Description
Highlights different ways of estimating cost of capital, estimating cost of equity as well as considerations to be given while estimating these.
Equity Research
Finding the Cost of Capital
Estimating the Discount Rate
?Critical ingredient in discounted cashflow
valuation. Errors in estimating the discount rate or
mismatching cashflows and discount rates can
lead to serious errors in valuation.
?At an intuitive level, the discount rate used should
be consistent with both the riskiness and the type
of cashflow being discounted.
? Equity versus Firm: If the cash flows being discounted are cash flows to equity, the
appropriate discount rate is a cost of equity. If the cash flows are cash flows to the
firm, the appropriate discount rate is the cost of capital.
? Currency: The currency in which the cash flows are estimated should also be the
currency in which the discount rate is estimated.
? Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e.,
reflect expected inflation), the discount rate should be nominal
Three Important Points About Cost of
Capital
• Cost of debt is different from the coupon rate.
• Cost of equity is different from dividend yield.
• The weights must be based on market values
and not book values.
Cost of Debt is not the same thing as
the Coupon Rate…
• Earnings before Interest and Tax Rs.100 m
• Book Value of Debt Rs.100 m
• Tax Rate 30%
• Cost of Equity 20%
• YTM = 12%. Coupon = 10%.
• Growth rate = 0% (as of now)
A project which requires an investment of Rs.100m is
available that generates 17% IRR. Should the company
accept the project?
Cost of Equity is not the same thing as
the Dividend Yield…
• Shareholders of an unlevered company expect
20% return on their investment (including 5%
dividend yield)
A project with an IRR of 10% is available. Should
the company accept the project?
The weights in WACC must be based
on Market Values…
• Cost of Equity 20%
• Cost of Debt 10%
• Tax Rate 30%
• Market Value of Equity Rs.120 millions
• Book Value of Equity Rs.16 millions
• Market (Book) value of Debt Rs.60 millions
A project (with an initial investment of Rs.100m) is
available that generates an IRR of 12%. Should it accept
the project?
Estimating Cost of Debt: The Pecking
Order
• Determine the YTM of the Bond
• Ask someone who knows
• Use credit rating of bonds issued by
companies
• Rate the bonds issued by the company
yourself
Determine the YTM of the Bond:
Pecking Order 1
T T
T
y
Facevlue
y
Coupon
y
Coupon
y
Coupon
ice Market
) 1 ( ) 1 (
...
) 1 ( ) 1 (
Pr _
2
2
1
1
+
+
+
+ +
+
+
+
=
Assumes a Flat Term Structure
Ask someone who knows: Pecking
Order 2
• Who is likely to know?
– Banks and Financial Institutions
– Investment Bankers
Use Credit Rating: Pecking Order 3
The Process
• Step 1: Find the rating of the bonds issued by the
company.
• Step2: Find out if similarly rated companies have issued
bonds in the recent past. Find out the coupon paid by
those companies.
• Step 3: Assume that the cost of debt of the company is
equal to the coupon rate obtained from Step2.
A Small Example
• Rating of Companies
– Bajaj Auto: AAA
– Tata Steel: AA
– Tata Sky: A-
(Source: http://www.crisil.com/credit-ratings-risk-assessment/outstanding-ratings-list.jsp)
• 5-year Yield Spread (http://finance.yahoo.com/bonds/composite_bond_rates)
Ratings Spread (U.S.)July
2010
Spread (India):
May 2010
A 1.6% 2.26% (2.22%)
AA 0.87% 1.44% (1.38%)
AAA 0.46% 0.87% (1.03%)
What is the Risk-free rate?
• Take the short-term rate or the
long-term rate?
• The 1-year rate is: 5.47%
• The 30-year rate is: 8.35%
• So the Cost of debt for Tata
Steel would be:
– 8.35% + 1.44% = 9.79%
• The cost of debt of Bajaj Auto
would be:
– 8.35% + 0.87% = 9.22%
• I assumed here that the default
spread for 5-year and 30-year
bonds will be the same.
