m
2.
3.
4.
s.
6.
D U L E
ng the bear markets of the early and late 2000s, many utility companies experienced a large market value decline. In an
ort to prevent further decline, many of these utilities sold off their underperforming assets and consolidated their operations.
se strategic business decisions allowed those in the utilities industry to generate positive earnings and cash flows in more
recent years. Their stock prices also rebounded from the declines of the
early and late 2000s.
One utility company that has performed well in recent years is The
Southern Company (SO). The Southern Company serves approximately
4.4 million customers through its various subsidiaries in Alabama, Florida,
Georgia and Mississippi. The Southern Company generates, transports,
provides electricity. It also invests in, among other things, synthetic fuels and the marketing of natural gas.
The Southern Company has experienced some stock price volatility. SO's stock price on July 1, 2006, was $32.05 per
are. Five years later its stock traded for $40.72 per share. Charting its price from mid-2006 through mid-2011 , adjusting for
ock splits, reveals a reasonable increase despite the economic downturn, which is graphically portrayed below.
$42
$40
$38
$36
$34
$32
$30
$28
$26
~~~'--~--''--~_.L~~---<-~~-'-~~-<-~~-"-~~"""-~~'--~---/
Jan 2007
Jan 2008
Jan 2009
Jan 2010
Jan 2011
SO's dividends per share also increased during this period. Finance.Yahoo.com predicts SO's dividend stream at approxiately $1 .89 per share. The sum of its annual stock price change (capital gains) and its annual dividend, yields the investors'
nual return from SO. Does this annual return adequately compensate investors for their risk and foregone interest return?
at is, is the company fairly priced given its predicted dividend stream? This question, and those similar to it, is the focus of
is mod ule.
rces: The Southern Company 2010 Annual Report and 10-K Filing ; Finance.Yahoo com , July 2011 .
12-2
12-3
0 3:
lJ 0
C>
s, taste , and appearance), as well as the overall supply of apples in the market, determine the
'ce. The same logic holds for the pricing of stocks.
The process for valuation described in this and subsequent modules is useful for valuing
urities. We can use valuation techniques to:
J> c
Zr
-m
J>
-t
Intrinsic Value
Valuation of Debt
Valuation of Stock
Compare our stock-price estimate to the observed trading price and then decide whether to
buy, sell, or hold the stock
Basics of Valuation
Recursive Process of
Valuation
DDM Framework
Applying DDM
Valuation plays an important role in today 's market e~o~omy . Indeed , valuation is impli~it i~ all
financial deci sions and transactions in that market part1c1pants compare the value .of what 1s g1~en
up to the value of what is received. For instance, valuation plays a central role m the followmg
situations:
a mero-er decision depe nds crucially on the estimated fair value of the target company
the sh:Ce price of an initial public offering depends on the business valuation by the issuer as
well as by potential investors
identifying stocks or bonds that are over (or under) valued , which is a key task of a portfolio
manager, depends on business valuations.
An important question is how do we value a stock , a ?ond , or any other financial instrument?
A financial instrument entitles its owner to a senes of future payoffs fr?m a com~any. The
amount of such payoffs depends on the company's abi li.ty to generate pr?f1t th~ou~~ its future
operations. Previous modules have dealt with the evaluation of a company s prof1tab1hty and the
adjusting and forecasting of financial statement numbers. In su~sequent m?dules, we ~se thes~
adjustments and forecasts to estimate the value of the company via seve~al d1ffere~t equity valua
tion models and approaches . This module introduces a fundamental equ~ty valuat~on model- the
dividend discount model-and introduces features common to most e~U1ty valuation models.
Most valuation models incorporate an estimate of the cost of capital and a forecast of future
payoffs . Cost of capital is the discount rate that an investor (an equity or debt hol~er) uses to va~u~
the future payoffs , and reflects the return the investor expects based on the pe~ce1ved ~e:el of n.s
associated with that investment. Dividends are the forecasted future payoffs m the d1 v1dend discount model. (Free cash flow s are the forecasted future payoffs in the di~co~nted free cash fl~~
model , and excess earnings are the future payoffs for the residual operating income modelModules 13 and 14.)
mWe begin with valuation basics, including a review of present value concepts and t?e co
putations for lump-sum payoffs and annuities . Those familiar with pres~nt value calculat1?ns c~~
skip this review. The module then covers two key items: the computat10n of co~t of c~p1tal ~he
application of the dividend discount model. The cost of capital section includes ?1scuss1on on de
cost of equity capital, cost of debt capital , and ~h~ weigh.ted average cost of capital. We concl u
with a discussion of the pros and cons of the d1v1dend discount model.
BASICS OF VALUATION
LO 1 Explain the
basics of valuation,
including intrinsic
value, discounting ,
and payoffs.
Step I: Understanding the business environment and accounting information. Before we can
value a company, we must understand its business environment. This includes understanding
competiti ve and macroeconomic threats, evaluating future growth opportunities, and assessing
the quality of the accounting environment.
Step 2: Adjusting and assessing financial and accounting information. This includes assessing
profitability and its drivers , along with understanding growth potential , strategic actions, and
their implications for financial reports. This step also includes making any necessary accounting
adjustments to the general-purpose financial statements.
S~ep 3: Forecasting financial information. Forecasting is crucial in security valuation as it provides the key inputs to valuation models. Choice of what payoffs we forecast will be determined
by data avai labi lity, models utilized, and our confidence in future estimates. Without good forecasts, the output from any va luation model is dubious no matter how good the model.
12-4
12-5
Step 4: Using information for ~aluation . Thi s ste~ involves estimating the cost o_f capita] llnd
then applying the proper valuation model to the est1m~ted pa.yo~s. The cost _of capital we select
reflects both the time value of money and the cost of nsk. Adjustmg for the time value of mone
acknowledges that a dollar received in the fu.ture is worth l~ss than a dollar received toda:
Adjusting for ri sk takes account of the uncertam nature of projected payoffs. Returns to investments in bonds and , especially, stocks are unpredictable and often volatile . A dollar invested in
Google at its lPO in 2004 would have earned more than a 400% return by 20 l I . On the other
hand , if we invested i_n ~~ron , ~~r investment w~u~d ha~e been lost. These .cases refl~ct a saying:
" life is uncertain until 1t 1s not. Most people dislike n sk . In stock valuat10n we adjust for risk
by determining a discount rate that is applied to projected payoffs. Valuation models differ in the
forecasted payoffs, the forecast horizon , and the use of a discount rate. It is imp~rtant to identify
the crucial assumptions underlying each model , and to apply the proper model m the right way,
and under the right circumstances.
Step 1-Understandlng the Business Environment
and Accounting Information
Modules 1 and 2
-.
Where 1s the
firm currently?
Where 1s the
firm going?
What 1s the
firm worth?
These four steps are not mutually exclusive. They are part of a valuation process and, as
such, they are interrelated. For instance , identifying the proper valuation model is li sted as part
of step 4. Yet , choice of a valuation model is determined by a careful analysis of the business
environment (step 1) and its impact on the accuracy of forecasts of company payoffs (step 3).
Likewise, the analysis of prior results in reported financial statements (step 2) form s the foundation for what is forecasted (step 3). This interconnected series of steps provides us with a
structure for understanding where the company operates, where it is currently, where it is going,
and what it is worth.
~~~~~~~~~~~__J
~ntr~ns~c value represents . "true" value. Investors and analysts attempt to identify a company's
intrinsic value by forecasting payoffs and the cost of capital via financial statement analysis and
then use these payoffs as inputs into a valuation model. For a publicly traded company, its stock
price represents the price that the stock is traded for on an exchange. In a competitive market
stock price should equal intrinsic value. However, there are times when intrinsic value can diffe;
from stock pr.ice. For exam~le , when an important piece of new information regarding a company
becomes available to some investors, stock price differs from its intrinsic value before such investors take action. Identifying those situations where intrinsic value differs from stock price allows
investors to earn excess returns.
Lump-Sum Payoffs
The pr~sent value factor applied to a lump-sum payoff is I/( I + r)", where r is the discount rate
and n is the number of .periods before the payoff is received . To illustrate , what is the present
~alue of $100 t? b~ received two years hence at a discount rate of 1l %? The present value factor
2
JS 0 .8 l 162,_ w~1ch is co~puted as 1/(1.11 ) . This present value factor is identical to the present
factor multiplier found m Table 1 of Appendix A (titled Present Value of a Single Amount). We
compute the present value of the $100 payoff by multiplying it by this 0.81162 present value
factor as follows:
Present value factor
for 2 years at 11 %
Future payoff
$100
Present value
0.81162
$81.16
We can also us_e a financial calc~lator to compute the present value. The typical financial
calculator has five mput buttons for time value of money calculations; we enter four values to
comp~te a fifth value, which is the solution. We illustrate use of a calculator with the following
graphic:
Intrinsic Value
Valuation involves estimating the intrinsic value (IV) of a company, which is the economic value
of the company assuming that actual future payoffs are known today. The following (balance
sheet) equation reflects the relation between intrinsic value of the firm and the intrinsic values of
debt and equity.
