A Cost of Cooker - NACVAedu.nacva.com/2012TrainingMaterials/CUV_2012_v2/HeatIsOn_BCGH_… · These slides are only a summary of ... Duff & Phelps. 2011 ANNUAL CONSULTANTS’CONFERENCE

2011 ANNUAL CONSULTANTS’ CONFERENCE JUNE 8 – 11, 2011 SAN DIEGO BAYFRONT HILTON

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NATIONAL ASSOCIATION OF CERTIFIED VALUATION ANALYSTS INSTITUTE OF BUSINESS APPRAISERS

The Heat Is On: A Cost of Capital Pressure CookerMarc Bello, CPA/ABV, MST, CVA, CFFA

KC Conrad, CBA, CMEA, ABAR, ASA

Roger Grabowski, ASA

James Hitchner, CPA, CFF, ASA

Wednesday, June 8, 2011 Current Update in Valuations

• Please set pagers, cell phones, etc. on vibrate mode or turn them off.

• Please complete and hand in the Presenter Evaluation forms.

• Don’t forget to complete your CPA Attestation Form. Add your Membership Number (located on your name badge) and sign it. Keep the white copy for your records. Turn in the yellow copy at the Registration Desk.


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The Heat Is OnMarc Bello,

CPA/ABV, MST, CVA, CFFA

KC Conrad, CBA, CMEA, ABAR, ASA

Roger Grabowski, ASAJames Hitchner,

CPA, CFF, ASA

NATIONAL ASSOCIATION OF CERTIFIED VALUATION ANALYSTS INSTITUTE OF BUSINESS APPRAISERS

Wednesday, June 8, 2011 Current Update in Valuations


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Acknowledgements• We would like to thank Morningstar, Inc. for permission to

use most of the information on these slides. These slides are only a summary of the material contained in Morningstar’s Ibbotson SBBI Valuation Edition 2007, 2008, 2009 and 2010 Yearbooks.

• Analysts should not use this information on a standalone basis without first reading the Ibbotson book. It is highly recommended that analysts purchase and read each yearly edition of this book.

• Source: Stocks, Bonds and Bills and Inflation Valuation Edition 2010, 2009, 2008, 2007 Yearbooks. Copyright 2007, 2008, 2009 and 2010 Morningstar, Inc. All rights reserved. Used with permission. To purchase copies of the Valuation Edition, or for more information on other Morningstar publications, please visit global.morningstar.com/DataPublications.

Copyright 2011 Valuation Products and Services, LLC


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Acknowledgements

• We would like to thank Duff & Phelps, LLC for permission to use most of the information on these slides. These slides are only a summary of the material contained in Duff & Phelps, LLC Risk Premium Report 2007, 2008, 2009 and 2010.

• Analysts should not use this information on a standalone basis without first reading the Duff & Phelps Report. It is highly recommended that analysts purchase and read each yearly Report.

• Source: Duff & Phelps, LLC Risk Premium Report 2007, 2008, 2009 and 2010, Copyright 2007, 2008, 2009, 2010 Duff & Phelps, LLC. All rights reserved. Used with permission. To purchase copies of the Report or for more information please visit www.bvresources.com



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Objectives/Outline

• Equity Risk Premium: Adjusted v. Unadjusted• Equity Risk Premium: Unconditional v Conditional• Size Premium: What is in there & does it still

exist?• The Beta Debate• Revisiting WACC• Overview of Cost of Private Capital Model


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Components of Cost of Capital

• Risk Free Rate – Investment free of default risk.

• Additional Premium – Additional premium an investor requires to compensate that investor for taking on risk of particular investment.

How Many Components Make up the Cost of Capital?


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Cost of Equity

Adjustments to the “Market”


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Risk Free Rate

• Selecting the Risk Free Rate has a direct effect on the Equity Risk Premium.

EPR = Rm - Rf


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Risk Free Rate


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Risk Free Rate

Analysts Typically use the 20 year U.S. Government Bond Rate for Build-up Method.

1)Closely matches time horizon or life of the investment.

2)Long term yield less susceptible to short term events

3)Matches empirical data used by Ibbotson and Duff & Phelps


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Issues with Rf = Risk-free rate of return• At December 31, 2008, U.S. Treasury bond (“T-bond”) yields, the

typical benchmark used in either the Build-up or Capital Asset Pricing Model (“CAPM”) methods of estimating cost of equity capital, were likely temporarily low due to a “flight to quality”, resulting in low estimates of cost of equity capital.

• Again in the summer of 2010 the flight-to-quality drove down the risk-free yield again as the sovereign credit crisis unfolded.

ISSUE: How does one match this abnormally low risk-free rate with the Equity Risk Premium?

Excerpted and updated from Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.


