Strategic Financial Management Lecture 7 PDF

Strategic Financial Management Lecture 7: Risk and Return & Estimating the Cost of Capital Dr. Marc Broekema LL.M Discover theworld Discover at theworld Leiden University at Leiden University Ba...

Strategic Financial Management Lecture 7: Risk and Return & Estimating the Cost of Capital Dr. Marc Broekema LL.M Discover theworld Discover at theworld Leiden University at Leiden University Background Cash is not free; it comes at a price. The price is the cost to the firm of using investors’ money. Expressed as the return they expect for the capital they supply, it is called the cost of capital The rate investors expect from their investment in a project is the return they expect to receive from an alternative investment that has the same risk profile as the risk profile of the project Further, the rate expected by investors will depend on the type of security they held (bonds or shares) Discover theworld at Leiden University Background Discover theworld at Leiden University 3 Background Total Cost of Capital (WACC) Distributing Free Cash Flows The total cost of capital (WACC) reflects the risk to be run. Invested Capital Capital Employed Ke Components of the capital structure: Equity -Interest-bearing debt. (common shares & Dividend prefered shares) -Equity Free Cash Flow Operating Fixed Kd Assets + Net Working Debt-like Capital (NWC) (converitble loans) Providers of interest-bearing debt and equity expect Interest their own return from their investment. Long-term Debt (credits, factoring, leasing, mortgage Koller e.a. (2010): “Since free cash flow is the cash Repayment group loans) flow available to all financial investors, the company ’s WACC must also include the required return for each investor Cost of Capital (WACC) ROIC ROIC > WACC = value creation E D ROIC < WACC = value destruction WACC = K e × + K d × (1 − t) × ) V V Discover theworld at Leiden University Highlights - How to estimate the cost of equity capital - How to estimate the cost of debt capital - How to combine the cost of different sources of financing to obtain a project’s weighted average cost of capital (WACC) - Distress and Bankruptcy Discover theworld at Leiden University Estimating the Cost of Capital Summary Value is a function of: 1. Cash flows (real money; FCF) 2. Risk (discount rate; r), and 3. Time (time value of money; n) Discount Rate (Cost of Capital) FCF1 FCF2 FCF3 FCFn DCF = + + +….+ (1+r)1 (1+r)2 (1+r)3 (1+r)n Discover theworld at Leiden University Cost of Capital (r) Literature “in economic terms, the cost of capital for a particular investment is an opportunity cost” (Pratt, 2014) “the opportunity cost of capital is equal tot the return that could have been earned on alternative investments at a similar level of risk and liquidity” (Ibbotson, 2013) Principle of substitution “an investor will not invest in a particular asset if there is a more attractive substitute available at the same price” Discover theworld at Leiden University Cost of Capital (r) Importance of the Cost of Capital Extremely important business and financial tool. It determines company valuation and shapes corporate strategy Used for taking decisions regarding investments for which capital is required Capital in this context refers to financial resources that businesses need in order to pursue a business enterprise or implement an investment project A business needs capital where resources are committed/paid for in advance, to which it is committed delivering a payback It’s a monetary item Discover theworld at Leiden University Cost of Capital (r) Types of costs Cost of Debt: - Defined in terms of payment the company must honor contractually - Easy if a company is entirely financed with debt - Interest rates vary over time and between different businesses Cost of Equity: - Offering the expectation that returns on the equity investment will be as good as those available from other opportunities, and over time achieving those returns - Much more complex than cost of debt; payments to equity holders are not contractually defined, nor is there a clearly defined contractual cost - Payments to equity holders are done after debt payments have been made; therefore, equity finance is more expensive than debt finance and equity holders bear a higher level of