IV Firm
= IV Debt + IV Equity
11
81.16
100
On the fi_nancial calculator, N is the number of periods (2), I/Yr is the interest rate per period
(l J ): PY 1s the current or present value, PMT refers to periodic payment (0 in our example), and
FY is the future value (100). Because we are solving for present value in this illustration that
value of 81.16 .is highlighted in red. (Most calculators show a solution of - 81.16; thi s is be~ause
~he calculator mtei:r.rets FY as a payoff to be received and the PY as the investment. So, if FY
~s en~ered as a pos1~1v~ amount, then PY shows negative, and vice versa.) Our solution of 81.16
implies that we are md1fferent between receiving $81 .16 today and receiving $100 two years from
12-6
12-7
now. Stated differently, if o ne invests $8 L.16 in a bank account that earns 11 % annual interest it
'
wil l grow to $100 in two years.
Continu ing with the ill ustration above, in the first year we would earn $8.93 of interest 0
$81. 16 invested , computed as 0 .11 x $8 1.16. l n the second year, we woul d again earn interes:
but fo r that year the interest would be earned on a larger amount consisti ng of the original $8 l
and the $8.93 interest earned fro m the fi rst year. Ex hibit 12. l shows t~e 11 % P.er year interest that
would be earned on an initial investment of $8 1.16 over a two-year time horizon.
e tables because the factors in the tables are rounded. Our discussion proceeds with the more
xact present value , $3,102.45.
Calculator
.t6
3,102.45
1,000
theor~, we .are indiffe:ent between receiving a payoff today that is equivalent to a future pay-
Interest rate
Interest earned
ff that is adjusted for interest. Using the payoffs in the above il lustration, we are indifferent
0.11
0.11
$8.93
$9.91
tween re~eiving $3,102.45 t~ay and receiving $ 1,000 at the end of each of the next four years .
Assuming the payoffs are invested and earn 11 % annual interest, then at the end of four years
they grow to $4 ,709 .74 . This is shown in Exhibit 12.3.
$81.16
90.09 ~
1 . .. . . .. .. .... .
2 .. . . . . .. ..... .
11
Investment at beginning
Time period
Lump Sum: Time Line Representation of Present and Future Values and Interest
Annuity Payoffs
An annuity is a series of equal lump sums at regul ar intervals. For a series of payoffs to qualify
as an annuity, it must meet three criteria: (l) the series must be of equal amounts, (2) payments
must occur at equal time periods, and (3) the same discount rate is applicable over the time horizon of the payoffs .
To illustrate, assume $ 1,000 is rece ived at the end of each of the next fo ur years with an
11 % discount rate. Exhibit 12.2 shows the present value factors fo r each of the four lump-sum
payments and then appli es these factors to determine the fo ur-year present value annuity factors.
formula
Present value
factor
Series of
Interest rate
Payoffs
value
11%
11%
11%
11%
1/(1.11)1
1/(1 .11)2
1/(1 .11)3
1/(1.11)4
0.90090
0.81162
0.73119
0.65873
$1,000
1,000
1,000
1,000
$ 900.90
811.62
731.1 9
658.73
Present value
1 . . . .. .. . . .. .
2 . . . .. .. . ....
3 .. .. ... . . . ..
4 .. . ... . .. . . .
$3,102.44
3.10244
$3,102.45
$ 341.27
$ 378.81
$ 420.48
$3,102.45 x 0.11
$ 466.73
$3.443.72 x 0.11
$3,822.53 x 0.11
$4,243.01 x 0.11
$3,443.72
$3,822 .53
$4,243.01
$4,709.74
The $4,709.74 future value fo ur years hence is eq uivalent to the $3,102.45 Jump sum invested
today, and is also equivalent to the $1,000 annu ity invested at the end of each of the next four
years . T he latter resu lt is portrayed in Exhibit 12.4. Comparing Ex hibits 12.3 and 12.4 shows
that both of these payment patterns -the $3,102.45 invested today and the $1,000 invested at the
end of ~ac h of the ~~xt four years-yield the identical future value of $4,709.74. In summary, a
compari son ofExh1b1 ts 12.3 and 12.4 reveals that we are indifferent between receiving $3,102.45
today ver~us receiving $1,000 at the end of each of the next fo ur years. Each of these payment
patterns yields a present value of $3,102.45 and a futu re value of $4,709.74. These "ti me value of
money" concepts are important to understanding valuation models and the role of discount rates.
Annuity: Time Line Representation of Present and Future Values and Interest
Exhibit 12.2 shows that a 4-year, $ 1,000 annuity yields a present value of $3, 102.44. This can be
computed in two ways. We can treat each of the four payoffs as a separate lump sum , compute
the present value fo r each, and then sum them as follows: $900 .90 + $8 11.62 + $731.19 +
$658 .73. Alternatively, we can sum the four present value factors to yield the present value factor
of 3.10244 for the fo ur-year annuity (also fo und in Table 2 of Appendix A), and then multiply it
.
by the $ 1,000 annuity amount to yield $3,102.44.
Spec ifica lly, summing the lump- sum present value fac tors yields the present value annuL~Y
factor of 3 .1024 . Ex hibit 12.2 shows that the present value of the series of fo ur payments LS
computed as:
($ 1,000
0 .90090)
+ ($ 1,000 x
0 .8 11 62)
+ ($ 1,000 x
0 .73 11 9)
+ ($ 1,000 x
0 .65873)
Applying algebra, the $ l ,000 can be taken out of each of the parentheses and written as:
$ 1,000
(0 .90090
$1 ,000.00
$1 ,000.00
$1 ,000.00
$1 ,000.00
$0.00
$110.00
$1 ,000.00
$1 ,000.00
$1,000.00 + $0.00
x 0.11
$2, 110.00
$367.63
$3,342.10 x 0.11
$3,342.10
$4,709.73*
$3 ,102.45
Difference due to rounding
~ sin g a fina ncial calculator, we can determine that the fu ture value of the Ju mp sum of $3,102.45
LS equal to the future value of the annuity of $ 1,000 per year.
X 3. 10244
The 3 .10244 is the present value factor of a four-year annuity at 11 % . T his shows the equivalence
of the two approaches.
To use a fi nancial calculator to obtain the solution: we enter N=4, l/Yr=ll , PMT=I,000,
FV=O , and the solution is PV, hi ghli ghted in red . This value is more precise than the value using
$232.10
$2,11 0.00 x 0.11
11
3,102.45
4,709.74
12-8
12-9
$90
$90
$90
$983
$991
$1,000
$975.13
Thus , the $975.13 present value of this debt instrument is computed as the sum of (1) the $223.82
present value of the coupon payments ($90 X 2.48685) plus (2) the $751.31 present value of the
maturity value ($1 ,000 X 0.75131 ) . The 2.48685 present value factor is for a 3-year annuity at
10% , which is equivalent to the sum of the three lump-sum present value factors of 0 .90909 +
0.82645 + 0 .75131. The 0.75131 present value factor is for a lump-sum face value to be received
at the end of year three. (We see that computation of future value differs from that in Exhibit 12.3
because the payoffs in Exhibit 12.5 are not reinvested but, instead , are paid out.) Using a financial
calculator, we enter N=3 , I/Yr=IO (market rate of interest), PMT=90 (coupon rate of 9% times
$ 1,000 face value), FY=l ,000 (face value), and then the solution is PY, hi ghlighted in red , below.
10
975.13
90
1,000
975.13
90
1,000
To this point, we have shown how to value different payoffs. We have explicitly identified
the payoffs received and the discount rate used. This information can be readily programmed into
a spreadsheet. However, expertise is required to project future payoffs (such as dividends, free
cash flows , or earn ings) for va.luation purposes and to identify the proper cost of capital to use as
the djscount rate.
The di scount rate we use depends on the payoff stream being valued. Payoffs to debt holders are
discounted using the cost of debt capital. Payoffs to equity holders are di scounted using the cost of
equity capital . Payoffs to the entire firm are discounted using the weighted average cost of capital. We descri be how investors estimate these different cost of capital measures in the next section .
10
The value of a monetary unit commonly changes over time due to inflation or deflation. Payoffs and
discount rates that include the effects of these price level changes are referred to as nominal or riskadjusted {because they include this risk). If the effects of price level changes are not included, the
payoffs and discount rates are referred to as real. So, should we use nominal or real amounts for valuation? Consider the following example where a nominal payoff of $200 million is expected in two years.
Assume that there is 3% inflation per year expected and the nominal discount rate for this payoff is
10%, which implies a real discount rate of 6.8% (0.068 = [(1 .00 + 0.10)/(1.00 + 0.03)) - 1.00) . We
can estimate the value of the expected future payoff using either nominal or real amounts as follows:
Inputs:
Nominal:
Payoff
$200 million
x
x
(nominal)
Real:
Discount Rate
1/1.102
Value Today
$165.3 million
(nominal-includes inflation)
1/ 1.0682
$165.3 million
(real-excludes inflation)
The computed value of the payoff is unaffected by whether nominal or real inputs are used in the
calculation (remember that use of nominal payoffs requires use of nominal discount rates and use
of real payoffs requires use of real discount rates). In practice it is easier to use nominal inputs as
analysts do not forecast real payoffs nor take time to convert nominal rates to real rates. Accordingly, we use nominal inputs for valuations in this book.
