RiskandReturn:  Cost of Capital

FINC361 Fall2016
Professor Mahdi Mohseni

Cost of equity
GOAL:
Determine the cost of equity

APPROACH:
In two steps:
1. Quantifying the risk-return trade-off in Finance
2. CAPM model

Motivation for studying CAPM

Capital Asset Pricing Model (CAPM): Nobel prize winning
idea developed by Sharpe (1964), Lintner (1965), and
Black (1972), extending the work of Markowitz (1952)

Risk and Return: The big picture

Humans are generally risk averse
Seek to avoid risk
Need compensation for taking risk
Risk premium

Most important concept in finance:

The risk/return tradeoff

There is no free lunch

You cannot get higher returns without taking on more risks

This lecture is about quantifying this tradeoff

Goal of this lecture: Getting to CAPM formula

Fundamental questions in Finance

1. How do we define risk?
2. Can we eliminate some of the risks involved in
an investment?
3. What is the required rate of return for a given
investment?
Cost of equity
Key ingredient for appropriate discount rate of a firm
(WACC)

Returns and Risk

People make decisions based on expected returns
and risks every day
Should you skip the corporate finance class this week?
Return: Extra hours to prepare for exams
Risk: May miss important tips for exams

Different people have different perceptions of

expected returns and risk

Returns and Risk in Finance

To assess returns and risks in financial markets we
need to use an objective measure
Need to describe the distribution of stock returns
What do we mean by distribution?

Distribution: Summarizing the future!

Risky = Uncertain outcome
To gauge this uncertainty:
1. List all possible outcomes
2. Probability of occurrence for each outcome

Expected return
Measure of central tendency of distribution
Definition: Weighted average of each outcome
weights = probabilities of each outcome
Expected Return
=

E
=
[ R]

PR R

In our example of BFI:

E [ RBFI ] = 25%( 0.20) + 50%(0.10) + 25%(0.40) = 10%

Expected profit of a coin toss game

Suppose:
Heads: $1 gain
Tails: $1 loss

Probability of each event: 50% (fair coin!)

Hence expected profit = 0.5*(-1)+0.5*(1)=0
If we played this game a million times, our
profit/loss would be close to zero!

Variance and Standard deviation

Measures of dispersion around mean
Mathematically:

Variance: Expected squared deviation from the mean

Var (R ) =

E ( R E [ R ]) =

PR

(R

E [ R ])

Standard deviation = Square root of variance

SD( R) =

Var ( R)

Finance language:
Volatility = Standard deviation

Example
If we take again our example of BFI:
Var [ RBFI =
]

25% ( 0.20 0.10) 2 + 50% (0.10 0.10) 2

+ 25% (0.40 0.10) 2 =
0.045

=
SD( R)

=
Var ( R)

=
0.045

21.2%

Higher volatility = Higher risk

Example with the normal (bellshaped) distribution
1. In red
Normal distribution with
mean = 0 and std dev = 10
2. In green
Normal distribution with
mean = 0 and std dev = 20
The distribution with greater
standard deviation (volatility)
has greater risk (more
uncertainty): Its distribution is
more spread out around the
mean!

How do we come up with a

distribution for stock returns?
The future is unknown
Distribution summarizes our best guess

But how do we form our best guess?

Typically: Use the past as a predictor of the future!

When is the past a good predictor?

When the distribution is relatively stable

Risk-return trade-off in the past

STOCKS: RISKIER (MORE VOLATILE) BUT ALSO HIGHER RETURN IN THE LONG-RUN

Plotting the corresponding returns

Estimate of expected returns

using historical data
The average or mean is computed using
historical stock return data

1
R
=
( R1 + R2 + + RT =
)
T
Where, for each time period:
Pt + Dt Pt 1
Rt =
,
Pt 1
where Pt 1 = Price at beginning of period
where Pt = Price at end of period

1 T
Rt

T t =1

Estimate of standard deviation

using historical data
Estimate of variance:
Var (R )

1
T 1

(R

t =1

R)

Why (T-1)?
Estimate of the standard deviation (volatility)
is just the square root of that number

Simple Example
Compute the standard deviation of the numbers 1, 2, 3, 4 and 5.
Step 1: Compute the average (here equal to 3)
Step 2: Compute the deviation and squared deviation from the
average:
Value
1
2
3
4
5

Deviation
(1 3)
(2 3)
(3 3)
(4 3)
(5 3)

Squared Deviation
4
1
0
1
4

The sum of the squared deviations is 10

This sum divided by 4 (= 5 1) equals 2.50
Sample variance = 2.50
Sample standard deviation 1.58

The relation between returns and volatility

of large portfolios

Define excess returns

Equal to the difference between:

1. Average return for a given investment
2. Average return for T-Bills (risk-free rate)

Beware: Realized returns expected returns

Think of the relatively flat realized return on stocks over the last decade
Does it mean we expect to earn close to nothing in the coming 10 years?

