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Source: www.bondsonline.com.

than would lower-rated bonds. The difference between the interest rate on a bond with default risk and a default-free government bond is defined to be the default spread. Table 2.2 summarizes default spreads over the treasury for 10-year bonds in S&P’s different ratings classes as of September 30, 2011.

These default spreads, when added to the riskless rate, yield the interest rates for bonds with the specified ratings. For instance, a D-rated bond has an interest rate about 14 percent higher than the riskless rate. This default spread may vary by maturity of the bond and can also change from period to period, depending on economic conditions, widening during economic slowdowns and narrowing when the economy is strong.

C O N C L U S I O N

Risk, as we define it in finance, is measured based on deviations of actual returns on an investment from its expected returns. There are two types of risk. The first, which we call equity risk, arises in investments where there are no promised cash flows but there are expected cash flows. The second, default risk, arises on investments with promised cash flows.

For investments with equity risk, the risk is measured by looking at the variance of actual returns around the expected returns, with greater variance

indicating greater risk. This risk can be broken down into risk that affects one or a few investments, which we call firm-specific risk, and risk that affects many investments, which we refer to as market risk. When investors diversify, they can reduce their exposure to firm-specific risk. By assuming that the investors who trade at the margin are well diversified, we conclude that the risk we should be looking at with equity investments is the market risk. The different models of equity risk introduced in this chapter share this objective of measuring market risk, but they differ in the way they do it. In the capital asset pricing model, exposure to market risk is measured by a market beta, which estimates how much risk an individual investment will add to a portfolio that includes all traded assets. The arbitrage pricing model and the multifactor model allow for multiple sources of market risk and estimate betas for an investment relative to each source. For those who remain skeptical of risk and return models based on portfolio theory, we looked at alternatives: risk measures based on accounting ratios, using market capitalization or other proxies for risk, backing out the implied risk from market prices, risk-adjusting the cash flows, and building in a margin of safety when making investments.

On investments with default risk, risk is measured by the likelihood that the promised cash flows might not be delivered. Investments with higher default risk should have higher interest rates, and the premium that we demand over a riskless rate is the default premium. For most U.S. companies, default risk is measured by ratings agencies in the form of a company rating; these ratings determine, in large part, the interest rates at which these firms can borrow. Even in the absence of ratings, interest rates will include a default premium that reflects the lenders’ assessments of default risk. These default-risk-adjusted interest rates represent the cost of borrowing or debt for a business.

E X E R C I S E S

Pick a company that you are familiar with in terms of its business and history. Try doing the following:

1.Find an annualized standard deviation for the stock of the company over a period (a year, two years, five years). Compare it to the standard deviation in stock prices for the sector in which it operates (from my website).

2.Find a beta for your company on a service (Yahoo! Finance, Morningstar, Value Line). Better still, find the betas for your company on many services and look at the range.

a.Compare the beta to the average beta for the sector in which the company operates.

b.Use the beta in conjunction with a risk-free rate and equity risk premium (also available on my website) today to estimate an expected return for the stock. What does that expected return tell you? Why does it matter?

3.Check to see if your company has a bond rating. If it does, use that rating to estimate a default spread and a cost of debt for your firm.

4.If you can compute a cost of capital for your firm, do so, and compare it to the average for the sector in which it operates.

Lessons for Investors

Your perceptions of how risky an investment is may be very different from the risk perceived by the marginal investors (the large institutional investors who set prices at the margin). The market prices assets based on the marginal investors’ perceptions of risk.

If the marginal investors in a company are well diversified, the only risk that is priced is the risk that cannot be diversified away in a portfolio. Individual risk and return models differ on how to measure this nondiversifiable risk. The capital asset pricing model tries to measure it with one beta, whereas multifactor models try to measure it with multiple betas. The measure of risk allows us to estimate an expected return on a risky investment for the future. This expected return becomes the benchmark that the investment has to beat to be a good investment.

To the extent that you do not buy into beta or betas as measures of risk, you should consider the alternatives, which can range from using proxy measures for risk (size of the company, the industry it operates in) to accounting ratios.

For bonds, risk is measured as default or downside risk, since there is not much potential on the upside. Bonds with higher default risk should command higher interest rates.

transaction and be able to quantify future benefits with reasonable precision. The accounting view of asset value is to a great extent grounded in the notion of historical cost, which is the original cost of the asset, adjusted upward for improvements made to the asset since purchase and downward for the loss in value associated with the aging of the asset. This historical cost is called the book value. Though the generally accepted accounting principles for valuing an asset vary across different kinds of assets, three principles underlie the way assets are valued in accounting statements.

1.An abiding belief in book value as the best estimate of value. Accounting estimates of asset value begin with the book value. Unless a substantial reason is given to do otherwise, accountants view the historical cost as the best estimate of the value of an asset.

