PROSPECTIVE ANALYSIS:

CALCULATING THE DISCOUNT RATE

THE INPUTS:

- BETA ESTIMATE
- COST OF EQUITY
- COST OF DEBT
- WACC

FCFF VS. FCFE APPROACHES TO

EQUITY VALUATION

Equity Value

FCFE FCFF
Discounted at Discounted at
Required Equity WACC – Debt
Return (RE) Value

1
 ESTIMATING COST OF EQUITY
THE CAPM APPROACH

(Recalled…) CAPM says that Required return on a

risky investment depends on three factors:

 The risk-free rate, Rf

 The market risk premium, (RM – Rf)
 The systematic risk of the asset relative to the
average asset, 

RE  R f   E  RM  R f  
Beta measures the stock’s sensitivity to market risk factors (systematic risk);
measured by the expected % change in the excess return of a security for a 1%
change in the excess return of the market portfolio 3

ESTIMATING COST OF EQUITY

DETERMINANTS OF BETAS

Operating
leverage
Type of Financial
business leverage

Beta

2
 ESTIMATING COST OF EQUITY
DETERMINANTS OF BETAS
Type of Business:
- Cyclical firms are expected to have higher Betas than
non-cyclical firms.
- Firms whose products are more discretionary to
customers should have higher betas than firms whose
products are viewed as necessary or less discretionary
Degree of Operating leverage: the relationship b/w
fixed costs and total costs. A firm that has high fixed costs
to total costs is said to have “high operating leverage” 
higher variability in operating income  higher beta

Degree of Financial leverage: Increase in leverage will

increase the beta of equity in a firm
5

BETA FACTS – A REVIEW

VALUE OF
INTERPRETATION
BETA
Asset generally moves in opposite direction
β<0 with market
Movement of the asset is uncorrelated with the
β=0 movement of market
Movement of the asset is generally in the same
0<β<1 direction as, but less than the movement of
market
Movement of the asset is generally in the same
β=1 direction as, and about the same amount as
the movement of market
Movement of the asset is generally in the same
β>1 direction as, but more than the movement of the
benchmark 6

3
 ESTIMATING COST OF EQUITY
CALCULATING BETAS
REFER FREQUENTLY TO THE “BETA ESTIMATES”
HANDOUTS…
The standard procedure for estimating betas is to
regress stock returns (Ri) against market returns
(RM):
Ri = a + β RM
Where
a = intercept from the regression
β = Slope of the regression = covariance (Ri, RM)/ s2M
The slope of the regression corresponds to the Beta
of the stock and measures the riskiness of the stock
7

ESTIMATING COST OF EQUITY

CALCULATING BETAS
Revisit the original CAPM formula:
Ri = Rf + β (RM – Rf)
= Rf (1- β) + β RM
...Compare to the return equation from the regression:
Ri = a + β RM
A comparison of the intercept “a” to [Rf (1- β)] would provide
a measure of the stock’s performance, at least relative to the
capital asset pricing model (CAPM):
If a > Rf (1- β) : stock did better than expected during regression period
If a = Rf (1- β) : stock did as well as expected during regression period
If a < Rf (1- β) : stock did worse than expected during regression period

Note: Rf used in this formula must be compatible with the return interval we select
for running the regression (monthly, yearly, weekly, quarterly…) 8

4
 ESTIMATING COST OF EQUITY
ESTIMATION CHOICES FOR BETA ESTIMATION
Length of the estimation period: A longer period provides more data, but
the firm itself might have changed its business mix and its risk
characteristics over the time period

The return interval: Using too short interval increases the number of
observations in the regression, but it exposes the estimation process to a
significant bias related to non-trading

Choice of a market index: Usually…

- US stocks’ Betas are estimated relative to S&P 500
- Japanese stocks’ beta to the Nikkei
- Vietnamese stocks’ beta to VN-Index
…while this is a reasonable measure of risk for domestic investor, it may not
be the best approach for international or cross-border investor!!!