12-10
12-11
The capital asset pricing model (CAPM) equates the expected return on a particular asset as the
sum of three components-the risk-free rate , the beta risk, and the stock-specific risk. The first
two components are used in estimating the cost of eq uity capital. The third component, the stockspecific risk, is the risk that is diversified away in large portfolios.
In equation form , the CAPM estimation of a company's expected return, or cost of equity
capital (re), follows:
12.1
the asset's market return to the overall market return. The market risk premium is the difference
between the expected market return (rm) and the expected risk-free rate:
= rm -
rf
12.2
f'lis.tori call y, rr has fluctuated around 5% . The overall market return, while dependent on the time
per10?, has generally fluctuated between 9% and 13%. These figures yield a usual market risk
prerruum of about 4% to 8% . 1 The sensitivity of the asset's market return to the overall market is
referred to as the company's market beta (/3) . Market beta is a statistical coefficient that reflects
a company 's historical stock price volati lity relative to the overall market volatility. Market beta
is comrr_ionl y estimated f~om a regressio~ of a company's stock returns (dependent variable) on a
market index of returns (inde~endent variable) over a representative time period (often the previous 60 months). The market index of returns represents returns from a portfolio of risky assets
an example of a market index is the S&P 500.
'
. Market beta re~ects the risk that cannot be diversified away by investing in a portfolio of
nsky assets (accordmgly called systematic risk) . In this CAPM framework, the market has a beta
of 1.0. (Another way to think of this is that if we had a portfolio consisting of all available stock
market assets, the value of our portfolio would move perfectly with the value of all available stock
market assets.) A market beta greater than (less than) 1.0 indicates the company's stock price will
change by a larger (smaller) percent with a change in the overall market. For example accordinoto Fin~nce,~ahoo.com , The Southern Company {SO) has a market beta of 0.35 as of mid-20
~pplymg th1s estimate, a change in the overall market return yields a change in SO's stock that
is 35% of the market change . A negative market beta implies that the company stock price moves
contrary to the market.
Although beta is a risk measure, it is also associated with returns. The hio-her the risk an
investor is willing to accept , the higher the expected return; and , accordingly, th; lower the risk,
the lower the ex pected return.
To illustrate , let 's apply the CAPM to The Southern Company. In mid-2011 , according to
bankrate,com '. the 1~-year Treasury rate was 3.1 %. Assuming a market risk premium of 5%, then
the cost of equity capital (re) for Southern Company with a market beta of 0.35, is 4.9%, which is
computed as 0.031 + [0.3~ x (0.?8 1 - 0.031)] . This estimate implies that an investor requires an
ex~cte.d return o~ 4.9% to mvest m.Southern Company's stock. Stated differently, the cost of equity
capital 1s the required return to eqmty holders for investing in SO 's stock.
Lt
~For readings on thi s topic , see E. F. Fama and K. R. French, "The Cross-Section of Expected Stock Return s," Journal
if Finance, June 1992, pp. 427-465; W. Gebhardt, C. Lee, and B. Swaminathan, "Towards an
~ournal? of A.ccounting Research , (!une 200 I) , pp. 135-176; J. Claus and J. Thomas, " Equi ty Premia as low as Three
T he first component is the expected risk-free rate , rr (expectation symbols are not included in the
equation) . The return on ten-year U.S . treasury bills is common ly used as an estimate of rr. The
second component is the product of the market risk premium (rm - rr) and the sensitivity (/3) of
ercent. Evidence from Analysts Earnings Forecasts for Domestic and International Stock Markets ," Journal of
Finance, (October 2001), pp. 1629-1666; and P. Easton, G. Taylor, P. Shroff, and T. Sougiannis , " Using Forecasts of
Earnings to Simultaneously Estimate Growth and the Rate of Return on Equity In vestments," Journal of Accountin
Research, (June 2002) , pp. 657-676.
g
12-12
12-13
Module 12
Module 12
iJtterest-coverag~ rati_o, and_long-term financial stability measures such as the debt-to-equity ratio .
Seve_ral co~pan1es? mcludmg Moody's Investors Service, Standard and Poor's, and Fitch
prov1d_e ratmg services for bonds and notes. For instance, those organizations classify debt issuances mto the following categories.
12.3
The r represents the premium of risk factor j , and B. captures the sensitivity of the stock to factor j, \vhere j = 1, 2, 3, .. . The CAPM can be view6d as a special case with only one factor: the
market risk premium .
Researchers have attempted to identify the risk factors. One set of research studies relies on
large sample data analysis. For instance, researchers have found that stocks with a high book-t0market ratio (defined as total book value of the company divided by its total market value) tend
to have higher subsequent stock returns, on average, compared with stocks with a low book-t0market ratio.
This result seems to indicate that companies with a high book-to-market ratio are regarded
by investors as being more risky and the excess return simply reflects the compensation for such
risk . Other risk factors identified based on similar large sample analysis include the company's
size and the liquidity of its stock.
Identifying risk factors based on large sample analysis has a shortcoming; that is, we do not
know why such factors matter. Why are small companies more risky than large companies? To
answer this question , researchers have tried to identify risk factors based on fundamental analysis.
Such risk factors can be classified as:
Moody's
AA+
Aa2
AA
AA-
.AA+
AA
AA-
Aa3
A1
A2.
External riskfactors: such as exchange risk, political risk, supply chain risk, industry competition, and so forth.
The market rate on debt instruments is known as the cost of debt capital. The cost of debt capital
is usually reported in financial statements or can be computed using the stated coupon (interest)
rate on a debt instrument along with the fair value of the debt instrument that is either recorded
on the balance sheet or disclosed in its footnotes. The reported fair value of the debt instrument
should approximate its present value.
A company's borrowing rate depends on its perceived level of risk by the lenders . Usual
factors considered by lenders include short-term liquidity measures such as the quick ratio and
A+
A
ABBB +
BBB
BBBBB+
BB
BBB+
B
BCCC+
CCC
CCC-
A+
Upper-Medium Grade
ABBB+
BBB
BBBBB+
BB
BBB+
Lower-Medium Grade
Non-Investment Grade
Speculative
Highly Speculative
BCCC
ODD
DD
Research on identifying and measuring risk factors is ongoing. Those factors can be viewed as
part of the broader five forces that confront the company and its industry discussed in module I.
AAA
Aa1
Internal risk factors: such as operating leverage, financial leverage, effectiveness of internal
control , management team, and so forth.
Description
AAA
CAPM is a misnomer in that it is not truly an asset pricing model but instead is a model used to
estimate cost of capital. A strength of CAPM is its simplicity. It assumes that the only risk factor
is the market return (referred to as {3) and it assumes that prior period's {3 is a suitable estimate
for future risk. However, CAPM is also criticized by academics and practitioners who argue that
a firm's systematic risk varies over time and that CAPM estimates are sensitive to the particular
model inputs chosen. In theory, CAPM is applied using a market index representing all available
investments. Use of a stock-based index such as the S&P 500 neglects other investment opportunities. Further, CAPM attempts to measure covariance with the risk premium of the market, which is
arguably time-varying with recent estimates ranging from 2% to 7% versus the 4% to 8% historical
numbers. CAPM relies on one risk factor and ignores additional risk factors such as company size.
Some argue that inclusion of additional risk factors yields a "better" cost of capital estimate. Due
to these concerns, we must carefully consider the sensitivity of our valuation estimates to our cost
of capital assumptions.
Fitch
Aaa
A3
Baa1
Baa2
Baa3
Ba1
Ba2
Ba3
B1
B2
B3
Caa1
Caa2
Caa3
Ca
S&P
Substantial Risk
In Poor Standing
Extremely Speculative
May be in Default
Default
The top category is A~A , meaning the bond is very unlikely to default. Bonds with a rating of
BB~ - (or Baa3) and higher are referred to as investment grade, meaning these bonds are of high
qual1t~. In cont~ast, bonds with a rating of BB+ (or Bal) and lower are referred to as a junk bond,
reflect1~g the ~1gher default risk of those bonds. 2 The cost of debt capital is closely related to the
debt ratmg assigned to the company.
