2017 Valuation Handbook - U.S. Guide to Cost of Capital

Acknowledgements xiv

Introduction xv

Chapter 1 Cost of Capital Defined 1-1

Introduction 1-1

Income Approach Overview 1-2

Discounting versus Capitalizing Concepts 1-2

Valuation Date 1-5

Basic Cost of Capital Concepts 1-5

Sources of Capital 1-9

Cost of Capital Input Assumptions 1-10

Capital Structure Considerations 1-16

Calculating WACC 1-18

Estimates of Cost of Capital are Imprecise 1-19

Key Things to Remember about Cost of Capital 1-21

Chapter 2 Methods for Estimating the Cost of Equity Capital 2-1

Basic Framework 2-1

Types of Risk 2-6

Cost of Equity Capital Estimation Methods 2-8

Build-up 2-10

CAPM 2-11

Other Cost of Equity Capital Estimation Methods 2-15

Key Things to Remember about the Methods for Estimating the Cost of Equity Capital 2-17

Chapter 3 Basic Building Blocks of the Cost of Equity Capital– Risk-free Rate and Equity Risk Premium 3-1

The Risk-free Rate and Equity Risk Premium: Interrelated Concepts 3-1

Spot Risk-free Rates versus Normalized Risk-free Rates 3-2

Global Turbulence and Impact on Interest Rates 3-14

Methods of Risk-free Rate Normalization 3-19

Spot Yield or Normalized Yield? 3-23

Concluded Normalized Risk-free Rate 3-25

Equity Risk Premium 3-26

Estimating the Equity Risk Premium 3-27

Duff & Phelps Recommended U.S. ERP 3-38

Economic and Financial Market Indicators 3-39

Quantitative Models 3-44

Concluding on an ERP 3-48

Chapter 4 Basic Building Blocks of the Cost of Equity Capital – Size Premium 4-1

Size as a Predictor of Equity Returns 4-1

Possible Explanations for the Greater Returns of Smaller Companies 4-2

The Size Effect: Empirical Evidence 4-2

The Size Effect Over Longer Periods 4-3

The Size Effect Tends to Stabilize Over Time 4-6

The Size Effect Changes Over Time 4-7

Criticisms of the Size Effect 4-8

Data Issues 4-12

Has the Size Effect Disappeared in More Recent Periods? 4-17

Relationship of Size and Liquidity 4-21

Key Things to Remember about the Size Premium 4-26

Chapter 5 Basic Building Blocks of the Cost of Equity Capital – Betas and Industry Risk Premia 5-1

Beta 5-1

Differences in Estimation of Equity Betas 5-7

Full-Information Beta 5-11

Industry Risk Premia 5-12

Full-Information Beta Methodology 5-16

Debt Betas 5-17

Unlevering and Levering Equity Betas 5-18

Key Things to Remember about Betas and the Industry Risk Premia 5-19

Chapter 6 Basic Building Blocks of the Cost of Equity Capital – Company-specific Risk Premia 6-1

Introduction 6-1

Adjustments for Differences in Risk 6-2

Adjustments for Risk in Net Cash Flows and Biased Projections 6-5

Adjustments for Other Risk Factors 6-7

Matching Fundamental Risk and Return 6-8

Key Things to Remember about Company-specific Risk Premia 6-10

Chapter 7 The CRSP Deciles Size Premia Studies and the Risk Premium Report Studies– A Comparison 7-1

