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Part 1: Risk-Free Rates and Risk Premiums

While discount rates obviously matter in DCF valuation, they don’t matter as much as
most analysts think they do.
- Must have Consistency (Euro must have a euro disc rate and cash flows)
- Consistent in the discount rate as well as the currency

▪ At an intuitive level, the discount rate used should be consistent with both the riskiness
and the type of cashflow being discounted.
− Equity versus Firm: If the cash flows being discounted are cash flows to
equity, the appropriate discount rate is a cost of equity.
− If the cash flows are cash flows to the firm, the appropriate discount rate
is the cost of capital.
− Discount rates should reflect the risk perceived by the marginal investor
in the company

▪ Currency: The currency in which the cash flows are estimated should also be the currency
in which the discount rate is estimated.

▪ Nominal versus Real: If the cash flows being discounted are nominal cash flows (i.e.,
reflect expected inflation), the discount rate should be nominal

Estimating Cost of Equity Capital

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Estimating Cost of Equity Capital

- Risk-free
- The relative risk of the company (estimated beta)
- The price of risk depends on what investors want for equity
- Economic uncertainty is the most troublesome risk and cannot be taken away
- Risk cannot be fully taken away with risk

Input Factors for Estimating Cost of Equity Capital: Risk-free

Rate
▪ For an investment to be risk-free, then, it has to have
− Actual return is equal to the expected return
− No default risk
− No reinvestment risk (Not all government securities are risk-free)

▪ In valuation, we estimate cash flows forever (or at least for very long time periods). The
right risk free rate to use in valuing a company in US dollars would be…

a) A three-month Treasury bill rate

- Cant happen because no duration
b) A ten-year Treasury bond rate
- Too long, but much more liquid, picking the rate is just the start and other
rates will have to match (easier than the 30 year), term structure flattens near
maturity (Best option)
c) A thirty-year Treasury bond rate
- Too long, unusual supply deman, biased in liquidity
d) A TIPs (inflation-indexed treasury) rate
- If cash flow is nominal, then the real rate wont help
e) None of the above

There are no global risk free rates

▪ Since we are valuing cashflows for the long term, we want a long-term risk-free
rate (rule out the 3-month T-bills rate) → Reinvestment risk

▪ Since the valuation is in US dollars (a nominal rate), we can also rule out the TIPS rate.

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- If cash flow is nominal, then the real rate wont help
e) None of the above

There are no global risk free rates

▪ Since we are valuing cashflows for the long term, we want a long-term risk-free
rate (rule out the 3-month T-bills rate) → Reinvestment risk

▪ Since the valuation is in US dollars (a nominal rate), we can also rule out the TIPS rate.

▪ In theory, the 30-year rate should be the best choice.

▪ In practice, I would go with the 10-year bond for the following reasons:
− Most liquid of the treasuries (fresh auction rate from the previous
Monday)
− Getting other inputs such as equity risk premiums and default spreads
is easier with a 10-year rate than a 30-year rate
− Term structure flattens out by the time you get to the 10-year rate….

Spread Between 10-year Treasury Rate and 1-year Treasury Rate

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Spread Between 10-year Treasury Rate and 1-year Treasury Rate

Spread Between 10-year Treasury Rate and 30- year Treasury Rate

- Not too large of a difference

- 10 year is a good substitute of the 30 year bond given enough information is provided

Risk-free Rates Across the World and Across Currencies

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Risk-free Rates Across the World and Across Currencies

- Default does not explain the difference

- Vary across currency because of inflation, (High rates lead to high rates)

Estimating Risk-free Rate

▪ You have been asked to estimate the risk free rate for a Swiss multinational company,
which gets 10% of its revenues in Switzerland (in Swiss Francs), 30% of its revenues in the
European Union (in Euro), 40% of its revenues in the U.S. (in US$), and 20% of its revenues
in India (in Indian rupees). The risk-free rates are 0.5% in Swiss Franc, 1% in Euros, 2.5% in
US$ and 6% in Indian Rupees. What is the risk-free rate you use in your valuation?

a) The simple average of the risk-free rates

b) The weighted average of the risk-free rates
c) The Swiss franc rate, since it is a Swiss company
d) The lowest of the rates, since it has to be risk-free
e) The highest of the rates, to be conservative
f) None of the above
- Depends on the currency used for the valuation, will just have to adjust cash
flows to the currency used
- Would be like comparing C and F temperatures

Risk-free Rates and Government Yields

▪ The Indian government had 10-year Rupee bonds outstanding, with a yield to maturity of
about 7.73%.

▪ In January 2016, the Indian government had a local currency sovereign rating of Baa3. The
typical default spread (over a default free rate) for Baa3 rated country bonds was 2.44%.

▪ The risk-free rate in Indian Rupees is

a) The yield to maturity on the 10-year bond (7.73%)
- Believe there will be no default risk, so this is out because they are not default
free
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▪ The Indian government had 10-year Rupee bonds outstanding, with a yield to maturity of
about 7.73%.

▪ In January 2016, the Indian government had a local currency sovereign rating of Baa3. The
typical default spread (over a default free rate) for Baa3 rated country bonds was 2.44%.

▪ The risk-free rate in Indian Rupees is

a) The yield to maturity on the 10-year bond (7.73%)
- Believe there will be no default risk, so this is out because they are not default
free
b) The yield to maturity on the 10-year bond + Default spread (10.17%)
- Added risk, thus accounting for it twice
c) The yield to maturity on the 10-year bond – Default spread (5.29%)
- Risk free equivalent rate to account for the rating of the currency
d) None of the above

Sovereign Default Spread: Three Paths to the Same

Destination…
▪ Sovereign dollar or euro denominated bonds:
− Find sovereign bonds denominated in US dollars, issued by an emerging
sovereign.
− Default spread = Emerging Govt Bond Rate (in US $) – US Treasury Bond
rate with same maturity.
- Same currency takes away the spread risk

▪ CDS spreads:
− Obtain the traded value for a sovereign Credit Default Swap (CDS) for
the emerging government.
− Default spread = Sovereign CDS spread (with perhaps an adjustment for
CDS market frictions).
- Looks at what the market pays for risk

▪ Sovereign-rating based spread:

− For countries which don’t issue dollar denominated bonds or have a CDS
spread, you have to use the average spread for other countries with the
same sovereign rating

Approach 1: Default Spread from Government Bonds

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Approach 1: Default Spread from Government Bonds

- Excel- blank sheet, item lookup

● Look up brazil
● Minute 31 in EV 5 Part 1
● Look for the rate that reflects the default risk

Approach 2: CDS Spreads

- List the Credit default savings by countries on FactSet

- Look for the lowest spread as the safest

Approach 3: Sovereign-rating Based Spread

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- List the Credit default savings by countries on FactSet

- Look for the lowest spread as the safest

Approach 3: Sovereign-rating Based Spread

- Economics on fact set, find the default spread

- Link on the slid will provide the updated the better results
- Worst approach

Getting to a Risk-free Rate in a Currency: Example

The 10-year Brazilian government bond rate in nominal real on October 20, 2020 was
8.05% (see https://my.apps.factset.com/navigator/markets/government-yields)
- Markets --> government yields
▪ To get to a risk-free rate in nominal real, we can use one of three approaches.
− Approach 1: Government Bond spread
− The 2030 Brazil bond, denominated in US dollars, has a spread of 2.79%

over the US treasury bond rate.

− Risk-free rate in $R = 8.05% - 2.79% = 5.26%

▪ Approach 2: The CDS Spread

− The CDS spread for Brazil, adjusted for the US CDS spread was 5.19%.
− Risk-free rate in $R = 8.05% - 2.79% = 5.26%

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Markets > government yields
▪ To get to a risk-free rate in nominal real, we can use one of three approaches.
− Approach 1: Government Bond spread
− The 2030 Brazil bond, denominated in US dollars, has a spread of 2.79%

over the US treasury bond rate.

− Risk-free rate in $R = 8.05% - 2.79% = 5.26%

▪ Approach 2: The CDS Spread

− The CDS spread for Brazil, adjusted for the US CDS spread was 5.19%.
− Risk-free rate in $R = 8.05% - 2.79% = 5.26%

▪ Approach 3: The Rating based spread

− Brazil has a BB- (~Ba3) local currency rating from S&P’s. The default
spread for that rating is 3.01%
− Risk-free rate in $R = 8.05% - 3.01% = 5.04%
● Risk free rate will be lower but equity premium will be higher, thus will not
make a difference when using the consistent rate

One More Test on Risk-free Rates…

▪ On October 20, 2020, the 10-year treasury bond rate in the United States was 0.84%, a
historic low.

▪ Assume you are valuing a company in US dollars, but you are wary about the risk free rate
being too low. Which of the following should you do?
a) Replace the current 10-year bond rate with a more reasonable normalized risk-
free rate (the average 10-year bond rate over the last 30 years has been about 5-6%)
- Cost of capital will be high and the return is low
- Cannot normalize risk free rates
b) Use the current 10-year bond rate as your risk-free rate but make sure that
your other assumptions (about growth and inflation) are consistent with the
risk-free rate
- Take the risk free rate and move on
c) Something else

Negative Interest Rates?

▪ In 2020, there were at least three currencies (Swiss Franc, Japanese Yen, Euro) with
negative interest rates. Using fundamentals how would you explain negative interest rates?

▪ How negative can rates get? (Is there a bound?) ▪ Would you use these negative interest
rates as risk free rates?
− If no, why not and what would you do instead?
− If yes, what else would you have to do in your valuation to be internally
consistent?

Historical Market Premiums

▪ The historical market premium is the difference between the realized annual return from
investing in stocks and the realized return from investing in the risk-free security (treasuries)

over a past time period.

▪ To estimate this risk premium, how long a time period should you use?
a) Just one year (last year)
- Wrong, heavily depends on what happens in the last year
b) Last 5 years (to reflect current conditions)
- Wrong stocks are volatile may get an okay standard deviation but not
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Historical Market Premiums
▪ The historical market premium is the difference between the realized annual return from
investing in stocks and the realized return from investing in the risk-free security (treasuries)

over a past time period.