risk Discover theworld at Leiden University Cost of Capital (r) Total Cost of Capital Overall cost of capital of a business Weighted average of the cost of debt and the cost of equity (WACC) Weighted to their relative proportions of the business which are financed by debt and equity Firm E D WACC = 𝐊𝐊 𝐞𝐞 × + 𝐊𝐊 𝐝𝐝 × (1 − t) × V V Ke = Cost of equity Kd = Cost of debt E = Market value of equity Debt D = Market value of debt Equity t = Corporate tax rate V = Market value of equity + Market value of debt Discover theworld at Leiden University Cost of Equity (Ke) Determining the Cost of Equity How is the cost of equity determined when there is no contractual defined cost? 1. Opportunity cost Choosing between a range of opportunities when investing in equity Invest in the equity of a business when they believe that’s the best option given the other opportunities available A business must convince the investor that the return matches the best alternative available The equity’s ‘Opportunity Cost of Capital’ 2. Expected/Required return on the investment Not actual or achieved returns (ex post) No guarantees on the returns (ex ante) > delivering lower returns than alternative investments is risky when attracting new equity! Discover theworld at Leiden University Cost of Equity (Ke) How does risk affect the cost of capital? People want to avoid risk and are risk averse Choosing between a level of income with certainty or a higher level with uncertainty? Most people prefer the certain option Risk averse individuals will require higher expected returns in the future to be compensated for accepting risk An investment is made with certainty – often committed - however, the expected future rewards are uncertain Risk is not the same as uncertainty Risk can be calculated: probability distribution Uncertainty: metaphor ‘black swans’ Discover theworld at Leiden University Cost of Equity (Ke) Risks are not equal Investors who holds a diversified portfolio of equity investments, require a return to compensate only for the risks associated to the portfolio as a whole Unique or specific risks to a particular equity investment are ‘diversified’ away by holding the portfolio, and therefore not requiring any additional return This a fundamental assumption in financial economics and counter-intuitive Poor returns on stock A might be compensated by high returns on stock B in a completely unrelated sector If equity investors have a well-diversified portfolio, specific risks are eliminated Only systematic risk remains that cannot be diversified away (e.g., a drop of the rate of economic growth, Covid-19) Modern Portfolio Theory (MPT) of Harry Markowitz (1952): reducing variability of returns by investing in a few different investments (reducing risk) Discover theworld at Leiden University Cost of Equity (Ke) Risks are not equal Total risk = Systematic risk + Unsystematic risk Standard deviation (SD) measures the volatility of returns, hence the risk Risk (SD) reduces when there are more investments in the portfolio Although it is impossible to find two investments whose returns move in exactly opposite directions and in the same proportions, diversification helps reduce risk The risk of holding a single security can be divided into two types of risks One risk that can be eliminated through portfolio diversification, called diversifiable or unsystematic risk A remaining risk that cannot be diversified away, called undiversifiable or systematic risk Discover theworld at Leiden University Cost of Equity (Ke) CAPM Systematic and unsystematic risk (Capital Asset Pricing Model) By investing in a portfolio of stocks, specific risk of an individual stock can be diversified away Adding one extra stock to the portfolio, exposes the investor only to the risk that contributes to the overall riskiness of the portfolio Examples of systematic risk Examples of unsystematic risk Growth in gross domestic product is faster than Construction of a new plant is cheaper than expected expected Interest rates rise There is a labor force strike in the factory The local currency appreciates Products need to be withdrawn due to a safety scare The rate of inflation falls A rival company goes out of business There is an increase in the world price of gas A gas well turns out to be dry Discover theworld at