Few technical questions about DCF
Hello guys,
Thanks for the forum, very helpful. I have a few questions about DCF and would appreciate your replies:
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I understand that in finding the WACC, the "appropriate" capital structure for the target should be used and not the current capital structure. How do you go about finding this appropriate structure in practice? Is it based on Comps?
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Can this capital structure change over time in modelling of DCF? For example if we assume to decrease it a lot in 3 years, can that be reflected in the model? Or would an lbo model be the only way out for that?
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In CAPM, why do we not reward investors for unsystematic risk?
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When unlevering the betas of comparable companies, do we use the "appropriate" capital structure of the industry or do we use the "actual" capital structure of the industry? And i understand that while relevering the beta, we use the "appropriate" capital structure for the target, right?
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In the WACC formula, for the debt part the formula is [Cost of debt * (1-Marginal Tax Rate) * (E/E+D)]. Two questions here:
5.a I understand the cost of debt is multiplies with (1-t) to take into account the debt tax shield. But I don't quite understand why it is done and how it impacts the tax shield calculation?
5.b In the unlevering / levering beta formulas in the expression (E/E+D), we multiply (1-marginal tax rate) with the "D" as well while in the WACC forumula it is simply (E/E+D), why is that? -
Half year convention - I understand it is done to show as if the cash flow is coming in throughout the year but why does taking the year as 0.5 does that?
Any answers would be very highly appreciated. Cheers!
- talk with management, ask what is their target capital structure, - take an industry average.
Sure it can.
Because this risk is diversifiable - an investor can create a big enough portfolio in which all the unsystematic risk parts of his securities will cancel out. This means he can pay more for those securities (conversly - he requires a lower rate of return) and he will price investors who do not apply diversification out of the market. It is not 'us' not compensating for unsystematic risk - sophisticated investors don't require such compensation as they do not bear such risk.
Actual capital structure of the company/industry for which the beta was calculated. And when you are relevering the beta you use the capital structure you want (which you think is the target capital structure, or which applies to the company you are valuing) - that is the whole point of this excercise.
5.a I don't know what your problem is here, please clarify. 5.b See above, but you should really try to derive the equations you're talking about. It's not that hard and you'll gain a much better understanding of why they are what they are.
I'll answer the quick ones: 1) Use "target" capital structure 2) DCF assumes a constant D/E ratio, APV assumes constant notional amount of debt. Model accordingly 3) Idiosyncratic risk can be diversified away and thus investors are not rewarded with extra return on that risk 4) Unlever with current capital structure numbers EDIT: nevermind the guy above beat me
a) Within the band of typical debt levels, capital structure has no effect on total cost of capital b) the "appropriate" debt level should be the amount that realizes the most tax shields while not putting the company into any financial danger
feenans got this one
in general, people pay you a premium for bearing risk because you wouldn't bear it for free. if it were possible to simply and costlessly diversify away the risk, rather then paying someone to bear it, a person would have to be pretty stupid to spend any money on neutralizing it. Thus, diversifiable risks pay the risk free rate.
when unlevering betas, you use the actual cap structure of the company you are unlevering. This is why cap structure has nothing to do with cost of capital - because we're taking the equity return, eliminating the effect of leverage, and revealing the overall asset return. If their were more leverage, the equity beta would have been higher, and unlevering would simply reveal the same asset return. The point of this exercise has nothing to do with figuring out some optimal cap structure. What we're trying to do is find out what return the market has decided on for similar risks to the one we're looking at. Since we can only observe traded equity, we must remove the effect of leverage to get to the actual return of all the capital invested. Once we've done that, we average the unlevered asset returns and that's a good estimate for the opportunity cost of investing in the company we're analyzing. This opportunity cost does not include any information about the target in it, so obviously will not change no matter what the capital structure is, or what the name of the CEO is, or if their corporate address starts with an even or odd number.
part of your problem is you have the formula wrong. it's cost of debt * (1 - tax rate) * D/D+E. The reason we do this is because as you correctly pointed out, we need to take into account tax shields. After we observe the cost of equity in the market, the next step is to unlever to find the return if firm was 100% equity. But since the debt has actual cash effects (tax shield) we essentially lower the cost of the debt (5% * .65 = 3.25%). This lowers the overall asset return. The intuition here is since the debt is creating a tax shield, the overall risk of the invested capital is lower than what it would have been as an all equity firm. We're only talking about the comps here, by the way. The tax shield of our target has nothing to do with the opportunity cost of investing in it.
Half year convention refers to depreciation law. Not sure what you're talking about here.
In general, remember that cost of capital is an opportunity cost. I often wonder why the concept of an opportunity cost gives people so much trouble, but apparently it does. Opportunity cost has nothing to do with what you're actually investing in. Let me repeat: NOTHING TO DO WITH IT. What an opportunity cost is measuring is the return you are giving up by investing here and not there. In other words, opportunity cost has to do with what we are NOT investing in.
In a 2005 survey at the annual meeting of American Economic Association, 21.6% of professional economists surveyed chose the correct answer to a question on opportunity cost. The researchers later asked a similar but differently phrased question, to which a majority of the economists surveyed gave an incorrect answer. When the researchers posed the original question to a larger group of college students, 7.4% of those who had taken a course in economics answered correctly, compared to 17.2% of those who had never taken one. The researchers, Paul J. Ferraro and Laura O. Taylor of Georgia State University, labeled the results "a dismal performance from the dismal science."
Could be wrong, but think he's referring to mid-period convention. Instead of discounting at a factor of 1 / ((1+Wacc)^1), we do 1/((1+Wacc)^.5) because the timing of cash flows isn't all at year end, and comes before the year end and therefore is worth more as timing of cash flows is nearer to the present. In industries like retail the timing of cash flows is more towards year end.
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