Strategic Corporate Finance

Applications in Valuation and Capital Structure

Justin Pettit

• Publisher: Wiley
• Year: 2011
• ISBN:
  9781118160626
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

Essential guidance for the corporate finance professional — advisor, Board Director, CFO, Treasurer, business development executive, or M&A expert—to ask the right questions and make the critical decisions. Strategic Corporate Finance is a practical guide to the key issues, their context, and their solutions. From performance measurement and capital planning to risk management and capital structure, Strategic Corporate Finance, translates principles of corporate finance theory into practical methods for implementing them. Filled with in-depth insights, expert advice, and detailed case studies, Strategic Corporate Finance will prepare you for the issues involved in raising, allocating and managing capital, and its associated risks.

Justin Pettit (New York, NY) draws on his 15 years of senior advisory experience as an investment banker and management consultant. He advises corporate boards and executives on matters of capital structure, financial policy, valuation, and strategy. He also lectures on topics in advanced corporate finance to graduate and undergraduate students at universities in the New York area.

PART ONE

Managing the Left-Hand Side of the Balance Sheet

CHAPTER 1

The Cost Of Capital

The weighted average cost of capital (WACC) is a critical input for evaluating investment decisions: It is typically the discount rate for net present value (NPV) calculations. And it serves as the benchmark for operating performance, relative to the opportunity cost of capital employed to create value.

Though the Capital Asset Pricing Model (CAPM) has been challenged, it remains the most practical approach to determine a cost of equity. In fact, many perceived limitations arise from challenges in applying the model. We will provide suggestions to deal with the primary difficulties in applying the CAPM: (1) estimating the market risk premium (MRP) for equities; (2) measuring the systematic risk, or beta, of a company; (3) normalizing the riskless rate; (4) estimating an appropriate cost of debt; and (5) estimating global capital costs. Finally, we will also address the related issue of corporate hurdle rates for investment.

The cost of capital is an estimation that should be applied with care to avoid any illusions of false precision. Despite its many degrees of freedom, financial planning time and resources are often better allocated to other areas, such as value creation and risk management. Ultimately, it is the business case, quality of cash flow forecasts, sensitivity analysis, and strategic risk management that will have the greatest impact on value creation.

CALCULATION PITFALLS

WACC is a market-weighted average, at target leverage, of the cost of after-tax debt and equity. We estimate the cost of equity as Rf + beta × MRP, where Rf is the riskless return, market risk premium (MRP) is the expected return premium for bearing equity market risk over the riskless rate, and beta is the systematic risk of the business relative to the market. Estimation of these key inputs (riskless rate, the market risk premium and beta), or degrees of freedom, can lead to a wide range of outcomes.

We normalize the riskless rate with a forward view of the capital markets. We continue to believe that 5 percent is a reliable estimate of the MRP, based on historical data and forward-looking market data.1 We will provide tools for deriving more reliable estimates of beta in the most problematic areas. This will be especially helpful for business units, unlisted companies, and illiquid stocks with unreliable betas. Direct regression is the most commonly used approach but we also employ alternative methodologies such as constructed betas, portfolio betas, segment regression betas, and multi-variable regression betas.

Beyond these key inputs, the most common pitfalls regard the weightings of debt and equity.

• Financing events per se may not reflect changes in financial policy and may not be permanent changes to the capital structure. Temporary fluctuations in the mix should not affect WACC.
• The WACC for financial institutions is (generally) the cost of equity, as most debt is funding debt (not financing debt) and should be expensed (not capitalized) where the cost of funds is a cost of goods sold (COGS).

Our approach to global corporate capital costs quantifies and captures both sovereign risk and inflation risk. But we recommend that the cash flows be adjusted for the costs and unsystematic risks of global investing, coupled with a more rigorous risk analysis. Given the many opportunities for profitable growth abroad, more reliable estimates of global capital costs can help ensure companies will choose to undertake investments that show promise to add value.

The key points of our conceptual rationale and approach are as follows:

• Most companies adjust for sovereign risk. Approaches vary widely between made-up risk premiums and qualitative adjustments to a wide range of quantitative methods, largely based on questionable methods, but most companies do something. Many large-capitalization companies (large caps) approach their five favorite banks each year, with a long list of countries in hand, and compare the responses.
• Most adjustments are too large. Much of the international risk is not systematic risk but is execution risk (poor sourcing and logistics, using too much high-cost expatriate labor, misunderstanding of local market execution) that should be accommodated in the cash flows and not in the discount rate. This parochial view leads to lower growth prospects and lower stock valuations.
• A sovereign risk adjustment for the systematic risk should be made to the cost of debt and the cost of equity. Actual financing choices need not complicate the picture unless the value of economic subsidies is to be included.
• Sovereign risk premiums may be “triangulated” from country ratings, sovereign yields, stripped Brady yields, and Euros.
• The volatility of a yield is as important as the yield itself. A point estimate of sovereign risk premium may represent false precision. In some cases, a range, derived from the volatility, offers a more practical perspective.
• Avoid quoting a local currency WACC in any market that does not have long-dated local currency borrowings. Though a local currency WACC may be theoretically derived from long-term inflation estimates, the market does not exist for a reason.
• Theoretically, the economic benefit of global diversification can be quantified from country betas and correlations; however, in practice, the numbers are too unstable to be used for financial planning and policy purposes.

