MIN 100 Investment Analysis

Roy Endr Dahl University of Stavanger E-mail: roy.e.dahl@uis.no

Curriculum changes
I have decided to revise the curriculum after feedback from several of you about the magnitude of the curriculum. This course can be divided by the 4 parts in our textbook: 1. Background (Chapter 1-3) 2. Investment rules and analysis (Chapter 4-9) 3. Risk and return (Chapter 10-12) 4. Capital Structure (Chapter 13-16) Part 4 is a bit too extensive concerning market efficiency (chap. 13) and will only be discussed briefly. We have already discussed dividend policy (chap. 16) sufficiently, and I will therefore drop this chapter. However, chapter 14 and 15 provides valuable insight concerning debt management and debt analysis, and will be covered. In addition, chapter 17 is omitted and financial options are not presented in this course.
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Changes in lecture plan

By far, the most important parts of the curriculum is part 2 and 3. Therefore, I have planned this lecture as a workshop where we use a real estate company as an example on how to apply the theory of investment analysis on a real life project. Next week, we will be covering chapter 14 and 15, before I end the lecture series with a repetition of chapters 4 12 in week 43.
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MIN 100 Investment Analysis

Week / date
35 29.08.2012 37 12.09.2012 38 19.09.2012 39 26.09.2012 40 03.10.2012 41 42 17.10.2012 43 24.10.2012 44 31.10.2012 49 05.12.2012

Chapters / Topic
1-3 / Introduction and basic concepts. 4-5 / Net present value, bonds, markets 6-7 / Stocks, NPV and other investment rules 8-9 / Cash flow and capital budgeting, decision tree, sensitivity, Monte Carlo 10-11 / Return and Risk, expected return, CAPM Mandatory assignment 11-13 / CAPM, Risk, Cost of Capital Workshop. Applying part 2 and 3 to a Real Estate company. 14-15/ Capital structure, Modigliani & Miller, use of debt, leverage. Review of chapter 4-12.

Note
Part 1: Overview Part 2: Valuation and Capital budgeting

Part 3: Risk and Return

Workshop. Part 4: Capital Structure and Dividend Policy Review.

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Chapter 11 CAPM revisited

Last lecture we developed the Capital Asset Pricing Model (CAPM), which says that
Return on asset = risk free rate + [risk premium] * market risk E[ri] = rf + [E(rm) - rf] * where = im/Var(rm) identifies the volatility (uncertainty) of one stock compared to the market portfolio. E.g. a = 2, means the stock is twice as volatile compared to the market portfolio, and will likely move up (down) by 2% if the market 5 portfolio moves up (down) by 1%.

Chapter 11 CAPM revisited

By combining the market portfolio with a risk free interest rate, we can find the Security Market Line (SML) which identify the relationship between beta and the expected return. Generally, a higher beta means more uncertainty and risk, and 6 therefore implies a higher expected return.

Chapter 12
Risk, Cost of Capital, and Capital Budgeting

McGrawHill/Irwin

Key Concepts and Skills

Measure a firms cost of equity capital Grasp and interpret the impact of beta in determining the firms cost of equity capital Comprehend and calculate the firms overall cost of capital Incorporate the impact of flotation costs on capital budgeting

Chapter Outline
12.1 12.2 12.3 12.4 12.5 12.6 12.7 12.8 12.9 12.10 (12.11 The Cost of Equity Capital Estimating the Cost of Equity Capital with the CAPM Estimation of Beta Beta and Covariance Determinants of Beta Dividend Discount Model Cost of Capital for Divisions and Projects Cost of Fixed Income Securities The Weighted Average Cost of Capital Estimating Eastman Chemicals Cost of Capital Flotation Costs and the Weighted Average Cost of Capital)

Opening Case Euro Debt

No doubt that debt matters. The financial crisis has learned us that even though increased leverage provides a higher expected return, it also adds uncertainty and risk, as in times of trouble when liquidity (cash availability) dries up, money is king.

