Transcript Module 12 – Cost of Capital and Valuation Basics

FINANCIAL STATEMENT
ANALYSIS & VALUATION
Third Edition
Peter D.
Easton
©Cambridge Business Publishers, 2013
Mary Lea
McAnally
Gregory A.
Sommers
Xiao-Jun
Zhang
Module 12:
Cost of Capital
and Valuation Basics
©Cambridge Business Publishers, 2013
Financial Instruments
■
Entitles its owner to claim a series of future
payoffs from a company
■
■
Payoff amount depends on the ability of the
company to generate a profit through future
operations
Includes
■
■
■
Cash
Equity ownership such as stock
Debt instruments such as notes and bonds
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Valuation Model Components
■
Generally include these estimates
■
Cost of capital
■
■
■
■
Discount rate that an investor uses to value future
payoffs
Reflects the return investors expect on their
investment
Based on perceived risk of investment
A forecast of future payoffs
■
Such as dividends and free cash flows depending on
the model used
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Payoffs from Equity Instruments
Payoffs of Stock
Investments
■
■
Receipt of
dividends, if any
Cash from selling
the stock to another
investor or back to
the company
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Payoffs of Bond
Investments
■
■
Receipt of interest
payments
Receipt of principal
after bond matures
All benefits
occur in the
future
Basics of Valuation
Step 1:
Understanding the Business Environment and
Accounting Information
Step 2:
Adjusting and Assessing Financial and Accounting Information
Step 3:
Forecasting Financial Information
Step 4:
Using Information for Valuation
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Where does
the firm
operate?
Where does
the firm
currently?
Where does
the firm
going?
What is
the firm
worth?
Stock Valuation – Step 1
Business and accounting analysis
■ Assessing profitability
■ Assessing the quality of accounting
■ Evaluating future growth opportunities
■ Understanding competitive and macroeconomic
threats
■ Making accounting adjustments, if necessary
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Stock Valuation – Step 2
Forecasting
■ Predicting payoffs from the company
■
■
Crucial step in security valuation
Produces key inputs into the valuation models
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Stock Valuation – Step 3
Risk assessment
■ Estimating the cost of capital
■
Adjust for time value of money
■
■
Takes account of future nature of payoffs
Adjust for risk
■
Takes account of the uncertain nature of payoffs
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Stock Valuation – Step 4
Valuation
■ Applying the proper valuation
■
■
Identify the crucial assumptions underlying each
model
Apply the proper model
In the right way
■ Under the right circumstances
■
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Intrinsic Value
■
■
■
Defined as the economic value of the company
assuming that actual payoffs are known
Part of the valuation process
Estimates the intrinsic value of debt and equity
IVFirm= IVDebt + IVEquity
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Time Value of Money
■
■
Used to compute the present value of payoffs
To compute
1) Forecast the payoffs to be received
2) Determine the discount rate to be used
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Lump-Sum Payoff
■
Present value factor applied to a lump-sum
payoff
1
(1 + r)n
Present value =
Future payoff × Present value factor
Found in Table 1 - Present Value of a Single Amount
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Lump-Sum Payoff Example
What is the present value of $100 to be received two
years hence at a discount rate of 11%?
Present value = $100 × 0.81162 = $81.16
PV Factor
for 2 years @ 11%
$81.16 × 0.11 = $8.93
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$81.16 + $8.93 = $90.09
Annuity Payoffs
■
■
A series of equal lump sums at regular intervals
Must meet three criteria
1) The series must be of equal amounts
2) Payment must occur at equal time periods
3) The same discount rate is applicable over the time
horizon of the payoffs
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Annuity Payoff Example
What is the present value of $1,000 to be received at
the end of each of the next 4 years at a discount rate
of 11%?
Present value = $100 × 3.10244 = $3,102.44
PV Annuity Factor for 4 years @ 11%
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Present Value, Future Value, & Interest
$4,709.73 future
value 4 years
in the future
=
$3,102.45
lump sum
invested today
=
$1,000 annuity
invested at the end of
each year for 4 years
Investors are indifferent to the three investments.
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Bond Terminology
Coupon Rate
Determines the annuity payments
Face Value
Stipulates the lump-sum payment to be made
at the bond’s maturity
Market Rate
The interest rate an investor could earn by investing
in other bonds with similar risks
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Valuing a Debt Instrument Example
Determine the present value of a 3-year bond with
a 9% coupon rate, a face value of $1,000, and a
market rate of 10%.
