Risk-Return

Understanding the component of return and

Measuring It…
 What are the component of return
 Pure time value of money component
 Reward for taking risk
 Quantity of risk * amount of risk
 Arithmetic mean or arithmetic average rate of return
T
1
R   Ri
T i 1
 Geometric mean or geometric average rate of return

1  R1  1  R2   1  R3 ... 1 RT 

1/ T
1
Understanding the component of risk and measuring It…
 What is risk?
 Any unfavorable event or uncertainty arising which is not
anticipated
 What are the component of return
 Risk arising out of individual assets – Un-systematic risk
 This risk can be diversified
 Risk arising out of inter-linkage of assets – Systematic risk
 This risk can not be diversified
 Total risk = Systematic + Unsystematic risk
 How to measure risk?
 Variability of return can be measured by variance

 R  R  ,
N 2
1
 ( R) 
2

N 1
i
i 1
N
1
where R 
N
R
i 1
i is the sample  mean of R
Understanding the component of risk and measuring It…
 What happens when all outcomes are not equally
likely?

 p  R  R ,
n 2

  2
i i
i 1
n
where R  p R
i 1
i i is the sample  mean of R

[ p i is the probability of state i and there are n states]

Understanding the Implication of Normality…
 Suppose the return on an asset is Normally distributed
with mean = 12% and st-dev = 7%; Then,

 68.26% of time, its return will lie within 5% (=12% - 7%) and 19%
(=12% + 7%)

 95.44% of time, its return will lie within -2% (= 12% - 2 x 7%) and
26% (=12% + 2 x 7%)

 99.74% of time, its return will lie within -9% (= 12% - 3 x 7%) and
33% (=12% + 3 x 7%)

 What is the probability that its return would exceed 26%?

 (100% - 95.44%) / 2 = 2.28%

 What is the chance that its return would fall below 5%?
 (100% - 68.26%) / 2 = 15.87%
 Understanding Portfolio Return
 Portfolio is a pool or collection of individual assets
 Example; if you have put $400 in Asset-A and $600 in Asset-B, and I have
put $200 in Asset-A and $300 in Asset-B, we both are holding the same
portfolio of A, B, C: (40%, 60%, 0%)]
 Portfolio return and risk are measured by its Expected Return and
Variance, as we have so far done for individual assets.
 Portfolio return is

m
RP   wi Ri
i 1

where wi is the weight of asset i,

Ri is the return on asset i,
Rp is return on the portfolio
Understanding Portfolio Return
Consider the portfolio weights on the previous page, where Expected return
from
Asset 1 is 12%, Asset 2 is 12% and Asset 3 is 10%

What is the expected return on the (40%, 60%, 0%) portfolio?

(40% x 12%) + (60% x 12%) + (0% x 10%) = 12%
What if the weights were (30%, 70%, 0%): still 12%
What is the expected return on another portfolio: (25%, 0%, 75%)?
(25% x 12%) + (0% x 12%) + (75% x 10%) = 10.50%
What is the expected return on yet another portfolio: (20%, 0%, 80%)?
(20% x 12%) + (0% x 12%) + (80% x 10%) = 10.40%
Understanding Portfolio Return: What we Found?

When we combine assets with the same mean,

the portfolio mean is the same as
the common mean of the individual assets
=>
portfolio mean is independent of weights on assets
(example: first two portfolios of 1 and 2)

But, when we combine assets with different means,

portfolio-mean changes as we change the weights.
(example: last two portfolios of 1 and 3)
Understanding Historical Risk and Return Trade-
off (figures are in %)
Arithmetic Risk Standard Geometric
Mean Premium* Deviation Mean
Inflation 3.1 - 4.3 3.0
Treasury Bill 3.8 0 3.1 3.7
Intermediate 5.5 1.7 5.7 5.3
-term Govt
Long-term 5.8 2.0 9.2 5.5
Govt
Long-term 6.2 2.4 8.5 5.9
Corporates
Small 17.4 13.6 32.9 12.6
Companies
Large 12.3 8.5 20.2 10.4
Companies
Understanding the Portfolio Risk and Return
 The historical return we saw was on portfolios, NOT on
individual stocks or bonds

 Thus, 17.4% is not the arithmetic-mean return earned by every (or a

typical) small-firm stock; it’s return earned by a portfolio of small-firm
stocks

 Moreover, a Mean return is an “average” figure; it’s NOT return

guaranteed to be earned every year

 So, even a portfolio of small-firm stocks would not give you 17.4%
return every year; it would give “on the average” 17.4% over many
years

 Small-firms portfolio gave higher average return since it was

riskier
Understanding the Portfolio Risk and Return
 There is a reward for bearing risk - but only over the long
haul.

 So, if you invest in a risky asset, you would sometimes

end up with very high returns and sometimes get very
low returns
 In fact, this fluctuation is the risk

 Over a long period, a riskier-asset gives you a higher

average (or expected) return than a less risky asset.

 In fact, the riskier an asset, higher is the return.

