Residual Value and

Cost Of Capital
Presented by:
Akhil Kohli
presented to :
Bandeep Jaswal
Dr. Parmjit Kaur
Deepika Mahajan
Prabhjot Singh
Ramneek Singh
Valuation
Economic theory teaches that VALUE of any resource
equals present value of returns expected from the
resource, discounted at a rate that reflects the risk
inherent in those expected returns. Thus:

Valuet = Σ t=1, t=n Returnst

( 1 + Discount Rate)t
Rationale for Cash Flow-Based Valuation
It is two-fold:
1. Cash is the ultimate source of value. A resource has
value because of its ability to provide future cash
flows.
2. Cash serves as a measurable common denominator
for comparing future benefits of alternative
investment opportunities.
Cash Flow-Based Valuation
Valuation of any resource using Cash Flows involves 3
elements:
1. The expected periodic cash flows.
2. The expected cash flow at the end of the forecast
horizon, referred to as residual or terminal value.
3. The discount rate used to compute the present value
of the future cash flows.
Periodic Cash Flow
1. Cash Flow to the Investor VS Cash Flows to the Firm:
Cash flows to the investor in the stock and cash flows
generated by a firm each period will differ to the extent
that the firm reinvests a portion (or all) of the cash flows
generated during the period
It has been seen that the same valuation results whether
analyst discounts
a) Expected periodic and liquidating dividends to the
investor
b) The expected cash flows to the firm
2. Relevant Firm-Level Cash Flows
Another issue is WHICH cash flow amounts from the
projected statement of cash flows the analyst should
discount to a present value when valuing a firm. There
are 2 types of free cash flows:
a) Unleveraged Free Cash Flow
b) Leveraged Free Cash Flows
Measuring Free Cash Flows
Unleveraged Free Cash Flow Leveraged Free Cash Flows
Cash Flow from operation before Cash Flow from operation before
subtracting Cash outflows for Interest subtracting Cash outflows for Interest
Costs Costs

- Minus Cash outflows for Interest Costs

Equals Unleveraged Cash Flow from Equals Leveraged Cash Flow from
operations operations
Plus or Minus Cash flow for investing Plus or Minus Cash flow for investing
activities activities

- Plus/minus cash flows for changes in

short and long term borrowing
- Plus/minus cash flows for changes in
and Dividends on Preferred stock
Equals Unleveraged Free Cash Flow to Equals Leveraged Free Cash Flow to
All providers of capital Common Shareholders
Which Cash Flow to Use
The appropriate cash flow measure depends on the
RESOURCE TO BE VALUED
1. If the objective is to value the assets of a firm, then
Unleveraged Free Cash Flow is used
2. If the objective is to value the common
shareholder’s equity of a firm, then the Leveraged
Free Cash Flow is appropriate.
3. Nominal VS Real Cash Flows
The question arises – Should the projected cash flows
to be used in valuing a resource reflect nominal
amounts, which includes inflationary or deflationary
components OR real amounts, which filter out the
effect of changes in general purchasing power.

If projected cash flows ignore changes in general

purchasing power of the monetary unit, then discount
rate should INCORPORATE an inflation component

If projected cash flows filters out the effects of general

price changes, then discount rate should EXCLUDE the
inflation component.
Example
A firm owns a tract of land that it expects to sell one
year from today for $115 million. The general price
level is expected to increase 10% during this period.
The real interest rate is 2 %.

Nominal Cash Flows Discount Rate Including Value

* Expected Inflation
=
$115 million 1/(1.02)(1.10) $102.5 million
*
Real Cash Flow Discount Rate Value
* Excluding Expected
Inflation =

$115 million /1.10 1/(1.02) = $102.5 million

PreTax VS After-Tax Cash Flows
Same valuation does not arise if the analyst discounts
pretax cash flows at a pretax cost of capital and after-
tax cash flow at an after tax cost of capital.
This difference arise because cash inflows from assets
are taxed at 40%, and cash outflows to service debt
gives rise to tax savings of 40%
Thus, we use After Tax Cash Flows at after tax cost
of capital
Selecting a Forecast Horizon
For how many future years should the periodic cash
flows be projected? – For expected life of the resource
to be valued
For resources with an infinite life (like portfolio of net
assets of a firm), we calculate future periodic cash
flows for some number of years, and then estimate the
likely residual, or terminal, value at the end of this
forecast horizon.
Selecting a Forecast Horizon
Selecting a forecast horizon involves trade-offs:

