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CREATING VALUE THROUGH REQUIRED RETURNS
•Industry attractiveness
1
•Competitive Advantage
2
•Valuation underpinning
3
FOUNDATION OF VALUE CREATION:
Relative position of an industry in the
spectrum of return generating possibilities.
Favorable industries:
Growth
Monopoly power
Oligopoly pricing
INDUSTRY ATTRACTIVENESS :
Cost advantage
Marketing and price advantage
Superior organizational capability
Avenues to Competitive Advantage :
Required rate of return : The return on a risk free asset + market price of risk.
Greater the systematic risk, greater expected return by financial market.
Separation of required Return and the Firm.
Valuation Underpinnings :
Required Market-Based Return
Single project
Division with similar risk
Over all company (WACC)
Incompatibility
Security returns
Capital project returns
Proxy Company Estimates :
• Deriving surrogate company returns
Sample of matching companies
Betas for each proxy company
Calculate central tendency
Derive RRR on equity using proxy beta
Required Rate of Return:
Median Beta = 1.60 Market portfolio return= 11%
Risk free rate = 6%
Rk= .06+(.11-.06)1.60= 14.0%
SAMRA ZAFAR
MODIFICATION FOR LEVERAGE
Modification for Leverage
• Unlevered Situation = Financed by Equity Only
• DEFINITION
– “The use of various financial instruments or borrowed capital, to increase the potential
return of an investment.”
Modification for Leverage • Most companies use debt to finance operations. By doing so,
a company increases its leverage because it can invest in business operations without increasing its equity.
• Leverage = Gearing = Solvency
• Greater the Leverage = Greater the Risk
• Adjustment of βeta (β) is needed …. WHY?– Relationship between Required return on equity (RRoE) and Leverage
Relationship b/t RRoE & Leverage
Modification for Leverage • With an increase in “Debt Financing”, the "β”and the
“Required Return” (RR), also increase.
• Consider the case when;– Proxy company = Leverage– Our company = No leverage
β will be biased and the result would be a higher RRoE, which is not what we were looking for….
Adjusting β for Leverage • Β For Absence Of Leverage:
• Β For An Amount Of Leverage
Adjusting β for Leverage • Note:
– For calculation of “β” with absence of leverage, we use the proxy company’s debt to equity ratio and tax rate.
– For calculation of “β” for an amount of leverage, we use our own company’s debt to equity ratio and tax rate.
– Assumption is taken that the “Capital Market is Perfect”, and Corporate taxes are the only adjustment.
Weighted Average Required Return (WARR)
• Use adjusted β to determine “Cost of Equity Capital” for the project and than go on to determine the “Weighted Average Required Return”.
• We solve for “Cost of Debt” and “Preferred Stock”….
Weighted Average Required Return (WARR)
• COST OF DEBT:
– To get cost of debt we solve for discount rate (k), which equated the proceeds of debt issue and Present value of Interest plus Principle payments.
Weighted Average Required Return (WARR)
• COST OF PREFERRED STOCK:
– Stocks offered by the company, which take priority over the common stocks.
– Not an obligation but the discretion of board members.– No risk of legal bankruptcy– No maturity date
Weighted Average Required Return (WARR)
• COST OF PREFERRED STOCK:
– The dividend is paid after taxes.– Why preferred stock?
• 70% of the dividend received by one company from another company is tax free.
• Return is less than that of “Bonds”
KASHMALA LATIF
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Weighted Average Cost of Capital(WACC)
Definition: WACC is a blended required return of the various capital costs making up capital structure
Other types of financing• EQUITY• DEBT and• PREFERRED STOCK are Major sources
• Leasing, convertible securities, warrants and other options
• Sources proportions• Debt 30%• Preferred stock 10• Common stock equity 60 100%WACC=KdWd+KpWp+KeWeKd=4.80%Kp=8.68%Ke=?
