RETURN AND RISK

CALCULATION
Return
Components of Return
 Returns = [Income / Investment] + [Price change /
Investment]
Calculating Historical Return
 I had bought a security at Rs. 60 a year back. I sell
this security at Rs. 69. Calculate the historical return.
Calculating Historical Return
 Total Return = Price change over the period /
Beginning Price

 Total Return = (69 – 60) / 60

 Total Return = 15%

Calculating Historical Return
 In addition to the increase in price, the security also
paid a dividend of Rs 2.4 during the year.
Calculate the total historical return
Calculating Historical Return
 Total Return = (Price change over the period + Investment
Income) / Beginning Price

 Total Return = [(Ending Price – Beginning Price) / Beginning

Price] + [Investment Income / Beginning Price]

 Total Return = ((69 – 60) + 2.4) / 60

 Total Return = 19%

Risk
Measuring Risk
 What is Risk?
 Risk is always linked to danger or negativity
 Should Risk always be avoided?
 Risk as a combination of Danger and Opportunity

 How do we calculate Risk?

 Difference between real and expected return:
◼ T Bill
◼ 2 year Government Bond
◼ Corporate Bond
◼ Equity

 What measure of risk captures difference between actual and

expected return?
Comparing Risk when expected returns
are equal
Estimating Risk
Return Return – Difference Probability
Expected Squared
Return
(1) (2) (3) (2) * (3)
7 7 – 10 = -3 9 0.05 0.45
8 8 – 10 = -2 4 0.1 0.4
9 9 – 10 = -1 1 0.2 0.2
10 10 – 10 = 0 0 0.3 0
11 11 – 10 = 1 1 0.2 0.2
12 12 – 10 = 2 4 0.1 0.4
13 13 – 10 = 3 9 0.05 0.45
1 Variance = 2.1
S.D. = 1.45
Estimating Risk

Return Return – Difference Probability

Expected Squared
Return
(1) (2) (3) (2) * (3)

9 9 – 10 = -1 1 0.3 0.3

10 10 – 10 = 0 0 0.4 0

11 11 – 10 = 1 1 0.3 0.3

1 Variance = 0.6
S.D. = 0.77
Practice Problem – Calculate Variance and
Standard Deviation - Sample

Period Return
1 15
2 12
3 20
4 -10
5 14
6 9
Answer

Period Return Deviation Squared

Deviation
1 15 5 25
2 12 2 4
3 20 10 100
4 -10 -20 400
5 14 4 16
6 9 -1 1
Total: 60 Total = 546
Avg. Return = 10 Variance = 109.2
S.D. = 10.45
Practice Problem
Calculate Variance and Standard Deviation for the below set of
returns

Period Return Probability

1 15 0.3
2 20 0.4
3 25 0.3
 Answer

Return –
Exp Difference
Period Return Expected Probability
Return Squared (5) *(6)
(1) (2) Return (6)
(3) (5)
(4)

1 15 20 -5 25 0.3 7.5

2 20 20 0 0 0.4 0

3 25 20 5 25 0.3 7.5

Variance = 15
S.D. = 3.873
PORTFOLIO RISK AND
RETURN
Portfolio Return
❑ A portfolio is a combination of 2 or more assets

❑ Return for a portfolio is a weighted average of return

earned by each security in the portfolio

❑ Weights in the portfolio is the market value proportion

of each asset as a percentage of the market value of
the portfolio
Portfolio Return

Asset % Proportion % Return

A 20 12
B 30 10
C 50 15
Portfolio Return

Asset Proportion (1) % Return (2) (1) * (2)

A 0.20 12 2.4
B 0.30 10 3
C 0.50 15 7.5
Wt. Avg. 12.9
Return
Practice Problem
 A portfolio consists of 2 assets, asset A and asset B.
Asset A has a return of 12% and Asset B has a
return of 15%. Asset A has a 70% share in the
portfolio. Calculate the portfolio return
Answer

Asset Proportion (1) % Return (2) (1) * (2)

A 0.70 12 8.4

B 0.30 15 4.5

Wt. Avg. 12.9

Return
Portfolio Return
 The general formula for a 2 asset portfolio return is,

Rport = WARA + WBRB

Basic Concepts in Statistics
 Please refer to the Excel Sheet
Portfolio Risk
 Portfolio Risk is different from Portfolio Return and is
not simply the Weighted Average Risk of Assets in
the portfolio
Portfolio Risk
MODERN PORTFOLIO
THEORY
Objective
❑ Creating the optimum portfolio

❑ Efficiency of the portfolio is judged on the basis of risk and

return of individual securities and the relation between them

❑ An investor would prefer to maximize return and minimize risk

as they are assumed to be risk averse
CALCULATION OF COST
OF CAPITAL
 Stakeholders