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Estimating the Equity Risk Premium and Matching to Risk-free Rate


10-Year 20-Year 10-Year 20-YearYear End 2005 4.39 4.61 May-09 3.47 4.34Year End 2006 4.71 4.91 Jun-09 3.53 4.30Year End 2007 4.04 4.50 Jul-09 3.52 4.29

Aug-09 3.40 4.14Jan-08 3.67 4.35 Sep-09 3.31 4.02

Feb-08 3.53 4.37 Oct-09 3.41 4.19Mar-08 3.45 4.30 Nov-09 3.21 4.07Apr-08 3.77 4.49 Dec-09 3.85 4.58

May-08 4.06 4.74 Jan-10 3.63 4.38Jun-08 3.99 4.59 Feb-10 3.61 4.40Jul-08 3.99 4.63 Mar-10 3.84 4.55

Aug-08 3.83 4.47 Apr-10 3.69 4.36Sep-08 3.85 4.43 May-10 3.31 4.05Oct-08 4.01 4.74 Jun-10 2.97 3.74

Nov-08 2.93 3.71 Jul-10 2.94 3.74Dec-08 2.25 3.05 Aug-10 2.47 3.23Jan-09 2.87 3.86 Sep-10 2.53 3.38Feb-09 3.02 3.98 Oct-10 2.63 3.64

Mar-09 2.71 3.61 Nov-10 2.81 3.80Apr-09 3.16 4.10 Dec-10 3.30 4.13

U.S. Government Bond Yields

U.S. Government Bond Yields


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Yields on 20-Year (Constant Maturity) U.S. Government Bonds

2.5%

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Equity Risk Premium


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Adjusted v. Unadjusted Equity Risk Premiums

• Prior costs of equity are raw, i.e., unadjusted• D&P has a suggested uses and examples to

determine a forward looking equity risk premium for use in the Build Up Model and MCAPM not just based on the raw data

• Ibbotson does not present these adjustments in its Valuation Yearbook examples



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Equity Risk Premium

Long Term Horizon

• 1926 – Current• Arithmetic Mean• Unconditional• Normal• Ex-Post

Cyclical

• ERP fluctuates based on current business cycle

• Adjusted for current conditions

• Conditional• Ex-Ante

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Equity Risk Premium(Historical/Unconditional/Ex Post)

• Theory that historical results are a valid alternative for current expectations about future returns.

– Common in litigation settings, such as divorce and tax court valuations.

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Problem with Historical ERP and The Crisis of 2008-2010

December 2008: Just at the time that the risk in the economy increased to maybe the highest point, the base cost of equity capital using realized risk premiums decreased from 11.6% (4.5% plus 7.1%) to 9.5% (3.0% plus 6.5%).Assume one obtains the estimate of ERP from the SBBI Valuation Yearbook. We get the following base cost of equity capital:Excerpted and updated from Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.

12/31/2006 12/31/2007 12/31/2008 12/31/2009 12/31/2010

ERP (%) 7.1 7.1 6.5 6.7 6.7

Long-term Treasury Yield (%) 4.9 4.5 3.0 4.6 4.1

Base Cost of Equity (%) 12.0 11.6 9.5 11.2 10.9


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Historical Equity Risk Premium

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1920s 17.6%1930s 2.3%1940s 8.0%1950s 17.9%1960s 4.2%1970s 0.3%1980s 7.9%1990s 12.1%2000s -3.7%2001-2010 -1.1%

Long-Horizon Equity Risk Permium by Decade (%)

Source: Ibboston SBBI 2011 Valuation Yearbook


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Historical Equity Risk Premium

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Length (Yrs) Period Dates

Large Co. Stock Arithmetic Mean Total Return (%)

Long-Horizon Equity Risk

Premium (%)

85 1926-2010 11.8% 6.7%70 1941-2010 12.6% 7.0%60 1951-2010 12.3% 6.1%50 1961-2010 11.2% 4.4%40 1971-2010 11.8% 4.5%30 1981-2010 12.2% 5.0%20 1991-2010 11.0% 5.3%15 1996-2010 8.9% 3.7%10 2001-2010 3.6% -1.1%5 2006-2010 5.2% 0.8%

Stock market Return and Equity Risk Premium Over Time

Source: Ibboston SBBI 2011 Valuation Yearbook


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Conditional/Ex AnteEquity Risk Premium

• Under this theory the ERP fluctuates with business cycles:– Lowest in periods of business expansion– Highest in periods of recession.

• Three Approaches– Bottom-up implied ERP Estimates– Top-Down implied ERP Estimates– Surveys

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Source: Developing the Cost of Equity Capital: Risk-Free Rate and ERP During Periods of “Flight to Quality”, Roger Grabowski, ASAExcerpted and updated from Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with

permission.


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Conditional/Ex AnteEquity Risk Premium

“Based on the studies and the data presented we conclude that a reasonable long-term range of conditional ERP estimates over the entire business cycle is 3.5% to 6.0%. This compares to the realized risk premiums for the periods 1926 – 2010 of 6.72%.”

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Source: Developing the Cost of Equity Capital: Risk-Free Rate and ERP During Periods of “Flight to Quality”, Roger Grabowski, ASAExcerpted and updated from Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.


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Data Use Examples - AdjustedD&P (2009) p. 12

• “This average was 3.84% over the period 1963-2008. If one’s estimate of the equity risk premium for the S&P 500 on a forward looking basis (“ERP”) were materially different from the average historical risk premium since 1963, it may be reasonable to assume that the other historical portfolio returnsreported here would differ on a forward-looking basis by approximately a similar differential.”