• How do I find the cost of debt of
Tata Sky? Source:
http://www.ccilindia.com/NewZCYC.aspx
Rate the Company Yourself: Pecking
Order 4
• Use accounting/ financial ratios available.
• Use statistical models.
Using Accounting and Financial Variables: S & P
Model
Updated S&P Rating (2009)
Source:
http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245199778453
Model for India (As on 31 March,
2010)
Source: Prowess Database and my own teaching notes.
Wrong way of finding Cost of debt
Certain Related Issues…
• What is the tax rate?
– Cash (effective) tax rate
– Statutory tax rate
– An Example:
• In 2004, Ambuja Cements reported Profit Before Tax of
Rs.383.77 crores. It paid a tax of Rs.46.98 crores (@12.24%).
The statutory tax rate in 2004 was: 35%
• What if there are multiple sources of debt?
– Bank loans and term loans
– Debentures and bonds
– Short term and long term loans
Cost of Other Liabilities
• Non-Interest Bearing Liabilities (NIBL)
• Foreign Currency Loans
• Convertible Bonds
A Simple Example
• Expected EBIT = Rs.100m
• Debt
1
=Rs.100m (8%)
• Debt
2
=Rs.50m (7%)
• Cost of equity = 15%
• Tax rate = 20%
• What happens if interest on Debt
2
is deducted
before arriving at EBIT?
Cost of NIBL
• Sundry creditors of Rs.10 m are outstanding
on the date of valuation.
• Credit period given by supplier is 30 days.
Supplier is willing to receive Rs.9.7m as cash
payments if paid now.
How do we adjust for this in Cost of Capital?
Cost of Foreign Currency Loans
• Company has borrowed US$10000 @ 6% p.a.
• Spot Rs./$: 46
• 1-year Forward Rs./$: 48
Cost of Debt: To Summarize…
• Find the yield if the bond trades actively. Else
ask the bank about the likely yield. Else get
the rating of the company (or rate yourself)
and find the spread for that rating.
• Do not adjust for NIBL as it is difficult to do.
Models to Estimate Cost of Equity
• Capital Assets Pricing Model
• Arbitrage Pricing Model
• Multi-Factor Model
Capital Assets Pricing Model
• Estimating risk free rate of return
• Estimating market risk premium
• Estimating beta
Estimating Market Risk Premium
• Which market proxy?
– Sensex and Nifty are better than other indices
– Correlation between Sensex and Nifty in the 18
month period ending June 2010 was 0.99.
• What is the expected risk premium?
– Use econometric models
– Use historical average
– 10% seems to be the consensus figure in India
Estimating Beta
• What should be the estimation period?
• How frequently should returns be estimated?
• Other econometric adjustments
2
,
) (
) , ( var
m
m i
m
m i
R Variance
R R iance Co
o
o
| = =
Estimation Period
• Longer estimation period gives us more data points.
• The period should not be so large however that
– The operating risk has changed
– The financing risk has changed
• In July 2004, L&T got the permission of the High
Court to demerge the cement division (into Ultra
tech)
• Infosys became an unlevered company in 1997
Financing Risk and Beta
E
D
E
D
t
D U L
× ÷ × ÷ + = | | | ) ) 1 ( 1 ( *
Hamada Equation:
To be used if the level of debt is constant
An Example: Finding Beta for Ultra
Tech in 2004
I first considered cement companies similar to Ultra Tech (in
terms of profitability).
The median unlevered beta is: 0.72
Debt-to-Equity of Ultra Tech: 1.56 (How to find it?)
Median Price-Earnings Ratio for these companies was: 26.91
Profit after Tax of Ultra Tech was Rs.38.83 crores.
