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Finance (Subject) / WACC (Lesson)
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- Company Cost of Capital Expected return on a portfolio of all the company’s existing securities. It is the opportunity cost of capital for investment in the firm’s assets, and therefore the appropriate discount rate for the firm’s average-risk projects. If the firm has no debt outstanding, then the company cost of capital is just theexpected rate of return on the firm’s stock. company cost of capital is not the correct discount rate if the new projects are moreor less risky than the firm’s existing business.
- Fudge Factors Fudge Factor: Factor added to the WACC in order to determing the hurdle rate (required rate of return) Adding fudge factors to discount rates undervalues long-lived projects compared with quick-payoff projects Projects should be taken in they have a positive NPV based on WACC No good justification: Poor arguments CFs are too optimistic, so we fix hurdle rates We need to build in a profit target More uncertainty about a project
- What is included in Debt if we take the Book Value? Net Debt = LT Debt + ST Debt - Cash If Cash is not needed for WC Purposes it can be used to pay off debt Only use when firm is not highly leveraged Include PV of Financial Lease Payments Include Operating Leases: Not Capitalized (Rating agencies treat them as debt with value = 8*Annual Lease Expense) Deficits in company sponsored pension plans Do not Include: Trade debt, as it is part of WC
- How to compare 2 similar companies with different degrees of leverage? We cannot simply average out equity betas for firms with different leverage WACC of a firm is affected by Business Risk of the firm: How do firm revenues co-vary with economic conditions? What is the firm's cost structure? (Industry Risk) Financial Risk of the firm: How leveraged is the firm? - Equity Beta of each firm will reflect both underlying risk of the business and the risk from financial leverage - 2 Firms with the same Business Risk can have different WACC if they have different capital structures You can only compare firms with similar capital structures. Best: Only compare the cost of capital for all-equity firms = Cost of Assets or the Return on assets It is the Cost of Capital (WACC) for a similar all-equity firm
- What proportion of a stocks return was estimated by market movements? R Square of Scatterplot was due to market movements. Risk that SE care about Market Risk Systematic Risk Undiversifiable Risk 1- R Square was diversifiable. Diversifiable risk shows up in the scatter about the fitted line. Risk that SE do not care about Firm specific Risk Unsystematic Risk Diversifiable Risk Ideosyncratic Risk The SE of the estimated beta was unusually high at 2. If you said that the true beta was 2*SE either side of your estimate, you would have a 95% chanc eof being right.
- Beta Captures extent to which a share contributed to Portfolio Risk a measure of cyclicality. How much does your share move then when the market moves Why is std not a good measure? Std is too specific and can be removed Beta is the undiversifiable Risk A volatile stock can have a low Beta as its correlation with the market is los Betas are Estimations: Different services come up with differenct betas, beause they use different approaches to measure co-movement Depends on years of data, periodicity, which market, etc. How to estimate Beta? Obtain data on monthly returns i.e. Barlcays Returns on FTSE100 Make scatterplot of monthly returns onn the individual security you want to compute the beta and monthly returns on the market (i.e. commodities, stocks, bonds, currency) Beta is the slope of a regression line which best fits the scattter plot of monthly return on the shared of the firm on the market index. Beta = cov(Ri,Rm)/Var(Rm) R Square= How much of the stock variance is explained by the FTSE100 (Market Risk) Trade Off between Long-time series data (statistical Power) s. Structural breaks (i.e.relevance?)
- Risk Premium Compensation for taking on risk higher in Bad times than in Good Times due to expectations, due to Risk tolerance (risk seeking people sell to people who are risk averse) When Investor is Risk Averse, he is happy with a lower Risk Premium
- Sharpe Ratio Max Slope of the efficient frontier
- Private Companies Use return on equity for similar publicly traded firms in the same industry make sure the leverage ratios are similar, or to adjust for the different degrees of leverage ratios since the required rate of return on equite depends on leverage
- WACC Assets of a busienss are financed by both debt and equity If we want to value the assets, we should take into account both sources of financing Risk on assets is not directly traded WACC belongs to the assets. We use cost of equity and debt to infer WACC, but we should never forget that the true WACC depends on the risk of the assets to the business. Weights should be based on market values Debt should be chaper as they get money first (1) Value of Equity = #shares outstanding * price (2) Value of Debt = difficult unless firm has publicly traded bonds outstanding BV or balance sheet value is used, which is good if leverage is not very high --> What would the interest rate be on my debt if we refinanced all our debt now?
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- Asset Beta Asset Beta of a firm is the Beta that the firm would have if it was 100% financed from Equity Reflects only Business risk of a firm = underlying systematic risk (Beta) No impact of financial structure on equity Beta of each firm Can be averaged across firms with similar addets Can be inferred from debt and equity betas from formula