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CREATING VALUE THROUGH REQUIRED RETURNS

•Industry attractiveness

1

•Competitive Advantage

2

•Valuation underpinning

3

FOUNDATION OF VALUE CREATION:

Relative position of an industry in the

spectrum of return generating possibilities.

Favorable industries:

Growth

Monopoly power

Oligopoly pricing

INDUSTRY ATTRACTIVENESS :

Cost advantage

Marketing and price advantage

Superior organizational capability

Avenues to Competitive Advantage :

Required rate of return : The return on a risk free asset + market price of risk.

Greater the systematic risk, greater expected return by financial market.

Separation of required Return and the Firm.

Valuation Underpinnings :

Required Market-Based Return

Single project

Division with similar risk

Over all company (WACC)

Incompatibility

Security returns

Capital project returns

Proxy Company Estimates :

• Deriving surrogate company returns

Sample of matching companies

Betas for each proxy company

Calculate central tendency

Derive RRR on equity using proxy beta

Required Rate of Return:

Median Beta = 1.60 Market portfolio return= 11%

Risk free rate = 6%

Rk= .06+(.11-.06)1.60= 14.0%

SAMRA ZAFAR

MODIFICATION FOR LEVERAGE

Modification for Leverage

• Unlevered Situation = Financed by Equity Only

• DEFINITION

– “The use of various financial instruments or borrowed capital, to increase the potential

return of an investment.”

Modification for Leverage • Most companies use debt to finance operations. By doing so,

a company increases its leverage because it can invest in business operations without increasing its equity.

• Leverage = Gearing = Solvency

• Greater the Leverage = Greater the Risk

• Adjustment of βeta (β) is needed …. WHY?– Relationship between Required return on equity (RRoE) and Leverage

Relationship b/t RRoE & Leverage

Modification for Leverage • With an increase in “Debt Financing”, the "β”and the

“Required Return” (RR), also increase.

• Consider the case when;– Proxy company = Leverage– Our company = No leverage

β will be biased and the result would be a higher RRoE, which is not what we were looking for….

Adjusting β for Leverage • Β For Absence Of Leverage:

• Β For An Amount Of Leverage

Adjusting β for Leverage • Note:

– For calculation of “β” with absence of leverage, we use the proxy company’s debt to equity ratio and tax rate.

– For calculation of “β” for an amount of leverage, we use our own company’s debt to equity ratio and tax rate.

– Assumption is taken that the “Capital Market is Perfect”, and Corporate taxes are the only adjustment.

Weighted Average Required Return (WARR)

• Use adjusted β to determine “Cost of Equity Capital” for the project and than go on to determine the “Weighted Average Required Return”.

• We solve for “Cost of Debt” and “Preferred Stock”….

Weighted Average Required Return (WARR)

• COST OF DEBT:

– To get cost of debt we solve for discount rate (k), which equated the proceeds of debt issue and Present value of Interest plus Principle payments.

Weighted Average Required Return (WARR)

• COST OF PREFERRED STOCK:

– Stocks offered by the company, which take priority over the common stocks.

– Not an obligation but the discretion of board members.– No risk of legal bankruptcy– No maturity date

Weighted Average Required Return (WARR)

• COST OF PREFERRED STOCK:

– The dividend is paid after taxes.– Why preferred stock?

• 70% of the dividend received by one company from another company is tax free.

• Return is less than that of “Bonds”

KASHMALA LATIF

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Weighted Average Cost of Capital(WACC)

Definition: WACC is a blended required return of the various capital costs making up capital structure

Other types of financing• EQUITY• DEBT and• PREFERRED STOCK are Major sources

• Leasing, convertible securities, warrants and other options

• Sources proportions• Debt 30%• Preferred stock 10• Common stock equity 60 100%WACC=KdWd+KpWp+KeWeKd=4.80%Kp=8.68%Ke=?

Ke=6%+(11%-6%)1.10=11.50%Rm=11%Rf=6%Beta for proxy company=1.10

WACC=KdWd+KpWp+KeWe

source proportion After tax cost Weighted costDebt 30% 4.80% 1.44%Preferred stock 10 8.68 .87equity 60 11.50 6.90

9.21%

Weighting the costs

In WACC , the weights employed must be according to the proportions of financing inputs the firm intends to employ.

