cost of capital, beta, risk, risky project,weighted average cost of capital, market efficiency, semi-efficient market, weak efficient market

1. Lecture 7
use of CAPM for calculating
cost of Capital for risky project
and efficient market
By Muhammad Shafiq
forshaf@gmail.com
http://www.slideshare.net/forshaf

2. Basic terms
• You get compensated for taking on systematic risk measured by beta. Std
Dev measure volatility due to both systematic and unsystematic risk.
• Beta Means: A measure of the volatility, or systematic risk, of a security or
a portfolio in comparison to the market as a whole. Beta is used in the
capital asset pricing model (CAPM), a model that calculates the expected
return of an asset based on its beta and expected market returns
• Beta is calculated using regression analysis, and you can think of beta as
the tendency of a security's returns to respond to swings in the market.
• A beta of 1 indicates that the security's price will move with the market. A
beta of less than 1 means that the security will be less volatile than the
market. A beta of greater than 1 indicates that the security's price will be
more volatile than the market. For example, if a stock's beta is 1.2, it's
theoretically 20% more volatile than the market

3. Introduction: Cost of Capital
 Expected return on a portfolio of all the company’s existing securities.
 It is the opportunity for investment in the firm’s assets
 Hence, the appropriate discount for the firm’s risk projects
 If company has no debt outstanding then the cost of capital is just the
expected rate of return on firm’s stock
 Eg
a company has beta of about 0.55, risk free rate is 7.4 and
market risk premium is 8% then CAPM would imply rate of return:
r= rf +[(Beta (rm)] =.074+ .55*.08

4. Cost of Capital and risk factor
• Two project, never have the same expected rate of return
• Based on the risk factor
• More the risk, higher the expected rate of return
Security market line showing RoR on project
11.8 company CoC
7.4
project beta
Average beta of company investment=0.55
Figure showing a comparison between the company CoC and the RoR under the CAPM at 11.8% returns. It is correct only if project beta 0.55.
** correct discount rate increase with increase of beta. Company should accept the project with the rate of return above security line

6. Perfect pitch and the cost of capital
• If true cost of capital depends on risk of project then why time is
spent on estimating more time on company CoC (Cost of Capital):
Two reasons:
• Company CoC is good starting point to estimate a project (whether more risky
or less risky).
• For average risky or less risky project company CoC is considered the best rate

7. Debt and the Company CoC(Cost of Capital)
• Portfolio usually includes debt and equity, so, it is blend of two
• Suppose the company market value Balance Sheet looks as:
• CoC is different as we can calculate:
company CoC = rD D/V + rE E/V
=7.5*.30 + 15 *.70 = 12.75%
rD = Ror on debt D = Debt V = value rE required rate on equity E = equity
This Blended measure of company is weighted average cost of Capital (WACC)
Debt D=30 at 7.5%
Equity E=70 at 15%Asset Value 100
Firm Value value=100Asset Value 100

8. Calculating WACC
• Calculating WACC is bit complicated than our last example
Suppose: Interest is a tax-deductible expense for corporations so after
tax Cost of Debt is (1- t) rD, where Tc is the marginal corporate tax rate.
If Te = 35%. Then after tax WACC is:
After tax WACC = (1-tc) rD D/V + rE E/V
rD = Ror on debt D = Debt V = value rE required rate on equity
E = equity

9. Measuring the cost of equity
• To calculate the weighted-average CoC, you need an estimate of cost
of equity
• You decide to use CAPM as most US companies do; CAPM says;
expected stock return= rf = + Beta (rm - rf)

10. Estimating beta
• Future beta are estimated by historical evidence
• We fit a line through the points(different dots).
• Slope of the line is an estimate of beta; tells how much on average
the stock price changed when the market index are 1% higher/lower.
• Small risk from market but specific/non systematic risk.
• R squared (R2) provides the proportion of total variation in the stock’s
return that can be explained by market movement.

