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High-beta stocks Whole Market Low-beta stocks



While the initial tests of the APM and the multi-factor models suggested that they
might provide more promise in terms of explaining differences in returns, a distinction
has to be drawn between the use of these models to explain differences in past returns and
their use to get expected returns for the future. The competitors to the CAPM clearly do a
much better job at explaining past returns since they do not constrain themselves to one
factor, as the CAPM does. This extension to multiple factors does become more of a
problem when we try to project expected returns into the future, since the betas and
premiums of each of these factors now have to be estimated. As the factor premiums and


16 Chan, L.K. and J. Lakonsihok, 1993, Are the reports of Beta's death premature?, Journal of Portfolio
36


betas are themselves volatile, the estimation error may wipe out the benefits that could be
gained by moving from the CAPM to more complex models. The regression models that
were offered as an alternative are even more exposed to this problem, since the variables
that work best as proxies for market risk in one period (such as size) may not be the ones
that work in the next period. This may explain why multi-factor models have been
accepted more widely in evaluating portfolio performance evaluation than in corporate
finance; the former is focused on past returns whereas the latter is concerned with future
expected returns.
Ultimately, the survival of the captial asset pricing model as the default model for
risk in real world application is a testament both to its intuitive appeal and the failure of
more complex models to deliver significant improvement in terms of expected returns.
We would argue that a judicious use of the capital asset pricing model, without an over
reliance on historical data, in conjunction with the accumulated evidence17 presented by
those who have developed the alternatives to the CAPM, is still the most effective way of
dealing with risk in modern corporate finance.

In Practice: Implied Costs of Equity and Capital
The controversy surrounding the assumptions made by each of the risk and return
models outlined above and the errors that are associated with the estimates from each has
led some analysts to use an alternate approach for companies that are publicly traded.
With these companies, the market price represents the market™s best estimate of the value
of the company today. If you assume that the market is right and you are willing to make
assumptions about expected growth in the future, you can back out a cost of equity from
the current market price. For example, assume that a stock is trading at $ 50 and that
dividends next year are expected to be $2.50. Furthermore, assume that dividends will
grow 4% a year in perpetuity. The cost of equity implied in the stock price can be
estimated as follows:


Management, v19, 51-62.
17 Barra, a leading beta estimation service, adjusts betas to reflect differences in fundamentals across firms
(such as size and dividend yields). It is drawing on the regression studies that have found these to be good
proxies for market risk.
37


Stock price = $ 50 = Expected dividends next year/ (Cost of equity “ Expected growth
rate)
$ 50 = 2.50/(r - .04)
Solving for r, r = 9%. This approach can be extended to the entire firm and to compute
the cost of capital.
While this approach has the obvious benefit of being model free, it has its limitations. In
particular, our cost of equity will be a function of our estimates of growth and cashflows.
If we use overly optimistic estimates of expected growth and cashflows, we will under
estimate the cost of equity. It is also built on the presumption that the market price is
right.


The Risk in Borrowing: Default Risk and the Cost of Debt
When an investor lends to an individual or a firm, there is the possibility that the
borrower may default on interest and principal payments on the borrowing. This
possibility of default is called the default risk. Generally speaking, borrowers with higher
default risk should pay higher interest rates on their borrowing than those with lower
default risk. This section examines the measurement of default risk, and the relationship
of default risk to interest rates on borrowing.
In contrast to the general risk and return models for equity, which evaluate the
effects of market risk on expected returns, models of default risk measure the
consequences of firm-specific default risk on promised returns. While diversification can
be used to explain why firm-specific risk will not be priced into expected returns for
equities, the same rationale cannot be applied to securities that have limited upside
potential and much greater downside potential from firm-specific events. To see what we
mean by limited upside potential, consider investing in the bond issued by a company.
The coupons are fixed at the time of the issue, and these coupons represent the promised
cash flow on the bond. The best-case scenario for you as an investor is that you receive
the promised cash flows; you are not entitled to more than these cash flows even if the
company is wildly successful. All other scenarios contain only bad news, though in
varying degrees, with the delivered cash flows being less than the promised cash flows.
38


Consequently, the expected return on a corporate bond is likely to reflect the firm-
specific default risk of the firm issuing the bond.

The Determinants of Default Risk
The default risk of a firm is a function of its capacity to generate cashflows from
operations and its financial obligations - including interest and principal payments. 18 It is
also a function of the how liquid a firm™s assets are since firms with more liquid assets
should have an easier time liquidating them, in a crisis, to meet debt obligations.
Consequently, the following propositions relate to default risk:
Firms that generate high cashflows relative to their financial obligations have

lower default risk than do firms that generate low cashflows relative to
obligations. Thus, firms with significant current investments that generate high
cashflows, will have lower default risk than will firms that do not.
The more stable the cashflows, the lower is the default risk in the firm. Firms that

operate in predictable and stable businesses will have lower default risk than will
otherwise similar firms that operate in cyclical and/or volatile businesses, for the
same level of indebtedness.
The more liquid a firm™s assets, for any given level of operating cashflows and

financial obligations, the less default risk in the firm.
For as long as there have been borrowers, lenders have had to assess default risk.
Historically, assessments of default risk have been based on financial ratios to measure
the cashflow coverage (i.e., the magnitude of cashflows relative to obligations) and
control for industry effects, to capture the variability in cashflows and the liquidity of
assets.




