Saturday, July 23, 2011

Will the Real Capital Asset Pricing Model Please Stand Up? – Part Two

By the end of our last episode on this topic we had 108 combinations of alternatives to arrive at our cost of equity.
Peer Groups
When assessing our cost of capital, we are usually making these cost of equity calculations across a group of relevant peer companies. So there is the issue of who is included in this peer group?
Again, going to the extreme at either end - you can keep this peer group small and narrow or you can make it broad and wide. And again, arguments both ways.
Example - our group project in one of my University of Chicago classes was to evaluate the acquisition value of a grocery store firm. Are grocery stores considered grocery stores – so we should just use comparables involved in that business? Or are they retailers, so we should include other “big box” type players? Should Wal-Mart, who has some stores with no grocery, yet some stores with grocery, and is in the top 5 in grocery sales, be included in a comparable group or not?
So assuming only two extremes (no matter where you put Wal-Mart), we now have 216 combinations.
The next step in the process is to “unlever” the Beta. By this we mean the following chain of logic – the Nobel prize winning Modogliani-Miller theorem in finance holds that the financing of assets does not matter; in other words, the risk of the assets of a business is the same no matter how they were financed.
One of the primary critical assumptions is “a world without taxes”. Hmmmm….I wish we could all assume that in real life!
With taxes, because interest is tax deductible, debt financing actually adds value. So then the thinking goes “if debt adds value why aren’t firms 99.44% debt financed? Because this doesn’t happen, people thought about it and concluded that, since defaulting on debt causes bad things like bankruptcy, and prior to that the terms of bonds and bank debt can inhibit your operations, there exists something called “cost of financial distress”, which offsets the interest deduction on your tax form at some point.
So we unlever our Beta or equity cost of capital to reflect the fact that our comparison group consisted of some companies who might have had little to no debt, and other companies who had fair to middlin’ debt, and other companies who had loads of debt. We take them all back, no matter where they started, to no debt. It is the financial analyst equivalent of making the playing field level and fair.
Why have I gone on so long about this unlevering issue? Because again we have a choice.
Is the risk of debt Beta?
Remember from the previous blog that our beta calculation reflects “how much equity risk is shared by the market”. Well, if there is debt in our capital structure, doesn’t that debt share some market risk as well? After all, if inflation is expected to go up, doesn’t this impact the bond market as well as the equity market?
So, for our group of comparable companies, we need to decide that if there is debt in their capital structure, should we add some amount of beta due to the debt when we go through this unlevering process?
Again, using extremes (and there are arguments to both sides), we have two choices, and how we decide – yes, add some beta for debt, or no, assume no beta for debt – our 216 choices now expands to 532.
Unfortunately, we are not done yet. Look for a future blog to cover where we go from here.
I would love to hear your thoughts about this view of the cost of capital or your stories on this topic if you have them.
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