Weights corresponds market value

• Assume Current financing proportion will remain unchanged.

Some limitations

• WACC represent True cost of capital….critical question

• How accurately Measure marginal costs of the individual sources of financing

• Marginal weights• Floatation costs

Marginal weights

• Concern with new or incremental capital…. Work with Marginal cost of capital

• For WACC the weights employed must be marginal and according to proportions specified…. Effect on decision making

• Capital raising is lumpy…. Strict proportions cannot be maintained

Floatation costs

• Floatation costs…the cost associated with issuing securities, such as underwriting, legal, listing and printing fees…. Reduce inflows because they are out of pocket

• Adjustment of floatation costsin evaluation of investment proposal

adjusted to initial outlay(AIO) adjustment to discount rate(ADR)

AIO NPV=$12000/.10 MINUS($100,000+$4000)=$16000 NPV=$12000/.10 MINUS($100,000 )=$20,000

WHEREANNUAL CASH INFLOWS OF $12000 FOREVERCOST OF CAPITAL=10%INITIAL OUTLAY=$100,000FLOATATION COST=$4000Adjustments are made in projects cash flows and

not in cost of capital

ADR

In the presence of floatation costs Each component cost of capital is recalculated by finding the discount rate that equates the present value of cash flows to suppliers of capital with the net proceeds of security issue

Current market price of every security is replaced with current net proceeds of each new security…..biased estimate of true value so we favor AIO

Rationale for weighted average cost

• Financing in the proportion specified and accepting projects yielding more than the weighted average required return…Firm is able to increase the market price of stock

Laddering of returns required

Economic value addedNet operating profit after tax or economic profit $35 millionLess(capital employed *cost of capital) $180 million*12=$21.6millionEconomic value added=$13.4million

• Firm is earning return in excess of what the financial market requires

Market value added

• Wealth enhancement measureCompany’s total market value at a point in timeless: total capital invested in the company since

its originCommon stocks consideredthat is market value

of common stock less invested equity capitalIt relate to M/B ratio

Adjusted present value

Alternative to WACC Proposed by Stewart C. Mayers.

Adjusted Net Present Value (APV)

An approach to value a project as if it were

financed entirely by debt and then adding to this

the present value of the tax shields provided by

debt financing.

Adjusted Net Present Value (APV)

• With an APV method, project cash flows are broken down into two components

• Unlevered operating cash flows and those associated with financing the project. These components then are valued so that

APV = unlevered value + value of financing

MORE FORMALLY, THE adjusted present value is

• Where OCt= after tax operating cash flow in period t• Ku=required rate of return in the absence of leverage• Int=interest payment on debt in period t• Tc= corporate tax rate• Ki= cost of debt financing• F= after tax floatation cost associated with financing

Fk

TInt

k

OCAPV

n

tt

i

cn

tt

u

t

00 )1(

)(

)1(

Illustration• Gruber Alten Paper Company is considering a new production machine costing $ 2

million, that is expected to produce after tax cash saving of $ 400,000 per year for 8 years. The required rate of return on unlevered equity is 13%.

8

1

80$)13.1(

400$000,2$

tt

NPV

• Policy of the company to finance capital investment projects with 50%debt as that is targeted debt to capitalization of the company.

• Company is able to borrow $1million at 10 percent interest to finance the new machine part.

