Fall 2023

MAN 484 – Entrepreneurship and Venture Capital

Tolga Demir

Valuation Recap – FCFF & WACC

What do we need to know to value a company
or a project using DCF analysis?

1. Free cash flows

2. Growth rate of free cash flow in the terminal period

3. Appropriate discount rate (cost of capital)

What is free cash flow to the firm (FCFF)? (1 of 4)

 Free cash flow to the firm is the cash flow available to the firm’s suppliers
of capital after all operating expenses (including taxes) have been paid
and necessary investments in working capital (e.g., inventory) and fixed
capital (e.g., machine and equipment) have been made. A company’s
suppliers of capital include stockholders and bondholders.

 Free cash flow and accounting income are not the same thing.
What is free cash flow to the firm (FCFF)? (2 of 4)

 For present value (PV) calculation, we always discount actual free cash
flows. In PV calculations, using accounting income rather than free cash
flow could lead to erroneous decisions.
 Projects are financially attractive because of the cash they generate,
either for distribution to shareholders or for reinvestment in the firm.
Therefore, the focus of valuation is cash flows, not profits.
 An income statement will recognize revenue when the sale is made, even
if the bill is not paid for months. This practice results in a difference
between accounting profits and cash flow.
What is free cash flow to the firm (FCFF)? (3 of 4)

 When we compute free cash flows to firm from a new project, we mean
the incremental cash flows created by the new project. In such a case,
 Discount incremental cash flows
 Include all indirect effects
 Forget sunk costs
 Include opportunity costs
 Recognize the investment in working capital
 Remember terminal cash flows

Incremental cash flow cash flow

cash flow = with project - without project
What is free cash flow to the firm (FCFF)? (4 of 4)

 Include all indirect effects

 To forecast incremental cash flow, you must trace out all indirect effects of accepting the project.
 Forget sunk costs
 Sunk costs remain the same whether you accept the project or not. Therefore, they do not affect
project NPV.
 Include opportunity costs
 For example, suppose a new manufacturing operation uses land that could otherwise be sold for
$100,000. By using the land, you pass up the opportunity to sell it. There is no out-of-pocket cost,
but there is an opportunity cost, that is, the value of the forgone alternative use of the land.
 Recognize the investment in working capital
 Net working capital (often referred to simply as working capital) is the difference between a
company’s short-term assets and liabilities.
 Remember terminal cash flows.
 The end of a project almost always brings additional cash flows. For example, you might be able to
sell some of the plant, equipment, or real estate that was dedicated to it. Sometimes, there may be
costs to shutting down a project.
Calculating Free Cash Flows (FCFF)? (1 of 3)

When it comes to estimating free cash flows, we

should look at three elements.
Total free cash flow to the firm =
+ operating cash flows
+ cash flows from capital investments (expenditures)
+ cash flows from changes in working capital
Calculating Free Cash Flows (FCFF)? (2 of 3)

 Income statement and balance sheet can be used to calculate free cash flow to
the firm (FCFF). Free cash flows to the firm are based on after-tax operating
earnings:

FCFF = EBIT (1 – tax rate) + Depreciation – Capital expenditures (CAPEX)

– Change in net working capital (∆𝑁𝑊𝐶)

Operating cash flow = Revenue – Expenses – Taxes

= EBIT (1 – tax rate) + Depreciation
= (revenues - cash expenses) × (1 – tax rate)
+ (tax rate × depreciation)

• Working capital = Current assets - current liabilities. Change in working capital is the difference in the net
working capital amount from 𝑦𝑒𝑎𝑟𝑡−1 to 𝑦𝑒𝑎𝑟𝑡 .
 Calculating Free Cash Flows (FCFF)? (3 of 3)

 In addition to the definition in the previous page based on operating cash

flow, we can also compute FCFF using net income. See this alternative FCFF
definition below:

FCFF = Net Income + Interest expense (1 – tax rate) + Depreciation

– Capital expenditures (CAPEX) – Change in net working capital (∆𝑁𝑊𝐶 )
Growth rate of free cash flow in the terminal
period
 When we value a firm, we assume that the firm will continue to exist
forever, therefore we want to find out the average growth rate that a firm
is expected to grow at after the forecasted period, in the terminal period.

