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Cost of Capital

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Alessandro Previtero

Slide Pack Week 1 Part 2

Company Valuation Cost of Capital

Todays Content

I.

Announcements:

o

Attendance: not required (76%).

o

Using Laptops: anytime (47%).

o

Arriving on time: students can walk in and out at any time (71%).

o

Displaying name tags: not required (65%).

o

Turning your assignments in late: 30% penalty (88%).

II.

Discount Rate

a.

Why we discount FCF

b.

Risk-Return Tradeoff

c.

CAPM

d.

Compute Betas

Regressions

Comparables

III.

Homework Assignment #2

I. Company Valuation

Introduction

Discounted Cash Flow (DCF) Models

Discount Rate

No Friction Model

WACC (Weighted Average Cost of Capital)

APV (Adjusted Present Value)

Multiples

Other topics: LBOs, M&A, etc.

FFCF = EBIT (1 tC ) + DA NWC Capex + AS CGT

E[FFCFt ]

VA =

t

(

)

1

+

r

t =0

MVE

P=

N

Company Valua-on DCF Models Discount Rate 4

One dollar received today is more valuable than one dollar received

in the future (Time Value of Money).

Which would you choose?

I. $50 for sure TODAY or $50 for sure 1 YEAR FROM NOW

II. $40 for sure TODAY or $50 for sure 1 YEAR FROM NOW

Individuals are usually risk-averse:

Which would you choose?

I. $50 for sure or $0 / $100 at 50% each

II. $40 for sure or $0 / $100 at 50% each

The higher the risk, the higher the return (i.e. the discount rate)

Return ( r )

Common

Unique

Standard Deviation ()

Total Risk = Systematic (Common) Risk + Idiosyncratic (Unique) Risk

x =

Cov (rx , rm )

Var (rm )

Company
Valua-on
DCF
Models
Discount
Rate
6

Return ( r )

Common

Unique

Standard Deviation ()

Risk-free Rate

re = rf + e (rm rf )

rd = rf + d (rm rf )

rOA = rf + OA (rm rf )

rx = rf + x (rm rf )

Company Valua-on DCF Models Discount Rate 7

Estimation of cost of capital

CAPM

return

Multibeta CAPM

Investor expectations

Regulatory decisions

10

20

30

40

50

60

70

80

Source: Graham and Harvey, Journal of Financial Economics 2001

Company Valua-on DCF Models Discount Rate 8

r = rf + (rm rf )

Source:

h?p://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualiza-on.aspx

Company
Valua-on
DCF
Models
Discount
Rate
9

The CAPM is an opportunity cost model, where the riskfree rate represents the rate you would earn on an

equivalent maturity investment with no risk

I use the return on the 20-year or 30-year Treasury

(Matches the long-term maturity of equity, is risk-free).

However, if I need to value a short term project, I will use a

risk free rate that matches the duration of the project.

r = rf + (rm rf )

Market risk premium

r rf

(rm r(or

f ) controversy) regarding the

There is some disagreement

magnitude

the risk premium,

sinceregarding

the estimate

There

is some of

disagreement

(or controversy)

the

magnitude

of theon

riskthe

premium,

since

the estimate

Depends

sample

period

Depends

thethe

sample

period

Varies on

with

fixed

income instrument used

Varies with the fixed income instrument used

Depends on whether arithmetic or geometric means are used

Depends on whether arithmetic or geometric means are used

Which

type

of average

shouldshould

we use?we

Which

type

of average

Arithmetic

Average

ooArithmetic

Average

=

use?

= =1/

o Geometric Average

=&=1(1+) - 1

o Geometric Average =

1+

-1

http://faculty.london.edu/icooper/assets/documents/

http://faculty.london.edu/icooper/assets/documents/ArithmeticVersu

ArithmeticVersusGeometric.pdf

sGeometric.pdf

0.00%

Year

1929

1931

1933

1935

1937

1939

1941

1943

1945

1947

1949

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Annual market risk premium:

Stock - bond - Annual

60.00%

40.00%

20.00%

-20.00%

-40.00%

-60.00%

-80.00%

Average market risk premium with 5-year rolling periods:

5-yr moving average

0.3

0.25

0.2

0.15

0.1

Year

1929

1931

1933

1935

1937

1939

1941

1943

1945

1947

1949

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

0.05

-0.05

-0.1

-0.15

Company Valua-on DCF Models Discount Rate 13

0

Year

1929

1931

1933

1935

1937

1939

1941

1943

1945

1947

1949

1951

1953

1955

1957

1959

1961

1963

1965

1967

1969

1971

1973

1975

1977

1979

1981

1983

1985

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

2007

2009

2011

Average market risk premium with 10-year rolling periods:

10-yr moving average

0.25

0.2

0.15

0.1

0.05

-0.05

-0.1

r = rf + (rm rf )

Stocks-T.Bills (US)

Period

Stocks-T.Bonds (US)

Arithm. Mean

Geom. Mean

1928-2012

7.65%

5.74%

5.88%

4.20%

1962-2012

5.93%

4.60%

3.91%

2.93%

2002-2012

7.06%

5.38%

3.08%

1.71%

Company Valua-on DCF Models Discount Rate 15

Volatility of Dow Jones Industrial Index returns over time:

Is the whole time series from 1897-2013 relatively

uniform?