 Use international index like MSCI (Morgan Stanley Capital International

Index that is composed of stocks from different global markets)
9

ESTIMATING COST OF EQUITY

FROM BETA TO COST OF EQUITY


RE  R f   E  RM  R f 
FOR YOUR FINAL PROJECT, now that we have Beta…
Where do we have the Risk-free rate?
-US stocks: Use the T-bond rate at www.finra.org
-VN stocks: Use government bond rate available at
Hanoi Stock Exchange www.hnx.vn
Note: Match the bond term with your forecast period

Where do we get the Market risk premium?

Homepage of NYU Stern Professor A. Damodaran
Country default spreads and risk premiums (updated Jan
2015)
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/d
atafile/ctryprem.html 10

10

5
 ESTIMATING COST OF DEBT
WHAT IS DEBT?

Include interest-bearing Debt only (both short-term and

long-term) rather than all liabilities!!!
- Such items as A/P, deferred tax liability, accruals
accounts…are not interest-bearing  should not be
included
- If we apply an after-tax cost of Debt to these items would
create a misleading view of the true cost of capital for the
firm
Usually we also need to capitalize operating leases and
treat them as Debt, but for this course, we would skip this
step! (too complicated for you don’t you think?!)

11

11

ESTIMATING COST OF DEBT

Marketable Debt (widely traded bonds):

Bond’s YTM is the cost of Debt

Non-marketable Debt (not widely traded bonds):

use the credit ratings (if available) for the bonds to
estimate the cost of Debt
- If no ratings available: Use recent borrowing
history (revealed in the footnotes) or utilize the
financial statements of the firm

Bank loan: Use Book value for weight and

current market interest rate for cost of Debt 12

12

6
 COST OF CAPITAL IN FCFF VALUATION
THE WACC

WACC = the weighted average cost of possible

sources of capital (Debt, Preferred stock, Common
stock) by market value

WACC E  V  R  PV  R  DV  R

E P D  1  TC 

E = market value of Common Equity RE = cost of Common Equity

D = market value of Debt RD = cost of Debt
P = market value of Preferred Equity RP = cost of Preferred Equity
V = E + D + P = market value of Firm TC = tax rate

13

PROSPECTIVE ANALYSIS:
FORECASTING FCF

REFER TO THE HOME DEPOT. CASE IN HANDOUTS

FOR THIS WHOLE SECTION

14

7
 FORECASTING TECHNIQUES
THE INPUTS AND THE OUTPUT

THE INPUTS
- Start with historical
PRO-FORMA THE
financial statements
FINANCIAL OUTPUT
- Choose key drivers STATEMENTS
of performance FCFF/FCFE
- Make long-term
forecasts

15

15

FORECASTING TECHNIQUES
WHAT ARE THE KEY DRIVERS OF PERFORMANCE?

Usually are those that affect:

- Sales and behaviors of sales
- Growth rate of the firm (sustainable/transitory)
- Investment in PPE To maintain the growth
of the business;
- Investment in Working capital Investment in PPE and
in WC closely tracks
the growth in size of
the company, as
measured by the
growth in sales

16

16

8
 FORECASTING TECHNIQUES
ILLUSTRATION
Long-term,
sustainable
E.g. Forecasting growth rate growth

Year 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024

Growth
rate in 10% 10% 10% 9% 9% 8% 7% 6% 5% 5%
sales

- The initial forecasted growth rate is 10%, but high growth

attracts competition and eventually the market becomes
saturated
- Population growth and inflation determine the long-term,
sustainable growth rate for most companies that have no
international market 17

17

FORECASTING TECHNIQUES
ILLUSTRATION

FINANCIAL VARIABLES FORECASTING TECHNIQUES

COGS % of forecasted sales
SG&A % of forecasted sales
Depreciation % of company’s PPE, net
Interest expense % of company’s interest bearing Debt
Taxes % of taxable income
Dividend Constant initially
Retained Earnings (Net Income – Dividend)
Current assets % of forecasted sales OR historical turnover ratio
PPE, net % of forecasted sales OR historical turnover ratio OR
inferred from capital expenditure forecasts
Current liabilities % of forecasted sales OR historical turnover ratio
Long-term Debt Depends
Equity Initially the level in previous plus retained earnings 18

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