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

It's a risky business, don't you forget it

It's a risky business, don't you forget it

May 22, 2010

There was a time not so long ago when the markets were convinced that the risks the global financial crisis had exposed were contained. But that was then. Yesterday's market fightback aside, risk has been rediscovered and risk aversion is back in vogue.

It has been evident in the attack on the euro, the proxy for Europe's sovereign debt problem, and the message it sends that government debt taken on to save the financial system and prop up the global economy in 2008 and 2009 will be a long-term weight on growth everywhere.

It is also behind the Australian dollar's dive. The Rudd government's clumsily handled resource rent tax, signs of a pause on Reserve Bank rate rises and our commodity-heavy currency's vulnerability to concerns about global growth were other factors, as was a currency market version of programme trading. Selling by Japanese retail ''carry trade'' investors was triggered as the US dollar-yen rate moved below 90 yen and the Aussie-yen rate went below 75 yen. But however you cut it, what we are talking about is risk rediscovered and reinsured.

After misjudging how America's sub-prime property crisis would infect world markets, hedge funds and other big investors are determined not to be caught again, either by underestimating the possibility that Europe's sovereign debt crisis will fan out into a new systemic global crisis, or by mis-pricing the long-term impact of the debt-funded bailout.

The most fundamental risk insurance that investors take out is a fatter percentage return on the investments they make.

I can't tell you if hedge funds believe they have taken out enough insurance by beating down the quoted prices of shares and other vulnerable markers, including the euro and the Aussie. But I can tell you that insurance levels have been significantly increased worldwide.

In September the companies in the S&P/ASX 200 share index were promising to deliver earnings that equal a 5.9 per cent return on the cost of buying them. Totally safe 10-year Commonwealth bonds were yielding 5.5 per cent, so share investors were receiving a premium of less than half a percentage point for their higher risk, potentially higher return sharemarket exposure.

After this month's slide, the same share index is yielding 8.5 per cent, and the bond rate is down to 5.3 per cent, pushing the risk premium on the sharemarket up significantly, to 3.2 percentage points.

On the same measure Wall Street's share investing risk premium has moved from 3.4 percentage points to 5 percentage points, and even higher insurance has been taken out in Europe. The risk premium there was already big at 4.3 percentage points in September. Today it is 6.3 percentage points, as lower share prices push the euro market's share earnings yield up to 9 per cent, and as a flight to the safety of German government debt pushes its long-term government bond yield to 2.67 per cent - a level that is not only below anything seen during the global financial crisis, but the lowest seen since World War II.

That's a fat cushion by historical standards. It's worth noting that even as the markets have melted, some indicators have been pointing in the other direction.

• There are concerns that Europe's growth will be strangled by debt, 
• concern too about China's decision to restrict bank lending and slow the pace of its recovery, but global indicators in recent months have in the main been positive. 
• Thursday night's slight rise in US jobless claims was an exception, albeit a badly timed one for the markets.

While there's been a spike in a prominent sharemarket fear indicator, the Chicago Board Options Exchange's Vix index, interbank lending spreads are much narrower than they were during the financial crisis.

Yesterday's Australian market bounce showed that some investors see signs such as these as evidence that this is a crisis in name only, and see the elevated risk premiums as a buying signal.

Others will note that the markets remain hostage to political events - none more so than Australia's.

Last night, for example, Angela Merkel's coalition government was preparing to push Germany's share of the €750 billion rescue package for Greece and other debt-burdened European Union nations through its lower house. The vote was going to be close and the markets needed Merkel to win to hold their nerve.

Australia is running into an election that is shaping up as the most crucial for the markets here in decades. Tony Abbott's declarations that a Coalition government would call off the national broadband project that threatens Telstra's hegemony, scrap a tax that penalises highly profitable miners and rewards marginal ones, and find money elsewhere in part by cancelling the Rudd government's planned cut in company tax from 30 per cent to 28 per cent mean that Australian businesses and the markets face vastly different outcomes from a poll that is only months away.

mmaiden@theage.com.au

Source: The Age

http://www.brisbanetimes.com.au/business/its-a-risky-business-dont-you-forget-it-20100521-w1tw.html

Portfolio Theory: Market Risk Premiums

Market Risk Premiums

The variables also are integrated so that changes in one may indicate modification of another. For example, increases in the risk-free rate entail decreases in the market risk premium (the latter supposedly measures the difference between the risk-free rate and the expected return on common stocks). The need for estimation judgment, and the complex interrelationship among these variables, means that prudent analysis draws on multiple reasonable data points (by applying alternative methods and taking alternative measures of each variable).

The “market risk premium: is a guess based on history of what special inducements it takes to attract investors into stocks rather than buying U.S. Treasury securities or alternative investments. The idea is that investors must be given special compensation to bear the special risks of stocks or else they will not invest in them.

Data on Market Risk Premiums

Common practice is to consult data books published by leading economists, such as the one published by a firm run by Yale University professor Roger Ibbotson called the Ibbotson & Sinquefeld Yearbook. The harder way is doing it yourself, which is virtually impossible for non-professionals. But it is useful to understand why, so here goes.

Market risk premium data can be calculated up-to-the-minute at any time. Three crucial assumptions must be made to estimate the market risk premium.
1. First, the estimator must choose either historical data or some measure of future performance.
2. Second, one must define a “market” for the measure, such as the Standard & Poor’s 500, the New York Stock Exchange as a whole, or some other index.
3. Third, the estimate is based on a specified time period.

Alternatives include the period from the late 1800s (when market data were first recorded) to the time of valuation interest; from 1926 (when the University of Chicago began a database, thought to have the virtue of including a full business cycle before the 1929 market crash) to the time of valuation interest; for the 30-year period before the time of valuation interest (reflecting business cycles exhibiting more relevant business and financial risks and factors); or for specific environments being analysed, such as the early 2000s.

Challenges in using "market risk premium"

Seizing on a measure of the “market risk premium” became acutely tricky during the late 1990s because any such thing seemed to be evaporating. Any premium that once existed – e.g., in the period before 1990 – dwindled toward zero, as the most powerful bull market in world history produced investors who needed no inducements to join. Even staunch devotees of modern finance theory lamented the declining usefulness of “market risk premium” device during the 1990s.

Despite this well-known fact even among its fans, analysts sticking with this learning adhere to favourite benchmarks, such as 9 percent based on long-run historical returns on stocks dating back to the 1930s. Others respond to their gut sense that this is almost certainly wrong, and opt instead for rates of 7 percent, 5 percent, or less. Some believe it was moving towards zero in the late 1990s.

A group of the country’s leading financial economists assembled in mid-2000 to offer their measurements of the market risk premium. Eleven participated. Their estimates of the risk premium were: 0, 1-2, 3, 3-4, 4, 6, 6, and 8.1 percent, with three refusing to venture a guess giv en the concept’s indefiniteness and uncertain reliability.

Reasons for the decline or evaporation include powerful forces, such as U.S. investors became more long-term oriented, U.S. business efficiency heightened, fiscal policies and monetary management improved, capitalism spread globally, wealth increased, and business fundamentals exhibited less volatility.


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