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Express Scripts Cost of Capital

Express Scripts Cost of Capital. Ian Johnston. Three Costs of Capital. Cost of capital for enterprise operations Captures risk of a company’s enterprise operations ESRX: captures risk of PBM business Very hard to measure directly Cost of capital for debt

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Express Scripts Cost of Capital

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  1. Express Scripts Cost of Capital Ian Johnston

  2. Three Costs of Capital • Cost of capital for enterprise operations • Captures risk of a company’s enterprise operations • ESRX: captures risk of PBM business • Very hard to measure directly • Cost of capital for debt • Captures risk to company’s debt holders of default • Easy to measure • Cost of capital for equity • Captures risk to equity holders of getting distributions • Moderately easy to measure

  3. Relation Among Cost of Capitals • Enterprise and debt risk drive equity risk • No inherent risk in equity • Stems from enterprise risk • Debt and equity are used to estimate enterprise risk • Estimation of rEnt: rEnt = (rD*(VD/VEnt)) + (rEq*(VEq/VEnt)) • Changes in mix of debt/equity do not affect rEnt, but changes in operations do

  4. Steps to Estimate rEnt 1. Estimate Cost of Equity Capital • CAPM: rEq = rrf + [B*(rmkt-rrf)] • Risk free rate (30 year treasury notes) • 3.68% (as of close on 2/11/14) • Beta must be approximated • Regression data (ESRX return vs. S&P 500 return) • Bloomberg estimate • Various financial website estimates • Market risk premium must be approximated • Assumed to be 7%

  5. Steps to Estimate rEnt 2. Estimate Cost of Debt Capital • Measured on an after-tax basis • Two methods: • Examine credit rating • Examine ratio of FEAT to NFL 3. Combine using weighted average • Compute VEnt, VD, and VEq • Weight rd and req by the mix of equity and debt value

  6. Estimating req: Beta • 3 sources of beta • Bloomberg terminal • Various financial websites • Regression analysis • Return on ESRX stock regressed onto return on S&P 500 • Weekly returns from 1/1/2009 to 2/9/2014

  7. Bloomberg Analysis

  8. Bloomberg Analysis

  9. Various Financial Websites

  10. Regression Analysis

  11. Beta Estimation Summary • Bloomberg • Estimates 0.95 (0.97 adjusted) • Various financial websites • Minimum: Nasdaq at 0.63 • Maximum: Yahoo and Firstrade at 1.54 • 12 estimations above 1, 1 estimation below 1 • Regression analysis • Estimates 0.85 • 95% confidence interval: (0.69, 1.02)

  12. Estimation of req: CAPM B assumed to be .97 (Bloomberg analysis) rrf= 3.68% Market premium assumed to be 7% 3.68 + [.97(10.68% - 3.68%)] = 10.47%

  13. Estimating rD • ESRX credit rating is BBB+ (S&P) • Merrill Lynch estimates an effective yield of 3.73% on BBB+ debt. • After tax: 3.73*(1-.38) = 2.31% • FEBT to NFL analysis • FEBT = 608 • NFL = 14,979 • t = 38% (608/14,979)*(1-.38) = 2.52%

  14. Summary of rD • Credit rating estimate: 2.31% • FEBT to NFL ratio: 2.52% • Use 2.52% for this analysis • Based on a more specific analysis of financial statements, not just looking at average rates for credit rating

  15. Computing WACC • req= 10.47% • rD= 2.52% • VD = $14,979 (NFL) • Veq = $44,010 • $54 stock price on 12/31/2012 • 815 shares outstanding on 12/31/2012 • VEnt = $58,989

  16. Computing WACC rEnt= (2.52*(14,979/58,989))+(10.47(44,010/58,989)) rEnt= 0.64% + 7.81% rEnt= 8.45%

  17. Updated DCF Analysis using WACC

  18. WACC Estimation Issues • CAPM works well in theory, but inputs are nearly impossible to predict • Beta and market risk premium especially hard to predict • Huge sensitivity to changes in these estimates • Beta of 0.63 yields a WACC of 6.67% • Beta of 1.54 yields a WACC of 11.43% • Range of enterprise values from $18,765 to $51,597 • Good news: Bloomberg WACC was very close to my estimation • 8.45% to 8.4%

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