The Daily Technical #62: What is the cash conversion cycle?

Good morning. Welcome to the 62nd edition of The Daily Technical. You’re here for one reason so let’s dive in.

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OVERVIEW OF YESTERDAY’S QUESTION
How is the cost of equity calculated?

To calculate the cost of equity, you can use the Capital Asset Pricing Model (CAPM). This model connects the expected return of a security to its market risk, often mirrored against an index like the S&P 500. The formula is straightforward:

Cost of Equity (Re) = Risk-Free Rate + Beta × Equity Risk Premium

More on it’s components:

1. Risk-Free Rate: This is the return on a risk-free investment, typically government bonds. It represents the baseline return expected for taking no risk.

2. Beta: A measure of a stock's volatility or sensitivity to market movements. A beta greater than 1 indicates the stock is more volatile than the market, whereas a beta less than 1 indicates it's less volatile.

3. Equity Risk Premium: The additional return expected for taking on the risk of investing in the stock market over a risk-free rate.

Common Mistakes

1. Forgetting to define what the risk-free rate represents. It's crucial to remember that the risk-free rate is typically based on government bond yields with a suitable maturity.

2. Assuming a constant equity risk premium without acknowledging its variability. The equity risk premium can differ based on economic conditions, so using a historical average or reliable market estimates is key to an accurate calculation.

3. Mixing up the cost of equity with the cost of debt. The cost of equity involves expected returns to shareholders, while the cost of debt considers interest rates on borrowed funds.

TL;DR

• CAPM Formula: Cost of Equity (Re) is calculated as Risk-Free Rate + Beta × Equity Risk Premium.

• Risk-Free Rate: Typically the return from government bonds; baseline for no-risk investments.

• Beta: Measures stock volatility against the market; >1 means more volatile, <1 means less volatile.

• Equity Risk Premium: Extra return for market risk over the risk-free rate.

TODAY’S QUESTION
What is the cash conversion cycle?

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THAT’S A WRAP
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Mike Lukasevicz
Founder @ HirePrep