c
c
* At an intutive level, the discount rate used should be consistent with both the and the
! " being discounted.
# c$%
The cost of equity is the rate of return that investors require to make an equity investment in a
firm. There are two approaches to estimating the cost of equity;
* a dividendgrowth model.
(a) that investors have homogeneous expectations about asset returns and variances
(d) that there are no transactions costs and that there are no restrictions on short sales.
à
£eta: The nondiversifiable risk for any asset can be measured by the covariance of its returns
with returns on a market index, which is defined to be the asset's beta.
where,
Rf = Riskfree rate
m
* It is generally based upon historical data, and the premium is defined to be the difference
between average returns on stocks and average returns on riskfree securities over the
measurement period.
Historical
Stocks  T. Bills Stocks  T.Bonds
Period
Arithmetic Geometric Arithmetic Geometric
19261990 8.41% 6.41% 7.24% 5.50%
19621990 4.10% 2.95% 3.92% 3.25%
19811990 6.05% 5.38% 0.13% 0.19%
¢? The risk premiums will vary across markets, depending upon their riskiness. While
historical data can be used to estimate premiums outside the United States, it is not very
reliable. An alternative way of estimating premiums is to use country bond ratings to
estimate these premiums relative to the U.S. premium. For instance, the risk premiums
for South American countries can be estimated as follows:
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The longterm government bond rate is the appropriate riskfree rate. When the long term
government bond rate is not available, it may make sense to look at the rate at which large
corporations can borrow in the local market.
Glaxo Holdings had an estimated beta of 1.10 at the end of 1994. At the same point in time, the
thirtyyear treasury bond rate in the United States was 8.00%. The estimated cost of equity for
Glaxo in December 1994 was ñ
This is the cost of equity, if cash flows are estimated in dollars. The same estimation can be done
in British Pounds, using the long term Government Bond rate in the U.K., which was 8.50% at
the same point in time ñ
¢? Wellcome is planning an acquisition of Glaxo. Wellcome has a beta of 0.65. Which beta
would you use in valuing Glaxo?
%
!%
* The more sensitive a business is to market conditions, the higher is its beta. Thus cyclical firms
can be expected to have higher betas, other things remaining equal, than noncyclical firms.
* The beta of a firm is the weighted average of the betas of its different business lines.
* DOL is a function of the cost structure of a firm, and is usually defined in terms of the
relationship between fixed costs and total costs.
* A firm which has high operating leverage > higher variability in earnings before interest and
taxes (EBIT) > higher beta
¢? Sticking again with pharmaceutical firms, there are some firms which have very high
fixed costs, either because they focus heavily on research, or because of the nature of
their business. (Synergen, for instance, had a beta of 1.65 in 1994. It had research and
development expenses which were 670% of sales in 1994.) These firms will have higher
betas than other firms which have more traditional cost structures. (Wellcome is a good
example.)
) '(
* If all of the firm's risk are borne by the stockholders, i.e., the beta of debt is zero, and debt has
a tax benefit to the firm, then,
Glaxo, with a beta of 1.10, had a debt/equity ratio of 4% in 1994. If Glaxo were to raise its
debt/equity ratio to 20%, its beta would be much higher (Tax rate was 30%) ñ
* Use the betas of publicly traded firms which are comparable in terms of business risk and
operating leverage.
* Correct for differences in financial leverage between the firm being analyzed and the
comparable firms.
Assume that you are trying to estimate the beta for a private firm that is in the business of
manufacturing, selling and servicing fax machines. The betas of publicly traded firms involved
in office equipment and supplies are as follows (They face an average tax rate of 40%). The
private firm had a debt/equity ratio of 30%.
Beta for private firm involved in office supplies = 0.88 (1 + (10.4) (0.3)) = 1.04
* Income statement and balance sheet variables are important predictors of beta
* Following is a regression relating the betas of NYSE and AMEX stocks in 1991 to five
variables  dividend yield, coefficient of variation in operating income, size, debt/equity and
growth in earnings.
BETA = 0.9832 + 0.08 CV in Operating Income  0.126 Dividend Yield + 0.15 Debt/Equity
Ratio + 0.034 Growth in Earnings per Share  0.00001 Total Assets
where,
Assume that you are trying to estimate the beta for a private firm, with the following financial
characteristics (defined consistently with the regression):
* Logic behind the arbitrage pricing model (APM) same as the logic behind the CAPM, i.e.,
("
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# .
* Measure of this nondiversifiable risk in the APM, however, is not a single factor but is
determined by an asset's sensitivity to various economic factors that affect all assets.
* The number and the identity of the factors are determined by the data on historical returns.
