CFA LV2 Module 3: Cost of Capital: Advanced Topics
Summarization: International Considerations [Trivial Pursuit]
+ International Considerations: -> Sovereign Risk: It covers the risk of a country defaulting on its debt obligation. -> Country Risk: It covers the downside of a country's business environment including legal environment, levels of corruption, and socioeconomic variables such as income disparity. [When the cost of debt is estimated for international markets, it should reflect the currency in which the company's cash flows occur. One approach is to at a country risk rating (CRR). The CRR includes risks such as: economic conditions, political risk, exchange risk, and security market development and regulation.]
Summarization: The country risk rating model, Extended CAPM (Global CAPM) [Trivial Pursuit]
+ The country risk rating model, Extended CAPM: Global CAPM: -> Global CAPM: [My own word: We simply use the Global Market Index instead of SP 500 or Russell 2000 to estimate the ERP] -> In global CAPM, a global market is the single factor. The assumption is that there are no significant risk differences between countries.
-------------------------------------------
-------------------------------------------
*** L2CI-LM303-PQCA006_2211 Calculate the cost of equity for Jerry's Kans, a private company, using the Fama-French Five Factor model, and the following parameters calculated from listed companies in the same industry as Jerry's Kans: Factor Factor Beta Risk Premium Market (ERP) 1.10 6.5% Size (SMB) 0.55 1.5% Value (HML) 0.18 2.9% Profitability (RMW) −0.2 2.1% Investment (CMA) 0.25 2.7% Risk Free Rate 2.5% 11.25% 15.7% 8.75%
11.25% re = rf + β1 ERP + β2 SMB + β3 HML + β4 RMW + β5 CMA
****** L2CI-LM302-PQCA002_2211 Andrew Brown CFA is analysing Enfield plc - a UK manufacturing company. It borrowed £200m from its bank at a fixed interest rate in December 2020 when it had EBITDA of £45m, EBT of £150m and Net Income of £120m and pays £6m on interest each year. Due to supply chain problems EBITDA this year is expected to be £12m. What should Brown conclude about Enfield's cost of debt? 3% 2.4% More analysis is required.
2.4% This was the after-tax cost of debt when the debt was issued. [I don't know how did he get 2.4%, no explanation ]
*** L2CI-LM302-PQCA004_2211 Mourdant Corp has three outstanding, tradable straight bonds, each pays an annual coupon on a nominal value of £100 Term Price Coupon Rate 2 96.0 3.2% 4 99.5 3.6% 6 95.0 3.2% 5.4% 3.7% 4.2%
4.2% The cost of debt is the Yield to Maturity on the longest duration frequently traded bond. [I don't know how did he get 2.4%, no explanation ]
*** L2CI-LM302-PQCA005_2211 Mason Corp has just raised $400m of debt on which it will pay $20m of interest this year. The tax rate is 20% but due to negative Earnings Before Tax of -$5m, no tax is payable and Net Income is -$5m. Mason's after-tax cost of debt is: 4% 5% 6%
5% As Mason is not paying tax, there is no tax shield, and its cost of debt is the pre-tax cost of debt of 20/400 = 5%.
****** L2CI-LM303-PQCA002_2211 Jacob Johnson CFA is estimating the required return on a company within the S&P 500 using the bond yield plus risk premium approach. The following data is available: YTM on the company's most recent bond offering: 3.8% Historic returns on S&P 500 equities 11.2% Historic return on US corporate bonds 5.1% Calculate the expected return on stock. 11.2% 9.9% 8.9%
9.9% Historic risk premium = 11.2% − 5.1% = 6.1% Expected return on stock = 3.8% + 6.1% = 9.9%
*** L2CI-LM303-PQCA005_2211 Under which circumstances is the Grinold-Kroner model not appropriate to estimate the Equity Risk Premium? High expected inflation A developing country where the stock market is a small part of the overall economy High anticipated share buy-backs
A developing country where the stock market is a small part of the overall economy
*** L2CI-LM301-PQCA002_2211 Andrea Smith CFA is analysing Griffin Corp - a US manufacturing company - and comparing it with its peers. Which of the following characteristics would lead to a higher cost of capital? A higher marginal tax rate A high proportion of revenues from long-term subscription contracts A high proportion of intangible assets on the Balance Sheet
A high proportion of intangible assets on the Balance Sheet A relatively higher proportion of intangible assets on the balance sheet will lead to a relatively higher cost of debt. It is much easier to use tangible assets as collateral against a loan in order to reduce the cost of debt.
