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1. Explain the basics of valuation , m including intrinsic value, discounting , a n

1. Explain the basics of valuation ,

m including intrinsic value, discounting , and payoffs. (p . 12 -3)

2. Explain and estimate the cost of equity capital. (p. 12-11)

3. Describe and estimate the cost of debt capital. (p . 12- 13)

4. Explain and estimate the weighted average cost of capital 0/'JACC). (p . 12- 15)

s.

6.

Describe and apply the dividend discount model with a constant perpetuity. (p. 12-18)

Explain and apply the dividend di scount model with an increasing perpetu ity . (p. 12-18)

an increasing perpetu ity . ( p . 1 2 - 1 8 ) M 0

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0

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E

perpetu ity . ( p . 1 2 - 1 8 ) M 0 D U

ost of Capital and aluation Basics

·ng the bear markets of the early and late 2000s, many utility companies experienced a large market value decline. In an ort to prevent further decline, many of these utilities sold off their underperforming assets and consolidated their operations. se strategic business decisions all owed those in the utilities industry to generate positive earnings and cash flows in more recent years. Their stock prices also rebounded from the declines of the early and late 2000s . One utility company that has performed well in recent years is The Southern Company (SO). The Southern Company serves approximately 4.4 million customers through its various subsidiaries in Alabama, Florida, Georgia and Mississippi. The Southern Company generates, transports, provi des electricity . It al so invests in , among other things , synth etic fuels and the marketing of natural gas . The Southern Company has experienced some stock price volatility. SO 's stock price on July 1, 2006 , was $32 .05 per

are. Five years later its st ock tra ded for $40.72 per share. Charting its price from mid -2006 through mid-2011 , adjusting for

ock sp lits, reveals a reasonable increase despite the economic downturn, which is graphical ly po rt rayed below.

$42

$40

$38

$36

$34

$32

$30

$28

ly po rt rayed below. $42 $40 $38 $36 $34 $32 $30 $28 $26 ~~~'--~--''--~ Jan

$26 ~~~'--~--''--~

Jan 2007

L~~---<-~~-'-~

~-<-~ ~-"-~~"""-~~'-- ~ ---/

Jan 2008

Jan 2009

Jan 2010

Jan 2011

SO 's dividends per share also increased during this period. Finance.Yahoo .com predicts SO's dividend stream at approxi-

atel y

nual return from SO. Does this annual return adequately compensate investors for their risk and foregone interest return? at is, is the company fa irly priced given its pred icted dividen d stream? This question, and those similar to it, is the focus of is mod ule.

$1 .89 per share . The sum of its annual stock price change (capital gains) and its annua l div idend, yields the investors '

rces: The Southern Company 20 10 Annual Report and 10-K Filing ; Finance.Yahoo com , July 2011 .

12-2

12-3

Module 12 I Cost of Capital and Valuation Basics

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Cost of Capital and Valuation Basics

Basics of Valuation Estimating Cost of Capital • • Payoffs from Equity and Debt Securities
Basics of Valuation
Estimating Cost of Capital
• Payoffs from Equity and
Debt Securities
• Diversifiable and Non-
Diversifiable Risk
Recursive Process of
Valuation
DDM Framework
• Stock Valuation Issues
• Cost of Equity Capital
Using CAPM
DDM with Constant
• Intrinsic Value
Perpetuity
• Cost of Equity Capital
• Time Value of Money
Using Multi-Factor Model
DDM with Increasing
• Valuation of Debt
Perpetuity
• Cost of Debt Capital
• Valuation of Stock
Applying DDM
• Weighted Average Cost of
Capital

Valuation plays an important role in today 's market e~o~omy . Indeed , va lu ation is impli~it i~ all

financial deci s ion s

up to the value of what is received. For instance, va lu ation plays a central ro le m the follo wmg

situations:

• the sh:Ce price of a n initial public offerin g depend s on the business valuation by the iss uer as well as by potential investors

• identifying stocks or bonds that are over (or under) valued , which is a key task of a portfolio manager, depends on business valuations.

An important question is how do we val ue a stock , a ?ond , or any other

A financial instrument entitles its owner to a senes of future payoffs fr?m a com~any.The amount of such payoff s depend s on the company's abi li .ty to ge nerate pr?f1t th~ou~~ its fut ure operations. Previou s modules have dealt with the eva luation of a company s prof1tab1h ty and the

adjusting and forecasting of financial statement numbers. In su~sequent m?dules, we ~se thes~ adjustments and forecasts to estimate the value of the company via seve~ald1ffere~tequity valua

tion models and

dividend discount model -a nd introduces features common to most e~U1ty valuation models. Most valuation models incorporate an estimate of the cost of capital and a forecast of future payoffs . Cost of capita l is the discount rate that an investor (an equity or debt hol~er) u ses to va~u~ the future payoffs , and reflects the return the investor expects based on the pe~ce1ved~e:elof n.s associated with that inve s tment. Dividends are the forecasted future payoffs m the d1 v1dend dis-

count model. (Free cash flow s are the forecasted future payoffs in the di~co~ntedfree cash fl~~ model , and excess earnings are the future payoffs for the residual operating income model- Module s 13 and 14.) We begin with valuation basics, including a review of present value concepts and t?e co putations for lump-sum payoffs and annuities . Those familiar with pres~ntvalue calculat1?ns c~~ skip this review. The module then covers two key items: the computat10n of co~tof c~p1tal~he app lication of the dividend discount model. The cost of capita l section includes ?1scus s1on on de cost of equity capital, cost of debt capital , and ~h~weigh.ted average cost of capital. We concl u with a discussion of the pros and cons of the d1v1dend discount model.

and tran sac tion s in that market part1c1pant s compare the va lue .of what 1s g1~en

on the estimated fair value

of the ta rget company

a mero-er dec is ion depe nd s crucially

financial in strument?

approaches . This module introduces a fundamental

equ~ty valuat~on model- the

m-

LO 1 Explain the basics of valuation, including intrinsic value, di scounting , and payoffs.

BASICS OF VALUATION

ulti-

In some sense, valuing a stock is no different from valuing any another property . its pn · ce mately depends on demand and supply. Consider the pricing of, say, an apple. P~ople-:ant to :s~ apples mostly for nutrition . Hence the physical properties of an apple (such as its weight , fr

.

.

·

Module 12 I Cost of Capital and Valuation Basics

12-4

s, taste , and appearance), as well as the overall supply of apples in the market , determine the 'ce. The same logic holds for the pricing of stocks. The process for valuation described in this and subsequent modules is useful for valuing urities. We can use valuation techniques to:

Compare our stock-price estimate to the observed trading price and then decide whether to buy, sell, or hold the stock

Set a share price in an initial public offering

Determine the current price of a bond or other financial instrument

However, valuation methods apply more broadl y than s imply in secunt1es markets. For ample , this same valuation process is useful in addressing iss ues s uch

as :

Deciding whether a plant or divi sion should be expanded or closed

Determining how much s hould be paid in a merger or acquisition Evaluating an offer to acquire our company

e to the availability of quoted prices as a reference, the modules focus on valuation of publicly ded stock . However, the valuation principles and method s we describe in the modules can be ed to va lue any financial asset or liability .

ayoffs from Equity and Debt Instruments

e benefit from owning a stock or a bond comes from the cash it will bring to its owner in the ture. A bond holder is entitled to receive interest payments from the compa ny, as we ll as the payment of principal after the bond matures. For stockho ld ers , future cas h flows come from two urces (i) dividends paid , if any, by the company, and (ii) cash from se lling the stock to anot her vestor, or back to the company, in the future. For Southern Company (SO), a holder of each hare of its stock expects to receive $ 1.89 in dividend for 2011. In addition, when the stockholder lls SO 's stock in the future , the holder wi ll receive the current price of SO's stock. Regardl ess of whether future cash flows come in the form of interest and principal , or divi- nds and proceeds from stock sales , a ll these cash flow s have one thing in mmon: they occur in the future. This is the feature that makes valuing a financial instrument, such as Apple 's stocks or bonds , more difficult than valuing a commodity, such as app les . When we purchase an apple , its weight, its fre s hness, and its appearance can be readily measured. When we buy Apple 's stock, its future cash flows are yet to be determined , which makes

such cash flows diffi cult

to be determined , which makes such cash flows diffi cult to measure. Steps in Stock

to measure.

Steps in Stock Valuation

Because the payoffs from owning a stock or bond are in the future , such payoffs are uncertain and

predict. In practice , stock valuation can be viewed as a four- step process as explained

in Modul e 1 and depicted in the graphic on the next page .

Step I: Understanding the business environment and accounting information. Before we can

value a company, we must understand its business environment. This includes understanding

competiti ve and macroeconomic threats, evaluating future growth opportunities, and the quality of the accounting environment.

assessing

difficult to

Step 2: Adjusting and assessing financial and accounting information. This includes assessing

profitability and its drivers , a long with understanding growth potential , strategic actions, a nd their implications for financial reports. This step also includes making any necessary accounting adjustments to the general-purpose financial statements.

S~ep3: Forecasting financial information. Forecasting is crucial in security valuation as it pro- vides the key inputs to valuation models . Choice of what payoffs we forecast will be determined

by data avai labi lity, models utilized, and our casts, the output from any va luation model is

confidence in future estimates. Without good fore - dubious no matter how good the model.

