Global MBA

Business Accounting & Finance

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Creating value for your firm

Workshop: Day 2
 Overview
 Risk, return and cost of equity capital
Historical asset returns
Measuring risk and return
Diversification
Portfolio theory and efficient frontier
CAPM and security market line (SML)
Estimating stock betas and cost of equity
capital
 Capital structure

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 Investment of $1: 1900 to 2020 (nominal terms)

Source: Brealey et al. ‘Principles of Corporate Finance’, page 185. 3

 Investment of $1: 1900 to 2020 (real terms)

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Source: Brealey et al. ‘Principles of Corporate Finance’, page 186.
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Tesco share price (2012-2022)

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Expected Returns
 The expected return is the (probability) weighted
average (mean) return

E(R)=

 Note:
The expected return need not be one of the possible returns
(i.e. one of the realised outcomes).
The historical average return is often used as a proxy for
expected returns.

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Measuring Risk
1. Variance
2. Standard Deviation
 The variance is the average value of squared deviations
from mean.
 The variance is one measure of the “dispersion”,
“spread” or “volatility” of returns. (It is not the only
measure of dispersion.)
 The more dispersed returns are, the further they will be
away from their mean, on average, and so the higher the
variance.

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 Measuring Risk
 Which is riskier?
Stock A
Measuring Risk
Stock B
Average Return
0.1

0.05

0
Return

1 2 3 4 5 6 7 8 9 10 11 12

-0.05

-0.1

-0.15
Months 9
 Measuring Risk
 The variance is calculated as

 The units of variance is

 Often a more useful measure is the standard deviation of
returns which is the (positive) square root of the variance

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Portfolios
 A portfolio is a collection of assets.

 The risk and return of an asset, together with its

weights and correlation with other assets,
determine how it affects the risk and return of the
portfolio.

 The risk-return trade-off for a portfolio is

measured by the portfolio expected return and
standard deviation, just as with individual assets.
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Portfolio expected returns
 The expected return of a portfolio is the weighted
average of the expected returns for each asset j = 1,
2,…,N in the portfolio P

E()=
 Alternatively, find the expected return by
calculating the portfolio return in each possible state
and computing the expected value as with individual
securities.

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 Diversification
 Don’t put all eggs in one basket.
 Combining stocks into portfolios can reduce
portfolio standard deviation (risk) –
portfolio risk ≤ weighted average risk of separate
stocks—unlike the expected return.
The lower the correlation between the individual
assets, the lower the standard deviation of the
portfolio.

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Diversification

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 Total risk ( or 2)
Unique Risk Market Risk
 Can be diversified away  cannot be diversified away.
 aka unsystematic,  also known as systematic,
idiosyncratic, diversifiable non-diversifiable or
or firm-specific risk. covariance risk.

For which type of risk

(market or unique)
should investors be
rewarded? 15
 Stocks & portfolios
 Portfolio expected return and standard deviation
vary given different weighted combinations of the
constituent stocks
Expected Return (%)
Coca Cola

40% in Coca Cola, 60% in Exxon

Exxon Mobil

Standard Deviation
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 How can we calculate the rate of
return of an asset?
 CAPM describes the relationship between systematic risk
and the expected return for an asset.
 CAPM assumptions include
all investors have same information and expectations
about returns and variances

r i  r f   i r m  r f 
Where is risk-free rate of interest, is the systematic risk of the
asset and is the return on the market portfolio 17
Market portfolio and beta
 Market Portfolio
Portfolio of all assets in the economy.
In practice a broad stock market index is used to
represent the market;
e.g., the S&P Composite or the FTSE All Share Index.
 Beta 
Measure of market risk, i.e., the sensitivity of a stock’s
return to the return on the market portfolio.
Given an expected change in the market return of 1
percentage point, the return of stock i is expected to
change by I percentage points.