Practice Question: (Dividend discount models) An analyst determines that the forward rate dividend yield is 2%. The long term earnings growth is 5.5%. The long-term government bond rate is 1.75%. The short-term government bond rate is 1.25%. What's the equity risk premiums? A. 5.75% B. 6.25% C. 9.25%
A. 5.75% ERP = E * (D1 / V0) + E * (g) - Risk-free rate ERP = 2% + 5.5% - 1.75% = 5.75% The key here is to determine the risk-free rate proxy, which they have to sue a long term bond instead of short term bond.
Practice Question: An analyst assumes long-term inflation forecast (i): 2.25% Growth in real GDP (g): 3.75% Growth in market P/E (∆ P/E0): 0.75% Dividend Yield (D/V0): 1.25% 10-year risk-free return (rf) 4.25% The ERP estimate based on the Grinold-Kroner mode is closest to: A.3.75% B.4.25% C.8.00%
A.3.75% ERP = [Dividend yield + ∆ P/E + i + g - ∆S] − E(rf) = 1.25% + 0.75% + 2.25% + 3.75% - 0] - 4.25% = 3.75%
*** L2CI-LM301-PQCA003_2211 Spectre Foods is financed by debt, common equity and cumulative preferred equity. Which of these would you expect to be the most expensive? Debt as interest cover is only slightly above 1 Cumulative Preferred Equity as preferred dividends may not get paid on time Common equity
Common equity Common equity is the most expensive form of financing as its providers face the highest uncertainty in their returns
*** L2CI-LM302-PQCA001_2211 Analysts at Mogg Associates have prepared the following likely range of ratios for each Investment Grade credit rating class based on Interest Cover and Debt to Equity Leverage: Rating Class IC D/E AAA > 12x <30% AA 7x − 12x 30% − 35% A 4x − 7x 35 − 40% BBB 3x − 4x 40 − 45% BBB AA More analysis is required
More analysis is required Although the Interest Cover is consistent with a debt rating of BBB, its Debt/Equity suggests a higher rating of AA. The analyst should look at the trends in the ratios and try to decide where the company will be on each measure in the near future.
*** L2CI-LM302-PQCA003_2211 The rate implicit in a lease is calculated such that: PV Lease Payments + PV Residual Value = Fair Value of Asset + Initial Costs PV Lease Payments + Fair Value of Asset = PV Residual Value + Initial Costs PV Lease Payments − PV Residual Value = Fair Value of Asset − Initial Costs
PV Lease Payments + PV Residual Value = Fair Value of Asset + Initial Costs The RIIL equates the sum of present value of lease payments and residual value with the fair value of the asset and present value of the residual value.
*** L2CI-LM303-PQCA003_2211 In the Fama-French three-factor model the explanatory variables are: Single market factor; Size factor; Value factor Risk free rate, Expected return on market, Beta Risk free rate, Expected return on market, Inflation Premium
Single market factor; Size factor; Value factor The Fama-French three factor model is: re = rf + β1 ERP + β2 SMB + β3 HML , where ERP is the Equity Risk Premium, SMB is the premium for small companies over big companies, and HML is the value premium for high Book-to-Price companies over low Book-to-Price companies
*** L2CI-LM303-PQCA004_2211 In the Fama-French five-factor model the explanatory variables are: Single market factor; Size factor; Value factor, Profitability Factor, Investment factor Single market factor; Size factor; Value factor, Momentum Factor, Investment factor Single market factor; Size factor; Value factor, Profitability Factor, Inflation factor
Single market factor; Size factor; Value factor, Profitability Factor, Investment factor The Fama-French five factor model is: re = rf + β1 ERP + β2 SMB + β3 HML + β4 RMW + β5 CMA, where ERP is the Equity Risk Premium, SMB is the premium for small companies over big companies, HML is the value premium for High Book-to-Price companies over Low Book-to-Price companies, RMW is the profitability premium, and CMA is the investment premium - the difference in returns on conservative and aggressive investment portfolios
*** L2CI-LM303-PQCA007_2211 Which of the following characteristics might cause a private company to have a lower cost of capital than its peer group? More cyclicality in its revenues Higher proportion of its assets in intangible assets Low operating leverage
Low operating leverage Low operating leverage reduces volatility in operating profits, decreasing cost of capital.
