1PL lnvLS1MLn1 8lnClLL: 8lSk

Anu 8L1u8n MCuLLS

?ou cannoL swlng upon a rope LhaL ls auached only
Lo your own belL.
!"#$%& ($)*+$,$- 0
1
llrsL rlnclples
!"#$%& ($)*+$,$-
1
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The Financing Decision
Find the right kind of debt
for your rm and the right
mix of debt and equity to
fund your operations
The Dividend Decision
If you cannot nd investments
that make your minimum
acceptable rate, return the cash
to owners of your business
The hurdle rate
should reect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should reect the
magnitude and
the timing of the
cashows as welll
as all side effects.
The optimal
mix of debt
and equity
maximizes rm
value
The right kind
of debt
matches the
tenor of your
assets
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks
Maximize the value of the business (rm)
2
1he nouon of a benchmark
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2
! Slnce nanclal resources are nlLe, Lhere ls a hurdle LhaL
pro[ecLs have Lo cross before belng deemed accepLable.
1hls hurdle should be hlgher for rlskler pro[ecLs Lhan for
safer pro[ecLs.
! A slmple represenLauon of Lhe hurdle raLe ls as follows:
Purdle raLe = 8lskless 8aLe + 8lsk remlum
! 1he Lwo baslc quesuons LhaL every rlsk and reLurn model
ln nance Lrles Lo answer are:
! Pow do you measure rlsk?
! Pow do you LranslaLe Lhls rlsk measure lnLo a rlsk premlum?
3
WhaL ls 8lsk?
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3
! 8lsk, ln Lradluonal Lerms, ls vlewed as a negauve.
WebsLers dlcuonary, for lnsLance, denes rlsk as exposlng
Lo danger or hazard. 1he Chlnese symbols for rlsk,
reproduced below, glve a much beuer descrlpuon of rlsk

! 1he rsL symbol ls Lhe symbol for danger, whlle Lhe second
ls Lhe symbol for opporLunlLy, maklng rlsk a mlx of danger
and opporLunlLy. ?ou cannoL have one, wlLhouL Lhe oLher.
! 8lsk ls Lherefore nelLher good nor bad. lL ls [usL a facL of llfe.
1he quesuon LhaL buslnesses have Lo address ls Lherefore noL
wheLher Lo avold rlsk buL how besL Lo lncorporaLe lL lnLo Lhelr
declslon maklng.
4
A good rlsk and reLurn model should.
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4
1. lL should come up wlLh a measure of rlsk LhaL applles Lo all asseLs
and noL be asseL-speclc.
2. lL should clearly dellneaLe whaL Lypes of rlsk are rewarded and
whaL are noL, and provlde a rauonale for Lhe dellneauon.
3. lL should come up wlLh sLandardlzed rlsk measures, l.e., an
lnvesLor presenLed wlLh a rlsk measure for an lndlvldual asseL
should be able Lo draw concluslons abouL wheLher Lhe asseL ls
above-average or below-average rlsk.
4. lL should LranslaLe Lhe measure of rlsk lnLo a raLe of reLurn LhaL
Lhe lnvesLor should demand as compensauon for bearlng Lhe
rlsk.
3. lL should work well noL only aL explalnlng pasL reLurns, buL also ln
predlcung fuLure expecLed reLurns.
5
1he CaplLal AsseL rlclng Model
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5
1. uses varlance of acLual reLurns around an expecLed
reLurn as a measure of rlsk.
2. Specles LhaL a poruon of varlance can be dlversled
away, and LhaL ls only Lhe non-dlverslable poruon
LhaL ls rewarded.
3. Measures Lhe non-dlverslable rlsk wlLh beLa, whlch ls
sLandardlzed around one.
4. 1ranslaLes beLa lnLo expecLed reLurn -
LxpecLed 8eLurn = 8lskfree raLe + 8eLa * 8lsk remlum
3. Works as well as Lhe nexL besL alLernauve ln mosL
cases.
6
1. 1he Mean-varlance lramework
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6
! 1he varlance on any lnvesLmenL measures Lhe dlsparlLy
beLween acLual and expecLed reLurns.
Expected Return
Low Variance Investment
High Variance Investment
7
Pow rlsky ls ulsney? A look aL Lhe pasL.
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7
-23.00
-20.00
-13.00
-10.00
-3.00
0.00
3.00
10.00
13.00
20.00
23.00
C
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l
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A
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A
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C
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u
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l
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-
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0

