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Strategic Capital Group
Workshop #8: Cost of
Capital
Previously, on SCG Workshop…
We discussed ways to forecast revenue:
1.) Use past historical growth rates to predict future rates
Works well if you expect the company to remain stable at its
current levels, ineffective if company is changing.
2.) Use analyst estimates as a benchmark and adjust them slightly to
reflect the differences between your opinions
3.) Compute numbers yourself
We will work
on this today
Previously, on SCG Workshop…
We talked about how you can forecast revenue by taking analyst
estimates for the next 5 years, reading their report on why they
picked their numbers, then using your own opinion about the
company to adjust the projection accordingly.
Analyst Estimate: $50B
in revenue (10% growth
over 2011)
Analyst thinks
the product sell
decently this
year so picked
10% growth
rate.
You think the
product will
grow faster
than the
analyst thinks,
so you go 12%
Change in Net Working Capital
• We learned that you can forecast the change
in Net Working Capital by forecasting
multiples such as Days Sales Outstanding,
Days Payable Outstanding, Days Inventory
Held, etc. which are fairly stable (and thus
easy to forecast), then using the forecasted
numbers for revenue and COGS to figure out
the account balances of the current accounts.
So what’s left?
• We know what our revenue and costs will be over
the next 5 years, we know NWC and the
depreciation and CapEx.
• We’ve reached free cash flow, but we need to
figure out what the cash flows are worth today.
We need to discount them back to the future.
• But what discount rate do we use? How do we
find an discount rate that reflects the diversity of
risk within our specific company?
Weighted Average Cost of Capital
• What is it?
• Essentially the weighted average rate a
company expects to pay out to its financing
sources (both debt and equity holders)
• We use this rate as a discount rate for the cash
flows.
• It is also the long-term return we expect on
the investment
Weighted Average Cost of Capital
Equation:
WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity
Essentially:
How much return all of our financiers get =
How much return the equity holders demand * weighting of equity +
How much return the debt holders demand/get * weighting of debt
Cost of Debt
In order to find what the company pays to its debt holders, we
should find what the weighted average interest rate for their debt
is (on the 10-K)
We then weight the average interest rate they pay (by
multiplying it by what percentage of their capital comes from
debt capital) then multiply it again by (1-tax rate) to adjust for
the tax deductibility of interest expense.
(Average Interest Rate * %debt) * (1-tax Rate)
Check for Understanding
• So what is the cost of debt for a company that
has all of its money from equity holders?
0! If we don’t have any
debt, then we don’t care
about debt financing
costs.
(Average Interest Rate * %debt) * (1-tax Rate)
Check for Understanding
• If a company’s credit rating goes down, what
happens to its cost of debt?
(Average Interest Rate * %debt) * (1-tax Rate)
HINT: a decrease in credit rating will drive up your
average interest rate
Cost of debt will increase
Cost of Equity
Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf)
Essentially how
much an extra
return an investor
gets for taking on
equity risk.
Can take a 5-20 year
average of S&P or
DOW’s returns or just a
1 year.
10- Year
Treasury Yield
(Market Premium * Beta) + Risk-Free Rate = Cost of Equity
Adjusting the
equity returns
for risk
Typically a long
term beta
Check for Understanding
• If the returns in the equity market increases,
what happens to a company’s cost of equity?
Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf)
(Market Premium * Beta) + Risk-Free Rate = Cost of Equity
It increases, since now in order
to compete for financing dollars
through equity, the company
must effectively yield more
returns to entice investors.
WACC
So what is the calculation for it?
WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity
How much a company pays out
on its debt (its interest rate),
adjusted for how much debt it
holds
How much a company
return to equity holders (by
dividends or share price
appreciation) in order to
entice people to invest in its
equity
Weighted Average Cost of Capital
• What influences it?
– Market Interest Rates
– Company Volatility (beta)
– Equity market returns
– Risk-free rates
– Tax rates
STOP!
• We just learned how to calculate WACC, the
value we will be using for our discount rate.
• IT IS IMPERATIVE YOU YELL AT ME AND ASK
QUESTIONS!
Discounting
We use the PV equation to discount each cash
flow back to its present value.
