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Fall 2016
Equity Valuation
1.
2.
3.
Introduction
Chapter 4 considers discount rate determination and the cost of capital for
the firm as a whole.
WACC is the discount rate that should be used to discount the firms
expected free cash flows to estimate firm value.
It can be viewed as its opportunity cost of capital.
Average of the estimated required rates of return for the firms interestbearing debt (kd), preferred stock (kp), and common equity (ke). The
weights (ws) used for each source of funds are equal to the
proportions in which funds are raised.
Debt
Assets
(Firm)
WACC kd 1- T wd k p wp ke we
Preferred Equity
Common Equity
Sum of weights wd + wp + we = 1
WACC kd 1- T wd k p wp ke we
5
Firm Value0 =
t=1
1+ WACC
Step 1
Step 2
Estimate the opportunity cost of each of the sources of financing:
kd, kp, ke, and adjust for the effects of taxes where appropriate.
Step 3
Calculate WACC by computing a weighted average of the
estimated after-tax costs of capital sources used by the firm
Sales
COGS
Depreciation
EBIT
Taxes
NOPAT
+ Depreciation
CAPEX
DWC
PFCF / FFCF
$ 3,000,000
$ (1,800,000)
$ (500,000)
$ 700,000
$ (140,000)
$ 560,000
$ 500,000
$ (500,000)
$
$ 560,000
Debt
Equity
Tax Rate
40%
60%
20%
Interest
Interest
Principal New Debt Issue
+
Expense Tax Savings Payments
Proceeds
Firm Value
$560, 000
$5, 600, 000
0.10
Firm Interest
Interest
Principal New Debt Issue
+
+
FCF Expense Tax Savings Payments
Proceeds
10
Debt
Assets
(Firm)
Ve
Common Equity
n or
t 0
Equity FCFt
(1 ke ) t
where:
Equity FCFt is the Free Cash Flow to
Equity in period t.
ke is the cost of equity
11
Equity Valuation
Sales
COGS
Interest
Depreciation
EBT
Taxes
NOPAT
+ Depreciation
CAPEX
DWC
Equity FCF
Equity
Firm Interest
Interest
Principal New Debt Issue
=
+
+
FCF
FCF Expense Tax Savings Payments
Proceeds
PFCF/FFCF:
$560,000
Equity
FCF
$ 3,000,000
$ (1,800,000)
$ (112,000)
$ (500,000)
$ 588,000
$ (117,600)
$ 470,400
$ 500,000
$ (500,000)
$
$ 470,400
Debt
Equity
Tax Rate
Equity Value =
40%
60%
20%
k
5.0%
14.0%
$470, 400
= $3,360, 000
0.14
13
14
Benefits of Debt:
An Illustration of the Tax Benefit
$0
$1,000
$200
$800
$400
$600
$600
$400
7%
8%
9%
10%
$100
0
100
35
$65
$100
16
84
29
$55
$100
36
64
22
$42
$100
60
40
14
$26
$65
0
$65
$55
16
$71
$42
36
$78
$26
60
$86
Sales
COGS
Depreciation
EBIT
Taxes
NOPAT
+ Depreciation
CAPEX
DWC
PFCF / FFCF
15
$ 3,000,000
$ (1,800,000)
$ (500,000)
$ 700,000
$ (140,000)
$ 560,000
$ 500,000
$ (500,000)
$
$ 560,000
Debt
Equity
Tax Rate
40%
60%
20%
k
5.0%
14.0%
Firm Value =
$560, 000
= $5,384, 615
0.104
Vs.
$5, 600, 000 on slide 9
16
18
Risk-free rate plus default spread given actual (or projected) debt
rating
For debt with default risk, the expected cash flows must reflect the
probability of default (Pb) and the recovery rate (Re) on the debt in the
event of default.
