Chapter 5 Flashcards
What is the definition of cost of capital?
The expected rate of return that the market requires in order to attract funds to a particular investment.
What is cost of capital also referred to as?
Discount rate
What common approaches are used for calculating the return on common equity?
Capital asset pricing model (CAPM)
Modified CAPM
Build-Up (BU) method
What is the WACC?
Weighted average cost of capital utilizes the required rate of return for debt and equity at the proportion of the relative percentages in the company’s capital structure.
What must the rate of return take into account?
The perceived risk of the investment
Cost of capital ______ looking _____ rate of return
Forward, expected/required
What economic principle is cost of capital based on?
Substitution (an investor will not invest in a particular investment if a more attractive substitute investment is available
What are the three types of economic risk components inherent in capital markets for equity?
Maturity risk (interest rate risk) Market risk (systematic risk) Company-specific risk (unsystematic risk)
What is the primary way that CAPM and BU method differs?
The way they treat market risk (systematic risk). CAPM utilizes a beta applicable to the subject stock and multiplies by the market risk premium (equity risk premium) whereas BU method makes a direct adjustment (subjective)
What is market risk?
Uncertainty of future returns due to factors that affect the stock market as a whole that cannot be eliminated by diversification
What are common benchmarks for market risk?
S&P 500, NYSE, and Russell 2000 indices
What is beta?
The tendency of a stock to correlate with changes in the broader market (total returns with dividends and not just change in price should be used)
Often thought of as industry-specific risk
Measures market risk volatility (relative return volatility or systematic risk)
When is a beta greater than 1?
When a stock’s returns change to a greater degree (either up or down) than the broader market
When is the beta less than 1?
When a stock’s returns change to a lower degree than the broader market
When is the beta less than zero?
When the stock’s returns move in the opposite direction of the market
How is beta measured for a public company?
Compare the company’s beta with the market over the same look-back period
How is beta measured for a private company?
Using guideline public companies
What types of risk are reflected in betas?
Operating risk and financial risk (level of debt carried)
How is debt handled when using guideline public companies to estimate beta?
Unlevering betas to remove the impact of debt which captures the operating risk as if it were financed with all equity capital and relevering using the company’s capital structure = levered beta
What risk do unlevered betas capture?
Operating risk
What are the 8 assumptions of CAPM?
1) Investors are risk-averse
2) Rational investors seek to hold efficient (well diversified) portfolios
3) All investors have identical investment time horizons (expected holding periods)
4) All investors have identical expectations about such variables as expected rates of return and how capitalization rates are generated
5) There are no investment-related taxes/transaction costs
6) Relative return volatility (risk) is a modifier of equity market risk and required return
7) The rate received from lending money is the same as the cost of borrowing money
8) The market has perfect divisibility and liquidity
What size of company is typically valued using the CAPM econometric model?
Large or medium-sized companies
How does CAPM measure the relative volatility in returns?
Comparing returns to public market benchmarks such as the S&P 500
How is market or systematic risk measured in CAPM?
Beta
What is market or systematic risk?
Uncertainty of future returns due to uncontrollable movements in the market returns as a whole
What is the formula for CAPM?
Cost of equity = Rate of return on a risk-free security + (Equity risk premium for the market * Beta)
Why is there a modified CAPM?
To apply CAPM to smaller companies
What are the modifications to CAPM?
Add size and specific company risk or unsystematic risk
What is the formula for modified CAPM?
Cost of equity = Rate of return on a risk-free security + (Equity risk premium for the market * Beta) + Risk premium for smaller companies over the equity risk premium for the market + Specific company risk premium
What is the risk-free rate of return?
Based on yield to maturity of U.S. Treasury securities
What are the three components of the risk-free rate?
Rental rate, inflation, and maturity risk
What is the definition of rental rate?
The real return for lending the funds over the investment period therefore forgoing consumption for which the funds otherwise could be used
Maturity risk is also known as?
Investment rate risk
What is the definition of maturity risk?
The risk that the investment’s principal market value will rise or fall during the period to maturity as a function of changes in the general level of interest rates
Can market consensus be observed for expectations related to the components of the risk-free rate?
No, except for inflation which can be estimated based on the Treasury Inflation Protected Securities (TIPS)
Does the risk-free rate include expectations about inflation?
Yes
Should future net cash flows include expected inflation if using the risk-free rate?
Yes
Is the risk-free rate nominal or real?
Nominal
How do you estimate the long-term overall economic inflation forecast embedded in the risk-free rate?
Take the difference in yield between the risk-free security and the yield on TIPS
Is the result of the long-term overall economic inflation forecast embedded in the risk-free rate the same as inflation expectations in the cash flows?
Not necessarily
Are long-term U.S. government bonds considered risk-free?
No, but are considered free of default risk since they are sensitive to interest rate fluctuations
What two factors are investors unsure of when investing in long-term U.S. government bonds?
Purchasing power of dollars received at maturity
Reinvestment rate available to reinvest interest received over the bond term
What is the relationship between returns of long-term government bonds and T-bills?
LT government bond returns are higher than T-bill returns
What is a frequently used risk-free rate of return?
20-year U.S. Treasury bond yield because it is abenchmark per D&P Handbook
Is there an original issue 20-year U.S. Treasury bond?
No
How do you arrive at a 20-year U.S. Treasury bond now?
30-year Treasury bond with 20 years left until maturity as a proxy
Where can historical and current yields be found?
The Federal Reserve Statistical Release or FRED
What is the risk-free rate most often based on?
Market yields as of the valuation date
When have market yields been artificially low?
In the fall and winter of 2008-2009 and again during summer and fall of 2010 due to a temporary “flight to quality”
What happens if you use market yields during a period where such yields are artificially low?
