Cost of Capital

Valuation Modeling
The Income Approach:

The Cost of Capital
林家振
台灣大學管理學院商學研究所
The Cost of Capital
I. Introduction
II. Theory
A. DCF
B. Risk and Return
C. The Capital Asset Pricing Model
III. Application: WACC
A. Where it comes from
B. Strengths & weaknesses
IV. Sources of Confusion
A. Terminology
B. Conditional vs. conditional forecasts
V. Special Topics
A. Cross-border costs of capital
B. Small companies
C. Non-public companies
2 MBA, National Taiwan University

The Cost of Capital: Introduction
Why the lack of clarity?
Why the conflicting advice?
“Experts” (even academics) don’t agree.

Practitioners inside and outside CVC use different methods.
Even language - “cost of capital” - is a source of confusion.
Can we expect some convergence?
Within CVC, yes. We’re working on it.

In the rest of the world, no. Not any time soon. We must
be prepared to understand the issues and defend our
judgements in a world of unsettled issues.

The Cost of Capital: Introduction
To get started, let’s agree on a working definition of the cost of capital:
The cost of capital . . . is a discount rate to be applied to projected cash
flows when using the Income Approach.
is not a “cost of funds” used for comparing
alternative funding sources.
is not a prevailing interest rate or other indicator of
capital market or macroeconomic conditions.
The cost of capital . . . may be adjusted for risk.

may be adjusted for capital structure and tax
shields.
may be adjusted for currency and firm size.
may be (carefully) adjusted for certain investor
characteristics (but not others).
should not be adjusted for much else.
The Cost of Capital: Theory
Even riskless cash flows get We prefer a dollar
discounted. Why? today to a dollar
tomorrow.
This turns into:
The fundamental time-value
relationship: CF1
CF0 =
CF0(1 + r) = CF1 (1 + r)
The fundamental
where r = risk-free rate of interest. DCF relationship.
But business cash flows are risky.

We must adjust both the numerator
and the denominator of the DCF
formula.

General Formula for Expected cash flows
DCF Valuation of
Business Assets Future business cash flows, CF,
are uncertain, so we discount expected
cash flows, E(CF)
E (CF ) t
n
Present Value  
t  0 (1  k ) Time value
t
Timing and risk
We project cash flows in the future, The discount rate k represents the
discount them, and sum them all up equilibrium expected rate of return,
and contains a risk premium

These two sets of cash flows have
less risky
the same mean, but different risks.
Risk averse investors would not assign

riskier the same present value to them.
Probability distributions for The only way a standard DCF model

risky future cash flows can obtain different values is to assign
them different discount rates.
In a standard DCF model, the discount rate consists of:

a. Time value (the risk-free interest rate);
b. A risk premium that is asset-specific but usually not
investor-specific.

Expected return
Expected
return is an Risk premium
increasing
function of risk
Time value
0 Riskiness of Cash Flows
Observations:
1. This makes good intuitive sense.
2. Higher risk  higher expected return.
But: 3. We haven’t defined risk.
4. We haven’t shown that that the relationship is linear.

The Capital Asset Pricing Model (CAPM) Completes the Diagram.
CAPM assumes:
1. Investors care about portfolio risks and expected returns.
2. Individual agents optimize (e.g., maximize value) and have access to a market.
CAPM shows (among other things):
1. Only non-diversifiable risk earns a premium over the risk-free rate.
2. The risk premium is a linear function of non-diversifiable risk (beta).
3. E(return)x = rf + x(market risk premium).
)
mium
k pre
Expected return
k et ris
+ (mar
turn ) = rf
E(re Risk premium
Time value
0 Systematic (non-diversifiable) risk: 

The Cost of Capital: Estimation
Elements of the CAPM: Risk-free Rate of Return
Rx = Rf + x(MRP)
Typically, we use the yield on long-term Treasury securities, since most going-
concern business valuations are long-term (recall that the terminal value is
often approximated as a perpetuity).
 How long? Approximately 20 years to maturity (30-year T-bonds are not
as well-suited, due to their use in bond-portfolio immunization)
 Pay attention to the shape of the yield curve!
 Use yield-to-maturity as of the valuation date
 Sources: Wall Street Journal, Bloomberg, Ibbotson SBBI Yearbook