Shareholders

Customers Management

Company

Society Debt holders

Competitors
Objective Statement
 Maximizing Firm Value

 Maximizing Equity Value

 Maximizing Stock Price

Cost of Capital and the Objective Function

 Maximizing value of equity

 Return on Assets > Cost of Capital

Liabilities Assets
Fixed Assets
Equity
Investments
Debt
Net Working Capital
Cost of Capital Return on Assets
Measuring Cost of Capital
 Minimum acceptable return that projects have to
earn to be deemed acceptable

 Cost of Equity (Ke)

 Cost of Debt (Kd)

 Weighted Average Cost of Capital (WACC)

 WACC = We.Ke + Wd.Kd
Cost of Equity

 Returns based approach to Cost of Equity

 Return for Investor = Cost to Company

 Determining the Marginal Investor

 Linked to the value maximization objective
Determining the Marginal Investor for
Hindalco
Category 2023 Holdings
Promoter and Promoter Group 34.64%

Institutions 52.32%

Mutual Funds 12.06%

Foreign Portfolio Investors 26.08%

Insurance Companies 13.58%

Financial Institutions/ Banks 0.20%

Central/ State Governments 0.23%

Non-Institutions 12.40%

Individuals 5.16%

GDRs 3.77%
Determining the Marginal Investor for
Hindalco
Category 2023 Holdings
Promoter and Promoter Group 34.64%

Institutions 52.32%

Mutual Funds 12.06%

Foreign Portfolio Investors 26.08%

Insurance Companies 13.58%

Central/ State Governments 0.23%

Non-Institutions 12.40%

Individuals 5.16%

GDRs 3.77%
3 Step Process for Cost of Capital
Steps to calculate Cost of Equity
I. Measuring Risk

II. Classifying Risk

III. Capital Asset Pricing Model

Step 1: Measuring Risk
 What is Risk?
 Risk is always linked to danger or negativity
 Should Risk always be avoided?
 Risk as a combination of Danger and Opportunity

 How do we calculate Risk?

 Difference between real and expected return:
◼ T Bill
◼ 2 year Government Bond
◼ Corporate Bond
◼ Equity
 Step 2: A Break Down of Risk
Source: Aswath Damodaran
Competition
may be stronger Exchange rate
or weaker than and Political
expected risk

Project may Entire sector

do better or may be Interest rate,
worse than affected by Inflation & news
expected action about economy

Market
Firm Specific

Actions/ Risk that Actions/ Risk that

affect only one Affects few firms Affects many affect all
firm firms investments
Firms can Investing in lots Acquiring Diversifying Diversifying Cannot affect
reduce by of projects competitors across sectors across countries
Investors can Diversifying across domestic stocks Diversifying across
Diversifying globally
reduce by asset classes
Step 2: A Break Down of Risk
 Refer to the excel sheet to see benefits of
diversification statistically
Portfolio Risk and Return Calculation
 Assume that as a US investor, you decide to hold a portfolio with 80
percent invested in the S&P 500 US stock index and the remaining
20 percent in the MSCI Emerging Markets index.

 The expected return is 9.93 percent for the S&P 500 and 18.20
percent for the Emerging Markets index. The risk (standard
deviation) is 16.21 percent for the S&P 500 and 33.11 percent for
the Emerging Markets index.

 What will be the portfolio’s expected return and risk given that the
covariance between the S&P 500 and the Emerging Markets index
is 0.5 percent or 0.0050?
Portfolio Risk and Return Calculation
 Rport = WARA +(1 – WA)RB
 Rport = (0.8 * 0.0993) + (0.2 * 0.1820) = 0.1158 = 11.58%

 Varianceport = W2Aσ2A + W2Bσ2B + 2WAWBCov(A,B)

 Varianceport=(0.802*0.16212)+(0.202*0.33112)+(2*0.8*0.2* 0.0050)
 Varianceport = 0.02281
 σport = 0.15103 = 15.10%
Portfolio Risk and Return Calculation

 An investor has a two asset portfolio with the following risk and
return numbers. Calculate the Portfolio Return and Risk
assuming correlation is 0.5

 Would the portfolio return and risk calculations change if the

correlation was reduced to 0.2?

