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Module 6: Cost of Capital and Valuation Patrick Noonan

Module 6: Cost of Capital and Valuation Patrick Noonan. Estimating the Cost of Capital. Green Mountain Coffee Roasters. Estimating Cost of Capital. Time Value of Money Foregone interest from investing in an instrument with future payoffs Compensation for taking the risk of investing

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Module 6: Cost of Capital and Valuation Patrick Noonan

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  1. Module 6: Cost of Capital and Valuation Patrick Noonan

  2. Estimating the Cost of Capital Green Mountain Coffee Roasters

  3. Estimating Cost of Capital • Time Value of Money • Foregone interest from investing in an instrument with future payoffs • Compensation for taking the risk of investing • Investor’s compensation for bearing the risk associated with the uncertainty of the payoffs = Risk-Adjusted Discount Rate (Return Required by Investor)

  4. Assumptions in Estimating 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.

  5. Relations among Risk Elements

  6. Weighted Average Cost of Capital (WACC)

  7. Estimating Cost of Equity Capital Using the CAPM Model Green Mountain Coffee Roasters

  8. Capital Asset Pricing Model (CAPM) • Expresses the expected return on a particular asset as the sum of three components: • The risk-free rate of return (rrf) • Beta risk (β) • Stock-specific risk (rMkt – rrf)

  9. Arriving at Beta (β) • Commonly estimated as the slope coefficient from a linear regression of the difference between the fir’s stock returns and the risk free rate of return (the dependent variable) on the difference between the market index of returns and the risk free rate of return (the independent variable) over a recent period for which data is available.

  10. Green Mountain Coffee Roasters (GMCR) Range: 0.16 – 2.73

  11. Estimating Beta • The original formula can be re-arranged to focus on the relationship between the firm's risk premium and the market risk premium as follows:

  12. Regression • The rearranged formula yields a regression as follows:

  13. Wednesday, February 5, 2014 http://news.investors.com/print/business/021114-689652-green-mountain-price-target-raised-stock-hits-new-high.aspx

  14. Green Mountain Coffee Roasters (GMCR) Range: 0.16 – 2.73

  15. Cost of Capital Green Mountain Coffee Roasters

  16. Cost of Equity Capital • Can arrive at cost of equity capital through the use of the CAPM β = 1.78 (from Bloomberg)

  17. Cost of Debt using RNFL Average = 5.16%

  18. Cost of Debt Capital • We want an after-tax cost of debt capital: rD = Pretax borrowing rate for debt x (1 – Tax Rate) • Pre-tax borrowing rate often proxied by: • Interest rate expense / Average amount of interest-bearing debt We will assume 5.8% cost of debt.

  19. Cost of Enterprise Capital • For GMCR: • VD = $89 million (book value of NFL) • VEq = $17,761 million (stock price of $119.40 at February 11, 2014 times 148,750,000 shares outstanding) • Implied VEnt = $17,850 million ($89 + $17,761)

  20. Weighted Average Cost of Capital (WACC):

  21. Valuing GMCR • Estimated growth rate beyond 2017: 9.05%

  22. Questions? 25

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