Académique Documents
Professionnel Documents
Culture Documents
Corporate Models
Valuation
Oct 1, 2015
Cost of Capital
Oct 1, 2015
Cost of Capital
Oct 1, 2015
Cost of Capital
Oct 1, 2015
Surveys of Managers
Late Fifties
Payback period
Sixties
Present Value
Seventies (Fremgen)
Internal rate of return
Net Present Value
Eighties
Mean Cost of Capital 14.2%
Gordon model and CAPM
Nineties
Risk premium of 6%
10% use 5%
Current
Equity premium of 5% or less
Cost of Capital
Oct 1, 2015
OPFCF
FCFE
WACC
Cost of equity
Enterprise value
Equity value
The key is to match the right cash flow with the right discount rate
And to the thing being valued
Cost of Capital
Oct 1, 2015
Cost of Capital
Oct 1, 2015
Valuation
Oct 1, 2015
WACC Points
Use target capital structure
Use nominal cost of capital in currency consistent with the free cash flow
Should be market weights and incremental cost of capital
Tricky Items
Convertible Bonds
Lower rate is due to equity value
Bond value
Equity Option
Term of Debt
Credit Spread on Debt
Callable and No callable debt (effect on cash flow)
Cost of Capital
Oct 1, 2015
WACC Computation
In the WACC formula, we know
Debt percent
Equity percent
Cost of new debt
Income tax rate
The hard part is the cost of equity
If the capital structure changes, the cost of equity should change
In theory, if the capital structure changes, the cost of equity should change
to maintain the same overall WACC
Therefore, if the capital structure changes in the model, careful with
assumption about how the WACC changes.
Cost of Capital
10
Oct 1, 2015
Step 2
Debt Cost from Rf plus Credit Spread
Kd = Rf + CS
After tax Kd
Step 3
WACC = (D/V) * Kd x (1-t) + (E/V) * Ke
Cost of Capital
11
Oct 1, 2015
WACC Problems
Whenever you have an equity-based cash flow stream like a real
estate development or something like that, there are better
techniques than using weighted average cost of capital.
Cost of Capital
12
Oct 1, 2015
Cost of Capital
13
Oct 1, 2015
CAPM: k = rf + x rm
Valuation
14 Oct 1, 2015
CAPM Inputs
Rf,i is the risk free rate for the current period (i) and it is the only variable
directly affected by movements in the overall cost of capital in the
economy.
i is the covariance between returns on the security and the market
returns divided by the overall variance of market returns. This parameter
is the only input affected by the risk of the security in question and the i
parameter is not expected to vary over time unless there is a change in
business and/or the financial risk of the company.
EMRP is the expected return on a fully diversified portfolio of equity
securities over and above the rate of return on risk free securities. This
variable is a function only of aggregate preferences by people in the
economy for risky investments versus risk free investments. It is not
affected by current interest rates, the risk of the security, or movements in
the overall stock market.
Cost of Capital
15
Oct 1, 2015
Geared Equity
Be
Asset/Ungeared
equity Ba x Market
Market Premium
Real
Average
Debt
Inflation
Plus Real
Rate - Rf
Cost of Capital
16
Oct 1, 2015
CAPM Theory
CAPM has many problems, but the basic theory upon which the
CAPM is built is a foundation of finance.
The foundation of the CAPM is:
Risk is measured by variation and standard deviation in
returns
Standard deviation is reduced from diversification
Variance (a + b) where the portfolio if a and b are have a
weight of .5 is:
.25 variance (a) + .25 variance (b) + .5 covariance(a,b)
If the covariance is zero, the variance of the portfolio is much
lower than the variance without diversification
Cost of Capital
17
Oct 1, 2015
CAPM Problems
Problems with the CAPM theory are recounted by Ravi Jagannathan and
Iwan Meier in their 2001 article Do We Need CAPM for Capital
Budgeting:
The CAPM as a model has been seriously challenged in the academic
literature. [S]ince the critique by Fama and French (1992) there is
consensus in the academic literature that the CAPM as taught in MBA
classes is not a good model it provides a very imprecise estimate of the
cost of capital. [T]here is overwhelming evidence in the academic
literature that for over two decades business schools have been teaching
the wrong model or at least recommending the use of the wrong inputs
for calculating the cost of capital.[1]
Cost of Capital
18
Oct 1, 2015
CAPM Problems
Not only has the CAPM proved wrong, but we do not even know that the
market premium is.
