Chapter Three

Determining the Value of the Firm

3.1. Overview
The WACC is also the appropriate risk-adjusted discount rate for firm projects whose riskiness is
similar to the average riskiness of the firm’s cash flows. When used in this context, the WACC is
often referred to as the firm’s “hurdle rate.” The WACC is a weighted average of the firm’s cost
of equity rE and its cost of debt rD, with the weights created by the market values of the firm’s
equity (E) and debt (D):
E D rD 1 −
WACC = E + D rE + E + D TC

Where,
E = market value of the firm’s equity
D = market value of the firm’s debt
TC = firm’s corporate tax rate
rE = firm’s cost of equity
rD = firm’s cost of debt
3.2. Computing the Value of the Firm’s Equity, E
Of all the computations related to the WACC, computing the value of the firm’s equity is the
easiest: As long as the company is publicly listed, take E to be the product of the number of
shares outstanding times the current value per share. As an example, consider El Paso Pipeline
Partners (EPB), a New York Stock Exchange company that owns gas pipelines and gas storage
facilities. On 29 June 2012, EPB has 205.7 million shares outstanding, each trading at $33.80.
The equity value of the company is $6.953 billion.
A B C
COMPUTING THE VALUE OF EQUITY, E, FOR
EL PASO PIPELINE PARTNERS (EPB)
1
2 Shares outstanding 205.70 Million
3 Share price, 29 June 2012 33.80
4 Equity value ("market cap") 6,953 =B3*B2, million $

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3.3. Computing the Value of the Firm’s Debt, D
We compute the value of the firm’s debt by the market value of its financial debt minus the
market value of its excess liquid assets. A common approximation for this number is to take the
balance sheet value of the firm’s debt minus the value of the firm’s cash balances and minus the
value of its marketable securities. Here’s an example for Kroger:
A B C D

KROGER, COMPUTING NET DEBT

1 (thousand $)
2 2011 2010
3 Cash 825,000 188,000
4 Marketable securities 0 0
5
Short-term and current
6 portion of long-term debt 588,000 1,315,000
7 Long-term debt 7,304,000 6,850,000
8
9 Net debt 7,067,000 7,977,000 =SUM(C6:C7-SUM(C3:C4)

For purposes of computing the weighted average cost of capital, our definition of debt excludes
other debt-like items such as pension liabilities and deferred taxes. Though we consider these
items as debts, it is hard to attach a cost to them; we prefer to approximate the WACC by using
only financial obligations net of liquid assets.
It is not uncommon for a company to have negative net debt—this occurs when the company
has more cash and marketable securities than debt. When this occurs, we set D in the WACC
computation to be a negative number. Both ABC and XYZ Foods Markets are examples:

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 A B C D

ABC has Negative Net Debt

1 (million $)
2 2010 2011
3 Cash 5,498 5,065
4 Marketable securities 16,387 9,772
5
6 Short-term debt and current portion of long- term debt 38 247
7 Long-term debt 2,077 7,084
8 Net debt -19,770 -7,506=SUM(C6:C7)-SUM(C3:C4)
9
XYZ Foods has Negative Net Debt
10 (thousand $)
11 2010 2011
12 Cash 218,798 303,960
13 Marketable securities 329,738 442,320
14
Short-term debt and
current portion of long-
15 term debt 410 466
16 Long-term debt 508,288 17,439
=SUM(C15:C16)-
17 Net debt -39,838 -728,375 SUM(C12:C13)

3.4. Computing the Firm’s Tax Rate, TC

In the WACC formula, TC should measure the firm’s marginal tax rate, but it is common to
measure it by computing the firm’s reported tax rate. Usually this should cause no problems, as
the following example shows:

A B C D E

1 XYZ Foods Market Tax Rate

2 2009 2010 2011
3 Income before tax 250,942 411,781 551,712
4 Income tax expense 104,138 165,948 209,100
5 Tax rate, TC 41.50% 40.30% 37.90% =D4/D3

The tax rate for XYZ Foods is reasonably stable at 38% to 41%. In our WACC computation we
would most likely use the current tax rate or the average over the past several years. Sometimes,
however, this doesn’t work, as the following example shows:

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 A B C D E
1 MERCK TAX RATE
2 2009 2010 2011
3 Income before taxes 15,290,000 1,653,000 7,334,000
4 Income tax expense 2,268,000 671,000 942,000

5 Tax rate, TC 14.83% 40.59% 12.84% =D4/D3

Companies like Merck are very good at placing their income in comfortable tax venues, and it
appears that a reasonable estimate for the tax rate is some-where between 13% and 15%. In
2010, a year of low income for Merck, these tax-planning strategies evidently did not work.
Assuming that Merck’s future profitability is indicated by the two good years 2009 and 2011, we
would most likely assume that Merck’s company’s future tax rate TC is in the range of the 2009
and 2011 tax rate.