▪ To estimate this risk premium, how long a time period should you use?
a) Just one year (last year)
- Wrong, heavily depends on what happens in the last year
b) Last 5 years (to reflect current conditions)
- Wrong, stocks are volatile, may get an okay standard deviation, but not
historical mean
c) As long a time periods as you can get the historical data for
d) Should match the time period on your risk-free rate
- No reason to use
e) Should match the time period used to estimate your beta
- Not relevant

▪ Assume that next year turns out to be a terrible year for stocks. If that occurs, you should
expect to see the historical market premium next year to
a) Go up
b) Go down
- Governments will typically lower rates, thus risk premium will go up but
historical will go down
- Put an RP of 1, what would you be willing to pay for a stock

Estimating an additional country risk premium: The country

default spread
▪ Default spread for country: Country equity risk premium is set equal to the default spread
for the country, estimated in one of three ways:
− The default spread on a dollar denominated bond issued by the country
(October 2020 that spread was 2 79% for the Brazilian $ bond)
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Estimating an additional country risk premium: The country

default spread
▪ Default spread for country: Country equity risk premium is set equal to the default spread
for the country, estimated in one of three ways:
− The default spread on a dollar denominated bond issued by the country
(October 2020, that spread was 2.79% for the Brazilian $ bond)
− The sovereign CDS spread for the country (October 2020, the ten year
CDS spread for Brazil, adjusted for the US CDS, was 2.79%).
− The default spread based on the local currency rating for the country
(Brazil’s sovereign local currency rating is BB- and the default spread for a
was about 3.01%)

▪ Add the default spread to a “mature” market premium: This default spread is added on to
the mature market premium to arrive at the total equity risk premium for Brazil, assuming a
mature market premium of 5.20%.
− Country Risk Premium for Brazil = 2.79%
− Total ERP for Brazil = 5.20% + 2.79% = 7.99%

Take country risk premium, and the standard deviation of S&P 500 and country index
- Divide the standard deviations and multiply by the risk premium
- Will underestimate risk due to illiquidity of emerging assets

From Country Equity Risk Premiums to Corporate Equity Risk

premiums

- Use the Rp of India and US weighted by revenues

- If all software was in india, then rp should be based on where revenues earned
- If a situation like oil, oil is what causes the risk, not revenues, operations cannot be
moved so use the countries rp
- If a car manufacturer in mexico revenue weighted RP
- Just make sure you can justify your risk premium, the easier it is to move facilities,

the more important to look at revenues

-

Approaches 1 & 2: Estimating Country Risk Premium Exposure

▪ Location based CRP:
− The standard approach in valuation is to attach a country risk premium
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If a situation like oil, oil is what causes the risk, not revenues, operations cannot be
moved so use the countries rp
- If a car manufacturer in mexico revenue weighted RP
- Just make sure you can justify your risk premium, the easier it is to move facilities,

the more important to look at revenues

-

Approaches 1 & 2: Estimating Country Risk Premium Exposure

▪ Location based CRP:
− The standard approach in valuation is to attach a country risk premium
to a company based upon its country of incorporation. Thus, if you are an
Indian company, you are assumed to be exposed to the Indian country risk
premium.
− A developed market company is assumed to be unexposed to emerging
market risk.

▪ Operation-based CRP (more reasonable):

− The country risk premium for a company can be computed as a
weighted average of the country risk premiums of the countries that it
does business in, with the weights based upon revenues or operating
income. If a company is exposed to risk in dozens of countries, you can
take a weighted average of the risk premiums by region.

▪ Problem: Focus just on revenues -- only variable that you consider, when weighting risk
exposure across markets -- you may be missing other exposures to country risk. For
example risk from location of production facilities in the emerging market.

▪ Exposure not adjusted or based upon beta: To the extent that the country risk premium is
multiplied by a beta, we are assuming that beta in addition to measuring exposure to all
other macro economic risk also measures exposure to country risk.

Example: Estimating Revenue and Operation Based ERP/CRP

for Apple

- Weighted RP is 5.9%
- Problem is that the revenue can be one country vs the world. Maybe use the GDP
weighted average

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Revenue based Lambda for Apple

Summary ERP and CRP for Apple

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Summary ERP and CRP for Apple

- Approach 3 underestimates cost of equity because of the significant international

sales

Valuing Emerging Market Companies with Significant Exposure

in Developed Markets
▪ The conventional practice in investment banking is to add the country equity risk premium
on to the cost of equity for every emerging market company, notwithstanding its exposure to
emerging market risk.

▪ Thus, a firm such as Embraer would have been valued with a cost of equity of 17-18%
even though it gets only 3% of its revenues in Brazil. As an investor, which of the following
consequences do you see from this approach?
a) Emerging market companies with substantial exposure in developed markets will
be significantly over valued by equity research analysts.
b) Emerging market companies with substantial exposure in developed
markets will be significantly under valued by equity research analysts.

▪ Can you construct an investment strategy to take advantage of the misevaluation?

▪ What would need to happen for you to make money of this strategy?

Implied Premiums in the US: 1960-2018

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Implied Premiums in the US: 1960-2018

Why Implied Premiums Matter?

