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Corporate Models

Valuation

Oct 1, 2015

Actual Cost of Capital Process

WACC Computation and Theory

Alternative Models

Capital Asset Pricing Model

Beta Measurement

Market Premium

Asset Beta

Cost of Capital

Oct 1, 2015

A crucial issue in financial analysis is establishing the discount

rate and risk measurement using capital asset pricing models.

Financial principles of efficient markets, market expectations and

event studies lie behind a number of modeling and financial

management concepts.

The general opinion is that cost of capital is over-estimated and

compensated for with optimistic assumptions.

Recent work on cost of capital

Lower equity risk premium

CAPM discredited

Analyst growth rates are too high

Cost of Capital

Oct 1, 2015

Stanley performed a 5-year discounted cash flow analysis that included the use of

two different scenarios, or case assumptions. The Management Case reflects

Pennzoil-Quaker State management's estimates of the company's future financial

performance, excluding any future acquisitions.

The Market Case reflects publicly available estimates of Pennzoil-Quaker State's

future performance of certain securities research analysts. These cases were used

to project future cash flows which were discounted back to a present value using

a range of discount rates of 8% to 10%.

The range was determined based upon a calculation of Pennzoil-Quaker State's

weighted average cost of capital (WACC), which was calculated based upon the

WACC for comparable companies in three industry segments: Mid-Cap Consumer

Products, Auto Aftermarket and Auto OEM.

Morgan Stanley also applied a terminal EBITDA multiple of 7.0x to 9.0x to the

projected 2006 EBITDA, for purposes of calculating a terminal value of PennzoilQuaker State at the end of 2006. This terminal value together with the projected

annual un-levered free cash flows from 2002 through 2006 was then discounted to

the present, assuming cash flows occurred mid-year, using discount rates of 8% to

10%.

Cost of Capital

Oct 1, 2015

Surveys of Managers

Late Fifties

Payback period

Sixties

Present Value

Seventies (Fremgen)

Internal rate of return

Net Present Value

Eighties

Mean Cost of Capital 14.2%

Gordon model and CAPM

Nineties

Leading Investment Banks

DCF with WACC is dominant

valuation technique

WACC uses market rather than book

weights

Debt cost from marginal cost and

statutory tax rates

CAPM is predominant model for cost

of equity

Most use treasury as long-term

treasury rate

Equity premium

Majority less than 6%

Risk premium of 6%

10% use 5%

Current

Equity premium of 5% or less

Cost of Capital

Oct 1, 2015

OPFCF

FCFE

WACC

Cost of equity

Enterprise value

Equity value

The key is to match the right cash flow with the right discount rate

And to the thing being valued

Cost of Capital

Oct 1, 2015

Flow

capital in valuations.

Contracts

Risks

2001 Survey managers use 12.2%

Actual market premium is much less

Cost of Capital

Oct 1, 2015

Valuation

Oct 1, 2015

WACC Points

Use target capital structure

Use nominal cost of capital in currency consistent with the free cash flow

Should be market weights and incremental cost of capital

Tricky Items

Convertible Bonds

Lower rate is due to equity value

Bond value

Equity Option

Term of Debt

Credit Spread on Debt

Callable and No callable debt (effect on cash flow)

Cost of Capital

Oct 1, 2015

WACC Computation

In the WACC formula, we know

Debt percent

Equity percent

Cost of new debt

Income tax rate

The hard part is the cost of equity

If the capital structure changes, the cost of equity should change

In theory, if the capital structure changes, the cost of equity should change

to maintain the same overall WACC

Therefore, if the capital structure changes in the model, careful with

assumption about how the WACC changes.

Cost of Capital

10

Oct 1, 2015

Step 1:

Equity Cost from Asset Cost

Ke = Be x Rm + Rf

Ke = (Ba x (V/E)) x Rm + Rf

Step 2

Debt Cost from Rf plus Credit Spread

Kd = Rf + CS

After tax Kd

Step 3

WACC = (D/V) * Kd x (1-t) + (E/V) * Ke

Cost of Capital

11

Oct 1, 2015

WACC Problems

Whenever you have an equity-based cash flow stream like a real

estate development or something like that, there are better

techniques than using weighted average cost of capital.