*** L2CI-LM303-PQCA001_2211 Which of these is a disadvantage to using survey-based estimates to calculate Equity Risk Premium? Overly influenced by recent market returns. High level of share issuance. Expected economic recession.
Overly influenced by recent market returns. Survey based estimates tend to be sensitive to recent market returns.
*** L2CI-LM301-PQCA005_2211 A company's weighted average cost of capital is calculated as: WACC = wd rd (1 + t) + wp rp + we re WACC = wd rd (1 − t) + wp rp + we re WACC = wd rd + wp rp(1 − t) + we re
WACC = wd rd (1 − t) + wp rp + we re The weighted average cost of is the weighted average by market values of the cost of debt, cost of preferred equity, and cost of common equity.
Summarization: Factors Influencing Cost of Capital (Bottom-Up Internal Factors - IRP, Idiosyncratic Risk Premium) [Final review edit: I added a twist where I combined old notes and new lectures. The new Asian lecturer is useless and short on information here.] [Important]
+ Bottom-Up Company Specific Factors: 1. Revenue, earnings, and cash flow volatility: [You don't want volatility. Volatility (low) -> COC (low)] Revenue volatility can be related to the cyclicality of sales, revenues from subscription-based models, and revenues concentrated on the same customers. (1) The more earnings stability you have [depends on the degree of operating leverage and financial leverage] -> the lower of total leverage -> the lower your risk -> the lower the volatility, the lower the cost of capital (2) Lower sales cyclicality and lower customer concentration of revenues reduce revenue volatility [No higher operating and financial leverage because it will lead to higher volatility in earnings, which leads to higher cost of capital and higher risk premium] 2. Assets Natures and Security: [Tangible or intangible? how liquid?] 1. More tangible and liquid assets -> lower the risk -> lower the cost of capital. 2. Higher intangible assets or higher operating and financial leverage -> higher the risk -> higher the cost of capital 3. Financial strength, profitability, and financial leverage: weakening profitability, poor cash flow generation, tight liquidity, etc. will have a higher cost of capital and wider credit spreads. 4. Security features: if the feature of that security favors the investors, it will reduce the risk -> reduce the required rate of return -> reduce the cost of capital [Callability (cap on value), Portability (floor on value), Cumulative versus Non-cumulative, Share class] 5. Environmental, social, and governance (ESG) risks: [SKIP]
Summarization: International Considerations [Country Spread Model for ERP Estimation] (Continue) [Final review edit: I realized this is a different way to find the Cost of Equity relative to the traditional way , CAPM] [Scan through]
+ Country Spread Model for ERP Estimation: (The alternative) [The yield spread on sovereign bonds method may be inappropriate to estimate cost of equity due to differences in legal and market environments between countries.] -> Modification: adjust sovereign yield spreads for relative volatility between stocks and bonds Country risk premium = Sovereign yield spread × (σ equity / σ bond) where Sovereign yield spread = Yield of Target Market - Yield of Developed Market
Summarization: Credit Spreads and Equity Risk Premiums [Important]
+ Credit Spreads and Equity Risk Premiums: [Credit spread and equity risk premiums in cost of debt and equity are the premiums that investors demand for taking on risk] 1. rd = Risk-Free Rate (or rf) + Credit spread rd = Required return on debt [rf = Nominal risk free rate + Expected rate of Inflation] 2. re = Risk Free Rate (or rf) + β * (Equity Risk Premium) [This is CAPM: re = rf + β * (Expected Market Return - rf)]
Quick Recap: DDMs [Final review edit: DDMs have been reviewed in prior videos, so the lecture skipped here and moved on to the bond yield + risk premium approach. They all have been talked about in LV1. I put DDM here to help and remind yourself] [Important]
+ DDMs: (as we did earlier to estimate the ERP) -> The constant growth DDM use: 1. Company's own expected future dividend (D1) 2. Expected growth rate in dividends g, and 3. Current share price P0. ** re = (D1 / P) + g D1 = 1) Forecasted EPS * Payout 2) Today's dividend * (1 + g) P or V0 = Company's own share "prices" g = ROE * ( 1 - Payout) -> Example: If we were to have a current share price of $40, an expected future dividend of $1.04 and an expected perpetual growth rate in dividends of 4% the cost of equity would be: re = (1.04/40) + 0.04 = 0.066 or 6.6% + Multistage Growth: Ex: Div1 1$ Div2 1.25$ Div3 1.35$ Div4 1.5$ Terminal Value: Either given or calculated by you Ans: CF0 = 40 CF1 = 1 CF2 = 1.25 CF3 = 1.35 CF4 = 46.5 IRR = 6.015%
Summarization: Required Return on Equity [Estimating the Cost of Equity for Private Companies] [Scan through, and memorize each factor]