▪ In many investment banks, it is common practice (especially in corporate finance
departments) to use historical risk premiums (and arithmetic averages at that) as risk
premiums to compute cost of equity.

▪ If all analysts in the department used the arithmetic average premium (for stocks over
Tbills) for 1928-2018 of 6% to value stocks in 2018, given the implied premium of 4.19%,
what are they likely to find?
a) The values they obtain will be too low (most stocks will look overvalued)
b) The values they obtain will be too high (most stocks will look under valued)
c) There should be no systematic bias as long as they use the same premium to
value all stocks

If people should look overvalued with a high equity premium

- Should stay around the implied premium

Which Equity Risk Premium (ERP) Should You Use?

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Which Equity Risk Premium (ERP) Should You Use?

- Implied premiums

Part 2: Risk Parameter and Cost of Capital

- How to bring in risk on a country level

- How risky a firm is relative to the market

Where Does the Risk Comes From?

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Where Does the Risk Comes From?

- Need risk free, beta, risk premiu

Estimating Regression Beta and Cost of Equity for Apple

(excluding CRP)

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Recap: Estimating Beta

▪ Problems associated with these models
− Time-series regressions require a sufficient amount of valid data points
(IPOs? Private firms?) [not feasible for dominant and new firms, will lead to
bias]
− Time-series regressions assume stationarity of the model parameters
(what if a firm very recently has sold a significant business line?)

▪ Excurse Solution:
− Modify the regression beta by adjusting the regression beta estimate,
by bringing in information about the fundamentals of the company
− Estimate the beta for the firm from the bottom up without employing
the regression technique. This will require
➢ understanding the business mix of the firm
➢ estimating the financial leverage of the firm
− Use an alternative measure of market risk not based upon a regression

Measuring Relative Risk: Alternatives to CAPM

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Measuring Relative Risk: Alternatives to CAPM

Excurse Measuring Relative Risk: Alternatives to CAPM

▪ Relative Standard Deviation
− Relative Volatility = Std dev of Stock/ Average Std dev across all stocks
− Captures all risk, rather than just market risk

▪ Proxy Models
− Look at historical returns on all stocks and look for variables that explain
differences in returns.
− You are, in effect, running multiple regressions with returns on individual
stocks as the dependent variable and fundamentals about these stocks as
independent variables.
− This approach started with market cap (the small cap effect) and over
the last two decades has added other variables (momentum, liquidity etc.)

▪ CAPM Plus Models

− Start with the traditional CAPM (Rf + Beta (ERP)) and then add other
premiums for proxies.

Accounting risk measures: To the extent that you don’t trust market-priced based measures
of risk, you could compute relative risk measures based on
− Accounting earnings volatility: Compute an accounting beta or relative
volatility
− Balance sheet ratios: You could compute a risk score based upon
accounting ratios like debt ratios or cash holdings (akin to default risk
scores like the Z score)
- Cost of equity is typically twice the size as cost of debt

▪ Qualitative Risk Models: In these models, risk assessments are based at least partially on
qualitative factors (quality of management).

▪ Debt based measures: You can estimate a cost of equity, based upon an observable costs
of debt for the company.
− Cost of equity = Cost of debt * Scaling factor
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accounting ratios like debt ratios or cash holdings (akin to default risk
scores like the Z score)
- Cost of equity is typically twice the size as cost of debt

▪ Qualitative Risk Models: In these models, risk assessments are based at least partially on
qualitative factors (quality of management).

▪ Debt based measures: You can estimate a cost of equity, based upon an observable costs
of debt for the company.
− Cost of equity = Cost of debt * Scaling factor
− The scaling factor can be computed from implied volatilities.

Determinants of Betas and Relative Risk

Excurse: Alternative Bottom-up Beta

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Excurse: Alternative Bottom-up Beta

Excurse: Bottom-up Beta for Apple

Excurse: Why bottom-up betas?

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Excurse: Why bottom-up betas?

Bottom-up Betas
▪ We estimate “botton up” betas as an alternative to regression beats. To obtain bottom-up
beta for a firm, we average regression betas across “comparable” firms. Given a choice,
which of the following is likely to yield the best bottom up-beta?
a) A small sample of companies similar to yours
b) A large sample of companies that may have differences from yours
c) One company exactly like yours
d) Only your company is required for the regression
e) Three to five immediate competitors

Recap: Cost of Equity

Summary Cost of Equity for Apple

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Summary Cost of Equity for Apple

- Minute 27 EV 5 part 2

Estimating Cost of Debt

▪( The cost of debt () is the rate at which a firm can borrow at currently
- What a firm borrows long term
- If interest rates go up, only can borrow at a higher rate
- Liquid bond outstanding, look up the rate for 10 year maturity
● Minute 30 EV5 p2
● Take liquid bonds with maturity at 10 years to get the rate
● Often the bonds are tied to other securities (may influence reat maturity)