Time Line Representation of Payoffs Related to a Debt Instrument
End of Year
0
1
2
3
Interest earned
$90
$90
$90
Future value at year-end
$1,000
Present value of lump-sum
end of 3 years @ 10%
Present value of annuity for 3 years @ 10%
Present value
0.75131 × $1,000 =
2.48685 × $90 =
An investor is willing to pay $975.13 in exchange for
receiving three annual payments of $90, and one payment
of $1,000 at the end of three years.
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$751.31
223.82
$975.13
Valuing an Equity Instrument
Example
A stock pays a $90 dividend at the end of each year
for two years, along with a terminal dividend of
$1,090 at the end of years 3.
Time Line Representation of Payoffs Related to a Debt Instrument
End of Year
0
1
2
3
Interest earned
$90
$90
$90
Future value at year-end
$1,000
Present value of lump-sum
end of 3 years @ 10%
Present value of annuity for 3 years @ 10%
Present value
0.75131 × $1,000 =
2.48685 × $90 =
Same present value as the debt instrument
since the same 10% discount rate is used
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$751.31
223.82
$975.13
Using Discount Rates
■
Cost of debt capital
■
■
Cost of equity capital
■
■
Used for payoffs to debtholders
Used for payoffs to equity holders
Weighted average cost of capital
■
Used for payoffs to the entire firm
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Estimated Cost of Capital
Models assume an investor of a financial instrument
prices it with the expectation of recovering two
costs.
Risk-Adjusted Discount Rate Components
Time value of money
Cost of risk
Foregone interest
from investing in an
instrument with
future payoffs
Investor’s compensation
for bearing the risk
associated with the
uncertainty of the payoff
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Diversifiable Risk
■
■
Refers to risks that can be diversified away by
investors
Effect of diversification on risk
■
■
Stock price increases cancel out stock price
decreases, reducing large price movements
Returns of stock must be independent
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Capital Asset Pricing Model (CAPM)
■
■
Equates the expected return on a particular asset
as the sum of three components
Also called the cost of equity capital
CAPM = Risk-free rate + beta risk + stock-specific risk
re = rf + [β × (rm – rf)]
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CAPM Components
■
Risk-free rate (rf)
■
■
Market risk premium
■
■
Commonly based on the return on ten-year U.S.
treasury bills
Difference between the expected market return (rm)
and the expected risk-free rate
Market beta (β)
■
■
Sensitivity of the asset’s market return to the overall
market
Reflects historical stock price volatility
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Interpreting Market Beta
-1
Stock price
will change
contrary to a
change in the
overall market
0
+1
Stock price will
change with a
smaller % with
a change in
the overall
market
Stock price
will change
with a larger
% with a
change in the
overall market
The higher the risk an investor is willing to accept,
the higher the expected return.
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CAPM Example
Eastern Company has a market risk premium of
4.6% and a market beta of 0.56. The 10-year
Treasury rate is 5.2%. How much is CAPM?
re = rf + [β × (rm – rf)]
re = 0.052 + [0.56 × 0.046] = 7.8%
An investor requires an expected return of
7.8% to invest in Eastern Company’s stock.
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Multi-Factor Models
■
Developed to compute risk-adjusted returns
re = rf + β1 × r1 + β2 × r2 + β3 × r3 + …
■
■
Used to compute cost of equity capital
Risk factors based on fundamental analysis
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Internal risk factors
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Such as operating leverage, financial leverage, effectiveness
of internal control
External risk factors
■
Such as exchange risk, political risk, supply chain risk,
industry competition
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Average Annual Stock Return
for Small and Large Firms
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Factors as Part of Five Forces
Five forces that confront the company and its industry
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Cost of Debt Capital
■
■
■
■
Consists of the market rate on debt instruments
Reported fair value of a debt instrument should
approximate its present value
Borrowing rate depends on a company’s
perceived level of risk by lenders
Factors considered by lenders
■
■
■
Short-term liquidity measures
Interest-coverage ratio
Long-term financial stability
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Debt Ratings
Ratings provided by
■ Moody’s
■ Standard and Poors
■ Fitch
Investment Grade
Very unlikely to
default
Junk Bonds
Higher default risk
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Cost of Debt Capital
Two components
■ Average borrowing rate for interest-bearing debt
■
■
Interest expense ÷ Average interest-bearing debt
Marginal income tax rate
■
rd =
Tax savings due to interest reducing taxes
Average borrowing × (1 – Marginal tax rate)
rate for debt
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After-Tax Cost of Debt Capital
Example
Eastern Company has a marginal tax rate of 34.6%,
interest expense for 2009 totaling $648,000, and
average debt of $8,000,000. How much is its aftertax cost of debt capital?