 In a discounted cash flow model, terminal growth rate starts at the end of
the last forecasted cash flow period and goes into perpetuity.

 It cannot be bigger than the growth rate of GDP.

 Sometimes people abstain from using terminal growth rate to estimate FCFF
in the terminal period; instead, they use multiples such as revenue multiples
or EBITDA multiples.
A FCFF Calculation Example: The Baldwin
Company (1 of 9)
The Baldwin Company is considering investing in a machine to produce bowling balls. The
bowling balls would be manufactured in a warehouse owned by the firm and located near
Los Angeles. This warehouse, which is vacant, and the land can be sold for $150,000 after
taxes.

Assumptions are as follows: The cost of the bowling ball machine is $100,000 and it is
expected to last five years. At the end of five years, the machine will be sold at a price
estimated to be $30,000. Production by year during the 5-year life of the machine is
expected to be as follows: 5,000 units, 8,000 units, 12,000 units, 10,000 units, and 6,000
units. The price of bowling balls in the first year will be $20. The price of bowling balls will
increase at only 2 percent per year, as compared to the anticipated general inflation rate of
5 percent. Conversely, the plastic used to produce bowling balls is rapidly becoming more
expensive. Because of this, production cash outflows are expected to grow at 10 percent
per year. First-year production costs will be $10 per unit. The appropriate incremental
corporate tax rate for this project is 34%. Management determines that an initial
investment (Year 0) in net working capital of $10,000 is required. Subsequently, net working
capital at the end of each year will be equal to 10 percent of sales for that year. In the final
year of the project, net working capital will decline to zero as the project is ended. The
management believes that the appropriate discount rate for this project is 10%. Lastly,
Baldwin Company has already spent $250,000 for the test marketing of the bowling balls.
A FCFF Example: The Baldwin Company (2 of 9)

 Costs of test marketing (already spent): $250,000

 Current market value of proposed factory site (which we own): $150,000
 Cost of bowling ball machine: $100,000 (depreciated according to
modified accelerated cost recovery system, MACRS 5-year)
 Increase in net working capital: $10,000
 Production (in units) by year during 5-year life of the machine: 5,000,
8,000, 12,000, 10,000, 6,000
 Price during first year is $20; price increases 2% per year thereafter.
 Production costs during first year are $10 per unit and increase 10% per
year thereafter.
 Annual inflation rate is 5%, appropriate discount rate is 10%.
 Working Capital: Initial $10,000 changes with sales
A FCFF Example: The Baldwin Company (3 of 9)
($ thousands) (All cash flows occur at the end of the year.)

* We assume that the ending market value of the capital investment at year 5 is $30,000. Capital gain is the difference between ending
market value and adjusted basis of the machine. The adjusted basis is the original purchase price of the machine less depreciation. The
capital gain is $24,240 (= $30,000 – $5,760). We will assume the incremental corporate tax for Baldwin on this project is 34 percent.
Capital gains are now taxed at the ordinary income rate, so the capital gains tax due is $8,242 = [0.34 * ($30,000 – $5,760)]. The after-
tax salvage value is $30,000 – 8,242 = $21,758.
A FCFF Example: The Baldwin Company (4 of 9)
($ thousands) (All cash flows occur at the end of the year.)

Total cash flow of investments item (7) includes all the cash flows from capital investments (CAPEX)
and the cash flows from changes in working capital (∆𝑁𝑊𝐶).
At the end of the project, the warehouse is unencumbered, so we can sell it if we want to.
A FCFF Example: The Baldwin Company (5 of 9)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89

Recall that production (in units) by year during the 5-year life of the machine is
given by:
5,000, 8,000, 12,000, 10,000, 6,000.
Price during the first year is $20 and increases 2% per year thereafter.
Sales revenue in year 2 = 8,000×[$20×(1.02)1] = 8,000×$20.40 = $163,200.
A FCFF Example: The Baldwin Company (6 of 9)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs 50.00 88.00 145.20 133.10 87.85

Again, production (in units) by year during 5-year life of the machine is given
by:
(5,000, 8,000, 12,000, 10,000, 6,000).
Production costs during the first year (per unit) are $10, and they increase
10% per year thereafter.
Production costs in year 2 = 8,000×[$10×(1.10)1] = $88,000
A FCFF Example: The Baldwin Company (7 of 9)

