CAPITAL: everything that a company has in terms of resources (the value of the company).
BOOK VALUE of the COMPANY: calue of the assets of the company.
Rappresentation of the company:
| ASSET PERSPECTIVE | EQUITY & LIABILITIES PERSPECTIVE: |
| INVESTED CAPITAL: capital invested in the resources for the production or to provide services = equity + financial liabilities. | EQUITY: amount of money that would be returned to a company’s shareholders if all of the assets were liquidated and all of the company’s debt was paid off in the case of liquidation. LIABILITIES: FINANCIAL: liabilities with explicit interest rate (bank debts). -> Compute the interest: ICR = EBIT/financial expenses. NON-FINANCIAL: payables, liabilities due to other stakeholders like to employees, government. |
| WACC = Weighted Average Cost of Capital: statistically calculated based on previous data. -> The drawback is that it can not preview things. -> WACC is used a lot internally and externally to evaluate how well a company is doing. -> Usually WACC compared to ROI. | COST of the EQUITY CAPITAL = Ke COST of the DEBT CAPITAL (pre-tax) = Kd -> We need to understand the cost of different typologies of foundings to grow the company: how we want to increase the invested capital? Through equity or through debt? -> Depensd on the cost of the action (return higher than investments). |
📌In case of acquisition E = value of company sales – liabilities owed by the company not transferred with the sale.
WACC, Weighted Average Cost of Capital
- Ke: cost of equity (formula to calculate it), weighted on equity part of the formula;
- Kd: cost of debt (pre-tax), weighted on the debt portion of the formula.
- tc: corporate tax rate
- (1 – tc): tax shield
- E: shareholders’ equity
- D: debt (including only financial debt)
- E+D = invested capital (Equity + Financial Debts)
-> We need to understand the structure of the company (debt-to-equity ratio) and weights to attribute to each parameter;
-> Financial interests are paid before taxes => company has benefit because Kd is discounted on the tax rate.
-> (1-tc) = tax shield –> we need to multiply Kd for this factor because the cost of debt is computed before the taxes, so we need to subtract the tax rate.
-> Kd is cheaper than Ke because it is less risky (debtholders are repaid before shareholders).
-> DEF: cost of equity capital for an enterprise:
- How much an enterprise has to remunerate its shareholders for the risk they take by providing equity capital to the enterprise;
- Is the minimum expected return for shareholders;
- Is not contractually defined.
- Compareing Ke with a financial indicator to see if the company is doing good, we would compare it with ROE. If ROE > Ke => the company is doing good.
-> Can be estimated with…
CAPM Method (Capital Asset Pricing Model):
-> DEF: one of ways to calculate the cost of Equity.
- Compare the company to how the others are doing
- Calculate the minimum return that u can get from the market and how, in general, the industry is doing.
- Work on very well established market.
- rf= risk-free rate
- BL= Beta levered (equity beta)
- rm= market return or result
- (rm – rf)= market premium
-> DEF: theoretical return on an investment with no risk…
📌”no risk” means:
- Investment is done in condition of perfect information;
- No uncertainty about what will happen in the future.
=> We want to find the less risky security on the market: treasure bonds.
-> PROXY:
- Government bonds are less risky than corporate bonds;
- We select the return on the least risky government bond of the currency area of evaluation;
- We take 10 year of time.
- Is the percentage that we gain if buy a bond.
- EX: In Eurozone, the 10Y German Bond is used as a proxy of r_f.
❓Under these assumptions does a risk-free investment exist? No, there is not a security with zero risk on the market
-> DEF: Measures how volatile is the firm stock if compared to the overall market movements:
- βL>1 means that the stock is more volatile than the market (i.e. aggressive, high risck, bigger opportunity to profit)
- βL=1 means that the stock is as volatile as the market (price of security will move with the market)
- βL<1 means that the stock is less volatile than the market (i.e. defensive, low risk, smaller opportunity to profit)
VOLATILITY: means that a company stock value changes a lot during time compared to other companies in the market.
=> βL tells us how the company is doing compared to the market.
