©Cambridge Business Publishers, 2013 FINANCIAL STATEMENT ANALYSIS & VALUATION Third Edition Peter D. Mary LeaGregory A.Xiao-Jun EastonMcAnallySommersZhang

©Cambridge Business Publishers, 2013 Module 12: Cost of Capital and Valuation Basics

©Cambridge Business Publishers, 2013 Financial Instruments ■ Entitles its owner to claim a series of future payoffs from a company ■ Payoff amount depends on the ability of the company to generate a profit through future operations ■ Includes ■ Cash ■ Equity ownership such as stock ■ Debt instruments such as notes and bonds

©Cambridge Business Publishers, 2013 Valuation Model Components ■ Generally include these estimates ■ Cost of capital ■ Discount rate that an investor uses to value future payoffs ■ Reflects the return investors expect on their investment ■ Based on perceived risk of investment ■ A forecast of future payoffs ■ Such as dividends and free cash flows depending on the model used

©Cambridge Business Publishers, 2013 Payoffs from Equity Instruments Payoffs of Stock Investments ■ Receipt of dividends, if any ■ Cash from selling the stock to another investor or back to the company Payoffs of Bond Investments ■ Receipt of interest payments ■ Receipt of principal after bond matures All benefits occur in the future

©Cambridge Business Publishers, 2013 Using Information for Valuation Step 4: Forecasting Financial Information Step 3: Basics of Valuation Where does the firm operate? Where does the firm currently? Where does the firm going? What is the firm worth? Understanding the Business Environment and Accounting Information Step 1: Adjusting and Assessing Financial and Accounting Information Step 2:

©Cambridge Business Publishers, 2013 Stock Valuation – Step 1 Business and accounting analysis ■ Assessing profitability ■ Assessing the quality of accounting ■ Evaluating future growth opportunities ■ Understanding competitive and macroeconomic threats ■ Making accounting adjustments, if necessary

©Cambridge Business Publishers, 2013 Stock Valuation – Step 2 Forecasting ■ Predicting payoffs from the company ■ Crucial step in security valuation ■ Produces key inputs into the valuation models

©Cambridge Business Publishers, 2013 Stock Valuation – Step 3 Risk assessment ■ Estimating the cost of capital ■ Adjust for time value of money ■ Takes account of future nature of payoffs ■ Adjust for risk ■ Takes account of the uncertain nature of payoffs

©Cambridge Business Publishers, 2013 Stock Valuation – Step 4 Valuation ■ Applying the proper valuation ■ Identify the crucial assumptions underlying each model ■ Apply the proper model ■ In the right way ■ Under the right circumstances

©Cambridge Business Publishers, 2013 Intrinsic Value ■ Defined as the economic value of the company assuming that actual payoffs are known ■ Part of the valuation process ■ Estimates the intrinsic value of debt and equity IV Firm = IV Debt + IV Equity

©Cambridge Business Publishers, 2013 Time Value of Money ■ Used to compute the present value of payoffs ■ To compute 1)Forecast the payoffs to be received 2) Determine the discount rate to be used

©Cambridge Business Publishers, 2013 Lump-Sum Payoff ■ Present value factor applied to a lump-sum payoff 1 (1 + r) n Present value = Future payoff × Present value factor Present value = Future payoff × Present value factor Found in Table 1 - Present Value of a Single Amount

©Cambridge Business Publishers, 2013 Lump-Sum Payoff Example What is the present value of $100 to be received two years hence at a discount rate of 11%? Present value = $100 × = $81.16 PV Factor for 2 11% PV Factor for 2 11% $81.16 × 0.11 = $8.93 $ $8.93 = $90.09

©Cambridge Business Publishers, 2013 Annuity Payoffs ■ A series of equal lump sums at regular intervals ■ Must meet three criteria 1) The series must be of equal amounts 2) Payment must occur at equal time periods 3) The same discount rate is applicable over the time horizon of the payoffs

©Cambridge Business Publishers, 2013 Annuity Payoff Example What is the present value of $1,000 to be received at the end of each of the next 4 years at a discount rate of 11%? Present value = $100 × = $3, PV Annuity Factor for 4 11%

©Cambridge Business Publishers, 2013 Present Value, Future Value, & Interest $4, future value 4 years in the future $3, lump sum invested today $1,000 annuity invested at the end of each year for 4 years == Investors are indifferent to the three investments.

©Cambridge Business Publishers, 2013 Bond Terminology The interest rate an investor could earn by investing in other bonds with similar risks Stipulates the lump-sum payment to be made at the bond’s maturity Determines the annuity payments Coupon Rate Face Value Market Rate

©Cambridge Business Publishers, 2013 Valuing a Debt Instrument Example Determine the present value of a 3-year bond with a 9% coupon rate, a face value of $1,000, and a market rate of 10%. Time Line Representation of Payoffs Related to a Debt Instrument End of Year0123 Interest earned$90 Future value at year-end$1,000 Present value of lump-sum end of 3 10% × $1,000 = $ Present value of annuity for 3 10% × $90 = Present value$ An investor is willing to pay $ in exchange for receiving three annual payments of $90, and one payment of $1,000 at the end of three years.

