Class 7 Slides

Cost of Equity
WACC

Everything has a price

In finance we have a variety of terms for
this:
Time Value of Money
Opportunity Cost
Cost of Capital

We are going to focus on the Weighted

Average Cost of Capital (WACC)
Cost of Equity (Ke)
Cost of Debt (Kd)

What is WACC?
Review
What do we mean by cost of capital?
WACC?

Uses of WACC
Capital projects valuation
Asset appraisals
Performance evaluation

Do different uses require different

calculations/inputs?

Time Value of Money

Further investigate WACC
Target leverage ratio
Optimal leverage ratio

Impact of leverage on beta

Segment specific WACCs
Additional critiques

WACC Inputs
When computing WACC, consider key inputs:
Capital structure, both current and target (D
and E)
Cost of debt (Kd)
Tax rate (T)
Cost of equity (Ke)
Risk-free rate (Rf)
Beta ()
Equity Market Risk Premium (EMRP)

WACC impact on Valuation

Value

Remember the goal: value maximization

Value of
levered firm

Value if
no debt

Max Value

Optimal
Leverage
Ratio
Debt as % of Capital
Structure

Optimal WACC
Required
Return

Remember the goal: value maximization

Ke
WACC

RU

Kd

Optimal Debt
Level
Debt as % of Capital
Structure

The End Goal

We are looking for the Weighted Average
Cost of Capital (WACC)
D
E
WACC
* K d *(1 T)
* Ke
D E
D E
Where:
D = $ amount of debt outstanding (market capitalization)
E = $ amount of equity outstanding (market capitalization)

K e Rf * (EMRP)
K d Rf spread

Cost of Equity
This is the same as:
The Required Rate of Return for a
shareholder
In other words, what is the rate of return that I
must expect in order for me to want to own his
stock?

We will use the Capital Asset Pricing

Model (CAPM) to estimate the Cost of
Equity (Ke)
Commonly used, and easy to calculate

Calculating the Cost of Equity

Ke = Rf + *(EMRP)
Of the three inputs only EMRP is beyond
direct measurement or observation (sort
of)
The formula is being used to discount
future cash flows, so must be forward
looking
It is not important where the puck is now, but
where the puck is going to be tomorrow

Risk-Free Rate
Typically drawn from the government bond
yield curve
Common to use a long-term rate that is
liquid and widely followed
10-year bond yields
30-year bond yields

Remember that we are forecasting very far

into the future. Do current rates represent a
good estimate of the future?

Risk-Free Rate Estimates

The Federal Reserve has excellent data
on long-term interest rates
Lets look at 5-year, 10-year, and 30-year
bond yields since WWII
http://research.stlouisfed.org/fred2/
As we did with the other data we looked at, it
is important to first visually inspect the
interest rate information to get a feel for the
story

All rates
90-day T-Bills
10-year T-Bonds

5-year T-Bonds
30-year T-Bonds

90-Day T-Bills
Rates were near zero before
during the Great Depression
and didnt go back to normal
until after what?

5-year T-Bonds
Big, unstoppable trend in interest
rates. Think about the big events
since the peak, such as the end of the
Cold War, Asian Currency Crisis, Tech
Boom/Bust, etc.

10-year T-Bonds
The benchmark for
interest rates, used as the
Rf in many situations.

30-year T-Bonds
No US 30-year T-Bonds
being issued

What rate would you use?

90-day T-Bill rates have gone from near
0% in the 1930s to 16% in the 1980s to
near 0% in 2013
Similar patterns for the other T-Bonds, but with
a higher rate of interest

The interest rate differential across

maturities is less significant than the
changes in the interest rate levels over
time

Some averages
Lets look at the average yields over each
time series (keeping in mind each time
series covers a different set of years)
Are there any trends?
What is the minimum level of interest rates?
The maximum level?
Bond
90-Day T-Bills
5-year T-Bonds
10-year T-Bonds
30-year T-Bonds

Average Yield
3.63
6.18
6.51
7.36

Current Yield
0.03
1.63
2.42
3.33

Beta
Beta measures the relationship between
the stock and the overall market
This is usually done by regressing the
periodic returns of the stock against the
periodic returns of the market
A broad index is chosen to represent the
market, like the S&P 500 for US stocks or the
S&P/TSX Composite Index for Canadian
stocks

XOMs Beta
Beta estimation runs into the same problems as any
other forecast
How much data should we use?
What time period?
Is our historical basis a good representation of the future?

The same rules apply when building your models:

If no material difference in betas across different time
periods then your decision is easy
If there are differences you must exercise your judgment

Consider the context of sub-periods, such as bear vs. bull

markets, inflation rates, GDP growth, etc.

