Demystifying Valuation: A Comprehensive Guide to the Discounted Cash Flow (DCF) Approach

9th edition

In this edition, we explore essential aspects of estimating the cost of debt and equity, focusing on factors that impact financial leverage, default risk, and tax considerations. From the role of market value in computing WACC to the implications of earnings volatility, understanding these elements is crucial for accurate forecasting.

Estimation of Return on Capital

What is the implied assumption regarding Return on Capital (ROC)?

When estimating the expected growth rate, it is typically assumed that the current Return on Capital (ROC) will remain consistent for future investments. This means the company is expected to generate the same return on any new capital employed historically.

For instance, if a company currently has a ROC of 15%, the assumption is that future capital investments will continue to yield a 15% return. This assumption is critical when forecasting future growth and evaluating the sustainability of the company’s performance over time.

Example: If a firm’s current capital employed is ?1,00,00,000 and its NOPAT is ?15,00,000, the ROC would be:

Return on Capital = ?15,00,000 / ?1,00,00,000 = 15%

The implied assumption is that new capital investments will generate a 15% return, allowing the firm to maintain its expected growth rate.

However, it is important to carefully assess this assumption, as changes in market conditions, competitive landscape, or the efficiency of new investments could cause the actual return on future investments to deviate from the current ROC.

What are the implications of computing Return on Capital (ROC) based on the book value of capital?

Traditionally, Return on Capital (ROC) is calculated using the book value of capital rather than the market value. However, the book value of capital may not always accurately reflect its fair value, leading to potential miscalculations in ROC.

• Underestimation of ROC: When the book value of capital is higher than its fair value, the ROC is likely to be underestimated. For example, suppose a company’s book value of capital is ?1,20,00,000, but its fair value is only ?1,00,00,000. In that case, the ROC will appear lower than it should be, as more capital is being employed than required to generate the same level of returns.
• Overestimation of ROC: Conversely, if the book value of capital is lower than its fair value, the ROC is overestimated. For instance, if a firm’s book value of capital is ?80,00,000 but the fair value is ?1,00,00,000, its ROC will appear higher than it is.

Additionally, the book value of capital typically excludes intangible assets like research assets (e.g., R&D expenditures) and operating leases. These exclusions can further distort the true ROC, ignoring critical investments that drive future profitability and business growth.

Example: If a firm’s NOPAT is ?15,00,000 and the book value of capital is ?1,20,00,000, the ROC would be:

Return on Capital = ?15,00,000 / ?1,20,00,000 = 12.5%

However, if the fair value of the capital employed is ?1,00,00,000, the true ROC would be:

Return on Capital = ?15,00,000 / ?1,00,00,000 = 15%

This demonstrates how using book value can underestimate or overestimate the ROC, affecting the accuracy of financial analysis and decision-making.

In a nutshell, relying solely on the book value of capital can lead to significant distortions in ROC calculations, particularly when material differences between the book value and fair value or key assets like R&D and operating leases are excluded.

Is Return on Capital (ROC) expected to remain constant always?

No, the marginal Return on Capital (ROC) a company expects to achieve on new investments may not always equal the ROC on existing assets. This variation can arise due to different stages of returns to scale that a company experiences. As a result, it is not appropriate to assume that ROC will remain constant indefinitely.

For example, a company in its early growth phase may experience increasing returns to scale, where each additional investment generates higher returns. Conversely, as the company matures and enters a phase of diminishing returns to scale, new investments may yield a lower ROC than existing investments.

Example: A firm with a current ROC of 15% may find that its new investments, due to market saturation or increased competition, only generate a marginal ROC of 10%. In such a case, assuming a constant ROC of 15% would lead to overestimating the firm’s future profitability.

To estimate a fair ROC, it is crucial to consider the current ROC and any observed trends. For instance, if the company’s ROC has been steadily declining over the past five years, it would be prudent to factor this trend into the forecast. Additionally, comparing the firm’s ROC to the average ROC of the industry provides a more comprehensive understanding of whether the company’s performance is aligned with or deviates from industry standards.

In a nutshell, ROC is not expected to remain constant, and a thorough analysis should incorporate current ROC, observed trends, and industry benchmarks to estimate a realistic and fair ROC for future investments.

Estimation of Cost of Capital

Should asset book value or market value be used to compute the Weighted Average Cost of Capital (WACC)?

In the Weighted Average Cost of Capital (WACC) computation, the weights assigned to debt and equity should be based on their market value, not their book value. The rationale is that market values provide a more accurate reflection of the current cost of capital, as they represent the real-time valuation of the company’s assets in the market.

Using the book value of debt and equity, which is based on historical cost accounting, can lead to distortions in WACC because book values often differ significantly from market values. For instance, a company’s equity may have appreciated substantially over time, meaning its book value underrepresents its current value.

Example: If a firm has a debt with a book value of ?50,00,000 but its market value is ?45,00,000, and equity with a book value of ?1,00,00,000 but a market value of ?1,50,00,000, the WACC should use the market values:

• Debt: ?45,00,000
• Equity: ?1,50,00,000

In this case, the proportion of debt and equity used in WACC calculations would be:

Debt Weight = ?45,00,000 / (?45,00,000 + ?1,50,00,000) = 23% Equity Weight = ?1,50,00,000 / (?45,00,000 + ?1,50,00,000) = 77%

Using market values, the WACC calculation more accurately reflects the true cost of capital the company faces in current market conditions.