Elements of the CAPM: Beta
Rx = Rf + x(MRP)
 Typically estimated from historical stock price data:

 daily data are ideal, econometrically, but raise difficult practical problems
 monthly data give more stable estimates
 most sources use 60 months of data
 Sources:
 BARRA (available on CVC.Power TS 03555)
 Standard & Poor’s Compustat
 Bloomberg
 Merrill Lynch, etc.
 Estimate your own regression

 Direct estimation of beta requires public stock market data and

training in least-squares regression analysis.
 For private companies we use betas of comparable publicly traded
companies.
 Consider differences between subject and comparable
companies, both real and financial, and be especially careful of
leverage differences.
 Be wary of data from smaller public companies with relatively little
trading activity.
 Be wary of data from small, local stock exchanges where prices
may be affected by low trading volume, trading taxes, or
“administration” by some central authority.

 BARRA offers both “Predicted” Betas and “Historical” Betas

 “Historical” is based on regression using past 60 months
 “Predicted” incorporates adjustments for company characteristics
(industry, financial condition, trading activity)
 We typically considers the average of a group of comparable publicly traded
companies
 Beta estimation is a statistical exercise affected by noise, random errors.
 May be able to get better information by constructing an industry stock
price index (portfolio betas) - random errors tend to cancel one another.
 Global Cost of Capital Report gives benchmarks for unlevered betas and
unlevered risk premia by industry.

Elements of the CAPM: Beta and Leverage
 Theory:
 Financial leverage amplifies business risk
 In general, when leverage is positive, levered > unlevered
 It is crucial to distinguish between levered and unlevered betas.
 The Unlevering/Relevering Relationship:
 Ignoring taxes: unlevered = (Equity/Capital)levered
 With taxes: unlevered = levered /[1+(1-t)(D/E)]
 Excess cash should be netted against interest-bearing debt to obtain a measure of
“net debt” for use in this formula.
 In Practice:
 Comparable companies may have leverage that is different from our subject
company
 “Unlever” each of the comparable betas to remove the effect of their capital
structures (then probably compute an average unlevered beta)
 “Relever” the unlevered beta to reflect the target leverage of the subject company

Elements of the CAPM: Beta and Leverage
 In a CAPM setting the unlevered beta is the single most important company-
specific determinant of the risk premium inherent in the cost of capital.
 It dominates capital structure and tax considerations.
 What economic factors influence the the unlevered beta?
 Exposure to factor costs
 Demand elasticities
 Exposure to business cycles (durables vs. non-durables, flexibility of
operations, labor contracts, etc.)
 Operating leverage (fixed vs. variable costs)
 Position on the industry supply curve
 Relationships with suppliers, customers
 Etc.

Elements of the CAPM: The Market Risk Premium
Rx = Rf + bx(MRP)
 Definition: The expected total return on a diversified portfolio of risky

securities, over and above the risk-free rate.
 The MRP must be estimated as premium; do not use (for example)
historical returns on equity minus today’s risk-free rate.
 If you use historical data at all, you must use historical equity returns
minus contemporaneous historical risk-free returns.
 “Experts” disagree about what figure to use for the MRP.
 Non-experts disagree even more.
 In the US, we use MRP = 5% for US dollar discount rates.

