Advanced Business Analysis - Lecture 5 & 6 Notes

Exam 3 Information

  • Deadline is Sunday; aim to post before Monday's class.

  • Exam on Friday at 11 AM in the same room.

  • 2 hours, 25 multiple-choice questions.

  • More time allotted due to complex, multi-step problems (e.g., WACC).

Lecture 5: Cost of Capital

  • Content overlaps with Finance 3313.

  • Advanced Business Analysis builds upon basic concepts for deeper understanding.

  • Lecture 5: Most abstract concepts of the 6 lectures.

  • Focus on theory (risk measures, models).

Textbook

  • Topics align with the textbook.

  • Financial calculator needed for basic problems (exam 3).

  • Library offers financial calculators for borrowing.

  • Borrow a few days before the exam for a small fee.

  • Finance-related exams may require a financial calculator.

  • Any type of financial calculator is acceptable for the exam.

  • Congratulations to Dan for winning an investment fund competition.

Big Picture

  • Related to Module 1 (Lecture 1 & 2).

  • Lecture 1: Given cash flows and discount rate, determine project acceptability.

  • Lecture 2: Compute cash flows; discount rate is given.

  • Lecture 5: Calculate discount rate; not given.

Cost of Capital

  • Need to estimate discount rate (cost of capital).

  • Cost of capital is used interchangeably with the discount rate.

  • Fundamental question: What is cost of capital?

Capital

  • Who provides capital?

  • Related to capital structure (mix of capital types).

  • Capital structure: Equity and debt.

  • Equity = stock, debt = bonds.

  • Bonds: Fixed income; usually need to be paid back.

  • Stock: Ownership; investment is permanent unless stock is sold; original investment is not paid back.

Capital Structure

  • Companies have different mixes of equity and debt.

  • All-equity financed: No debt used.

Capital Budgeting (Lecture 2)

  • Cash flow formula from Lecture 2:
    OCF = (Revenue - Costs)(1 - Tax Rate) + Depreciation * Tax Rate

  • Operating cash flow (OCF) is key component.

  • Assumed project not financed by debt; ignored interest expenses.

  • Finance definition vs. accounting definition of operating cash flow.

NPV

  • Compute cash flow for each future year, then discount to time zero to compute NPV for investment decision.

  • Discount rate considers capital structure.

  • Equity and debt have different costs.

  • Different types of capital involve different levels of cost of capital when computing the discount rate, but not when computing the cash flow to avoid double counting.

Expected Return

  • Cost of capital = expected return for the capital provider.

  • Opportunity cost: Benchmark for required return.

  • Framework: How much capital providers give up by not using the money elsewhere with similar risk.

  • Excess cash can be paid to shareholders (dividends) or invested in a project.

Shareholder Value

  • Investing in a project with a big NPV increases shareholder value and share price.

  • Stock market reacts quickly to announced, but not completed events.

  • Illustrated opportunity cost: More than one option available.

Cost of Capital Definition

  • Cost of capital is essentially opportunity cost.

Terminology

  • Discount rate, cost of capital (company perspective).

  • Expected return, required return (shareholders' perspective).

  • Hurdle rate (interchangeable, depends on perspective).

Cost of Equity Capital

  • Temporarily assume no debt.

  • Finance 3313: Capital Asset Pricing Model (CAPM).

  • Missouri M cap helps remember CAPM.

  • Chapter 11 has more details on the Capm.

  • CAPM formula:
    E(Ri) = Rf + \betai [E(Rm) - R_f]

  • E(Ri) = Expected return for stock I.

  • R_f = Risk-free rate.

  • E(R_m) = Expected market return.

  • Beta measures risk; conceptual questions will be on final exam related to beta and CAPM.

CAPM

  • Risk-free rate: Minimum return; compensates for delaying consumption.

  • Second part: Compensation for taking risk.

  • Beta is measure of risk.

  • Market risk premium: E(Rm) - Rf

Market Return

  • E(R_m) = Expected market return or expected return on the market portfolio.

  • Market risk premium = the difference between market return and risk-free rate.

  • Expected excess market return = market risk premium.

Risk Clarification

  • Systematic (market, non-diversifiable) risk: Affects a large number of assets.

  • Example: Fed increasing interest rates, tariffs.

  • Unsystematic (idiosyncratic, diversifiable) risk: Affects a small number of assets.

  • Example: CEO having an accident.

  • Diversifiable risk can be reduced by holding a portfolio.

CAPM Compensation

  • Only market risk deserves compensation.

