WS8-11.15.2012

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Strategic Capital Group

Workshop #8: Cost ofCapital

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Previously, on SCG Workshop

We discussed ways to forecast revenue:

1.) Use past historical growth rates to predict future rates

Works well if you expect the company to remain stable at its

current levels, ineffective if company is changing.

2.) Use analyst estimates as a benchmark and adjust them slightly to

reflect the differences between your opinions

3.) Compute numbers yourself

We will work

on this today

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Previously, on SCG Workshop

We talked about how you can forecast revenue by taking analyst

estimates for the next 5 years, reading their report on why they

picked their numbers, then using your own opinion about the

company to adjust the projection accordingly.

Analyst Estimate: $50B

in revenue (10% growth

over 2011)

Analyst thinks

the product sell

decently this

year so picked10% growth

rate.

You think the

product will

grow faster

than theanalyst thinks,

so you go 12%

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Change in Net Working Capital

We learned that you can forecast the change

in Net Working Capital by forecasting

multiples such as Days Sales Outstanding,

Days Payable Outstanding, Days InventoryHeld, etc. which are fairly stable (and thus

easy to forecast), then using the forecasted

numbers for revenue and COGS to figure outthe account balances of the current accounts.

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So whats left?

We know what our revenue and costs will be over

the next 5 years, we know NWC and the

depreciation and CapEx.

Weve reached free cash flow, but we need to

figure out what the cash flows are worth today.

We need to discount them back to the future.

But what discount rate do we use? How do wefind an discount rate that reflects the diversity of

risk within our specific company?

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Weighted Average Cost of Capital

What is it?

Essentially the weighted average rate a

company expects to pay out to its financing

sources (both debt and equity holders)

We use this rate as a discount rate for the cash

flows.

It is also the long-term return we expect on

the investment

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Equation:

Essentially:

How much return all of our financiers get =

How much return the equity holders demand * weighting of equity +

How much return the debt holders demand/get * weighting of debt

WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity

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Cost of Debt

(Average Interest Rate * %debt) * (1-tax Rate)

In order to find what the company pays to its debt holders, we

should find what the weighted average interest rate for their debt

is (on the 10-K)

We then weight the average interest rate they pay (bymultiplying it by what percentage of their capital comes from

debt capital) then multiply it again by (1-tax rate) to adjust for

the tax deductibility of interest expense.

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Check for Understanding

So what is the cost of debt for a company that

has all of its money from equity holders?

0! If we dont have anydebt, then we dont care

about debt financing

costs.


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If a companys credit rating goes down, what

happens to its cost of debt?


HINT: a decrease in credit rating will drive up your

average interest rate

Cost of debt will increase

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Cost of Equity

Market Premium = Return in the Equity market (Rm) Risk-Free Rate (Rf)

10- YearTreasury Yield

Can take a 5-20 year

average of S&P orDOWs returns or just a

1 year.

Essentially howmuch an extra

return an investor

gets for taking on

equity risk.

(Market Premium * Beta) + Risk-Free Rate = Cost of Equity

Adjusting the

equity returns

for risk

Typically a long

term beta

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If the returns in the equity market increases,

what happens to a companys cost of equity?

It increases, since now in order

to compete for financing dollars

through equity, the companymust effectively yield more

returns to entice investors.

(Market Premium * Beta) + Risk-Free Rate = Cost of Equity

Market Premium = Return in the Equity market (Rm) Risk-Free Rate (Rf)

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WACC

So what is the calculation for it?

WACC = %Debt x Cost of debt x (1-Tax Rate) + %Equity x Cost of equity

How much a company pays out

on its debt (its interest rate),

adjusted for how much debt it

holds

How much a company

return to equity holders (by

dividends or share price

appreciation) in order toentice people to invest in its

equity

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What influences it?

Market Interest Rates

Company Volatility (beta)

Equity market returns

Risk-free rates

Tax rates

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STOP!

We just learned how to calculate WACC, the

value we will be using for our discount rate.

IT IS IMPERATIVE YOU YELL AT ME AND ASK

QUESTIONS!

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Discounting

We use the PV equation to discount each cash

flow back to its present value.