2.A distrust of market or estimated value. When a current market value exists for an asset that is different from the book value, accounting convention seems to view this market value with suspicion. The market price of an asset is often viewed as both much too volatile and too easily manipulated to be used as an estimate of value for an asset. This suspicion runs even deeper when values are estimated for an asset based on expected future cash flows. In recent years, though, there has been more acceptance of market value, at least in some quarters, embodied in the push toward fair value accounting.

3.A preference for underestimating value rather than overestimating it.

When there is more than one approach to valuing an asset, accounting convention takes the view that the more conservative (lower) estimate of value should be used rather than the less conservative (higher) estimate of value.

M e a s u r i n g A s s e t V a l u e

The financial statement in which accountants summarize and report asset value is the balance sheet. To examine how asset value is measured, let us begin with the way assets are categorized in the balance sheet. First, there are the fixed assets, which include the long-term assets of the firm, such as plant, equipment, land, and buildings. Next, we have the short-term assets of the firm, including inventory (including raw materials, work in progress, and finished goods); receivables (summarizing moneys owed to the firm); and cash; these are categorized as current assets. We then have investments in the assets and securities of other firms, which are generally categorized as financial investments. Finally, we have what is loosely categorized as intangible assets. These include assets such as patents and trademarks that presumably will create future earnings and cash flows, and also uniquely

that are not collectible. Firms can set aside a portion of their income to cover expected bad debts from credit sales, and accounts receivable will be reduced by this reserve. Alternatively, the bad debts can be recognized as they occur and the firm can reduce the accounts receivable accordingly. There is the danger, however, that absent a decisive declaration of a bad debt, firms may continue to show as accounts receivable amounts that they know are unlikely to ever be collected.

Cash Cash is one of the few assets for which accountants and financial analysts should agree on value. The value of a cash balance should not be open to estimation error. Having said this, we should note that fewer and fewer companies actually hold cash in the conventional sense (as currency or as demand deposits in banks). Firms often invest the cash in interest-bearing accounts, corporate bonds or in U.S. Treasury securities, so as to earn a return on their investments. In either case, market value can deviate from book value, especially if the investments are longer term or riskier. While there is may be little default risk in these investments, interest rate movements can affect their value. We will examine the valuation of marketable securities later in this section.

Inventory Three basic approaches to valuing inventory are allowed by GAAP: first in, first out (FIFO); last in, first out (LIFO); and weighted average.

1.First in, first out (FIFO). Under FIFO, the cost of goods sold is based on the cost of material bought earliest in the period, while the cost of inventory is based on the cost of material bought latest in the period. This results in inventory being valued close to the current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three valuation approaches, and the highest net income.

2.Last in, first out (LIFO). Under LIFO, the cost of goods sold is based on the cost of material bought latest in the period, while the cost of inventory is based on the cost of material bought earliest in the period. This results in finished goods being valued close to the current production cost. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three valuation approaches, and the lowest net income.

3.Weighted average. Under the weighted average approach, both inventory and the cost of goods sold are based on the average cost of all materials bought during the period. When inventory turns over rapidly, this approach will more closely resemble FIFO than LIFO.

Firms often adopt the LIFO approach for its tax benefits during periods of high inflation. The cost of goods sold is then higher because it is based on prices paid toward to the end of the accounting period. This, in turn, will reduce the reported taxable income and net income while increasing cash flows. Studies indicate that larger firms with rising prices for raw materials and labor, more variable inventory growth, and an absence of other tax-loss carryforwards are much more likely to adopt the LIFO approach.

Given the income and cash flow effects of inventory valuation methods, it is often difficult to compare the inventory values of firms that use different methods. There is, however, one way of adjusting for these differences. Firms that choose the LIFO approach to value inventories have to specify in a footnote the difference in inventory valuation between FIFO and LIFO, and this difference is termed the LIFO reserve. It can be used to adjust the beginning and ending inventories, and consequently the cost of goods sold, and to restate income based on FIFO valuation.

I n v e s t m e n t s ( F i n a n c i a l ) a n d M a r k e t a b l e S e c u r i t i e s In the category of investments and marketable securities, accountants consider investments made by firms in the securities or assets of other firms, and other marketable securities, including Treasury bills or bonds. The way in which these assets are valued depends on the way the investment is categorized and the motive behind the investment. In general, an investment in the securities of another firm can be categorized as a minority passive investment, a minority active investment, or a majority active investment. The accounting rules vary depending on the categorization.

Minority Passive Investments If the securities or assets owned in another firm represent less than 20 percent of the overall ownership of that firm, an investment is treated as a minority passive investment. These investments have an acquisition value, which represents what the firm originally paid for the securities and often a market value. Accounting principles require that these assets be subcategorized into one of three groups: investments that will be held to maturity, investments that are available for sale, and trading investments. The valuation principles vary for each.

1.For investments that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement under net interest expenses.

2.For investments that are available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized