Key Rule 3

Question 1

Key rule 3
- discount rates and WACC

Answer 1

Need to discount both company’s future FCFs and TV because of the time value of money.
- also discount rate reflects not just the time value of money, but also return that investors require before they can invest
- also represents risk of a company, as higher potential returns correspond to higher risk.

Smaller companies tend to have higher discount rate because higher growth and riskier.

Question 2

How to estimate a company’s discount rate

Answer 2

Separate its capital structure into components, normally equity, debt and preferred stock, and calculating the cost of each on
- cost of debt = interest rate on debt
- cost of preferred stock = effective yield on preferred stock

Question 3

Calculating cost of equity

Answer 3

1. If company issues dividends to common shareholders, actual cash expense right there
2. By issuing equity to other parties, the company is giving up future stock price appreciation to someone else rather than keeping it for itself
   Cost of equity = risk-free rate + equity risk premium x levered beta

Question 4

Why are equity expenses tricky to estimate

Answer 4

Because company’s share price changes over time, e.g. cant just assume one simple dividend yield and base everything on that

Question 5

What does risk-free rate mean?

Answer 5

What interest rate could we earn by investing in a ‘risk-less’ security like 30-year US treasury notes

Question 6

Equity risk premium

Answer 6

Is the extra yield you could earn by investing in an index that tracks the stock market in your country of choosing
- can be a wide range of values here

Question 7

What does Beta refer to

Answer 7

Refers to the riskiness of this company relative to all other companies in the stock market.
- if beta = 1, means that the company is just as risky as the overall index, meaning if the market goes up by 10%, company’s stock up by 10%
- if beta = 2, company is twice as risky as the markets if market goes up by 10%, company up by 20%, and down vice versa
Could just use company’s historical beta

Question 8

More popular method for estimating beta

Answer 8

Using public company comparables for the company you’re valuing and assuming that the company’s true beta is different from what the historical data suggests

Question 9

Un levering and re levering beta , why

Answer 9

Figuring out what a company’s riskiness should be rather than what it is currently

Question 10

Un levering and relevering beta

Answer 10

1. Look up beta for each company in the set of public company comparables you’re using to value the company.
2. Then you un-lever beta for each company using the following formula: = levered beta/ (1 + (1- tax rate)x(debt/EV))
3. Then calculate this for all the public comps, take the median and re-lever it to calculate the approximate levered beta for the company we’re valuing
   - you do this as you want to determine company’s true business risks, based on comps.

Question 11

what does unlevered beta formula mean?

Answer 11

Beta represents risk, there are two types of risk:
- inherent, business risk
- risk from debt
Formula removes additional risk from debt, as denominator is assuming that this risk from debt is directly proportional to company’s debt/Equuity ratio
- but remember interest paid on debt is tax deductible, so that helps reduce the risk from debt slightly, since we save on taxes/

Question 12

UnLevered Beta example

The company’s “Levered Beta” (i.e. the number you find when you look it up) is 1.0. Its tax rate is 40% and it has $200 million in Debt and an Equity Value (Market Cap) of $1.0 billion.

Answer 12

Unlevered Beta = 1.0 / (1 + (1 – 40%) * ($200 / $1000)) = 1.0 / (1 + 60% * 20%) = 0.89
- so if you ignore this company’s debt, it’s less risky than the market as a whole

Question 13

What to do after approximating levered beta

Answer 13

Debt creates additional risk, need to account for it.
- re-lever beta for company by multiplying by:

Levered Beta = Unlevered Beta * (1 + (1 – Tax Rate) * (Debt / Equity Value))

• essentially increasing unlevered beta by however much additional risk the debt adds, also taking into account that the tax-deductible interest reduce risk.

Then use either company’s historical beta, or this calculated beta

Question 14

Cost of Equity

Answer 14

Risk-Free Rate + Equity Risk Premium * Levered Beta.
Or
Cost of equity = dividends per share/ share price + growth rate of dividends, but for this one, not all companies issue dividends, so generally dont use.

Question 15

To recap:

Answer 15

We estimate Cost of Equity by approximating what a stock’s potential return in the future might be via the formula above.
We un-lever Beta to isolate inherent business risk, and then we assume that the company we’re analyzing has that same inherent business risk; then we re-lever it to capture the total risk, including inherent business risk + risk from Debt.

Question 16

Calculating WACC

Answer 16

WACC = (cost of equity x % equity) + (cost of debt x % debt) x (1 - tax rate) + (cost of preferred stock x % preferred stock)

Essentially determining the cost of each part of a company’s capital structure, and then calculating a weighted average based on how much Equity, Debt and Preferred stock it has.

Question 17

Why use WACC for Unlevered FCF

Answer 17

Use WACC as discount rate, as you care about all parts of the company’s capital structure - debt, equity and preferred - because you’re calculating enterprise value, which includes all investors.

Question 18

Why use Cost of equity for Levered FCF

Answer 18

Use cost of equity as the discount rate as you only care about equity investors there, and you’re calculating EV, not enterprise value.

Think: FCF to equity -> cost of equity -> EV

Question 19

Implications of this formula for WACC:

Answer 19

• debt will almost always push down WACC because the cost of debt is almost always lower than the cost of equity, interest rates on debt are lower and interest is tax-deductible
• preferred stock is generally cheaper than equity, but not as cheap as debt, because preferred dividends are not tax deductible
• equity tends to cost the most as it is the most risky - they get paid back last in chance of liquidation.

Question 20

Implications of cost of equity formula:

Cost of Equity = Risk-Free Rate + Equity Risk Premium x Levered Beta

Answer 20

• higher risk-free rates and equity risk premiums always increase it
• yes, debt increases cost of equity, as debt increases risk of investing in a company’s equity, as debt increases chances of defaulting and leaving you, common shareholder with nothing.

Question 21

Unlevered vs. Levered Beta has nothing to do with Unlevered vs. Levered Free Cash Flow

Answer 21

Regardless of FCF type, always use Levered Beta when calculating cost of equity, as if company has debt, it makes both the Equity of the company and the entire company itself riskier.

Question 22

What if the company’s capital structure changes in the future?

Answer 22

I.e. what if it raises additional debt, or issues more equity, or preferred stock or something else.
- if you know for sure company’s capital structure will change in the near future, you use new dent and Equity values in all these calcs.

“Yes, ideally we would use the company’s targeted or planned capital structure rather than the one they currently have… if we have access to that information.”