®2002 prentice hall publishing 1 chapter 8 creating value through required returns
TRANSCRIPT
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1®2002 Prentice Hall Publishing
Chapter 8Creating Value Through
Required Returns
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2®2002 Prentice Hall Publishing
Foundations of Value Creation
• Industry AttractionsIndustry Attractions
• Competitive AdvantageCompetitive Advantage
• Valuation UnderpinningsValuation Underpinnings
Create Excess
Returns
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3®2002 Prentice Hall Publishing
Favorable Industry Attractiveness
• GrowthGrowth
• Barriers to entryBarriers to entry
• PatentsPatents
• Temporary monopoly powerTemporary monopoly power
• Oligopoly pricingOligopoly pricing
– All competitors are profitableAll competitors are profitable
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4®2002 Prentice Hall Publishing
Avenues to Competitive Advantage
• Cost advantageCost advantage
• Marketing and price advantageMarketing and price advantage
• Superior organizational capabilitySuperior organizational capability
– Corporate cultureCorporate culture
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5®2002 Prentice Hall Publishing
Required Market-Based Return
• Single projectSingle project
• Division with similar riskDivision with similar risk
• Over all company (WACC)Over all company (WACC)
• IncompatibilityIncompatibility
– Security returnsSecurity returns
– Capital project returnsCapital project returns
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6®2002 Prentice Hall Publishing
Proxy Company Estimates
• Deriving surrogate company returnsDeriving surrogate company returns– Sample of matching companiesSample of matching companies– Betas for each proxy companyBetas for each proxy company– Calculate central tendencyCalculate central tendency– Derive Derive
• RRR on equity using proxy betaRRR on equity using proxy beta• Expected return on the market portfolioExpected return on the market portfolio• Risk-free rateRisk-free rate
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7®2002 Prentice Hall Publishing
APT Factor Model Approach
• Firm’s reaction coefficients x lambdaFirm’s reaction coefficients x lambda
– Lambda = market prices of factor risksLambda = market prices of factor risks
• Sum the productsSum the products
• Add the risk-free rateAdd the risk-free rate
• Risk is the function of the responsiveness Risk is the function of the responsiveness coefficients for each of the factors of coefficients for each of the factors of importance.importance.
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8®2002 Prentice Hall Publishing
Use of Accounting Betas
• Based on accounting dataBased on accounting data
– Related to an economywide indexRelated to an economywide index
• Data readily availableData readily available
• Useful in developing countriesUseful in developing countries
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9®2002 Prentice Hall Publishing
Modification for Leverage
• CAPMCAPM
– Business riskBusiness risk
– Degree of leverageDegree of leverage
• Beta modificationBeta modification
– Unlevers the proxy company’s betaUnlevers the proxy company’s beta
– Relevers for a different degree of leverageRelevers for a different degree of leverage
– Beta adjustment procedure is crudeBeta adjustment procedure is crude
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10®2002 Prentice Hall Publishing
Weighted Average Required Return• Separation of investment from financingSeparation of investment from financing
– Assumed target capital structureAssumed target capital structure• Cost of debtCost of debt
– After-taxAfter-tax– Uncertain future tax returnUncertain future tax return
• Cost of preferred stock (P/S)Cost of preferred stock (P/S)– Function of its stated dividendsFunction of its stated dividends– Corporate dividend exclusionCorporate dividend exclusion
• Other types of financingOther types of financing
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11®2002 Prentice Hall Publishing
Determining the Value of a Project
• WACCWACC
• APTAPT
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12®2002 Prentice Hall Publishing
Calculating WACC
• Weighting the costsWeighting the costs
– Weights correspond to the market values Weights correspond to the market values of the forms of financingof the forms of financing
– Do not use book valuesDo not use book values
– Each component is weighted according to Each component is weighted according to market-value proportionsmarket-value proportions
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13®2002 Prentice Hall Publishing
Limitations
• Marginal weightsMarginal weights
– Incremental capitalIncremental capital
– Ignore temporary deviationsIgnore temporary deviations