3.5. Computing the Firm’s Cost of Debt, rD

We now turn to calculating the cost of debt rD. In principle, rD is the marginal cost to the firm
(before corporate taxes) of borrowing an additional dollar. There are at least three ways of
calculating the firm’s cost of debt. We will state them briefly below and then go on to illustrate
the application of two of the methods that although they may not be theoretically perfect are
often used in practice:
 As a practical matter, the cost of debt can often be approximated by taking the average cost
of the firm’s existing debt. The problem with this method is that it runs the danger of
confusing the past costs with the future anticipated cost of debt that we actually want to
measure.
 We can use the yield of similar-risk, newly issued corporate securities. If a company is rated
A and has mostly medium-term debt, then we can use the average yield on medium-term, A-
rated debt as the firm’s cost of debt. Note that this method is somewhat problematic because
the yield on a bond is its promised return, whereas the cost of debt is the expected return on
a firm’s debt. Since there is usually a risk of default, the promised return is generally higher
than the expected return. Nevertheless, despite the problematic, this method is often a good
compromise.

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 We can use a model that estimates the cost of debt from data about the firm’s bond prices,
the estimated probabilities of default, and the estimated payoffs to bondholders in case of
default.
3.6. Two Approaches to Computing the Firm’s Cost of Equity, rE

The equation for the weighted average cost of capital is WACC = E/ (E + D)*r E
E/(E + D)*rD*(1 − TC). Thus far in this chapter we have discussed the estimation of four of the
five parameters of the WACC equation: E, D, TC, rD. We now come to the most problematic of
the computations related to the WACC parameters the computation of the cost of equity rE.
There are two approaches to rE that can readily be computed:
The Gordon dividend model computes rE based on current dividend Div0, current stock price P0,
and the anticipated growth of future dividends g:
Div 1 g
rE = 0 +  + g
P
0

The capital asset pricing model (CAPM) computes rE based on the risk-free rate rf, the expected
return on the market E(rM), and a firm-specific risk measure β:
rE = rf + β E rM − rf

Where
rf = the market risk-free rate of interest
E (rM) = the expected return on the market portfolio
Cov rstock ,
rM
β = a firm-specific risk measure = Var rM

Each model has its variations and problems.

3.7. Implementing the Gordon Model for rE

The Gordon dividend model derives the cost of equity from the following deceptively simple
statement:
The value of a share is the present value of the future anticipated dividend stream from the share,
where the future anticipated dividends are discounted at the appropriate risk-adjusted cost of
equity rE.

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The simplest application of the Gordon model is the case where the anticipated future growth
rate of dividends is constant. Suppose that the current stock price is P0, the current dividend is
Div0, and the anticipated growth rate of future dividends is g. The Gordon model states that the
stock price equals the discounted (at the appropriate cost of equity rE) future dividends:
Div1 ∗ 1 + Div1 ∗ 1 + Div1 ∗ 1 +
P0 = Div0 1 + g + g2 g 3 g4
+ + …
1 + rE  1 + rE2  1 + rE3  1 + rE4
Div0 ∗

= ∑ t
1 + gt
T

1  1 + rE

P0 = Div0  1 + g , provided
rE − g
|g|<rE

Solving the above equation for rE gives the Gordon formula for the cost of equity:

rE =
Div
0 1 + g + g , provided |g|<rE
P0

Note the proviso at the end of this formula: In order for the infinite sum on the first line of the
formula to have a finite solution, the growth rates of the dividends must be less than the discount
rate. In our discussion of the Gordon model with supernormal growth rates (see below) we return
to the case where this is not true.
To apply this formula, consider a firm whose current dividend is Div0 = $3 per share, whose
share price is P0 = $60. Suppose the dividend is anticipated to grow by 12% per year. Then the
firm’s cost of equity rE is 17.6%:

A B C
1 THE GORDON MODEL COST OF EQUITY
2 Current share price, P0 60
3 Current dividend, Div0 3
4 Anticipated dividend growth rate, g 12%
5 Gordon model cost of equity, rE 17.60% =B3*(1+B4)/B2+B4

Using the Gordon Model to Compute the Cost of Equity for Merck
We apply the Gordon model to Merck, whose 10-year dividend history is given below (note that
some of the data has been hidden):