Ke=6%+(11%-6%)1.10=11.50%Rm=11%Rf=6%Beta for proxy company=1.10
WACC=KdWd+KpWp+KeWe
source proportion After tax cost Weighted costDebt 30% 4.80% 1.44%Preferred stock 10 8.68 .87equity 60 11.50 6.90
9.21%
Weighting the costs
In WACC , the weights employed must be according to the proportions of financing inputs the firm intends to employ.
Weights corresponds market value
• Assume Current financing proportion will remain unchanged.
Some limitations
• WACC represent True cost of capital….critical question
• How accurately Measure marginal costs of the individual sources of financing
• Marginal weights• Floatation costs
Marginal weights
• Concern with new or incremental capital…. Work with Marginal cost of capital
• For WACC the weights employed must be marginal and according to proportions specified…. Effect on decision making
• Capital raising is lumpy…. Strict proportions cannot be maintained
Floatation costs
• Floatation costs…the cost associated with issuing securities, such as underwriting, legal, listing and printing fees…. Reduce inflows because they are out of pocket
• Adjustment of floatation costsin evaluation of investment proposal
adjusted to initial outlay(AIO) adjustment to discount rate(ADR)
AIO NPV=$12000/.10 MINUS($100,000+$4000)=$16000 NPV=$12000/.10 MINUS($100,000 )=$20,000
WHEREANNUAL CASH INFLOWS OF $12000 FOREVERCOST OF CAPITAL=10%INITIAL OUTLAY=$100,000FLOATATION COST=$4000Adjustments are made in projects cash flows and
not in cost of capital
ADR
In the presence of floatation costs Each component cost of capital is recalculated by finding the discount rate that equates the present value of cash flows to suppliers of capital with the net proceeds of security issue
Current market price of every security is replaced with current net proceeds of each new security…..biased estimate of true value so we favor AIO
Rationale for weighted average cost
• Financing in the proportion specified and accepting projects yielding more than the weighted average required return…Firm is able to increase the market price of stock
Laddering of returns required
Economic value addedNet operating profit after tax or economic profit $35 millionLess(capital employed *cost of capital) $180 million*12=$21.6millionEconomic value added=$13.4million
• Firm is earning return in excess of what the financial market requires
Market value added
• Wealth enhancement measureCompany’s total market value at a point in timeless: total capital invested in the company since
its originCommon stocks consideredthat is market value
of common stock less invested equity capitalIt relate to M/B ratio
Adjusted present value
Alternative to WACC Proposed by Stewart C. Mayers.
Adjusted Net Present Value (APV)
An approach to value a project as if it were
financed entirely by debt and then adding to this
the present value of the tax shields provided by
debt financing.
Adjusted Net Present Value (APV)
• With an APV method, project cash flows are broken down into two components
• Unlevered operating cash flows and those associated with financing the project. These components then are valued so that
APV = unlevered value + value of financing
MORE FORMALLY, THE adjusted present value is
• Where OCt= after tax operating cash flow in period t• Ku=required rate of return in the absence of leverage• Int=interest payment on debt in period t• Tc= corporate tax rate• Ki= cost of debt financing• F= after tax floatation cost associated with financing
Fk
TInt
k
OCAPV
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tt
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tt
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Illustration• Gruber Alten Paper Company is considering a new production machine costing $ 2
million, that is expected to produce after tax cash saving of $ 400,000 per year for 8 years. The required rate of return on unlevered equity is 13%.
8
1
80$)13.1(
400$000,2$
tt
NPV
• Policy of the company to finance capital investment projects with 50%debt as that is targeted debt to capitalization of the company.
• Company is able to borrow $1million at 10 percent interest to finance the new machine part.