Elements of the CAPM: The High Market Risk Premium- Take 90’s as an example:
Historical Realized Premia on the Market
Geometric Arithmetic
Period Average Average
201 Years (1798 - 1998) 3.9% 5.3%
73 Years (1926 - 1998) 6.1% 8.0%
50 Years (1949 - 1998) 7.3% 8.5%
40 Years (1959 - 1998) 4.8% 5.9%
30 Years (1969 - 1998) 4.5% 5.7%
20 Years (1979 - 1998) 8.0% 9.7%

Forward-Looking Approaches: What do investors actually expect?
 “Top Down” approach:

 Ask people what they think “The Market” is going to do
 “Bottom Up” approach:
 Gather expected returns for many individual companies
 Take an average to get an expected return on “The Market”

Elements of the CAPM: The Market Risk Premium at the end of 20th Century
Forward-Looking Market Premia
Average(1) Recent(2)
Merrill Lynch (bottom-up) 4.7% 4.7%

Value Line (bottom-up) 3.6% 3.1%
Greenwich Survey (top-down) 3.1% 4.5%
(1) Average of expected premiums prevailing during the last five years
(2) Expected premium as of the end of 1998 / beginning of 1999

What can we conclude?
 Historical data supports (roughly) 5% to 9%.

 Forward-looking sources support (roughly) 3% to 5%.
 Surveys of professional firms show clustering around 5%.
 Surveys of finance academics show clustering around 7% to 8%.
 The best recent survey and synthesis is: The Equity Risk Premium by Bradford
Cornell (UCLA), John Wiley & Sons.
 Cornell concludes: the equity risk premium is “on the order of 5.5% over treasury
bills and 4.3% over treasury bonds”.
 This topic remains controversial.

The Cost of Capital: WACC
WACC: Where it Comes From
Market Value B/S
WACC = [D/V]kd(1-t) + [E/V]ke

Debt
Assets
This formula doesn’t look like the
Equity
discount rates we’ve discussed.
Cash is
• It does not contain rf
generated here. Cash is
• It does not contain a risk premium Risk originates distributed
here. here.
• It contains (1-t) and leverage ratios.
Q: Why/when is it OK to use WACC? All risk on the

LHS must be
A: Consider the stylized B/S on the borne by
right.    investors on the
RHS.
All risk on the LHS must be borne by investors on the RHS.
Market Value B/S
Debt kd = rf + debt risk premium

k = rf + business risk premium Assets
Equity ke = rf + equity risk premium
Asset = Capital
Value Value
business risk debt risk equity risk
[Assets/Value] = [Debt/Value] + [Equity/Value]
premium premium premium
This is usually These may be observed in

unobservable. the securities markets.

• WACC works as a substitute for the asset-cash-flow discount rate (k) because the
risk premium on the LHS must equal the risk premium on the RHS.
• WACC contains a weighted average of the debt and equity risk premia.
• “Conservation of Risk” is the principle at work.
Q: But where did that (1-t) come from? EBIT(1-t)

A: It is a correction for the fact that the + depreciation
asset cash flows are typically mis-stated.
- capital
They overstate taxes because they omit
the tax shield due to the deductibility of expenditures
corporate tax payments. - change in NWC
= Free Cash Flow
This calculation
pays taxes on EBIT These free cash flows
rather than EBIT- are understated by the
interest amount: (interest)xt.

•Multiplying the cost of debt, kd, by (1-t) lowers the WACC by just the right
amount to make up for the value of the missing interest tax shields.
• If we omit (1-t) from WACC then the “pre-tax” WACC should equal the cost
of unlevered equity: kunlevered = rf +unlevered(MRP) = pre-tax WACC.
cost
cost of levered equity As leverage increases,
WACC decreases initially
due to the benefit of
cost of unlevered equity
interest tax shields.
WACC Eventually the costs of
financial distress
cost of debt
overcome the tax shield
benefit and WACC rises
0 leverage with leverage.

WACC: Strengths and Weaknesses
Strengths Weaknesses
WACC lets us exploit capital market WACC’s handling of tax issues is
data on expected returns, even simplistic - it requires very restrictive
when we are valuing non-traded assumptions.
assets.
WACC may be especially unreliable:
WACC handles interest tax shields • with high leverage
very simply. • with complex tax situations
WACC generally allows us to • with complex capital structures
perform the discounting operation
once only. • with unusual ownership structures
WACC is by far the most widely • with exotic securities
used discount rate for enterprise •in dynamic rather than static
value.
situations.

For WACC to properly treat the value of interest tax shields, it must be the
case that:
1. The leverage ratios are computed using market values for debt and equity.
2. Excess cash is treated as negative debt and so netted against interest-bearing
debt. [Q: Why is excess cash like negative debt in the assessment of risk?]
3. The leverage ratios must reflect the forward-looking, target capital structure
for the subject company (i.e., a long-range average of expected future capital
structures).
When assessing fair market value When estimating NPV or a

for tax or financial reporting reservation price for M&A or
purposes, the common practice capital budgeting, it is essential
is to use the industry average to use prospective
capital structure. management’s target capital
structure.
Don’t do this blindly! Examine
the average for reasonableness Don’t do this blindly either!
in the circumstance of the Examine the target for feasibility.
engagement..
Templates for calculating WACC have some built-
in limitations.
Be careful! •WACC templates ignore
costs of financial distress.
•This makes WACC
cost
cost of levered equity decrease monotonically
with increases in leverage.
True WACC • But this can’t be true!
cost of unlevered equity
• Many WACC templates
WACC as computed by treat the cost of debt as
cost of debt template invariant with respect to
leverage.
0 leverage • See WACC (WARR)

templates in CVC.Power
at MT 03505.

Tips for avoiding other problems:
1. Check to be sure that changes in leverage ratios do affect costs of debt and
equity.
2. Check your WACC against sensible benchmarks.
a. WACC must be higher than the risk-free rate.
b. WACC must be higher than the pre-tax cost of debt.
c. WACC must be lower than the cost of levered equity.
3. The best benchmark is the cost of unlevered equity. WACC should never be a
lot lower than the cost of unlevered equity.  WACC  kunlevered - small number.
4. Use long-term, fixed-rate debt to get a cost of debt. We suggest using the Baa
rate, but this advice is not infallible.
5. Always use market-value leverage ratios, either firm-specific targets or an
industry average.
6. Don’t use subsidized or administered costs of debt or equity in a DCF discount
rate. Use free-market rates prevailing at the valuation date.
Cost of Capital: Sources of Confusion
There are different kinds of “cash flows” and “discount rates”.
• There are at least four valid approaches to discounting uncertain future cash flows.
• Properly applied, they give the same result.
• Unfortunately, people mix them up. Then they can give wrong answers.
1. The risk-adjusted discount rate approach adds a risk premium to the

discount rate which is then applied to expected cash flows.
E(cash flows)
PV =
(1 + k)
where k > rf.

•This is the approach we have been talking about. It is the one most
commonly presented in finance texts as the “standard” DCF method.
• The discount rate is commonly chosen to be WACC (if CF are unlevered).
• Risk premia are typically estimated using a model such as CAPM.

2. The certainty-equivalent approach subtracts a cash risk

premium from the expected cash flows and then discounts at the
risk-free rate.
[E(cash flows) - cash risk premium]

PV =
(1 + rf)
•This approach, though rarely used in companies, also is a DCF

method. It is very appealing theoretically.
• The numerator is called a “certainty equivalent”.
•Here also, CAPM or other models can be used to estimate the
cash risk premium.

3. The risk-neutral approach adjusts the probabilities that are

used in the probability-weighted sum of all possible outcomes.
 pj(cash flow)j
PV =
(1 + rf)
where p =1
j (i.e., the risk-neutral probabilities sum to 1.)
• This approach is most commonly associated with options,

rather than ordinary operating assets, but it is valid generally.
•Note that the numerator here must have the same value as in
method #2.

4. The “bond-trader” approach uses promised cash flows and a

promised rate of return that also includes a risk premium.
[promised cash flows]

PV =
(1 + K)
where K contains a risk premium that must be different from #1,
the “risk-adjusted discount rate” approach.
• Note that this risk premium cannot be estimated from the CAPM
alone (though it may be correlated with beta).
• It can only come from carefully selected market comparables.
Many companies are confused by the differences between this method and
#1. Note that both numerator and denominator are different in each.

