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Aviation Industry Valuation
Published in Bijan Vasigh, Ken Fleming, Liam Mackay, Foundations of Airline Finance, 2018
Bijan Vasigh, Ken Fleming, Liam Mackay
A number of methods are available to estimate the cost of equity. However, the Capital Asset Pricing Model (CAPM) is the most popular, owing to its intuitive appeal and relative ease of application. The CAPM develops a relationship between the non-diversifiable risk of an asset (measured by its beta) and the opportunity cost of investing in that asset. The CAPM links the risk-free rate, the asset’s non-diversifiable risk and the expected return on the market portfolio. The standard CAPM model for return on equity (ke) is expressed by the following formula: ke = kf + ße(MRP) where: kf = risk-free rate14ße = equity betaMarket Risk Premium (MRP) = km − krf15
Electricity and Utility Industry
Published in Roy L. Nersesian, Energy Economics, 2016
A more up-to-date approach is the weighted average cost of capital (WACC) derived from the Capital Asset Pricing Model (CAPM). There are different approaches and degrees of sophistication—what is represented here should be considered the garden-variety WACC. To begin with, there are some major departures from the traditional methodology. Calculating percentage shares of equity and debt to arrive at a discount rate is not at all related to a company’s balance sheet. Equity is calculated by the number of outstanding shares multiplied by the stock price, and debt is the market value, not the book value, of a company’s long-term debt. If a company issued debt publicly, then the market value is the price of the bond easily obtainable from the financial press. For private debt entirely held by pensions and other financial institutions with no public trading, a market value can be assessed by examining the market value of debt issued by companies with a similar credit rating for the remaining tenure of the debt at the same interest rate. It is possible, in this manner, to estimate a company’s debt as if all were being traded on the public market. Suppose that the market value of a company’s debt has been estimated to be $450 million and there are 40 million shares outstanding selling for $60 per share. The sum of these is considered the company’s capitalization, regardless of what is on its balance sheet. What is the percentage share of the company’s debt and equity in its capital structure?
Corporate Finance II
Published in Willie Tan, Principles of Project and Infrastructure Finance, 2007
CAPM requires an estimate of the risk-free rate and time series data on the market index and the firm’s share price from which rates of return are computed. It is then necessary to run a simple regression model using statistical software. The main weaknesses of CAPM areit is a single-factor model, and hence neglects factors such as price to earnings ratio (found in Gordon’s model), country risk (say λC) or macroeconomic variables that may be added to the right hand side of the CAPM equation;the results are unreliable if the proxy stock market index used to compute market returns is inefficient so that prices do not fully reflect all the available information about the firm (Roll and Ross, 1994); andbeta may be unstable over time, which is expected in volatile stock markets (Bos and Newbold, 1984).
Risk pricing inefficiency in public–private partnerships*
Published in Transport Reviews, 2018
Dejan Makovšek, Marian Moszoro
In standard finance theory, investors in any project face two types of risk: systematic and non-systematic risk. Systematic risk relates to the risk that is not diversifiable; non-systematic risk relates to idiosyncratic project characteristics, such as geology, complexity of construction, country or counter-party risk, and is diversifiable. The private sector's standard tool for pricing risk within a portfolio of assets is the capital asset pricing model (CAPM) (Markowitz, 1952). In CAPM, the required rate of return on a risky asset is derived from (i) the risk-free rate, (ii) the market-risk premium, and (iii) the correlation between the asset and the market (“beta”)6 alone. Non-systematic risk is not relevant for pricing, as it can be diversified away by including other assets in the portfolio.
Valuing the unknown: could the real options have redeemed the ailing Western Australian junior iron ore operations in 2013–2016 iron price crash
Published in International Journal of Mining, Reclamation and Environment, 2019
Ajak Duany Ajak, Eric Lilford, Erkan Topal
If we applied the knowledge of the capital asset pricing model (CAPM) as a start to treat the drift as if it was a risk premium, the equation of total investment return, can then be applied. Where is the risk-adjusted discount rate and is the convenience yield or the average return between two successive periods and is the standard normal distribution, denoted as ɛ. However, the real simulation of GBM utilises the drift term αt, resulting in future price Pt [25].
DNPV: a valuation methodology for infrastructure and Capital investments consistent with prospect theory
Published in Construction Management and Economics, 2020
David Espinoza, Javier Rojo, Arturo Cifuentes, Jeremy Morris
Central to any investment decision is assessment of future cashflow risks and how these risks may affect the investment’s value. With the advent of modern portfolio theory (Markowitz 1952), academic research focused on assessing the market risk of bundled rather than individual securities. Furthermore, to facilitate comparison among differently traded securities, asset returns rather than values were analysed. From this work, the annualized standard deviation of returns (i.e., volatility) for a portfolio of securities was used as a proxy for market risk. Hence, it is the contribution (i.e., correlation) of a single security to a well-diversified portfolio that is important rather than the returns distribution of the individual security itself. Complementing Markowitz’s work, Sharpe (1964) introduced the Capital Asset Pricing Model (CAPM) to estimate the additional expected return over the risk-free rate (r) per unit of market risk (rm-r) borne. In other words, investments’ total expected return (α) were expressed as the risk-free rate plus a risk premium, effectively combining the time value of money with risk: where rm is the market return, and β is a parameter that correlates and (rm − r). Ensuing criticism regarding CAPM’s validity fuelled the development of alternative models (e.g., Ross 1976, Fama and French 1997). However, despite added complexity, these alternative models still relied on risk premiums (albeit calculated using more parameters) added to the risk-free rate. Although volatility of returns is widely accepted as a proxy for risk, increasing evidence indicates that this metric alone does not fully capture financial risk (Taleb 2007) nor investor’s risk preference (e.g., Kahneman and Tversky 1979, Chiu 2005, Ang et al. 2005).