Valuing companies in Emerging Markets

Valuation is usually difficult in emerging markets.

There are unique risks and obstacles not present in developed markets.

Additional considerations include

• macroeconomic uncertainty, 
• illiquid capital markets, 
• controls on the flow of capital into and out of the country, 
• less rigorous standards of accounting and 
• disclosure, and high levels of political risk.

To estimate value, three different methods are used:

1. a discounted cash flow (DCF) approach with probability-weighted scenarios that model the risks the business faces,
2. a DCF valuation with a country risk premium built into the cost of capital, and 
3. a valuation based on comparable trading and transaction multiples.

For developed nations, the analyst must:

• develop consistent economic assumptions,
• forecast cash flows, and 
• compute a WACC.

Computing cash flows, however, may require extra work because of accounting differences.

If done correctly, the two DCF methods (1 and 2 above) should give the same estimate of value.

Estimating the cost of capital

The weighted average cost of capital, WACC is the opportunity cost of choosing to invest in the assets generating the free cash flow (FCF) of that business as opposed to another business of similar risk.

For consistency, the estimate of the WACC should have the following properties:

1. it includes the opportunity cost of all investors,
2. it uses the appropriate market-based weights,
3. it includes related costs/benefits such as the interest tax shield,
4. it is computed after corporate taxes, 
5. it is based on the same expectations of inflation as used in the FCF forecasts, and 
6. the duration of the securities used in estimating the WACC equals the duration of the FCFs.

Given:
D/V = target weight in debt
E/V = target weight in equity
kd = required return of debt as source of capital
ke = required return of equity as source of capital
Tm = marginal tax rate

WACC = D/V * kd (1 - Tm) + E/V * ke



Cost of equity

The capital asset pricing model (CAPM) is a popular way to estimate the cost of equity.

It includes an estimate of

• the risk free rate, 
• beta, and 
• the market risk premium.

Estimated equity risk premium
= risk free rate + Beta x (market risk premium)
= risk free rate + Beta x (market risk - risk free rate)


Note:  there are alternatives to the CAPM such as the Fama-French three factor model and the arbitrage pricing theory.


Cost of debt

The after tax cost of debt requires

• an estimate of the required return on debt capital and 
• an estimate of the tax rate.

Other estimates include the weights in the target capital structure and, when relevant, the effects of debt equivalent and the effects of a complex capital structure

Conservation of Value and the Role of Risk. Increasing value through reducing the company's risk and its cost of capital.

Cash flow drives a firm's value creation.

Growth and ROIC generate cash flow.



Value creation

Companies create value:

• when they grow at returns on capital greater than their cost of capital or 
• when they increase their returns on capital.

Actions that don't increase cash flows over the long term will NOT create value, regardless of whether they improve earnings or otherwise make financial statements look stronger.

One Exception:  reducing the company's risks or its cost of capital can create firm's value

Actions the company takes to reduce a company's risk and therefore, its cost of capital.

There are different types of risk and it is important to explore how they enter into a company's valuation.

Only risk reductions that reduce a company's nondiversifiable risk will reduce its cost of capital.

Fundamental Principles of Firm's Value Creation

Value creation is determined by cash flows.

Cash flows are driven by 

• revenue growth and 
• return on invested capital (ROIC).

For any given level of revenue growth, increasing ROIC increases value.

However, increasing revenue growth does not always increases the firm's value.

• When ROIC is greater than the cost of capital, increasing growth increases the value of the firm.
• When the ROIC is less than the cost of capital, increasing growth decreases the firm's value.
• When ROIC equals the cost of capital, growth does not affect a firm's value.

Is McDonald's Losing Its Economic Castle?

May. 17, 2015 6:35 PM ET  |  7 comments  |  About: McDonald's Corporation (MCD), Includes: BWLD, CBRL, ZOES

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...)

Summary

• Is there really much to like about McDonald's anymore?
• Let's walk through its challenges, and whether it means the company's Economic Castle is deteriorating.
• We give our high-level thoughts on the turnaround plan and disclose our fair value estimate of shares.
• We also have some interesting ideas at the end of the article that many may be overlooking.

What in the world is an Economic Castle?

Berkshire Hathaway's Warren Buffett has popularized the concept of an "economic moat," perhaps best described in common language as sustainable competitive advantages. But an Economic Castle? Are we just confused?

In short, no.

