Hurdle rates for Firms _part 1_ by lonyoo

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									Hurdle Rates for Firms


       04/15/08
        Ch. 4
Investment Decision
 Firms should invest in projects that create
  value for the firm‟s shareholders

 These are projects that yield a return greater
  than the minimum acceptable hurdle rate with
  adjustments for project riskiness.

 Do you ever lend money and expect to get
  less back? Companies should not…
                                                   2
Investment Decision
 Components of the investment decision making
  process
      Determine the appropriate hurdle rate for the firm (Ch.
       4) -- WACC
      Make adjustments for project riskiness (Ch. 5)
      Calculate the cash flows associated with the project –
       Incremental Cash Flow
      Employ the appropriate decision tools -- NPV
      Evaluate project interactions (Ch.6)
 If NPV is positive go, if NPV is negative no-go


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What is a Hurdle Rate?
The hurdle rate for the firm represents the
  minimum rate of return that the firm as a
  whole must generate on its investments to
  satisfy its investors.
 It is the implicit cost of money for the firm…
 This is also referred to as the weighted
  average cost of capital (WACC) or simply
  the cost of capital.


                                                   4
Weighted Average Cost of Capital
 Percent of financing times the cost of
  financing for that funding source
 Sources
     Equity (Owners)
     Debt (Bondholders, Banks, etc.)
     Preferred Stockholders (often skipped)
 WACC = (E/V) x Re + (D/V) x Rd x (1 – Tc)



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Cost of Equity
 Required rate of return for equity investors (or shareholders)
  is also referred to as the cost of equity
 For publicly traded firms, we initially assume that the these
  equity investors are diversified investors. Consequently,
    Only the firm‟s risk relative to the market is relevant
      (systematic risk)
    Firm-specific risk is assumed to be diversified away




     re  rf   (rm  r f )

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Cost of Equity
 To calculate the cost of equity for a firm, we
  need estimates for each of its components:
    Risk-free rate, rf


    Market return, or alternatively the market
     risk premium, (rm- rf)
    Firm‟s beta, β




                                                   7
Risk-free Rate
 With the risk-free asset, the actual return and
  expected return do not vary.
 The risk-free asset assumes:
      No default risk (bonds and their ratings)
      No reinvestment risk (coupons reinvested)
 Ideally, this means that you should use a risk-
  free asset whose maturity matches the timing
  of cash flows
 Treasury securities
  http://screen.yahoo.com/bonds.html
                                                    8
Market Risk Premium
 The market risk premium represents the extra return
  beyond that of a risk-free asset that an investor
  demands for moving their funds from the risk-free
  asset to the risky (market portfolio) asset.

 E(rm) – rf = market risk premium…
    Consider this payment for units of risk
    Beta as units of risk
    Increase Beta and you increase demand for extra risk
     premium


                                                            9
Estimating the Market Risk Premium
 There are two methods to estimate the
  market risk premium.
     historical risk premium
     Implied risk premium

 The majority of analyses tend to employ the
  historical method or some form of weighted
  average between the two.


                                                10
The Historical Approach
 In most cases, historical market risk
  premiums can be estimated as follows:
      define a time period for the estimation (1926-
       Present, 1962-Present....)
      Arithmetic average (simple average)…Find each
       year‟s return, then average of the yearly returns
      Geometric average (compounding)…
 Take the difference between the average return
  of the market and the risk-free rate
 Look at Finance. Yahoo (ticker SPY) „93 to now

                                                           11
Historical Premium Limitations
 The limitations of this approach are:
      it assumes that the risk aversion of investors has
       not changed in a systematic way across time. (The
       risk aversion may change from year to year, but it
       reverts back to historical averages)

      it assumes that the riskiness of the “risky” portfolio
       (stock index) has not changed in a systematic way
       across time



                                                            12
Implied Premium Approach
 The implied risk premium approach estimates a risk
  premium based on current market values, dividends
  and growth rates.

 We can use a basic dividend discount model (DDM)
  to estimate the implied risk premium:

  Index value =         Expected index dividends
                  (RR on the index – growth rate in dividends)


 The implied risk premium would then be:
       RR on index – current risk-free rate
                                                                 13
Implied Premium Limitations
 The limitations of this approach are:
      It assumes that the DDM is correct to value
       the market.
      It assumes that the market is currently
       correctly valued (what other choice do we
       have?)
           If the market is not correctly valued how do we
            adjust for the errors of the many?
           Would we even care to estimate the correct value
            or would we “exploit” this error of the many?

