Prachi Deuskar: Corporate Finance I ISB - PGP Co2023 - Term 3

Recap
Quantifying and pricing Risks

The CAPM
Getting cost of capital
Conclusion
Chapter mapping
Corporate Finance I
ISB – PGP Co2023 – Term 3
Prachi Deuskar
Indian School of Business
August 2022, Session 2
Prachi Deuskar CFin I: Session 2

Recap
The CAPM
Conclusion
Chapter mapping
Agenda - Session 2
1 Recap
2 Quantifying and pricing Risks
3 The CAPM
4 Getting cost of capital
5 Conclusion
6 Chapter mapping

Recap
The CAPM
Conclusion
Chapter mapping
Investment Decisions
Objective: shareholder value maximization

Investment decisions: NPV rule
Net present value (NPV) = PV(cash inflows) - PV(cash
outflows)P
FCFt
NPV = t (1+r t)
t
FCF = Free Cash Flow (Expected)

Discount rate = cost of capital
Risk free interest rate for certain (i.e. risk free) cash flows.
Required rate of return for projects with similar risk for
uncertain (i.e. risky) cash flows.

Recap
The CAPM
Conclusion
Chapter mapping
Investment Decisions
NPV Decision rule

If projects are independent, choose all with NPV>0.
If projects are mutually exclusive, choose the project with
highest NPV and NPV>0.
NPV = Addition to shareholder value
This class:
Cost of capital for risky cash flows

Recap
The CAPM Risk: A shareholder’s perspective
Getting cost of capital Pricing risk
Conclusion
Chapter mapping
Summary
Shareholders hold a diversified portfolio

Diversification gets rid of idiosyncratic risk
Diversification cannot remove systematic risk

Risk from shareholders’ perspective = Systematic Risk

Recap
Conclusion
Chapter mapping
Summary



Recap
Conclusion
Chapter mapping
Summary



Recap
Conclusion
Chapter mapping
Compensation for Risk
N
!
X 1 1 1
Portfolio Variance = Var ri = Var + 1 − Cov
N N N
i=1
Imagine firms with only idiosyncratic risk and no systematic

risk
Cov = 0
Then, for a well-diversified portfolio (i.e. very large N)
Portfolio Variance → 0

The risk‐free interest rate is 5% p.a. A portfolio of assets
with only idiosyncratic risk has portfolio variance of 0. This
portfolio as well as a risk‐free bond pay 5,000 each, 1 year
later. Today's price i.e. PV (rounded off to nearest rupee) of
this diversified portfolio is
Recap
Conclusion
Chapter mapping
Imagine firms with both idiosyncratic risk and systematic risk

Investors require compensation only for the systematic
(market) risk
Why?

Recap
Conclusion
Chapter mapping
Concept summary
Diversification: Sharing risks

If risk is not systematic, the shareholders can get rid of it
If risk is systematic, they cannot get rid of it
Investors demand a risk premium (compensation) for bearing
risks that cannot be eliminated

Recap
The CAPM
Theory and intuition
Conclusion
Chapter mapping
Asset Pricing Models
Asset pricing models attempt to answer the following two

questions
1 What is the relevant measure of risk?
2 What is the compensation for this measure of risk (risk
premium)?
This will allow us to determine the opportunity cost of capital

Recap
The CAPM
Conclusion
Chapter mapping
Pricing Systematic Risks
The Capital Asset Pricing Model: CAPM

Required Return=Risk Free Rate + Beta×Market Risk Premium
Cov (ri , rm )
ERi = Rf + βi [ERm − Rf ], where βi =
Var (rm )
Market portfolio = The diversified portfolio

Beta: Measure of Systematic Risk
Market Risk Premium= Expected Return on Market Portfolio - Risk Free Rate

Recap
The CAPM
Conclusion
Chapter mapping
Pricing Systematic Risks
We can use the CAPM to determine the opportunity cost of

capital when cash flows are uncertain.

Recap
The CAPM
Conclusion
Chapter mapping
What the CAPM is saying (in English)
Covariance (with the market portfolio), not variance, is the

appropriate measure of risk for a firm
Contribution of an asset to the risk of investor’s portfolio
High beta assets have high expected returns
High return in good times (when market portfolio is doing
well) and low return in bad times
Beta, and not standard deviation, determines expected returns

Recap
The CAPM
Conclusion
Chapter mapping
Why CAPM ?
Who is valuing the cash flows?