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Security Market Line (CAPM)
Expected SML
return

E(Rm) . Market portfolio m

Expected market
risk premium
Rf

BETA 
0 1.0

S M L : r i  r f   i r m  r f 
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Estimating beta and cost of equity
 Ri is return investors expect/require on stock i given
its risk, i
 it therefore measures the cost of equity to the
company
Þ estimate i, rf, and rm– rf (annualized) to find cost of
equity capital
 To estimate a stock’s (historical) beta:
regress stock returns on market returns
broad stock market index to represent the market;
e.g., S&P Composite or FTSE All Share Index
we normally use monthly return data
we normally use at least 60 observations
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Capital structure and corporate taxes
 Business risk: the risk of the firm’s after-tax cash
flows; the risk reflected in the firm’s WACC; asset
risk.
 Financial risk: the additional risk to shareholders from
the use of debt; due to 

 Financial leverage/gearing: use of debt to increase the

expected return and the variability of the return
(i.e. risk) to shareholders
 Interest tax shield: tax saving from the deductibility of
debt interest payments

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Capital structure and corporate
taxes (cont.)
 If the cost of financing by debt is tax deductible
(subsidised by the tax-payer), but the cost of
financing by equity is not, why do firms not
choose 100% debt finance?
 First, we need to understand the effect of debt on
the financing costs and the WACC in the
absence of taxes 
 … contrast the “traditional” and (“modern”) Miller
and Modigliani (MM) views …

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Traditional view v. MM (no tax)
rE (MM)
rE (trad)

WACC (MM)

WACC (trad)
rD (trad&MM)

riskfree debt risky debt

WACC * (trad) 23
MM view of finance costs with
corporation tax Tc

rE

WACC
rD(1  TC)

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Value of the firm in presence/absence
of corporation tax
Value of the firm: no tax

Firm value as
leverage
increases (with
tax)
PV of
corporate
Value if all- debt tax
equity shield
financed
(with tax)

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 So why not increase debt without limit?
Clearly, firms do not do this
Offsetting disadvantages of debt
personal tax considerations
other ways of shielding earnings from tax
costs of financial distress
 trade-off theory of capital structure

Firm value if PV(costs

= PV(debt
value all-equity +  of financial
tax shield)
financed distress)
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Trade-off theory of capital structure
PV(costs of financial
distress)

VL

PV(debt
tax shield)
Value if Value of
all-equity levered
financed firm

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 Financial choices
 Trade-off theory: firms decide their capital structure
based on a trade-off between tax savings and
distress costs associated with debt.

 Pecking order theory: firms prefer to use internal

(equity) finance before anything else, but issue
debt rather than new equity if internal finance is
insufficient for investment requirements.

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 Pecking order theory
1. Announcements of new stock issues depress
stock prices because investors believe managers
are more likely to issue when shares are
overvalued
2. To avoid sending adverse signals, firms prefer
internal finance
3. If firms need external finance, they issue debt first
and equity as a last resort
4. More profitable firms borrow less not because
they have lower target debt ratios but because
they can finance themselves internally
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Implications of pecking order theory

Þ internal equity may be better than external equity

(and “equity” is not a homogeneous source of
finance)

Þ financial slack is valuable (mitigate underinvestment

problem)

Þ if the firm requires external capital, debt is better

(less room for differences in opinion over what debt
is worth), therefore bad signal is weaker

Þ No optimal capital structure 30

Evidence?
 Survey evidence on capital structure policies in
the UK, Netherlands, Germany, and France
(Brounen, de Jong, and Koedijk JBF 06)
“The static trade-off theory is confirmed by the
importance of a target debt ratio in general,
but also specifically by tax effects and
bankruptcy costs”
“Financial flexibility is important, but not driven
by the pecking-order theory”

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Evidence?
 Survey evidence from emerging markets (Korea:
Lee, Oh and Park, Emerging Markets Finance
and Trade, 2014)

“Korean CFOs generally behave in line with the

predictions of the traditional static trade-off theory.
Pecking-order theory appears to be moderately
supported by Korean firms’ emphasis on financial
flexibility and equity valuation in their security
issuance decisions, but their behaviour is not driven
by the asymmetric information that underlies the
theory.”
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