11. Estimating beta
• Generally returns obscure beta
• Hence, statisticians calculate standard error of the estimated beta to
shoe the extent of possible mismeasurement
• Then they setup confidence Interval of the value plus or minus two
standard error.
example. Confidence interval for PTCL beta is 0.34 plus or minus1.96*
.029. if you state that the true beta for PTCL company is between 0.29
and 0.4, you have 95% chance of being right.
• Financial managers often turn their attention toward industry betas

12. The expected return on Pakistan State Oil (PSO)
• You are asked to calculate CoC of PSO. We have two clues about the
true beta: one PSO direct estimate is 0.45 and average industry
estimate is 0.86. so we use industry average as Financial manager.
Next issue is to estimate the risk free interest rate, we can get it from
central Bank (State bank of Pakistan) T-bills rate which is on average
7.31.
• Since, CAPM is short term model. It works period to period and ask
for short term rate. Can a project use CAPM rate for 1 year to 10 year
in future
• FM can use long term rate in risk free rate or retains the difference
between the market risk premium and short term T-bills.
• Suppose you decide to use a market risk premium of 10% and risk ree
rate is 7.37% then we can calculate as:
• Cost of Equity= expected stock return= rf = + Beta (rm - rf)
= 7.4+0.86*10 = 16%

13. PSO after tax weighted average cost of Capital
• If calculate WACC then the company cost of debt was about 9% with
34% a corporate tax rate, the after tax cost of debt was:
• rD (1-tc)=9*(1-0.34)= 5.94%
• The ratio of debt to overall company value was D/V =7% therefore
After tax WACC = (1-tc) rD D/V + rE E/V
=(1-0.34)*9*0.07+16*0.93= 15.29%
Note: the formula is using debt which always less than equity.
Not suggested for acute calculation

14. PSO asset beta(β)
• After tax WACC depends on average risk of the company asst but also
depends on tax and financing.
• Direct measure is called the beta of asset
We calculate the asset beta as a blend of the separate betas of debt (βD)
and equity (βE). For Pakistan State oil company we have (βE)=0.86 and
(βD) =0.1610
Weights are the fraction of debt and equity financing, D/V=0.07 and
E/V= 0.93 then asset beta will be:
Asset beta ((βa) = (βD) (D/V) + (βE) (E/V)
= 0.16*0.07+ 0.86*0.93 = 0.81

15. Analyzing project risk

16. 1. Introduction
• The cost of capital is the cost of using the funds of creditors and
owners.
• Creating value requires investing in capital projects that provide a
return greater than the project’s cost of capital.
• When we view the firm as a whole, the firm creates value when it provides a
return greater than its cost of capital.
• Estimating the cost of capital is challenging.
• We must estimate it because it cannot be observed.
• We must make a number of assumptions.
• For a given project, a firm’s financial manager must estimate its cost of
capital.
Copyright © 2013 CFA Institute16

17. 2. Cost of capital
• The cost of capital is the rate of return that the suppliers of capital—
bondholders and owners—require as compensation for their
contributions of capital.
• This cost reflects the opportunity costs of the suppliers of capital.
• The cost of capital is a marginal cost: the cost of raising additional
capital.
• The weighted average cost of capital (WACC) is the cost of raising
additional capital, with the weights representing the proportion of
each source of financing that is used.
• Also known as the marginal cost of capital (MCC).
Copyright © 2013 CFA Institute17

18. CAPM is a model that describes the relationship between
risk and expected (required) return; in this model, a
security’s expected (required) return is the risk-free rate
plus a premium based on the systematic risk of the
security.
Works for both individual assets and portfolios
• A model that describes the relationship between risk and expected
return and that is used in the pricing of risky securities.
• default model for risk in equity valuation and corporate finance.
• The general idea behind CAPM is that investors need to be
compensated in two ways: time value of money and risk
Capital Asset Pricing Model (CAPM)

19. Definition: Efficient Capital Markets
• In an efficient capital market, security prices adjust
rapidly to the arrival of new information, therefore the
current prices of securities reflect all information about
the security
• Whether markets are efficient has been extensively
researched and remains controversial

20. Corporate Financing Decisions and Efficient
Capital Markets
• An efficient market is one in which current market prices reflect all
available information.
• What information is available? Depends on costs/benefits of
collection/evaluation/use of information.
• We will see that the EMH has strong implications for
investors/firms/financial managers.

21. Preview – An Efficient Market
• Because information is reflected in prices immediately,
investors should only expect to obtain an equilibrium
rate of expected return (as predicted by the SML).
Awareness of information when it is released does the
investor no good. The price adjusts before the
investor can trade on it.
• Firms should expect to receive a fair value for securities they
issue.
• Financial managers cannot time issues of securities.
• A firm can sell as many shares of stock or as many bonds as
it wants without fear of depressing the price.
• Stock and bond markets cannot (barring fraud) be affected
by firms artificially increasing earnings (cooking the books).