In summary, to obtain a realistic and accurate WACC, the weights for both debt and equity should be based on their market values, as these reflect the true economic value of the company’s capital structure.

How is the cost of equity computed for Discounted Cash Flow (DCF) analysis?

The cost of equity is typically computed using the widely recognized Capital Asset Pricing Model (CAPM), a single-factor asset pricing model developed by Nobel laureate William F. Sharpe in the 1960s. CAPM provides a systematic method to estimate the cost of equity by incorporating the risk-free rate, the market risk premium, and the security’s beta (a measure of its sensitivity to market movements).

The formula for calculating the cost of equity under CAPM is:

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

1. Risk-Free Rate: This is the return on a risk-free asset, usually represented by government bonds (e.g., 10-year government bond yield).
2. Beta: Beta measures the security volatility relative to the overall market. A beta greater than one indicates that the security is more volatile than the market, while a beta less than 1 suggests less volatility.
3. Market Risk Premium: This is the additional return expected by investors for taking on the risk of investing in the market, typically calculated as the difference between the expected market return and the risk-free rate.

Example: If the risk-free rate is 6%, the beta of the stock is 1.2, and the market risk premium is 5%, the cost of equity would be calculated as:

Cost of Equity = 6% + (1.2 × 5%) = 6% + 6% = 12%

In this example, the cost of equity is 12%, meaning that the expected return required by equity investors for investing in the company’s stock is 12%.

In a nutshell, CAPM provides a structured approach for estimating the cost of equity, which is a key input in DCF analysis. By factoring in the risk-free rate, market risk premium, and beta, CAPM offers a realistic measure of the return investors expect, given the risk risk associated with the security.

What causes a change in the Cost of Debt?

The cost of debt is primarily influenced by default risk, which plays a central role in determining the interest rate a company must pay on its borrowed funds. Default risk is closely tied to the company’s financial leverage—the higher the financial leverage (i.e., the proportion of debt in the capital structure), the greater the default risk. As a company takes on more debt, the likelihood of default increases, leading to a higher cost of debt.

Conversely, changes in the tax rate also impact the cost of debt, but in a positive manner. Higher tax rates result in greater savings from the tax shield on interest payments, lowering the after-tax debt cost. This is because interest expenses are tax-deductible, meaning that an increase in the tax rate reduces the net cost of borrowing.

Example: If a company has an interest rate of 8% on its debt and the corporate tax rate is 30%, the after-tax cost of debt is calculated as:

After-Tax Cost of Debt = Interest Rate × (1 - Tax Rate) After-Tax Cost of Debt = 8% × (1 - 0.30) = 8% × 0.70 = 5.6%

If the tax rate increases to 35%, the after-tax cost of debt would be:

After-Tax Cost of Debt = 8% × (1 - 0.35) = 8% × 0.65 = 5.2%

As the example illustrates, increasing the tax rate reduces the after-tax cost of debt, providing more savings from interest payments.

In a nutshell, the cost of debt is affected by both default risk, which increases with higher financial leverage, and changes in the tax rate, where an increase in the tax rate leads to lower after-tax borrowing costs.

What other factors should be considered when forecasting the future cost of debt?

When forecasting the future cost of debt, several additional factors must be considered, as the marginal cost of debt (the cost of new debt) may differ from the current cost of debt. One key factor is the potential increase in default risk, which can arise from changes in the company’s capital structure and financial health.

The future cost of debt will also depend on whether the company is currently under-leveraged, over-leveraged, or appropriately leveraged. If a company is under-leveraged, meaning it has less debt relative to its capacity, it may be able to take on new debt at a lower cost. Conversely, an over-leveraged company will likely face higher borrowing costs due to increased default risk.

Additional factors include:

1. Earnings Volatility: Companies with volatile earnings may experience fluctuations in their ability to cover interest payments, increasing perceived risk and resulting in higher borrowing costs. For instance, a company with fluctuating profits is considered a higher risk than a company with stable earnings, and lenders may charge a premium for that risk.
2. Positive Taxable Income: The ability to benefit from the tax shield on interest payments depends on the company’s future taxable income. If the company expects to generate positive taxable income, the interest expense can be deducted, lowering the after-tax cost of debt. However, if future taxable income is uncertain, the company may not fully benefit from this tax shield.

Example: If a company currently has a debt cost of 6% but is over-leveraged and facing earnings volatility, its marginal cost of debt for future borrowing could increase to 8% due to the higher perceived risk by lenders. Similarly, if the company is unsure about future taxable income, it may not be able to rely on the full tax shield to reduce the cost of debt.

Forecasting the future cost of debt requires considering factors such as the company’s current leverage position, earnings volatility, and taxable income, all of which influence the marginal cost of borrowing.

summary

his edition covered key factors influencing the cost of debt and equity, including default risk, leverage, and tax shields. Businesses can make informed decisions about future financing by accounting for market value, volatility, and marginal borrowing costs. Understanding these concepts is critical for managing capital structure and financial sustainability.