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High interest rate implies high risk

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20 France

Interest rate

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Germany Greece Ireland Italy

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Norway Spain United Kingdom

United States

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Where Do We Stand?
Earlier chapters on capital budgeting focused on the appropriate size and timing of cash flows. This chapter discusses the appropriate discount rate when cash flows are risky.

What is the correct discount rate r?

First lectures used inflation in order to calculate future/present values.
This provided us with change in purchasing power, as money loses value over time.

Since then we have discounted by using a stockholders required return.

Must equal expected return from assets with same risk profile.

Now, we will estimate a companys cost of capital, taking into account both equity and debt.

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12.1 The Cost of Capital

Debtholders Shareholders

Finance Must repay debt at interest rate rD.

Available information calculating the average interest rate on debt. Note: Need to take the tax effect into account. Make investments / generate cash flow 14

Company

Requires a return at rate rE.

Can be calculated using: 1. ROE or required return (Chap. 6) 2. Historical return on stock (Chap. 10) 3. CAPM (Chap. 12)

12.2 The Cost of Equity Capital CAPM Model

From the firms perspective, the expected return is the Cost of Equity Capital: E(R) = RF + (E(RM) RF)
To estimate a firms cost of equity capital, we need to know three things: 1. The risk-free rate, RF 2. The market risk premium, E(RM) RF
Use historical earnings (chap. 10) Use the dividend discount model (chap. 6)

3.

The company beta:

Cov( RS , RM ) S , M 2 Var ( RM ) M

12.8 Cost of Debt

The cost of debt is the decided by the interest rate required on new debt issuance (i.e., yield to maturity on outstanding debt).
Adjust for the tax deductibility of interest expense to find the aftertax cost of debt. Since interest rate is tax deductible, the cost of debt for the firm is reduced.

12.8 Cost of Debt

Consider two equal companies, having the same revenues and cost. Unlevered corporation is all-equity, while Levered corp. has a debt of 100 at 10% interest, costing $10 each year.
Still, the difference in aftertax earnings is not $10, but $6:
Unlevered Corp. Revenues Expenses EBIT Interest Pretax earnings Taxes (40% rate) Aftertax earnings 180 Revenues -70 Expenses 110 EBIT 0 Interest (10% of 100) 110 Pretax earnings -44 Taxes (40% rate) 66 Aftertax earnings Levered Corp. 180 -70 110 -10 100 -40 60

Aftertax cost of debt = (1 Tax rate) * Borrowing rate 6% = (1 0.40) * 10%

12.9 The Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) provides us with an estimate of the return required to meet demands from both debtholders and stockholders. WACC is given by:

Because interest expense is tax-deductible, we multiply the last term by (1 TC).

WACC = The Cost of Capital

Debtholders
Finance Must repay debt at interest rate rD.
Available information calculating the average interest rate on debt. Note: Need to take the tax effect into account.

Shareholders

Company

Requires a return at rate rE.

Can be calculated using: 1. ROE or required return (Chap. 6) 2. Historical return on stock (Chap. 10) 3. CAPM (Chap. 12)

Make investments / generate cash flow

= + (1 ) + +

Companies (and projects) providing a return r > rWACC, will meet the demand of both debt- and shareholders. rWACC is therefore a suitable estimate for the discount factor. 19

Case: Aker Solution WACC

Aker Solutions has a variety of loans/bonds: - Risk adjusted bonds (credit rating) - Floating bonds and loans (according to NIBOR and a risk premium) - Fixed loans (Brazilian Development Bank)

rD is calculated by: rD = wi ri rD = 5.29%

Case: Aker Solution WACC

Bond/Loan Risk Adjusted bond Floating bond Floating loan Fixed loan Fixed loan Floating loan Floating bond Floating bond SUM Date Q2 2009 Q2 2009 Q3 2009 Q3 2009 Q3 2010 Q2 2011 Q2 2012 Q3 2012 Amount 1 913 187 750 548 817 6 000 2 500 1 000 13 715 Interest rate 10.70 % 8.64 % 4.02 % 4.50 % 4.50 % 3.22 % 6.29 % 6.22 % 5.29 %