• “For example, assume that your current estimate of the ERP (i.e., the expected equity risk premium for the S&P 500) were 6.00%. The difference between the average historical risk premium since 1963 of 3.84% for Large Company stocks and the 6.00% ERP can be added to the average equity risk premium for the portfolio (observed or "smoothed")…”

From Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.



25 Copyright 2011 Valuation Products and Services, LLC




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Ibbotson D&P Comparison 12/31/09 and 12/31/10 Footnotes

1 Risk premiums over the risk free rate; total of ERP and size premiums; D&P A Exhibits (25th category)

2 Converts Ibbotson IRP to D&P IRP; not beta adjusted3 Converts Ibbotson IRP to D&P IRP; beta adjusted using

separately calculated ERP and size premiums; D&P B Exhibits (25th category)

4 Risk based on operating margin, CV(operating margin) and CV(ROE); D&P D Exhibits

5 Based on assessment that the subject company risk is meaningfully different from the average risk of the companies in the guideline portfolio (more risky or less risky than the average). The company-specific volatility is capturing risk (at least along that one dimension of risk) already.

27Copyright 2011 Valuation Products and Services, LLC


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Data Chart AssumptionsFor Comparative Purposes OnlyAssumptions Can and Will Differ

• Smaller company where Ibbotson 10th decile and D&P 25th category apply

• Risk free rate as of December 31 of each year – 2009 and 2010

• Present Ibbotson unadjusted, D&P unadjusted and D&P adjusted

• Used Ibbotson historical and supply side ERPs• Use suggested adjustments in D&P to convert Ibbotson

IRP to D&P IRP– Only used Ibbotson historical ERP for adjustment;

could have used supply side ERP• Specific company risk is the same for all calculations• Betas and IRPs are the same in each period



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Sources of Data Charts

• “Cost of Capital Update: Things You Need to Know,” Financial Valuation and Litigation Expert journal (FVLE), Issue 29, February/March 2011, Front Page, Valuation Products and Services, LLC

• “Cost of Equity Capital: Straight, with a Chaser,” FVLE Issue 25, June/July 2010, Front Page, Valuation Products and Services, LLC

• “Cost of Equity Capital: Straight, No Chaser,” FVLE Issue 24, April/May 2010, Front Page, Valuation Products and Services, LLC

• www.valuationproducts.com







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Recent Developments in Estimating ERPGlobal GT LP and Global GT LTD v. Golden Telecom, Inc. (Del. Court of Chancery, April 23, 2010)•Golden’s expert selected 7.1%, the long-term “historical” ERP from Morningstar’s 2008 Ibbotson SBBI Valuation Yearbook, which is based on the historical difference of the average annual return of the S&P 500 index (stocks), and the average annual income return of long-term U.S. government bonds (the risk free rate) over the selected time period (in this case 1926−2007). •The petitioners’ expert, on the other hand, selected an ERP of 6.0% “… based on his teaching experience, the relevant academic and empirical literature, and the ‘supply side’ ERP reported in the 2007 Ibbotson Yearbook.” 2008 Ibbotson Stocks, Bonds, Bills, and Inflation®(SBBI®) Valuation Yearbook (Chicago, Morningstar, 2008), page 72.


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Recent Developments in Estimating ERP(cont’d)

• In regards to the selection of ERP, the Court rejected the use of the Morningstar/Ibbotson ERP of 7.1% and instead chose the lower estimate of 6%. Citing the “… wealth of recent academic and professional writings that supports a lower ERP estimate…” that were put forth in the hearing. The Court went on to say that the“…relevant professional community has mined additional data and pondered the reliability of past practice and come, by a healthyweight of reasoned opinion, to believe that a different practiceshould become the norm...”

• The Court continued:“… to cling to the Ibbotson Historic ERP blindly gives undue weight to Ibbotson's use of a single data set. 1926 might have been a special year because, for example, that was the year when Marilyn Monroe was born, but it has no magic as a starting point for estimating long-term equity returns.…


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• If one is going to use an approach that simply involves taking into account historical equity returns, then one has to consider that very well-respected scholars have made estimates in peer-reviewed studies of long-term equity returns for periods much longer than Ibbotson, and have come to an estimate of the ERP that is closer to the supply side rate Ibbotson himself now publishes as a reliable ERP for use in a DCF valuation…In arguing that continued use of the simple Historic ERP is unjustifiable, (the petitioners’ expert) has substantial support in the professional and academic valuation literature. Shannon Pratt, for example, has urged his readers who still use an ERP of 7% to ‘immediately make a downward adjustment to reflect recent research results,’ and has written that the ‘ERP as of the beginning of 2007 should be in the range of 3.5% to 6%’”


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• …The petitioners’ expert “…also cites to a survey of finance professors, which found that the mean ERP taught by 369 professors is 5.96%, and a report of JP Morgan estimating the ERP to be in the range of 5% to 7%. Although the surveys cited by (petitioners’ expert) are not so compelling as to be conclusive, they suggest that current academic thinking puts the ERP closer to 6.0% than to 7.1%.”


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Size Premium


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Size Affect – What you need to Know?

