AFM 204 - Class 7 Slides - Cost of Equity (2).pptx

8/9/2019 AFM 204 - Class 7 Slides - Cost of Equity (2).pptx

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Class 7 Slides

Cost of Equity

WACC


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Everything has a price…

• In finance we have a variety of terms forthis: – ime !alue of "oney

– #pportunity Cost

– Cost of Capital

• We are going to focus on the Weighted

Average Cost of Capital $WACC% – Cost of Equity $&e%

– Cost of 'e(t $&d%


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What is WACC)

• *eview… – What do we mean (y cost of capital) – WACC)

• +ses of WACC – Capital pro,ects valuation – Asset appraisals –

-erformance evaluation• 'o different uses require different

calculations.inputs)


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ime !alue of "oney

• /urther investigate WACC – arget leverage ratio

– #ptimal leverage ratio

• Impact of leverage on (eta

• Segment specific WACCs

•

Additional critiques


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WACC Inputs

When computing WACC0 consider 1ey inputs:

– Capital structure0 (oth current and target $2'3

and 2E3% – Cost of de(t $2&d3% – a4 rate $23% – Cost of equity $2&e3%

• *is15free rate $2*f

3%• 6eta $23%• Equity "ar1et *is1 -remium $2E"*-3%


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WACC impact on !aluation

'e(t as 8 of CapitalStructure

!alue

!alue ifno de(t

*emem(er the goal: value ma4imi9ation

!alue of

levered firm

"a4 !alue

#ptimaleverage*atio


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#ptimal WACC

'e(t as 8 of CapitalStructure

*equired*eturn

WACC

*emem(er the goal: value ma4imi9ation

&e

&d

#ptimal 'e(tevel

*+


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he End ;oal

• We are loo1ing for the Weighted AverageCost of Capital $WACC%

Where:

' < = amount of de(t outstanding $mar1et capitali9ation%

E < = amount of equity outstanding $mar1et capitali9ation%

WACC =D

D+E *K d *(1−T )+

E

D+E *K e

K e = Rf + β * (EMRP)K d = Rf + spread


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Cost of Equity

• his is the same as: – he *equired *ate of *eturn for a

shareholder • In other words0 what is the rate of return that I

must e4pect in order for me to want to own hisstoc1)

• We will use the Capital Asset -ricing"odel $CA-"% to estimate the Cost ofEquity $&e%

– Commonly used0 and easy to calculate


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Calculating the Cost of Equity

• &e < *f > ?$E"*-%

• #f the three inputs only E"*- is (eyonddirect measurement or o(servation $sortof…%

• he formula is (eing used to discountfuture cash flows0 so must (e forward

loo1ing – It is not important where the puc1 is now0 (ut

where the puc1 is going to (e tomorrow


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*is15/ree *ate

• ypically drawn from the government (ondyield curve

• Common to use a long5term rate that isliquid and widely followed – @5year (ond yields

– B5year (ond yields

• *emem(er that we are forecasting very farinto the future 'o current rates represent agood estimate of the future)


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*is15/ree *ate Estimates

• he /ederal *eserve has e4cellent dataon long5term interest rates

• etDs loo1 at 5year0 @5year0 and B5year

(ond yields since WWII – http:..researchstlouisfedorg.fredF. – As we did with the other data we loo1ed at0 it

is important to first visually inspect the

interest rate information to get a feel for thestory

http://research.stlouisfed.org/fred2/http://research.stlouisfed.org/fred2/http://research.stlouisfed.org/fred2/http://research.stlouisfed.org/fred2/


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All rates…

G5day 56ills 5year 56onds

@5year 56onds B5year 56onds


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G5'ay 56ills

*ates were near 9ero (efore…during the ;reat 'epression…

and didnDt go (ac1 to 2normal3until after what)


