Corporate finance: The big picture

Corporate governance
Valuation
FIRM Raising funds from investors (A) FINANCIAL MARKET

Capital budgeting
Session 6 and investment
decisions (B) Investing retained
cash flows (G) Debt payments (D)
Capital structure
and financing
decisions (A)

COST OF CAPITAL Current assets Cash flow Return to shareholders

Debt
+
+ from firm (C) (F) Equity
Fixed assets

Taxes (E)
Total firm value
Total asset value to investors

Payout policy
Cost of capital Government
Capital budgeting Acquisitions
Valuation Capital structure Raising capital

Outline Key concepts and skills

 Understand the cost of capital concept
1. Intro & corporate governance
 Know how to determine a firm’s cost of equity capital
2. Time value of money
– Understand three methods to calculate the cost of equity
3. Stock valuation
1. Dividend Discount Model (DDM)
4. Bond valuation  Cost of capital overview
2. Earnings Capitalization Model (ECM)
 Estimate the cost of equity
5. Risk & return, CAPM & APT – Dividend discount model 3. Capital Asset Pricing Model (CAPM)
– Earnings cap model
6. Cost of capital – Understand the impact of beta in determining the firm’s cost of equity
– Capital asset pricing model - CAPM - risk free, risk premium, beta
7. Raising capital  Estimate the cost of debt  Know how to determine a firm’s cost of debt
– Yield to maturity
8. Capital budgeting – Rating and default premium
 Know how to use appropriate tax rate and debt equity mix

9. Payout policy  WACC  Know how to determine the firm’s overall cost of capital
Cost of capital overview Estimating the Cost of equity - DDM & ECM
The cost of capital is the minimum rate of return on the company’s investments that can satisfy the
providers of capital (both shareholders and bondholders). It is:  METHOD 1: Dividend Discount Model (DDM)  METHOD 2: Earnings Capitalization Model (ECM)
– the total cost of financing
D1 D
– the required rate of return P0   re  1  g re = EPS1 / P0
– the hurdle rate re  g P0
 E   D  EPS1 :projected earnings per share the following year
The Weighted Average Cost of Capital: WACC  re    rd 1  t   – Based on current stock price and dividend
P0 : price per share this year
DE DE – Assumes the stock price is efficient
The earnings capitalization model cannot estimate equity
– Inverse relation between price and cost of capital costs for growing firms: reasonable for only no growth firms.
Debt holders – Growth may be hard to estimate
Firm’s cost earn a return on
of debt their investment
 Example:
 Example:
Raising debt from debt holders – Coca Cola is trading at $50 per share
– IBM is trading at $160
– You expect its EPS to be constant at $2.5
– You expect its next dividend to be $1.6 indefinitely.
Raising equity from equity holders with a constant annual growth rate of 7%.
– What is the cost of equity for Coca Cola?
Firm’s cost Equity holders
– What is the cost of equity for IBM?
2.5 / 50 = 5%
of equity earn a return on 1.6/160 + 7% = 8%
their investment

Cost of equity - CAPM Cost of equity - Risk free rate (RF)

 METHOD 3: Capital Asset Pricing Model (CAPM)  What Rf asset should we use?
– No default risk: It is generally issued by the government.
The CAPM is used to determine a theoretically appropriate required rate of return of an
asset, if that asset is to be added to an already well-diversified portfolio, given that – No reinvestment risk: It is generally a zero-coupon security with the same
asset's non-diversifiable risk. maturity as the cash flows analyzed.
 Is a T-Bill free of reinvestment risk? How about a T-bond?
re = Rf + i (Rm – Rf)  Why is matching forecast horizon important?
where: Rf = risk-free rate
 Equity valuation favors the yield on 10-year STRIPS (Separate Trading of Registered
Rm = expected market return
Interest and Principal of Securities), or T-Bonds if T-strip is unavailable.
i = equity beta of firm i
– Very liquid bond, widely traded
– Based on risk: Market price of risk is (Rm – Rf ) – Current yields reflect market’s expectations of the future
– Linear relation between risk and cost of capital http://online.wsj.com/mdc/public/page/2_3020-
tstrips.html?mod=mdc_bnd_pglnk
 Cost of equity - Risk free rate - Evidence Cost of equity - Risk free rate - Rating and spread

http://chartsbin.com/view/1178
Source: Bancel and Mittoo (2014) The gap between the theory and practice of corporate valuation:
Survey of European experts, Journal of Applied Corporate Finance