12-5

Module 12 I Cost of Capital and Valuation Basics

Step

then

reflects both the time

acknowledges that a dollar received in the fu.ture is worth l~ssthan a dollar received toda:

Adjusting for ri s k takes account of the uncerta m nature of projected payoffs. Return s to invest- ments in bonds and , especially , stocks are unpredictable and often volatile . A doll ar invested in Google at its lPO in 2004 would have earned more than a 400 % return by 20 l I . On the other

hand , if we invested i_n ~~ron,~~r investment w~u~d ha~e been los t. These .cases refl~cta say ing:

4: Using information for ~aluation . Thi s ste~ involve s estimating the cost o_f capi ta] llnd

applying the proper valuation model to the est1m~ted pa.yo~s. The

value of money and the cost of nsk . Adjustmg for

cost _of capital we select

the tim e value of mone

Mo s t people dislike n s k . In stock valuat10n we adjust for risk

by determinin g a discount rate that is applied to projected payoffs. Valuation model s differ in the forecasted payoffs, the forecast horizon , and the use of a discount rate. It is imp~rtantto identify the crucial assumptions underlying each model , and to apply the proper model m the right way,

" life is uncertain until 1t 1s not.

and under the right circumstances.

until 1t 1s not. and under the right circumstances. Step 1-Understandlng the Business Environment and Accounting

Step 1-Understandlng the Business Environment and Accounting Information Modules 1 and 2

Step 2-Adjustlng and Assessing Financial and Accounting Information

and Assessing Fina ncial and Accounting Information Profitability Analysis-Module 3 Investing-Modules 6, 9, and

Profitability Analysis-Module 3 Investing-Modules 6, 9, and 10 Credit Analysis-Module 4 Financing-Modules 7 and 8 Operations-Module 5

Analysis-Module 3 Investing-Modules 6, 9, and 10 Credit Analysis-Module 4 Financing-Modules 7 and 8 Operations-Module 5

Step 3-Forecastlng Financial Information Module 11

Step 4-U slng Information for Valuation Cost of Capital and Valuation Basics-Module 12 Cash-Flow-Based Valuation-Module 13 Operating-Income-Based Valuation-Module 14 Market-Based Valuation-Module 15

12 Cash-Flow-Based Valuation-Module 13 Operating-Income-Based Valuation-Module 14 Market-Based Valuation-Module 15
Where does the firm operate? -. ~
Where does the
firm operate?
-.
~

Where 1s the firm currently?Valuation-Module 15 Where does the firm operate? -. ~ W here 1s the firm going? What

W here 1s the firm going? What 1s the firm worth?
W here 1s the
firm going?
What 1s the
firm worth?

These four steps are not mutually exclusive. They are part of a valuation pro cess an d, as such, they are interrelated. For instance , identifying the proper valuation model is li sted as part of step 4. Yet , choice of a valuation model is determined by a careful analy s is of the business environment (step 1) and its impact on the accuracy of forecasts of company payoffs (step 3). Likewise, the analysis of prior results in reported financial statements (s tep 2) form s the foun- dation for what is forecasted (step 3). Thi s interconnected series of steps provides us with a structure for understanding where the company operates, where it is currently, where it is goi ng, and what it is worth.

Intrinsic Value

Valuation involves estimating the intrinsic value (IV) of a company, which is the economic value of the company assuming that actual future payoffs are known today. The following (balance sheet) equation reflects the relation between intrinsic value of the firm and the intrinsic values of debt and equity.

where: IV Firm

IV Debi

IV Eq .

u1ty

IV Firm =

IV Debt + IV Equity

= intrinsic value of the company,

= intrinsic value of company liabilities , and

=

intrinsic value of company equity.

