Chapter 11

Risk- Adjusted
Expected Rates of
Return and the
Dividends Valuation
Approach

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Valuing the Firm

Economic theory teaches us that the value of an
investment is:
Projected Future Payoffs t
V0
t
(1

Discount
Rate)
t 1
n

Expected future payoffs can be measured

in terms of:
Dividends
Cash Flows
Earnings
Chapter: 11

Approaches to Firm Valuation

Chapter: 11

Risk-Adjusted Expected Rates of

Return
Risk-adjusted expected rate of return on

equity capital is used as discount rate to

compute present value of projected future
payoffs.
To develop discount rates, consider:
Expected future riskiness of the firm.
Expected future interest rates.
Expected future capital structure.
Chapter: 11

Risk-Adjusted Expected Rates of

Return (Contd.)
Can use Capital Asset Pricing Model

(CAPM) to develop discount rates.

Expected rate of return needs to be
adjusted if capital structure changes.

Chapter: 11

Capital Asset Pricing Model

E[REj ] E[R F ] j {E[RM ] E[RF ]}
Where :
E expectation
REj Required return on common equity in firm j
RF Risk - free rate of return
j Market beta for firm j
RM Required return on marketwide portfolio
For Risk-free rate of return (RF), yield on short- or

intermediate term US government securities can be

used.
{E[RM] E[RF]} known as market risk premium
Chapter: 11

Cost of Equity Capital and Systematic

Risk

Chapter: 11

Adjusting Market Equity Beta to Reflect a

New Capital Structure
The market beta reflects operating leverage, financial

leverage, variability of sales and earnings and other firm

characteristics.
Current Levered Market Beta Unlevered Market Beta x [1 (1 Income Tax Rate)
x (Current Market Value of Debt/Current Market Value of Equity)]

The analyst can unlever the current market beta by

adjusting it to remove the effects of leverage

Unlevered Market Beta Current Levered Market Beta x [1 (1 Income Tax Rate)
x (Current Market Value of Debt/Current Market Value of Equity)]

Then reveler it by adjusting leverage under the new

capital structure.

New Levered Market Beta Unlevered Market Beta x [1 (1 Income Tax Rate)
x (New Market Value of Debt/New Market Value of Equity)]
Chapter: 11

Evaluating the Use of the CAPM

Criticisms of CAPMBeta estimates are quite sensitive to the time

period and methodology used in computation.

Return index for a diversified portfolio of
assets that spans the entire economy does not
exist.
The market risk premium is not stable over
time.
Therefore, it is important to analyze the sensitivity of
share value estimates across different discount rates for
common equity.
Chapter: 11

Cost of Debt and Preferred Equity

Capital
Cost of Debt:
Computed as the yield to maturity on each

type of debt times one minus the statutory tax

rate applicable to income tax deductions for
interest.

Cost of Preferred Capital:

It is the dividend rate on the preferred stock. In

case of convertible preferred stock the cost will

be a blending of cost of non-convertible stock
and common stock.
Chapter: 11

10

Weighted Average Cost of Capital

WACC: Considers debt, preferred, and

equity capital used to finance

Calculated as:
RA [wD RD ( 1tax rate)] [wP RP ] [wE RE ]
Where :
wD wP wE 1
R is cost of each type of capital
w is proportion of each type of capital
Tax rate is rate applicable to debt costs
Chapter: 11

11

Dividends-Based Valuation
The rationale for using expected

dividends in valuation is two fold:

Dividends measure the cash that investors

ultimately receive from investing in an equity

share.
Cash serves as a measurable common
denominator for comparing the future benefits
of alternative investment opportunities.

Chapter: 11

12

Dividends-Based Valuation (Contd.)

Dividends include all cash flows between

firm and shareholders:

Periodic dividend payments
Stock buybacks
The liquidating dividend
And negative dividend when firm initially

issues stock

Chapter: 11

13

Dividends-Based Valuation (Contd.)

Dividends valuation model:
Dt
t
t 1 ( 1 RE )
D1
D2
DT
VT

....

1
2
T
( 1 RE ) ( 1 RE )
( 1 RE ) ( 1 RE )T

V0

With Growing Perpetuity :

D1
D2
[NI T ( 1 g)] BVT [BVT ( 1 g)]

....

( 1 RE )1 ( 1 RE )2
(RE -g) ( 1 RE )T

Chapter: 11

14

Dividends-Based Valuation (Contd.)

Involves measuring the following three

elements:
Dividend (Discount rate = RE)
Expected future dividends (Dt) for periods 1

through T over forecast horizon.

Continuing or final (DT+1), and long-run growth
rate (g).

Chapter: 11

15

Measuring Periodic Dividends

Assume clean surplus accounting is

followed.
Under U.S. GAAP and IFRS, clean surplus is

measured by other comprehensive income as

well as net income.

Chapter: 11

16

Measuring Periodic Dividends (Contd.)

Effects of transactions between firm and

common shareholders are included in

book value.
Thus, accounting for common equity is
represented by:
BVt BVt -1 I t Dt
Dt I t BVt -1 BVt
Chapter: 11

17

Forecast Horizon
Represented by periods 1 through T in

the dividends valuation equation.

Depending on:
The industry.
Firms maturity.
Expected growth and stability.

Should be until firm reaches steady-state

equilibrium.
Difficult for young, high-growth firms.
Chapter: 11

18

Continuing Value of future dividends

Represented by last term of equation on

slide 14.
Use long-term growth rate assumption
(1+ g) uniformly on the year T+1 income
statement and balance sheet projections
to derive the dividends for the year T+1
correctly.
Thus: DT 1 NI T 1 BVT BVT 1

[NI T ( 1 g)] BVT [BVT ( 1 g)]

Chapter: 11

19

What now?
Once valuation model is applied, then
Conduct sensitivity analysis:
Vary cost of equity capital rate (RE)
Vary long-run growth rate (g)
Discount rate assumptions
Vary these parameters and assumptions

individually and jointly.

Chapter: 11

20

Evaluation of the Dividends Valuation

Method
Advantages:
Dividends provide a classical approach to

valuing shares as they reflect the payoffs that

shareholders can consume.
Reflect the implications of analysts
expectations for the future operating,
investing, and financing decisions of a firm.

Chapter: 11

21

Evaluation of the Dividends Valuation

Method
Disadvantages:
Continuing value estimates are sensitive to

assumptions made about growth rates after

the forecast horizon and discount rates.
The projection can be time-consuming for the
analyst.

Chapter: 11

22