 The reward actually is in the form of risk premium: Ri – Rf, i.e.,
average return in excess of that earned on, say, T-Bill
 Understanding Portfolio Return and Risk
 Realized Return = Expected Return + Error
 The Error is actually the Unexpected Component and
on any date or at any point of time, the Unexpected
Component can be positive or negative
 Over time, “on the average”, the Unexpected
Component MUST be zero (unless there is a bias)
 Announcements and news contain an Expected
Component (which should have already been built
into price in an efficient market)
 A Surprise or Unexpected Component (which has
not already been built into price) when unexpected
component gets incorporated into price, the share-
price changes.
Understanding the Portfolio Risk and Return:
Implications of Efficient Market
 Efficiency refers to efficiency in “processing” or
“assimilating” material information
 Material: Information should have effect on value (price-sensitive
information: information that should affect price of a share)
 In an efficient capital market, price reflects all “available”
information
 Three types/layers of Efficient Capital Markets
depending on how we define “available”
 Weak-form Efficient: “Available”  Historically Available
 Semi-strong Form Efficient  Publicly (including
Historically) Available
 Strong Form Efficient  Privately (including Publicly)
Available
 Price of the assets are fairly priced: One can not make
money by trading on the assets consistently
Understanding the Portfolio Risk and Return:
Implications of Efficient Market
 EMH does not suggest that, since one cannot make
money, there is no point analyzing companies.
 In fact, it is the constant research on companies that
keeps the market efficient.

 EMH does NOT mean that, you cannot gain or lose in

the stock-market.
 It means that typically you would, make risk-adjusted
return

 EMH does not imply that prices would be steady; rather it

suggests that they should fluctuate, as they constantly
reflect newly available information.
Understanding Portfolio Return and Risk

Total (or Realized) Return =

Expected Return +
CanNOT Get Rid Of
Systematic Portion +
Induced by Risk
Can Get Rid Of
Unsystematic Portion
By Diversification

No reward for bearing this

risk.
 Understanding Portfolio Risk
 Systematic or Non-diversifiable or Market Risk: Affects
almost all stocks and thus the market indices
 Changes in GDP
 Rate cut or increase by Fed
 Changes in Exchange-Rates
 (whether due to domestic or foreign government action)
 Iraq War, Mortgage Market Collapse, 9/11, Market Panics
 Change in Securities Law in a major country
 Unsystematic or Idiosyncratic or Unique or Asset-
specific Risk: Affects a single or a specific class of assets
(what about one country?)
 Strikes and labor problems
 Raw-material shortages
 Shifting Preferences
 Understanding Portfolio Risk
 Risk-averse investors require compensation (or
risk-premium) for exposing themselves to risk.
 Market WOULD compensate them, but ONLY for
SYSTEMATIC risk, as Unsystematic Risk is
diversifiable.

 There is no reward for bearing risk

unnecessarily.

 So, RRR would depend ONLY upon the Systematic

Risk
 Understanding Portfolio Risk
 Explain from xls spreadsheet
 Understanding Portfolio Risk: What we have
learnt?
 Portfolio variance is less than the variance of the asset
 Why?
 Because of principle of diversification
 Risk of the portfolio depends on the weights of assets in the portfolio
 Effectiveness of diversification depends on the degree of correlation
between assets
 Lower the correlation higher is the possibility of diversification
 Higher the correlation lower is the possibility of diversification
 So, when you invest in firms in the same industry, you do not
diversify as much as when investing in different industries, which
itself is not as good as investing across countries.
 To hold a well-diversified portfolio, you should get rid of “unsystematic”
risks: firm-specific, industry-specific, and country-specific risk.
 But, you cannot get rid of the “systematic” risk: global-market-specific
risk that affects all stocks.
 Understanding Portfolio Risk: What we have
learnt?
 There is a MINIMUM level of risk that cannot be diversified, this is the non-
diversifiable risk or the market-risk that affects ALL shares

 If I hold only the shares of one computer company (Infy, TCS, or WIPPRO), I am
exposed to the risk that my company may lose market-share to the other
computer companies

 If I hold shares of all Indian technology companies, I am protected against this.

But, I am exposed to the risk that Indian technology firms may not do well.

 If I hold shares of all industries in India, I am protected against this risk. But, I am
exposed to the risk that Indian economy may NOT do well.

 If I hold shares across different countries, I am protected against this risk. But,
what if the Global Equity-Market does not do well?

 I CANNOT protect my portfolio against this NON-DIVERSIFIABLE risk

 Understanding Portfolio Risk: What we have
learnt?
 Except the risk-free asset, every asset and every portfolio
would have some Non-Diversifiable Risk.
 Sub-optimal portfolios would have, in addition, Diversifiable
Risk
 Best-diversified portfolio is Market portfolio, which has no
Diversifiable Risk
 The theoretical Market Portfolio consists of all assets, with
weight on any asset j equal to the fraction of total market
value accounted for by the asset j
MVj
where MVj is the Market Value of Asset  j
n
 MVk
k 1
and  is the sum of the MVs of all assets
Risk-Management
What is Risk, and Source?

 Risk is associated with loss that is expected to be

incurred due to the happening or non-happening of
certain events or activities.

 It arises as deviation between what happens and what

was expected to happen.

