Joy Global (JOY) Module 6: Cost of Capital and Valuation

1. Joy Global (JOY) Module 6: Cost of Capital and Valuation Thomas Maguire 2/12/2014

2. Joy Global Background • Manufactures and services mining equipment • Focus on: Coal, Copper, Iron Ore, Oil Sands, and Gold • Revenue split between • Surface Mining Equipment • Underground Mining Machinery

3. Cost of Capital and Valuation Background • To this point we have used an assumption of 10% for the cost of capital (discount rate) for discounting cash flows for Joy Global • Now that we have completed a parsimonious forecast we must consider whether there is room to improve on this assumption • We must also consider the source of information and other steps that must be taken to calculate this improved estimate of cost of capital • We must recognize the differences among: • Cost of Enterprise Capital • Cost of Equity Capital • Cost of Debt Capital

4. Cost of Capital and Valuation Background • Previously, the discount rate used for our parsimonious valuation was the cost of enterprise capital • We focused on valuing the entire enterprise while using the free cash flow model • Model values the company’s enterprise operations • Similarly to the cost of enterprise capital being used to calculate enterprise operations, • The cost of debt capital is used to value debt • The cost of equity capital is used to value equity

5. Estimating the Cost of Capital • Investors expect to recover two separate costs when they provide capital to an enterprise: • The time value of money • Consider this as the foregone interest from investing in an instrument with future payoffs • Compensation for taking the risk of investing in the enterprise operations • Compensation for bearing risk associated with the uncertainty of the payoffs • Together, these two components make up the risk-adjusted discount rate- the return investors require for investing in an asset: • Investor’s required rate of return or the cost of capital

6. Estimating the Cost of Capital • Assumptions when estimating the cost of capital • Current interest rates are a good approximation of expected (future) interest rates • Current risk of the enterprise operations is a good approximation of the expected enterprise risk • Most common approach to estimating the cost of enterprise capital • First, estimate the cost of debt capital and the cost of equity capital • Debt holders and equity holders provide capital at their respective required rates of return • Both sides are aware of the amount of capital provided by the other group

7. Estimating the Cost of Capital • Equity ownership is risky because: • It represents both risk of ownership of the enterprise AND • Risk of needing to satisfy the obligations to debt holders as they fall due • The risk in equity is driven by risks inherent in the enterprise and the cost of debt • Changes in the riskiness of the enterprise or changes in the cost of debt lead to changes in the riskiness of equity • Inherent risk in the enterprise and debt are sources of equity risk

8. Estimating the Cost of Capital • Though the riskiness of the enterprise operations (the cost of enterprise capital) is not affected by the capital structure of the firm: • Within reasonable bounds we can estimate the cost of enterprise capital as a weighted average of an estimate of the cost of debt capital and an estimate of the cost of equity capital • Calculating the weighted average of the rates at which the two groups of investors are prepared to contribute capital after they have assessed the riskiness of the enterprise

9. Weighted Average Cost of Capital • Cost of enterprise capital often referred to as the weighted average cost of capital • WACC • Value of the enterprise is equal to the sum of the value of debt and the value of equity: • Using this equation, we can come up with the weighted average cost of capital or cost of enterprise capital:

10. Weighted Average Cost of Capital The true WACC computation shouldbe using intrinsic values for the value of equity and debt However, since intrinsic values are unobservable, we typically use the market value of equity and debt in place of the intrinsic values

11. Diversifiable and Non-Diversifiable Risk • To understand the use of market data to estimate the cost of equity capital, we must understand diversifiable and non-diversifiable risk • Our model assumes that investors are only concerned with non-diversifiable risk, and are willing to accept diversifiable risk without compensation • Diversifiable risk refers to risks that can be diversified away by investors • Diversification refers to the practice of holding many different securities with different risk exposures in a portfolio

12. Diversifiable and Non-Diversifiable Risk • For diversification to reduce risk , returns of stock in the portfolio must be somewhat independent • If the returns are correlated- they move in harmony, diversification of risk is drastically reduced • Market Portfolio • By holding a market portfolio, we diversify all the risk away that is “diversifiable” and the only remaining risk in the portfolio is “non-diversifiable” • By then comparing the historical volatility of an individual stock to the historical volatility of the market portfolio, we can estimate the non-diversifiable risk in each individual stock • Basis of Capital Asset Pricing Model (CAPM)

13. Estimating Cost of Equity Capital Using the Capital Asset Pricing Model • The CAPM expresses the expected return on a particular asset- the asset’s cost of equity- as the sum of three components • The risk-free rate of return • Beta Risk • Stock Specific Risk • The first two components are used to estimate the cost of equity, the third component, stock-specific risk, however is diversified away in large portfolios