Module 12 I Cost of Capital and Valuation Basics

12-6

Intrinsic Value versus Market Value

~~~~~~~~~~~

J

~ntr~ns~c value represents . "true" value. Investors and analysts attempt to identify a company's intrinsic value by forecasting payoffs and the cost of capital via financial statement analysis and then use these payoffs as inputs into a valuation model. For a publicly traded company, its stock price represents the price that the stock is traded for on an exchange. In a competitive market stock price should equal intrinsic value. However, there are times when intrinsic value can diffe; from stock pr.ice. For exam~le,when an important piece of new information regarding a company becomes available to some investors, stock price differs from its intrinsic value before such inves- tors take action. Identifying those situations where intrinsic value differs from stock price allows investors to earn excess returns.

Review of Time Value of Money

money . Proficiency

with present value calculations is a prerequ1s1te for the materials covered in this module and the remamder of th.e book. If ~e are familiar with these materials , we can ski p this section and ju .mp to the next section on valumg debt and equity instruments.

Investors receive two kinds of payoffs (cash flows): lump sums and/or a series of equal pay- !°ents, equally spaced, known as an annuity. To compute the present value of these payoffs the investor must ( I) forecast the payoffs to be received and (2) determine the discount rate to be used.

~is section reviews the ~elev~nt concept~ ~ssociated with time value of

Lump-Sum Payoffs

The pr~sent value factor applied to a lump-sum payoff is I /( I + r)", where r is the discount rate and n is the number of .periods before the payoff is received . To illustrate , what is the present ~alue of $100 t? b~ received two years hence at a disco u nt rate of 1 l %? The present value factor JS 0 .8 l 162,_ w~1ch is co~puted as 1/(1.11 ) 2 . This present value factor is identical to the present factor multiplier found m Table 1 of Appendix A (titled Present Value of a Single Amount). We compute the present value of the $100 payoff by multiplying it by this 0.81162 present value factor as follows:

Future payoff

$100

x

Present value factor

for 2 years at

11 %

Present value

0.81162

=

$81.16

We can also us _e a financial calc~lator to compute the present value. The typical financial calculator has five mput buttons for time value of money calculations; we enter four values to comp~te a fifth value, which is the solution. We illustrate use of a calculator with the following graphic:

illustrate use of a calculator with the following graphic: 2 11 81.16 0 1 0 0
illustrate use of a calculator with the following graphic: 2 11 81.16 0 1 0 0

2

11

81.16

0

100

On the fi_nancial calculator, N is the number of periods (2), I/Yr is the interest rate per period (l J ): PY 1s the current or pre se nt value, PMT refers to periodic payment (0 in our example), and FY is the future value (100). Because we are solving for present value in this illustration that

value of 81.16 .is highlighted in red. (Most

~he calculator mtei:r.rets FY as a payoff to be received and the PY as the investment. So , if FY

~s en~ered as a pos1~1v~ amount , then PY shows negative, and vice versa.) Our solution of 81.16 implies that we are md1fferent between receiving $81 .16 today and receiving $100 two years from

calculators show a solution of - 81.16; thi s is be~ause

12-7

Module 12 I Cost of Capital and Valuation Basics

now . Stated differently , if o ne invests $8 L.16 in a bank account that earns 11 % annual inte rest it '

wil l grow to $100 in two years. Co nti nu ing with the ill ustration above, in the first yea r we wo uld earn $8.93 of interest 0

$81. 16 invested , co m puted as 0 .11 x $8 1. 16. l n the seco nd year, we wo ul d again earn in teres:

but fo r th at year th e in te rest wo ul d be earn ed o n and th e $8.93 in te r est earne d fro m t h e fi r s t year.

wo uld be earn ed o n a n ini t ia l in vest me nt of $8 1.16 over a two-year tim e ho ri zo n .

a la rge r a mou nt co nsisti ng of the original $8 l .t6 Ex hibi t 1 2. l s h ows t~e 11 % P.er year interes t that

Ex hibi t 1 2. l s h ows t~e 11 % P.er year interes t

Investment and Interest over a Two-Year Horizon

Investment at beginning

Time period

of period

Interest rate

Interest earned

1

.

$81.16

0.11

$8.93

2

.

90.09

0 .11

$9 .91

Annuity Payoffs

An annuity is a series of eq ua l lu mp su ms at reg ul a r in te rvals . Fo r a series of payoffs to qualify

as an an nuity, it must meet three crite ria: (l) the series must be of eq ual amoun ts, (2) payments

must occur at equal time periods, and (3) the same discount rate is ap pli cable over the time hori- zon of the payoffs . To illu strate, assume $ 1,000 is rece ived at the e nd of each of the nex t fo ur ye ars with an

11 % di sco un t rate. Ex hib it 12.2

pay me nts a nd the n a ppli es these

s hows th e prese n t va lu e facto r s fo r eac h of t he four lump- sum factors to determ ine the fo ur-year prese nt va lu e a nnuity factors .

Present Val ue Computat io ns for a n An nuity Present value Present value
Present Val ue Computat io ns for a n An nuity
Present value
Present value
Series of
Present
Payoffs
Interest rate
formula
factor
value

1

.

.

.

.

.

.

11%

2

11%

3

.

.

.

11%

4

.

.

.

11%

1

1/(1.11)

1/(1 .11) 2

1/(1 .11) 3

4

1/(1.11)

0.90090

$1,000

0.81162

1,000

0.73119

1,000

0.65873

1,000

3.10244

$

900.90

811.62

731.1 9

658.73

$3,102.44

Ex hibi t 12.2 s hows th a t a 4 - year , $ 1,000 a nnuit y y ie ld s a p rese nt valu e of $3, 102.44. Thi s ca n be

computed in two ways. We can

the present value fo r each , and the n sum the m as fo llows : $900 .90 + $8 11.62 + $731.19 +

$658 .73. A lte rn ati ve ly, we can sum the fo ur prese nt va lue of 3 .10244 fo r the fo ur- yea r annuity (also fo und in Ta bl e by the $ 1,000 annuity amount to yield $3,102.44.

treat each of th e fo ur payoffs as a se parate lump sum , compute

facto rs to yie ld th e prese nt valu e fac tor 2 of A ppendi x A), and then multiply it

. S pec ifica lly, summing the lump- sum present value fac tors yie lds the present va lue annuL~Y

fac tor of 3 .1024 . Ex hibit computed as:

12.2 sho ws th at the prese nt value of the seri es of fo ur

payments LS

($ 1 ,000

x 0 .9009 0 ) + ($ 1,000

x

0 .8

11 62) + ($ 1,000

x

0 .73 11 9)

+ ($ 1,000 x

0 .6587 3)

Appl ying algebra, the $ l ,000 can be taken o ut of each of th e parentheses and written as:

$

1 ,000 x

(0 .900 90

+ 0 .8 116 2 + 0 .7 3 11 9

+ 0 .6 5 87 3) or $ 1 ,000

X

3. 10244

The 3 .10244 is the prese nt value fac tor of a fo u r- year a nnuity a t 11 % . of the two approaches.

calcul ator to obtain the solutio n: we e nte r N=4, l/Yr=ll , PMT=I,000,

FV=O , and th e so lution is PV, hi ghli ghted in red . Thi s va lu e is mo re precise th a n t he value usi ng

T hi s s hows the e qu ival ence

To use a fi na ncial

Module 12 I Cost of Capital and Valuation Basics

12-8

e tables because the factors in the tables are rounded. Our discussion proceed s with the more xact p resent value , $3,102.45.

Calculator

s with the more xact p resent value , $3,102.45. Calculator 4 11 3 ,102.45 1

4

11

3 ,102.45

1,000

0

resent Value, Future Value, and Interest

theo r~, we . are indiffe:ent between receiving a payoff today th a t is equivalent to a future pay- ff th at is adjusted for interest. Using the payoffs in the above il lustration, we are indifferent tween re~eiving $3,102.45 t~ay and receiving $ 1,000 at the end of each of the next four years . Assuming the payoffs are invested and earn 11 % annual interes t , then at the end of four years

they grow to $4 ,709 .74 . This is shown

in Exhibit 12.3.

Lump Sum : Time Line Representation of Pre s ent and Future Valu e s an d Inte rest

0 1

$3,102.45

$

341.27

$3,102.45 x 0 .11

$3,443.72

$3,102.45 + $341 .27

2

$ 378.81

$3.443.72 x 0.11

$3,822 .53

$3,443.72 + $378.81

3

$ 420 .48

$3,822 .53 x 0 .11

$4,243.01

$3 ,822.53 + $420.48

4

$ 466 .73

$4,243.01 x 0 .11

$4,709.74

$4 ,243 .01 + $466 .73

The $4,709.7 4 fut ure va lue fo ur year s he nce is eq uivale nt to th e $3,102.45 Ju mp sum invested today, and is a lso eq uiva lent to t he $1,000 annu ity invested at the end of each of the next four

years . T he latter resu lt is portrayed in Ex hibit 12.4. Comparing Ex h ibits 12 .3

that both of these payment patterns-the $3,102.45 invested today and the $1,000 invested at the

end of ~ach of the ~~xt four years-yie ld the identical future value of $4,709.74. In summary, a

compari son ofExh1b1 ts 12.3 and 12.4 reveals that we are

today ver~us receivin g $1,000 at the end of eac h of the next fo ur years. Each of these payment

and 12.4 shows

ind ifferent between receiving $3,102.45

pattern s

yie lds a present value of $3,102.45 and a futu re va lue of $4,709.74. T hese " ti me va lue of

money"

concepts are important to understanding valuatio n models and the ro le of disco un t rates.

Annuity : Time Line Representation of Present and Fut ure Va lues and Inte rest

0 1

2

3

4

$3 ,102.45

$1 ,000.00

$1 ,000 .00

$1 ,000.00

$0.00

$110.00

$232.10

$1 ,000.00

$1,000.00 + $0.00

$1 ,000.00 x 0 .11

$2 ,110.00

$1 ,000 .00 + $ 11 0 .00

$2 ,11 0.00 x 0 .11

$3 ,342 .10

$2 ,110.00 + $232 .1 0

$1 ,000 .00

$367.63

$3 ,342.10 x 0 .11

$4,709.73*

$3,342.10 + $367 .63

• Difference due to rounding

~ sin g a fina n cia l calcu l ator, we ca n dete rm i n e t h at t h e fu tur e va lu e of t h e Ju m p s u m of $3,102.45 LS equal to the future value of the annuity of $ 1,000 per year.

u m of $3,102.45 LS equal to the future value of the annuity of $ 1,000

4

11

3,102.45

0

4 ,709.74

12-9

Module 12 I Cost of Capital and Valuation Basics

Valuation of a Debt Instrument

Estimating the intrinsic value of a debt instrument s.uch as a bond or note is si~ilarto the compu- tations in the prior section . For example, a bond stipulates a coupon rate , which determjnes the annuity payments, and the face value of the bond sti pulates the lump-sum payment to be made

at

the bond 's maturity. The final component necessary to determine the intrinsic value of a bond

is

the market rate of interest for the bond . The market rate is the interest rate an investor could

earn by investing in other bond s with similar ri sks. The market rate is the discount rate used in the prese nt value computation. (T hi s market rate is a lso called the effective rate or the cost of

debt capital.)

To illustrate , if we have a 3-year bond with a 9% coupon rate, a face value of $1,000, and

a market rate of 10 %, then the present value of the bond is $975 .13. The payoffs related to this

bond are determined by the coupon rate and th e face value, and tho se payoffs are portrayed in Exhibit 12.5 . (For simplicity, this section assumes no taxes; we explain the effect of taxes on the

discount rate later in this module.)

effect of taxes on the discount rate later in this module.) Time Line Representation of Payoffs

Time Line Representation of Payoffs Related to a Debt Instrument

0

1

2

3

Interest earned and received

$90

$90

$90

Future value at year-end

.

.

.

.

Lump sum (present value)

.

.

.

.

.

$975 .13

$983

$991

$1,000

Thus , the $975.13 prese nt value of this debt instrument is computed as the sum of (1) the $223.82 present value of the coupon payments ($90 X 2.48685) plus (2) the $751.31 present value of the maturity value ($1 ,000 X 0.75131 ) . The 2.48685 present value factor is for a 3-year annuity at 10% , which is equivalent to the sum of the three lump-sum present value factors of 0 .90909 + 0.82645 + 0 .75131. The 0.75131 prese nt value factor is for a lump-sum face value to be received

at the end of year three. (We see that computation of future value differs from that in Exhibit 12.3

because the payoffs in Exhibit 12.5 are not reinvested but , instead , are paid out.) Using a financ ial

calculator, we enter N=3 , I/Yr=IO (market rate of interest), PMT=90 (coupon rate of 9% times

$ 1,000 face value), FY=l ,000 (face value), and then the solution is PY, hi ghlighted in red , below.

