|
  
  


 
  
|
 
    
 

‡ Actual Cost of Capital Process

‡ WACC Computation and Theory

‡ Alternative Models

‡ Capital Asset Pricing Model

¦eta Measurement

Market Premium

Asset ¦eta

 
  
   

  
  
     

‡ A crucial issue in financial analysis is establishing the discount

rate and risk measurement using capital asset pricing models.
‡ Financial principles of efficient markets, market expectations and
event studies lie behind a number of modeling and financial
management concepts.
‡ The general opinion is that cost of capital is over-estimated and
compensated for with optimistic assumptions.
‡ Recent work on cost of capital
 Œower equity risk premium
 CAPM discredited
 Analyst growth rates are too high

 
  
   

 

  !       "


‡ In order to determine the value of Pennzoil-Quaker State's common stock, Morgan

Stanley performed a 5-year discounted cash flow analysis that included the use of
two different scenarios, or case assumptions. The Management Case reflects
Pennzoil-Quaker State management's estimates of the company's future financial
performance, excluding any future acquisitions.
‡ The Market Case reflects publicly available estimates of Pennzoil-Quaker State's
future performance of certain securities research analysts. These cases were used
to project future cash flows ^
 ^

  
   





 
‡ The range was determined based upon a calculation of Pennzoil-Quaker State's
weighted average cost of capital (WACC), which was calculated based upon the
WACC for comparable companies in three industry segments: Mid-Cap Consumer
Products, Auto Aftermarket and Auto OEM.
‡ Morgan Stanley also applied a terminal E¦ITDA multiple of 7.0x to 9.0x to the
projected 2006 E¦ITDA, for purposes of calculating a terminal value of Pennzoil-
Quaker State at the end of 2006. This terminal value together with the projected
annual un-levered free cash flows from 2002 through 2006 was then discounted to
the present, assuming cash flows occurred mid-year, using discount rates of 8% to
10%.

 
  
   

 $      

‡ Œate Fifties ‡ 27 Highly Regarded Corporations and 10

Œeading Investment ¦anks
Payback period
DCF with WACC is dominant
‡ Sixties valuation technique
Present Value WACC uses market rather than book
weights
‡ Seventies (Fremgen)
Debt cost from marginal cost and
Internal rate of return statutory tax rates
Net Present Value CAPM is predominant model for cost
of equity
‡ Eighties
Most use treasury as long-term
Mean Cost of Capital 14.2% treasury rate
Gordon model and CAPM Equity premium
‡ Nineties Majority less than 6%
CAPM Most popular 11% use lower than 4.5%

Risk premium of 6% 10% use 5%

50% use 7.0% to 7.4%
‡ Current
Current Equity Premium 5% or Œess
Equity premium of 5% or less

# 
  
   

 â    !       
)

u &'(( ((

     


Ñ   
Ñ

u
u

u
The key is to match the right cash flow with the right discount rate
And to the thing being valued

% 
  
   

 

 

  "
    
  

)

‡ Given difficulties in estimating cost of capital, present a range in cost of

capital in valuations.
‡ Discount rate should reflect project characteristics
 Contracts
 Risks
‡ Generally companies over-estimate the cost of capital (McKinsey)
 2001 Survey ± managers use 12.2%
 Actual market premium is much less
‡ Optimistic assumptions to compensate for high required return
‡ Over-payment for acquisitions
‡ Mis-timing of investments in commodity price businesses

* 
  
   

 ,   "      

+ 
  
|
 
 ," 

‡ Use target capital structure

‡ Use nominal cost of capital in currency consistent with the free cash flow

‡ Should be market weights and incremental cost of capital

‡ Tricky Items

Convertible ¦onds
Œower rate is due to equity value

¦ond value
Equity Option
Term of Debt

Credit Spread on Debt

Callable and No callable debt (effect on cash flow)

- 
  
   

 ," 
 

‡ In the WACC formula, we know

Debt percent

Equity percent

Cost of new debt

Income tax rate

‡ The hard part is the cost of equity

‡ If the capital structure changes, the cost of equity should change

‡ In theory, if the capital structure changes, the cost of equity should

change to maintain the same overall WACC

‡ Therefore, if the capital structure changes in the model, careful with

assumption about how the WACC changes.

 
  
   

 ,   "      

‡ Step 1:
 Equity Cost from Asset Cost
Ke = ¦e x Rm + Rf
Ke = (¦a x (V/E)) x Rm + Rf

‡ Step 2
 Debt Cost from Rf plus Credit Spread
Kd = Rf + CS
After tax Kd

‡ Step 3
 WACC = (D/V) * Kd x (1-t) + (E/V) * Ke

 
  
   

 ," 



‡ Whenever you have an equity-based cash flow stream like a real

estate development or something like that, there are better
techniques than using weighted average cost of capital.

