Lect 10 Fin 221 web

Lect 10 Fin 221 web - Managerial Finance Lecture 10...

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1 Managerial Finance Lecture 10 Estimating the Estimating the Cost of Capital and Ameritrade Last two sessions: Summary 1. Investors expect to be compensated for holding un-diversifiable , market or common risks Firm specific risk can be diversified away if investors hold portfolios Efficient portfolios of risky assets are fully diversified (common risk) Efficient frontier : set of efficient portfolios, i.e. highest expected return per unit of risk 2. Risk-free investments allow investors to determine the optimal or tangent portfolio Tangent portfolio: point of tangency to the efficient frontier of a line drawn from the riskless investment Tangent portfolio : portfolio of risky securities with the highest Sharp Ratio 3. The cost of capital or the expected return is determined by beta Beta: risk of an investment that is shared with the tangent portfolio 2 ) ( ) , ( ) ( ) ( * ) , ( tan tan tan tan tan , gent gent i gent i gent i gent i R Var R R Cov R Std R Std R R Corr ) ] [ ( * ] [ tan tan , f gent gent i f i r R E r R E
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2 Capital Asset Pricing Model (CAPM) Suppose All investors have similar information and expectations: Same expectations about returns • Same expectations about returns • Same estimates of covariances/correlations between returns All investors choose mean-variance efficient portfolios Then Each investor will compute the same tangent portfolio Aggregate Demand for Stocks = Tangent Portfolio 3 In equilibrium, Supply = Demand : Tangent Portfolio = Aggregate Supply of Stocks = Market Portfolio: value weighted Examples: = S&P 500 (500 large-cap US stocks) = Wilshire 5000 (Total US stock market) The Capital Market Line (CML) CAPM: the best possible risk-return possibilities are combinations of risk-free savings and the Market Portfolio Portfolios on the capital market line (CML) are determined by the fraction x invested in the market 15% 20% 25% ected return Capital Market Line x = 50% x = 150% 4 0% 5% 10% 0% 10% 20% 30% 40% 50% standard deviation exp Exp. Ret = fM k t f rx R r  Volatility = ( ) Mkt xStdR
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3 Intuition The market portfolio is the “benchmark” portfolio: The “best” deal: highest Sharpe ratio Fully diversified market portfolio If the CAPM holds, we can use the market portfolio to compute betas for specific projects/firms: Betas capture how costly it is to provide financing to a project, given the best alternatives in the market. Before: CAPM: 5 ) ] [ ( * ] [ tan tan , f gent gent i f i r R E r R E ) ] [ ( * ] [ , f market market i f i r R E r R E ) ( ) , ( ) ( ) ( * ) , ( , market market i market i market i market i R Var R R Cov R Std R Std R R Corr CAPM: The final frontier ) ] [ ( * ] [ , f market market i f i r R E r R E Three key components: 1. The risk free ( r f ) 2. The project specific (project i ) beta 3. The expected excess return of the market portfolio or expected market risk premium market i , ) ] [ ( f market r R E
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4 Survey: How do CFOs estimate discount rates?
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Lect 10 Fin 221 web - Managerial Finance Lecture 10...

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