Ten topics poorly explained in most corporate finance books
Pablo Fernandez
University of Navarre – IESE Business School
November 17, 2015
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Abstract:
This article discusses 10 corporate finance topics that aren’t covered well (or at all) in many corporate finance books. The subjects are:
- Where does the WACC equation come from.
- The WACC is not a cost.
- How is the WACC equation when the value of the debt is not equal to its face value.
- Textbooks differ widely on their recommendations for equity premium.
- The term equity premium is used to refer to four different concepts.
- What equity premium do professors and practitioners use?
- Calculated (historical) betas change significantly from day to day.
- Why do many teachers continue to use calculated (historical) betas in the classroom?
- EVA does not measure shareholder value creation.
- The relationship between the WACC and the value of tax shields (VTS).
Ten topics poorly explained in most corporate finance books – Introduction
The term equity premium is used to refer to four different concepts
Capital premium (also called market risk premium, capital risk premium, market premium and risk premium), is one of the most important and discussed, but elusive parameters in finance. Part of the confusion stems from the fact that the term capital premium is used to refer to four different concepts:
- Historical Equity Premium (HEP): historical differential return of the stock market relative to Treasuries.
- Expected equity premium (EEP): expected differential return of the stock market relative to Treasury bills.
- Required Equity Premium (REP): incremental return of a diversified portfolio (the market) relative to the risk-free rate required by an investor. It is used to calculate the required return on equity.
- Implicit Capital Premium (IEP): The required capital premium that arises from the assumption that the market price is correct.
Equity premium refers to four different concepts: Historical Equity Premium (HEP); Expected Capital Premium (EEP); Required Equity Premium (REP); and the implicit capital premium (IEP). Although the HEP is equal for all investors, the REP, EEP and IEP are different for different investors.
There is a sort of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors seek a single discount rate. It seems that the cash flow expectations of stocks are formed in a democratic regime, while the discount rate is determined in a dictatorship.
A single IEP requires assuming homogeneous expectations for expected growth (g), but we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole because it does not exist.
Chapter 13 shows that 129 out of 150 books identify the expected and required capital premium and 82 identify the expected and historical capital premium. This is also explained in Chapter 12 “Equity Premium: Historical, Expected, Required and Implied”, downloadable from http://ssrn.com/abstract=933070
Textbooks differ widely on their recommendations for equity premium
Chapter 15 (“The Equity Premium in 150 Textbooks”) reviews 150 textbooks on corporate finance and valuation published between 1979 and 2009 by authors such as Brealey, Myers, Copeland, Merton, Ross, Bruner, Bodie, Penman, Arzac, Damodaran… and shows that their equity premium recommendations vary from 3% to 10%, and that 51 books use different equity premiums in different pages. Figure 1 contains the evolution of the Required Equity Premium (REP) used or recommended by 150 Pounds, and helps explain the confusion that many students and practitioners have about the equity premium. The average is 6.5%.
What equity premium do professors, analysts and practitioners use?
A survey shows that the average Market Risk Premium (MRP) used in 2011 by professors for the USA (5.7%) is higher than that used by analysts (5.0%) and companies (5.6%) . The standard deviation of the MRP used in 2011 by analysts (1.1%) is lower than that of companies (2.0%) and professors (1.6%).
What equity premium do professors, analysts and practitioners use?
A survey shows that the average Market Risk Premium (MRP) used in 2011 by professors for the USA (5.7%) is higher than that used by analysts (5.0%) and companies (5.6%) . The standard deviation of the MRP used in 2011 by analysts (1.1%) is lower than that of companies (2.0%) and professors (1.6%).
See the full PDF below.
Updated