Salim Bhanji

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Salim Bhanji

  1. 1. IS 2 - Performance Measurement Session Prepared for CIA 2006 Stochastic Modeling Symposium & Investment Seminar A High Level Presentation on the Cost of Equity Capital and Use in Business Management Effective Date: April 3rd, 2006 Prepared by: Salim Bhanji, CFA, MBA, BMath Principal Consultant www.delfinconsulting.com
  2. 2. 1. Presentation Objectives Page 3 2. Why Care about the Cost of Equity? Pages 4-6 3. Approaches to Calculating Cost of Equity Page 7 4. Linking Cost of Equity to Business Management Pages 8-10 5. Appendix Pages 11-15 Table of Contents
  3. 3. <ul><li>A high level presentation on the cost of equity capital and its application in business management including: </li></ul><ul><ul><li>Why care about the cost of equity capital ? </li></ul></ul><ul><ul><li>Linking cost of equity capital to Business Management </li></ul></ul><ul><ul><li>Application Example </li></ul></ul>1.0 Presentation Objectives
  4. 4. The overall capital framework reflects capital required for various risks that a financial institution faces due to the businesses in which it is engaged (risk based capital) as well as for investment purposes such as goodwill, fixed assets etc. (investment capital). The funding of this capital is made up of common equity, preferred equity and debt financing with common equity being the largest (typically 75%+) and most important funding source. Market Risk Underwriting Risk Operating Risk Risk Based Capital Deduction for Diversification Investment Capital Total Capital Common Equity Preferred Shares Debt Capital Framework Capital Funding Cost of Capital Cost of Prefs Cost of Debt Capital Charge “ Economic Capital” Charge for Common Equity NOT reflected in accounting P&L Charge for Non-Common Equity funding reflected in accounting P&L <ul><li>Asset Default (C-1) </li></ul><ul><li>Interest Margin Pricing Risk </li></ul><ul><li>Interest Rate Environment (C-3) </li></ul><ul><li>Mortality, Morbidity & Lapse </li></ul><ul><li>Operational Risk </li></ul><ul><li>Operating Leverage </li></ul><ul><li>Financial Leverage </li></ul>Other Capital The cost of Equity, Prefs & Debt is the weighted averaged cost of capital (WACC) Cost of Equity 2.0 Why Care about the Cost of Equity Capital - “Big Picture”
  5. 5. Shareholders of multi-line financial firms have increasing expectations for BU differentiated cost of equity/hurdle rates. This expectation has in part been created by equity analysts who are “zeroing-in” on understanding the economic returns of each distinct BU. Therefore, multi-line firms must understand that the cost of equity capital is not the same across various BUs and should reflect this reality in their overall capital allocation decisions. Equity Analysts Shareholders Firm Management Increased sophistication in equity analysis is resulting in Analysts assessing performance and value of diversified financial firms on a BU basis Analyst firm coverage and reporting is leading shareholders to expect BU differentiated cost of equity/hurdle rates Shareholder expectations for equity supplied is creating need for management to calculate differentiated cost of equity and set varying hurdle rates Support for BU differentiated cost of equity/hurdle rates is discussed in the following research paper: Aswath Damodaran, New York University, “Estimating Risk Parameters”, 2.0 Why Care about the Cost of Equity Capital - Key Message
  6. 6. The cost of equity capital is an essential element in closely aligning the management of the firm to shareholder expectations as it is critical for purposes of 1) Developing a robust capital allocation framework, 2) Measuring risk adjusted profitability and 3) Setting executive compensation. Cost of Equity Capital Determined based on shareholder expectations Capital Allocation Framework Risk Adjusted Profitability Adjusting BU Net Income After Tax (NIAT) to reflect “charge” for equity capital results in meaningful BU performance comparison Executive Compensation Incorporating risk adjusted performance targets in executive compensation aligns management actions to shareholder expectations Leads to allocating capital in a more efficient manner to BUs within a firm 2.0 Why Care about the Cost of Equity Capital - Implications
  7. 7. There are a variety of different approaches to determining the cost of equity. All of the approaches are predicated on the notion that there is a relationship between the expected or required return demanded by shareholders and the uncertainty surrounding that return. Calculating Cost of Equity Capital Asset Pricing Model (CAPM) Peer Based CAPM Market-Derived Capital Pricing Model Fundamental CAPM Dividend Growth Model Calculated using risk free rate, a company’s stock “beta” and market risk premium Calculated using risk free rates, dividend & debt yields and stock price volatility Calculated using dividend level, dividend growth rate & stock price 3.0 Approaches to Calculating Cost of Equity