Method 1 Method 4
E(cash flows) [promised cash flows]

PV = PV =
(1 + k) (1 + K)
A common error is to combine Method 4

cash flows with a Method 1 discount rate.
But they are not the same!
•Internally, companies strive for consistency between figures used in

cash flow projections and those used in operating budgets: “promises”.
• In fact, expected cash flows should differ from budgeted cash flows.
•The more aggressive the budget, the more the discount rate requires an
additional “risk premium”.

To see how significant the problem is, consider a simple example.
How much is next year’s cash flow

Assume: actually worth?
1. Cash flow next year between PV = $750/1.10 = $682.
$500 (min) and $1000 (max).
2. Symmetric probabilities, so
“expected” CF = “most likely”
CF = $750. But suppose for consistency we
discount next year’s budget. Either:
3. Management sets a “budget”
or “goal” for next year of $850. a. We compute PV = $850/1.10 = $773
and we are wrong by 13%, or
4. Suppose standard CAPM
gives a discount rate of k = 10%. b. We need a fudge factor in the
discount rate. To get the right PV, we
need K = 24.6%, but CAPM won’t give
it to us.

Cost of Capital: Special Topics
The Cross-Border Problem
Q: “I know how to value a cement plant in the US, but this one is in Indonesia.
What should I use for a discount rate?”
A: “Good question. What are you worried about, exactly?”
Currency risk?
Country (economic) risk?
Country (political) risk?
Something else?
• The basic theory of risk and return still holds: discount expected future cash
flows at a rate that reflects their riskiness.
•No matter what refinements we make to the basic theory, we always need to
have the currency of the cash flows match the currency of the discount rate.

One useful way through this thicket is to begin with a pure currency adjustment:
(1+inflationforeign)
kforeign = {[1 + kdomestic] }-1
(1+inflationdomestic)
or (approximately, but perhaps more intuitively):
kforeign  rf,foreign + [US cement risk premium]

(1+inflationforeign)
where rf,foreign = {[1 + rf, domestic] (1+inflationdomestic) }-1
Now ask, “Suppose I use this rate, what am I missing?”

• Note there is no adjustment for currency “risk” (i.e., exchange rate volatility), nor
for any other type of risk (e.g. country).
• This is purely a currency translation, one that assumes parity conditions hold.
• You must have a reason for every adjustment you make to this basic benchmark.

There are several common approaches to incorporating

country factors into a discount rate.
1. Use a local, single country version of the CAPM:

ke = rf, local + local(Local MRP)
where: rf, local is the return on the local government’s (default-risk-free) paper
local is measured with respect to the local securities market.
Intuition: Local investors provide capital to local firms in the local market.
Objections: This approach is most justified in huge markets (e.g., the US) or in
the presence of nearly complete segmentation of capital markets. [It also
would be OK if all markets where the same everywhere, but in that case it
wouldn’t matter.] It is untenable as investors and firms have increasingly
extensive, inexpensive access to the world’s capital markets. In any event,
data are poor to non-existent in segmented, developing country settings.

2. Adjust a US cost of capital for non-US volatility spreads:

ke = rf + [US risk premium](subject/us)
where subject = volatility of subject stock market
us = volatility of US stock market.
Intuition: If even a diversified portfolio (“the market”) in the subject country has
higher volatility than the US market, that higher volatility must be perceived by
local market participants as systematic, and therefore justifies a higher risk
premium.
Objections: The difference in volatilities may reflect mostly a difference in the
composition of the subject country’s economy (e.g. lots of natural resources,
but not many service businesses). This is not a country effect. This adjustment
also is questionable when investors clearly have access to global markets.