• The principal amount of loan will be repaid in equal year end installments of $125,000 throgh the end of year 8. if the company tax rate 40% than interest tax shield and its present value can be calculated
PRESENT VALUE OF INTEREST TAX SHIELD FOR GRUBEN ELTON PAPER COMPANY(IN THOUSANDS)
Begining Debt Interest Interest Tax Present valueof Year outstanding Shield*(40%) @10% discount rate
1 $1000**$100 $40 $36 2 875 88 35 29 3 750 75 30 23 4 625 62 25 17 5 500 50 20 12 6 375 38 15 8 7 250 25 10 5 8 125 12 5 2
total 132
• APV= -$80+$132=$52• After tax FLOATATION COSTS= $40,000• Cost of lawyer, investment bankers, printers,
and other fees involved in issuing securitiesAPV= -$80+$132-$40=$12
WACC vs APV
• WACC when firms maintain constant debt ratio over time in projects….financial and business risk are invariant over time
easy, n widely used but biassness• APV when company depart from previous
financing pattern and invest in new line of business
AMNA TABASSUM
The method of dividing investment funds among a variety of
securities with different risk, reward and correlation
statistics so as to minimize unsystematic risk is called
diversification
Shareholders purchase shares in the income stream of the
company as a whole, not in the income streams of the
individual assets of the company
DIVERSIFICATION OF ASSETS AND TOTAL RISK ANALYSTS :
As long as there is information available about the
actual returns on the individual assets, investors can
effectively diversify across capital assets of individual
companies
An investor can replicate the return stream of the
individual capital asset held by a firm
INVESTORS DIVERSIFYING ACROSS CAPITAL ASSETS :
• Some companies have tracking stocks for certain stand-
alone business units. It is a device for transparencies.
• Tracking stock permit investors to buy a particular part of the
enterprise, in the sense of participating in the income stream,
but not necessarily the overall enterprise
• Tracking stock investors don’t have a claim on the business
units assets, they participate in the value creation of the
business units
• The firm is said not to be able to do some thing for investors
through diversification of capital assts that they cannot do for
themselves according to the value additive principal.
Investors diversifying across capital Assets cont……
• Value additive principal states that the value of the whole is
equal to the sum of the units
• Projects would be evaluated on the basis of the their
systematic risk because various empirical studies confirm
that diversified companies are less values than are more
focused companies.
• The variability of cash flows of a company depends upon
total risk not just systematic risk as
total risk = systematic risk + unsystematic risk
• The probability of a company of becoming insolvent is a
function of its total risk
• Bankruptcy is the state of insolvency of an individual or an
organization i.e., inability to pay debts.
• Bankruptcy costs are the principal imperfection that may
make firm diversification a thing of value
Imperfection and unsystematic risk
• As the marginal risk of individual proposal to the firm as a
whole depends on its correlation with existing projects and
its correlation with proposals under consideration
• Standard deviation and expected value of the probability
distribution of possible net present values for all feasible
combinations of existing projects and proposals under
considerations, are the appropriate information
Evaluation of combination of risky investments
• Selecting the best combination
– The selection of the most desirable combination of investment will
depend on management utility performances with respect to net present
value and variance or standard deviation
– Graphical representation between net present value and standard
deviation
• Project combination dominance
– Total risk of the firm is what important, therefore investment decision
should be made in light of their marginal impact on total risk
Evaluation of combination of risky investments cont…..
• There are two ways to evaluate risky investments as
i. Evaluate a project in relation to its systematic risk, the
market model approach.
ii. Analyze the incremental impact of the project on the
business-risk complexion of the firm as a whole, the total
variability approach
Note: total risk is relevant only if imperfections are important
When should we take account of unsystematic risk
• One company taking over controlling interest in another
company is called acquisition.
• Acquisition can be analyzed according to its expected return
and risk in the same manner as we analyze any capital
investment
• The relevant future cash flows are free cash flows, those left
over after making all investments necessary to produce the
expected cash flow stream
Evaluation of acquisitions
• Market Model Implications
– Under the assumption of market model (CAPM or APT factors) it is
clear that investors are able to achieve the same diversification as the
firm can achieve for them
– Above point is particularly apparent in the acquisition of a company
whose stock is publically held
– The acquiring company must be able to effect operating economies,
distribution economies or other synergies if the acquisition is to be
the thing of value
Evaluation of acquisitions cont…
– Synergy means efficiency gains such that the whole is worth more
than the sum of the parts as 2 + 2 = 5
– It is an easy matter to measure the required rate of return for the
acquisition of a company whose stock is publically traded
– The important point to remember is that under the assumptions of
market model, the present values of cash flows will exceed the
purchase price only if there are operating economies and/or
improved management
Evaluation of acquisitions cont…..
