®2002 Prentice Hall Publishing 1 Chapter 8 Creating Value Through Required Returns

1®2002 Prentice Hall Publishing

Chapter 8Creating Value Through

Required Returns


Foundations of Value Creation

• Industry AttractionsIndustry Attractions

• Competitive AdvantageCompetitive Advantage

• Valuation UnderpinningsValuation Underpinnings

Create Excess

Returns


Favorable Industry Attractiveness

• GrowthGrowth

• Barriers to entryBarriers to entry

• PatentsPatents

• Temporary monopoly powerTemporary monopoly power

• Oligopoly pricingOligopoly pricing

– All competitors are profitableAll competitors are profitable


Avenues to Competitive Advantage

• Cost advantageCost advantage

• Marketing and price advantageMarketing and price advantage

• Superior organizational capabilitySuperior organizational capability

– Corporate cultureCorporate culture


Required Market-Based Return

• Single projectSingle project

• Division with similar riskDivision with similar risk

• Over all company (WACC)Over all company (WACC)

• IncompatibilityIncompatibility

– Security returnsSecurity returns

– Capital project returnsCapital project returns


Proxy Company Estimates

• Deriving surrogate company returnsDeriving surrogate company returns– Sample of matching companiesSample of matching companies– Betas for each proxy companyBetas for each proxy company– Calculate central tendencyCalculate central tendency– Derive Derive

• RRR on equity using proxy betaRRR on equity using proxy beta• Expected return on the market portfolioExpected return on the market portfolio• Risk-free rateRisk-free rate


APT Factor Model Approach

• Firm’s reaction coefficients x lambdaFirm’s reaction coefficients x lambda

– Lambda = market prices of factor risksLambda = market prices of factor risks

• Sum the productsSum the products

• Add the risk-free rateAdd the risk-free rate

• Risk is the function of the responsiveness Risk is the function of the responsiveness coefficients for each of the factors of coefficients for each of the factors of importance.importance.


Use of Accounting Betas

• Based on accounting dataBased on accounting data

– Related to an economywide indexRelated to an economywide index

• Data readily availableData readily available

• Useful in developing countriesUseful in developing countries


Modification for Leverage

• CAPMCAPM

– Business riskBusiness risk

– Degree of leverageDegree of leverage

• Beta modificationBeta modification

– Unlevers the proxy company’s betaUnlevers the proxy company’s beta

– Relevers for a different degree of leverageRelevers for a different degree of leverage

– Beta adjustment procedure is crudeBeta adjustment procedure is crude


Weighted Average Required Return• Separation of investment from financingSeparation of investment from financing

– Assumed target capital structureAssumed target capital structure• Cost of debtCost of debt

– After-taxAfter-tax– Uncertain future tax returnUncertain future tax return

• Cost of preferred stock (P/S)Cost of preferred stock (P/S)– Function of its stated dividendsFunction of its stated dividends– Corporate dividend exclusionCorporate dividend exclusion

• Other types of financingOther types of financing


Determining the Value of a Project

• WACCWACC

• APTAPT


Calculating WACC

• Weighting the costsWeighting the costs

– Weights correspond to the market values Weights correspond to the market values of the forms of financingof the forms of financing

– Do not use book valuesDo not use book values

– Each component is weighted according to Each component is weighted according to market-value proportionsmarket-value proportions


Limitations

• Marginal weightsMarginal weights

– Incremental capitalIncremental capital

– Ignore temporary deviationsIgnore temporary deviations

• Flotation costsFlotation costs

– Adjustment made in the project’s cash flowsAdjustment made in the project’s cash flows– Adjusting the cost of capital Adjusting the cost of capital ((biased estimate)biased estimate)


Rational for WACCIncrease the market price of the company’s stock

RRR

SML

CAPM

Rf

ki

kp

ko

X

ke

Laddering of returns required


EVA

Operating profits Required dollar-amount return for the capital employed

-

Force attention to the balance sheet


MVA

Company’s total market value

Total capital invested since origin-

Debt & equity


Interpreting EVA & MVA Results

• Use accounting book values as measures of Use accounting book values as measures of invested capitalinvested capital

• Make adjustments to better approximate Make adjustments to better approximate invested cashinvested cash

• Calculated capital employedCalculated capital employed

– Historical, sunk costHistorical, sunk cost


Adjusted Present Value

APV Projected cash flows=

= Unlevered value + Value of financing

As risk increases the discount rate increases


WACC Versus APV• WACC is accurateWACC is accurate

– Maintain constant debt ratioMaintain constant debt ratio

– Invest in similar projectsInvest in similar projects

– Easy to understand & widely usedEasy to understand & widely used

• APV is accurateAPV is accurate

– Depart radically from previous financing patternsDepart radically from previous financing patterns

– Invest in a new line of businessInvest in a new line of business

– Not widely used in businessNot widely used in business


Divisional Required Returns

• The proxy company approachThe proxy company approach

• Solving for betaSolving for beta

– Sum of the divisions = the wholeSum of the divisions = the whole

• Proportion of debt financingProportion of debt financing

• Adjusting costs of debt and equityAdjusting costs of debt and equity

• Alternative approachAlternative approach

– Use both proxy debt & equityUse both proxy debt & equity


Implications for Project Selection

• Consider risk involvedConsider risk involved

• Divisional hurdle versus WACCDivisional hurdle versus WACC

• Adverse IncentivesAdverse Incentives

– ConservativeConservative

– AggressiveAggressive

• Risk-adjusted returnsRisk-adjusted returns

– System for allocating capital to divisionsSystem for allocating capital to divisions


Company’s Overall Cost of Capital

• Dividend Discount Model DDMDividend Discount Model DDM

• Perpetual growth situationsPerpetual growth situations

– Constant rateConstant rate

– Growth segmentsGrowth segments

• DDM versus market model approachesDDM versus market model approaches

– AssumptionsAssumptions


Diversification of Assets & Total Risk Analysis

• Investors diversifying across capital assetsInvestors diversifying across capital assets– Tracking stocksTracking stocks

• Imperfections & unsystematic riskImperfections & unsystematic risk– Bankruptcy costsBankruptcy costs

• Evaluation of combinations of risky investmentsEvaluation of combinations of risky investments– Standard deviationStandard deviation– Expected valueExpected value– Selecting the best combinationSelecting the best combination– Project combination dominanceProject combination dominance


When Should We Take Account of Unsystematic Risk?

• Conflicting signalsConflicting signals

– Market approach Market approach

– Total variability approachTotal variability approach

• Company’s stock is traded in inefficient Company’s stock is traded in inefficient marketsmarkets


Evaluation of Acquisitions

• Free cash flowsFree cash flows

• Market model implicationsMarket model implications

– Enhance the value of a companyEnhance the value of a company

– Purchase price & required returnPurchase price & required return

– SynergySynergy

• Diversification effectDiversification effect

– Effect on total riskEffect on total risk

Documents

®2002 Prentice Hall Publishing 1 Chapter 8 Creating Value Through Required Returns