  • Analogy: Paying a window cleaner a million dollars for unnecessarily risking their life.

  • Beta Formula
    \beta = \frac{Cov(Ri, Rm)}{Var(R_m)}

  • Beta measures market risk, sensitivity of a stock return to the market return.

  • CAPM assumes rationality and market portfolio holding to minimize unsystematic risk.

Risk as Sensitivity

  • Having friends whose attitude is highly sensitive to your money is a risk.

  • Beta is the slope of the regression when regressing Y on X.

  • In CAPM, stock I return is Y, market return is X.

  • If slope is 1.7, then a 1% increase in market return is associated with 1.7% increase in the individual stock return.

  • Market beta is one (by definition).

  • Higher beta stocks have more returns than market.

Estimating Beta

  • Use Yahoo Finance to download stock returns and S&P 500 returns.

  • Calculate slope in Excel.

  • Use industry average when individual stock return is too volatile.

Determinants of Beta

  • A company's beta can change over time.

  • Product lines, technology, deregulation, financial leverage.

  • There are three: Two under business risk, one under financial risk.

Cyclicality of Revenues

  • How highly correlated a company's revenue is to economic fluctuation.

  • Cyclical firms do well in expansion and poorly in contraction phases.

  • Highly cyclical stocks have high betas.

  • Retailers, car firms: Revenues fluctuate more (high beta).

  • Utility, food firms: Revenues are less correlated (low beta).

  • Luxury goods have high beta; necessary goods have low beta.

Concept Clarification

  • Cyclicality is not the same as variability.

  • A stock with high standard deviation needs not have high beta.

  • Volatility and sensitivity aren't the same.

  • Movie studios have volatile revenues but not necessarily high betas.

Operating Leverage

  • If a high percentage of a firm's total costs are fixed, the firm has a high degree of operating leverage.

  • Fixed costs do not change with sales/production level (e.g., rent).

  • Variable costs change with production level (e.g., raw materials).

Notes

  • "Fixed" refers to aggregate level total costs. Unit level fixed cost changes with production levels.

  • High operating leverage leads to higher beta.

  • Airline industry has high operating leverage.

  • Operating leverage magnifies the effect of cyclicality of beta.

  • During a boom, sales increase, unit cost decreases.

  • During a recession, sales decrease, unit cost increases.

Degree of Operating Leverage (DOL)

  • DOL = \frac{\% \Delta EBIT}{\% \Delta Sales}

  • Elasticity measures revenue sensitivity to profit.

Determinants of Beta

  • Two previously discussed determinants are placed under Business risk

  • The following, Financial risk, will be revisited later

Firm vs. Project

  • A project's cost of capital depends on the use to which the capital is being put, and not on the source.

  • Cost of capital depends on project risk, not company risk.

Conglomerate example

  • A conglomerate had one third of their assets in car retailing industry, BETA=2

  • Another third in computer hard drive manufacturing BETA = 1.31

  • Lastly, electric Utility (low beta).

  • In evaluating a new electrical generation investment (3rd business) of a company, the cost of capital will depend based on the specific business division it belongs to.

Debt Introduction

  • Previously living in world without debt, now we are to integrate it.

** Debt Beta + Financial Leverage**
Formula
Beta asset= (Debt/Debt+Equity) debt beta + ( Equity/ Debt+Equity)equity beta

  • Asset beta is a weighted average of DEBT BETA and EQUITY BETA.

  • The equation from special situation: if debt is zero; beta follows equity.

  • Debt B is commonly considered to be 0 (Beta). Making the equity side of the equation greater than the left, causing the equity weight to be 1 (or 100%).

  • The mathematical result: shows financial leverage increases the EQUITY BETA in relation to ASSET BETA

Discussion about CBS Equity Data

Company had, for a short time, high B compared to utility. Since it comes from stock slope it is known as EQUITY DATA.
It contains two forms of risk, it could contain two factors from Business and a financial risk.
Real World example, CBS stock that went against theory of being cable yet listed with similar utility
In the world now the goal is to use data, instead of a simplified understanding from weeks ago.

More on Finance for Cost

In order to use the formulas, and data it requires understanding of the importance of: Stock equity and debt.

Before moving on a skit occurs about a person asking to hold items. Also joke is a guy borrowing debt from a bank and paying for parking for lower cost than any parking facility they could find in the location.

Calculations regarding Hack

  • Need to figure out cost of equity and cost of debt to calculate the cost of capital for a company.

