Cost of equity

The cost of equity is an estimation of the expected return on the company’s stock. This is most commonly estimated using CAPM²¹, or some variation of the CAPM depending on the risk of the individual company (Koller et al., 2005). The CAPM theory is based on the principle that the expected return of any security is a function of the risk free rate, the systematic risk, measured as the covariance between the security and the movements in the overall market (β) and the market risk premium. Evidently, when valuing a private company challenges arise since the company’s shares are not publicly traded and the CAPM cannot be used in a traditional sense. Despite this, Petersen at al. (2006) find that CAPM still is the most commonly used method for estimating the cost of equity for private companies. As such, in line with research approach of this thesis, the CAPM model is will be applied. Before doing so, there are three inputs that need to be estimated: the risk-free rate, the systematic risk component (beta), and the market risk premium.

Risk-Free Rate

The risk-free rate is the return that investors can expect when investing in a “riskless” security (Pearl

& Rosenbaum, 2013). Both practitioners and academics have discussed the issue of whether there is an asset that is truly risk-free, reaching the conclusion that long-term U.S. or Western European government bonds are considered as good proxies for a “riskless” security since in practice these are considered default-free (Kollet et al., 2005; Petersen & Plenborg, 2012). Ideally, each cash flow should be discounted using a

21 CAPM: rE= r_f+ β × (Market Risk Premium)

77 government similar maturity, however, this is disregarded by both academics and practitioners as incorporating this in the valuations is a tedious process (Petersen & Plenborg, 2012; Kollet et al., 2005).

Further, since the applied valuation assume infinite cash flows, this implies using a bond with the longest possible maturity. Yet, longer-dated bonds, such as those with 30-year maturity likely suffer from decayed prices and yield premiums due to their illiquidity. In addition, theory suggest zero-coupon bonds as the most valid proxy to eliminate reinvestment risk (Koller et al., 2005).

For valuation purposes, finance literature therefore suggests using a 10-year zero-coupon government bond.

As such, this thesis will use the 10-year German government bond as a proxy for the risk-free rate. This will treat issues such as inflation consistently since cash flows and risk free rate will be on a nominal basis and measured in the same currency. The current yield for a 10-year German government bond is quoted at 0,454% (see appendix 14)

Systematic Risk

Beta is a function of the return on an individual stock and the market portfolio and is a measure of the systematic risk. As stated previously, the shares of privately held companies are not traded on a stock exchange, which leads to the inability of estimating company specific beta. Thus, alternate approaches have to be adapted. Petersen and Plenborg (2012) suggest estimating beta using publicly traded comparable companies and Koller, Goedhart, and Wessels (2005) suggest using industry beta as the superior alternative, both approaches will be adapted to increase the accuracy of the beta estimate.

Estimating Beta: Comparable company approach

Damodaran (2009) state the three major components for estimating beta:

i. The market index ii. The time period iii. The return interval

As Damodaran (2009) points out, though there are no indices that truly represent the market portfolio, market weighted indices containing as many securities as possible is an accepted substitute. Further, the market index should reflect the extent to which the marginal investor is diversified to better represent the systematic risk that the investor is exposed to. Considering the fact that Volvo operates globally, the MSCI World Index is arguable the most appropriate index²². The choice of index is supported by the suggestions of Koller et. al. (2005). Further, the time period is to be chosen in a way that yields the beta that best represents the future. That means, a longer observation period does not necessarily yield a “better” estimate of future beta (Damodaran, 2009). However, the beta has been derived through regression analysis on both a five and ten-year interval to also cover the global financial crisis.

22 The MSCI World Index is a broad global equity benchmark that represents large and mid-cap equity performance across 23 developed markets countries (Source: www.msci.com/world)

78 Damodaran (2009) and Koller et al. (2005) suggest that the return interval should be sufficiently long to not be affected by non-trading days which could affect the beta estimate and suggest monthly data points as the most appropriable interval. Koller et al (2005) state the number observations should exceed 60, which is in line with common statistic methodology, and that monthly returns are the most appropriable to avoid systematic bias. This is ensured when performing both a five and ten-year regression analysis on monthly data points.

