SlidesSession 7 FMII BM 2015-17

8/19/2019 SlidesSession 7 FMII BM 2015-17

http://slidepdf.com/reader/full/slidessession-7-fmii-bm-2015-17 1/24

BM 15-17: FM IISession 7

Uday Damodaran XLRI Jamshedpur

1

Session 7:Can the Capital Structure Be a Source ofValue? Understanding Risk Drivers




2

Value Drivers ….

The Valuation Formula..ROE and Profitability, Competitive Advantage Period/Sustainability, Reinvestment/ GrowthAnd… possibly the discount rate (The opportunity cost ofcapital)





3

Cost of Equity….

Or the Equity Investors’ Desired Rate of Return or theOpportunity Cost of Capital for the Equity Investor= Real Risk-Free Rate of Return + Premium for Inflation +Premium for Risk


Of these, whatare economy-wide factors,and thereforeout of yourcontrol?




4

Risk, and the Risk Premium

Therefore, we now focus on measuring risk, and evaluatingthe risk premium





5

Risk……

What is it for you:If you are running your own business? A direct investor?

What are you bothered about? What are the sources ofyour risk?

If you are investing in stocks of businesses? A portfolioinvestor?





6

Portfolio Theory: Return and Risk

How would you measure return and risk?

A B2015 7 82014 7 82013 3 22012 3 22011 3 22010 7 8Mean 5% 5%SD 2% 3%

And isonebetter?





7

Portfolio Theory: Return and Risk

How would you measure return and risk?

A B2015 7 82014 7 82013 3 22012 3 22011 3 22010 7 8Mean 5% 5%SD 2% 3%

And how manyportfolios can you nowcreate?


d d




8

Security Characteristics- Portfolio Perspective

Infinite portfolios possible with just 2 securities, but considerXA = .5, X B = .5

A B A+B

2015 7 8 7.52014 7 8 7.52013 3 2 2.52012 3 2 2.52011 3 2 2.52010 7 8 5.5Mean 5% 5% 5%SD 2% 3% 2.5%


Ud D d




9

Portfolio Construction

What about B’? How does it compare with B? Would youconsider B’?

B’ 2015 22014 22013 82012 82011 82010 2Mean 5%SD 3%


Ud D d




10

Portfolio Construction

Infinite portfolios possible with just 2 securities, but considerXA = .5, X B’ = .5

A B’ A+B’ 2015 7 2 4.52014 7 2 4.52013 3 8 5.52012 3 8 5.52011 3 8 5.52010 7 2 4.5Mean 5% 5% 5%SD 2% 3% 0.5%

HarryMarkowitz,

1952


Ud D d




11

Data Requirements

So to ‘characterize’ a portfolio,Expected Returns, Dispersions, and Comovements


Uday Damodaran




12

Portfolio Characteristics

Mean: R p = ∑XiR i

Standard Deviation: σp = √∑Xi2σ i

2 + ∑∑XiX j (ρ ij σ iσ j)For a 2-security case Standard Deviation

σp = √XA2σA

2 + X B2σB

2 + 2X AXB (ρAB σAσB)


Uday Damodaran




13

Diversification and Portfolio Risk

So when does diversification work best? What does it dependon?


Uday Damodaran




14

Portfolio Characteristics

Mean: R p = ∑XiR i

Standard Deviation: σp = √∑Xi2σ i

2 + ∑∑XiX j (ρ ij σ iσ j)Now consider an equally weighted ‘n’ security portfolio


Uday Damodaran




15

Portfolio Sigma

σp = √∑σi2 + ∑∑σij

N2 N2

= √1∑σi2 + (N-1) ∑∑σij

N N N N(N-1)

= √σi2 + (N-1) σ ij

N N

As N increases, this tends to σ ij

Implications?


Uday Damodaran




16

Read…

Section 7-1, 7-2 and 7-3


Uday Damodaran




17

Modern Portfolio Theory: Implementation Problems

Data Intensive!n X isn σ is(n 2-n)/2 ρ ij s

And a practical ‘organizational problem’

Solution?


Uday Damodaran




18

Simplifying the Correlation Structure

Stock A

Stock B

Stock C

Stock D

Stock E

TheMarket

Stock A Stock B

Stock C

Stock D

Stock E


Uday Damodaran




19

‘Market’ in Investments, Pivotal Player in Cricket

Player A

Player B

Player C

Player D

Player E

Ponting??/Tendulkar??

Player A Player B

Player C

Player D

Player E


Uday Damodaran




20

Modern Portfolio Theory: Implementation Problems

Data Intensive!n X isn σ is(n 2-n)/2 ρ ij s

And a practical ‘organizational problem’

Solution? Have we nailed both the problems?


Uday Damodaran




21

Simplifying the Correlation Structure

Stock A

Stock B

Stock C

Stock D

Stock E

TheMarket

Stock A Stock B

Stock C

Stock D

Stock E

But then how do weformalize/ estimate/model these links?


Uday Damodaran



y XLRI Jamshedpur

22

Data

What data do we require?What will the scatter diagram look like?


Uday Damodaran



y XLRI Jamshedpur

23

Single Index Model

R it = a i + βi R mt + e it


And if youtake thevariance?

Uday Damodaran



y XLRI Jamshedpur

24

Single Index Model

σ i2 = βi

2σm2 + σei

2

Total Risk = Systematic Risk + Unique Risk


SlidesSession 7 FMII BM 2015-17

Documents