3. Adjust a US rate for country yield spreads observed in sovereign debt.

ke = rf + US risk premium + (YTM, sovereign Euro$ issue - YTM, US T-bonds)
Intuition: The fact that non-US sovereign debt denominated in US$ has a higher
expected return indicates a country-specific risk of default. This country-
specific risk is clearly not included in the US risk premium, so must be added
separately.
Objections: The local government’s credit quality may be a poor proxy for
risks affecting business cash flows. Further, this approach will double count
non-systematic country-level risks that may already have been incorporated
into cash flow projections.

4. Use a global version of CAPM.

ke = rf + global(Global MRP)
where rf is the US risk-free rate, adjusted if necessary for currency
global is systematic risk measured with respect to a global portfolio
Global MRP is the market risk premium on a globally diversified portfolio.
Intuition: Markets are integrated. This merely recognizes cross-border

diversification opportunities and prices securities accordingly.
Objections: Markets may not (yet) be that integrated. High quality data are still
lacking in some places (further suggesting that integration is not complete). Truly
global versions of CAPM are multi-factor models (containing, e.g., currency
factors) for which data for estimating betas for some factors are poor.

In today’s economy there is little theoretical justification for large country risk premia.
• Exchange rate volatility appears to not be wholly unsystematic, but the beta for FX
risk is small and variable - it is clearly immaterial in most CVC engagements.
•Real risk-adjusted free-market interest rates do not differ across countries for
extended periods. This has been empirically documented for large economies.
• Different stock markets do not obviously price risk (volatility) differently. Ditto.
•From a theoretical perspective, discrete risks, such as political risk, are clearly
better treated in the cash flows than in the discount rate.
•Yet, real world managers and their advisors insist on adjusting the discount rate.
Why?
Part of the problem is confusion about conditional and

unconditional expected cash flows. If this is the problem,
there is no neat
• Some companies want to use consistent “generic” cash theoretical solution.
flows (e.g. for a cement plant, regardless of location). Every case will be
different!
• Then the only way to get a different PV is to adjust the
discount rate (add a “country risk factor” for Indonesia).
Where is best practice headed? Towards recognition of global integration.
• More and more investors have access to foreign investments.
• Taxes, regulations, and other barriers to integration are falling.
• Developments in telecom services, on-line trading, computerized market-
clearing, all-hours trading, etc. all promote integration.
• The US Treasury market has emerged as the “gold standard” for r f.
• Large stock markets already have significant trading of non-local stocks.
Does this mean we should adopt and promote a Global CAPM?

Prediction: It will matter less and less going forward. Eventually, the answer
you get using a US CAPM will not differ significantly from a Global CAPM.
However, if confusion about conditional/unconditional expected CF persists,
then the problem of cross-border adjustments to k will never go away.

Small Companies (Size Premia)
It is an empirical fact (skeptics call it an anomaly) that small companies have
historically earned higher returns than predicted by CAPM.
The residuals (leftover noise) from an estimated CAPM regression should be
unrelated to anything. But they are related to firm size, regardless of how size is
defined.
 CAPM seems to be missing something systematic and significant.
Several studies estimate the additional expected return associated with given
firm sizes.
• Ibbotson Associates
• Grabowski & King
We use these studies to adjust estimated costs of equity for the size of the
subject firm.
Procedure: Estimate the cost of equity, ke, using CAPM as usual.
Look up the estimated premium associated with subject firm size.
Add it to ke.
Ibbotson's Size Premiums: 2019 Yearbook, pages 140 -142
NYSE Recent Market Size BETA

Decile Capitalization Premium
(largest Co. (Above CAPM)
in Millions)
1 $222,298 - 0.30% 0.90
2 8,647 0.42 1.04
3 4,014 0.65 1.09
4 2,346 1.04 1.13
5 1,359 1.56 1.16
6 945 1.45 1.19
7 657 1.60 1.24
8 432 2.36 1.28
9 261 2.56 1.35
10 130 5.36 1.46

Research strategy employed by Grabowski & King:1
 Sorted companies by size into 25 portfolios.

 Used eight different measures of “size”
 Re-ranked annually starting in 1963.
 Calculated returns for annual holding periods.
 Computed average premiums over bonds since 1963.
 Result: Smaller companies have offered investors higher average returns.
1. See Grabowski & King, Business Valuation Review, various issues; http://valuation.ibbotson.com.

