# RESEARCH PAPERS | CORPORATE VALUATION

Capital Structure

### TARGET CAPITAL STRUCTURE IN THE WACC, DE-LEVERN AND RE-LEVERN IN CORPORATE VALUATION - GROSS DEBT OR NET DEBT?

Bernhard Schwetzler

2017

When transferring industry or peer group betas to non-listed individual firms differences in the capital structure have to be taken into account. The standard adjustment for this differences is referred as the “de-levering and re-levering” procedure of the beta factor. This paper analyzes whether this adjustment shall be based on the gross leverage or on the net leverage of the peer group and the firm. For the valuation of the firm, it is shown that the target capital structure of the firm's WACC may be defined in both ways as long as the free cash flow definition used reflects the corresponding assets invested properly. However, when transferring peer group betas to individual firms by "de- and re-levern" only the leverage based on net debt yields correct results. >more

Discount Rates

### DISCOUNT RATE (RISK-FREE RATE AND MARKET RISK PREMIUM) USED FOR 41 COUNTRIES IN 2017: A SURVEY

Pablo Fernandez, Vitaly Pershin, and Isabel Fernández Acín

2017

This paper contains the statistics of a survey about the Risk-Free Rate (RF) and the Market Risk Premium (MRP) used in 2017 for 41 countries. We got answers for 68 countries, but we only report the results for 41 countries with more than 25 answers. The average (RF) used in 2017 was smaller than the one used in 2015 in 12 countries (in 5 of them the difference was more than 1%). In 10 countries the average (RF) used in 2017 was more than a 1% higher than the one used in 2015. The change between 2015 and 2017 of the average Market risk premium used was higher than 1% for 11 countries. Most of the respondents use for Europe and UK a Risk-Free Rate (RF) higher than the yield of the 10-year Government bonds. Due to Quantitative Easing, the Risk-Free Rate (RF) and the Market Risk Premium (MRP) reported for Euro countries are negatively correlated (Spain - 51%; Germany -28%; France -47%; Italy -30%). >more

Equity Premium

### MACRO-FINANCE

John H. Cochrane

2016

Macro-finance addresses the link between asset prices and economic fluctuations. Many models reflect the same rough idea: the market’s ability to bear risk is greater in good times, and less in bad times. Models achieve this similar result by quite different mechanisms. I contrast their strengths and weaknesses. I highlight directions for future research, including additional facts to be matched, and limitations of the models that should prod future theoretical work. I describe how macro-finance models can fundamentally alter macroeconomics, by putting time-varying risk premiums and risk-bearing capacity at the center of recessions rather than variation in the interest rate and intertemporal substitution. >more

Bank Valuation

### THE IMPACT OF TERM STRUCTURE AND TERM TRANSFORMATION STRATEGIES ON THE CORPORATE VALUE OF BANKS – A COMPARISON BETWEEN CONTROLLING-BASED VALUATION CONCEPTS AND DCF-MODEL

Bernhard Schwetzler

2016

This paper compares two different concepts for bank valuation: a controlling-based concept splitting the bank into three parts (credit-, deposit-, and treasury bank) and valuing them separately, against a standard DCF-Flow to Equity valuation model. The controlling-based concept allows to separate current realized and future expected interest income generated by term transformation, i.e. by exploiting differences between different maturities via maturity mismatch of assets and liabilities, from the bank´s excess interest income (or interest savings) against market interest rates with the same TM. The results show that depending on the shape of the term structure and the term transformation strategy chosen by the bank´s management significant differences between the corporate values derived by the two valuation models may occur when being applied upon the same bank. >more

Market Risk Premium

### DIE IMPLIZITE MARKTRISIKOPRÄMIE AM ÖSTERREICHISCHEN KAPITALMARKT

Christian Aders, Ewald Aschauer, and Markus Dollinger

2016

This paper empirically estimates the implicit market risk premium for the Austrian capital market and presents average returns of the ATX index. >more

Equity Risk Premium

### THE EQUITY RISK PREMIUM IN 2016

John R. Graham, and Campbell R. Harvey

2016

We analyze the history of the equity risk premium from surveys of U.S. Chief Financial Officers (CFOs) conducted every quarter from June 2000 to June 2016. The risk premium is the expected 10-year S&P 500 return relative to a 10-year U.S. Treasury bond yield. The average risk premium in 2016, 4.02%, is slightly higher than the average observed over the past 16 years. We also provide results on the risk premium disagreement among respondents as well as asymmetry or skewness of risk premium estimates. We also link our risk premium results to survey-based measures of the weighted average cost of capital and investment hurdle rates. The hurdle rates are significantly higher than the cost of capital implied by the market risk premium estimates. >more

Risk Premium

### THE GLOBALIZATION RISK PREMIUM

Jean-Noel Barrot, Erik Loualiche, and Julien Sauvagnat

2015

We investigate how globalization is reflected in asset prices. We use shipping costs to measure U.S. firms’ exposure to globalization. We find that firms in low shipping cost industries carry a 7.8 percent risk premium, suggesting that their cash-flows covary negatively with U.S. investors’ marginal utility. To understand the origins of this globalization risk premium, we develop a dynamic general equilibrium model of trade and asset prices. Guided by the model, we find that the premium emanates from the risk of displacement of least efficient firms triggered by import competition. These findings suggest that foreign productivity shocks are associated with times where consumption is dear for U.S. investors. >more

Cost of Capital

### ASSESSING COST-OF-CAPITAL INPUTS

Yaron Levi, and Ivo Welch

2016

Cost-of-capital assessments with factor models require quantitative estimates. Our paper investigates the forward performance of simple and common historical beta estimators. Because underlying betas are themselves time-varying, we recommend estimating Vasicek-shrunk betas with one to four years of daily stock returns and then shrinking these betas a second time — and more so for smaller stocks and longer-term projects. If own historical stock returns are not available, market cap-based peer betas (and not industry betas) should be used. We could not identify meaningful improvements to this simple estimator. This estimator also worked well in other OECD countries and for SMB and HML exposures. A duration-based cost-of-capital estimator ignoring the market-beta performs about as well. >more

CAPM

### THE MARKET PORTFOLIO IS NOT EFFICIENT: EVIDENCES, CONSEQUENCES AND EASY TO AVOID ERRORS

Pablo Fernandez, Jose Paulo Carelli, and Alberto Ortiz Pizarro

2016

The Market Portfolio is not an efficient portfolio. There are many evidences that tell us that: the equal weighted indexes have beaten their market-value weighted indexes for many years, many easy-to-build portfolios (some “smart-beta”, “multifactors”) have beaten market-value weighted indexes. We document evidences about seven Equal weighted indexes that have had higher returns than the corresponding market-value weighted index: S&P500, MSCI Emerging Markets, FTSE 100, MSCI World. MSCI, DAX 30 and IBEX 35. However, many finance and investment books still recommend to diversify in the same relative proportions as in a broad market index such as the Standard & Poor’s 500, many funds compare their performance with the return of market-value weighted indexes. Without homogeneous expectations, the market portfolio cannot be an efficient portfolio for all investors. In this document we also cover: a) volatility and beta being bad measures of risk; b) the unhelpfulness of the Sharpe ratio; and c) common (and easy to avoid) errors in portfolio management and corporate finance. >more

Equity Returns

### THE TERM STRUCTURE OF EQUITY RETURNS: RISK OR MISPRICING?

Michael Weber

2015

The term structure of equity returns is downward-sloping: stocks with high cash-flow duration earn 1.10% per month lower returns than short-duration stocks in the cross section. I create a measure of cash-flow duration at the firm level using balance-sheet data to show this novel fact. The difference in returns is three times larger after periods of high investor sentiment than it is following low-sentiment periods. Factor models can explain only 50% of the return differential between high- and low-duration stocks. I use institutional ownership as a proxy for short-sale constraints, and find the negative cross-sectional relationship between cash-flow duration and returns is only contained within short-sale constrained stocks. This set of facts holds for small and large stocks, as well as for value and growth stocks. >more

Asset Pricing

### INTERNATIONAL TESTS OF A FIVE-FACTOR ASSET PRICING MODEL

Eugene F. Fama, and Kenneth R. French

2015

Average stock returns for North America, Europe, and Asia Pacific increase with the book-to-market ratio (B/M) and profitability and are negatively related to investment. These patterns are strong for small stocks but weaker for big stocks. For Japan the relation between average returns and B/M is strong in all Size groups, but average returns show little relation to profitability or investment. Especially for big stocks, a five-factor model that adds profitability and investment factors to the three-factor model of Fama and French (1993) largely absorbs the patterns in average returns. As in Fama and French (2015a,b), the model’s prime problem is failure to capture fully the low average returns of small stocks whose returns behave like those of unprofitable firms that invest aggressively. >more