 Source of Risk: Risk management depends on source of

risk
 Impact of past
 Instability of present
 Uncertainty of future.
Objective and Process of Risk Management?
Types of Risk

Variability in earnings caused by:

Market Risk
Exposure to market instruments

Variability in earnings caused by :

Credit Risk Changes in the value of loan, loan equivalents

Operation Risk Variability in earnings caused by:

All operating processes of the business
Objective and Process of Risk Management?
 Objective: Value optimization through…
 Loss Minimization
 Driving point is to preserve the capital
 Profit Maximization
 Driving point is to maximize the return on capital

 Process: Risk management involve following steps

 Identification of risk
 Measurement of risk
 Mitigation mechanism of risk
 Control mechanism of risk

 Objective and types of risk drives the importance of each steps for the
execution of risk management strategies
Valuation of Assets
(Debt & Equity)
Valuation of Equity
Introduction
 Valuation of an equity would depend on the required return the
investor would demand to invest in the equity.
 What are the factors that determine the required rate of return on an
investment?
 Risk associated with the investment. The greater the risk, greater
will be the required return.
 The size of the cash flows received from it. Greater the cash flow
greater would be the valuation
 The timing of the cash flows.
 How do we define and measure risk of an investment and what do we
mean when we say that investment in asset A is riskier than the
investment in asset B?
 What is the relationship between an asset’s risk and its required
return?
 Risk associated with an asset can be of two types
 Systematic risk: The risk contributed by the factors that affect all
the assets. For example decline in growth rate of the economy.
 Unsystematic risk: The risk contributed by the factors that affect
only the asset under consideration. For example decline in growth
rate of the company where the investment has been made.
Equity Valuation: Role of Diversification
 When an investor makes an investment he takes two kind of risk
 One that is specific to the equity
 Other that is related to the macro economic factor, which would affect all
equities
 If two equities are co-related with each other by combining these two
equities one can reduce the risk associated with individual equities.
 If we take a very large number of equities and the investors will
allocate the invest able fund across all these equities then the
portfolios will not have any equity specific risk (unsystematic risk)
 The portfolio would only have systematic risk, and market would only
provide incremental return for taking the systematic risk.
 This has an important implication
 To a diversified investor only systematic risk matters
 The investment decision would depend on individual assets contribution
to the systematic risk
Understanding Systematic Risk
 There is a reward on an average for bearing incremental risk and the
reward depends only on the systematic risk of the investment
 Why?
 Unsystematic risk can be eliminated by diversification, hence no
reward for taking the risk. Market will not reward for taking
unnecessary risk.
 Only systematic risk is relevant for determining the expected return
and the risk premium of an asset
 Systematic risk is measured by the BETA of an asset -  (Beta)
 Beta measures the systematic risk of an asset relative to market
portfolio. By definition market portfolio has a beta of 1.0
 So an asset with a beta of 0.50 has half as much systematic risk
as the market portfolio
 An asset with a beta of 2.0 has twice as much systematic risk as
the market portfolio
 The larger the beta, the higher the systematic risk and the greater
will be the expected return
 Security A may have higher unsystematic risk than security B, if
security B has more systematic risk then the expected return on
security B would be higher than security A
Understanding the Portfolio Return and Risk
 Portfolio return can be calculated by taking a weighted average of
expected return of all assets that constitute the portfolio.
 Risk of an asset can be measured by calculating the standard
deviations of returns of the asset.
 Calculation of portfolio risk is more complex because of interaction
among assets
 The portfolio risk is measured by summing of all the co-variances
 A well diversified portfolio has only systematic risk. Therefore we
can calculate the contribution of an individual asset to the portfolio
risk by measuring the co-variances between the asset and well
diversified portfolio (market portfolio)
 The Beta which measure the systematic risk of an asset is nothing
but the co-variance between the asset and a market portfolio (well
diversified portfolio)
 A security would enter a portfolio only when its contribution towards
portfolio return is higher in comparison to its contribution towards
portfolio risk
Risk Premium & CAPM
 A risk averse investor demands risk premium if he is taking
incremental risk
 If Ri is the return from an asset i and risk-free rate is Rf then the risk
premium of the asset I is Ri – Rf
 Is the risk premium (Ri – Rf) adequate for the asset i
 How would we know adequacy of risk premium of an asset?
 First we need to calculate the risk premium market demand for a market
portfolio, which is (Rm – Rf) where Rm is the expected return from the market
 Multiply (Rm – Rf) with the quantity of risk associate with the asset I, which is
measure by Beta
 Once we know the risk premium of the asset i we can easily
calculate the expected return from the asset I
 The expected return from asset i is described in the form CAPM
Deriving the CAPM
 Let us take an asst i
 Asset i’s contribution to risk premium is Ri – Rf
 Asset i’s contribution to risk is Cov(Ri, Rm)
 Risk premium per unit of risk is = (Ri – Rf)/ Cov(Ri, Rm)
 Let us take the market portfolio m
 The risk premium in the market is Rm – Rf
 The risk of the market portfolio is Cov(Rm, Rm) = σm2
 Risk premium per unit of risk is = (Rm – Rf)/ σm2
 In the equilibrium the risk premium per unit of risk for the asset I will
be equal to the risk premium per unit of risk for the market portfolio
 Therefore (Ri – Rf)/ Cov(Ri, Rm) = (Rm – Rf)/ σm2
 (Ri – Rf) = (Rm – Rf) * [Cov(Ri, Rm)/ σm2]
 Ri = Rf + Cov(Ri, Rm)/ σm2] * (Rm – Rf)
 Ri = Rf + βi * (Rm – Rf) where β = Cov(Ri, Rm)/ σm2]
 Now we have equation which would help us in calculating the
expected return for an asset
Using CAPM
 The CAPM can be used for many purpose
 Pricing of risky assets
 If the expected return is higher then the asset is over priced
 If the expected return is lower then the asset is under priced
 As a investor one is always looking for under priced asset