+ Estimating the Cost of Equity for Private Companies: [Private companies are less liquid and information is not publicly available] -> The required return on equity for private companies often includes: [Memorize what you need to find the required return on equity for private companies. Not the details.] 1) Size premium (SP) [It accounts for "smaller size." Smaller size is associated with greater "company risk" (it can arise from difficulty in securing capital), uncertain growth prospects, and riskier business operations] 2) An industry risk premium (IP) [It accounts for "industry risk." It identifies additional risk for companies in riskier industries] 3) A specific company risk premium (SCRP) [It reflects geographic, key-person, or other firm-specific risks that are difficult to diversify away. We will look at both "qualitative" and 'quantitative". 1. "Qualitative": Industry, Competitiveness, Management, Customers, Suppliers, and Assets (tangible or intangible.) 2. "Quantitative": DFL, DOL, Volatility in earning, etc.]
Summarization: Factors influencing Cost of Capital (Top-Down External Factors, ERP, Equity Risk Premium) CMLT: Capital availability Market conditions Legal and regulatory considerations, country risk Tax jurisdiction. [Final review edit: I added a twist where I combined old notes and new lectures. The new Asian lecturer is useless and short on information here.] [Important]
+ Factors influencing Cost of Capital: [We're now looking at the factors that affect WACC from the top-down approach] 1. Capital availability: Greater capital availability leads to lower associated costs of capital and more favorable terms for corporate issuers. [There are lower perceived risks of investing in companies in mature economies because they have more abundance of capital. On the other hand, corporate borrowers may rely on shadow banking in less developed economies. Shadow banking: refers to any type of lending by financial institutions that are not regulated as banks.] 2. Market Condition: This represents "macroeconomic factors" such as inflation (benchmark rate), the overall level of credit spreads, recessions, and decreases in economic expansions. ERPs increase in recessions and decrease in economic expansions. [Common sense: Better the market, lower the rates. The worse the market, the higher the rate such as spreads tend to tighten during expansion and widen during recession] 3. Legal and regulatory considerations, country risk: Countries with a common law-based legal system tend to have stronger legal systems (greater enforceability of investor rights). [Another word: On the exam, common law-based legal system -> Stronger legal system and investor protection rights -> Cost (down)] 4. Tax Jurisdiction: Where interest expense is tax deductible, the higher the marginal tax rate the greater the tax benefit associated with using debt in the capital structure. [Another word: Marginal tax rate (up) -> Cost (down)]
Summarization: Factors to Consider When Analyzing Debt [SKIP]
+ Factors to Consider When Analyzing Debt: The method an analyst could choose to use to estimate the cost of debt depends on: 1) Type of debt - Public or private? Bank or lease? [Public traded debt is easier to estimate] 2) Debt liquidity - Marketability [The more liquid the debt, the lower the cost of debt] 3) Credit rating - Do they have one? If so, how is it? [If there are credit ratings, it's easier to use matrix pricing to estimate by referring to other similar debt] 4) Debt currency - What currency? [If the currencies are different you may have to consider country risk]
Summarization: Equity Risk Premium [Historical Approach] (ex-ante) [Final review edit: I realized this is a different way to find ERP in relative to the traditional way (Market return - Risk free rate] [Scan through]
+ Historical Approach: [The historical approach works best with reliable "long-term equity return data." The historical ERP is calculated as the average difference between an equity market index return (e.g. SP 500) and a government debt return (proxy for risk-free rate) over a sample period.] -> Key assumption: [Note: They're not always realistic. The returns aren't always stationary. The markets are not always informational efficient.: Strong, semi-strong, and weak market efficiency.] 1) The analyst assumes that markets are "relatively efficient" (average historical returns are an unbiased estimate) 2) Returns are "stationary. + Four key questions in the development of a "historical ERP": 1. Index Selection (SP 500, Russell 3000, MSCI, etc) [What equity index best represents equity market returns? It needs to be broad-based, market value-weighted indexes and it accurately represents the typical returns. (ex: Dow Jones is price-weighted, thus it's not always a good representative and a good proxy)] 2. Time Horizon [What period is best for calculating the estimate? Long period may cancel out noises but won't represent the current market. The short period may represent the current market but will capture noises and abnormality] 3. Choice of Mean [What measure should be used for the "mean" return? Arithmetic mean or Geometric mean? Recap: Geometric mean is always lower than arithmetic mean and less sensitive to outliers] 4. Risk-Free Proxy [Which is the best proxy for the risk-free rate? 1) ST government bonds have no re-investment risk (they're zero-coupon bonds) 2) industry practice favors LT government bonds (It has reinvestment risk)]
