Chapter 8
Creating Value Through
Required Returns
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Foundations of Value Creation
• Industry Attractions
• Competitive Advantage
Create
Excess
Returns
• Valuation Underpinnings
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Favorable Industry
Attractiveness
•
•
•
•
•
Growth
Barriers to entry
Patents
Temporary monopoly power
Oligopoly pricing
– All competitors are profitable
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Avenues to Competitive
Advantage
• Cost advantage
• Marketing and price advantage
• Superior organizational capability
– Corporate culture
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Required Market-Based
Return
•
•
•
•
Single project
Division with similar risk
Over all company (WACC)
Incompatibility
– Security returns
– Capital project returns
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Proxy Company Estimates
• Deriving surrogate company returns
– Sample of matching companies
– Betas for each proxy company
– Calculate central tendency
– Derive
• RRR on equity using proxy beta
• Expected return on the market portfolio
• Risk-free rate
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APT Factor Model Approach
• Firm’s reaction coefficients x lambda
– Lambda = market prices of factor risks
• Sum the products
• Add the risk-free rate
• Risk is the function of the responsiveness
coefficients for each of the factors of
importance.
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Use of Accounting Betas
• Based on accounting data
– Related to an economywide index
• Data readily available
• Useful in developing countries
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Modification for Leverage
• CAPM
– Business risk
– Degree of leverage
• Beta modification
– Unlevers the proxy company’s beta
– Relevers for a different degree of leverage
– Beta adjustment procedure is crude
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Weighted Average Required Return
• Separation of investment from financing
– Assumed target capital structure
• Cost of debt
– After-tax
– Uncertain future tax return
• Cost of preferred stock (P/S)
– Function of its stated dividends
– Corporate dividend exclusion
• Other types of financing
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Determining the Value of a
Project
• WACC
• APT
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Calculating WACC
• Weighting the costs
– Weights correspond to the market values
of the forms of financing
– Do not use book values
– Each component is weighted according to
market-value proportions
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Limitations
• Marginal weights
– Incremental capital
– Ignore temporary deviations
• Flotation costs
– Adjustment made in the project’s cash flows
– Adjusting the cost of capital (biased estimate)
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Rational for WACC
Increase the market price of the company’s stock
RRR
CAPM
SML
ke
ko
Laddering
of returns
required
kp
ki
Rf

X
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EVA
Operating profits
-
Required dollar-amount return
for the capital employed
Force attention to the balance sheet
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MVA
Company’s total
market value
- Total capital invested since origin
Debt & equity
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Interpreting EVA & MVA
Results
• Use accounting book values as measures of
invested capital
• Make adjustments to better approximate
invested cash
• Calculated capital employed
– Historical, sunk cost
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Adjusted Present Value
APV
=
Projected cash flows
= Unlevered value + Value of financing
As risk increases the discount rate increases
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WACC Versus APV
• WACC is accurate
– Maintain constant debt ratio
– Invest in similar projects
– Easy to understand & widely used
• APV is accurate
– Depart radically from previous financing
patterns
– Invest in a new line of business
– Not widely used in business
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Divisional Required Returns
• The proxy company approach
• Solving for beta
– Sum of the divisions = the whole
• Proportion of debt financing
• Adjusting costs of debt and equity
• Alternative approach
– Use both proxy debt & equity
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Implications for Project
Selection
• Consider risk involved
• Divisional hurdle versus WACC
• Adverse Incentives
– Conservative
– Aggressive
• Risk-adjusted returns
– System for allocating capital to divisions
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Company’s Overall Cost of
Capital
• Dividend Discount Model DDM
• Perpetual growth situations
– Constant rate
– Growth segments
• DDM versus market model approaches
– Assumptions
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Diversification of Assets &
Total Risk Analysis
• Investors diversifying across capital assets
– Tracking stocks
• Imperfections & unsystematic risk
– Bankruptcy costs
• Evaluation of combinations of risky investments
– Standard deviation
– Expected value
– Selecting the best combination
– Project combination dominance
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When Should We Take Account
of Unsystematic Risk?
• Conflicting signals
– Market approach
– Total variability approach
• Company’s stock is traded in inefficient
markets
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Evaluation of Acquisitions
• Free cash flows
• Market model implications
– Enhance the value of a company
– Purchase price & required return
– Synergy
• Diversification effect
– Effect on total risk
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