Diversified investors
Invest in the market portfolio
What is their opportunity cost? What else could they do with
the money?
They could invest in a diversified portfolio that is equivalent in
terms of risk, i.e., has the same beta
Since β is the only relevant measure of risk in determining the
opportunity cost of capital, we only need to price a
comparable portfolio that has the same β to value the project

Recap
The CAPM
Conclusion
Chapter mapping
What if some investors are not diversified?
Shouldn’t they be compensated for idiosyncratic risk?

Not in competitive financial markets!

Recap Big picture
Quantifying and pricing Risks Different betas
The CAPM WACC
Getting cost of capital Cost of capital: Firm or Project
Conclusion Determinants of Beta
Chapter mapping Risk-free rate and market risk premium
CAPM and cost of capital
Cov (ri ,rm )

ERi = Rf + βi [ERm − Rf ], where βi = Var (rm )
If market goes up by 1%, stock i goes up by βi %.

Recap Big picture
The CAPM WACC
Beta - shortcut
General formula for beta
Cov (ri , rm )
βi =
Var (rm )
When there are only two possibilities, e.g. “Boom” and
“Recession”
Market has return of Um % in Boom and Dm % in Recession
Stock i has return of Ui % in Boom and Di % in Recession
Then,
Ui − Di
βi =
Um − Dm

Recap Big picture
The CAPM WACC
Assets, debt and equity betas
Value of assets = Value of the business = Debt + Equity
A=D +E
Note: D and E are market values of debt and equity. Also, D

is net debt i.e. debt net of extra cash.
Asset beta = weighted average of debt beta and equity beta
What are asset beta, equity beta and debt beta?

Recap Big picture
The CAPM WACC
Yeh beta, beta kya hai, yeh beta, beta!
https://youtube.com/clip/
UgkxqTjcuvW3nxBZ3oeS6aS0m27JMhyAIDFK

Recap Big picture
The CAPM WACC
Understanding asset beta

Recap Big picture
The CAPM WACC
Understanding asset beta

Recap Big picture
The CAPM WACC
Business and financial risk

Recap Big picture
The CAPM WACC
Levered and unlevered betas
Asset beta, debt beta, and equity beta

D E
βA = βD + βE
D +E D +E
Equity beta is the beta with leverage (incorporates both business
and financial risk)
Also called levered beta
Asset beta represents only business risk of firm assets
Also called unlevered beta

Recap Big picture
The CAPM WACC
Unlevering betas
If βD = 0,
Unlevering equity beta (calculating asset beta from equity
beta)
E βE
βA = βE =
D +E 1+ D E
For firms with low risk of default on their debt, βD is very
close to 0

Recap Big picture
The CAPM WACC
Levering betas
If βD = 0,
Levering asset beta (calculating equity beta from asset beta)

D +E D
βE = βA = 1 + βA
E E
For firms with low risk of default on their debt, βD is very

close to 0

Recap Big picture
The CAPM WACC
Steps in getting cost of capital
Estimate the equity beta from comparable firms (same

business)
Unlever equity beta to get asset beta
Relever asset beta with the target D/E to get equity beta for
your project
Compute the cost of equity using the CAPM by plugging in
equity beta
Cost of debt = Borrowing cost (adjusted for taxes)
Weighted Average Cost of Capital (WACC) = Firm’s cost of
capital = weighted average of the costs of debt and equity

Recap Big picture
The CAPM WACC
Asset Beta of a Multi-division Firm
Consider a firm with three divisions
A = A1 + A2 + A3
A1 A2 A3
βA = βA + βA + βA
A1 + A2 + A3 1 A1 + A2 + A3 2 A1 + A2 + A3 3
To evaluate projects, the firm should use cost of capital based

on beta of that project - not average beta of the firm.
What if a beverages company wanted to start an airline?
Use “pure play” comparables with similar business to get beta
for each project

Recap Big picture
The CAPM WACC
Asset Beta of a Multi-division Firm
Consider a firm with three divisions
A = A1 + A2 + A3
A1 A2 A3
βA = βA + βA + βA
A1 + A2 + A3 1 A1 + A2 + A3 2 A1 + A2 + A3 3
To evaluate projects, the firm should use cost of capital based

on beta of that project - not average beta of the firm.
What if a beverages company wanted to start an airline?
Use “pure play” comparables with similar business to get beta
for each project

Recap Big picture
The CAPM WACC
The Determinants of Beta
Cyclicality : Firms more affected by the business cycle tend to

have higher betas.
Industrywise unlevered betas for India.

Source: https://pages.stern.nyu.edu/˜adamodar/
Recap Big picture
The CAPM WACC
The Determinants of Beta
Leverage - Leverage magnifies the effects of sensitivity to

market movements.
Operating Leverage: Proportion of fixed costs to variable costs.
Financial Leverage: Debt in a firm’s capital structure.
Affects only equity beta.