 Calculating the cost of equity

 The CAPM equation would help us in calculating the cost of
equity by giving the return that an investor is looking from the
specific equity investment
 Calculating the risk premium
 CAPM gives us the frame work to calculate the market price
for risk
 It would help us to calculate the incremental return that is
required to take an unit of incremental risk
 Establishes the relationship between risk and return
Valuation of Equity: Cash Flow Method
 What are the cash flows from an equity investment?
 Dividend for each holding period
 Inflow from sale of the stock at the end of investment horizon.
 Consider the case of an investor who plans to hold the stock for one
period
 Price of the equity can be expressed by
Generalization of the Cash Flow Equation
 If we assume that the person who buys the stock after one period
also has a one period investment horizon, then:

 Extending the same logic for t period would give us

 Therefore value of any equity share is the present value expected

stream dividends expected to be paid over infinite period
Equity Valuation: The Constant Growth Model
 It is extremely difficult to forecast an infinite stream of dividends,
which is required to derive the valuation of equity.
 To make it simple we can assume that the dividends are going to
grow at a constant rate over the infinite period
 Let us assume dividends is going to grow at g% per year and the
declared declared dividend now is d0
 The value of the equity is
Equity Valuation: Solving for r
 The cash flow method would require us to use the most appropriate
value for r (the discount rate)
 The discount rate would depend on risk associated with the equity in
question
 To derive the value of r we need know the risk associated with the
equity, and the relationship between risk and expected return
 The relationship between risk and return can be derived if we know
the risk premium market would pay to take an extra unit of risk
 This relationship is described in Capital Asset Pricing Model (CAPM)
 The CAPM would help us determine the expected return from a
asset.
 The CAPM only provides incremental return for taking systematic risk
because the unsystematic risk can be eliminated through
diversification
Valuation of Debt
Understanding the Debt Instrument
 What is debt and who issues it?
 It is a financial claim issued by borrower of funds for whom it is a liability.
 Who holds it?
 The lender of funds for whom it is an asset
 What is the difference between debt and equity?
 Equity confer ownership rights where as debt does not.
 Debt promises to pay interest at periodic intervals and to repay the
principal itself at a pre-specified maturity date, where as equity gives
right to the surplus generated by the organization without any promise
 Debt usually has a finite life span where as equity has infinite life
 The interest payments are contractual obligations borrowers are required
to make payments irrespective of their financial performance
 In the event of liquidation
 The claims of debt holders must be settled first, Only then can equity
holders be paid.
Terminology Associate with Debt Instrument
Face Value
 It is the principal value and the amount payable by the borrower to
the lender at maturity.
 Periodic interest payments are calculated on this amount

Term to Maturity
 It is the time remaining for the bond to mature and time remaining for
which interest has to be paid as promised.

The Coupon Rate and the Coupon Value

 Periodic interest rate (coupon rate) need to paid by the borrower.
 The value of the coupon can be calculated by multiplying the face
value with the coupon rate.

Yield to Maturity (YTM)

 YTM is the rate of return an investor will get if held to maturity and all
coupon received before maturity must be reinvested at the YTM
Terminology Associate with Debt Instrument
Discount Bonds
 If the price of the bond is less than the face value at the time of issue then it
is a discount bond
 If the bond is trading at lower than face value then also is called discount
bond
 This will happen when the YTM is higher than the coupon rate.
Par Bonds
 If the price of the bond is equal to the face value at the time of issue then it is
a par bond
 If the bond is trading at face value then also is called par bond
 This will happen when the YTM is equal to coupon rate.
Premium Bonds
 If the price of the bond is more than the face value at the time of issue then it
is a premium bond
 If the bond is trading at higher than face value then also is called discount
bond
 This will happen when the YTM is lower than the coupon rate.
A Zero Coupon Bonds
 In a zero coupon bond coupon rate is zero
 It is issued at a discount and repays the principal at maturity. The difference
between the offer price and the face value is the return received by the
investor.
Valuing Debt: Discounted Cash-flow Method
 Value of a bond is derived from the stream of cash flows that the bond
holders have the right to receive at periodic interval.
 How would we derive the value when the cash-flows are received at different
time intervals?
 All future cash flows including the payment of principal at maturity needs to be
discounted to the present to derive the value of the cash flows
 Value of bond is a function YTM which is determined by;
 The face value or the maturity amount
 The coupon rate
 The term to maturity
 The market price of the bond
 The valuation can be arrived by treating periodic cash flows as annuity and
the terminal face value is a lump sum payment.
 If the coupon is paid more often than once per year then the coupon amount
needs to calculated accordingly
 Nuances of Valuing bonds
 If the investor know the yield that is required by him, then he can calculate the
price that would give him the expected yield.
 Conversely, if the investor buys the bond at a certain price, he could calculate the
yield he would receive from the investment.
 Therefore the yield and price is dependent on each other and need to be
determined simultaneously
Valuing Debt: Example
 Let us take following example;
 Tata Motors were to issue a bond with 10 years to maturity.
 The maturity amount at the end of 10 year is Rs.1000
 The coupon rate is 8%, and coupon amount is Rs. 80.
 The coupon is paid at the end of the year