• The principal amount of loan will be repaid in equal year end installments of $125,000 throgh the end of year 8. if the company tax rate 40% than interest tax shield and its present value can be calculated

PRESENT VALUE OF INTEREST TAX SHIELD FOR GRUBEN ELTON PAPER COMPANY(IN THOUSANDS)

Begining Debt Interest Interest Tax Present valueof Year outstanding Shield*(40%) @10% discount rate

1 $1000**$100 $40 $36 2 875 88 35 29 3 750 75 30 23 4 625 62 25 17 5 500 50 20 12 6 375 38 15 8 7 250 25 10 5 8 125 12 5 2

total 132

• APV= -$80+$132=$52• After tax FLOATATION COSTS= $40,000• Cost of lawyer, investment bankers, printers,

and other fees involved in issuing securitiesAPV= -$80+$132-$40=$12

WACC vs APV

• WACC when firms maintain constant debt ratio over time in projects….financial and business risk are invariant over time

easy, n widely used but biassness• APV when company depart from previous

financing pattern and invest in new line of business

AMNA TABASSUM

The method of dividing investment funds among a variety of

securities with different risk, reward and correlation

statistics so as to minimize unsystematic risk is called

diversification

Shareholders purchase shares in the income stream of the

company as a whole, not in the income streams of the

individual assets of the company

DIVERSIFICATION OF ASSETS AND TOTAL RISK ANALYSTS :

As long as there is information available about the

actual returns on the individual assets, investors can

effectively diversify across capital assets of individual

companies

An investor can replicate the return stream of the

individual capital asset held by a firm

INVESTORS DIVERSIFYING ACROSS CAPITAL ASSETS :

• Some companies have tracking stocks for certain stand-

alone business units. It is a device for transparencies.

• Tracking stock permit investors to buy a particular part of the

enterprise, in the sense of participating in the income stream,

but not necessarily the overall enterprise

• Tracking stock investors don’t have a claim on the business

units assets, they participate in the value creation of the

business units

• The firm is said not to be able to do some thing for investors

through diversification of capital assts that they cannot do for

themselves according to the value additive principal.

Investors diversifying across capital Assets cont……

• Value additive principal states that the value of the whole is

equal to the sum of the units

• Projects would be evaluated on the basis of the their

systematic risk because various empirical studies confirm

that diversified companies are less values than are more

focused companies.

• The variability of cash flows of a company depends upon

total risk not just systematic risk as

total risk = systematic risk + unsystematic risk

• The probability of a company of becoming insolvent is a

function of its total risk

• Bankruptcy is the state of insolvency of an individual or an

organization i.e., inability to pay debts.

• Bankruptcy costs are the principal imperfection that may

make firm diversification a thing of value

Imperfection and unsystematic risk

• As the marginal risk of individual proposal to the firm as a

whole depends on its correlation with existing projects and

its correlation with proposals under consideration

• Standard deviation and expected value of the probability

distribution of possible net present values for all feasible

combinations of existing projects and proposals under

considerations, are the appropriate information

Evaluation of combination of risky investments

• Selecting the best combination

– The selection of the most desirable combination of investment will

depend on management utility performances with respect to net present

value and variance or standard deviation

– Graphical representation between net present value and standard

deviation

• Project combination dominance

– Total risk of the firm is what important, therefore investment decision

should be made in light of their marginal impact on total risk

Evaluation of combination of risky investments cont…..

• There are two ways to evaluate risky investments as

i. Evaluate a project in relation to its systematic risk, the

market model approach.

ii. Analyze the incremental impact of the project on the

business-risk complexion of the firm as a whole, the total

variability approach

Note: total risk is relevant only if imperfections are important

When should we take account of unsystematic risk

• One company taking over controlling interest in another

company is called acquisition.

• Acquisition can be analyzed according to its expected return

and risk in the same manner as we analyze any capital

investment

• The relevant future cash flows are free cash flows, those left

over after making all investments necessary to produce the

expected cash flow stream

Evaluation of acquisitions

• Market Model Implications

– Under the assumption of market model (CAPM or APT factors) it is

clear that investors are able to achieve the same diversification as the

firm can achieve for them

– Above point is particularly apparent in the acquisition of a company

whose stock is publically held

– The acquiring company must be able to effect operating economies,

distribution economies or other synergies if the acquisition is to be

the thing of value

Evaluation of acquisitions cont…

– Synergy means efficiency gains such that the whole is worth more

than the sum of the parts as 2 + 2 = 5

– It is an easy matter to measure the required rate of return for the

acquisition of a company whose stock is publically traded

– The important point to remember is that under the assumptions of

market model, the present values of cash flows will exceed the

purchase price only if there are operating economies and/or

improved management

Evaluation of acquisitions cont…..