Implied Equity Value = Rs.1045 crores
Debt to Equity ratio = 1.56 (Actual DE was 0.38)
Levered Beta = 1.47
Another Example: Software Sector in
India
Median Levered Bets in the software industry: 0.97
Median Debt-Equity Ratio: 0.01
Median Net Debt-to-Equity: -0.02
Infosys’s beta is 0.45. What problems will we face here?
Source: Prowess (as updated on 4 July, 2010)
Frequency of Return Estimation
• We can get more data points if we use daily
returns. However they are noisy.
• Problem of infrequent trading and non-
synchronous trading.
• Research in India shows monthly returns have
better econometric properties.
Estimating Returns
• Two Definitions
– Arithmetic return
– Logarithmic return
• Four accounting adjustments
– Adjustment for dividend
– Adjustment for bonus
– Adjustment for split
– Adjustment for rights issue
Adjustment for Rights Issue
? Rights Ratio 1:5.
? The issue price = Rs.40 per share.
? The current stock price = Rs.100.
? Bonus component in the rights issue is given
by:
1
Pr _ _
Pr _
÷
ice XR l Theoretica
ice Current
When to use Industry beta?
• Almost always…
• Beta depends on operating and financing risk.
• Compare the regression beta with your
intuition. Is it too low? Too high?
• Beta is affected by liquidity in the market.
– Illiquid stocks have lower beta
Cost of Convertible Bonds: Warren Buffet Issues
Bonds With Negative Interest Rate
?Face Value of Bond = $1000 (assumed)
?Coupon Rate = 3%
?Holding Charges = 3.75%
?You get the right to buy the share at $89585
per share
?Market Price on Issue Date = $77900
Cost of Warrant
? Difference between a warrant and a call
? Valuation of a warrant
? Cost of warrant:
Stock Warrant
Value Call
ice Stock
d N | | *
Pr _
* ) (
1
÷
=
Finding d
1
t
t r
K
S
d
o
o
|
|
.
|
\
|
+ +
|
.
|
\
|
=
2
ln
2
1
doc_983914826.pptx
Highlights different ways of estimating cost of capital, estimating cost of equity as well as considerations to be given while estimating these.
Equity Research
Finding the Cost of Capital
Estimating the Discount Rate
?Critical ingredient in discounted cashflow
valuation. Errors in estimating the discount rate or
mismatching cashflows and discount rates can
lead to serious errors in valuation.
?At an intuitive level, the discount rate used should
be consistent with both the riskiness and the type
of cashflow being discounted.
? Equity versus Firm: If the cash flows being discounted are cash flows to equity, the
appropriate discount rate is a cost of equity. If the cash flows are cash flows to the
firm, the appropriate discount rate is the cost of capital.
? Currency: The currency in which the cash flows are estimated should also be the
currency in which the discount rate is estimated.
? Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e.,
reflect expected inflation), the discount rate should be nominal
Three Important Points About Cost of
Capital
• Cost of debt is different from the coupon rate.
• Cost of equity is different from dividend yield.
• The weights must be based on market values
and not book values.
Cost of Debt is not the same thing as
the Coupon Rate…
• Earnings before Interest and Tax Rs.100 m
• Book Value of Debt Rs.100 m
• Tax Rate 30%
• Cost of Equity 20%
• YTM = 12%. Coupon = 10%.
• Growth rate = 0% (as of now)
A project which requires an investment of Rs.100m is
available that generates 17% IRR. Should the company
accept the project?
Cost of Equity is not the same thing as
the Dividend Yield…
• Shareholders of an unlevered company expect
20% return on their investment (including 5%
dividend yield)
A project with an IRR of 10% is available. Should
the company accept the project?
The weights in WACC must be based
on Market Values…
• Cost of Equity 20%
• Cost of Debt 10%
• Tax Rate 30%
• Market Value of Equity Rs.120 millions
• Book Value of Equity Rs.16 millions
• Market (Book) value of Debt Rs.60 millions
A project (with an initial investment of Rs.100m) is
available that generates an IRR of 12%. Should it accept
the project?
