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Cost of Capital in Valuation and

Corporate Models
Valuation

Oct 1, 2015

Cost of Capital Contents


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

Financial Management and Finance Theory


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

Example of Discount Rates in Merger Analysis

In order to determine the value of Pennzoil-Quaker State's common stock, Morgan


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

27 Highly Regarded Corporations and 10


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%

CAPM Most popular

11% use lower than 4.5%

Risk premium of 6%

10% use 5%

Current
Equity premium of 5% or less

Cost of Capital

50% use 7.0% to 7.4%

Current Equity Premium 5% or Less

Oct 1, 2015

Use Correct Discount Rate for Correct Cash Flow

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

Common Problems in Applying Cost of Capital to Cash


Flow

Given difficulties in estimating cost of capital, present a range in cost of


capital in valuations.

Discount rate should reflect project characteristics


Contracts
Risks

Generally companies over-estimate the cost of capital (McKinsey)


2001 Survey managers use 12.2%
Actual market premium is much less

Optimistic assumptions to compensate for high required return

Over-payment for acquisitions

Mis-timing of investments in commodity price businesses

Cost of Capital

Oct 1, 2015

Weighted Average Cost of Capital

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

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Oct 1, 2015

Weighted Average Cost of Capital


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

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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

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Oct 1, 2015

Alternative Approaches to Computing the Cost of Capital

Dividend growth model (analogous to P/E ratio)


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

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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

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Oct 1, 2015

CAPM and Real and Risk Free Rate

Geared Equity
Be
Asset/Ungeared
equity Ba x Market
Market Premium

Real

Average
Debt

Inflation
Plus Real
Rate - Rf

Cost of Capital

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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

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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]

[1] Jagannathan, R. and Meier, I. 2001, Do We Need CAPM For Capital


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

Cost of Capital

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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

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Oct 1, 2015

Cost of Capital and the CAPM


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

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Oct 1, 2015

Discussion of CAPM Components


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

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Oct 1, 2015

Risk Free Rate in CAPM

Valuation

22 Oct 1, 2015

Risk Free Rate Discussion


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

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Oct 1, 2015

CAPM - Risk Free Rate

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

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Oct 1, 2015

Sources of Risk Free Rate

CH
HK
ID
MA
TH
KO
IN
PH
SI
TW

10 Year RMB Govt bond


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

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Oct 1, 2015

Country Adjustments to Risk Free Rate

Cost of Capital

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Oct 1, 2015

Equity Market Risk Premium

Valuation

27 Oct 1, 2015

General Points on EMRP

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

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Oct 1, 2015

Current Opinions with Respect to EMRP


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

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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

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Oct 1, 2015

Use of DCF to Estimate EMRP


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

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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

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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

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Oct 1, 2015

Equity Market Risk Premium


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

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Oct 1, 2015

Estimated Risk Premiums from Actual Returns


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

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Oct 1, 2015

CAPM - Market Premium

McKinsey -- 4.50%

Investment Bank Low -- 3.5%

Investment Bank High -- 5.5%

Brealy and Meyers 6% to 8.5%

Gordons model 2.9%

Exelon Rate Case -- 9.98%

Issue: Sample Bias from Bankruptcy

Cost of Capital

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Oct 1, 2015

Equity Risk Premium in Hong Kong


Hong Kong equity premium calculation

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

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Oct 1, 2015

Problems with historic data in estimating market


premium

The problem with market premium estimates is that the market


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

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Oct 1, 2015

Beta

Valuation

39 Oct 1, 2015

Sources of Beta and Differences in Measurement


The table below shows that beta measurement can be
dramatically different for the same companies.

Cost of Capital

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Oct 1, 2015

Betas

Cost of Capital

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Oct 1, 2015

Beta Measurement

Beta is measured from historic returns

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

Cost of Capital

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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

[1] Patterson, C.S., 1995, The Cost of Capital: Theory and


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

Cost of Capital

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Oct 1, 2015

Beta Adjustments for Mean Reversion


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

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Oct 1, 2015

Example of Beta Adjustments


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

Asset Beta versus Equity Beta


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

Or, Be = (Ba (D/V)*Bd) * V/E


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

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Oct 1, 2015

Example of Asset and Equity Beta


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

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Oct 1, 2015

WACC Illustration Using Unlevered Beta


The WACC
Slide shows
the relation
between the
WACC and
the Asset
Beta

Cost of Capital

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Oct 1, 2015

Asset Beta

Cost of Capital

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Oct 1, 2015

Adjustments to Cost of Equity


Additional Premiums for
Size
Liquidity
Three Factor Model: Size,
Beta, Market to Book
Arbitrage Pricing Model
Liquidity Dimensions
Size
Time
Quantity

Cost of Capital

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Oct 1, 2015

Gordons Model and Implicit Discount Rates


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.

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Oct 1, 2015

Growth Rate Issues


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

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Oct 1, 2015

Use of ROE x (1-Payout) to Estimate Growth


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

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Oct 1, 2015

Importance of Cost of Capital in Decision Making

Investment decisions and cost of capital

Cost of capital and valuation

Cost of capital applied to free cash flow

Residual value

Relative valuation

DCF Compared to payback rule and accounting earnings criteria

Cost of Capital

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Oct 1, 2015

Example of Discounted Dividends

Morgan Stanley calculated terminal values by applying a range


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.

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Oct 1, 2015

Company Profiles

Cost of Capital

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Oct 1, 2015

Impact of the Cost of Capital on Value


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

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Oct 1, 2015

Deriving Implicit Discount Rate with Corporate Models

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

Step by Step Approach


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

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Adjusted Net Present Value

Valuation

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Objectives of APV
NPV assumes
Capital structure remains the same
Leveraged Buyout

Constant Tax Rates


NOL

APV corrects for some assumptions


Changing WACC
Distortions in WACC for capital structure
Changing tax rates

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Oct 1, 2015

Adjusted Net Present Value


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

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Oct 1, 2015

Adjusted Net Present Value


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

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Oct 1, 2015

Comparison between AVP and DCF with WACC


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

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Oct 1, 2015

APV and WACC


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)

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Oct 1, 2015

APV Case

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Oct 1, 2015

Growth Rate and Discount Rate


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.

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Oct 1, 2015

Common errors in dividend discount model valuation


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.

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Oct 1, 2015

Asset and Equity Beta with Taxes


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

Vd(1- Tax rate)




Ve

thus

ungeared

Cost of Capital

geared
Vd(1- Tax rate)


Ve

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Oct 1, 2015

What Term of Treasury Bond Should be Used


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

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Oct 1, 2015

What Term of Treasury Bond Should be Used


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.

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Oct 1, 2015

Duration of 10 Year Bond

Cost of Capital

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Oct 1, 2015

What Term of Treasury Bond Should be Used


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.

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Oct 1, 2015

WACC and Cost of Capital Estimation in Practice


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

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Oct 1, 2015

WACC and Cost of Capital Estimation in Practice


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

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Oct 1, 2015

Practical Estimation of WACC and Cost of Capital


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

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Oct 1, 2015

Example of Beta and Risk Premium Computation


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

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Oct 1, 2015

WACC and Cost of Capital Estimation in Practice


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

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Oct 1, 2015

WACC and Cost of Capital Estimation in Practice


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

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Oct 1, 2015