Assets Return Std Deviation Proportion

A 10% 5% 60%

B 20% 10% 40%

 Portfolio Risk and Return Calculation
 Correlation of 0.5
 Rport = WARA +(1 – WA)RB
 Rport = (0.6 * 0.1) + (0.4 * 0.2) = 0.14 = 14%

 Varianceport = W2Aσ2A + W2Bσ2B + 2WAWBσAσBρ(A,B)

 Varianceport=(0.602*0.052)+(0.402*0.102)+(2*0.6*0.4*0.05*0.1*0.5)
 Varianceport = 0.0037
 σport = 0.0608 = 6.08%
 Portfolio Risk and Return Calculation
 Correlation of 0.2
 Rport = WARA +(1 – WA)RB
 Rport = (0.6 * 0.1) + (0.4 * 0.2) = 0.14 = 14%

 Varianceport = W2Aσ2A + W2Bσ2B + 2WAWBσAσBρ(A,B)

 Varianceport=(0.602*0.052)+(0.402*0.102)+(2*0.6*0.4*0.05*0.1*0.2)
 Varianceport = 0.003
 σport = 0.0546 = 5.46%
Practice Problem
 Two stocks have the same return and risk (standard deviation):
10 percent return with 20 percent risk. You form a portfolio
with 50 percent each of Stock 1 and Stock 2 to examine the
effect of correlation on risk.
1. Calculate the portfolio return and risk if the correlation is 1.0.
2. Calculate the portfolio return and risk if the correlation is 0.0.
3. Calculate the portfolio return and risk if the correlation is –1.0.
4. Compare the return and risk of portfolios with different
correlations.
Answers
1.
Rport = 10%
σport = 20%

2.
Rport = 10%
σport = 14%

3.
Rport = 10%
σport = 0%
Practice Problem
 An investor is considering investing in a small-cap stock fund and a general bond
fund. Their returns and standard deviations are given below and the correlation
between the two fund returns is 0.10.
1. If the investor requires a portfolio return of 12 percent, what should the
proportions in each fund be?
2. What is the standard deviation of the portfolio constructed in Part 1?

Expected Standard
Return(%) Deviation(%)

Small cap Fund, S 19 33

Bond Fun, B 8 13
 Answers
1.
0.12 = WS(0.19) +(1 – WS)(0.08) =
Small cap Fund, S = 36.4%
Bond Fund, B = 63.6%

2.
Varianceport = W2Sσ2S + W2Bσ2B + 2WSWBσSσBρ(S,B)
Varianceport=(0.3632*0.332)+(0.6372*0.132)+(2*0.36*0.64*0.33*0.13*0.1)
Varianceport = 0.0231
σport = 0.15226
Standard Deviation = 15.23%
Case of Diversification
 Assume a company Beachwear rents beach equipment. The annual return
from the company’s operations is 20 percent in years with many sunny days
but falls to 0 percent in rainy years with few sunny days. The probabilities of a
sunny year and a rainy year are equal at 50 percent. You want to invest in
Beachwear but do not like the risk. Having heard about diversification, you
decide to add another business to the portfolio to reduce your investment
risk

 There is a snack shop on the beach that sells all the healthy food you like. You
estimate that the annual return from the Snackshop is also 20 percent in
years with many sunny days and 0 percent in other years. As with the
Beachwear shop, the average return is 10 percent

 You decide to invest 50 percent each in Snackshop and Beachwear, thinking

that adding securities to would reduce your risk through diversification
 Case of Diversification

Type Company Percent Return in Return in Average

Invested Sunny Year Rainy Year Return (%)
(%) (%)

Single Stock Beachwear 100 20 0 10

Single Stock Snackshop 100 20 0 10
Portfolios of Beachwear 50 20 0 10
2 stocks Snackshop 50 20 0 10

Total 100 20 0 10
Case of Diversification
 However, the result are not satisfactory. Investing in SnackShop did not
lead to any reduction of risk as both businesses do well during sunny days
and badly during rainy days. You find a company that rents DVDs.
DVDrental company is similar to the Beachwear company, except that its
annual return is 20 percent in a rainy year and 0 percent in a sunny year,
with an average return of 10 percent. DVDrental’s 10 percent return is
also risky just like Beachwear’s return.

 If you invest 50 percent each in DVDrental and Beachwear, then the

average return is still 10 percent, with 50 percent of 10 percent from
DVDrental and 50 percent of 10 percent from Beachwear.
 Case of Diversification

Type Company Percent Return in Return in Average

Invested Sunny Year Rainy Year Return (%)
(%) (%)

Single Stock Beachwear 100 20 0 10

Single Stock DVDRental 100 0 20 10

Portfolios of Beachwear 50 20 0 10
2 stocks DVDRental 50 0 20 10

Total 100 10 10 10
Risk and Return Measures
 Applicable to all assets

 Only measure rewarded risk or systematic risk

 Risk that cannot be diversified away

 Standardized Risk Measure

 Good Estimation Measure

 Is CAPM a good estimation measure?
Step 3: Capital Asset Pricing Model
Moving from 2 asset portfolio to a combination
of Market Portfolio and Risk Free Asset
CAPM Assumptions
 There are no transaction costs and securities are
infinitely divisible

 All assets are correctly valued and information flows

freely

 Investors are diversified across all asset classes

 This is the reason marginal investors in your company

should be well diversified for CAPM to work
Determining the Marginal Investor for
Hindalco
Category 2023 Holdings
Promoter and Promoter Group 34.64%