20
Coupon
14%
Principal
$1,000.00
Price
$829.41
Recovery rate
50%
Year Promised CF
0
$ (829.41)
1
$140.00
2
$140.00
3
$140.00
4
$140.00
5
$140.00
6
$140.00
7
$140.00
8
$140.00
9
$140.00
10
$1,140.00
YTM
17.76% IRR
21
22
Example: $1,000 face one year to maturity selling for $985 and paying 9%
annually
Promised
B o n d P ric e =
In te re s t + P a ym e n t
1 + Y T M
985 =
90 + 1000
1 + Y T M
YTM =
90 + 1000
- 1 = 0 .1 0 6 6
985
Suppose theres a 15% probability of default (Pb) and a 75% recovery rate
(Re):
B o n d P ric e =
985 =
In te re s t + P a ym e n t 1 - P b + In te re s t + P a ym e n t P b R e
1 + k d
9 0 + 1 0 0 0 1 - 0 .1 5 + 9 0 + 1 0 0 0 0 .1 5 0 .7 5
1 + k d
k d = 0 .0 6 5 1
AverageCumulativeDefaultRates
35%
30%
25%
20%
15%
Investment
Grade
10%
5%
0%
Year Year Year Year Year Year Year Year Year Year
1
2
3
4
5
6
7
8
9
10
Investment
0.05
Grade
0.17
0.35
0.60
0.84
1.08
1.28
1.47
1.62
1.73
Speculative
3.69
Grade
8.39
12.8
16.8
20.3
23.6
26.4
29.0
31.2
32.8
Speculative
Grade
Promised
Close
Expected, or
YTM kd
Expected
23
24
Calculating kp
Preferred
Preferred Dividend, Div p
Stock =
Required Return, k p
Price, Pp
kp =
Div p
Pp
Series
C
F
G
Liquidation
Preference
Shares
$50.00
2,000,000
$25.00
5,000,000
$25.00
5,000,000
Value
Dividends
$100,000,000
$4.27
$125,000,000 $1.6875
$125,000,000 $1.6875
Closing Price
$50.00
$24.14
$23.90
kps
8.54%
6.99%
7.06%
26
Unsystematic Risk
Systematic Risk
Estimation Approaches:
Variants of Capital Asset Pricing Model (CAPM)
Traditional CAPM
Risk-adjusted return CAPM takes into account beta, the risk free
rate, and the expected return on the market. It is also the equation for
the Security Market Line:
Market Rate of
Return of All Assets
k e k rf e k m k rf
Risk Free
Rate of Return
Expected Market
Stock Beta
Risk Premium
(Firms
Systematic Risk)
krf
29
30
Estimating e
Choosing krf
Intermediate-term
Short-term
ke k rf t e k m k rf t t
Firms excess returns
32
Estimating e
2.
Un-lever the e s
3.
33
34
portfolio wi i
i 1
35
D
E
f
d
e
DE
DE
Debt
f eUNlevered
Assets
(Firm)
Equity
eLevered 1
D
E
d
eLevered
DE
DE
D UNlevered D
- d
e
E
E
eLevered 1 eUNlevered 1 a
E
E
f
d
e
DE
DE
37
D E - TC D
T D
f
UA C TC D
DE
DE
Levered
= 1+
Assume TC D = 0 and plug into e
eLevered 1 1- TC
D
a
E
D
D UNlevered
UA 1 1- TC e
E
E
38
Debt
Equity
See Eq.
(5), p. 117
39
D E - TC D
T D
UA C TC D
DE
DE
40
Levered
e
1 1- TC eUNlevered
E
When D/E ratio is constant why does tax shield drop out?
eUNlevered
eLevered
1 1- TC
E
D E - TC D
T D
UA C TC D
DE
DE
Substitute f for T D
Since later is perfectly
correlated with firm
C
D E - TC D
T D
f
UA C f
DE
DE
Levered
e
D
D
1 eUNlevered - d
E
E
eUNlevered
f 1D
E
D
1
E
eLevered d
TC D TC D
1 UA
DE DE
eLevered 1 eUNlevered - d
E
E
f UA
i.e., go back to
Slide 38
41
42
eLevered 1 eUNlevered - d
E
E
From
Slide 42
eLevered 1 ua - d
E
44
45
46
Historical Estimates of km
Average Return?