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Income:
(8) Sales Revenues 100.00 163.20 249.70 212.24 129.89
(9) Operating costs -50.00 -88.00 -145.20 -133.10 -87.85
(10) Depreciation -20.00 -32.00 -19.20 -11.52 -11.52

Depreciation is calculated using the Modified Year ACRS %

Accelerated Cost Recovery System (shown at 120.00%
right). 232.00%
Our cost basis is $100,000. 319.20%
Depreciation charge in year 4 411.52%
511.52%
= $100,000×(.1152) = $11,520. 6 5.76%
Total 100.00%
A FCFF Example: The Baldwin Company (8 of 9)
A FCFF Example: The Baldwin Company (9 of 9)
Estimating appropriate discount rate (cost of
capital)
 In the previous example, a discount rate was given, but we often
compute the appropriate discount rate ourselves in practice. Discount
rate is the critical ingredient in discounted cash flow valuation. Errors in
estimating the discount rate or mismatching cash flows and discount
rates can lead to serious errors in valuation.
 At an intuitive level, the discount rate used should be consistent with
both the riskiness and the type of cash flow being discounted.
 Equity versus Firm: If the cash flows being discounted are cash flows to equity, the
appropriate discount rate is a cost of equity. If the cash flows are cash flows to the
firm, the appropriate discount rate is the cost of capital.

 Currency: The currency in which the cash flows are estimated should also be the
currency in which the discount rate is estimated.

 Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e.,
reflect expected inflation), the discount rate should be nominal.
What is cost of capital?

Cost of Capital
The return a firm’s investors could expect to earn if they invested in
securities with similar degrees of risk.
The cost of capital of a business depends on the capital structure of
the business. Capital structure is the mix of long-term debt and equity
financing.
 Let’s clarify these concepts with an example.
Geothermal Corp’s cost of capital (1 of 3)

Geothermal is a company with 22.65 million shares trading at

$20 each and bonds worth $194 million.

Geothermal is considering expanding its existing operations via

investing into a new project and managers need to compute
the cost of capital of the firm to value this expansion project.
Can you use the cost of debt or cost of equity alone as a
discount rate for this expansion? NO!
Geothermal Corp’s cost of capital (2 of 3)

 If you owned all the shares and all the bonds of Geothermal, you would own the
entire business of the company single-handedly. In that case:
Value of the business = Value of the portfolio of the firm’s all debt and equity
Risk of business = Risk of portfolio
Rate of return on business = Rate of return on portfolio
Investors’ required return on business (company cost of capital) = investors’ required
return on portfolio
 To compute Geothermal’s cost of capital, we need to calculate the expected rate of
return on a portfolio of the firm’s securities (debt and equity). If we are told that debt is
yielding 8% (i.e. bondholders require 8% return) and equity investors require 14% return
on their investment, we could easily compute the average return on the investors’
portfolio of debt and equity. From the previous slide, we know that the portfolio would
contain 30% debt and 70% equity, so
Company cost of capital = Portfolio return = (.3 × 8%) + (.7 × 14%) = 12.2%
The company cost of capital is just a weighted average of returns on debt and
equity, with weights depending on relative market values of the two securities.
Geothermal Corp’s cost of capital (3 of 3)

 When interest expense is tax-deductible as in the US, we need to modify

the previous equation slightly. If Geothermal pays $1 of interest, taxable
income is reduced by $1, and the firm’s tax bill drops by 21 cents
(assuming a 21% tax rate). The net cost is only 79 cents. So, the after-tax
cost of debt is not 8%, but .79 × 8 = 6.3%.
 The updated weighted-average cost of capital with after-tax cost of debt:
WACC = (.3 × 6.3%) + (.7 × 14%) = 11.7%

 Weighted Average Cost of Capital (WACC) = Company’s cost of capital

 The expected rate of return on a portfolio of all the firm’s securities, adjusted for tax
savings due to interest payments.
 Weighted average of debt and equity returns
Weighted Average Cost of Capital (WACC) (1 of 5)

total income 𝐷 × 𝑟debt + (𝐸 × 𝑟equity )

