Appunti Applied Corporate Finance

BOTTOM-UP BETA

Sometimes beta cannot be estimated from data, for example because a company

(letʼs call it “X”) is not public (not listed).

The bottom-up (BU) beta approach estimates beta as follows:

1. Identify comparable companies and compute their levered beta from stock

market data

2. Compute unlevered beta of each of these companies

3. Take a weighted average of these unlevered betas. This is our estimate of

company Xʼs unlevered beta

4. Adjust beta for leverage company X.

5. Use this (levered) beta to compute Xʼs cost of equity and WACC

How can we average the weight of the competitors? We can weight more companies

which are very similar to me.

Logical process of bottom-up beta:

- Note on step 1: Comparable companies are companies that are operating in the

same industry as company X. If company X is operating in multiple industries,

you should select comparable companies from each industry.

- Note on step 3: A simplified approach is to equally weight unlevered betas of

comparable companies. If company X is active in multiple industries (e.g., 40%

in industry A and 60%) in industry B, one should use a weighted average of

unlevered beta of industries accordingly.

MENSAM:WACC

MENSAM is not listed on the Nuovo Rican stock exchange, but you are able to find data

from comparable companies. Compute MENSAMʼs WACC using the bottom-up beta

approach.

- Assume MENSAM maintains a D/E ratio of 1. (50% of the debt and 50%



equity)

- In the accompanied spreadsheet you can find a list of comparable companies as

well as their D/E ratio

- Assume all debt is riskless (r = 10%)

- The tax rate is 50%.

Compute the levered beta using the bottom-up approach.

Solution

This table is provided by the test!. We have to use the data in order to estimate the

unleveraged beta.

1. Computing the individual leveraged beta of each company. (Posso usare

direttamente la funzione PENDENZA(rendimenti dell’azienda;rendimenti del

mercato)

2. Once i get the levered beta, we can compute each unlevered beta using the

following formula (use the inverse formula):

We can use directly this formula because the debt is assumed riskless.

3. Computing the averaged unlevered beta of the market using as weight 25% for

each company. (questo perchè come detto all’inizio del cerso MENSAM serve il

mercato middle price e considerando che: due di questi competitor servono

l’upper market e gli altri due servono il lower).

4. Now that we know the average beta we can use it in order to compute MENSAM

leveraged beta we still use the formula at point 2 but now in the direct way



(because we want to know the value of levered beta). (Remember to use the

D/E ratio of our company!

5. Use this beta to compute the MENSAM cost of capital using the CAPM model:

Remember! To compute the necessary Rm (market return) it is sufficient to do

the averaged of the past market return (Use the function media on Excell)

6. Compute the cost of debt using the following formula: Kd = i(1-t)

7. Finally compute the wacc using 50% debt and 50% equity

Fine esercizio

BANKRUPTCY COSTS

Now we’re relaxing the third assumption including bankruptcy cost. fourth



assumption still holds.

We have two different types of bankruptcy cost:

Direct bankruptcy costs:

- Incurred in the process of selling assets of a bankrupt firm. I might occur that



an asset has been sold at a lower value than its face value.

- Examples: lawyers, fire sales, accountants etc.

Indirect bankruptcy costs:

- Cost involved as indirect result of bankruptcy.

- Could potentially be substantially larger than direct bankruptcy costs.

- Examples: decrease in sales, loss of key employees, underinvestment,

excessive risk taking, excessive dividend payout.

UNDERINVESTMENT

PACKING-ORDER THEORY

Pecking order theory (POT): Cost of financing increases with the degree of asymmetric

information of the source of funds:

1. Firms prefer fist finance by using internal cash

2. If that is not possible debt is required (because less information is needed to get

it) debtholders ask only an interest rate depending on my risk (rating



agencies)

3. If debt issuance is not available or excessively costly, the firm finances its

project with equity as a last resort. this because Equity requires a lot of



information and information leads to a higher cost of capital.

WRAPPING UP

M&M 1 implies that whatever source of financing I choose the WACC doesn’t change!

This because increasing the debt part, the cost of equity is adjusted in order to makes

the wacc unchanged.

M&M2 the cost of equity is increasing in the firm’s leverage.

Corporate taxes debt is useful because I can deduce interest payments from profit,



paying less taxes. Thanks to this, the part that goes to investors becomes larger (pie

chart).

Lesson 26/03/2024

PROJECT EVALUTATION

Haedquartes generate every year a stream of cash flows. 99,9% firms will use cash

flows to finance the project or the NOPAT.

Let’s analyze the income statement of MANSAN. Here, there are the summarizing of

the financial triangle of the last five years of MANSAN analyzed previously:

in order to understand if the NOPAT is good or not in relation with the cost of capital, I

should compute the ROE first:

A project is profitable il ROE is larger than cost of equity. ROE>K e

But why? Let’s take as example MANSAM: the cost of equity was 25% so shareholders

want to receive 25% to compensate their capital, and the ROE which is the return of

equity provides shareholder with an higher remuneration.