 The company is going to pay 10 coupons which can be treated as annuity

and the present value of the annuity would be
 (R80 / 0.08) * [1 - 1 / (1+0.08)10] = 1000 * [1 – 1 / 2.1589]
= 1000 * 0.53681 = Rs.536.81

 The company is going to pay Rs.1000 at the end of 10th year. The present
value of the maturity amount would be
 1000 / (1+0.08)10 = 1000 / 2.1589 = Rs.463.19

 The two parts can be added to get the value of the bond
 Rs.536.81 + Rs.463.19 = Rs.1000

 The bond is selling at its face value. Given the coupon rate is 8% and coupon
amount is Rs.80, the bond will be valued at Rs.1000
Valuing Debt: Example of Change in Interest rate
 Let us a year has gone by and the interest rate has changed to 10%;
 Tata Motors bond has 9 years to maturity.
 The maturity amount at the end of 9 year is Rs.1000
 The coupon rate is 8%, and coupon amount is Rs. 80.
 The coupon is paid at the end of the year
 The company is going to pay 9 coupons which can be treated as annuity and the
present value of the annuity would be
 (R80 / 0.1) * [1 - 1 / (1+0.1)9] = 800 * [1 – 1 / 2.3579] = 800 * 0.57590 = Rs.460.72
 The company is going to pay Rs.1000 at the end of 9th year. The present value of the
maturity amount would be
 1000 / (1+0.1)9 = 1000 / 2.3579 = Rs.424.10
 The two parts can be added to get the value of the bond
 Rs.460.72 + Rs.424.10 = Rs.884.82
 The bond would sell at Rs.885 after one year when the interest rate is 10%
 Given the going interest rate is 10%, the YTM has to be 10%. The investor would
only get YTM of 10% on 8% coupon rate bond only if the investor get the bond at
discount
 Loss in interest rate of 2% will compensated by the difference in value at maturity
and market price
 Rs.1000 – Rs. 884.82 = Rs.115.18 is nothing but the present value of difference in
coupon value at 8% and 10% coupon rate which is value of annuity of Rs.20 for 9
years discounted at 10%.
 (R20 / 0.1) * [1 - 1 / (1+0.1)9] = 200 * [1 – 1 / 2.3579] = 200 * 0.57590 = Rs.115.18
Valuing Debt: Example of Change in Interest rate
 Let us a year has gone by and the interest rate has changed to 6%;
 Tata Motors bond has 9 years to maturity.
 The maturity amount at the end of 9 year is Rs.1000
 The coupon rate is 8%, and coupon amount is Rs. 80.
 The coupon is paid at the end of the year
 The company is going to pay 9 coupons which can be treated as annuity and the present
value of the annuity would be
 (R80 / 0.06) * [1 - 1 / (1+0.06)9] = 1333.333 * [1 – 1 / 1.6895] = 1333.333 * 0.40810
= Rs.544.14
 The company is going to pay Rs.1000 at the end of 9th year. The present value of the
maturity amount would be
 1000 / (1+0.06)9 = 1000 / 1.6895 = Rs.591.89
 The two parts can be added to get the value of the bond
 Rs.544.14 + Rs.591.89 = Rs.1,136.03
 The bond would sell at Rs.1,136 after one year when the interest rate is 6%
 Given the going interest rate is 6%, the YTM has to be 6%. The investor would only
get YTM of 6% on 8% coupon rate bond only if the investor get the bond at premium
 Gain in interest rate of 2% will compensated by the difference in value at maturity
and market price
 Rs.1136.03 – Rs. 1000 = Rs.136.03 is nothing but the present value of difference in
coupon value at 8% and 6% coupon rate which is value of annuity of Rs.20 for 9
years discounted at 10%.
 (R20 / 0.06) * [1 - 1 / (1+0.06)9] = 333.33 * [1 – 1 / 1.6895] = 333.33 * 0.40810 =
Rs.136.03
Valuing Debt: Generalizing
 Based on the learning from the examples we can generalize the formula for
valuing the bond
 V = [C/r] * [1 – 1/(1+r)t] + [F/(1+r)t, where
 V is the price of the bond
 C is the coupon amount
 r is the yield required from the bond
 F is the face value or the amount received at the maturity
 t is the time term left to maturity