We must also consid~r the ~ffect of taxes because the expected cost of debt capital is computed on an after-tax basis and 1s denoted rd. Specifically, cost of debt capital is determined as
follows:
rd = Pretax borrowing rate for debt x ( 1 - Tax rate)
12.4
The ~fter-tax cost of de_bt capital requires identifying the pretax (average) borrowing rate for interest~an~g debt and the mcome tax rate, both available from financial statement footnotes. Multiplication by the ter_m "1 - ~~ rate" yields the cost of debt after the tax savings from the inter-
~st expense d~du~t1on. Spec1f1cally, the tax rate is often proxied by the statutory tax rate for the
ompany, which is the 35% federal statutory rate plus or minus the state statutory rate net of
any federal benefit~. (Ideally, th_e marginal tax rate is used in estimating the cost of debt capital;
howev~r, the marg1~al tax rate is unobservable.) The pretax borrowing rate (also called average
borrowing rate) for interest-bearing debt, including both short- and long-term, is computed as:
Interest expense/Average amount of interest-bearing debt
~.Differences .'.n
the_borrowing rates of hi gh grade and low grade bonds are referred to as "credit spreads." In eras of
_easy ~~ney, credit spreads are l_ow_. meaning that investors do not demand much of a risk premium for lending to high
nsk entities.: In 2007, a s.~dden shift m mvestors' appeti te for risk led to a marked increase in credit spreads, and caused
substantial d1 slocat1ons m the market for certain types of high risk debt.
12-14
12-15
We encourage the use of adjusted numbers in th~s computatio~ ; for examp.le , debt would include
capitalized operating leases , and interest would mclude the adjustment to interest from any such
capitalized leases .
To illustrate , we use Southern Company 's tax rate and pretax borrowing rate to approximate
its after-tax cost of debt capital. SO's 2010 statutory tax rate is 36.8%, consisting of the 35% federal rate and the 1.8% state rate, net of federal benefits-both reported in footnotes to its financial
statements. Its pretax borrowing rate is approximately 4.6% , which is computed by dividing its
2010 interest expenses of $895 million by its average total debt of $19 ,350 million (see SO's 2010
statements of capitalization). Consequently, its after-tax cost of debt capital is 2.9%, computed as
0.046 x (l - 0.368).
weighted average cost of capital formula , to estimate the ri sk of the company. The followin g chart
helps to vi sualize these relations:
Inherent risk in the firm and debt are sources of equity risk
In our examples to this point, the discount rate for debt valuation or for equity valuation was
approximated by either the cost of debt capital or the cost of equity capital, respectively. The cost
of debt capital would be used to value debt instruments while the cost of equity capital would be
used to discount the payoffs for an all-equity company. The nature of the stream of futu re payoffs
that we desire to value dictates the discount rate we use to compute the present value. When valuing a debt instrument such as a bond , the cash payoffs are received by debt holders , so the cost of
debt capital is used for valuation. When valuing equity instruments using the dividend discount
model (discussed later in this module), the payoffs received by equity holders are discounted
using the cost of equity capital.
Some valuation models , such as the discounted free cash flow and the residual operating
income models , assume the payoffs (free cash flows and operating income) are di stributed to
both equity holders and debt holders. For these models, a company's cost of capital includes both
debt and equity. Accordingly, cost of capital , too, must recognize that payoffs will be distributed
to both debt holders and equity holders. This means that those companies' cost of capital is a
weighted average of the cost of debt capital and the cost of equity capital.
To better understand the computation for the weighted average cost of capital (WACC), recall
the balance sheet equation that reflects the relation between the intrinsic value of the firm and the
intrinsic values of debt and equity.
IV Firm
= IV Debt + IV Equity
Where IV Fmn
. is the intrinsic value of the company, IV 0 ebt is the intrinsic value of company liabilities, and IV Equity is the intrinsic value of com~any equity.
.
, . . .
Multiply mg the after-tax cost of debt capital (rd) by the ratio of the company s mtnns1c value
that is financed by debt holders (IV Deb/ IV Firm) , and then adding this to the product of the cost of
equity capital (r) and the ratio of the company's intrinsic value that is financed by equity holders (IV . / IVe ) yields the weighted average cost of capital, denoted r v Specifically, the
~
~
'
weighted average cost of capital is computed as follows :
rw
= ( rd
IV Debt)
x IV Firm
r. x IV Equity)
IV Firm
rw = (0.029
X [ $20,073/$52,320])
+ (0.049
X [ $32,247 /$52,320 ])
= 4.1%
A final point is how to treat any preferred stock. When preferred stock exists , the WACC computation includes a third term:
r = (r x
d
IV Debt)
IV
(r x
Firm
ce
IV Common Equity )
IV
+(
IV Preferred Equity )
IV Firm
This formulation separates equity into common equity, ce, and preferred equity, pe. The r is the
cost of preferred equity, which is usually the preferred dividend rate on the preferred sto~k. The
IV Preferred Equity is the preferred stock's market value , or book value if market value is difficult to
determine .
w
Firm
r pe
You are considering investing in a company that has announced that it plans to alter its capital
structure; that is, change its ratio of debt to equity. How might this change affect the company 's
weighted average cost of capital? [Answer p. 12-221
12.5
The WACC computation uses intrinsic values instead of numbers reported on balance shee.ts.
However because intrinsic values are unobservable, we typically use the market value of eqmty
in place ;f the instrinsic value of equity, and the market value of debt in place of the intrinsic
value of debt (or book value when market value is difficult to determine). (The market value of
debt is usually reported in the 10-K footnote explaining debt.)
To clarify the relation among a company 's debt and equity and the cost of capital, we must
understand the difference between the sources of underlying risk and the methods by which cost
of capital is estimated . Equity does not contain risk in and of itself. Rather it is risky be~au~e
it represents both ownership of the firm and obligations to debtholders. Therefore, the n sk in
equity is driven by risks inherent in the company and its debt. Changes in either of these areas
cause changes in the riskiness of equity. When we estimate cost of capital, it is straightforward
to estimate cost of capital for debt and for equity. These two estimates are then applied , using the
According to Finance.yahoo.com, IBM has a beta of 1.6. IBM's market value of debt is approximately $12.08 billion and its total market value of equity is $143.48 billion. IBM's average cost
of debt capital (pretax) is approximately 7 .5% and its marginal (statutory) income tax rate is 35 %.
Assume that the risk-free rate is 4.6% and the market risk premium is 5%.
Required
12-16
12-17
This DDM model equates current stock price to the present value of all future expected dividends
IV 0 =
D1
+ IV 1
1 +re
$2 + $41
$
= D11 ++ IV
=
=
39.45
re
1.09
To illustrate use of this model, assume that we forecast a $3 per share dividend for Kimbrell
Company for the ini.ti~I two years, followed by a $3.50 per share dividend in the third year,
and a. $4 per share d1v1dend. thereafter. Assume also that we estimate the cost of equity capital
for Kimbrell at 12% . As a first step, we compute the present value of the initial three years of
dividend s from:
$3
$3
$3.50
1.12 + (1.12)2 + (1.12 )3
l+re
D2
+
03
+
(l +re) 2
( l+re)3
...
= $2.68 +
$2.39 + $2.49
Second, we compute the present value of the perpetuity of $4 to be $33.33, computed as of the
end of year 3 as:
$4
0.12
= $33.33
The $33.33 is t?e ~resent v~lue of the $4 perpetuity as of the end of year 3. To find the present
value at the begmnmg of penod I we discount the $33 .33 lump-sum payment from the end of year
3 to th; start of year .1. ~hu_s, the present value of this perpetuity is $23 .73 , computed as ($4/0 .12)/
(l.12) . In sum, the mtnns1c value of a Kimbrell share is computed as follows :
0 -
(!ii) =
$3
$3.50
1.12 + (1.12)2 + (1.12)3 + (1.12)3
= $31.29
To generalize , the following formula reflects the dividend discount model when we assume
a constant dividend beginning in period n + l and continuing in perpetuity:
Constant
Perpetuity
IVo = 1 D+1 + (1 D2 )2 + (1 D3 )3 + ... ( Dn ) +
re
DDM
+re
1 +re n
(1 + re)"
re
+ re
Dn+I
We typic~l~y refer tot.he last t~rm ~s. the "ter~i~al dividend," although it is not paid out in period n
+ l and it is not terminal. A s1mplif1ed application of this model is to assume the current dividend
continues in perpetuity. This model was defined at the start of this section.
One sol ution to the recursive process in equation 12.6 is the following:
=~ +
L 0 5 Describe and
apply the dividend
discount model with a
constant perpetuity.
IVo = D1
re
IV _
ity. Two. metho?s to forec~st and discount infinite dividends are the constant perpetuity method
and the mcreasmg perpetuity method.
Further, IV can be equated to 0 2 and IV 2 ; and then, IV 2 can be equated to 0 3 and IV 3 , and so
1
forth. This continual substitution of future payoffs illustrates the recursive process of asset valuation, meaning that the price of stock today depends on the expected price of the stock tomorrow,
which in tum depends on the expected price of the stock the day after tomorrow, and so forth.
This process continues for infinity. (In practice, valuation is affected by the investor's time horizon and any differences in the investor's expectations about dividends and future intrinsic values
compared with the market; these differences are what make a market.)