Remember:

PV = (FV/ (1+ Discount Rate) ^ years away)

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Discounting

Were still missing part of the value of the

company, the company wont stop functioningafter 5 years, technically we need to do this

for the entire life of the company to find whatthe company is worth.

We call the estimation of a companys cashflows from t=5 to t= infinity its terminalvalue

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Critical Thinking

If were taking the PV of an infinite number of

years cash flows, shouldnt the PV end up

being infinity?

No- as you get further and further into the

future, a dollar becomes worth less and less

until it eventually becomes worth nothing.

If I offer you $1 100 years from now, it

will cost more to buy a post-it note to

remember I owe you money than the

PV of $1

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Terminal Value

2 ways to calculate this:

Exit Multiple Approach

Long-term growth rate approach

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Terminal Value: The Exit Multiple

Approach

We can multiply the 5thyears cash flow by a

multiple of EV/EBITDA we plan to sell the

company at in the future, then discount it

back at year 5.

Terminal Value = 5th Year Cash Flow * Projected (EV/EBITDA)

2012 2013 2014 2015 2016

1000 1200 1400 1600 1800 Exit: 5x

Terminal Value = 1800 * 5 = 9000

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So how do we know what to make

EV/EBITDA?

Several methods with differing degrees ofdifficulty:

Use the current multiple the company is trading at

Does not capture the future potential

Use the current industry multiple

Effective if you think the company will return to thisvalue (because it is currently undervalued)

Calculate your own Use your 5th year projections to come up with a 5th year

EBITDA, use current EV and compute a multiple.

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Terminal Value: The Exit Multiple

Approach

We discount this terminal value back to the

present value using year=5, not infinity.

PV Terminal Value =Calculated FV Terminal Value

(1+Discount Rate) ^5

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Terminal Value: The Long-Term Rate

We can also calculate terminal value by

figuring out the long-term growth rate of a

company- essentially the amount we expect a

company to grow consistently in the futureonce it has matured. Typically this number is

just slightly larger than US or world GDP

growth.Terminal Value =

5th Year Cash Flow * (1+LT Rate)

Discount Rate LT Rate

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Terminal Value: the Long Term Rate

Terminal Value =

5th Year Cash Flow * (1+LT Rate)

Discount Rate LT Rate

Terminal Value =

1800 x (1+3%)

12% 3%

Problems you may encounter: In companies with

low WACC, this makes the terminal value VERY

high, making this method ineffective.

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So

At this point weve figured out how to forecast

a companies revenues and costs to get to free

cash flow.

After this, we discount the cash flows and a

terminal value back to the present value using

our WACC as a discount rate.

So now we have a pile ofPVd cash, and need

to figure out a share price from this.

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We do this

By turning this lump of cash into its enterprise

value (more on this next slide), then figuring

out equity value from this through some

simple algebra.

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Enterprise Value

We need to discuss another way to measurethe size of a company.

Previously we said market cap was a way to

size a company (Price * shares outstanding) But this had the issue of not taking into

account the debt that was used to fund a

company. We adjust for this problem by calculating

Enterprise Value

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Enterprise Value

EV is essentially the amount of money you

would have to pay to take over a company,

buying all of its debt and equity.

EV = Market Cap + Debt Cash +Preferred Shares + Minority Interest

We take out cashbecause when we

buyout a company,

we are paying cash

for cash, which

cancels out.

Here we are taking

into account non-

equity shares we

have to buyout

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Getting to Enterprise Value from Cash

Flows

After discounting the terminal value and the

FCFs from the 5 projected years, we add them

all up to reach our implied Enterprise Value.

From this, we solve for market cap by taking outthe current years debt, preferred shares, and

minority interest, leaving us with Market Cap +

Cash. We divide this value by the sharesoutstanding to find the implied price per share.

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EV = Market Cap + Debt Cash +Preferred Shares + Minority Interest

So essentially, we are left with Market Cap after taking out all the debt and stuff

from our big pile ofPVd cash. Since market cap is just Price * shares oustanding,

we divide the remainder of the PVd cash (after everything else is taken out) by

shares outstanding to get an implied share price.

WS8-11.15.2012

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