 In case the coupon is paid more than once in a year, we need to

change the r and t accordingly, for example;
 If the coupon is paid twice in a year then the appropriate yield would be r/2
 The time left to maturity would be 2t
Valuing Debt: Risk Associated with Bonds
 All bonds are exposed to one or more sources of risk.
 Credit risk: This risk refers to the possibility of default on payment of principal or the
periodic interest payments.
 Interest rate risk: This risk refer to change in value of bonds due to change in
interest rate and risk of re-investment return due to change in Change in interest
rate.
 Liquidity risk: This risk refers to not able to sell the bond
 Inflation risk: This refers to risk associated with inflation
 Foreign exchange risk: This risk involved only if bond is issued in foreign currency
 The potential investor need to evaluate the risk associated with the bond
 At the time of issue, it is the issuer’s responsibility to provide accurate information
about his financial soundness and creditworthiness, which is provided in the offer
document or the prospectus.
 Given the complexity of offer document, a general investor may not able to evaluate
the bond issuer’s credibility
 This work is generally done by credit rating agencies
 This agencies take all available information and provide ratings in simple terms so
that the investor can understand the risk associated with the bond
 Higher the risk associate with the bonds higher would be the yield
 If the risk change before the maturity period then it can be reflected on the price of
the bond
 Credit rating agencies provide rating updates to help the investors to make
appropriate decisions
Understanding Complex Bonds
Floaters
 Floaters is a types of bond where the coupon rate can that can change
over time instead of a fixed coupon in case of plain vanilla bond
 Floaters can be linked to a benchmark rate like LIBOR or
government treasury bonds.
 The coupon rate would be Benchmark Rate +/- x%
 The difference between the benchmark and coupon rate is call the
spread
 The spread can be positive as well as negative

Inverse Floater
 In the case of an inverse floater the coupon varies inversely with the
benchmark.
 For instance the rate on an inverse floater may be specified as 10% -
LIBOR.
 In this case as LIBOR rises, the coupon will decrease, whereas as LIBOR
falls, the coupon will increase.
 In case of inverse floater a a floor has to be specified for the coupon
because if the in the absence of a floor the coupon can become
negative
Callable Bonds
 In the case of callable bonds the issuer has the right to call back the
bond before the maturity of the bond by paying the face value.
 When the yield is falling the issuer would be better of calling back the
bond if he has the option
 On the other hand the buyer would like to hold on to the bond because
he is getting higher yield, and he has a re-investment risk
 The call option always works in favor of the issuer

 Buyers of callable bonds would like to expect a higher yield because

he faces uncertainty over the cash flow
 To compensate for the risk the buyer would demand higher coupon rate
or lower price of the bond.

 Freely callable bonds can be called at any time and hence offer the
lender no protection. On the other hand deferred callable bonds can
be called after some pre-specified time

 In some cases some premium is paid (one years coupon) at the time
of calling the bond, which is called the call premium
Putt-able Bonds
 In the case of putt-able bonds the subscriber has the right to return the
bond before the maturity and collect the face value.
 When the yield is rising the subscriber would be better of surrendering the
bond if he has the option
 On the other hand the issuer would like the lender to hold on to the bond
because the issuer would have to pay higher yield, and he has a re-
issuance risk
 The put option always works in favor of the lender

 Seller of putt-able bonds would like to provide a lower yield because

the issuer faces uncertainty over the withdrawal of bond
 To compensate for the risk the issuer would demand a premium resulting
in lower coupon rate or higher price of the bond.

 Freely putt-able bonds can be returned at any time and hence offer
the issuer no protection. On the other hand deferred putt-able bonds
can be returned after some pre-specified time