rD = 5.29 % D = 13 715 D / (D+E) = 0.3 TC = 28 %

rWACC = (E / (D+E)) * rE + (D / (D+E)) * rD * (1 - TC) = 0.7 * 0.2087 + 0.3 * 0.0529 * (1-0.28) = 0.1575 = 15.75 %

According to Oslo Stock Exchange: the market value of Aker Solutions is 31 216 MNOK. the stock has increased from 22.63 to 113.40 NOK/share in 8.5 years: FV = C0 (1 + r)T r = (FV / C0)1/T 1 = (113.4 / 22.63)1/8.5 1 r = 0.2087 = 20.87 %

rE = 20.87 % E = 31 216 E / (D+E) = 0.7 21

Calculating rE using CAPM

Alpha Air is an all-equity firm (no debt) with a beta of 1.21. The market risk premium is currently 9.5% and the risk-free rate is 5%. What is the appropriate discount rate for an expansion of this firm?
rE = E(R) = RF + (E(RM) RF) E(R) = 5% + 1.21 * 9.5% E(R) = 16.495% rWACC = (E / (D+E)) * rE + (D / (D+E)) * rD * (1 - TC) = 1 * 0,16495 + 0 = 16.495 %

Example 12.2: Using RS and the SML to Evaluate Projects

Suppose Alpha Air Freight is evaluating the following independent projects. Each costs $100 and lasts one year.
Project A B C Project's beta 1,21 1,21 1,21 Investment Cash flow -100 125 -100 116.5 -100 110

We know the expected return is equal to 16.495% and can therefore use this as our discount rate. Calculate IRR and NPV and compare this to the Security Market Line (SML) when deciding which project(s) to initiate.

Application: Using the SML for Project Selection

A

Good projects

SML

rAir = 16,5% rM = 14,5%

B M

C
Bad projects

Project A B C

Project's beta Investment Cash flow IRR 1,21 -100 125 1,21 -100 116,5 1,21 -100 110

NPV 25,0 % 16,5 % 10,0 %

Accept/Reject 7,30 Accept 0,00 Accept -5,58 Reject

24 An all-equity firm should accept projects whose IRRs exceed the cost of equity capital and reject projects whose IRRs fall short of the cost of capital.

12.3 Definition of Beta

Remember from chapter 11 about CAPM: 1. Market Portfolio - Portfolio of all assets in the economy. In practice, a broad stock market index, such as the S&P 500, is used to represent the market. 2. Beta - Sensitivity of a stocks return to the return on the market portfolio.

Estimation of Beta
Cov( Ri , RM ) Var ( RM )
Problems
1. Betas may vary over time. 2. The sample size may be inadequate. 3. Betas are influenced by changing financial leverage and business risk.

Solutions
Problems 1 and 2 can be moderated by more sophisticated statistical techniques. Problem 3 can be lessened by adjusting for changes in business and financial risk. Look at average beta estimates of comparable firms in the industry.

Stability of Beta
Most analysts argue that betas are generally stable for firms remaining in the same industry. That is not to say that a firms beta cannot change.
Changes in product line Changes in technology Deregulation Changes in financial leverage

Stability of Beta change in time

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Using an Industry Beta

It is frequently argued that one can better estimate a firms beta by involving the whole industry. If you believe that the operations of the firm are similar to the operations of the rest of the industry, you should use the industry beta. If you believe that the operations of the firm are fundamentally different from the operations of the rest of the industry, you should use the firms beta. Do not forget about adjustments for financial leverage.

12.4 Beta and Covariance

i
Cov( Ri , RM )

2 ( RM )

( Ri ) ( RM )

Beta is qualitatively similar to the covariance since the denominator (market variance) is a constant. Beta measures responsiveness of a single stock to the market as a whole.

Whenever a set of values are divided by a constant, the relative position of each value remains the same.

