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Together that's what we call the risk premium and the risk premium is well of

Â course beyond, expecting compensation for the expected loss of purchasing power.

Â If I'm going to bear some risk, I want some extra compensation so the CAPM.

Â Is basically a model that tells you,

Â how you actually calculate the raised premium for a specific company.

Â Now, what is the MRP times beta?

Â Well, the MRP is the market risk premium, as we said before.

Â And that is sort of a historical difference,

Â between the return of equity and the return of debt.

Â And so year over year, you look at the return of equities in the market,

Â you look at the return of government debt, and you subtract one from the other.

Â And if you do that over, and over, and over, and

Â over again, you can calculate in some sort of average of that.

Â What is that average?

Â Well, it gives you an idea.

Â Of how much more return,

Â have investors required from investing in equity than from investing in debt?

Â And that number as we'll see, you know, in the U.S. the typical number is

Â somewhere between five and 6% and the typical interpretation is that.

Â Historically people have required about five percent of or six percent more,

Â to invest in equities as opposed to in investing risk free at government debt.

Â That is what market risk premium is.

Â But now you could say well but wait a minute.

Â I'm not investing just in equities.

Â I'm investing in this particular company, and

Â that's where beta actually comes in and that's why,

Â as you see, the beta has an i because now we're talking about a specific company.

Â And that company, remember what beta is all about.

Â That company might magnify or mitigate, the markets fluctuation.

Â So everything else equal.

Â The more that a company magnifies market fluctuations,

Â the more return that you're going to require.

Â And the more a company mitigates market fluctuations,

Â the less return that you're going to require.

Â Now look again at the expression, and notice that Rf and MRP, they don't

Â have a subscript i, that basically means that if you look at the cost of equity,

Â of Oracle, Microsoft, Apple, GE, all those companies will, will be using the same Rf.

Â And we will be using the same MRP.

Â The only thing that is going to change as we go from company to company is

Â the beta of the company, so on the right-hand side of the CAPM expression.

Â What we have only one component that is a specific for

Â the company that we are looking at.

Â The other two are common to all the companies, that we may be looking at.

Â So at the end of the day, the CAPM is a very intuitive model that says,

Â that the required return on putting your money in this specific company,

Â is going to depend on, first requiring a return from not losing purchasing power,

Â but on top of that, requiring a return from bearing risk.

Â First of investing in equities and

Â second from investing in the equity of this specific company,

Â when you put all that together then you get the expression from the CAPM.

Â Now this brief intuition of the CAPM that I just gave you very quickly is,

Â is developed a little, a little bit more detail in one of

Â the technical notes that is going to accompany this particular session.

Â But you, you, you see where we're going with this.

Â What we're, we're going to require in return.

Â That the depends on not losing purchasing power, and depends on bearing risk.

Â And that is what the CAPM is at the end of the day.

Â Now, this seems to be very clear.

Â And it seems that well it's going to be easy to calculate this with a CAPM,

Â because I just need to throw three numbers into that expression and I'm done.

Â But as they say the devil is in the details once we ask the question.

Â So what is RF?

Â What is MRP, and what is beta that are very many different ways in which we.

Â We, we, we could actually these numbers.

Â That is where, remember from the very beginning of the session.

Â When we said that there are some arguable issues.

Â This is a very arguable one.

Â And I'm going to show you some possibilities now.

Â But, there are many different ways of thinking how, what number we can put

Â into RF, what number we can put into MRP, and what number we can put into beta.

Â Whereas, on the side of debt, the fact that we need to use the yield to maturity,

Â as opposed to the interest rate.

Â And that is one of those undisputable issues.

Â Just about everybody would agree that that is the way to go.

Â Not everybody agrees on what are the exact numbers that we need to

Â put on a CAPM expression.

Â That's why.

Â This is just a,

Â a, an article that was published in the Harvard Business Review not long ago and

Â it's asking executives the question of, whether you know your cost of capital?

Â And it's posing that question simply because, there so

Â many uncertainties on the way of calculating.

Â Not only the cost of capital, but particularly the, the cost of equity.