The estimated beta coefficients are seen in table 17 and regression output in appendix 15 and show that the estimated company specific betas are much higher on average when using a ten-year period than a five.

Further, to limit the probability of operational changes the five-year period is considered the most appropriate, which is supported by Koller et al (2006) who suggest the interval as common practice.

The average levered beta during the five-year period is 1,67 providing with a 95% confidence that the true beta lay between 0,99 to 2,34. In order to derive Volvo’s beta from the peer group one must first unlever the betas seen in table 17. This is done by dividing the levered beta with one plus the debt to equity ratio²³. The key assumptions underlying this equation is that the beta on debt is zero, the capital structure constant and future tax shields unknown (Koller et. al., 2005). The average unlevered beta is 0,97, with Mazda driving up the average with an unlevered beta of 1,9.

Table 17. Comparable companies unlevered beta

Source: Own construction

Estimating Beta: Industry approach

Another way to estimate beta is using industry average, which is suggested by Koller et al (2006) as a way to improve the estimate of future beta. Given the rather large group of comparable companies used to derive peer group beta this measure should lay in the proximity of the previously derived beta. In the long run company beta should approach the industry average. Damodaran (2017b) provide an estimate of the

23 𝛽𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 =^{𝛽𝐿𝑒𝑣𝑒𝑟𝑒𝑑}

(1+^𝐷 𝐸)

(€ millions) Levered Book Market Debt/ Unlevered

Company Beta Value of NIBD Value of Equity Equity Beta

BMW 1,12 86.121 54.270 1,59 0,43

Renault 2,48 31.543 23.736 1,33 1,07

Ford 2,08 88.221 42.406 2,08 0,68

GM 1,45 62.605 56.506 1,11 0,69

Fiat Chrysler 2,19 17.197 19.388 0,89 1,16

Mazda 2,08 1.214 7.777 0,16 1,80

Average 1,90 47.817 34.014 1,19 0,97

79 unlevered industry beta using 128 companies of 0,7. This is considerably lower and provides an unlevered beta range of 0,7-0,97.

Based on the above discussion, Volvo’s unlevered beta is estimated 0,83, which is the average of the peer group and industry beta. By re-levering the beta using Volvo’s target debt to equity ratio of 0,94, the levered beta is estimated to 1,66.

Market Risk Premium

The market risk premium reflects the excess return of the market portfolio relative to the risk-free rate.

Petersen and Plenborg (2012) state three main methods to estimate the premium, construct a sample of investor estimates and take the average, calculate the premium based on historical data or calculate the implicit premium based on current share price. The first approach will be used in this thesis because it allows the potential for leveraging several estimations performed by professionals. Petersen and Plenborg (2012) report a risk premium between 5,3-7,9 % depending on the geographical region where the lower bound represents mature markets and the upper represent “other” which is based on the risk premium used by 224 industry professionals. Damodaran (2017b) provides a global weighted average risk premium of 7,06%.

In line with the reasoning throughout this thesis, the global average of 7,06% is considered the most suitable market risk premium.

Adjustments to cost of equity

As highlighted by Petersen et al. (2006), scholars often times suggest adding a premium for lack of marketability (illiquidity) due to the difficulties of turning privately held ownership shares into cash. This does not only comply to private firms but also publicly traded ones with low trading volumes (Mellen and Evans, 2010). The determination of whether a marketability premium is appropriate or not is determined by the identity of the investor. In case of a private buyer, both financial and strategic, this would be appropriate as the owners would not be able to easily convert ownership to cash. On the other hand, in case of a publicly traded buyer or an IPO, a marketability premium is not deemed appropriate. This is based on that even though Volvo is the smallest company in the peer group, analysts deem it likely that the company would make the third largest IPO on the Nordic stock markets after Telia and Dong, and thus, trading volumes are expected to be high (Hägerstrand, 2017).

Thus with no adjustments, using the CAPM and estimated risk free rate of 0,454%, equity beta of 1,66 and a market risk premium of 7,06%, yields a cost of equity of 12,2%.

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