Whereas economic moat analysis focuses on the duration of a company's economic profit stream, as measured by return on invested capital less the costs of which to attain that capital, economic castle analysis focuses on the magnitude of economic profit creation over the realizable near term.

Unlike the substantial duration risk inherent to predicting economic profits 20, 30 or more years into the future, the economic castle framework posits that the strongest performing companies during certain phases of the economic cycle will be those that generate the most economic value over the foreseeable future.

http://seekingalpha.com/article/3190106-is-mcdonalds-losing-its-economic-castle?auth_param=ii05t:1ali5us:13045f7ae0127a1efc301785d852f4b2&uprof=44

How to Pick Fundamentally Strong Stocks

You are a lot better estimating the Cost of Capital without using fancy formulas

Estimate the Cost of Capital 

You have to estimate the cost of capital.  

First of all, the cost of equity will always be above the cost of the debt.  Secondly, the most expensive cost of equity is the type that venture capitalists have to pay.  If you read the VC magazines, they will tell you what returns they have to show on their old funds to raise money on their new funds.  These days that number is 15%.  Without doing any betas, you know the cost of equity is between 7% and 15% which is a lot better than the beta estimates.  

• Usually for the low risk firm with not a lot of debt, the cost of capital will be about 7% to 8%. 
• For a medium risk firm these days with reasonable debt, it will be about 9% to 10%.  
• For high risk firms, it will be 11% to 13%.

You are a lot better doing that than trying to estimate using fancy formulas.  So you get a cost of capital.

And the nice thing about not including the growth is that errors in the cost of capital are typically not that big. If you are 1% off in the WACC, you are 10% error in the valuation and that is not a killer error in valuation. 


Notes from video lecture by Prof Bruce Greenwald

http://csinvesting.org/wp-content/uploads/2012/06/greenwald-vi-process-foundation_final.pdf

 

 

Cue:  7/11

How to Value a Company in 3 Easy Steps

How to Value a Company in 3 Easy Steps - Valuing a Business Valuation Methods Capital Budgeting


Valuing a Business
How much is a business worth?
Don't care about the 'asset value' or 'owner equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its horizon value".



Step2 - How to Value a Company for Valuing a Business Valuation Methods Capital Budgeting



Step3 How to Value a Compay for Valuing a Business Valuation Methods Capital Budgeting

Uploaded on 15 Mar 2010

Clicked here http://www.MBAbullshit.com/ and OMG wow! I'm SHOCKED how easy.. 

Just for instance I possessed a company comprising of a neighborhood store. To put together that center, I invested $1,000 one year ago on apparatus along with other assets. The equipment in addition to other assets have depreciated by 10% in a single year, so now they're valued at only $900 inside the accounting books. In case I was going to make an effort to offer you this company, what amount would an accountant value it? Relatively easy! $900. The cost of the whole set of assets (less liabilities, if any) can give accountants the "book value" of a typical organization, and such is systematically how accountants observe the worth of an enterprise or company. (We employ the use of the word "book" because the worth of the assets are penned within the company's accounting "books.") 
http://www.youtube.com/watch?v=6pCXd4...
However, imagine this unique company is earning a juicy cash income of $2,000 annually. You would be landing a mighty incredible deal in the event I sold it to you for just $900, right? I, on the flip side, might be taking out a pretty sour pact in the event I offered it to you for just $900, on the grounds that as a result I will take $900 but I will shed $2,000 per annum! Due to this, business directors (dissimilar to accountants), don't make use of merely a company's book value when assessing the value of an organization.So how do they see how much it really is worth? To replace utilizing a business' books or even net worth (the market price of the firm's assets minus the business enterprise's liabilities), financial managers opt to source enterprise worth on how much money it gets in relation to cash flow (real cash acquired... contrary to only "net income" that may not generally be in the format of cash). Basically, a company making $1,000 "free cash flow" monthly having assets worth a very small $1 would remain to be worth a great deal more versus a larger company with substantial assets of $500 in the event the humongous company is attaining only $1 yearly.So far, how do we achieve the exact value of your business? The simplest way would be to mainly look for the net present value of the total amount of long run "free cash flows" (cash inflow less cash outflow).Needless to say, you will come across much more sophisticated formulas to find the value of a company (which you wouldn't genuinely need to learn in detail, since there are numerous gratis calculators on the web), but practically all of such formulas are in a way driven by net present value of cash flows, plus they are likely to take into consideration a few factors for example growth level, intrinsic risk of the company, plus others.