 
  
   

 "
   "    
     

‡ Dividend growth model (analogous to P/E ratio)

Works if there are stable dividends

A variant is P/E = (1-g/r)/(k-g)

‡ Debt capacity model (project finance)

‡ Risk premium method (analogous to the CAPM)

K = Rf + Risk Premium

‡ Implied cost of capital in E¦ITDA ratios

‡ Arbitrage Pricing Model (extension of CAPM and related to risk neutral

valuation)

‡ Implied cost of capital from reverse engineering financial models

(described in the M&A discussion)

 
  
   

 " . / 0  1 2  


  
|
 
 "  3

‡ Rf,i is the risk free rate for the current period (i) and it is the only variable
directly affected by movements in the overall cost of capital in the
economy.

‡ ȕi is the covariance between returns on the security and the market

returns divided by the overall variance of market returns. This parameter
is the only input affected by the risk of the security in question and the ȕi
parameter is not expected to vary over time unless there is a change in
business and/or the financial risk of the company.

‡ EMRP is the expected return on a fully diversified portfolio of equity

securities over and above the rate of return on risk free securities. This
variable is a function only of aggregate preferences by people in the
economy for risky investments versus risk free investments. It is not
affected by current interest rates, the risk of the security, or movements in
the overall stock market.

# 
  
   

 "   !
 !/  ! 

Geared Equity
¦e

Asset/Ungeared
equity ± ¦a x Market Average
Market Premium
Debt
Inflation
Plus Real
Rate - Rf
Real

% 
  
   

 "   

‡ CAPM has many problems, but the basic theory upon which the
CAPM is built is a foundation of finance.
‡ The foundation of the CAPM is:
Risk is measured by variation and standard deviation in
returns
Standard deviation is reduced from diversification
Variance (a + b) where the portfolio if a and b are have a
weight of .5 is:
.25 variance (a) + .25 variance (b) + .5 covariance(a,b)
If the covariance is zero, the variance of the portfolio is much
lower than the variance without diversification

* 
  
   

 "  



‡ Problems with the CAPM theory are recounted by Ravi Jagannathan and
Iwan Meier in their 2001 article ³Do We Need CAPM for Capital
¦udgeting:´

‡ The CAPM as a model has been seriously challenged in the academic

literature«. [S]ince the critique by Fama and French (1992) there is
consensus in the academic literature that the CAPM as taught in M¦A
classes is not a good model ± it provides a very imprecise estimate of the
cost of capital«. [T]here is overwhelming evidence in the academic
literature that for over two decades business schools have been teaching
the wrong model ± or at least recommending the use of the wrong inputs
± for calculating the cost of capital.[1]

‡
[1] Jagannathan, R. and Meier, I. 2001, ³Do We Need CAPM For Capital
¦udgeting?´, Kellogg School of Management, Finance Department, pp 1-
3.

+ 
  
   

 "  



‡ ³Not only has the CAPM proved wrong, but we do not even know that the
market premium is.´

Ravi Jagannathan and Iwan Meyer, ³Do We Need CAPM for Capital
¦udgeting´ Kellog School of Management

‡ Fama and French:

Statistical analysis showing no relation between returns and beta

Statistical modeling: Time series to compute the ¦eta and then

cross section to compute the significance

Statistical problems: errors in variables and all variables should be

based on expectations rather than actual

CAPM may be un-testable

- 
  
   

    
  " 

‡ Use of CAPM to compute equity cost of capital and cost of capital

to apply to free cash flow
Risk free rate to apply in the CAPM
Alternative methods to evaluate the risk premium for the
overall market
Data sources and computation of ¦eta
Adjustments to ¦eta to compute ¦eta for application to free
cash flow
Adjustments to CAPM for interest tax shield
Theoretical problems with the CAPM
Alternative approaches to the CAPM

 
  
   

   "  
 

‡ The CAPM requires estimation of three components (Rf, Rm and ¦eta).

Each of these has some controversy.

Rf
Should the long-term treasury rate be used

Country premiums

Rm
Method of estimation expected returns

Actual use in practice

¦eta
Estimation

Accuracy

 
  
   

 !/  !   " 


  
|
 
 !/  !  

‡ There are debates concerning implementation of the risk free rate in the
CAPM.
Some suggest using long-term Treasury bond yields, some
advocate short-term Treasury ¦ills and still others argue for use of
the yield on inflation indexed bonds plus the expected rate of
inflation.
The primary argument against using long-term Treasury ¦ond yields
as a proxy for the risk free rate is that holders of long-term bonds
accept inflation risk and those yields are therefore not risk-free.
Further, during times at which an inverted yield curve exists, the
long-term treasury yield will produce a lower risk free parameter than
the Treasury ¦ill rate.
Those opposed to use of a short-term rate contend that the duration
of cash flows from short-term investments does not match the
duration of cash flows received from an investment in a stock.

 
  
   

 "  4 !/  ! 