Annualized 1-yr Moving Average Daily Return Volatility

VIX index for the last 25 years

Some economists (especially before the 2009 financial

crisis) believe that the earlier sample does not look

representative of todays market

The vol stats show that the market was more volatile

pre-1950

We know that important mechanics of the market such

as liquidity and information are much better today

The 20 and 30 year periods starting after about 1950 show

MRP of around 5%-6%

The academic community is in virtual agreement that

6%-7% is too high, and a reasonable number is 4-6%

What happen if you use a low MRP?

Company Valua-on DCF Models Discount Rate 18

Estimating beta

r = rf + (rm rf )

equity of a company:

1. Regression Approach: compute how the stock

returns co-vary with the stock market returns

2. Comparables Approach: Choose comparable

companies, unlever and relever betas.

Firms historical or predicted e

Estimated by regressing the firms excess stock returns

on the excess returns of a market portfolio

USE SAME rf

(r r ) = + (r

e

f t

rf )t + t

returns, because monthly Treasury returns are not as easy

to find as equity returns, and theres not much difference

in the calculated beta

Time Period: As a default, we aim for 3-5 years of monthly

data (trade-off: more data is better, but use recent data)

Company Valua-on DCF Models Discount Rate 20

Market Portfolio: There are plenty of choices for the

market portfolio (S&P 500, NYSE, NYSE/NASDAQ)

Thankfully, market proxies are so highly correlated it

doesnt matter much what you use.

I almost always use the S&P 500, and so does almost

everyone else in practice (is easy to get)

in academic papers we use the bigger index

measures like NYSE/AMEX/NASDAQ

e is an estimate subject to random error

Individual stock beta estimates have HIGH sd.s

Sometime stock returns are not available:

New/IPO companies

Private companies

Unique projects/assets

Subsidiary

Use COMPARABLES approach

Take two identical companies (same size, industry, products,), but

one with high leverage, and the other with low leverage

e1

d1

E1

D1

A1

E2

e2

D2

d2

A2

The higher the leverage, the higher the e and d

e s are not directly comparables between companies

A s are not affected by leverage comparable

NB: The textbook calls

A =Unlevered Equity Betas

E =Levered Equity Betas

e_c1 Ec1

e_c2 Ec2

e_c3 Ec3

d_c1 Dc1

d_c2 Dc2

d_c3 Dc3

A_c1

A_c2

e??

Levering

Unlevering

Comparables

A_c3

A_c

A

Levering/Unlevering Formula

D

E

A =

d +

e

D+E

D+E

Company
Valua-on
DCF
Models
Discount
Rate
25

To find the e of a company using the Comparables approach:

1. Find a set of comparable public firms matching in size, industry,

product, life-cycle, (but not in Leverage!)

2. Unlever the comp e to find the A (unlevered e )

3. Compute weighted-average of the comp A

4. Re-lever the average A to the target firms capital structure

Comparables

e_c1

Ec1

e_c2

Ec2

e_c3

Ec3

d_c1

Dc1

d_c2

Dc2

d_c3

Dc3

A_c1

A_c1

A_c

e??

Levering

Unlevering

A_c1

A

Compute Genentechs e using the comparable companies below,

assuming that

Genentechs and the comparables d =0.20

Genentechs Market Leverage = 15%

Company Name

Abbott Laboratories

Johnson & Johnson

Merck

Pfizer

Average

e

0.36

0.35

0.81

0.71

Market

Leverage

30.05%

3.30%

10.00%

17.65%

A

0.31

0.35

0.75

0.62

0.51

Genentech
e
=
0.56

D

E

d +

e = L d + (1 L) e

D+E

D+E

D

Where : L =

= Leverage

D+E

A =

NB:

e =

A

1 L

d L

1 L

If d=0 then the levering/unlevering formula is:

A =

E

e = (1 L)e

D+E

company (Leverage, Interest coverage ratio, etc)

Never rely only on one comparable. Choose at least 3 or 4, and then take a

weighted average

Size, life-cycle statges)

Some textbooks (including ours!) use a different levering/unlevering

formula where D is replaced by D(1-T):

Well see later on why different levering formulas exist

Homework Assignment #2

Individual Assignment posted on the course website

Objective: Find the cost of equity capital for your

company.

