Junior Debt

What Does Junior Debt Mean?

Junior debt is debt that is either unsecured or has a lower priority than of another debt
claim on the same asset or property. It is a debt that is lower in repayment priority than
other debts in the event of the issuer's default. Junior debt is usually an unsecured form
of debt, meaning there is no collateral behind the debt.

Investopedia explains Junior Debt

In the event that the issuing company goes out of business, the junior debt has a
smaller probability of being paid back, either with money or with assets, since all higher-
ranking debt will be given priority. Junior debt is also called subordinated debt, due to its
position in the debt hierarchy. One common junior debt is the seconds mortgage which
ranks behind the first mortgage and has a lesser claim in the event of default.

Discount Rate

What Does Discount Rate Mean?

1. The interest rate that an eligible depository institution is charged to borrow short-term
funds directly from a Federal Reserve Bank.

2. The interest rate used in determining the present value of future cash flows.

Investopedia explains Discount Rate

1. This type of borrowing from the Fed is fairly limited. Institutions will often seek other
means of meeting short-term liquidity needs. The Federal funds discount rate is one of
two interest rates the Fed sets, the other being the overnight lending rate, or the Fed
funds rate.

2. For example, let's say you expect $1,000 dollars in one year's time. To determine the
present value of this $1,000 (what it is worth to you today) you would need to discount it
by a particular rate of interest (often the risk-free rate but not always). Assuming a
discount rate of 10%, the $1,000 in a year's time would be the equivalent of $909.09 to
you today (1000/[1.00 + 0.10]).

Hurdle Rate

What Does Hurdle Rate Mean?

The minimum amount of return that a person requires before they will make an
investment in something.

Investopedia explains Hurdle Rate

This is the rate of return that will get someone "over the hurdle" and invest their money.
Required Rate Of Return (RRR)

What Does Required Rate Of Return (RRR) Mean?

The rate of return needed to induce investors or companies to invest in something.

Investopedia explains Required Rate Of Return (RRR)

For example, if you invest in a stock, your required return might be 10% per year. Your
reasoning is that if you don't receive 10% return, then you'd be better off paying down
your outstanding mortgage, on which you are paying 10% interest.

Internal Rate Of Return – IRR

The internal rate of return (IRR) is a rate of return used in capital budgeting to
measure and compare the profitability of investments. It is also called the discounted
cash flow rate of return (DCFROR) or simply the rate of return (ROR). [1] In the context of
savings and loans the IRR is also called the effective interest rate. The term internal
refers to the fact that its calculation does not incorporate environmental factors (e.g., the
interest rate or inflation).

Calculation

Given a collection of pairs (time, cash flow) involved in a project, the internal rate of
return follows from the net present value as a function of the rate of return. A rate of
return for which this function is zero is an internal rate of return.

Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number
of periods N, and the net present value NPV, the internal rate of return is given by r in:

Note that the period is usually given in years, but the calculation may be made simpler if
r is calculated using the period in which the majority of the problem is defined (e.g.,
using months if most of the cash flows occur at monthly intervals) and converted to a
yearly period thereafter.

Note that any fixed time can be used in place of the present (e.g., the end of one
interval of an annuity); the value obtained is zero if and only if the NPV is zero.

In the case that the cash flows are random variables, such as in the case of a life
annuity, the expected values are put into the above formula.

Often, the value of r cannot be found analytically. In this case, numerical methods or
graphical methods must be used.
Example if an investment may be given by the sequence of cash flows
Year (n) Cash Flow (Cn)

0 −4000

1 1200

2 1410

3 1875

4 1050

then the IRR r is given by

In this case, the answer is 14.3%.

Numerical solution

Since the above is a manifestation of the general problem of finding the roots of the
equation NPV(r), there are many numerical methods that can be used to estimate r. For
example, using the secant method, r is given by

where rn is considered the nth approximation of the IRR.

This r can be found to an arbitrary degree of accuracy

This makes IRR a suitable (and popular) choice for analyzing venture capital and other
private equity investments, as these strategies usually require several cash investments
throughout the project, but only see one cash outflow at the end of the project (e.g., via
IPO or M&A).

Since IRR does not consider cost of capital, it should not be used to compare projects
of different duration. Modified Internal Rate of Return (MIRR) does consider cost of
capital and provides a better indication of a project's efficiency in contributing to the
firm's discounted cash flow.
In the case of positive cash flows followed by negative ones and then by positive ones
(for example, + + - - - +) the IRR may have multiple values. In this case a discount rate
may be used for the borrowing cash flow and the IRR calculated for the investment cash
flow. This applies for example when a customer makes a deposit before a specific
machine is built.

In a series of cash flows like (-10, 21, -11), one initially invests money, so a high rate of
return is best, but then receives more than one possesses, so then one owes money, so
now a low rate of return is best. In this case it is not even clear whether a high or a low
IRR is better. There may even be multiple IRRs for a single project, like in the example
0% as well as 10%. Examples of this type of project are strip mines and nuclear power
plants, where there is usually a large cash outflow at the end of the project.

In general, the IRR can be calculated by solving a polynomial equation. Sturm's

theorem can be used to determine if that equation has a unique real solution. In general
the IRR equation cannot be solved analytically but only iteratively.

When a project has multiple IRRs it may be more convenient to compute the IRR of the
project with the benefits reinvested.[3] Accordingly, MIRR is used, which has an
assumed reinvestment rate, usually equal to the project's cost of capital.

It has been shown[4] that with multiple internal rates of return, the IRR approach can still
be interpreted in a way that is consistent with the present value approach provided that
the underlying investment stream is correctly identified as net investment or net
borrowing.

See also [5] for a way of identifying the relevant value of the IRR from a set of multiple
IRR solutions.

Despite a strong academic preference for NPV, surveys indicate that executives prefer
IRR over NPV.[6] Apparently, managers find it easier to compare investments of different
sizes in terms of percentage rates of return than by dollars of NPV. However, NPV
remains the "more accurate" reflection of value to the business. IRR, as a measure of
investment efficiency may give better insights in capital constrained situations.
However, when comparing mutually exclusive projects, NPV is the appropriate
measure.

The discount rate often used in capital budgeting that makes the net present value of all
cash flows from a particular project equal to zero. Generally speaking, the higher a
project's internal rate of return, the more desirable it is to undertake the project. As
such, IRR can be used to rank several prospective projects a firm is considering.
Assuming all other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken first.

IRR is sometimes referred to as "economic rate of return (ERR)".

Investopedia explains Internal Rate Of Return - IRR
You can think of IRR as the rate of growth a project is expected to generate. While the
actual rate of return that a given project ends up generating will often differ from its
estimated IRR rate, a project with a substantially higher IRR value than other available
options would still provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the securities market. If
a firm can't find any projects with IRRs greater than the returns that can be generated in
the financial markets, it may simply choose to invest its retained earnings into the
market.

The risk-free rate of return is one of the most basic components of modern finance and
many of its most famous theories - the capital asset pricing model (CAPM), modern
portfolio theory (MPT) and the Black-Scholes model - use the risk-free rate as the
primary component from which other valuations are derived. The risk-free asset only
applies in theory, but its actual safety rarely comes into question until events fall far
beyond the normal daily volatile markets. Although it's easy to take shots at theories
that have a risk-free asset as their base, there are limited options to use as a proxy.

This article looks at the risk-free security in theory and in reality (as a government
security), evaluating how truly risk free it is. The model assumes that investors are risk
averse and will expect a certain rate of return for excess risk extending from the
intercept, which is the risk-free rate of return.

The T-Bill Base

The risk-free rate is an important building block for MPT. As referenced in Figure 1, the
risk-free rate is the base of the line where the lowest return can be found with the least
amount of risk.
Risk-free assets under MPT, while theoretical, typically are represented by Treasury
bills (T-bills), which have the following characteristics:
 T-bills are assumed to have zero default risk because they represent and are
backed by the good faith of the U.S. government. (Read Why do commercial bills
have higher yields than T-bills? to learn more.)
 T-bills are sold at auction in a weekly competitive bidding process and are sold at
a discount from par. (Read Bond Market Pricing Conventions for more on how
prices are determined.)
 They don't pay traditional interest payments like their cousins, the Treasury notes
and Treasury bonds.
 They're sold in various maturities in denominations of $1,000.
 They can be purchased by individuals directly from the government. (Buy
Treasuries Directly From The Fed can show you how.)
Because there are limited options to use instead of the United States T-bill, it helps to
have a grasp of other areas of risk that can have indirect effects on risk-free
assumptions.

