RI, economic profit and cost of capital Flashcards
(9 cards)
Explain why residual income might be deemed more economically meaningful than accounting net income?
Accounting profit (i.e. net income) only deducts a cost for debt type capital. It ignores any charge for equity capital. Consequently, it could be viewed as an incomplete measure of ‘profit’. Residual income also includes the charge for equity capital and so recognises the cost of all capital.
RI: “After covering all expenses and also giving investors their expected return, how much value did we really add?” It tells us whether the company is generating value above and beyond the cost of all the capital it use.
Explain each element of a residual income valuation model.
RIVM has the following elements:
* Book Value at t0
* Stream of residual income
* Terminal value
RIVM = BV + PVRI
BV = Book Value at the time of the valuation
RI = Residual value = Accounting profit - Charge for equity capital
PV = The present value calculated using the Ke if an equity model
You overhear an analyst mentioning that the residual income valuation model is superior to DCF when looking at how value builds up when a company is investing heavily in CAPEX. Explain what the analyst means.
In a DCF FCFF model the entire CAPEX in any year is deducted
- So, if a company is investing heavily it will often show negative or depressed FCF and little or negative value creation.
- In residual income the entire capex is not deducted in each year. Instead we embrace the accruals methodology of accounting and so CAPEX is recognised via depreciation which is spread over many years.
- Hence residual income is more likely to show positive value creation in the investing phase.
An investor is considering using DCF or Residual income valuation for a research report on a listed company. They would like to choose a method that will result in the terminal value being a smaller proportion of the overall value. Which method should they choose?
Residual income as it allocates value across 3 different areas:
* Book Value
* Explicit forecast period
* Terminal Value
This contrasts with DCF which allocates more of the value to the terminal value and none to the existing book value.
Explain why it is possible to use a single WACC for a valuation even if there are some changes to the debt equity mix?
WACC is relatively constant over a range of debt-equity mixes. As leverage increases the cost of equity increases. But debt is generally cheaper (tax deductible and lower risk). So, the increase in the cost of equity is offset by more (cheaper) debt.
Note this does not apply at the extremes of debt and equity.
You overhear an analyst argue that it is impossible to use a different WACC for each year of a valuation. Set out with reasons whether you agree with the analyst.
This is not true except for the terminal value period. For this period, assuming we are using the Gordon Shapiro model, we can only use a single WACC in the formula. In the explicit period a time-varying WACC can be used.
What does Beta represent and explain its role in the Capital Asset pricing Model (CAPM).
All discount rates are structured around a risk-free rate + an additional extra element for risk.
In CAPM only systematic risk is measured and recognised.
The risk parameter that captures this risk is BETA which is the covariance between the return on the market and the return on the stock.
What are some of the problems/limitations with using the CAPM to determine the cost of equity?
There are several assumptions underpinning CAPM including the following:
- Investors are rational and risk-averse, meaning they aim to maximize returns for a given level of risk or minimize risk for a given level of return.
- All investors make decisions based on the same information, which is freely and instantly available to everyone.
- All investors have the same expectations about future returns, risks, and correlations of assets.
- Investors evaluate portfolios solely based on their expected return (mean) and risk (variance or standard deviation measured in CAPM as BETA).
These assumptions are unlikely to be valid. Additionally, even if we agree the assumptions are acceptable, questions remain about how to estimate the BETA parameter, for example.
Most cost of capital calculations are structured around a risk-free rate and a risk parameter.
CAPM uses BETA as a measure of risk. Explain, in this context, what risk BETA measures?
Beta measures a stock’s systematic risk, or its sensitivity to market movements, relative to the overall market. It does not account for unsystematic risk, which is specific to the company and can be diversified away in a portfolio.