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5year 56onds

6ig0 unstoppa(le trend in interestrates hin1 a(out the 2(ig3 events

since the pea10 such as the end of theCold War0 Asian Currency Crisis0 ech

6oom.6ust0 etc


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@5year 56onds

2he3 (enchmar1 forinterest rates0 used as the

*f in many situations


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B5year 56onds

Ho +S B5year 56onds(eing issued


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What rate would you use)

• G5day 56ill rates have gone from near8 in the @GBs to @8 in the @GJs tonear 8 in F@B – Similar patterns for the other 56onds0 (ut with

a higher rate of interest

• he interest rate differential across

maturities is less significant than thechanges in the interest rate levels overtime


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Some averages…

• etDs loo1 at the average yields over eachtime series $1eeping in mind each timeseries covers a different set of years% – Are there any trends)

– What is the minimum level of interest rates)he ma4imum level)

Bond Average Yield Current YieldG5'ay 56ills BB B

5year 56onds @J @B

@5year 56onds @ FKF

B5year 56onds 7B BBB


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6eta

• 6eta measures the relationship (etweenthe stoc1 and the overall mar1et

• his is usually done (y regressing theperiodic returns of the stoc1 against theperiodic returns of the mar1et – A (road inde4 is chosen to represent the

mar1et0 li1e the SL- for +S stoc1s or theSL-.SM Composite Inde4 for Canadianstoc1s


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M#"Ds 6eta

• 6eta estimation runs into the same pro(lems as anyother forecast – Now much data should we use)

–

What time period) – Is our historical (asis a good representation of the future)

• he same rules apply when (uilding your models: – If no material difference in (etas across different time

periods then your decision is easy• If there are differences you must e4ercise your ,udgment

– Consider the conte4t of su(5periods0 such as (ear vs (ullmar1ets0 inflation rates0 ;'- growth0 etc


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M#"Ds 6eta #ver ime

• he ne4t set of slides loo1s at M#"Ds dailyreturns $y5a4is% graphed against the SL-Ds daily returns $45a4is% – 2@5Oear3 e4tends (ac1wards F days from

Aug FG0 F@K

– 2F5Oear3 e4tends (ac1wards days from

Aug FG0 F@K – Etc


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!isual Inspection

• Pust li1e our loo1 at revenue and ;'- data0 whenloo1ing at stoc1 mar1et data for your company0graph your companyDs daily stoc1 returns against

the SL- Ds daily returns – Any general trend in the data)

– he longer the time period the more data points0 andthe more data points•

Covers more e4treme economic environments• "ore data < more information in your result $the mass of

data points 1eeps getting (igger…%

– Hotice the regression line in each graph


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@5Oear


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F5Oear


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B5Oear


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5Oear


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@5Oear

5@8 5@8 58 8 8 @8 @85F8

5@8

5@8

58

8

8

@8

@8

F8

S&P 500 Daily Return

XOM Daily Return


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@5Oear


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F5Oear

5@8 5@8 58 8 8 @8 @85F8

5@8

5@8

58

8

8

@8

@8

F8


XOM Daily Return


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M#" 6eta #(servations)

• !ery little change in the slope or positionof the regression line over time

• 'oes this mean it is sta(le)

Time Period Beta

@5year JG7

F5year J7GJ

B5year JJG7

5year JGBB

@5year G@G

@5year JBBB

F5year JF


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A 'ifferent -erspective

• What does M#"Ds 6eta loo1 li1e indifferent @5year periods – 6eta using only FB data

– 6eta using only F data

– 6eta using only F7 data

– Etc


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FB


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F


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F7

5J8 58 5K8 5F8 8 F8 K8 8 J85J8

58

5K8

5F8

8

F8

K8

8

J8


XOM Daily Return


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FG


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F@@

5J8

58

5K8

5F8

8

F8

K8

8

J8

XOM Daily Return


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F@B


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M#"Ds Annual 6etas

• Su(stantial variance in M#"Ds (eta fromyear to year – What was the economic situation in F vs