History of the CRSP Deciles Size Premia Studies 7-1

History of the Risk Premium Report Studies 7-2

Data Sources 7-2

Definitions of “Size” 7-6

Time Period Examined 7-7

Number of Portfolios 7-7

Portfolio Overlap 7-7

Guideline Portfolio Method and Regression Equation Method 7-8

Risk Premia Over CAPM (Size Premia) 7-8

“Smoothed” Premia versus “Average” Premia 7-12

OLS Beta versus Sum Beta 7-12

Risk Premia Over the Risk Free Rate 7-12

Unlevered Premia 7-13

Risk Study 7-13

Characteristics of Companies in Portfolios 7-13

Online Applications 7-14

Chapter 8 CRSP Deciles Size Premia Examples 8-1

Build-up Example 8-1

CAPM Example 8-4

Key Things to Remember about the CRSP Deciles Size Premia 8-7

Chapter 9 Risk Premium Report Exhibits – General Information 9-1

Appropriate Use of the Risk Premium Report Exhibits 9-1

How the Risk Premium Report Exhibits are Organized 9-2

Cost of Equity Capital Estimation Methods Available 9-3

Proper Application of the Equity Risk Premium (ERP) Adjustment 9-4

“Smoothed” Premia versus “Average” Premia 9-7

The “Guideline Portfolio Method” versus the “Regression Equation Method” 9-8

Example: Calculating an Interpolated Premium Using the Regression Equation Method 9-9

Tips Regarding the Regression Equation Method 9-10

Can the Regression Equation Method be Used If the Subject Company Is Small? 9-10

Size Study or Risk Study? 9-11

Key Things to Remember About the Risk Premium Report Exhibits 9-12

Chapter 10 Risk Premium Report Exhibits – Examples 10-1

Size Study 10-1

Reasons for Using Additional Measures of Size 10-1

The Difference Between the Size Study’s A Exhibits and the B Exhibits 10-2

The Difference Between “Risk Premia Over the Risk-free Rate” and “Risk Premia Over CAPM” 10-2

Calculating Custom Interpolated Premia for Smaller Companies 10-6

Overview of Methods Used to Estimate Cost of Equity Capital Using the Size Study 10-9

Size Study Examples: Assumptions Used 10-10

Size Study Examples 10-12

Unlevered Cost of Equity Capital 10-17

Overview of the Methodology and Assumptions Used to Unlever Risk Premia 10-18

Estimating Cost of Equity Capital Using the “Build-up 1-Unlevered” Method 10-22

Estimating Cost of Equity Capital Using the Capital Asset Pricing Model (CAPM) 10-26

Estimating Cost of Equity Capital Using the “Build-up 2” Method 10-30

Risk Study 10-35

Overview of Methods Used to Estimate Cost of Equity Capital Using the Risk Study 10-42

Risk Study Examples 10-45

Build-up 3-Unlevered 10-49

High-Financial-Risk Study 10-51

Overview of Methods Used to Estimate Cost of Equity Capital Using the High-Financial-Risk Study 10-57

Estimating Cost of Equity Capital Using the “Build-up 1-High-Financial-Risk” Method 10-58

Estimating Cost of Equity Capital Using the “CAPM-High-Financial-Risk” Method 10-61

Comparative Risk Study 10-63

Using the Comparative Risk Study to Refine Build-up Method Estimates 10-67

Using the Comparative Risk Study to Refine CAPM Estimates 10-69

Chapter 11 Real Estate 11-1

Individual Real Estate Assets 11-1

Real Estate Investment Trusts (REITs) 11-2

Structure of Real Estate Entities 11-3

Correlation of U.S. REITs Compared to Other U.S. Asset Classes 11-4

Summary Statistics of U.S. REITs Compared to Other U.S. Asset Classes 11-6

Real Estate Property Valuation Inputs 11-8

Key Things to Remember about Real Property Valuation 11-17

Chapter 12 Answers to Commonly Asked Questions 12-1

Glossary

Index

Appendix 1 – Definitions of Standard & Poor’s Compustat Data Items Used to Calculate the Risk Premium Report Exhibits

Appendix 2 – Changes to the Risk Premium Report Over Time

Appendix 3 – CRSP Deciles Size Premia Study: Key Variables

Appendix 3a – Industry Risk Premium (RPi)

Appendix 3b – Debt Betas

Appendix 4 – Risk Premium Report Study Exhibits