and then the solution is PY, hi ghlighted in red , below. 3 1 0 975.13

3

10

975.13

90

1,000

Valuation of an Equity Instrument

Estimating the intrinsic value of an equity instrument begins with the assumption that the stock pays

a constant dividend each year for n future years, and then it is sold (or liquidated) with a lump-sum

payment at the end of year n + l . To illustrate, assume that we forecast dividend payouts of $90 at the end of years 1 and 2 along with a termjnal dividend of $1,090 at the end of year 3. The terminal dividend is the fin al payoff associated with the investment, and can be viewed as the proceeds from the sale of the stock or the proceeds received upon liquidation. If we assume that the discount rate is 10%, then valuation of this company is identical to that of the debt valuation illustration above. Tills mea ns the value of thi s company's equity is $975.13. (Di scount rates for debt and equity instruments of the same company differ-here we use 10% for both the debt and equity instruments to show the simjlarity in valuation approaches.) Again , using a financial calculator, we enter N=3, l/Yr=l O (market rate of interest) , PMT=90 (annual dividend) , FY=l ,000 ("extra dividend " in year 3), and then the solution is PY, highlighted in red , below.

Module 12 I Cost of Capital and Valuation Basics

12-10

Module 12 I Cost of Capital and Valuation Basics 12-10 3 10 975.13 9 0 1

3

10

975.13

90

1,000

To this point, we have shown how to value different payoffs. We have explicitly identified the payoffs received and the discount rate used. This information can be readily programmed into a spreadsheet. However, expertise is required to project future payoffs (such as dividends, free cash flows , or earn ings) for va.luatio n purposes a nd to identify the proper cost of capital to use as the djscount rate. The di scount rate we use depends on the payoff stream being valued. Payoffs to debt holders are discounted usi ng the cost of debt capital. Payoffs to equity holders are di scounted usi ng the cost of equity capital . Payoffs to the entire firm are discounted using the weighted average cost of capi- tal. We descri be how investors estimate these different cost of capital measure s in the next section .

ESTIMATING COST OF CAPITAL

There are different ways to estimate the cost of capital us in g observable market data. Investo rs, who price financial instruments, expect to recover two costs: the time value of money and the cost of risk . The time value of money can be viewed as the foregone interest from investing in an instrument with future payoffs. The second cost is the in vestor's compensation for bearin g the risk associated with the uncertainty of the payoffs. These two components make up what we call the r isk-adjusted discount rate . Jt is intuitive that the components of the risk-adjusted di sco unt rate (foregone interest and compensation for risk) equal the return that investors require for investing in an asset. Hence , the risk-adju sted di sco unt rate used in the valuation calculation, is exactly equal to the investor 's required rate of return or cost of capital. When we estimate cost of capital, we usually make the following assumptions. First, we assume that current interest rates are a good approximation of expected (future) interest rates. Second , we assume that the current risk of the firm is a good approximation of the expected firm risk . We can adjust this assumption if we know of plan s to alter that risk. For example, if the firm is entering into an acquisition that will result in a new line of bu si ness with a substantially differ- ent level of ri sk than current operations we can adjust our expectation of future risk . When using estimates of cost of debt or equity capital, we assume that the current capital structure (mix of debt and equity financing) will persist.

BUSINESS INSIGHT

Use of Nominal (Risk-Adjusted) vs Real Payoffs

The value of a monetary unit commonly changes over time due to inflation or deflation. Payoffs and discount rates that include the effects of these price level changes are referred to as nominal or risk- adjusted {because they include this risk). If the effects of price level changes are not included, the payoffs and discount rates are referred to as real . So, should we use nominal or real amounts for valu- ation? Consider the following example where a nominal payoff of $200 million is expected in two years. Assume that there is 3% inflation per year expected and the nominal discount rate for this payoff is 10% , which implies a real discount rate of 6.8% (0.068 = [(1 .00 + 0.10)/(1.00 + 0.03)) - 1.00) . We can estimate the value of the expected future payoff using either nominal or real amounts as follows:

Inputs:

Payoff

x

Discount Rate

=

Value Today

Nominal:

$200 million

x

1/1.10 2

$165.3 million

(nominal)

(nominal-includes inflation)

Real:

$200 million/ 1.03 2 x

1/ 1.068 2

$165.3 million

(real)

(real-excludes inflation)

The computed value of the payoff is unaffected by whether nominal or real inputs are used in the calculation (remember that use of nominal payoffs requires use of nominal discount rates and use of real payoffs requires use of real discount rates) . In practice it is easier to use nominal inputs as analysts do not forecast real payoffs nor take time to convert nominal rates to real rates. Accord- ingly , we use nominal inputs for valuations in this book.

12-11

Module 12 I Cost of Capital and Valuation Basics

Diversifiable and Non-Diversifiable Risk

To explain the use of market data to estimate the cost of capital, we must introduce the idea f

diversifiable and non-diversifiable risk. The models used to estimate cost of capital assume th~t investors are only concerned with non-diversifiable risk, and are willing to accept diversifiabl risk without compensation. Diversifiable risk refers to risks that can be diversified away by investors. Diversification refers to the practice of holding many stocks and bonds in one's investment portfolio . How does diversification affect risk? To answer that, suppose we invest our entire worth of $ 1,000 into

one sing le stock . Assume that during

meaning, on average, the stock value could go up or down by 10% during each and every day'. In contrast, if we invest our $1 ,000 into a portfolio (bund le) of S&P 500 stocks, th e volati lity of our portfolio would be, say , 4 % . This is because each day some of the stocks in the S&P 500 index might go up , while others might go down . In this case these stock price movements can- cel each other out, dampening large price movements. This is the basic idea of diversification. Simply put , it reflects the wisdom in the saying " don ' t put all your eggs in one bas ket." On the other hand , if we are confident that we are smarter than average (and who is not?) we might e lect to put al l our eggs in one basket; but, as Mark Twain cautioned , " Watch that basket!" An important condition for diversification to reduce risk is that the returns of stocks in a

portfolio must be somewhat independent. If the returns of stocks in our portfolio are correlated, meaning they tend to go up or down at the same time, then the effect of diversification on risk

e

the previous year

the volatility of the stock equ als 10%

is reduced.

To illustrate this concept , suppose we have two stocks in our portfolio: Pepsi and Coca Cola . For these two stocks, there is the risk that some consumers switch from Coke to Pepsi, or vise versa . Since we hold both stocks, we are not bothered with this risk because with Pepsi or Coke, the consumer is drinking one of our products. However, there is a lso the ri sk that consumers choose to reduce their consumption of sodas in favor of, say, Starbucks coffee. If this happens, then both Pepsi and Coca Cola ' s sa les will suffer. Diversification by inv es ting in these two stocks (instead of only one) does not shie ld us from risk of product substitution. In

ot her words, some risk is non-diversifiable given the pool of stocks.

It is difficult to determine whether a particular risk is diversifiable or non-diversifiable. One way to proceed in this s itu ation is to hold what is called a "market portfolio" - meani ng to hold all stocks avai lable in the market. The underlying assumption is that , by doin g thi s, we diversify away al l t he risks that are diversifiable . Hence the rema inin g risk in a marke t portfo- lio is "non-diversifiable." (Of course, holding the market portfolio does not diversify away the

ri sks associated with ho ldin g stock as assets rather than some ot her c lass of assets -s uch as

land , precious metals, foreign currencies, artwork, baseball cards, and memorabilia .)

By comparing the historical vo latility of a n individual

stock to the hi storica l volatility of

the market portfolio, we can estimate the non-diversifiable risk in

is the notion behind the capital asset pricing model .

each

individual stoc k . This

Cost of Equity Capital Using the Capital Asset Pricing Model

L 0 2

esti mate the cost of equity cap ital.

Explain and

The capital asset pricing model (CAPM) equates the expected return on a particular ass et as the sum of three components-the risk-free rate , the beta risk, and the stock-specific risk. The first two components are used in estimati ng the cost of eq uit y capital. The third component, th e stoc k- specific risk, is the risk that is diversified away in large portfolios. In equ ati on form , the CAPM estimation of a company's expected return, or cost of equity capital (re), fo ll ows:

Module 12 I Cost of Capital and Valuation Basics

the asset's market return to the overall market return. The market risk premium is the difference between the expected market return (rm) and the expected risk-free rate:

Market risk premium = r

-

m f

r

12.2

f'lis.tori call y,

per10?, has generally fluctuated betwee n 9% and 13% . These figures yield a usual market risk

of th e asset's market return to the overall market is

prerruum of about 4% to 8% . 1 The se nsiti vity

referred to as the company's market beta (/3) . Market beta is a statistical coefficient that reflects

rr has fluctuated arou nd 5% . The overa ll market return, while dependent on the time

a

compan y ' s hi stori cal stock price volati lity relative to the overall market vo latility. Market beta

is

comrr_io nl y estimated f~om a regressio~ of a company's stock returns (dependent variable) on a

market index of returns (inde~endent variable) over a representative time period (often the previ- ous 60 months). The market index of returns represents returns from a portfolio of risky assets · '

Market beta re~ects the risk that cannot be diversified away by investing in a portfolio of nsky assets (accordmgly called systematic risk) . In this CAPM framework, the market has a beta of 1.0. (Another way to think of this is that if we had a portfolio consisting of all avai lab le stock market assets, the value of our portfolio would move perfectly with the value of all available stock market assets.) A market beta greater than (less than) 1.0 indicates the company's stock price will change by a larger (small er) percent with a change in the overall market. For example accordino-

an example of a market index is the S&P 500.

.

Fin~nce,~ahoo.com,The Southern Company {SO) h as a market b eta of 0.35 as of mid-20 Lt

~pplymg th1s estimate, a change in the overall market return yield s a change in SO ' s stock that

company stock price moves

contrary to the market. Althoug h beta is a risk measure, it is also associated with returns. The hio-her the risk an investor is willing to accept , the higher the expected return; and , according ly, th; lower the risk, the lower the ex pected return. To illu strate , let 's ap ply the CAPM to The Southern Company. In mid-2011 , according to bankrate,com '. the 1~-yearTreasury rate was 3.1 % . Assuming a mark et risk premium of 5 % , then the cost of eq ui ty capital (re) for Southern Company with a market beta of 0.35, is 4.9 % , which is computed as 0.031 + [0.3~ x (0.?8 1 - 0.031)] . This estimate impli es that an investor requires an ex~cte.d return o~ 4.9 % to m vest m . Southern Company's stock. Stated differently , the cost of eq uit y capital 1s the required return to eqmty holders for investing in SO 's stock.

