To Rebecca, Natasha, and Hannah, for the love and for being there J. B. To Kaui, Pono, Koa, and Kai, for all the love and laughter P. D. Editor in Chief: Donna Battista Acquisitions Editor: Katie Rowland Executive Development Editor: Rebecca Ferris-Caruso Editorial Project Manager: Emily Biberger International Publisher: Laura Dent International Programme Editor: Leandra Paoli International Editorial Assistant: Laura Thompson International Marketing Manager: Dean Erasmus Managing Editor: Jeff Holcomb Senior Production Project Manager: Nancy Freihofer Senior Manufacturing Controller, Production, International: Trudy Kimber Cover Designer: Jodi Notowitz Cover Photo: UIG via Getty Images Media Director: Susan Schoenberg Content Lead, MyFinanceLab: Miguel Leonarte Executive Media Producer: Melissa Honig Project Management and Text Design: Gillian Hall, The Aardvark Group Pearson Education Limited Edinburgh Gate Harlow Essex CM20 2JE England and Associated Companies throughout the world Visit us on the World Wide Web at : www.pearson.com/uk Pearson Education Limited 2014 The rights of Jonathan Berk and Peter DeMarzo to be identified as authors of this work has been asserted by them in accordance with the Copyright, Designs and Patents Act 1988. Authorised adaptation from the United States edition, entitled Corporate Finance, Third Edition, ISBN: 978-0-13-299247-3 by Jonathan Berk and Peter DeMarzo, published by Pearson Education 2014. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without either the prior written permission of the publisher or a licence permitting restricted copying in the United Kingdom issued by the Copyright Licensing Agency Ltd, Saffron House, 6 10 Kirby Street, London EC1N 8TS. All trademarks used herein are the property of their respective owners. The use of any trademark in this text does not vest in the author or publisher any trademark ownership rights in such trademarks, nor does the use of such trademarks imply any affiliation with or endorsement of this book by such owners. Microsoft and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published as part of the services for any purpose. All such documents and related graphics are provided as is without warranty of any kind. Microsoft and/ or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all warranties and conditions of merchantability, whether express, implied or statutory, fitness for a particular purpose, title and non-infringement. In no event shall Microsoft and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from the services. The documents and related graphics contained herein could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Microsoft and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time. Partial screen shots may be viewed in full within the software version specified. Microsoft and Windows are registered trademarks of the Microsoft Corporation in the U.S.A. and other countries. This book is not sponsored or endorsed by or affiliated with the Microsoft Corporation. Credits and acknowledgments borrowed from other sources and reproduced, with permission, in this textbook appear on appropriate page within text and on this copyright page. Credits: p. xxiii, Author photo by Nancy Warner. ISBN-13: 978-0-273-79202-4 ISBN-10: 0-273-79202-4 British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library 10 9 8 7 6 5 4 3 2 1 17 16 15 14 13 Typeset in Adobe Garamond by Laserwords Printed and bound by Courier/Kendallville in United States of America The publisher s policy is to use paper manufactured from sustainable forests.
