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FINANCE FOR EXECUTIVES Managing for Value Creation. Gabriel Hawawini Claude Viallet. ESTIMATING THE COST OF CAPITAL. EXHIBIT 10.1: Risk and Return for the Sun Cream and Umbrella Investments. EXHIBIT 10.2: SMC Stock Monthly Returns versus the S&P 500 Monthly Returns.

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slide1

FINANCE FOR EXECUTIVES

Managing for Value Creation

Gabriel Hawawini

Claude Viallet

ESTIMATING THE COST OF CAPITAL

slide2

EXHIBIT 10.1:

Risk and Return for the Sun Creamand Umbrella Investments.

slide3

EXHIBIT 10.2:

SMC Stock Monthly Returns

versus the S&P

500 Monthly

Returns.

slide4

EXHIBIT 10.3:

Beta Coefficients of a Sample of U.S. Stocks.

Southwest Air 1.60 Anheuser-Busch 1.00

Texas Instrument 1.60 McDonald’s 1.00

Compaq Computer 1.40 Walgreen Co. 1.00

Whirlpool Corp. 1.40 Coca-Cola 0.95

AMR Corp. 1.35 Pepsi-Cola 0.95

Motorola, Inc. 1.30 AT&T 0.90

Maytag Corp. 1.30 McGraw-Hill 0.85

BancOne Corp. 1.25 GTE 0.80

Abbott Laboratories 1.20 Bell Atlantic 0.80

Air Gas 1.20 Quaker Oats 0.80

Baxter International 1.15 Ameritech0.75

General Electric1.15Continental Edison 0.75

Viacom, Inc. 1.10 Amoco Corp. 0.75

Turner Broadcasting 1.10 Energy Corp. 0.70

Ford Motor Company 1.05 Texas Utilities 0.65

General Motors 1.05 American Water Works 0.65

Source: Value Line Investment Survey, 1996.

slide5

EXHIBIT 10.4:

Average Annual Rate of Return on Common Stocks, Corporate Bonds, U.S. Government Bonds, and U.S. Treasury Bills, 1926 to 1995.

AVERAGE RISK PREMIUM

TYPE OF AVERAGE ANNUAL DIFFERENCE BETWEEN RETURN

INVESTMENT RETURN OF INVESTMENT AND RETURN OF

TREASURY GOVERNMENT

BILLS BONDS

Common stocks (S&P 500) 12.2% 8.5% 7.0%

Corporate bonds 5.7% 2.0% 0.5%

Government bonds 5.2% 1.5% —

Treasury bills 3.7% — —

Source: Ibbotson Associates, Inc., 1996 Yearbook.

slide6

EXHIBIT 10.5:

The Capital Asset Pricing Model.

slide7

EXHIBIT 10.6a:

Estimation of the Cost of Equity Based on the Capital Asset Pricing Model (CAPM) for a Sample of Companies Listed on the London Stock Exchange (1996).

GOVERNMENT MARKET RISK

COMPANY INDUSTRY BOND RATE PREMIUM

REUTERS Agency 6% 7%

PEEK Electronics 6% 7%

BRITISH AEROSPACE Aerospace 6% 7%

INCHCAPE Trading 6% 7%

GLAXO HOLDINGS Health 6% 7%

LUCAS INDUSTRIES Motor 6% 7%

MARKS & SPENCER Stores 6% 7%

BRITISH TELECOM Phone network 6% 7%

SAVOY HOTELS Hotels 6% 7%

slide8

EXHIBIT 10.6b:

Estimation of the Cost of Equity Based on the Capital Asset Pricing Model (CAPM) for a Sample of Companies Listed on the London Stock Exchange (1996).

BETA ESTIMATED COST OF

COMPANY COEFFICIENT EQUITY WITH THE CAPM

REUTERS 1.73 6% + (7%)(1.73) = 18.1%

PEEK 1.52 6% + (7%)(1.52) = 16.6%

BRITISH AEROSPACE 1.34 6% + (7%)(1.34) = 15.4%

INCHCAPE 1.30 6% + (7%)(1.30) = 15.1%

GLAXO HOLDINGS 1.27 6% + (7%)(1.27) = 14.9%

LUCAS INDUSTRIES 1.21 6% + (7%)(1.21) = 14.5%

MARKS & SPENCER 0.88 6% + (7%)(0.88) = 12.2%

BRITISH TELECOM 0.73 6% + (7%)(0.73) = 11.1%

SAVOY HOTELS 0.40 6% + (7%)(0.40) = 8.8%

slide9

EXHIBIT 10.7:

SMC’s Managerial Balance Sheet.

INVESTED CAPITAL OR NET ASSETS CAPITAL EMPLOYED

Cash $10,000,000 Long-term debt 1 $90,000,000

90,000 bonds

at par value $1,000

Working capital $50,000,000

requirement

Owners’ equity $90,000,000

2,500,000 shares $25,000,000

at par value $10

Net fixed assets $120,000,000 Retained earnings $65,000,000

Total $180,000,000 Total $180,000,000

1 SMC has no short-term debt.

slide10

EXHIBIT 10.8a:

The Estimation of a Firm’s Weighted Average Cost of Capital (WACC), Including an Application to Sunlight Manufacturing Company (SMC).