to

is 35% of the market c han ge . A negative market beta implies that the

BUSINESS INSIGHT

Market Beta

Numerous financial service firms and online investor Websites provide estimates of a company's

~ar~et beta. Betas are

firm s stock returns on a market index of returns over a recent time period . One common estima- tion method is to run a regression of a firm 's monthly stock returns on the returns to the S&P 500 index over the last 60 months. Estimated betas are measured with error. In addition , those betas ar~ bac.kward looking estimates , but are used for decisions about the future. A key assumption in this est1mat1on method is that a company's risk does not change substantially. Because beta is es~imated from historical information, it likely fails to account for any business changes or industry shifts that alter a company's future risk. Financial service Websites for beta estimates report a ran~e of beta estimates. These differences arise due to choices involving the time period for esti- mation , .frequency of measurement (monthly, weekly, daily), and market index used. In mid-2011, a sampling of several beta estimates from Websites found beta estimates for Southern Company

commonl~ estimated as the slope coefficient from a linear regression of the

ranging from 0.31 at Finance.Google.com to 0.55 at Valueline.com.

from 0.31 at Finance.Google.com to 0.55 at Valueline.com. 12.1 ~For readings on t hi s topic

12.1 ~Forreadings on t hi s topic , see E. F. Fama and K . R . French, " The Cro ss -Section of Expected Stock Return s," J o urnal

Gebhardt , C . Lee, and B. Swaminat han, "Towards an Ex Ante Cost of Capita l, "

~ournal?of A.ccounting Research , (!une 200 I) , pp. 135- 176; J. Claus and J. Thomas, " Equi ty Premia as low as Three

if Finan ce, June 1992, pp. 427-465; W.

T he first component is the expected risk-free rate , rr (expectation symbols are not included in the

eq uation ) . The return on ten-year U.S . treasury bills is common ly used as an estimate of rr. The

second component is the product of the market risk premium (rm -

rr) and the sensitivity (/3) of

ercent.

Evidence from Analysts

Earnings Forecas ts for Domestic a nd International

Stock Markets ," Journal of

Fin ance, (October 2001), pp. 1629-1666 ; and P. Easton, G. Taylor, P. Shroff, and T. So u giannis , " Using Forecasts of Earnings to Simu ltaneously Estimate Growth and the Rate of Return on Equity In vestments," Journal of Accountin Research, (June 2002) , pp. 657-676.

g

12-12

12-13

Module 12 I Cos t of Capita l and Va luation Basics

Cost of Equity Capital Using a Multi-Factor Model

Given the limitations with CAPM, researchers have developed other models to compute ri k- adjusted returns. These so-called multi-factor models share the following basic form : s

multi-factor models share the following basic form : s 12.3 The r represents the premium of

12.3

The r represents the premium of risk factor j , and B. captures the sensitivity of the stock to fac-

tor j, \vhere j = 1, 2, 3,

market risk premium .

Researchers have attempted to identify the risk factors. One set of resea rch studies relies on large sample data analysis. For instance, researchers have found that stocks with a high book-t0- market ratio (defined as total book value of the company divided by its total market value) tend to have higher subsequent stock returns, on average, compared with stocks with a low book-t0- market ratio. This result seems to indicate that companies with a high book-to-market ratio are regarded by investors as being more risky and the excess return simply reflects the compensation for such risk . Other risk factors identified based on similar large sample analysis include the company's size and the liquidity of its stock. Identifying risk factors based on large sample analysis has a shortcoming; that is, we do not know why such factors matter. Why are small companies more risky than large companies? To answer this question , researchers have tried to identify risk factors based on fundamental analysis. Such risk factors can be classified as:

The CAPM can be view6d as a special case with only one factor: the

Internal risk factors: such as operating leverage, financial leverage, effectiveness of internal control , management team, and so forth.

chain risk, indu stry com-

External riskfactors: such as exchange risk, political risk, supply petition, and so forth.

Research on identifying and measuring risk factors is ongoing. Those factors can be viewed as part of the broader five forces that confront the company and its industry discussed in module I.

L03

Describe and

estimate the cost of debt ca pital.

RESEARCH INSIGHT

CAPM and Cost of Capital

CAPM is a misnomer in that it is not truly an asset pricing model but instead is a model used to estimate cost of capital. A strength of CAPM is its simplicity. It assumes that the only risk factor is the market return (referred to as {3) and it assumes that prior period's {3 is a suitable estimate for future risk. However, CAPM is also criticized by academics and practitioners who arg ue that a firm's systematic risk varies over time and that CAPM estimates are sensitive to the particular model inputs chosen. In theory, CAPM is applied using a market index representing all available investments. Use of a stock-based index such as the S&P 500 neglects other investment opportu- nities. Further, CAPM attempts to measure covariance with the risk premium of the market , which is arguably time-varying with recent estimates ranging from 2% to 7% versus the 4% to 8% historical numbers. CAPM relies on one risk factor and ignores additional risk factors such as company size. Some argue that inclusion of additional risk factors yields a "better" cost of capital estimate. Due to these concerns, we must carefully consider the sensitivity of our valuation estimates to our cost of capital assumptions.

Cost of Debt Capital

The market rate on debt instruments is known as the cost of debt capital. The cost of debt capital is usually reported in financial statements or can be computed using the stated coupon (interest) rate on a debt instrument along with the fair value of the debt instrument that is either recorded on the balance sheet or disclosed in its footnotes. The reported fair value of the debt instru ment should approximate its present value. A company's borrowing rate depends on its perceived level of risk by the lenders . Usu al factors considered by lenders include short-term liquidity measures such as the quick ratio and

Module 12 I Cost of Capital an d Valuation Basics

12-14

iJtterest-coverag~rati_o, and_long-term financial stability measures such as the debt-to-equity ratio .

Seve_ral co~pan1es? mcludmg Moody's Investors Service , Standard and Poor's , and Fitch

prov1d_e ratmg services for bonds and notes. For instance, those organizations classify debt issu- ances mto the following categories.

Moody's

S&P

Fitch

Description

Aaa

AAA

AAA

Prime Maximum Safety High Grade, High Quality

Aa1

AA+

.AA+

Aa2

AA

AA

Aa3

AA -

AA -

A1

A+

A+

Upper-Medium Grade

 

A2.

A

A

A3

A-

A-

Baa1

BBB+

BBB+

Lower-Medium Grade

Baa2

BBB

BBB

Baa3

BBB-

BBB-

Ba1

BB+

BB+

Non-Investment Grade

Ba2

BB

BB

Speculative

 

Ba3

BB -

BB -

B1

B+

B+

Highly Speculative

B2

B

B

B3

B-

B-

Caa1

CCC+

CCC

Substantial Risk In Poor Standing

 

Caa2

CCC

Caa3

CCC-

Ca

c

Extremely Speculative May be in Default Default

 
 

ODD

DD

 

D

D

The top category is A~A,meaning the bond is very unlikely to default. Bonds with a rating of

BB~- (or Baa3) and higher are referred to as investment grade, meaning these bonds are of high qual1t~.In cont~ast,bonds with a rating of BB+ (or Bal) and lower are referred to as a junk bond, reflect1~gthe ~1gherdefault risk of those bonds. 2 The cost of debt capital is closely related to the debt ratmg assigned to the company.

We must also consid~rthe ~ffectof taxes because the expected cost of debt capital is com- puted on an after-tax basis and 1s denoted rd. Specifically , cost of debt capital is determined as follows:

rd = Pretax borrowing rate for debt x

( 1 -

Tax rate)

12.4

The ~fter-taxcost of de_bt capital requires identifying the pretax (average) borrowing rate for interest-

~an~g debt and the plication by the ter _m

~~ rate" yields the cost of debt after the tax savings from the inter-

mcome tax rate, both available from financial statement footnotes. Multi- -

"1

~stexpense d~du~t1on. Spec1f1cally, the tax rate is often proxied by the statutory tax rate for the

ompany, which is the 35% federal statutory rate plus or minus the state statutory rate net of any federal benefit~.(Ideally, th_e marginal tax rate is used in estimating the cost of debt capital; howev~r,the marg1~altax rate is unobservable.) The pretax borrowing rate (also called average borrowing rate) for interest-bearing debt, including both short- and long-term, is computed as:

Interest expense/Average amount of interest-bearing debt

~.Differences.'.n the_borrowing rates of hi gh grade and low grade bonds are referred to as "credit spreads." In eras of

meaning that investors do not demand much of a risk premium for lending to high

nsk entities.: In 2007, a s.~ddenshift m mvestors' appeti te for risk led to a marked increase in credit spreads, and caused

substanti a l d1 s loc a t1on s

_easy ~~ney, credit spreads are l_ow

m the market for certain types of high risk debt.

12-15

Module 12 I Cost of Capi t al and Valuation Basics

Module 12 I Cost of Capital and Valuation Basics

12-16

We encourage the use of adjusted numbers in th~s computatio~;for examp.le , debt would include

weighted average cost of capital formula , to estim ate the ri s k of the company. The followin g chart

capitalized

operating leases , and interest would mclude the adjustment to interest from any such

helps to vi sualize these re lation s:

capitalized

leases .

To illustrate , we use Southern Company ' s tax rate and pretax borrowing rate to approximate its after-tax cost of debt capital. SO's 2010 statutory tax rate is 36.8 %, consisting of the 35% fed- eral rate and the 1.8% state rate, net of federal benefits-both reported in footnotes to its financi al statements. Its pretax borrowing rate is approximately 4.6 % , which is computed by dividing its 2010 interest expenses of $895 million by its average total debt of $19 ,350 million (see SO's 2010 statements of capitalization). Consequently , its after-tax cost of debt capital is 2 .9 %, computed as

0.046 x (l - 0.368).

L04 Exp lai n and estimate the weighted average cost of capital (WACC).

Weighted Average Cost of Capital

In our examples to this point, the discount rate for debt valuation or for equity valuation was approximated by either the cost of debt capital or the cost of equity capital, respectively. The cost of debt capital would be used to value debt instruments while the cost of equity capital would be used to discount the payoffs for an all-equity company. The nature of the stream of futu re payoffs that we desire to value dictates the discount rate we use to compute the present value . When valu- ing a debt instrument such as a bond , the cash payoffs are received by debt holders , so the cost of debt capital is used for valuation. When valuing equity instruments using the dividend di scount model (discussed later in this module), the payoffs received by equity holders are di scounted using the cost of equity capital. Some valuation models , such as the discounted free cash flow and the residual operating income models , assume the payoffs (free cash flows and operating income) are di stributed to both equity holders and debt holders. For these models, a company's cost of capital includes both debt and equity. Accordingly, cost of capital , too, must recognize that payoffs will be distributed to both debt holders and equity holders. This means that those companies' cost of capital is a weighted average of the cost of debt capital and the cost of equity capital. To better understand the computation for the weighted average cost of capital (WAC C), reca ll the balance sheet equation that reflects the relation between the intrinsic value of the firm and the intrinsic values of debt and equity.