A relatively short forecast horizon (3-5 years) enhances the

likely accuracy of the periodic cash flows. However, it causes a
large portion of the total present value to be related to the lest
detailed estimated residual value

A Longer period (10-15 years) reduces the influence of

estimated residual value on the total present value. However
the predictive accuracy of detailed cash flow is questionable.

Thus, security analysts typically select a forecast horizon in

the range of 4-6 yrs.
Residual Value
The expected cash flow at the end of the forecast
horizon. Also referred to as the terminal value.
In most cases it is the largest portion of the value of
the firm.
Its size is directly dependent upon the assumptions
made for the forecast horizon.
The analyst must project future periodic cash flows for
some number of years, and then estimate the likely
residual value at the end of this forecast horizon.
Selecting a forecast horizon involves trade-offs. Using a relatively
short forecast horizon, such as 3 to 5 years, enhances the likely
accuracy of the projected cash flows. But this causes a large portion
of the total present value to be related to the residual value.
Selecting a longer period in the forecast of periodic cash flows such
as 10 to 15 years, reduces the influence of the estimated residual
value on the total present value. However, the predictive accuracy
of detailed cash flow forecasts this far into the future is likely to be
questionable.
It is best to select as a forecast horizon the point at which a firm’s
cash flow pattern has settled into an equilibrium. This equilibrium
position could be either no growth in future cash flows or growth at
a stable rate.
Typically – 4 to 7 years
Discounted cash flow (economic approach)
When a firm’s cash flow pattern has settled into an
equilibrium at the end of the forecast horizon:
Residual Value at End of Forecast Horizon (n) =
Periodic Cash Flow (n-1) * (1+g)
(r-g)
Where: n= forecast horizon;
g= annual growth rate in periodic cash flows after the forecast
horizon; and
r= discount rate
If the final year’s cash flow continues at the same level in
perpetuity. Residual value = cash flow / r
Example
An analysts forecasts that the leveraged free cash flow
of a firm in Year 5 is $ 30 million. This is a mature firm
that expects zero growth in future cash flows. The
residual value of the cash flow, assuming a 15 percent
cost of equity capital, is computed as:
Residual Value at End of Forecast Period = $30 million/
0.15 = $200 million
The present value at the beginning of Year 1 of this
residual value = $99.4 million
(ii) If the analyst expects the cash flow after Year 5 to grow at 6
percent each year
Residual Value at End of Forecast period=
$30 million * (1+ 0.06) = $353.5 million
(0.15 - 0.06)
(ii) If the analyst expects the cash flow after Year 5 to grow at 6
percent each year
Residual Value at End of Forecast period=
$30 million * (1 - 0.06) = $134.3 million
0.15 - (-0.06)
The cash flow of a firm in decline will eventually reach zero (or
the firm will become bankrupt)
Analysts frequently estimate a residual value using
multiples of six to eight times leveraged free cash flow
in the last year of the forecast horizon to value the
common stock of a firm
Table: Cash flow multiples using (1+g)/(r-g)
Cash Flow Multiples
Growth rate
2% 4% 6%
Cost of Equity Capital
15% 7.8 9.5 11.8
18% 6.4 7.4 8.8
20% 5.7 6.5 7.6
Problems with the model
This residual valuation model does not work well when:
Discount rate and the growth rate are approximately equal
=> Denominator approaches zero and the multiple
becomes exceedingly large
Growth rate exceeds the discount rate => Denominator
becomes negative and the resulting multiple is
meaningless
These difficulties arise because the growth rate assumed
is too high.
The model assumes that the growth rate will continue in
perpetuity. But competition, technological change, new
entrants and similar factors reduce growth rates.
Other approaches
Alternative approach to estimate residual value is to use
the free cash flow multiples for comparable firms that
currently trade in the market.
Provides a degree of market validation for the theoretical
model.
Analysts identifies comparable companies by studying
growth rates in free cash flows, profitability levels, risk
characteristics and similar factors.
Analysts also use earnings-based models such as price-
earnings ratios or market to book value ratios to estimate a
residual value.
COST OF CAPITAL
Definition
To a firm, it is the cost of obtaining funds

To an investor, it is the minimum rate of return

expected by it without which the market value of
shares would fall.

