Live Case Study

Risk and Return: Analysis for the Firm Objective: To develop a risk profile for your company, estimate its risk parameters and use these parameters to estimate costs of equity and capital for the firm.

Key Questions:

• What is the risk profile of your company? (How much overall risk is there in this firm? Where is this risk coming from (market, firm, industry or currency)? How is the risk profile changing?)

• What is the performance profile of an investment in this company? What return would you have earned investing in this company's stock? Would you have under or out performed the market? How much of the performance can be attributed to management?

• How risky is this company's equity? Why? What is its cost of equity?

• How risky is this company's debt? What is its cost of debt?

• What is this company's current cost of capital?

Framework for Analysis:

1. Estimating Historical Risk Parameters (Top Down Betas)

Run a regression of returns on your firm's stock against returns on a market index, preferably using monthly data and 5 years of observations (or) If you have access to Bloomberg, go into the beta calculation page and print of the page (after setting return intervals to monthly and using 5 years of data)

• What is the intercept of the regression? What does it tell you about the performance of this company's stock during the period of the regression?

• What is the slope of the regression?

• What does it tell you about the risk of the stock?

• How precise is this estimate of risk? (Provide a range for the estimate.)

• What portion of this firm's risk can be attributed to market factors? What portion to firm-specific factors? Why is this important?

• How much of the "risk" for this firm is due to business factors? How much of it is due to financial leverage?

2. Comparing to Sector Betas (Bottom up Betas)

• Break down your firm by business components, and estimate a business beta for each component

• Attach reasonable weights to each component and estimate a unlevered beta for the business.

• Using the current leverage of the company, estimate a levered beta for each component.

3. Choosing Between Betas

• Which of the betas that you have estimated for the firm (top down or bottom up) would you view as more reliable? Why?

• Using the beta that you have chosen, estimate the expected return on an equity investment in this company to

• a short term investor

• a long term investor

• As a manager in this firm, how would you use this expected return?

4. Estimating Default Risk and Cost of Debt

• What is the most recent rating for the firm?

• What is the default spread and interest rate associated with this rating?

• If your company has bonds outstanding, estimate the yield to maturity on a long term bond? Why might this be different from the rate estimated in the last step?

• What is the company's marginal tax rate?

• Does it have any recent borrowings? If yes, what interest rate did the company pay on these borrowing?

• Can you estimate a "synthetic" rating? If yes, what interest rate would correspond to this rating?)

5. Estimating Cost of Capital

• Weights for Debt and Equity

• What is the market value of equity?

• Estimate a market value for debt. (To do this you might have to collect information on the average maturity of the debt, the interest expenses in the most recent period and the book value of the debt)

• What are the weights of debt and equity? • Cost of Capital

• What is the cost of capital for the firm?

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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