THE REQUIRED RATE OF RETURN ON INVESTMENT AND SHAREHOLDER VALUE

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					THE REQUIRED RATE OF RETURN
     ON INVESTMENT AND
SHAREHOLDER VALUE ANALYSIS
                     The Cost of Equity
   Assuming all-equity finance,what is the required
    return i.e. the cost of equity
   Essentially an opportunity cost – investors look at
    rates of return achieved by comparable firms
   How to measure it?
       A. Refer to past achieved returns
       B. “Read the market” - what required return is implied by
        current market value of company?
       C. Capital Asset Pricing Model
            (Modern Portfolio Theory)
    A. Analysis of Past Equity Returns (1)

   XZZ earned PAT of $12m in 2002
   Balance Sheet shows:
   Net Assets                   $96m
   Issued Share Capital        $30m
   Reserves                     $66m
   Shareholders’ Funds          $96m
   What is the ROE?
                   The ROE
   ROE = PAT/Equity = ($12m/$96m) = 13%
   Is this the required return??
   Year 2002 ROE may be untypically high/low
    - use a run of years
   PAT may be distorted by accounting policies
    - why use accounting data at all?
   Preferable to base analysis on returns on
    market value, not book value
    A. Analysis of Past Equity Returns (2)
   Calculate Total Shareholder Return year-by-year
   TSR = Dividend +/- capital gain as a % of opening
    share price
   Average out over selected time period

   How typical is the time period?
   Measures achievement, not requirements.
   Even if it measured requirements, would
    shareholders continue to seek same returns in the
    future?
           B. Analysis of Share Price

    Dividend Discount Model states:
   “The value of a share is the sum of all future
    discounted dividends’

   For growing dividend stream:
   Po = D1 = Do(1 + g)
          ke - g     ke - g
                  Application

   Re-arranging the formula:
    ke = D1 + g = Do(1 + g) + g
           Po                   Po
   Required information:
   Today’s share price:            Po = $20
   Last year’s dividend per share: Do = $1.85
   Recent growth in dividends: g = 8%
                  Solution
    ke = D1 + g = Do(1 + g) + g
             Po                Po
    ke = ($2/$20) + 8% = (10% + 8%) = 18%
   Implies that stock market values future
    dividends at 18% discount, hence:
   18% = required return on firm’s shares
   i.e. cost of equity capital
                       Problems!
   Assumes recent growth is representative of future
    expectations
   Assumes constant rate of growth
   Requires that share price is set by an efficient
    market
   Gives company-wide required return - unable to
    assess return required on segments of differing
    degrees of risk
   Susceptible to date of analysis - focus share price
    should be ex-dividend
   What if company is unquoted?
        C. Capital Asset Pricing Model

   Cornerstone of Modern Finance Theory
   Helps us determine:
     how the market values assets of differing degrees
      of risk
     what risk premium to apply for specified levels of
      risk
     hence, what rate of return is required for
      activities of varying risk
                     Application
   Required information:
   Current risk-free rate
      take yield on short-dated govt. stock, say 5%
   Beta value
      consult a “Beta Book” - say, Beta = 1.25
   Expected risk premium on market portfolio
      look at historical result - 6% for UK
   Required return on XYZ’s shares:
           = 5% + 1.25[6%] = 12.5%
                   The hierarchy of Betas




Figure 12.2 The Beta pyramid
        The CAPM and Project Appraisal

   Would you apply the 12.5% rate to all cash flows for
    all new activities?
   No, because Beta of 1.25 is the company average
      Some activities have higher risk, others lower

   Using a uniform discount rate invites errors –
       Se following diagram
   Solution: look for surrogates
      take Betas of comparable companies
                  Risk premiums in activities
                        of varying risk




Figure 12.1 Risk premiums for activities of varying risk
               Some Issues To Resolve
   Risk differences between and within divisions
   Identify the Revenue Sensitivity Factors (RSFs)
    and the Operating Gearing Factors (OGFs)
   Individual divisional Betas
   RSF = variation in divisional revenue relative to
    overall firm revenue variation for given fluctuation
    in economic activity
   e.g. economy grows by 5%, firm’s revenue grows by
    8%, divisional revenue grows by 4%:
       RSF = (4%/8%) = 0.5
                Operating Gearing
              Factor/Divisional Beta
   Operating Gearing Factor = variation in
    divisional cash flow relative to overall firm cash flow
    variation for given fluctuation in sales
   Depends on relative importance of fixed costs and
    variable costs as between firm and the division
   e.g. operating gearing factor for firm = 1.2, operating
    gearing factor for division = 1.5
   Relative OGF = 1.5/1.2 = 1.25
   If firm Beta = 1.1, divisional Beta =
     Firm Beta x RSF x OGF = 1.1 x 0.5 x 1.25 = 0.7
   Hence, this division is less risky than the firm
                   Two Other Issues

   1. Impact of borrowing:
       Financial risk raises the equity Beta


   2. The Beta for foreign investment projects:
     FDI not necessarily more risky!
     Remember the portfolio principle

				
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