• Flotation costsFlotation costs
– Adjustment made in the project’s cash flowsAdjustment made in the project’s cash flows– Adjusting the cost of capital Adjusting the cost of capital ((biased estimate)biased estimate)
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14®2002 Prentice Hall Publishing
Rational for WACCIncrease the market price of the company’s stock
RRR
SML
CAPM
Rf
ki
kp
ko
X
ke
Laddering of returns required
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15®2002 Prentice Hall Publishing
EVA
Operating profits Required dollar-amount return for the capital employed
-
Force attention to the balance sheet
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16®2002 Prentice Hall Publishing
MVA
Company’s total market value
Total capital invested since origin-
Debt & equity
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17®2002 Prentice Hall Publishing
Interpreting EVA & MVA Results
• Use accounting book values as measures of Use accounting book values as measures of invested capitalinvested capital
• Make adjustments to better approximate Make adjustments to better approximate invested cashinvested cash
• Calculated capital employedCalculated capital employed
– Historical, sunk costHistorical, sunk cost
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18®2002 Prentice Hall Publishing
Adjusted Present Value
APV Projected cash flows=
= Unlevered value + Value of financing
As risk increases the discount rate increases
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19®2002 Prentice Hall Publishing
WACC Versus APV• WACC is accurateWACC is accurate
– Maintain constant debt ratioMaintain constant debt ratio
– Invest in similar projectsInvest in similar projects
– Easy to understand & widely usedEasy to understand & widely used
• APV is accurateAPV is accurate
– Depart radically from previous financing patternsDepart radically from previous financing patterns
– Invest in a new line of businessInvest in a new line of business
– Not widely used in businessNot widely used in business
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20®2002 Prentice Hall Publishing
Divisional Required Returns
• The proxy company approachThe proxy company approach
• Solving for betaSolving for beta
– Sum of the divisions = the wholeSum of the divisions = the whole
• Proportion of debt financingProportion of debt financing
• Adjusting costs of debt and equityAdjusting costs of debt and equity
• Alternative approachAlternative approach
– Use both proxy debt & equityUse both proxy debt & equity
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21®2002 Prentice Hall Publishing
Implications for Project Selection
• Consider risk involvedConsider risk involved
• Divisional hurdle versus WACCDivisional hurdle versus WACC
• Adverse IncentivesAdverse Incentives
– ConservativeConservative
– AggressiveAggressive
• Risk-adjusted returnsRisk-adjusted returns
– System for allocating capital to divisionsSystem for allocating capital to divisions
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22®2002 Prentice Hall Publishing
Company’s Overall Cost of Capital
• Dividend Discount Model DDMDividend Discount Model DDM
• Perpetual growth situationsPerpetual growth situations
– Constant rateConstant rate
– Growth segmentsGrowth segments
• DDM versus market model approachesDDM versus market model approaches
– AssumptionsAssumptions
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23®2002 Prentice Hall Publishing
Diversification of Assets & Total Risk Analysis
• Investors diversifying across capital assetsInvestors diversifying across capital assets– Tracking stocksTracking stocks
• Imperfections & unsystematic riskImperfections & unsystematic risk– Bankruptcy costsBankruptcy costs
• Evaluation of combinations of risky investmentsEvaluation of combinations of risky investments– Standard deviationStandard deviation– Expected valueExpected value– Selecting the best combinationSelecting the best combination– Project combination dominanceProject combination dominance
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24®2002 Prentice Hall Publishing
When Should We Take Account of Unsystematic Risk?
• Conflicting signalsConflicting signals
– Market approach Market approach
– Total variability approachTotal variability approach
• Company’s stock is traded in inefficient Company’s stock is traded in inefficient marketsmarkets
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25®2002 Prentice Hall Publishing
Evaluation of Acquisitions
• Free cash flowsFree cash flows
• Market model implicationsMarket model implications
– Enhance the value of a companyEnhance the value of a company
– Purchase price & required returnPurchase price & required return
– SynergySynergy
• Diversification effectDiversification effect
– Effect on total riskEffect on total risk