Value of Firm/Project when you use WACoC or add ITS

to the value of the unlevered firm is the same

Leverage and Cost of

Equity
Leverage and Expected Returns
Market Value Balance Sheet example

Asset Value 100 Debt (D) 40

•
Equity (E) 60
Asset Value 100 Firm Value (V) 100

Kd = 7.5% Ka = Kd*(D/(D+E))+Ke*(E/(D+E))
Ke = 15% = .075*(40/100) + .15*(60/100)
= 12.75%
Can we find the levered cost of equity

• Ke=Ka+(D/E)*(Ka-Kd)
• What if you want to adjust this for taxes
• =Ka+(D*(1-t)/E)*(Ka-Kd)
• OR
• =Ka+(D/E)*(Ka-Kd*(1-t))

11
Dialogue
• Will the MRP change for Infosys or Tata Steel?
• Will the Rf change while valuing Infosys or Tata Steel?
• So ceteris paribus we can replace K with b..
 •Two Financing Rules:
•Financing Rule 1: Fixed Amount of Debt
•Financing Rule 2: Constant Debt to Firm Value

Leverage and
Beta
 Equity Betas and Leverage:
Financing Rule 1
• Financing Rule 1: Constant Amount of Debt
• The beta of equity alone can be written as a function of the
unlevered beta and the debt-equity ratio
L = u (1+ ((1-t)D/E))
where
L = Levered or Equity Beta
u = Unlevered Beta (Asset Beta)
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
 Equity Betas and Leverage:
Financing Rule 2
• Financing Rule 2: Constant Proportion of Debt
• The beta of equity alone can be written as a function of the
unlevered beta and the debt-equity ratio
L = u (1+D/E)
where
L = Levered or Equity Beta
u = Unlevered Beta (Asset Beta)
t = Corporate marginal tax rate
D = Market Value of Debt
E = Market Value of Equity
 Bottom-up Betas
• The bottom up beta can be estimated by :
• Taking a weighted (by sales or operating income) average of the unlevered betas of the different businesses a
firm is in.

(The unlevered beta of a business can be estimated by looking at other firms in the same
business)
• Lever up using the firm’s debt/equity ratio

• The bottom up beta will give you a better estimate of the true beta when
• It has lower standard error (SEaverage = SEfirm / √n (n = number of firms)
• It reflects the firm’s current business mix and financial leverage
• It can be estimated for divisions and private firms.

• Adjusting for Operating Leverage—Hamada, R.S. , 1972, “The Effect of

Firms Capital Structure on Systematic risk of Common Stocks, Journal of
Finance, 27, pp 435-452
Comparable Firms?
Can an unlevered beta estimated using U.S. steel companies be used to
estimate the beta for an Argentine steel company?
Yes
No
III. Estimating Growth

DCF Valuation
Growth Rates
• Historical Growth
• (3-5-10 years CAGR)
• Analyst Estimates
• Tend to be short term
• Based on DDM
• What is a sustainable growth rate?
• ROE*Retention Ratio
• Why do you call it sustainable?
• Because this growth is sustained entirely by internal sources of
financing
I. Expected Long Term Growth in EPS
• When looking at growth in earnings per share, these inputs can be cast as follows:
Reinvestment Rate = Retained Earnings/ Current Earnings = Retention Ratio
Return on Investment = ROE = Net Income/Book Value of Equity
• In the special case where the current ROE is expected to remain unchanged
gEPS = Retained Earningst-1/ NIt-1 * ROE
= Retention Ratio * ROE
= b * ROE
• Proposition 1: The expected growth rate in earnings for a company
cannot exceed its return on equity in the long term.
II. Expected Growth in Net Income
• The limitation of the EPS fundamental growth equation is that it
focuses on per share earnings and assumes that reinvested earnings
are invested in projects earning the return on equity.
• A more general version of expected growth in earnings can be
obtained by substituting in the equity reinvestment into real
investments (net capital expenditures and working capital):
Equity Reinvestment Rate = (Net Capital Expenditures + Change in Working Capital) (1 - Debt Ratio)/ Net
Income
Expected GrowthNet Income = Equity Reinvestment Rate * ROE
III. Expected Growth in EBIT And Fundamentals:
Stable ROC and Reinvestment Rate
• When looking at growth in operating income, the definitions are
Reinvestment Rate = (Net Capital Expenditures + Change in WC)/EBIT(1-t)
Return on Investment = ROC = EBIT(1-t)/(BV of Debt + BV of Equity)