Ravi Jagannathan and Iwan Meyer, Do We Need CAPM for Capital
Budgeting Kellog School of Management
Fama and French:
Statistical analysis showing no relation between returns and beta
Statistical modeling: Time series to compute the Beta and then
cross section to compute the significance
Statistical problems: errors in variables and all variables should be
based on expectations rather than actual
CAPM may be un-testable
Cost of Capital
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Oct 1, 2015
20
Oct 1, 2015
Rm
Method of estimation expected returns
Actual use in practice
Beta
Estimation
Accuracy
Cost of Capital
21
Oct 1, 2015
Valuation
22 Oct 1, 2015
Cost of Capital
23
Oct 1, 2015
The primary issue in estimating the risk free rate is what risk free
security should be used:
Common equity pays cash flow to investors over a long
period
In theory the duration of dividends could be computed
Use t-bill yield to maturity of 10 years
Example
Treasury Bond Yield -- 2016 -- 5.53%
Treasury Bond Yield -- 2011 -- 4.98%
Cost of Capital
24
Oct 1, 2015
CH
HK
ID
MA
TH
KO
IN
PH
SI
TW
Cost of Capital
25
Oct 1, 2015
Cost of Capital
26
Oct 1, 2015
Valuation
27 Oct 1, 2015
The EMRP is expressed in real terms and is not a nominal number. This means the EMRP does
not increase or decrease when interest rates change or when the expected rate of inflation
changes. It would be wrong, for example, to update this number in the midst of a case because of
changes in the interest rate.
The EMRP comes from the general risk preferences of agents in an economy for equities relative
to risk free securities. If people did not have risk aversion for equities relative to risk free bonds,
the EMRP would be zero. This means changes in the EMRP are driven by changes in general
preferences for equities relative to risk free securities. Because the EMRP comes from risk
preferences, it should be stable over long time periods as risk preferences do not swing from
month to month or year to year.
Third, the EMRP is an expected number rather than a number that can be directly measured from
actual realized returns. The fact that the EMRP is an expected number means that it does not
change when the stock market goes up or down because realized earnings change or because
general economic activity is robust or depressed.
Fourth, the EMRP is an economy wide number not unique to ComEd. Unlike Beta which
measures the risk associated with a specific company, the EMRP is the same whether it is used in
valuing a paper company, gauging the rate of return for an oil project or assessing the share price
of an airline company.
Fifth, the EMRP has been the subject of a very large body of research. This research has been
performed by people who are not funded by parties who have a vested interest in producing a
particularly high or a particularly low risk premium number. Since the EMRP is not unique to
ComEd, since it is an expected number difficult to calculate, and since it is not expected to change
over short time periods, the EMRP research is directly relevant to this and other regulatory
proceedings.
Cost of Capital
28
Oct 1, 2015
Cost of Capital
29
Oct 1, 2015
Historic EMRP
Enrique Arzac refers to research by Blanchard who developed a
dynamic model of the expectations of real returns on stocks and
bonds. He found that the risk premium during the 1930s and
1940s was unusually high ranging from 3 to 5% in the early
1930s to more than 10% in the 1940s. Afterwards, it started a
gradual decline with some relatively minor fluctuations and
reached between 2 and 3% in the early 1990s.
Claus and Thomas emphasize the notion that historic returns
exceed the expected amounts: Despite substantial variation in
the underlying fundamentals across markets and over time,
observing that every one of our 69 country-year estimates lies
well below eight percent suggests that the Ibbotson estimate is
too high for our sample period.
Cost of Capital
30
Oct 1, 2015
Cost of Capital
31
Oct 1, 2015
Surveys of Investors
In the US, Merrill Lynch publishes bottom up expected returns on the Standard
and Poors 500, derived by averaging expected return estimates for stocks in the
Standard & Poors 500.In recent years, the Merrill Lynch expected return
estimates have indicated an EMRP in the region of 4% to 5%.
The Value Line projected market risk premia are somewhat more volatile than those
from the Merrill Lynch DDM model. In recent years they have generally ranged from
2% to 6%....
Greenwich Associates had published the results of an annual survey of pension plan
officers regarding expected returns on the Standard and Poors 500 for a five-year
holding period. The Greenwich Associates survey has generally indicated and
EMRP in a 2%-3% range.
Claus and Thomas also cite investor expectations. They summarize the information
as follows: Surveys of institutional investors also suggest an equity premium
substantially below eight percent (e.g., Burr (1998)), and there are indications that
this belief has been held for many years (e.g., Benore (1983)) . Also, the weighted
average cost of capital used in discounted cash flow valuations provided in analysts
research reports usually implies an equity premium below five percent.