Sources of Risk
The term risk is often taken for granted and used very loosely, especially when it comes
to the risk-free rate. At its most basic level, risk is the probability of events or outcomes.
When applied to investments, risk can be broken down a number of ways:
 Absolute risk as defined by volatility: Absolute risk as defined by volatility can be
easily quantified by common measures like standard deviation. Since risk-free
assets typically mature in three months or less, the volatility measure is very
short-term in nature. While daily prices relating to yield can be used to measure
volatility, they are not commonly used. (For more insight, read The Uses And
Limits Of Volatility.)
 Relative risk: Relative risk when applied to investments is usually represented by
the relation of price fluctuation of an asset to an index or base. One important
differentiation is that relative risk tells very little about absolute risk - it only tells
how risky the asset is compared to a base. Again, since the risk-free asset used
in the theories is so short-term, relative risk does not always apply. (To learn
more about degrees of risk, read Determining Risk And The Risk Pyramid.)
 Default risk: What risk is assumed when investing in the three-month T-bill?
Default risk, which in this case is the risk that the U.S. government would default
on its debt obligations. Credit-risk evaluation measures deployed by securities
analysts and lenders can help define the ultimate risk of default. (Learn more
about credit risk in Corporate Bonds: An Introduction To Credit Risk.)
Although the U.S. government has never defaulted on any of its debt obligations, the
risk of default has been raised during extreme economic events, when the U.S.
government has stepped in to provide a level of security,which provided a perception of
safety. The U.S. government can spin the ultimate security of its debt in unlimited ways,
but the reality is that the U.S. dollar is no longer backed by gold, so the only true
security for its debt is the government's ability to make the payments from current
balances or tax revenues. (Read more about the relationship between gold and the U.S.
dollar in The Gold Standard Revisited and Does It Still Pay To Invest In Gold?)
This raises many questions of the reality of a risk-free asset. For example, say the
economic environment is such that there is a large deficit being funded by debt, and the
current administration plans to reduce taxes and provide tax incentives to both
individuals and companies to spur economic growth. If this plan were used by a publicly
held company, how could the company justify its credit quality if the plan were to
basically decrease revenue and increase spending? That in itself is the rub: there really
is no justification or alternative for the risk-free asset. There have been attempts to use
other options, but the U.S. T-bill remains the best option, because it is the closest
investment – in theory and reality – to a short-term riskless security.

Conclusion
The risk-free rate is rarely called into question until the economic environment falls into
disarray. Catastrophic events, like credit-market collapses, war, stock market collapses
and dramatic currency devaluations, can all lead people to question the safety and
security of the U.S. government as a lender. The best way to evaluate the riskless
security would be to use standard credit evaluation techniques, such as those an
analyst would use to evaluate the creditworthiness of any company. Unfortunately,
when the rubber hits the road, the metrics applied to the U.S. government rarely hold
up, due to the fact that they exist in perpetuity by nature and have unlimited powers to
raise funds both short- and long-term for spending and funding.

Net Present Value - NPV

In finance, the net present value (NPV) or net present worth (NPW)[1] of a time series
of cash flows, both incoming and outgoing, is defined as the sum of the present values
(PVs) of the individual cash flows. In the case when all future cash flows are incoming
(such as coupons and principal of a bond) and the only outflow of cash is the purchase
price, the NPV is simply the PV of future cash flows minus the purchase price (which is
its own PV). NPV is a central tool in discounted cash flow (DCF) analysis, and is a
standard method for using the time value of money to appraise long-term projects. Used
for capital budgeting, and widely throughout economics, finance, and accounting, it
measures the excess or shortfall of cash flows, in present value terms, once financing
charges are met.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate
or discount curve and outputs a price; the converse process in DCF analysis - taking a
sequence of cash flows and a price as input and inferring as output a discount rate (the
discount rate which would yield the given price as NPV) - is called the yield, and is more
widely used in bond trading.

What Does Net Present Value - NPV Mean?

The difference between the present value of cash inflows and the present value of cash
outflows. NPV is used in capital budgeting to analyze the profitability of an investment or
project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or
project will yield.

Formula:

In addition to the formula, net present value can often be calculated using tables, and
spreadsheets such as Microsoft Excel.

Investopedia explains Net Present Value - NPV

NPV compares the value of a dollar today to the value of that same dollar in the future,
taking inflation and returns into account. If the NPV of a prospective project is positive, it
should be accepted. However, if NPV is negative, the project should probably be
rejected because cash flows will also be negative.

For example, if a retail clothing business wants to purchase an existing store, it would
first estimate the future cash flows that store would generate, and then discount those
cash flows into one lump-sum present value amount, say $565,000. If the owner of the
store was willing to sell his business for less than $565,000, the purchasing company
would likely accept the offer as it presents a positive NPV investment. Conversely, if the
owner would not sell for less than $565,000, the purchaser would not buy the store, as
the investment would present a negative NPV at that time and would, therefore, reduce
the overall value of the clothing company.

Which is a better measure for capital budgeting, IRR or NPV?

The net present value (NPV) and the internal rate of return (IRR) could as well be
defined as two faces of the same coin as both reflect on the anticipated performance of
a firm or business over a particular period of time. The main difference however should
be more evident in the method or should I say the units used. While NPV is calculated
in cash, the IRR is a percentage value expected in return from a capital project.

Due to the fact that NPV is calculated in currency, it always seems to resonate more
easily with the general public as the general public comprehends monetary value better
as compared to other values. This does not necessarily mean that the NPV is
automatically the best option when evaluating a firm’s progress. The best option would
depend on the perception of the individual doing the calculation, as well as, his
objective in the whole exercise. It is evident that managers and administrators would
prefer the IRR as a method, as percentages give a better outlook that can be used to
make strategic decisions over the firm.

Another major shortfall associated with the IRR method is the fact that it cannot be
conclusively used in circumstances where the cash flow is inconsistent. While working
out figures in such fluctuating circumstances may prove tricky for the IRR method, it
would pose no challenge for the NPV method since all that it would take is the
collection of all the inflows-outflows and finding an average over the entire period in
focus.

Evaluating the viability of a project using the IRR method could cloud the true picture if
the figures on the inflow and outflow remain to fluctuate persistently. It may even give
the false impression that a short term venture with high return in a short time is more
viable as compared to a bigger long-term venture that would otherwise make more
profits.

In order to make a decision between any of the two methods, it is important to take
note of the following significant differences.

Summary:
1. While the NPV will work better in helping other people such as investors in
understanding the actual figures in so far as the evaluation of a project is concerned,
the IRR will give percentages which can be better understood by managers
2. As much as discrepancies in discounts will most likely lead to similar
recommendations from both methods, it is important to note that the NPV method can
evaluate big long-term projects better as opposed to the IRR which gives better
accuracy on short term projects with consistent inflow or outflow figures.

Key differences between the most popular methods, the NPV (Net Present Value)
Method and IRR (Internal Rate of Return) Method, include:

• NPV is calculated in terms of currency while IRR is expressed in terms of the

percentage return a firm expects the capital project to return;

• Academic evidence suggests that the NPV Method is preferred over other methods
since it calculates additional wealth and the IRR Method does not;

• The IRR Method cannot be used to evaluate projects where there are changing cash
flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be
required in the case of land reclamation by a mining firm);

• However, the IRR Method does have one significant advantage -- managers tend
to better understand the concept of returns stated in percentages and find it easy to
compare to the required cost of capital; and, finally,
• While both the NPV Method and the IRR Method are both DCF models and can even
reach similar conclusions about a single project, the use of the IRR Method can lead to
the belief that a smaller project with a shorter life and earlier cash inflows, is preferable
to a larger project that will generate more cash.

• Applying NPV using different discount rates will result in different

recommendations. The IRR method always gives the same recomendation.

In capital budgeting, there are a number of different approaches that can be used to
evaluate any given project, and each approach has its own distinct advantages and
disadvantages.

All other things being equal, using internal rate of return (IRR) and net present value
(NPV) measurements to evaluate projects often results in the same findings.
However, there are a number of projects for which using IRR is not as effective as
using NPV to discount cash flows. IRR's major limitation is also its greatest strength:
it uses one single discount rate to evaluate every investment.

Although using one discount rate simplifies matters, there are a number of situations
that cause problems for IRR. If an analyst is evaluating two projects, both of which
share a common discount rate, predictable cash flows, equal risk, and a shorter time
horizon, IRR will probably work. The catch is that discount rates usually
change substantially over time. For example, think about using the rate of return on
a T-bill in the last 20 years as a discount rate. One-year T-bills returned between 1%
and 12% in the last 20 years, so clearly the discount rate is changing.

Without modification, IRR does not account for changing discount rates, so it's just
not adequate for longer-term projects with discount rates that are expected to vary.
(To learn more, read Taking Stock Of Discounted Cash Flow, Anything But
Ordinary: Calculating The Present And Future Value Of Annuities and Investors
Need A Good WACC.)

Another type of project for which a basic IRR calculation is ineffective is a project
with a mixture of multiple positive and negative cash flows. For example, consider
a project for which marketers must reinvent the style every couple of years to stay
current in a fickle, trendy niche market. If the project has cash flows of -$50,000 in
year one (initial capital outlay), returns of $115,000 in year two and costs of $66,000
in year three because the marketing department needed to revise the look of the
project, a single IRR can't be used. Recall that IRR is the discount rate that makes a
project break even. If market conditions change over the years, this project can have
two or more IRRs, as seen below.

Thus, there are at least two solutions for IRR that make the equation equal to zero,
so there are multiple rates of return for the project that produce multiple IRRs. The
advantage to using the NPV method here is that NPV can handle multiple discount
rates without any problems. Each cash flow can be discounted separately from the
others.

Another situation that causes problems for users of the IRR method is when the
discount rate of a project is not known. In order for the IRR to be considered a valid
way to evaluate a project, it must be compared to a discount rate. If the IRR is
above the discount rate, the project is feasible; if it is below, the project is
considered infeasible. If a discount rate is not known, or cannot be applied to a
specific project for whatever reason, the IRR is of limited value. In cases like this,
the NPV method is superior. If a project's NPV is above zero, then it is considered to
be financially worthwhile.

So, why is the IRR method still commonly used in capital budgeting? Its popularity is
probably a direct result of its reporting simplicity. The NPV method is inherently
complex and requires assumptions at each stage - discount rate, likelihood of
receiving the cash payment, etc. The IRR method simplifies projects to a single
number that management can use to determine whether or not a project is
economically viable. The result is simple, but for any project that is long-term, that
has multiple cash flows at different discount rates, or that has uncertain cash flows -
in fact, for almost any project at all - simple IRR isn't good for much more
than presentation value.
Cost Of Capital

What Does Cost Of Capital Mean?

The required return necessary to make a capital budgeting project, such as building a
new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.

Investopedia explains Cost Of Capital

The cost of capital determines how a company can raise money (through a stock issue,
borrowing, or a mix of the two). This is the rate of return that a firm would receive if it
invested in a different vehicle with similar risk.

Cost Of Equity

Once the cost of equity is calculated, adjustments can be made to take account of risk
factors specific to the company, which may increase or decrease the risk profile of the
company. Such factors include the size of the company, pending lawsuits, concentration
of customer base and dependence on key employees. Adjustments are entirely a matter
of investor judgment and they vary from company to company.

The cost of equity is more challenging to calculate as equity does not pay a set return
to its investors. Similar to the cost of debt, the cost of equity is broadly defined as the
risk-weighted projected return required by investors, where the return is largely
unknown. The cost of equity is therefore inferred by comparing the investment to other
investments (comparable) with similar risk profiles to determine the "market" cost of
equity. It is commonly equated using the CAPM formula (below), although articles such
as Stulz 1995 question the validity of using a local CAPM versus an international
CAPM- also considering whether markets are fully integrated or segmented (if fully
integrated, there would be no need for a local CAPM).

Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta x (market rate of return- risk free rate of
return) Where Beta= sensitivity to movements in the relevant market:

Where:

Es The expected return for a security

Rf The expected risk-free return in that market (government bond yield)

βs The sensitivity to market risk for the security

RM The historical return of the stock market/ equity market

(RM-Rf ) The risk premium of market assets over risk free assets.
Determine the cost of equity (required return of equity)?

should consider correlated volatility (beta) instead of simple volatility (sigma).

This expected return on equity, or equivalently, a firm's cost of equity, can be estimated
using the Capital Asset Pricing Model (CAPM). According to the model, the expected
return on equity is a function of a firm's equity beta (β E) which, in turn, is a function of
both leverage and asset risk (βA):

where:

 KE = firm's cost of equity

 RF = risk-free rate (the rate of return on a "risk free investment"; e.g., U.S.
Treasury Bonds)
 RM = return on the market portfolio

because:

and

Firm Value (V) = Debt Value (D) + Equity Value (E)

An indication of the systematic riskiness attaching to the returns on ordinary shares. It

equates to the asset Beta for an ungeared firm, or is adjusted upwards to reflect the
extra riskiness of shares in a geared firm., i.e. the Geared Beta.[3]

 We use the CAPM (capital asset pricing model) to determine the cost of equity.
CAPM equals the risk free rate plus beta times the market risk premium. The
cost of equity is the rate a target company would have to pay for equity capital
(financing) such as in an IPO.

The risk free rate is taken from the lowest yielding bonds in the particular market, such
as government bonds.
Unlike debt, which the company must pay at a set rate of interest, equity does not have
a concrete price that the company must pay. But that doesn't mean that there is no cost
of equity. Equity shareholders expect to obtain a certain return on their equity
investment in a company. From the company's perspective, the equity holders' required
rate of return is a cost, because if the company does not deliver this expected return,
shareholders will simply sell their shares, causing the price to drop.

Therefore, the cost of equity is basically what it costs the company to maintain a share
price that is satisfactory (at least in theory) to investors. The most commonly accepted
method for calculating cost of equity comes from the Nobel Memorial Prize-winning
capital asset pricing model (CAPM), where: Cost of Equity (Re) = Rf + Beta (Rm-Rf).

Let's explain what the elements of this formula are:

Rf - Risk-Free Rate - This is the amount obtained from investing in securities

considered free from credit risk, such as government bonds from developed countries.
The interest rate of U.S. Treasury bills or the long-term bond rate is frequently used as a
proxy for the risk-free rate.

ß - Beta - This measures how much a company's share price moves against the market
as a whole. A beta of one, for instance, indicates that the company moves in line with
the market. If the beta is in excess of one, the share is exaggerating the market's
movements; less than one means the share is more stable. Occasionally, a company
may have a negative beta (e.g. a gold mining company), which means the share price
moves in the opposite direction to the broader market. (To learn more, see Beta: Know
The Risk.)

In finance, the Beta (β) of a stock or portfolio is a number describing the relation of its
returns with that of the financial market as a whole.[1]

An asset has a Beta of zero if its returns change independently of changes in the
market's returns. A positive beta means that the asset's returns generally follow the
market's returns, in the sense that they both tend to be above their respective averages
together, or both tend to be below their respective averages together. A negative beta
means that the asset's returns generally move opposite the market's returns: one will
tend to be above its average when the other is below its average. [2]

The beta coefficient is a key parameter in the capital asset pricing model (CAPM). It
measures the part of the asset's statistical variance that cannot be removed by the
diversification provided by the portfolio of many risky assets, because of the correlation
of its returns with the returns of the other assets that are in the portfolio. Beta can be
estimated for individual companies using regression analysis against a stock market
index.

The formula for the beta of an asset within a portfolio is

 ,

where ra measures the rate of return of the asset, rp measures the rate of return of the
portfolio, and cov(ra,rp) is the covariance between the rates of return. The portfolio of
interest in the CAPM formulation is the market portfolio that contains all risky assets,
and so the rp terms in the formula are replaced by rm, the rate of return of the market.

Beta is also referred to as financial elasticity or correlated relative volatility, and can
be referred to as a measure of the sensitivity of the asset's returns to market returns, its
non-diversifiable risk, its systematic risk, or market risk. On an individual asset level,
measuring beta can give clues to volatility and liquidity in the marketplace. In fund
management, measuring beta is thought to separate a manager's skill from his or her
willingness to take risk.

The beta coefficient was born out of linear regression analysis. It is linked to a
regression analysis of the returns of a portfolio (such as a stock index) (x-axis) in a
specific period versus the returns of an individual asset (y-axis) in a specific year. The
regression line is then called the Security characteristic Line (SCL).

αa is called the asset's alpha and βa is called the asset's beta coefficient. Both
coefficients have an important role in Modern portfolio theory.

For an example, in a year where the broad market or benchmark index returns 25%
above the risk free rate, suppose two managers gain 50% above the risk free rate.
Because this higher return is theoretically possible merely by taking a leveraged
position in the broad market to double the beta so it is exactly 2.0, we would expect a
skilled portfolio manager to have built the outperforming portfolio with a beta somewhat
less than 2, such that the excess return not explained by the beta is positive. If one of
the managers' portfolios has an average beta of 3.0, and the other's has a beta of only
1.5, then the CAPM simply states that the extra return of the first manager is not
sufficient to compensate us for that manager's risk, whereas the second manager has
done more than expected given the risk. Whether investors can expect the second
manager to duplicate that performance in future periods is of course a different
question.

Security market line

The SML graphs the results from the capital asset
pricing model (CAPM) formula. The x-axis represents
the risk (beta), and the y-axis represents the expected
return. The market risk premium is determined from the
slope of the SML.

The relationship between β and required return is

plotted on the security market line (SML) which shows
expected return as a function of β. The intercept is the
nominal risk-free rate available for the market, while the
slope is E(Rm)− Rf. The security market line can be
regarded as representing a single-factor model of the The Security Market Line
asset price, where Beta is exposure to changes in
value of the Market. The equation of the SML is thus:

It is a useful tool in determining if an asset being considered for a portfolio offers a

reasonable expected return for risk. Individual securities are plotted on the SML graph.
If the security's risk versus expected return is plotted above the SML, it is undervalued
because the investor can expect a greater return for the inherent risk. A security plotted
below the SML is overvalued because the investor would be accepting a lower return for
the amount of risk assumed.

(Rm – Rf) = Equity Market Risk Premium - The equity market risk premium (EMRP)
represents the returns investors expect, over and above the risk-free rate, to
compensate them for taking extra risk by investing in the stock market. In other words, it
is the difference between the risk-free rate and the market rate. It is a highly contentious
figure. Many commentators argue that it has gone up due to the notion that holding
shares has become riskier.

What Does Cost Of Equity Mean?

In financial theory, the return that stockholders require for a company. The traditional
formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in
exchange for owning the asset and bearing the risk of ownership.

Investopedia explains Cost Of Equity

Let's look at a very simple example: let's say you require a rate of return of 10% on an
investment in TSJ Sports. The stock is currently trading at $10 and will pay a dividend of
$0.30. Through a combination of dividends and share appreciation you require a $1.00
return on your $10.00 investment. Therefore the stock will have to appreciate by $0.70,
which, combined with the $0.30 from dividends, gives you your 10% cost of equity.

The capital asset pricing model (CAPM) is another method used to determine cost of
equity.

Cost Of Debt

Compared to cost of equity, cost of debt is fairly straightforward to calculate. The rate
applied to determine the cost of debt (Rd) should be the current market rate the
company is paying on its debt. If the company is not paying market rates, an
appropriate market rate payable by the company should be estimated.

The cost of debt is relatively simple to calculate, as it is composed of the rate of

interest paid. In practice, the interest-rate paid by the company can be modeled as the
risk-free rate plus a risk component (risk premium), which itself incorporates a probable
rate of default (and amount of recovery given default). For companies with similar risk or
credit ratings, the interest rate is largely exogenous (not linked to the company's
activities).

The cost of debt is computed by taking the rate on a risk free bond whose duration
matches the term structure of the corporate debt, then adding a default premium. This
default premium will rise as the amount of debt increases (since, ceteris paribus,"all
other things being equal", the risk rises as the amount of debt rises). Since in most
cases debt expense is a deductible expense, the cost of debt is computed as an after
tax cost to make it comparable with the cost of equity (earnings are after-tax as well).
Thus, for profitable firms, debt is discounted by the tax rate.

The formula can be written as (Rf + credit risk rate)(1-T), where T is the corporate tax
rate and Rf is the risk free rate.

Determine the cost of debt (required return of debt)?

 Wikiwealth uses the BBB corporate bond yield to determine the cost of debt.
There are several assumptions underlying this measure. The cost of debt is the
rate a target company would have to pay for debt capital (financing) such as in a
debt offering to the public.
o The BBB measure is the assumed average measure of the debt rating for
the target company. If the debt rating is significantly different from the
market, then we would use a different corporate bond yield, like AAA or
CCC. We rarely diverge from the BBB average unless the entire industry
was significantly different from BBB. The BBB rating equates to the risk of
the target companies debt.
 o We use the 20 year bond rating, because 20 years matches the expected
holding period of the investment.
o After-tax cost: Wikiwealth uses the after-tax cost of debt, because
companies get a tax shield on interest expenses.
 The tax rate is the domestic corporate tax rate. For US companies,
this rate equals 40%, which is the federal and state blended tax
rate. Foreign companies use different tax rate.

The yield to maturity can be used as cost of capital.

What Does Cost Of Debt Mean?

The effective rate that a company pays on its current debt. This can be measured in
either before- or after-tax returns; however, because interest expense is deductible, the
after-tax cost is seen most often. This is one part of the company's capital structure,
which also includes the cost of equity.

Investopedia explains Cost Of Debt

A company will use various bonds, loans and other forms of debt, so this measure is
useful for giving an idea as to the overall rate being paid by the company to use debt
financing. The measure can also give investors an idea as to the riskiness of the
company compared to others, because riskier companies generally have a higher cost
of debt.

To get the after-tax rate, you simply multiply the before-tax rate by one minus the
marginal tax rate (before-tax rate x (1-marginal tax)). If a company's only debt were a
single bond in which it paid 5%, the before-tax cost of debt would simply be 5%. If,
however, the company's marginal tax rate were 40%, the company's after-tax cost of
debt would be only 3% (5% x (1-40%)).

Capital Asset Pricing Model - CAPM

What Does Capital Asset Pricing Model - CAPM Mean?

A model that describes the relationship between risk and expected return and that is
used in the pricing of risky securities.
The general idea behind CAPM is that investors need to be compensated in two ways:
time value of money and risk. The time value of money is represented by the risk-free
(rf) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The other half of the formula represents risk and
calculates the amount of compensation the investor needs for taking on additional risk.
This is calculated by taking a risk measure (beta) that compares the returns of the asset
to the market over a period of time and to the market premium (Rm-rf).

Investopedia explains Capital Asset Pricing Model - CAPM

The CAPM says that the expected return of a security or a portfolio equals the rate on a
risk-free security plus a risk premium. If this expected return does not meet or beat the
required return, then the investment should not be undertaken. The security market line
plots the results of the CAPM for all different risks (betas).

Using the CAPM model and the following assumptions, we can compute the expected
return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk
measure) of the stock is 2 and the expected market return over the period is 10%, the
stock is expected to return 17% (3%+2(10%-3%)).

 many other variables that go into the WACC calculation.

Variables and assumptions in the CAPM?

 Risk free rate: we use a risk-free rate equal to the US Treasury 20 year
benchmark. This rate is risk free, because the US government is considered the
closest measure of a risk free investment.
o If the target company is foreign, we would use the appropriate government
risk free rate in their domestic market.
o We use the 20 year rate, because an investor is expected to hold a long
term investment for 20 years. Why not a 30 year risk free rate? The 30
year rate is usually lower than the 20 year rate, because of the market’s
lopsided demand for longer duration securities. The most conservative
number to use is the 20 year rate.

 Beta: This determines the risk of an investment as compared to the stock market
in general. If the beta of an investment is 2.0, then it would move with twice the
magnitude of the market. For example, if the market was down 5%, a beta of 2.0
means that your investment would drop by 10%.
o Ideally, the beta should measure the expected future risk of the company.
Most beta measures take the historical beta (or regression versus the
stock market in the past) and assume the relationship would stay the
same going forward.
 o Wikiwealth currently uses a beta calculated by a proprietary source, but
this will change in the near future. In an effort to be more transparent,
Wikiwealth will calculate the beta using historical regressions versus the
stock market.

 Market Risk Premium: The market risk premium equals the equity risk premium
minus the risk free rate.
o The equity risk premium is the amount of return an investor expects from
equity investments. It is calculated using historical information. The risk
free rate is explained above.
o Wikiwealth uses a market risk premium of 5%, which is the long-term
conservative risk premium for the market.

