Investors' Minimum Required Rates of Return, Cost of Debt and Cost of Equity

A company may raise capital by issuing

• debt or 
• equity, 

Both of which have associated costs.



Investors' Minimum Required Rates of Return

Investors' minimum required rates of return refer to the return they require for providing funds to the company.



Cost of Debts

A company's cost of debt is easy to estimate as it is reflected in the interest payments that the company is contractually obligated to make to debt holders.

For investors who provide debt capital to the company, their minimum required rate of return is the periodic interest rate they charge the company for using their funds.

All providers of debt capital receive the same interest rate.

Therefore, the company's cost of debt and investor's minimum required rate of return on debt are the same.



Cost of Equity

Estimating cost of equity is difficult because the company is not contractually obligated to make any payments to common shareholders.

For investors who provide equity capital tot he company, the future cash flows that they expect to receive are uncertain (in both timing and amount), so their minimum required rate of return must be estimated.

Further, each investor may have different expectations regarding future cash flows.

Therefore, the company's cost of equity may be different from investors' minimum required rate of return on equity.





Additional notes:

The company's cost of equity can be estimated using the dividend discount model (DDM) and capital asset pricing model (CAPM).

The costs of debt and equity are used to estimate a company's weighted average cost of capital (WACC), which represents the minimum required rate of return that the company must earn on its investments.

Importance of Equities in Global Financial Markets

In 2008, on a global level, the equity market capitalization to GDP ratio was close to 100% (more than twice the long run average of 50%)

During 1900 - 2008, government bonds and bills earned annualized real returns of 1% to 2% on average, which is in line with the inflation rate.   Equity markets earned real returns in excess of 4% per year in most markets.

In most developed countries, equity ownership as a percentage of the population was between 20% and 50%.

Equity Securities and Company Value (Intrinsic Value of a company)

Book values and ROE do help analysts evaluate companies, but they cannot be used as the primary means to determine a company's intrinsic value.

Intrinsic value refers to the present value of the company's expected future cash flows.

Intrinsic value can only be estimated as it is impossible to accurately predict the amount and timing of a company's future cash flows.

Astute investors aim to profit from differences between market prices and intrinsic values.

Accounting Return on Equity

Return on Equity (ROE) measures the rate of return earned by a company on its equity capital.

It indicates how efficient a firm is in generating profits from every dollar of net assets.


The ROE is computed as net income available to ordinary shareholders (after preference dividends have been paid) divided by the average total book value of equity.

ROE
= Net Income / Average Book Value of Equity
= Net Income /[ (Book Value of Equity FY1 + Book Value of Equity FY2)/2]


An increase in ROE might not always be a positive sign for the company.

• The increase in ROE may be the result of net income decreasing at a slower rate than shareholders' equity.  A declining net income is a source of concern for investors.
• The increase in ROE may be the result of debt issuance proceeds being used to repurchase shares.  This would increase the company's financial leverage (risk).

Primary aim of management is to increase the book value and the market value of the company.

The primary aim of management is to increase

• the book value and 
• market value of the company.

Book Value

Book value (shareholders' equity on the company's balance sheet) is calculated as total assets less total liabilities.

It reflects the historical operating and financing decisions made by the company.

Management can directly influence book value (e.g., by retaining net income).


Market Value

However, management can only indirectly influence a company's market value.

Market value of a company is primarily determined by investors' expectations about the about, timing and uncertainty of the company's future cash flows

A company may increase its book value by retaining net income, but it will only have a positive effect on the company's market value if investors expect the company to invest its retained earnings in profitable growth opportunities.

If investors believe that the company has a significant number of cash flow generating investment opportunities coming through, the market value of the company's equity will exceed its book value.



Price to book ratio (market to book ratio)

A useful ratio to evaluate investor's expectations about a company is the price to book ratio.

If a company has a price to book ratio that is greater than industry average, it suggests that investors believe that the company has more significant future growth opportunities than its industry peers.

It may not be appropriate to compare price to book ratios of companies in different industries because the ratio also reflects investors' growth outlook for the industry itself.


Accounting Return on Equity

An important measure used by investors to evaluate the effectiveness of management in increasing the company's book value is accounting return on equity.

Risks of Equity Securities

Preference shares are less risky than common shares.

Putable common shares are less risky than callable or non-callable common shares.

Callable common and callable preference shares are more risky than their non-callable counterparts.

Cumulative preference shares are less risky than non-cumulative preference shares as they accrue unpaid dividends.



Risks (> = more risky than)

Common shares  >  Preference shares

Callable or non-callable common shares > Putable common shares

Callable common stocks > Non-callable common stocks

Callable preference shares > Non-callable preference shares

 Non-cumulative preference shares > Cumulative preference shares

Convertible Preference Shares or Preferred Stock

Preference shares can be classified into the following categories:

• Cumulative
• Non-cumulative
• Participating 
• Non-participating
• Convertible

Convertible Preference Shares

These are convertible into a specified number of common shares based on a conversion ratio that is determined at issuance.