- It depends on the capital structure of the firm;
- Also known as “equity beta”
- Measure of the risk of the company without any debt.
- Strips off the debt component to isolate the risk due solely to comapny assets.
- Depends on industry/ business of a firm but not on the capital structure of the firm;
- Also known as “asset beta“.
-> ESTIMATION:
- In case of a listed company: It can be computed through a regression of the stock returns against the market returns;
- Some sources:
- In case of an unlisted company:
- We cannot use the regression since basically the company
does not have listed stocks - We have to infer the unlevered beta. We can follow two methods:
- Comparable companies
- Beta industry
- We cannot use the regression since basically the company
1.Comparable Companies Method (unlisted):
-> First: we have to know company’s capital structure (D/E)
=> In order to choose companies traded on the market that have similar capital structure.
📌Assumption: companies with similar D/E should be able to generate the same value and same return for shareholders.
-> IDEA:
- We take comparable companies for which we have βL;
- We compute the βU of each comparable company
(i.e. by stripping out the capital structure characteristics from βL)
- We compute the average beta βU,avg of the comparable companies;
- We re-lever βU,avg with the capital structure characteristics of the target company
2.Beta Industry (unlisted):
-> IDEA: we use the one of the industry in which company operates.
📌Assumption: companies in same industry are very similar in the way they are structured.
-> We are not choosing ourselves the comparable companies, we already have the βL,avg, the average D/E and tax rate so we can calculate the βU,avg of the industry:
-> DEF: return on a theoretical market portfolio which contains all the stocks in the market;
-> PROXY: Market indexes that are representative of the market where the company operates:
-> NASDAQ is a good one if we’re not only focusing on the market but even on the industry.
EXAMPLES:
❓You want to evaluate the ke of a company operating only in Italy which rf and market index would you use?
-> 10Y German bonds, FTSE MIB
-> If the company is working only in Italy or even in the other european zones, it change a lot because change the minimum that the company are going to pay to the market!
-> You want to evaluate the ke of an Italian company operating only in Europe (Eurozone)…
❓ Which rf and market index would you use?
-> 10Y German bonds, EUROSTOXX 50
❓You want to evaluate the ke of an IT start-up company operating only in the US which rf and market index would you use?
-> 10Y Treasury Bonds of US, NASDAQ
-> DEF: cost of debt for an enterprise;
- Is the interest that the enterprise has to pay on financial debts to remunerate the debtholders for the risk taken
- Is the return of the debtholders;
- Is contractuary defined.
- Kd can be computed as the Cost of Debt = Interest Expenses/Financial Liabilities.
-> COMPUTED AS:
Where:
- rf: risk-free rate;
- CDS: Credit Default Spread (is associated with the enterprise credit rating);
-> CDS can be estimated using the “financial” characteristics of the firm (is not calculated by the company).
-> As first step we can just refer to the interest coverage ratio:
ICR = EBIT / Interest Expenses
-> EXAMPLES:
- Two companies are identical (same business, same size etc.) but they have a different capital structure. While company A has D/E=5, company B has D/E=1. All other things being equal, which company has the riskier profile?
-> Company A is riskier because it has more debt.
=> If D/E > 3, the company is quite risky. Between 1 and 3 is normal when a company is growing, then you will convert it into assets, then into equity.
- Two companies are identical (same business, same size, same capital structure etc.) but while company C has a liquidity shortage, company D has stable cash flows. All other things being equal, which company has the riskier profile?
-> C is riskier because whenever we have similar companies, but we should have enough money to repay our suppliers (many companies are trying to shorten the days to receive money in order to maintain the cash flows)
-> When the economic situation of the country is NOT stable => We consider Country Spread: it measure the environmental in which the company is insert.
Leveraging on the WACC:
-> If we are leveraging (🔺 D):
- Kd increases;
- D/(D+E) increases (series);
- E/(E+D) decreases;
- Ke increases because it depends on the D/E ratio.
-> Ke> kD always;
-> 🔼 Cost of debts =>
-> Not immediate that Kd increase, but is immediate that company became more risky.