Institutions 52.32%

Mutual Funds 12.06%

Foreign Portfolio Investors 26.08%

Insurance Companies 13.58%

Central/ State Governments 0.23%

Non-Institutions 12.40%

Individuals 5.16%

GDRs 3.77%
Capital Allocation Line (CAL)
 Portfolio Return = Wa.Ra + Wb.Rb

 Portfolio Return = Rb + Wa(Ra – Rb)

 Portfolio Risk = 𝑊 2 𝑎. 𝜎 2 𝑎 + 𝑊 2 𝑏. 𝜎 2 𝑏 +W𝑎.𝜎𝑎.W𝑏.𝜎𝑏.𝜌(𝑎, 𝑏)

𝝈 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐
 Wa = (Assuming Asset B is Risk Free)
𝝈𝒂

𝜎 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
 Portfolio Return = Rb + (Ra – Rb) (Substituting the value of Wa)
𝜎𝑎

𝜎 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
 Portfolio Return = Rf + (Rm – Rf) (Substituting the value of Wa)
𝜎𝑚
Capital Asset Pricing Model
 Portfolio Return = Wa.Ra + Wb.Rb

 Portfolio Return = Rb + Wa(Ra – Rb)

 Portfolio Risk = 𝑊 2 𝑎. 𝜎 2 𝑎 + 𝑊 2 𝑏. 𝜎 2 𝑏 +2.W𝑎.𝜎𝑎.W𝑏.𝜎𝑏.𝜌(𝑎, 𝑏)

𝝈 𝑷𝒐𝒓𝒕𝒇𝒐𝒍𝒊𝒐
 Wa = (Assuming Asset B is Risk Free)
𝝈𝒂

𝜎 𝑃𝑜𝑟𝑡𝑓𝑜𝑙𝑖𝑜
 Portfolio Return = Rf + (Rm – Rf) (Substituting the value of Wa)
𝜎𝑚

 CAPM = Rf + Beta (Rm – Rf) (Moving from 2 asset to Market Portfolio)

Risk Preference in CAPM
 100% Government Bonds

 50% G. Bonds and 50% Market Portfolio

 25% G. Bonds and 75% Market Portfolio

 100% Market Portfolio

 Borrow money and invest in Risk Portfolio

COST OF EQUITY WITH
CAPM
Capital Asset Pricing Model
 Risk Free Rate

 Beta

 Equity Risk Premium

 Expected Return = Risk Free Rate + Risk Premium

Risk Free Rates
Risk Free Rate
 Actual Return = Expected Return

 No Default Risk

 No Reinvestment Risk
 Why do we still take 10 year bond rate for India?
◼ Almost every analysis is long term
◼ Cash flows weighted towards the end
◼ 10 Year bond is Liquid
Risk Free Rate
 Risk Free Rate should be in the same currency as the
estimated cash flows

 Do we consider the Indian Government Risk Free?

 Difference in yields are explained by currency and credit

rating

 Ratings based approach to measure Risk Free

 Country with a rating of Aaa
 Country Rating for India Baa3
 India Risk Free Rate = India G. Bond Rate – Country Default
Spread
Risk Free Rate – Country Default Spread

 Difference in yields of dollar denominated bonds of different

countries
 Brazil US$ Bond = 6.76%
 US US$ Bond = 4.34%
 Default Spread = 6.76% - 4.34% = 2.42%

 Country Default Spreads

Country Country Rating Average Wt. Avg. Spread of
Rating Bucket

India Baa3/ BBB- 2.39%

 India Risk Free Rate = India G. Bond Rate – Country Default Spread
 India Risk Free Rate = 6.86% - 2.39% = 4.47%
Estimating Equity Risk Premium
Equity Risk Premium
 Every individual has his/her own Risk Premium

 Should be greater than zero

 Should be positively related to risk aversion in the

market

 We are trying to find out the average Risk Premium of

all investors weighted by the money invested

 Different methods for estimating Equity Risk Premium

Method 1: Survey
Method 2: Historical Risk Premium
 Historical Risk Premium - USA
Arithmetic Average Geometric Average
Stocks – T Bills Stocks – T Bonds Stocks – T Bills Stocks – T Bonds
1928-2023 8.32% 6.80% 6.50% 5.23%
Std Error 2.03% 2.14%
1974-2023 8.18% 5.95% 6.79% 4.97%
Std Error 2.45% 2.73%
2014-2023 11.70% 11.17% 10.63% 10.44%
Std Error 4.97% 3.86%
Source: Aswath Damodaran

 Time Frame
 Errors are more important than averages
 Arithmetic Vs Geometric Averages
 T Bonds Vs T Bills
Limitations of Approach
 Assumes Risk Aversion has not changed over the
years