𝑟assets = 𝑟assets =
value of investments 𝑉

𝐷 𝐸
𝑟assets = × 𝑟debt + × 𝑟equity
𝑉 𝑉

V=D+E
IMPORTANT
D = market value of debt
E = market value of equity = price per share × # shares E, D, and V are all
rdebt = cost of debt = YTM on bonds market values of
requity = cost of equity (i.e. return on equity) = rf + β(rm - rf) equity, debt, and
total firm value
Weighted Average Cost of Capital (WACC) (2 of 5)

𝐷 𝐸
WACC = × (1 − 𝑇𝑐 )𝑟debt + × 𝑟equity
𝑉 𝑉

After-tax cost of debt = (1 - tax rate) × pretax cost

= (1 - Tc) × rdebt

V=D+E
D = market value of debt (all interest-bearing liabilities such as short-term and
long-term bank debt and bonds)
E = market value of equity = price per share × # shares
rdebt = cost of debt = YTM on bonds
requity = cost of equity (i.e. return on equity) = rf + β(rm - rf)
Weighted Average Cost of Capital (WACC) (3 of 5)

𝐷 𝐸
WACC = × (1 − 𝑇𝑐 )𝑟debt + × 𝑟equity
𝑉 𝑉

 Three steps to calculate WACC

1. Calculate the value of each security as a proportion of the firm’s market value
2. Determine the required rate of return on each security
3. Calculate a weighted average of the after-tax return on the debt and the
return on the equity

Market Value of Bonds: PV of all coupons and face value discounted at the current YTM
Market Value of Equity: Market price per share multiplied by the number of outstanding shares
Weighted Average Cost of Capital (WACC) (4 of 5)

 Weighted Average Cost of Capital with Preferred Stock

𝐷 𝑃 𝐸
WACC = × (1 − 𝑇𝑐 )𝑟debt + × 𝑟preferred + × 𝑟equity
𝑉 𝑉 𝑉

V=D+P+E
D = market value of debt (all interest-bearing liabilities such as short-term and long-
term bank debt and bonds)
P = market value of preferred equity = # preferred shares × price per preferred share
E = market value of common equity = # common shares × price per share

rdebt = YTM on bonds

r preferred = required return on preferred shares
requity = rf + β(rm - rf) (from CAPM)
Weighted Average Cost of Capital (WACC) (5 of 5)

Example: Executive Fruit has issued debt, preferred stock and common
stock. The market value of these securities are $4 million, $2 million, and $6
million, respectively. The required returns are 6%, 12%, and 18%,
respectively. Determine the WACC for Executive Fruit. Tax rate is 21%.
 Step 1
Firm Value = 4 + 2 + 6 = $12 million
 Step 2
Required returns are given
 Step 3
𝐷 𝑃 𝐸
𝑊𝐴𝐶𝐶 = × (1 − 𝑇𝑐 )𝑟debt + × 𝑟preferred + × 𝑟equity
𝑉 𝑉 𝑉
4 2 6
𝑊𝐴𝐶𝐶 = × 1 − 0.21 ∗ 0.06 + × 0.12 + × 0.18 = 12.58%
12 12 12
Decomposition of Weighted Average Cost of
Capital (WACC)
As we have already seen, we need to know the cost of equity
and cost of debt to be able to compute WACC for a company.

Debt Equity
WACC = (1-tax rate) 𝑅𝑑 + 𝑅𝑒
Debt + Equity Debt + Equity

• 𝑅𝑑 : cost of debt
• 𝑅𝑒 : cost of equity (i.e., return on equity)

Most of the time, these values are not given to us. Therefore, in the rest of
these slides, we discuss various approaches to the estimation of cost of
equity and cost of debt.
Estimating Cost of Debt (𝑅𝑑 ) (1 of 4)

 The cost of debt measures the current cost to the firm of borrowing
funds to finance its assets. It should be a function of the default risk that
lenders perceive in the firm.
 In contrast to the risk and return models for equity which evaluate the
effects of market risk on expected returns, models of default risk
measure the consequences of firm-specific default risk on promised
returns.
 The default risk is a function of two variables
 Firm’s capacity to generate cash flows from operations and the extent of its financial
obligations.
 Volatility in these cash flows.
 The most widely used measure of a firm’s default risk is its bond rating
which is generally assigned by an independent ratings agency.
Estimating Cost of Debt (𝑅𝑑 ) (2 of 4)

 The two most widely used approaches to estimating cost of debt are:
 Looking at the yield to maturity on a straight bond issued by the firm. The limitation
of this approach is that few firms have long term straight bonds that are liquid and
widely traded.
 Checking the rating for the firm and estimating a default spread based upon the
rating. While this approach is more robust, different bonds from the same firm can
have different ratings. You must use a median rating for the firm.

