equity) + ß
Debt (
Debt/Debt + Equity)
ß unlevered = ß levered (1/1+Debt/Equity) (1-t) + 0
ß unlevered (1+Debt/Equity) (1-t) = ß levered
Accounting Betas
A third approach is to estimate the market risk parameters from
accounting earnings rather than from traded prices. Thus, changes in
earnings at a division or a firm, on a quarterly or annual basis, can be
regressed against changes in earnings for the market, in the same
periods, to arrive at an estimate of a “market beta” to use in the
CAPM.
 While the approach has some intuitive appeal, it suffers from
three potential pitfalls.
a) accounting earnings tend to be smoothed out relative to the
underlying value of the company
b) accounting earnings can be influenced by non-operating
factors, such as changes in depreciation or inventory methods
c) accounting earnings are measured, at most, once every
quarter, and often only once every year
Own bond yield –plus –judgmental Risk
Premium Approach
Some analysts use a subjective, ad hoc procedure to
estimate a firm’s cost of common equity: They simply
add a judgmental risk premium of 3% to 5% to the
interest rate on the firm’s own long-term debt.
Discounted Cash Flow (DCF) Approach
Marginal investor expects dividends to grow at a constant
rate and if the company makes all payouts in the form of
dividends (the company does not repurchase stock), then
the price of a stock can be found as follows:
P0 = D1 / ( ke – growth )
Solving for ke such that
ke = ( D1 / P0 ) + growth
Where g = ROE( Retention Ratio)
If g = 0
ke = ???