Post on 07-Jul-2018
8/19/2019 SlidesSession 7 FMII BM 2015-17
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BM 15-17: FM IISession 7
Uday Damodaran XLRI Jamshedpur
1
Session 7:Can the Capital Structure Be a Source ofValue? Understanding Risk Drivers
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
2
Value Drivers ….
The Valuation Formula..ROE and Profitability, Competitive Advantage Period/Sustainability, Reinvestment/ GrowthAnd… possibly the discount rate (The opportunity cost ofcapital)
BM 15-17: FM IISession 7
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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
BM 15-17: FM IISession 7
Of these, whatare economy-wide factors,and thereforeout of yourcontrol?
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
4
Risk, and the Risk Premium
Therefore, we now focus on measuring risk, and evaluatingthe risk premium
BM 15-17: FM IISession 7
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
d d
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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%
BM 15-17: FM IISession 7
Ud D d
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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%
BM 15-17: FM IISession 7
Ud D d
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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
BM 15-17: FM IISession 7
Ud D d
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
11
Data Requirements
So to ‘characterize’ a portfolio,Expected Returns, Dispersions, and Comovements
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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)
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
13
Diversification and Portfolio Risk
So when does diversification work best? What does it dependon?
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
16
Read…
Section 7-1, 7-2 and 7-3
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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Uday Damodaran XLRI Jamshedpur
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
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
http://slidepdf.com/reader/full/slidessession-7-fmii-bm-2015-17 20/24
Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
http://slidepdf.com/reader/full/slidessession-7-fmii-bm-2015-17 21/24
Uday Damodaran XLRI Jamshedpur
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?
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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y XLRI Jamshedpur
22
Data
What data do we require?What will the scatter diagram look like?
BM 15-17: FM IISession 7
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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y XLRI Jamshedpur
23
Single Index Model
R it = a i + βi R mt + e it
BM 15-17: FM IISession 7
And if youtake thevariance?
Uday Damodaran
8/19/2019 SlidesSession 7 FMII BM 2015-17
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y XLRI Jamshedpur
24
Single Index Model
σ i2 = βi
2σm2 + σei
2
Total Risk = Systematic Risk + Unique Risk
BM 15-17: FM IISession 7