‡ The primary issue in estimating the risk free rate is what risk free
security should be used:

 Common equity pays cash flow to investors over a long

period

 In theory the duration of dividends could be computed

 Use t-bill yield to maturity of 10 years

 Example
Treasury ¦ond Yield -- 2016 -- 5.53%

Treasury ¦ond Yield -- 2011 -- 4.98%

 
  
   

 $   !/  ! 

`
 
 
    

  
    
  !
"  

"
# # 
"  
 
$  

" 

 
"  

% % &&

'#! #' 
  !  !(&'
"  ")*
 
#+ #,
"  
 
  

# 
  
   

  "5
  !/  ! 

% 
  
   

 6  /  !/ 


*
  
|
 
 7  
  !

‡ The EMRP is expressed in real terms and is not a nominal number. This means the EMRP does
not increase or decrease when interest rates change or when the expected rate of inflation
changes. It would be wrong, for example, to update this number in the midst of a case because of
changes in the interest rate.
‡ The EMRP comes from the general risk preferences of agents in an economy for equities relative
to risk free securities. If people did not have risk aversion for equities relative to risk free bonds,
the EMRP would be zero. This means changes in the EMRP are driven by changes in general
preferences for equities relative to risk free securities. ¦ecause the EMRP comes from risk
preferences, it should be stable over long time periods as risk preferences do not swing from
month to month or year to year.
‡ Third, the EMRP is an expected number rather than a number that can be directly measured from
actual realized returns. The fact that the EMRP is an expected number means that it does not
change when the stock market goes up or down because realized earnings change or because
general economic activity is robust or depressed.
‡ Fourth, the EMRP is an economy wide number not unique to ComEd. Unlike ¦eta which measures
the risk associated with a specific company, the EMRP is the same whether it is used in valuing a
paper company, gauging the rate of return for an oil project or assessing the share price of an
airline company.
‡ Fifth, the EMRP has been the subject of a very large body of research. This research has been
performed by people who are not funded by parties who have a vested interest in producing a
particularly high or a particularly low risk premium number. Since the EMRP is not unique to
ComEd, since it is an expected number difficult to calculate, and since it is not expected to change
over short time periods, the EMRP research is directly relevant to this and other regulatory
proceedings.

+ 
  
   

    ) !    !

‡ Enrique Arzac recaps a wide body of research by stating ³We show that
both the historic record, financial theory, and prospective estimates based
on stock prices and growth expectations, all indicate that the future equity
premium in developed capital markets is likely between 3 and 5%...´

‡ Seth Artimage summarizes many different studies by noting: ³Consensus

is lacking at present on the best way of estimating the equity premium,
and reasonable estimates lie in the rage of 1% or 5%...´

‡ Koller et al. describe the general biases in EMRP: ³Historical estimates

found in most textbooks (and locked in the mind of many), which often
report numbers near 8% are too high for valuation purposes because they
compare the market risk premium versus short-term bonds, use only 75
years of data, and are biased by the historical strength of the U.S. market.

- 
  
   

 8 !

‡ Enrique Arzac refers to research by ¦lanchard who ³developed a

dynamic model of the expectations of real returns on stocks and
bonds. He found that the risk premium during the 1930¶s and
1940¶s was unusually high ranging from 3 to 5% in the early
1930¶s to more than 10% in the 1940¶s. Afterwards, it started a
gradual decline with some relatively minor fluctuations and
reached between 2 and 3% in the early 1990¶s.´

‡ Claus and Thomas emphasize the notion that historic returns

exceed the expected amounts: ³Despite substantial variation in
the underlying fundamentals across markets and over time,
observing that every one of our 69 country-year estimates lies
well below eight percent suggests that the Ibbotson estimate is
too high for our sample period.´

 
  
   

 â    
 !

‡ Seth Armitage describes the DCF studies as follows: ³The arithmetic mean real
premium between 1900 and 2000 was « 7.0% for the United States, measured
against the yield on long-term bonds. ¦ut a simple forward looking estimate based
on applying the dividend discount model to the market suggests a risk premium of
3% to 4%. This is why many people do not expect the premium in the future to be as
large as it has been in the past, especially in the second half of the twentieth century.
They place more faith in reasonable expectations about the future than in outcomes
observed in recent decades. Furthermore, several researchers have argued recently
that investors did not expect premiums as large as they got in the twentieth century.
Armitage concludes that Most of the studies indicate a range for historic ex ante
premiums « of between 1.5% and 4.5% -- considerably below the actual arithmetic
mean premium since 1920«´
‡ Enrique Arzac uses a DCF model to estimate the equity market premium of between
3.08% and 3.32%.
‡ In their widely cited 2002 article, Fama and French state that ³the equity premium
estimates from the dividend and earnings growth models, 2.55 percent and 4.32
percent, are far below the estimate from the average return, 7.43 percent«.The
expected return estimates from the dividend and earnings growth models are more
precise than the average return. The standard error of the dividend growth estimate
of the expected return for 1951 to 2000 is 0.74 percent, versus 2.43 percent for the
average stock return«.The earnings growth model is not, however, clearly superior
to the dividend growth model.´

