4.11. Conclusions. The roadmap to determining WACC. Some objections to using normal distributions

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来自 Moscow Institute of Physics and Technology 的课程

Principles of Corporate Finance – A Tale of Value

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Moscow Institute of Physics and Technology

Principles of Corporate Finance – A Tale of Value

1 个评分

课程 2（共 5 门，Specialization Understanding Modern Finance）

The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models. This Course is an attempt to avoid the above extremes. We discuss the core basis and mechanisms of modern corporate finance in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests and preferences of investors, reveal the true meaning of specific financial terms, and uncover important issues that are so often ignored in choosing and valuing investment projects. The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.

从本节课中

Risk and Return – From Basics to Reality

In Week 4 we study risk and return. We present a stochastic mathematical model of risk and apply it to find the returns and standard deviations of portfolios of assets. We discuss diversification and the role of special portfolios – the riskless portfolio and the market portfolio – in approaching asset risk. We demonstrate how any asset contributes to the market risk and introduce the β coefficient. Then we derive the capital asset pricing model (CAPM) and study how it is used on examples. We discuss the application of the company cost of capital (CCC) rule to choosing investment projects. Then we use CAPM to determine the cost of capital – first, for an equity-financed company and then in the general case with debt and equity. We present the weighted average cost of capital (WACC) formula and discuss it. Finally, on an example we study the steps in applying CAPM.

4.1. Mathematics of risk8:36

4.2. The expected return and the standard deviation for a portfolio of securities. Some empirical evidence9:56

4.3. Diversification. “Special” portfolios6:58

4.4. Contribution to the portfolio risk. β6:22

4.5. Efficient portfolios. The market portfolio’s efficiency7:21

4.6. Capital asset pricing model (CAPM). Examples9:59

4.7. The company cost of capital (CCC) rule10:03

4.8. Applying CAPM – a no debt case4:05

4.9. Applying CAPM – the general case. WACC13:14

4.10. Steps in applying CAPM – an example15:40

4.11. Conclusions. The roadmap to determining WACC. Some objections to using normal distributions7:42

与讲师见面

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Well, we have now arrived to the final episode

of the fourth week in which we talk about risk.

Let me briefly recap what we did and then I'll tell you where we will go from here.

Well, we said that the overall approach to risk,

it deals with the ideology around the variables and it contains the following steps.

Again, step 1,

this is R is a random and,

normally, with normal distribution.

And from here, we got all these Rs

for portfolios, Rs and Sigmas.

Now, step 2, here,

from these portfolios, we got diversification,

beta, co-variances, and all the stuff.

Then came step 3 that I will call special portfolios namely that was RF RM.

And then from here,

we also talk about efficiency and from here,

we get to CAPEM saying that CAPEM is equivalent

to saying that the market portfolio is efficient.

And then, step 4 was this weighted average cost of capital.

Basically, that's about how this goes.

Now, what's good and what's bad about all that?

We know that the general set of challenges dealt with

the idea of expected versus factual and also,

we dealt with the idea of all the ability of measuring some of these parameters,

primarily, the beta and also

the important objection was the composition of the market portfolio.

That is not crystal clear for anyone right now.

Then there are some other objections in this area.

One objection is this normal distribution of the famous ideal of

black swan sthat was so nicely put in the famous books of Dr. Nassim Talem,

is about the fact that when we ignore the fact that some of these

extremely unlikely but potentially damaging events

may indeed occur and they do occur every now and then.

Then the whole fabric of finance changes.

And the important thing to observe here is that indeed,

in many cases, there are certain areas in

which we do have to take these black swans into account.

But in the vast majority of more simplistic cases,

especially in the evaluation of real projects,

not of the evaluation of really very risky,

the root of securities,

that's a nice approximation.

And so the idea is always like that.

You have to realize every time when you deal with evaluation of

certain instruments to what extent

the overall set of assumptions is adequate with respect to them.

In most cases, it is.

And in these exceptions,

they oftentimes just support the rule in general.

Now, the other thing that must be taken into account and from here,

we are sort of building a bridge to our next week is so far,

with all these objections dealt with the idea when we said that the MPV

is not on the best criterion but

the uniform thing to come up with the value of the project.

And now we can ask a big question.

Are there areas in which MPV does not hold and why?

And in order to come closer to that,

I will introduce the following idea.

Remember, we said that we make a decision now with point zero.

But then maybe at some future point in time,

some piece of important information arrives.

What if we had an opportunity to adjust

our project at the later point to this newly arrived information?

And will that the ability would be extremely valuable?

And that introduces the whole general idea of an option.

And although options are widely known as

popular financial instruments that are traded in huge volumes, but for us,

we will use this idea but we'll apply that to,

let's say, the projects that deal with something real.

Actually, it oftentimes will be even more

challenging and we will see that in the areas where these options are important,

and there are quite a few, oftentimes,

we will see that the question of how we can the value this option,

that becomes a crucial point.

And unfortunately, the approach to option evaluation is much

more advanced than the approach that uses MPV.

We will study that in week 5 in quite some detail trying to avoid

the most intimidating formulas but

still trying and realizing not only the ideas but the mechanics behind them.

And then we'll see that sometimes,

in option evaluation, the MPV formula fails.

But we will be able to see how the combination of MPV without an option

plus valuable option may result in a better and more adequate project evaluation.

So now, I will close this week and as always,

I wish you good luck with your assignments with regard to risk.

And I'll see you next week in the interesting and more advanced,

if you will, week that deals with options and options evaluation.

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