Strategic Capital Group Workshop #8: Cost of Capital

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## Strategic Capital Group Workshop #8: Cost of Capital

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**Strategic Capital Group**Workshop #8: Cost of Capital**Previously, on SCG Workshop…**We discussed ways to forecast revenue: 1.) Use past historical growth rates to predict future rates Works well if you expect the company to remain stable at its current levels, ineffective if company is changing. 2.) Use analyst estimates as a benchmark and adjust them slightly to reflect the differences between your opinions 3.) Compute numbers yourself We will work on this today**Previously, on SCG Workshop…**We talked about how you can forecast revenue by taking analyst estimates for the next 5 years, reading their report on why they picked their numbers, then using your own opinion about the company to adjust the projection accordingly. You think the product will grow faster than the analyst thinks, so you go 12% Analyst thinks the product sell decently this year so picked 10% growth rate. Analyst Estimate: $50B in revenue (10% growth over 2011)**Change in Net Working Capital**• We learned that you can forecast the change in Net Working Capital by forecasting multiples such as Days Sales Outstanding, Days Payable Outstanding, Days Inventory Held, etc. which are fairly stable (and thus easy to forecast), then using the forecasted numbers for revenue and COGS to figure out the account balances of the current accounts.**So what’s left?**• We know what our revenue and costs will be over the next 5 years, we know NWC and the depreciation and CapEx. • We’ve reached free cash flow, but we need to figure out what the cash flows are worth today. We need to discount them back to the future. • But what discount rate do we use? How do we find an discount rate that reflects the diversity of risk within our specific company?**Weighted Average Cost of Capital**• What is it? • Essentially the weighted average rate a company expects to pay out to its financing sources (both debt and equity holders) • We use this rate as a discount rate for the cash flows. • It is also the long-term return we expect on the investment**Weighted Average Cost of Capital**Equation: WACC = %Debtx Cost of debtx (1-Tax Rate) + %Equityx Cost of equity Essentially: How much return all of our financiers get = How much return the equity holders demand * weighting of equity + How much return the debt holders demand/get * weighting of debt**Cost of Debt**In order to find what the company pays to its debt holders, we should find what the weighted average interest rate for their debt is (on the 10-K) We then weight the average interest rate they pay (by multiplying it by what percentage of their capital comes from debt capital) then multiply it again by (1-tax rate) to adjust for the tax deductibility of interest expense. (Average Interest Rate * %debt) * (1-tax Rate)**Check for Understanding**• So what is the cost of debt for a company that has all of its money from equity holders? 0! If we don’t have any debt, then we don’t care about debt financing costs. (Average Interest Rate * %debt) * (1-tax Rate)**Check for Understanding**• If a company’s credit rating goes down, what happens to its cost of debt? (Average Interest Rate * %debt) * (1-tax Rate) HINT: a decrease in credit rating will drive up your average interest rate Cost of debt will increase**Cost of Equity**Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf) Can take a 5-20 year average of S&P or DOW’s returns or just a 1 year. Essentially how much an extra return an investor gets for taking on equity risk. 10- Year Treasury Yield (Market Premium * Beta) + Risk-Free Rate = Cost of Equity Adjusting the equity returns for risk Typically a long term beta**Check for Understanding**• If the returns in the equity market increases, what happens to a company’s cost of equity? Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf) (Market Premium * Beta) + Risk-Free Rate = Cost of Equity It increases, since now in order to compete for financing dollars through equity, the company must effectively yield more returns to entice investors.**WACC**So what is the calculation for it? WACC = %Debtx Cost of debtx (1-Tax Rate) + %Equityx Cost of equity How much a company return to equity holders (by dividends or share price appreciation) in order to entice people to invest in its equity How much a company pays out on its debt (its interest rate), adjusted for how much debt it holds**Weighted Average Cost of Capital**• What influences it? • Market Interest Rates • Company Volatility (beta) • Equity market returns • Risk-free rates • Tax rates**STOP!