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Divisional Required Return

• Company has more than one Business Line– Each Business Line is a division or Subunit of that

company

• In order to implement financial Policy we have to made Cost of Capital for Each Unit and make planning,

• The Company transfer it cost of Capital for its unit

Solving of Beta

• Beta – Measuring the systematic risk of different investment.– The company or divisions of company has larger beta are

more riskier.– Divisional Beta– we make beta for each unit of the company that tell us

which unit is more riskier than other.– It can be calculated by– The sum of proxy betas multiplied by market value weights– Market to book value

Cost and Propotion of debt funds

Cost Of Debt

• Debt costs differ according to a division’s systematic risk

• The greater the risk the greater the interest rate

• Diversification of cash flows among divisions the

probability of payment for the whole may be greater then

the sum of parts

Proportion of Debt funds

If one division is allocated much higher proportion of debt, it

will have lower overall required rate of return

High leverage for one division may cause the cost of debt

funds for the overall company to rise.

The high leverage incurred by the division may increases the

uncertainty of the tax shield associated with the debt for the

company as a whole

High leverage for one division increases the volatility of

returns to stock holders of the company, together with the

possibility of insolvency and bankruptcy costs being incurred.

Adjusting Both Costs

• Both the cost of debt funds and the proportion assigned to division can be varied.

• The greater the systematic risk the higher the interest cost and lower the proportion of debt assigned

• The riskier the business the more equity required to support the activities

Alternate Approach

• An alternate approach is to determine the overall cost of capital composed of both debt and equity funds of proxy companies.

Implication of project selection

• Allocation of capital throughout the firm on a risk-adjusted

return basis.

• Single cutoff rate for project selection

• “No project shall be undertaken unless it provides a return

of 15% “

• Divisions characterized by large systematic risk may

accept projects with expected returns higher then the

companywide.

Divisional hurdle versus WACC

Adverse Incentive

• Divisions with low systematic risk often are too

conservative in project generation and selection vice

versa.• Too often companies put money in those divisions

provides greatest growth opportunities and they will prefer to accept projects consistent with over all growth

• If selected projects too low expected return the company may become riskier

• The incentive scheme is skewed in the direction of growtg and acceptance of risky projects.

COMPANY’S OVERALL COST OF CAPITAL

• If the various investment projects undertaken by a firm do

not differ materially from each other, it is unnecessary to

derive separate project or divisional required rates of return.

• With homogenous risk across investments, it is appropriate

to use firm’s overall required rate of return.

• The cost of equity capital is the minimum rate of return that a

company must earn on the equity-financed portion of its

investments in order to leave unchanged the market price of

its stock.

Dividend Discount Model Approach

• DDM estimates the required rate of return on the equity

for a company overall.

• DDM equates share price with the present value of

expected future dividends. Because dividends are all that

stockholders as a whole receive from their investment,

this stream of income is the cash dividends paid in future

periods and perhaps a final liquidating dividend.

• At time 0 the value of share of stock is

P0 is the value of share of stock at time 0

Dt is the dividend per share expected to be paid in

period t

ke is the appropriate rate of discount

Perpetual growth situation

• If dividends per share are expected to grow at a

constant rate (g) and ke is greater then g, then

Dt is the dividend per share expected to be paid at the

end of period 1

• Thus the cost of equity capital would be

Growth phase

• When the expected growth on dividends per share is other

then perpetual then modification in DDM formula can be

used

Do the current dividend, is the base on which the expected

growth in future dividend is built

ke by solving for k we obtain the cost of equity capital\

Po market price per share

DDM Versus Market Model Approach

• The discount rate determined by the DDM model would be the

same as required rate of return determined by the market model

approach ( if measurement were exact and certain assumptions

are held).

• Both methods suggested enable us to make such an

approximation more or less accurately depending on the situation

• For a large company whose stock is actively traded and whose

systematic risk is close to the market we estimate more confidently

the we can do for moderate size company.

• When the cost