Risk and Return – Finance
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:
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?
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
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
Comparing to Sector Betas (Bottom up Betas)
Break down your firm by business components, and estimate a business beta for
Attach reasonable weights to each component and estimate an unlevered beta for
Using the current leverage of the company, estimate a levered beta f
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
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?
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?)
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?
ost of Capital
What is the cost of capital for the firm?
Abudhabi National Energy Company (Taqa)
Dubai Financial Market