Value-Based Management

Transcription

1 Value-Based Management Lecture 5: Calculating the Cost of Capital Prof. Dr. Gunther Friedl Lehrstuhl für Controlling Technische Universität München

2 Overview 1. Value Maximization and Corporate Objectives 2. Measuring Income: Financial Statements 3. Measuring Value Creation: Value-Based Performance Measures 4. Management Compensation: Objectives and Alternatives 5. Calculating the Cost of Capital 6. Accounting Adjustments: Overview 7. Accounting Adjustments: Goal Congruent Performance Measures 8. Valuing and Managing Real Options 9. Identifying the Drivers of Value Creation Value-Based Management: Lecture 5 105

3 Required/suggested readings Required readings: Young, S. David and O Byrne, Stephen F.: EVA and Value-Based Management: A Practical Guide to Implementation, New York et al. 2001, chapter 5. Suggested readings: Brealey, R. A., Myers, S. C., and Marcus, A. J.: Fundamentals of Corporate Finance, 9/e Boston Value-Based Management: Lecture 5 106

4 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 107

5 Measuring the cost of capital is mainly a question of how to measure the cost of equity Cost of capital = opportunity cost that reflects the returns investors expect from other investments of similar risk Different forms of financing (equity, debt) carry different risks for investors and therefore different costs weighted-average cost of capital (WACC) S WACC r S B S B r S B B (1 T C ) S = market value of equity (stock) B = market value of debt (bond) r B = cost of debt T C = corporate tax rate r S = cost of equity Alternative approach: target weightings (target capital structure) instead of marketbased weightings How to get an estimate of the cost of equity? Value-Based Management: Lecture 5 108

6 The Capital Asset Pricing model (CAPM) delivers an estimate of how risky assets like a firm s equity are priced by capital markets The expected return on a risky asset is given by the following equation: E(R ) R i f [E(R i M ) R Market risk premium f ] E(R i ) = expected return on risky asset i R f = return on a risk-free asset E(R M ) = expected return on the stock market β i = measure of risk of asset i (company risk factor) with The CAPM gives the return expected by the capital markets for investing in a risky asset like a company s stock Main assumptions of the CAPM: Either quadratic utility functions of investors or normally distributed returns Investors have a unique planning horizon and homogenous expectations concerning the means, variances and covariances of the asset returns No capital market restrictions like transaction costs or restrictions of short sales cov R i,r i Var R M M Value-Based Management: Lecture 5 109

7 The total risk of a company s equity can be separated into the market risk and the company-specific risk Total risk = market risk + company-specific risk Company-specific risk Also called unsystematic, diversifiable, idiosyncratic risk Market risk Also called systematic, nondiversifiable risk Examples: management errors, production downtimes (only a few (or one) companies are concerned) Examples: GDP, inflation, interest rates (almost the whole market is concerned, to more or less extent) Can be eliminated by diversification Bearing that risk is not paid for by the capital market Cannot be eliminated through diversification Capital market pays investors for bearing that risk β i measures the volatility of a company s stock price with respect to the overall stock market (reflects market risk) β i =1 for companies with a risk identical to the overall market risk, β i > 1 for more risky, β i < 1 for less risky companies Value-Based Management: Lecture 5 110

8 Graphical representation of the security market line Security market line ) E(R i E(R ) R i f [E(R i M ) R f ] E(R M ) R f M 1 i cov R i,r Var R M M Value-Based Management: Lecture 5 111

9 Industry Survey KPMG 2014 Value-Based Management: Lecture 5 112

10 Sample and scope of KPMG (2014): Cost of Capital Study 2014 Data collected between May and September 2014 Survey among 130 companies in Europe (Germany, Austria Switzerland) Main industries of the survey: Automotive Chemicals & Pharmaceuticals Consumer Markets Energy & Natural Resources Financial Services Health Care Industrial Manufacturing Media & Telecommunications Real Estate Technology Transport & Leisure Value-Based Management: Lecture 5 113

11 Average WACC by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 114

12 Average cost of debt by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 115

13 Average cost of equity by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 116

14 Average beta by year and industry Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 117

15 Average risk free rate and market risk premium by period Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 118

16 Average risk free rate and its determination Source: KPMG (2014): Cost of Capital Study 2014 Value-Based Management: Lecture 5 119