• Reinvestment Rate and Return on Capital

gEBIT = (Net Capital Expenditures + Change in WC)/EBIT(1-t) * ROC
= Reinvestment Rate * ROC
• Proposition: The net capital expenditure needs of a firm, for a given
growth rate, should be inversely proportional to the quality of its
investments.
Growth Rates
No Net Capital Expenditures and Long Term
Growth
• You are looking at a valuation, where the terminal value is based upon
the assumption that operating income will grow 3% a year forever,
but there are no net cap ex or working capital investments being
made after the terminal year. When you confront the analyst, he
contends that this is still feasible because the company is becoming
more efficient with its existing assets and can be expected to increase
its return on capital over time. Is this a reasonable explanation?
 Yes
 No
• Explain.
IV. Closure in Valuation
Getting Closure in Valuation
• A publicly traded firm potentially has an infinite life. The value is
therefore the present value of cash flows forever.

• Since we cannot estimate cash flows forever, we estimate cash flows

for a “growth period” and then estimate a terminal value, to capture
the value at the end of the period:
Ways of Estimating Terminal Value

Terminal Value

Liquidation Multiple Approach Stable Growth

Value Model

Most useful Easiest approach but Technically soundest,

when assets makes the valuation but requires that you
are separable a relative valuation make judgments about
and when the firm will grow
marketable at a stable rate which it
can sustain forever,
and the excess returns
(if any) that it will earn
during the period.
Stable Growth and Terminal Value
•When a firm’s cash flows grow at a “constant” rate forever, the present value
of those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of Capital)
g = Expected growth rate

•This “constant” growth rate is called a stable growth rate and cannot be higher
than the growth rate of the economy in which the firm operates.
•While companies can maintain high growth rates for extended periods, they
will all approach “stable growth” at some point in time.
•When they do approach stable growth, the valuation formula above can be
used to estimate the “terminal value” of all cash flows beyond.
Limits on Stable Growth
• The stable growth rate cannot exceed the growth rate of the economy
but it can be set lower.
• If you assume that the economy is composed of high growth and stable growth firms, the growth rate
of the latter will probably be lower than the growth rate of the economy.
• The stable growth rate can be negative. The terminal value will be lower and you are assuming that
your firm will disappear over time.
Growth Patterns
• A key assumption in all discounted cash flow models is the period of
high growth, and the pattern of growth during that period. In general,
we can make one of three assumptions:
• there is no high growth, in which case the firm is already in stable growth
• there will be high growth for a period, at the end of which the growth rate will drop to the stable
growth rate (2-stage)
• there will be high growth for a period, at the end of which the growth rate will decline gradually to a
stable growth rate(3-stage)
• Each year will have different margins and different growth rates (n stage)
Determinants of Growth Patterns
•Size of the firm
• Success usually makes a firm larger. As firms become larger, it becomes much more difficult for them to
maintain high growth rates

•Current growth rate

• While past growth is not always a reliable indicator of future growth, there is a correlation between current
growth and future growth. Thus, a firm growing at 30% currently probably has higher growth and a longer
expected growth period than one growing 10% a year now.

•Barriers to entry and differential advantages

• Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and
differential advantages.
• The question of how long growth will last and how high it will be can therefore be framed as a question
about what the barriers to entry are, how long they will stay up and how strong they will remain.
Which Growth Pattern Should I use?
• If your firm is
• large and growing at a rate close to or less than growth rate of the economy, or
• constrained by regulation from growing at rate faster than the economy
• has the characteristics of a stable firm (average risk & reinvestment rates)
Use a Stable Growth Model
• If your firm
• is large & growing at a moderate rate or
• has a single product & barriers to entry with a finite life (e.g. patents)
Use a 2-Stage Growth Model
• If your firm
• is small and growing at a very high rate or
• has significant barriers to entry into the business
• has firm characteristics that are very different from the norm
Use a 3-Stage or n-stage Model
The Building Blocks of Valuation
Summary
Generic DCF Valuation Model

DISCOUNTED CASHFLOW VALUATION

Expected Growth
Cash flows Firm: Growth in
Firm: Pre-debt cash Operating Earnings
flow Equity: Growth in
Net Income/EPS Firm is in stable growth:
Equity: After debt
Grows at constant rate
cash flows
forever

Terminal Value
CF1 CF2 CF3 CF4 CF5 CFn
Value .........
Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate
Firm:Cost of Capital

Equity: Cost of Equity

 EQUITY VALUATION WITH DIVIDENDS

Dividends Expected Growth

Net Income Retention Ratio *
* Payout Ratio Return on Equity
= Dividends Firm is in stable growth:
Grows at constant rate
forever

Terminal Value= Dividend n+1 /(ke-g n)