Data Case 309 2. Next, click Key Statistics from the left side of the page. From the Key Statistics page, gather the following information and enter it on the same spreadsheet: a. The number of shares of stock outstanding. b. The Payout ratio. 3. Next, click Analyst Estimates from the left side of the page. From the Analyst Estimates page, find the expected growth rate for the next five years and enter it onto your spreadsheet. It will be near the very bottom of the page. 4. Next, click Income Statement near the bottom of the menu on the left. Copy and paste the entire three years of income statements into a new worksheet in your existing Excel file. (Note: if you are using IE as your browser, you can place the cursor in the middle of the statement, rightclick, and select Export to Microsoft Excel to download an Excel version.) Repeat this process for both the balance sheet and cash flow statement for General Electric. Keep all the different statements in the same Excel worksheet. 5. To determine the stock value based on the dividend-discount model: a. Create a timeline in Excel for five years. b. Use the dividend obtained from Yahoo! Finance as the current dividend to forecast the next five annual dividends based on the five-year growth rate. c. Determine the long-term growth rate based on GE s payout ratio (which is one minus the retention ratio) using Eq. 9.12. d. Use the long-term growth rate to determine the stock price for year five using Eq. 9.13. e. Determine the current stock price using Eq. 9.14. 6. To determine the stock value based on the discounted free cash flow method: a. Forecast the free cash flows using the historic data from the financial statements downloaded from Yahoo! to compute the three-year average of the following ratios: i. EBIT/Sales ii. Tax Rate (Income Tax Expense/Income Before Tax) iii. Property Plant and Equipment/Sales iv. Depreciation/Property Plant and Equipment v. Net Working Capital/Sales b. Create a timeline for the next seven years. c. Forecast future sales based on the most recent year s total revenue growing at the five-year growth rate from Yahoo! for the first five years and the long-term growth rate for years 6 and 7. d. Use the average ratios computed in part (a) to forecast EBIT, property, plant and equipment, depreciation, and net working capital for the next seven years. e. Forecast the free cash flow for the next seven years using Eq. 9.18. f. Determine the horizon enterprise value for year 5 using Eq. 9.24. g. Determine the enterprise value of the firm as the present value of the free cash flows. h. Determine the stock price using Eq. 9.22. 7. Compare the stock prices from the two methods to the actual stock price. What recommendations can you make as to whether clients should buy or sell GE stock based on your price estimates? 8. Explain to your boss why the estimates from the two valuation methods differ. Specifically, address the assumptions implicit in the models themselves as well as those you made in preparing your analysis. Why do these estimates differ from the actual stock price of GE?
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Part 4 Risk and Return THE LAW OF ONE PRICE CONNECTION. To apply the Law of One Price correctly requires comparing investment opportunities of equivalent risk. In this part of the book, we explain how to measure and compare risks across investment opportunities. Chapter 10 introduces the key insight that investors only demand a risk premium for risk they cannot eliminate without cost by diversifying their portfolios. Hence, only non-diversifiable market risk will matter when comparing investment opportunities. Intuitively, this insight suggests that an investment s risk premium will depend on its sensitivity to market risk. In Chapter 11, we quantify these ideas and derive investors optimal investment portfolio choices. We then consider the implications of assuming all investors choose their portfolio of investments optimally. This assumption leads to the Capital Asset Pricing Model (CAPM), the central model in financial economics that quantifies the notion of equivalent risk and thereby provides the relation between risk and return. In Chapter 12, we apply these ideas and consider the practicalities of estimating the cost of capital for a firm and for an individual investment project. Chapter 13 takes a closer look at the behavior of individual, as well as professional, investors. Doing so reveals some strengths and weaknesses of the CAPM, as well as ways we can combine the CAPM with the principle of no arbitrage for a more general model of risk and return. Chapter 10 Capital Markets and the Pricing of Risk Chapter 11 Optimal Portfolio Choice and the Capital Asset Pricing Model Chapter 12 Estimating the Cost of Capital Chapter 13 Investor Behavior and Capital Market Efficiency 311
Chapter 10 Capital Markets and the Pricing of Risk 312 Notation p R probability of return R Var (R ) variance of return R SD (R ) standard deviation of return R E [R ] expectation of return R Div t dividend paid on date t P t price on date t R t realized or total return of a security from date t - 1 to t R average return b s beta of security s r cost of capital of an investment opportunity OVER THE FIVE-YEAR PERIOD 2003 THROUGH 2007, investors in General Mills, Inc., earned an average return of 7% per year. Within this period, there was some variation, with the annual return ranging from -1.2% in 2003 to almost 20% in 2006. Over the same period, investors in ebay, Inc., earned an average return of 25%. These investors, however, gained over 90% in 2003 and lost 30% in 2006. Finally, investors in three-month U.S. Treasury bills earned an average return of 2.9% during the period, with a low return of 1.3% in 2004 and a high return of 5% in 2007. Clearly, these three investments offered returns that were very different in terms of their average level and their variability. What accounts for these differences? In this chapter, we will consider why these differences exist. Our goal is to develop a theory that explains the relationship between average returns and the variability of returns and thereby derive the risk premium that investors require to hold different securities and investments. We then use this theory to explain how to determine the cost of capital for an investment opportunity. We begin our investigation of the relationship between risk and return by examining historical data for publicly traded securities. We will see, for example, that while stocks are riskier investments than bonds, they have also earned higher average returns. We can interpret the higher average return on stocks as compensation to investors for the greater risk they are taking. But we will also find that not all risk needs to be compensated. By holding a portfolio containing many different investments, investors can eliminate risks that are specific to individual securities. Only those risks that cannot be eliminated by holding a large portfolio determine the risk premium required by investors. These observations will allow us to refine our definition of what risk is, how we can measure it, and thus, how to determine the cost of capital.