 
  
   

 $   3 

‡ ³In the US, Merrill Œynch publishes µbottom up¶ expected returns on the Standard and
Poor¶s 500, derived by averaging expected return estimates for stocks in the
Standard & Poor¶s 500«.In recent years, the Merrill Œynch expected return estimates
have indicated an EMRP in the region of 4% to 5%.
‡ ³The Value Œine projected market risk premia are somewhat more volatile than those
from the Merrill Œynch DDM model. In recent years they have generally ranged from
2% to 6%....´
‡ Greenwich Associates had published the results of an annual survey of pension plan
officers regarding expected returns on the Standard and Poor¶s 500 for a five-year
holding period. The Greenwich Associates survey has generally indicated and
EMRP in a 2%-3% range.´
‡ Claus and Thomas also cite investor expectations. They summarize the information
as follows: ³Surveys of institutional investors also suggest an equity premium
substantially below eight percent (e.g., ¦urr (1998)), and there are indications that
this belief has been held for many years (e.g., ¦enore (1983)) . Also, the weighted
average cost of capital used in discounted cash flow valuations provided in analysts¶
research reports usually implies an equity premium below five percent.´

 
  
   

 !/ 


‡ There is a wide range in premiums used in theory and practice. The following
shows results from one study.

 
  
   

 6  /  !/ 


‡ A well known study by Fama and French, published in 2002, finds that
³estimates [of the equity market risk premium] for 1951 to 2000, 2.55
percent and 4.32 percent, are much lower than the equity premium
produced by the average stock return, 7.43 percent.´

‡ In another oft cited paper published in 2001 by Claus and Thomas titled
³Equity Premia as Œow as Three Percent? Evidence from Analysts¶
Earnings Forecasts for Domestic and International Stock Markets,´ the
authors conclude that ³for each year between 1985 and 1998, we find that
the equity premium is around three percent (or less) in the United States
and five other markets.´

‡ ³The Cost of Capital: Intermediate Theory´ which was published in 2005

summarizes the current research as follows: ³Almost all researchers on
this question agree that the premium in the twentieth century in the United
States « has turned out to be larger than investors expected it to be.´

 
  
   

 
  !/ 

 
"
! 

‡ The market premium is unobservable

‡ Studies have attempted to measure the expected market premium using the PE
method
‡ Actual Market Risk Premiums
1926-1998
Arithmetic 7.8%
Geometric 5.9%

1974 ± 1998
Arithmetic 5.5%
Geometric 4.9%

1964 ± 1998
Arithmetic 4.7%
Geometric 3.6%

# 
  
   

 "  4  /  


‡ McKinsey -- 4.50%

‡ Investment ¦ank Œow -- 3.5%

‡ Investment ¦ank High -- 5.5%

‡ ¦realy and Meyers ± 6% to 8.5%

‡ Gordon¶s model ± 2.9%

‡ Exelon Rate Case -- 9.98%

‡ Issue: Sample ¦ias from ¦ankruptcy

% 
  
   

 6 !/ 

 8 9


u
u u
u  
u

u
u

u
The median estimate of ERP is in the 4-5% range for mature markets
* 
  
   

 

 )     

/ 



‡ The problem with market premium estimates is that the market

premium should be an expected return rather than the historical
actual returns that may or may not have been expected:

 Real time now matters more than historic periods.

 Samples drawn from the past have little relevance to what

investors expect now.

 What was 75% probable yesterday has an unknown

probability tomorrow.

+ 
  
   

 : 

-
  
|
 
 $   :         


‡ The table below shows that beta measurement can be

dramatically different for the same companies.

u ¦eta from ¦eta from

Googlefinance Yahoo Value
Website Website Œine ¦eta

AGΠResources Inc. (ATG) 0.49 0.13 0.95

Energy East Corp. (EAS) 0.50 0.34 0.90
IdaCorp, Inc. (IDA) 0.80 0.49 1.00
Nisource Inc. (NI) 0.61 0.18 0.90
Peoples Energy Corp. (PGŒ) 0.37 0.66 0.90
Pepco Holdings Inc. (POM) 0.45 0.57 0.90
SCANA Corp. (SCG) 0.53 0.36 0.80
Southern Co. (SO) (0.12) 0.23 0.65
WGŒ Holdings Inc. (WGŒ) 0.25 0.71 0.80
Wisconsin Energy Corp. (WEC) 0.14 0.46 0.80
Xcel Energy Inc. (XEŒ) 1.13 0.52 0.90

Median 0.49 0.46 0.90

Average 0.47 0.42 0.86

 
  
   