Cost of equity - Equity risk premium (RM – RF) Cost of equity - Equity risk premium (RM – RF)
 Equity risk premium: an excess return that investing in the stock
market provides over a risk-free rate to compensate investors for taking a
relatively higher risk of equity investing. The equity risk premium:
– Increases with the risk aversion of investors in that market
– Increases with the riskiness of the average risk investment
 Methods to estimate equity market risk premium include:
1. Survey premiums: from portfolio managers, CFOs, institutions, academics, etc.
2. Historical premiums: need to define a time period for estimation
3. Implied premiums: reverse-engineer to back out the implied expected market return
Source: Damodaran (2020) Equity Risk Premiums (ERP): Determinants, Estimation and Implications
4. Default spread premiums: Approximate the country’s risk premium by adding the
default spread to the U.S risk premium. Equity default spread can be approximated  The current and average implied equity risk premium are the best predictors for the next
with bond default spread scaled by the ratio of the riskiness of the equity and bond. period while historical risk premium performs worst.
 No approach to estimating equity risk premiums will work for all analyses.
 Cost of equity - Equity risk premium (RM – RF) Cost of equity - Equity risk premium (RM – RF)

Source: Damodaran (2020) Equity Risk Premiums (ERP): Determinants, Estimation and Implications –
Damodaran (2024): 4.5%. See also https://www.aranca.com/assets/docs/cost-of-equity.pdf

Cost of equity - Equity risk premium (RM – RF) Cost of equity - Beta
The measure of the risk of a security in a large portfolio is the beta () of
Historical risk premium across equity markets (1900-2017) the security. Beta measures the responsiveness of a security to
6% movements in the market portfolio: how sensitive its underlying revenues
and cash flows are to general economic conditions. (i.e., systematic risk).
5%
E(Ri) SML
4%
3%
E(Rm)
2% M
1% Market risk
premium
0%
Austria

Canada
Denmark

Germany

U.K.
Belgium

Ireland
Italy
Japan

New Zealand
Norway
Portugal

Sweden

U.S.

World
Australia

Finland
France

Netherlands

Spain

Switzerland
South Africa

Europe

Rf
Risk-free rate

m = 1 i

– β = 1: asset has the same systematic risk as overall market

Country stock market minus long-term governance bond yield using geometric means
– β < 1: asset has less systematic risk than overall market
Sources: Credit Suisse Yearbook 2019; Damodaran (2020) Equity Risk Premiums (ERP) http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ctryprem.html – β > 1: asset has more systematic risk than overall market
Cost of equity - Beta Cost of equity - Beta - Industry vs firm beta
Cov( Ri , R M ) σ i , M σ  One can estimate a firm’s beta by involving the
β  2   i,M i Firm A
Var ( R M ) σM σM whole industry.
 Asset (A)
 If the firm’s operations are similar to those of
• Problems with betas obtained from regressions the rest of the industry, i.e. same business risk,
you should use the industry beta (asset beta of Firm B Firm X
1. Betas may vary over time.
similar firms in the same industry). Do not  Asset (B)  Asset (X)
2. The sample size may be inadequate.
forget to adjust for financial leverage.
3. Betas are influenced by changing financial leverage and business risk.
 If the firm’s operations of the firm are Firm C
• Solutions fundamentally different from those of the rest  Asset (C)
– Problems 1 and 2 can be moderated by more sophisticated statistical techniques. of the industry, you should use the firm’s own
asset beta.
– Problem 3 can be lessened by adjusting for changes in business and financial risk. Same business risk for Firms A, B, C and X
– Look at average beta estimates of comparable firms in the industry.  Asset (X)  Asset (A)  Asset (B)  Asset (C)

Cost of equity - Beta - Financial leverage Cost of equity - Beta - Financial leverage
 Financial leverage is the sensitivity to a firm’s fixed costs of financing.
 Debt beta is very low in practice so we make common assumption that it is zero. With
– Capital structure flexibility corporate tax effect, the levered beta is estimated using Hamada’s equation. This
– More debt, more risk, higher beta equation is used to separate the financial risk of a levered firm from its business risk.
– We can decompose the leverage effects on beta
𝐷𝑒𝑏𝑡
 The asset beta (unlevered beta) is the beta of a company on the assumption that the 𝛽 𝛽 1 1 𝑡
𝐸𝑞𝑢𝑖𝑡𝑦
company uses only equity financing. In contrast, the equity beta (levered beta, project
beta) takes into account different levels of the company's debt.

