Assignment 4 controllership

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Risk- Adjusted Expected Rates of

Return and the Dividends Valuation

Approach

Chapter: 11 2

Valuing the Firm Economic theory teaches us that the

value of an investment is:

Expected future payoffs can be measured in terms of:  Dividends  Cash Flows  Earnings

∑ = +

= n

t V

1 0 t

t

Rate) Discount (1 Payoffs Future Projected

Chapter: 11 3

Approaches to Firm Valuation

Chapter: 11 4

Risk-Adjusted Expected Rates of Return  Risk-adjusted expected rate of return on

equity capital is used as discount rate to compute present value of projected future payoffs.

 To develop discount rates, consider:  Expected future riskiness of the firm.  Expected future interest rates.  Expected future capital structure.

Chapter: 11 5

Risk-Adjusted Expected Rates of Return (Contd.)  Can use Capital Asset Pricing Model

(CAPM) to develop discount rates.  Expected rate of return needs to be

adjusted if capital structure changes.

Chapter: 11 6

Capital Asset Pricing Model

 For Risk-free rate of return (RF), yield on short- or intermediate term US government securities can be used.

 {E[RM] – E[RF]} known as “market risk premium”

portfolio marketwide on return Required j firm for beta Market

return of rate free-Risk j firm inequity common on return Required

nexpectatio :Where

= = = = =

×+=

M

j

F

Ej

FMjFEj

R ß R R E

]}] –E[R {E[R ß] E[R] E[R

Chapter: 11 7

Cost of Equity Capital and Systematic Risk

Chapter: 11 8

 The market beta reflects operating leverage, financial leverage, variability of sales and earnings and other firm characteristics.

 The analyst can “unlever” the current market beta by adjusting it to remove the effects of leverage

 Then reveler it by adjusting leverage under the new capital structure.

Adjusting Market Equity Beta to Reflect a New Capital Structure

Equity)] of ValueMarket ntDebt/Curre of ValueMarket (Current x Rate)Tax Income (1 [1 x Beta Market Levered Current Beta Market Unlevered −+=

Equity)] of ValueMarketDebt/New of ValueMarket(New x Rate)Tax Income (1 [1 x Beta Market Unlevered Beta Market LeveredNew −+=

Equity)] of ValueMarket ntDebt/Curre of ValueMarket (Current x Rate)Tax Income (1 [1 x Beta Market Unlevered Beta Market Levered Current −+=

Chapter: 11 9

Evaluating the Use of the CAPM Criticisms of CAPM-  Beta estimates are quite sensitive to the time

period and methodology used in computation.  Return index for a diversified portfolio of

assets that spans the entire economy does not exist.

 The market risk premium is not stable over time.

Therefore, it is important to analyze the sensitivity of share value estimates across different discount rates for common equity.

Chapter: 11 10

Cost of Debt and Preferred Equity Capital  Cost of Debt:  Computed as the yield to maturity on each

type of debt times one minus the statutory tax rate applicable to income tax deductions for interest.

Cost of Preferred Capital:  It is the dividend rate on the preferred stock. In

case of convertible preferred stock the cost will be a blending of cost of non-convertible stock and common stock.

Chapter: 11 11

Weighted Average Cost of Capital  WACC: Considers debt, preferred, and

equity capital used to finance  Calculated as:

costs debt to applicable rate is rateTax capital of type each of proportion isw

capital of type each of cost is R

:Where 1

1

=++

×+×+××=

EPD

EEPPDDA

www

]R[w]R[w]–tax rate)(R[wR

Chapter: 11 12

Dividends-Based Valuation  The rationale for using expected dividends

in valuation is two fold: Dividends measure the cash that investors

ultimately receive from investing in an equity share.

Cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities.

Chapter: 11 13

Dividends-Based Valuation (Contd.) Dividends include all cash flows between

firm and shareholders: Periodic dividend payments Stock buybacks The liquidating dividend And “negative dividend” when firm initially

issues stock

Chapter: 11 14

Dividends valuation model:

T E

T T

E

T

EE

t t

E

t

)R( V

)R( D

)R( D

)R( D

)R( D

V

+ +

+ ++

+ +

+ =

+ = ∑

∞

=

11 ....

11

1

2 2

1 1

1 0

T EE

TTT

EE )R(-g)(R g)]([BVBVg)]([NI

)R( D

)R( D

+× +×−++×

++ +

+ +

= 1

11 ....

11 2 2

1 1

:Perpetuity Growing With

Dividends-Based Valuation (Contd.)

Chapter: 11 15

Involves measuring the following three elements: Dividend (Discount rate = RE) Expected future dividends (Dt) for periods 1

through T over forecast horizon. Continuing or final (DT+1), and long-run growth

rate (g).

Dividends-Based Valuation (Contd.)

Chapter: 11 16

Measuring Periodic Dividends  Assume clean surplus accounting is

followed.  Under U.S. GAAP and IFRS, clean surplus is

measured by other comprehensive income as well as net income.

Chapter: 11 17

Measuring Periodic Dividends (Contd.)  Effects of transactions between firm and

common shareholders are included in book value.

 Thus, accounting for common equity is represented by:

t-ttt

tt-tt

BVBVID DIBVBV

−+= −+=

1

1

Chapter: 11 18

Forecast Horizon Represented by periods 1 through T in the

dividends valuation equation. Depending on: The industry. Firm’s maturity. Expected growth and stability.

Should be until firm reaches steady-state equilibrium. Difficult for young, high-growth firms.

Chapter: 11 19

Continuing Value of future dividends  Represented by last term of equation on

slide 14.  Use long-term growth rate assumption (1+

g) uniformly on the year T+1 income statement and balance sheet projections to derive the dividends for the year T+1 correctly.

 Thus: g)](–[BVBVg)]([NI

–BVBVNID

TTT

TTTT

+×++×= += +++

11 111

Chapter: 11 20

What now? Once valuation model is applied, then Conduct sensitivity analysis: Vary cost of equity capital rate (RE) Vary long-run growth rate (g) Discount rate assumptions Vary these parameters and assumptions

individually and jointly.

Chapter: 11 21

 Advantages:  Dividends provide a classical approach to

valuing shares as they reflect the payoffs that shareholders can consume.

 Reflect the implications of analyst’s expectations for the future operating, investing, and financing decisions of a firm.

Evaluation of the Dividends Valuation Method

Chapter: 11 22

 Disadvantages:  Continuing value estimates are sensitive to

assumptions made about growth rates after the forecast horizon and discount rates.

 The projection can be time-consuming for the analyst.

Evaluation of the Dividends Valuation Method