 When in trouble (because you have no ratings for a firm):

 Look at the recent borrowing history of the firm as many firms that are not rated
still borrow money from banks and other financial institutions.
 Estimate a synthetic rating for your firm and find the cost of debt based upon that
rating.
Estimating Cost of Debt (𝑅𝑑 ) (3 of 4)

Synthetic Ratings
 The synthetic rating of a firm can be estimated using the financial characteristics of
the firm. In its simplest form, the rating can be estimated from the interest coverage
ratio (EBIT/Interest expense). Combinations of other financial ratios can also be
considered. Consider a private firm with $10 million in EBIT and $3 million in
interest expenses. According to table below, it should have a rating of A-.
Estimating Cost of Debt (𝑅𝑑 ) (4 of 4)

 Interest is tax deductible, and the tax savings reduce the cost of
borrowing. However, to obtain the tax advantages, a firm has to be
profitable.
 One should keep in mind that interest expenses offset the marginal dollar
of income and the tax advantage has to be calculated using the marginal
tax rate. The best source of the marginal tax rate is the tax code of the
country where the firm earns its operating income. If marginal tax rate is
unknown, average corporate tax rate can be used.
Example: Disney has bonds outstanding and is rated by S&P and Moody’s. The S&P
bond rating is BBB+ and the default spread for BBB+ rated bonds is 1.25%. Tax rate
is 21%.
If Treasury-bond rate is 4%, then pretax cost of debt is 4% + 1.25% = 5.25%. The
after-tax cost of debt is 5.25% × (1 – 0.21) = 4.15%
Estimating Cost of Equity (𝑅𝑒 ) (1 of 20)

 The cost of equity (return on equity) is what investors in the equity of a

business expect to make on their investment.
 Unlike the interest rate on debt, the cost of equity is an implicit cost and
cannot be directly observed.
 The cost of equity should be higher for riskier investments and lower for
safer investments.
 Risk refers to the likelihood that we will receive a return on an investment
that is different from the return we expected to make. Thus, risk includes
not only the bad outcomes, but also the good outcomes.
 Investors buy assets to earn good returns over their investment horizon.
Investors’ actual returns over this holding period may be very different from
their expected returns and it is this difference between actual and expected
returns that gives rise to risk.
Estimating Cost of Equity (𝑅𝑒 ) (2 of 20)

 The spread of the actual returns around the expected return, in other
words risk, is measured by the variance or standard deviation of the
distribution.
 In practice, expected returns and variances are estimated using past
returns. This assumes that past returns are good indicators of future
return distributions.
 There are many reasons that actual returns differ from expected returns,
but we can group them into two categories: Diversifiable and systematic.
 Diversifiable risks arise from firm-specific actions, affect one or a few
investments, e.g. project risk, competitive risk, sector risk.
 Non-diversifiable (systematic) risks are more pervasive and affect many
investments. Non-diversifiable risks are also called market risk, e.g.
interest rate changes, shocks to the economy.
Estimating Cost of Equity (𝑅𝑒 ) (3 of 20)

Capital Asset Pricing Model (CAPM)

 CAPM is the default model to measure market risk. If we expand (diversify)
our portfolio to include a large number of stocks, we can reduce or even fully
eliminate our exposure to firm-specific risk, but market risk cannot be
eliminated.
 CAPM is built on two key assumptions: There are no transaction costs and
investors have no access to private information. These ensure that the
investors will keep diversifying until they hold a piece of every traded asset, in
other words the market portfolio. Investors only differ in terms of the
proportion of their wealth they invest in the market portfolio as opposed to a
riskless asset.
 Statistically, we can measure the risk added by an asset to the market
portfolio by the asset’s covariance. We standardize this covariance by dividing
it with the variance of the market portfolio. This would give us the beta.
Estimating Cost of Equity (𝑅𝑒 ) (4 of 20)