1. Ibbotson 10, 10a, 10b, 10w, 10x, 10y, 10z– How far down can you go?

2. Duff & Phelps Fundamental Measures of Risk– Are size and specific company risk included?


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Is there Really a Size Effect?• Size effect: observed return in excess of that predicted by CAPM• Critics claim that the size effect is:

– due to measuring size using market value (i.e., caused by troubled companies, start-ups)

– due to differences in liquidity, not size– really the “January effect”– caused by “delisting return bias”– function of measuring average annual returns as an arithmetic

average instead of a geometric average– due to “bid-asked bounce”– due to poor analyst coverage causing returns to be impacted by

unexpected events– “comes and goes” (cyclical)– disappeared after 1980



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Is the Size Effect Biased by Troubled Companies? -Composition of the Smallest Decile

• SBBI also reports data with the 10th decile divided into subdeciles 10a and 10b, with 10a being the top half of the 10th decile and 10b the bottom half of the 10th decile.

• Starting with the 2010 SBBI Valuation Yearbook, more detailed size premium data was reported for small cap companies. The 10th decile is now further split: subdecile 10a is split into 10w and 10x, and subdecile 10b is split into 10y and 10z.

• A SBBI supplemental report split the subdeciles 10a into 10w and 10x and 10b into 10y and 10z for the period 1926–2008 (measured by market capitalization) and reported the size premium. – The reported size premiums for subdecile 10y were 8.69% and for 10z,

11.45%, compared with the reported size premium for 10b of 9.53%.Exhibits reproduced from Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010.

Used with permission.


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SBBI Returns in Excess of CAPM –10th Decile Split

Decile Beta* Arithmetic Mean Return

Realized Return in Excess of Riskless Rate†

Estimated Return in Excess of Riskless Rate‡

Size Premium (Return in Excess of CAPM)

1-Largest 0.91 10.75% 5.56% 5.91% −0.36%

2 1.03 12.51% 7.31% 6.69% 0.62%

3 1.10 13.06% 7.87% 7.13% 0.74%

4 1.12 13.45% 8.25% 7.28% 0.97%

5 1.16 14.23% 9.03% 7.49% 1.54%

6 1.18 14.48% 9.28% 7.65% 1.63%

Long-term Returns in Excess of CAPM Estimation for Decile Portfolios of the NYSE/AMEX?NASDAQ, with 10th Decile Split, 1926-2008Exhibit 14.2 Returns in Excess of CAPM – Tenth-Decile Split

*Betas are estimated from monthly portfolio total returns in excess of the 30-day U.S. Treasury bill total return versus the S&P 500 total returns in excess of the 30-day U.S. Treasury bill, January 1926–December 2008.†Historical riskless rate is measured by the 83-year arithmetic mean income return component of 20-year U.S. government bonds (5.20%).‡Calculated in the context of the CAPM by multiplying the equity risk premium by beta. The equity risk premium is estimated by the arithmetic mean total return of the S&P 500 (11.67%) minus the arithmetic mean income return component of 20-year U.S. government bonds (5.20%) from 1926–2008.For Mid, Low and Micro Cap data see Exhibit 13.1.

Source: Stocks, Bonds, Bills, and Inflation® 2009 Valuation Yearbook and 2009 Ibbotson SBBI Valuation Supplement. Copyright © 2009 Morningstar, Inc. All rights reserved. Used with permission. (Morningstar, Inc. acquired Ibbotson in 2006.) Calculated (or derived) based on CRSP® data, Copyright © 2009 Center for Research in Security Prices (CRSP®), Graduate School of Business, The University of Chicago.


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SBBI Returns in Excess of CAPM –10th Decile Split (cont’d)

Decile Beta* Arithmetic Mean Return

Realized Return in Excess of Riskless Rate†

Estimated Return in Excess of Riskless Rate‡

Size Premium (Return in Excess of CAPM)

7 1.24 14.84% 9.65% 8.03% 1.62%

8 1.30 15.95% 10.76% 8.41% 2.35%

9 1.35 16.62% 11.42% 8.71% 2.71%

10a 1.42 18.49% 13.29% 9.19% 4.11%

10b-

Smallest

1.38 23.68% 18.48% 8.95% 9.53%

*Betas are estimated from monthly portfolio total returns in excess of the 30-day U.S. Treasury bill total return versus the S&P 500 total returns in excess of the 30-day U.S. Treasury bill, January 1926–December 2008.†Historical riskless rate is measured by the 83-year arithmetic mean income return component of 20-year U.S. government bonds (5.20%).‡Calculated in the context of the CAPM by multiplying the equity risk premium by beta. The equity risk premium is estimated by the arithmetic mean total return of the S&P 500 (11.67%) minus the arithmetic mean income return component of 20-year U.S. government bonds (5.20%) from 1926–2008.For Mid, Low and Micro Cap data see Exhibit 13.1.

Source: Stocks, Bonds, Bills, and Inflation® 2009 Valuation Yearbook and 2009 Ibbotson SBBI Valuation Supplement. Copyright © 2009 Morningstar, Inc. All rights reserved. Used with permission. (Morningstar, Inc. acquired Ibbotson in 2006.) Calculated (or derived) based on CRSP® data, Copyright © 2009 Center for Research in Security Prices (CRSP®), Graduate School of Business, The University of Chicago.