18 Financial obligation refers to any payment that the firm has legally obligated itself to make, such as
interest and principal payments. It does not include discretionary cashflows, such as dividend payments or
new capital expenditures, which can be deferred or delayed, without legal consequences, though there may
be economic consequences.
39


Default Risk and Interest rates
When banks did much of the lending to firms, it made sense for banks to expend
the resources to make their own assessments of default risk, and they still do for most
lenders. The advent of the corporate bond market created a demand for third party
assessments of default risk on the part of bondholders. This demand came from the need
for economies of scale, since few individual bondholders had the resources to make the
assessment themselves. In the United States, this led to the growth of ratings agencies
like Standard and Poor™s and Moody™s which made judgments of the default risk of
corporations, using a mix of private and public information, converted these judgments
into measures of default risk (bond rating) and made these ratings public. Investors
buying corporate bonds could therefore use the bond ratings as a shorthand measure of
default risk.

The Ratings Process
The process of rating a bond starts when a company requests a rating from the
ratings agency. This request is usually precipitated by a desire on the part of the company
to issue bonds. While ratings are not a legal pre-requisite for bond issues, it is unlikely
that investors in the bond market will be willing to buy bonds issued by a company that is
not well known and has shown itself to be unwilling to put itself through the rigor of a
bond rating process. It is not surprising, therefore, that the largest number of rated
companies are in the United States, which has the most active corporate bond markets,
and that there are relatively few rated companies in Europe, where bank lending remains
the norm for all but the largest companies.
The ratings agency then collects information from both publicly available sources,
such as financial statements, and the company itself, and makes a decision on the rating.
If it disagrees with the rating, the company is given the opportunity to present additional
information. This process is presented schematically for one ratings agency, Standard
and Poors (S&P), in Figure 3.9:
40

THE RATINGS PROCESS
Issuer or Requestor
S&P assigns Analysts
authorized completes S&P
analytical research S&P
representative rating request form
team to issue library,
request rating and issue is
internal files
entered into S&P's
and data bases
administrative and
control systems.




Final Analytical Issuer meeting:
review and presentation to
preparation S&P personnel
of rating or
committee S&P personnel
presentation tour issuer
facilities


Presentation of Notification of Does issuer Format
wish to appeal No
the analysis to the rating decision notification to
S&P rating to issuer or its by furnishing issuer or its
commitee authorized additional authorized
Discussion and representative information? representative:
vote to determine Rating is
rating Yes released


Presentation of
additional
information to
S&P rating
committee:
Discussion and
vote to confirm
or modify rating.

The ratings assigned by these agencies are letter ratings. A rating of AAA from Standard
and Poor™s and Aaa from Moody™s represents the highest rating granted to firms that are
viewed as having the lowest default risk. As the default risk increases, the ratings
decrease toward D for firms in default (Standard and Poor™s). Table 3.1 provides a
description of the bond ratings assigned by the two agencies.
Table 3.1: Index of Bond Ratings
Standard and Poor's Moody's
AAA The highest debt rating assigned. Aaa Judged to be of the best quality
The borrower's capacity to repay with a small degree of risk.
debt is extremely strong.
AA Capacity to repay is strong and Aa High quality but rated lower than
differs from the highest quality Aaa because margin of protection
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only by a small amount. may not be as large or because
there may be other elements of
long-term risk.
A Has strong capacity to repay; A Bonds possess favorable
Borrower is susceptible to adverse investment attributes but may be
effects of changes in circumstances susceptible to risk in the future.
and economic conditions.
BBB Has adequate capacity to repay, but Baa Neither highly protected nor poorly
adverse economic conditions or secured; adequate payment
circumstances are more likely to capacity.
lead to risk.
BB,B, Regarded as predominantly Ba Judged to have some speculative
CCC, speculative, BB being the least risk.
CC speculative andd CC the most. B Generally lacking characteristics of
a desirable investment; probability
of payment small.
D In default or with payments in Caa Poor standing and perhaps in
arrears. default.
Ca Very speculative; often in default.
C Highly speculative; in default.

In Practice: Investment Grade and Junk Bonds
While ratings can range from AAA (safest) to D (in default), a rating at or above
BBB by Standard and Poor™s (Baa for Moody™s) is categorized as investment grade,
reflecting the view of the ratings agency that there is relatively little default risk in
investing in bonds issued by these firms. Bonds rated below BBB are generally
categorized as junk bonds or as high-yield bonds. While it is an arbitrary dividing line, it
is an important one for two reasons. First, many investment portfolios are restricted from

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