IV Firm

= IVDebt + IVEquity

Where IV . is the intrinsic value of the company, IV

. Multiply mg the after-tax cost of debt capital (rd) by the ratio of the company s mtnn s1c val ue that is financed by debt holders (IV Deb/ IV Firm) , and then adding this to the product of the cost of equity capital (r) and the ratio of the company's intrinsic value that is financed by equity hold- ers (IV . / IVe ) yields the weighted average cost of capital , denoted r v · Specifi cally, the weighted average cost of capital is computed as follows :

ties, and IV Equity is the intrinsic value of

0

e

b is the intrinsic value of company liabili-

t

.

,

.

.

Fmn

com~any equity.

'

~

~

rw =

(

IVDebt)

rd x --

IVFirm

+

(

r.

x

IVEquity)

IVFirm

12.5

The WACC computation uses intrinsic values instead of numbers reported on balance shee.ts. However because intrinsic values are unobservable, we typically use the market value of eqmty in place ;f the instrinsic value of equity, and the market value of debt in place of the intri nsic value of debt (or book value when market value is difficult to determine). (The market value of

debt is usually reported in the 10-K

To clarify the relation among a company 's debt and equity and the cost of capital, we must understand the difference between the sources of underlying risk and the methods by which cost of capital is estimated . Equity does not contain risk in and of itself. Rather it is risky be~au~e it represents both ownership of the firm and obligations to debtholders. Therefore, the n sk in equity is driven by risks inherent in the company and its debt. Changes in either of these areas cause changes in the riskiness of equity . When we estimate cost of capital, it is straightforward to estimate cost of capita l for debt and for equity. These two estimates are then applied , usin g the

footnote exp laining debt.)

Inherent risk in the firm and debt are sources of equity risk

Inherent risk in the firm and debt are sources of equity risk Debt and equity are

Debt and equity are used to estimate firm risk

To illustrate the WACC computation, we con sider The Southern Company . According to SO's financial statements, at December 31 , 2010 , the market valu e of its debt is approximately $20 ,073 million (from its 2010 10-K) ; the market value of its equity is $32 ,247 million, computed from its December 31 , 2010 , stock price of $38.23 time s it s 843.5 million shares ou standing

intrinsic value (for the entire firm)

is $52,320 million . Usin g thi s information we compute SO 's weighted average cost of capital as

follows (SO 's rd and re are computed earlier in thi s module ;$ in million s) :

(Finance.Yahoo.com) . Taken

together this means that

SO 's

rw =

(0.029 X

= 4.1%

[ $20,073 /$52,320 ]) + (0.049 X [ $32,247 /$52,320 ])

A final point is how to treat any preferred stock. When preferred stock exi sts , the WACC compu-

tation includes a third term:

r

w

= (r xIV Debt) + (r

d

IV

Firm

ce

xIV Common Equit y )

IV

Firm

+ (

r pe

xIV Preferred Equit y ) IVFirm

is the

the preferred sto~k . The

IV Preferred Equit y is the preferred stock 's market value , or book value if market value is difficult to

determine.

This formulation separates equity into common equity, ce, and preferred equity, pe. The r

cost of preferred

equity , which i s usually the preferred dividend rate on

You are considering investing in a company that has announced that it plans to alter its capital structure; that is, change its ratio of debt to equity. How might this change affect the company 's weighted average cost of capital? [Answer p. 12-221

's weighted average cost of capital? [Answer p. 12-221 According to Finance.yahoo .com, IBM has a

According to Finance.yahoo .com, IBM has a beta of 1.6. IBM's market value of debt is approxi- mately $12.08 billion and its total market value of equity is $143.48 billion. IBM's average cost of debt capital (pretax) is approximately 7 .5% and its marginal (statutory) income tax rate is 35 %. Assume that the risk-free rate is 4.6 % and the market risk premium is 5 %.

Required

a.

Interpret IBM 's beta value.

b.

Estimate its after-tax cost of debt capital.

c.

Estimate its cost of equity capital.

d.

Estimate its weighted average cost of capital.

The solution is on page 12-30.

12-17

Module 12 I Cost of Capital and Valuation Basics

Module 12 I Cost of Capital and Valuation Basics

12-18

DIVIDEND DISCOUNT MODEL

The divide?~ discount mode~ (DDM)

all future d!v1dends . 3 As ~e ~1scussed earlier,_ a debt instrument is v~ued b~ d1scount _m g it s cou pon payments, 1f any, along with its face value usmg the cost of debt capital. With an equity in strument dividends can be viewed as similar to coupon payments on debt, and the terminal dividend (the finai

payment) can be viewed as similar to the face value of debt. (We assume most companies are going concerns, meaning they continue to ~perate indefin~t~ly; thus, the '.'terminal_ dividend" is most likely the proceeds upon the sale of the equity.) Further, d1v1dends are paid to equity holders , which means that the proper discount rate is the cost of equity capital instead of the cost of debt capital. The reasoning underlying the dividend discount model is that the right to the expected future payoffs from a company is what is being purchased by a shareholder. An investor gives up the use of funds today in expectation of future distributions of cash from the company . This valuation method recognizes the role of cash as the method of exchange and ties value directly to distribution s of cash via dividends and/or a future selling price. This section shows how the dividend discount model is derived. We explain how to estimate the present value of the regular dividends and the terminal dividend. We conc lude this section with a discussion of issues in applying the dividend discount model.

equ~tes the val_ue of comp_any equity wit _h the p~esent value of

Recursive Process of Valuation

Earlier in the module we showed how two types of payoffs in the future can be discounted to find the present value. Similarly, the intrinsic value of equity at the beginning of period one (IV 0 ) can be characterized as the sum of the dividends to be received during period l (0 1 ) plus the value of equity at the end of period I (IV 1 ) and then this quantity is divided by I + re, or spec ifi cally :

This DDM model equates current stock price to the present value of all future expected dividends To apply the dividend discount model , we must forecast the company's future dividends for infin~ ity. Two. metho?s to forec~st and discount infinite dividends are the constant perpetuity method and the mcreasmg perpetuity method.

Dividend Discount Model with Constant Perpetuity

We can simplify the dividend discount model by assuming that the forecasted dividends sta-

bilize at . some poi~t in the . future and remain constant thereafter. The latter pattern yields a

ord .mary annuity (meaning payment s occur regularly at the end of each

~r~od) with an mfrnlt~ ?onzon. The present value for a perpetuity of constant (non-changing)

d1v1dends equals the d1V1dend amount divided by the discount model follows:

per_p etmt~ , wh1~ h !s . an

rate (cost of equity capital) . This

IVo =

D1

re

To illu strate use of this model, assume that we forecast a $3 per share dividend for Kimbrell Company for the ini.ti~I two years, followed by a $3.50 per share dividend in the third year, and a. $4 per share d1v1dend. thereafter. Assume also that we estimate the cost of equity capital for Kimbrell at 12% . As a first step, we compute the present value of the initial three years of dividends from:

$3

$3

$3.50

1.12 +

(1.12)2 +

(1.12 )3 = $2.68 + $2.39 + $2.49

Second, we compute the present value of the perpetuity of $4 to be $33.33, computed as of the end of year 3 as:

IV 0 =

D 1 + IV 1

1 +re

12.6

$4

0.12

= $33.33

To illustrate, suppose we decide to buy a share of stock in Western Company. What is today's

9 % , the expected di vidend

for period l is $2, and the expected intrinsic value of equity at the end of period l is $4 1, then

Western

intrinsic value

of Western Company? If

the cost of equity capital is

Company 's intrinsic value today (IV 0 ) is $39.45 , computed as:

IV 0 =

D1

1

+

+

IV I

re

=

$2

+

$41

1.09

=

$

39.45

Further, IV 1 can be equated to 0 2 and IV 2 ; and then, IV 2 can be equated to 0 3 and IV 3 , and so forth. This continual substitution of future payoffs illustrates the recursive process of asset valua- tion, meaning that the price of stock today depends on the expected price of the stock tomorrow, which in tum depends on the expected price of the stock the day after tomorrow, and so forth. This process continues for infinity. (In practice , valuat ion is affected by the investor's time hori- zon and any differences in the investor's expectations about dividends and future intrinsic va lues compared with the market; these differences are what make a market.)

The $33.33 is t?e ~resent v~lue of the $4 perpetuity as of the end of year 3. To find the present value at the begmnmg of penod I we discount the $33 .33 lump-sum payment from the end of year 3 to th; start of year .1. ~hu_s,the present value of this perpetuity is $23 .73 , computed as ($4/0 .12)/ (l.12) . In sum, the mtnns1c value of a Kimbrell share is computed as follows :

IV

0

_

-

~

1.12 +

$3

(1.12)2 +

$3.50

(1.12)3 +

(!ii)

(1.12)3 = $2.68 + $2.39 + $2.49 + $23.73 = $31.29

To generalize , the following formula reflects the dividend discount model when we assume

a constant dividend beginning in

period n + l and continuing in perpetuity :

IVo =

1 D+1

+

( 1

D2

)2

+

( 1

D3

)3

+

(

Dn

)

+

 

r e

+

r e

+re

1

+re n

 

(1

Dn+I

Constant

Perpetuity

re

+ re)"

DDM

Framework of the Dividend Discount Model

One sol ution to the recursive process in equation 12.6 is the following:

IV

0

= ~

l+re

+

D2

(l +r e) 2

+

03

( l+r e)3

+

We typic~l~yrefer tot.he last t~rm ~s.the "ter~i~aldividend," although it is not paid out in period n + l and it is not terminal. A s1mplif1ed application of this model is to assume the current dividend continues in perpetuity. This model was defined at the start of this section.

DDM

Dividend Discount Model with Increasing Perpetuity

3 There is debate about whether taxes affect the value of dividend s. It is possible that investors discount the value of dividends if dividends are taxed at a higher rate than capital gains . However, since tax exempt institutional in vestors make up a huge pa rt of the market , it is a rgued that if ta xe s affected the value of dividend s then tax exempt in vestors would have an arbitrage opportunity . It is argued that such an arbitrage opportunity, if it exists , would force di vi dend paying compani e s to yield the same return as non-dividend paying compan ies. Accordingly, we as s ume th at taxes do not affect the value of dividends.

Ano~~ er means to si~p~ify the dividend discount model is to assume that the forecasted dividends stabilize at some pomt m the future and continue to grow at some constant rate thereafter-this is

yields an increas-

~eferred to a~the G?rd~n growt~ model. T~e la~tergr~wth_pattern for dividends

ng perpetmty , which 1.s an ordinary annuity with an mfirute horizon where the amount grows at a constant rate. The equation for the present value of an increasing perpetuity follows; in this equation,

L 0 5 Describe and apply the dividend discount model with a constant perpetuity.

LOG Exp lai n and apply the dividend disco unt model with an increasing perpetuity.

12-19

Module 12 I Cost of Capital and Valuation Basics

0 1 is the dividend amount when the constant growth period begins, re is the discount rate, and g is a constant growth rate.

D1

IV 0 = --

r.

-

g