  8. 8. The cost of equity capital should be an integral part of a firm’s business management framework and impacts product pricing, business initiatives, business valuation and mergers and acquisition (M&A) activities. Cost of Equity Capital Robust approach widely used across the firm in all projects requiring equity capital spend Product Hurdle Rates Product pricing should be done based on hurdle rates derived from the firm’s cost of equity Business Initiatives Projects requiring usage of equity funding; determining “go/no-go” decisions Performance Measurement BU risk adjusted returns and shareholder value added measures M&A Minimum return; higher return depending on acquirer's market implied RoC 4.0 Linking Cost of Equity to Business Management
  9. 9. Economic Profit (EP) rather than Net Income is the appropriate measure of the “true profitability” of a product or BU. EP is an after-tax measure that includes a charge for the opportunity cost of equity capital invested by shareholders to cover risk and fund growth. Shareholder Value Added (SVA) is the amount by which the estimated future market value of a firm’s equity exceeds its book value. Economic Profit (EP) EP = Net Income Applicable to Common Equity Less (Economic Capital x Cost of Equity) EP = NIAC less Cost of Equity Capital Charge Cost of non-common equity funding capital i.e. preferred shares and debt transfer priced and reflected in NIAC Shareholder Value Added (SVA) Economic Profit Cost of Equity (Ke) – Growth Rate (g) g = normalized annual growth rate in earnings SVA = Unlike the embedded value approach, SVA measures both the value of a firm’s existing business & VNB “ SVA is equal to present value of future EP growing at annual rate of ‘g’” VNB - value of new business 4.1 Linking Cost of Equity…. Framework
  10. 10. Market Cap is equal to the capital invested by shareholders plus its estimated future market value. Shareholder wealth creation is most efficiently measured as the difference between a firm’s market cap & invested capital – SVA. It can also be expressed as the “price/book” or P/B ratio. Change in SVA or P/B ratio is an excellent metric for assessing incremental wealth created by management. Additionally, the ratio can be used in setting hurdle rates. Firm Market Capitalization Market Cap = Book Value of Equity + SVA Market Cap 1 + ROE - Ke Book Equity Ke - g where: ROE = Net Income Applicable to Common Book Equity = “ Price to Book” Ratio RoC = Ke x Price/Book Ratio where RoC = Return on Capital i.e. hurdle rate The hurdle rate needs to be set at a minimum rate equal to cost of equity plus the current equity spread. Otherwise, a lower return over time will result in reduced SVA unless accompanied by an increase in g Hurdle Rates 4.2 Linking Cost of Equity…. Hurdle Rates
  11. 11. Please Refer to Next Page 5.0 Appendix
  12. 12. Return on Equity Market Share 10% 11% 12% 13% 14% 15% Cost of Equity Capital BU #1 BU #1 has a ROE that is more than 300 bps lower than Ke – in the absence of decent turnaround plan, firm should exit BU BU #2 BU #2 has a high ROE but low market share – potential opportunities to increase SVA via more competitive pricing BU #3 BU #3 has ROE that is lower than Ke – investigate opportunities for risk based pricing BU #4 BU #4 has high market share but ROE that is only marginally higher than Ke – investigate opportunities to increase pricing Observations BUs with ROEs lower than the cost of equity destroy shareholder value BU exit decisions must be considered in the context of any BU interdependencies 5.0 Application - Using Cost of Equity in BU Strategy
  13. 13. Please Refer to Next Page Given that the firm generates earnings exactly equal to its market implied hurdle rate, it will not enhance its SVA Setting hurdle rate equal to cost of equity or lower will destroy SVA Observations Overall Firm Hurdle Rate 5.1 Application - Firm Uses BU Differentiated Hurdle Rate
  14. 14. Please Refer to Next Page The firm generated exactly the same net income after tax earnings as before of $1,447 However, EP and SVA are both lower by 9% and 15% respectively The firm’s stock price as measured by market cap is down by approximately 4.5% despite exactly same earnings! Frequent Mgmt Explaination: “stock has declined due to market conditions and resulting lower P/E multiple”! Observations 5.2 Application - Firm Uses Common Hurdle Rate
  15. 15. Equity Spread = Hurdle Rate – Ke Market Share 5% 6% 7% 8% 9% 10% BU LG BU HG BU AG BU LG Loss in market share for low growth BU as product pricing is uncompetitive BU HG Huge increase in market share for high growth BU driven by very competitive product pricing BU AG Slight increase in market share for average growth BU driven by marginally more competitive product pricing Overall firm equity spread under differentiated hurdle rates Overall firm equity spread under common hurdle rates Observations Firms using a common hurdle rate across the organization overvalue higher growth BUs and undervalue lower growth BUs Low growth BUs subsidize the cost of equity for higher growth BUs at the peril of shareholders – SVA and stock price are not maximized! 5.3 Application - Differentiated vs Common Hurdle Rates

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