17 WACC estimations for EON, Thyssen & Metro Group (Source: Annual Reports 2013, 2010 & 2008) Company WACC 2013 WACC 2010 WACC 2008 EON 7,5% 8.3% 9.1% Thyssen 9% 8.5% 8.5% METRO Group 9,6% 7.2% 6.5% WACC - Thyssen Business Segments (Source: Annual Reports) Services Elevator Technologies Stainless Steel 7 7,5 8 8,5 9 9,5 10 Value-Based Management: Lecture 5 120

18 WACC estimations for Metro Group (Source: Metro Group Annual Report 2010, p. 087) Value-Based Management: Lecture 5 121

19 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 122

20 Calculating the company s beta some problems to cope for Beta can be calculated by regressing monthly or weekly returns of the company on the returns of the whole stock market Problems of conceptual as well as practical relevance in calculating beta: Choice of the return interval (monthly, weekly, daily etc.) Time period for data (5 years of data, 10 years of data etc.). Attention: Betas may change over time! Choice of market? Which market index is the appropriate proxy? Choice of the risk free rate of return (government bonds etc.) Conceptual problems of the CAPM: CAPM based on expectations of future returns, not on historical returns (model really testable?) CAPM theoretically based on the overall market which isn t observable in reality each index as a proxy will fail in representing the overall market Empirical work shows varying results concerning a confirmation of the model s implications, sometimes depending on the periods employed Value-Based Management: Lecture 5 123

21 Calculating the beta of private firms and divisions without data of observable returns requires a more pragmatic approach The procedure depends on how the divisions are organized: Organized geographically Division funded in the division s home currency Organized by product line Estimate betas from comparable firms in the same or similar industries Add company or product line risk premium to the rate of return of the division s local government bonds Adjust for different capital structure that influences the beta (the more leverage through debt the more risky the equity!) Division not self-financing (financing mainly from parent) Add risk premium to the government bond rate in the parent company s home currency, eventually plus an additional risk premium for undeveloped market economies Choose a target capital structure to calculate the WACC Calculate a fictitious unlevered beta by adjusting the levered beta of the other firm for its debt-to-equity ratio: β other U L 1 other U β other 1 T B other C 1 other L Adjust the fictitious unlevered beta of the other firm for the own division s debt-toequity ratio: own β β S own own 1 T B C S Value-Based Management: Lecture 5 124

22 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 125

23 The Arbitrage Pricing Theory (APT) as an alternative to compute the company s cost of equity Multi-factor model that assumes that returns on securities are generated by a number of industry- and market-wide factors and therefore supposed to explain a greater percentage of stock price movements than the CAPM Return on asset = expected return + unanticipated return (surprise) Example: Using inflation (F INF ), gross domestic product (F GDP ) and interest rate (F RATE ) as possible systematic risk factors influencing asset return, the return on a risky asset is given by: R E(R i ) = expected return on risky asset i ε = unsystematic portion of stock returns = volatility associated with risk factor β i i E(R ) i i,inf F INF i, GDP F GDP i,rate F Problems: Which are the relevant risk factors? Not given in the theory Does not resolve the problem of the use of historical data for beta estimation More difficult to apply in practice (estimation of betas) RATE Value-Based Management: Lecture 5 126

24 Outline 5.1 Calculating the cost of equity: The CAPM Calculating the Cost of Capital 5.2 Calculating the relevant beta 5.3 Alternatives to the CAPM: The APT 5.4 The capital structure choice Value-Based Management: Lecture 5 127

25 A company should choose the appropriate capital structure to minimize the cost of capital Choose the financing alternatives that reduce the firm s cost of capital Financing alternatives Straight debt Short-term debt (bank-loans or money market instruments) Long-term debt (fixed- or floating-rate bonds or bank loans) Straight equity Retained earnings New equity issues (public or private placement) Factors for debt-equity choice Tax shield from interest payments Costs of financial distress Agency costs because of shareholder-debtholder conflicts manager-shareholder conflicts Asymmetric information (capital structure serving as informative signal for the market) Hybrid instruments Convertibles Preferred shares Warrants Value-Based Management: Lecture 5 128