Summarization: International Considerations [Country Spread Model for ERP Estimation] [Trivial pursuit]
+ International Considerations: Country Spread Model for ERP Estimation: [Exchange rates, inflation, data, and models in emerging markets are considerations for an analyst when estimating the required rate of return (re) for international companies.] -> A Country Spread Premium (CSP) or Country Risk Rating Models (CRP): 1. CSP/CRP are required to account for the added risk of investing in a higher-risk "local" country 2. Could be due to economic, expropriation, or political risk. ERP = ERP (developed country) + (λ * CRP Emerging country) [λ is the level of exposure of the company to the emerging country.] 3. CRP can be measured by taking a sovereign yield spread, which is the difference between the bond yield (a spread) of the emerging country and the developed country.
Summarization: Leases Financing [Trivial Pursuit]
+ Leases Financing: -> Finance Lease: 1. Economically similar to financing the purchase of a capital asset. [Companies lease expensive assets (PPE or aircraft). This is equivalent to seller financing; a company issue debt to finance a purchase except the seller is financing it][A finance (or capital) lease is an example of an amortized loan. Operating leases involve expenses without the property being capitalized on the lessee's financial statements.] 2. Often lower costs than if the company borrowed unsecured to purchase the asset 3. Rate Implicit in The Lease (RIIL) - The discount rate that equates the sum of the present value of lease payments and the present value of the residual value to the sum of the fair value of the leased asset and the lessor's direct cost. [SKIP] 4. Incremental Borrowing Rate (IBR) - The rate of interest the company would pay on a collateralized loan over the same term. [SKIP] [Our job is to determine the interest rate or the implicit lease rate in a finance lease, which can be inferred from the lease payments and the fair value of the leased asset.] [Elaboration: The implicit lease rate in a finance lease can be inferred from the lease payments and the fair value of the leased asset. As there is an asset involved in leases these often have lower associated borrowing costs than unsecured loans given that they are basically secured loans. If the present value of the residual value and the lessor's direct initial costs are not known, an incremental borrowing rate (a rate of interest that a company would pay to borrow using a collateralized loan over the same term) can be used. If this rate is not known the analyst might use the non-traded debt estimation method. Fortunately, however, most public companies will disclose the interest rates for their lease liabilities]
Summarization: Required Return on Equity [Risk-Based] (Continue) [Final review edit: I realized this is a different way to find the Cost of Equity relative to the traditional way , CAPM] [Scan through]
+ Required Return on Equity: -> Risk Based Model: It says the required return on equity is comprised of the sum of the compensation for the time value of money and compensation for bearing risk [Reqruied return on equity, re = compensation for the time value of money + compensation for bearing risk] 1. CAPM re = rf + β * (Equity Risk Premium) [Required return on equity measured against average sensitivity (β) to market equity risk premiums.] [The primary difference among risk models is how they model compensation for bearing risk. The capital asset pricing model (CAPM) is a single-factor risk-based model. The Fama-French model involves multi-factors (more precise.) Statistical factor models, fundamental factor models, and macroeconomic factor models are other examples.] 2. Farma French [Check the next couple of flashcards]
Summarization: Required Return on Equity [Estimating the Cost of Equity for Private Companies] (Continue) [Final review edit: I realized this is a different way to find the Cost of Equity relative to the traditional way , CAPM] [Scan through, and memorize each factor]
+ Required Return on Equity: -> To estimate the required return on equity for a private company, analysts commonly have two choices: 1. The Expanded CAPM: re = rf + βpeer(ERP) + SP + IP + SCRP or ** re = rf + β1peer(ERP) + β2Size + β3Value + β4Company β5Specific [βpeer: Industry beta. Why? we don't have enough data] 2. Build-up Approach: [Not beta adjusted. It doesn't have beta][The build-up approach involves "building up" the required return on equity. 1. It starts with the risk-free rate 2. Adds relevant risk premia for each important risk consideration. ] ** re = rf + ERP + SP + SCRP Note: This starts with ERP; we exclude β. [Why no beta? My own words: beta is implicitly 1.0 because we're using the return on equity for average systematic risk from large-cap public equity stock.]