 Assumes the riskiness of the market portfolio has not

changed over the years
Method 3: Implied Risk Premium
Implied Equity Risk Premium
 Calculation of Expected returns by matching off Price paid
for a market portfolio today Vs Expected Cash Flows from
the market over the long term

 The Yield to Maturity formula is used to calculate the return

that matches the current price of the bond with its expected
cash flows over the tenure of the bond

 Implied Equity Risk Premium is the Rate of Return that

matches the Price of market Index with the expected cash
flows over the tenure of the equity security (assumed to be
non maturing)
Implied ERP (2024)

Source: Aswath Damodaran

Equity Risk Premium – India
 Lesser historical data available

 High Standard Errors

 Inputs for Implied Equity Risk Premiums are difficult

Equity Risk Premium - India

 Using Average Default Spread per rating

Country Rating Default Spread US ERP ERP for India
India Baa3 2.39% 4.60% 6.99%

 Using CDS Spread

Country Rating CDS Spread US ERP ERP for India
India Baa3 0.50% 4.60% 5.10%
Equity Risk Premium - India
 A Better Approach:
𝜎𝐸𝑞𝑢𝑖𝑡𝑦
 Country Risk Premium = 𝐶𝑜𝑢𝑛𝑡𝑟𝑦 𝐷𝑒𝑓𝑎𝑢𝑙 𝑆𝑝𝑟𝑒𝑎𝑑 ∗
𝜎𝐵𝑜𝑛𝑑

 India Country Risk Premium = 2.39% * (15.55%/11.58%) = 3.21%

 India Equity Risk Premium = 4.60% + 3.21% = 7.81%

Equity Risk Premium for a Firm
 Country of incorporation cannot be used as a proxy
for calculating Equity Risk Premium (ERP)

 ERP should be calculated in proportion to value

derived from each country
 Equity Risk Premium - Hindalco
Revenue 2023 (Rs Equity Risk Wt. Avg.
Country % Revenue
crores) Premium Premium
India 59,190 27% 7.81% 2.08%
United States 56,946 26% 4.60% 1.18%
Brazil 20,081 9% 9.00% 0.81%
Korea 10,908 5% 5.32% 0.26%
United
5,720 3% 5.48% 0.14%
Kingdom
Germany 10,275 5% 4.60% 0.21%
China 5,713 3% 5.63% 0.14%
Others 53,946 24% 6.41% 1.55%
TOTAL 2,22,779 100% 6.37%
Estimating Beta
Beta
 The beta of a security measures the systematic risk
in a stock
 It is a standardized measure of risk
 Greater than one indicated above average risk
 Less than one indicates below average risk

 Less than zero indicates systematic risk reducing

investment
 Securities with low Beta and high risk
Estimating Beta

 Equation of the line = Rx = a + bRm

b = slope of line = Beta
 a = Intercept

 R2 = Coefficient of Determination
Estimating Beta
 Select the Estimation tenure
 Trade off between longer and shorter periods

 Select the return interval

 Daily Vs Weekly Vs Monthly Vs Quarterly

 Calculating Returns

 Select a Market Index

Estimating Beta - Hindalco
Calculating Returns on Stock and Index

Refer to the excel sheet for Beta calculation

Jensen’s Alpha - Hindalco
 Rj = Rf + ß(Rm-Rf)
 Rj = Rf(1- ß) + ßRm
 Rj = a + ßRm

 Calculating Jensen’s Alpha for Hindalco:

 4.47%/52 = 0.085961%
 0.085961%(1 – 1.27) = -0.023209%
 -0.0575% – (-0.023209%) = -0.034291%
 (1-0.00034291)^12 – 1 = -0.41%
Jensen’s Alpha
 Average Jensen’s Alpha across the market

 Can you credit the management for this

performance?

 Are these securities good investments?

R2 – Coefficient of Determination
 How much of a company’s risk comes from
systematic and unsystematic risk

 What would you prefer as an investor?

 DiversifiedInvestor
 Non diversified Investor
Expected Returns or Cost of Equity - Hindalco

 Exp Return = Rf + Beta (Rm – Rf)

 Exp Return = 4.47% + 1.27(6.37%)

 Min. Exp Return = 12.56%

 Cost of Equity = 12.56% (Assuming management

works towards shareholder’s expectation)
Determinants of Beta
 Can a company lower its beta and thereby reduce its cost of equity?
 Mix of businesses
 Conglomerate
 Risky Businesses
 Vice Businesses
 Gold
 Cash
 Contrarian Businesses
 Discretionary and Non-Discretionary Products (Elasticity of demand)
 Business based Beta effects can vary across Emerging and Developed
markets
 Operating Leverage
 Financial Leverage
Operating Leverage
 Sales
 (-) VC
 (=) Contribution
 (-) FC
 (=) EBIT
 (-) Interest
 (=) EBT
 (-) Tax
 (=) EAT
 (-) Preference dividend
 (=) NEAES
 (\) No. of shares
 (=) EPS
Operating Leverage
 Refer to the excel sheet for the leverage
calculations
Operating Leverage
 Fixed costs create operating leverage