Recap Big picture
The CAPM WACC
Risk-free rate
Typically the government bond (Treasury bond) return proxies

for the risk-free rate.
An often used (and reasonable) practice is to choose a
Treasury with a duration roughly matching the duration of the
project cash flows

Recap Big picture
The CAPM WACC
Market risk premium
Estimating the market risk premium is very difficult!

Usually, we consider broad stock market indices such as the
S&P 500, NIFTY 50, etc. as proxies of market portfolio.
The historical average excess return is often used but:
Lot of historical data needed to reduce estimation error.
However, this is problematic if expected excess returns are not
stable over time.

Recap
The CAPM
Conclusion
Chapter mapping
Risk and return in corporate finance
Only systematic risk is compensated

In CAPM, beta captures systematic risk
Get cost of equity using CAPM
ERi = Rf + βi [ERm − Rf ]
βi in the above equation is equity beta of firm i

Recap
The CAPM
Conclusion
Chapter mapping
Async 3
Chapter 10
Sections 10.5-10.6: These develop one of the most important
ideas of modern finance, which is critical in estimation of
discount rate. Specifically, understand relevance of distinction
between systematic vs. unsystematic risk.

Recap
The CAPM
Conclusion
Chapter mapping
Sync 2 and Async 4

Chapter 10
Sections 10.7-10.8: Continued discussion of important ideas of
modern finance critical in estimation of discount rate. Beta as
a measure of systematic risk and its use in estimation of cost
of capital, and finally, meaning and importance of holding a
diversified portfolio.
12.1, 12.2, 12.3: These develop key concepts for application of
the CAPM to estimate equity cost of capital. Make sure that
you master these concepts.
12.5: Unlevering and levering of betas. Critical concept needed
to use comparable firms’ betas as inputs for a project’s cost of
capital.
12.6: Only focus on the first part with differing project risk.
Not on “Financing and the Weighted Average Cost of Capital”.
12.7: Short discussion on practicality of CAPM. Quick read.

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Recap

Quantifying and pricing Risks

Indian School of Business

August 2022, Session 2

Prachi Deuskar CFin I: Session 2

2 Quantifying and pricing Risks

4 Getting cost of capital

Prachi Deuskar CFin I: Session 2

Objective: shareholder value maximization

FCF = Free Cash Flow (Expected)

Prachi Deuskar CFin I: Session 2

NPV Decision rule

Prachi Deuskar CFin I: Session 2

Shareholders hold a diversified portfolio

Diversification cannot remove systematic risk

Prachi Deuskar CFin I: Session 2

Shareholders hold a diversified portfolio

Diversification cannot remove systematic risk

Prachi Deuskar CFin I: Session 2

Shareholders hold a diversified portfolio

Diversification cannot remove systematic risk

Prachi Deuskar CFin I: Session 2

Compensation for Risk

Imagine firms with only idiosyncratic risk and no systematic

Then, for a well-diversified portfolio (i.e. very large N)

Prachi Deuskar CFin I: Session 2

Compensation for Risk

Imagine firms with both idiosyncratic risk and systematic risk

Prachi Deuskar CFin I: Session 2

Diversification: Sharing risks

Prachi Deuskar CFin I: Session 2

Asset Pricing Models

Asset pricing models attempt to answer the following two

Prachi Deuskar CFin I: Session 2

Pricing Systematic Risks

The Capital Asset Pricing Model: CAPM

Market portfolio = The diversified portfolio

Prachi Deuskar CFin I: Session 2

Pricing Systematic Risks

We can use the CAPM to determine the opportunity cost of

Prachi Deuskar CFin I: Session 2

What the CAPM is saying (in English)

Covariance (with the market portfolio), not variance, is the

Prachi Deuskar CFin I: Session 2

Who is valuing the cash flows?

Prachi Deuskar CFin I: Session 2

What if some investors are not diversified?

Shouldn’t they be compensated for idiosyncratic risk?

Prachi Deuskar CFin I: Session 2

CAPM and cost of capital

Cov (ri ,rm )

Prachi Deuskar CFin I: Session 2

General formula for beta

Prachi Deuskar CFin I: Session 2

Assets, debt and equity betas

Value of assets = Value of the business = Debt + Equity

Note: D and E are market values of debt and equity. Also, D

Prachi Deuskar CFin I: Session 2

Yeh beta, beta kya hai, yeh beta, beta!

Prachi Deuskar CFin I: Session 2

Understanding asset beta

Prachi Deuskar CFin I: Session 2