Leiden University Cost of Equity (Ke) Most cost of equity models assume that equity investors hold well-diversified portfolios The cost of equity for any investment increases only with the extent of systematic risk to which the investment exposes the equity investor. This holds true for the Capital Asset Pricing Model (CAPM) that is built on the MPT Cost of Equity under the CAPM: Ke = R f + βe × EMRP Ke = Cost of equity Rf = Risk-free rate Equity Risk Premium ße = Equity Beta of the investment EMRP = Equity market risk premium CAPM derives the cost of equity by adding a premium for risk to the risk-free rate (of interest) The risk premium is a product of the EMRP (average market risk) and the investment’s beta (measure of the relative systematic risk of a particular investments) Discover theworld at Leiden University Cost of Equity (Ke) Total risk CAPM suggests that the cost of equity vary between different investments only to the extent that investments exhibit differing degrees of systematic risk CAPM assumes in the basis no unsystematic risk Business risk Financial risk Relates to whether a company can make enough in sales and Relates to how a company uses its financial leverage and revenue to cover its expenses and turn a profit manages its debt load With business risk, the concern is that the company will be unable With financial risk, there is a concern that a company may default to function as a profitable enterprise on its debt payments Refers to the basic viability of a business, whether a company will is concerned with a company's ability to generate sufficient cash be able to make sufficient sales and generate sufficient revenues flow to be able to make interest payments on financing or meet to cover its operational expenses and turn a profit. While financial other debt-related obligations. A company with a relatively higher risk is concerned with the costs of financing, business risk is level of debt financing carries a higher level of financial risk since concerned with all the other expenses a business must cover to there is a greater possibility of the company not being able to remain operational and functioning. meet its financial obligations and becoming insolvent. Discover theworld at Leiden University Cost of Equity (Ke) Do specific risks matter? Cost of Equity under the CAPM: Ke = R f + βe × EMRP + α Equity Risk Premium Company-specific risk can be diversified away: too far away from realities of corporate life? Company-specific risks are extremely important Because specific risk diversification is based on the premise that for each bad-performing stock in the portfolio, there is a good-performing stock. Does this hold true? The role of the company’s management is therefore vital Discover theworld at Leiden University Cost of Equity (Ke) Summary of the Cost of Equity Related to the perceived risk of the investment Systematic risk: business risk and financial risk Unsystematic risk: Company-specific risks can be diversified away; however, they are extremely important for all investors Calculating the Cost of Equity is difficult CAPM for determining equity returns above the risk-free rate Calculating the cost of equity is forward-looking as we value future cash flows Discover theworld at Leiden University Risk-free rate (Rf) The risk-free rate represents the return an investor can achieve on the least risky asset in the market. Total Cost of Capital Investors require a positive return even where the repayment of the principal is E D WACC = K e × + K d × (1 − t) × guaranteed because: V V Time preference: attaching less value to future money because of later consumption Cost of Equity The risk-free rate is based on two elements: Ke = R f + βe × EMRP 1. The real interest rate (or rate of time preference) (in order to be persuaded to lend today and defer consumption until tomorrow) Risk-free rate 2. The expected inflation rate (compensation for depreciation in purchasing power over which funds are lent) = Nominal risk-free rate (in order to be persuaded to lend today and defer consumption until tomorrow) Discover theworld at Leiden University Risk-free rate (Rf) Converting nominal rates of return into real rates of return E.g., the nominal risk-free rate is 6% and the projected inflation is 3%: The underlying real risk-free rate can be