If we assume that the constant growth rate equals zero, then the model reverts to the dividend discount model with constant perpetuity explained above. To illustrate use of this model for Kim- brell Company , assume that we forecast a $3 per share dividend for the initial two years, followed

by a $3.50 per share dividend in the third year, and a $4 per share dividend in year four that con- tinually grows at a 3% rate per year for year 5 and thereafter. Assume also that we estimate the cost of equity capital for Kimbrell at 12%. The present value for the initial three years is identical to that for the constant perpetuity model in the prior section. Next , the present value of an increas- ing perpetuity is $44.44 as of the end of year 3, computed as D/( r - g) = $4/(0.12 - 0 .03). Then, we discount the $44.44 as of the end of year 3 to today 's date to get $31 .63, computed as ($44.44)/

( J .12) 3 .

In sum, the intrinsic value of a Kimbrell share as of today is computed as:

- IV 0 -

~

$3

$3.50

1.12 + (1.12) 2 + (1.12) 3

+ ( 0 . 12 ~o.o 3 )

( 1.12) 3

= $2.68 + $2.39 + $2.49 + $31.63 = $39.19

To generalize, the following formula reflects the dividend discount model where the terminal dividend is assumed to continue in perpetuity and to grow at a constant rate:

D

1

IVo = -- +

1 + r.

(1

D

+ r.) 2

2

+

(1

D

+ r .) 3

3

+

(1

Dn

+ r.)"

+

Dn x

(1

+ g )

(

r. - 1 + r e n

g

)

Gordon

Growth

DDM

A simplified application of this model is to assume the current dividend continues to grow in perpetuity. This model was defined at the start of this section.

Issues in Applying the Dividend Discount Model

There are several thorny issues with when applying the dividend discount model. One issue is

that a large percentage of publicly traded companies do not issue dividends. Further, many of those non-dividend-paying firms will continue to have a zero payout for several years to come.

Forecasting the dividend stream for those companies is

but creneratincr reliable long-term forecasts is a different matter. Another ~sueis how to deal with companies that have unusually high dividend payouts given their profit levels. For example, Microsoft paid a one-time dividend ?f $3.40 per share_ in 200 5; its earnincrs that year were $1.12 per share. These companies are unlikely able to sustain sue~ a high dividend payout, which presents another obstacle to forecasting dividends. (Some companies even borrow money to sustain dividend payments. It seems intuitive that a company that finances its dividends with debt should be valued differently than one that finances its dividend s with oper- ating profit. However, the dividend discount model does n?t diffe_re?tia~e_between these cases.) Still another issue with the dividend discount model 1s that 1t 1s d1fficult to create accurate dividend forecasts. Most analysts do not forecast dividends , especially terminal dividend s (which are estimates of future prices!) Analysts focus on the wealth creation aspects of the compan y and forecast items such as sa les and profit. Dividends are considered a financing decision, and com-

. include all distributions to or from common shareholders . This includes

both funds distributed to the share holder such as cash dividends or stock repurchases as well as monies transferred from shareholders to the firm such as stock issuances (a " negative" dividend).

challenging;

that is , anyone can foreca st,

panies generally do not create value from financing activities.

Broadly, dividends

.

Two approaches are used to compute the total distributions. The first approach uses cash flows:

+ Ordinary dividend payments to common shareholders

+ Net cash paid for common share repurchases

- Net cash received from common share issuances

Total dividends to common shareholders

Module 12 I Cost of Capital and Valuation Basics

12-20

Dividend Yields

Many companies have especially low or especially high dividend payout rates. A search on Finance. y_ahoo.com finds over 500 companies with a dividend yield (dividend per share divided by price per share) of zero-see an abbreviated listing below .

Company

DivNld

Symbol

Company

DivNld

AAPL

APPLE INC.

BP

BP P.L.C .

TM

TOYOTA MOTOR CORP

c

CITIGROUP

LFC

CHINA LIFE INSURANCE

DCM

NTTDOCOMO

MTU

MITSUBISHI

UBS

UBS AG

COMMON STOCK

NTT

NIPPON TELEGRAPH

CAJ

CANON , INC. AMERICA

AI G

AMERICAN INTL GROUP

F

FORD MOTOR COMPANY

0.0%

LYG

0.0%

DTV

0.0%

HMC

0.0%

SNE

0.0%

HIT

0 .0 %

PC

0.0%

RIG

0.0%

KYO

0.0%

MBT

0.0%

NMR

0.0%

KB

0.0 %

s

LLOYDS BANKING DIRECTV HONDA MOTOR COMPANY SONY CORPORATION HITACHI, LTD. PANASONIC CORP TRANSOCEAN LTD KYOCERA CORPORATION MOBILE TELESYSTEMS NOMURA HOLDINGS KB FINANCIAL GROUP SPRINT NEXTEL

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0.0%

0 . 0%

0.0%

There were also 75 companies identified that had a dividend yield exceeding 10 percent-see an abbreviated listing below. This is a high dividend yield, which brings into question the ability of those companies to sustain that dividend level.

Company

DivNld

Symbol

Company

DivNld

 

SEADRILL LIMITED

NLY

ANNALY CAPITAL

AGNC

AMERICAN CAPITAL

CIM

CHIMERA INVESTMENT

GOL

GOL LINHAS AEREAS

MFA

MFA FINANCIAL

CEL

CELLCOM ISRAEL

TNH

TERRA NITROGEN

PTNR

PARTNERCOMMUNICATION

PVX

PROVIDENT ENERGY

HTS

HATTERAS FINANCIAL

AINV

APOLLO INVESTMENT

10.2%

DRH

15.8 %

PVD

20.5%

PHK

17 .2%

IVR

12.2%

UTF

10.3%

FRO

10 .9%

CVS

10.7%

CMO

10.3%

ENP

11 . 3 %

PSEC

15.3%

BGCP

11.7%

ANH

DIAMONDROCK HOSPITAL

14.5%

ADMINISTRADORA

10.2%

PIMCO HIGH INCOME

11

.7%

INVESCO MORTGAGE

14.2%

COHEN & STEERS

16.5 %

FRONTLINE LTD.

11

.2 %

CYPRESS SHARPRIDGE

17.7%

CAPSTEAD MORTGAGE

12.4%

ENCORE ENERGY

10.8%

PROSPECT CAPITAL

12.8%

BGC PARTNERS

10.3%

ANWORTH MORTGAGE

14.9%

The second approach uses the balance sheet:

+ Beginning common equity

- Ending common equity

+ Comprehensive income

Total dividends to common shareholders

These historical distributions ("dividends") are used to forecast future dividends. Valuation using dividends requires estimating all future transfers to shareholders including the future liqui- dating dividend or the anticipated sale price. This creates a challenge for the analyst or investor. There are instances, however, when the dividend discount model might perform well. If dividends are determined based on the long-run average of projected profits, they can provide a good indication of the company's long-run profitability. The model performs well in valu- ing companies that experience stable growth and a stable or slightly growing dividend stream . Companies in the utility industry are often cited as examples of companies for which the dis- count dividend model performs well. To illustrate, Southern Company's dividend for 2010 is

12-21

Module 12 I Cost of Capital and Valuation Basics

$ 1.8025 per share. Assume that its di vide nds will

va lu e at $~0 .97 using a

co mp ares to its $40 stock

price in mid-2011 . We can also explore the sensiti vity of thi s estimate to variations in the

growth rate a nd d iscount rate. Those res ults are in Ex hibit 12.6. We see that intrinsic value

inc reases

from thi s e xample and the above Kimbrell examples a s well , the stock value e sti mate is espe-

cially sensitive to the growth assumption used to estimate the terminal di vidend .

th e G o rd o n G row th m o d e l , we es tim a t e S o uth e rn C o mp a n y s mtn _n s 1c

d isco unt rate of 4.9 % , co mp ute d

grow at a ,m?de~at~0.5% per year. Applying

0 .005 ) . Thi s

di scount rates. Further, as we see

as $ 1.80 25/(0 .049 -

w ith ri s in g g rowth rates, but dec reases w ith ri sin g

EXHIBIT 12.6

Intrinsic Value Estimates with Variation in Growth and Discount Rates

Dl8cowlt Rate

0.00%

4.5%

5.5%

6.5%

 

$40.06

32.77

· · ··· · ··

· ··

 

27.73

GrowthRate

1.00%

$51.50

40.06

32.77

2.00%

$72.10

51 .50

40.06

In Modules 13 and 14 we use a variant of the Gordon G rowth model that is writte n as follows:

of the Gordon G rowth model that is writte n as follows: 04 x (1 +

04 x

(1 + g)

G rowth model that is writte n as follows: 04 x (1 + g) w he

w he re D re presents free cas h

Modul e 14. This ex pa nded versio n of

dividends shown here. Each of these models can be derived from equation 12.6. The choice of what payoff to use to estimate the firm 's value will depend on the availability and reliability of

the various forecasted payoffs.

flo ws to the firm in Module 13, and residual operating income in

the mod e l is ma th e m ati call y equi val e nt to the equation for

RESEARCH INSIGHT

Circularity .;;.of;

Be~ ta;;;;

_

_

The intrinsic value of both debt and equity are used in estimating the weighted averag e cost of capital. The market value of debt is usually reported either on the balance sheet or dis closed in footnotes and , therefore , the debt recorded on the balance sheet or the present value of debt disclosed in footnotes can be used as a proxy for the market value of debt. The market valu e of equity is often used as a proxy for the intrinsic value of equity. However, this creates ~ probl~m in that the market value of equity is used to determine the weighted average cost of cap ital which will be used to discount the payoffs in the valuation model to estimate the intrinsic value of eq uity. This intrinsic value of equity will then be compared to the market value of equity to determ ine if the company is under- or overvalued . While we might prefer to estimate the weighted average c?st of capital without referring to the market value of equity , this is problematic in that cost of cap ital estimation requires us to estimate the intrinsic value of the company prior to discounting the com- pany's payoffs.

MODULE-END REVIEW

 

Following are relevant financial details for Harley-Davidson (NYSE: HOG). Assume that the expected ri sk-free rate , rf' is 4 .6 % and the expected market return is 9.6 %.

 

Marginal

 

Market value

Totalftnn

Dividend per

PNtax

(8tatutoly)

Ma'ltet price

of equity

market value

Beta

borrowll19 nde

taxnde

per share

$18 .26 bi l.

$18.30 bil.

1.42

$0 .84

9%

35 %

$70.47

Module 12 I Cost of Capital and Valuation Basics

ReqUlred Estimate its after-tax cost of debt capital. Estimate its cost of equity capital. Estimate its weighted average cost of capital. Estimate its per share intrinsic value using the dividend discount model assuming that its current dividend per share continues in perpetuity. Estimate its per share intrinsic value using the dividend discount model assuming that its current dividend per share continues at $0.84 for the next two years and then grows at a continual rate of 1% for year 3 and thereafter.

, rn

The solution is on page 12-30-.

12-22

You Are an Investor Altering a company's capital structure (changing its debt to equity ratio) alters its finan- cial risk. For the shareholder, increasing leverage will increase the financial risk, which will have a correspond - ing increase in the expected return demanded by the shareholder . However, a company 's WACC , which is the weighted average of cost of debt and cost of equity, is determined by the volatility of the company 's operations. If we assume that changing the capital structure has minimal impact on company operations , ignoring any tax effects, its WACC would remain approximately the same.

Desc ribe how to co mpute th e prese nt va lue

Di sc uss differences between valuin g a debt

Wh at is a market beta? Di sc uss wh at a beta of 1.0 re presents. Wh at does a beta of 0 .5 rep rese nt?

of a debt sec urity such as a bond . security and va luin g the equity of a co mpany.

A

beta of 2.0?

 

Di

sc uss

the

limitati ons associated with

usin g beta to co mpute the cos t of equit y capital.

Di

sc uss

the

diffe rence between a co mpany ' s intrin sic va lue and the comp any ' s stock pri ce.

Desc ribe how to co mpute th e after-tax cos t of debt capital.

Ex pl ai n what th e market pre mium re pre sents. Describe how to compute the cos t of equity capital usin g

beta , the ri sk-free rate , and the market premium .

Q12-8.

Wh at

is a co mpany's cost of

cap ital? Expl ain .

Q12-9.

Wh at are the three criteria fo r a series of pay ments to be co nsidered an annuity?

 

Q12-10.

Wh at is a perpetuity ? How is the present value of a perpetuity co mputed?