                                                           14
Looking at Beta
 Co-movement with the market (regression)
 Estimated with stock returns of the individual
  company as the dependent variable
     Return = [(PriceT+! + Dividends)/ PriceT] – 1
     Why add dividends to price?
 Independent variable is usually large market
  index
     S&P 500 is very popular
     Return of S&P 500, should add in dividends
                                                      15
Regression to Find Beta
 Independent Variable is Market Return
 Dependent Variable is Individual Stock
  Return
 Regression estimates slope and intercept
     Slope, beta = Covariance (y, x) / Variance of X
     Intercept, alpha = mean (y) – beta x mean (x)
     R2 = (beta times variance of x) / variance (y)
 Problem #12 – AnaDome
   Beta 0.735, intercept -0.0015, R-squared 0.29

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Issues with Beta Estimation
 Time period of returns
    Longer periods provide more data
    Longer periods introduce problems with shifts
     in the beta of the company (all firms moving to
     a beta of 1?)
 What is the right return interval? Daily,
  Monthly, Quarterly, Annual…more data better
 What is the Market Return? What do you use
  for the market? Should be all assets…we use
  S&P 500 for US stocks and we are “happy”

                                                   17
Bottom-up betas
 The bottom-up approach relies on the fundamental
   characteristics of the firm to determine the riskiness of the firm
   and thus the firm beta.

 These fundamental characteristics include:
    Type of Business: Firms in more cyclical businesses or that sell
     products that are more discretionary to their customers will have
     higher betas than firms that are in non-cyclical businesses or sell
     products that are necessities or staples.

       Operating Leverage: Firms with greater fixed costs (as a
        proportion of total costs) will have higher betas than firms with
        lower fixed costs (as a proportion of total costs)

       Financial Leverage: Firms that borrow more (higher debt, relative
        to equity) will have higher betas than firms that borrow less.


                                                                            18
Bottom-up betas
 The first component of a firm‟s risk is that
  associated with its operations:
     We can measure this risk by calculating the
      firm‟s unlevered beta (βU), i.e., a beta that
      removes the effect of financial leverage.
 This unlevered beta is also referred to as an
  asset beta as it represents the riskiness of
  a firm‟s assets.
 βU = Current Beta / (1+(1-TC)(D/E))

                                                      19
Equity Betas and Leverage
 The following equation provides us with the mathematical
  relationship between the unlevered and levered beta:
                             L
            u 
                   1  1  TC D / E 
where
   L = Levered Beta
   u = Unlevered Beta
   t = Corporate marginal tax rate
   D = Debt Value
   E = Equity Value

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Cost of Equity
 Once we know
   Risk-free Rate
   Market Premium
   Beta of the firm…

 Calculate the Cost of Equity




    re  rf   (rm  r f )

                                 21
What is debt?
 General Rule: Debt generally has the following
   characteristics:
       Commitment to make fixed payments in the future
       The fixed payments are tax deductible
       Failure to make the payments can lead to either default or
        loss of control of the firm to the party to whom payments are
        due.

 As a consequence, debt should include
    Any interest-bearing liability, whether short term or long
     term.
    Any lease obligation, whether operating or capital.


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Cost of debt vs. required rate of return
for debtholders
 The required rate of return for bondholders of a
  particular firm is a function of:
      Current interest rate for the risk-free asset
      Default risk associated with the firm, i.e., how likely is the
       firm to go bankrupt (risk premium).
 Bondholders are compensated in interest payments
  (or coupon payments) for this required rate of return.
 Because from the firm‟s perspective interest expense
  is tax-deductible, the after-tax cost of debt (rd) is:
              rd * (1 – tax rate)


                                                                        23
Estimating the cost of debt
 Depending on whether or not the firm in question has
  bonds that are publicly traded and on available
  information, there are three ways (in order of
  preference) to estimate the before-tax cost of debt:
    Look for prices and yields of bonds outstanding
    Estimate the cost of debt from the firm‟s credit
     rating
    Estimate the cost of debt by calculating a synthetic
     credit rating



                                                        24
Estimating the cost of debt
 If the firm has bonds outstanding, and the bonds are
  traded, the yield to maturity (YTM) on a long-term,
  straight (no special features) bond can be used as
  the before tax cost of debt.
  http://screen.yahoo.com/bonds.html


                                      1         
                               1 -
                                1  YTM N     
                                                 
                     Coupon                   
           FV
   P
      1  YTM N
                                    YTM

                                                         25
Estimating the cost of debt
 If the firm is rated, use the credit rating and a
  typical default spread on bonds with that
  rating to estimate the cost of debt.

 See page 139 of text for default spreads by
  rating

 Start again with risk-free rate and add default
  spread
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Back to WACC
 Once we know the required return for equity
  and debt
 And we know the percentage of each funding
 And we know the tax rate…
 We can estimate the hurdle rate by
  calculating the WACC
 (E/V) x Re + (D/V) x Rd x (1 – Tc)
 Note…the riskiness of the cash flows will be
  implied by beta and the bond rating
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Homework
 Chapter 4 --
     5,
     8,
     9,
     14,
     19,
     and 23



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