Source: Shannon Pratt and Roger Grabowski, Cost of Capital: Applications and Examples, 4th ed. (John Wiley & Sons, 2010). Used with permission. All Rights Reserved.


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Composition of the Smallest Decile (cont’d)

• What kind of companies populate subdeciles 10b and its top and bottom halves, 10y and 10z?

• SBBI includes all companies with no exclusion of speculative (e.g., start-up companies) or distressed companies whose market capitalization is small because they are speculative or distressed. The inclusion of speculative or distressed companies in the database is the basis for criticism of the size effect.

• The following exhibits display information on the type of companies that are included in – subdecile 10y (New York Stock Exchange [NYSE], American Stock

Exchange [AMEX], and NASDAQ companies) (Exhibit 14.3).– subdecile 10z (NYSE, AMEX, and NASDAQ companies)(Exhibit 14.4).

Exhibits reproduced from Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.


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Issues with Composition of theSmallest Decile

• From these data we can conclude:– Betas used for calculating the size premium for subdecile 10z

(OLS method) generally understate the beta estimates and overstate the size premium.

– Subdecile 10y is populated by many large (see companies as measured by Total Assets section of Exhibit 14.3 in 95th percentile) but highly leveraged companies with small-market capitalizations that probably do not match the characteristics of financially healthy but small companies.

– There are companies with no sales included in the data (e.g., speculative start-ups).



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Issues with Composition of theSmallest Decile (cont’d)

– Stocks of the troubled companies included in the data (companies with negative returns on the latest fiscal year book value) probably are trading like call options (unlimited upside,limited downside). Even if you were to use the sum beta method, the beta estimates would likely be underestimated and the size premium overstated.

– Before one uses the size premium data for 10b or its top and bottom halves, 10y and 10z, one needs to determine if the mix ofcompanies that comprise the subdeciles are indeed comparable to the subject company.



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Duff & Phelps (D&P) Risk Premium Report- Size Study

• Research into the relationship between company “size” and equity risk premiums realized

• Applications to cost of capital estimation– Build-up method: measures historical realized risk premiums including

size premium since 1963: market risk premium plus size premium (RPm plus size premium)

– CAPM: measures historical realized size premiums since 1963• Size is proxy for risk• Complement/alternative to SBBI Yearbook data• Risk Premium Report annually updated at

Morningstar: http://corporate.morningstar.com/ibBusiness Valuation Resources: www.bvresources.comValuSource: www.valusource.com



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Size Effect is CyclicalSmall Minus Large Company Returns


Shaded gray are times of recession


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Did the Size Effect Die after 1980? • Exhibit 14.6 in the Cost of Capital: Applications and Examples 4th ed.

present size premium data for the CRSP deciles for various recent periods (1959-2008; 1969-2008; 1979-2008; 1989-2008) . These size premiums are calculated relative to the SBBI income returns on long-term U.S. government bonds using annual betas.

• As shown, while the size premium has varied in magnitude, it still exists in the most recent 20-year period (even after 1989).

• Some authors’ claims that it did not exist after 1980 is just due to the specific period chosen (as it did not appear in the numbers in the period 1979–2008). But then again, it does not appear in the period 1969–2008 either, while it appeared in the period 1959–2008. This is evidence that the size effect as an aggregate effect is cyclical. That cyclicality is part of the risk of small companies; if they always earned more than large companies, they would not be riskier in the aggregate.



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Did the Size Effect Die after 1980? (cont’d)

• The following Exhibits present size premium data for the 25 Duff & Phelps size-based portfolios from the Size Study for various recent periods. These size premiums are calculated relative to the SBBIincome returns on long-term U.S. government bonds.

• As shown, while the size premium has varied in magnitude, it still exists in the most recent 20-year period (even after 1990).

• We also present exhibits showing the measures of fundamental risk from the D&P Risk Study for various recent periods


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Returns in Excess of CAPM: 1980-2010Size Measured by Market Value of Equity

Companies Ranked by Market Value of Equity Premium over CAPM Exhibit B-1Historical Equity Risk Premium: Average Since 1980 Equity Risk Premium Study: Data through December 31, 2010Data for Year Ending December 31, 2010 Data Smoothing with Regression Analysis

Dependent Variable: Premium over CAPMIndependent Variable: Log of Average Market Value of Equity

SmoothedPortfolio Average Log Beta Arithmetic Arithmetic Indicated Premium Premium

Rank Mkt Value of (SumBeta) Average Average Risk CAPM over over Regression Output:by Size ($mils.) Size Since '63 Return Premium Premium CAPM CAPM Constant 8.164%