Estimating Cost of Debt: The Pecking
Order
• Determine the YTM of the Bond
• Ask someone who knows
• Use credit rating of bonds issued by
companies
• Rate the bonds issued by the company
yourself
Determine the YTM of the Bond:
Pecking Order 1
T T
T
y
Facevlue
y
Coupon
y
Coupon
y
Coupon
ice Market
) 1 ( ) 1 (
...
) 1 ( ) 1 (
Pr _
2
2
1
1
+
+
+
+ +
+
+
+
=
Assumes a Flat Term Structure
Ask someone who knows: Pecking
Order 2
• Who is likely to know?
– Banks and Financial Institutions
– Investment Bankers
Use Credit Rating: Pecking Order 3
The Process
• Step 1: Find the rating of the bonds issued by the
company.
• Step2: Find out if similarly rated companies have issued
bonds in the recent past. Find out the coupon paid by
those companies.
• Step 3: Assume that the cost of debt of the company is
equal to the coupon rate obtained from Step2.
A Small Example
• Rating of Companies
– Bajaj Auto: AAA
– Tata Steel: AA
– Tata Sky: A-
(Source: http://www.crisil.com/credit-ratings-risk-assessment/outstanding-ratings-list.jsp)
• 5-year Yield Spread (http://finance.yahoo.com/bonds/composite_bond_rates)
Ratings Spread (U.S.)July
2010
Spread (India):
May 2010
A 1.6% 2.26% (2.22%)
AA 0.87% 1.44% (1.38%)
AAA 0.46% 0.87% (1.03%)
What is the Risk-free rate?
• Take the short-term rate or the
long-term rate?
• The 1-year rate is: 5.47%
• The 30-year rate is: 8.35%
• So the Cost of debt for Tata
Steel would be:
– 8.35% + 1.44% = 9.79%
• The cost of debt of Bajaj Auto
would be:
– 8.35% + 0.87% = 9.22%
• I assumed here that the default
spread for 5-year and 30-year
bonds will be the same.
• How do I find the cost of debt of
Tata Sky? Source:
http://www.ccilindia.com/NewZCYC.aspx
Rate the Company Yourself: Pecking
Order 4
• Use accounting/ financial ratios available.
• Use statistical models.
Using Accounting and Financial Variables: S & P
Model
Updated S&P Rating (2009)
Source:
http://www.standardandpoors.com/prot/ratings/articles/en/us/?assetID=1245199778453
Model for India (As on 31 March,
2010)
Source: Prowess Database and my own teaching notes.
Wrong way of finding Cost of debt
Certain Related Issues…
• What is the tax rate?
– Cash (effective) tax rate
– Statutory tax rate
– An Example:
• In 2004, Ambuja Cements reported Profit Before Tax of
Rs.383.77 crores. It paid a tax of Rs.46.98 crores (@12.24%).
The statutory tax rate in 2004 was: 35%
• What if there are multiple sources of debt?
– Bank loans and term loans
– Debentures and bonds
– Short term and long term loans
Cost of Other Liabilities
• Non-Interest Bearing Liabilities (NIBL)
• Foreign Currency Loans
• Convertible Bonds
A Simple Example
• Expected EBIT = Rs.100m
• Debt
1
=Rs.100m (8%)
• Debt
2
=Rs.50m (7%)
• Cost of equity = 15%
• Tax rate = 20%
• What happens if interest on Debt
2
is deducted
before arriving at EBIT?
Cost of NIBL
• Sundry creditors of Rs.10 m are outstanding
on the date of valuation.
• Credit period given by supplier is 30 days.
Supplier is willing to receive Rs.9.7m as cash
payments if paid now.
How do we adjust for this in Cost of Capital?
Cost of Foreign Currency Loans
• Company has borrowed US$10000 @ 6% p.a.