Discounted Cash Flow – DCF

In finance, discounted cash flow (DCF) analysis is a method of valuing a project,

company, or asset using the concepts of the time value of money. All future cash flows
are estimated and discounted to give their present values (PVs) – the sum of all future
cash flows, both incoming and outgoing, is the net present value (NPV), which is taken
as the value or price of the cash flows in question.

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate
and gives as output a price; the opposite process – taking cash flows and a price and
inferring a discount rate, is called the yield.

Discounted cash flow analysis is widely used in investment finance, real estate
development, and corporate financial management

Mean?
A valuation method used to estimate the attractiveness of an investment opportunity.
Discounted cash flow (DCF) analysis uses future free cash flow projections and
discounts them (most often using the weighted average cost of capital) to arrive at a
present value, which is used to evaluate the potential for investment. If the value arrived
at through DCF analysis is higher than the current cost of the investment, the
opportunity may be a good one.

The most widely used method of discounting is exponential discounting, which values
future cash flows as "how much money would have to be invested currently, at a given
rate of return, to yield the cash flow in future." Other methods of discounting, such as
hyperbolic discounting, are studied in academia and said to reflect intuitive decision-
making, but are not generally used in industry.
The discount rate used is generally the appropriate Weighted average cost of capital
(WACC), that reflects the risk of the cashflows. The discount rate reflects two things:

1. The time value of money (risk-free rate) – according to the theory of time
preference, investors would rather have cash immediately than having to wait
and must therefore be compensated by paying for the delay.
2. A risk premium – reflects the extra return investors demand because they want to
be compensated for the risk that the cash flow might not materialize after all.

An alternative to including the risk in the discount rate is to use the risk free rate, but
multiply the future cash flows by the estimated probability that they will occur (the
success rate). This method, widely used in drug development, is referred to as rNPV
(risk-adjusted NPV), and similar methods are used to incorporate credit risk in the
probability model of CDS valuation.

Analysis

It can be hard to understand how stock analysts come up with "fair value" for
companies, or why their target price estimates vary so wildly. The answer often lies in
how they use the valuation method known as discounted cash flow (DCF). However,
you don't have to rely on the word of analysts. With some preparation and the right
tools, you can value a company's stock yourself using this method. This tutorial will
show you how, taking you step-by-step through a discounted cash flow analysis of a
fictional company.

In simple terms, discounted cash flow tries to work out the value of a company today,
based on projections of how much money it's going to make in the future. DCF analysis
says that a company is worth all of the cash that it could make available to investors in
the future. It is described as"discounted" cash flow because cash in the future is worth
less than cash today. (To learn more, see The Essentials Of Cash Flow and Taking
Stock Of Discounted Cash Flow.)

For example, let's say someone asked you to choose between receiving $100 today
and receiving $100 in a year. Chances are you would take the money today, knowing
that you could invest that $100 now and have more than $100 in a year's time. If you
turn that thinking on its head, you are saying that the amount that you'd have in one
year is worth $100 dollars today - or the discounted value is $100. Make the same
calculation for all the cash you expect a company to produce in the future and you have
a good measure of the company's value.

There are several tried and true approaches to discounted cash flow analysis, including
the dividend discount model (DDM) approach and the cash flow to firm approach. In this
tutorial, we will use the free cash flow to equity approach commonly used by Wall Street
analysts to determine the "fair value" of companies.
As an investor, you have a lot to gain from mastering DCF analysis. For starters, it can
serve as a reality check to the fair value prices found in brokers' reports. DCF analysis
requires you to think through the factors that affect a company, such as future sales
growth and profit margins. It also makes you consider the discount rate, which depends
on a risk-free interest rate, the company's costs of capital and the risk its stock faces. All
of this will give you an appreciation for what drives share value, and that means you can
put a more realistic price tag on the company's stock.

To demonstrate how this valuation method works, this tutorial will take you step-by-step
through a DCF analysis of a fictional company called The Widget Company. Let's begin
by looking at how to determine the forecast period for your analysis and how to forecast
revenue growth.

Calculating The Discount Rate

Having projected the company's free cash flow for the next five years, we want to figure
out what these cash flows are worth today. That means coming up with an appropriate
discount rate which we can use to calculate the net present value (NPV) of the cash
flows.

So, how do we figure out the company's discount rate? That's a crucial question,
because a difference of just one or two percentage points in the cost of capital can
make a big difference in a company's fair value.

A wide variety of methods can be used to determine discount rates, but in most cases,
these calculations resemble art more than science. Still, it is better to be generally
correct than precisely incorrect, so it is worth your while to use a rigorous method to
estimate the discount rate.

A good strategy is to apply the concepts of the weighted average cost of capital
(WACC). The WACC is essentially a blend of the cost of equity and the after-tax cost of
debt. (For more information, see Investors Need A Good WACC.) Therefore, we need to
look at how cost of equity and cost of debt are calculated.

Calculated as:

Also known as the Discounted Cash Flows Model.

Investopedia explains Discounted Cash Flow - DCF
There are many variations when it comes to what you can use for your cash flows and
discount rate in a DCF analysis. Despite the complexity of the calculations involved, the
purpose of DCF analysis is just to estimate the money you'd receive from an investment
and to adjust for the time value of money.

Discounted cash flow models are powerful, but they do have shortcomings. DCF is
merely a mechanical valuation tool, which makes it subject to the axiom "garbage in,
garbage out". Small changes in inputs can result in large changes in the value of a
company. Instead of trying to project the cash flows to infinity, terminal
value techniques are often used. A simple annuity is used to estimate the terminal value
past 10 years, for example. This is done because it is harder to come to a realistic
estimate of the cash flows as time goes on.

DCF Analysis: Pros & Cons Of DCF

Having worked our way through the mechanics of discounted cash flow analysis, it is
worth our while to examine the method's strengths and weaknesses. There is a lot to
like about the valuation tool, but there are also reasons to be cautious about it.

Advantages
Arguably the best reason to like DCF is that it produces the closest thing to an intrinsic
stock value. The alternatives to DCF are relative valuation measures, which use
multiples to compare stocks within a sector. While relative valuation metrics such as
price-earnings (P/E), EV/EBITDA and price-to-sales ratios are fairly simple to calculate,
they aren't very useful if an entire sector or market is over or undervalued. A carefully
designed DCF, by contrast, should help investors steer clear of companies that look
inexpensive against expensive peers. (To learn more, see Relative Valuation: Don't Get
Trapped.)

Unlike standard valuation tools such as the P/E ratio, DCF relies on free cash flows. For
the most part, free cash flow is a trustworthy measure that cuts through much of the
arbitrariness and "guesstimates" involved in reported earnings. Regardless of whether a
cash outlay is counted as an expense or turned into an asset on the balance sheet, free
cash flow tracks the money left over for investors.

Best of all, you can also apply the DCF model as a sanity check. Instead of trying to
come up with a fair value stock price, you can plug the company's current stock price
into the DCF model and, working backwards, calculate how quickly the company would
have to grow its cash flows to achieve the stock price. DCF analysis can help investors
identify where the company's value is coming from and whether or not its current share
price is justified.

Disadvantages
Although DCF analysis certainly has its merits, it also has its share of shortcomings. For
starters, the DCF model is only as good as its input assumptions. Depending on what
you believe about how a company will operate and how the market will unfold, DCF
valuations can fluctuate wildly. If your inputs - free cash flow forecasts, discount rates
and perpetuity growth rates - are wide of the mark, the fair value generated for the
company won't be accurate, and it won't be useful when assessing stock prices.
Following the "garbage in, garbage out" principle, if the inputs into the model are
"garbage", then the output will be similar.

DCF works best when there is a high degree of confidence about future cash flows. But
things can get tricky when a company's operations lack what analysts call "visibility" -
that is, when it's difficult to predict sales and cost trends with much certainty. While
forecasting cash flows a few years into the future is hard enough, pushing results into
eternity (which is a necessary input) is nearly impossible. The investor's ability to make
good forward-looking projections is critical - and that's why DCF is susceptible to error.

Valuations are particularly sensitive to assumptions about the perpetuity growth rates
and discount rates. Our Widget Company model assumed a cash flow perpetuity growth
rate of 4%. Cut that growth to 3%, and the Widget Company's fair value falls from
$215.3 million to $190.2 million; lift the growth to 5% and the value climbs to $248.7
million. Likewise, raising the 11% discount rate by 1% pushes the valuation down to
$182.7 million, while a 1% drop boosts the Widget Company's value to $258.9 million.