Cost of Capital
32
Oct 1, 2015
Risk Premium
There is a wide range in premiums used in theory and practice. The following
shows results from one study.
Cost of Capital
33
Oct 1, 2015
Cost of Capital
34
Oct 1, 2015
1974 1998
Arithmetic 5.5%
Geometric 4.9%
1964 1998
Arithmetic 4.7%
Geometric 3.6%
Cost of Capital
35
Oct 1, 2015
McKinsey -- 4.50%
Cost of Capital
36
Oct 1, 2015
The median estimate of ERP is in the 4-5% range for mature markets
Cost of Capital
37
Oct 1, 2015
Cost of Capital
38
Oct 1, 2015
Beta
Valuation
39 Oct 1, 2015
Cost of Capital
40
Oct 1, 2015
Betas
Cost of Capital
41
Oct 1, 2015
Beta Measurement
Beta is cov(Rm,Rt)/variance(Rm)
Cost of Capital
42
Oct 1, 2015
Beta Adjustments
Value Line computes its beta from a regression equation that
measures an unadjusted beta. Then, Value Line adds an
adjustment to move the beta toward 1.0 using the following
equation[1]:
Adjusted beta = 2/3 x Unadjusted beta + 1/3 x 1.0
or
Unadjusted beta = Adjusted beta x 3/2 1/2
Cost of Capital
43
Oct 1, 2015
Cost of Capital
44
Oct 1, 2015
Index
1.40
NICOR
1.20
S&P 500
1.00
0.80
Cost of Capital
9/3/2005
5/3/2005
1/3/2005
9/3/2004
5/3/2004
1/3/2004
9/3/2003
5/3/2003
1/3/2003
9/3/2002
5/3/2002
1/3/2002
9/3/2001
5/3/2001
1/3/2001
9/3/2000
5/3/2000
1/3/2000
0.60
45
Oct 1, 2015
Cost of Capital
46
Oct 1, 2015
Cost of Capital
Equity beta
Debt/ Equity
Asset beta
CPA
1.3
50%
0.91
SIA
1.09
25%
0.91
47
Oct 1, 2015
Cost of Capital
48
Oct 1, 2015
Asset Beta
Cost of Capital
49
Oct 1, 2015
Cost of Capital
50
Oct 1, 2015
51 Oct 1, 2015
DCF Issues
How should one select an appropriate sample of comparable
companies with similar risk to ComEd to derive the implied cost of
equity capital;
What method should be used to compute the constant expected
growth rate of marginal investors for each company in the
comparable sample;
Whether a valuation model for using earnings is a better way to
derive the implicit cost of equity capital than dividend growth
model; and,
Should adjustments for quarterly compounding be made in
deriving implicit discount rates.
Cost of Capital
52
Oct 1, 2015
Cost of Capital
53
Oct 1, 2015
Cost of Capital
54
Oct 1, 2015
Residual value
Relative valuation
Cost of Capital
55
Oct 1, 2015
Cost of Capital
56
Oct 1, 2015
Company Profiles
Cost of Capital
57
Oct 1, 2015
Cost of Capital
58
Oct 1, 2015
Using the same discount rate is a very lose form of risk neutral
valuation
Using the this process illustrates how your stock is the currency
of the transaction
Cost of Capital
59
Oct 1, 2015
Valuation
60 Oct 1, 2015
Objectives of APV
NPV assumes
Capital structure remains the same
Leveraged Buyout
Cost of Capital
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Oct 1, 2015
Cost of Capital
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Oct 1, 2015
Cost of Capital
63
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Cost of Capital
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Oct 1, 2015
Cost of Capital
65
Oct 1, 2015
APV Case
Cost of Capital
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Oct 1, 2015
Cost of Capital
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Oct 1, 2015
Cost of Capital
68
Oct 1, 2015
geared ungeared 1
thus
ungeared
Cost of Capital
geared
Vd(1- Tax rate)
Ve
69
Oct 1, 2015
Cost of Capital
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Cost of Capital
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Cost of Capital
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Cost of Capital
73
Oct 1, 2015
Cost of Capital
74
Oct 1, 2015
Use US Rm, otherwise, the Beta would not be consistent with the
Rm
Cost of Capital
75
Oct 1, 2015
.8
1.0
Find out what investors expect in local markets in terms of the premium
above the risk free rate.
E.g. 5% in London and 7% in China
Add the local risk free rate to the market premium adjusted for the three
categories of beta.
Make adjustments for country risk with political risk insurance rates
Cost of Capital
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Oct 1, 2015
Cost of Capital
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Cost of Capital
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Cost of Capital
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Oct 1, 2015