# THE REQUIRED RATE OF RETURN ON INVESTMENT AND SHAREHOLDER VALUE

Document Sample

```					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
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

```
DOCUMENT INFO
Shared By:
Categories:
Stats:
 views: 37 posted: 4/18/2011 language: English pages: 17