®2002 prentice hall publishing 1 chapter 8 creating value through required returns

1®2002 Prentice Hall Publishing

Chapter 8Creating Value Through

Required Returns

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Foundations of Value Creation

• Industry AttractionsIndustry Attractions

• Competitive AdvantageCompetitive Advantage

• Valuation UnderpinningsValuation Underpinnings

Create Excess

Returns

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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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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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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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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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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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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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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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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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Determining the Value of a Project

• WACCWACC

• APTAPT

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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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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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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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EVA

Operating profits Required dollar-amount return for the capital employed

-

Force attention to the balance sheet

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MVA

Company’s total market value

Total capital invested since origin-

Debt & equity

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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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Adjusted Present Value

APV Projected cash flows=

= Unlevered value + Value of financing

As risk increases the discount rate increases

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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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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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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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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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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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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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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