Tag Archives: Cost of Capital

Solution to Management Science Series #178: Real-world example: Bottom up beta 🧮Workday, Adobe, Salesforce

Real-world example: Bottom up beta

8 years ago, you co-founded a SaaS company, ‘The Blue Hedgehog’ with your fellow classmates from Cornell University.

You want to estimate the equity beta of your company by using a bottom up beta.

Although there are not many comparable companies, you think that Salesforce, Adobe, and Workday are fair comparables given their business models and their business strategies.

Check whether these companies have a similar operating leverage.

The tax rate for your company is 21%.

Use current risk-free rate and assume that equity risk-premium is 6%.

Calculate the equity beta of your company given that its debt-to-equity ratio is a stable 45% for the last 5 years by using bottom-up beta method.

What would the equity beta of the Blue Hedgehog have been if the required return on the company stock had been 15%?

Compare your results!

Note: Solution of this question, as well as those of all the questions asked so far, is shared on my website.

Solution to Management Science Series #177: How to estimate beta in mergers and acquisitions: Real-world example 🧮 Nvidia and Texas Instruments

How to estimate beta in mergers and acquisitions: Real-world example 🧮

NVIDIA’s top executives are looking for potential targets that could provide economies of scale and scope.

They consider Texas Instruments a top candidate.

Estimate the post-merger beta of NVIDIA for the following two scenarios!

Scenario A: Assume that NVIDIA will pay in equity for this acquisition. Assume that the acquisition will take place on the 31st of December, 2023.

Scenario B: Assume that NVIDIA will issue bonds worth $12B and fund the rest with equity. Assume that the acquisition will take place on the 31st of December, 2023.

Note: Solution of this question, as well as those of all the questions asked so far, is shared on my website.

Solution to Management Science Series #176: Estimating the optimal WACC 🧮

You have calculated the unlevered beta of Adobe as 0.79. Adobe’s cost of debt is estimated to be 3% as of August 2024.

For the risk-free rate, use the current yield on 10-year US Treasuries (20th of August, 2024). Equity risk premium will be 6.5%.

Corporate tax rate for Adobe is 21%. You want to investigate how the WACC of Adobe will change in changing capital structures.

Assume that the cost of debt for Adobe increases with the amount of debt in the capital structure, by 2.75% at each 15% incremental increase in the debt-to-asset ratio.

Investigate how the cost of equity and WACC will change with changing debt-to-assets ratios, i.e. start from 0% and incrementally increase it by 15% and stop when the ratio hits 90%.

Plot the cost of equity, cost of debt, and WACC at changing debt to asset ratios!

Calculate the optimal value of WACC!

Solution to Management Science Series #174: Capital Structure and WACC🧮

You have calculated the unlevered beta of Adobe as 0.79 (actually, this is the answer of the question posted on the 4th of January, 2025. If your estimate were different from that value in higher orders of magnitude, you should check your model and assumptions).

Adobe’s cost of debt is estimated to be 3% as of August 2024.

For the risk-free rate, use the current yield on 10-year US Treasuries (9th of August, 2024).

Equity risk premium will be 6.5%. Corporate tax rate for Adobe is 21%.

You want to investigate how the WACC of Adobe will change in changing capital structures.

Assume that the cost of debt for Adobe does not increase with the amount of debt in the capital structure (seemingly not realistic but there are such cases; do you know why?).

Investigate how the cost of equity and WACC will change with changing debt-to-assets ratios, i.e. start from 0% and incrementally increase it by 15% and stop when the ratio hits 90%.

Plot the cost of equity, cost of debt, and WACC at changing debt to asset ratios!

Solution to Management Science Series #173: How to estimate project betas 🧮Adobe Example

How to estimate project betas 🧮

Adobe plans to invest in a project, risk of which is similar to company’s own risk.

Nonetheless, Adobe plans to finance this project with only equity (100% equity-financed).

Estimate the beta of this project!

On Capital Asset Pricing Model (CAPM) and its real-world validity: Investigating Amazon stock

Does CAPM really do its job of simplifying the calculation of cost of equity and returns on individual stocks? How is its predictive power in estimating stock returns? Can it cause the returns on very disparate stocks to converge? What can one do to assess the risk of and returns on stocks better?
In this article, I investigate Amazon stock and compare the expected returns on Amazon stock calculated through the use of different approaches while also discussing the perils of CAPM.

Solution to Management Science Series #172: Real world example: Cost of Equity of Netflix 🧠

Calculate the cost of equity for Netflix.

Calculate two betas; one for the last 10 years and the other for the last 5 years.

Use the equity risk premium you calculated in the previous post through the historical approach.

Solution to Management Science Series #171: Estimating Equity Risk Premiums

Calculate the implied equity risk premium!

Assume that S&P 500 is the market portfolio.

Base your calculations on the data for 2022 year-end.

Assume that consensus analysts’ 5-year growth rate to forecast cash flows for the next five years is 5% a year.

For the terminal growth rate, use the yield on the 10-year US Treasury.

Also calculate the equity risk premium by using the historical approach and observing the last 50 years, using 2022 as the end year!

Compare the results you get from both methods!

Solution to Management Science Series #170: Which risk-free rate?  🧠

Which risk-free rate?
1. You need to value a Turkish company whose revenues and expenses are in Turkish Liras. What should the risk-free rate be in this valuation?
2. As an investor, you want to consider the default risk of the government in your valuation for this company. What should the risk-free rate be in that valuation?