©Cambridge Business Publishers, 2013 Valuing an Equity Instrument Example A stock pays a $90 dividend at the end of each year for two years, along with a terminal dividend of $1,090 at the end of years 3. Time Line Representation of Payoffs Related to a Debt Instrument End of Year0123 Interest earned$90 Future value at year-end$1,000 Present value of lump-sum end of 3 10% × $1,000 = $ Present value of annuity for 3 10% × $90 = Present value$ Same present value as the debt instrument since the same 10% discount rate is used

©Cambridge Business Publishers, 2013 Using Discount Rates ■ Cost of debt capital ■ Used for payoffs to debtholders ■ Cost of equity capital ■ Used for payoffs to equity holders ■ Weighted average cost of capital ■ Used for payoffs to the entire firm

©Cambridge Business Publishers, 2013 Estimated Cost of Capital Models assume an investor of a financial instrument prices it with the expectation of recovering two costs. Risk-Adjusted Discount Rate Components Foregone interest from investing in an instrument with future payoffs Investor’s compensation for bearing the risk associated with the uncertainty of the payoff Time value of money Cost of risk

©Cambridge Business Publishers, 2013 Diversifiable Risk ■ Refers to risks that can be diversified away by investors ■ Effect of diversification on risk ■ Stock price increases cancel out stock price decreases, reducing large price movements ■ Returns of stock must be independent

©Cambridge Business Publishers, 2013 Capital Asset Pricing Model (CAPM) ■ Equates the expected return on a particular asset as the sum of three components ■ Also called the cost of equity capital CAPM = Risk-free rate + beta risk + stock-specific risk r e = r f + [β × (r m – r f )]

©Cambridge Business Publishers, 2013 CAPM Components ■ Risk-free rate (r f ) ■ Commonly based on the return on ten-year U.S. treasury bills ■ Market risk premium ■ Difference between the expected market return (r m ) and the expected risk-free rate ■ Market beta (β) ■ Sensitivity of the asset’s market return to the overall market ■ Reflects historical stock price volatility

©Cambridge Business Publishers, 2013 Interpreting Market Beta Stock price will change with a larger % with a change in the overall market +10 Stock price will change with a smaller % with a change in the overall market Stock price will change contrary to a change in the overall market The higher the risk an investor is willing to accept, the higher the expected return.

©Cambridge Business Publishers, 2013 CAPM Example Eastern Company has a market risk premium of 4.6% and a market beta of The 10-year Treasury rate is 5.2%. How much is CAPM? r e = r f + [β × (r m – r f )] r e = [0.56 × 0.046] = 7.8% An investor requires an expected return of 7.8% to invest in Eastern Company’s stock.

©Cambridge Business Publishers, 2013 Multi-Factor Models ■ Developed to compute risk-adjusted returns r e = r f + β 1 × r 1 + β 2 × r 2 + β 3 × r 3 + … ■ Used to compute cost of equity capital ■ Risk factors based on fundamental analysis ■ Internal risk factors ■ Such as operating leverage, financial leverage, effectiveness of internal control ■ External risk factors ■ Such as exchange risk, political risk, supply chain risk, industry competition

©Cambridge Business Publishers, 2013 Average Annual Stock Return for Small and Large Firms

©Cambridge Business Publishers, 2013 Factors as Part of Five Forces Five forces that confront the company and its industry

©Cambridge Business Publishers, 2013 Cost of Debt Capital ■ Consists of the market rate on debt instruments ■ Reported fair value of a debt instrument should approximate its present value ■ Borrowing rate depends on a company’s perceived level of risk by lenders ■ Factors considered by lenders ■ Short-term liquidity measures ■ Interest-coverage ratio ■ Long-term financial stability

©Cambridge Business Publishers, 2013 Debt Ratings Very unlikely to default Investment Grade Junk Bonds Higher default risk Ratings provided by ■Moody’s ■Standard and Poors ■Fitch

©Cambridge Business Publishers, 2013 Cost of Debt Capital ■ Average borrowing rate for interest-bearing debt ■ Interest expense ÷ Average interest-bearing debt ■ Marginal income tax rate ■ Tax savings due to interest reducing taxes Average borrowing rate for debt r d =× (1 – Marginal tax rate) Two components