 Higher the fixed cost, higher the operating leverage

 Leverage works both ways, positive and negative

 Measures of operating leverage:

 Contribution/
EBIT
 % Change in EBIT/ % Change in Revenues
Operating Leverage
 Refer to the excel sheet for the leverage
calculations
Determinants of Beta
 Mix of businesses
 Contrarian Businesses
 Discretionary and Non-Discretionary Products
 Operating Leverage
 Financial Leverage
Levered and Unlevered Beta - Hindalco

 What Beta do you get out of the Regression

Equation?
Levered and Unlevered Beta - Hindalco

 What Beta do you get out of the Regression

Equation?

 Raw Beta = 1.27

 Avg. Debt/Equity Ratio = 1.22
 Unlevered Beta = Levered Beta/(1+(1-T)(D/E))
 Unlevered Beta = 1.27/(1+(1-0.3245)(1.22))
 Unlevered Beta = 0.70
Effect of Leverage - Hindalco

Debt to Capital Debt to Equity Beta Effect of Leverage

0.00% - 0.695
10.00% 0.11 0.748 0.05
20.00% 0.25 0.813 0.12
30.00% 0.43 0.897 0.20
40.00% 0.67 1.009 0.31
50.00% 1.00 1.165 0.47
60.00% 1.50 1.400 0.70
70.00% 2.33 1.792 1.10
80.00% 4.00 2.574 1.88
90.00% 9.00 4.923 4.23
Special Cases
 Banks
 We do not unlever and relever betas
 No cost of capital for banks

 Private Companies
 Using comparable firm’s beta by averaging Levered
Betas and debt to equity ratios
 Can we use average market betas for Private firms?
Private Firms

 Private Beta = Market Beta/ √R Squared

 Private Beta = 1.643 / SQRT(0.582605 )
 Private Beta = 2.152
Weighted Average Betas
 A portfolio Beta would be the weighted average of
Betas of it’s constituents

 At a company level, each business will have it’s own

Beta
Beta: Example
 You invest 20 percent of your money in the risk-free
asset, 30 percent in the market portfolio, and 50
percent in RedHat, a US stock that has a beta of 2.0.
Given that the risk-free rate is 4 percent and the
market return is 16 percent, what are the portfolio’s
beta and expected return?
Beta: Example
Portfolio Beta would be a weighted average of the individual
investments:

Beta = (0.2 * 0) + (0.3 * 1) + (0.5 * 2)

Beta = 1.30

Portfolio expected return:

Exp. Return = Rf + Beta(Rm – Rf)
Exp. Return = 4 + 1.3(16 – 4)
Exp. Return = 19.6%
Beta: Example
 Assuming that the risk (standard deviation) of the market is
25 percent, calculate the beta for the following assets:
1. A short-term US Treasury bill
2. Gold, which has a standard deviation equal to the standard
deviation of the market but a zero correlation with the market
3. A new emerging market that is not currently included in the
definition of “market”—the emerging market’s standard
deviation is 60 percent, and the correlation with the market is –
0.1
4. An initial public offering or new issue of stock with a standard
deviation of 40 percent and a correlation with the market of
0.7 (IPOs are usually very risky but have a relatively low
correlation with the market)
Beta: Example
1. By definition, a short-term US Treasury bill has
zero risk. Therefore, its beta is zero
2. Because the correlation of gold with the market is
zero, its beta is zero.
3. Beta of the emerging market is –0.1 × 0.60 ÷
0.25 = –0.24
4. Beta of the initial public offering is 0.7 × 0.40 ÷
0.25 = 1.12
Beta & Expected Return: Example
Alpha Natural Resources (ANR), a coal producer, buys a large but
privately held coal producer in China. As a result of the cross-border
acquisition of a private company, ANR’s standard deviation of returns is
reduced from 50 percent to 30 percent and its correlation with the
market falls from 0.95 to 0.75. Assume that the standard deviation and
return of the market remain unchanged at 25 percent and 10 percent,
respectively, and that the risk-free rate is 3 percent.
 Calculate the beta of ANR stock and its expected return before the
acquisition.
 Calculate the expected return after the acquisition.
Beta & Expected Return: Example
Before the acquisition:

Beta = (0.95 * 0.5) / 0.25 = 1.9

Exp. Return = Rf + Beta(Rm – Rf)