22. Stock
Price Overreaction and
reversion
Early
response
Delayed response
Efficient market
response to new information
Days before (–) and
after(+) announcement
Public announcement day
Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
–30 –20 –10 0 +10 +20 +30

23. Market Efficiency
• Weak Form Efficiency
• A capital market is said to be weakly efficient or to satisfy weak-
form efficiency if current prices fully incorporate the information
in past prices (more generally trading information).
• In a financial market that is weak form efficient, investors can't
trade on the basis of past returns and expect abnormal profits.

24. Market Efficiency
• Semi-Strong Form Efficiency
• A market is said to be semi-strong form efficient if current market prices fully
incorporate all publicly available information (e.g., information in the WSJ).
• Since past prices are publicly available information, if a market is semi-strong
form efficient, it is necessarily weak form efficient.
• In a market that is semi-strong form efficient investors cannot trade based on
publicly available information and expect profits in excess of an equilibrium
expected return (as specified by, for example, the SML).

25. Corporate Insider Trading
• Corporate insiders include major corporate officers, directors, and
owners of 10% or more of any equity class of securities
• Insiders must report to the SEC each month on their transactions in
the stock of the firm for which they are insiders
• These insider trades are made public about six weeks later and
allowed to be studied

26. Role of Corporate Insider Trading
• Corporate insiders generally experience above-average profits
especially on purchase transaction
• This implies that many insiders had private information from which
they derived above-average returns on their company stock

27. Corporate Insider Trading
• Studies showed that public investors who traded with the insiders
based on announced transactions would have enjoyed excess risk-
adjusted returns (after commissions), but the markets now seem to
have eliminated this inefficiency (soon after it was discovered)

28. Corporate Insider Trading
• Other studies indicate that you can increase returns from using
insider trading information by combining it with key financial ratios
and considering what group of insiders is doing the buying and selling

29. Stock Exchange Specialists
• Specialists have monopolistic access to information about unfilled
limit orders
• You would expect specialists to derive above-average returns from
this information
• The data generally supports this expectation

30. Security Analysts
• Tests have considered whether it is possible to identify a set of
analysts who have the ability to select undervalued stocks
• This looks at whether, after a stock selection by an analyst is made
known, a significant abnormal return is available to those who follow
their recommendations

31. Professional Money Managers
• Trained professionals, working full time at investment management
• If any investor can achieve above-average returns, it should be this
group
• If any non-insider can obtain inside information, it would be this
group due to the extensive management interviews that they conduct

32. Performance of Professional Money
Managers
• Most tests examine mutual funds
• New tests also examine trust departments, insurance companies, and
investment advisors
• Risk-adjusted, after expenses, returns of mutual funds generally show
that most funds did not match aggregate market performance

33. Implications of Efficient Capital Markets
• Overall results indicate the capital markets are efficient as related to
numerous sets of information
• There are substantial instances where the market fails to rapidly
adjust to public information

34. Efficient Markets and Technical Analysis
• Assumptions of technical analysis directly oppose the notion of
efficient markets
• Technicians believe that new information is not immediately available
to everyone, but disseminated from the informed professional first to
the aggressive investing public and then to the masses

35. Efficient Markets and Technical Analysis
• Technicians also believe that investors do not analyze information and
act immediately - it takes time
• Therefore, stock prices move to a new equilibrium after the release of
new information in a gradual manner, causing trends in stock price
movements that persist for periods

36. Efficient Markets and Fundamental Analysis
• Fundamental analysts believe that there is a basic intrinsic value for
the aggregate stock market, various industries, or individual securities
and these values depend on underlying economic factors
• Investors should determine the intrinsic value of an investment at a
point in time and compare it to the market price

37. Why Should Capital Markets Be Efficient?
The assumptions of an efficient market
• 1. A large number of competing profit-maximizing
participants analyze and value securities, each
independently of the others
• 2. New information regarding securities comes to the
market in a random fashion, new information is not
predictable.
• 3. Profit-maximizing investors adjust security prices rapidly
to reflect the effect of new information
Conclusion: random unpredictable information + large
competing investors react to news 

38. Thank you very much for your time and
discussion