Since beta is a transformation of covariance, covariance measure the same

12.5 Determinants of Beta

Business Risk
Cyclicality of Revenues Operating Leverage

Financial Risk
Financial Leverage

Cyclicality of Revenues
Highly cyclical stocks have higher betas.
Such firms do well in the expansion phase of the economic cycle and more poorly in the contraction phase Cyclical industries include retail and automotive Non-cyclical industries include transportation Stocks with high standard deviations need not have high betas. Price movement of such stocks is more dependent on quality of performance than market movement Example: Movie studio hits and flops.

Note that cyclicality is not the same as variability

Operating Leverage
The degree of operating leverage measures how sensitive a firm (or project) is to its fixed costs. Operating leverage increases as fixed costs rise and variable costs fall. Operating leverage magnifies the effect of cyclicality on beta. The degree of operating leverage is given by:

DOL =

D EBIT Sales EBIT D Sales

Operating Leverage
14000 12000 10000 8000 6000 10000 8000 6000 4000 2000 0 -2000 -4000 -6000 0 20 40 60 80 100 120 140 160 180 200 Fixed costs (A) Fixed costs (B) -8000 -100 -80 -60 -40 -20 0 20 40 60 80 100

4000
2000 0 Total costs (A) Total costs (B)

-10000
EBIT change (A) EBIT change (B)

Consider two firms, one with a high operating leverage (blue line), the other with a low operating leverage (red line). Notice how operating leverage increases as fixed costs rise and variable costs fall. Also, notice how the firm with a high operating leverage has higher marginal profit from sales.

Financial Leverage and Beta

Operating leverage refers to the sensitivity to the firms fixed costs of production. Financial leverage is the sensitivity to a firms fixed costs of financing. The relationship between the betas of the firms debt, equity, and assets is given by:

Financial Leverage and Beta

Usually the beta of debt is very low, and often close to 0 (return does not vary with market portfolio). Therefore we can rearrange and find:

This implies that the equity beta will always be greater than the asset beta, and financial leverage always increases the equity beta relative to the asset beta.

Example
Consider Grand Sport, Inc., which is currently all-equity financed and has a beta of 0.90. The firm has decided to lever up to a capital structure of 1 part debt to 1 part equity. Since the firm will remain in the same industry, its asset beta should remain 0.90. However, assuming a zero beta for its debt, its equity beta would become twice as large:
Asset = 0.90
1 Equity 1+1

Equity = 2 0.90 = 1.80

12.7 Capital Budgeting & Project Risk

RF FIRM ( R M RF )

FIRM

A firm that uses one discount rate for all projects may over time increase the risk of the firm while decreasing its value. Need to adjust for the possibility of borrowing and lending (seen by the SML), and adjust the required return according to the risk of the project (beta).

Capital Budgeting & Project Risk

Suppose the Conglomerate Company has a cost of capital, based on the CAPM, of 17%. The risk-free rate is 4%, the market risk premium is 10%, and the firms beta is 1.3. 17% = 4% + 1.3 10% This is a breakdown of the companys investment projects: 1/3 Automotive Retailer b = 2.0 1/3 Computer Hard Drive Manufacturer b = 1.3 1/3 Electric Utility b = 0.6

average b of assets = 1.3

When evaluating a new electrical generation investment, which cost of capital should be used?

Capital Budgeting & Project Risk

SML Project IRR 24% 17% Investments in hard drives or auto retailing should have higher discount rates. Projects risk (b) 0.6 1.3 2.0

10%

R = 4% + 0.6(10% ) = 10% 10% reflects the opportunity cost of capital on an investment in electrical generation, given the unique risk of the project.

Closing Case Debt-Equity ratio matters!

As shown by cases
Man Utd needs to increase its equity share, and is therefore forced to an IPO. In order to buy up competitors or suppliers, companies may consider buying it with an alldebt, hoping that future synergy and profits will return more than interest on the loans.

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12.10 Example Statoil

We have previously calculated the implied required return of Statoils shareholders at 25.3% by using the dividend growth model in lecture 3 and the financial statement providede by Statoil. Now lets apply WACC and see how the results differ from our previous results.