 :  
D
     
     
            
—     u   u —      u   u u
u u       u   u
u u 
  
u
 u   
u   u
   u       u u  
 u   u
     u   u    u   u
 
  u   u   u
 
  
u   u
!    "u
  "u  # u   u     $ u
    u   u
 

u     u   u %   u   u
& 

u   u      
u   u
  $
    u u '  # u  #   u u
   u  ( u ) *   u   u   u
   u  u  ( u —   u   u   u
+   u  ( u  
  u   #   u   u
)  u
    u   u    
   u  , u
-       u   u &    u   
 
u   u
&   u  ( u  
  u     u   u
)  u  u   u .
 
 u  / u
%   
  u
 u  $
u   u  $#  u   u
) 

  u u —   u   u
- 
 u   u !     u u
.
  
u   u — 

u   u
0 $ u    
u   u 1 u  ( u
.
    
u 

 u   u &     
 u  #   u u
!   u   u   u          u   u

   u$

u   u   
 u   2 3  u
   u   u
u u 0    u   u
u u     u   u
u u       u   u4 u *  u   u
u u    u   
u   u
u

 
  
   

 :   


‡ ¦eta is measured from historic returns

‡ ¦eta is cov(Rm,Rt)/variance(Rm)

 
  
   

 :  "5


‡ Value Œine computes its beta from a regression equation that

measures an unadjusted beta. Then, Value Œine adds an
adjustment to move the beta toward 1.0 using the following
equation[1]:

‡ Adjusted beta = 2/3 x Unadjusted beta + 1/3 x 1.0

‡ or

‡ Unadjusted beta = Adjusted beta x 3/2 ± 1/2

‡
[1] Patterson, C.S., 1995, r
uuu 
ur
 uu
  , Westport CT: Quorum ¦ooks, p. 130.

 
  
   

 :  "5
    !  

‡ The adjustment for betas is generally accepted in cost of capital

literature for companies with betas above 1.0 because of a
tendency of betas to revert to the mean. Statistical studies have
demonstrated that ³there appeared to be greater measurement
error associated with the betas of extreme values.´[1] The mean
reversion adjustment is accepted for companies with observed
high betas. The risk of these high beta companies often moves
towards 1.0 over time due to statistical measurement problems
and due to the tendency of high business risk companies to
eventually moderate. However, the mean reversion is far less
accepted for utility companies with betas of below 1.0.
[1] Ogier, T, Rugman, J., Spicer, Œ., 2004, r
u

uuu
 
uu 
u

u 
uu

u  
u
  ,
Great ¦ritain: FT Prentice Hall, page 54.

 
  
   

 

 :  "5


‡ The case of NICOR demonstrates that using a mean reversion adjustment wherein
betas are pushed towards 1.0 to correct statistical irregularity is inappropriate for
utility companies. Instead, the statistical anomalies should push the beta back to the
industry average beta for utility companies. The 1.10 beta obviously does not
measure prospective risk and making a correction by moving the beta towards 1.0
would not help. The NICOR example effectively demonstrates that mean reversion
adjustments of utility betas are not appropriate. These adjustments do not improve
the measurement of beta but instead simply result in increased cost of equity
numbers.


3 !  $; 3 . :  
<  <# 44 =#
:  
*<  <# 44 =+ :  
<  *< 44 =#
:  
+<  <# 44 =

1.60

1.40
3 

1.20 NICOR
S&P 500
1.00

0.80

0.60
9/3/2000

9/3/2001

9/3/2003

1/3/2004
1/3/2000

5/3/2000

1/3/2001

5/3/2001

1/3/2002

5/3/2002

9/3/2002

1/3/2003

5/3/2003

5/3/2004

9/3/2004

1/3/2005

5/3/2005

9/3/2005
‡ .
u

# 
  
   

 "  :    6 : 

‡ Without Taxes

¦a = (D/V)*¦d + (E/V)*¦e

¦e measured with stock prices

D,V,E are debt, enterprise value and equity value measured at

market value.

Often assume ¦d = 0

Or, ¦e = (¦a ± (D/V)*¦d) * V/E

‡ With taxes

¦a = (D x (1-t))/(E+D*(1-t)) * ¦d + (E/(D*(1-t) + E *(1-t))*¦e

Assumes that all cash flows from debt are tax deductible

% 
  
   

 

 "   6 : 

‡ Cathay Pacific has an observed beta of 1.3 and a debt to equity

ratio of 50%. Singapore Airlines has a debt equity ratio of 25%.
Calculate the equity beta of Singapore Airlines. The tax rates in
Hong Kong and Singapore are 15 and 20% respectively.