One may obtain an unrealistically low cost of capital when your cost of capital would be expected to increase to account for additional systemic risk factors
During a period of artificially low market yields, what should be utilized for the risk-free rate?
Longer term average
What is the definition of the equity risk premium?
A premium that investors require over and above the risk-free rate to compensate for the increased risk of an equity investment
What is a commonly used source for equity risk premiums?
D&P Valuation Handbook - U.S. Guide to Cost of Capital
Equity risk premium is a __________ concept
Forward looking
What is equity risk premium often based on?
Historical arithmetic average return on stocks less the histrorical average risk-free rate
Is the risk free rate used to arrive at the equity risk premium the same as the risk free rate component of CAPM?
No, because the risk free rate used to arrive at the equity risk premium is often a historical average and the risk free rate in in CAPM is as of the valuation date
What size of company is used to arrive at equity risk premium?
Very large companies
When unlevering the beta, what tax rate is used?
The marginal tax rate for the guideline companies
When unlevering the beta, what is the percentage of debt and equity in the capital structure based on?
Market not book value
When unlevering the beta, what information is used?
Information on the guideline companies
When relevering the beta, what information is used?
Subject company information
When relevering the beta, what is the percentage of debt and equity in the capital structure based on?
Market not book value
What is the unlevering/relevering formula commonly referred to?
Hamada formula
What do other formulas for unlevering/relevering typically take into account?
The risks that the cash tax savings from taking an income tax deduction on the payment of interest will be realized in the periods in which the interest is paid
What is the size risk premium?
The additional premium investors require over and above the equity risk premium to compensate for the increased risk of an investment in smaller companies for size characteristics only
What is a common source for the size risk premium?
D&P Risk Premium Report
What is the size risk premium usually based on?
The historical average return on small stocks in excess of the return expected given the betas of the small stocks (meaning the beta multiplied by the historical average return on large stocks)
What is the size risk premium in D&P based on?
The size of the public companies where size is measured by market value of equity
What is another name for size risk premium?
Beta adjusted size premium
What is specific company risk premium?
Premium to address risks specific to the company that are not already captured in beta (industry risk) and the size risk premium
Is a specific company risk premium the preferred method for company specific risk?
No, it is preferred to adjust the prospective information rather than the discount rate
What are 11 company-specific risk factors?
1) Thin management
2) Smaller in size relative to small cap stocks
3) Financial performance factors (volatility of returns, leverage)
4) Lack of diversification of products/services
5) Geographic concentration or location
6) Demographic factors
7) Limited access to capital
8) Litigation
9) Environmental issues
10) High percentage of revenue from a small group of customers
11) Limited supply sources
Is company-specific risk premium subjective?
Yes, no data sources provide support
Should a formula be applied to weight various risk factors to arrive at company-specific premiums?
No, because they can be misleading or imply accuracy that does not really exist
What is the formula for the build-up method?
Cost of equity = rate of return on risk-free security + equity risk premium for the market + risk premium for small companies over equity risk premium + specific company risk premium
What is the implied beta under the build-up method?
No beta impact, meaning beta is assumed to be 1
How is industry risk incorporated into the build-up method?
Incorporated into the specific company risk premium
What is a common source for industry risk?
D&P
What is the concern with industry risk premiums from D&P?
Sample size is often very small
What is the new version of the Ibbotson Stocks Bonds Bills and Inflation (SBBI) data?
D&P Risk Premium Report
What does the SBBI data report reflect?
The differences in stock returns as a function of firm size measured by the market value of equity
What does the Size Study measure?
Returns based on eight different indicators of size from selected publicly traded companies
What do the exhibits of the Size Study reflect?
The smoothed average market risk premium plus size risk premium for each of the 25 size categories called portfolios and high-financial-risk-portfolio exhibits
What is considered high-financial risk for the high-financial-risk-portfolio in the Size Study?
Companies in bankruptcy, companies with a negative five-year average net income available to common equity, or negative book value of equity at any of the previous FYEs
What are the 8 metrics analyzed in the Size Study?
1) Market value of common equity
2) Book value of common equity
3) Five-year average net income before extraordinary items for previous five FYs
4) Market value of invested capital
5) Total assets
6) Five-year average EBITDA for previous five FYs
7) Sales
8) Number of employees
What is the smallest D&P portfolio in the Size Study?
Portfolio 25 - average market cap of approximately $100 million
What can you do for companies smaller than those included in the Size Study?
Perform a regression analysis to estimate a size-adjusted benchmark using the data in the exhibits
When might other calculations need to be used with the Size Study?
If the subject company’s leverage is not comparable with its peer group, or if the valuation analyst prefers an alternative estimate of the equity risk premium such as the supply side estimate rather than the historical equity risk premium in the Size Study
Can you use a metric in the Size Study if the metric for the subject company is negative?
No
Can the D&P Size Study be used for financial companies in SIC code 6?
No, because the Size Study excludes financial companies in SIC Code 6
The WACC is the discount rate applied to net cash flows to _______
Invested capital
Net cash flows to invested capital are prior to ______ and ____
Dividend and debt service payments (including principal and interest)
What is the formula for WACC?
Weight of common equity * cost of common equity capital + weight of debt * (cost of debt pretax *(1-tax rate)) + weight of preferred equity * cost of preferred stock (all based on market value weights)
What does the WACC formula assume about income tax deductions
That cash tax savings occur in the period on which interest is paid
What is the debt discount rate formula?
Pretax borrowing rate * (1-tax rate)
What is the debt discount rate formula based on?
Based on subject company’s borrowing rates and capacity which can consider the collateral value of the company’s assets, derived from an analysis of existing lending agreements, interview with clients/lenders, and a review of public corporate bonds
