Lecture 9 Cost of Capital Analysis Investment Analysis

Riskless Rates & Risk Premiums An asset is risk free if we know the expected returns on it with certainty – i.e., the actual return is always equal to the expected return. Practical Implication: When doing investment analysis on longer term projects or valuation, the risk free rate should be the long term government bond rate. If the analysis is shorter term, the short term government security rate can be used as the risk free rate. Investment Analysis

Risk Premiums A premium for risk is an expected amount of return over and above the risk-free rate to compensate the investor for accepting risk. The generalized cost of capital relationship is as: E(R i ) = R f + RP i where: E(R i ) = Expected return of security i R f = Risk-free rate Rp i = Risk premium for security i Investment Analysis

Three Variables The value of a company is a function of three variables: 1.The economic benefit stream, typically cash flows 2.The growth potential of the company being valued, both short and long term 3.The risk involved in receiving the benefits (i.e., the discount rate) The value of any enterprise will vary directly with its expected level of economic benefit and the expected growth of such benefits. The value will vary inversely with the riskiness of that anticipated economic benefit stream because the increase in risk demands a higher rate of return. Often a business enterprise, particularly in the small and midsize markets, is focused on the benefit stream and growth potential variables while too often the risk is left to chance. Assuming no change in the first two variables, reducing the risk attributes of a business will increase its value. Investment Analysis

Basic Concepts The value of an interest in a closely held business typically is considered to be the present value of the future economic benefit stream, typically cash flow. This economic benefit is discounted at an appropriate discount rate to reflect the risks associated with the certainty of receiving such future economic benefits. No one buys a business or other property simply because of what it has accomplished in the past or even what it consists of at present. Although these may be important considerations in determining what the business or other property is likely to d in the future, it is the anticipated future performance of a business that gives economic value. Values are reflections of the future, not the past, not even the present. Investment Analysis

Types of Risks Financial economics divides risk into three major categories: maturity, systematic and unsystematic. Maturity Risk is the reflection of changes in interest rates over the term of the investment. Maturity risk (also called horizon risk or interest rate risk) is the risk that the value of an investment may go up or down because of changes in the general level of interest rates. The longer the term of the investment, the greater the maturity risk. For example, market prices of long-term bonds fluctuate much more in response to changes in levels of interest rates than do short-term securities. Investment Analysis

Types of Risks (cont’d …) Systematic Risk can be defined as the uncertainty of future returns due to uncontrollable movements in the market as a whole. This type of risk generally arises from external, macroeconomic factors that affect all economic assets within the economy as a whole. For publicly held companies, systematic risk is captured by a measurement referred to as the beta of an enterprise. Investment Analysis

BETA (β) β measures the risk of the company being valued, i.e., it is the correlation of the risk of that company and the market. Covariance (R m, R company ) β = σ m 2 β measures systematic/market risk sensitivity. β of a risk free security is zero. Lower the β, safer the company. Investment Analysis

Types of Risks (cont’d …) Unsystematic Risk is the uncertainty of future returns as a function of something other than movements in market rates of return, such as the characteristics of an industry, enterprise or type of investment. Examples of circumstances that can create or increase unsystematic risk include high product or technological obsolescence, unforeseen loss of management expertise, and negative changes in labor relations. Unsystematic risk has four primary sources: the size of the firm, its macro environment, its industry and specific company attributes. The estimation of unsystematic risk is one of the more difficult aspects of calculating rates of return. Investment Analysis

Types of Risks (cont’d …) Classical financial theory, formulated in CAPM, assumes that rational investors will eliminate their exposure to unsystematic risk through maintaining fully diversified portfolios. However, this assumption is based on the existence of other interlocking assumptions, the absence of which, in a privately held company setting, creates the need for the valuation analyst to identify and quantify unsystematic risk as a part of an overall rate of return. Some of these assumptions include: – Investors have access to perfect information for decision making purposes. – There are no taxes to be considered. – The decision maker is fully rational. Investment Analysis

Cost of Capital Methods Several methods are available to calculate the cost of capital or discount rate for a specific investment. Some are: – Buildup method – Capital asset pricing model (CAPM) method – Modified capital asset pricing model (MCAPM) method – Arbitrage pricing theory (APT) method – Weighted average cost of capital (WACC) method Investment Analysis

Buildup Method The buildup method is often used by analysts who work with small and medium size businesses. The typical “buildup model” for estimating the cost of common equity capital consists of two primary components, with three subcomponents: 1.A “risk-free” rate 2.A premium for risk, including any or all of these subcomponents: – A general equity risk premium – A small company premium – A company-specific risk premium Investment Analysis

Buildup Method (cont’d …) The basic formula for the traditional buildup model is: E(R i ) = R f + RP m + RP s + RP u where: E(R i )= Expected (market required) rate of return on a security R f = Rate of return for a risk-free security RP m = Equity risk premium for the market RP s = Risk premium for small size RP u = Risk premium for specific company, where u stands for unsystematic risk Investment Analysis

Buildup Method (cont’d …) Equity Risk Premium (RP m ) The next component after riskless rate is the equity risk premium, the premium that investors must receive to entice them to invest in the public markets instead of long-term government securities. ERP is computed by using historical data, by first finding the total excess returns of the 20 years for public markets over the returns on annual 20 year government security rates and then taking either an arithmetic or a geometric mean average return for that period. The use of the arithmetic mean is recommended as the best indication of the equity risk premium. The arithmetic calculation gives the best indication of what will occur next, assuming past history is the correct proxy. Investment Analysis

Buildup Method (cont’d …) Company Size Premium (RP s ) The size premium often is added when valuing smaller, closely held businesses. Evidence demonstrates that as the size of a company decreases, the risk to that company increases. Therefore, a smaller company must pay an additional premium to attract funds. The studies also show that this addition to the realized market premium is over and above the amount that would be warranted solely for the companies systematic risk. An analyst has presented a list of factors that reflect the increased risks of smaller companies: – Difficult to raise finance – Lack of product diversification – Lack of management expertise – Lack of dividend history – Lack of infrastructure etc. Investment Analysis

Buildup Method (cont’d …) Company Specific Risk Premium (RP u ) The final component of the discount rate in buildup model is the risk specific to the company being valued and/or the industry in which it operates. This is one of the most subjective areas of business valuation. Company specific risk includes risk associated with the particular industry in which the subject company operates in relation to the economy as a whole as well as the risks associated with the internal working of the subject company, including such things as management, dependence on specific suppliers and customers. Normally “RP u ” adjustments are based on (but not necessarily limited to) analysis of five factors: 1.Size smaller than the smallest size premium group 2.Industry risk 3.Volatility of returns 4.Leverage 5.Other company specific factors Investment Analysis

Buildup Method (cont’d …) Other company specific factors Other factors specific to a particular company that affect risk could include, Key person dependence Key supplier dependence Pending lawsuits Volatility of returns Concentration of customer base Buildup Method is a widespread model used by analysts but because of limited academic research on the topic and company specific risk premium remaining the realm of the analyst’s judgment, it has somewhat low level of reliability. Investment Analysis