Chapter 11 Risk-Adjusted Expected Rates of Return and the Dividends Valuation Approach

Economic theory teaches us that the value of an investment is: Valuing the Firm Economic theory teaches us that the value of an investment is: Expected future payoffs can be measured in terms of: Dividends Cash Flows Earnings Chapter: 11

Approaches to Firm Valuation Chapter: 11

Risk-Adjusted Expected Rates of Return Risk-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

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

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” Chapter: 11

Cost of Equity Capital and Systematic Risk Chapter: 11

Adjusting Market Equity Beta to Reflect a New Capital Structure 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. Chapter: 11

Evaluating the Use of the CAPM Criticisms 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

Cost of Debt and Preferred Equity Capital 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

Weighted Average Cost of Capital WACC: Considers debt, preferred, and equity capital used to finance Calculated as: Chapter: 11

Dividends-Based Valuation The 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

Dividends-Based Valuation (Contd.) Dividends include all cash flows between firm and shareholders: Periodic dividend payments Stock buybacks The liquidating dividend And “negative dividend” when firm initially issues stock Chapter: 11

Dividends-Based Valuation (Contd.) Dividends valuation model: Chapter: 11

Dividends-Based Valuation (Contd.) 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). Chapter: 11

Measuring Periodic Dividends Assume 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

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: Chapter: 11

Should be until firm reaches steady-state equilibrium. Forecast Horizon Represented 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

Continuing Value of future dividends Represented 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: Chapter: 11

Once valuation model is applied, then Conduct sensitivity analysis: What now? Once valuation model is applied, then Conduct sensitivity analysis: Vary cost of equity capital rate (RE) Vary long-run growth rate (g) Discount rate assumptions Vary these parameters and assumptions individually and jointly. Chapter: 11

Evaluation of the Dividends Valuation Method 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. Chapter: 11

Evaluation of the Dividends Valuation Method 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. Chapter: 11