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Industry attractiveness Competitive Advantage

Valuation underpinning

Relative position of an industry in the spectrum of return generating possibilities.

Favorable industries: Growth Monopoly power Oligopoly pricing

Avenues to Competitive Advantage :

Cost advantage

Marketing and price advantage

Superior organizational capability

Valuation Underpinnings :
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.

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 eta () 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 "and the Required Return (RR), also increase. Consider the case when;
Proxy company = Leverage Our company = No leverage will be biased and the result would be a higher RRoE, which is not what we were looking for.

Adjusting for Leverage

For Absence Of Leverage:

For An Amount Of Leverage

Adjusting for Leverage

Note:
For calculation of with absence of leverage, we use the proxy companys debt to equity ratio and tax rate.

For calculation of for an amount of leverage, we use our own companys 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 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

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

proportions 30% 10 60 100% WACC=KdWd+KpWp+KeWe Kd=4.80% Kp=8.68% Ke=?

Sources Debt Preferred stock Common stock equity

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

WACC=KdWd+KpWp+KeWe
source Debt Preferred stock proportion 30% 10 After tax cost 4.80% 8.68 Weighted cost 1.44% .87

equity

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 coststhe 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

WHERE
ANNUAL CASH INFLOWS OF $12000 FOREVER COST OF CAPITAL=10% INITIAL OUTLAY=$100,000 FLOATATION COST=$4000 Adjustments 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 returnFirm is able to increase the market price of stock

Laddering of returns required

Economic value added

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

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

Market value added

Wealth enhancement measure Companys total market value at a point in time less: total capital invested in the company since its origin Common stocks consideredthat is market value of common stock less invested equity capital It 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

n OC t Int (Tc ) APV F t t t 0 (1 k u ) t 0 (1 k i ) n

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

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%.

NPV $2,000
t 1

$400 (1.13)
t

$80

 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 of Year 1 2 3 4 5 6 7 8 total Debt outstanding $1000** 875 750 625 500 375 250 125 Interest
$100 88 75 62 50 38 25 12

Interest Tax Present value Shield*(40%) @10% discount rate $40 $36 35 29 30 23 25 17 20 12 15 8 10 5 5 2 132

 APV= -$80+$132=$52 After tax FLOATATION COSTS= $40,000 Cost of lawyer, investment bankers, printers, and other fees involved in issuing securities APV= -$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

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

 Some companies have tracking stocks for certain standalone 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

Investors diversifying across capital Assets cont

Tracking stock investors dont 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.

 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.

Imperfection and unsystematic risk

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

Evaluation of combination of risky investments

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 cont..

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

When should we take account of unsystematic risk

There are two ways to evaluate risky investments as
i. ii. Evaluate a project in relation to its systematic risk, the market model approach. 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

Evaluation of acquisitions
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 cont

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

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 divisions 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 riskadjusted 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.

COMPANYS 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 firms 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