  • Determine the weight, compute hack formula. Formulas are below:

    • Hack or: R(w acc) = (E/V)R(E )+ (D/V)R(d ) *(1-Tc)

Notation

TC = Tax Rate
Other methods for formula use S for stocks B for bonds.
Interest expense is tax deductible to the point of 1- TAX ratio value.
P and G examples the book provide if interested. A numerical one to show. The purpose of it is to help understand. However the examples do not commonly show up in exams.

Testing Time

  • $rs=rf + Beta * Market Risk Premium$. Simple plug and chug for the simple math to calculate it. If test is to come is what that is usually seen for that type.
    For equity side of the Hack numerical example is simple. The only thing to look for if the given PREMIUM is already calculated.

  • In cost of debt has 6.2 yield or cost of equity, marginal tax rate is used because some students get.
    For market value to use since equity:value is a factor Value means VALUE FOR THE FIRM: Summation of Equity and Debt combined

In a 3 part bullet below are factors or tips to remember ___

For given scenarios ask this before calculating

  • What Return on capital by Capital provider

  • Rational Framework on setting return

  • Compare apples to apples and factor excess cash as shareholder Value

If Both values are give which what to use.

  • To find Excess Cash use framework, then is the cost for the company and what is expected return on the market place
    Remember value is made of current time because of time sensitive situation: The formula is 1.000001 is used.

For the record this a recap. Is always based on questions asked or problems that need to be tackled on and are for personal growth. It is an additional part for numerical skills

### Extra Questions for Better Success. More Numerical problems to test yourself

  • Numerical are great and if there is a need, you may ask yourself look from what we are given is not directly in front, what needs finding and what variables can do that. So ask with framework and work towards said plan.

4/16 Lecture 6 Notes

Review of Exam 2 Results

  • Grades are posted on Canvas.

  • No perfect scores, but many students only missed a few questions.

  • Extra credit points are added to the numerator of the grade calculation.

  • Total points (including extra credit) / (25 + 25 + 10 + 3 + 1 + 1) = Percentage grade.

Exam Comparison

  • Some students improved significantly.

  • Some scores decreased.

  • Many had stable or identical scores.

Exam 3 Question Distribution Warning

  • Questions from the two most recent lectures only.

  • Both numerical and conceptual questions.

  • Questions derive from class discussion and assigned practice problems.

Week's Lecture Preview

  • Lecture 6 is over Corporate Payout (Dividends and Repurchases

  • Screenshots show Google stock price jump due to dividend and buyback announcements, plus share split. A follow up example shares a decrease in the price and cut back do to a dividend payment.

  • The previous events from companies is from decade or years ago before information is expressed before anything is considered for an idea or help. The stock price itself and company can move differently.

Dividend Types

Dividends: There exist two kinds. Cash and stock options

Cash: This will reduce firm equity and the process very is intuitive . One company's loss will provide the equity owner a pay out. As money goes out something in turn be affected.

Stocks: The equity of does not changes

  • It only impacts the number of shares: They can either consolidate or multiply. There is no inherent gain or loss from a monetary perspective. It does not cost any monetary value from investors or to investors.
    Current cash = no cash leaving firm; no value change; change price per share only. Usually described with percentages
    There after is description that Stock has a framework very similar to M and As by a name and acronym and has the following for any examination of notes

Types of dividends or dates, with each is to to determine if money is or isn't given
After declaring that one wants to give or take, to get it.
The process is of these 4

  • Declaration date is there the news occurs with no real affect on day.

  • Record date set so company figure it out to whom the dividends check. Once names are recorded the process moves on.

  • Ex dividend date determines whose is whose. If after the timeline passes, one does not get paid, nor vice verse. An actual cut off gate to take or to go further with an sale or buy.

  • Payment date. For that set to go give the owners of the equity the check in hand with the tax to consider.
    In this timeline there occurs no loss or affect but it is a process to follow as a timeline. The is just a transition and not event.
    When talking to a student all is understood expect for all the 4 steps. This shows the value of actual conversation for all parties is in hand so the understanding is there.

If on slide of cash with examples and timeline review. Here is what to consider.

  • Those 4 days as that’s critical with 3 with dates given. That all these are only relevant at that time and what to consider when talking. Or it is a cash or not equity based.

  • That said do not show or let student get mislead for not knowing and what to expect or to have said dates and not those. Do what needs for each process.
    Then as if any has questions if no, provide an example and then you make be on track. Now does that makes sense and now are there questions after. Then keep going.

  • The is example from the same year about GPT share the exactness what you need.
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