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  #21  
Old 11-28-2005, 11:20 PM
Evan Evan is offline
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Default Re: Cost of equity

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Okay, in general it may be true, but not often enough to make the blanket statement that indices are less risky than stocks.

The beta of a market is 1, it is not true that no stock's beta is <1.

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In the way that you used it, Beta represents correlation to the market.

Thus, while it can be used to measure the level of market risk; it can not be used to measure individual stock risk.

I suggest you spend some time on riskgrades

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I know beta is not a measure of an individual stock's risk. I didn't mean to imply that. It was a seperate but somewhat related statement, just in case people reading this thread weren't aware that betas can be <1.
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  #22  
Old 11-28-2005, 11:32 PM
FatOtt FatOtt is offline
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Default Re: Cost of equity

Evan,
Have you had Damodaran at NYU? I was just flipping through one of his books today. How is he as a teacher?

Anyway, I'll stick to the part that I think we disagree on: the idea that market pricing does not determine cost of equity (or debt). The cost of equity is going to be how much the firm has to pay to acquire equity funding. When that firm is faced with a marginal project, how much will they be charged to finance that project via equity funding?

Looking at the stock price and (assuming you can estimate them) the expected future cash flows to equity holders will tell you what discount rate is currently implied by the stock price. If a firm were to issue new shares to finance the project, that's the discount rate that would presumably be applied to those shares as well.

I'm really surprised to see you disagree with the cost of debt. Suppose a firm issues a bond that specifies 10 annual payments of $4 million, plus 1 payment of $50 million at the end of 10 years. Looking at the price of that bond (the proceeds) will tell you the firm's cost of debt. If the firm receives $76,947,755, their cost of debt was 2%. If the firm receives exactly $50,000,000, their cost of debt was 8%. If the firm receives exactly $38,699,554, their cost of debt was 12%. It doesn't matter if buyers of the bonds were perfectly rational economic agents or if they were calculating the value of the bonds by multiplying their shoe size by their hat size - the proceeds from the bond issuance determine the cost of debt. How could it be otherwise?

The implied cost of debt may not be observable for illiquid offerings, but the theory is still the same - the discount rate that equates future cash flows to the current price is that firm's cost of debt (at least for that issuance).

Getting to the Berkshire meeting isn't hard. Every shareholder gets 4 invitations, so you can grab one from someone else who owns it. Because people were starting to sell them online last year, Berkshire started selling tickets on ebay to non-shareholders. $5 apiece, I think.
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  #23  
Old 11-29-2005, 12:15 AM
Evan Evan is offline
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Default Re: Cost of equity

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Have you had Damodaran at NYU? I was just flipping through one of his books today. How is he as a teacher?

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He only teaches grad classes, so I haven't had him yet. I've sat in on some of his classes and he's given a few presentations to a club I'm in. He is exceptionally good at explaining difficult ideas in ways that make them easy to understand.

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When that firm is faced with a marginal project, how much will they be charged to finance that project via equity funding?

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Okay, I can agree with that. But does that means that's the rate you should be using to value the company? If it is then every company you value will be excactly fairly valued because you're taking the market price as a given. I'm not saying that's not the current market cost of equity, so I guess we agree. However, that is not necessarily the rate you should discount future cash flows at. I think you have to agree with that, right?

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I'm really surprised to see you disagree with the cost of debt.

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Your example is correct when examined in a vacuum. The problem is that bonds are issues/traded much less frequently than stocks. If there was a debt issue or trade very recently then it is fine to use market quotes. In many instances though, there may have been months or years since any market data was quoted.