IV
To apply the dividend discount model , we must forecast the company's future dividends for infin~
12.6
To illustrate, suppose we decide to buy a share of stock in Western Company. What is today's
intrinsic value of Western Company? If the cost of equity capital is 9 % , the expected dividend
for period l is $2, and the expected intrinsic value of equity at the end of period l is $4 1, then
Western Company 's intrinsic value today (IV 0) is $39.45 , computed as:
IV 0
12-18
DDM
is debate about whether taxes affect the value of dividends. It is possible that investors discount the value of
dividends if dividends are taxed at a higher rate than capital gains . However, since tax exempt institutional in vestors
make up a huge part of the market , it is argued that if taxes affected the value of dividends then tax exempt investors
would have an arbitrage opportunity. It is argued that such an arbitrage opportunity, if it exists , would force di vi dend
paying companies to yield the same return as non-dividend paying companies. Accordingly, we assume that taxes do
not affect the value of dividends.
Ano~~er means to si~p~ify the dividend discount model is to assume that the forecasted dividends
stabilize at some pomt m the future and continue to grow at some constant rate thereafter-this is
~eferred to a~ the G?rd~n growt~ model. T~e la~ter gr~wth_ pattern for dividends yields an increasng perpetmty , which 1.s an ordinary annuity with an mfirute horizon where the amount grows at a
constant rate. The equation for the present value of an increasing perpetuity follows; in this equation,
12-19
0 1 is the dividend amount when the constant growth period begins, re is the discount rate, and g is
a constant growth rate.
D1
IV 0 = - r. - g
If we assume that the constant growth rate equals zero, then the model reverts to the dividend
discount model with constant perpetuity explained above. To illustrate use of this model for Kimbrell Company, assume that we forecast a $3 per share dividend for the initial two years, followed
by a $3.50 per share dividend in the third year, and a $4 per share dividend in year four that continually grows at a 3% rate per year for year 5 and thereafter. Assume also that we estimate the
cost of equity capital for Kimbrell at 12%. The present value for the initial three years is identical
to that for the constant perpetuity model in the prior section. Next , the present value of an increasing perpetuity is $44.44 as of the end of year 3, computed as D/(r - g) = $4/(0.12 - 0 .03). Then,
we discount the $44.44 as of the end of year 3 to today 's date to get $31 .63, computed as ($44.44)/
( J .12) 3 . In sum, the intrinsic value of a Kimbrell share as of today is computed as:
IV 0
~+ (
1.12
$3
$3.50
1.12 ) 2 + (1.12 )3
+ ( 0.12
(
~ o.o
1.12 )3
3)
To generalize, the following formula reflects the dividend discount model where the terminal
dividend is assumed to continue in perpetuity and to grow at a constant rate:
Dn x (1 + g)
IVo
1
=1 +r. +
D2
D3
(1 + r.) 2 + (1 + r.) 3 +
Dn
+
(1 + r.)"
r. - g
(1 + re)n
Gordon
Growth
DDM
A simplified application of this model is to assume the current dividend continues to grow in
perpetuity. This model was defined at the start of this section.
Dividend Yields
Many companies have especially low or especially high dividend payout rates. A search on Finance.
y_ahoo.com finds over 500 companies with a dividend yield (dividend per share divided by price per
share) of zero-see an abbreviated listing below.
Company
AAPL
BP
TM
c
LFC
DCM
MTU
UBS
NTT
CAJ
AIG
F
APPLE INC.
BP P.L.C.
TOYOTA MOTOR CORP
CITIGROUP
CHINA LIFE INSURANCE
NTTDOCOMO
MITSUBISHI
UBS AG COMMON STOCK
NIPPON TELEGRAPH
CANON , INC. AMERICA
AMERICAN INTL GROUP
FORD MOTOR COMPANY
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0 %
LYG
DTV
HMC
SNE
HIT
PC
RIG
KYO
MBT
NMR
KB
LLOYDS BANKING
DIRECTV
HONDA MOTOR COMPANY
SONY CORPORATION
HITACHI, LTD.
PANASONIC CORP
TRANSOCEAN LTD
KYOCERA CORPORATION
MOBILE TELESYSTEMS
NOMURA HOLDINGS
KB FINANCIAL GROUP
SPRINT NEXTEL
DivNld
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
0.0%
There were also 75 companies identified that had a dividend yield exceeding 10 percent-see an
abbreviated listing below. This is a high dividend yield, which brings into question the ability of
those companies to sustain that dividend level.
Company
NLY
AGNC
CIM
GOL
MFA
CEL
TNH
PTNR
PVX
HTS
AINV
SEADRILL LIMITED
ANNALY CAPITAL
AMERICAN CAPITAL
CHIMERA INVESTMENT
GOL LINHAS AEREAS
MFA FINANCIAL
CELLCOM ISRAEL
TERRA NITROGEN
PARTNERCOMMUNICATION
PROVIDENT ENERGY
HATTERAS FINANCIAL
APOLLO INVESTMENT
10.2%
15.8%
20.5%
17.2%
12.2%
10.3%
10.9%
10.7%
10.3%
11 .3 %
15.3%
11.7%
DRH
PVD
PHK
IVR
UTF
FRO
CVS
CMO
ENP
PSEC
BGCP
ANH
DIAMONDROCK HOSPITAL
ADMINISTRADORA
PIMCO HIGH INCOME
INVESCO MORTGAGE
COHEN & STEERS
FRONTLINE LTD.
CYPRESS SHARPRIDGE
CAPSTEAD MORTGAGE
ENCORE ENERGY
PROSPECT CAPITAL
BGC PARTNERS
ANWORTH MORTGAGE
DivNld
14.5%
10.2%
11 .7%
14.2%
16.5 %
11 .2%
17.7%
12.4%
10.8%
12.8%
10.3%
14.9%
These historical distributions ("dividends") are used to forecast future dividends. Valuation
using dividends requires estimating all future transfers to shareholders including the future liquidating dividend or the anticipated sale price. This creates a challenge for the analyst or investor.
There are instances , however, when the dividend discount model might perform well. If
dividends are determined based on the long-run average of projected profits , they can provide
a good indication of the company's long-run profitability. The model performs well in valuing companies that experience stable growth and a stable or slightly growing dividend stream .
Companies in the utility industry are often cited as examples of companies for which the discount dividend model performs well. To illustrate, Southern Company's dividend for 2010 is
12-20
12-21
$ 1.8025 per share. Assume that its divide nds will grow at a ,m ?de~at~ 0.5% per year. Applying
the Gordon G rowth mode l, we estimate Southe rn C o mpany s mtn_n s1c value at $~0 .97 using a
discount rate of 4.9 % , computed as $ 1.8025/(0 .049 - 0 .005 ) . Thi s compares to its $40 stock
price in mid-2011 . We can also explore the sensiti vity of thi s estimate to variations in the
growth rate a nd discount rate. Those results are in Exhibit 12.6. We see that intrinsic value
inc reases w ith ri s ing growth rates, but dec reases w ith rising di scount rates. Further, as we see
from thi s example and the above Kimbrell examples as well , the stock value e stimate is especiall y sensitive to the growth assumption used to estimate the terminal di v idend .
ReqUlred
Estimate its after-tax cost of debt capital.
Estimate its cost of equity capital.
Estimate its weighted average cost of capital.
Estimate its per share intrinsic value using the dividend discount model assuming that its current
dividend per share continues in perpetuity.
Estimate its per share intrinsic value using the dividend discount model assuming that its current
dividend per share continues at $0.84 for the next two years and then grows at a continual rate of
1% for year 3 and thereafter.
, rn
EXHIBIT 12.6
GrowthRate
Dl8cowlt Rate
0.00%
1.00%
2.00%
4.5% . . . . . .. .. .. . .. . ..
$40.06
32.77
27.73
$51.50
40.06
32.77
$72 .10
51 .50
40.06
5.5% . . ....
6.5% . .. . . ... . ... . ... .
In Modules 13 and 14 we use a variant of the Gordon G rowth model that is writte n as follows:
04 x (1 + g)
where D re presents free cash flo ws to the firm in Module 13, and residual operating income in
Module 14. This expanded version of the model is mathematically equivalent to the equation for
dividends shown here. Each of these model s can be derived from equation 12.6. The choice of
what payoff to use to estimate the firm 's value will de pe nd on the availability and reliability of
the various forecasted payoffs.
RESEARCH INSIGHT
Circularity
.;;.
of
;..Be
~ta
;;;;_
_ _ _ _ _ _ _ _ _ _ _ _ _ _ _ __ _
The intrinsic value of both debt and equity are used in estimating the weighted average cost of
capital. The market value of debt is usually reported either on the balance sheet or disclosed in
footnotes and , therefore, the debt recorded on the balance sheet or the present value of debt
disclosed in footnotes can be used as a proxy for the market value of debt. The market value of
equity is often used as a proxy for the intrinsic value of equity. However, this creates ~ probl~m
in that the market value of equity is used to determine the weighted average cost of capital which
will be used to discount the payoffs in the valuation model to estimate the intrinsic value of equity.
This intrinsic value of equity will then be compared to the market value of equity to determine if the
company is under- or overvalued. While we might prefer to estimate the weighted average c?st
of capital without referring to the market value of equity, this is problematic in that cost of capital
estimation requires us to estimate the intrinsic value of the company prior to discounting the company's payoffs.