F7 vs FG) Commodity mar1ets) Year Beta

FB JF

F @KFF

F7 @@JBB

FG 7

F@@ GG

F@B J@G


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Caveats a(out 6eta

• he relationship descri(ed (y 6eta can (egreatly impacted (y the actual returnpatterns of the stoc1 and underlying inde4 – he following charts use the monthly returns

of the SL- for the past F years

– #ne of the return series has (een altered (y

reversing the sign on the largest gain and loss• Pust F outliers out of FB7 o(servations


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-erfect Correlation


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Pust wo Alterations…


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#utlier Impact


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#utlier Impact

• *emem(er0 the other FB o(servationsare a perfect fit…

• &eep this in mind when evaluating yourconfidence level vs your predictiveaccuracy

Criteria Benchmark AlteredBenchmark

Beta 1.0000 0.8281

R2 1.0000 0.6878


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Equity "ar1et *is1 -remium

– he E"*- is the amount of return that aninvestor e4pects from the equity mar1etsa(ove the return they e4pect to receive from

the ris1 free rate – he E"*- is an e4pectation0 so is forward

loo1ing and difficult $or impossi(le)% toaccurately determine• #ften estimated using actual historical return

differences0 (ut is this realistic)

• ypically (etween B8 and 78


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Equity "ar1et *is1 -remium

• 'eep topic0 much continuing research• hin1 a(out historical ;'-0 stoc1 and (ond returns

– E"*- < long5term required return premium – What is Hominal ;'- growth rate since WWII)

•Q 8

– What is the average (ond yield since WWII)• Q KFB8 for G5day 56ills• Q @8 for @5Oear 56onds $since @GF%

– What is the average annual return for the SL- since

WWII)• Q 7@8 e4cluding dividends $QB8 since WWII% – Stoc1s return Q@8 giving us an E"*- (etween B8

and 78 depending on the (ond…


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E"*- Estimates

• 'amodaran musings F@B

• E4ample from P- "organ $see page B%

• -WC study of Horwegian *is1 -remiaF@F and F@B

• Hote: P- "organ and -WC hyperlin1sdirect you to -'/s

http://aswathdamodaran.blogspot.ca/2013/05/equity-risk-premiums-erp-and-stocks.htmlhttps://www.jpmorganmf.com/inec/en/KnowledgeCentre/Presentation%20-%20JPMorgan%20US%20Value%20Equity%20Offshore%20Fund.pdfhttp://www.pwc.no/no/publikasjoner/deals/risikopremie-eng.pdfhttp://www.pwc.no/no/publikasjoner/deals/risikopremie-eng.pdfhttps://www.jpmorganmf.com/inec/en/KnowledgeCentre/Presentation%20-%20JPMorgan%20US%20Value%20Equity%20Offshore%20Fund.pdfhttp://aswathdamodaran.blogspot.ca/2013/05/equity-risk-premiums-erp-and-stocks.html


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-utting it all together

• &eep you inputs and assumptions consistent with eachother – 'onDt use a G5day 56ill rate with a (eta from @ years ago and

a 5year E"*-

• wo (asic positions: – Nistorical5Nistorical5Nistorical

• @ year average of (ond yield R @ years of (eta data R @ year E"*-

– Current5Current5Current• Current (ond yield R @ year (eta R @ year E"*-

• /or our purposes $and for most situations% 1eep E"*- at8 – *easona(le assumption


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And *E"E"6E*

• AWAOS (e prepared to answer questionson N#W you calculated the cost of equity – 2easy3 question for an audience mem(er

– "ore li1ely if your &e varies from the norm

Risk-FreeRate

Beta EMRPCost of Equity

(Ke)Column

7.36% .8333 5.00% 11.53%Historical 30-yr & 20-yearbeta

3.33% .8597 5.00% 7.63%Current 30-yr& 1-yearbeta

AFM 204 - Class 7 Slides - Cost of Equity (2).pptx

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