• Spot Rs./$: 46
• 1-year Forward Rs./$: 48
Cost of Debt: To Summarize…
• Find the yield if the bond trades actively. Else
ask the bank about the likely yield. Else get
the rating of the company (or rate yourself)
and find the spread for that rating.
• Do not adjust for NIBL as it is difficult to do.
Models to Estimate Cost of Equity
• Capital Assets Pricing Model
• Arbitrage Pricing Model
• Multi-Factor Model
Capital Assets Pricing Model
• Estimating risk free rate of return
• Estimating market risk premium
• Estimating beta
Estimating Market Risk Premium
• Which market proxy?
– Sensex and Nifty are better than other indices
– Correlation between Sensex and Nifty in the 18
month period ending June 2010 was 0.99.
• What is the expected risk premium?
– Use econometric models
– Use historical average
– 10% seems to be the consensus figure in India
Estimating Beta
• What should be the estimation period?
• How frequently should returns be estimated?
• Other econometric adjustments
2
,
) (
) , ( var
m
m i
m
m i
R Variance
R R iance Co
o
o
| = =
Estimation Period
• Longer estimation period gives us more data points.
• The period should not be so large however that
– The operating risk has changed
– The financing risk has changed
• In July 2004, L&T got the permission of the High
Court to demerge the cement division (into Ultra
tech)
• Infosys became an unlevered company in 1997
Financing Risk and Beta
E
D
E
D
t
D U L
× ÷ × ÷ + = | | | ) ) 1 ( 1 ( *
Hamada Equation:
To be used if the level of debt is constant
An Example: Finding Beta for Ultra
Tech in 2004
I first considered cement companies similar to Ultra Tech (in
terms of profitability).
The median unlevered beta is: 0.72
Debt-to-Equity of Ultra Tech: 1.56 (How to find it?)
Median Price-Earnings Ratio for these companies was: 26.91
Profit after Tax of Ultra Tech was Rs.38.83 crores.
Implied Equity Value = Rs.1045 crores
Debt to Equity ratio = 1.56 (Actual DE was 0.38)
Levered Beta = 1.47
Another Example: Software Sector in
India
Median Levered Bets in the software industry: 0.97
Median Debt-Equity Ratio: 0.01
Median Net Debt-to-Equity: -0.02
Infosys’s beta is 0.45. What problems will we face here?
Source: Prowess (as updated on 4 July, 2010)
Frequency of Return Estimation
• We can get more data points if we use daily
returns. However they are noisy.
• Problem of infrequent trading and non-
synchronous trading.
• Research in India shows monthly returns have
better econometric properties.
Estimating Returns
• Two Definitions
– Arithmetic return
– Logarithmic return
• Four accounting adjustments
– Adjustment for dividend
– Adjustment for bonus
– Adjustment for split
– Adjustment for rights issue
Adjustment for Rights Issue
? Rights Ratio 1:5.
? The issue price = Rs.40 per share.
? The current stock price = Rs.100.
? Bonus component in the rights issue is given
by:
1
Pr _ _
Pr _
÷
ice XR l Theoretica
ice Current
When to use Industry beta?
• Almost always…
• Beta depends on operating and financing risk.
• Compare the regression beta with your
intuition. Is it too low? Too high?
• Beta is affected by liquidity in the market.
– Illiquid stocks have lower beta
Cost of Convertible Bonds: Warren Buffet Issues
Bonds With Negative Interest Rate
?Face Value of Bond = $1000 (assumed)
?Coupon Rate = 3%
?Holding Charges = 3.75%
?You get the right to buy the share at $89585
per share
?Market Price on Issue Date = $77900
Cost of Warrant
? Difference between a warrant and a call
? Valuation of a warrant
? Cost of warrant:
Stock Warrant
Value Call
ice Stock
d N | | *
Pr _
* ) (
1
÷
=
Finding d
1
t
t r
K
S
d
o
o
|
|
.
|
\
|
+ +
|
.
|
\
|
=
2
ln
2
1
doc_983914826.pptx