 In some cases some premium is paid (one years coupon) at the time
of returning the bond, which is called the put premium
Convertible and Exchangeable Bonds
 A convertible bond is right for the bond holder to convert the bond into
common stocks of the issuing corporation.
 The conversion ratio (# of common stock per bond) is
predetermined.
 The conversion can be made after the a pre-specified time or over
a pre-specified period.
 The stated conversion ratio may also decline over time depending
on the provision
 The conversion ratio generally adjusted proportionately for stock
splits and stock dividends.
 Exchangeable bonds are a category of convertible bond, that grants
the holder a privilege to gets the shares of a different company.
 Exchangeable bonds may be issued by firms which own blocks of
shares of another company and intend to sell them eventually by
doing in a exchangeable bond way is to defer the selling decision
because
 The expectation that the price of the exchangeable stock will
rise
 Tax benefit involved
Cost of Capital
Understanding Cost of Capital
 Firms need capital for creating assets that would generate return for
the owners of firm
 The capital is provided by organizations that have surplus capital
 Capital can have two types of claim
 Debt
 Equity
 The SBU demand a return to provide capital
 The expected return demanded by the SBU is the cost of capital for the
firm, the DBU
 The expected return would be a function of types of capital
 The firm’s overall cost of capital will reflect the required return on the
firms composition of types of capital
 Overall cost of capital will be a mixture of the returns required by the
creditors (debt capital provider) and the returns required by the
shareholders (equity capital provider)
 The cost of capital is related to the expected return required by the
provider of both of capital
 A firm’s cost of capital is nothing but the weighted average cost of debt
and equity
Required Return vis-à-vis Cost of Capital
 What is required rate of return?
 Required rate of return is the rate of return above which the investor
would be better of
 For example
 If the required rate of return on a investment is 10%, the investor would be
better of if the return is more than 10%
 On the other hand the investor would not invest if the rate of return is below
10%
 In this specific example the cost of capital for the investment would be 10%
 The required return would be a function of the risk associated with the
project
 Let us evaluate a risk-free project
 How would we determine the required rate of return for the risk-free project?
 Required return for a risk free project is nothing but the return an investor gets
when the investor invest in risk free instrument, which is nothing but return
available on government bonds
 Let us evaluate a risky project
 Required return would be higher for a risky project and will depend on the risk-
free rate and the risk premium demanded by the investor
 The cost of capital associated with an investment depends on the risk of the
investment
 Cost of capital primarily depends on the use of funds
Understanding Cost of Equity
 Cost of equity of firm is the expected return form the
firm’s equity
 How would we know the firm’s cost of equity?
 This is a difficult question
 Why?
 There is no way of directly measuring the expected return of the
investor in the firm’s equity.
 Therefore the cost of equity of firm need to be estimated.
 We will discuss four approaches for estimating the cost
of equity
 The dividend growth model approach
 The security market line (SML) approach
 Bond yield plus risk premium approach
 Earning-Price ratio approach
The Dividend Growth Model Approach
 Let us assume that;
 A firm is currently paying D0 dividend
 The dividend is expected to grow at a constant rate g
 The required return on equity is RE
 From our valuation of equity classed we know that:
 P0 = D0x(1+g) / RE – g = D1 / RE – g
 By rearranging we will get RE = [D1 / P0] + g
 Given that RE is the required rate of return on firm’s equity, it would be
the cost of equity capital for the firm
 To estimate the RE we need to know P0, D1, and g
 It would be easy to get P0 and D1 for listed firm, but estimating the g
would a challenge
Pros & Cons of the Dividend Growth Model
Approach
 It is a simple model
 There are some practical difficulties we would face when
we are calculating the cost of equity for firms
 Who does not pay any dividends
 Even if companies pay dividends there is no guaranty that it would
grow at a constant rate
 Importantly the estimated cost of equity is very sensitive to the
estimated growth rate
 Conceptually this approach excludes risk associated with
the firms business
 Investors expected return would increase if the risky-ness of
investment increases
 However, there is no direct adjustment for the risky-ness of an
investment in this model
 There is no allowance for the degree of uncertainty associate with
the estimated growth rate of the dividend payout
The SML Approach
 From our valuation of equity classed we know that
 Ri = Rf + βi * (Rm – Rf)
 Where;
 Ri is the expected return from the firm i (which is nothing but the cost
of equity for firm i)
 Rf is the risk free rate of return
 βi is mthe risk associate with the firm I
 Rm is the market return from equity investment
 To use the SML approach for estimating the cost of equity we would
require
 The available risk-free rate, which can be easily found by
considering 1 year return from investment in government security
 Estimate for the market return, which can be calculated by
considering the return from the investment in the equity index fund
(in case of India it can be return from NIFFTY or SENSEX)
 Estimate of the risk associated with the company, which can be
estimated from the historical data of the firms equity
Pros & Cons of the SML Approach
 What are the advantages?
 The SML approach has two distinctive advantages
 It explicitly quantifies risk associate with the investment
 It can be estimated for the firms that do not pay any dividends
 What are the disadvantages?
 The SML approach has two distinctive disadvantages
 It is quite difficult to estimate the risk associate with the firm and the
market return
 We would be using few estimates to estimate cost of equity.
Therefore if our estimates are poor then the cost of equity will be
inaccurate
 The dividend growth as well as the SML approach uses
the past data to predict the future
 Economic conditions can change quickly and the past may not be
the best guide to the future
 The cost of equity can be sensitive to change is economic
conditions
Bond Yield Plus Risk Premium & Earning-Price
Ratio Approach
Bond Yield Plus Risk Premium Approach
 In case of this approach
 The cost of equity = Yield on long term yield bonds + Risk-premium
 The logic of this approach is simple
 The firm which is risky will have higher cost of equity
 The cost of equity is linked to cost of debt
 However, this approach is silence on how one should calculate the
risk premium, the calculation is subjective approach by analysts