ROE is a simple intuitive measure but has a drawback: Operation managers typically

do not know the capital structure and cannot estimate net Income nor equity and

hence cannot compute ROE.

The table above shows the ROE computation for MENSAM. We can notice that the

computation is structured in the following way:

Equity of the previous year

Net income of the current year

Return on Capital Employed (ROCE) is defined as:

NOPAT

ROCE = Capital employed

Where:

- Capital employed is the sum of Equity and debt from the previous period used

to undertake the project. REMEMBER! In computing this ratio, we have to



take the capital employed of the previous year.

- Tax advantage of debt (tax shield) is considered in WACC.

- Firm headquarters communicate WACC (or target rate) to operational managers,

who can themselves compute NOPAT and evaluate projects.

It should be compared with the wacc because now we’re taking into account both debt

and equity.

We can notice that ROCE is lower than ROE and this because of debt. Debt has a lower

cost of capital, which lowered the ratio.

This table shows the ROCE computation of the years analyzed. It is important to notice

that ROCE is computed by using:

Capital Employed of the previous years

NOPAT of the current year

How can we express this excess return in dollar or euros?

We can use the Economic Value Added measures profitability expressed in

EVA

dollars taking into account the cost of funds:

EVA= (ROE-K )*Equity

d

Or EVA = (ROCE – WACC) X Capital Employed

Where: k is our threshold, the ROE is what we’ve got and equity is the amount we’ve

d

put in the company. the same statement holds for the other formula.



A project is profitable if: EVA > 0

- If EVA =0, the project breaks even (va in pareggio) (same expected return as

cost)

- Two methods to compute EVA yield same results.

- Operative managers with limited information’s about capital structure use

method 2 this because the ROCE does not take into account of interest.



We have just demonstrated that both methods yield the same results, using the real

MENSAM data.

It is important to notice that the EVA computation is run in the following way:

EVA = (ROE of the current year – cost of equity of the firm) x Equity of the PREVIOUS

year; as well as in the other way: EVA = (ROCE of the current years – WACC of the

firm ) x Capital Employed of the previous year.

CASH IS KING

Even profitable companies can default without proper cash management:

- Market share is vanity

- Profit is sanity

- Cash is king

Therefore, companies impose constraints on cash availability:

- Project could be rejected for excessive cash requirements.

- Issue with EVA and other profitability measures: it is unclear how much cash is

needed to generate profits.

- Cash-Flow based measures of profitability evaluate a project based on Free

Cash Flows.

PROJECT EVALUTATION WITH FCF

A business proposal will raise the firm’s value if the present value (PV) of its

discounted free cash flows is positive.

Free Cash Flows of MENSAM:

TIME VALUE OF MONEY

A dollar today is worth more than a dollar in the future.

Problem: cash flows in the future cannot be compared to cash flows today! We need

to express future dollars in today dollars.

Example: You consider buying a piece of land today for $95. Assume it is certain that

you can sell the land in 1 year for $100. The interest rate is 10%. Should you buy the

land? There are two methods that to solve this:

1. If you put your money on the bank account, you get 95*(1+10%) = 104.5,

which is larger than 100 (do not buy land).

2. The $100 tomorrow is worth 100/(1+10%) = 90.9 dollars today. In other words:

- PV(100) + 95 = -4.1 < 0 (do not buy the land)

NET PRESENT VALUE

The Present Value of a single FCF received i years from now:

i

Where:

- The discount rate r is the cost of capital (typically WACC).

The Net Present Value (NPV) f a stream off free cash flows:

Generally:

- If the NPV is positive than we undertake the project (this because a positive NPV

means more cash today)

- If the NPV is negative we do not undertake the project.

We can do this computation referring to the MENSAM cases. We can say that the FCF

generated and discounted at the wacc generate a positive result. So, we undertake

the project!

However, if we assume wacc equals to 21,681% the NPV breaks even:

Internal rate of return is the maximum cost of capital we can have in order to

accept a project.

A project should be undertaken if:

This rule holds if we are taking into account investment decisions!

If IRR is higher than cost of capital it means that our FCF will be discounted

at a lower rate than IRR meaning a positive NPV!

- The cost of capital for a company is the WACC. If a company has multiple

projects, headquarters can decide to give different (risk and strategy

dependent) targets for each project.

- This expression for IRR is solved numerically.

NVP is good when you want to see the size of the project while IRR is generally better

because is a percentage; so, it is easy to understand.

EXAMPLE

Question: Compute the NPV and IRR

- Sales: 2.00