Dividend 1 Dividend 2 Dividend 3 Dividend 4 Dividend 5 Dividend n
Value of Equity .........
Forever
Discount at Cost of Equity

Cost of Equity

Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
 Financing Weights EQUITY VALUATION WITH FCFE
Debt Ratio = DR

Cashflow to Equity Expected Growth

Net Income Retention Ratio *
- (Cap Ex - Depr) (1- DR) Return on Equity
- Change in WC (!-DR) Firm is in stable growth:
= FCFE Grows at constant rate
forever

Terminal Value= FCFE n+1 /(ke-g n)

FCFE1 FCFE2 FCFE3 FCFE4 FCFE5 FCFEn
Value of Equity .........
Forever
Discount at Cost of Equity

Cost of Equity

Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
- In same currency and + - Measures market risk X
risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium Premium
 VALUING A FIRM

Cashflow to Firm Expected Growth

EBIT (1-t) Reinvestment Rate
- (Cap Ex - Depr) * Return on Capital
Firm is in stable growth:
- Change in WC
= FCFF Grows at constant rate
forever

Terminal Value= FCFF n+1 /(r-gn)

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn
Value of Operating Assets .........
+ Cash & Non-op Assets Forever
= Value of Firm
Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))
- Value of Debt
= Value of Equity

Cost of Equity Cost of Debt Weights

(Riskfree Rate Based on Market Value
+ Default Spread) (1-t)

Riskfree Rate :
- No default risk Risk Premium
- No reinvestment risk Beta - Premium for average
X
- In same currency and + - Measures market risk risk investment
in same terms (real or
nominal as cash flows
Type of Operating Financial Base Equity Country Risk
Business Leverage Leverage Premium for Premium
a mature eq
market
The Cost of Equity: A Recap

Preferably, a bottom-up beta,

based upon other firms in the
business, and firm’s own financial
leverage

Cost of Equity = Riskfree Rate + Beta * (Risk Premium)

Has to be in the same Historical Premium Implied Premium

currency as cash flows,
and defined in same terms
(real or nominal) as the
cash flows
1. Mature Equity Market Premium: Based on how equity
Average premium earned by or market is priced today
stocks over T.Bonds in U.S. and a simple valuation
2. Country risk premium = model
Country Default Spread* ( Equity/Country bond)
Assignment
Ch 8: 3,6,7,13,18,20
Ch 10: 1,4,5,6
Ch 11: 3,4
 Chapter 8
Ch -8.3

Biogen Inc., a biotechnology firm, had a beta of 1.70 in 1995. It had no

debt outstanding at the end of that year. (MRP=5.5%)

a. Estimate the cost of equity for Biogen if the Treasury bond rate is 6.4%.

b. What effect will an increase in long-term bond rates to 7.5% have on

Biogen’s cost of equity?

c. How much of Biogen’s risk can be attributed to business risk?

Chapter 8
• Ch-8.6

• Safecorp, which owns and operates grocery stores across the United States, currently has
$50 million in debt and $100 million in equity outstanding. Its stock has a beta of 1.2. It
is planning a leveraged buyout (LBO), where it will increase its debt-to-equity ratio of 8.
If the tax rate is 40%, what will the beta of the equity in the firm be after the LBO?
Chapter 8
• Ch-8.7

• Novell, which had a market value of equity of $2 billion and a beta of

1.50, announced that it was acquiring WordPerfect, which had a market
value of equity of $1billion and a beta of 1.30. Neither firm had any debt
in its financial structure at the time of the acquisition, and the corporate
tax rate was 40%.

• a. Estimate the beta for Novell after the acquisition , assuming that the
entire acquisition was financed with equity.

• b. Assume that Novell had to borrow the 1$ billion to acquire

WordPerfect. Estimate the beta after the acquisition.
Chapter 8
Ch-8.13
You run a regression of monthly returns of Mapco Inc., an oil – and gas- production
firm, on the S &P 500 index, and come up with the following output for the period
1991 to 1995.
Intercept of the regression = 0.06%
Slope of the regression = 0.46
Standard error of X-Coefficient = 0.20
R-squared = 5%
There are 20 million shares outstanding , and the current market price is $2 per share.
The firm has $20 million in debt outstanding . (The firm has a tax rate of 36%)
a. What would an investor in Mapco’s stock require as a return if the T-bond rate is
6%?
b. What proportion of this risk is diversifiable?
C. Assume now that Mapco has three divisions of equal size (in market value terms). It plans to
divest itself of one of the divisions for $20 million in cash and acquire another for $50 million
(it will borrow $30 million to complete this acquisition ). The division is its divesting is in a
business line where the average unlevered beta is 0.20, and the division it is acquiring is in a
business line where the average unlevered beta is 0.80. What will be beta of Mapco be after
this acquisition
?
Chapter 8
Ch-8.18