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 A B C D E F

1 Merck Dividend History

Dividend

Dividend growth

2 Date per share

3 4-Sep-02 0.36 Whole period

4 4-Dec-02 0.36 Quarterly growth 0.39% =(B43/B3)^(1/40)-1

5 5-Mar-03 0.36 Annual growth 1.55% =(1+E4)^4-1

6 4-Jun-03 0.36

7 20-Aug-03 2.88 Last 5 years

8 3-Sep-03 0.37 Quarterly growth 0.50% =(B43/B12)^(1/20)-1

9 3-Dec-03 0.37 Annual growth 2.02% =(1+E8)^4-1
10 3-Mar-04 0.37
11 2-Jun-04 0.37
12 1-Sep-04 0.38
40 13-Sep-11 0.38
41 13-Dec-11 0.42
42 13-Mar-12 0.42
43 13-Jun-12 0.42

The annualized growth rate of Merck’s historical dividends may be either 1.55% or 2.02%,
depending on the period taken. For purposes of computing the cost of equity rE, the question is
which of these rates better predicts future anticipated dividend growth rates. In the spreadsheet
below, we allow for both possibilities. The calculations use Merck’s stock price at the end of
June 2012, P0 = $41.75:
A B C

Computing Merck's rE With the Gordon Model

2 Merck stock price P0, 29 June 2012 10-Feb-00

3 Current dividend

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 4 Quarterly 0.42

5 Annualized dividend, Div0 1.68 =4*B4

6 Dividend growth rate, g

7 Last 5 years 1.55%

8 Last 10 years 2.02%

10 Gordon model cost of equity, rE

11 Using last 5 years' growth 5.64% =$B$5/$B$2*(1+B7)+B7

12 Using last 10 years' growth 6.13% =$B$5/$B$2*(1+B8)+B8

Use this formula rE =

Div
0 1 + g + g
P0
For all practical purposes, given the margin of error in our estimates of the future, these numbers
are identical—remember that we are trying to predict future dividend growth based on past
dividend payouts.

Adjusting the Gordon Model to Account for all Cash Flows to Equity
As illustrated above, the Gordon model is computed on a per-share basis and for dividends only.
However, for purposes of valuing the firm’s equity, the Gordon model should be extended to
include all cash flows to equity. In addition to dividends, cash flows to equity include at least
two additional components:
Share repurchases now account for around 50% of the total cash disbursed by American
corporations to their shareholders.
The issuance of stock by the firm is an important negative cash flow to equity. In many firms the
most important instance of stock issuance is the exercise by employees of their stock options.

3.8. The CAPM: Computing the Beta, β

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The capital asset pricing model (CAPM) is the only viable alternative to the Gordon model for
calculating the cost of capital. It is also the most widely used cost of equity model, the reasons
being both its theoretical elegance and its implementational simplicity. The CAPM derives the firm’s
cost of capital from its covariance with the market return. The classic CAPM formula for the firm’s cost
of equity is:

rE = rf + β E rM − rf where

rf = the market risk-free rate of interest

E(rM) = the expected return on the market portfolio
Cov rstock ,
rM
β = a firm-specific risk measure = Var rM
3.9. Using the Security Market Line (SML) to Calculate Merck’s Cost of
Equity, rE
In the capital asset pricing model, the security market line (SML) is used to calculate the risk-
adjusted cost of capital. In this section we consider two SML formulations. The difference
between these two methods has to do with the way taxes are incorporated into the cost of capital
equation.
Method 1: The Classic SML
The classic CAPM formula uses a security market line (SML) equation that ignores taxes:
Cost of equity, rE = rf + β [ E ( rM ) − rf ]
Here rf is the risk-free rate of return in the economy and E(RM) is the expected rate of return on
the market. The choice of values for the SML parameters is often problematic. A common
approach is to choose:
rf equal to the risk-free interest rate in the economy (for example, the yield on Treasury bills).
E(rM) equal to the historic average of the market return, defined as the average return of a broad-
based market portfolio. There is an alternative approach based on market multiples; both of these
are discussed below. For the current section, we use E(rM) = 8%.
The following spreadsheet illustrates the classic CAPM cost of equity computation for Merck’s
cost of equity:
A B C
COMPUTING THE COST OF EQUITY FOR MERCK
Classic CAPM: rE = rf + b*[E(rM) - rf ]
1

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 2 Merck beta, β 0.6435
3 Risk-free rate, rf 2.00%
4 Expected market return, E(rM) 8.00%
5 Merck cost of equity, rE 5.86% =B3+B2*(B4-B3)

