1. FIN449 Valuation Michael Dimond

2. Announcements Exam was moved out by one week, but it is now a take-home exam. The exam will be distributed on February 16 at our usual time. You will have one week to complete it (by Feb 23).

3. The Cost of Equity: A Recap Cost of Equity = Risk Free Rate + β x (Market Risk Premium) The best approach is usually a bottom-up beta based on other firms in the business and the firm’s own capital structure R f must be in the same economy & currency as the cash flows being discounted, and defined in the same inflationary terms (real or nominal) MRP can be the Historical Premium or the Implied Premium. The Historical Premium in the U.S. is the mature equity market premium earned by stocks over TBonds (between 4.5% & 5.5%).

4. Cost of Debt

5. Estimating the Cost of Debt The cost of debt is the rate at which you can borrow at currently, It will reflect not only your default risk but also the level of interest rates in the market. The cost of debt is not the rate at which you borrowed money historically. That is why you cannot use the book cost of debt in the cost of capital calculation. The two most widely used approaches to estimating cost of debt are: Looking up the yield to maturity on a straight bond outstanding from the firm. The limitation of this approach is that very few firms have long term straight bonds that are liquid and widely traded Looking up the rating for the firm and estimating a default spread based upon the rating. While this approach is more robust, different bonds from the same firm can have different ratings. You have to use a median rating for the firm

6. Estimating the Cost of Debt While ratings seem like useful tools for coming up with the cost of debt, there can be problems: A firm may have no publicly traded debt. A firm can have multiple ratings. You need a rating across all of a firm’s debt, not just its safest. While many companies have bonds outstanding, corporate bonds often have special features attached to them and are not liquid, making it difficult to use the yield to maturity as the cost of debt. A firm’s bonds can be structured in such a way that they can be safer than the rest of the firm’s debt - they can be more senior or secured than the other debt of the firm. The alternative is to estimate a synthetic rating for your firm and determine the cost of debt based upon that rating.

7. Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio Cov.RatioEst. Bond Rating > 8.50AAA 6.50 - 8.50AA 5.50 - 6.50A+ 4.25 - 5.50A 3.00 - 4.25A– 2.50 - 3.00BBB 2.00 - 2.50BB 1.75 - 2.00B+ 1.50 - 1.75B 1.25 - 1.50B – 0.80 - 1.25CCC 0.65 - 0.80CC 0.20 - 0.65C < 0.20D

8. Estimating Synthetic Ratings Interest Coverage Ratio = EBIT / Interest Expenses Consider two firms, Company Y and Company Z For Company Y EBIT = $161MM Interest Expense = $48MM Interest Coverage Ratio = For Company Z EBIT = $55,467MM Interest Expense = $4,028MM Interest Coverage Ratio =

9. Estimating Synthetic Ratings Interest Coverage Ratio = EBIT / Interest Expenses Consider two firms, Company Y and Company Z For Company Y EBIT = $161MM Interest Expense = $48MM Interest Coverage Ratio = 161/48 = 3.33 For Company Z EBIT = $55,467MM Interest Expense = $4,028MM Interest Coverage Ratio = 55,467/ 4028= 13.77

10. Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio Cov.RatioEst. Bond Rating > 8.50AAA 6.50 - 8.50AA 5.50 - 6.50A+ 4.25 - 5.50A 3.00 - 4.25A– 2.50 - 3.00BBB 2.00 - 2.50BB 1.75 - 2.00B+ 1.50 - 1.75B 1.25 - 1.50B – 0.80 - 1.25CCC 0.65 - 0.80CC 0.20 - 0.65C < 0.20D Company Y Company Z

11. Estimating Synthetic Ratings The rating for a firm can be estimated using the financial characteristics of the firm. In its simplest form, the rating can be estimated from the interest coverage ratio Cov.RatioEst. Bond RatingSpread > 8.50AAA0.50% 6.50 - 8.50AA0.65% 5.50 - 6.50A+0.85% 4.25 - 5.50A1.00% 3.00 - 4.25A–1.10% 2.50 - 3.00BBB1.60% 2.00 - 2.50BB3.35% 1.75 - 2.00B+3.75% 1.50 - 1.75B5.00% 1.25 - 1.50B –5.25% 0.80 - 1.25CCC8.00% 0.65 - 0.80CC10.00% 0.20 - 0.65C12.00% < 0.20D15.00% Company Y Company Z

12. Estimating Synthetic Ratings Assuming the appropriate Risk Free Rate is 4.71%... Company Y’s Cost of Debt is 5.81% (4.71% + 1.10%) Company Z’s Cost of Debt is 5.21% (4.71% + 0.50%) Cov.RatioEst. Bond RatingSpread > 8.50AAA0.50% 6.50 - 8.50AA0.65% 5.50 - 6.50A+0.85% 4.25 - 5.50A1.00% 3.00 - 4.25A–1.10% 2.50 - 3.00BBB1.60% 2.00 - 2.50BB3.35% 1.75 - 2.00B+3.75% 1.50 - 1.75B5.00% 1.25 - 1.50B –5.25% 0.80 - 1.25CCC8.00% 0.65 - 0.80CC10.00% 0.20 - 0.65C12.00% < 0.20D15.00% Company Y Company Z