Â Just to give you a glimpse of this, and I don't want to confuse you.

Â Just want to give you an idea that this is less a stride forward than it seems to be.

Â This is when you ask people around,

Â again these are surveys of practitioners using the model.

Â Look at the possibilities for the risk-free rate.

Â Some people use gov, everybody uses government bonds.

Â But the question is for how long, what is the maturity of those government bonds.

Â So there you have a people that use three month treasury bonds.

Â Some other people that use one year, five years, ten years, 20 years, or 30 years.

Â As you see they are the most popular option with 46% of users, almost 50%.

Â It's a ten year bond.

Â And that is typically indeed the most typical option.

Â But as you see you know, there are people that actually beg to disagree.

Â And there are people that use longer maturities, and

Â people that use shorter maturities.

Â That's what I mean.

Â By saying well it's very easy to understand to rationalize what

Â the risk-free rate means in the context of the require rate on an equity, and

Â in the context of the CAPM, but

Â it's much more difficult to put a specific number to that most people would agree.

Â That ten ten year bond yield to maturity is the number we should use, but,

Â as you see many other people would use other possibilities.

Â And again this is not to confuse you.

Â This is just to show you that, that our differences of opinion and

Â that this is much more arguable than many of the things that we discussed before.

Â This is for the.

Â Market risk premium, or the equity risk premium.

Â And as you see there these are specific number for the U.S. market.

Â Let me make just a quick point here.

Â When you look at different numbers, these numbers might change dramatically.

Â In other words remember what the market risk premium is.

Â Is the extra compensation required by investors for

Â investing in equity as opposed to investing risk free government debt.

Â Well that extra compensation doesn't have to be the same across countries.

Â And the data actually showed that maybe very different across countries.

Â So the numbers that you're seeing there are from the U.S. and

Â as you see there, the range between five and six percent is very popular.

Â About half the people use that range.

Â But as you also see, some people actually use higher numbers.

Â And some people actually use lower numbers.

Â Again.

Â It's very difficult to argue that you're right and

Â I'm wrong, depending on what our views are the only thing that we can do

Â when it comes down to the CAPM, is just look around us.

Â And see what people tend to do, what are the most popular options as opposed to

Â saying this is the way it should go, and everything else is actually wrong.

Â Finally on the beta, and, and

Â beta remember this is basically, we need to look back to estimate beta.

Â And one of the questions.

Â There are many questions on the estimation of beta, but

Â one of the questions is, so how many years are we going to go back?

Â And as you see there, you know, the,

Â the five year estimation period is very popular.

Â But, it's not the only one.

Â Some people estimate betas with one year, some people with two years, some

Â people with three years, and some people do something else altogether different,

Â so again, five years seems to be a popular estimation period, but

Â it doesn't have to be and it's not actually the only one.

Â Where does five years come from?

Â Well, some people will tell you, ideally we would like to go more years back to

Â capture whether the company magnifies or mitigates other markets' fluctuation.

Â But here is where, you know,

Â a practitioner can help you a little bit thinking about these issues.

Â Because the company might have changed a lot over time, and

Â if the company did change a lot over time, and you go back many,

Â many years you're picking up information that is no longer relevant.

Â Case in point think about telecommunication companies in Europe in

Â the early nineties that was when all the telecommunications market was

Â being deregulated.

Â So if I had stood here in 1995, and I had looked at

Â the beta of Deutsche Telekom, or France Telecom, or Telefonica Spain, and

Â I would have gone back 20 or 30 years to calculate that beta.

Â But, I would use that beat looking ahead than I

Â would be basically picking up information that is totally relevant.

Â Because 20, 30 years before 19 95 all the telecommunications companies

Â were monopolies, were a state owned, they had only one product.

Â And back in 1995, and looking ahead then, the, the business changed completely.

Â There was competition, there was different lines of business with cellular phones and

Â so forth, and so, you know, if you go many years back,

Â you'll run the risk of picking up a lot of information that data,

Â that is no longer relevant when you start looking ahead.

Â And at the end of the day we always want to look ahead.

Â Now the, the other alternative is to look just a little bit back.