26 Because of the tax-deductibility of interest payments a higher leverage may result in a higher firm value Capital structure does not matter in a world without taxes and bankruptcy costs and with perfect capital markets (Modigliani-Miller) Increase in leverage replaces equity with cheaper debt but also raises the risk and therefore the costs of the remaining equity Sufficient taxable income and tax-deductibility of interest payments: Tax shield = i B T C i B T C V U (V L ) = interest rate = book value of debt = corporate tax rate = value of unlevered (levered) firm Firm value V L Present value of tax shield V U Debt/equity Inclusion of personal tax rates complicates the theory: Personal tax rate (of bondholders) on interest is in general higher than the effective personal tax rate on equity distribution (share buybacks etc.) Personal tax penalties to bondholders (partly) offset the tax benefits of debt at the corporate level (bondholders must be offered higher yields) Problem: How can the tax shield be valued? Value-Based Management: Lecture 5 129

27 The risk of financial distress gives rise to a theory of an optimal capital structure balancing benefits and costs of debt financing Direct costs of financial distress: Payments to lawyers, accountants etc. for reorganization, debt renegotiation and other necessary activities to avoid bankruptcy Firm value Present value of financial distress costs Indirect costs of financial distress: Loss of reputation and confidence in the firm by customers and suppliers Declining sales and disruptions in the supply chain Managerial effort devoted solely to survival Inability to raise necessary capital for new profitable projects V U V L Debt/equity Problem: Quantifying the costs of financial distress Differing opinions about importance of these costs (difference between financial distress and economic distress caused by economic shocks, operating inefficiencies or strategic failure) Value-Based Management: Lecture 5 130

28 Conflicts with managers and bondholders give rise to agency costs for the shareholders depending on the capital structure There are two different types of conflicts concerning the capital structure: Shareholders vs. managers Shareholders vs. bondholders Managers are generally more risk averse than the more diversified shareholders Managers, bearing a high risk in the company tend to have the company underleveraged, since they are not rewarded for that risk by the market (in contrast to the shareholders) Managers might spend the free cash flows for their own purposes A higher debt burden decreases free cash flows due to interest and principal payments Limited liability of the shareholders and limited profit of the bondholders causes a gambling strategy of the shareholders (mainly when in financial distress) at the cost of the bondholders They might invest in high risk projects when there is the chance of a high profit if, in the other case, the shareholders outcome (as residual stake) is worthless even for low risk projects creditors cope with this through higher yields Value-Based Management: Lecture 5 131

29 Asymmetric information between capital markets and the firms or their managers gives capital structure the role of a signal Empirical work supports the hypothesis that announcements of actions that change the company s capital structure have an informational content: Equity issues tend to have a negative effect on stock prices Share buybacks are mainly interpreted as a positive signal by the market Straight debt issues are sometimes interpreted as a positive signal Some reasoning of theoretic research: Managers with private information might issue equity only when they assume that company stock is overpriced (otherwise preferring internal financing in the first place or debt issues: pecking order of financing alternatives) A company that buys back shares might assume its shares undervalued Managers might issue debt (and accept a higher risk of bankruptcy) only when they have reliable information of high future prospects of an investment Disadvantage of these theories: Only descriptive approach, explaining possible capital market reactions Does not give an explicit advise for specific financing decisions Value-Based Management: Lecture 5 132

30 The capital structure choice is an ongoing process a decisionframework of how to achieve a chosen target capital structure Firm overlevered Under threat of bankruptcy? Firm underlevered Under threat of takeover? Yes No Yes No Reduce debt quickly: Sell assets and use proceeds to pay off debt Renegotiate debt terms Debt/equity swaps Reduce debt gradually Positive NPV projects available? Increase debt quickly: Leveraged recap Increase debt gradually Positive NPV projects available? Yes No Finance projects with internally generated cash flows or new equity issue Pay off debt with cash flows Issue new equity and use proceeds to pay off debt Cut dividends Yes Finance projects with debt No Increase regular dividends Special dividend Buy back shares Value-Based Management: Lecture 5 133