MODULE-END REVIEW
Following are relevant financial details for Harley-Davidson (NYSE: HOG). Assume that the expected
risk-free rate , rf' is 4 .6% and the expected market return is 9.6%.
.....
PNtax
borrowll19 nde
$0.84
9%
Dividend per
Market value
Totalftnn
of equity
market value
Beta
$18.26 bil.
$18.30 bil.
1.42
Marginal
(8tatutoly)
taxnde
Ma'ltet price
per share
35 %
$70.47
You Are an Investor Altering a company's capital structure (changing its debt to equity ratio) alters its financial risk. For the shareholder, increasing leverage will increase the financial risk, which will have a correspond ing increase in the expected return demanded by the shareholder. However, a company's WACC, which is the
weighted average of cost of debt and cost of equity, is determined by the volatility of the company's operations.
If we assume that changing the capital structure has minimal impact on company operations, ignoring any tax
effects, its WACC would remain approximately the same.
Describe how to compute the present value of a debt security such as a bond .
Discuss differences between valuing a debt security and valuing the equity of a company.
What is a market beta? Discuss what a beta of 1.0 represents. What does a beta of 0 .5 represent?
A beta of 2.0?
Discuss the limitations associated with using beta to compute the cost of equity capital.
Discuss the difference between a company 's intrinsic value and the company's stock price.
Describe how to compute the after-tax cost of debt capital.
Explain what the market premium represents. Describe how to compute the cost of equity capital using
beta, the risk-free rate , and the market premium .
Q12-8. What is a company's cost of capital? Explain .
Q12-9. What are the three criteria fo r a series of payments to be considered an annuity?
Q12-10. What is a perpetuity? How is the present value of a perpetuity computed?
Q12-11. Describe how to compute the present value of an increasing perpetuity.
Q12-12. Describe the circularity that occurs when beta is used to help estimate an intrinsic value fo r comparison
to market prices.
\
Assignments with the $ logo in the margin are available in an online homework system.
See the Preface of the book for details.
12-22
12-23
Assume that the company's market beta equals - 0.8, that the risk-free rate is 5% , and the market return
equals 8% . Compute the company 's cost of equity capital.
(L03)
Assume that the interest rate on a company's debt is 6% and that the company 's tax rate is 35%. Compute the company 's cost of debt capital.
{L03)
Assume that a company's financial statements report that its average outstanding debt totals $ 1.6 billion,
and its total interest expense equals $80 million. If its tax rate is 35% , compute its cost of debt capital.
Assume that a company has $ 1.2 billion in debt , its cost of debt is 5% , it has $2 billion in equity, and
its cost of equity capital is 7%. Compute the company 's WACC .
(LOS)
Assume that a company 's dividends per share are projected to remain at $ 1.20 each year, and that its
cost of equity capital is 5% . Estimate the company 's per share stock price.
(LOS)
(L06)
(LOS)
{L03)
Kellogg Company (K) manufactures cereal and other convenience food under its many well-known
brands such as Kellogg's , Keebler , and Cheez-Jt . The company, with more than $ 12 billion in annual
sales worldwide , partially finances its operation through the issuance of debt. At the beginning of its 20 10
fiscal year, it had $4.8 billion in total debt. At the end of fiscal year 2010, its total debt had increased to
$5.9 billion . !ts fiscal 2010 interest expense was $248 million , and its assumed statutory tax rate was 35%.
Required
a. Compute the company's average pretax borrowing cost. (Hint: Use the average amount of debt as
the denominator in the computation.)
b. Assume that the book value of its debt equals its market value. Then, estimate the company's cost
of debt capital.
KELUll:G CUMrANY
(K)
(MAT)
(L02)
Refer to the information about Mattel, Inc. (MAT) in EJ2-30. After further research we find that beta
estimates for Mattel reported on financial Websites ra nge from 0 .85 to 1.13.
Refer to information about Kellogg Company (K) in El 2-27 . Kellogg has an estimated market beta of
0.47. Assume that the expected risk-free rate is 3.1 % and the expected market premium is 5% .
MATTEL, INI:.
(MAT)
Required
a. Estimate the range of cost of equity capital estimates for Mattel implied by the different beta
estimates .
b. What steps are necessary for business valuation due to the range of cost of equity capital estimates?
E12-32. Estimating Stock Value using Dividend Discount Model with Constant Perpetuity
Estimating Stock Value using Dividend Discount Model with Increasing Perpetuity
(LOS)
KELLOGG COMPANY
(K)
(L06)
Kellogg pays $ 1.72 in annual per share dividends to its common stockholders , and its recent stock price
was $5 1.08. Assume that Kellogg 's cost of equity capital is 5.5 % .
KELLOGG l:llMPANY
(K)
Required
Estimate Kellogg's expected growth rate based on its recent stock price using the dividend discount
model with increasing perpetuity.
MATTEL, INC.
Required
What does Mattel 's market beta imply about its stock returns?
b. Estimate Mattel's cost of debt capital, cost of equity cap ital, and weighted average cost of capital.
Assume that a company 's dividends per share are projected to grow at 2% each year, its next year's d~vi
dends per share is $ 1.20, and its cost of equity capital is 5% . Estimate the company 's per share stock pnce.
in
Assume that a company paid $ 1.20 dividend per common share , its dividend per share is expected to
grow at a constant rate of 2% , and its cost of equity capital is 5% . Estimate the company 's per share
stock price .
(K)
(L02, 3, 4)
Mattel, Inc. (MAT) engages in the design, manufacture , and marketing of various toy products worldwide. At December 3 J, 20 I0 , Mattel 's market value of eq uity was $8 .9 billion , and its total market value
was $ 10 .1 billion . Mattel 's statutory tax rate was 35%, its average pretax borrowing rate was 5 .4% , and
its estimated market beta was 0.99. Assume also that the expected ri sk-free rate is 3.1 % and the expected
market risk premium is 5% .
Required
a. Estimate Kellogg 's stock price using the dividend discount model with constant perpetuity.
b. Compare the esti mate obtained in part a with Kellogg 's $5 1.08 price. What does the difference
between these amounts imply about Kellogg 's future grow th?
(K)
Required
What is Kellogg's total market capitalization as of December 3 1, 20 IO?
b. Use the information and results of El 2-27 andE12-28 to compute Kellogg 's WACC.
KELLOGG COMrANY
a.
Kellogg pays$ I .72 in annual per share dividends to its common stock holders, and its recent stock price
was $5 1.08 . Assume that Kellogg's cost of equity cap ital is 5.5 % .
Assume that a company 's dividends per share are projected to remain at $ 1.10
per share stock price is $22. Estimate the company 's cost of equity capital.
KELLOl:G CUMrANY
(L04)
Refer to information about Kellogg Company (K) in El2-27 and El2-28. Kellogg 's stock closed at
$5 1.08 on December 3 1, 20 10. On that same date , the company had 419,272,027 shares issued , of which
53,667 ,635 shares were in treasury.
a.
(L04)
Required
What does Kellogg 's market beta imply about its stock returns?
b. Estimate Kellogg 's cost of equ ity capital.
a.
{L02)
Assume that a company 's begi nning-of-period price is $ I0 per common share, its dividends are $0.2S
per share , and its end-of-period price is $ 10.50 per common share . What is the company 's expected
cost of capital?
Hint: Review
Equation 12.6
12-24
(L06)
Kellogg Company (K) is ex pected to pay $1.72 in an nual dividends to its common shareholders in the
future. Our best estimate of the expected cost of eq uity capital is 5.5 % and the' expected growth rate in
dividends is 2% .
KELLOGG COMPANY
(K)
Required
Compute Kellogg 's intrin sic value . Recompute intrinsic value to reflect increases and decreases of
0.5 % in both (i) cost of equity capital and (ii) growth rate.
b. Given the intrinsic values computed in part a, what level of confidence do we have in the intrinsic
value estimate from the dividend discount model ?
a.
E12-35. Estimating Intrinsic Share Value using Dividend Discount Model {LOS, 6)
Mattel, Inc. (MAT) is expected to pay a $0.92 dividend per share annually. Estimate its intrinsic value
per common share using the dividend discount model (DOM) under each of the following separate
assumptions . (Ass ume MAT's cost of equity capital is 8.0%.)
MATTEL, INI:.
(MAT)
12-25
MATTEL, INI:.
(MAT)
Required
Ex plain how the assumption we make about a firm 's terminal di vidend affects the intrinsic value
we compute fo r the fir m.
b. Di scuss how the terminal di vide nd assumption made fo r Mattel in E 12-35 above , might explain the
diffe rence between the estimated intrinsic value and the actual trading price per common share.
a.
MATTEL, INI:.
(MAT)
PllUl:TEll AND
CAMBLE
(PG)
Convertible Class A preferred stock, stated value $1 per share (600 shares authorized) . . . .
Non-Voting Class B preferred stock, stated value $1 per share (200 s hares authorized) ... .