A
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!
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A
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C
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l
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A
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!
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A
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C
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u
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1

l
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1
2

A
p
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-
1
2

!
u
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-
1
2

A
u
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-
1
2

C
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-
1
2

u
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1
2

l
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3

A
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!
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A
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3

./%0,-" *- (1"-/2 3 455634578
Average monLhly reLurn = 1.63
Average monLhly sLandard devlauon = 7.64
Average annual reLurn = 21.70
Average annual sLandard devlauon = 26.47
8
uo you llve ln a mean-varlance world?
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8
! Assume LhaL you had Lo plck beLween Lwo lnvesLmenLs. 1hey
have Lhe same expecLed reLurn of 13 and Lhe same
sLandard devlauon of 23, however, lnvesLmenL A oers a
very small posslblllLy LhaL you could quadruple your money,
whlle lnvesLmenL 8s hlghesL posslble payo ls a 60 reLurn.
Would you
a. be lndlerenL beLween Lhe Lwo lnvesLmenLs, slnce Lhey have Lhe
same expecLed reLurn and sLandard devlauon?
b. prefer lnvesLmenL A, because of Lhe posslblllLy of a hlgh payo?
b. prefer lnvesLmenL 8, because lL ls safer?
! Would your answer change lf you were noL Lold LhaL Lhere ls
a small posslblllLy LhaL you could lose 100 of your money on
lnvesLmenL A buL LhaL your worsL case scenarlo wlLh
lnvesLmenL 8 ls -30?
9
1he lmporLance of ulverslcauon: 8lsk 1ypes
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9
Actions/Risk that
affect only one
firm
Actions/Risk that
affect all investments
Firm-specific Market
Projects may
do better or
worse than
expected
Competition
may be stronger
or weaker than
anticipated
Entire Sector
may be affected
by action
Exchange rate
and Political
risk
Interest rate,
Inflation &
news about
economy
Figure 3.5: A Break Down of Risk
Affects few
firms
Affects many
firms
Firm can
reduce by
Investing in lots
of projects
Acquiring
competitors
Diversifying
across sectors
Diversifying
across countries
Cannot affect
Investors
can
mitigate by
Diversifying across domestic stocks Diversifying across
asset classes
Diversifying globally
10
Why dlverslcauon reduces/ellmlnaLes
rm speclc rlsk
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10
! llrm-speclc rlsk can be reduced, lf noL ellmlnaLed, by
lncreaslng Lhe number of lnvesLmenLs ln your poruollo
(l.e., by belng dlversled). MarkeL-wlde rlsk cannoL. 1hls
can be [usued on elLher economlc or sLausucal
grounds.
! Cn economlc grounds, dlverslfylng and holdlng a larger
poruollo ellmlnaLes rm-speclc rlsk for Lwo reasons-
a. Lach lnvesLmenL ls a much smaller percenLage of Lhe poruollo,
muung Lhe eecL (posluve or negauve) on Lhe overall
poruollo.
b. llrm-speclc acuons can be elLher posluve or negauve. ln a
large poruollo, lL ls argued, Lhese eecLs wlll average ouL Lo
zero. (lor every rm, where someLhlng bad happens, Lhere
wlll be some oLher rm, where someLhlng good happens.)
11
1he 8ole of Lhe Marglnal lnvesLor
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11
! 1he marglnal lnvesLor ln a rm ls Lhe lnvesLor who ls
mosL llkely Lo be Lhe buyer or seller on Lhe nexL Lrade
and Lo lnuence Lhe sLock prlce.
! Cenerally speaklng, Lhe marglnal lnvesLor ln a sLock has
Lo own a loL of sLock and also Lrade LhaL sLock on a
regular basls.
! Slnce Lradlng ls requlred, Lhe largesL lnvesLor may noL be
Lhe marglnal lnvesLor, especlally lf he or she ls a
founder/manager of Lhe rm (Larry Llllson aL Cracle,
Mark Zuckerberg aL lacebook)
! !" $%% &'() $"* &+,-&" ./*+%( '" 0"$"1+2 3+ $((-.+ ,4$,
,4+ .$&5'"$% '"6+(,/& '( 3+%% *'6+&('0+*.
12
ldenufylng Lhe Marglnal lnvesLor ln your rm.
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12
Percent of Stock held
by Institutions
Percent of Stock held by
Insiders
Marginal Investor
High Low Institutional Investor
High High Institutional Investor, with insider influence
Low High (held by
founder/manager of firm)
Tough to tell; Could be insiders but only if they
trade. If not, it could be individual investors.
Low High (held by wealthy
individual investor)
Wealthy individual investor, fairly diversified
Low Low Small individual investor with restricted
diversification

