Key Rule #5 Flashcards
What is the discount rate?
Represents opportunity cost for investor- what they could earn each year by investing in similar cos
What does a higher discount rate mean?
Increased risk and increased potential returns, but less valuable b/c investor has better options elsewhere
What does a lower discount rate mean?
Lower risk, lower potential returns, but more valuable b/c investor has worse options elsewhere
Why do multiple DR exist?
b/c co have many different sources of capital
What are the components of DR?
cost of equity
cost of debt
cost of preferred stock
What is overall DR?
WACC
What happens if an investor invests proportionately in a co’s struc?
WACC gives expected long term annualized return
What is the WACC formula?
cost of equity x % equity +
cost of debt x (1-tax rate) x % debt +
cost of preferred stock x % preferred stock
What is cost of preferred stock?
rate co would pay to issue issue additional preferred stock
How do you predict cost of preferred stock?
estimate by looking at co’s current PS
or calculate weighted average coupon rate on existing PS
or median coupon rate on comp public companies
What is cost of debt
The rate co pays if it issues additional debt
What are the 3 ways of calculating cost of debt?
- estimate
- YTM
- risk free rate (RFR)
- weighted average coupon rate of co’s existing
- median coupon rate of outstanding issuances of comp public cos
What is the estimation way of calculating cost of debt?
- estimate by looking at coupon rate of current debt
How do you work the YTM method of cost of debt?
- find YTM on current debt OR
- debt issued by comparable cos
How do you find the cost of debt with RFR (risk free rate)?
- yield of 10-20 yr “safe” gov bonds in the country (RFR)
- what’s the new credit rating after co issues extra debt?
- what do cos of that credit rating pay above the RFR? (%) (add this to RFR to get cost of debt)
What is cost of equity in valuation?
How much the co’s stock should return each year on average over the long term, factoring appreciation and dividends
How do you calculate COE?
capital asset pricing model (CAPM)
risk free rate + equity risk premium x levered beta
What is equity risk premium?
%tage stock market will return each year on average above and beyond yield on safe gov bonds
What is the conflict w calculating Equity Risk Premium?
Which period? Historical/ projected nums?
What is levered beta?
How volatile this stock is relative to market as a whole, factoring in intrinsic biz risk and risk via leverage (debt)
What are the 3 ways of calculating COE?
1) COE w LB from comparable cos + current cap str
2) COE w LB from comparable cos + optimal cap str
3) COE w cos historic LB + current cap str
Why use comparable companies to get LB?
- get range of COE, WACC values
- get implied value
- The CAPM mtd uses past performance of co to calc beta and COE-> current value instead of implied value -> this isn’t valuation
What is levered beta?
- beta from capiq
- has to be unlevered to get rid of the intrinsic biz risk and leverage risk
Unlevered beta vs Re-levered beta
ULB less than or equal to re-levered beta
Unlevered beta formula
levered beta / (1 + d/e x (1-taxrate) + preferred/equity)
What is re-levering beta?
make it reflect risk of company being valued
What is the re-levering beta formula?
ULB x (1 + d/e x (1-taxrate) + preferred/equity)
If company has no debt or preferred stock what is Unlevered beta?
Unlevered beta = Levered Beta
What does it mean to unlever beta w optimal cap str?
- use median cap str % of comparable company in the formula instead
Why is there such a thing as unlever beta w optimal cap str?
gets closer to implied value
What is the COE to the company?
cost of funding its operations by issuing additional shares
What does WACC mean to the company?
cost of funding its operations by
- using all its sources of capital and
- keeping its capital str percentages the same over time.
How does IRR relate to WACC?
Investors invest if IRR > WACC
company invest in prok if IRR > WACC
What should you use for the Risk-Free Rate if government bonds in the country are NOT risk-free (e.g., Greece)?
- take the risk-free rate in a country that is risk-free eg. US UK
- then add a default spread based on the risky country’s credit rating
- b/c country has higher risk of defaulting
How is Equity Risk Premium calculated?
- no universal method
- Ibbotson’s
- historical data
How do you calc Equity Risk Premium for a multinational company that operates in many different geographies?
weighted average ERP = % revenue earned in each country x ERP in that market & add everything
Could beta ever be -ve?
yes
- stock price must move in opp dir of entire market
- rare- revert back to +ve quickly
What is a way of looking at re-levered beta as?
What the volatility of this company’s stock
price, relative to the market as a whole, should be, based on the median business risk of its peer companies and this company’s capital structure
What does it mean to unlever beta?
- remove risk from leverage and isolate the inherent biz risk
The formulas for Beta do not factor in the interest rate on Debt. Isn’t that wrong? More expensive Debt should be riskier.
- interest rates are factored in to a degree alr- debt/ equity ratio is a proxy for interest rates on debt b/c cos w higher debt/equity ratios have to pay higher interest rates
- But risk isn’t directly proportional to interest rates- higher interest on debt will result in lower coverage ratios but can’t say- interest is 4% instead of 1% -> risk from leverage is 4x higher
How would you estimate the Cost of Equity for a U.S.-based high-growth technology
company?
