Presented by:

presented to :

Dr. Parmjit Kaur

Akhil Kohli Bandeep Jaswal Deepika Mahajan Prabhjot Singh Ramneek Singh

Residual Value
The expected cash flow at the end of the forecast

horizon. Also referred to as the terminal value. In most cases it is the largest portion of the value of the firm. Its size is directly dependent upon the assumptions made for the forecast horizon. The analyst must project future periodic cash flows for some number of years, and then estimate the likely residual value at the end of this forecast horizon.

 Selecting a forecast horizon involves trade-offs. Using a

relatively short forecast horizon, such as 3 to 5 years, enhances the likely accuracy of the projected cash flows. But this causes a large portion of the total present value to be related to the residual value. Selecting a longer period in the forecast of periodic cash flows such as 10 to 15 years, reduces the influence of the estimated residual value on the total present value. However, the predictive accuracy of detailed cash flow forecasts this far into the future is likely to be questionable. It is best to select as a forecast horizon the point at which a firms cash flow pattern has settled into an equilibrium. This equilibrium position could be either no growth in future cash flows or growth at a stable rate. Typically 4 to 7 years

Discounted cash flow (economic approach)

When a firms cash flow pattern has settled into an

equilibrium at the end of the forecast horizon: Residual Value at End of Forecast Horizon (n) = Periodic Cash Flow (n-1) * (1+g) (r-g) Where: n= forecast horizon; g= annual growth rate in periodic cash flows after the forecast horizon; and r= discount rate If the final years cash flow continues at the same level in perpetuity. Residual value = cash flow / r

Example
An analysts forecasts that the leveraged free cash flow

of a firm in Year 5 is $ 30 million. This is a mature firm that expects zero growth in future cash flows. The residual value of the cash flow, assuming a 15 percent cost of equity capital, is computed as: Residual Value at End of Forecast Period = $30 million/ 0.15 = $200 million The present value at the beginning of Year 1 of this residual value = $99.4 million

(ii) If the analyst expects the cash flow after Year 5 to grow at 6 percent each year Residual Value at End of Forecast period= $30 million * (1+ 0.06) = $353.5 million (0.15 - 0.06) (ii) If the analyst expects the cash flow after Year 5 to decline at 6 percent each year Residual Value at End of Forecast period= $30 million * (1 - 0.06) = $134.3 million 0.15 - (-0.06) The cash flow of a firm in decline will eventually reach zero (or the firm will become bankrupt)

 Analysts frequently estimate a residual value using

multiples of six to eight times leveraged free cash flow in the last year of the forecast horizon to value the common stock of a firm Table: Cash flow multiples using (1+g)/(r-g)
Cash Flow Multiples Growth rate 2% Cost of Equity Capital 4% 6%

15%
18% 20%

7.8
6.4 5.7

9.5
7.4 6.5

11.8
8.8 7.6

Problems with the model

This residual valuation model does not work well when:

Discount rate and the growth rate are approximately equal => Denominator approaches zero and the multiple becomes exceedingly large Growth rate exceeds the discount rate => Denominator becomes negative and the resulting multiple is meaningless These difficulties arise because the growth rate assumed is too high. The model assumes that the growth rate will continue in perpetuity. But competition, technological change, new entrants and similar factors reduce growth rates.

Other approaches
Alternative approach to estimate residual value is to

use the free cash flow multiples for comparable firms that currently trade in the market. Provides a degree of market validation for the theoretical model. Analysts identifies comparable companies by studying growth rates in free cash flows, profitability levels, risk characteristics and similar factors. Analysts also use earnings-based models such as priceearnings ratios or market to book value ratios to estimate a residual value.

Definition
To a firm, it is the cost of obtaining funds
To an investor, it is the minimum rate of return

expected by it without which the market value of shares would fall.

In accounting sense, it is the weighted average cost of

various sources of finance used by a firm.

Definition (Contd..)
According to James C Van Horne It is the cut off rate

for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.
According to John J. Hampton Cost of Capital is the

rate of return the firm requires from the investment in order to increase the value of the firm in the market place

WACC
Company typically has several options for raising

capital including :

Issuing Equity Issuing Debt Issuing Preferred Stocks.

Each Selected source becomes a component of company's cost and may be called as a Component cost of capital. The weighted average of all these costs is called Weighted average cost of capital or WACC. It is also called Marginal cost of capital.

WACC = wp rp +
Where

we re

+ Wd Rd (1-t)

wp

= the proportion of preferred stock that the company uses to raise new funds.

Rp = the marginal cost of preferred stock.

we = the proportion of equity that the company uses to raise new

funds.

Re = the marginal cost of equity.

wd
Rd

= the proportion of debt that the company uses to raise new funds.
= the before tax marginal cost of

debt.

T= companys marginal tax rate.

Significance Of Cost Of Capital

The acceptance criterion in capital budgeting (in NPV,

as a discounting factor and in IRR it is used as a cut off rate to compare with)
The determinant of optimal capital mix in the capital

structure decision (i.e., the mix that minimizes the overall cost of capital)
A basis of evaluating the financial performance( i.e.

EVA = capital employed (ROI-COC)

 Firms employ several types of capital, called capital

components, with common and preferred stock, along with debt, being the three most frequently used types with one thing in common The investors who provide the funds expect to receive a return on their investment
However, because of varying risks, these different

securities have different required rate of return.