A good example of when market interest rates have been useless is Salton. About a year ago they went through massive refinancing after taking huge (see HUGE) writedowns and restructuring charges that equated to losses of about $8.50/share on a stock trading for ~$6 at the time. Obviously this was more an example of "big bath accounting" than anything else, but the point is they were doing very, very poorly. During this time their market quoted cost of debt remained the same, even though they were obviously sucking wind pretty hard (they had a TON of debt at this time, so it's not like these rates were immaterial). Next, they defaulted. For those that aren't familiar with finance, this is sort of like bancruptcy, excpet that in this case it was a technical default. When you borrow huge amounts of money, as Salton had, you get convenants put on your debt like, "you have to make $x/year in operating income". Needless to say, Salton fell WELL below the required interest coverage ratio due to the writedowns and restructuring. Here's the twist, they lose a bunch of money, default on their debt, but their cost of debt doesn't move up at all. Why? Because the debt holders really had no leverage to do anything to the company. Management was already getting fired, there were new and promising products comign to market, and it looked like things could turn around. Salton didn't issue any new debt and no one wanted to buy their old debt (and the current debt holders didn't really want to sell since they'd get next to nothing for it anyway).

I know that got a little longwinded, but the point is that market rates, for debt or equity, really don't imply as much as you might think about future rates that should be applied to future cash flows.
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  #24  
Old 11-29-2005, 01:05 AM
FatOtt FatOtt is offline
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Default Re: Cost of equity

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Okay, I can agree with that. But does that means that's the rate you should be using to value the company?
If it is then every company you value will be excactly fairly valued because you're taking the market price as a given. I'm not saying that's not the current market cost of equity, so I guess we agree. However, that is not necessarily the rate you should discount future cash flows at. I think you have to agree with that, right?

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Ok, so now we're back at the distinction between:
1) The cost of equity that the firm faces: that will change with the market price of the firm's stock. When the firm's stock price goes down (assuming consistent expected future cash flows), the firm's cost of equity goes up.

2) The cost of equity that you, the investor, would use to value the firm to determine if you believe it's over or undervalued.

At this point, frankly, I'll just stop and say what I do. If I'm trying to value a firm, I estimate future cash flows and calculate the discount rate that equates those future cash flows to the current stock price. If that rate is satisfactory to me, then I may invest. So, for example, I might think that DLTR's future cash flows appear to be discounted at somewhere between 15-20%. That's an acceptable return for me, so I might be DLTR. (I do, in fact, own DLTR.) If that wasn't an acceptable way of doing it, then you could use a beta calculation to estimate the cost of equity you think is appropriate. I agree that using the implied cost of equity to value the firm would be circular - you'd always get the current market price.

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I don't understand your Salton example at all. You state that "During this time [of huge writedowns and bad performance] their market quoted cost of debt remained the same", but then you also say "Here's the twist, they lose a bunch of money, default on their debt, but their cost of debt doesn't move up at all. Why? Because the debt holders really had no leverage to do anything to the company. Management was already getting fired, there were new and promising products comign to market, and it looked like things could turn around. Salton didn't issue any new debt and no one wanted to buy their old debt (and the current debt holders didn't really want to sell since they'd get next to nothing for it anyway). "

That bolded part is exactly what I'm talking about. If the market value of the firm's bonds significantly decreases, that represents an increase in the firm's cost of debt. You can look at the quoted prices of the firm's bonds and calculate the YTM of those bonds, which represents the firm's cost of debt.

Here's some evidence:
In their 2004 10-K (for the year ended July 3, 2004), Salton disclosed that the fair value of their senior subordinated debt was $225.3 million, compared to $274.9 million a year earlier. That significant drop in the fair value of the debt represents a significant increase in the firm's cost of debt - the discount rate (or YTM) that equates the future cash flows to the price of the bonds is the firm's cost of debt.

What is your evidence of the market value of the bonds not changing?


Edited to add:
I just looked up some bond rating changes for Salton. It looks like they had to big issues outstanding recently, one maturing in December 2005 and one maturing in April 2008. The December 2005 bond had the following rating changes (from S&P):
9/25/2003: B-
2/11/2004: CCC+
5/11/2004: CCC-

The ratings for the 2008 maturity bond have the same downward pattern from late 2003 to mid-2004. I think this is more evidence that the firm's cost of debt did, in fact, increase over time as their performance declined. You will admit that a firm's cost of debt is increasing as their credit rating decreases, right?
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  #25  
Old 11-29-2005, 01:17 AM
Evan Evan is offline
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Default Re: Cost of equity

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What is your evidence of the market value of the bonds not changing?