13
Cauglng Lhe marglnal lnvesLor: ulsney ln
2013
Aswath Damodaran
14
LxLendlng Lhe assessmenL of Lhe lnvesLor
base
! ln all ve of Lhe publlcly Lraded companles LhaL we
are looklng aL, lnsuLuuons are blg holders of Lhe
company's sLock.
Aswath Damodaran
15
1he Llmlung Case: 1he MarkeL oruollo
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15
! 1he blg assumpuons & Lhe follow up: Assumlng dlverslcauon
cosLs noLhlng (ln Lerms of Lransacuons cosLs), and LhaL all asseLs
can be Lraded, Lhe llmlL of dlverslcauon ls Lo hold a poruollo of
every slngle asseL ln Lhe economy (ln proporuon Lo markeL value).
1hls poruollo ls called Lhe markeL poruollo.
! 1he consequence: lndlvldual lnvesLors wlll ad[usL for rlsk, by
ad[usung Lhelr allocauons Lo Lhls markeL poruollo and a rlskless
asseL (such as a 1-8lll):
9,/:/,,/+ ,1"; </=/< !<<*>$?*- +/>1"1*-
no rlsk 100 ln 1-8llls
Some rlsk 30 ln 1-8llls, 30 ln MarkeL oruollo,
A llule more rlsk 23 ln 1-8llls, 73 ln MarkeL oruollo
Lven more rlsk 100 ln MarkeL oruollo
A rlsk hog.. 8orrow money, lnvesL ln markeL poruollo
16
1he 8lsk of an lndlvldual AsseL
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16
! 1he essence: 1he rlsk of any asseL ls Lhe rlsk LhaL lL adds Lo
Lhe markeL poruollo SLausucally, Lhls rlsk can be measured by
how much an asseL moves wlLh Lhe markeL (called Lhe
covarlance)
! 1he measure: 8eLa ls a sLandardlzed measure of Lhls
covarlance, obLalned by dlvldlng Lhe covarlance of any asseL
wlLh Lhe markeL by Lhe varlance of Lhe markeL. lL ls a
measure of Lhe non-dlverslable rlsk for any asseL can be
measured by Lhe covarlance of lLs reLurns wlLh reLurns on a
markeL lndex, whlch ls dened Lo be Lhe asseL's beLa.
! 1he resulL: 1he requlred reLurn on an lnvesLmenL wlll be a
llnear funcuon of lLs beLa:
! LxpecLed 8eLurn = 8lskfree 8aLe+ 8eLa * (LxpecLed 8eLurn on Lhe
MarkeL oruollo - 8lskfree 8aLe)
17
LlmlLauons of Lhe CAM
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17
1. 1he model makes unreallsuc assumpuons
2. 1he parameLers of Lhe model cannoL be esumaLed
preclsely
! 1he markeL lndex used can be wrong.
! 1he rm may have changed durlng Lhe 'esumauon' perlod'
3. 1he model does noL work well
! - lf Lhe model ls rlghL, Lhere should be:
" A llnear relauonshlp beLween reLurns and beLas
" 1he only varlable LhaL should explaln reLurns ls beLas
! - 1he reallLy ls LhaL
" 1he relauonshlp beLween beLas and reLurns ls weak
" CLher varlables (slze, prlce/book value) seem Lo explaln
dlerences ln reLurns beuer.
18
AlLernauves Lo Lhe CAM
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18
The risk in an investment can be measured by the variance in actual returns around an
expected return
E(R)
Riskless Investment Low Risk Investment High Risk Investment
E(R) E(R)
Risk that is specific to investment (Firm Specific) Risk that affects all investments (Market Risk)
Can be diversified away in a diversified portfolio Cannot be diversified away since most assets
1. each investment is a small proportion of portfolio are affected by it.
2. risk averages out across investments in portfolio
The marginal investor is assumed to hold a diversified portfolio. Thus, only market risk will
be rewarded and priced.
The CAPM The APM Multi-Factor Models Proxy Models
If there is
1. no private information
2. no transactions cost
the optimal diversified
portfolio includes every