**• We just learned how to calculate WACC, the value we will be using for our discount rate. • IT IS IMPERATIVE YOU YELL AT ME AND ASK QUESTIONS!**Discounting**We use the PV equation to discount each cash flow back to its present value. Remember: PV = (FV/ (1+ Discount Rate) ^ years away)**Discounting**• We’re still missing part of the value of the company, the company wont stop functioning after 5 years, technically we need to do this for the entire life of the company to find what the company is worth. • We call the estimation of a company’s cash flows from t=5 to t= infinity its “terminal value”**Critical Thinking**• If we’re taking the PV of an infinite number of years’ cash flows, shouldn’t the PV end up being infinity? No- as you get further and further into the future, a dollar becomes worth less and less until it eventually becomes worth nothing. If I offer you $1 100 years from now, it will cost more to buy a post-it note to remember I owe you money than the PV of $1**Terminal Value**• 2 ways to calculate this: • Exit Multiple Approach • Long-term growth rate approach**Terminal Value: The Exit Multiple Approach**• We can multiply the 5th year’s cash flow by a multiple of EV/EBITDA we plan to sell the company at in the future, then discount it back at year 5. Terminal Value = 5th Year Cash Flow * Projected (EV/EBITDA) Terminal Value = 1800 * 5 = 9000**So how do we know what to make EV/EBITDA?**• Several methods with differing degrees of difficulty: • Use the current multiple the company is trading at • Does not capture the future potential • Use the current industry multiple • Effective if you think the company will return to this value (because it is currently undervalued) • Calculate your own • Use your 5th year projections to come up with a 5th year EBITDA, use current EV and compute a multiple.**Terminal Value: The Exit Multiple Approach**• We discount this terminal value back to the present value using year=5, not infinity. Calculated FV Terminal Value PV Terminal Value = (1+Discount Rate) ^5**Terminal Value: The Long-Term Rate**• We can also calculate terminal value by figuring out the “long-term growth rate” of a company- essentially the amount we expect a company to grow consistently in the future once it has matured. Typically this number is just slightly larger than US or world GDP growth. 5th Year Cash Flow * (1+LT Rate) Terminal Value = Discount Rate – LT Rate**Terminal Value: the Long Term Rate**5th Year Cash Flow * (1+LT Rate) Terminal Value = Discount Rate – LT Rate 1800 x (1+3%) Terminal Value = 12% – 3% Problems you may encounter: In companies with low WACC, this makes the terminal value VERY high, making this method ineffective.**So…**• At this point we’ve figured out how to forecast a companies revenues and costs to get to free cash flow. • After this, we discount the cash flows and a terminal value back to the present value using our WACC as a discount rate. • So now we have a pile of PV’d cash, and need to figure out a share price from this.**We do this…**• By turning this lump of cash into its enterprise value (more on this next slide), then figuring out equity value from this through some simple algebra.**Enterprise Value**• We need to discuss another way to measure the size of a company. • Previously we said market cap was a way to size a company (Price * shares outstanding) • But this had the issue of not taking into account the debt that was used to fund a company. • We adjust for this problem by calculating Enterprise Value**Enterprise Value**• EV is essentially the amount of money you would have to pay to “take over” a company, buying all of its debt and equity. EV = Market Cap + Debt – Cash +Preferred Shares + Minority Interest We take out cash because when we buyout a company, we are paying cash for cash, which cancels out. Here we are taking into account non-equity shares we have to buyout**Getting to Enterprise Value from Cash Flows**After discounting the terminal value and the FCF’s from the 5 projected years, we add them all up to reach our implied Enterprise Value. From this, we solve for market cap by taking out the current year’s debt, preferred shares, and minority interest, leaving us with Market Cap + Cash. We divide this value by the shares outstanding to find the implied price per share.**EV = Market Cap + Debt – Cash +Preferred Shares + Minority**Interest So essentially, we are left with Market Cap after taking out all the debt and stuff from our big pile of PV’d cash. Since market cap is just Price * shares oustanding, we divide the remainder of the PV’d cash (after everything else is taken out) by shares outstanding to get an implied share price.