Unit 6- Risk, Return, Cost of Capital, and Firm Valuation Flashcards
Cost of Capital
Rate of return the corporation must earn on its invested capital in order to compensate for the time value of money and risk
Weighted Average Cost of Capital (WACC)
Weighted average of Cost of debt and Cost of equity
WACC=
(Cost of Debt) x (1-Tax Rate) x (Debt/(Debt+Equity)) + Cost of Equity x (Equity/Debt+Equity))
Interest paid on debt is…
Tax deductable
Most important factors that influence a company’s choice of capital structure
- Taxes
- Stability of cash flows and earnings
- Financial and operating flexibility
- Type of assets
Companies that can support higher debt levels are…
in mature industries with fairly stable cash flows, tangible assets, and few investment opportunities
Companies that can support low debt levels are…
in growth industries with significant investment opportunities, high variable cash flows, and intangible assets
Cost of Debt
the rate of interest that the firm would pay on any new bank borrowing or bond issue
Factors that Cost of Debt Depend on…
- Current interest rate on US Treasury bonds with the same maturity
- Default risk
Cost of Debt =
Treasury Bond Rate + Default Premium
High Quality Bond Ratings
AAA, AA
Medium Quality Bond Ratings
A, Baa, BBB
Low quality bond ratings
Ba, B, BB
Lowest Quality Bond Ratings
Caa, Ca, C, CCC, CC, C
Speculative Grade:
Low or Lowest bond ratings, “Junk Bonds”
Pre-Tax Cost of Debt=
Treasury Yield (10 year Bond) + Default Spread (Bond Rating)
Cost of Equity
an Opportunity Cost. The rate of return that stockholders expect the firm to earn on its equity capital.
2 Most important factors that Cost of Equity depends on…
1) Current interest rate on long-term US Treasury Bonds
2) Risk of Equity
Cost of Equity=
Treasury Bond Rate + Risk Premium
Reducing Risk through Diversification
As the number of companies gets larger, the standard deviation of the portfolio approaches the average covariance between companies
Firm-Specific Risk
- Firm’s CEO suddenly dies
- A company loses a major lawsuit
- A wildcat strike in one of the firm’s plants
- An unexpected entry of a competitor
Market Risk Factors
- An unexpected increase in long-term interest rates
- Changes in monetary or fiscal policy
- US Congress votes for a massive tax cut
- An unexpected decline in the value of the US Dollar
Since firm-specific risk can be…
diversified away, only market risk matters to investors.
Stock’s Beta
The market risk for an individual stock
The average stock has a beta of…
1.0
Stocks with betas greater than 1.0 are…
more sensitive to economy-wide risk factors
Stocks with betas less than 1.0 are…
less sensitive to economy-wide risk factors
The more cyclical a company’s business, the…
higher will be its beta
The risk of a well-diversified portfolio depends on…
the average beta of the stocks in the portfolio
Total Portfolio Risk=
Avg. beta x Market standard deviation
Cost of Equity=
US Treasury Rate + (Market Risk Premium) x Beta
Market Risk Premium
The average difference in the rate of return on stocks and long-term US Treasury bonds
Firm Valuation used for…
- Structuring mergers and leveraged buyouts
- Security analysts and undervalued stocks
- Pricing Initial Public Offerings
- Corporate strategy and value based management
- Venture Capitalists evaluation of new investment opportunities
Firm Value
PV of expected future free cash flow - WACC
Equity Value =
Firm Value - Cost of Debt
WACC is the…
overall expected return the firm must earn on its existing assets to maintain it’s value
The WACC reflects…
the risk and the capital structure of the firm’s existing assets
The WACC is an appropriate…
discount rate for the firm or for a project that is a replica of the firm
CF =
Free Cash Flow
EBIT=
Earnings before Interest and Taxes
T=
Corporate Tax Rate
DEPR=
Depreciation
CAPEX=
Capital Expenditures
NWC=
Increase in Net Working Capital
CF t=
EBITt * (1-T) + DEPRt - CAPEXt - NWCt
Comparables Method
Choose firms with Similar Value Characteristics
Similar Value Characteristics:
- Risk
- Growth Rate
- Capital Structure
- Size and Timing of Cash Flows
Weaknesses of Comparables Method
- Valuation of Private Firms
- Financial Information often unavailable
- Valuations may by misguided
Public Firms (Comparables Method)
- Price/Earnings Ratio
- Price/EBIT as an alternative
- Enterprise Value/Sales
- Market Value of Equity/Book Value of Equity
Private Firms (Comparables Method)
- Internet- Number of Subscribers
- Biotechnology- Number of Patents
- Industry Specific Multiples More Explanatory Power
If you use Public Market Comparables to Value Private companies…
Use discount for liquidity- 20-25%
Opportunity Cost of Capital
the incremental return on investment that a business foregoes when it elects to use funds for an internal project, rather than investing cash in a marketable security
Opportunity Cost
the loss of potential gain from other alternatives when one alternative is chosen.
