Valuation - the Strategic Perspective
Autor: Maryam • December 27, 2017 • 2,581 Words (11 Pages) • 487 Views
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- Brief evaluation of spreadsheet approach
- Advantages
- Expressed in financial statements familiar to business community
- Data are year by year with any desired detail of individual balance sheet or income statement accounts
- Flexibility and judgment in formulating projections
- Disadvantages
- Numbers used in projections may create illusion that they are actual or correct numbers
- Link between projected numbers and economic or business logic may not be clear
- May become highly complex
- Details may obscure driving factors important in making projections
- Cost of Capital
- Steps involved in calculation of cost of capital
- Calculate cost of equity capital
- Calculate cost of debt
- Formulate applicable financial structure or financial proportions
- Apply applicable financial proportions to cost of equity and cost of debt
- Final result is weighted cost of capital
- Cost of equity
- Capital Asset Pricing Model (CAPM)
- Required return on equity is a risk-free return plus a risk component
- [pic 8]
where:
Rf = risk-free rate
[pic 9]Rf = market price of risk
β = the systematic risk of the individual asset or firm
ke = the cost of equity capital
- Risk-free rate
- Related to returns on U.S. government bonds
- Rates on relatively long-term bonds should be used since discount factor is used in valuation involving long periods
- Market price of risk [pic 10]
- For many years, the market price of risk was estimated to be in range of 6.5 to 7.5 percentage points
- For new economic paradigm in mid 1990s, market price of risk estimated to be in the range 4% to 5%
- For stock market adjustments beginning in 2000, historical range of 6.5 to 7.5 percentage points is again reflected in market valuations
- Returns on the market as a whole have been measured by use of the S&P 500, all stock in the New York Stock Exchange, or other broad benchmark groupings
- Calculation of differential between equity yields and government bonds should be based on geometric or arithmetic means
- Use geometric mean because returns from investments use compounded rates
- Use arithmetic mean because expected returns are calculated by some weighted arithmetic average of future returns
- Beta (β )
- Measures how returns on the firm's common stock vary with returns on the market as a whole
- High beta stocks exhibit higher volatility than low beta stocks in response to changes in market returns
- Market beta is 1.0 by definition
- Estimate available from a large number of source, e.g., Value Line
- Bond yield plus equity risk adjustment
- On average, cost of equity should exceed cost of debt — equity is junior in priority to debt
- Procedure is to analyze historical yield on equity as compared with average yield to maturity on bonds for the company
- Cost of equity = Average yield to maturity of bonds for the company + historical average firm's equity risk premium over its bond yield
- Cost of debt
- Cost of debt calculated on an after-tax basis because interest payments are tax deductible
After-tax cost of debt
- Before-tax cost of debt,
- Can be obtained from published promised yields to maturity of debt issues based on bond rating category of the firm
- Can be obtained from a weighted average of the yields to maturity of all the firm's outstanding publicly held bonds
- Preferred stock
- Most have no maturity and pay fixed dividends
- Cost of preferred stock = Promised dividend / Current market price
- Yield on preferred stock is about the same as yield on long-term debt
- Preferred stocks have greater risk than debt because of its junior position — higher required yield than debt
- Preferred stock dividends received by another corporation are tax exempted from corporate taxes — lower required yield than debt
- Two influences tend to balance out
- Weighted average cost of capital
- Cost of capital, k, is weighted average of marginal cost of equity and debt
- [pic 11]
where:
= cost of debt
[pic 12] = cost of equity
T = tax rate
B = market value of debt
S = market value of equity
V = total market value of firm = B + S
- Methodology focuses on current market opportunity costs,
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