▪ It should reflect default risk and the level of interest rates in the market

▪ The two most widely used approaches to estimating cost of debt are:
− Version 1: Looking up the yield to maturity on a straight bond outstanding from the
firm (if the firm has liquid straight bonds that are liquid issued)
− Version 2: Looking up the rating for the firm and estimating a default
spread based upon the rating (robust, but different bonds from the same
firm can have different ratings → use a median rating for the firm)
● Look at the synthetic rating, z score and interest coverage ratio

▪ Alternatives:
− Use the risk free rate and adjust Weighted Average Cost of Capital for
default risk
− Estimate a synthetic rating for your firm and the cost of debt based

upon that rating

➢ With Altman z-score (sophisticated)
➢ With Interest Coverage Ratio (simplest): EBIT / Interest Expenses

Altman z-score Ratios, Ratings and Default Spreads

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− Use the risk free rate and adjust Weighted Average Cost of Capital for
default risk
− Estimate a synthetic rating for your firm and the cost of debt based

upon that rating

➢ With Altman z-score (sophisticated)
➢ With Interest Coverage Ratio (simplest): EBIT / Interest Expenses

Altman z-score Ratios, Ratings and Default Spreads

- Similar to interest coverage ratio for the riskyness of the firm

- Add 3.25 to the z score to get the ratting
1
- Default probability is z
1+ e

X1- Working capital /total assets

X2- retained earnings /total assets
X3- EBIT /total assets
X4- MV Equity/total Liabilities
X5- Sales /total assets

X1- higher wc is better

Higher RE is more cash available to payoff debt
EBIT- more Profitable
X4- more leverage
X5 is more profitable

Default Spreads Over Time

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Default Spreads Over Time

- Not all firms in a AAA or any sector are equally risky

Corporate Default Spreads for Specific Industries

- Market and corporate spreads on factset

● Report spread industry groups
- Sometimes a bond rating class is not diversified enough and can be biases

Interest Coverage Ratios, Ratings and Default Spreads

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Interest Coverage Ratios, Ratings and Default Spreads

- Moderan firms, the firms are sorted by group

- Look into the spread as well

Estimating Cost of Debt for Apple– Version 1

Estimating Cost of Debt for Apple– Version 2

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Estimating Cost of Debt for Apple– Version 2

Estimating Cost of Debt for Apple– Version 3 and 4

Summary Cost of Debt for Apple

▪ Approach 1:
− 1.2% for the average bonds outstanding adjusted for CRP, overweight of
short term rates / low interest rates because term structure is not linear

− 1.36% for the bond closest to 10 year maturity may misevaluate risk for
complete debt

▪ Approach 2:
− 0.85% risk free rate + Spread of 0.53% = 1.38% (spread my be biased
by Apple bond dominating the market)

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y pp
▪ Approach 1:
− 1.2% for the average bonds outstanding adjusted for CRP, overweight of
short term rates / low interest rates because term structure is not linear

− 1.36% for the bond closest to 10 year maturity may misevaluate risk for
complete debt

▪ Approach 2:
− 0.85% risk free rate + Spread of 0.53% = 1.38% (spread my be biased
by Apple bond dominating the market)

▪ Approach 3:
− Altman z-score and implied rating: 1.48%
− Interest Coverage and implied rating: 1.48%

Some Final Notes on the Estimation of Cost of Debt

▪ Companies in countries with low bond ratings and high default risk might bear the burden
of country default risk, especially if they are smaller or have all of their revenues within the
country.
- May be a bias in approaches 2 and 3

▪ Larger companies that derive a significant portion of their revenues in global markets may
be less exposed to country default risk. In other words, they may be able to borrow at a rate
lower than the government.

Estimating Cost of Debt

▪ You are assessing the cost of debt, to use in the cost of capital. The firm has $1 billion in
bank loans outstanding, carrying an interest rate of 4% and a remaining maturity of 8 years,
the loans were taken on a couple of years ago when interest rates were lower. The current
risk-free rate is 5% and you anticipate that your default spread to borrow long term is 2%.
What is the pre-tax cost of debt for this firm?
a) 4%
b) 5%
c) 7%
d) 5.5%
e) None of the above
- Always use 7% because it is todays rate
-

Estimating Cost of Debt

▪ You are valuing a firm that has $1 billion in bank loans outstanding, at a rate of 4%. Loans
were taken on a couple of years back and need to be renewed at some future point in time
at a higher interest rate because interest rates had increased over time. That is the risk-free
rate is at 5%. The firm has a market value of equity of $1 billion. You are computing the debt
to capital ratio (DR) for the firm. What is the debt to capital ratio?
a) 50%
b) >50%
c) <50%

- Discount rate will be less than the market rate thus the loan will be trading
below 1 billion, thus it will be less than 50%

Weights for the Cost of Capital Computation

▪ In computing the cost of capital for a publicly traded firm, the general rule for computing
weights for debt and equity is that you use market value weights (and not book value
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to capital ratio (DR) for the firm. What is the debt to capital ratio?
a) 50%
b) >50%
c) <50%

- Discount rate will be less than the market rate thus the loan will be trading
below 1 billion, thus it will be less than 50%

Weights for the Cost of Capital Computation

▪ In computing the cost of capital for a publicly traded firm, the general rule for computing
weights for debt and equity is that you use market value weights (and not book value
weights). Why?
a) Because the market is usually right
b) Because market values are easy to obtain
c) Because book values of debt and equity are meaningless
d) None of the above