rd =
rd =
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Average borrowing
× (1 – Marginal tax rate)
rate for debt
$648,000
$8,000,000
× (1 – 0.346) = 5.3%
Weighted Average Cost of Capital
■
Used for valuation models that assume payoffs
are distributed to both equity holders and debt
holders
rw = rd ×
■
IVDebt
IVFirm
+ re ×
IVEquity
IVFirm
Uses intrinsic values instead of numbers from
financial statements
■
Market value typically used
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Weighted Average Cost of Capital
Example
Eastern Company has a 5.3% cost of debt and 7.8%
cost of equity. Its equity has a market value of
$4,350 (thousands), and its debt has a market value
of $2,560 (thousands). How much is the weighted
average cost of capital?
Intrinsic value of the firm = $2,560 + $4,350 = $6,910
(thousands)
rw =
$2,560
0.053 ×
$6,910
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+
$4,350
0.078 ×
$6,910
= 6.9%
WACC with Preferred Stock
■
■
■
A third term is added
Equity is split into common and preferred
sections
If market value is hard to determine for
preferred stock, use book value
rw =
rd ×
IVDebt
IVFirm
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+ rce ×
IVCommonEquity
IVFirm
+ rpe ×
IVPreferredEquity
IVFirm
Dividend Discount Model (DDM)
■
■
■
Equates the value of company equity with the
present value of all future dividends
Dividends are viewed similar to coupon
payments on debt
Discount rate is the cost of equity capital
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Recursive Process of Valuation
The stock price today depends on the expected price of
the stock tomorrow, which in turn depends on the
expected price of the stock the day after.
Intrinsic value of
equity at the
=
beginning of
period one
Value of equity
Dividends to be
received during + at the end of
period
period 1
IV0 =
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1 + Cost of equity
D1 + IV1
1 + re
Recursive Process of Valuation
Example
Eastern Company has an expected dividend for period 1
of $1.50, and its expected intrinsic value of equity at the
end of period 1 is $32. The cost of equity capital for
similar firms is 7.6%. What is today’s intrinsic value?
IV0 =
IV0 =
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D1 + IV1
1 + re
$1.50 + $32
1.076
= $31.13
Dividend Discount Model Framework
■
Equates current stock price to the present value
of all future expected dividends
IV0 =
■
D1
1 + re
+
D2
(1 + re)2
+
D3
(1 + re)3
+
D4
(1 + re)4
Two methods to forecast future dividends
through infinity
■
■
Perpetuity method
Constant growth method
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+…
Dividend Discount Model with
Constant Perpetuity
■
■
Assumes that forecasted dividends stabilize at
some point in the future and remain constant
thereafter
Yields an ordinary annuity with payments
occurring at the end of a period through infinity
IV0 =
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D1 + IV1
1 + re
DDM with Constant Perpetuity
Example
Eastern Company has an expected dividend for 2 years of
$1.50, followed by a $2.25 dividend in year 3, and $2.75 per
year thereafter. The cost of equity capital is estimated at
7.6%. What is today’s intrinsic value?
Perpetuity
Years 1, 2, and 3
IV0 =
$1.50
1.076
+
$1.50
(1.076)2
+
$2.75
$2.25
(1.076)3
0.076
+
(1.076)3
= $1.61 + $1.30 + $1.81 + $36.18 = $40.90
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Dividend Discount Model with
Increasing Perpetuity
■
■
■
Referred to as the Gordon growth model
Considered more realistic than the constant
perpetuity model
Present value of an increasing perpetuity
Present value of
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D
(r – g)
DDM with Increasing Perpetuity
Example
Eastern Company has an expected dividend for 2 years of
$1.50, followed by a $2.25 dividend in year 3, and $2.75 in
year 4 with a growth of 2% per year thereafter. The cost of
equity capital is estimated at 7.6%. What is today’s intrinsic
value?
Perpetuity
Years 1, 2, and 3
IV0 =
$1.50
1.076
+
$1.50
(1.076)2
+
$2.75
$2.25
(1.076)3
0.076 - 0.02
+
(1.076)3
= $1.61 + $1.30 + $1.81 + $39.42 = $44.14
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Issues in Applying the
Dividend Discount Model
■
Create
challenges in
forecasting
dividends and
generating
reliable
forecasts
A large percentage of publicly
traded companies do not issue
dividends
■
■
Some companies have unusually
high dividend payouts given their
profit levels
■
■
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Zero payout may continue
indefinitely
Sustaining may not be possible
Difficult to find analysts’ forecasts
of dividends to use in the model
End Module 12
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