Weighted Average Cost of Capital (WACC)

What It Is:

Weighted average cost of capital (WACC) is the average rate of return a company expects to compensate all its different investors. The weights are the fraction of each financing source in the company's target capital structure.

How It Works/Example:

Here is the basic formula for weighted average cost of capital:

WACC = ((E/V) * R_e) + [((D/V) * R_d)*(1-T)]
E = Market value of the company's equity
D = Market value of the company's debt
V = Total Market Value of the company (E + D)
R_e = Cost of Equity
R_d = Cost of Debt
T= Tax Rate

A company is typically financed using a combination of debt (bonds) and equity (stocks).  Because a company may receive more funding from one source than another, we calculate a weighted average to find out how expensive it is for a company to raise the funds needed to buy buildings, equipment, andinventory.

Let's look at an example:

Assume newly formed Corporation ABC needs to raise $1 million in capital so it can buy office buildings and the equipment needed to conduct its business. The company issues and sells 6,000 shares of stock at $100 each to raise the first $600,000. Because shareholders expect a return of 6% on their investment, the cost of equity is 6%.

Corporation ABC then sells 400 bonds for $1,000 each to raise the other $400,000 in capital. The people who bought those bonds expect a 5% return, so ABC's cost of debt is 5%.

Corporation ABC's total market value is now ($600,000 equity + $400,000 debt) = $1 million and its corporate tax rate is 35%. Now we have all the ingredients to calculate Corporation ABC's weighted average cost of capital (WACC).

WACC = (($600,000/$1,000,000) x .06) + [(($400,000/$1,000,000) x .05) * (1-0.35))] = 0.049 = 4.9%
Corporation ABC's weighted average cost of capital is 4.9%.

This means for every $1 Corporation ABC raises from investors, it must pay its investors almost $0.05 in return. 

Why It Matters:

It's important for a company to know its weighted average cost of capital as a way to gauge the expense of funding future projects. The lower a company's WACC, the cheaper it is for a company to fund new projects.

A company looking to lower its WACC may decide to increase its use of cheaper financing sources.  For instance, Corporation ABC may issue more bonds instead of stock because it can get the financing more cheaply. Because this would increase the proportion of debt to equity, and because the debt is cheaper than the equity, the company's weighted average cost of capital would decrease.

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/weighted-average-cost-capital-wacc-2905

How to Value a Company in 3 Easy Steps

Valuing a Business:
How much is a business worth?
Don't care about the 'asset value' or 'owner's equity' of the business.
We look at the present value of its net free cash flows (FCF) plus present value of its "horizon value".

Corporate Finance - Effects of Debt on the Capital Structure

Using Greater Amounts of DebtRecall that the main benefit of increased debt is the increased benefit from the interest expense as it reduces taxable income. Wouldn't it thus make sense to maximize your debt load? The answer is no.

With an increased debt load the following occurs: 
Interest expense rises and cash flow needs to cover the interest expense also rise.
Debt issuers become nervous that the company will not be able to cover its financial responsibilities with respect to the debt they are issuing.

Stockholders become also nervous. First, if interest increases, EPS decreases, and a lower stock price is valued. Additionally, if a company, in the worst case, goes bankrupt, the stockholders are the last to be paid retribution, if at all. 

In our previous examples, EPS increased with every increase in our debt-to-equity ratio. However, in our prior discussions, an optimal capital structure is some combination of both equity and debt that maximizes not only earnings but also stock price. Recall that this is best implied by the capital structure that minimizes the company's WACC.

Example:The following is Newco's cost of debt at various capital structures. Newco has a tax rate of 40%. For this example, assume a risk-free rate of 4% and a market rate of 14%. For simplicity in determining stock prices, assume Newco pays out all of its earnings as dividends.

Figure 11.15: Newco's cost of debt at various capital structures

At each level of debt, calculate Newco's WACC, assuming the CAPM model is used to calculate the cost of equity.

