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Cost Of Capital Estmation - Considering Industry Risk

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Cost Of Capital Estmation - Considering Industry Risk

  1. 1. Cost of Capital Estimation: Considering Industry Risk Brown Bag Presentation September 15, 2008 Paul Daddio
  2. 2. Introduction <ul><li>Methods to incorporating industry risk into cost of equity estimates </li></ul><ul><ul><li>Modified CAPM </li></ul></ul><ul><ul><li>Build-up Method with SBBI Industry Risk Premium (“IRP”) </li></ul></ul><ul><ul><li>Build-up Method with Industry Risk Factored into Company-Specific Risk Premium (“CSRP”) (the “Traditional Build-up Method”) </li></ul></ul><ul><li>Presentation will address: </li></ul><ul><ul><li>SBBI IRP </li></ul></ul><ul><ul><li>Use of alternative equity risk premia (“ERP”) </li></ul></ul><ul><ul><li>Application of the size risk premium (“SP”) </li></ul></ul><ul><li>Presentation will not address: </li></ul><ul><ul><li>Adjustments for leverage </li></ul></ul><ul><ul><li>Beta measurement issues </li></ul></ul><ul><ul><li>Some underlying theoretical issues </li></ul></ul>
  3. 3. Subject Company for Examples: “Aero Pieces” <ul><li>Capital structure equal to that of similarly sized companies and those in industry. As such, no leverage adjustments are necessary. </li></ul><ul><li>Note : if the subject company has a different capital structure than the industry or overall market data used, then leverage adjustments would have to be applied. </li></ul><ul><li>Industry: aircraft parts (SIC 372) </li></ul><ul><li>Beta for the aircraft parts industry: 1.31 (per Ibbotson Cost of Capital Book ) </li></ul><ul><li>SBBI IRP for the aircraft parts industry: 2.06% (per SBBI Valuation Yearbook ) </li></ul><ul><li>Size ($millions): </li></ul><ul><li>Risk-free rate as of the valuation date: 4.5% </li></ul>
  4. 4. Size Risk Premia: Aero Pieces <ul><li>SBBI Size Premia, Micro Cap (SBBI 9 th and 10 th size deciles combined): </li></ul><ul><ul><li>Beta-adjusted size premium: 3.65% </li></ul></ul><ul><ul><li>Non-Beta-adjusted size premium: 6.20% </li></ul></ul><ul><li>Duff & Phelps Size Premia: </li></ul>
  5. 5. Overview of Modified CAPM Method <ul><li>E(R) = R f + ß(ERP) + SP +/- CSRP </li></ul><ul><ul><li>where: </li></ul></ul><ul><ul><li>E(R) = expected return on equity </li></ul></ul><ul><ul><li>R f = risk-free rate of return </li></ul></ul><ul><ul><li>ß = beta </li></ul></ul><ul><ul><li>ERP = equity risk premium </li></ul></ul><ul><ul><li>SP = size risk premium </li></ul></ul><ul><ul><li>CSRP = company-specific risk premium </li></ul></ul><ul><li>Industry risk is considered for through the beta. Beta is a measure of the correlation between (1) the return on an individual security and (2) the return on the market as a whole. </li></ul><ul><li>CAPM measures systematic risk. Therefore, the company-specific risk premium needs to consider risk specific to the subject company, but not to the subject industry. </li></ul>
  6. 6. Modified CAPM Method Considerations <ul><li>Assumes relative price volatility (beta) is a measure of risk (i.e., higher beta results in higher cost of equity). </li></ul><ul><li>Assumes stocks are held in a well-diversified portfolio and deals only with risk and return traits of portfolios, not of individual stocks. </li></ul><ul><li>Assumes subject company is similar to the companies used to calculate beta. </li></ul><ul><li>There are several different measures and sources of beta. The analyst needs to (1) understand how the betas he/she is using are calculated (formula, time frame of data, etc.) and (2) determine whether these are suitable for use in valuing the subject. </li></ul><ul><li>The analyst needs to make adjustments to beta for the differences in capital structure between the guideline companies and the subject company. </li></ul>
  7. 7. Modified CAPM Method Using SBBI Historical ERP: Aero Pieces <ul><li>Cost of equity conclusion: </li></ul>
  8. 8. Modified CAPM Method Using SBBI Supply Side ERP: Aero Pieces <ul><li>Cost of equity conclusion: </li></ul>
  9. 9. Modified CAPM Method Using Duff & Phelps ERP: Aero Pieces <ul><li>Cost of equity conclusion: </li></ul>
  10. 10. Overview of SBBI Industry Risk Premium <ul><li>Industry risk premia have been published in the SBBI Valuation Yearbook since 2000. They are derived from CAPM and based on a “full information beta,” meaning each guideline company used in deriving the beta contributes to its calculation based on the segment sales reported in its form 10-K for the given industry SIC code. This allows for inclusion of conglomerates in addition to “pure play” companies. </li></ul><ul><li>IRP are available for two, three, and four digit SIC codes. </li></ul><ul><li>Build-up Method with IRP: </li></ul><ul><li>E(R) = R f + ERP + IRP + SP +/- CSRP </li></ul><ul><ul><li>Where: </li></ul></ul><ul><ul><li>E(R) = expected return on equity </li></ul></ul><ul><ul><li>R