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Chapter 11Chapter 11Risk- Adjusted Risk- Adjusted

Expected Rates of Expected Rates of Return and the Return and the

Dividends Dividends Valuation ApproachValuation Approach

Chapter: 11 2

Valuing the FirmEconomic theory teaches us that the value of an investment is:

Expected future payoffs can be measured in terms of:

Dividends Cash Flows Earnings

n

t

V1

0 tt

Rate) Discount (1Payoffs Future Projected

Chapter: 11 3

Approaches to Firm Valuation

Chapter: 11 4

Risk-Adjusted Expected Rates of ReturnRisk-adjusted expected rate of return on

equity capital is used as discount rate to compute present value of projected future payoffs.

To develop discount rates, consider:Expected future riskiness of the firm.Expected future interest rates.Expected future capital structure.

Chapter: 11 5

Risk-Adjusted Expected Rates of Return (Contd.)Can use Capital Asset Pricing Model

(CAPM) to develop discount rates.Expected rate of return needs to be

adjusted if capital structure changes.

Chapter: 11 6

Capital Asset Pricing Model

For Risk-free rate of return (RF), yield on short- or intermediate term US government securities can be used.

{E[RM] – E[RF]} known as “market risk premium”

portfolio marketwide on return Required j firm for beta Market

return of rate free-Risk j firm inequity common on return Required

nexpectatio :Where

M

j

F

Ej

FMjFEj

RßRRE

]}] –E[R {E[R ß] E[R] E[R

Chapter: 11 7

Cost of Equity Capital and Systematic Risk

Chapter: 11 8

The market beta reflects operating leverage, financial leverage, variability of sales and earnings and other firm characteristics.

The analyst can “unlever” the current market beta by adjusting it to remove the effects of leverage

Then reveler it by adjusting leverage under the new capital structure.

Adjusting Market Equity Beta to Reflect a New Capital Structure

Equity)] of ValueMarket ntDebt/Curre of ValueMarket (Current x Rate)Tax Income (1 [1 x Beta Market Levered Current Beta Market Unlevered

Equity)] of ValueMarketDebt/New of ValueMarket(New x Rate)Tax Income (1 [1 x Beta Market Unlevered Beta Market LeveredNew

Equity)] of ValueMarket ntDebt/Curre of ValueMarket (Current x Rate)Tax Income (1 [1 x Beta Market Unlevered Beta Market Levered Current

Chapter: 11 9

Evaluating the Use of the CAPMCriticisms of CAPM-

Beta estimates are quite sensitive to the time period and methodology used in computation.

Return index for a diversified portfolio of assets that spans the entire economy does not exist.

The market risk premium is not stable over time.

Therefore, it is important to analyze the sensitivity of share value estimates across different discount rates for common equity.

Chapter: 11 10

Cost of Debt and Preferred Equity CapitalCost of Debt:

Computed as the yield to maturity on each type of debt times one minus the statutory tax rate applicable to income tax deductions for interest.

Cost of Preferred Capital:It is the dividend rate on the preferred stock. In

case of convertible preferred stock the cost will be a blending of cost of non-convertible stock and common stock.

Chapter: 11 11

Weighted Average Cost of CapitalWACC: Considers debt, preferred, and

equity capital used to financeCalculated as:

costs debt to applicable rate is rateTax capital of type each of proportion isw

capital of type each of cost is R

:Where1

1

EPD

EEPPDDA

www

]R[w]R[w]–tax rate)(R[wR

Chapter: 11 12

Dividends-Based ValuationThe rationale for using expected

dividends in valuation is two fold:Dividends measure the cash that investors

ultimately receive from investing in an equity share.

Cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities.

Chapter: 11 13

Dividends-Based Valuation (Contd.)Dividends include all cash flows between

firm and shareholders:Periodic dividend paymentsStock buybacksThe liquidating dividendAnd “negative dividend” when firm initially

issues stock

Chapter: 11 14

Dividends valuation model:

TE

TT

E

T

EE

tt

E

t

)R(V

)R(D

)R(D

)R(D

)R(DV

11....

11

1

22

11

10

TEE

TTT

EE )R(-g)(Rg)]([BVBVg)]([NI

)R(D

)R(D

1

11....11 2

21

1

:Perpetuity Growing With

Dividends-Based Valuation (Contd.)

Chapter: 11 15

Involves measuring the following three elements:Dividend (Discount rate = RE)Expected future dividends (Dt) for periods 1

through T over forecast horizon.Continuing or final (DT+1), and long-run growth

rate (g).

Dividends-Based Valuation (Contd.)

Chapter: 11 16

Measuring Periodic DividendsAssume clean surplus accounting is

followed.Under U.S. GAAP and IFRS, clean surplus is

measured by other comprehensive income as well as net income.

Chapter: 11 17

Measuring Periodic Dividends (Contd.)Effects of transactions between firm and

common shareholders are included in book value.

Thus, accounting for common equity is represented by:

t-ttt

tt-tt

BVBVID DIBVBV

1

1

Chapter: 11 18

Forecast HorizonRepresented by periods 1 through T in

the dividends valuation equation.Depending on:

The industry.Firm’s maturity.Expected growth and stability.

Should be until firm reaches steady-state equilibrium.

Difficult for young, high-growth firms.

Chapter: 11 19

Continuing Value of future dividendsRepresented by last term of equation on

slide 14.Use long-term growth rate assumption

(1+ g) uniformly on the year T+1 income statement and balance sheet projections to derive the dividends for the year T+1 correctly.

Thus:g)](–[BVBVg)]([NI

–BVBVNID

TTT

TTTT

11111

Chapter: 11 20

What now?Once valuation model is applied, thenConduct sensitivity analysis:

Vary cost of equity capital rate (RE)Vary long-run growth rate (g)Discount rate assumptionsVary these parameters and assumptions

individually and jointly.

Chapter: 11 21

Advantages:Dividends provide a classical approach to

valuing shares as they reflect the payoffs that shareholders can consume.

Reflect the implications of analyst’s expectations for the future operating, investing, and financing decisions of a firm.

Evaluation of the Dividends Valuation Method

Chapter: 11 22

Disadvantages:Continuing value estimates are sensitive to

assumptions made about growth rates after the forecast horizon and discount rates.

The projection can be time-consuming for the analyst.

Evaluation of the Dividends Valuation Method