DCF analysis is a moving target that demands constant vigilance and modification. A
DCF model is never built in stone. If the Widget Company delivers disappointing
quarterly results, if its major customer files for bankruptcy, or if interest rates take a
dramatic turn, you will need to adjust your inputs and assumptions. If any time
expectations change, the fair value will change.

That's not the only problem. The model is not suited to short-term investing. DCF
focuses on long-term value. Just because your DCF model produces a fair value of
$215.3 million that does not mean that the company will trade for that any time soon. A
well-crafted DCF may help you avoid buying into a bubble, but it may also make you
miss short-term share price run-ups that can be profitable. Moreover, focusing too much
on the DCF may cause you to overlook unusual opportunities. For example, Microsoft
seemed very expensive back in 1995, but its ability to dominate the software market
made it an industry powerhouse and an investor's dream soon after.

DCF is a rigorous valuation approach that can focus your mind on the right issues, help
you see the risk and help you separate winning stocks from losers. But bear in mind that
while the DCF technique we've sketched out can help reduce uncertainty, it won't make
it disappear.

What's clear is that investors should be conservative about their inputs and should not
resist changing them when needed. Aggressive assumptions can lead to inflated values
and cause you to pay too much for a stock. The best way forward is to examine
valuation from a variety of perspectives. If the company looks inexpensive from all of
them, chances are better that you have found a bargain.

As you have seen, DCF analysis tries to work out the value of a company today, based
on projections of how much money it will generate in the future. The basic idea is that
the value of any company is the sum of the cash flows that it produces in the future,
discounted to the present at an appropriate rate.

we have shown you the basic technique used to generate fair values for the stocks that
you follow. But keep in mind that this is just one approach to doing DCF analysis; every
analyst has his or her own theories on how it should be done.

Although manually working your way through all the numbers in DCF analysis can be a
time-consuming and tricky process at times, it's not impossible. Yes, using a DCF model
probably entails a lot more work than relying on traditional valuation measures such as
the P/E ratio, but we hope this step-by-step guide has shown you that it is worth the
effort.

DCF analysis treats a company as a business rather than just a ticker symbol and a
stock price, and it requires you to think through all the factors that will affect the
company's performance. What DCF analysis really gives you is an appreciation for what
drives stock values.

At a time when financial statements are under close scrutiny, the choice of what metric
to use for making company valuations has become increasingly important. Wall Street
analysts are emphasizing cash flow-based analysis for making judgments about
company performance.

A key valuation tool at analysts' disposal is discounted cash flow (DCF) analysis.
Analysts use DCF to determine a company's current value according to its estimated
future cash flows.

Forecasted free cash flows (operating profit + depreciation + amortization of goodwill -

capital expenditures - cash taxes - change in working capital) are discounted to a
present value using the company's weighted average costs of capital. For investors
keen on gaining insights on what drives share value, few tools can rival DCF analysis.

Recent accounting scandals and inappropriate calculation of revenues and capital

expenses give DCF new importance. With heightened concerns over the quality of
earnings and reliability of standard valuation metrics like P/E ratios, more investors are
turning to free cash flow, which offers a more transparent metric for gauging
performance than earnings. It is harder to fool the cash register. Developing a DCF
model demands a lot more work than simply dividing the share price by earnings or
sales. But in return for the effort, investors get a good picture of the key drivers of share
value: expected growth in operating earnings, capital efficiency, balance sheet capital
structure, cost of equity and debt, and expected duration of growth. An added bonus is
that DCF is less likely to be manipulated by aggressive accounting practices.

DCF analysis shows that changes in long-term growth rates have the greatest impact
on share valuation. Interest rate changes also make a big difference. Consider the
numbers generated by a DCF model offered by Bloomberg Financial Markets. Sun
Microsystems, which recently traded on the market at $3.25, is valued at almost $5.50,
which makes its price of $3.25 a steal. The model assumes a long-term growth rate of
13.0%. If we cut the growth rate assumption by 25%, Sun's share valuation falls to
$3.20. If we raise the growth rate variable by 25%, the shares go up to $7.50. Similarly,
raising interest rates by one percentage point pushes the share value to $3.55; a one
percent fall in interest rates boosts the value to about $7.70.

Investors can also use the DCF model as a reality check. Instead of trying to come up
with a target share price, they can plug in the current share price and, working
backwards, calculate how fast the company would need to grow to justify the valuation.
The lower the implied growth rate, the better - less growth has therefore already been
"priced into" the stock.

Best of all, unlike comparative metrics like P/Es and price-to-sales ratios, DCF produces
a bona fide stock value. Because it does not weigh all the inputs included in a DCF
model, ratio-based valuation acts more like a beauty contest: stocks are compared to
each other rather than judged on intrinsic value. If the companies used as comparisons
are all over-priced, the investor can end up holding a stock with a share price ready for
a fall. A well-designed DCF model should, by contrast, keep investors out of stocks that
look cheap only against expensive peers.

DCF models are powerful, but they do have shortcomings. DCF is merely a mechanical
valuation tool, which makes it subject to the axiom "garbage in, garbage out". Small
changes in inputs can result in large changes in the value of a company. Investors must
constantly second-guess valuations; the inputs that produce these valuations are
always changing and susceptible to error.

Meaningful valuations depend on the user's ability to make solid cash flow projections.
While forecasting cash flows more than a few years into the future is difficult, crafting
results into eternity (which is a necessary input) is near impossible. A single,
unexpected event can immediately make a DCF model obsolete. By guessing at what a
decade of cash flow is worth today, most analysts limit their outlook to 10 years.
Investors should watch out for DCF models that are taken to ridiculous lengths.
Samantha Gleave, a London-based analyst with Credit Suisse First Boston, published a
DCF model for Eurotunnel that runs through 2085!

These are not the only problems. With its focus on long-range investing, the DCF model
isn't suited for short-term investments. A model that shows that Sun Microsystems is
worth $5.50 does not mean that it will trade for that any time soon; furthermore, over-
reliance on DCF can cause investors to overlook unusual opportunities. DCF can
prevent investors from buying into a market bubble. DCF can also prompt investors to
sell, which might mean they miss those big share price run-ups that can be so profitable
(provided the shares are sold at the peak).

Don't base your decision to buy a stock solely on discounted cash flow analysis. It is a
moving target, full of challenges. If the company fails to meet financial performance
expectations, if one of its big customers jumps to a competitor, or if interest rates take
an unexpected turn, the model's numbers have to be re-run. Any time expectations
change, the DCF-generated value is going to change.

Annuity

What Does Annuity Mean?

A financial product sold by financial institutions that is designed to accept and grow
funds from an individual and then, upon annuitization, pay out a stream of payments to
the individual at a later point in time. Annuities are primarily used as a means of
securing a steady cash flow for an individual during their retirement years.

Investopedia explains Annuity

Annuities can be structured according to a wide array of details and factors, such as the
duration of time that payments from the annuity can be guaranteed to continue.
Annuities can be created so that, upon annuitization, payments will continue so long as
either the annuitant or their spouse is alive. Alternatively, annuities can be structured to
pay out funds for a fixed amount of time, such as 20 years, regardless of how long the
annuitant lives.

Annuities can be structured to provide fixed periodic payments to the annuitant or

variable payments. The intent of variable annuities is to allow the annuitant to receive
greater payments if investments of the annuity fund do well and smaller payments if its
investments do poorly. This provides for a less stable cash flow than a fixed annuity, but
allows the annuitant to reap the benefits of strong returns from their fund's investments.

The different ways in which annuities can be structured provide individuals seeking
annuities the flexibility to construct an annuity contract that will best meet their needs.

Perpetuity

What Does Perpetuity Mean?

A constant stream of identical cash flows with no end. The formula for determining
the present value of a perpetuity is as follows:
Investopedia explains Perpetuity
This is not as abstract a concept as you may think; the British issued bonds,
called consols, which are a great example of a perpetuity. By purchasing a consol from
the British government, the bondholder is entitled to receive annual interest payments
forever. Although it may seem a bit illogical, an infinite series of cash flows can have a
finite present value. Because of the time value of money, each payment is only a
fraction of the last.

The concept of a perpetuity is used often in financial theory, such as the dividend
discount model (DDM).

Capital Budgeting

What Does Capital Budgeting Mean?

The process in which a business determines whether projects such as building a new
plant or investing in a long-term venture are worth pursuing. Oftentimes, a prospective
project's lifetime cash inflows and outflows are assessed in order to determine whether
the returns generated meet a sufficient target benchmark.