In accounting sense, it is the weighted average cost of

various sources of finance used by a firm.
Definition (Contd..)
According to James C Van Horne “It is the cut off rate
for the allocation of capital to investments of projects.
It is the rate of return on a project that will leave
unchanged the market price of the stock.”

According to John J. Hampton “Cost of Capital is the

rate of return the firm requires from the investment in
order to increase the value of the firm in the market
place”
WACC
Company typically has several options for raising capital
including :
• Issuing Equity
• Issuing Debt
• Issuing Preferred Stocks.
 Each Selected source becomes a component of company's
cost and may be called as a Component cost of capital.
 The weighted average of all these costs is called Weighted
average cost of capital or WACC.
 It is also called Marginal cost of capital.
WACC = wp rp + we re + Wd Rd (1-t)
Where
wp = the proportion of preferred stock that the company uses to
raise new funds.
Rp = the marginal cost of preferred stock.
we = the proportion of equity that the company uses to raise new
funds.
Re = the marginal cost of equity.
wd = the proportion of debt that the company uses to raise new
funds.
Rd = the before tax marginal cost of debt.
T= company’s marginal tax rate.
Significance Of Cost Of Capital
The acceptance criterion in capital budgeting (in NPV,
as a discounting factor and in IRR it is used as a cut off
rate to compare with)

The determinant of optimal capital mix in the capital

structure decision (i.e., the mix that minimizes the
overall cost of capital)

A basis of evaluating the financial performance( i.e.

EVA = capital employed (ROI-COC)
Firms employ several types of capital, called capital
components, with common and preferred stock, along
with debt, being the three most frequently used types
with one thing in common

“The investors who provide the funds expect to

receive a return on their investment”

However, because of varying risks, these different

securities have different required rate of return.
Cost Of Debt
The first step is to determine the rate of return debt
holders require i.e. rd
A calculated estimate, because it is difficult to project
the type of debt used over a period.
Now, we calculate the after-tax cost of debt

After Tax Cost of Debt = Interest Rate – Tax Savings

= rd - rd T
= rd (1 - T)
E.g.: Incorporating the effects of Taxes on the
Cost of Capital
Jorge Richard , A financial Analyst is
estimating the cost of capital for ABC
company. Richard has calculated the before
tax costs of capital for ABC’s debt and equity
as 4% and 6% respectively. What would be
the after tax costs of debt and equity if the
marginal tax rate is :
1. 30%
2. 48%
Solution
After Tax
Marginal Tax After Tax Cost of Cost of
  Rate Debt Equity
Solution
to 1 30% .04(1-.30 ) = 2.80 % 6%
Solution
to 2 48% .04(1-.48 ) =2.08 % 6%
 Calculating the Cost of Debt (Yield to
maturity approach )
YTM is the annual return that an investor earns if the
investor purchases a bond today and holds it until
maturity.
P0= PMT1/(1+rd/2) +…PMTn/(1+rd/2) + FV/ (1+rd/2)
Where:
 P0= the current market price of the bond.
 PMT t = interest payment in the period t.
 rd=the yield to maturity.
 n= no of periods remaining to maturity
 FV – the maturity value of the bond.
Calculating the Cost of Debt (Debt
Rating Approach)
When reliable current market price for a company’s
debt is not available Debt rating approach is used.
Based on a company’s debt rating, we estimate the
before tax cost of debt by using the yield on
comparably rated bonds for maturities that closely
match that of the company’s existing debt.
Cost Of Preferred Stock
Because, Preferred Stock are not tax deductible, not tax
adjustment is used when calculating the cost of preferred
stock

