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 ratesWorks 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.

Analyst Estimate: $50B in revenue (10% growth over 2011)

Analyst thinks the product sell decently this year so picked 10% growth rate.

You think the product will grow faster than the analyst thinks, so you go 12%

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:

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

WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity

Cost of Debt

(Average Interest Rate * %debt) * (1-tax Rate)

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.

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 EquityMarket Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf)

10- Year Treasury Yield

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.

(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?

It increases, since now in order to compete for financing dollars

through equity, the company must effectively yield more returns to entice investors.

(Market Premium * Beta) + Risk-Free Rate = Cost of Equity

Market Premium = Return in the Equity market (Rm) – Risk-Free Rate (Rf)

WACC

So what is the calculation for it?

WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity

How much a company pays out on its debt (its interest rate),

adjusted for how much debt it holds

How much a company return to equity holders (by

dividends or share price appreciation) in order to

entice people to invest in its equity

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)

2012 2013 2014 2015 20161000 1200 1400 1600 1800 Exit: 5x

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.

PV Terminal Value = Calculated FV 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.

Terminal Value = 5th Year Cash Flow * (1+LT Rate)

Discount Rate – LT Rate

Terminal Value: the Long Term Rate

Terminal Value = 5th Year Cash Flow * (1+LT Rate)

Discount Rate – LT Rate

Terminal Value = 1800 x (1+3%)

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.