Std Err of Y Est 1.264%1 109,765 5.04 0.82 13.62% 6.32% 4.57% 1.75% 0.16% R Squared 46%2 32,309 4.51 0.95 12.41% 5.11% 5.31% -0.21% 1.00% No. of Observations 253 22,008 4.34 0.91 13.52% 6.22% 5.07% 1.15% 1.27% Degrees of Freedom 234 14,717 4.17 0.92 15.50% 8.20% 5.12% 3.08% 1.54%5 11,048 4.04 0.96 13.32% 6.02% 5.33% 0.69% 1.74% X Coefficient(s) -1.588%6 8,579 3.93 0.99 14.50% 7.20% 5.49% 1.71% 1.92% Std Err of Coef. 0.361%7 6,629 3.82 0.96 14.98% 7.68% 5.37% 2.31% 2.09% t-Statistic -4.408 5,104 3.71 1.02 16.19% 8.89% 5.71% 3.18% 2.28%9 4,250 3.63 1.05 16.46% 9.16% 5.82% 3.34% 2.40% Smoothed Premium = 8.164% - 1.588% * Log(Market Value )

10 3,730 3.57 1.08 16.13% 8.83% 6.00% 2.83% 2.49%11 3,319 3.52 1.04 15.84% 8.54% 5.77% 2.77% 2.57%12 2,844 3.45 1.03 15.53% 8.23% 5.73% 2.50% 2.68%13 2,394 3.38 1.05 14.88% 7.58% 5.83% 1.75% 2.80%14 2,072 3.32 1.09 16.36% 9.06% 6.08% 2.97% 2.90%15 1,786 3.25 1.06 17.21% 9.91% 5.89% 4.02% 3.00%16 1,520 3.18 1.13 17.57% 10.27% 6.29% 3.98% 3.11%17 1,325 3.12 1.14 15.82% 8.52% 6.36% 2.16% 3.21%18 1,132 3.05 1.18 14.80% 7.50% 6.59% 0.91% 3.31%19 939 2.97 1.12 16.10% 8.80% 6.26% 2.53% 3.44%20 782 2.89 1.13 16.11% 8.81% 6.31% 2.49% 3.57%21 656 2.82 1.20 17.94% 10.64% 6.67% 3.98% 3.69%22 501 2.70 1.15 16.65% 9.35% 6.41% 2.93% 3.88%23 358 2.55 1.18 16.39% 9.09% 6.56% 2.53% 4.11%24 232 2.36 1.17 18.55% 11.25% 6.50% 4.75% 4.41%25 68 1.83 1.15 22.40% 15.10% 6.39% 8.71% 5.26%

Large Stocks (Ibbotson SBBI data) 12.87% 5.57%Small Stocks (Ibbotson SBBI data) 14.91% 7.61%

Long-Term Treasury Income (Ibbotson SBBI data) 7.30%

© Duff and Phelps, LLC© 201102 CRSP®, Center for Research in Security Prices. University of Chicago Booth School of Business used with permission. All rights reserved. www.crsp.chicagogsb.edu

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Std Err of Y Est 1.295%1 109,765 5.04 0.81 13.50% 7.00% 4.72% 2.28% 0.87% R Squared 28%2 32,309 4.51 0.96 12.67% 6.17% 5.61% 0.57% 1.45% No. of Observations 253 22,008 4.34 0.91 12.85% 6.35% 5.34% 1.01% 1.64% Degrees of Freedom 234 14,717 4.17 0.92 15.54% 9.04% 5.37% 3.67% 1.83%5 11,048 4.04 0.95 13.22% 6.72% 5.57% 1.15% 1.97% X Coefficient(s) -1.104%6 8,579 3.93 1.00 13.56% 7.06% 5.83% 1.22% 2.09% Std Err of Coef. 0.370%7 6,629 3.82 0.97 14.42% 7.92% 5.66% 2.26% 2.21% t-Statistic -2.998 5,104 3.71 1.02 16.06% 9.56% 5.97% 3.58% 2.34%9 4,250 3.63 1.05 16.23% 9.73% 6.16% 3.57% 2.43% Smoothed Premium = 6.432% - 1.104% * Log(Market Value )

10 3,730 3.57 1.07 16.18% 9.68% 6.28% 3.40% 2.49%11 3,319 3.52 1.04 15.39% 8.89% 6.09% 2.80% 2.54%12 2,844 3.45 1.03 14.41% 7.91% 6.01% 1.90% 2.62%13 2,394 3.38 1.06 14.61% 8.11% 6.18% 1.93% 2.70%14 2,072 3.32 1.10 15.46% 8.96% 6.45% 2.51% 2.77%15 1,786 3.25 1.07 16.31% 9.81% 6.27% 3.54% 2.84%16 1,520 3.18 1.13 17.19% 10.69% 6.58% 4.10% 2.92%17 1,325 3.12 1.13 15.60% 9.10% 6.63% 2.47% 2.98%18 1,132 3.05 1.18 13.78% 7.28% 6.89% 0.39% 3.06%19 939 2.97 1.12 15.43% 8.93% 6.53% 2.40% 3.15%20 782 2.89 1.11 15.09% 8.59% 6.51% 2.08% 3.24%21 656 2.82 1.18 16.66% 10.16% 6.93% 3.23% 3.32%22 501 2.70 1.14 16.11% 9.61% 6.67% 2.95% 3.45%23 358 2.55 1.18 15.25% 8.75% 6.89% 1.86% 3.61%24 232 2.36 1.18 17.52% 11.02% 6.91% 4.11% 3.82%25 68 1.83 1.14 20.89% 14.39% 6.65% 7.74% 4.41%




