Todays Content
I.
Announcements:
II.
Discount Rate
a.
Why we discount FCF
b.
Risk-Return Tradeoff
c.
CAPM
d.
Compute Betas
Regressions
Comparables
III.
Homework Assignment #2
I. Company Valuation
Introduction
Discounted Cash Flow (DCF) Models
Discount Rate
No Friction Model
WACC (Weighted Average Cost of Capital)
APV (Adjusted Present Value)
Multiples
Other topics: LBOs, M&A, etc.
E[FFCFt ]
VA =
t
(
)
1
+
r
t =0
Return ( r )
Common
Unique
Standard Deviation ()
Total Risk = Systematic (Common) Risk + Idiosyncratic (Unique) Risk
x =
Cov (rx , rm )
Var (rm )
Company
Valua-on
DCF
Models
Discount
Rate
6
Return ( r )
Unique
Standard Deviation ()
re = rf + e (rm rf )
rd = rf + d (rm rf )
rOA = rf + OA (rm rf )
rx = rf + x (rm rf )
Multibeta CAPM
Investor expectations
Regulatory decisions
10
20
30
40
50
60
70
80
Source:
h?p://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-Yield-Data-Visualiza-on.aspx
Company
Valua-on
DCF
Models
Discount
Rate
9
Arithmetic
Average
ooArithmetic
Average
=
use?
= =1/
o Geometric Average
=&=1(1+) - 1
o Geometric Average =
1+
-1
http://faculty.london.edu/icooper/assets/documents/
http://faculty.london.edu/icooper/assets/documents/ArithmeticVersu
ArithmeticVersusGeometric.pdf
sGeometric.pdf
0.00%
Year
1929
1931
1933
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
60.00%
40.00%
20.00%
-20.00%
-40.00%
-60.00%
-80.00%
Year
1929
1931
1933
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
0.05
-0.05
-0.1
-0.15
0
Year
1929
1931
1933
1935
1937
1939
1941
1943
1945
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
2011
0.25
0.2
0.15
0.1
0.05
-0.05
-0.1
Stocks-T.Bonds (US)
Arithm. Mean
Geom. Mean
1928-2012
7.65%
5.74%
5.88%
4.20%
1962-2012
5.93%
4.60%
3.91%
2.93%
2002-2012
7.06%
5.38%
3.08%
1.71%
Estimating beta
r = rf + (rm rf )
(r r ) = + (r
e
f t
rf )t + t
d1
E1
D1
A1
E2
e2
D2
d2
A2
e_c1 Ec1
e_c2 Ec2
e_c3 Ec3
d_c1 Dc1
d_c2 Dc2
d_c3 Dc3
A_c1
A_c2
e??
Levering
Unlevering
Comparables
A_c3
A_c
A
Levering/Unlevering Formula
D
E
A =
d +
e
D+E
D+E
Company
Valua-on
DCF
Models
Discount
Rate
25
Comparables
e_c1
Ec1
e_c2
Ec2
e_c3
Ec3
d_c1
Dc1
d_c2
Dc2
d_c3
Dc3
A_c1
A_c1
A_c
e??
Levering
Unlevering
A_c1
A
e
0.36
0.35
0.81
0.71
Market
Leverage
30.05%
3.30%
10.00%
17.65%
A
0.31
0.35
0.75
0.62
0.51
Genentech
e
=
0.56
D
E
d +
e = L d + (1 L) e
D+E
D+E
D
Where : L =
= Leverage
D+E
A =
NB:
e =
A
1 L
d L
1 L
A =
E
e = (1 L)e
D+E
Never rely only on one comparable. Choose at least 3 or 4, and then take a
weighted average
Homework Assignment #2
Individual Assignment posted on the course website
Objective: Find the cost of equity capital for your
company.
Three Approaches
Regression analysis
Comparables approach
Due Wednesday Jan 27th at the beginning of class
Paper format only. Do not email me or the TA with
the assignment.
Problem #1
Firm
1
Firm
2
Firm
3
You
are
the
manager
of
the
hockey
helmet
division
of
your
Firm.
There
are
three
rms
Total
Assets
20000
1000
500
that
compete
with
you
in
the
hockey
Debt
500
200
200
helmet
business.
Firm
1
is
a
large,
15000
800
300
diversied
plas-cs
business
which
derives
Equity
Total
Liab
+
Equity
20000
1000
500
10%
of
its
revenues
from
hockey
helmet
sales.
Firm
2
is
a
single-division
hockey
Earnings
1500
100
-5
helmet
manufacturer
that
has
been
in
Bond
Ra-ng
AA
AA
BBB
business
for
30
years
(prior
to
that
hockey
Shares
Outstanding
1000
100
100
players
didnt
wear
helmets).
Firm
3
is
a
Share
Price
20
15
2
recent
entrant
into
the
hockey
helmet
Equity
Beta
1.3
1.5
2.2
business
a[er
many
years
in
the
football
helmet
business.
The
table
shows
some
nancial
informa-on
on
the
comparable
rms
(all
units
are
in
millions
except
the
share
price).
The
risk-free
rate
is
5%,
the
market
risk
premium
is
6%,
and
the
marginal
corporate
tax
rate
is
35%.
The
target
debt-to-
value
for
the
division
is
1/3.
Compute
the
cost
of
equity
capital
for
the
hockey
helmet
division.
Company
Valua-on
DCF
Models
Discount
Rate
31
Problem #2
In
1989,
General
Motors
(GM)
was
evalua-ng
the
acquisi-on
of
Hughes
Aircra[
Corpora-on.
Recognizing
that
the
appropriate
discount
rate
for
the
projected
cash
ows
of
Hughes
was
dierent
than
its
own
cost
of
capital,
GM
assumed
that
Hughes
had
approximately
the
same
risk
as
Lockheed
and
Northrop,
which
had
low-risk
defense
contracts
and
products
that
were
similar
to
Hughes.
Specically,
assume
the
following
inputs:
Comparison
E
D/E
GM
1.20
0.4
Lockheed
0.90
0.9
Northrop
0.85
0.7
Also
assume
that
GMs
target
debt/equity
ra-o,
in
market
value
terms,
for
the
Hughes
acquisi-on
is
1.
Hughes
expected
nominal
cash
ow
next
year
will
be
$300
million
and
will
grow
therea[er
at
the
rate
of
5
percent
per
year,
the
risk-
free
rate
is
8%,
and
the
market
risk
premium
is
6%.
Compute
the
equity
cost
of
capital
for
the
Hughes
acquisi-on,
assuming
no
taxes.
Company
Valua-on
DCF
Models
Discount
Rate
32
Problem #3
Your
so[ware
rm
is
considering
a
diversifying
investment
in
the
donut
business.
The
logic
at
headquarters
is
that
your
programmers
eat
so
many
donuts
that
you
might
as
well
get
a
piece
of
the
ac-on.
There
are
two
other
publicly-traded
rms
compe-ng
in
the
donut
business:
one
is
a
mature
rm
with
signicant
interests
in
other
businesses
and
a
young,
upstart
rm
which
is
a
pure-play
in
the
business
you
are
considering.
Summary
nancial
data
(in
$
millions)
for
the
two
comparables
are
given
below:
Mature
comp
Upstart
comp
Total
assets
1000
200
Short-term
debt
25
5
Long-term
debt
475
20
Equity
500
175
Total
liab+equity
1000
200
Earnings
100
1
EPS
(
$)
1
0.05
Share
price
($)
10
40
Dividend
yield
5%
0
Equity
beta
0.8
1.5
To
get
a
be?er
understanding
of
the
mature
comparable,
you
es-mate
that
half
of
its
revenue
is
generated
in
the
donut
business
and
the
remaining
half
of
its
revenue
is
generated
in
a
variety
of
businesses
which
have
average
market
risk.
(a)
Ignoring
taxes,
give
an
es-mate
of
the
cost
of
capital
of
asset
using
the
CAPM
(assume
risk-
free
rate
is
5%
and
whatever
market
risk
premium
you
deem
appropriate).
Jus-fy
all
other
assump-ons.
(b)
What
three
other
pieces
of
informa-on
would
you
like
to
have
to
improve
your
es-mate?
Company
Valua-on
DCF
Models
Discount
Rate
33