Fairfax
Formulas Midterm
Cost of Capital
1.1 Basic Formula
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The Equity-Beta is the covariance of the stock-return with the market-return
1.2 Betas Non Investment Grade (< BBB)
The Equity-Beta can be analyzed as follows:
[pic]
The Equity-Beta is a function of the risk of a firm’s assets (operating risk) and the amount of financial leverage.
[pic]
An Asset-Beta (= unlevered Beta) reflects a firm’s operating risks without the effects of leverage.
The Debt-Beta is the covariance of a firm’s debt with the market.
A relevered Beta is the Equity-Beta of a firm with a new capital structure, underlying the old Asset-Beta.
1.3 Betas Investment Grade (>= BBB)
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Debt-Beta for Investment Grade firms is statistically not relevant and can be dropped.
1.4 Financial/Operating/Market Risk
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βasset = operating risk
Rest of term = financial risk (drops out when debt = 0)
Βdebt = 0 if debt carries no market risk
1.5 Cost of Debt
rD = rf + Credit Spread
1.6 Cost of Equity
CAPM: rE = rf + βE(rm-rf)
1.7 Cost of Capital (WACC)
• Capital structure components should be measured on a market value basis, not a book value or historic basis
• Use a target capital structure rather than the current or historic capital structure
• T always means the incremental tax-rate
• Debt includes long-term debt, financing leases, short-term debt, operating leases used as permanent financing, off-balance financing transactions
• If cash flows are real, first compute nominal WACC, then subtract inflation to get the real WACC (or better use transformation formula)
• Use firm or divisional capital structure not project
1.8 Divisional WACC
1. Determine capital structure of division
2. Find comparable firm (pure play) ( βequity of comparable
3. βequity of comparable: remove effects of capital structure ( βasset of comparable
4. Assume βasset of comparable = best
Cost of Capital
1.1 Basic Formula
[pic]
The Equity-Beta is the covariance of the stock-return with the market-return
1.2 Betas Non Investment Grade (< BBB)
The Equity-Beta can be analyzed as follows:
[pic]
The Equity-Beta is a function of the risk of a firm’s assets (operating risk) and the amount of financial leverage.
[pic]
An Asset-Beta (= unlevered Beta) reflects a firm’s operating risks without the effects of leverage.
The Debt-Beta is the covariance of a firm’s debt with the market.
A relevered Beta is the Equity-Beta of a firm with a new capital structure, underlying the old Asset-Beta.
1.3 Betas Investment Grade (>= BBB)
[pic]
[pic]
Debt-Beta for Investment Grade firms is statistically not relevant and can be dropped.
1.4 Financial/Operating/Market Risk
[pic]
βasset = operating risk
Rest of term = financial risk (drops out when debt = 0)
Βdebt = 0 if debt carries no market risk
1.5 Cost of Debt
rD = rf + Credit Spread
1.6 Cost of Equity
CAPM: rE = rf + βE(rm-rf)
1.7 Cost of Capital (WACC)
• Capital structure components should be measured on a market value basis, not a book value or historic basis
• Use a target capital structure rather than the current or historic capital structure
• T always means the incremental tax-rate
• Debt includes long-term debt, financing leases, short-term debt, operating leases used as permanent financing, off-balance financing transactions
• If cash flows are real, first compute nominal WACC, then subtract inflation to get the real WACC (or better use transformation formula)
• Use firm or divisional capital structure not project
1.8 Divisional WACC
1. Determine capital structure of division
2. Find comparable firm (pure play) ( βequity of comparable
3. βequity of comparable: remove effects of capital structure ( βasset of comparable
4. Assume βasset of comparable = best