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Std Err of Y Est 1.482%1 109,765 5.04 0.76 11.38% 5.52% 3.42% 2.10% -0.06% R Squared 59%2 32,309 4.51 0.95 10.47% 4.61% 4.27% 0.34% 1.22% No. of Observations 253 22,008 4.34 0.88 10.52% 4.66% 3.94% 0.71% 1.62% Degrees of Freedom 234 14,717 4.17 0.90 13.89% 8.03% 4.04% 3.99% 2.05%5 11,048 4.04 0.93 10.85% 4.99% 4.15% 0.84% 2.35% X Coefficient(s) -2.415%6 8,579 3.93 1.00 11.63% 5.77% 4.49% 1.28% 2.61% Std Err of Coef. 0.423%7 6,629 3.82 0.98 14.21% 8.35% 4.40% 3.96% 2.88% t-Statistic -5.718 5,104 3.71 1.05 14.17% 8.31% 4.69% 3.61% 3.16%9 4,250 3.63 1.05 15.43% 9.57% 4.70% 4.87% 3.35% Smoothed Premium = 12.111% - 2.415% * Log(Market Value )

10 3,730 3.57 1.10 14.31% 8.45% 4.91% 3.54% 3.49%11 3,319 3.52 1.05 14.37% 8.51% 4.72% 3.78% 3.61%12 2,844 3.45 1.05 12.89% 7.03% 4.70% 2.34% 3.77%13 2,394 3.38 1.04 14.36% 8.50% 4.67% 3.83% 3.95%14 2,072 3.32 1.13 14.66% 8.80% 5.07% 3.73% 4.10%15 1,786 3.25 1.08 16.18% 10.32% 4.83% 5.49% 4.26%16 1,520 3.18 1.16 17.14% 11.28% 5.21% 6.07% 4.43%17 1,325 3.12 1.15 15.21% 9.35% 5.16% 4.19% 4.57%18 1,132 3.05 1.22 13.68% 7.82% 5.47% 2.34% 4.74%19 939 2.97 1.15 14.48% 8.62% 5.14% 3.48% 4.93%20 782 2.89 1.14 14.94% 9.08% 5.09% 3.99% 5.13%21 656 2.82 1.21 16.83% 10.97% 5.43% 5.54% 5.31%22 501 2.70 1.17 16.35% 10.49% 5.24% 5.25% 5.59%23 358 2.55 1.21 15.26% 9.40% 5.44% 3.96% 5.94%24 232 2.36 1.24 17.98% 12.12% 5.54% 6.58% 6.40%25 68 1.83 1.18 22.45% 16.59% 5.31% 11.28% 7.69%




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Average Annual Return, Three Measures of Fundamental Risk1963-2010

© Duff & Phelps LLC

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Coefficient of Variation of Return on Equity (ROE

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2011 ANNUAL CONSULTANTS’ CONFERENCE JUNE 8 – 11 2011 SAN DIEGO BAYFRONT HILTON

erage Annual Return, Three Measures of Fundamental Risk1990-2010


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Risk Premium Report 2011

What is new?Newly Rewritten Text – more user friendly

Updated risk premium unlevering formula and discussionsk Premium Calculator – exclusive to Business Valuation

Resources


The Beta Debate


Total Beta and the Butler-Pinkerton Interpretation

Total Beta and Total Risk Some authors have postulated that it is appropriate to adjust pure CAPM when considering the rate of return appropriate for an undiversified investor.One method for quantifying the risk taken on by an undiversifiedinvestor that has been promulgated by some authors is called total beta. Total beta is an alternative risk measure equal to the standard deviation of total returns expected for a stock divided by the standard deviation of total returns expected for the market portfolio. Practitioners promulgating total beta generally use the standarddeviation of realized returns over a look-back period as an estimate of expected future returns for the subject stock and the market portfolio.

Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.


Total Beta and the Butler-Pinkerton Interpretation (cont’d)

Some proponents of total beta believe it can be used to estimatethe opportunity cost for an undiversified investor as follows:




Two proponents of total beta for use in estimating the cost of equity capital for closely held businesses, Butler and Pinkerton (Butler-Pinkerton), contend that total beta is a “pure measure of the relative volatility”between an individual asset and the market and that, unlike the market risk measure, beta, does not require consideration of the correlated relative volatility (i.e., sensitivity) of the subject stock to the market as a whole.




The cost of equity capital estimated using total beta assumes that the returns of the subject company are perfectly correlated with the returns on the market portfolio:




But assume that one uses total beta to estimate the cost of equity capital for a small, closely held company for which the pool of willing buyers are generally less diversified or completely undiversified. The total cost of equity capital estimate using total beta include an embedded discount for lack of marketability (PCD discussed in Chapter 28 for entire companies) because total beta purports to capture total risk and is applicable only for investments that are not freely traded (either contractual restriction or closely held) The value implied using total beta for the cost of equity capital imbeds the discount for lack of marketability.Caution- do not double count




Total Beta and Inferring Company-specific Risk From the total cost of equity, Formula 15.4, Butler and Pinkerton (Butler-Pinkerton) contend that one can infer the company-specific risk premium for a closely held business using Formula 15.4 in conjunction with Formula 8.5, theexpanded CAPM formula, and get the following:

RPu is a residual percentage. According to Butler-Pinkerton, all of the variances in the rates of return not attributed to either the beta or the size premium are attributable to company-specific risk.Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.