Cost of Capital

12

Oct 1, 2015

Works if there are stable dividends

A variant is P/E = (1-g/r)/(k-g)

Debt capacity model (project finance)

Risk premium method (analogous to the CAPM)

K = Rf + Risk Premium

Implied cost of capital in EBITDA ratios

Arbitrage Pricing Model (extension of CAPM and related to risk neutral

valuation)

Implied cost of capital from reverse engineering financial models

(described in the M&A discussion)

Cost of Capital

13

Oct 1, 2015

CAPM: k = rf + x rm

Valuation

14 Oct 1, 2015

CAPM Inputs

Rf,i is the risk free rate for the current period (i) and it is the only variable

directly affected by movements in the overall cost of capital in the

economy.

i is the covariance between returns on the security and the market

returns divided by the overall variance of market returns. This parameter

is the only input affected by the risk of the security in question and the i

parameter is not expected to vary over time unless there is a change in

business and/or the financial risk of the company.

EMRP is the expected return on a fully diversified portfolio of equity

securities over and above the rate of return on risk free securities. This

variable is a function only of aggregate preferences by people in the

economy for risky investments versus risk free investments. It is not

affected by current interest rates, the risk of the security, or movements in

the overall stock market.

Cost of Capital

15

Oct 1, 2015

Geared Equity

Be

Asset/Ungeared

equity Ba x Market

Market Premium

Real

Average

Debt

Inflation

Plus Real

Rate - Rf

Cost of Capital

16

Oct 1, 2015

CAPM Theory

CAPM has many problems, but the basic theory upon which the

CAPM is built is a foundation of finance.

The foundation of the CAPM is:

Risk is measured by variation and standard deviation in

returns

Standard deviation is reduced from diversification

Variance (a + b) where the portfolio if a and b are have a

weight of .5 is:

.25 variance (a) + .25 variance (b) + .5 covariance(a,b)

If the covariance is zero, the variance of the portfolio is much

lower than the variance without diversification

Cost of Capital

17

Oct 1, 2015

CAPM Problems

Problems with the CAPM theory are recounted by Ravi Jagannathan and

Iwan Meier in their 2001 article Do We Need CAPM for Capital

Budgeting:

The CAPM as a model has been seriously challenged in the academic

literature. [S]ince the critique by Fama and French (1992) there is

consensus in the academic literature that the CAPM as taught in MBA

classes is not a good model it provides a very imprecise estimate of the

cost of capital. [T]here is overwhelming evidence in the academic

literature that for over two decades business schools have been teaching

the wrong model or at least recommending the use of the wrong inputs

for calculating the cost of capital.[1]

Budgeting?, Kellogg School of Management, Finance Department, pp 13.

Cost of Capital

18

Oct 1, 2015

CAPM Problems

Not only has the CAPM proved wrong, but we do not even know that the

market premium is.

Ravi Jagannathan and Iwan Meyer, Do We Need CAPM for Capital

Budgeting Kellog School of Management

Fama and French:

Statistical analysis showing no relation between returns and beta

Statistical modeling: Time series to compute the Beta and then

cross section to compute the significance

Statistical problems: errors in variables and all variables should be

based on expectations rather than actual

CAPM may be un-testable

Cost of Capital

19

Oct 1, 2015

Use of CAPM to compute equity cost of capital and cost of capital

to apply to free cash flow

Risk free rate to apply in the CAPM

Alternative methods to evaluate the risk premium for the

overall market

Data sources and computation of Beta

Adjustments to Beta to compute Beta for application to free

cash flow

Adjustments to CAPM for interest tax shield

Theoretical problems with the CAPM

Alternative approaches to the CAPM

Cost of Capital

20

Oct 1, 2015

The CAPM requires estimation of three components (Rf, Rm and Beta).

Each of these has some controversy.

Rf

Should the long-term treasury rate be used

Country premiums

Rm

Method of estimation expected returns

Actual use in practice

Beta

Estimation

Accuracy

Cost of Capital

21

Oct 1, 2015

Valuation

22 Oct 1, 2015

There are debates concerning implementation of the risk free rate in the

CAPM.