Application of Grabowski-King Premium to a Hypothetical Firm
Subject Indicated
Size Premium ke (1)
Market equity $85mil. 12% 19%
Book equity $36 13% 20%
Average NI $4.7 12% 19%
Average EBITDA $18 12% 19%
Sales $141 11% 18%
Employees 1,100 11% 18%
(1) cost of equity using risk free rate of 7%

Non-Public Companies
Do privately held firms have a different cost of capital than publicly-traded firms?
• Traditional theory says no (there are some interesting technical exceptions).
• It suggests that we simply use a publicly traded comparable firm to estimate beta.
Practice suggests there may be important exceptions, such as entrepreneur-

and family-owned enterprises. Such owners behave as though they had a
higher cost of capital than theory predicts.
Lack of diversification, due to the importance of control, may explain this
behavior.
One way to adjust ke for non-diversification: This is formally equivalent to the
adjustment for non-US volatility
spreads presented above.
ke = rf + [MRP](subject/market)
where subject = estimated volatility of subject firm (from comparables)
market = volatility of stock market.

Non-Public Companies
Warnings:
1. Theory implies that this premium is not sustainable in the long run:
diversified investors will outbid family members for control of the firm.
2. Theory further suggests this premium is not justified even in the short run:
it is inconsistent with value-maximizing behavior. If we’re not maximizing
value anyway, why even bother with NPV? [Response: real families do seem to
behave this way - as though NPV matters, but with a higher cost of capital.]
3. The adjustment above over-estimates the cost of equity to the extent that
owners are partially diversified. It must be regarded as an upper bound.
4. The adjustment is least questionable when applied over a finite (short)
period. For example, an entrepreneur is undiversified for 5 years until an IPO
occurs. S/he would apply a premium for non-diversification only for 5 years.
5. This adjustment is different from a discount for lack of marketability.
Nevertheless, they are related and should generally not be used together.
6. Do not use this for tax / audit / reporting“FMV” estimates; only (maybe) for
hurdle rates in capital budgeting.

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Valuation Modeling

The Income Approach:

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“Experts” (even academics) don’t agree.

Can we expect some convergence?

Within CVC, yes. We’re working on it.

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The cost of capital . . . may be adjusted for risk.

But business cash flows are risky.

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Risk averse investors would not assign

Probability distributions for The only way a standard DCF model

In a standard DCF model, the discount rate consists of:

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0 Riskiness of Cash Flows

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0 Systematic (non-diversifiable) risk: 

Elements of the CAPM: Risk-free Rate of Return

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 Typically estimated from historical stock price data:

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 Direct estimation of beta requires public stock market data and

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 BARRA offers both “Predicted” Betas and “Historical” Betas

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 Definition: The expected total return on a diversified portfolio of risky

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Historical Realized Premia on the Market

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Elements of the CAPM: The Market Risk Premium

Forward-Looking Approaches: What do investors actually expect?

 “Top Down” approach:

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Forward-Looking Market Premia

Merrill Lynch (bottom-up) 4.7% 4.7%

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 Historical data supports (roughly) 5% to 9%.

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WACC = [D/V]kd(1-t) + [E/V]ke

Q: Why/when is it OK to use WACC? All risk on the

Market Value B/S

Debt kd = rf + debt risk premium

Equity ke = rf + equity risk premium

This is usually These may be observed in

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Q: But where did that (1-t) come from? EBIT(1-t)

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When assessing fair market value When estimating NPV or a

0 leverage • See WACC (WARR)

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1. The risk-adjusted discount rate approach adds a risk premium to the

where k > rf.

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2. The certainty-equivalent approach subtracts a cash risk

[E(cash flows) - cash risk premium]

•This approach, though rarely used in companies, also is a DCF

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3. The risk-neutral approach adjusts the probabilities that are

• This approach is most commonly associated with options,