Top 5 – Review of the Year 2012

Just before 2013 begins, we recall the most popular posts of 2012, which shed light on creativity and innovation, the economy and the crisis. These 5 posts attracted the most views from February to December 2012 (as we started blogging on this platform in February). If you missed these articles the first time around, now is your time to see why our readers found these pieces so compelling.

The fifth most viewed post was Types of Innovation and Economic Growth posted in November 2012. This post discussed the different ways in which innovation can lead to economic growth, based on an article published by Clay Christensen in the NYT.

Number 4 was Bad loans, ECB intervention and competitive advantages which addressed the problems of the portuguese financial situation regarding bad loans. We argue that the bad loans problem will be solved once the innovation challenge is properly addressed.

Portugal’s austerity measures and the impact on business innovation , a post about the lack of impact of the announced austerity measures on business innovation, was number 3 in terms of readership. This post was published on 20 September, after the Portuguese prime minister’s announcement (on 7 September) of the Government’s intention to change the rates of social security contributions. This announcement sparked a political crisis, which culminated in large-scale demonstrations.

The second place goes to Stop obsessing about the next black swan and innovate which addresses the themes of business innovation and financial modeling.

The top post of 2012 is Innovation and Portuguese film production from January, which describes the problems and barriers met in film production in Portugal, which stifle innovation in this industry.

Due to the nature of blogging, these statistics are not 100% relevant, since posts published in early 2012 attract more viewers as time passes. The most viewed post has been online for nearly 12 months, but it is likely for instance that “Types of innovation and economic growth” (published in November) will attract more readers when compared on a like-for-like basis.

This was a year of change, during which we commented on some of the major political and business developments and tried to put forward actual examples of good practices. It was a pleasure to interact with our readers and we hope we can continue to count on you in 2013. Have a great year!

 

Estimating the cost of capital

In the subject of project valuation, most companies adopt a method that suits their financial and overall economic environment. When valuing a project (or an acquisition), companies need to choose the right parameters for their financial models, consistent with the risks involved and do not behave in the same way. Between choosing the risk-free rate and its periodicity, the cost of debt and equity and the data sources, companies use different valuation methods.

The 2011 survey by the Association for Finance Professionals on the cost of capital (“Current Trends in Estimating and Applying the Cost of Capital”) provides evidence on the project valuation process of 309 companies. The average company evaluates projects using the Discounted Cash Flow model, develops an explicit cash flow forecast for the first five years of the project or investment, and applies an estimated terminal value to all cash flows thereafter.

One of the most surprising facts in this survey is that 84 of the 309 companies surveyed forecast using a one-year horizon, which is inappropriate, as a short projection period will not produce a realistic financial analysis.

Another surprising fact is that the choice of the risk-free rate that is all but consensual in project valuation. Assuming that all the companies in the survey are based in the US, the risk-free rate used should be the returns on US long-term Government bonds, adjusted by the respective country risk premiums if the company in question has operations outside the country. However, this is not the case.

The choices of the typical company

The survey concludes that, on average, a typical company uses discounted cash flow (DCF) analysis to evaluate the uses of its capital when considering competing projects and long-term investments. When estimating the cash flows to be discounted, the organisations develop an explicit cash flow forecast for the first five years of the project or investment, and applies an estimated terminal value to all cash flows thereafter, using the perpetuity growth model to estimate that terminal value.

Recognising the unpredictability of forecasted cash flows, the typical company uses multiple cash flow scenarios, including best case, expected case, and worst case forecasts. To find the rate at which to discount cash flows, the typical organisation calculates its weighted average cost of capital (WACC) and reviews that calculation only when needed for a valuation.

Furthermore, the companies surveyed do not usually adjust the WACC to reflect factors unique to the project or investment being considered. Those companies recognise that the estimate of WACC is not perfect, but believe it to be accurate within a range of plus or minus 75 basis points. When valuing a potential acquisition, these companies use the estimated cost of capital from a group of companies comparable to the potential acquisition target.

To determine the weights to apply to the cost of debt and the cost of equity in determining the WACC, the typical organisation uses the current book debt-to-equity ratio. The nominal cost of debt is based on the current interest rate on the company’s outstanding debt, with the after-tax cost of debt being calculated using the company’s effective tax rate.

The typical company uses the capital asset pricing model (CAPM) to calculate their cost of equity. To perform that calculation, it uses the current rate on the 10-year Treasury note as risk-free rate. Regardless of where that rate is, the typical company does not impose any floor or cap on the risk-free rate.

The following are some charts that summarise the most relevant valuation assumptions used to produce valuation estimates, according to the survey:

[Updated December 2012 by Hugo Mendes Domingos]

Free valuation e-book: Modelling Innovation – Chapter on Net Present Value of Free Cash Flows

We are now releasing the preview of the next installment of our free valuation e-book. Chapter 5 can be downloaded here.  Continuing with the company valuation theme, Chapter 5 focuses on describing how to calculate the Net Present Value of Free Cash Flows, answering the following questions:

• What is the Mid-Period Convention?
• How to calculate the NPV of FCF.
• Practical example on valuation of company project.

We look forward to hearing from you, so do let us know your comments.