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Quotes from Bloomberg at the time. I don't remember the exact numbers, they did change slightly, but not nearly as much as they "should" have. This company had negative earnings almost 1.5x their market cap! Let's say your numbers were the market prices, that's a change of 22% or about equivalent to a downgrade from BBB to BBB-. Do you really think that's all the true cost of debt changed?
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  #26  
Old 11-29-2005, 01:23 AM
FatOtt FatOtt is offline
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Default Re: Cost of equity

Sorry - we crossed streams. Take a look at my edit. Their debt ratings changed substantially during that time.
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  #27  
Old 11-29-2005, 02:08 AM
FatOtt FatOtt is offline
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Default Re: Cost of equity

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Let's say your numbers were the market prices, that's a change of 22% or about equivalent to a downgrade from BBB to BBB-. Do you really think that's all the true cost of debt changed?

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All right, I just did some quick calculations. First, the company is claiming in their 10-K that the figures I gave were the market values of their structured debt (estimated based on dealer quotes). So I think it's reasonable to say they actually are the market values.

Let's take a look at the implied YTM of these items. We're looking at two notes, one issued on 12/16/98 (face value of $125 million, maturity 12/15/2005, coupon 10.75%), one issued on 4/23/2001 (face value of $150 million, maturity 4/15/2008, coupon 12.25%). I assumed that coupon payments were made annually on the anniversary date, so that coupon payments of $13.4375 million were made annually on 12/15 for the first issue and coupon payments were made annually on 4/15 for the second issue.

At 7/1/2003, when the fair value (market value) of these bonds totaled $274.9 million, I calculate a weighted yield to maturity of 11.86% for the two bonds.

At 7/1/2004, when the fair value was $225.3 million, I calculate a weighted yield to maturity of 21.79% for the two bonds.

That's what I'm talking about when I say that the firm's cost of debt increased significantly. Also, these are relatively short-term maturities. The first issue expires about 18 months after the 10-k, while the second one expires about 4 years after the 10-k. I suspect that change in cost of debt would be much more substantial for longer-duration instruments.

I don't mean to be argumentative, I just happen to be interested in this stuff.
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  #28  
Old 11-29-2005, 02:51 AM
Evan Evan is offline
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Default Re: Cost of equity

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Edited to add:
I just looked up some bond rating changes for Salton. It looks like they had to big issues outstanding recently, one maturing in December 2005 and one maturing in April 2008. The December 2005 bond had the following rating changes (from S&P):
9/25/2003: B-
2/11/2004: CCC+
5/11/2004: CCC-

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Okay, so this basically substantiates what I'm saying. The point is that they never paid these rates. Their public debt stayed at rates relative to the B- rating.

They may well be paying this rate on new debt. I haven't looked at the company is over a year.

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You will admit that a firm's cost of debt is increasing as their credit rating decreases, right?

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Yes, but the rate they pay doesn't always change accordingly. Usually it does; I'm not trying to rework the entire economy, just saying that quoted interest rates do not always equal cost of debt.

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  #29  
Old 11-29-2005, 03:03 AM
Evan Evan is offline
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Default Re: Cost of equity

Okay man, you're obviously doing your homewokr here. I think we're getting too cuaght up in an irrelevant example and losing track of the real discussion. Maybe a more direct example will be better

Let's say a company has ZERO on balance sheet debt. None, nothing, interest expense is zero. But, they have a ton of operating leases. This company will have no bond rating and no publicly traded debt to quote. This does NOT mean that their cost of debt is zero. A good example of such a company is Bed Bath and Beyond (although I don't think they have zero debt, it's very very low and their operating leases are MUCH bigger).

My only point is that market quotes are not a good way to attain your cost of debt. At times they will be right, when recetn trades/issues were long ago they will not be. When companies don't have public debt they will not be. That is all I'm trying to say.
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