solved by the Fisher equation: (1 + r) = (1 + i) x (1 + p) r = nominal risk-free rate of interest i = real risk-free rate of interest p = projected rate of inflation Real rate of return: (1+ i) = (1 + 0.06) / (1 + 0.03) = 1.029 = 2.9% or the real rate of return of 2.9% is a 6% nominal rate (1 + r) = (1 + 0.029) x (1 + 0.03) = 1.06 = 6.0% Discover theworld at Leiden University Risk-free rate (Rf) Which fixed-income instrument is risk-free? A proxy for risk-free are government securities (OECD countries) The yield available in the market for an investment that does not carry a bankruptcy risk, is normally the total yield on a government loan from a first-class debtor (e.g., the Dutch or German state) Nominal figures can be misleading Discover theworld at Leiden University Beta (ß) Total cost of capital Beta is the expected % change in a stock’s return given a 1% change in the market index E D WACC = K e × + K d × (1 − t) × V V The market is the independent variable, and the stock (movement) is the dependent variable Cost of equity Beta is the systematic risk; the market risk (that correlates with the stock market). Ke = R f + βe × EMRP The sensitivity of the return of an investment object to non-diversifiable risks (market risks) Beta Beta reflects the risk associated with equity. We refer to the equity beta Cov (Ri, Rm) = Covariance between returns on stock (i) and the 𝐂𝐂𝐂𝐂𝐂𝐂(𝑹𝑹𝒊𝒊 , 𝑹𝑹𝒎𝒎 ) returns on the market index (m) 𝜷𝜷𝒆𝒆 = 𝝈𝝈𝟐𝟐 (𝑹𝑹𝒎𝒎 ) σ2 (Rm) = Variance of the market index (m) Discover theworld at Leiden University Beta (ß) Calculate historical covariance between the returns on the firm’s equity and the returns from the stock market as a whole: a proxy for future beta Beta is calculated through a regression analysis: only historical information is available to perform the analysis Being careful with interpreting beta (it’s historic) The beta of the market is 1.0: the average beta must be representative of the index itself and regressed on itself, which would imply a beta of 1.0 (i.e., the average company in the market has a beta of 1.0) Firms that expose their equity investors to greater systematic risk than the average firm in the market have betas in excess of 1.0 and vice versa Betas can be estimated for nonlisted companies using comparator or synthetic analyses Discover theworld at Leiden University Beta (ß) Factors that drive beta: 1. Cyclicality of revenues: to what extent are the cash flows of a firm affected by factors systematic to all companies? 2. Operational leverage: the degree of fixed cost as a proportion of total cost, and its level has an impact on the systematic risk to which equity investors are exposed 3. Financial leverage: investors face further risk when a part of the business is funded with debt. Debt is service has a priority call and does not vary with the state of revenues Discover theworld at Leiden University Beta (ß) 𝐃𝐃 Observable betas include the effects of operational risk and financial leverage, being Equity beta = 𝛃𝛃𝐞𝐞 = 𝛃𝛃𝐚𝐚 × (𝟏𝟏 + ) 𝐄𝐄 𝛃𝛃𝐞𝐞 Asset beta only include the operational risk of the underlying business asset = 𝛃𝛃𝐚𝐚 = 𝐃𝐃 (𝟏𝟏+ 𝐄𝐄 ) Increasing the proportion of debt increases the firm’s equity beta, hence the risk for equity investors. Calculate ßa when ße = 0.72, debt 20%, and equity 80% Operational Financial risk risk Equity beta βe 𝛃𝛃𝐞𝐞 𝟎𝟎.𝟕𝟕𝟕𝟕 𝟎𝟎.𝟕𝟕𝟕𝟕 𝛃𝛃𝐚𝐚 = 𝐃𝐃 = 𝟎𝟎.𝟐𝟐 = = 𝟎𝟎. 𝟓𝟓𝟓𝟓 Asset beta βa (𝟏𝟏+ 𝐄𝐄 ) 𝟏𝟏+ 𝟎𝟎.𝟖𝟖 𝟏𝟏.𝟐𝟐𝟐𝟐 Explanation A beta equity (levered) of 0.72 exposes equity investors to less systematic risk than the stock market as a whole (1.0) 0.14 of this beta can be attributed to the gearing structure of the company (i.e., 20/80) The operating systematic risk (cash flow cyclicality and operational leverage) is 0.58 (asset beta; 0.72 less 0.14) Qualifying the asset beta of 0.58 as high or low can only be done by unlevering every firm’s equity beta and available gearing Discover theworld at Leiden University Equity Market Risk Premium (EMRP) Total cost of capital E D WACC = K e × + K d × (1 − t) × V V Cost of Equity Ke = R f + βe × EMRP Equity Market Risk Premium Discover theworld at Leiden University Equity Market Risk Premium (EMRP) Equity Market Risk Premium The additional expected return that investors demand putting money into equities of average risk EMRP = (R m − R f ) Rm = the