* The arbitrage pricing model relates expected returns to economic factors, with a beta specific
to each factor. If these factorspecific betas and the factor risk premia can be estimated, the cost
of equity can also be estimated.
where,
Rf = Riskfree rate
k = Number of factors
m #
Assume that the parameters for the arbitrage pricing model have been estimated, and that there
are three factors,
Assume that the betas specific to each of these factors are estimated for Pepsi Cola in 1992 and
that the estimates are as follows:
1 = 1.20
2 = 0.90
3 = 1.10
Cost of Equity = 3.35% + 1.20 (3%) + 0.90 (4%) + 1.1 (1.5%) = 12.20%
* Capital asset pricing model can be considered to be a specialized case of the arbitrage pricing
model, where there is only one underlying factor and that underlying factor is completely
measured by the market index.
* In general, the CAPM has the advantage of being a simpler model to estimate and to use, but it
will underperform the richer APM when the company is sensitive to economic factors not well
represented in the market index.
Example: Oil companies, which derive most of their risk from oil price movements, tend to have
low CAPM betas.
* The biggest intuitive block in using the arbitrage pricing model is its failure to identify
specifically the factors driving expected returns.
* Unidentified factors in the arbitrage pricing model are replaced with macroeconomic
variables,
* For example, Chen, Roll and Ross (1986) suggest that the following macroeconomic variables
are highly correlated with the factors that come out of factor analysis  industrial production,
changes in default premium, shifts in the term structure, unanticipated inflation and changes in
the real rate of return. These variables can then be correlated with returns to come up with a
model of expected returns, with firmspecific betas calculated relative to each variable.
* Costs of going from the arbitrage pricing model to a macroeconomic multifactor model can
be traced directly to the errors that can be made in identifying the factors.
* The factors in the model can change over time, as will the risk premia associated with each
economic factor.
* Using the wrong factor(s) or missing a significant factor in a multifactor model can lead to
inferior estimates of cost of equity.
For a firm which has a stable growth rate in earnings and dividends, the present value of a share
of equity can be written as:
where,
ke = Cost of Equity
ke = DPS1 / P0 + g
More importantly, since the current price is a key input to the model, it is inappropriate to use
this approach to value stock in a firm. There is a strong element of circular reasoning involved
that will lead the analyst to conclude, using this cost of equity, that equity is fairly valued.
In 1992, Southwestern Bell paid dividend per share of $2.82 and the stock traded at $66 in
December 1992. The estimated growth rate in dividends is 5.5% and the firm is assumed to be in
steady state. The dividend growth model can then be used to estimate the cost of equity;
To illustrate the circular reasoning involved in using this cost of equity to value stock,
o!& 'o(
The weighted average cost of capital is defined as the weighted average of the costs of the
different components of financing used by a firm.
where,
ke = Cost of Equity
* Equity comprised 85.00% (in market value terms) of the funding mix and debt made up the
remaining 15.00%.
* The cost of capital for Genzyme can then be calculated as follows:
c
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o
Revenues
 Operating Expenses
 Interest Expenses
 Taxes
= Net Income
 Preferred Dividends
 Capital Expenditures
 Principal Repayments
Net Income
 (1 DR) (Capital Expenditures  Depreciation)
Proceeds from new debt issues = Principal Repayments +DR (Capital Expenditures 
Depreciation + Working Capital Needs)
4+
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#
The following is an estimation of free cash flows to equity for WarnerLambert in 1994 and for
1995 (projected).
¢? The company had $1.5 billion in debt outstanding and $ 9 billion in market value of
equity, leading to a debt to capital ratio (ìdebt ratioî) of 14%. This debt ratio is assumed
to be stable. (How does one know?)
¢? The company reported net income of $695 million in 1994 and is projected to have a net
income of $765 million in 1995.
¢? The company reported depreciation of $180 million in 1994 and is expected to have
depreciation of $200 million in 1995.
¢? The company had capital expenditures of $362 million in 1994 and is expected to have
capital expenditures of $400 million in 1995.
¢? The companyís working capital increased to $225 million in 1994 from $203 million in
1993. It is expected to maintain working capital at the same percentage of sales in 1995,
and sales are expected to increase from $6420 million in 1994 to $7100 million in 1995.
22* +22,
Net Income $ 695.00 $ 765.00
 (Cap Ex  Depreciation) (DR =
$ 156.52 $ 172.00
(1DR) 14%)
 ( Change in Working (DR =
$ 18.92 $ 20.50
Capital) (1DR) 14%)
FCFE $ 519.56 $ 572.50
Proposition : The Free Cash Flow to Equity will increase as the amount of debt financing used
by the firm increases. Thus FCFE will be an increasing function of _.