13. Historic Spreads The Default Spread is the amount above the Risk Free Rate at the applicable time. Ratio Est. RatingSpread(1/99)Spread(1/01) > 8.50AAA0.20%0.75% 6.50 - 8.50AA0.50%1.00% 5.50 - 6.50A+0.80%1.50% 4.25 - 5.50A1.00%1.80% 3.00 - 4.25A–1.25%2.00% 2.50 - 3.00BBB1.50%2.25% 2.00 - 2.50BB2.00%3.50% 1.75 - 2.00B+2.50%4.75% 1.50 - 1.75B3.25%6.50% 1.25 - 1.50B –4.25%8.00% 0.80 - 1.25CCC5.00%10.00% 0.65 - 0.80CC6.00%11.50% 0.20 - 0.65C7.50%12.70% < 0.20D10.00%15.00%

14. Weights for Cost of Capital Computation The weights used to compute the cost of capital should be the market value weights for debt and equity. There is an element of circularity that is introduced into every valuation by doing this, since the values that we attach to the firm and equity at the end of the analysis are different from the values we gave them at the beginning. As a general rule, the debt that you should subtract from firm value to arrive at the value of equity should be the same debt that you used to compute the cost of capital.

15. What About International Ratings? To develop an interest coverage ratio/ratings table, you need lots of rated firms and objective ratings agencies. This is most feasible in the United States. The relationship between interest coverage ratios and ratings developed using US companies tends to travel well, as long as we are analyzing large manufacturing firms in markets with interest rates close to the US interest rate. They are more problematic when looking at smaller companies in markets with higher interest rates than the US. When interest rates are high, interest coverage ratios will come under downward pressure and the premiums may need to be adjusted to reflect this.

16. Cost of Debt computations When estimating the cost of debt for an emerging market company, you have to decide whether to add the country default spread to the company default spread when estimating the cost of debt. Companies in countries with low bond ratings and high default risk might bear the burden of country default risk For example, if Company Y is in such a country and the Country Default Risk is estimated as 5.25%, the rating estimated of A- yields a cost of debt as follows: = US T.Bond rate + Country default spread + Company Default Spread = 4.71% + 5.25% + 1.10% = 11.06%

17. Estimating A U.S. $ Cost of Capital for a Foreign Firm Equity Cost of Equity = 4.71% + 0.71 (4.5% +10.53%) = 15.38% Market Value of Equity = 995 million (94.40%) Debt Cost of debt = 4.71% + 5.25% (Country default) +1.10% (Company default) = 11.06% Market Value of Debt = 59 Mil (5.60%) Cost of Capital Cost of Capital = 15.38 % (.9440) + 11.06% (1-.3345) (.0560)) = 15.38 % (.9440) + 7.36% (.0560) = 15.70 % Mature Market Premium Country Risk Premium for Argentina

18. What About Large Multinationals? For smaller, less well known firms, it is safer to assume that firms cannot borrow at a rate lower than the countries in which they are incorporated. For larger firms, you could make the argument that firms can borrow at lower rates. In practical terms, you could ignore the country default spread or add only a fraction of that spread.

19. Dealing with Preferred Stock When dealing with significant amounts of preferred stock, it is better to keep it as a separate component. As a rule of thumb, if the preferred stock is less than 5% of the outstanding market value of the firm, lumping it in with debt will make no significant impact on your valuation. Preferred stock is non-tax deductible, which makes it unlike debt and unlike common equity. Here, you would make the exception and allow for a third source of capital. The cost of preferred stock is the preferred dividend yield.

20. Dealing with Hybrids Keep your cost of capital simple. If possible, consolidate all of your capital into either debt or equity. With convertible bonds, this is fairly simple to do. When dealing with hybrids (convertible bonds, for instance), break the security down into debt and equity and allocate the amounts accordingly. Thus, if a firm has $ 125 million in convertible debt outstanding, break the $125 million into straight debt and conversion option components. The conversion option is equity.

21. Recapping the Cost of Capital

22. Where are we going with all this? Risk & Cost of Capital Forecast Financials Recasting & Sust. OCF DCF Calculations Comps Value & Perspective Exam Pepsi Burger King Final Project Facts & Information

23. Valuation – The Big Picture

24. Assignment See online document Due Monday. You may turn it in to me directly or to the SBA Faculty Services office on the 5 th Floor. Please pick up previous assignments

25. Next Week Monday: We put Starbucks together from top to bottom We review for the exam Wednesday: We begin valuing PepsiCo You receive the take-home exam