BUSINESS VALUATION AND COST OF CAPITAL

PRESENTED BY

Deepak jaiswal

Prateek khare

Rohit shukla

Akshat bajpai

Mayank shukla

Sisir show

BUSINESS VALUATION Business valuation determines the value of a

business enterprise or ownership interest. A valuation estimates the economic benefits that arise from combining a group of physical assets with a group of intangible assets of the business as a going concern.

The business valuation can be done through discount it’s expected cash flows at it’s cost of capital.

FINANCIAL ECONOMICS OF THE COST OF CAPITAL

The term cost of capital is the expected rate of return required by investors on investment with

Identical risk.

The cost of capital also denotes the opportunity cost of funds associated with the subject business or project.

COMPONENTS OF COST OF CAPITAL

Debt.

Preferred.

Common equity .

THE OPPORTUNITY COST OF FUND IS COMPRISED OF TWO COMPONENTS.

Time value Risk premium

The trade off between risk and return

Return

Risk

Low Risk

High Return

High Risk

High Return

Low Risk

Low Return

High Risk

Low Return

TIMELINE

CAPITAL ASSET PRICING MODEL (CAPM)

Method for predicting how investment returns are determined in an efficient capital market.

USE OF CAPM

For valuation of risky assets.

For estimating required rate of return of risky projects.

Slope = Beta

rm

rf

“Market Risk Premium”

1.0 = market

SML

Return

BETA

SML Equation = rf + B ( rm - rf )

Security Market Line

CAPITAL STRUCTURECapital structure composition

Consists of long-term liabilities, preferred stock, common stock, and retained earnings. Sufficient equity must exist to provide financial stability Debt can be used as leverage to increase returns to shareholders, but it can also reduce returns on shareholders’ investments

COST OF DEBT

The effective rate that a company pays on it’s current debt. This can be measured in either before or after tax returns. However, interest expense is deductible, the after tax cost is seen most often. This is one part of the company’s capital structure.

COST OF EQUITYThe cost of equity is the return required by equity investors given the risk of the cash flows from the firm

Business riskFinancial risk

There are two major methods for determining the cost of equity

1. Dividend growth model2. SML or CAPM

THE DIVIDEND GROWTH MODEL APPROACH

Start with the dividend growth model formula and rearrange to solve for RE

gP

DR

gR

DP

E

E

0

1

10

THE SML APPROACH

Use the following information to compute the cost of equity

Risk-free rate, Rf

Market risk premium, E(RM) – Rf

Systematic risk of asset,

))(( fMEfE RRERR

WACCMeasures the returns demanded by all providers of capital Investments must offer this return to be worth using the capital providers.

WACC = wERE + wDRD (1-TC) +wpRp

Dividends are not tax deductible, so there is no tax impact on the cost of equity.