 From an equity investor’s perspective, Re is the expected return. From the

firm’s perspective, Re is the cost of the equity capital that the firm received
from shareholders. You can estimate the cost of equity using CAPM:
Return on equity = Cost of equity = Re = Rf + 𝛽×[E(Rm) – Rf]
where,
Rf = Risk-free rate
E(Rm) = Expected return on the market index (diversified portfolio)
𝛽 = Equity beta of the firm

 In practice,
 Medium-term or long-term government bond rates are used as risk-free rates
 Historical risk premiums are used as the risk premium
 Betas are estimated by regressing stock returns against market returns
Estimating Cost of Equity (𝑅𝑒 ) (5 of 20)

 To estimate firm i’s cost of equity 𝑅𝑒 , we need to know three things:

𝑅𝑒 = 𝑅𝑓 + 𝛽𝑖 (𝐸(𝑅𝑀 )−𝑅𝑓 )

1. The risk-free rate, 𝑅𝑓

2. The equity market risk premium, (𝐸(𝑅𝑀 )−𝑅𝑓 )
Cov (R i , R M )  i,M
3. Firm i’s equity beta, i = = 2
Var(R M ) M
 In the following slides, we are going to learn how to estimate these three
ingredients of cost of equity.

Estimating Cost of Equity (𝑅𝑒 ) (6 of 20)

 On a risk-free asset, the actual return is equal to the expected return. Therefore,
there is no variance around the expected return.
 For an investment to be risk-free, then, it has to have
 No default risk which implies that the security needs to be issued by a government.
Note that not all governments are default free. There are many emerging economies
for which the assumption that the government does not default is not reasonable. To
find the risk-free rate of such economies, subtract the default spread from local
government bond rate.
 No reinvestment risk. If you are holding a 5-year Treasury bond, the 6-month
Treasury-bill rate will not be a relevant risk-free rate.
 Thus, the risk-free rates in valuation will depend upon when the cash flow is
expected to occur and will vary across time. In valuation of firms, the time
horizon is generally infinite, leading to the conclusion that a long-term risk-free
rate will always be preferable to a short-term rate.
Estimating Cost of Equity (𝑅𝑒 ) (7 of 20)

 Example: Suppose Brazilian government bond rate is 12% and the rating
assigned to the Brazilian government is BBB. If the default spread for BBB
rated bonds is 2%, the risk-free Brazilian rate would be 12% - 2% = 10%.

 What is equity market risk premium supposed to measure?

 The risk premium measures the extra return that would be demanded by investors
for shifting their money from a riskless investment to an average-risk investment.
 There are three ways of estimating equity market risk premium in CAPM
 Large investors can be surveyed about their expectations for the future.
 The actual premiums earned over a past period can be obtained from historical data.
 The implied premium can be extracted from the current market data.
Estimating Cost of Equity (𝑅𝑒 ) (8 of 20)

 Survey premiums: Very few practitioners use survey premiums because

 There are no constraints on reasonability; survey respondents could provide expected returns
lower than the risk-free rate
 Survey premiums are extremely volatile
 Survey premiums tend to be short-term; even the longest surveys do not go beyond one year.

 Implied equity market risk premium: If we assume that stocks are correctly priced in the
aggregate and we can estimate the expected cashflows from buying stocks, we can
estimate the expected rate of return on stocks by computing an internal rate of return.
Subtracting out the risk-free rate should yield an implied equity risk premium.
 This implied equity premium is a forward-looking number and can be updated as often as
you want.
 The disadvantage is that the accuracy of implied risk premiums is bounded by whether
the model used for valuation is the right model and the availability and reliability of the
inputs to that model.
Estimating Cost of Equity (𝑅𝑒 ) (9 of 20)

Historical Equity Market Risk Premium

 The historical premium is the premium that stocks have historically earned over riskless
securities.
 Practitioners never seem to agree on the premium; it is sensitive to
 How far back you go in history. Using a short sample provides a more updated
estimate but increases the standard error of the estimate.
 Whether you use T-bill rates or T-Bond rates. (short-term vs long-term)
 Whether you use geometric or arithmetic averages. Geometric risk premiums are
closer to how investors think about risk premiums over long periods.