10.1 Risk and Return: Insights from 86 Years of Investor History 313 10.1 Risk and Return: Insights from 86 Years of Investor History We begin our look at risk and return by illustrating how risk affects investor decisions and returns. Suppose your great-grandparents invested $100 on your behalf at the end of 1925. They instructed their broker to reinvest any dividends or interest earned in the account until the beginning of 2012. How would that $100 have grown if it were placed in one of the following investments? 1. Standard & Poor s 500 (S&P 500): A portfolio, constructed by Standard and Poor s, comprising 90 U.S. stocks up to 1957 and 500 U.S. stocks after that. The firms represented are leaders in their respective industries and are among the largest firms, in terms of market value, traded on U.S. markets. 2. Small Stocks: A portfolio, updated quarterly, of U.S. stocks traded on the NYSE with market capitalizations in the bottom 20%. 3. World Portfolio: A portfolio of international stocks from all of the world s major stock markets in North America, Europe, and Asia. 1 4. Corporate Bonds: A portfolio of long-term, AAA-rated U.S. corporate bonds with maturities of approximately 20 years. 2 5. Treasury Bills: An investment in one-month U.S. Treasury bills. Figure 10.1 shows the result, through the start of 2012, of investing $100 at the end of 1925 in each of these five investment portfolios, ignoring transactions costs. During this 86-year period in the United States, small stocks experienced the highest long-term return, followed by the large stocks in the S&P 500, the international stocks in the world portfolio, corporate bonds, and finally Treasury bills. All of the investments grew faster than inflation, as measured by the consumer price index (CPI). At first glance the graph is striking had your great-grandparents invested $100 in the small stock portfolio, the investment would be worth more than $2.6 million at the beginning of 2012! By contrast, if they had invested in Treasury bills, the investment would be worth only about $2,000. Given this wide difference, why invest in anything other than small stocks? But first impressions can be misleading. While over the full horizon stocks (especially small stocks) did outperform the other investments, they also endured periods of significant losses. Had your great-grandparents put the $100 in a small stock portfolio during the Depression era of the 1930s, it would have grown to $181 in 1928, but then fallen to only $15 by 1932. Indeed, it would take until World War II for stock investments to outperform corporate bonds. Even more importantly, your great-grandparents would have sustained losses at a time when they likely needed their savings the most in the depths of the Great Depression. A similar story held during the 2008 financial crisis: All of the stock portfolios declined by more than 50%, with the small stock portfolio declining by almost 70% (over $1.5 million!) from its peak in 2007 to its lowest point in 2009. Again, many investors faced a double whammy: an increased risk of being unemployed (as firms started laying off employees) 1 Based on the Morgan Stanley Capital International World Index from 1970. Prior to 1970, the index is constructed by Global Financial Data, with approximate initial weights of 44% North America, 44% Europe, and 12% Asia, Africa, and Australia. 2 Based on Moody s AAA Corporate Bond Index.