Lecture 9 - Prospective Analysis - valuation implementation.ppt

Lecture 9 Prospective Analysis – Valuation Implementation The steps involved in Business Analysis Introduction To move from the valuation theory discussed in the prior lectures, we have to deal with: Need to estimate a cost of capital to use as a discount rate Need to deal with other practical issues Learning Objectives At the conclusion of this lecture you should understand: Chapter 8: How to estimate costs of capital How to deal with other issues in valuation Discount Rates 3 discount rates discussed in this course: Cost of capital – equity (re) Used in DDM and residual abnormal earnings valuations Cost of capital – debt (rd) Cost of capital – firm / operations (rf) Used in DCF and residual abnormal operating earnings valuations Discount Rates Investing is like gambling – you are buying a range of possible outcomes with different probabilities of occurring Most people are risk averse, so want to be compensated for taking on greater levels of risk – i.e., want to earn at least the risk-free rate, plus a premium for any risk taken Discount rate = time value of money (risk free rate) + premium for any risk taken The cost of capital for debt The cost of capital for equity The cost of capital for equity – asset pricing models Asset pricing models all recognise that the market will not provide a risk premium for risk that can be diversified away in a portfolio Asset pricing models all have a common form: Normal return = risk-free return + risk premium The risk premium is calculated as: The reward for a common risk that cannot be diversified, times the sensitivity of the returns on a particular investment to that factor (the beta) The total risk premium is the sum of the effects of all of the risk factors Estimating a discount rate for equity:Capital Asset Pricing Model CAPM Identifies the return on all investment assets (market return) as the only risk factor: re = risk-free return + (risk premium x CAPM beta) Risk premium = the expected return on a portf