Some suggest using long-term Treasury bond yields, some

advocate short-term Treasury Bills and still others argue for use of

the yield on inflation indexed bonds plus the expected rate of

inflation.

The primary argument against using long-term Treasury Bond yields

as a proxy for the risk free rate is that holders of long-term bonds

accept inflation risk and those yields are therefore not risk-free.

Further, during times at which an inverted yield curve exists, the

long-term treasury yield will produce a lower risk free parameter than

the Treasury Bill rate.

Those opposed to use of a short-term rate contend that the duration

of cash flows from short-term investments does not match the

duration of cash flows received from an investment in a stock.

Cost of Capital

23

Oct 1, 2015

The primary issue in estimating the risk free rate is what risk free

security should be used:

Common equity pays cash flow to investors over a long

period

In theory the duration of dividends could be computed

Use t-bill yield to maturity of 10 years

Example

Treasury Bond Yield -- 2016 -- 5.53%

Treasury Bond Yield -- 2011 -- 4.98%

Cost of Capital

24

Oct 1, 2015

CH

HK

ID

MA

TH

KO

IN

PH

SI

TW

HKMA Hong Kong Exchange Fund Notes 10 Years

Indonesia SBI 1 Month Auction Average Yield

Malaysia Government Bonds 10 Year Government

Thailand Government Bonds 10 Year Note

South Korea 10 Year Government Generic

India Government Bonds 10 Year

Philippines Generic 10-Year Fix Treasury Note T-Bond

Monetary Authority of Singapore - Government Benchmark : 10 Year Yield

Taiwan Government Bonds 10 Year Note Generic Bid Yield

Cost of Capital

25

Oct 1, 2015

Cost of Capital

26

Oct 1, 2015

Valuation

27 Oct 1, 2015

The EMRP is expressed in real terms and is not a nominal number. This means the EMRP does

not increase or decrease when interest rates change or when the expected rate of inflation

changes. It would be wrong, for example, to update this number in the midst of a case because of

changes in the interest rate.

The EMRP comes from the general risk preferences of agents in an economy for equities relative

to risk free securities. If people did not have risk aversion for equities relative to risk free bonds,

the EMRP would be zero. This means changes in the EMRP are driven by changes in general

preferences for equities relative to risk free securities. Because the EMRP comes from risk

preferences, it should be stable over long time periods as risk preferences do not swing from

month to month or year to year.

Third, the EMRP is an expected number rather than a number that can be directly measured from

actual realized returns. The fact that the EMRP is an expected number means that it does not

change when the stock market goes up or down because realized earnings change or because

general economic activity is robust or depressed.

Fourth, the EMRP is an economy wide number not unique to ComEd. Unlike Beta which

measures the risk associated with a specific company, the EMRP is the same whether it is used in

valuing a paper company, gauging the rate of return for an oil project or assessing the share price

of an airline company.

Fifth, the EMRP has been the subject of a very large body of research. This research has been

performed by people who are not funded by parties who have a vested interest in producing a

particularly high or a particularly low risk premium number. Since the EMRP is not unique to

ComEd, since it is an expected number difficult to calculate, and since it is not expected to change

over short time periods, the EMRP research is directly relevant to this and other regulatory

proceedings.

Cost of Capital

28

Oct 1, 2015

Enrique Arzac recaps a wide body of research by stating We show that

both the historic record, financial theory, and prospective estimates based

on stock prices and growth expectations, all indicate that the future equity

premium in developed capital markets is likely between 3 and 5%...

Seth Artimage summarizes many different studies by noting: Consensus

is lacking at present on the best way of estimating the equity premium,

and reasonable estimates lie in the rage of 1% or 5%...

Koller et al. describe the general biases in EMRP: Historical estimates

found in most textbooks (and locked in the mind of many), which often

report numbers near 8% are too high for valuation purposes because they

compare the market risk premium versus short-term bonds, use only 75

years of data, and are biased by the historical strength of the U.S. market.

Cost of Capital

29

Oct 1, 2015

Historic EMRP

Enrique Arzac refers to research by Blanchard who developed a

dynamic model of the expectations of real returns on stocks and

bonds. He found that the risk premium during the 1930s and

1940s was unusually high ranging from 3 to 5% in the early

1930s to more than 10% in the 1940s. Afterwards, it started a

gradual decline with some relatively minor fluctuations and

reached between 2 and 3% in the early 1990s.

