Investment decision is about discounting cash flows,
and for that we need
PROJECTED CASH FLOWS
RATE OF DISCOUNT
It is chosen arbitrarily
It has to reflect the RISK of the investment
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Free Cash Flow (FCF) Cash Flow to equity
It is the CF that goes
It does not take into account to the shareholders the debt after repaying debt and paying interests
Cost of capital Return expected by the
Rate of (WACC) shareholders (KE) discount
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
WEIGTHED
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CAPM in a nutshell
The CAPM is a theoretical representation of the behavior of financial markets,
but can be used for estimating a company’s cost of equity capital The CAPM is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security
CAPM implementation in practice
Risk-free rate
Market premium
Beta
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How to calculate Beta
DAILY, WEEKLY, WHICH MONTHLY LEVERAGE? DATA
BETA
1, 5, 10,…. WHICH YEARS MARKET?
Return expected by the shareholders CAPM
Private company Public company
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Cost of debt
Loans Bonds
Interest rate Coupon YTM
A project’s cost of capital
Which capital structure: Same rate of discount
corporation, division, other,…? for every project or depends on the risk of each project?
Which value of cost of debt? How to quantify the specific risk
of each project?
How realiable are
Which value of cost of equity? the cash flows?
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Cost of capital
Return required Average cost Minimum of financing a required return Cost
company’s on a company’s investment investment projects projects
Levered and unlevered Betas
Levered beta (a.k.a equity beta) is the
beta of a company that we estimate (using market data)
The levered beta or equity beta is a
measure of combined risk encompassing both business risk and financial risk
A company has only one asset beta.
However, depending on its debt-to-equity ratio, it can have many different equity betas
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Unlevered beta (a.k.a. asset beta) is the beta of a
company without the impact of debt
Unlevered beta is usually either equal to or less
than the levered beta. This is because removing the effect of debt indicates seemingly less risk for a company
Unlevered beta is a more accurate measure of a
company's fundamental risk, while levered beta is a more useful measure for investors who are considering investing in a company's equity
We use the process of unlevering
betas and then levering again when we want to estimate the cost of equity with a different capital structure (target deb-equity ratio)
Or when we want to estimate the beta
for a specific división within a company
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Steps to estimate Beta through comparable companies:
1. Gather levered betas for the comparable companies.
2. Convert levered betas into unlevered betas
3. Find the average unlevered beta
4. Covert unlevered beta into levered beta. This is where you would ‘relever’ the beta using the financing structure of your target company