Historical trade-off between returns

and volatility

For portfolios, we seem to have a straight line between:

1.
2.

Standard deviation (measure of risk)

Returns

Simple model for risk premium of portfolios:

Expected returns are proportional to volatility

But does this relationship hold for individual stocks?

Is there a positive linear relationship between

volatility and average returns for individual stocks?
Largest 50
stocks in
S&P500

NO! One can see that at the individual stock level:

1. Higher volatility does not lead to higher returns
2. Also, for a given return level, most individual stocks
have higher volatility than those of large portfolios

Volatility: Measure of total risk

For an individual stock

Volatility = Firm-specific risk + Systematic risk

1. Firm-specific risk

New drug approval, fire at a warehouse, etc.

Diversifiable

2. Systematic risk

Fed decision on interest rates, recession, etc.

Un-diversifiable

By forming a portfolio:

Firm-specific risk can be eliminated at no cost

No compensation for holding that type of risk

Returns for a portfolio:

Smoother than individual stocks

The first type of risk (firm-specific) can be eliminated by

creating a portfolio at virtually no cost (five trades online)!

No risk premium should be associated with a risk that can be

eliminated at no cost!!

Types of risk
Diversifiable
risk

Systematic
risk

For an individual stock:

Volatility = Systematic risk + Diversifiable risk

For a portfolio:
Volatility = Systematic risk

Estimating expected returns

Only exposure to systematic risk should be priced
For stocks, it cannot be captured by volatility

Expected stock returns are determined by:

1. Systematic risk carried by the stock
2. Risk premium required to compensate investors for bearing
systematic risk

Need a valid measure of systematic risk for individual

stocks:
Beta ()

 Goal:

Measuring Systematic Risk

Determine how much a firms stock returns are due to

systematic risk
Practically: How much does a stock co-move with the
general market

Why compare to market portfolio?

Market portfolio is only driven by systematic risk

Market portfolio is also an efficient portfolio

Example
If a stock has =2, it means that when market portfolio has
an excess return of 1%, the stock will have an excess return
of 2%

Only systematic risk matters!

Beta () of a stock: Measure of systematic risk
Measures co-movement between excess
returns on a given stock and market portfolio
High beta stock

Low beta stock

Returns

Returns
Market

Time

Market

Time

Beta () of a stock
A securitys beta is related to how
sensitive its underlying revenues and
cash flows are to general economic
conditions (business cycle) as
measured by broad market
movements
Stocks in cyclical industries (e.g.
semi-conductors), are likely more
exposed to systematic risk and tend
to have high betas
Stocks in consumer staple goods
(e.g. Coca-Cola) are likely less
exposed to systematic risk and tend
to have low betas
Beta can be estimated using
regression analysis

Cost of Equity: CAPM

At the firm level:

E (ri ) =

rf

+ i (E (rMkt ) rf )

Risk free rate

Stock risk premium

Risk premium is a function of systematic risk

- Investors are not rewarded for firm-specific risk

i captures the systematic risk

Measure of how much stock i moves with the market

Estimating the expected return

1. Need to estimate i
2. Need to estimate the Market Risk Premium
Market Risk Premium
=

E [ RMkt ] rf

Example: Cost of equity

Suppose:

Risk free rate: 5%

Market risk premium: 6%
Beta: Intel = 2.17 and Hersheys = -0.10

What is the expected returns for these stocks?

E ( RIntel ) = 5% + 2.17 6% = 18.0%
E ( RHersheys ) = 5% + (0.10) 6% = 4.4%

Why would investors be willing to expect a lower

return than the risk-free return for Hersheys?
Think of its beta

Recap: Cost of equity

Recall:
For an individual stock:
Volatility = Systematic risk + Diversifiable risk
1. Diversifiable risk: No premium should be attached to it!

Investors should not be compensated for risk that can be

diversified away at no cost

2. Systematic risk: A premium should be attached to it!

Diversification has its limits; one cannot diversify all risks by

creating portfolios. The un-diversifiable risk has to be borne by
investors and they require compensation for bearing that risk.