Equity beta Debt/ Equity Asset beta

CPA 1.3 50% 0.91

SIA 1.09 25% 0.91

* 
  
   

 ," 3

  â â
   : 

‡ The WACC
Slide shows
the relation
between the
WACC and
the Asset
¦eta

+ 
  
   

 "  : 

- 
  
   

 "5
    6

‡ Additional Premiums for

Size

Œiquidity

Three Factor Model: Size,

¦eta, Market to ¦ook

‡ Arbitrage Pricing Model

‡ Œiquidity Dimensions

Size

Time

Quantity

# 
  
   

7> 
 3

  !  
/ 0 < 1 

#
  
|
 
  3 

‡ How should one select an appropriate sample of comparable

companies with similar risk to ComEd to derive the implied cost of
equity capital;

‡ What method should be used to compute the constant expected

growth rate of marginal investors for each company in the
comparable sample;

‡ Whether a valuation model for using earnings is a better way to

derive the implicit cost of equity capital than dividend growth
model; and,

‡ Should adjustments for quarterly compounding be made in

deriving implicit discount rates.

# 
  
   

 7) !  3 

‡ In their text titled ³Valuation: Measuring and Managing the Value of Companies´
published in 2005, Tim Koller, Marc Goedhart and David Wessels state that ³
u

uuu
u u
uu
u



uu 
.´
‡ Enrique Arzac comments on the difficulty of predicting growth rates and the potential
for the DCF model to over-estimate the cost of equity as follows: ³The problem with
[the DCF] approach is that long-term dividend growth rate of an individual company
cannot be estimated with any degree of precision. Hence, the dividend growth
model is not likely to produce reliable estimates of the cost of equity capital of
individual companies«.A number of empirical studies have documented optimistic
bias in analysts¶ opinions«.Thus, it seems reasonable to conclude that [the DCF
equation] yields an upper bound to the equity premium.´
‡ Claus and Thomas conclude that earnings and dividend growth rates used for the
DCF model ³exhibit substantial optimism bias and need to be adjusted downward.´
‡ Œouis Chan and his coauthors conclude that ³over the period 1982 to 1998, the
median of the distribution of I¦ES growth forecasts is about 14.5 percent, a far cry
from the median realized five year growth rate of about 9 percent for income before
extraordinary items.´
‡ Fama and French state that ³In short, we find no evidence to support a forecast of
strong future dividend or earnings growth at the end of our sample period.´

# 
  
   

 â  !   ?4 @  
 7)

‡ If the dividend payout ratio is 100% then even when a utility is currently
earning more than its cost of capital (such as Exelon and NICOR) the
earnings and book value do not grow (unless equity is issued at a market
to book value above 1.0). Since the equity base does not increase
because no earnings are retained, a constant future return on equity
applied to a constant amount of equity means that the income also
remains constant. With no earnings growth, the EPS growth is zero.
‡ At the other extreme, if the dividend payout ratio is zero, then earnings
increase book value of equity on a one for one basis. In this case without
dividend payments (again assuming a constant return on equity) the book
value of equity increases by the return on equity multiplied by the initial
amount of equity on the balance sheet. Assuming a constant return is
multiplied by the book value that increases at a growth rate defined by the
return on equity, the earnings also growth at the return on equity. This is
the growth rate implied by the formula above.
‡ For intermediate cases where the dividend payout is between zero and
one, the growth rate in earnings is the return on equity multiplied by one
minus the dividend payout ratio under the assumption of a constant return
on equity.

# 
  
   

 3
      
   /

‡ Investment decisions and cost of capital

‡ Cost of capital and valuation

‡ Cost of capital applied to free cash flow

‡ Residual value

‡ Relative valuation

‡ DCF Compared to payback rule and accounting earnings criteria

## 
  
   

 

    

‡ Morgan Stanley calculated terminal values by applying a range

of multiples to the estimated EPS in fiscal year 2009 and the
dividend streams and terminal values were then discounted to the
present using a range of discount rates representing an estimated
range of the cost of equity for each of PSEG and Exelon. ¦ased
on this analysis, Morgan Stanley calculated per share values for
PSEG ranging from $42.75 to $47.10. Morgan Stanley noted that
the implied consideration to be paid for each share of PSEG
common stock was $53.14 as of December 15, 2004, which was
greater than the range implied by this analysis. In addition, based
on this analysis, Morgan Stanley calculated per share values for
Exelon ranging from $38.15 to $42.01 and noted that the closing
price of Exelon common stock on December 15, 2004 was
$43.38, which was greater than the range implied by this analysis.