If Total Beta imbeds the effect of the lack of marketability in the cost of equity capital, then RPu is not a pure measure of company-specific risk.RPu includes the effect of the lack of marketabilityCaution- do not double count



Re-Visiting WACC


Issues with WACC

rengths of the WACC include:WACC lets one exploit capital market data, even when we are valuing non-traded assets.WACC handles the interest tax shield very simply.WACC is by far the most widely used discount rate for valuing the business enterprise.



Issues with WACC (cont’d)

eaknesses of the WACC include:WACC handling of income tax issues is simplistic and ignores personal taxes and capital gains treatment that are important considerations in the valuing of pass-through entities.Implicitly, the interest tax shield equals the cost of debt capital times the market value of debt and assumes that the income tax deductions from interest expense result in reduced cash income taxes in the period in which the interest is paid.There may be a risk of realizing the interest tax shield.More likely, interest deductions equal the face amount of debt times a coupon rate.




ACC assumptions are violated:Any time the market value of debt differs from the book value of debtWhen the coupon on the debt does not equal the expected return on the market value of debt capitalWhen the income tax deduction does not equal the coupon multiplied by the face value of the debtWhen the interest tax shields do not result in reduced cash taxes (though the varying WACC method can adjust for this error by setting t = 0 in periods when the tax shield will not be realized)When the equity-to-invested capital ratio is not constant in market value terms (though the varying WACC method can adjust for this error)




ACC may be especially unreliable with:gh-leverage capital structuresomplex tax situationsomplex capital structures, including exotic securities in the capital ucturedynamically changing rather than static situations (though the ying WACC method can adjust for this error)

m Cost of Capital: Applications and Examples 4th ed. Copyright John Wiley & Sons, 2010. Used with permission.


Private Cost of Capital


Private Cost of Capital Model

Value Depends on Cost of Capital

Cost of Capital Depends on Capital Structure (debt/equity mix)

Debt & Equity rates obtained from Pepperdine Private Capital Market Line survey information.



Pepperdine Surveys (every six months).

WACC Based Model.

Rates driven by credit box survey information.PCOC is applicable to pre-tax cash flow.





Source of Capital Amount 1st Median 3rdBank (CF Loan) $1m 5.4% 6.5% 7.1%

$5m 5.0% 6.0% 6.8%$10m 4.5% 5.5% 6.6%$25m 3.8% 5.0% 7.0%$50m 3.8% 5.0% 6.3%$100m 3.6% 4.8% 6.1%

Asset Based Lender $1m 6.5% 12.0% 18.0%$5m 5.5% 7.0% 10.0%$10m 4.4% 5.5% 7.4%$25m 3.0% 3.5% 4.5%$50m 3.0% 3.3% 4.0%$100m 2.8% 3.0% 3.5%

Mezzanine (EBITDA) $1m 18.0% 20.0% 22.0%$5m 17.0% 19.5% 22.1%$10m 17.3% 18.9% 20.0%$25m 17.9% 18.5% 19.0%

PEG's (EBITDA) $1m 25.0% 30.0% 30.8%$5m 25.0% 30.0% 30.0%$10m 24.5% 30.0% 31.3%$25m 25.0% 28.0% 30.0%$50m 22.0% 25.0% 30.0%

Note: Venture Capital, Angel and Factor rates removed for brevity

Quartile



Where:

N is the number of capital sources.MVi is market value of all outstanding securities i.CAPi equals median expected return for capital type i.SCAPi equals the specific CAP risk adjustment for capital type i.



Private Cost of Capital Calculation (Step 1)

EBITDA (mil) $4Select EBITDA Market Multiple 5xMarket Value (mil) $20



Private Cost of Capital Calculation (Step 2)

apital TypeMarket Value

Debt Equity

Survey Rate

Tax Effect

Cost of Capital

COD (debt $5 mil) 5$ 25% 8% % 2.0%

COE 15$ 75% 30% % 22.5%

arket Value (mil) 20$ 24.5%Private Cost of Capital



Pre-tax cash flow is defined as; pre-tax net cash flow.No Discount for Lack of Marketability is required.However, DLOM may be required for Minority Shareholder.

According to Rob Slee & John Paglia………



Circular problem by (debt/equity percentage).

Little empirical evidence for DLOC or DLOM.

Rates are observations from survey participants.

Survey information starts at $1.0 mil.

Not widely accepted.

SBA Guarantee Skews Model

Presenter’s Comments:


Participant Question

As Rob Slee's data about private companies becomes more widely distributed, will it become acceptable to use private capital market data (if enough is available) and to avoid the traditional build up method completely in determining the cost of capital/risk in valuations?


Documents

A Cost of Cooker - NACVAedu.nacva.com/2012TrainingMaterials/CUV_2012_v2/HeatIsOn_BCGH_… · These slides are only a summary of ... Duff & Phelps. 2011 ANNUAL CONSULTANTS’CONFERENCE