Summarization: Required Return on Equity [The Bond Yield + Risk Premium Build-Up Approach] (Continue) [Final review edit: I realized this is a different way to find the Cost of Equity relative to the traditional way , CAPM] [Scan through]
+ Required Return on Equity: (The Bond Yield + Risk Premium Build-Up Approach) -> The Bond Yield + Risk Premium Build-Up Approach: a method for calculating the cost of equity for a company that has publicly traded debt 1. re = rd + RP rd = company's cost of debt [typically proxied by a YTM on the company's long-term debt] RP = risk premium. [RP is a risk premium to compensate equity investors for the additional risk.] 2. Risk premium is calculated as the historical mean difference in returns between an equity market index and a corporate bond index. 3. This is problematic if the company has issued many securities having different features.
Summarization/Calculation/Quick Recap: Required Return on Equity [Farma French] [Final review edit: We will focus on CAPM and Farma-French in Module 3. YOU MUST KNOW BOTH MODELS INSIDE AND OUT !! we will see Farna-French in Equity as well] [On the exam day, Farma-French will be tested] [Final review edit: I realized this is a different way to find the Cost of Equity relative to the traditional way , CAPM] [Important]
+ Required Return on Equity: [Farma French] -> Five Factor Fama French models: [Must Memorize] 1. We do CAPM, Size, Value, Profitability, and Investment. [Another word: We just add Profitability and Investment. after 3 Factors Model] re = rf + β1*(ERP) + β2*(SMB) + β3*(HML) + β4(RMW) + β3*(CMA) or ** re = CAPM + Size Premium + Value Premium + Profitability + Investment SMB = size premium [the average difference in equity returns between companies with small and large capitalizations] HML = value premium [the average difference in equity returns between companies with high and low book-to-market ratios.] RMW = is the average difference in equity returns between companies with robust and weak profitability CMA = is the average difference in equity returns between companies with conservative and aggressive investment portfolios. [The new lecture just scanned through this part a bit.]
*** L2CI-LM301-PQCA001_2211 What is the calculation for a company's cost of debt? re = rf + (ERP + IRP) rd = rf − Credit spread rd = rf + Credit spread
rd = rf + Credit spread A company's cost of debt is the risk-free rate + an additional return for credit risk
Calculation: Required Return on Equity [CAPM] [Final review edit: We will focus on CAPM and Farma-French in Module 3. YOU MUST KNOW BOTH MODELS INSIDE AND OUT !! we will see Farna-French in Equity as well] [Final review edit: I realized this is a different way to find the Cost of Equity relative to the traditional way , CAPM] [Important]
+ Risk-Based [CAPM]: -> ** CAPM: re = rf + forecasted β * (ERP) [Add on: Forecasted β: 1) Private company: We might have to find these from the "Pure play method." Remember the lever and reliever lesson from LV1. 2) Public Company: We look at historical risk relative to the market: Covariance / Market's Variance] [** The beta measures the sensitivity of a stock's return to the sensitivity of the equity's return. Beta is commonly estimated using the "market model," which performs a linear regression on actual historical returns for the stock and the market to estimate the beta. (ri.t − rf,t) = b0 + b1*(rm,t − rf,t) + εr. (YOU SKIP the calculation of BETA here! Don't confuse yourself)]
Summarization: Security Features [SKIP]
+ Security Features: [In here, WACC up benefits the issuer, and WACC down disadvantages the 1. Callability [WACC (up)]: Allows borrower to retire debt early to refinance at lower rates 2. Putability (WACC (down)]: Allows lender ti retire debt early to reinvest proceeds at higher rates 3. Convertiblitliy [WACC (down)]: Allows the lender to convert debt into common shares 4. Cumulative preferred stock [WACC (down)]: Entitles preferred shareholders to receive dividends in arrears before common shareholders get paid 5. Share class [WACC (down)]: Entitles certain shareholders to more voting rights [WACC (up) benefits company (issuer). WACC (down) benefits investors]