Exp. Return = 0.03 + 1.9 (0.1 – 0.03)
Exp. Return = 16.3%
Beta & Expected Return: Example
After the acquisition:

Beta = (0.75 * 0.3) / 0.25 = 0.90

Exp. Return = Rf + Beta(Rm – Rf)

Exp. Return = 0.03 + 0.9 (0.1 – 0.03)
Exp. Return = 9.3%
Expected Return: Example
Mr. Miles observes the strong demand for iPods and iPhones
and wants to invest in Apple stock. Unfortunately, Mr. Miles
doesn’t know the return he should expect from his investment.
He has been given a risk-free rate of 3 percent, a market
return of 10 percent, and Apple’s beta of 1.5.
1. Calculate Apple’s expected return.
2. An analyst looking at the same information decides that
the past performance of Apple is not representative of its
future performance. He decides that, given the increase in
Apple’s market capitalization, Apple acts much more like
the market than before and thinks Apple’s beta should be
closer to 1.1. What is the analyst’s expected return for
Apple stock?
Expected Return: Example
E(Ri) = Rf + βi[E(Rm) – Rf] = 0.03 + 1.5 × (0.10 –
0.03) = 0.135 = 13.5%

E(Ri) = Rf + βi[E(Rm) – Rf] = 0.03 + 1.1 × (0.10 –

0.03) = 0.107 = 10.7%
Expected Return: Example
Suppose the risk-free rate is 3 percent, the expected
return on the market portfolio is 13 percent, and its
standard deviation is 23 percent. An Indian company,
Bajaj Auto, has a standard deviation of 50 percent but
is uncorrelated with the market. Calculate Bajaj Auto’s
beta and expected return.
Expected Return: Example
Baja Auto:
Beta = (0 * 0.5)/0.23 = 0

E(Ri) = Rf + βi[E(Rm) – Rf] = 0.03 + 0 × (0.13 – 0.03) =

E(Ri) = 3%
Expected Return: Example
Suppose the risk-free rate is 3 percent, the expected
return on the market portfolio is 13 percent, and its
standard deviation is 23 percent. A German company,
Mueller Metals, has a standard deviation of 50 percent
and a correlation of 0.65 with the market. Calculate
Mueller Metal’s beta and expected return.
Expected Return: Example
Mueller Metal:
Beta = (0.65 * 0.5)/0.23 = 1.41

E(Ri) = Rf + βi[E(Rm) – Rf] = 0.03 + 1.41×(0.13 – 0.03)

= E(Ri) = 17.1%
COST OF DEBT
Debt Funding
 Main features of debt
 It is a tax-deductible expense
 It has a fixed payment schedule
 It is a contractual commitment
 Failure to make payments have consequences

 Which items on the Balance Sheet would classify as Debt based on

the above characteristics?
 Long Term Bank Borrowing
 Corporate Bonds
 Short Term Liabilities
 Accounts Payable
 Provisions
 Lease payments
Cost of Debt

How do you estimate cost of debt for your

company?
Cost of Debt
 Objective is to compute the likely cost of raising debt
capital in the current market

 If the firm is rated

 Cost of debt (before tax) = Rf + Synthetic Default Spread
+ Default Spread (India)

 If the firm is not rated

 Estimate synthetic spreads
 Classify them into ranges
 Cost of debt (before tax) = Rf + Synthetic Default Spread
Average Spreads
Large/ developed market firms Small/ emerging market firms
If interest If interest
coverage coverage
ratio is ratio is
> ≤ to Rating is Spread is greater than ≤ to Rating is Spread is
-100000 0.199999 D2/D 17.44% -100000 0.499999 D2/D 17.44%
0.2 0.649999 C2/C 13.09% 0.5 0.799999 C2/C 13.09%
0.65 0.799999 Ca2/CC 9.97% 0.8 1.249999 Ca2/CC 9.97%
0.8 1.249999 Caa/CCC 9.46% 1.25 1.499999 Caa/CCC 9.46%
1.25 1.499999 B3/B- 5.94% 1.5 1.999999 B3/B- 5.94%
1.5 1.749999 B2/B 4.86% 2 2.499999 B2/B 4.86%
1.75 1.999999 B1/B+ 4.05% 2.5 2.999999 B1/B+ 4.05%
2 2.2499999 Ba2/BB 2.77% 3 3.499999 Ba2/BB 2.77%
2.25 2.49999 Ba1/BB+ 2.31% 3.5 3.9999999 Ba1/BB+ 2.31%
2.5 2.999999 Baa2/BBB 1.71% 4 4.499999 Baa2/BBB 1.71%
3 4.249999 A3/A- 1.33% 4.5 5.999999 A3/A- 1.33%
4.25 5.499999 A2/A 1.18% 6 7.499999 A2/A 1.18%
5.5 6.499999 A1/A+ 1.07% 7.5 9.499999 A1/A+ 1.07%
6.5 8.499999 Aa2/AA 0.85% 9.5 12.499999 Aa2/AA 0.85%
8.50 100000 Aaa/AAA 0.69% 12.5 100000 Aaa/AAA 0.69%
Cost of Debt - Hindalco
 If the firm is rated
 Cost of debt (before tax) = Rf +Default Spread (A1+) + Default
Spread (India)
 Cost of debt (before tax) = 4.47% + 1.07% + 2.39% = 7.93%
 Cost of debt (after tax) = 7.93% (1 – 0.3245) = 5.36%