Cost Of Debt
The first step is to determine the rate of return debt

holders require i.e. rd A calculated estimate, because it is difficult to project the type of debt used over a period. Now, we calculate the after-tax cost of debt After Tax Cost of Debt = Interest Rate Tax Savings = rd - rd T = rd (1 - T)

E.g.: Incorporating the effects of Taxes on the Cost of Capital

Jorge Richard , A financial Analyst is estimating the cost of capital for ABC company. Richard has calculated the before tax costs of capital for ABCs debt and equity as 4% and 6% respectively. What would be the after tax costs of debt and equity if the marginal tax rate is :
30% 2. 48%
1.

Solution
Marginal Tax After Tax Cost of Rate Debt Solution to 1 Solution to 2 30% 48% .04(1-.30 ) = 2.80 % .04(1-.48 ) =2.08 % After Tax Cost of Equity 6% 6%

Calculating the Cost of Debt (Yield to maturity approach )

YTM is the annual return that an investor earns if the investor purchases a bond today and holds it until maturity.

P0= PMT1/(1+rd/2) +PMTn/(1+rd/2) + FV/ (1+rd/2)

Where:
P0= the current market price of the bond. PMT t = interest payment in the period t.

rd=the yield to maturity.

n= no of periods remaining to maturity FV the maturity value of the bond.

Calculating the Cost of Debt (Debt Rating Approach)

When reliable current market price for a companys

debt is not available Debt rating approach is used. Based on a companys debt rating, we estimate the before tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of the companys existing debt.

Cost Of Preferred Stock

Because, Preferred Stock are not tax deductible, not tax

adjustment is used when calculating the cost of preferred stock

The component cost of preferred stock rps is the preferred

dividend, Dps divided by the net issuing price, Pn , which is the price the firm receives after deducting floatation costs: COMPONENT COST OF PREFERRED STOCK = rps = Dps / Pn

Cost Of Common Stock

A company can raise common equity in 2 ways : (1)

directly issuing new shares (2) indirectly, by retaining earnings When, new shares issued, shareholders require a return, rs . Also, retained earnings have a cost known as opportunity cost - the earnings could have been paid out as dividends which could have been reinvested in other investments.

 Thus, the firm should earn on its reinvested earnings

at least as much as its stockholders themselves could earn on alternate investments of equivalent risks, which is rs Thus rs is the cost of common equity raised internally by reinvesting earnings

 Whereas, debt and Preferred Stock are contractual

obligations that have easily determined costs, it is more difficult to estimate rs

3 Methods are typically used :-

(a) The CAPM (b) Discounted Cash Flow Method (c) The Bond-Yield-Plus-Risk-Premium Approach

The CAPM Approach

STEP 1 . Estimate the risk free Rate, rRF
STEP 2. Estimate the current market Risk premium, RPm, which is expected market return minus the risk free rate. STEP 3. Estimate the stocks beta coefficient, bi, and use it as an index of the stocks risk

STEP 4. Substitute the preceding values into the CAPM equation to estimate the required rate of return in:

rs = rRF + (RPM)bi
Risk free rate is taken as the return from the long term

Treasury securities.
The Risk Premium is the result of investor risk

aversion.

 The Risk Premium is estimated on the basis of (1)

Historical Data (2) Forward looking data Beta I the relevant risk of an individual stock, it contributes to the market portfolio ( or well diversified portfolio)

DIVIDEND-YIELD-PLUS-GROWTHRATE, OR DCF APPROACH

If dividends grow at g rate, then expected price is

P0 = D1 /(rs - g) where P0 is the current price; D1 is the dividend expected to be paid, and rs is the required ROR on common equity Hence rs = (D1 / P0 ) +Expected g

 The investors expect to receive a dividend yield plus a

capital gain as expected return. The method of estimating the cost of equity is called Discounted Cash Flow method.
Growth rates calculated either as historical growth

rates, or retention growth model, or by forecasts.

BOND-YIELD-PLUS-RISK-PREMIUM Approach
Subjective, adhoc procedure
Adding a judgmental risk premium to the interest

rates on firms own long term debt.

ASSUMPTION Firms with risky, low rated, and high

interest-rate debt will also have risky, high-cost equity rs = Bond Yield + Bond risk premium

WEIGHTED AVERAGE COST OF CAPITAL

The weighted average cost of capital (WACC) is the

rate that a company is expected to pay on average to all its security holders to finance its assets. It is the weighted sum of cost of all the sources used to finance the investments. If a firm uses preferred stock, common equity and debt, the WACC will be

WACC = wd rd (1-T) + wps rps + wce rs

FACTORS AFFECTING WACC

The cost of capital is affected by a number of factors.

Some are beyond the firms control, but others are influenced by its financing and investment policies.
FACTORS THE FIRM CANNOT CONTROL 1. The Level of interest Rates If IR increases, cost

of debt increases and equity cost increases. 2. Market Risk Premium 3. Tax Rates

FACTORS the FIRM CAN CONTROL 1. Capital Structure Policy The amount of debt used in capital structure depends on the policies of the firm 2. Dividend Policy The amount of payout depends on the management 3. Investment Policy

References
CFA Level-I book
Financial Reporting and Statement Analysis: A

Strategic Perspective- Clyde P. Stickney and Paul R. Brown Financial Management: Text and Cases- Brigham and Ehrhardt