Estimating Discount Rates

Dr. Himanshu Joshi

Estimating Discount Rates

In DCF Valuations, the discount rates used should reflect the riskiness of the cash flows. Cost of debt has to incorporate a default premium or spread for the default risk in the debt. Cost of equity has to include a risk premium for equity risk. How do we come up with default and equity risk premiums?

What is Risk?

Chinese: Danger Financial Terms: Risk

Opportunity Expected Return

What is Risk?
In Valuation, risk as we see it, refers to the likelihood that we will receive a return on investment that is different from the return we expected to make. Thus, risk includes not only the bad outcomes, (returns that are lower than expected) but also good outcomes (return that are higher than expected). Down side Risk and Up side Risk.

Discounting Rate
For Business or Firm Valuation: WACC = KdT * WD + Ke * WE For Equity Valuation: Ke using CAPM Model CAPM Model: Ke = Rf + * (Rm Rf)
Risk Free Rate

Covariance

Market Risk Premium

Cost of Equity
Cost of Equity is Implied Cost. Cost of equity is what investors in the equity in a business expect to make on their investment. Two difficulties in measuring it: 1. Unlike interest rate on debt, the cost is an implicit cost and cannot be directly observed. 2. This expected rate need not be the same for all equity investors in the same company.

Cost of Equity
The challenge in Valuation is therefore twofold. The first task is to make the implicit cost into explicit cost by reading the mind of the investors. The second and more daunting task is to then come up with a rate of return that these diverse investors will accept as the right cost of equity in valuing the company.

Three Estimation Approaches..

1. Risk and Return Models: We derive models that measure the risk in an investment and convert this risk measure into an expected return, which in turn becomes cost of equity for that investment. 2. Look at difference in actual returns across stock over long period of time periods and identify the characteristics of companies that best explain the difference in returns. We then use this relationship to forecast expected equity returns for individual companies.

Three Estimation Approaches..

3. The last approach uses observed market prices on risky assets to back out the rate of return that investors are willing to accept on these investments.

Risk and Return Model Approach

Risk is defined in terms of the distribution of actual returns around and expected return. Differentiate between the risk that is specific to one or few investments and the risk that affects a much wider cross section of investments. In a market where marginal investor is well diversified, it is only the market risk that will be rewarded.

Diversifiable and Non Diversifiable Risk.

Competition Project may do
better or Worse than expected may be stronger or weaker than the expected

Firm Specific

Entire Sector may be affected by action

Exchange Rate and Political Risk

Interest Rates, Inflation and news about economy Market

Affects Few Firms

Affects Many firms

CAPM the Default Model

Expected Return on Asset i = Risk Free Rate + Beta of asseti *(Risk Premium for Average-Risk Asset). CAPM Model: Ke = Rf + * (Rm Rf)
Risk Free Rate

Covariance

Market Risk Premium

Components of CAPM: Risk Free Rate

Risk free asset is defined as an asset on which investor know the return with certainty. For an investment to be risk free, two conditions have to be met: 1. There can be no default Risk: Govt. Securities 2. There can be no uncertainty about Reinvestment Rates: Zero Coupon Bonds with matching Maturity.

Risk Free Rates..

A purists view of risk-free rates would then require different risk free rates for cash flows in each period and different expected returns. As a practical compromise, however, it is worth noting that the present value effect of using riskfree rates that vary from year to year tends to be small for most well behaved term structures. In these cases, we can use a duration matching strategy, where the duration of the default free security used as Rf, is matched up with the duration of the cash flows in analysis.

Duration for level perpetuity

Duration of perpetuity = 1+y/y At 10% yield, the duration of a perpetuity that pays $100 once a year forever is 1.10/.10 = 11 years. But at an 8% yield 1.08/0.08 = 13.5 years.

2. Risk Premium
What Is the Risk Premium Supposed to Measure? The risk premium in CAPM measures the extra return that would be demanded by investors for shifting their money from a riskless investment to an average risk (market) investment. It should be function of two variables: 1. Risk Aversion of Investors 2. Riskiness of the average risk Investment.

