Discount Rate

Question 1

What do corporations typically use when selecting a discount rate?

Answer 1

Weighted Average Cost of Capital (WACC)
(WACC) is a financial metric that represents the weighted average cost of all the capital (equity and debt) employed by a company
minimum rate of return that they need to earn on their investments in order to create value for their shareholders

Question 2

Weighted Average Cost of Capital (WACC)

Answer 2

Company’s assets are financed by either debt or equity. The WACC is the weighted average of these sources of financing.

also called “hurdle rate”: earned returns should be greater than the costs of capital

mixed interest rate used to discount expected Free Cash Flows (FCF)

Question 3

Circular reference

Answer 3

• Market Value of Equity (Shareholder Value) depends on Market Value of Total Capital
• Market Value of Debt also depends on the Market Value of Total Capital
• in case the Market Value of Total Capital changes it is assumed that the amount of Debt Capital is adjusted (increased or decreased) accordingly
• constant future Debt/Equity-Ratio is assumed -> value-based („breathing“) Financing Policy

Due to this link, Debt and interest payments are uncertain

Question 4

Capital Structure

Answer 4

different sources of financing used by a company to fund its operations

interest bearing Debt:
* at book values
* an explicit component of interest (bank, liabilities, bonds)
* hidden in other debt items (accounts payables, other liabilities)

equity:
* for listed companies: market capitalization
* unlisted: hidden assets and reserves must be disclosed
* real estate, buildings, financial assets

Question 5

Cost of debt

Answer 5

required rate of return that the company must pay to its debt financiers
factors:
* terms of credit
* market condition
* credit worthiness of debtor (rating)

Question 6

What is the significance of the “hurdle rate” in relation to WACC?

Answer 6

The hurdle rate is the rate at which a business must earn returns greater than its cost of capital to be profitable. WACC is sometimes referred to as the hurdle rate.

Question 7

What is the “hurdle rate”

Answer 7

The hurdle rate is the rate at which a business must earn returns greater than its cost of capital to be profitable. WACC is sometimes referred to as the hurdle rate.

Question 8

Cost of equity

Answer 8

required rate of return that investors demand for holding equity (shares) in a company
factor:
* rist free interest rate: theoretical rate of return by investing in risk free asset (government bond)
* market risk premium: additional return for extra risk (e.g. stocks)

Question 9

Risk-free Interest Rate

Answer 9

theoretical ideal case of a rate of return on an investment that carries no default risk and has no correlation with other investments

not constant over the total term of the investment, reflects time preference of investors and expectations towards inflation etc.

expressed by interest yield curve, the longer the term of the investment, the higher the interest rate

Question 10

Risk Premium using Beta

Answer 10

additional return that investors demand for investing in a company compared to a risk-free investment

based on the level of risk associated with the company

Strategic Risks:
Corporate governance, critical success factors, financing structure

Operating Risks:
Sales market, labor market, technological trends

Financial Risks:
Capital market, stability of earnings, liquidity

Cross-Functional Risks:
Legal environment, social and political trends, data processing

Question 11

Segregation of beta

Answer 11

Operating-Beta = risk measure representing the operating business risk
Financial-Beta = risk measure representing the capital structure risk

Question 12

derivation of the beta based on the CAPM (Capital Asset Pricing Model)

Answer 12

Beta = measure of the systematic risk of a security

expresses the sensitivity of the return of a security in comparison to the return of the market (= portfolio of stocks)

market portfolio can be defined as a national or international share index, or a peer group index, depending on the shareholder’s structure

higher beta means higher risk, beta of market porfolio = 1

beta of risk free = 0

slope of regression line = beta

Question 13

beta > 1, < 1, = 1

Answer 13

Beta > 1 indicates higher risk than the market, business risk fluctuating more than market risk, return reacting disproportionally
Beta = 1 means equal risk, fluctuating same
Beta < 1 indicates lower risk, fluctuating less

Question 14

beta in the context of Debt/Equity-Ratio

Answer 14

beta of a security is influenced by the level of leverage used by the company
A higher Debt/Equity-Ratio leads to an increase in the (financial) Beta coefficient of a security, indicating a higher level of risk associated with the security.