Chrysler , the automotive manufacturer, had a beta of 1.05 in 1995. It has $13 billion in
debt outstanding in that year and 355 million shares trading at $50 per share. The firm had
a cash balance of $8 billion at the end of 1995. The marginal tax rate was 36%.
a. Estimate the unlevered beta of the firm.
b. Estimate the effect of paying out a special dividend of $5 billion on this unlevered beta.
c. Estimate the beta for Chrysler after the special dividend.
Chapter 8
•Ch-8.20

As the result of stockholder pressure, RJR Nabisco is considering spinning off its food
division. You has been asked to estimate the beta for the division , and decide to do so by
obtaining the beta of comparable publicly traded firms. The average beta of comparable
publicly traded firms is 0.95 , and the average debt –to – equity ratio of these firms is
35%. The division is expected to have a debt of 25%. The marginal corporate tax rate is
36%.
a. What is the beta for the division?
b. Would it make any difference if you knew that RJR Nabisco had a much higher fixed
cost structure than the comparable firms used here?
Chapter 10
• Ch-10.1
• You are valuing GenFlex, a small manufacturing firm, which
reported paying taxes of $12.5 million on taxable income of $50
million and reinvesting $15 million in the most recent year. The firm
has no debt outstanding , the cost of capital is 11%, and the marginal
tax rate for the firm is 35%. Assuming that the firm’s earnings and
reinvestment are expected to grow 10% a year for three years and 5%
a year forever after that, estimate the value of this firm:
• a. Using the effective tax rate to estimate after – tax operating
income.
• b. Using the marginal tax rate to estimate after-tax operating income.
• c. Using the effective tax rate for the next three years and the
marginal tax rate in year 4.
 Chapter 10

•Ch-10.4

•The following is the balance sheet for Ford Motor Company as of December 31,1994(in millions).

•Assets Liabilities
•Cash $ 19,927 Accounts Payable $ 11,635
•Receivables $ 61469 Debt due within 1 year $ 36,540
•Inventory $ 10,128 Other current liabilities $ 2,721
• Current assets $ 91,524 Current liabilities $ 50,596
•Fixed assets $ 45,586 Mid term debt $ 36,200
• Long term debt $ 37,490
• Equity $ 12,824

•Total assets $137,110 Total liabilities $ 137,110

•The firm had revenues of $ 154,951 million in 1994 and cost of goods sold of $ 103,817 million.
•a. Estimate the net working capital.
•b. Estimate the noncash working capital.
•c. Estimate noncash working capital as a percent of revenues.
Chapter 10
•Ch-10.5

•Continuing problem 4, assume that you expect Ford’s revenues to grow 10 % a year for the
next five years.

•a. Estimate the expected changes in noncash working capital each year , assuming that
noncash working capital as a percent of revenues remains at 1994 levels.

•b. Estimate the expected changes in noncash working capital each year, assuming that
noncash working capital as a percent of revenues will converge on the Industry average of
4.3% of revenues.
•Ch-10.6

•Newell Stores is a retail firm that reported $1 billion in revenues, $ 80 million in after - tax
operating income, and noncash working capital of -$50 million last year.
•a. Assuming that working capital as a percent of revenues remains unchanged next year
and that there are no net capital expenditures, estimate the free cash flow to the firm if
revenues are expected to grow 10%
•b. If you are projecting free cash flows to the firm for the next 10 years, would you make
the same assumptions about working capital? Why or why not?
Chapter 11
• Ch-11.3

• You are trying to estimate the expected growth in net income at Metallica Corporation , a
manufacturing firm that reported $ 150 million in net income in the just – completed
financial year; the book value of equity at the beginning of the year was $ 1 billion. The
firm had capital expenditures of $160 million, depreciation of $100 million, and an
increase in working capital of $ 40 million during the year. The debt outstanding
increased by $ 40 million during the year. Estimate the equity reinvestment rate and
expected growth in net income.
Chapter 11
•Ch-11.4

•You are trying to estimate a growth rate for HipHop Inc., a record producer and
distributor. The firm earned $100 million in after –tax operating income on capital
invested of $800 million last yar. In addition the firm reported net capital expenditures
of $25 million and an increase in noncash working capital of $15 million.

•a. Assuming that the firm’s return on capital and reinvestment rate remain unchanged,
estimate the expected growth in operating income next year.
•b. How would your answer to (a) change if your were told that the firm’s return on
capital next year will increase by 2.5%? (Next year’s return on capital = This year’s
return on capital + 2.5%).