#% 
  
   

 
  


#* 
  
   

 3
       
 |


‡ Compute free cash flow from calculations sheet in the corporate

model

‡ Apply different discount rates to the free cash flow

‡ Assume the final year cash flow occurs into perpetuity

‡ Compute enterprise value, equity value and equity value per

share

#+ 
  
   

  3

  !  )   


‡ Using the same discount rate is a very lose form of risk neutral
valuation
‡ Using the this process illustrates how your stock is the currency
of the transaction
‡ Step by Step Approach
 Value your company using a set of base case assumptions
 ¦ack into the discount rate that makes the value in the
model equal to the current market value
 Use same discount rate and same set of assumptions to
value the target

#- 
  
   

 "5       |


%
  
|
 
 5    " |

‡ NPV assumes

Capital structure remains the same

Œeveraged ¦uyout

Constant Tax Rates

NOŒ

‡ APV corrects for some assumptions

Changing WACC

Distortions in WACC for capital structure

Changing tax rates

% 
  
   

 "5       |


‡ Value the Company as if it were entirely financed by equity using

the statutory income rates

‡ Add the tax shields due to interest expense separately and use
the debt discount rate to value this shield

‡ Compute the present value of net operating losses using the

equity discount rate

% 
  
   

 "5       |


‡ Steps

Present Value of Free Cash Flow at discount rate using ¦a

without tax adjustments

Present value of tax shield from interest at the debt rate

Present Value of net operating loss

‡ Interest Tax Shield

PV of interest x tax rate

Plus: terminal value of debt

% 
  
   

 
   )  "|   ) ,"

‡ WACC

Tax shield in the discount rate

Different accounting for NOŒ (WACC must use changing

effective tax rates)

Changing value of debt

Timing of debt repayments

‡ Example

Same operating cash flows

Alternative debt payoff assumptions

% 
  
   

 " |  ,"

‡ APV (No taxes)

K = ¦a x (Rm) + Rf
Since ¦a = (E/V) x ¦e + 0
WACC = (E/V) x ¦e x Rm + Rf
‡ Normal WACC assuming Rf = Kd
WACC = (E/V) x (¦e x Rm + Rf) + (D/V) x Kd
 WACC = (E/V) x (¦e x Rm + Rf) + (D/V) x Rf
WACC = (E/V) x (¦e x Rm ) + Rf
‡ Since Kd = Rf + Credit Spread
WACC = (E/V) x (¦e x Rm) + (E/V) * Rf + (D/V) * (Rf + Credit Spred)

%# 
  
   

 " |  

%% 
  
   

 7) !    ! 

‡ j ^  
 ^   

 






 

 
 
^ 

 
 ^
 
 
!  ^  


 
 ^   
 

‡ "


  ^  



  
 
     ^
 

  # 



$    ^

‡ "
  
 ^  

 
 


   
!  



 

 ^
 

   !  
^ 

 
 
 %

 

 

%* 
  
   

 

     


 

‡ r 








  

 

   

      
 
 ^  


‡ &

 ^ 

  ^







j ^  
  


  
 
  
"

  
^

^ 
   

 

%+ 
  
   

 "   6 :  )   

‡ The asset beta can be computed using the formula:

‡ ¦(asset) = ¦(equity) x (Equity/EV) + ¦(debt) x (Debt/EV)

‡ The weights must be at market value

   ( - T
 r
t )  
° Ú  °  O
 

r 
r 

  
 
°
r 
 °
r  Ú
   ( - T
 r
t )  
 O
 

  

%- 
  
   

 ,   
   : $
  â 

‡ *
 
 ^   !      

! "^   
     
    !  '


  
 


^ 
(!  
  
!  


‡ In theory, the duration of the risk free rate should be the same as
the duration of the equity cash flows to eliminate interest rate risk.
To see this, consider the venture capital example when the cash
flows all occurred in 7 years. Pretend that somehow the cash
flow could be hedged in futures markets in year 7 and there is no
risk. In this example, a risk free zero coupon rate bond that
matures in 7 years would clearly match the cash flow of the
equity. A bond with a seven year duration would accomplish this.

* 
  
   

 ,   
   : $
  â 

‡ *
 
 ^   !      

! "^   
     
    !  '


  
 


^ 
(!  
  
!  


‡ In practice of course, the duration of equity cash flows is not

known. The duration is computed using the formula:

‡ Duration = ™ (t x PV of Cash Flow)/Present Value

‡ The duration can be computed for a 10 year bond and for equity
as illustrated in the following slides.

* 
  
   

     A  :

uration of 10
ear ¦ond at 5%
uration of 10 ear ¦ond at 5%

`oupon 5%
 PV  t
Value 1000 `oupon 0% Value
 610.27094
Ter 10
Suuration 15,979 Ter  10 Su  PV t 12,205