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Divisional Required Return
• Company has more than one Business Line– Each Business Line is a division or Subunit of that
company
• In order to implement financial Policy we have to made Cost of Capital for Each Unit and make planning,
• The Company transfer it cost of Capital for its unit
Solving of Beta
• Beta – Measuring the systematic risk of different investment.– The company or divisions of company has larger beta are
more riskier.– Divisional Beta– we make beta for each unit of the company that tell us
which unit is more riskier than other.– It can be calculated by– The sum of proxy betas multiplied by market value weights– Market to book value
Cost and Propotion of debt funds
Cost Of Debt
• Debt costs differ according to a division’s systematic risk
• The greater the risk the greater the interest rate
• Diversification of cash flows among divisions the
probability of payment for the whole may be greater then
the sum of parts
Proportion of Debt funds
If one division is allocated much higher proportion of debt, it
will have lower overall required rate of return
High leverage for one division may cause the cost of debt
funds for the overall company to rise.
The high leverage incurred by the division may increases the
uncertainty of the tax shield associated with the debt for the
company as a whole
High leverage for one division increases the volatility of
returns to stock holders of the company, together with the
possibility of insolvency and bankruptcy costs being incurred.
Adjusting Both Costs
• Both the cost of debt funds and the proportion assigned to division can be varied.
• The greater the systematic risk the higher the interest cost and lower the proportion of debt assigned
• The riskier the business the more equity required to support the activities
Alternate Approach
• An alternate approach is to determine the overall cost of capital composed of both debt and equity funds of proxy companies.
Implication of project selection
• Allocation of capital throughout the firm on a risk-adjusted
return basis.
• Single cutoff rate for project selection
• “No project shall be undertaken unless it provides a return
of 15% “
• Divisions characterized by large systematic risk may
accept projects with expected returns higher then the
companywide.
Divisional hurdle versus WACC
Adverse Incentive
• Divisions with low systematic risk often are too
conservative in project generation and selection vice
versa.• Too often companies put money in those divisions
provides greatest growth opportunities and they will prefer to accept projects consistent with over all growth
• If selected projects too low expected return the company may become riskier
• The incentive scheme is skewed in the direction of growtg and acceptance of risky projects.
COMPANY’S OVERALL COST OF CAPITAL
• If the various investment projects undertaken by a firm do
not differ materially from each other, it is unnecessary to
derive separate project or divisional required rates of return.
• With homogenous risk across investments, it is appropriate
to use firm’s overall required rate of return.
• The cost of equity capital is the minimum rate of return that a
company must earn on the equity-financed portion of its
investments in order to leave unchanged the market price of
its stock.
Dividend Discount Model Approach
• DDM estimates the required rate of return on the equity
for a company overall.
• DDM equates share price with the present value of
expected future dividends. Because dividends are all that
stockholders as a whole receive from their investment,
this stream of income is the cash dividends paid in future
periods and perhaps a final liquidating dividend.
• At time 0 the value of share of stock is
P0 is the value of share of stock at time 0
Dt is the dividend per share expected to be paid in
period t
ke is the appropriate rate of discount
Perpetual growth situation
• If dividends per share are expected to grow at a
constant rate (g) and ke is greater then g, then
Dt is the dividend per share expected to be paid at the
end of period 1
• Thus the cost of equity capital would be
Growth phase
• When the expected growth on dividends per share is other
then perpetual then modification in DDM formula can be
used
Do the current dividend, is the base on which the expected
growth in future dividend is built
ke by solving for k we obtain the cost of equity capital\
Po market price per share
DDM Versus Market Model Approach
• The discount rate determined by the DDM model would be the
same as required rate of return determined by the market model
approach ( if measurement were exact and certain assumptions
are held).
• Both methods suggested enable us to make such an
approximation more or less accurately depending on the situation
• For a large company whose stock is actively traded and whose
systematic risk is close to the market we estimate more confidently
the we can do for moderate size company.
• When the cost
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