Mean
Geometric Arithmetic
9.8%
11.8%
11.9%
16.5%
6.1%
6.4%
5.7%
6.1%
5.4%
5.5%
3.5%
3.6%
3.0%
3.1%
Standard
Deviation
20.2%
32.3%
8.3%
9.7%
5.6%
3.1%
4.1%
Historical data suggest that the risk premium for the market portfolio has averaged 6% 8% per year over the past 75 years. There is good reason to believe that looking forward
the market risk premium will not be this high.
47
What is your average return (r) over the last two years?
Geometric Mean
Arithmetic Mean
1 r 1- 0.51 1
r 1- 0.5 1 1 -1
2
r0
-0.5 1
2
r 0.25
r
Relationship between the beta estimates of stocks and their future rates
of return?
The CAPM SML and decile portfolios with the smallest decile (10) cut in half
ke krf e km - krf
Large-cap
Mid-Cap
Low-Cap
Micro-Cap
Size
Premium
0.00%
1.12%
1.85%
3.81%
Equity Value
e > 7.687B
1.912B < e < 7.687B
514M < e < 1.912B
e < 514M
49
50
Factor Models
Risk factors:
Macroeconomic variables: changes in interest rates, inflation, or
GDP
Factor portfolios
Premium
Premium
Premium
51
52
Fama-French
Apple analysis
Coefficients
b
s
h
Recall CAPM:
Page 125
Coefficient
Estimates
0.9718
0.1482
-0.5795
Risk premium =
+ Risk free rate =
=Cost of equity
Risk
Premia
5.00%
3.23%
4.08%
Product
4.86%
0.48%
-2.36%
2.97%
3.00%
5.97%
54
Value Today
CAPM 10%
$ 100.00
FF Growth 8%
$ 101.85
Apple
IBM
Merck & Co
Pepsico
Pfizer
Wal Mart
FF Value 12%
$ 98.21
Fama-French Coefficients
b
s
h
0.9716
0.1586 (0.5859)
0.6801
(0.0017) (0.5720)
0.7705
(1.0911) (0.0308)
0.4957
(0.4501) (0.0300)
0.9404
(1.1152) (0.3177)
0.1597
0.2979 (0.2502)
FF Cost CAPM
of Equity Beta
5.98%
0.82
3.84%
0.49
3.20%
0.52
3.90%
0.37
5.40%
0.78
5.78%
0.35
CAPM
Cost
of Equity Difference
7.10%
1.12%
5.43%
1.59%
5.58%
2.38%
4.83%
0.93%
6.88%
1.48%
4.74%
-1.04%
55
56
Historical Returns
Stock Price0
t 1
Dividend Year t
1 ke
58
Stock Price0 =
Dividend Year 1
+g
Stock Price0
ke =
$3.12 1+ 0.0392
+ 0.0392 = 8.5%
$70.91
59
60
Three-stage Example
Stock Price0 =
1+ ke
5
t-5
10
Dividend Year 0 1+ g5 1+ g 6-10
+
t
t=6
1+ ke
Dividend Year 0 1+ g5 5 1+ g 6-10 5 1+ g >10
+
t=1
Rushmore Electronics
ke - g >10
24 =
2.2 1+ 0.14
1+ ke
5
t-5
2.2 1+ 0.14 1+ 0.10
+
t
t=6
1+ ke
2.2 1+ 0.14 5 1+ 0.10 5 1+ 0.065
+
t=1
ke = 20.38%
10
1+ ke
10
ke - 0.065
1+ k e
10
61
62
Overconfidence and ke
We can use the same idea of a forward looking model for MRP:
Dividend Year 0 1+ g
ke =
Dividend Year 0 1+ g
+g
Stock Price0
63
64
What do we do?
Capital Structure
Cost of Equity
CAPM
3-Factor Fama-French
Discounted cash flow (3-stage)
Average
6.25%
7.25%
8.55%
7.35%
Source
of Capital
Capital
Structure
After-tax
Cost
Weighted
Debt
20%
3.94%
0.788%
Equity
80%
7.35%
5.880%
65
WACC =
6.668%
66