Estimating Market Value of Debt

- Book value to market value

Estimating Weighted Average Cost of Capital (WACC)

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Estimating Weighted Average Cost of Capital (WACC)

Estimating Market Value of Debt and Equity for Apple

Exercise: Estimating WACC for Apple (Solution)

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Exercise: Estimating WACC for Apple (Solution)

Exercise: Estimating WACC for Apple

Dealing with Hybrids and Preferred Stock

▪ When dealing with hybrids (convertible bonds, for instance), break the security down into
debt and equity and allocate the amounts accordingly.
− If a firm has $ 125 million in convertible debt outstanding, break the
$125 million into straight debt and conversion option components.
− The conversion option is equity.

▪ When dealing with preferred stock, it is better to keep it as a separate component.

− The cost of preferred stock is the preferred dividend yield. (As a rule of
thumb, if the preferred stock is less than 5% of the outstanding market
value of the firm, lumping it in with debt will make no significant impact on
your valuation).

Part 3: Closure in Valuation

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Part 3: Closure in Valuation

- Do not stay too far the equity premium when doing valuation
- EV2

Intrinsic Valuation Models and Terminal Value

- No need to terminal valuation when something ends

- If you are a valuing a publicly traded company, it may just continue indefinenly
- Cannot estimate cash flows forever, thus the need to find the terminal value to come
after the period out of predicted cash flows

Ways of Estimating Terminal Value

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Ways of Estimating Terminal Value

3 ways to get to a terminal value:

- Liquidation- pretend you close your company in 5 to 10 years and discover what you
would get out of it
- Multiple- apply a multiple in five to 10 years, don't find the value of the equity today,
but 5 years out
● Most commonly used approach
● Relative valuation
- Stable growth- put future cash flows into perpetuity
● Can be used to serve the purpose of whomst is writing the terminal value

Intrinsic Valuation Models and Terminal Value

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Intrinsic Valuation Models and Terminal Value

- Terminal value is always the year after

- Tweaking the long term growth can be dangerous
- Will want to follow rules such as:
● Do not put growth larger than the industry growth rate (okay to assume a
negative growth rate)
● Use the nominal growth rate, but will also have to estimate the future growth
rate in the country of option

Nominal GDP Forecast

- Risk free rate is a good proxy for the nominal rate

- Can use the fisher effect

When Will “Stable Growth” Start?

▪ Analysts routinely assume very long high growth periods (with substantial excess returns
during the periods), but the evidence suggests that they are much too optimistic.

▪ Most growth firms have difficulty sustaining their growth for long periods, especially while
earning excess returns.

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When Will “Stable Growth” Start?

▪ Analysts routinely assume very long high growth periods (with substantial excess returns
during the periods), but the evidence suggests that they are much too optimistic.

▪ Most growth firms have difficulty sustaining their growth for long periods, especially while
earning excess returns.
- Don't wait too long

▪ It is not growth per se that creates value but growth with excess returns.

▪ For growth firms to continue to generate value creating growth, they have to be able to
keep the competition at bay.
− Proposition 1: The stronger and more sustainable the competitive advantages,
the longer a growth company can sustain “value creating” growth.
− Proposition 2: Growth companies with strong and sustainable competitive
advantages are rare.

▪ Assume that you are valuing a young, high growth firm with great potential, just after its
initial public offering. How long would you set your high growth period? (zoom)
a) < 5 years
b) 5 years
c) 10 years
d) >10 years
- Medium high growth is between 3-4 years
- Need to understand why they would keep such a competitive advantage in
the longer run

Growth Has to Be Earned!

- In steady state growth can come from two sources,

● Must reinvest to deliver growth

● Reinvestment rate is a function of the stable growth rate and the return on
capital in perpetuity that is forcasted

Terminal Value, Growth, and Return on Invested Capital

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- In steady state growth can come from two sources,

● Must reinvest to deliver growth

● Reinvestment rate is a function of the stable growth rate and the return on
capital in perpetuity that is forcasted

Terminal Value, Growth, and Return on Invested Capital

- If using Return on capital, higher growth shows to be unstable

- Return on capital is unprofitable growth and becomes lower than the cost of capital
until 10%
● Biggest assumption is not the growth but setting the return on capital
● If you don't see the company is in good standing set a lower ROC to punish
growth

Typical Assumptions
▪ A typical assumption in many DCF valuations, when it comes to stable growth, is that
− Capital expenditures offset depreciation
− There are no working capital needs.
− Stable growth firms “just” have to make maintenance cap ex (replacing
existing assets ) to deliver growth.

▪ If you make this assumption, what expected growth rate can you use in your terminal value
computation?