Claus and Thomas emphasize the notion that historic returns

exceed the expected amounts: Despite substantial variation in

the underlying fundamentals across markets and over time,

observing that every one of our 69 country-year estimates lies

well below eight percent suggests that the Ibbotson estimate is

too high for our sample period.

Cost of Capital

30

Oct 1, 2015

Seth Armitage describes the DCF studies as follows: The arithmetic mean real

premium between 1900 and 2000 was 7.0% for the United States, measured

against the yield on long-term bonds. But a simple forward looking estimate based

on applying the dividend discount model to the market suggests a risk premium of

3% to 4%. This is why many people do not expect the premium in the future to be as

large as it has been in the past, especially in the second half of the twentieth century.

They place more faith in reasonable expectations about the future than in outcomes

observed in recent decades. Furthermore, several researchers have argued recently

that investors did not expect premiums as large as they got in the twentieth century.

Armitage concludes that Most of the studies indicate a range for historic ex ante

premiums of between 1.5% and 4.5% -- considerably below the actual arithmetic

mean premium since 1920

Enrique Arzac uses a DCF model to estimate the equity market premium of between

3.08% and 3.32%.

In their widely cited 2002 article, Fama and French state that the equity premium

estimates from the dividend and earnings growth models, 2.55 percent and 4.32

percent, are far below the estimate from the average return, 7.43 percent.The

expected return estimates from the dividend and earnings growth models are more

precise than the average return. The standard error of the dividend growth estimate

of the expected return for 1951 to 2000 is 0.74 percent, versus 2.43 percent for the

average stock return.The earnings growth model is not, however, clearly superior

to the dividend growth model.

Cost of Capital

31

Oct 1, 2015

Surveys of Investors

In the US, Merrill Lynch publishes bottom up expected returns on the Standard

and Poors 500, derived by averaging expected return estimates for stocks in the

Standard & Poors 500.In recent years, the Merrill Lynch expected return

estimates have indicated an EMRP in the region of 4% to 5%.

The Value Line projected market risk premia are somewhat more volatile than those

from the Merrill Lynch DDM model. In recent years they have generally ranged from

2% to 6%....

Greenwich Associates had published the results of an annual survey of pension plan

officers regarding expected returns on the Standard and Poors 500 for a five-year

holding period. The Greenwich Associates survey has generally indicated and

EMRP in a 2%-3% range.

Claus and Thomas also cite investor expectations. They summarize the information

as follows: Surveys of institutional investors also suggest an equity premium

substantially below eight percent (e.g., Burr (1998)), and there are indications that

this belief has been held for many years (e.g., Benore (1983)) . Also, the weighted

average cost of capital used in discounted cash flow valuations provided in analysts

research reports usually implies an equity premium below five percent.

Cost of Capital

32

Oct 1, 2015

Risk Premium

There is a wide range in premiums used in theory and practice. The following

shows results from one study.

Cost of Capital

33

Oct 1, 2015

A well known study by Fama and French, published in 2002, finds that

estimates [of the equity market risk premium] for 1951 to 2000, 2.55

percent and 4.32 percent, are much lower than the equity premium

produced by the average stock return, 7.43 percent.

In another oft cited paper published in 2001 by Claus and Thomas titled

Equity Premia as Low as Three Percent? Evidence from Analysts

Earnings Forecasts for Domestic and International Stock Markets, the

authors conclude that for each year between 1985 and 1998, we find that

the equity premium is around three percent (or less) in the United States

and five other markets.

The Cost of Capital: Intermediate Theory which was published in 2005

summarizes the current research as follows: Almost all researchers on

this question agree that the premium in the twentieth century in the United

States has turned out to be larger than investors expected it to be.