Answer:At debt level 0%:
Cost of equity = 4% + 1.2(14% - 4%) = 16%
Cost of debt = 0% (1-40%) = 0%
WACC = 0%(0%) + 100%(16%) = 16%
Stock price = $18.00/0.16 = $112.50

At debt level 20%:
Cost of equity = 4% + 1.4(14% - 4%) = 18%
Cost of debt = 4%(1-40%) = 2.4%
WACC = 20%(2.4%) + 80%(18%) = 14.88%
Stock price = $22.20/0.1488 = $149.19

At debt level 40%:
Cost of equity = 4% + 1.6(14% - 4%) = 20%
Cost of debt = 6% (1-40%) = 3.6%
WACC = 40%(3.6%) + 60%(20%) = 13.44%
Stock price = $28.80/0.1344 = $214.29

Recall that the minimum WACC is the level where stock price is maximized. As such, our optimal capital structure is 40% debt and 60% equity. While there is a tax benefit from debt, the risk to the equity can far outweigh the benefits - as indicated in the example.

Company vs. Stock ValuationThe value of a company's stock is but one part of the company's total value. The value of a company comprises the total value of the company's capital structure, including debtholders, preferred-equity holders and common-equity holders. Since both debtholders and preferred-equity holders have first rights to a company's value, common-equity holders have last rights to a company value, also known as a "residual value".

Read more: http://www.investopedia.com/exam-guide/cfa-level-1/corporate-finance/debt-effects-capital-structure.asp#ixzz1yezxSCbw

Video on WACC
Weighted average cost of capital may be hard to calculate, but it's a solid way to measure investment quality
Read more: http://www.investopedia.com/video/play/what-is-wacc#ixzz1yfHGTd8N
http://www.investopedia.com/video/play/what-is-wacc#axzz1ybqROWiK

Wall Street Prep Lessons: Cash Flow, DCF, WACC, LBO, M&A, Trading and Transactions

Shareholder value and Economic Profit

Shareholders invest in a company to make a profit.  This can come from an increase in the share price and/or the dividends the company pays.

The challenge is to find a measure of business performance that correlates with share price movements.  Then, if we plan our business to raise this measure, we should raise the share price, and hence create value for our shareholders.



EBITDA

Earnings before interest, tax, depreciation and amortisation (EBITDA)

Profit is not a good measure of the value a business is generating for its shareholders.  Ultimately, a shareholder is interested in the amount of cash generated, rather than profit (which is after all only an accounting calculation). It is cash which enables the business to expand and develop, and pay dividends.  And it is the expectation of future cash flows that drives the share price up, and creates values for shareholders.

In calculating profit, depreciation is included as a cost.

Depreciation and amortisation are not cash transactions but an accounting exercise to balance the reducing value of assets over time.  We can measure earnings before interest, tax, depreciation and amortisation - EBITDA!  This is the amount of operating profit that will eventually be turned into cash.  But EBITDA alone doesn't tell us if we are creating value.


Economic profit or Economic Value Added (EVA)

Economic profit (EP) takes account of the fact that investors have choices.  They can invest in your company, or your competitor; in art; in another industry; or put their money in the bank.  Every investment has a certain amount of risk, and a level of reward.

If your company generates more cash for each pound invested than other investments with a similar level of risk, it is making an 'economic profit'.  

• Studies of real companies show clearly that an increase in EP correlates strongly with an increase in share price, and the creation of shareholder value.  
• A fall in EP goes with a reduction in share price, and destruction of shareholder value.

Economic profit is calculated by taking the cash flow generated by the business (EBITDA) and subtracting a 'charge' for the 'cost of capital'.  The cost of capital is the profit the business must make, simply to meet the expectations of investors who take this level of risk.

If the company was financed only by shareholders' funds, the cost of capital would be the average return of investments after tax with the same level of risk; for example, a group of companies of similar size in the same industry.  This is the 'cost of equity'.

Most companies are financed partly by shareholders' funds, and partly by bank loans.  So, their cost of capital is not simply the cost of equity, but takes into account the interest paid on loans as well.  This is known as the 'weighted average cost of capital', or the WACC rate.

Economic profit is calculated by

• subtracting a capital charge (the net asset value of a business multiplied by the WACC rate) from EBITDA.  
• Tax is also deducted because this is paid out of cash flow.  
• Interest is not deducted, as the capital charge has already taken this into account.

Economic profit = Profit (Earnings) - Tax - Capital charge

Capital charge = Net Asset Value of a business X WACC rate


Example of application of Economic Profit
http://spreadsheets.google.com/pub?key=t7BiKoYpNh8QNDvzcZoN8xA&output=html

Looking for the firm with an economic moat (Evaluating Profitability)

The first thing we need to do is look for hard evidence that a firm has an economic moat by examining its financial results. (Figuring out whether a company might have a moat in the FUTURE is much tougher.)

