Risk and Return – Finance

Order Description

III. Risk and Return

•

To understand the risk profile of the company, estimate risk parameters and the hurdle

rates for the firm, try answering the following questions:

1.

Estimati

ng Historical Risk Parameters (Top Down Betas)

Run a regression of returns on your firm’s stock against returns on a market index, preferably

using monthly data and 5 years of observations (or)

If you have access to Bloomberg, go into the beta calculat

ion page and print off the page (after

setting return intervals to monthly and using 5 years of data)

•

What is the intercept of the regression? What does it tell you about the performance of

this company’s stock during the period of the regression?

•

What

is the slope of the regression?

–

What does it tell you about the risk of the stock?

–

How precise is this estimate of risk? (Provide a range for the estimate.)

•

What portion of this firm’s risk can be attributed to market factors? What portion to

firm

–

specific factors? Why is this important?

•

How much of the risk for this firm is due to business factors? How much of it is due to

financial leverage?

1.

Comparing to Sector Betas (Bottom up Betas)

•

Break down your firm by business components, and estimate a business beta for

each component

•

Attach reasonable weights to each component and estimate an unlevered beta for

the business.

•

Using the current leverage of the company, estimate a levered beta f

or each

component.

2.

Choosing Between Betas

•

Which of the betas that you have estimated for the firm (top down or bottom up)

would you view as more reliable? Why?

•

Using the beta that you have chosen, estimate the expected return on an equity

investment i

n this company to

*

a short term investor

*

a long term investor

•

As a manager in this firm, how would you use this expected return?

3.

Estimating Default Risk and Cost of Debt

If your company is rated,

•

What is the most recent rating for the firm?

•

What is the default spread and interest rate associated with this rating?

•

If your company has bonds outstanding, estimate the yield to maturity on a long

term bond? Why might this be different from the rate es

timated in the last step?

•

What is the company’s marginal tax rate?

If your company is not rated,

•

Does it have any recent borrowings? If yes, what interest rate did the

company pay on these borrowing?

•

Can you estimate a synthetic rating? I

f yes, what interest rate would

correspond to this rating?)

4.

Estimating Cost of Capital

Weights for Debt and Equity

•

What is the market value of equity?

•

Estimate a market value for debt. (To do this you might have to collect

information on the average maturity of the debt, the interest expenses in the

most recent period and the book value of the debt)

•

What are the weights of debt and equity?

C

ost of Capital

•

What is the cost of capital for the firm?

–COMPANIES ARE—

Abudhabi National Energy Company (Taqa)

Dubai Financial Market