1 ( #à
'
#
The following are the cash flows to equity for Warner Lambert, using a debt ratio of 40% instead
of a debt ratio of 14%.
22* +22,
Net Income $ 695.00 $ 765.00
 (Cap Ex  Depreciation) (DR =
$ 109.20 $ 120.00
(1DR) 40%)
 ( Change in Working (DR =
$ 13.20 $ 14.30
Capital) (1DR) 40%)
FCFE $ 572.60 $ 630.70
The following graph illustrates the effect on free cash flows to equity of changing the debt ratios
from 0% to 100% ñ
)
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+ Depreciation
 Capital Spending
Consider a firm which has cash flows to equity currently of $100 million and is expected to
grow, in real terms, at 5% a year for the next three years and 3% a year after that. The firm has a
beta of 1.0 and the current T.Bond rate is 6.5%. The expected inflation rate is 3% in both the
firm's cash flows and the general economy. The valuation of this firm can be done on either a
real or a nominal basis:
The estimates of growth on a real and nominal basis are done first
Real Nominal
The discount rate can similarly be estimated on a real and nominal basis:
Real Nominal
The expected nominal return is estimated using the CAPM, with a historical premium earned by
stocks over T.Bonds of 5.5%.
Using these growth rates the cash flows can be generated in both nominal and real terms:
à
" 7
"
!
7
!
8
)+
9
" 9
1 $105 $108
2 $110 $117
3 $116 $2,078 $126 $2,271
The terminal values are calculated as follows for real and nominal cash flows:
Terminal value (Real Cash flows) = $ 116 * 1.03 / (.0874  .03) = $ 2,078
Terminal value (Nominal Cash flows) = $ 126 * 1.0609 / (.12  .0609) = $ 2,271
This calculation assumes that the growth rates after year 3 are steady state growth rates and will
continue through infinity.
The present values of the cash flows to equity and the terminal value can then be calculated
using the appropriate discount rate:
Present value (using real cash flows) = $105/1.0874 + $ 110 / 1.08742 + ($116 + $2,078) /
1.08743 = $ 1,896
Present value (using nominal cash flows) = $108/1.12 + $ 117 / 1.122 + ($126 + $2,271) / 1.123
= $ 1,896
The terminal values are miscalculated because cash flows and discount rates are not matched.
Terminal value (using nominal rate and real cash flows) = $ 116 *1.03 / (.12.03) = $1,325
Terminal value (using real rate and nominal cash flows) = $ 126 * 1.0609 / (.0874 .0609) = $
5,068
If real cash flows are discounted at the nominal discount rate, the present value is:
Present value (real cash flows discounted at nominal rates) = $105/1.12 + $ 110 / 1.122 + ($116
+ $1,325) / 1.123 = $ 1,207 < True value of $1,896
If nominal cash flows are discounted at the real discount rate, the present value is:
Present value (nominal cash flows discounted at real rates) = $108/1.0874 + $ 117 / 1.08742 +
($126 + $5,068) / 1.08743 = $4,293 > True value of $1,896
./& !
where,
Rf = Riskfree rate
j = Beta of asset j
j = Dividend Yield of asset j
D0 = A constant term
*+ 6 " + '
The expected dividends and the terminal price were estimated for Eli Lilly at the beginning of
1992 for the next five years (before personal taxes). The firm had a beta of 1.05 and the treasury
bond rate wass 7.15%. The following example values Eli Lilly on the basis of cash flows after
personal taxes for an investor with a tax rate of 40% for ordinary income and 28% for capital
gains. The cash flows on a pre and post tax basis are as follows:
%
6
6
( !
( !
8
1 $2.27 $1.36
2 $2.60 $1.56
3 $2.98 $1.79
4 $3.41 $2.05
5 $3.91 $93.43 $2.35 $84.41
The discount rate can be estimated before personal taxes and used to calculate the present value
per share:
Present Value per share (based upon pretax cash flows and pretax discount rates)
The initial price is assumed to be $62.20. The cash flows after personal taxes are estimated after
personal taxes as follows:
Dividends per share after taxes = Dividends per share before taxes * (1  Ordinary tax rate)
Terminal price after taxes = Terminal price before taxes  (Terminal price  Initial price) *
Capital Gains tax rate = $ 93.43  ($93.43  $62.20) * 0.28 = $84.41
The discount rate before personal taxes can be apportioned into dividend yield and price
appreciation:
Expected Dividend Yield = Expected Dividends next year/ Initial Price
Discount rate after personal taxes = 3.71% (1  0.40) + 9.22% (1  0.28) = 8.86%
Present Value per share (based upon aftertax cash flows and aftertax discount rates)
Thus the value is unaffected by whether cash flows are before or after personal taxes, as long as
the discount rates are adjusted accordingly.
