Coc
Coc
Coc
Key issues:
Preliminaries
1. Vocabulary--the following all mean the same thing: a. Required return b. Appropriate discount rate c. Cost of capital (or cost of money) d. Hurdle rate
The various Long term sources of finance available to a Company are: Equity Debt Preference capital Retained earnings
Debt
Equity
Cost of Capital What it is? Cost of capital to a company is the minimum rate of return expected by the providers of funds. It is the rate of return that a company has to offer finance providers to induce them to buy and hold a financial security. Hence, it is the minimum acceptable return on any current average risk project under consideration today. The cost of capital is an opportunity cost--it depends on where the money goes, not where it comes from.
Performance Appraisal
Valuing a share
Shareholders perspective
Thinking: Am I getting a return appropriate for the risk, when compared with other investments
Rate of Return
Financial Manager: What is the minimum rate of return on projects we must produce to satisfy shareholders
WACC k e ( E / D E P ) K d ( D /( D E P ) K p ( P / E D P )
Cost of equity is the return that investors require to make an equity investment in a firm Approaches to estimating cost of equity - Capital Asset Pricing Model (CAPM)
Some of the risk in equity investment is firm specific (nonsystematic risk) and some of the risk is borne by everyone in the market (all investments) and is referred to as systematic or market risk Firm specific risk can be diversified, so the market compensates us only for the non diversifiable (systematic) risk Using CAPM, we can estimate the cost of capital for a firm by estimating its beta, the return on the risk-free asset and the market portfolio Beta is a relative measure of risk. It is the amount of volatility our stock adds to the volatility of the market portfolio For a given systematic risk level, the firm should earn the risk free return plus beta times the market risk premium
E ( Re ) R f ( E ( Rm ) R f )
Expected Return Beta
Risk Premium
Cost of Equity
CAPM:Computation of Risk Free Rate (Rf)
Risk free asset is one for which the investor knows the expected returns with certainty. Default Rates and Reinvestment Rates The cash flows on a project and the discount rate used should be defined in the same terms. Risk less rate used should match the time horizon of cash flows being analyzed If cash flows are in dollars, the discount rate has to be a dollar discount rate & the risk free rate has to be a dollar rate
Cost of Equity
CAPM:Risk Free Rate (Rf)
GSec Rate
Beta of an investment is the risk that the investment adds to a market portfolio Approaches to estimating Beta Historical Market Beta-historical data on market prices for individual investments Fundamental Beta-fundamental characteristics of investments
Historical Market Beta-Regression of returns on stock against market returns Stock index used as a proxy for market portfolio R squared-provides an estimate of the proportion of the risk of a firm that can be attributed to market risk; the balance (1-R squared) can be attributed to firm specific risk. Issues in calculating historical beta: Length of the estimation period Choice of return interval Choice of market index
Fundamental Beta-fundamental characteristics of business Beta of a firm is determined by three variables: The type of business the firm is in: the more sensitive a business is to market conditions, the higher its beta Degree of operating leverage: High fixed cost relative to total costhigh operating leverage. High operating leverage, high beta Degree of financial leverage: High financial leverage, high beta Beta of an unleveraged firm (unlevered beta) is determined by the type of business and operating leverage. Also called asset beta. Beta of a leveraged firm (levered beta) is determined by the riskiness of business & its financial leverage It is expected that firms that face high business risk should be reluctant to take on financial leverage
B1=u (1+(1-t)(D/E)
Historical premium-premium earned by risky investments in the past Defining the time period Implied risk premium-Forward looking risk premiums Expected dividends next period = Required return on Equity-Expected growth rate Based on the PV of dividend growing at a constant rate forever Assumption-Overall market prices stocks correctly
E(Re) = Rf + (E(Rm)-Rf)
If the risk free rate is 7.00%, Risk premium is 5.50%, beta is 1.01, estimate the cost of equity
Estimates the cash expected to be paid to shareholders Most theoretically correct of-all approaches Hard to use in practice
Many firms dont pay dividends Dividends may be volatile Many firms dont increase dividends in line with earnings Some models substitute earnings for dividends or other simplifying assumptions
P0
D1 D2 D .... 2 (1 k e ) (1 k e ) (1 k e )
ke
D1 P0 ke
t 1
D1 P 0
Constant Growth Model: dividends are expected to grow at a constant rate `g Cost of equity is equal to dividend yield + expected dividend growth rate
r = (D1/P0) + g
D1 = expected dividend per share next year Div0(1+g) r = required return g = expected dividend growth rate P0 = price of the stock today The current market price of a cos share is Rs.90, current year dividend 4.50, if dividends are expected to grow at a rate of 10%, calculate the shareholders required rate of return
g ( Dt / D0 )
Year 2000 2001 2002 2003 2004 2005
1 t
As per this model the future growth rate in dividend is expected to be based on past dividend growth
Dividend 4.5 5.0 6.0 7.5 12.5 15.0 Growth 11% 20% 25% 67% 20% 29% (AM)27% (CAGR)
This model is based upon two stages of growth, an extraordinary growth phase that lasts for `n years, and a stable growth phase that lasts forever after n.
Extraordinary growth rate g each year for n years Stable growth rate gn forever
Ke = required rate of return Pn = price at the end of year n Gn = growth rate forever after year n Example: Price of a share is 134, D0 is 3.50. Expected to grow at 15% over six years and 8% forever
Ke = required rate of return Pn = price at the end of year n Gn = growth rate forever after year n Example: Price of a share is 134, D0 is 3.50. Expected to grow at 15% over six years and 8% forever
Are retained earnings free of cost? Cost of retained earnings is the rate of return on dividends forgone by equity shareholders. Cost of equity is taken as cost of retained earnings
Cost of Capital Cost of Debt The cost of debt is the rate at which you can borrow from the market currently. It reflects:
Yield on the instrument calculated from the market price, coupon and maturity, can be used as cost of debt-looking up to the ytm on a bond outstanding from the firm Ratings and associated default spread
Yield on the instrument calculated from the market price, coupon maturity, can be used as cost of debt-looking up to the ytm on a bond outstanding from the firm Cost of debt is the rate which equates the current market price with the PV of future cash flows on the debt instrument
Bn C1 C2 B ......... B0 is amount is amount realized per2debenture (or market price) 0 n ( 1 k ) ( 1 k ) ( 1 k ) d d d Bn is redemption price per debenture. Debt trading at Par, Premium, Discount
Cost of Equity
CAPM:Risk Free Rate (Rf)
Evaluate recent borrowing history Estimating a synthetic rating Once we get the cost of debt we adjust the explicit cost obtained for the tax effect
After tax cost of debt kd = Before tax cost of debt kd (1 - t)
These costs are one time costs incurred at the time of raising finances.
Can you apply the firms cost of capital i.e. the hurdle
Analysis of Risk
Type of Risk
Examples
Project Specific
Estimation mistakes. Product/ Location Unexpected Response/ New Product Change that affects all companies Currency changes Political Changes Interest Rate/ Inflation
Competitive
Diversifiable but not for small private firms Diversifiable but not for small private firms Not diversifiable except for International companies
Industry
International
Market / Macro
Assume that a company is considering three projects-A,B and C, having identical outlays. The expected return on investment in Project A is 22%, B 18% and C 19%. WACC for the firm is 20%. Which project satisfies the base criterion and will be accepted? If further analysis reveals that Project C is almost risk less, while project A is highly risky. Project B is of average risk. The perspective betas for the projects A, B and C are 3, 1 and 0.80 respectively. If the market rate of return is 11% and risk free rate is 5%, the project cost of capital will be A-23%, B-11% and C-9.8%. Would your selection change?
When a firm has businesses with very different risk profiles, different investments can have different costs of equity and capital. What is the relationship between the firms cost of equity and capital and its projects costs of equity and capital? The firms costs of equity and capital should reflect the weighted average of the costs of equity and capital of all of the different businesses that the firm operates in, which the weights depending upon the contribution they make to firm value
Cost of Capital
Estimating Beta for firm from Project betas
In 2003, General Motors had three divisions: GM Automotive, Aircraft division and GM Acceptance Corp. The betas of each division and their market values are given below. What is the beta for the entire corp. Division Beta Market Value Automotive 0.95 $22269mn Aircraft 0.85 $2226mn GMAC 1.13 $15812mn In 2004, GM acquired Electronic Data Systems for $2000mn. Its beta is 1.25 How does this acquisition affect the beta of GM?
Cost of Capital
Factors Affecting WACC
Non Controllable - Interest rate, market risk premium Controllable - Capital Structure, Dividend & Investment Policy
Cost of Capital
CoC: Points to Remember