f = risk-free rate of return </li></ul></ul><ul><ul><li>IRP = industry risk premium </li></ul></ul><ul><ul><li>SP = size risk premium </li></ul></ul><ul><ul><li>CSRP = company-specific risk premium </li></ul></ul><ul><li>Criteria used to select companies for inclusion in SBBI IRP calculation: </li></ul><ul><ul><li>At least 36 months of return data available. </li></ul></ul><ul><ul><li>Sales greater than $1 million. </li></ul></ul><ul><ul><li>Market capitalization equal to or greater than $10,000. </li></ul></ul><ul><li>Industry must have at least five companies that meet the criteria above to be included in the study. </li></ul><ul><li>Formula used by SBBI to calculate IRP: </li></ul><ul><ul><li>FI-Beta = (IRP + SBBI Historical ERP) / SBBI Historical ERP </li></ul></ul><ul><ul><li>IRP = (FI-Beta x ERP) – ERP </li></ul></ul><ul><ul><li>where: </li></ul></ul><ul><ul><li>FI-Beta = full-information beta for industry </li></ul></ul><ul><li>Aero Pieces FI-Beta = (2.54% + 7.05%) / 7.05% = 1.36 </li></ul>
  11. 11. SBBI Industry Risk Premium Considerations <ul><li>Review the companies incorporated into IRP to make sure they are sufficiently comparable to the subject company. A complete listing of each company incorporated into each SBBI IRP can be found at: http:// corporate.morningstar.com/ib/asp/detail.aspx?xmlfile =1431.xml </li></ul><ul><li>Consider whether the reported SBBI IRP makes sense. For instance, the plumbing industry’s IRP is reported as 0.83, while electrician industry IRP reported as 9.33. </li></ul><ul><li>Because IRP is calculated using CAPM, applying an IRP to a build-up method, in effect, causes it to become a CAPM method. </li></ul><ul><li>Industry risk premia are somewhat limited in terms of the number of companies per industry, the number of industries represented, and the broad definitions of industry categories. As a result, the selection of appropriate adjustments for industry risk is subjective. </li></ul><ul><li>Beta-adjusted size risk premia should be applied when incorporating IRP. </li></ul>
  12. 12. Adjusting SBBI Industry Risk Premium When Using Alternative Equity Risk Premium Measures <ul><li>The SBBI IRP is based on the long-term, historical ERP measured from 1926 through the most recent period. For example, as of the end of 2007, the SBBI historical ERP equaled 7.05% and the SBBI supply side ERP equaled 6.23%. The historical ERP measured from 1963 through 2007, and used in the Duff & Phelps data averaged 4.85%. </li></ul><ul><li>To incorporate an IRP when using an ERP other than the SBBI historical ERP, an adjustment should be made for the differences in the ERP. </li></ul><ul><ul><li>The equation for this adjustment is derived from the following: </li></ul></ul><ul><ul><li>New IRP = (New ERP estimate ) x (Full Information Beta – 1) </li></ul></ul><ul><ul><li>where, Full Information Beta = (IRP + SBBI Historical ERP) / SBBI Historical ERP </li></ul></ul><ul><ul><li>or, simplified: </li></ul></ul><ul><ul><li>New IRP = SBBI IRP x (New ERP estimate / SBBI Historical ERP) </li></ul></ul>
  13. 13. Build-up Method with IRP Using SBBI Historical ERP: Aero Pieces <ul><li>Cost of equity conclusion*: </li></ul><ul><li>* See page 18 of the Duff & Phelps Risk Premium Report 2008 for the preferred application of SBBI IRP. </li></ul>
  14. 14. Build-up Method with IRP Using SBBI Supply Side ERP: Aero Pieces <ul><li>Adjust SBBI IRP for use with SBBI Supply Side ERP. </li></ul><ul><ul><li>IRP for use with SBBI Supply Side ERP = SBBI IRP x (SBBI Supply Side ERP / SBBI Historical ERP) </li></ul></ul><ul><ul><li>2.24% = 2.54% x (6.23% / 7.05%) </li></ul></ul><ul><li>Cost of equity conclusion: </li></ul>
  15. 15. Build-up Method with IRP Using Duff & Phelps ERP: Aero Pieces <ul><li>Adjust SBBI IRP for use with Duff & Phelps ERP: </li></ul><ul><ul><li>IRP for use with Duff & Phelps ERP = SBBI IRP x (Duff & Phelps ERP / SBBI Historical ERP) </li></ul></ul><ul><ul><li>1.75% = 2.54% x (4.85% / 7.05%) </li></ul></ul><ul><li>Cost of equity conclusion: </li></ul>
  16. 16. Overview of the Traditional Build-up Method <ul><li>E(R) = R f + ERP + SP +/- CSRP </li></ul><ul><ul><li>Where: </li></ul></ul><ul><ul><li>E(R) = expected return on equity </li></ul></ul><ul><ul><li>R f = risk-free rate as of the valuation date </li></ul></ul><ul><ul><li>SP = size risk premium </li></ul></ul><ul><ul><li>CSRP = company-specific risk premium </li></ul></ul><ul><li>Industry risk is considered through the company-specific risk premium. </li></ul>
  17. 17. Traditional Build-up Method Using SBBI Historical ERP: Aero Pieces <ul><li>Cost of equity conclusion: </li></ul>
  18. 18. Traditional Build-up Method Using SBBI Supply Side ERP: Aero Pieces <ul><li>Cost of equity conclusion: </li></ul>
  19. 19. Traditional Build-up Method Using Duff & Phelps ERP: Aero Pieces <ul><li>Cost of equity conclusion: </li></ul>
  20. 20. Summary: Aero Pieces

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