MARKET RISK PREMIUM (MRP)

The return premium afforded by stocks over long government bonds (i.e., MRP) is generally believed to be anywhere from 3 to 8 percent. The widely cited Ibbotson and Sinquefeld study (now down from 8 percent, to about 6 to 7 percent) is based on the U.S. arithmetic mean from 1926. It is not that 1926 was an important year in econometric history; this is just when the market tapes started to be archived.

If the study started one year earlier or later, the risk premium would have changed by a full percentage point. Other U.S. studies (employing manual data retrieval) do go back much further (to when the market was largely railroad stocks) and provide estimates closer to the low end of the range.2 Some studies rely on more recent history and this, again, leads to the lower end of the range.

Provided the data represent a “random walk” and there are no discernible trends up or down, more observations will lead to greater predictive accuracy. However, structural economic changes over the past century make the early data less relevant for estimating expected returns today. Macroeconomic factors have conspired such that, in our opinion, a shorter history is more appropriate.

Based on the arithmetic average of annualized monthly return premiums and on forward looking multiples, stock market investors today are likely to expect about a 5 percent premium for bearing the market risk of equities. The risk of holding equities has generally declined; at the same time, the risk of investing in government bonds has increased, reducing the premium between these two security classes. Though this is based on monthly returns on the S&P 500 index (which included only 90 stocks before 1957) and on U.S. Treasury long bonds, results are similar using a value-weighted index of all NYSE, AMEX, and NASDAQ stocks as a market proxy.

Converging Volatilities and Returns

The volatility of stock returns versus bond returns has decreased. The trailing average standard deviation of annualized monthly stock returns fell from 25 percent in the 1950s to about 16 percent in 2004. During that period, the standard deviation of bond returns increased from 4 percent to almost 12 percent. Similar trends emerge when using 10-year and 20-year averaging periods as 30 years.

Consistent with changes in relative volatility over the past century, the premium that investors received for stocks relative to bonds fell from over 10 percent to about 5 percent. This drop in the risk premium was attributable to a reduction in the level of stock market risk and to an increase in real required returns on bonds.

Why Is The Market Risk Premium Lower?

Several factors contribute to support the notion that earlier history may be less relevant to the ex post derivation of expected equity returns. We speak to the possible causes below:

Regulation and Public Policy

Prudent monetary policies of the Federal Reserve and its foreign counterparts, as well as the general liberalization of regulatory policies, appear to have reduced the volatility of business cycles.3 Liberalization of developing economies, establishment of trading blocks, and the increase of international trade have all contributed to global economic growth and stability, despite tremendous political change and upheaval.

Growth and Globalization

Growth in worldwide market capitalization affords more liquidity, less net volatility, and less net risk. The growth of emerging markets helps to buffer the down cycles of developed economies. Emerging markets help drive developed economies to invest further in human and technical capital. Emerging market volatility is often, in turn, buttressed by the developed markets. Although claims of a borderless global economy are overstated, there is a reduced sensitivity to the economics of any single nation, which reduces systematic risk.

Risk Liquidity

Despite claims to the contrary, the proliferation of risk management products (insurance, credit, interest rate, f/x, and commodity) has increased risk liquidity, allowing it to be isolated, traded, syndicated, and managed. Most individuals invest in the market through funds and institutions leading to an increased sophistication and change in the nature of our equity markets.

Information and Technology

Despite recent accounting scandals, disclosure is more immediate and comprehensive, reducing uncertainty and required returns. Notwithstanding Regulation FD, segment data, reporting requirements, and analyst coverage are all more extensive and of higher quality today than 50 years ago. And technology has reduced the price and raised the quality of information processing.

Labor Mobility

The nature of employment has changed. Tremendous growth in the service sector allows service and manufacturing cycles to be somewhat offsetting. Service economies have fewer fixed costs and are, thus, less susceptible to pricing pressures in times of overcapacity. The trend toward mobile, marketable knowledge workers helps reduce fixed costs and improve resource allocation.

Agency Costs

Hedge funds and large institutional investors today are much more active in influencing companies to maximize shareholder value, which reduces the risk of common stock. This force is supported by the success of LBOs and the widespread adoption of value-based management. The importance of agency costs and ownership concentration in improving corporate performance are well documented.

How Much History?

Consistent with changes over the past century, the premium investors received for stocks relative to bonds fell from ov...

Table of contents

• Cover
• Contents
• Title
• Copyright
• Dedication
• Preface
• List of Figures
• List of Tables
• Acknowledgments
• About the Author
• Part One: Managing the Left-Hand Side of the Balance Sheet
• Part Two: Managing the Right-Hand Side of the Balance Sheet
• Part Three: Managing the Enterprise
• References
• Index