Earning-Price Ration Approach

 In case of this approach
 The cost of equity = E1 / P0, where
 E1 = E0 (1+growth of earning for equity share)
 P0 is the current price of the equity
 This approach is quite useful when the firm is not listed
 This approach would provide appropriate cost of equity, when;
 The EPS is expected to be constant and the dividend pay-out is 100%
 Retained earnings are expected to generate rate of return equal to cost of equity
 Both the conditions are rare occurring all the time, making it a weak approach
Understanding Cost of Debt
 The cost is debt of firm is the return that the firm’s lenders demand
 The cost of debt unlike the cost of equity can be observed either
directly or indirectly
 The cost of debt is the interest rate that the firm must pay on new
borrowings
 Interest rates can be observed from the financial market
 Let us take the case of a firm that has already issued bonds
 The YTM of the outstanding bonds is the required rate of return on the
firm’s debt
 Cost of debt in case of such firms is equal to the YTM of existing bonds
 The coupon rate of the existing bonds is irrelevant to cost of debt for
new debt
 Let us say the firm is going to issue new bonds
 The bond needs to be rated by the credit rating agencies
 The rating of bonds would provide the benchmark rate for the bond
 In case of first time bond offerings the cost of debt would be equal to the
YTM of the bonds corresponding to the same risk category
Understanding Cost of Preferred Stock
 Some times firms raise capital by using hybrid form of
capital
 This hybrid form of capital having some characteristics of debt and
equity
 The debt characteristic
 It pays fixed amount
 It has higher rights than equity in case of insolvency
 The equity capital
 It is for perpetuity
 It has lower rights than the debt in case of insolvency
 This type of hybrid capital is called preferred stock
 The cost of preferred stock is given by:
Rp = D/P0 where
 Rp expected return from the preferred stock
 D is the fixed annual dividend
 P0 is the current price per share
 Thus the cost of preferred stock is equal to the dividend
yield on the equity
Weighted Average Cost of Capital
 We have discussed the three types of capital employed by a firm.
 How would we calculate the cost of capital for the firm?
 First estimate the share of each type of capital
 Calculate cost of each types of capital
 Calculate the weighted average costs of capital where the weights are the shares
of each type of capital
 Let us take a hypothetical example where E is the market value of a firm’s
equity, D is the market value of a firm’s debt, and P is the market value of
firms preferred stock
 Total value of the firm is (V); V = E + P + D
 Therefore E/V is the share of equity, P/V is the share of preferred stock and D/V is
the share of debt.
 E/V + P/V + D/V = 100%
 We need to calculate the value of equity, preferred stock, and debt
 The market value of equity = market price per share * the number of shares
outstanding.
 The market value of debt = market value of a bond * the number of bonds
outstanding.
 If there are multiple bond issues repeat the calculation of D for each bond issue and add
up the values.
 What is some of the debt is not publicly traded?
 We must estimate the yield from similar debt that is publicly traded and this yield should be used
to price the privately held debt.
 The market value of preferred stock is ………………………………..
Weighted Average Cost of Capital – Tax
Implications

 The firm is always concerned with after-tax cash

flows
 Therefore the cost of capital should incorporate
the effect of tax
 This has implications for cost of debt because debt
gives the firm a tax shield
 If T is the tax rate the effective cost of debt is RD*(1-T)
 Therefore;
 WACC = RE x E/V + P/V x RP + D/V xRD(1-T)
Divisional and Project Costs of Capital
 What would be cost of capital for a new project, will it be same as
before the new project?
 A manufacturer company is thinking of expanding production by setting
up a new plant
 A manufacturing company is thinking of expanding to retail business
 There will be situations where the cash flows from the new project could
have different risk from the risk with the current cash flows of the overall
firm.

 Let us assume that the riskless rate is 8%, and the market risk
premium is 10%. If the firm is an all-equity firm with a beta of 1.2
 The cost of equity = WACC = 21.6%
 If the firm has to evaluate new projects using this cost of capital, it would
accept project that would provide return in excess of 21.6%.

 If the risk of the new project is lower then the risk premium required
for the same project would be lower than 10%, hence the cost of
capital would be less than 21.6%.
 Use of same cost of capital could reject project that are relatively safe
 Therefore, if the new project risk is different from the risk of the existing
business then using the same cost of capital to would result in sub-
optimal investment decision
Divisional and Project Costs of Capital
 The same type of error can arise if a company has multiple lines of business.
 Assume a corporation has two business divisions
 A grocery retail business
 An electronics manufacturing operation
 The first has relatively low risk
 The second has relatively high risk
 The corporation’s cost of capital is a mixture of the costs of capitals of two distinct
business
 It is natural to say that both of these divisions would be competing for capital
 The retail business wants to expand to new cities
 Manufacturing unit wants to set up a new plant
 What happen if we use WACC as a tool to allocate capital?
 The manufacturing division would get more capital
 The cost of capital is same for both the division
 It would provide more return in comparison to retail business because
the business has more risk
 The less risky retail division may have great profit potential, but it would not get
capital for expansion
 Therefore WACC may not be suitable criterion for evaluating project with different
levels of risk.
 Ideally the cost of capital needs to estimated for not only for new projects but also for
the different divisions with in an existing business conglomerate
 This can be done by following the same method we have discussed before with
minor modifications
Illustration - 21
 A company has 2MM shares outstanding
 The stock price is Rs.40
 The debt is quoted at 90% of face value and the face value of debt is
10 MM
 The YTM for the debt is 10%
 The risk-free rate is 5%
 The market risk premium is 10% and the beta is .75
 The tax rate is 30%
 RE = 5 + .75 x 10 = 12.5% and RD = 10%
 The value of equity is 2 x 40 = 40MM
 Value of debt is 0.90 x 10 = 9MM
 Total value V = 49MM
 WACC = 40/49 x 12.5 + 9/49 * 10 x (1-0.3) = 11.49%
Thank You