Method 2: The Tax-Adjusted SML

The classic CAPM approach makes no allowance for taxation. Benninga-Sarig (1997) show that
the SML has to be adjusted for the marginal corporate tax rate in the economy. Denoting the
corporate tax rate by TC, the tax-adjusted SML is:
Cost of equity = rf (1 − TC) + β [ E ( rM ) − rf (1 − TC)]
This formula can be applied by substituting rf(1 − TC) for rf in the classic CAPM. Note that the
Tax-adjusted cost of equity has a lower intercept and a higher slope than the classic CAPM:
The intercept is rf (1 − T C) instead of rf. This intercept is lower than the rf intercept of the classic
CAPM.
A B C
Computing the Cost of Equity for Merck
Tax-adjusted CAPM: rE = rf*(1-TC) + b*[E(rM) - rf*(1-TC) ]
1
2 Merck beta, β 0.6435
3 Merck tax rate, TC 12.84% ='Merck tax rate'!D5
4 Risk-free rate, rf 2.00%
5 Expected market return, E(rM) 8.45%
Merck tax-adjusted cost of
6 equity, rE 6.06%=B4*(1-B3)+B2*(B5-B4*(1-B3))
Although the tax-adjusted CAPM is more consistent with an economy with taxation, we confess
that—given the uncertainties surrounding cost of capital computations—the difference between
the classic CAPM and the tax-adjusted CAPM may not be worth the trouble.
3.10. Three Approaches to Computing the Expected Return on the Market, E(rM)
Two critical questions remain in the computation of the cost of equity rE using the CAPM:
 What is the expected return on the market, E(rM)? Should it be computed from historical
data? (And if so, how long should the data series be?) Or perhaps it can be computed
from current market data without resort to history?
 What is the risk-free rate, r f? Should it be a short-term or a long-term rate?
There are three major approaches to computing E(rM):
 The historical return on a major market index

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  The historical market risk premium on the market index
 The Gordon model
All three approaches are illustrated in this section, and their effect on computing Merck’s cost of
equity is illustrated at the end of this section.
E(rM) as the Historical Average Return on a Market Portfolio
A simple approach to computing E(rM) is to take it as the average of the historical returns of a
major market index. In the computation below we illustrate this approach by using Vanguard’s
500 Index Fund as a proxy for the market. The annualized return on this fund since 1987 is
8.27%. We can take this as a reliable proxy for the historical annual average return from holding
the S&P 500:
A B C D

Measuring E(rM) Using Historical Data

Derived from prices for the Vanguard 500 Index Fund (symbol: VFINX)
1 These prices include dividends; April 1987 - June 2012
2 Average monthly return 0.69% =AVERAGE(C10:C311)
3 Monthly standard deviation 4.58% =STDEV(C10:C311)
4
5 Annualized return 8.27% =12*B2
6 Annualized standard deviation 15.87% =SQRT(12)*B3
7
8 Date Price Return
9 1-Apr-87 15.66
10 1-May-87 15.82 1.02% =LN(B10/B9)
11 1-Jun-87 16.62 4.93% =LN(B11/B10)
12 1-Jul-87 17.44 4.82% =LN(B12/B11)
13 3-Aug-87 18.11 3.77% =LN(B13/B12)
293 1-Dec-10 113.11 6.46%
294 3-Jan-11 115.77 2.32%
295 1-Feb-11 119.73 3.36%
296 1-Mar-11 119.76 0.03%
297 1-Apr-11 123.29 2.90%
298 2-May-11 121.88 -1.15%
299 1-Jun-11 119.84 -1.69%
300 1-Jul-11 117.39 -2.07%
301 1-Aug-11 110.99 -5.61%
302 1-Sep-11 103.16 -7.32%
303 3-Oct-11 114.42 10.36%

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 304 1-Nov-11 114.15 -0.24%
305 1-Dec-11 115.32 1.02%
306 3-Jan-12 120.47 4.37%
307 1-Feb-12 125.66 4.22%
308 1-Mar-12 129.78 3.23%
309 2-Apr-12 128.95 -0.64%
310 1-May-12 121.19 -6.21%
311 1-Jun-12 125.55 3.53%

Calculating the Expected Return on the Market Using the Gordon Model

Setting E(rM) = 4.40% approximates the historic market return in the United States for 1987–
2012. Historic averages are appropriate if we think that the future anticipated rates of return will
correspond to the historic average. On the other hand, we may want to take current market data
to calculate directly the future anticipated market yield.
We can do this computation by using the Gordon model. Recall from section 3.6 that the model
says that the cost of equity rE is given by:

rE
Div
0
1 g
    g 
P
0

This formula also applies to the market portfolio, so that we can write:
Div0 1
r
M  g  g, interpreting Div0, P0, and g to be the current dividend,
P
0

price, and growth rate of the market portfolio. Assume that the firm pays out a constant
proportion a of its earnings as dividends; then, indicating by EPS0 the current earnings per share,
Div0 = a*EPS0. Interpreting g to be the earnings growth of the firm, we can write:

a ∗  1 a ∗ 1

E 
rM EPS0 g g
g g
P
0 P0 / EPS0
The term on the right-hand side of this equation, P 0/EPS0, is the price earnings ratio of the
market. We can use this formula to compute E(rM), and thus tie the cost of equity to currently
observable market parameters.

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