Lecture 1 – Introduction, CAPM, Risk and the Cost of
Capital
CAPM – Capital Asset Pricing Model
In a portfolio of different stocks, diversification reduces risk.
Correlation of +1 = perfect positive correlation, a 10% increase in stock A
corresponds to a 10% price increase in stock B
Correlation of -1 = perfect negative correlation (10% increase A -> 10% decrease
B), with this, you can find perfect combinations of stocks with 0 risk.
Market risk: risk that cannot be eliminated by diversification, the risk that a stock
shares with the total market. = beta x square root of the variance of the returns
on the market.
Market portfolio: portfolio of all assets in the economy.
Beta: sensitivity of a stock’s return to the return on the market portfolio,
measures undiversifiable risk = covariance between the returns on stock and the
returns on the market / the variance of the returns on the market
Total risk = market risk + specific risk
If the return on stock A changes on average 1.55% for each 1% change in the
market return, the Beta is 1.55
The beta of a portfolio is the weighted average of the betas of the individual
stock in the portfolio.
Security Market Line (SML) Equation: E ( r )=R f + B( R m−R f )
-> applies to all stocks, securities and portfolios.
The Capital Market Line only applies to efficient portfolios.
De-risking; adding low-beta stocks to a portfolio (lowers the overall risk), as well
as investing a higher proportion of wealth in Treasury bills.
CAPM in the real world
Assumptions:
- Investors choose portfolios based on expected risk and return
- All investors have the same information
…?
Arbitrage Pricing Theory (APT) -> alternative to CAPM
Assumes that each stocks risk premium depends on pervasive macroeconomic
factors
Return=a+ b1 ( r factor 1 ) +b 2 ( r factor 2 ) + etc
, Efficient markets and Behavioral Finance, Debt Policy
Assumption: no transaction costs nor taxes
Capital structure: the mix of debt and equity a firm uses to finance its assets.
Financial leverage or gearing: when a firm uses debt in the capital structure.
The objective of investment and financing decisions is to maximize the firm's
value.
Investment activities affect the Debit side (left) of the balance sheet.
Financing activities affect the Credit side (right) of the balance sheet.
Financial markets are more competitive than product markets, therefore it is
more difficult to find positive NPV financing strategies than positive NPV
investment strategies.
The implication of market efficiency: all available information is used in
determining prices; the prices are ‘right’. There will only be (financial)
investments with NPV’s of 0. This is because of the arbitrage of other investors.
For investments in real assets, a positive NPV is possible, because there is no
arbitrage and companies have competitive advantages with the investments (for
example in new technologies through R&D).
When there are debtholders as well as equity holders, the debtholder’s return will
increase first as the firm starts making profits (revenues) up until the debt is
covered. Only from that point on, the equity holders will receive a return as well.
Proposition 1: In perfect (frictionless) markets, the total value of the firm (value
Debt + value Equity) does not depend on its capital structure.
Proposition 2: The expected rate of return on the common stock of a levered firm
increases in proportion to the debt-equity ratio (combination of the formula of
cost of capital and the CAPM).
If a firm has no debt, you can buy 1% of the shares and receive 1% of the profits.
If a firm has debt and equity, buy 1% of each and receive 1% of the interest and
1% of (profits – interest), which results in the same; 1% of the profits.
Under the law of one price, these 2 investments should have the same price, as
they yield the same.
When a firm has debt as well as equity (instead of only equity), the graph of
earnings per share vs. operating income will become steeper. The earnings per
share (at the expected operating income) are likely to be higher, because the
profits are divided amongst fewer equity holders. (in the example in the
lecture) but, when the operating income falls, interest has to be paid first, and
equity holders come after, possibly receiving nothing.
Corresponding to Proposition 2:
Re = Ra + (D/E) * (Ra – Rd) -> return on/cost of equity = return on assets +
debt/equity ratio * (return on assets – return on debt)
Capital
CAPM – Capital Asset Pricing Model
In a portfolio of different stocks, diversification reduces risk.
Correlation of +1 = perfect positive correlation, a 10% increase in stock A
corresponds to a 10% price increase in stock B
Correlation of -1 = perfect negative correlation (10% increase A -> 10% decrease
B), with this, you can find perfect combinations of stocks with 0 risk.
Market risk: risk that cannot be eliminated by diversification, the risk that a stock
shares with the total market. = beta x square root of the variance of the returns
on the market.
Market portfolio: portfolio of all assets in the economy.
Beta: sensitivity of a stock’s return to the return on the market portfolio,
measures undiversifiable risk = covariance between the returns on stock and the
returns on the market / the variance of the returns on the market
Total risk = market risk + specific risk
If the return on stock A changes on average 1.55% for each 1% change in the
market return, the Beta is 1.55
The beta of a portfolio is the weighted average of the betas of the individual
stock in the portfolio.
Security Market Line (SML) Equation: E ( r )=R f + B( R m−R f )
-> applies to all stocks, securities and portfolios.
The Capital Market Line only applies to efficient portfolios.
De-risking; adding low-beta stocks to a portfolio (lowers the overall risk), as well
as investing a higher proportion of wealth in Treasury bills.
CAPM in the real world
Assumptions:
- Investors choose portfolios based on expected risk and return
- All investors have the same information
…?
Arbitrage Pricing Theory (APT) -> alternative to CAPM
Assumes that each stocks risk premium depends on pervasive macroeconomic
factors
Return=a+ b1 ( r factor 1 ) +b 2 ( r factor 2 ) + etc
, Efficient markets and Behavioral Finance, Debt Policy
Assumption: no transaction costs nor taxes
Capital structure: the mix of debt and equity a firm uses to finance its assets.
Financial leverage or gearing: when a firm uses debt in the capital structure.
The objective of investment and financing decisions is to maximize the firm's
value.
Investment activities affect the Debit side (left) of the balance sheet.
Financing activities affect the Credit side (right) of the balance sheet.
Financial markets are more competitive than product markets, therefore it is
more difficult to find positive NPV financing strategies than positive NPV
investment strategies.
The implication of market efficiency: all available information is used in
determining prices; the prices are ‘right’. There will only be (financial)
investments with NPV’s of 0. This is because of the arbitrage of other investors.
For investments in real assets, a positive NPV is possible, because there is no
arbitrage and companies have competitive advantages with the investments (for
example in new technologies through R&D).
When there are debtholders as well as equity holders, the debtholder’s return will
increase first as the firm starts making profits (revenues) up until the debt is
covered. Only from that point on, the equity holders will receive a return as well.
Proposition 1: In perfect (frictionless) markets, the total value of the firm (value
Debt + value Equity) does not depend on its capital structure.
Proposition 2: The expected rate of return on the common stock of a levered firm
increases in proportion to the debt-equity ratio (combination of the formula of
cost of capital and the CAPM).
If a firm has no debt, you can buy 1% of the shares and receive 1% of the profits.
If a firm has debt and equity, buy 1% of each and receive 1% of the interest and
1% of (profits – interest), which results in the same; 1% of the profits.
Under the law of one price, these 2 investments should have the same price, as
they yield the same.
When a firm has debt as well as equity (instead of only equity), the graph of
earnings per share vs. operating income will become steeper. The earnings per
share (at the expected operating income) are likely to be higher, because the
profits are divided amongst fewer equity holders. (in the example in the
lecture) but, when the operating income falls, interest has to be paid first, and
equity holders come after, possibly receiving nothing.
Corresponding to Proposition 2:
Re = Ra + (D/E) * (Ra – Rd) -> return on/cost of equity = return on assets +
debt/equity ratio * (return on assets – return on debt)