Also known as "investment appraisal".

Investopedia explains Capital Budgeting

Ideally, businesses should pursue all projects and opportunities that enhance
shareholder value. However, because the amount of capital available at any given time
for new projects is limited, management needs to use capital budgeting techniques to
determine which projects will yield the most return over an applicable period of time.

Popular methods of capital budgeting include net present value (NPV), internal rate of
return (IRR), discounted cash flow (DCF) and payback period.

Capital Structure

In finance, capital structure refers to the way a corporation finances its assets through
some combination of equity, debt, or hybrid securities. A firm's capital structure is then
the composition or 'structure' of its liabilities. For example, a firm that sells $20 billion in
equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed.
The firm's ratio of debt to total financing, 80% in this example, is referred to as the firm's
leverage. In reality, capital structure may be highly complex and include dozens of
sources. Gearing Ratio is the proportion of the capital employed of the firm which come
from outside of the business finance, e.g. by taking a short term loan etc.
The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms
the basis for modern thinking on capital structure, though it is generally viewed as a
purely theoretical result since it assumes away many important factors in the capital
structure decision. The theorem states that, in a perfect market, how a firm is financed
is irrelevant to its value. This result provides the base with which to examine real world
reasons why capital structure is relevant, that is, a company's value is affected by the
capital structure it employs. Some other reasons include bankruptcy costs, agency
costs, taxes, and information asymmetry. This analysis can then be extended to look at
whether there is in fact an optimal capital structure: the one which maximizes the value
of the firm

As companies benefit from the tax deductions available on interest paid, the net cost of
the debt is actually the interest paid less the tax savings resulting from the tax-
deductible interest payment. Therefore, the after-tax cost of debt is Rd (1 - corporate tax
rate).

Finally, Capital Structure

The WACC is the weighted average of the cost of equity and the cost of debt based on
the proportion of debt and equity in the company's capital structure. The proportion of
debt is represented by D/V, a ratio comparing the company's debt to the company's
total value (equity + debt). The proportion of equity is represented by E/V, a ratio
comparing the company's equity to the company's total value (equity + debt). The
WACC is represented by the following formula: WACC = Re x E/V + Rd x (1 - corporate
tax rate) x D/V.

A company's WACC is a function of the mix between debt and equity and the cost of
that debt and equity. On the one hand, in the past few years, falling interest rates have
reduced the WACC of companies. On the other hand, corporate disasters like those at
Enron and WorldCom have increased the perceived risk of equity investments.

Be warned: the WACC formula seems easier to calculate than it really is. Rarely will two
people derive the same WACC, and even if two people do reach the same WACC, all
the other applied judgments and valuation methods will likely ensure that each has a
different opinion regarding the components that comprise the company's value.

What Does Capital Structure Mean?

A mix of a company's long-term debt, specific short-term debt, common equity and
preferred equity. The capital structure is how a firm finances its overall operations and
growth by using different sources of funds.

Debt comes in the form of bond issues or long-term notes payable, while equity is
classified as common stock, preferred stock or retained earnings. Short-term debt such
as working capital requirements is also considered to be part of the capital structure.

Investopedia explains Capital Structure

A company's proportion of short and long-term debt is considered when analyzing
capital structure. When people refer to capital structure they are most likely referring to
a firm's debt-to-equity ratio, which provides insight into how risky a company is. Usually
a company more heavily financed by debt poses greater risk, as this firm is relatively
highly levered.

The weighted average cost of capital (WACC) is the rate that a company is expected
to pay on average to all its security holders to finance its assets.

The WACC is the minimum return that a company must earn on an existing asset base
to satisfy its creditors, owners, and other providers of capital, or they will invest
elsewhere. Companies raise money from a number of sources: common equity,
preferred equity, straight debt, convertible debt, exchangeable debt, warrants, options,
pension liabilities, executive stock options, governmental subsidies, and so on. Different
securities, which represent different sources of finance, are expected to generate
different returns. The WACC is calculated taking into account the relative weights of
each component of the capital structure. The more complex the company's capital
structure, the more laborious it is to calculate the WACC.

Companies can use WACC to see if an investment projects available to them are
worthwhile to undertake

Widget Company WACC

Returning to our example, let's suppose The Widget Company has a capital structure of
40% debt and 60% equity, with a tax rate of 30%. The borrowing rate (Rd) on the
company's debt is 5%. The risk-free rate (Rf) is 5%, the beta is 1.3 and the risk premium
(Rp) is 8%. The WACC comes to 10.64%. So, rounded up to the nearest percentage,
the discount rate for The Widget Company would be 11% .

 WACC is the weighted average cost of capital. An expanded definition is

available by clicking here.

How does Wikiwealth use the WACC?

 Wikiwealth projects the expected free cash flow of a business and discounts
those cash flows using the WACC calculation.
o However, the WACC calculation is currently company specific, whereas a
better measure would be to use an industry WACC calculation. In the near
future, Wikiwealth will convert all WACC calculation to take an industry
number.
Why is an industry WACC more accurate?

 Wikiwealth makes the assumption that an industry average WACC calculation is

the optimal configuration of a company. If a company has more debt than the rest
of the industry, we assume company-specific debt level will match the industry
level in the future. The same assumption is made for equity, taxes, beta and
Determine the percentage of equity in a company?

 The equation equals the percentage of equity divided by total capital in a

company.
o Equity equals the stock price multiplied by the shares outstanding. Shares
outstanding are found on the cover of financial statements.

Determine the percentage of debt in a company?

 Wikiwealth adds long term and short term interest bearing debt plus capital
leases, preferred debt and minority interest to equal total debt in a target
company. These are all the debt holders in the company who have claim to the
equity of the company in case of bankruptcy.
o Why do we use interest-bearing debt? This is the return owed to debt
holders of the company. In the cash flow valuation, we determine the
value of the total company to both equity and debt holders combined. So
part of the cash flow goes to debt holders and the rest goes to equity
holders.
 We find cash flow to both debt and equity combined, because it
requires fewer assumptions and is thus a less risky valuation
model.

What is the Country Risk Premium?

 This is the added premium needed by investors in order to invest in risky

countries. The CPR is added to the cost of equity (required return on equity).
o There is no risk premium for the United States or many other developed
countries with fluid capital markets.

What is Alpha?

 The risk factors not incorporated into the financial data of a company, such as in
the case of bankruptcy or other financial distress. Wikiwealth adds alpha to the
ending value of the WACC.

Why do we round the WACC calculation?

 We at Wikiwealth are not genius, so we round the WACC to indicate that the
value is very difficult to predict with accuracy. A non-rounded number creates the
illusion of perfection and contributes to manipulation of the results. Hopefully,
 only fundamental changes will cause differences in the value of the WACC and
thus the company’s value.

WACC (weighted average cost of capital) Definition

Weighted Average Cost of Capital (WACC). The two components of capital include the
cost of debt and the cost of equity capital. The weighted average cost of capital (WACC)
is the rate that a company is expected to pay to finance its assets. WACC is the
minimum return that a company must earn on their existing asset base to satisfy its
creditors, owners, and other providers of capital.

The Industry WACC is an average WACC measurement for companies in an industry.

The Industry WACC used statistics such as debt, equity, tax rate, beta measurements
to find the correct average WACC for an industry. Wikiwealth applies the industry
WACC to individual companies to find a stable and optimal WACC discount rate for that
particular company. All individual companies are expected to converge to the industry
WACC over time.

Companies raise money from a number of sources: common equity, preferred equity,
straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities,
executive stock options, governmental subsidies, and so on. Different securities are
expected to generate different returns. WACC is calculated taking into account the
relative weights of each component of the capital structure. Calculation of WACC for a
company with a complex capital structure is a laborious exercise.

WACC = wd (1-T) rd + we re

wd = debt portion of value of corporation

T = tax rate
rd = cost of debt (rate)
we = equity portion of value of corporation
re = cost of internal equity (rate)
How it works

Since we are measuring expected cost of new capital, we should use the market values
of the components, rather than their book values (which can be significantly different). In
addition, other, more "exotic" sources of financing, such as convertible/callable bonds,
convertible preferred stock, etc., would normally be included in the formula if they exist
in any significant amounts - since the cost of those financing methods is usually
different from the plain vanilla bonds and equity due to their extra features.