Â But of course, the problem with looking just a little bit back with a few months,

Â or one year, or maybe even two, the problem is

Â that the company might have done spectacularly well or spectacularly awful.

Â And you don't want to actually take that little bit of information and

Â predict it maybe five, ten, 15, 20 years forward.

Â And so, you know, between not going too far back, and

Â not going too little back appears this sort of

Â compromise of going back five years, and that is why it's a popular option.

Â Now all that being said, what is important about these graphs that I just showed you,

Â is that there are differences of opinion.

Â Not everybody agrees, on what is the best way to.

Â Estimate a risk free rate, a market risk premium, and a beta.

Â Now we have one final thing and we're done.

Â And then we'll actually get to on the next session to to estimate an actual cost of

Â capital, but remember.

Â We call it technically the weighted average cost of capital, and

Â that means that we need to take into account the proportions.

Â How much we're using each of the different sources of financing?

Â How much debt we're using, and how much equity we're, we're using?

Â And those proportions are the one that in terms of notation we said before that

Â we're going to denote with x.

Â So xD is a proportion of debt.

Â xE is the proportion of, of equity.

Â And remember we're also calling D and E stand for debt and equity.

Â So xD and xE, if there are the only two sources of

Â financing that a company's going to use, if we use part of debt and part of equity,

Â when we put them together, that's all the capital that we have to invest.

Â In other words,

Â we're mathematically putting that, is that xD plus xE must be equal to 1.

Â And so the question now is a question of proportions.

Â Of all my capital, what proportion I'm using in terms of debt, and

Â what proportion I'm using in terms of In terms of equity.

Â So these are very simple definitions.

Â D divided D plus E is xD.

Â E divided D plus E is xE.

Â And the sum of these two things must be equal to 1.

Â And then we're going to put specific numbers,

Â in the next session to these two proportions.

Â One final thing and we'll be done with this.

Â Sometimes a question comes up, what type of debt we need to consider?

Â And here this is more or less quote unquote undisputable.

Â That most of the time we do not look at short term debt.

Â We do not look at the debt that a company uses to run the day-to-day operations.

Â Basically we're looking when we estimate the cost of capital, we're looking at

Â long-term debt, the debt that we'll raise in order to make long-term investments.

Â And sometimes that's not exactly, I mean, there's sort of a gray line here.

Â But typically that is interest bearing debt.

Â So some people would tell you,

Â well what you need to take into account is interest bearing debt.

Â What you need to take into account is long-term debt.

Â Most of the time these two things are the same.

Â There may be some examples, or

Â some specific cases in which that is not the case.

Â But debt for which we pay a, a specific interest.

Â A, an explicit interest.

Â And long term debt.

Â These two things actually have a lot of overlapping, and

Â that is the type of debt that we consider to estimate the the, the cost of capital.

Â Final thing and

Â we'll go back to this, when we estimate the numbers in session four.

Â Now we could use book values or

Â market values to calculate the proportions of debt and equity.

Â How much debt, how much equity, and what proportions we have?

Â Well typically here that is one of those sort of almost undisputed issues,

Â that we need to use market values as opposed to book values.

Â And if you think for a minute.

Â About what we discussed about the cost of debt you realize why.

Â And if, if you remember the market prices that people are willing to pay for

Â those bonds fluctuate with the riskiness of the company.

Â So if we want to properly reflect,

Â how much we have capital in terms of capital invested today,

Â that is going to be depending on market values as opposed to book values.

Â In other words, if I wanted to get rid of my debt by buying the debt in the market,

Â then what I pay in the market is the market value, and

Â is not the book value of the debt.

Â So because the market value, is the one that is going to reflect everything we

Â know about the company today, when we calculate how much debt we have, how much

Â equity we have and the proportions of the two, we use market values not book values.

Â So, this is just about it for session three.

Â We're going to, before we start session four, we're going to do a little review of

Â the main concepts that we have discussed today and then we're going to jump

Â right on, and estimate the cost of capital of Starbucks by the end of the year 2030.

Â See you soon.

Â [MUSIC]

Â