Cost of Capital

34

Oct 1, 2015

The market premium is unobservable

Studies have attempted to measure the expected market premium using the PE

method

Actual Market Risk Premiums

1926-1998

Arithmetic 7.8%

Geometric 5.9%

1974 1998

Arithmetic 5.5%

Geometric 4.9%

1964 1998

Arithmetic 4.7%

Geometric 3.6%

Cost of Capital

35

Oct 1, 2015

McKinsey -- 4.50%

Cost of Capital

36

Oct 1, 2015

Hong Kong equity premium calculation

The median estimate of ERP is in the 4-5% range for mature markets

Cost of Capital

37

Oct 1, 2015

premium

premium should be an expected return rather than the historical

actual returns that may or may not have been expected:

Real time now matters more than historic periods.

Samples drawn from the past have little relevance to what

investors expect now.

What was 75% probable yesterday has an unknown

probability tomorrow.

Cost of Capital

38

Oct 1, 2015

Beta

Valuation

39 Oct 1, 2015

The table below shows that beta measurement can be

dramatically different for the same companies.

Cost of Capital

40

Oct 1, 2015

Betas

Cost of Capital

41

Oct 1, 2015

Beta Measurement

Beta is cov(Rm,Rt)/variance(Rm)

Cost of Capital

42

Oct 1, 2015

Beta Adjustments

Value Line computes its beta from a regression equation that

measures an unadjusted beta. Then, Value Line adds an

adjustment to move the beta toward 1.0 using the following

equation[1]:

Adjusted beta = 2/3 x Unadjusted beta + 1/3 x 1.0

or

Unadjusted beta = Adjusted beta x 3/2 1/2

Estimation, Westport CT: Quorum Books, p. 130.

Cost of Capital

43

Oct 1, 2015

The adjustment for betas is generally accepted in cost of capital

literature for companies with betas above 1.0 because of a

tendency of betas to revert to the mean. Statistical studies have

demonstrated that there appeared to be greater measurement

error associated with the betas of extreme values.[1] The mean

reversion adjustment is accepted for companies with observed

high betas. The risk of these high beta companies often moves

towards 1.0 over time due to statistical measurement problems

and due to the tendency of high business risk companies to

eventually moderate. However, the mean reversion is far less

accepted for utility companies with betas of below 1.0.

[1] Ogier, T, Rugman, J., Spicer, L., 2004, The Real Cost of

Capital A Business Field Guide to Better Financial Decisions,

Great Britain: FT Prentice Hall, page 54.

Cost of Capital

44

Oct 1, 2015

The case of NICOR demonstrates that using a mean reversion adjustment wherein

betas are pushed towards 1.0 to correct statistical irregularity is inappropriate for utility

companies. Instead, the statistical anomalies should push the beta back to the industry

average beta for utility companies. The 1.10 beta obviously does not measure

prospective risk and making a correction by moving the beta towards 1.0 would not

help. The NICOR example effectively demonstrates that mean reversion adjustments

of utility betas are not appropriate. These adjustments do not improve the

measurement of beta but instead simply result in increased cost of equity numbers.

NICOR and S&P Indicies: Beta from 02/00 to 12/05 -- 0.50

Beta from 07/02 to 12/05 -- 1.18 Beta from 02/00 to 07/03 -- 0.53

Beta from 08/03 to 12/05 -- 0.32

1.60

Index

1.40

NICOR

1.20

S&P 500

1.00

0.80

Cost of Capital

9/3/2005

5/3/2005

1/3/2005

9/3/2004

5/3/2004

1/3/2004

9/3/2003

5/3/2003

1/3/2003

9/3/2002

5/3/2002

1/3/2002

9/3/2001

5/3/2001

1/3/2001

9/3/2000

5/3/2000

1/3/2000

0.60

45

Oct 1, 2015

Without Taxes

Ba = (D/V)*Bd + (E/V)*Be

Be measured with stock prices

D,V,E are debt, enterprise value and equity value measured at

market value.

Often assume Bd = 0

With taxes

Ba = (D x (1-t))/(E+D*(1-t)) * Bd + (E/(D*(1-t) + E *(1-t))*Be

Assumes that all cash flows from debt are tax deductible

Cost of Capital

46

Oct 1, 2015

Cathay Pacific has an observed beta of 1.3 and a debt to equity

ratio of 50%. Singapore Airlines has a debt equity ratio of 25%.

Calculate the equity beta of Singapore Airlines. The tax rates in

Hong Kong and Singapore are 15 and 20% respectively.