Three Approaches

Regression analysis

Comparables approach

Due Wednesday Jan 27th at the beginning of class

Paper format only. Do not email me or the TA with

the assignment.

Problem #1

Firm
1
Firm
2
Firm
3

You
are
the
manager
of
the
hockey
helmet

division
of
your
Firm.
There
are
three
rms
Total
Assets

20000
1000

500

that
compete
with
you
in
the
hockey

Debt

500

200

200

helmet
business.
Firm
1
is
a
large,

15000
800

300

diversied
plas-cs
business
which
derives
Equity

Total
Liab
+
Equity
20000
1000

500

10%
of
its
revenues
from
hockey
helmet

sales.
Firm
2
is
a
single-division
hockey

Earnings

1500

100

-5

helmet
manufacturer
that
has
been
in

Bond
Ra-ng

AA

AA

BBB

business
for
30
years
(prior
to
that
hockey

Shares
Outstanding
1000

100

100

players
didnt
wear
helmets).
Firm
3
is
a

Share
Price

20

15

2

recent
entrant
into
the
hockey
helmet

Equity
Beta

1.3

1.5

2.2

business
a[er
many
years
in
the
football

helmet
business.

The
table
shows
some
nancial
informa-on
on
the
comparable
rms
(all
units

are
in
millions
except
the
share
price).
The
risk-free
rate
is
5%,
the
market
risk

premium
is
6%,
and
the
marginal
corporate
tax
rate
is
35%.
The
target
debt-to-

value
for
the
division
is
1/3.
Compute
the
cost
of
equity
capital
for
the
hockey

helmet
division.

Company
Valua-on
DCF
Models
Discount
Rate
31

Problem #2

In
1989,
General
Motors
(GM)
was
evalua-ng
the
acquisi-on
of
Hughes
Aircra[

Corpora-on.
Recognizing
that
the
appropriate
discount
rate
for
the
projected

cash
ows
of
Hughes
was
dierent
than
its
own
cost
of
capital,
GM
assumed

that
Hughes
had
approximately
the
same
risk
as
Lockheed
and
Northrop,
which

had
low-risk
defense
contracts
and
products
that
were
similar
to
Hughes.

Specically,
assume
the
following
inputs:

Comparison

E

D/E

GM

1.20

0.4

Lockheed

0.90

0.9

Northrop

0.85

0.7

Also
assume
that
GMs
target
debt/equity
ra-o,
in
market
value
terms,
for
the

Hughes
acquisi-on
is
1.
Hughes
expected
nominal
cash
ow
next
year
will
be

$300
million
and
will
grow
therea[er
at
the
rate
of
5
percent
per
year,
the
risk-

free
rate
is
8%,
and
the
market
risk
premium
is
6%.

Compute
the
equity
cost
of
capital
for
the
Hughes
acquisi-on,
assuming
no

taxes.

Company
Valua-on
DCF
Models
Discount
Rate
32

Problem #3

Your
so[ware
rm
is
considering
a
diversifying
investment
in
the
donut
business.
The
logic
at

headquarters
is
that
your
programmers
eat
so
many
donuts
that
you
might
as
well
get
a
piece

of
the
ac-on.
There
are
two
other
publicly-traded
rms
compe-ng
in
the
donut
business:
one

is
a
mature
rm
with
signicant
interests
in
other
businesses
and
a
young,
upstart
rm
which
is

a
pure-play
in
the
business
you
are
considering.
Summary
nancial
data
(in
$
millions)
for
the

two
comparables
are
given
below:

Mature
comp

Upstart
comp

Total
assets

1000

200

Short-term
debt

25

5

Long-term
debt

475

20

Equity

500

175

Total
liab+equity

1000

200

Earnings

100

1

EPS

(

$)

1

0.05

Share
price
($)

10

40

Dividend
yield

5%

0

Equity
beta

0.8

1.5

To
get
a
be?er
understanding
of
the
mature
comparable,
you
es-mate
that
half
of
its
revenue

is
generated
in
the
donut
business
and
the
remaining
half
of
its
revenue
is
generated
in
a

variety
of
businesses
which
have
average
market
risk.

(a)
Ignoring
taxes,
give
an
es-mate
of
the
cost
of
capital
of
asset
using
the
CAPM
(assume
risk-

free
rate
is
5%
and
whatever
market
risk
premium
you
deem
appropriate).
Jus-fy
all
other

assump-ons.

(b)
What
three
other
pieces
of
informa-on
would
you
like
to
have
to
improve
your
es-mate?

Company
Valua-on
DCF
Models
Discount
Rate
33

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