Chapter 11
Risk- Adjusted
Expected Rates of
Return and the
Dividends Valuation
Approach
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Valuing the Firm
Economic theory teaches us that the
value of an investment is:
n
Projected Future Payoffs t
V0  
t
(1

Discount
Rate)
t 1
Expected future payoffs can be measured
in terms of:
 Dividends
 Cash Flows
 Earnings
Chapter: 11
2
Approaches to Firm Valuation
Chapter: 11
3
Risk-Adjusted Expected Rates of
Return
 Risk-adjusted expected rate of return on
equity capital is used as discount rate to
compute present value of projected future
payoffs.
 To develop discount rates, consider:
 Expected future riskiness of the firm.
 Expected future interest rates.
 Expected future capital structure.
Chapter: 11
4
Risk-Adjusted Expected Rates of
Return (Contd.)
 Can use Capital Asset Pricing Model
(CAPM) to develop discount rates.
 Expected rate of return needs to be
adjusted if capital structure changes.
Chapter: 11
5
Capital Asset Pricing Model
E[REj ]  E[RF ]  ß j  {E[RM ] –E[RF ]}
Where :
E  expectatio n
REj  Required return on common equity in firm j
RF  Risk - free rate of return
ß j  Market beta for firm j
RM  Required return on marketwide portfolio
 For Risk-free rate of return (RF), yield on short- or
intermediate term US government securities can be
used.
 {E[RM] – E[RF]} known as “market risk premium”
Chapter: 11
6
Cost of Equity Capital and Systematic
Risk
Chapter: 11
7
Adjusting Market Equity Beta to Reflect a
New Capital Structure
 The market beta reflects operating leverage, financial
leverage, variability of sales and earnings and other firm
characteristics.
Current Levered Market Beta  Unlevered Market Beta x [1  (1  Income Tax Rate)
x (Current Market Value of Debt/Current Market Value of Equity)]
 The analyst can “unlever” the current market beta by
adjusting it to remove the effects of leverage
Unlevered Market Beta  Current Levered Market Beta x [1  (1  Income Tax Rate)
x (Current Market Value of Debt/Current Market Value of Equity)]
 Then reveler it by adjusting leverage under the new
capital structure.
New Levered Market Beta  Unlevered Market Beta x [1  (1  Income Tax Rate)
x (New Market Value of Debt/New Market Value of Equity)]
Chapter: 11
8
Evaluating the Use of the CAPM
Criticisms of CAPM Beta estimates are quite sensitive to the time
period and methodology used in computation.
 Return index for a diversified portfolio of
assets that spans the entire economy does not
exist.
 The market risk premium is not stable over
time.
Therefore, it is important to analyze the sensitivity of
share value estimates across different discount rates for
common equity.
Chapter: 11
9
Cost of Debt and Preferred Equity
Capital
 Cost of Debt:
 Computed as the yield to maturity on each
type of debt times one minus the statutory tax
rate applicable to income tax deductions for
interest.
 Cost of Preferred Capital:
 It is the dividend rate on the preferred stock. In
case of convertible preferred stock the cost will
be a blending of cost of non-convertible stock
and common stock.
Chapter: 11
10
Weighted Average Cost of Capital
 WACC: Considers debt, preferred, and
equity capital used to finance
 Calculated as:
RA  [wD  RD  ( 1–tax rate)]  [wP  RP ]  [wE  RE ]
Where :
wD  wP  wE  1
R is cost of each type of capital
w is proportion of each type of capital
Tax rate is rate applicable to debt costs
Chapter: 11
11
Dividends-Based Valuation
 The rationale for using expected dividends
in valuation is two fold:
 Dividends measure the cash that investors
ultimately receive from investing in an equity
share.
 Cash serves as a measurable common
denominator for comparing the future benefits
of alternative investment opportunities.
Chapter: 11
12
Dividends-Based Valuation (Contd.)
 Dividends include all cash flows between
firm and shareholders:
 Periodic dividend payments
 Stock buybacks
 The liquidating dividend
 And “negative dividend” when firm initially
issues stock
Chapter: 11
13
Dividends-Based Valuation (Contd.)
 Dividends valuation model:

Dt
t
t 1 ( 1  RE )
D1
D2
DT
VT



....


( 1  RE )1 ( 1  RE )2
( 1  RE )T ( 1  RE )T
V0  
With Growing Perpetuity :

Chapter: 11
D1
D2
[NIT  ( 1  g)]  BVT  [BVT  ( 1  g)]


....

( 1  RE )1 ( 1  RE )2
(RE -g)  ( 1  RE )T
14
Dividends-Based Valuation (Contd.)
 Involves measuring the following three
elements:
 Dividend (Discount rate = RE)
 Expected future dividends (Dt) for periods 1
through T over forecast horizon.
 Continuing or final (DT+1), and long-run growth
rate (g).
Chapter: 11
15
Measuring Periodic Dividends
 Assume clean surplus accounting is
followed.
 Under U.S. GAAP and IFRS, clean surplus is
measured by other comprehensive income as
well as net income.
Chapter: 11
16
Measuring Periodic Dividends (Contd.)
 Effects of transactions between firm and
common shareholders are included in
book value.
 Thus, accounting for common equity is
represented by:
BVt  BVt -1  I t  Dt
Dt  I t  BVt -1  BVt
Chapter: 11
17
Forecast Horizon
 Represented by periods 1 through T in the
dividends valuation equation.
 Depending on:
 The industry.
 Firm’s maturity.
 Expected growth and stability.
 Should be until firm reaches steady-state
equilibrium.
 Difficult for young, high-growth firms.
Chapter: 11
18
Continuing Value of future dividends
 Represented by last term of equation on
slide 14.
 Use long-term growth rate assumption (1+
g) uniformly on the year T+1 income
statement and balance sheet projections
to derive the dividends for the year T+1
correctly.
 Thus: DT 1  NIT 1  BVT –BVT 1
 [NIT  ( 1  g)]  BVT –[BVT  ( 1  g)]
Chapter: 11
19
What now?
Once valuation model is applied, then
 Conduct sensitivity analysis:
 Vary cost of equity capital rate (RE)
 Vary long-run growth rate (g)
 Discount rate assumptions
 Vary these parameters and assumptions
individually and jointly.
Chapter: 11
20
Evaluation of the Dividends Valuation
Method
 Advantages:
 Dividends provide a classical approach to
valuing shares as they reflect the payoffs that
shareholders can consume.
 Reflect the implications of analyst’s
expectations for the future operating,
investing, and financing decisions of a firm.
Chapter: 11
21
Evaluation of the Dividends Valuation
Method
 Disadvantages:
 Continuing value estimates are sensitive to
assumptions made about growth rates after
the forecast horizon and discount rates.
 The projection can be time-consuming for the
analyst.
Chapter: 11
22