𝐸 𝐷  Note: The regression beta for Tesco is 0.51 (https://finance.yahoo.com/quote/TSCO.L/)

β β β 1 𝑡
𝐷 𝐸 𝐷 𝐸  This regression beta is a levered beta because it’s based on stock prices, which reflect
leverage. The leverage implicit in the beta estimates is the average market debt equity
 Financial leverage increases the equity beta relative to the asset beta. over the period used for estimation.

𝐷
β β 1 𝑡 β β
𝐸
Cost of equity - Beta - Estimation methods Cost of equity - Beta - Comparable firm method
 Regression: The top down beta for a firm comes from a regression. unlever the effect Take the average
– Regress the firm’s stock returns on the market returns Firm A of D/E & tax Firm A (mean or median)
 Equity (A)  Asset (A)
 Comparables: The bottom-up beta is estimated as follows: Firm B
unlever the effect
of D/E & tax Firm B Firm X
lever up the effect
of firm X’s D/E & tax Firm X
– Identify the business the firm operates in  Equity (B)  Asset (B)  Asset (X)  Equity (X)
– Find the unlevered betas of comparable firms in these businesses
unlever the effect
– Correct for cash holding: Unlevered  Op = Unlevered  Firm / (1 – Cash/Firm value) Firm C of D/E & tax Firm C
– Calculate the weighted average of these Unlevered  Op  Equity (C)  Asset (C)
– Lever up the beta for the firm using the Hamada’s equation

 Notes: The bottom-up approach gives you a better estimate when: Different D/E and Same business risk for Firms A, B, C and X Different D/E and tax
tax rate for firms A,  Asset (X)  Asset (A)  Asset (B)  Asset (C)  rate for firms A, B, C
– The standard error of the beta from the regression is high and the estimated beta B and C and X
is very different from the average in the business/industry.  Equity (A)≠  Equity (B)  Equity (A)≠  Equity (B) ≠
– The firm is privately held, reorganized, or restructured. In these cases, we use ≠  Equity (C)  Equity (C) ≠  Equity (X)
comparable firms and/or accounting earnings.

Cost of equity - Beta - Example Cost of equity - Beta - Evidence

Analysts identify the three following firms that they believe to be appropriate
comparable firms for ACQ. They will rely on the mean (average) beta of these
comparable firms to value ACQ. They also assume that neither ACQ nor these
comparable firms have a significant amount of cash to be adjusted. Calculate ACQ’s
beta given its D/E ratio of 0.5 and tax rate of 30%.
 Calculate the unlevered beta for each comparable firm:
Unlevered beta comparables = Levered beta comparables / [1+(1-t)D/E ] comparables

Ideally, 5 years to get meaningful

statistical results (degrees of freedom)

 Mean unlevered beta of comparables = 1.1002

 Levered beta ACQ = Unlevered beta comparables x [ 1 + (1 –t)(D/E) ] ACQ

= 1.1002 x [ 1 + (1-30%) 0.5 ] = 1.4853 Source: Bancel and Mittoo (2014) The gap between the theory and practice of corporate
valuation: Survey of European experts, Journal of Applied Corporate Finance
Cost of equity - Practice Cost of equity - Practice
How do firms estimate the cost of equity? % of respondents Parameters of the cost of equity estimation

Source: Graham and Harvey (2001) and Brounen et al. (2004) survey of cost of equity estimation techniques