The following are the earnings per share at Glaxo Pharmaceuticals, starting in 1989 and ending
in 1994:
Growth
Year EPS
Rate
1989 $0.66
1990 $0.90 36.36%
1991 $0.91 1.11%
1992 $1.27 39.56%
1993 $1.13 11.02%
1994 $1.27 12.39%
Arithmetic mean = (36.36%+1.11%+39.56%11.02%+12.39%)/5 = 15.68%
The following table provides earnings per share at Glaxo, starting in 1988 instead of 1989 and
uses six years of growth rather than five to estimate the arithmetic and geometric averages.
The earnings per share from 1988 until 1994 is provided for Glaxo., and the linear and log linear
regressions are done below:
= $ 1.53
Calculating growth rates when earnings become negative is problematic, since the traditional
growth rate measures often fail. For instance, if earnings per share goes from <$1.00> to $1.00,
the traditional growth rate measures would be ñ
The following series lists earnings per share from 1988 to 1994 for Sterling Chemicalsñ
Growth Modified
Time (t) Year EPS log(EPS)
Rate Growth Rate
1 1988 $3.56 1.27
2 1989 $1.77 0.57 50.28% 50.28%
3 1990 $1.07 0.07 39.55% 39.55%
4 1991 $0.67 0.40 37.38% 37.38%
5 1992 $0.08 2.53 88.06% 88.06%

6 1993 ($0.10) NMF 225.00%
225.00%

7 1994 $0.34 1.08 129.41%
440.00%
Using the slope coefficient from the linear regression
Amgen increased its net income from $19.1 million in 1989 to $430 million in 1994. The
following table shows the growth in net income for Amgen from 1989 to 1994, in both
percentage and dollar terms.
;0" <7
8
7
à
1989 $19.10
1990 $86.20 351.31% $67.10
1991 $186.30 116.13% $100.10
1992 $306.70 64.63% $120.40
1993 $354.90 15.72% $48.20
1994 $430.00 21.16% $75.10
Assuming that this growth rate continues for the next five years,
;0" <7
8
7
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1995 $801.60 86.42% $371.60
1996 $1,494.32 86.42% $692.72
1997 $2,785.67 86.42% $1,291.35
1998 $5,192.98 86.42% $2,407.31
1999 $9,680.63 86.42% $4,487.65
Studies indicate that analysts do better than mechanical models at forecasting earnings in the
short term, but do not do much better than such models over the long term.
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197074
197275
196979
Some analysts are better at predicting earnings than other analysts. They are also usually better at
picking stocks. Studies examining how effective analysts are conclude the following ñ
= b * ROE
Proposition 1: The expected growth rate in earnings for a company cannot exceed its return on
equity in the long term.
Small changes in return on equity can lead to large shifts in the growth rate for some firms. The
relationship between growth rates and changes in return on equity is as follows ñ
The following table provides information on the retention ratio and the return on equity for
Merck for 1994 and projections for 1995.
1994 1995
BV of Equity 11700
A drop in the return on equity of 0.5% translates into a drop in the growth rate of 2.20%. If the
ROE drops by 2% the expected growth rate in 1995 would be 4.72%.
à&+ '(
Procter & Gamble decided to reduce prices on their disposable diapers in April 1993 to compete
better with lowprice private label brands. The preinterest, aftertax profit margin is expected to
drop from 7.43% to 7% as a consequence and the asset turnover is expected to increase from
1.6851 to 1.80. The following table provides projections in profit margins, asset turnover and
growth rates after the shift in corporate strategy:
Sales $ 29,362
0"à
4;4.*;
5$ > 7
The following table provides estimates of return on assets, retention ratio and interest rates for
Neutrogena, a cosmetics manufacturer. Neutrogena is expected to grow at an extraordinary rate
in the first five years (growth phase) and at a stable rate after that (steady state).
Debt/Equity 0% 25%
Consider Autodesk Inc,a software company, with earnings per share available from 1987 to
1992. The following table also provides analyst forecasts of expected growth over the next five
years from nine analysts following Autodesk.
?
+
1
+
Growth Analyst Estimated
Year EPS
Rate Number Growth
1987 $0.89 1 10.00%
1988 $1.35 51.69% 2 10.50%
1989 $1.91 41.48% 3 12.00%
1990 $2.30 20.42% 4 12.50%
1991 $2.31 0.43% 5 13.00%
1992 $1.98 14.29% 6 16.00%
7 16.00%
8 18.00%
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