▪ What if the stable growth rate = inflation rate? Is it okay to make this assumption then?
- If growing at the inflation rate, then you must account for reinvestment at inflation
(buying new equipment and purchases)
- A company needs to reinvest to grow

Be Consistent
▪ Risk and costs of equity and capital, stable growth firms tend to
− Have betas closer to one
− Have debt ratios closer to industry averages (or mature company
averages)
− Country risk premiums (especially in emerging markets should evolve
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A company needs to reinvest to grow

Be Consistent
▪ Risk and costs of equity and capital, stable growth firms tend to
− Have betas closer to one
− Have debt ratios closer to industry averages (or mature company
averages)
− Country risk premiums (especially in emerging markets should evolve
over time)
- If groth comes down, cost of capital needs to decrease as well
- Mature companies are typically at 7.5%

▪ The reinvestment needs and dividend payout ratios should reflect the lower growth and
excess returns:
− Stable period payout ratio = 1 - g/ ROE
− Stable period reinvestment rate = g/ ROC

“Best of Both Worlds”: Combine DCF with Multiples – Example

Apple

- Most widespread is EV/EBITDA for stable growth

- Multiply with a forecasted meaning multiple
- Terminal Value= Multiple*eanings

Lower net cap reinvestme, etc. leeads to lower EV/EBITDA multiples, Low Working capital
means high EV/EBITDA

Part 4: Choosing the Right Valuation Models

Ch 13-15

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Part 4: Choosing the Right Valuation Models

Ch 13-15

Summarizing the Inputs

▪ In summary, we should have an estimate of the…
− …Current cash flows on the investment, either to equity investors
(dividends or free cash flows to equity) or to the firm (cash flow to the
firm)
− …Current cost of equity and/or capital on the investment
− Expected growth rate in earnings, based upon historical growth,
analysts forecasts and/or fundamentals

▪ The next step in the process is deciding

− Which cash flow to discount, which should indicate
− Which discount rate needs to be estimated and
− What pattern we will assume growth to follow

Which Cash Flow SHould I Discount?

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Which Cash Flow SHould I Discount?

- First question of the valuation: am I doing a Firm or equity valuation

● Should get the same equity either way, Equity is better with stable leverage
(Stable debt ratio)
● With leverage it is Firm and use cost of capital
- If taking equity, DDM (what is paid out to equity holders) or FCFE model (what
investors could have)
● Ddm is the last resort, can lead to bad valuations if dividends are potentially
not sticky
- If you choose CF to equit- cost of equity, FCFF- cost of capital

Which Growth Pattern Should I Use?

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Which Growth Pattern Should I Use?

- If a mature company, can use a terminal valuation right now

- Typically only up to 5 years for mature growth
- 2 stage model is not that realistic because it is an immediate change in the growth
rate in stead of a real life adjustment. That is why the 3 stage is more of a guide to
steady growth

Building Blocks of Valuation

Discounted Cash Flow Models – Practical Problems

▪ In practice
− Values from DCF models may differ
− Analysts are always forced to make simplifying assumptions

▪ Problems with DCF

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Discounted Cash Flow Models – Practical Problems

▪ In practice
− Values from DCF models may differ
− Analysts are always forced to make simplifying assumptions

▪ Problems with DCF

− Calculations are sensitive to small changes in inputs
− Growth opportunities and growth rates are hard to pin down

Discounted Cash Flow Models (DCF): Constant Growth Model

Exercise - Discounted Cash Flow Models (DCF)

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Exercise - Discounted Cash Flow Models (DCF)

Exercise - Discounted Cash Flow Models (DCF) Solution

- Relation is the interest expenses and change sin net borrowing

Discounted Cash Flow Models (DCF): Two-Stage Models

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Discounted Cash Flow Models (DCF): Two-Stage Models

- Most common model

- First stage is high growth, the second stage is to find the terminal value
● Looking for the stock price in 10 years, equity value in 10 years, or the firm
value in 10 years

Simplifications to 2-stage Models

Exercise – Apple

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Exercise – Apple

▪ Apple started to pay dividends in 2013 with an approximate payout rate of 25%, you
assume for the following years (2020 to 2024) Apple will continue with its payout policy and
dividends are payed in September each year.

▪ Assume the company is expected to increase its payout ratio to 50% in 2025 and at the
same time the growth is expected to drop to 2.1% (starting with year 2024 to 2025)

▪ Assume the cost of equity in the high growth is 6.7% and in the stable growth 6.0%.

▪ What is the expected price for Apples share?

▪ For reasons of simplification, assume the 2020 dividends have just been payed.

Exercise – Two-Stage FCFE Model: An Extended Application

- Minute 20

Exercise – Two-Stage FCFF Model: Lockheed Corporation

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Exercise – Two-Stage FCFF Model: Lockheed Corporation

Discounted Cash Flow Multistage Models

Some Open Questions (1) The Value of Cash

▪ The Value of Cash
− The simplest and most direct way of dealing with cash and marketable

securities is to keep it out of the valuation – the cash flows should be

before interest income from cash and securities, and the discount rate
should not be contaminated by the inclusion of cash. (Use betas of the
operating assets alone to estimate the cost of equity).
− Once the operating assets have been valued, you should add back the
value of cash and marketable securities.

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Some Open Questions (1) The Value of Cash
▪ The Value of Cash
− The simplest and most direct way of dealing with cash and marketable

securities is to keep it out of the valuation – the cash flows should be

before interest income from cash and securities, and the discount rate
should not be contaminated by the inclusion of cash. (Use betas of the
operating assets alone to estimate the cost of equity).
− Once the operating assets have been valued, you should add back the
value of cash and marketable securities.