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Statoil WACC
Balance sheet found at:
http://www.statoil.com/AnnualReport2010/en/financialperformance/ LiquidityAndCapitalResources/Pages/SelectedBalanceSheetInformatio n.aspx

Long term debt = 167.7 NOK billion. Total equity = 226.4 NOK billion.

Bonds found at:

http://quicktake.morningstar.com/stocknet/bonds.aspx?symbol=sto

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Statoil WACC
Required return equity Long term debt Total equity Debt interest rate Tax rate 25.3 % (found in lecture 3, Dividend Growth Model) 167.7 billion NOK 226.4 billion NOK 4.841 % (as calculated in bonds table) 78 %

R(WACC)

14,99 %

Bonds value (Mill. USD) 1 500,00 1 302,60 1 250,00 900,00 750,00 500,00

Coupon 5,250 % 6,875 % 3,125 % 2,900 % 5,100 % 5,125 %

Interest 78,75 89,55 39,06 26,10 38,25 25,63

500,00
500,00 250,00 7 452,60

3,875 %
5,125 % 7,375 % 4,841 %

19,38
25,63 18,44 360,78

Debt interest rate = Total Interest / Total Bonds Value

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Statoil WACC
Due to
a relatively high leverage (debt/equity ratio = 0.74) a very high tax rate (78%) low interest rate (4.84%, due to high credit rating)

Statoils WACC is considerably lower than the implied required return of their shareholders. 14.99 % > 25.3 % When choosing a discount rate, the debt can have a significant impact on a project analysis. In general, the cost of capital is a more appropriate discounting rate.

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Statoil WACC
You should notice that if we had calculated the required return on equity using CAPM, the effect of debt would not be that drastic:
Market risk premium = 7.0 % (from chapter 10) Risk-free interest rate = 2.15% (10 year US Treasury Bond) Beta Statoil = 1.5 R(CAPM) = 2.15% + 1.5*7.0% = 12.65%.

However, there may be reasons why the market risk premium today is higher than the historical average (1925 2009), since we experience high uncertainty about future earnings.
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12.11 Flotation Costs

Flotation costs represent the expenses incurred upon the issue, or float, of new bonds or stocks. These are incremental cash flows of the project, which typically reduce the NPV since they increase the initial project cost (i.e., CF0).
Amount Raised = Necessary Proceeds / (1-% flotation cost)

The % flotation cost is a weighted average based on the average cost of issuance for each funding source and the firms target capital structure: fA = (E/V)* fE + (D/V)* fD

Chapter 13
Efficient Capital Markets and Behavioral Challenges

McGrawHill/Irwin

Chapter 13
Covers theory efficient market hypothesis:
The market knows everything? The market is always right? No arbitrage opportunity? Good projects will always be financed?

Not true as witnessed in market bubbles and crashes.

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15

20

25

30

35

10

0 Jan-01 Jun-01 Nov-01 Apr-02 Sep-02 Feb-03 Jul-03 Dec-03 May-04 Oct-04 Mar-05 Aug-05 Jan-06 Jun-06 Nov-06 Apr-07 Sep-07 Feb-08 Jul-08 Dec-08 May-09 Oct-09 Mar-10 Aug-10 Jan-11 Jun-11 Nov-11 Apr-12 Sep-12 Italy

Spain

Was the market too efficient?

France

Ireland

Greece

Germany

United Kingdom

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Opening Case Financial crisis

The financial crisis hit the world with tons of debt. USA had to bail out huge companies like AIG by paying $85 billion. The company then had about $190 billion in debt outstanding, with a market value of about $65 billion. While USA bailed out AIG, Fannie Mae and Freddig Mac; Lehmann and Merrill wasnt saved, and their losses were taken by the shareholders and other interested parties.
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Lecture summary
Chapter 11 CAPM revisited Chapter 12 Risk, Cost of Capital and Capital Budgeting
Cost of equity and cost of debt Impact of beta (CAPM) when determining cost of equity Weighted Average Cost of Capital Flotation Costs

Chapter 13 Efficient Capital Markets and Behavioral Challenges

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