Chapter 8 Creating Value Through Required Returns

1. Chapter 8Creating Value Through Required Returns

2. Foundations of Value Creation • Industry Attractions • Competitive Advantage • Valuation Underpinnings Create Excess Returns

3. Favorable Industry Attractiveness • Growth • Barriers to entry • Patents • Temporary monopoly power • Oligopoly pricing • All competitors are profitable

4. Avenues to Competitive Advantage • Cost advantage • Marketing and price advantage • Superior organizational capability • Corporate culture

5. Required Market-Based Return • Single project • Division with similar risk • Over all company (WACC) • Incompatibility • Security returns • Capital project returns

6. 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 • Expected return on the market portfolio • Risk-free rate

7. APT Factor Model Approach • Firm’s reaction coefficients x lambda • Lambda = market prices of factor risks • Sum the products • Add the risk-free rate • Risk is the function of the responsiveness coefficients for each of the factors of importance.

8. Use of Accounting Betas • Based on accounting data • Related to an economywide index • Data readily available • Useful in developing countries

9. Modification for Leverage • CAPM • Business risk • Degree of leverage • Beta modification • Unlevers the proxy company’s beta • Relevers for a different degree of leverage • Beta adjustment procedure is crude

10. Weighted Average Required Return • Separation of investment from financing • Assumed target capital structure • Cost of debt • After-tax • Uncertain future tax return • Cost of preferred stock (P/S) • Function of its stated dividends • Corporate dividend exclusion • Other types of financing

11. Determining the Value of a Project • WACC • APT

12. Calculating WACC • Weighting the costs • Weights correspond to the market values of the forms of financing • Do not use book values • Each component is weighted according to market-value proportions

13. Limitations • Marginal weights • Incremental capital • Ignore temporary deviations • Flotation costs • Adjustment made in the project’s cash flows • Adjusting the cost of capital (biased estimate)

14. Rational for WACC Increase the market price of the company’s stock CAPM RRR SML ke ko Laddering of returns required kp ki Rf  X

15. EVA - Required dollar-amount return for the capital employed Operating profits Force attention to the balance sheet

16. MVA Company’s total market value - Total capital invested since origin Debt & equity

17. Interpreting EVA & MVA Results • Use accounting book values as measures of invested capital • Make adjustments to better approximate invested cash • Calculated capital employed • Historical, sunk cost

18. Adjusted Present Value APV = Projected cash flows = Unlevered value + Value of financing As risk increases the discount rate increases

19. WACC Versus APV • WACC is accurate • Maintain constant debt ratio • Invest in similar projects • Easy to understand & widely used • APV is accurate • Depart radically from previous financing patterns • Invest in a new line of business • Not widely used in business

20. Divisional Required Returns • The proxy company approach • Solving for beta • Sum of the divisions = the whole • Proportion of debt financing • Adjusting costs of debt and equity • Alternative approach • Use both proxy debt & equity

21. Implications for Project Selection • Consider risk involved • Divisional hurdle versus WACC • Adverse Incentives • Conservative • Aggressive • Risk-adjusted returns • System for allocating capital to divisions

22. Company’s Overall Cost of Capital • Dividend Discount Model DDM • Perpetual growth situations • Constant rate • Growth segments • DDM versus market model approaches • Assumptions

23. Diversification of Assets & Total Risk Analysis • Investors diversifying across capital assets • Tracking stocks • Imperfections & unsystematic risk • Bankruptcy costs • Evaluation of combinations of risky investments • Standard deviation • Expected value • Selecting the best combination • Project combination dominance

24. When Should We Take Account of Unsystematic Risk? • Conflicting signals • Market approach • Total variability approach • Company’s stock is traded in inefficient markets

25. Evaluation of Acquisitions • Free cash flows • Market model implications • Enhance the value of a company • Purchase price & required return • Synergy • Diversification effect • Effect on total risk