Common stock, stated value $1 per share (10,000 shares authorized; issued: 4,007.6) . .. .
Additional paid-in capital .. ... . . . . . . .. . .. ..... . ... . .. . . . . .. . .. . . . . . .. . .... . .. .
Reserve for ESOP debt retirement . .. .. . . . .. . . .. .. . . . ... . . .. . . . . . . . . .. ... . . .. . . .
Accumulated other comprehensive income .. . . . .. .. .. .. . .. .. . .. . . .. .. . . . . .. . . . .. .
Treasury stock, at cost (shares held: 1,164.1) . . . . . . . . .. .. .. .. . . . . ... ... .. . ... . . . . .
Retained earnings . . .. .. .... .. . . . . .. . .. . .. . . . . . .. . . . .. . . ... . .. . .. ... . . .. . .. .
Noncontrolling interest . . . . . . . . . . ... .. .. . ... . ... . . .. . . . . . . . . . . . . . . . . . ..... ... .
$ 1,277
$61,439
4,008
61 ,697
(1 ,350)
(7,822)
(61 ,309)
64,614
324
Required
Verify Yahoo 's computatio n of P&G 's market capitalization using data from above .
~ JPU-39.
SPl\INT NEXTEL
( s)
a.
3M l:UMPANY
(MMM)
Pl2-40. E stimating Market and Book Values and Cost of Capital Measures (L01, 2, 3, 4)
The December 3 1, 20 10 , partial balance sheet of 3M Company fo llows ($ millions, except per share
amounts). ycharts.com reported that the total market capitalization of 3M was $6 1.86 billion and its
stock price was $86.30 as of December 3 1, 201 0 . Also , ycharts.com estimates its total enterprise value
at $63.94 billion, and its market beta at 0 .83. 3M 's average pretax borrowing cost is 3.7% , and its statutory tax rate is 35% . Assume that the risk-free rate equals 3. 1% and the market premi um equals 5%.
Liabilities
Current liabilities
Short-term borrowings and current portion of long-term debt .... . ... . ... . . . . .. .. . .
Accounts payable . . ... . . . .. .... .. . .... . .. .. . .... . . ... .. .. ... .. . . .. . .. .... .
Accrued payroll . .. . . . . ... . .. . . . .. .. . ... ... . . . . . .. . .. . . . .... .. . . . . . . ... . .. .
Accrued inco.me taxes .. ..... . . .. ... . .. . .. ... . . . .. .. . . ...... . . . .. . . . . . . . . . .
Other current liabilities ... . .. . . .. . . . .. .. . . . ... . ... .... . . . .. . .. ... . . . .. . .. . . .
12 -26
$ 1,269
1,662
778
358
2,022
6,089
4,183
2,013
1,854
$14,139
Equity
3M Company shareholders' equity:
Common stock, par value $.01 per share .... . ... . . . . .. . .. . . . .... . .. .. . .. . .. . . .
Shares outstanding - 2010: 711 ,977 ,608
Shares outstanding - 2009: 710,599, 119
Additional paid-in capital . . . .. . . .... . . . . .. .... ... . . .. . . . . . .. . . . .. . ... . .... . .
Retained earnings .. . . . . . .. . . ...... . . . . . ... . . . . . . . . . ... . .... .. . .. .... . . . . . .
Treasury stock .. .. . ...... . .. ... . .. . . .. . .. . . . . . .. . . .. . . . . . . . . .. . . ... .. . . . .
Accumulated other comprehensive income (loss) . . . . ... .. . . . . . ... .. . .. . . . . . . . . . .
,3,468
25,995
(10,266)
(3,543)
15,663
354
Total equity . .... . ... ... . . . . . . .. .. . . ... ... . .. . . . . . .... .. . .... . . .. . . .. . .... .
$16,017
Total liabilities and equity . .. . .. .... . . . ..... . ... . ... . . . ... .. .... . .. . .. . . . . .. . .
$30,156
Required
a. Verify ychart .com 's computation of 3M 's market capitalization using the data fro m its fi nancial
report excerpts above .
b. Compute the book value of 3M 's Jong-term debt as of December 3 I , 2010 .
c. Compute the market va lue of 3M 's debt using the data fro m ychart.com.
d. Identify at least two reasons behind the differe nce between the amoun ts computed in parts band c.
e. Compute 3M 's cost of debt capital.
f. Compute 3M 's cost of equity capital.
g . Compute 3M 's weighted average cost of capital. Use the market capitalization fro m ychart.com for
this calculation.
(L02, 3, 4, S)
Analysts estimate the cost of debt capital fo r Abbott Laboratories (NYSE: ABT) is 2.56% and that its
cost of equi ty capital is 4 .1% . Assume that ABT's statutory tax rate is 36% , the risk-free rate is 4 .6%,
the market ri sk premium is 5% , the ABT market price is $47 .73 per common share, and its dividends
are $ 1.18 per commo n share .
ABBOTT
LABllllA TlllllES
(ABT)
Required
a. Compute ABT 's average pretax borrowing rate and its market beta.
b. Assume that its di vidends continue at the current level in perpetuity. Use the constant perpetuity
dividend discount mode l and the market price to infer the market's expected cost of equi ty capital.
(Hint: Use the equatio n for di vidend di scount model with constant perpetuity, on page 12- 18.)
c . Compare the inferred cost of equity capital fro m part b to the 4. 1% estimated cost of equity capital
fro m analysts. Comment on any difference.
(L02, 3, 4, S, 6)
FedEx Corporation (NYSE: FDX) was trading at $93.64 at May 31, 20 11. Its dividend per share was
$0 .48, its market beta was estimated to be 1.1 9 , its average pretax borrowing rate was 4 .8% , and its
statuto ry tax rate was 36 .7% , consisting of the 35% federal rate plus the 1.7% state rate , net of federal
benefits. FedEx 's market value of equity (market capitalization) was $29.68 billion, computed as 3 17
million shares times its $93 .64 price , and its total market value (enterprise value) was $3 1.77 billion,
computed as $29 .68 billion in equity plus $2.09 billion in lo ng-term debt ($ I .69 reported plus $0.4 fair
value adj ustment). Assume a risk-free rate of 3. 1% and a market risk premium of 5% to answer the
fo llowi ng req uirements .
FEUEX
COllPUllATION
(FOX)
12-27
Required
a.
b.
c.
Estimate FedEx's cost of debt capital, cost of equity capital, and weighted average cost of capital
The company's market capitalization exceeds its enterprise value. Thi s mea~ s that.the.compan;
is a " net lender" or alternately, that the company has negative net nonoperating obltgattons. (See
Module 3 for explanation.)
Using the dividend discount model, and assuming a constant perpetuity at its current dividend level
'
estimate FedEx 's intrinsic value per share.
Using the Gordon growth DDM, and assuming next period 's dividends equal $0 .52 and grow at
a constant rate for each period thereafter, infer the market's expected growth in dividends that are
necessary for FedEx 's intrinsic value to equal $93.64 per common share. Di scuss the reasonableness of this growth facto r. (Assume that its cost of equity capital is 9.2% .)
~ .J PI2-43. Estimating Cost of Capital Measures and Applying the DDM Model (L02, 5, 6)
PRUl:TEI\ ANO
CAMI\ LE
(PG)
Procter and Gamble (PG ) has a June fiscal year-end. On June 30, 2006 , analysts expected the company
to pay $ 1.41 dividends per share in fiscal year 2007, and its market beta was estimated to be 0.7. Assume
that the risk-free rate is 4.6% and the market premium is 5 % . During fiscal year 2006, the company's
sales growth was 20 .2% . However, analysis reveals that P&G 's fiscal 2006 sales include eight months
of sales from Gillette after its acquisition by P&G during 2006. Footnotes report proforma sales that
show what the income statement would have reported had Gillette's full-year sales been included in both
2005 and 2006-specifically, P&G 's sales growth would have been 4.4%.
Required
a.
b.
c.
d.
e.
Estimate P&G 's cost of equity capital using the CAPM model.
Estimate P&G 's intrinsic value using the DDM assuming that dividends per share are projected at
$ 1.41 per share after 2007. (Hint: Apply the DDM with constant perpetuity, shown on page 12- 18.)
Discuss the appropriateness of the estimate computed in part bin light of the DDM assumption of
zero future dividend growth.
If we use the Gordon growth DDM to estimate stock value per share, which of the two growth rates
should we use: 20.2% or 4.4%? Explain.
On June 30 , 2006, the stock of P&G was priced at $55.60 per share. Infer the market expectation
about the future growth rate of P&G 's dividend using the DDM with an increasing perpetuity
(Gordon growth DDM). Comment on the reasonableness of this inferred growth rate.
now CHEMll:AL
(DOW)
(L02, 4)
The consolidated balance sheets of Dow Chemical (DOW) show that the company has 4,000 ,000 shares
of preferred stock outstanding at the end of 2010. That preferred stock has a book value of $1 ,000 per
share . During fiscal 2010 , the company declared $340 million in dividends for its preferred stock.
Required
a.
b.
c.