traded asset. Everyone
will hold this market portfolio
Market Risk = Risk
added by any investment
to the market portfolio:
If there are no
arbitrage opportunities
then the market risk of
any asset must be
captured by betas
relative to factors that
affect all investments.
Market Risk = Risk
exposures of any
asset to market
factors
Beta of asset relative to
Market portfolio (from
a regression)
Betas of asset relative
to unspecified market
factors (from a factor
analysis)
Since market risk affects
most or all investments,
it must come from
macro economic factors.
Market Risk = Risk
exposures of any
asset to macro
economic factors.
Betas of assets relative
to specified macro
economic factors (from
a regression)
In an efficient market,
differences in returns
across long periods must
be due to market risk
differences. Looking for
variables correlated with
returns should then give
us proxies for this risk.
Market Risk =
Captured by the
Proxy Variable(s)
Equation relating
returns to proxy
variables (from a
regression)
Step 1: Defining Risk
Step 2: Differentiating between Rewarded and Unrewarded Risk
Step 3: Measuring Market Risk
19
Why Lhe CAM perslsLs.
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19
! 1he CAM, noLwlLhsLandlng lLs many crlucs and llmlLauons,
has survlved as Lhe defaulL model for rlsk ln equlLy valuauon
and corporaLe nance. 1he alLernauve models LhaL have
been presenLed as beuer models (AM, MulufacLor model..)
have made lnroads ln performance evaluauon buL noL ln
prospecuve analysls because:
! 1he alLernauve models (whlch are rlcher) do a much beuer [ob Lhan
Lhe CAM ln explalnlng pasL reLurn, buL Lhelr eecuveness drops o
when lL comes Lo esumaung expecLed fuLure reLurns (because Lhe
models Lend Lo shl and change).
! 1he alLernauve models are more compllcaLed and requlre more
lnformauon Lhan Lhe CAM.
! lor mosL companles, Lhe expecLed reLurns you geL wlLh Lhe Lhe
alLernauve models ls noL dlerenL enough Lo be worLh Lhe exLra
Lrouble of esumaung four addluonal beLas.
20
Appllcauon 1esL: Who ls Lhe marglnal lnvesLor
ln your rm?
!"#$%& ($)*+$,$-
20
! ?ou can geL lnformauon on lnslder and lnsuLuuonal
holdlngs ln your rm from:
! hup://nance.yahoo.com/
! LnLer your companys symbol and choose prole.
! Looklng aL Lhe breakdown of sLockholders ln your
rm, conslder wheLher Lhe marglnal lnvesLor ls
! An lnsuLuuonal lnvesLor
! An lndlvldual lnvesLor
! An lnslder
21
llrsL rlnclples
!"#$%& ($)*+$,$-
21
The Investment Decision
Invest in assets that earn a
return greater than the
minimum acceptable hurdle
rate
The Financing Decision
Find the right kind of debt
for your rm and the right
mix of debt and equity to
fund your operations
The Dividend Decision
If you cannot nd investments
that make your minimum
acceptable rate, return the cash
to owners of your business
The hurdle rate
should reect the
riskiness of the
investment and
the mix of debt
and equity used
to fund it.
The return
should reect the
magnitude and
the timing of the
cashows as welll
as all side effects.
The optimal
mix of debt
and equity
maximizes rm
value
The right kind
of debt
matches the
tenor of your
assets
How much
cash you can
return
depends upon
current &
potential
investment
opportunities
How you choose
to return cash to
the owners will
depend on
whether they
prefer dividends
or buybacks
Maximize the value of the business (rm)