expected return of a fully diversified (market) portfolio of securities Rf = the expected return on a risk-free security proxied by the return of a government bond Two approaches to determine the EMRP - Historic approach - Forward-looking approach Discover theworld at Leiden University Equity Market Risk Premium (EMRP) Historic approach Relies on the past being the best indicator of how the market will behave in the future, supported by the belief that investors’ expectations are influenced by the historic performance of the market, and future market Average market risk premium in the United States from 2011 to 2024 conditions will not differ substantially - Arithmetic and geometric calculations - Ranges from 5% to 6% in the US (30 years) Forward-looking approach Determine future returns today’s investors expect when investing in the market Discover theworld at Leiden University Cost of Debt Calculating the Debt Margin 1. Directly from the debt margin of traded corporate bonds issued by the enterprise itself, or based on first-hand information from the firm about very recently determined borrowing margins on debt provided to it by third-party banks Direct method 2. Based on the debt margins of other firms that are good close comparators to the firm in question and that have traded debt 3. If the firm has a credit rating, then spreads observed for comparable rated companies can inform you on the debt margin Indirect method 4. No traded debt, no suitable comparators with traded debt, no credit rating? Then using financial ratios to synthesize a credit rating and use this to calculate a debt margin Discover theworld at Leiden University Cost of Debt The cause of default risk There is a possibility that pre-interest cash flows and cash reserves will be insufficient to pay interest costs and debt repayments E.g., lower revenues, higher costs, too much Capex, and increasing debt service costs can increase the risk of default Measuring or estimating default risk Credit rating agencies evaluating the relative risk of different companies defaulting on their debt by examining their financial situation Providing a ranking from the safest to the least creditworthy Aim: informing investors to the risk of default for companies Discover theworld at Leiden University Cost of Debt Pre-tax cost of debt Kd = Pre-tax cost of debt Kd = R f + Dm Rf = Risk-free rate Dm = Debt margin for default risk Debt Margin Can be calculated using the information on bonds traded in the market Debt Margins are the observed difference or ‘spread’ between the redemption yield on a government bond and on a traded corporate bond of comparable maturity Spread: a measure of the higher yield that compensates for the default/credit risk of the corporate bond is an additional return for investors above a government bond for taking the default/credit risk Discover theworld at Leiden University Weighted Average Cost of Capital Cost of equity Ke = R f + βe × EMRP Cost of debt Kd = R f + Dm WACC = Cost of Equity x % of Equity in the Capital Structure + After-tax Cost of Debt x % of Debt in the Capital Structure E D WACC = K e × + Kd × 1 − t × V V Discover theworld at Leiden University Weighted Average Cost of Capital (WACC) Steps for calculating WACC Step 1: Determine Target Capital Structure Step 2: Estimate Cost of Debt (Kd) Step 3: Estimate Cost of Equity (Ke) Step 4: Calculate WACC Discover theworld at Leiden University Weighted Average Cost of Capital (WACC) Calculate WACC on CAPM Target Capital Structure is: 31 December Market Value Assets 100 Market Value Debt 20 Market Value Equity 80 Total Value 100 Total Value (capital) 100 Marginal tax rate: 25% Debt margin: 3.5% Risk-free rate: 1.5% Asset beta: 0.96 (only operational risk, financial risk is missing but there is leverage!) Equity Market Risk Premium: 6.0% Discover theworld at Leiden University Weighted Average Cost of Capital Step 1: Determine Target Capital Structure D 20 20 = = = 0.2 = 20% debt (D+E) (20+80) 100 E 80 80 = = = 0.8 = 80% equity (D+E) (20+80) 100 D/E ratio = 20%/80% = 0.25 (for every dollar of equity, the company only has 25 cents in debt) V = D + E = 20% + 80% = 100% Discover theworld at Leiden University Weighted Average Cost of Capital Step 2: Estimate Cost of Debt (Kd) Kd = Rf+ Dm Rf = 1.5% Dm = 3.5% Pre-tax Cost of