Extra: Details of Expanded CAPM and the Build-up Approach: (Continue) [SKIP] [This is the new lecture slides and notes. I decided to keep the old ones prior to this flashcard and add the new lectures on this flashcard. I also fixed up the old ones, and they're simply better. I wrote the new one down here so you don't get confused. You can skip this one]
+ Details of Expanded CAPM and the Build-up Approach: (Continue) -> Expanded CAPM: re = rf + βpeer(ERP) + Size + Value + Company Specific 1. Estimate an industry beta, βpeer, from a peer group of publicly traded companies in the same industry 2. Given an estimate of the risk-free rate, rf, and the ERP, compute a CAPM estimate for re. 3. If warranted, add relevant size and company-specific risk premia to arrive at a final estimate of re for the subject company -> Build-up Approach: re = rf + ERP + SP + SCRP Note: This starts with ERP, We did not include β. [The build-up approach involves "building up" the required return on equity. 1. It starts with the risk-free rate 2. Adds relevant risk premia for each important risk consideration. ] Where 1. rf + ERP = Large cap public equity 2. rf + ERP + SP = Small cap public equity 3. SCRP = Specific company risk premium [Why no beta? My Own word: beta is implicitly 1.0 because we're using the return on equity for average systematic risk from large-cap public equity stock.]
Summarization Equity Risk Premium [Scan through, move on]
+ Equity Risk Premium -> Equity Risk Premium (ERP) is the expected incremental return equity investors require in excess of the risk-free rate [Excess return that investors require for taking on the risk of the equity] -> Two broad approaches to estimating the ERP: 1) The historical approach (ex-post): It uses backward-looking data [You regress historical data] 2) The forward-looking approach (ex-ante): It uses forward-looking expectations [You're using a lot of economic forecasts]
Summarization: Equity Risk Premium [Dividend Discount Models Approach](Forward Looking approach) (ex-post) [Final review edit: I realized this is a different way to find ERP in relative to the traditional way (Market return - Risk free rate] [Scan through]
+ Equity Risk Premium (Forward Looking approach): -> Dividend Discount Models [Gordan Growth Model or Constant Growth DDM. GGM Assumes earnings, dividends, and prices all grow at the same rate leading to a constant P/E. It's not a good assumption.] -> Gordon Growth Model assumes that long-term growth in dividends will be constant:V0 = D1 / (re - g) -> Solving for the required return on equity (re): re = (D1 / V0)* g -> * The return becomes the dividend yield plus the earnings growth rate. In order to get an expected ERP, subtract the risk-free rate: ERP = E * (D1 / V0) + E g - Risk-free rate E * (D1 / V0) = Expected Dividend Yield Eg = Expected Dividend Growth Rate rf = Risk-free rate [The underlying assumption of the constant growth DDM is that dividends and prices will grow at the same rate resulting in a constant P/E ratio. Note: There's a positive relationship between ∆ in P/E and Expected Loss] [The only difference from LV1 is that instead of looking for the DDM of a single company we're looking for DDM for the overall market]
Summarization: Equity Risk Premium [Macroeconomic modeling](Forward Looking approach) (ex-post) [Final review edit: I realized this is a different way to find ERP in relative to the traditional way (Market return - Risk free rate] [Must memorize]
+ Equity Risk Premium (Forward Looking approach): -> Macroeconomic modeling [Forecast economic variables when coming up with the market, the equity risk premium, Grinold Kroner approach] -> Estimating ERP from macroeconomic models requires using several "forecasted" economic variables such as inflation and expected growth in real earnings per share. [** When are macroeconomics more accurate? When public equity represents a large proportion of the economy] [Note: On the exam, when are macroeconomic or Grinold Kroner more appropriate? When public equities represent a large portion of the economy] *** 1. ERP = [Dividend yield + Expected capital gain] − E(rf) or, it's broken down into: 2. ERP = [Dividend yield + ∆ P/E + i + g - ∆S] − E(rf) ∆ P/E = Repricing (i + g - ∆S) = Earning growth per share [Or, (i + g - ∆S) = Expected inflation + Real GDP growth − Changes in shares outstanding] [Note: E(rf) is ST or LT government bond yields]