14. Estimating Cost of Equity Capital Using the Capital Asset Pricing Model • CAPM represented in an equation: • The first component, , is the expected risk-free rate of return • The return on long-term US treasury bills is commonly used • The second component is the product of the market risk premium,, and beta, , which measures the sensitivity of the asset’s market return to the overall market • The market risk premium represents the difference between the expected market return and the expected risk free rate • Market beta measures the company’s historical stock price volatility relative to the overall market volatility • Commonly estimated from a regression of the difference between the company’s stock returns and the market index of returns over a recent period of time- often the previous 60 months • The market index of returns represents returns from a market portfolio- S&P 500 can be used

15. Estimating Cost of Equity Capital Using the Capital Asset Pricing Model • Market beta reflects risk that cannot be diversified away by investing in a portfolio of risky assets • Market has a beta of 1 • Market beta greater than 1 indicates the company’s stock price will change by a larger percent with a change in the overall market • Reverse is true for a beta less than one

16. Issues with CAPM for Cost of Equity • Regression based estimates of beta are only estimates • Inevitably measured with error • Betas are backwards looking estimates • Assuming equity risk will not change substantially • Could shrink historical beta towards one • Multi Factor Model can help to address some issues with CAPM • Identifying other risk factors

17. Cost of Equity for Joy Global • Using CAPM we must come up with measures for all inputs • Must use a historical estimate of Beta • Using the past 60 months of realizations for firm returns, risk free rates and market returns • For purposes of this regression, we can eliminate from both sides of the equation

18. Empirical Estimate of Beta for Joy Global

19. Empirical Estimate of Beta for Joy Global

20. Empirical Estimate of Beta for Joy Global • Using historical data, we get an estimate for Joy Global’s Beta of 1.69 • This tells us that if the market index moves by 1 %, Joy’s stock return would be expected to change by 1.69% • Note, regression was run with elimination of outliers, however results were not substantially improved • The R Square of .096 is particularly worrisome in this example • This is a very low R Square and tells us that there was not a good fit with the data • Standard error of .2156- very high • Looking at our 95% confidence interval we see a large distribution of .3293 and 3.0513 respectively • Large array can be worrisome • Intercept estimate of , we see .02

21. Outside Estimates of Beta for Joy Global • Estimates for Beta from outside sources are much higher than my estimate, averaging 1.9 • Also of note is the tendency of these observations to gravitate towards 2.1 • Note- bloomberg beta in this case is calculated using 59 months

22. Bloomberg Estimate of Beta for Joy Global

23. Bloomberg Estimate of Beta for Joy Global Raw Beta= 1.461 This default beta calculation for Joy Global, using 103 weekly data points, seems to be a much better approximation of beta The R squared in this regression is much higher than when using monthly data

24. Final Estimate of Beta for Joy Global Because of the better regression results from the Bloomberg output, I have chosen to use a Beta of 1.46 This more accurately reflects the risk of the firm going forward- using more current data

25. Cost of Equity for Joy Global • Now that we have the beta estimate for Joy Global, we can come up with the cost of equity • = 3.68% • As of 2/7 this was the yield for 30 year treasury • Assume a Market risk premium of 7% • With a beta of 1.46, we come up with a cost of equity capital of 13.9%

26. Cost of Debt Capital • The market interest rate on the debt instruments of the firm is the cost of debt capital • A company’s borrowing rate depends on its perceived level of risks in the eyes of lenders • Joy Global rated BBB • Above Junk

27. Cost of Debt Capital- Joy Global • Pretax Borrowing Rate= Interest Expense/ Average Amount of Interest Bearing Debt • Pre Tax Borrowing Rate= 66,285/1,343,769= 4.93% • Tax Rate= 30.13% • Company’s Effective Tax Rate for 2013 • = 4.93% X (1-.3013)= 3.45%

28. Computing the Cost of Enterprise Capital • Now that we have estimated the cost of equity and debt capital, we can return to the process of estimating a cost of enterprise capital • We have computed & in the previous slides: • = 3.45% • = 13.9% • Market Value of Debt- assumed to be equal to the book value of NFL • = $1,010,141 • = Market Value of Equity- Stock Price X Common Shares Outstanding • = $5,590,000 • = Summing the Value of Equity and Value of Debt, we get an implied enterprise value: • = $6,600,141

29. Computing the Cost of Enterprise Capital • WACC= 12.30% • Joy Global does not issue preferred stock, thus we do not need to include it in this computation

30. Bloomberg’s Estimate of Cost of Enterprise Capital

31. Revisiting Valuation

32. Revisiting Valuation • Newly Calculated Enterprise Value= $8,612,485 • Previously Calculated Enterprise Value= $11,341,583 • Higher WACC causes bigger discounting and brings down Enterprise Value

33. Questions? Thank You!