debt (Kd) = 1.5% + 3.5% = 5% After-tax Cost of debt (Kd) = 5.0% x (1 - 25%) = 3.75% Discover theworld at Leiden University Weighted Average Cost of Capital Step 3: Estimate Cost of Equity (Ke) Cost of Equity = Rf + Be x EMRP Asset beta: 0.96 Equity beta (levered) = 0.96 x (1+ D/E) = 0.96 x 1.25 = 1.2 𝐃𝐃 𝛃𝛃𝐞𝐞 = 𝛃𝛃𝐚𝐚 × (𝟏𝟏 + ) 𝐄𝐄 Cost of Equity = 1.5% + (1.2 x 6.0%) = 8.7% Discover theworld at Leiden University Weighted Average Cost of Capital Step 4: Calculate WACC E D WACC = K e × + Kd × 1 − t × V V 80% 20% WACC = 8.7% × + 5.0% × 1 − 25% × 100% 100% WACC = 6.96% + 0.75% = 7.71% Discover theworld at Leiden University Capital Structure Effects Financing policies affect company value Two policies: 1. Static trade-off Trade-off between value tax shield (advantage Debt Capital) and bankruptcy costs (disadvantage Debt Capital) Direct costs 'distress' (legal, accountant, bank, etc.) Indirect costs 'distress' (delayed investments, customers and staff walking away, suppliers demanding cash payment, etc.) Target equity/debt ratio ('fixed debt ratio’) 2. Pecking order Fixed preference of managers for raising capital No fixed capital ratio ("fixed debt") Discover theworld at Leiden University Capital Structure Effects Discover theworld at Leiden University What are the major causes of business failure? General economic conditions, industry trends, shifting consumer tastes, obsolete technology, and changing demographics e.g. in existing retail locations. Financial factors, such as too much debt and unexpected increases in interest rates Most failures occur because a number of factors combine to make the business unsustainable. Discover theworld at Leiden University 42 What size firm, large or small, is more prone to business failure? Bankruptcy is more frequent among smaller firms. Large firms tend to get more help from external sources to avoid bankruptcy, given their greater impact on the economy. Discover theworld at Leiden University 43 What key issues must managers face in the financial distress process? Is it a temporary problem (technical insolvency) or a permanent problem caused by asset values below debt obligations (insolvency in bankruptcy)? Who should bear the losses? Would the firm be more valuable if it continued to operate or if it were liquidated? Should the firm file for bankruptcy, or should it try to use informal procedures? Who would control the firm during liquidation or reorganization? Discover theworld at Leiden University Bankruptcy Terminology Voluntary bankruptcy - A bankruptcy petition filed in court by the distressed firm’s management. Involuntary bankruptcy - A bankruptcy petition filed in court by the distressed firm’s creditors. Discover theworld at Leiden University 45 Typical Priority of Claims Secured creditors Trustee’s administrative costs Expenses incurred after involuntary case begun but before trustee appointed Wages due workers within 3 months prior to filing Unsecured claims for customer deposits Taxes due Unfunded pension plan liabilities General (unsecured) creditors Preferred stockholders Common stockholders Discover theworld at Leiden University What informal remedies are available to firms in financial distress? Informal reorganization Informal liquidation Why might informal remedies be preferable to formal bankruptcy? What types of companies are most suitable for informal remedies? Discover theworld at Leiden University 47 Informal Bankruptcy Terminology Workout: Voluntary informal reorganization plan. Restructuring: Current debt terms are revised to facilitate the firm’s ability to pay. - Extension: Creditors postpone the dates of required interest or principal payments, or both. Creditors prefer extension because they are promised eventual payment in full. - Composition: Creditors voluntarily reduce their fixed claims on the debtor by either accepting a lower principal amount or accepting equity in lieu of debt repayment. Assignment: An informal procedure for liquidating a firm’s assets. Title to the debtor’s assets is transferred to a third party, called a trustee or assignee, and then the assets are sold off. Discover theworld at Leiden University 48 General Conclusion No return without risk Discover theworld at Leiden University 49 Discover theworld Discover at theworld Leiden University at Leiden University 50