Capital Charge=
r x TC
Opportunity cost of capital (r) x Total Capital?
To create economic value the investment project must earn…
positive economic profits, not just positive accounting profits
Economic Profits=
Accounting profits - charge for capital
Creating economic value for shareholders requires the corporation to…
earn positive economic profits
A corporation’s ability to earn positive economic profits depends on its…
- Operating efficiency
- Capital efficiency
Operating Efficiency=
NOPAT/Sales
Capital Efficiency=
Capital Turnover
Capital Turnover (CT)=
Sales/Total Capital
ROTC (Return on Total Capital)=
NOPAT/TC
Economic Profit=
- Accounting Profit - Capital Charge
- NOPAT - (R x TC)
- (R* - r) x TC
Companies earn a positive economic profits only if…
the Return on Total Capital (r*) is greater than its Cost of Capital
Key to financial success:
Earning positive economic profit
Companies that cannot earn economic profits will find it difficult to…
attract capital from investors
Economic profits are also sometimes called…
Economic Value Added (EVA)
NPV=
(EVA1/(1 + r)) + (EVA2/(1+R)^2)…
MVA (Market Value Added)=
Market Value or Equity - Book Value of Equity
MVA measures
the total wealth created for shareholders by the corporation
A large positive MVA of publicly traded company represents…
the belief that the company can achieve return on invested capital which exceeds the capital cost over a sustained period in future. (if competitive advantage is sustainable)
3 ways a company can improve it’s economic profits and increase it’s stock price:
1) Manage
2) Build
3) Harvest
Manage
Increase efficiency of existing operations and thus improve the spread between r* and r.
Build
Invest in businesses and projects with positive spreads between r* and r.
Harvest
Withdraw capital from operations or activities where r* is less than r.
Advantages of economic profits as a measure of performance
- Rewards managers for what shareholders value the most- economic profits.
- Accounts for all the costs associated with running a business, including the cost of capital.
- Gives managers the incentive to improve both operating efficiency and capital efficiency
- Provides clear-cut benchmark for evaluating performance.
The economic value created by the long-lived investments projects is measured by…
NPV
To create value for shareholders…
invest in projects with positive NPV
Stocks are valued as the…
present value of all future expected dividends
The cost of equity depends on…
the current level of interest rates and the risk of the stock
Risk is measured by…
a stock’s beta
The Capital Asset Pricing Model (CAPM) provides…
a practical method for estimating the cost of equity based upon the stock’s beta
Cost of Equity=
Treasury bond rate + (Market Risk Premium) x Beta
Cost of Capital is the …
rate of return the corporation must earn on it’s invested capital in order to compensate for the time value of money and risk
The cost of capital is a weighted average of the…
cost of debt and the cost of equity. (WACC)
WACC=
Cost of Debt x (1 - Tax Rate) x (Debt/(Debt+Equity)) + Cost of Equity x (Equity/(Debt + Equity))
The value of a firm =
PV of projected FCF - WACC
Economic Profits measure…
the value created for shraeholders in a given year. Earning positive economic profits is the key to financial success for any business
Economic Profits=
- NOPAT - (R x Total Capital)
- (r* - r) x Total Capital
Stock Prices are highly correlated with…
Changes in the company’s economic profits
Market Value Added (MVA) measures
the total wealth created for shareholders by management. It reflects investor’s confidence in the company’s ability to create economic profits in the future.
MVA=
Market Value of Equity- Book Value of Equity