At the firm-level, systematic risk is measured by beta ()

How do we measure exposure to

systematic risk () for a stock?
Idea: Figure the % change in a stocks excess return for a 1% change in
a portfolios excess return that fluctuates solely due to systematic risk
Step 1: Take a portfolio with only systematic risk
Market portfolio is an obvious candidate

Step 2: Measure how your stock co-moves with this portfolio

A.
B.
C.
D.
E.

If it co-moves perfectly and with same amplitudes -> = 1

If it moves with the market but with larger amplitudes -> > 1
If it moves with the market but with smaller amplitudes -> < 1
If it is perfectly uncorrelated with market -> = 0
If it moves in opposite direction to market movements -> < 0

Cost of equity:
Implementing the CAPM formula
Formula:

E (ri ) = rf + i (E (rMkt ) rf )

Hence, we need:
1. Risk-free rate

YTM (annual rate) on US Treasury bonds with longterm maturity to reflect long term use of firm assets

Implicitly, we are taking into account the yield curve

2. Estimates for:

1. (E (rMkt ) rf ) : Market risk premium

2. i : Firm i' s beta

Expected market risk premium

Use the past!
Historical average excess return of the market over
the risk-free interest rate (RM-Rf)
For example: {April 1953-March 2009} = 5.6%
Beware: Past could be a poor predictor of the future!
Usually people take a long window for realized returns

Researchers generally report estimates in the 36%

range for the future equity risk premium

Beta
Measures the co-movement of a security with the market
Mathematically:
Volatility of i that is common with the market

Mkt
i

SD(Ri ) Corr (Ri ,RMkt )

=
SD(RMkt )

Cov(Ri ,RMkt )
Var (RMkt )

Given that definition, what should be the beta for:

1. The market portfolio
2. The risk-free investment
3. An individual stock

What is the critical ingredient in this case?

A simple example
Assume:
Risk-free return is 5%
Expected return on market portfolio of 12% and a
standard deviation of 44%
AXP Oil and Gas has a standard deviation of 68%
and a correlation with the market of 0.91

What is AXPs beta with the market?

Under the CAPM assumptions, what is its
expected return?

Solution
Simply use the previous formula:
SD(Ri ) Corr (Ri ,RMkt ) (.68)(.91)
=
= = 1.41
i
.44
SD(RMkt )

E[Ri ] =rf + iMkt (E[RMkt ] rf ) =5% + 1.41(12% 5%) =14.87%

Beta in practice:
Estimating beta from historical returns
Definition of beta:
Expected % change in the excess return of the
security for a 1% change in the excess return of the
market portfolio
We use the past (statistics) to make inferences about
the future (probabilities)

Example: Cisco Systems

Lets look at its recent past

Monthly excess returns for

Cisco and the S&P500 (19962005)

1. Frequency:
2. Window:

Why monthly data, why not weekly or daily data?

Why 10 years, why not five years?

Lets look at a better picture to visualize the co-movement between

the market and Cisco

Another way to look at the data

E (ri ) rf = i (E (rMkt ) rf )
Y-axis

Slope

X-axis

Statistics
Beta = Slope of the best-fitting line of the cloud of points representing
Ciscos excess returns versus the market excess return
Excess return: Frequency is monthly/weekly/daily.

How do we estimate that slope?

Use linear regression analysis!
CAPM model

Ri -Rf = i + i (RMkt-Rf )+i

i = Intercept

According to CAPM, what should it be?

What does it mean to generate alpha?
Check the t-stat!

i = error term

Deviations from the best-fitting line

According to regression analysis, what should it be on average?

= 1.55 for Cisco

See Excel file

Caveat: The approach contains a lot of estimation error

Industry beta: Alternative technique using set of comparable firms

PuttingItAllTogether:TheCapitalAssetPricingModel

Investorsrequireariskpremiumproportional
totheamountofsystematic risktheyare
bearing
Wecanmeasuresystematicriskusingbeta()
Themostcommonwaytoestimatebetaisto
uselinearregression theslopeofthelineis
thestocksbeta

PuttingItAllTogether:TheCapitalAssetPricingModel

TheCAPMsayswecancomputetheexpected
(required)returnonstockofanyfirmusing
thefollowingequation:


E (ri ) = rf + i (E (rMkt ) rf )

which,whengraphed, iscalledthesecurity
marketline.

Figure 12.9 Expected Returns,

Volatility, and Beta (Panel )

Figure 12.9 Expected Returns,

Volatility, and Beta (Panel B)
The Security Market Line