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Consider conversion tables (Stickney-
p. 766)
114
Cost of Capital
Debt
Market rate (1-tax rate)
Leases: use borrowing rate
Preferred Equity
Dividend rate
Common Equity
Risk free rate + (Mkt. Rate - RFR)
Betas published in S&Ps stock reports
115
Releveraging @ New Capital
Structure
B
L0
=B
U
[1+(1-tax rate)(
Current Debt
)]
Current Equity
Substitute B
U
with new capital structure
B
L1
=B
U
[1+(1-tax rate)(
New Debt
)]
New Equity
116
CAPM Critique
Unstable s
Unstable MROR
Size vs. s
117
Valuation Techniques
Equity
CF
U
-[(interest)(1-tax rate)]
Cost of equity capital
Debt plus equity
CF
U
Wtd. average cost of capital
Adjusted present value
CF
U
Unleveraged cost of equity cap.
[interest(tax rate)] cost of debt cap.
118
Unleveraging
CEC
U
= CEC
L
- [(
current debt
)(1-tax rate)(CEC
U
-CDC)]
current equity
119
Cash Flow Evaluation
Advantages
Economic base
Rigorous methodology
Disadvantages
Residual value dominant
Time consuming
Subjective
120
Price-Earnings Ratio
Chapter 12
Higher risk -> lower PE
Theoretical model
P/Actual earnings = (1+g)/(r-g)
121
Theoretical Variances: PE
Earnings persistance
Transitoryno change in PE
Permanentchange in PE
Accounting principles
Lower earningshigher PE
122
Trending
Penman found transitory earnings
consistencythat is high PE caused
by lower than normal earnings is
counterbalanced in the following
year.
5-7 years reversion to mid-teens
growth
123
PE Ratio Factors
Risk (cost of capital)
Growth
Earnings persistence
GAAP
124
PE Analysis Keys
Use a sustainable growth rate
Doesnt work when g>r
Doesnt work when g approximates r
Test reasonableness with actual PE
Existence of transitory earnings
Impact of GAAP
125
Price to Book Value
Market rewards growth in excess of
cost of capital
Ultimately reverts to 1.0
Function of
Profitability
BV growth
126
P/BV-Theoretical Model
1+ [(Expected ROCE-r)(BV
t
)/(1+r)
t
]
BV
0
127
Theoretical Variances: P/BV
ROCE errors
Cost of capital errors
Growth rate errors
Transitory earnings
GAAP impact
lower earningshigher P:BV
128
Trending: P/BV
ROCE remains consistent and
reverts to 1.0 slowly.
129
Cash Flow vs. Earnings
Long term impact is indifferent
Short term impact: earnings more
indicative
Use multiple approaches