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Estimating Hurdle Rates I: Defining & Measuring Risk

The document discusses estimating hurdle rates by defining and measuring risk. It notes that risk is both danger and opportunity, not purely negative. A simple representation of the hurdle rate is: Hurdle Rate = Risk-free Rate + Risk Premium It also discusses two key questions financial models try to answer: how to measure risk, and how to translate the risk measure into a risk premium. Finally, it outlines the investment, financing, and dividend decisions a firm must make to maximize value, and how risk affects each decision.

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Anshik Bansal
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
73 views

Estimating Hurdle Rates I: Defining & Measuring Risk

The document discusses estimating hurdle rates by defining and measuring risk. It notes that risk is both danger and opportunity, not purely negative. A simple representation of the hurdle rate is: Hurdle Rate = Risk-free Rate + Risk Premium It also discusses two key questions financial models try to answer: how to measure risk, and how to translate the risk measure into a risk premium. Finally, it outlines the investment, financing, and dividend decisions a firm must make to maximize value, and how risk affects each decision.

Uploaded by

Anshik Bansal
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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ESTIMATING

HURDLE RATES I:
DEFINING & MEASURING RISK
Risk = Danger + Opportunity

Set Up and Objective


1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk


5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision


Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision


If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

First Principles
Maximize the value of the business (firm)

The Investment Decision


Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate

The hurdle rate


should reflect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.

The return should


reflect the
magnitude and
the timing of the
cashflows as welll
as all side effects.

The Financing Decision


Find the right kind of debt
for your firm and the right
mix of debt and equity to
fund your operations

The optimal
mix of debt
and equity
maximizes firm
value

The right kind


of debt
matches the
tenor of your
assets

The Dividend Decision


If you cannot find investments
that make your minimum
acceptable rate, return the cash
to owners of your business

How much
cash you can
return
depends upon
current &
potential
investment
opportunities

How you choose


to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks

The noGon of a benchmark

Since nancial resources are nite, there is a hurdle that


projects have to cross before being deemed acceptable.
This hurdle will be higher for riskier projects than for
safer projects.
A simple representaGon of the hurdle rate is as follows:
Hurdle rate =
Riskless Rate + Risk Premium
The two basic quesGons that every risk and return model
in nance tries to answer are:
How do you measure risk?
How do you translate this risk measure into a risk premium?

What is Risk?

Risk, in tradiGonal terms, is viewed as a negaGve.


Websters dicGonary, for instance, denes risk as exposing
to danger or hazard. The Chinese symbols for risk,
reproduced below, give a much beXer descripGon of risk:

The rst symbol is the symbol for danger, while the second
is the symbol for opportunity, making risk a mix of danger
and opportunity. You cannot have one, without the other.
Risk is therefore neither good nor bad. It is just a fact of life.
The quesGon that businesses have to address is therefore not
whether to avoid risk but how best to incorporate it into their
decision making.

AlternaGves to the CAPM


Step 1: Defining Risk
The risk in an investment can be measured by the variance in actual returns around an
expected return
Riskless Investment
Low Risk Investment
High Risk Investment

E(R)
E(R)
E(R)
Step 2: Differentiating between Rewarded and Unrewarded Risk
Risk that is specific to investment (Firm Specific)
Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio
Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio
are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a diversified portfolio. Thus, only market risk will
be rewarded and priced.
Step 3: Measuring Market Risk
The CAPM
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold thismarket portfolio
Market Risk = Risk
added by any investment
to the market portfolio:
Beta of asset relative to
Market portfolio (from
a regression)

The APM
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors
Betas of asset relative
to unspecified market
factors (from a factor
analysis)

Multi-Factor Models
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.

Proxy Models
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Betas of assets relative Equation relating
to specified macro
returns to proxy
economic factors (from variables (from a
a regression)
regression)

LimitaGons of the CAPM


1. The model makes unrealisGc assumpGons
2. The parameters of the model cannot be esGmated
precisely
- DeniGon of a market index
- Firm may have changed during the 'esGmaGon' period'

3. The model does not work well

- If the model is right, there should be


a linear relaGonship between returns and betas
the only variable that should explain returns is betas
- The reality is that
the relaGonship between betas and returns is weak
Other variables (size, price/book value) seem to explain
dierences in returns beXer.
7

Why the CAPM persists

The CAPM, notwithstanding its many criGcs and limitaGons, has survived
as the default model for risk in equity valuaGon and corporate nance.
The alternaGve models that have been presented as beXer models (APM,
MulGfactor model..) have made inroads in performance evaluaGon but
not in prospecGve analysis because:

The alternaGve models (which are richer) do a much beXer job than the CAPM in
explaining past return, but their eecGveness drops o when it comes to
esGmaGng expected future returns (because the models tend to shid and change).
The alternaGve models are more complicated and require more informaGon than
the CAPM.
For most companies, the expected returns you get with the the alternaGve models
is not dierent enough to be worth the extra trouble of esGmaGng four addiGonal
betas.

Gauging the marginal investor: Disney in 2009

Extending the assessment of the investor base

In all ve of the publicly traded companies that we are looking at,


insGtuGons are big holders of the companys stock.

10

6ApplicaGon Test: Who is the marginal investor in


your rm?

Looking at the breakdown of stockholders in your


rm, consider whether the marginal investor is
An insGtuGonal investor
An individual investor
An insider

B DES Page 3
PB Page 13

11

Task
Who is the
marginal
investor in
your rm?

12

Read
Chapter 3

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