“The Risk-Free Rate is around 1.3% for 10-year U.S. Treasuries. A high-growth
tech company is more volatile than the market as a whole, with a likely Beta of around 1.5. So, if you assume an Equity Risk Premium of 6%, the Cost of Equity might be around 10.3%.”
WACC reflects the company’s entire capital structure, so why do you pair it with
Unlevered FCF? WACC is not capital structure-neutral!
cap str neutrality is for FCF, not DR
no DR can be cap str neutral
why is equity more expensive than debt?
debt is cheaper b/c
- debt investor has a prior claim if co goes bankrupt -> debt is safer than eq -> warrants lower return -> lower interest rate than expected return on equity
- interest paid by bonds is tax deductible
- when issue equity, dividends are paid out. Divs are corporate income and are subject to doubel taxation- (1) corporation (2) equity holder
- debt circumvents taxation at the corporate level (tax shield on debt)
Should you use co’s current capstr or optimal capstru to calculate WACC?
- the best capstr is one that minimizes WACC.
- but no way to calculate it b/c can’t tell in advance how costs of eq, d and p will change as cap str changes
- rather, use median cap str percentages from comparable public cos as proxy for optimal capstr
- why? want to capture what capstr should be, not what it is right now
- implied value in DCF is based on expected future cash flows
Cost of Preferred Stock vs Cost of Debt, Cost of Equity?
- PS more ex than Debt but less so that E
Why?
- higher risk and potential returns than debt, lower risk and potential returns than E
- b/c coupon rates on PS > coupon rates on Debt
- PS not tax-deductible
- yields are still lower than stock market returns
Convertible bonds in WACC?
- if share price > converstion price = count bonds as equity, use higher diluted share count -> higher EqV and greater equity in WACC
- if bonds not currently convertible = count as debt, use YTM of equivalent, non-convertible bonds to calc cost of debt
- don’t use stated coupon rate or YTM on convertible bonds b/c lower than standard bonds
How do cost of equity, cost of debt and WACC change as a co uses more debt?
- COE, COD always increase b/c more debt increases risk of bankruptcy, which affects all investors
- WACC intially decreases b/c debt cheaper than equity
- WACC increases at higher levels of debt b/c risk of bankruptcy starts to outweigh cost benefits of debt
. If the company already has a very high level of Debt, WACC is likely to increase with more Debt;
at lower levels of Debt, WACC is more likely to decrease with more Debt.
If a company previously used 20% Debt and 80% Equity, but it just paid off all its Debt,
how does that affect its WACC?
- using co’s current capstr- WACC increase b/c 20% debt is low level
- at that low level benefits of debt tend to outweight its risks, so less debt will increase WACC
- if using targeted/ optimal/ medical capstr from comparable companies, change won’t affect WACC b/c not using current capstr
How does WACC change with more debt in relation to how much existing debt it has?
. If the company already has a very high level of Debt, WACC is likely to increase with more Debt;
at lower levels of Debt, WACC is more likely to decrease with more Debt.
Suppose you’re calculating WACC for two similarly sized companies in the same industry, but one company is in a developed market (DM), and the other is in an emerging market (EM). Will the EM company always have a higher WACC?
- RFR, ERP, COD, higher for EM -> WACC higher
- If Levered Beta is higher for EM, cap str % are similar -> WACC is higher
- but might not be eg. if gov controls industry, Lev beta lower b/c of reduced volatility
What is CAPM like in a small company?
small co stocks tend to have higher returns and large betas
How to calc cost of debt for private company?
- come up w synthetic bond rating of firm- can use debt to equity ratio
- then calculate cost of debt
- estiamte rating for private debt based on comparable publicly traded debt to come up w appropriate yield.
- and add a liquidity premium to account for less liquid nature of private debt
How do you calculate WACC?
- COE- determined by CAPM
- to estimate COD- interest rates on debt issued by comparable cso
- to estimate COPS- look at div yields on preferred stock by comparable cos
What factors affect a firm’s COD?
- external interest rates eg. fed funds rate
- riskiness of biz eg. cyclical biz debt (auto) more expensive than non cyclical (healthcare)
- tax rates: as TR increase, cost of debt decreases
- public debt market conditions: supply and demand in bond market at time of issuance- if d<s, debt cheaper
How do external interest rates affect firm’s COD?
fed funds rate eg. the higher they are the cost of debt goes up
How does riskiness of biz affect COD?
- riskiness of biz eg. cyclical biz debt (auto) more expensive than non cyclical (healthcare)
How does tax rate affect firm’s COD?
as TR increase, cost of debt decreases
How does public debt market condition affect COD?
supply and demand in bond market at time of issuance- if d<s, debt cheaper