Cost of Capital

Equity beta

Debt/ Equity

Asset beta

CPA

1.3

50%

0.91

SIA

1.09

25%

0.91

47

Oct 1, 2015

The WACC

Slide shows

the relation

between the

WACC and

the Asset

Beta

Cost of Capital

48

Oct 1, 2015

Asset Beta

Cost of Capital

49

Oct 1, 2015

Additional Premiums for

Size

Liquidity

Three Factor Model: Size,

Beta, Market to Book

Arbitrage Pricing Model

Liquidity Dimensions

Size

Time

Quantity

Cost of Capital

50

Oct 1, 2015

k = D1/P + g

Valuation

51 Oct 1, 2015

DCF Issues

How should one select an appropriate sample of comparable

companies with similar risk to ComEd to derive the implied cost of

equity capital;

What method should be used to compute the constant expected

growth rate of marginal investors for each company in the

comparable sample;

Whether a valuation model for using earnings is a better way to

derive the implicit cost of equity capital than dividend growth

model; and,

Should adjustments for quarterly compounding be made in

deriving implicit discount rates.

Cost of Capital

52

Oct 1, 2015

In their text titled Valuation: Measuring and Managing the Value of Companies

published in 2005, Tim Koller, Marc Goedhart and David Wessels state that analyst

forecasts focus on the short term and are severely upward biased.

Enrique Arzac comments on the difficulty of predicting growth rates and the potential

for the DCF model to over-estimate the cost of equity as follows: The problem with

[the DCF] approach is that long-term dividend growth rate of an individual company

cannot be estimated with any degree of precision. Hence, the dividend growth

model is not likely to produce reliable estimates of the cost of equity capital of

individual companies.A number of empirical studies have documented optimistic

bias in analysts opinions.Thus, it seems reasonable to conclude that [the DCF

equation] yields an upper bound to the equity premium.

Claus and Thomas conclude that earnings and dividend growth rates used for the

DCF model exhibit substantial optimism bias and need to be adjusted downward.

Louis Chan and his coauthors conclude that over the period 1982 to 1998, the

median of the distribution of IBES growth forecasts is about 14.5 percent, a far cry

from the median realized five year growth rate of about 9 percent for income before

extraordinary items.

Fama and French state that In short, we find no evidence to support a forecast of

strong future dividend or earnings growth at the end of our sample period.

Cost of Capital

53

Oct 1, 2015

If the dividend payout ratio is 100% then even when a utility is currently

earning more than its cost of capital (such as Exelon and NICOR) the

earnings and book value do not grow (unless equity is issued at a market

to book value above 1.0). Since the equity base does not increase

because no earnings are retained, a constant future return on equity

applied to a constant amount of equity means that the income also

remains constant. With no earnings growth, the EPS growth is zero.

At the other extreme, if the dividend payout ratio is zero, then earnings

increase book value of equity on a one for one basis. In this case without

dividend payments (again assuming a constant return on equity) the book

value of equity increases by the return on equity multiplied by the initial

amount of equity on the balance sheet. Assuming a constant return is

multiplied by the book value that increases at a growth rate defined by the

return on equity, the earnings also growth at the return on equity. This is

the growth rate implied by the formula above.

For intermediate cases where the dividend payout is between zero and

one, the growth rate in earnings is the return on equity multiplied by one

minus the dividend payout ratio under the assumption of a constant return

on equity.

Cost of Capital

54

Oct 1, 2015

Residual value

Relative valuation

Cost of Capital

55

Oct 1, 2015

of multiples to the estimated EPS in fiscal year 2009 and the

dividend streams and terminal values were then discounted to the

present using a range of discount rates representing an estimated

range of the cost of equity for each of PSEG and Exelon. Based

on this analysis, Morgan Stanley calculated per share values for

PSEG ranging from $42.75 to $47.10. Morgan Stanley noted that

the implied consideration to be paid for each share of PSEG

common stock was $53.14 as of December 15, 2004, which was

greater than the range implied by this analysis. In addition, based

on this analysis, Morgan Stanley calculated per share values for

Exelon ranging from $38.15 to $42.01 and noted that the closing

price of Exelon common stock on December 15, 2004 was

$43.38, which was greater than the range implied by this analysis.