©Cambridge Business Publishers, 2013 After-Tax Cost of Debt Capital Example Eastern Company has a marginal tax rate of 34.6%, interest expense for 2009 totaling $648,000, and average debt of $8,000,000. How much is its after- tax cost of debt capital? Average borrowing rate for debt r d =× (1 – Marginal tax rate) $648,000 $8,000,000 × (1 – 0.346) = 5.3% r d =

©Cambridge Business Publishers, 2013 Weighted Average Cost of Capital ■ Used for valuation models that assume payoffs are distributed to both equity holders and debt holders rw =rw =rw =rw = rd ×rd ×rd ×rd × IV Debt IV Firm IV Equity IV Firm + r e × r e × ■ Uses intrinsic values instead of numbers from financial statements ■ Market value typically used

©Cambridge Business Publishers, 2013 Weighted Average Cost of Capital Example Eastern Company has a 5.3% cost of debt and 7.8% cost of equity. Its equity has a market value of $4,350 (thousands), and its debt has a market value of $2,560 (thousands). How much is the weighted average cost of capital? Intrinsic value of the firm = $2,560 + $4,350 = $6,910 (thousands) rw =rw =rw =rw = × $2,560$6,910$4,350$6, × × = 6.9%

©Cambridge Business Publishers, 2013 WACC with Preferred Stock ■ A third term is added ■ Equity is split into common and preferred sections ■ If market value is hard to determine for preferred stock, use book value rw =rw =rw =rw = rd ×rd ×rd ×rd × IV Debt IV Firm IV CommonEquity IV Firm + r ce × r ce × IV PreferredEquity IV Firm + r pe × r pe ×

©Cambridge Business Publishers, 2013 Dividend Discount Model (DDM) ■ Equates the value of company equity with the present value of all future dividends ■ Dividends are viewed similar to coupon payments on debt ■ Discount rate is the cost of equity capital

©Cambridge Business Publishers, 2013 Recursive Process of Valuation Value of equity at the end of period Dividends to be received during period 1 + = Intrinsic value of equity at the beginning of period one 1 + Cost of equity IV 0 = D 1 + IV r e The stock price today depends on the expected price of the stock tomorrow, which in turn depends on the expected price of the stock the day after.

©Cambridge Business Publishers, 2013 Recursive Process of Valuation Example Eastern Company has an expected dividend for period 1 of $1.50, and its expected intrinsic value of equity at the end of period 1 is $32. The cost of equity capital for similar firms is 7.6%. What is today’s intrinsic value? IV 0 = = $31.13 $ $ D 1 + IV r e

©Cambridge Business Publishers, 2013 Dividend Discount Model Framework ■ Equates current stock price to the present value of all future expected dividends ■ Two methods to forecast future dividends through infinity ■ Perpetuity method ■ Constant growth method IV 0 = D r e D 2 (1 + r e ) 2 + D 3 (1 + r e ) 3 + D 4 (1 + r e ) …

©Cambridge Business Publishers, 2013 Dividend Discount Model with Constant Perpetuity ■ Assumes that forecasted dividends stabilize at some point in the future and remain constant thereafter ■ Yields an ordinary annuity with payments occurring at the end of a period through infinity IV 0 = D 1 + IV r e

©Cambridge Business Publishers, 2013 DDM with Constant Perpetuity Example Eastern Company has an expected dividend for 2 years of $1.50, followed by a $2.25 dividend in year 3, and $2.75 per year thereafter. The cost of equity capital is estimated at 7.6%. What is today’s intrinsic value? = $ $ $ $36.18 = $40.90 IV 0 = $ $1.50 (1.076) 2 $2.25 (1.076) 3 ++$ (1.076) 3 Perpetuity Years 1, 2, and 3

©Cambridge Business Publishers, 2013 Dividend Discount Model with Increasing Perpetuity ■ Referred to as the Gordon growth model ■ Considered more realistic than the constant perpetuity model ■ Present value of an increasing perpetuity Present value of D (r – g)

©Cambridge Business Publishers, 2013 DDM with Increasing Perpetuity Example Eastern Company has an expected dividend for 2 years of $1.50, followed by a $2.25 dividend in year 3, and $2.75 in year 4 with a growth of 2% per year thereafter. The cost of equity capital is estimated at 7.6%. What is today’s intrinsic value? = $ $ $ $39.42 = $44.14 IV 0 = $ $1.50 (1.076) 2 $2.25 (1.076) 3 ++$ (1.076) 3 Perpetuity Years 1, 2, and 3

©Cambridge Business Publishers, 2013 Issues in Applying the Dividend Discount Model ■ A large percentage of publicly traded companies do not issue dividends ■ Zero payout may continue indefinitely ■ Some companies have unusually high dividend payouts given their profit levels ■ Sustaining may not be possible ■ Difficult to find analysts’ forecasts of dividends to use in the model Create challenges in forecasting dividends and generating reliable forecasts

©Cambridge Business Publishers, 2013 End Module 12