Compute the total book value of its preferred stock at the end of 2010.
Estimate the cost of preferred equity capital, rpe'
.
.
.
Explain how to incorporate the cost of preferred equity capital into the est1mat1on of the weighted
average cost of capital. (No computations are required .)
FE DEX
CllRPORA TlllN
(FDX)
(L02, 4, 6)
2010
2008
$ 53,510
28,315
27,479
3,935
11,041
$ 48,563
32,324
25,561
4, 724
11,341
124,280
122,5 13
Operating expenses
Cost of services and sales (exclusive of depreciation
and amortization shown separately below) ..... . .... . .. . ... ...... .
Selling , general and administrative ... .. .. ... .. . ....... . .... . . . ... .
Depreciation and amortization .. . .. .. . . . ........... .. . . .... ... ... .
52,263
33,065
19,379
50,571
31,427
19,515
104,707
101 ,513
Operating income . . . . ... ... ....... .. .... . . . ... ..... . ... . ..... .
19,573
21,000
(2,994)
762
897
(3,368)
734
152
(1 ,335)
(2,482)
18,238
(1,162)
18,518
6,091
19,400
779
12,427
20
$ 20,179
$ 12,447
Operating revenues
Wireless service .............. . ..... . ..... . .. . ... .. . . .... . .... .
Voice .. ... . . .. . ..... . ..... . .. . . .. . . ..... . ...... . .. .......... .
Data ... . . . . . . .... ..... ....... . .. ... . . .. . .... . .. .. .... . ....
Directory ..... . ..... .. . . .. ...... .. .. . .. ... ...... . .. ....... . ..
Other.... . . . ............... .. . ... .... . ..... .... .. ... .... .. . . .
Total ope r~t ir:i.g
2010
$
7,196
20,055
4,086
72
2,542
2008
$
7,361
21,260
4, 170
1,681
2,479
33,951
36,951
58,971
64,720
22,070
28,803
12,743
23,579
27,847
13,226
Required
63,616
64,652
a.
Stockholders' equity
Common stock ($1 par value, 14,000,000,000 authorized at
December 31 , 2010 and 2009: issued 6,495,231 ,088 at
December 31 , 2010 and 2009) ... . .. . . . .. .......... . .... ... . . .. .
Additional paid-in capital . ... . ..... . . . ....... . ... . ... ... ... . ... . .
Retained earnings . ...... . ...... . . . . . ............ . ....... . . .. . .
Treasury stock (584, 144,220 at December 31, 2010, and 593,300, 187
at December 31 , 2009, at cost) .. . .. . . . .. .. ........... . . . ..... . .
Accumulated other comprehensive income . .. ................. . . .. . .
Noncontrolling interest ............ . .... . . . .. .. ............ . .. .. .
6,495
91,731
31,792
6,495
91 ,707
21 ,944
(21,083)
2,712
303
(21, 260)
2,678
425
111,950
101 ,989
$268,488
$268 ,312
Estimate Fedex 's cost of equity capital and its weighted average cost of capital assuming it enters
into the hedges .
Assume that the market's expected growth in FedEx dividends is 7 .5%, and that the cost of the
hedge transactions would reduce FedEx 's projected dividend growth by 0.20%. Using the Gordon
growth DDM, infer the stock value per share.
(L03)
The December 3 l , 20 l O, partial financial statements taken from the annual report for AT&T (T) follow .
(T)
Refer to the information regarding FedEx Corporation in Pl2-42 . Assume that FedEx 1s cons1denng
implementing certain transactions to hedge against potential fluctuations in gas and fuel costs and m
exchange rates. It is estimated that such transactions would reduce FedEx 's cash flow volat1ltty and,
thus, decrease the firm's market beta from l . l 9 to l .10.
b.
AT&T
12-28
12-29
-...m.
ComollclMld
ol 8laclchold9r9' ~
Dolm9 end ................. except per ...... emounte
....
Common Stock
Balance at beginning of year .......................
Issuance of shares ... . . . ......... . ......
6,495
6,495
Treasury Shares
Balance at beginni ng of year ..... . ........... . . .. . . ........
Purchase of shares ...... . .. .. . ... . ..... .. ... .... . . .
Issuance of shares ... . . . ... . ... . ........ . .. . . . ........ . .
Balance at end of year .. .. ... .. . ... . .......... .... . . . . ..
21D10
(593)
9
(584)
a.
$6,495
$(21,260)
177
$(21,083)
Retained Earnings
Balance at beginning of year ...... ... .. . . .. . ... ... . ..... . .. ... . . .
Net income ($3.35 per share) ... . ................ .. .. .. . . .. .. . .
Dividends to stockholders ($1.69 per share) . . . . . . . ......... . . . .
Other . ... . ............ . .. . ........ . ... . ..... . .. . . . . ...... . .. .
$21,944
19,864
(9,985)
(31)
$ 31,792
Required
a. How much interest expense did AT&T incur during 2010?
b. What is the book value of AT&T' interest-bearing debt at the end of 2010? At the beginning of
2010?
c. Estimate AT&T' 2010 pretax cost of debt capital.
d. Estimate AT&T's 20 IO effective (that is , average) tax rate from information in its income statement.
e. Estimate AT&T's 2010 after-tax cost of debt capital. The company 's statutory tax rate is 35%.
Which tax rate , the statutory rate or the effective rate, is appropriate for computing its cost of debt
capital ?
D12-47. Estimating Cost of Equity Capital and Weighted Average Cost of Capital (L02, 4)
AT&T
(T)
Refer to the information regarding AT&T in 012-46. In early 2011, Yahoo reports that AT&T has a
market beta of 0 .65, and that its closing stock price at the end of 2010 was $29 .38 .
Required
Explain what AT&T's market beta of 0.65 implies regarding its stock price volatility.
.
b. Assume that the market ri k premium equals 5% and that the risk-free rate equals 3.1 %. Estimate
AT&T's cost of equity capital using the CAPM model.
c. Footnote 8 of AT&T's 10-K reports that the market value of its debt approximates its book value.
Assume that the company 's after-tax cost of debt is 2.81 %. Using this information , estimate
AT&T's weighted average cost of capital.
a.
AT&T
(T)
AT&T
(T)
Required
Compute the range of estimates of Best Buy 's cost of equity capital if the analysts' estimate of beta
is off by as much as +/- O. l.
b. Up.on further con~ideration, we realize that a growth in dividends is necessary for an intrinsic value
estimate. D~term1~e the range of Best Buy intrin sic value estimates that are possi ble utilizing the
cost of capital estimates from part a and an as umption that the growth rate in dividends could
range from 0% to 2%.
$6,495
On December JI, 2007, AT&T announced that it would increase its dividend per share by 12.7%. At
the same time the company announced a $ 15 .2 billion stock buyback plan . The stock price of AT&T
closed up 4.1 % on that day.
Required
a. Explain why AT&T's stock price reacted positively to those announcements.
.
b. Speculate as to why the stock price of AT&T rose only 4 .1% while its dividends per share increased
12 .7%.
Its beta value of .l .6 in~icates that IBM is more volatile than the market index (in the case of .F inance.
yahoo.com , the mdex IS the S&P 5~). A beta of. l .6 implies that IBM's stock price would change as
much as 160%, both up and down, with changes m the overall market index .
Its after-tax cost of debt capital is 4.9%, computed as 7.5 % x (I - 0.35) .
Its cost of equity capital is 12.6%, computed as 4.6% + (1 .6 x 5%) .
Its weighted average cost of capital is 12%, computed as:
rw
= ( 0 .049
$ 12.08 billion)
. .
$155.56 billion
0.126 X
= O 12
rd = Pretax average borrowing rate for debt x (1 - Marginal [statutory] incom e tax rate)
rd = 0.09 x (1 - 0.35)
rd= 0.0585
Its cost of equity cap ital is estimated using the CAP M fo llowing Eq uation 12.l.
= rr + fJ X
(rm - re)
re = 0.046 + [l.42 X (0.096 - 0.046)]
re = 0.117
re
Its weighted average cost of capital is estimated using Equation 12.5 (B is billions).
IVFinn
18.30B
0.1167
.26B)
$18.30B
=0.1168
S~nce its payo~s (di vidends) are paid to equity holders , the proper discount factor for the dividend
d iscount model IS the cost of equity capital. If intrinsic value is estimated assumina that dividend pay"'
ments continue in perpetuity, its intrinsic value follows:
IVpersbare -- $0.84
O.l1 7 -- $7.18
12-30
BEST BUY
(BBY)
12-31
e. Here we assume that intrinsic value is estimated assuming that the dividend payments continue to
at l % beginning three years hence. The present value of the dividend payments for the first two y
is treated as lump-sum payments. The present value of the increasing perpetuity is computed using
Gordon growth model; we obtain the present value of this perpetuity as of the end of year two, w
we must then discount back two years to the present.
$0.84
$0.84
$0.84
0.117 - 0.01
IVpershare = 1.ll 7 + (1.117)2 +
(1.117)2
IV per share
IV per share
= $7 .71
'"