➢ U.S. equity risk premium ranges between 5.0% to 7.0% depending on how far you go back
in history.
➢ In many emerging markets, there is very little historical data and the data that exists is
too volatile to yield a meaningful estimate of the equity risk premium.
Estimating Cost of Equity (𝑅𝑒 ) (10 of 20)

Equity market risk premiums in emerging markets such as Brazil, Turkey:

 Let’s start with a basic proposition
 Equity risk premium = Base premium for mature market + Country premium

 Two major questions:

 What should the base premium for a mature equity market be?
 How do we estimate the additional risk premium for individual countries?

 To answer the first question, one can make the argument that the U.S. equity
market is a mature market and that there is sufficient historical data to make a
reasonable estimate of the risk premium.
 Assume U.S. equity risk premium = 6.0%
Estimating Cost of Equity (𝑅𝑒 ) (11 of 20)

 A country’s bond default spread can be used as a measure of that

country’s risk premium.
 Bond ratings assigned by rating agencies come with default spreads over the U.S.
Treasury bonds.

 For instance, Brazil was rated B1 by Moody’s and 10-year Brazilian bond,
which was a dollar-denominated bond, was priced to yield 7.75%.
 The yield on the 10-year U.S. Treasury bond was 4.25% at the same time.
 Therefore, the default premium of the 10-year Brazilian bond over the 10-year US
Treasury bond was 7.75 – 4.25 = 3.50%. So, at that time 3.50% could be used as the
country risk premium for Brazil.

 Given that the equity risk premium for U.S. (mature market) was 6.0%, the
equity risk premium for Brazil could be estimated as 6.0% + 3.50% = 9.5%.
Estimating Cost of Equity (𝑅𝑒 ) (12 of 20)

Estimating Company Beta

 The standard approach to estimate equity betas relies on historical market
prices. For firms that have been publicly traded for a long time, it is easy to
compute returns that an investor would have made on its equity in various
intervals.

 These returns can be related to returns on a market portfolio. In line with

CAPM, we regress stock returns 𝑅𝑖 against market returns (Rm):

𝑅𝑖 = 𝑎 + 𝛽𝑖 𝑅𝑚

where 𝑎 is the intercept and 𝛽𝑖 is the slope of the regression. The slope of
the regression corresponds to the beta of the stock and measures the
riskiness of the stock.
Estimating Cost of Equity (𝑅𝑒 ) (13 of 20)

Estimating Company Beta: Financial Leverage and Beta

 The relationship between the betas of the firm’s debt, equity, and assets is
given by:

Asset = Debt × Debt + Equity × Equity

Debt + Equity Debt + Equity

 If beta of debt is assumed as equal to zero, the equation becomes:

Equity
Asset = × Equity
Debt + Equity

 Financial leverage always increases the equity beta relative to the asset
beta because asset beta is constant.
Estimating Cost of Equity (𝑅𝑒 ) (14 of 20)

Estimating Company Beta: Adjusting for Financial Leverage When

Firm Has Interest Tax Shields
 When firm has interest tax shields, sum of equity and debt becomes equal to the
sum of unlevered firm value and tax shields:
E + D = Vunlevered + t×D
Vunlevered is the value of the firm without any debt, t is tax rate. Beta equation becomes

 βu is unlevered beta, it is equal to asset beta (βAsset). βAsset and βu are used
interchangeably. βITS is the beta of the firm’s interest tax shields. If we assume
βD = 0 and βITS = βAsset then the equation above becomes:

Asset = Equity × Equity

Debt + Equity
Estimating Cost of Equity (𝑅𝑒 ) (15 of 20)

Estimating Company Beta: Adjusting for Financial Leverage When

Firm Has Interest Tax Shields
 However, if we assume that βITS = βD = 0, then the equation changes.
 If firm has interest tax shields and we assume that both beta of debt and beta of tax
shields are zero, the beta of equity alone can be written as a function of the
unlevered (asset) beta and the debt-equity ratio:

βEquity = βAsset {1+ (1-t)×(Debt/Equity)}

Equity
Asset =
1+ (1-t)×(Debt/Equity)

 You can use either this βAsset definition or the βAsset definition in the
previous slide. I use this definition more often.
Estimating Cost of Equity (𝑅𝑒 ) (16 of 20)

 Issues with Historical Equity Betas

 There are three decisions that an analyst needs to make
 Length of the estimation period: 1 vs 3 vs 5 years.
 Return interval: Using daily or intraday returns.
 Market index: S&P500 or all Nasdaq stocks…

 The historical market betas have three problems

 They have high standard errors.
 They reflect the firm’s business mix over the period of the regression, not the current
business mix.
 They reflect the firm’s average financial leverage over the period rather than the
current leverage.
Estimating Cost of Equity (𝑅𝑒 ) (17 of 20)

Alternative to Historical Beta: Bottom-up Beta

1. Identify the business or businesses that make up the firm whose beta we are trying to
estimate. Most firms provide a breakdown of their revenues and operating income by
business in their annual reports.
2. Use the unlevered (asset) betas of other public firms that are primarily or only in each
of these businesses.
I. Unlever the betas: One can compute an unlevered beta for each firm in the comparable firm
list, using the debt-to-equity ratio and tax rate for that firm.
II. Average the unlevered betas: The average beta can be a simple average, or a weighted average
based on market capitalization.
III. Adjustment for cash: Investments in cash and marketable securities have betas close to zero. To
obtain an unlevered beta cleansed of cash you apply
Corrected unlevered beta = Unlevered beta / [1 – (Cash/Firm Value)]
It’s OK if you don’t adjust your unlevered beta for cash and marketable securities.
Estimating Cost of Equity (𝑅𝑒 ) (18 of 20)

Alternative to Historical Beta: Bottom-up Beta

3. To calculate the unlevered beta of the firm, take a weighted average of the unlevered
betas of the businesses firm operates in, using the proportion of firm value derived
from each business as the weights. These business values will have to be estimated
since divisions in a firm usually do not have market values available. If these values
cannot be estimated, operating incomes or revenues can be used as weights. This
weighted average is called the bottom-up unlevered beta or asset beta.

4. Calculate the current debt-to-equity ratio for the firm, using market values if available.
If not, use the target debt-to-equity ratio specified by the management or industry-
typical debt ratios.

5. Estimate the levered beta of the firm and each of its businesses using the unlevered
beta from step 3 and leverage from step 4.
Estimating Cost of Equity (𝑅𝑒 ) (19 of 20)
Bottom-up Beta Example: Disney
Businesses # of similar firms Avg. levered beta Median D/E Unlevered beta

Media Networks 24 1.23 20.45% 1.08

Parks and Resorts 9 1.63 120.80% 0.91
Studio Entertain. 11 1.35 27.96% 1.14
Consumer Prod. 77 1.14 9.18% 1.07
 Estimated unlevered (asset) betas for Disney’s businesses are in the last column.
Value as % of Unlevered
Businesses Estimated Value
Disney beta
Media Networks 33,162.27 47.3% 1.08
Parks and Resorts 15,334.08 21.9% 0.91
Studio Entertain. 17,618.07 25.1% 1.14
Consumer Prod. 3,970.60 5.7% 1.07
Disney 70,085.02 100.0% 1.06

 Estimate the asset beta of Disney = 47.3% * 1.08 + 21.9% * 0.91 + 25.1% * 1.14 + 5.7% *1.07 = 1.06
 If Disney’ debt-to equity ratio is 40% and marginal tax rate is 35%, then we calculate its
equity beta = levered beta = 1.06 * [1 + (1-0.35)(0.40)] = 1.33
Estimating Cost of Equity (𝑅𝑒 ) (20 of 20)

Alternative to Historical Beta: Why Bottom-up Beta?

 The standard error in a bottom-up beta estimation will be significantly
lower than the standard error in a single regression beta. The standard
error will decrease in proportion to the number of firms in the sample.

 The bottom-up beta can be adjusted to reflect changes in the firm’s

business mix and financial leverage. Regression betas reflect the past.

 You can estimate bottom-up betas even when you do not have historical
stock prices. This is the case with initial public offerings, private companies
or divisions of companies.