STEPS TO FOLLOW HOW TO

Step 1: Estimate the firm’s relative proportions of debt (D) and equity (E) financing:

D E

E + D E + D

• Use the firm’s market values of debt and equity.

• The market value of debt is computedfrom data on outstanding bonds using the bond valuation formula (equation 10.1).

• The market value of equity is the share price times the number of shares outstanding.

• If the firm’s securities are not publicly traded use the market value rations of proxy firms.

and

slide11

EXHIBIT 10.8b:

The Estimation of a Firm’s Weighted Average Cost of Capital (WACC), Including an Application to Sunlight Manufacturing Company (SMC).

STEPS TO FOLLOW HOW TO

Step 2: Estimate the firm’s aftertax cost of debt: k D(1 – Tc).

• If the firm has outstanding bonds that are publicly traded, use equation 10.1 to

estimate k D.

• Otherwise, use the credit spread equation (equation 10.2) or ask the bank.

• Use the marginal corporate tax rate for Tc .

slide12

D

E + D

E

E + D

• WACC = k D(1 – Tc) + KE

EXHIBIT 10.8c:

The Estimation of a Firm’s Weighted Average Cost of Capital (WACC), Including an Application to Sunlight Manufacturing Company (SMC).

STEPS TO FOLLOW HOW TO

Step 3: Estimate the firm’s cost of equity: KE.

•Use the capital asset pricing model (equation 10.11).

•The risk-free rate is the rate on government bonds.

• The market risk premium is 7% (historical average).

• Use the beta of the firm’s stock. If the firm’s shares are not publicly traded, estimate beta from proxies.

Step 4: Calculate the firm’s

weighted average cost of capital (WACC).

slide13

EXHIBIT 10.9a:

Proxies for Buddy’s Restaurants.

EQUITY DEBT-TO-EQUITY RATIO1,2 ASSET

BETA1 D BETA3

E

At market value

McDonalds 1.01 0.17 0.92

Wendy’s International 0.92 0.23 0.81

CKE Restaurants 1.15 0.22 1.02

Average values 1.03 0.21 0.92

1 Data from Alcar, June 1996.

2 D = debt; E = equity.

3 Calculated according to equation 10.7 with a corporate tax rate of 40 percent.

slide14

EXHIBIT 10.9b:

Proxies for Buddy’s Restaurants.

DEBT RATIO1,2 EQUITY RATIO1,2

D E

E + D E + D

At market value At book value At market value At book value

McDonalds 0.14 0.41 0.86 0.59

Wendy’s International 0.19 0.36 0.81 0.64

CKE Restaurants 0.18 0.47 0.82 0.53

Average values 0.17 0.41 0.83 0.59

1 Data from Alcar, June 1996.

2 D = debt; E = equity.

3 Calculated according to equation 10.7 with a corporate tax rate of 40 percent.

slide15

EXHIBIT 10.10a:

The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project.

STEPS TO FOLLOW HOW TO

Step 1: Estimate the project’s relative proportions of debt (D) and equity (E) financing:

D E

E + D E + D

using proxy firms.

• Use the proxies’ market values of debt and equity.

• The market value of debt is computed from data on outstanding bonds using the bond valuation formula (equation 10.1).

• The market value of equity is the share price times the number of shares outstanding.

• Take the mean of the proxies’ ratios.

and

slide16

EXHIBIT 10.10b:

The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project.

STEPS TO FOLLOW HOW TO

Step 2: Estimate the project’s aftertax cost of debt: kD(1 – Tc).

• If the proxies have outstanding bonds that are publicly traded, use equation 10.1 to estimate their cost of debt kD.

• Otherwise, use the credit spread equation (equation 10.2) or ask the bank.

• Take the mean of the proxies’ cost of debt.

• Use the marginal corporate tax rate for Tc .

slide17

EXHIBIT 10.10c:

The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project.

STEPS TO FOLLOW HOW TO

Step 3: Estimate the project’s cost of equity: k E.

• Use the capital asset pricing model (equation 10.11).

• The risk-free rate is the rate on government bonds.

• The market risk premium is 7% (historical average).

• Un-lever the proxies’ equity betas using equation 10.7 to get their unlevered asset betas.

• Re-lever the mean of the proxies’ asset betas at the project’s target debt-to-equity ratio using equation 10.6 to get the project’s equity beta.

• Apply the CAPM to the project’s equity beta to get the project’s cost of equity kE.

slide18

D

E + D

E

E + D

EXHIBIT 10.10d:

The Estimation of a Project’s Cost of Capital when the Project Risk Is Different from the Risk of the Firm, Including an Application to the Buddy’s Restaurants Project.

STEPS TO FOLLOW HOW TO

• WACC = k D(1 – Tc) + KE

Step 4: Calculate the project’s

weighted average cost of

capital (WACC).

slide19

EXHIBIT 10.11:

Company-Wide Cost of Capital and Projects’ Expected Rates of Return.