▪ In which of the following firms is cash most likely to be A) a neutral asset (worth 100), B) a
wasting asset (worth less than 100) or C) a potential value creator (worth more than 100)

Some Open Questions (2) Dealing with Holdings in Other firms

▪ Holdings in other firms can be categorized into
− Minority passive holdings, in which case only the dividend from the
holdings is shown in the balance sheet
− Minority active holdings, in which case the share of equity income is
shown in the income statements
− Majority active holdings, in which case the financial statements are
consolidated.

▪ For majority holdings, with full consolidation, convert the minority interest from book value
to market value by applying a price to book ratio (based upon the sector average for the
subsidiary) to the minority interest.
− Estimated market value of minority interest = Minority interest on
balance sheet * Price to Book ratio for sector (of subsidiary)
− Subtract this from the estimated value of the consolidated firm to get to
value of the equity in the parent company.

▪ For minority holdings in other companies, convert the book value of these holdings (which
are reported on the balance sheet) into market value by multiplying by the price to book ratio
of the sector(s). Add this value on to the value of the operating assets to arrive at total firm
value

Some Open Questions (3 cont‘d) Other Assets That Have Not

Been Counted Yet
▪ If you have contingent liabilities - for example, a potential liability from a lawsuit that has not
been decided - you should consider the expected value of these contingent liabilities
− Value of contingent liability = Probability that the liability will occur *
Expected value of liability ‘
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Some Open Questions (3 cont‘d) Other Assets That Have Not

Been Counted Yet
▪ If you have contingent liabilities - for example, a potential liability from a lawsuit that has not
been decided - you should consider the expected value of these contingent liabilities
− Value of contingent liability = Probability that the liability will occur *
Expected value of liability ‘

▪ Restricted Stock Grants and Employee Options

− For restricted stock grants in the past, make sure you count those in
shares outstanding, it will reduce your value per share
− To account for expected stock grants in the future, estimate the value of
these grants as a percent of revenue and forecast that as expense as part
of compensation expenses. That will reduce future income and cash flows.
− Employee options can increase the number of shares outstanding but
dilution per se is not the problem.
− Options affect equity value before exercise because we have to build in
the expectation that there is a probability of and a cost to exercise.
− See http://www.stern.nyu.edu/~adamodar/pc/optlt.xls for a basic long
term option pricing model.

Some Open Questions (4) Debt for Costs of Debt

▪ General Rule: Debt generally has the following characteristics:
− Commitment to make fixed payments in the future
− The fixed payments are tax deductible
− Failure to make the payments can lead to either default or loss of control
of the firm to the party to whom payments are due.

▪ Defined as such, debt should include

− All interest bearing liabilities, short term as well as long term
− All leases, operating as well as capital

▪ Debt should not include

− Accounts payable or supplier credit

▪ Be wary of your conservative impulses which will tell you to count everything as debt (such
as all liabilities). That will push up the debt ratio and lead you to understate your cost of
capital.

Discounted Cash Flow Models (DCF) – Apple Valuation

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Discounted Cash Flow Models (DCF) – Apple Valuation

Combine DCF with Multiples Example Apple

Discounted Cash Flow Models DCF with EV/EBITDA Exit

Multiple - Apple

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Discounted Cash Flow Models DCF with EV/EBITDA Exit

Multiple - Apple

Sensitivity Analysis: Intrinsic and Relative Valuation

The Dark Side of Valuation…

▪ Valuing stable, money making companies with consistent and clear accounting statements,
a long and stable history and lots of comparable firms is easy to do.

▪ The true test of your valuation skills is when you have to value “difficult” companies. In
particular, the challenges are greatest when valuing:

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The Dark Side of Valuation…

▪ Valuing stable, money making companies with consistent and clear accounting statements,
a long and stable history and lots of comparable firms is easy to do.

▪ The true test of your valuation skills is when you have to value “difficult” companies. In
particular, the challenges are greatest when valuing:
− Young companies, early in the life cycle, in young businesses
− Companies that don’t fit the accounting mold
− Companies that face substantial truncation risk (default or
nationalization risk)

▪ Difficult to value companies…

− Across the life cycle:
− Across markets
− Across sectors

Excurse: Consistency of DDM and DCF

▪ The DDM and DCF (FCFE) serve the same purpose, i.e. to value a firm. Yet the inputs to
both models differ.

▪ Therefore, the following questions arise:

− Can the two models deliver the same results?
− Under which conditions do they deliver the same results? Under which
conditions are the two models consistent?

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Discounted Cash Flow Models Appendix

Equity Valuation with Dividends (DDM)

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Equity Valuation with Dividends (DDM)

Two-Stage Dividend Discount Model (DDM)

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Three-stage Dividend Discount Model (DDM)

Multistage Dividend Discount Model (DDM)

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Multistage Dividend Discount Model (DDM)

Exercise

Solution

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Solution

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Equity Valuation with FCFE

Valuation of a firm

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Valuation of a firm

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