They have the following advantages:

• They allow investors to earn a higher dividend than if they had invested in the company's common shares.
• They offer investors the opportunity to share the profits of the company.
• They allow investors to benefit from a rise in the price of common shares through the conversion option.
• Their price is less volatile than the underlying common shares because their dividend payments are known and more stable.

Convertible preference shares are becoming increasingly common in venture capital and private equity transactions.

Return Characteristics of Equity Securities

The two main sources of an equity security's total return are:

• Capital gains from price appreciation
• Dividend income

The total return on non-dividend paying stocks only consists of capital gains.

Investors in depository receipts and foreign shares also incur foreign exchange gains (or losses).

Another source of return arises from the compounding effects of reinvested dividends.

Psychological Biases

Loss Aversion

Behavioural finance asserts that investors exhibit loss aversion, that is, they dislike losses more than they like comparable gains.

This results in a strong preference for avoiding losses as opposed to achieving gains.

Advocates of this bias argue that loss aversion is more important to investors than risk aversion,, which is why the "overreaction" anomaly is observed.

While loss aversion can explain the overreaction anomaly, studies have shown that under reactions are just as common as overreactions, which counters the assertions of this bias.



Herding

Herding behaviour is a behavioural bias that explains both under reactions and overreactions in financial markets.

Herding occurs when investors ignore their own analysis, and instead make investment decisions in line with the direction of the market.



Overconfidence

Overconfdence bias asserts investors have an inflated view of their ability to process new information appropriately.

Overconfident investors are inaccurate when it comes to valuing securities given new information, and therefore stocks will be mispriced if there is an adequate number of such investors in the market.

Evidence has suggested that overconfidence has led to mispricing in most major markets around the world, but the bias has been observed predominantly in higher-growth companies, whose prices are slow to factor in any new information.

Another aspect of this bias is that overconfident investors tend to maintain portfolios that are less-than-optimally diversified because they tend to overestimate their stock-picking abilities.




Information Cascades

An information cascade refers to the transfer of information from market participants who are the first to take investment action upon the release of new information, and whose decisions influence the decisions of others.

Studies have shown that information cascades tend to be greater for stocks when reliable and relevant information about the underlying company is not easily available.




Representativeness

Investors assess probabilities of future outcomes based on how similar they are to the current state.



Mental Accounting

Investors tend to keep track of gains and losses from different investments in separate mental accounts.



Conservatism

Investors are slow to react to changes and continue to maintain their initial views.



Narrow framing

Investors focus on issues in isolation

Behavioural Finance

Behavioural finance looks at investor behaviour to explain 

• why individuals make the decisions that they do, 
• whether these decisions are rational or irrational.

It is based on the premise that individuals, due to the presence of behavioural biases:

• do not always make "efficient" investment decisions, or 
• do they always act "rationally" 

These behavioural biases include:

• Loss Aversion
• Herding
• Overconfidence
• Information Cascades
• Representativeness
• Mental Accounting
• Conservatism
• Narrow Framing

Whether investor behaviour can explain market anomalies is a subject open to debate.

• If investors must be rational for the market to be efficient, then markets cannot be efficient.
• If markets are defined as being efficient, investors cannot earn superior risk-adjusted profits consistently. 

Momentum and Overreaction Anomalies

Overreaction

Investors tend to inflate (depress) stock prices of companies that have released good (bad) news.

Studies have shown that "losers" (stocks that have witnessed a recent price decline due to the release of bad news) have outperformed the market in subsequent periods, while winners have underperformed in subsequent periods.


Momentum

Other studies have also shown that securities that have outperformed in the short term continue to generate high returns in subsequent periods (carrying on price momentum).



Note:  The overreaction and momentum anomalies go against the assertions of weak-form efficiency in markets.

Earnings Surprises

Several studies have shown that although earnings surprises are quickly reflected in stock prices most of the time, this is not always the case.

Investors may be able to earn abnormal returns using publicly available earnings information by purchasing stocks of companies that have announced positive earnings surprises.

However, recent evidence has suggested that abnormal returns observed after earnings surprises do not control for transaction costs and risk.

Closed-End Investment Fund Discounts

Several studies have shown that closed-end funds tend to trade at a discount (sometimes exceeding 50%) to their per share NAVs.

Theoretically, investors could purchase all the shares in the fund, liquidate the fund, and make a profit by selling the constituent securities at their market prices.

However, after accounting for management fees, unrealized capital gain taxes, liquidity and transactions costs, any profit potential is eliminated.

Objectives of Market Regulation

• Control fraud or deception of uninformed market participants.
• Control agency problems by setting minimum standards of competence for agents and by defining and enforcing minimum standards of practice.
• Promote fairness by creating a level playing field for market participants.
• Set mutually beneficial standards for financial reporting.
• Prevent undercapitalized financial firms from exploiting their investors by making excessively risky investments
• Ensure that long-term liabilities are funded.