Question 15

Calculation of the Beta

Answer 15

linear Regression of the return of the stock price to the return of the market price

non-listed company: via the approximation using an industry-beta or derivation from Betas of a Peer Group of other non-listed

betas of levered comparables -> delevering -> betas of unlevered comparables -> aggregation -> betas of the unlevered business (valuation object) -> relevering -> beta of leverd business (valuation object)

Question 16

Market risk premium

Answer 16

measure of the expected additional return that investors require for taking on the risk of investing in the stock market compared to a risk-free investment

methods:
* historical MRP (past sotck market data)
* expert opinion
* implicit MRP (pricing of financial instruments, indicate expected future returns)

key parameters:
* length of period
* generation of mean (arithmetic, geometric)

austria: 5.5-7%
germany: austria: 5.5-7%

Question 17

Beta (Calculation based on historical Capital Market Data)

Answer 17

determined by performing a univariate regression of the return of a security on the return of the market portfolio

Covariance of the security and the market portfolio / Variance of the market portfolio

Question 18

Beta (Calculation based on historical Capital Market Data)

Answer 18

determined by performing a univariate regression of the return of a security on the return of the market portfolio

Covariance of the security and the market portfolio / Variance of the market portfolio

Question 19

Assessment of the Quality of the Beta

Answer 19

liquidity of the security is a fundamental assumption -> ability to be bought or sold quickly without affecting the price

factors:
* trade volume: number of shares traded per time interval
* sales volume: total sales volume divided by the sum of the total outstanding shares
* bid-ask spread

by means of standard error: standard deviation of the error of estimation, determine how reliable the Beta estimate is, degree of dispersion of the estimated Beta from the true Beta, measures the accuracy of the mean

by means of t-test

by means of coefficient of determination (R^2)

Question 20

Assessment of the Quality of the Beta by means of t-test

Answer 20

whether the calculated Beta deviates significantly from a predetermined value of the null hypothesis, which is typically set to zero (H0: βi=βh=0)

βi…calculated Beta
βh…null hypothesis value

examines the difference between the calculated Beta and the predetermined value

provides a measure of how likely it is that the difference is due to chance

empirical t-value exceeds the critical t-value: then the null hypothesis is rejected -> empirical Beta is considered statistically significant

statistically significant Beta indicates: stock’s returns are correlated with the overall market returns

Question 21

Assessment of the Quality of the Beta by means of coefficient of determination (R^2)

Answer 21

R-squared measures the proportion of the total variation in the dependent variable (stock returns) that is explained by the variation in the independent variable (market returns)

calulated as the proportion of the explained dispersion of the total dispersion
total dispersion is the total variation of the dependent variable
explained dispersion is the variation of the dependent variable that can be explained by the independent variable
residual dispersion is the portion of the total variation of the dependent variable that is not explained by the regression line

take values between 0 and 1
0 indicates regression line does not explain any of the variation in the dependent variable
1 indicates regression line explains all of the variation in the dependent variable

Question 22

bid-ask spread

Answer 22

difference between the bid price (sales price) and the ask price (purchasing price)
the higher the difference the higher are the transaction costs of the investor

Question 23

discount rate

Answer 23

determine the present value of future cash flows

The individual investor’s required rate of return is their discount rate

• not a scientific certainty, but rather an educated guess
• investors decide based on opportunity cost of capital, rate of return they could earn
• Corporations often use the Weighted Average Cost of Capital (WACC) when selecting a discount rate: weighted average of the sources of financing (debt and equity) used by a company to finance its assets
• to be profitable, the earned returns should be greater than the costs of capital
• When using WACC, the company’s beta is also considered: measure of market risk and can be calculated as either unlevered beta (asset beta) or levered beta (risk of the firm with debt and equity in its capital structure).