Chapter 8 Creating Value Through Required Returns

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Foundations of Value Creation

Industry Attractions
Competitive Advantage Valuation Underpinnings Create Excess Returns

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Favorable Industry Attractiveness

Growth Barriers to entry Patents Temporary monopoly power Oligopoly pricing All competitors are profitable
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Avenues to Competitive Advantage

Cost advantage
Marketing and price advantage Superior organizational capability Corporate culture
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Required Market-Based Return

Single project Division with similar risk Over all company (WACC) Incompatibility Security returns Capital project returns
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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 Expected return on the market portfolio Risk-free rate
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APT Factor Model Approach

Firms reaction coefficients x lambda Lambda = market prices of factor risks Sum the products Add the risk-free rate Risk is the function of the responsiveness coefficients for each of the factors of importance.
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Use of Accounting Betas

Based on accounting data Related to an economywide index
Data readily available

Useful in developing countries

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Modification for Leverage

CAPM Business risk Degree of leverage Beta modification Unlevers the proxy companys beta Relevers for a different degree of leverage Beta adjustment procedure is crude
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Weighted Average Required Return

Separation of investment from financing Assumed target capital structure Cost of debt After-tax Uncertain future tax return Cost of preferred stock (P/S) Function of its stated dividends Corporate dividend exclusion Other types of financing
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Determining the Value of a Project

WACC APT

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Calculating WACC
Weighting the costs Weights correspond to the market values of the forms of financing Do not use book values Each component is weighted according to market-value proportions

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Limitations
Marginal weights Incremental capital Ignore temporary deviations Flotation costs Adjustment made in the projects cash flows Adjusting the cost of capital (biased estimate)
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Rational for WACC

Increase the market price of the companys stock
RRR ke ko

CAPM
SML

kp
ki Rf

Laddering of returns required

X
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EVA Required dollar-amount return for the capital employed

Operating profits

Force attention to the balance sheet

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MVA
Companys total market value

- Total capital invested since origin

Debt & equity

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Interpreting EVA & MVA Results

Use accounting book values as measures of invested capital Make adjustments to better approximate invested cash Calculated capital employed Historical, sunk cost
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Adjusted Present Value

APV

Projected cash flows

= Unlevered value + Value of financing

As risk increases the discount rate increases

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WACC Versus APV

WACC is accurate Maintain constant debt ratio Invest in similar projects Easy to understand & widely used APV is accurate Depart radically from previous financing patterns Invest in a new line of business Not widely used in business
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Divisional Required Returns

The proxy company approach Solving for beta Sum of the divisions = the whole Proportion of debt financing Adjusting costs of debt and equity Alternative approach Use both proxy debt & equity
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Implications for Project Selection

Consider risk involved Divisional hurdle versus WACC Adverse Incentives Conservative Aggressive Risk-adjusted returns System for allocating capital to divisions
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Companys Overall Cost of Capital

Dividend Discount Model DDM Perpetual growth situations Constant rate Growth segments DDM versus market model approaches Assumptions
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Diversification of Assets & Total Risk Analysis

Investors diversifying across capital assets Tracking stocks Imperfections & unsystematic risk Bankruptcy costs Evaluation of combinations of risky investments Standard deviation Expected value Selecting the best combination Project combination dominance
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When Should We Take Account of Unsystematic Risk?

Conflicting signals Market approach Total variability approach Companys stock is traded in inefficient markets

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Evaluation of Acquisitions
Free cash flows Market model implications Enhance the value of a company Purchase price & required return Synergy Diversification effect Effect on total risk
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