XOMs Beta Over Time

The next set of slides looks at XOMs daily
returns (y-axis) graphed against the S&P
500s daily returns (x-axis)
1-Year extends backwards 250 days from
Aug 29, 2014
2-Year extends backwards 500 days from
Aug 29, 2014
Etc.

Visual Inspection
Just like our look at revenue and GDP data, when
looking at stock market data for your company,
graph your companys daily stock returns against
the S&P 500s daily returns
Any general trend in the data?
The longer the time period the more data points, and
the more data points
Covers more extreme economic environments
More data = more information in your result (the mass of
data points keeps getting bigger)

Notice the regression line in each graph

1-Year

2-Year

3-Year

5-Year

10-Year
20%
15%
10%
5%
XOM Daily Return

0%
-5%
-10%
-15%
-20%
-15%

-10%

-5%

0%

5%

S&P 500 Daily Return

10%

15%

15-Year

20-Year
20%
15%
10%
5%
XOM Daily Return

0%
-5%
-10%
-15%
-20%
-15%

-10%

-5%

0%

5%

S&P 500 Daily Return

10%

15%

XOM Beta Observations?

Very little change in the slope or position
of the regression line over time
Does this mean it is stable?
Time Period
1-year
2-year
3-year
5-year
10-year
15-year
20-year

Beta
0.8597
0.8798
0.8897
0.8933
0.9619
0.8333
0.8062

A Different Perspective
What does XOMs Beta look like in
different 1-year periods
Beta using only 2003 data
Beta using only 2005 data
Beta using only 2007 data
Etc.

2003

2005

2007
8%
6%
4%
2%
XOM Daily Return

0%
-2%
-4%
-6%
-8%
-8%

-6%

-4%

-2%

0%

2%

S&P 500 Daily Return

4%

6%

8%

2009

2011
8%
6%
4%
2%
XOM Daily Return

0%
-2%
-4%
-6%
-8%

2013

XOMs Annual Betas

Substantial variance in XOMs beta from
year to year
What was the economic situation in 2005 vs.
2007 vs. 2009? Commodity markets?
Year
2003
2005
2007
2009
2011
2013

Beta
0.6802
1.4252
1.1833
0.7605
0.9509
0.8195

Caveats about Beta

The relationship described by Beta can be
greatly impacted by the actual return
patterns of the stock and underlying index
The following charts use the monthly returns
of the S&P 500 for the past 20 years
One of the return series has been altered by
reversing the sign on the largest gain and loss
Just 2 outliers out of 237 observations

Perfect Correlation

Just Two Alterations

Outlier Impact

Outlier Impact
Remember, the other 235 observations
are a perfect fit
Criteria
Benchmark AlteredBenchmark
Beta
1.0000
0.8281
R2
1.0000
0.6878
Keep this in mind when evaluating your
confidence level vs. your predictive
accuracy

Equity Market Risk Premium

The EMRP is the amount of return that an
investor expects from the equity markets
above the return they expect to receive from
the risk free rate
The EMRP is an expectation, so is forward
looking and difficult (or impossible?) to
accurately determine
Often estimated using actual historical return
differences, but is this realistic?
Typically between 3% and 7%

Equity Market Risk Premium

Deep topic, much continuing research
Think about historical GDP, stock and bond returns
EMRP = long-term required return premium
What is Nominal GDP growth rate since WWII?
~ 6.6%

What is the average bond yield since WWII?

~ 4.23% for 90-day T-Bills
~ 6.51% for 10-Year T-Bonds (since 1962)

What is the average annual return for the S&P 500 since
WWII?
~ 7.1% excluding dividends (~3% since WWII)

Stocks return ~10% giving us an EMRP between 3.5%

and 5.75% depending on the bond

EMRP Estimates
Damodaran musings 2013
Example from JP Morgan (see page 3)
PWC study of Norwegian Risk Premia
2012 and 2013
Note: JP Morgan and PWC hyperlinks
direct you to PDFs

Putting it all together

Keep you inputs and assumptions consistent with each
other
Dont use a 90-day T-Bill rate with a beta from 10 years ago and
a 60-year EMRP

Two basic positions:

Historical-Historical-Historical
10 year average of bond yield 10 years of beta data 10 year EMRP

Current-Current-Current
Current bond yield 1 year beta 1 year EMRP

For our purposes (and for most situations) keep EMRP at

5%
Reasonable assumption

And REMEMBER!
ALWAYS be prepared to answer questions
on HOW you calculated the cost of equity
easy question for an audience member
More likely if your Ke varies from the norm
Risk-Free
Rate

Beta

EMRP

Cost of Equity
Column1
(Ke)

7.36%

.8333

5.00%

11.53%

3.33%

.8597

5.00%

7.63%

Historical 30yr & 20-year

beta
Current 30-yr
& 1-year
beta