Picking the Right Investments Choosing the Right Discount

Picking the Right Investments Choosing the Right Discount Rate P. V. Viswanath Based on Damodaran’s Corporate Finance

What is a investment or a project? w Any decision that requires the use of resources (financial or otherwise) is a project. w Broad strategic decisions n n n Entering new areas of business Entering new markets Acquiring other companies w Tactical decisions w Management decisions n n The product mix to carry The level of inventory and credit terms w Decisions on delivering a needed service n n Lease or buy a distribution system Creating and delivering a management information system P. V. Viswanath 2

The notion of a benchmark w Since financial resources are finite, there is a hurdle that projects have to cross before being deemed acceptable. w This hurdle will be higher for riskier projects than for safer projects. w A simple representation of the hurdle rate is as follows: Hurdle rate = Return for postponing consumption + Return for bearing risk Hurdle rate = Riskless Rate + Risk Premium w The two basic questions that every risk and return model in finance tries to answer are: n n How do you measure risk? How do you translate this risk measure into a risk premium? P. V. Viswanath 3

The Capital Asset Pricing Model w Uses variance as a measure of risk w Specifies that a portion of variance can be diversified away, and that is only the non-diversifiable portion that is rewarded. w Measures the non-diversifiable risk with beta, which is standardized around one. w Relates beta to hurdle rate or the required rate of return: Reqd. ROR = Riskfree rate + b (Risk Premium) w Works as well as the next best alternative in most cases. P. V. Viswanath 4

The Mean-Variance Framework w The variance on any investment measures the disparity between actual and expected returns. Low Variance Investment High Variance Investment Expected Return P. V. Viswanath 5

The Importance of Diversification: Risk Types w The risk (variance) on any individual investment can be broken down into two sources: firm-specific risk and market-wide risk, which affects all investments. w The risk faced by a firm can be fall into the following categories: n n n (1) Project-specific; an individual project may have higher or lower cash flows than expected. (2) Competitive Risk: the earnings and cash flows on a project can be affected by the actions of competitors. (3) Industry-specific Risk: covers factors that primarily impact the earnings and cash flows of a specific industry. (4) International Risk: arising from having some cash flows in currencies other than the one in which the earnings are measured and stock is priced (5) Market risk: reflects the effect on earnings and cash flows of macro economic factors that essentially affect all companies P. V. Viswanath 6

The Effects of Diversification w Firm-specific risk (project specific, competitive and industry -specific) can be reduced, if not eliminated, by increasing the number of investments in your portfolio. w International risk can be reduced by holding a globally diversified portfolio. w Market-wide risk cannot be avoided. w Diversifying and holding a larger portfolio eliminates firmspecific risk for two reasonsn n (a) Each investment is a much smaller percentage of the portfolio, muting the effect (positive or negative) on the overall portfolio. (b) Firm-specific actions can be either positive or negative. In a large portfolio, it is argued, these effects will average out to zero. (For every firm, where something bad happens, there will be some other firm, where something good happens. ) P. V. Viswanath 7

The Role of the Marginal Investor w The marginal investor in a firm is the investor who is most likely to be the buyer or seller on the next trade. w Since trading is required, the largest investor may not be the marginal investor, especially if he or she is a founder/manager of the firm (Michael Dell at Dell Computers or Bill Gates at Microsoft) w We assume that the marginal investor is well diversified. This makes sense since diversified investors will, all else being the same, be willing to pay a higher price for a given asset, and will drive non-diversified investors out of the market. w The marginal investor determines the price of an asset since s/he is the most likely trader of the asset. P. V. Viswanath 8

The Market Portfolio w Assuming diversification costs nothing (in terms of transactions costs), and that all assets can be traded, the limit of diversification is to hold a portfolio of every single asset in the economy (in proportion to market value). This portfolio is called the market portfolio. w We assume that the marginal investor holds the market portfolio as the risky part of his/her portfolio. w (The overall risk of an investor’s portfolio can be modified by investing a portion of the total investment in the riskless asset. This does not affect diversification. ) P. V. Viswanath 9

The Risk and Risk Premium of an Individual Asset w We already know that the pricing of an asset is determined with respect to the marginal investor w Hence the risk premium required for a particular asset is the risk premium demanded by the marginal investor for that asset. w And since the marginal investor holds the market portfolio, n n the risk premium for an average security, i. e. one that mimics the market, is the required risk premium on the market, i. e. , the excess of the expected return on the market over the riskfree rate (E(Rm) – Rf). the risk of any asset is the risk that it adds to the market portfolio. w Beta is a measure of the non-diversifiable risk for any asset. P. V. Viswanath 10

The Required ROR on an Individual Asset w This asset risk can be measured by how much an asset moves with the market (called the covariance) w Beta is a standardized measure of this covariance. w An asset’s beta can be measured by the covariance of its returns with returns on a market index, normalized by the variance of returns on the market portfolio: b = Cov(Rasset, Rm)/Var(Rm). w The risk premium for an asset with a given asset risk of b is equal to b times the risk premium for a stock of average risk. w That is, the required rate of return on an asset will be: Required ROR = Rf + b (E(Rm) - Rf) P. V. Viswanath 11