Outline Cost of debt

1. Intro & corporate governance
 The cost of debt measures the current cost to the firm of
2. Time value of money borrowing funds to finance projects.
3. Stock valuation  Borrowing costs are determined by:
4. Bond valuation  Cost of capital overview – Interest rate levels (yield curve)
 Estimate the cost of equity
5. Risk & return, CAPM & APT – Dividend discount model
– Default risk of the company
– Earnings cap model Cost of debt = Risk free rate + Default spread
6. Cost of capital
– Capital asset pricing model - CAPM - risk free, risk premium, beta
7. Raising capital  Estimate the cost of debt – Tax advantages of debt:
– Yield to maturity After-tax cost of debt = rD(1 – marginal tax rate)
8. Capital budgeting – Rating and default premium
9. Payout policy  WACC
 Cost of debt: YTM Cost of debt: Rating and default premium
 If the firm’s debt is publicly traded, use Yield-to-Maturity (YTM): the rate of return investors  Example:
would make if they bought the bond at a given price. – The firm’s long term debt rating is BBB
– To purchase the bond, we must spend money. So, the price is an outflow.
– The risk-free rate is 4%
– Once we own the bond, we receive coupon payments C and the terminal par value F.
These are therefore entered as inflows
 Cost of debt = RF + default premium
0 1 2 ……… T
= 4% + 128 x 0.01% = 5.28%
 If the debt is not publicly traded, but is rated:
P C C C+F – Identify bond ratings: Moody’s/S&P’s/Fitch/Duff &
Phelps
– Add default premium to risk-free rate that corresponds
 Example: A 30-year bond pays semi-annual coupon of $50 per $1,000 par value and is trading at to the firm’s rating and measurement period.
$838.39. What is its YTM?  If debt is not publicly traded and not rated:
Use Excel: Inputs: N = 30 x 2 =60, C = 50, P = 838.39, F = 1000 – Estimate a synthetic rating or yield from firms in similar
 r = rate(nper,pmt,pv,fv) = rate(60,50,–838.39,1000) = 6% per 6 months  YTM = 6% x 2 = 12% businesses.
 If the firm has several issues of bonds with different YTM: – Estimate a rating from a ratio analysis (e.g. interest
– Combine all and attach a long-term cost to it, or coverage ratio)
– Do the weighted average. – Use borrowing cost of a recent debt issue if available.

Cost of debt - Evidence Outline

1. Intro & corporate governance

2. Time value of money

3. Stock valuation

4. Bond valuation  Cost of capital overview

 Estimate the cost of equity
5. Risk & return, CAPM & APT – Dividend discount model
– Earnings cap model
6. Cost of capital
– Capital asset pricing model - CAPM - risk free, risk premium, beta
7. Raising capital  Estimate the cost of debt
– Yield to maturity
8. Capital budgeting – Rating and default premium
Source: Bancel and Mittoo (2014) The gap between the theory and practice of corporate valuation:
9. Payout policy  WACC
Survey of European experts, Journal of Applied Corporate Finance
WACC - Debt and equity weights WACC - Debt and equity weights - Evidence
 E   D 
WACC  re    rd 1  t  
 D  E  DE

 Use market value (MV) weights NOT book value (BV) weights
E = MV of common stock= Price x Number of shares outstanding
D = MV of total debt = Price x Number of bonds outstanding

 How to get MV of total debt if debt is not publicly traded?

1. Firms may report MV of debt in notes to financial statements.
2. Treat all debt as one bond with coupons equal to future interest expense and
discount rate rD. Estimate the PV of debt.
3. Use book value of debt when:
• The debt was recently issued or refinanced.
• Stable interest rate environment since issuance. Source: Bancel and Mittoo (2014) The gap between the theory and practice of corporate valuation:
Survey of European experts, Journal of Applied Corporate Finance
• Underlying risk (rating) of the firm has not changed.

WACC - Estimation Summary

 E   D 
  rd 1  t 
 How do we determine the cost of equity capital?
WACC  re  
DE DE – Dividend discount model
– Earnings capitalization model
Must the WACC remain constant? – CAPM
• How can we estimate a firm or project beta?
 No, the WACC will change over time if:
• How does leverage affect beta?
– Firm uses up internal equity  How do we determine the cost of debt?
– Risk of firm changes (beta) – Bond yield
– Bond rating, synthetic rating or comparables
– Interest rate or risk-free rate changes – Debt beta and CAPM
– Debt rating changes (default premium)  How to calculate WACC?

– Mix of debt, equity, preferred changes  E   D 

WACC  re    rd 1  t  
 D  E  DE
A source of data: http://pages.stern.nyu.edu/~adamodar/