Q12-11.

Desc ribe

ho w to compute the

prese nt value of an in creas in g perpe tuity.

Q12-12.

Describe

th e circularity th at occ urs when beta is used to he lp es tim ate an intrin sic va lue fo r co mp arison

to

market prices.

 

\

 

Assignments with the $

logo in the margin are available in an online homework system. See the Preface of the book for details.

y

Computing the Present Value of a Debt Security

(L01)

Co

mpute th e

fi ve-year bo nd wi th a face value of $ 1,000 , a 10 %

a nnu a l co upo n

pay-

ment , and an

present value of a 8% effecti ve rate .

M12-14.

Computing the Present Value of a Debt Security

(L01)

Compute th e present value of a three-year

bond with a face value of $5 ,000 , an 8% annu al coupon

pay-

ment , and a

9% effective rate .

Estimating Cost of Equity Capital

(L02)

Ass ume th at a compa ny 's market beta equ als 0 .8 , the ri sk-free rate is 5% , and the market return equ als 8%. Compute the company's cos t of equity ca pital.

12-23

Module 12 I Cost of Capital and Valuat ion Bas ics

M12-16.

Estimating Cost of Equity Capital

(L02)

Assume that th e company's market beta equals - 0.8, that the risk-free rate is 5 % , and the market return

equa ls 8% . Compute the

company 's cost

of equity cap ita l.

M12-17.

Estimating the Implied Cost of Equity Capital

{L02)

Hint: Review

Equation 12.6

Assume that a co mpany 's begi nnin g-of- period pri ce is $ I0 per common share, its divid ends are $0.2S per share , a nd its end-of-period pri ce is $ 10.50 per co mm o n share . What is the co mp any 's ex pected cost of capital?

M12-18. Estimating the Implied End-of-Year Share Price

(L01, 2)

Assume that a co mpany 's per share , a nd its expected common share?

be g innin g-of- period pri ce is $ 15 per common share , its dividend s are $1 cost of equity capital is 10% . What is the expected end-of-period price per

v

M12-19.

Estimating Cost of Debt Capital

(L03)

 

Assume that the interest rate on a company's debt is 6% and that the company 's tax rate is 35%. Com- pute the company ' s cost of debt capita l.

 

M12-20.

Estimating Cost of Debt Capital

{L03)

 

Assume that a company's financial statements report that its average outstanding debt totals $ 1.6 billion, and its total interest expense equals $80 million. If its tax rate is 35 % , compute its cost of debt cap ital.

v

M12-21.

Estimating Weighted Average Cost of Capital

(L04)

Assume th at a company

its cost of equity ca pital is 7 %. Compute the company 's WACC .

has $ 1.2 billion in debt , its cos t of debt is 5 % , it has $2 billi on in equity, and

M12-22. Estimating Weighted Average Cost of Capital

(L04)

Assume that a co mpany has $ 1 billion in preferred stoc k and $3 billion in common stock. Al so , it pays

6 % dividend s on preferred stock and its cost of equity cap ita l is 7 % . The the company 's WACC.

company ha s no debt . Compute

./ M12-23. Estimating Company Value using DDM with Constant Perpetuity

(LOS)

Assume that a company 's dividends per share are projected to remain at $ 1.20 each year, and that its cost of equity capital is 5%. Estimate the company 's per share stock price.

M12-24. Applying DDM with Constant Perpetuity

(LOS)

.

.

Assume that a company 's dividends per share are projected to remain at $ 1.10 in perpetuity , a nd that per share stock price is $22. Estimate the company 's cost of equity capital.

M12-25. Estimating Company Value using DDM with Increasing Perpetuity

(L06)

.

its

Assume that a company 's dividends per share are projected to grow at 2% each year, its next year 's d~vi­ dends per share is $ 1.20, and its cost of equity capital is 5 % . Estimate the co mpany 's per s hare stoc k pnce.

M12-26. Estimating Company Value using DDM with Increasing Perpetuity

(LOS)

As sume that a company paid $ 1.20 dividend per co mmon share , its dividend per share is expected to grow at a constant rate of 2 % , and its cost of equity capital is 5% . Estimate the company 's per share

KELLOl:GCUMrANY

(K)

 

stock

price .

E12-27.

Estimating the Cost of Debt Capital

{L03)

Kellogg Company (K) manufactures cereal and other convenience food under its many well-known brands such as Kellogg's® , Keebler® , and Chee z-Jt® . The company, with more than $ 12 billion in ann ual

sales worldwide , partially finances its operation through the iss uance

of debt. At the beginning of its 20 10

fiscal year, it had $4.8 billion in total debt. At the end of fiscal year 2010, its total debt had increased to $5.9 billion . !ts fiscal 2010 interest expense was $248 million , and its assumed statutory tax rate was 35 %.

Required

 

a.

Compute the company's average pretax borrowin g cost. (Hint: Use the average amount of debt as the denominator in the computation.)

b.

Assume that the book value of its debt equals its market value. Then, estimate the com pan y's cost

 

of debt capital.

E12-28.

Estimating the Cost of Equity Capital

(L02)

KELUll:GCUMrANY

Refer to information about Kellogg Company (K) in El 2-27 . Kello gg has an estimated market beta of

(K) 0.47. Assume that the expected risk-free rate is 3.1 % and the expected market premium is 5% .

Module 12 I Cost of Capital and Valuation Basics

12-24

Required

a. What does Kellogg 's market beta imply about its stock returns ?

b. Estimate Kell ogg 's cost of equ ity

cap ital.

Estimating the Weighted Average Cost of Capital

(L04)

Refer to information about Kellogg Company ( K) in El2-27 and El2-28. Kellogg 's stock closed at $5 1.08 on December 3 1, 20 10. On that same date , the company had 419,272,027 shares issued , of which 53,667 ,635 share s were in treasury.

Required

a. What is

b. Use the information and results of El 2-27 andE12 -28 to compute Kellogg 's WACC.

Kellogg's total market capita liz at ion as of December 3 1, 20 IO?

Estimating Weighted Average Cost of Capital

(L02, 3, 4)

Mattel , Inc. (MAT) e ngages in the design, manufacture , and marketing of various toy products world- wide. At December 3 J , 20 I0 , Mattel 's market va lue of eq uity was $8 .9 billion , and its total market va lue was $ 10 .1 billion . Mattel 's statutory tax rate was 35 %, its average pretax borrowing rate was 5 .4 % , a nd its estimated market beta was 0.99. Assume a lso that the expected ri sk-free rate is 3.1 % and the expected market risk premium is 5 % .

Required

a .

What does Mattel 's market beta imply

about its stock returns ?

b. Estimate Mattel's

cost of debt capita l , cost of equity cap ita l, and weighted average cost of ca pita l.

E12-31.

Sensitivity of Cost of Equity Capital Estimates to Beta

(L02)

Refer to the information about Mattel, Inc. (MAT) in EJ2-30. After further research we find that beta estimates for Mattel reported on financial Websites ra nge from 0 .85 to 1.13.

Required

 

a .

Estimate the range of cost of equity capi tal estimates for Mattel impli ed by the different beta estimates.

b.

What steps are necessary for business valuation due to the ra nge of cost of equity ca pital estimates?

E12-32.

Estimating Stock Value using Dividend Discount Model with Constant Perpetuity

(LOS)

Kellogg pays$ I .72 in annual per share dividends to its commo n stock holders , a nd its recent stock price

was $5 1.08 . Assume that Kell ogg's

cost of equity cap ita l is 5.5 % .

 

Required

 

a.

Estimate Kellogg's stock price using the dividend discount model with constant perpetuity.

b.

Compare the esti mate obtained in part a with Kellogg ' s $5 1.08 price. What does the difference between these amounts imply abo ut Kellogg 's future grow th ?

Estimating Stock Value using Dividend Discount Model with Increasing Perpetuity

(L06)

Kellogg pays $ 1.72 in a nnu a l per share dividend s to its common stockho lders , and its recent stock price was $5 1.08. Assume th at Kellogg 's cost of equity ca pita l is 5.5 % .

Required Estimate Kellog g 's expected grow th rate based on its recent stock price model with increasing perpetuity.

using the dividend discount

E12-34.

Sensitivity of Intrinsic Value Estimates

(L06)

,

Kellogg Company (K) is ex pected to pay $1.72 in an nu a l dividend s to its common share ho lders in the future. Our best estimate of the expected cost of eq uity ca pita l is 5.5 % and the' expected growt h rate in dividends is 2%.

Required

 

a.

Compute Kellogg ' s intrin sic va lue . Recompute intrin sic value to reflect increases and decreases of 0.5 % in both ( i) cost of equity capital and ( ii ) grow th rate.

b.

Given the intrin s ic values computed in part a, what leve l of confidence do we have in the intrinsic

 

value estimate from the

dividend discount model ?

 

E12-35.

Estimating Intrinsic Share Value using Dividend Discount Model

{LOS, 6)

intrin sic value

per common share using the dividend di scount mod el (DOM ) under each of the following separa te assumptions . (Ass ume MAT's cost of equity capital is 8.0%.)

Mattel , Inc. (MAT) is expected to pay a $0.92 dividend

per share annually . Estimate its

KELLOGGCOMrANY

(K)

MATTEL, INC.

(MAT)

MATTEL, INI:.

(MAT)

KELLOGGCOMPANY

(K)

KELLOGGl:llMPANY

(K)

KELLOGGCOMPANY

(K)

MATTEL, INI:.

(MAT)

12-25

Module 12 I Cost of Capital and Valuation Basics

MATTEL, INI:.

(MAT)

MATTEL, INI:.

(MAT)

E12-36.

,JE12-37.

Required

a. T he $0.92 div ide nd pe r share occurs at the e nd of eac h of th e next three years, after no add itio na l di vide nd pay me nts .

b. T he $0.92 divi de nd pe r share occ urs at the end of eac h yea r in pe rpetuity.

c .

whi ch there are

T he $0 .92 div id e nd pe r share occ urs at th e en d of each of th e nex t th ree years , afte r which the

d ivide nds increase at a rate of 4 % pe r year.

Assessing Terminal Dividend Assumptions for Intrin s ic Value Estimates

At Dece mbe r 3 1, 2010 , Mattel, Inc. (MAT ) was tradin g at

(LOS, 6)

co mm o n share of $25.43.

a pri ce per

Required

a. Ex pl ain ho w th e ass umpti on we make abo ut a firm 's we co mpute fo r th e fir m.

b .

te rmin a l di v ide nd affec ts th e intrinsic va lue

fo r Matte l in E 12-35 above , m ig ht ex plai n the th e actu a l tradin g pri ce per co mmon share.

di v ide nd assumpti o n made

d iffe re nce betwee n th e es tim ated intrin sic va lu e and

Di sc uss how the termin al

Estimating the Market's Expected Growth Rate in Dividends

Mattel, Inc. (M AT) was t radin g at a pri ce of

the

(LOS, 6)

$ 25.43 per co mm o n s ha re at Dece mber 3 1, 201 0 . Us ing

ex pected grow th in d iv idend s th at is required to yield

Go rd on grow th mode l, es tim ate th e mark et 's

th

e

$25.43 price per co mmo n s hare . Assum e th at

th e current di vide nd per s ha re is $0 .92 a nd is

ex pected

to grow th ereafter, and th at

th e cost of eq ui ty ca pi ta l is 8 .0 % . ( H int : Use the equ ati o n for th e

dividend

d isco unt mo de l w ith

in crea s in g pe rpe tuity, a t th e to p of pa ge 12-1 9 .)

PllUl:TEll AND

CAMBLE

(PG)

Pl2-38.

Estimating Market Capita lization from Public Disclosures

Finance .Yahoo .com reported that Procter and Gamble 's (PG) market ca pita li zati o n

30 , 2010 . T he eq u ity secti o n

li o n a nd its stock price pe r s hare wa s $59 .98 as of

Ga mbl e's Jun e 30 , 2010 , ba lance shee t fo ll ow s ( in milli o ns) .

(L01)

Jun e

wa s $ 170 .55 bil- fro m Procte r and

Converti bl e Class A preferred stock , stated value $1 per share (600 shares authorized )

 

$ 1,277

Non-Voting Class B preferred stock, stated value $1 per share (200 s hares authorized) Commo n stock , s tated value $1 per share (10 ,000 shares authorized ; issued: 4 ,007 .6)

4,008

Additi onal paid -in capital

.

.

.

.

.

.

.

.

61 ,697

   

(1 ,350)

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

Reserve for ESOP debt retirement Accumulated other comprehens ive income

 

.

.

.

.

.

.

.

.

.

(7,822)

Treasury stock , at cost (shares held : 1,164 .1)

 

.

.

.

.

.

.

(61 ,309)

Retained earnings

 

64,614

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

Noncontrolling interest

 

324

 

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

Total Shareholders' Equity

.

.

.

.

.

.

.

.

.

.

$61,439