 If the firm is not rated

 Cost of debt(before tax) = Rf + Synthetic Default Spread (A1+)
 Cost of debt(before tax) = 4.47% + 1.07% + = 5.54%
 Cost of debt(after tax) = 5.54%(1 – 0.3245) = 3.74%
Cost of Capital
 Cost of capital is a weighted average cost of the
different sources of funding done by a company

 Should we use book or value or market value

weights?
 Market value weights updated too frequently
 Book value weights taken from accounting values, which
is same source as other data
 Book value is more conservative than market value
Cost of Capital - Hindalco

Source Type Values INR Weight

Debt 65,92,60,00,000 6.75%
Equity 9,10,56,32,45,842 93.25%
TOTAL 9,76,48,92,45,842 100.00%

 Weighted Average Cost of Capital (WACC)

 WACC = We.Ke + Wd.Kd
 WACC = 0.9325 (12.56%) + 0.0675 (5.36%)
 WACC = 12.08%
Practice Problems
An analyst gathers the following information:
Security Expected Annual Expected Standard Correlation
Return Deviation between security
and market
Security 1 11 25 0.6
Security 2 11 20 0.7
Security 3 14 20 0.8
Market 10 15 1

Which security has the highest total risk?

Which security has the highest Beta measure?

Which security has the least amount of market risk?

 Practice Problems
Which security has the highest total risk?
Security 1 has the highest amount of standard deviation and hence the highest
amount of total risk

Which security has the highest Beta measure?

Security 3 has the highest Beta

Which security has the least amount of market risk?

Security 2 has the lowest Beta
Security Exp Annual Exp Standard Correlation Beta
Return (%) Deviation (%)
Security 1 11 25 0.6 (0.6 * 0.25)/0.15 = 1
Security 2 11 20 0.7 (0.7 * 0.20)/0.15 = 0.93
Security 3 14 20 0.8 (0.8 * 0.20)/0.15 = 1.07
Market 10 15 1
Practice Problems
An analyst gathers the following information
Security Standard Deviation Beta
Security 1 25 1.5
Security 2 15 1.4
Security 3 20 1.6
 With respect to the capital asset pricing model, if the expected market risk
premium is 6% and the risk-free rate is 3%. What is the expected return
for Security 1?
 With respect to the capital asset pricing model, if expected return for
Security 2 is equal to 11.4% and the risk-free rate is 3%. What is the
expected return for the market?
 With respect to the capital asset pricing model, if the expected market risk
premium is 6%. Which security has the highest expected return?
 With respect to the capital asset pricing model, if the expected market
return declines, which security will get impacted the most in terms of returns?
Practice Problems
 With respect to the capital asset pricing model, if the expected market risk
premium is 6% and the risk-free rate is 3%. What is the expected return
for Security 1?
 Exp Return = Rf + Beta(Rm = Rf) = 3% + 1.5(6%) = 12%

 With respect to the capital asset pricing model, if expected return for
Security 2 is equal to 11.4% and the risk-free rate is 3%. What is the
expected return for the market?
 Exp Return = Rf + Beta(Rm = Rf); 11.4% = 3% + 1.4(Rm – 3%); 9%

 With respect to the capital asset pricing model, if the expected market risk
premium is 6%. Which security has the highest expected return?
 Security 3 as Beta is highest (No calculation required)

 With respect to the capital asset pricing model, if the expected market
return declines, which security will get impacted the most in terms of returns?
 Security 3 as Beta is highest (No calculation required)
Practice Problems
An analyst observes the following historic geometric returns:
Asset Class Geometric Return
(%)
Equities 8
Corporate Bonds 6.5
Treasury Bills 2.5
Inflation 2.1

What is the real rate of return on equities?

What is the real rate of return on corporate bonds?
What is the risk premium on equities?
What is the risk premium on corporate bonds?
Practice Problems
 What is the real rate of return on equities?
= 1.08/1.021 = 5.78%
 What is the real rate of return on corporate bonds?

= 1.065/1.021 = 4.3%
 What is the risk premium on equities?

=8 – 2.5 = 5.5%
 What is the risk premium on corporate bonds?

=6.5 – 2.5 = 4%