The component cost of preferred stock rps is the preferred

dividend, Dps divided by the net issuing price, Pn , which is
the price the firm receives after deducting floatation costs:

COMPONENT COST OF PREFERRED STOCK =

rps = Dps / Pn
Cost Of Common Stock
A company can raise common equity in 2 ways : (1)
directly issuing new shares (2) indirectly, by retaining
earnings
When, new shares issued, shareholders require a
return, rs .
Also, retained earnings have a cost known as
opportunity cost - the earnings could have been paid
out as dividends which could have been reinvested in
other investments.
Thus, the firm should earn on its reinvested earnings
at least as much as its stockholders themselves could
earn on alternate investments of equivalent risks,
which is rs
 Thus rs is the cost of common equity raised internally
by reinvesting earnings
Whereas, debt and Preferred Stock are contractual
obligations that have easily determined costs, it is
more difficult to estimate rs

 3 Methods are typically used :-

(a) The CAPM
(b) Discounted Cash Flow Method
(c) The Bond-Yield-Plus-Risk-Premium Approach
The CAPM Approach
STEP 1 . Estimate the risk free Rate, rRF

STEP 2. Estimate the current market Risk premium,

RPm, which is expected market return minus the risk
free rate.

STEP 3. Estimate the stock’s beta coefficient, bi, and use

it as an index of the stock’s risk
STEP 4. Substitute the preceding values into the CAPM
equation to estimate the required rate of return in:

rs = rRF + (RPM)bi

Risk free rate is taken as the return from the long term
Treasury securities.

The Risk Premium is the result of investor risk

aversion.
The Risk Premium is estimated on the basis of (1)
Historical Data (2) Forward – looking data
Beta I the relevant risk of an individual stock, it
contributes to the market portfolio ( or well diversified
portfolio)
DIVIDEND-YIELD-PLUS-GROWTH-RATE, OR
DCF APPROACH
If dividends grow at ‘g’ rate, then expected price is
P0 = D1 /(rs - g)
where P0 is the current price; D1 is the dividend
expected to be paid, and rs is the required ROR on
common equity

Hence
rs = (D1 / P0 ) +Expected g
The investors expect to receive a dividend yield plus a
capital gain as expected return. The method of
estimating the cost of equity is called Discounted
Cash Flow method.

Growth rates calculated either as historical growth

rates, or retention growth model, or by forecasts.

RETENTION GROWTH MODEL

g = ROE(Retention Ratio)
BOND-YIELD-PLUS-RISK-PREMIUM Approach
Subjective, adhoc procedure
Adding a judgmental risk premium to the interest
rates on firm’s own long term debt.

ASSUMPTION – Firms with risky, low rated, and high

interest-rate debt will also have risky, high-cost equity

rs = Bond Yield + Bond risk premium

WEIGHTED AVERAGE COST OF CAPITAL
The weighted average cost of capital (WACC) is the
rate that a company is expected to pay on average to all
its security holders to finance its assets.
It is the weighted sum of cost of all the sources used to
finance the investments. If a firm uses preferred stock,
common equity and debt, the WACC will be

WACC = wd rd (1-T) + wps rps + wce rs

FACTORS AFFECTING WACC
The cost of capital is affected by a number of factors.
Some are beyond the firm’s control, but others are
influenced by its financing and investment policies.

FACTORS THE FIRM CANNOT CONTROL

1. The Level of interest Rates – If IR increases, cost
of debt increases and equity cost increases.
2. Market Risk Premium
3. Tax Rates
FACTORS the FIRM CAN CONTROL
1. Capital Structure Policy – The amount of debt
used in capital structure depends on the policies of
the firm
2. Dividend Policy – The amount of payout depends
on the management
3. Investment Policy
References
CFA Level-I book
Financial Reporting and Statement Analysis: A
Strategic Perspective- Clyde P. Stickney and Paul R.
Brown
Financial Management: Text and Cases- Brigham and
Ehrhardt