Copyright © 2011 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Chapter 11 Risk- Adjusted Expected Rates of Return and the Dividends Valuation Approach

Chapter: 112 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: 113 Approaches to Firm Valuation

Chapter: 114 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: 115 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: 116 Capital Asset Pricing Model For Risk-free rate of return (R F ), yield on short- or intermediate term US government securities can be used. {E[R M ] – E[R F ]} known as “market risk premium”

Chapter: 117 Cost of Equity Capital and Systematic Risk

Chapter: 118 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. Adjusting Market Equity Beta to Reflect a New Capital Structure

Chapter: 119 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: 1110 Cost of Debt and Preferred Equity Capital Cost of Debt: 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: 1111 Weighted Average Cost of Capital WACC: Considers debt, preferred, and equity capital used to finance Calculated as:

Chapter: 1112 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: 1113 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: 1114 Dividends valuation model: Dividends-Based Valuation (Contd.)

Chapter: 1115 Involves measuring the following three elements: Dividend (Discount rate = R E ) Expected future dividends (D t ) for periods 1 through T over forecast horizon. Continuing or final (D T+1), and long-run growth rate (g). Dividends-Based Valuation (Contd.)

Chapter: 1116 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: 1117 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: 1118 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: 1119 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: 1120 What now? Once valuation model is applied, then Conduct sensitivity analysis: Vary cost of equity capital rate (R E ) Vary long-run growth rate (g) Discount rate assumptions Vary these parameters and assumptions individually and jointly.

Chapter: 1121 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. Evaluation of the Dividends Valuation Method

Chapter: 1122 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. Evaluation of the Dividends Valuation Method