Remember:
PV = (FV/ (1+ Discount Rate) ^ years away)
Discounting
• We’re still missing part of the value of the
company, the company wont stop functioning
after 5 years, technically we need to do this
for the entire life of the company to find what
the company is worth.
• We call the estimation of a company’s cash
flows from t=5 to t= infinity its “terminal
value”
Critical Thinking
• If we’re taking the PV of an infinite number of
years’ cash flows, shouldn’t the PV end up
being infinity?
No- as you get further and further into the
future, a dollar becomes worth less and less
until it eventually becomes worth nothing.
If I offer you $1 100 years from now, it
will cost more to buy a post-it note to
remember I owe you money than the
PV of $1
Terminal Value
• 2 ways to calculate this:
– Exit Multiple Approach
– Long-term growth rate approach
Terminal Value: The Exit Multiple
Approach
• We can multiply the 5th year’s cash flow by a
multiple of EV/EBITDA we plan to sell the
company at in the future, then discount it
back at year 5.
Terminal Value = 5th Year Cash Flow * Projected (EV/EBITDA)
Terminal Value = 1800 * 5 = 9000
2012
1000
2013
1200
2014
1400
2015
1600
2016
1800
Exit:
5x
So how do we know what to make
EV/EBITDA?
• Several methods with differing degrees of
difficulty:
– Use the current multiple the company is trading at
• Does not capture the future potential
– Use the current industry multiple
• Effective if you think the company will return to this
value (because it is currently undervalued)
– Calculate your own
• Use your 5th year projections to come up with a 5th year
EBITDA, use current EV and compute a multiple.
Terminal Value: The Exit Multiple
Approach
• We discount this terminal value back to the
present value using year=5, not infinity.
Calculated FV Terminal Value
PV Terminal Value =
(1+Discount Rate) ^5
Terminal Value: The Long-Term Rate
• We can also calculate terminal value by
figuring out the “long-term growth rate” of a
company- essentially the amount we expect a
company to grow consistently in the future
once it has matured. Typically this number is
just slightly larger than US or world GDP
growth.
5th Year Cash Flow * (1+LT Rate)
Terminal Value =
Discount Rate – LT Rate
Terminal Value: the Long Term Rate
5th Year Cash Flow * (1+LT Rate)
Terminal Value =
Discount Rate – LT Rate
1800
x
(1+3%)
Terminal Value =
12%
–
3%
Problems you may encounter: In companies with
low WACC, this makes the terminal value VERY
high, making this method ineffective.
So…
• At this point we’ve figured out how to forecast
a companies revenues and costs to get to free
cash flow.
• After this, we discount the cash flows and a
terminal value back to the present value using
our WACC as a discount rate.
• So now we have a pile of PV’d cash, and need
to figure out a share price from this.
We do this…
• By turning this lump of cash into its enterprise
value (more on this next slide), then figuring
out equity value from this through some
simple algebra.
Enterprise Value
• We need to discuss another way to measure
the size of a company.
• Previously we said market cap was a way to
size a company (Price * shares outstanding)
• But this had the issue of not taking into
account the debt that was used to fund a
company.
• We adjust for this problem by calculating
Enterprise Value
Enterprise Value
• EV is essentially the amount of money you
would have to pay to “take over” a company,
buying all of its debt and equity.
EV = Market Cap + Debt – Cash +Preferred Shares + Minority Interest
We take out cash
because when we
buyout a company,
we are paying cash
for cash, which
cancels out.
Here we are taking
into account nonequity shares we
have to buyout
Getting to Enterprise Value from Cash
Flows
After discounting the terminal value and the
FCF’s from the 5 projected years, we add them
all up to reach our implied Enterprise Value.
From this, we solve for market cap by taking out
the current year’s debt, preferred shares, and
minority interest, leaving us with Market Cap +
Cash. We divide this value by the shares
outstanding to find the implied price per share.
EV = Market Cap + Debt – Cash +Preferred Shares + Minority Interest
So essentially, we are left with Market Cap after taking out all the debt and stuff
from our big pile of PV’d cash. Since market cap is just Price * shares oustanding,
we divide the remainder of the PV’d cash (after everything else is taken out) by
shares outstanding to get an implied share price.