Summarization: Equity Risk Premium [Survey-based estimates] (Forward Looking approach) (ex-post) [Final review edit: I realized this is a different way to find ERP in relative to the traditional way (Market return - Risk free rate] [Scan through]
+ Equity Risk Premium (Forward Looking approach): [Investor's returns depend only on expected future cash flows using a forward-looking approach to estimate the ERP and the discount rate is more consistent.] 1. Survey-based estimates: Ask a sample of experts (about their expectations for the ERP.) [Issue: These estimates are sensitive to recent market conditions.] 2. Surveys tend to show higher ERPs for developed countries. 3. Estimates tend to be: (1) Sensitive to recent market returns (e.g. recency bias) (2) Pay attention to factors that support current thinking (e.g. confirmation bias)
Summarization: Estimating Cost of Debt (Publicly Traded Debt vs Nontraded Debt) [Scan through]
+ Estimating Cost of Debt -> Publicly Traded Debt: (Straight debt) 1. YTM reflects the current market interest rate on the debt [It can be interpreted as the current cost of issuing new debt with similar features.] 2. If the company has publicly traded debt with no embedded options (straight debt) then the yield to maturity (YTM) on the company's debt with the longest maturity could be a reasonable estimate of the company's cost of issuing straight debt. [Generally, we would prefer the longest-term debt only if that debt trades frequently enough for its price to be indicative of the return that the marginal investor requires. Otherwise, shorter-term but more frequently traded debt might be preferable.] -> Non-Traded Debt: [If it's non-traded debt, we will use matrix pricing and synthetic rating] 1. Matrix pricing estimates a company's cost of debt based on yields to maturity of bonds of other companies with the same or similar maturities and credit ratings. [For non-traded debt, the analyst can use matrix pricing at approximate cost from companies with similar debt maturities if credit ratings are available. If credit ratings aren't available, analysts use financial ratios such as leverage ratios or interest ratio to derive a credit rating for this bond. Then, we use that estimated credit rating to reference matrix pricing.] -> Bank Debt: 1. Bank debt is typically amortized (reference recent borrowing rates) [An analyst should try to determine the interest rate paid by the company on new debt financing to estimate the cost of bank debt.]
Summarization: The country risk rating model, Extended CAPM (International CAPM) [Trivial Pursuit]
+ The country risk rating model, Extended CAPM (International CAPM): -> The returns on a stock in an emerging market are regressed against the risk premium of a global index (r gm) in addition to that of a wealth-weighted foreign currency index (r c) -> The return of each currency consists of the expected change in the exchange rate plus the country's risk-free return. -> Lower values of β for companies less connected to the global economy E(re) = rf + βG*(E (rgm) − rf) + βc*(E(rc) − rf) βG = Sensitivity to the global index E(rgm - rf) = risk premium of global market index βc = Sensitivity to the foreign currency index (E(rc) − rf) = risk premium of a wealth-weighted foreign currency index [The issue is to selecting the appropriate global index. As broad equities, we will use MSCI All Country World Index (MSCI ACWI) or FTSE All-World Index (They will be the proxy of your global index)] -> No generally accepted methodology for estimating the CRP if the company operates in developing country -> If the company's operations are limited to developed countries, the GCAPM and ICAPM are reasonable methods. However, if operations extend to developing countries the methodology is less clear. -> If a company has operations in developing countries, CRP estimation using the sovereign yield approach might be appropriate
*** L2CI-LM301-PQCA004_2211 David Lidington CFA is analysing Tufton plc - a European chemicals manufacturer - and comparing it with its peers. Which of the following characteristics would lead to a lower cost of capital: Putability Callability Non-voting shares
Putability A putable bond benefits lenders so they require lower returns reducing Tufton's cost of capital