Characteristics of a Well-Functioning Financial System

Timely and accurate information on the price and volume of recent transactions.  If timely information is not available, a seller may not get the best possible price and a buyer may end up paying too high a price.

Liquidity, which refers to the ability to buy or sell the asset quickly, at a price close to that of a recent market transaction, assuming no new information has been received.  To achieve price continuity, the market must be significantly deep.

Internal efficiency in that there are low transaction costs, which include the costs of reaching the market and brokerage costs.

External or informational efficiency, which is achieved when market prices reflect all external available information about an asset.  Prices should rapidly adjust to reflect any new information.

A Dealer Market

A dealer market (quote driven market or price driven market) consists of individual dealers who are assigned specific securities.

These dealers create liquidity by purchasing and selling against their own inventory of securities.

Competition between dealers ensures that competitive prices are available.

Private Placements

In a private placement, securities are not offered to the public.

Companies sell securities directly to a group of qualified investors, usually through an investment bank.

Qualified investors are generally those who understand associated risks and have sufficient wealth to withstand significant losses.

Private placements are typically cheaper than public offerings as they do not require as much public disclosures.

However, since privately placed securities do not trade on organized secondary markets, investors require a higher rate of return from them.

Risk Objectives

An example of an absolute risk objective would be that the client does not want to lose more than 5% of her capital over a particular period.

Relative risk objectives relate risk to a certain benchmark that represents an appropriate level of risk.

Risk tolerance is a function of BOTH:

• a client's ability to take risk, as well as,
• her willingness to take risk.

Ability to take risk

The ability to take risk is a function of several factors including:

• time horizon,
• expected income, and 
• net worth.

Generally speaking, a client with a longer time horizon, high expected income and greater net worth has a greater ability to bear risk.

Willingness to take risk

A client's willingness to bear risk, on the other hand, is based on more subjective factors including 

• her psychological makeup and 
• level of understanding of financial markets.

4 scenarios:

1.  Ability to take risk - below average.  Willingness to take risk - below average

The investor's overall risk tolerance is below average

2.  Ability to take risk - above average.  Willingness to take risk - above average

The investor's overall risk tolerance is above average

3.  Ability to take risk - below average.  Willingness to take risk - above average

The investor's overall risk tolerance is below average

4.  Ability to take risk - above average.  Willingness to take risk - below average

The investment manager should explain the conflict and implications to the client.

When there is a mismatch between a client's ability and willingness to take risk, the prudent approach is to conclude that the client's tolerance for risk is the lower of the two factors.

Any decisions made must be documented.

The Investment Policy Statement

The Investment Policy Statement (IPS)

An investment policy statement is an invaluable planning tool that adds discipline to the investment process.

Before developing an IPS, an investment manager must conduct a fact finding discussion with the client to learn about the client's risk tolerance and other specific circumstances.

The IPS can be thought of as a roadmap which serves the following purposes:

• It helps the investor decide on realistic investment goals after learning about financial markets and associated risks.
• It creates a standard according to which the portfolio manager's performance can be judged.
• It guides the actions of portfolio managers, who should refer to it from time to time to assess the suitability of particular investments for their clients.

Major components of an IPS

• An introduction that describes the client.
• A statement of purpose.
• A statement of duties and responsibilities, which describes the duties and responsibilities of the client, the custodian of the client's assets, and the investment manger.
• Procedures that outline the steps required to keep the IPS updated and steps required to respond to various contingencies.
• The client's investment objectives.
• The client's investment constraints.
• Investment guidelines regarding how the policy should be executed (e.g., whether use of leverage and derivatives is permitted) and specific types of assets that must be excluded.
• Evaluation and review guidelines on obtaining feedback on investment results.
• Appendices that describe the strategic asset allocation and the rebalancing policy.

Investment Constraints

Liquidity

Liquidity refers to the ability to readily convert investments into cash at a price close to fair market value.

Investors may require ready cash to meet unexpected needs and could be forced to sell their assets at unfavourable terms if the investment plan does not consider their liquidity needs.

Time Horizon

Time horizon refers to the time period between putting funds into an investment and requiring them for use.  

A close relationship exists between an investor's time horizon, liquidity needs and ability to take risk.
The shorter the time horizon the harder it would be for an investor to overcome losses.

Tax Concerns

Tax concerns play a very important role in investment planning because, unlike tax-exempt investors, taxable investors are really only concerned with after-tax returns on their portfolios.

Legal and Regulatory Factors

Investors also need to be aware of legal and regulatory factors.

For example, some countries impose a limit on the proportion of equity securities in a pension fund's portfolio.

Unique Circumstances

There may be a number of individual and unusual considerations that affect investors.

For example, many investors may want to exclude certain investments from their portfolios based on personal or socially conscious reasons.