Par 1000 7.99 Par 1000 uration 10.00
YT 5% YT  5%
`redit Spread 0% `redit Spread 0%

 iout 
ate 
`a h
ate t 
`a h iout t
Period Flo PV
ate Period Flo ate PV
1/1/2005 1 25 0.98 24.39
1/1/2005 1 0 0.98 -
7/1/2005 2 25 0.95 47.59
7/1/2005 2 0 0.95 -
1/1/2006 3 25 0.93 69.64
7/1/2006 4 25 0.91 90.60 1/1/2006 3 0 0.93 -
1/1/2007 5 25 0.88 110.48 7/1/2006 4 0 0.91 -
7/1/2007 6 25 0.86 129.34 1/1/2007 5 0 0.88 -
1/1/2008 7 25 0.84 147.22 7/1/2007 6 0 0.86 -
7/1/2008 8 25 0.82 164.15 1/1/2008 7 0 0.84 -
1/1/2009 9 25 0.80 180.16 7/1/2008 8 0 0.82 -
7/1/2009 10 25 0.78 195.30 1/1/2009 9 0 0.80 -
1/1/2010 11 25 0.76 209.59 7/1/2009 10 0 0.78 -
7/1/2010 12 25 0.74 223.07 1/1/2010 11 0 0.76 -
1/1/2011 13 25 0.73 235.76 7/1/2010 12 0 0.74 -
7/1/2011 14 25 0.71 247.70 1/1/2011 13 0 0.73 -
1/1/2012 15 25 0.69 258.92 7/1/2011 14 0 0.71 -
7/1/2012 16 25 0.67 269.45 1/1/2012 15 0 0.69 -
1/1/2013 17 25 0.66 279.31 7/1/2012 16 0 0.67 -
7/1/2013 18 25 0.64 288.52 1/1/2013 17 0 0.66 -
1/1/2014 19 25 0.63 297.13 7/1/2013 18 0 0.64 -
7/1/2014 20 1025 0.61 12,510.55 1/1/2014 19 0 0.63 -
7/1/2014 20 1000 0.61 12,205.42

* 
  
   

 ,   
   : $
  â 

‡ *
 
 ^   !      

! "^   
     
    !  '


  
 


^ 
(!  
  
!  


‡ Practical ± ³The 10-year rate is less susceptible to two problems

involved in using a longer rate, such as a 30 year Treasury ¦ond
rate. Its price is less sensitive to unexpected changes in inflation
and so has a smaller beta that the thirty year rate. Also, the
liquidity built into 10 year rates may be lower than that of 30 year
bonds.

* 
  
   

 ,"     

   

‡ u  
) 


    j 
^ 
 


 


^ 

  

   
^ 
   
 
  

Should we include country risk, exchange rate risks etc and

how to get them.

Copeland says: ³the most common errors in setting the

WACC are:
Making ad hoc adjustments for risk, and

Using the WACC to discount foreign currency cash flow

* 
  
   

 ,"     

   

‡ u  
) 


    j 
^   



 


^ 

  
   

^ 
    
  
Example: Assume that you are valuing Dragon Air and there is no
¦eta available for this company.
Assume you use US Airlines with and that the average ¦eta is 1.0.
The ¦eta is Cov(Rm,Ri)/Var(Rm)
In this case Rm is US Market
Cost of Capital in US is Rf+Rm
Cost of capital in HK should by Rf(HK) + Rm (US),
not Rf(HK) + Rm (HK), because the ¦eta was computed from the US Rm
Use US Rm, otherwise, the ¦eta would not be consistent with the
Rm

*# 
  
   

  

  ,"     

‡ Try some very simple steps:

‡ Divide the market into three beta groups

Above average 1.2

¦elow average .8

Average 1.0

‡ Find out what investors expect in local markets in terms of the premium
above the risk free rate.

E.g. 5% in Œondon and 7% in China

‡ Add the local risk free rate to the market premium adjusted for the three
categories of beta.

‡ Make adjustments for country risk with political risk insurance rates

*% 
  
   

 

 :   !/ 


 

‡ Assume that Rm in Hong Kong is 7% and the Rm is the US is

5%.

‡ If ¦eta is used for a comparable 1.0 and is measured in the US,

the expected return is 5% plus the Rf. This reflects the return
investors require to be compensated for risk. If it is applied to a
company with similar risks in Hong Kong, the

‡ If this ¦eta is applied to the Hong Kong Rm, the cost of capital
implied is 7% plus the Rf.

** 
  
   

 ,"     

   

‡ u  
) 


    j 
^ 
 


 


^ 

  

   
^ 
   
 
  
In computing WACC in a merger, should you use the
incremental cost of debt for the target or the acquirer
Often the debt is retired, in which case it is clear that the
cost of debt of the acquirer should be used
Future debt will be financed by the acquirer not the target, so
the acquirer cost of debt should be used
The value of debt in the valuation should also be at the
acquirer cost of debt as in the example we developed in
class

*+ 
  
   

 ,"     

   

‡ u  
) 


    j 
^ 
 


 


^ 

  

   
^ 
   
 
  
To compute premiums for country risk, I suggest using risk
insurance premiums that are offered by institutions such as
the AD¦.
The AD¦ provides insurance for nationalization, non
conversion of currency and contract abrogation. After these
risks are removed, the risk should be similar to places where
these risks are not present.
The AD¦ provides percentages to add to debt which can be
added to the Rf

*-