WACC is a special way to measure the capital discount of the firms gaining and
spending.

Sources of information

How do we find out the values of the components in the formula for WACC? First let us
note that the "weight" of a source of financing is simply the market value of that piece
divided by the sum of the values of all the pieces. For example, the weight of common
equity in the above formula would be determined as follows:

Market value of common equity / (Market value of common equity + Market value of
debt + Market value of preferred equity).

So, let us proceed in finding the market values of each source of financing (namely the
debt, preferred stock, and common stock).

 The market value for equity for a publicly traded company is simply the price per
share multiplied by the number of shares outstanding, and tends to be the
easiest component to find.

 The market value of the debt is easily found if the company has publicly traded
bonds. Frequently, companies also have a significant amount of bank loans,
whose market value is not easily found. However, since the market value of debt
tends to be pretty close to the book value (for companies that have not
experienced significant changes in credit rating, at least), the book value of debt
is usually used in the WACC formula.

 The market value of preferred stock is again usually easily found on the market,
and determined by multiplying the cost per share by number of shares
outstanding.

Now, let us take care of the costs.

 Preferred equity is equivalent to a perpetuity, where the holder is entitled to fixed

payments forever. Thus the cost is determined by dividing the periodic payment
by the price of the preferred stock, in percentage terms.
  The cost of common equity is usually determined using the capital asset pricing
model.

 The cost of debt is the yield to maturity on the publicly traded bonds of the
company. Failing availability of that, the rates of interest charged by the banks on
recent loans to the company would also serve as a good cost of debt. Since a
corporation normally can write off taxes on the interest it pays on the debt,
however, the cost of debt is further reduced by the tax rate that the corporation is
subject to. Thus, the cost of debt for a company becomes (YTM on bonds or
interest on loans) × (1 − tax rate). In fact, the tax deduction is usually kept in the
formula for WACC, rather than being rolled up into cost of debt, as such:

WACC = weight of preferred equity × cost of preferred equity

 + weight of common equity × cost of common equity

 + weight of debt × cost of debt × (1 − tax rate).

And now we are ready to plug all our data into the WACC formula.

WACC for The Widget Company

Cost of Debt Cost of Equity

0.40 [Rd x (1-.30)] + 0.60 [RF + b(RP)]

0.40 [5.0 x 0.7)] + 0.60 [5.0 + 1.3(8)]

0.40 [3.5] + 0.60 [15.4]

1.40 + 9.24

WACC 10.64%

Rounded WACC 11%

Figure 1
Capital Market Line - CML

What Does Capital Market Line - CML Mean?

A line used in the capital asset pricing model to illustrate the rates of return for efficient
portfolios depending on the risk-free rate of return and the level of risk
(standard deviation) for a particular portfolio.

Investopedia explains Capital Market Line - CML

The CML is derived by drawing a tangent line from the intercept point on the efficient
frontier to the point where the expected return equals the risk-free rate of return.
The CML is considered to be superior to the efficient frontier since it takes into account
the inclusion of a risk-free asset in the portfolio. The capital asset pricing model (CAPM)
demonstrates that the market portfolio is essentially the efficient frontier. This is
achieved visually through the security market line (SML).

Modern Portfolio Theory: Why It's Still Hip

by Ben McClure (Contact Author | Biography)

If you were to craft the perfect investment, you would probably want its attributes to
include high returns coupled with low risk. The reality, of course, is that this kind of
investment is next to impossible to find. Not surprisingly, people spend a lot of time
developing methods and strategies that come close to the "perfect investment". But
none is as popular, or as compelling, as modern portfolio theory (MPT). Here we look at
the basic ideas behind MPT, the pros and cons of the theory, and how MPT affects the
management of your portfolio.

The Theory
One of the most important and influential economic theories dealing with finance and
investment, MPT was developed by Harry Markowitz and published under the title
"Portfolio Selection" in the 1952 Journal of Finance. MPT says that it is not enough to
look at the expected risk and return of one particular stock. By investing in more than
one stock, an investor can reap the benefits of diversification - chief among them, a
reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification,
also known as not putting all of your eggs in one basket.

For most investors, the risk they take when they buy a stock is that the return will be
lower than expected. In other words, it is the deviation from the average return. Each
stock has its own standard deviation from the mean, which MPT calls "risk".

The risk in a portfolio of diverse individual stocks will be less than the risk inherent in
holding any one of the individual stocks (provided the risks of the various stocks are not
directly related). Consider a portfolio that holds two risky stocks: one that pays off when
it rains and another that pays off when it doesn't rain. A portfolio that contains both
assets will always pay off, regardless of whether it rains or shines. Adding one risky
asset to another can reduce the overall risk of an all-weather portfolio.

In other words, Markowitz showed that investment is not just about picking stocks, but
about choosing the right combination of stocks among which to distribute one's nest
egg. (To learn more, see Introduction To Diversification and The Importance Of
Diversification.)

Two Kinds of Risk

Modern portfolio theory states that the risk for individual stock returns has two
components:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates,
recessions and wars are examples of systematic risks.

Unsystematic Risk - Also known as "specific risk", this risk is specific to individual stocks
and can be diversified away as you increase the number of stocks in your portfolio (see
Figure 1). It represents the component of a stock's return that is not correlated with
general market moves.

For a well-diversified portfolio, the risk - or average deviation from the mean - of each
stock contributes little to portfolio risk. Instead, it is the difference - or covariance -
between individual stock's levels of risk that determines overall portfolio risk. As a result,
investors benefit from holding diversified portfolios instead of individual stocks.

Figure 1

The Efficient Frontier

Now that we understand the benefits of diversification, the question of how to identify
the best level of diversification arises. Enter the efficient frontier.

For every level of return, there is one portfolio that offers the lowest possible risk, and
for every level of risk, there is a portfolio that offers the highest return. These
combinations can be plotted on a graph, and the resulting line is the efficient frontier.
Figure 2 shows the efficient frontier for just two stocks - a high risk/high return
technology stock (Google) and a low risk/low return consumer products stock (Coca
Cola).
 Figure 2

Any portfolio that lies on the upper part of the curve is efficient: it gives the maximum
expected return for a given level of risk. A rational investor will only ever hold a portfolio
that lies somewhere on the efficient frontier. The maximum level of risk that the investor
will take on determines the position of the portfolio on the line.

Modern portfolio theory takes this idea even further. It suggests that combining a stock
portfolio that sits on the efficient frontier with a risk-free asset, the purchase of which is
funded by borrowing, can actually increase returns beyond the efficient frontier. In other
words, if you were to borrow to acquire a risk-free stock, then the remaining stock
portfolio could have a riskier profile and, therefore, a higher return than you might
otherwise choose.

What MPT Means for You

Modern portfolio theory has had a marked impact on how investors perceive risk, return
and portfolio management. The theory demonstrates that portfolio diversification can
reduce investment risk. In fact, modern money managers routinely follow its precepts.

That being said, MPT has some shortcomings in the real world. For starters, it often
requires investors to rethink notions of risk. Sometimes it demands that the investor
take on a perceived risky investment (futures, for example) in order to reduce overall
risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated
portfolio management techniques. Furthermore, MPT assumes that it is possible to
select stocks whose individual performance is independent of other investments in the
portfolio. But market historians have shown that there are no such instruments; in times
of market stress, seemingly independent investments do, in fact, act as though they are
related.

Likewise, it is logical to borrow to hold a risk-free asset and increase your portfolio
returns, but finding a truly risk-free asset is another matter. Government-backed bonds
are presumed to be risk free, but, in reality, they are not. Securities such as gilts
and U.S. Treasury bonds are free of default risk, but expectations of higher inflation and
interest rate changes can both affect their value.

Then there is the question of the number of stocks required for diversification. How
many is enough? Mutual funds can contain dozens and dozens of stocks. Investment
guru William J. Bernstein says that even 100 stocks is not enough to diversify away
unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book
"Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would
come very close to achieving optimal diversity after adding the twentieth stock.

Conclusion
The gist of MPT is that the market is hard to beat and that the people who beat the
market are those who take above-average risk. It is also implied that these risk takers
will get their comeuppance when markets turn down.

Then again, investors such as Warren Buffett remind us that portfolio theory is just that -
theory. At the end of the day, a portfolio's success rests on the investor's skills and the
time he or she devotes to it. Sometimes it is better to pick a small number of out-of-favor
investments and wait for the market to turn in your favor than to rely on market
averages alone