What we are looking for are firms that can earn profits (ROIC) in excess of their cost of capital (WACC) - companies that can generate substantial cash relative to the amount of investments they make.

Use the metrics in the following questions to evaluate profitability:

1. Does the firm generate free cash flow? If so, how much?
Firms that generate free cash flow essentially have money left over after reinvesting whatever they need to keep their businesses humming along. In a sense, free cash flow is money that could be extracted from the firm every year without damaging the core business.

FCF Margin:  Divide FCF by sales (or revenues). This tells what proportion of each dollar in revenue the firm is able to convert into excess profits.

If a firm's FCF/Sales is around 5% or better, you've found a cash machine.

Strong FCF is an excellent sign that a firm has an economic moat.

(FCF/Total Capital Employed or FCF/Enterprice Value are some measures.)


2. What are the firm's net margins?
Net margins look at probability from another angle.

Net margin = net income/ Sales

It tells how much profits the firm generates per dollar of sales.

In general, firms that can post net margins above 15% are doing something right.

3. What are the returns on equity?
ROE = net income/shareholders' equity
It measures profits per dollar of the capital shareholders have invested in a company.

Although ROE does have some flaws -it still works well as one tool for assessing overall profitability.

As a rule of thumb, firms that are able to consistently post ROEs above 15% are generating solid returns on shareholders' money, which means they're likely to have economic moats.

4. What are returns on assets?
ROA = (net income + Aftertax Interest Expense )/ firm's average assets
It measures how efficient a firm is at translating its assets into profits.

Use 6% to 7% as a rough benchmark - if a firm is able to consistently post ROAs above these rates, it may have some competitive advantage over its peers.

The company's aftertax interest expense is added back to net income in the calculation.  Why is that?  ROA measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.


Study these metrics over 5 or 10 years

When looking at all four of these metrics, look at more than just one year.

A firm that has consistently cranked out solid ROEs, ROA, good FCF, and decent net margins over a number of years is much more likely to truly have an economic moat than a firm with more erratic results.

Five years is the absolute minimum time period for evaluation, 10 years is even better, if you can.


Consistency is Important

Consistency is important when evaluating companies, because it's the ability to keep competitors at bay for an extended period of time - not just for a year or two - that really makes a firm valuable.



These benchmarks are rules of thumb, not hard-and-fast cut-offs.

Comparing firms with industry averages is always a good idea, as is examining the trend in profitability metrics - are they getting higher or lower?

There is a more sophisticated way of measuring a firm's profitability that involves calculating return on invested capital (ROIC), estimating a weighted average cost of capital (WACC), and then looking at the difference between the two.

Using a combination of FCF, ROE, ROE and net margins will steer you in the right direction.


Additional notes:

DuPont Equation

ROA = Net Profits / Average Assets
ROA = Asset Turnover x Net Profit Margin

ROA
= (Sales/Average Assets) x (Net Profits/Sales)
= Net Profits/Average Assets

ROE = Net Profits / Average Shareholder's Equity
ROE = Asset Turnover x Net Profit Margin x Asset/Equity Ratio*

ROE
= (Sales/Average Assets) x (Net Profits/Sales) x (Average Assets/Average Equity)
= Net Profits./ Average Equity

*Asset/Equity Ratio = Leverage

What do people mean when they say debt is a relatively cheaper form of finance than equity?

What do people mean when they say debt is a relatively cheaper form of finance than equity?

 

--------------------------------------------------------------------------------

In this case, the "cost" being referred to is the measurable cost of obtaining capital.

• With debt, this is the interest expense a company pays on its debt.
• With equity, the cost of capital refers to the claim on earnings which must be afforded to shareholders for their ownership stake in the business.

 

For example, if you run a small business and need $40,000 of financing, you can either take out a $40,000 bank loan at a 10% interest rate or you can sell a 25% stake in your business to your neighbor for $40,000.

 

• Suppose your business earns $20,000 profits during the next year. If you took the bank loan, your interest expense (cost of debt financing) would be $4,000, leaving you with $16,000 in profit.
• Conversely, had you used equity financing, you would have zero debt (and thus no interest expense), but would keep only 75% of your profit (the other 25% being owned by your neighbor). Thus, your personal profit would only be $15,000 (75% x $20,000).
• From this example, you can see how it is less expensive for you, as the original shareholder of your company, to issue debt as opposed to equity.
• Taxes make the situation even better if you had debt, since interest expense is deducted from earnings before income taxes are levied, thus acting as a tax shield (although we have ignored taxes in this example for the sake of simplicity).

