Firm valuation Basic mode VALUING A FIRM Cashflow to firm xpected Grow th EBI(1-0 hange nwc Frm s nstable grow Grows at oonstant rate Teminal Value FCFF nH+1/cgn) Value ofOperating Assets FCFF FCFF2 FCF3 FCF4 FCF5 FCFn Cash&Nonop Assets Value ofF Value of Debt Disoout af WACC= Cost of Equity(Equity/Debt+ Equity )) Cost of Debt (DebMDebt Equity) Value of Equty Cost of Equ Cost of debt Weights Based on Market Value Dea成Sp爬ad(10 Risk Premium nsk investmen nominal as cash flows
Firm Valuation: Basic Model
Estimating WACC% The CAPM: Cost of Equity Consider the standard approach to estimating cost of equity: Equity =R+ Equity Beta*(E(Rm-Re where R= riskfree rate E(rm)=Expected Return on the Market Index iversified Portfolio) Pra Short term govemment secunity rates are used as risk free rates Histoncal nsk premiums are used for the risk premium Betas are estimated by regressing stock retums against market returns
Estimating WACC%
Rf (10 year T-bond yield) Short term governments are not riskfree in valuation On a riskfree asset, the actual return is equal to the expected return Therefore, there is no variance around the expected return. For an investment to be riskfree, then, it has to have No default risk No reinvestment risk Thus, the riskfree rates in valuation will depend upon when the cash d to occur and will If you are a purist, you should match the riskfree rate to the period of the cash Aow-l year rate for the l year cash flow. In valuation, the time horizon is generally infinite, leading to the conclusion that a long-term riskfree rate will always be preferable to a hort term rate, if you have to pick one
Rf (10 year T-bond yield)
Rf differs per country and in time Riskfree rates in 2004 Riskfree Rates: An Exploration 10-ywar euro Bonds
Rf differs per country and in time
Here are some historical rf's Everyone uses historical premiums, but The historical premium is the premium that stocks have historically eamed over riskless securties Practitioners never seem to agree on the premium; it is How far back you go in hist Whether you use T.bill rates or T Bond rates Whether you use geometric or arithmetic averages For instance, looking at the US: Arithmetic average Geometric avera Histoncal penod T Bils T Bonds T Bills T Bonds 19282003 792%654% 599%482% 1963-2003 6.09%4.70% 4.85%3.82% 19932003 843%487% 6.68%3.57%
Here are some historical Rf’s