Cost of Capital

56

Oct 1, 2015

Company Profiles

Cost of Capital

57

Oct 1, 2015

Compute free cash flow from calculations sheet in the corporate

model

Apply different discount rates to the free cash flow

Assume the final year cash flow occurs into perpetuity

Compute enterprise value, equity value and equity value per

share

Cost of Capital

58

Oct 1, 2015

Using the same discount rate is a very lose form of risk neutral

valuation

Using the this process illustrates how your stock is the currency

of the transaction

Value your company using a set of base case assumptions

Back into the discount rate that makes the value in the

model equal to the current market value

Use same discount rate and same set of assumptions to

value the target

Cost of Capital

59

Oct 1, 2015

Valuation

60 Oct 1, 2015

Objectives of APV

NPV assumes

Capital structure remains the same

Leveraged Buyout

NOL

Changing WACC

Distortions in WACC for capital structure

Changing tax rates

Cost of Capital

61

Oct 1, 2015

Value the Company as if it were entirely financed by equity using

the statutory income rates

Add the tax shields due to interest expense separately and use

the debt discount rate to value this shield

Compute the present value of net operating losses using the

equity discount rate

Cost of Capital

62

Oct 1, 2015

Steps

Present Value of Free Cash Flow at discount rate using Ba

without tax adjustments

Present value of tax shield from interest at the debt rate

Present Value of net operating loss

Interest Tax Shield

PV of interest x tax rate

Plus: terminal value of debt

Cost of Capital

63

Oct 1, 2015

WACC

Tax shield in the discount rate

Different accounting for NOL (WACC must use changing

effective tax rates)

Changing value of debt

Timing of debt repayments

Example

Same operating cash flows

Alternative debt payoff assumptions

Cost of Capital

64

Oct 1, 2015

APV (No taxes)

K = Ba x (Rm) + Rf

Since Ba = (E/V) x Be + 0

WACC = (E/V) x Be x Rm + Rf

Normal WACC assuming Rf = Kd

WACC = (E/V) x (Be x Rm + Rf) + (D/V) x Kd

WACC = (E/V) x (Be x Rm + Rf) + (D/V) x Rf

WACC = (E/V) x (Be x Rm ) + Rf

Since Kd = Rf + Credit Spread

WACC = (E/V) x (Be x Rm) + (E/V) * Rf + (D/V) * (Rf + Credit Spred)

Cost of Capital

65

Oct 1, 2015

APV Case

Cost of Capital

66

Oct 1, 2015

A stable growth rate is a growth rate that can be sustained

forever. Since no firm, in the long term, can grow faster than

the economy which it operates it - a stable growth rate

cannot be greater than the growth rate of the economy.

It is important that the growth rate be defined in the same

currency as the cash flows and that be in the same term (real

or nominal) as the cash flows.

In theory, this stable growth rate cannot be greater than the

discount rate because the risk-free rate that is embedded in

the discount rate will also build on these same factors - real

growth in the economy and the expected inflation rate.

Cost of Capital

67

Oct 1, 2015

The most common errors in dividend discount model

valuation are in the assumptions about the payout ratio as

the growth rate changes.

Many high growth firms either pay low dividends or no

dividends. As the growth rate changes, the dividend payout

ratio should rise. If it does not, these firms will not be worth

much using these models.

Cost of Capital

68

Oct 1, 2015

The asset beta can be computed using the formula:

B(asset) = B(equity) x (Equity/EV) + B(debt) x (Debt/EV)

The weights must be at market value

geared ungeared 1

Ve

thus

ungeared

Cost of Capital

geared

Vd(1- Tax rate)

Ve

69

Oct 1, 2015

One of the slides says we should use 10-year treasury as

risk-free rate. It would be helpful to give more depth, such

as, do you use a 10-year US government bond or local

currency bond and why not 30-years bond rather than 10year bond.

In theory, the duration of the risk free rate should be the same as

the duration of the equity cash flows to eliminate interest rate risk.

To see this, consider the venture capital example when the cash

flows all occurred in 7 years. Pretend that somehow the cash

flow could be hedged in futures markets in year 7 and there is no

risk. In this example, a risk free zero coupon rate bond that

matures in 7 years would clearly match the cash flow of the

equity. A bond with a seven year duration would accomplish this.