 

Of course, the advantage of the fixed-interest nature of debt can also be a disadvantage, as it presents a fixed expense, thus increasing a company's risk.

• Going back to our example, suppose your company only earned $5,000 during the next year.
• With debt financing, you would still have the same $4,000 of interest to pay, so you would be left with only $1,000 of profit ($5,000 - $4,000).
• With equity, you again have no interest expense, but only keep 75% of your profits, thus leaving you with $3,750 of profits (75% x $5,000).
• So, as you can see, provided a company is expected to perform well, debt financing can usually be obtained at a lower effective cost.
• However, if a company fails to generate enough cash, the fixed-cost nature of debt can prove too burdensome. This basic idea represents the risk associated with debt financing.

 

Companies are never 100% certain what their earnings will amount to in the future (although they can make reasonable estimates), and the more uncertain their future earnings, the more risk presented.

• Thus, companies in very stable industries with consistent cash flows generally make heavier use of debt than companies in risky industries or companies who are very small and just beginning operations.
• New businesses with high uncertainty may have a difficult time obtaining debt financing, and thus finance their operations largely through equity.

 

(For more on the costs of capital, see Investors Need A Good WACC.)

 

http://www.investopedia.com/ask/answers/05/debtcheaperthanequity.asp

Traditional Discount rate or WACC (II)

Traditional Method: Discount rate or Weighted average cost of capital (WACC)

Most generally, the practice is to estimate the returns investors are insisting upon for companies bearing like qualities (in terms of industry, capital structure, maturation, size, competitive outlook, and so on).

• For companies with long records of sustained earnings, low rates are indicated, perhaps just a few points above the risk-free rate.
• For newer, more volatile operations, a larger premium is required.

The estimate requires exercising practical judgment based on learning what compensation is given to investors bearing comparable business and financial risks.

• What special business and financial risk do common stockholders face?
• What are the debt levels?
• What is the likelihood that debt investors would be paid before them or that high debt would throw the company into bankruptcy?
• What is the company’s financial strength and industry leadership?
• Is its market expanding or contracting?
• Is there room for growth that will add value?

In short, assessing risk relevant to the discount rate implicates the same questions value investors ask when defining circles of competence.

Value investors see risk as arising from either

• deterioration in an investment’s business value or
• overpaying for it in the first place.

Overpayment can result from inadequate or mistaken analysis of these questions. The possibility of misrelating price and value implies a commonsense point: High stock prices compared to earnings make for high-risk investments.

A value investor’s conception of risk differs from that of modern finance theory, today’s dominant model for defining risk. This theory measures risk using market price fluctuations as proxies for underlying business-value changes. While the exercise appears precisely scientific, in fact it is as judgment-laden as the traditional method. It also defies common sense: In this model, the fact that a stock price is high or low compared to earnings has no bearing on risk. Despite these weaknesses, the widespread use of this model warrants summarizing it as a contrast to value investing.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary

Traditional Discount rate or WACC (I)

Traditional Method: Discount rate or Weighted average cost of capital (WACC)

To the risk-free is added an amount reflecting risks associated with a particular investment. This produces the discount rate to apply to determine the present value of an asset.

For a business with debt and equity in its capital structure, this is commonly called the weighted average cost of capital (WACC). It is the proportional cost of a company’s debt, determined by the after-tax interest cost, and the cost of equity, determined by a more judgment –laden but conceptually identical inquiry.

The cost of equity is conceptually identical to the cost of debt because they involve the same question:

• What must the company pay to induce investment, whether from debt lenders or equity holders?

The cost-of-equity exercise is more judgment-laden than the cost-of-debt exercise because there are no maturity dates or set coupons on equity (dividends are payable solely in the corporate board’s discretion).

The key reference is what other capital market participants are paying investors to attract equity financing form enterprises of comparable risk.

• To estimate the cost of equity capital for high-risk venture capital projects, for example, one could consult the returns offered by venture capitalists in such enterprises.
• For low-risk enterprises, underwritten secondary public offerings of blue-chip companies can be examined.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary