Objective is to maximize value of the firm

THREE PRINCIPLES
Investment Principle
Only invest in projects which can give returns beyond hurdle rate
Hurdle rate should be higher for high risk investments
hurdle rate will also depend on type of capital
ROI should be based on cash flows and not on earnings - better if earlier

Financing Principle
Find a mix of debt and equity that maximizes value and minimizes hurdle rate
Match debt to type of asset and currency of investment

Dividend Principle
If no appropriate investments are available, return cash to owners
Riskfree rate
Riskfree rate should be in the same currency as the cashflows
Use 10 year treasury bond rates of AAA rated countries directly
For countries where governments are not AAA rated, check their rating and estimate the associated default spread from Mood
For example, in Nov 2013, the Indian government's rupee bond rate was 8.82%. The local surrency rating at Moody's was BAA3
Getting a default spread
1. If the local govt. has a Dollar bond, then subtract the US rate from the local govt; rate
2. CDS market spread for a country
3. If 1 and 2 not available, use sovereign rating of a country to estimate what would be the typical spread for that rating

If local currency riskfree rate is not available, do the entire analysis is another currency. Will require an expected exchange rate
TIBS rate - Real riskfree rate (adjusted for inflation)

Risk Premium
Premium that investors demand on an average risk investment

Historical method = Average return on stocks - Return on risk-free govt securities

Time period should be as big as possible to reduce standard error
Use geometric average instead of arithmetic average to incorporate the effects of componsing
If historical data is not available
1. Use sovereign bond ratings to get the default spread and add it to the risk premium of US
2. Use CDS default spread and add it to the risk premium of US
Multiply the premium with the ratio of st. dev. Of equity to std. dev. Of govt. bond
EPR = EPR USD + (Default risk) x Sdequity/Sdbond
This is needed to adjust for the additional risk of equities as compared to bonds
To estimate for a company, do weighted average of risk premiums of each country based on revenue share.
Revenues are available and always positive and hence it is logical to use that.

Implied equity risk premium

Value of index = Expected dividends next period/(Required return on equity - Expected growth rate of dividends)
This can be used to calculate the implied equity return rate. We can then subtract the risk free rate to get the risk premium.
If the market is expected to have high growth in the near future before stabilising, then use cash flows for for few years and the
Long term growth can be treasury bond rate
For expected dividend, use dividend as percentage of market value in current year on the market value of future years

Beta
Betas are weighted averages
Beta company = Beta cash x % cash of firm value + Beta business (1-%cash of firm value). Beta cash is 0
Beta business is the Beta of operating assets

Regression Beta
Regression of stock and market gives beta. It is the slope of the line
Time interval - Don't go too far back as companies change with time - usually 2 to 5 years
Interval of return (daily, weekly monthly) - use weekly or monthly
Return - (Price end - Preice beginning + Divident period)/ Price beginning
Index should be wide eg. S&P 500
Calculate returns on index in similar way
The regression standard error gives the range of Beta
Also, Betas can be different based on the index that is used. Hence, this estimate is noisy and hence cannot completely trusted

Fundamentals that drive Beta

Cyclical companies have higher Beta
Firms that sell discretionary products have higher Beta
Higher debt and higher fixed cost lead to higher Beta as earnings are variable
Beta levered = Beta unleverd (1+(1-t)D/E)

Bottom up Betas
Average regression betas of all publicly traded companies in the industry. Use median if there are outliers.
Unlever the beta to get the average company Beta and remove the effect of cash to get the Beta for the business. Eg. Beta busi
Find weighted beta for all the businesses of the firm
Unlever the beta and lever up with the firm's D/E ratio
Weights can be by revenue. Better if by value. Eg. Use comparable companies' sales by EV and own company's sales to get EV
For a firm in multiple businesses, instead of assuming D/E to be the same for all businesses, allocate the debt based on the we
Calculate separate Betas and cost of equity for each business. Use the Beta for the business to evaluate investments and not th
Else, the safer businesses will subsidise the riskier ones. Hence, multi-business companies should always use different Betas fo
Betas can be across countries
Sample size should be large
Cost of Equity in Brazil = (1+ Cost of Equity in US) x [(1+Inflation estimate in Brazil)/(1+ Inflation estimate in US)] - 1
For private businesses, use average D/E ratios of comparable companies

The beta is calculated for marginal investor. The investor is diversified and hence is only exposed to market risk and not to firm
For private businesses, the cost of equity underestimates the risk as the owner is not diversified
Divide Beta by root of average R squared of the comparable companies to get the Total Beta and use it t o calculate rate of equ

Debt
Commitment to make payments in the future - contractual obligation
Failure to make payments leads to loss of control
Interest is non-deductible
All interest bearing liabilities - loans and bonds - come under debt. Lease commitments are also commitments and hence can b
Cost of debt is the rate at which the firm can borrow money long term today
Cost of debt = Risk free rate + default spread. Use the bond ratings to estimate default spread. Both should be in same currenc
For emerging market companies, also add the country risk unless the risk free rate incorporates that
Cost of Debt in INR = (1+ Cost of debt in USD) x (1+Expected inflation in INR)/(1+Expected inflation in USD) - 1
If bond rating is not available, use interest coverage ratio to estimate rating.
This gives the pre tax cost of debt.
Use the marginal tax rate to get the after tax cost of debt = pre-tax cost of debt (1-marginal tax rate)
Market value of debt
Treat all the debt as a bond with face value equal to total debt and interest payments based on last year's interest and maturity

Hurdle Rate
Use Cost of capital or cost of equity based on whether the cash flows are to firm or equity holders

Additional risk for foreign projects

Exchange risk - Not needed as it averages out for investers who are diversified
Country risk - The new country maybe riskier than the existing country. For examplle a US company investing in Brazil.
In such a case, add the country risk premium to the market risk premium while calculating cost of equity and calculate cost of c

Currency Adjustment
To do analysis in another currency, convert Dollar cashflows to local currency
Use current exchange rate for Year 0. For subsequent years use the multiply by (1+Inflation in local)/(1+ inflation in USD) to adj
At the same time, discount rate will change.
NPV in local currency will be same as product of current exchange rate and NPV in USD

Payback Period: Time by which cumulative cashflows equals investment

Discounted payback: Same as payback but future cashflows are discounted with the rate of return

Sensitivity Analysis can be used to show different scenarios

Monte Carlo simulation can be used with distributions of the assumptions such as revenue, risk, etc.
 iated default spread from Moody's and adjust the bond rate.
ency rating at Moody's was BAA3 and the default spread was 2.25%. Thus, riskfree rate = 8.82-2.25 = 6.57%

ical spread for that rating

quire an expected exchange rate.

venue share.

rate of dividends)
rate to get the risk premium.
sh flows for for few years and then terminal value to find the rate of return

ket value of future years

hence cannot completely trusted.

are outliers.
ta for the business. Eg. Beta business = Beta company/(1-median cash % of Firm value of comparables)

own company's sales to get EV of business. Do this for each business and use the EVs to weight the Betas)
ocate the debt based on the weight of identifiable assets
evaluate investments and not the Beta for the company.
uld always use different Betas for different businesses.

n estimate in US)] - 1

ed to market risk and not to firm specific risks. However, this is not true for private businesses.

nd use it t o calculate rate of equity

o commitments and hence can be treated as debt

Both should be in same currency.

tion in USD) - 1
n last year's interest and maturity at weighted average maturity of the debt

pany investing in Brazil.

t of equity and calculate cost of capital again.

ocal)/(1+ inflation in USD) to adjust for inflation.

Debt vs Equity
Advantages of Debt
1. Tax Benefit - Interest on debt is tax deductibe
2. Discipline - Since interest payments are mandatory, managers have to take projects that ensure earnings are sufficient
Disadvantage of Debt
1. Cost of bankruptcy goes up. Greater the debt, higher the cost.
2. Agency cost - what's good for equity investors may not be as good for lenders. Lenders don't like risky projects and prefer co
3. Loss of flexibility - On borrowing money, the future capacity to borrow money goes down

Companies in early stage should have low debt as almost all earnings need to be reinvested and the growth lies in the future.
Matured companies with steady earnings with low re-investment needs take debt

If there is no tax, no bankruptcy cost and no agency cost, then debt or equity is irrelevant - Miller Modiglani

Financing Mix

Cost of capital approach

Right mix of debt and equity is the one that minimizes the cost of capital
As debt ratio increases, cost of debt and cost of equity increase.
How to calculate Cost of Equity and Debt for different D/E?
Use the different D/E ratios to lever the Beta and calculate the cost of equity
Use interest coverage ratio at different debt levels to estimate bond ratings. Use the rating to calculate cost of debt.
Problem: To compute interest expense at a D/V ratio, the cost of debt is needed. But that is what is being calculated.
To overcome this, use the previous D/V ratio's Cost of debt to calculate interest and get the rating. If the cost of debt changes,
Note that as interest increases, the tax rate will change
ure earnings are sufficient

t like risky projects and prefer companies which have tangible assets.

d the growth lies in the future.

ler Modiglani

alculate cost of debt.

hat is being calculated.
ting. If the cost of debt changes, recalculate interest and cost of debt. Continue till steady state is reached