Estimating Risk Premiums..

Geometric Average Vs. Simple Average Geometric Average =[ ValueN ]1/N - 1 Value0

Estimating Risk Premium

Historical Risk Premium US Market 1928-2004 1964-2004 1994-2004 Stock Treasury Bills Stock Treasury Bonds

Arithmetic 7.92% 5.82% 8.60%

Geometric 6.53% 4.34% 5.82%

Arithmetic 6.02% 4.59% 6.85%

Geometric 4.84% 3.47% 4.51%

Estimating Risk Premiums..

1. Country Based Risk Premium Approach: Rating Assigned to countrys debt by a rating agency. 2. Relative Standard Deviation: Relative S.D Country X = S.D of Country Xs Eq. S.D of U.S Equity Equity Risk Premium for Country X = Risk Premium in US * Relative SD of Country X.

Estimating Risk Premium..

3. Default Spread Plus Relative S.D: Country Risk Premium = Country Default Spread * (Equity/ country Bond)

3. Beta
There are three approaches available for estimating beta: 1. Using historical data on market prices and individual assets. 2. Estimating betas from fundamentals. 3. Using Accounting data.

Approach 1. Historical Market Betasbeta.xlsx

Conventional approach for the firms that are publicly traded for the long time. The Standard procedure for estimating CAPM beta is to regress Stock Returns (Ri) against Market Returns (Rm): Ri = a + b R m Where a = intercept from the regression. b = slope of the regression = Covariance (Ri,Rm)/m2

Approach 1. Historical Market Betasbeta.xlsx

There are three decisions that analyst must make in setting up the regression just described: 1. The length of the Estimation Period: The Trade-Off is simple: A longer estimation period provides more data, but the firm itself might have changed in its risk characteristics over the time period.

Approach 1. Historical Market Betasbeta.xlsx

2. The estimation of the Return Interval: Returns on stock and market are available on an annual, monthly, weekly, daily or ever intra-day basis. Using daily or intraday returns will increase number of observations in the regression, but it exposes the estimation process to a significant bias in beta estimates related to non-trading.

 Non Trading Bias: Returns in non-trading periods are zeros (even though the market may have moved up or down significantly in these periods). Using these non-trading periods returns will reduce the correlation between stock returns and market returns and in turn the beta of the stock.)

Approach 1. Historical Market Betas RelainceData_beta.xls

3. Choice of Market Index: The right index to use in analysis should be determined by holdings of the marginal investor in the company being analyzed. If the marginal investor in the company is a global investor, a more relevant measure of risk may emerge by using a global index.

Determinants of Betas
1. The type of business or businesses the firms is in. (cyclicality) 2. The degree of operating leverage. 3. The firms financial leverage.

The Leveraging Effect..Levered Beta.xlsx

If all of the firms market risk is borne by the stockholders (i.e., the beta of debt is zero), and debt creates tax benefit to the firm, then:

L = U [ 1 + (1-t)* D/E]
Where L = levered Beta, U = Unlevered Beta D/E = Debt- Equity ratio (Market Value Terms), t = tax rate.

Approach 2. Bottom Up Betas..

Breaking Down betas into their business, Operating Leverage, and financial leverage components provides us with an alternative way of estimating betas, where we do not need historical returns on an assets to estimate its beta. Property: The beta of two asset put together is a weighted average of the individual asset betas, with the weights based on the market value.

Bottom Up Beta Estimation..

1. 2. 3. 4. 5. Identify Comparable Firms in industry. Beta Estimation using Common Index Unlever Beta Averaging Approach (Simple or Weighted Avg.) Adjustment for Cash (unlevered Beta corrected for Cash = U/(1-Cash/Firm Value). 6. Calculate Levered Beta for the Firm L = U * (1 + (1-Tc)* D/E)

Bottom Up Beta for Disney

Bottom Up Beta.xlsx

Private and Closely Held Business..

Adjust the Beta to Reflect Total Risk rather than just the market risk. Total Beta = Market Beta/R2