Cost of Capital

70

Oct 1, 2015

One of the slides says we should use 10-year treasury as

risk-free rate. It would be helpful to give more depth, such

as, do you use a 10-year US government bond or local

currency bond and why not 30-years bond rather than 10year bond.

In practice of course, the duration of equity cash flows is not

known. The duration is computed using the formula:

Duration = (t x PV of Cash Flow)/Present Value

The duration can be computed for a 10 year bond and for equity

as illustrated in the following slides.

Cost of Capital

71

Oct 1, 2015

Cost of Capital

72

Oct 1, 2015

One of the slides says we should use 10-year treasury as

risk-free rate. It would be helpful to give more depth, such

as, do you use a 10-year US government bond or local

currency bond and why not 30-years bond rather than 10year bond.

Practical The 10-year rate is less susceptible to two problems

involved in using a longer rate, such as a 30 year Treasury Bond

rate. Its price is less sensitive to unexpected changes in inflation

and so has a smaller beta that the thirty year rate. Also, the

liquidity built into 10 year rates may be lower than that of 30 year

bonds.

Cost of Capital

73

Oct 1, 2015

Rather than just providing the formula of WACC, it would be

useful to give instructions on where to find the market

premium data, betas and what is the best method vs the

most practical method.

Should we include country risk, exchange rate risks etc and

how to get them.

Copeland says: the most common errors in setting the

WACC are:

Making ad hoc adjustments for risk, and

Using the WACC to discount foreign currency cash flow

Cost of Capital

74

Oct 1, 2015

Rather than just providing the formula of WACC, it would be useful to

give instructions on where to find the market premium data, betas

and what is the best method vs the most practical method.

Example: Assume that you are valuing Dragon Air and there is no

Beta available for this company.

Assume you use US Airlines with and that the average Beta is 1.0.

The Beta is Cov(Rm,Ri)/Var(Rm)

In this case Rm is US Market

Cost of Capital in US is Rf+Rm

Cost of capital in HK should by Rf(HK) + Rm (US),

not Rf(HK) + Rm (HK), because the Beta was computed from the US Rm

Use US Rm, otherwise, the Beta would not be consistent with the

Rm

Cost of Capital

75

Oct 1, 2015

Try some very simple steps:

Divide the market into three beta groups

Above average 1.2

Below average

Average

.8

1.0

Find out what investors expect in local markets in terms of the premium

above the risk free rate.

E.g. 5% in London and 7% in China

Add the local risk free rate to the market premium adjusted for the three

categories of beta.

Make adjustments for country risk with political risk insurance rates

Cost of Capital

76

Oct 1, 2015

Assume that Rm in Hong Kong is 7% and the Rm is the US is

5%.

If Beta is used for a comparable 1.0 and is measured in the US,

the expected return is 5% plus the Rf. This reflects the return

investors require to be compensated for risk. If it is applied to a

company with similar risks in Hong Kong, the

If this Beta is applied to the Hong Kong Rm, the cost of capital

implied is 7% plus the Rf.

Cost of Capital

77

Oct 1, 2015

Rather than just providing the formula of WACC, it would be

useful to give instructions on where to find the market

premium data, betas and what is the best method vs the

most practical method.

In computing WACC in a merger, should you use the

incremental cost of debt for the target or the acquirer

Often the debt is retired, in which case it is clear that the

cost of debt of the acquirer should be used

Future debt will be financed by the acquirer not the target, so

the acquirer cost of debt should be used

The value of debt in the valuation should also be at the

acquirer cost of debt as in the example we developed in class

Cost of Capital

78

Oct 1, 2015

Rather than just providing the formula of WACC, it would be

useful to give instructions on where to find the market

premium data, betas and what is the best method vs the

most practical method.

To compute premiums for country risk, I suggest using risk

insurance premiums that are offered by institutions such as

the ADB.

The ADB provides insurance for nationalization, non

conversion of currency and contract abrogation. After these

risks are removed, the risk should be similar to places where

these risks are not present.

The ADB provides percentages to add to debt which can be

added to the Rf

Cost of Capital

79

Oct 1, 2015

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