Price efficiency

### WHEN TRANSPARENCY IMPROVES, MUST PRICES REFLECT FUNDAMENTALS BETTER?

Snehal Banerjee, Jesse Davi, and Naveen Gondhi

2015

Regulation often mandates increased transparency to improve how informative prices are about fundamentals. We show that such policy can be counterproductive. We study the optimal decision of an investor who can choose to acquire costly information not only about asset fundamentals but also about the behavior of liquidity traders. We characterize how changing the cost of information acquisition affects the extent to which prices reflect fundamentals. When liquidity demand is price-dependent (i.e., driven by feedback trading), surprising results emerge: higher transparency, even if exclusively targeting fundamentals, can decrease price informativeness, while cheaper access to non-fundamental information can improve efficiency. >more

Discount Factor

### MISSPECIFIED RECOVERY

Jaroslav Borovi?ka, Lars Peter Hansen, and Jose A. Scheinkman

2015

Asset prices contain information about the probability distribution of future states and the stochastic discounting of these states. Without additional assumptions, probabilities and stochastic discounting cannot be separately identified. To understand this identification challenge, we extract a positive martingale component from the stochastic discount factor process using Perron-Frobenius theory. When this martingale is degenerate, probabilities that govern investor beliefs are recovered from the prices of Arrow securities. When the martingale component is not trivial, using this same approach recovers a probability measure, but not the one that is used by investors. We refer to this outcome as "misspecified recovery." We show that the resulting misspecified probability measure absorbs long-term risk adjustments. Many structural models of asset prices have stochastic discount factors with martingale components. Also empirical evidence on asset prices suggests that the recovered measure differs from the actual probability distribution. Even though this probability measure may fail to capture investor beliefs, we conclude that it is valuable as a tool for characterizing long-term risk pricing. >more

Asset Pricing Models

### EQUITY RISK FACTORS AND THE INTERTEMPORAL CAPM

Ilan Cooper, and Paulo F. Maio

2015

We evaluate whether several equity factor models are consistent with the Merton's Intertemporal CAPM (Merton (1973), ICAPM) by using a large cross-section of portfolio returns. The state variables associated with (alternative) profitability factors help to forecast the equity premium in a way that is consistent with the ICAPM. Additionally, several state variables (particularly, those associated with investment factors) forecast a significant decline in stock volatility, being consistent with the corresponding factor risk prices. Moreover, there is strong evidence of predictability for future economic activity, especially from investment and profitability factors. Overall, the four-factor model of Hou, Xue, and Zhang (2014a) presents the best convergence with the ICAPM. The predictive ability of most equity state variables does not seem to be subsumed by traditional ICAPM state variables. >more

Return Predictibility

### RETURN PREDICTABILITY: LEARNING FROM THE CROSS-SECTION

Julien Penasse

2015

This paper develops an estimation framework in which the true parameters of international return processes share a common distribution. The model (i) makes efficient use of the cross-sectional correlation in the residuals, (ii) incorporates cross-sectional information in the estimation process, and (iii) introduces economic constraints on equity premium forecasts. The effect on estimation precision is remarkably strong and manifests itself both in- and out-of-sample. Once cross-sectional information is accounted for, the international evidence of return predictability appears much less heterogeneous than previously reported. The United States stands out as the exception rather than the rule in having both an unusually large long-term equity premium and an unusually strong return predictability. >more

Risk Premium

### TIME-VARYING RISK PREMIUM IN LARGE CROSS-SECTIONAL EQUITY DATASETS

Patrick Gagliardini, Elisa Ossola, and O. Scaillet

2011

We develop an econometric methodology to infer the path of risk premia from large unbalanced panel of individual stock returns. We estimate the time-varying risk premia implied by conditional linear asset pricing models through simple two-pass cross-sectional regressions, and show consistency and asymptotic normality under increasing cross-sectional and time series dimensions. We address consistent estimation of the asymptotic variance, and testing for asset pricing restrictions. Our approach also delivers inference for a time-varying cost of equity. The empirical illustration on over 12,500 US stock returns from January 1960 to December 2009 shows that conditional risk premia and costs of equity are large and volatile in crisis periods. They exhibit large positive and negative strays from standard unconditional estimates and follow the macroeconomic cycles. The asset pricing restrictions are rejected for the usual unconditional four-factor model capturing market, size, value and momentum effects but not for its conditional version using scaled factors. >more

Cross-sectional Equity & Bond Returns

### ANOMALIES AND MARKET (DIS)INTEGRATION

Jaewon Choi, and Yongjun Kim

2015

If the equity and corporate bond markets are integrated, risk premia in one market should also appear in the other, and the magnitudes of these premia should be consistent with contingent claim pricing. We use this insight to test market integration by examining the joint cross section of equity and corporate bond returns. We find evidence inconsistent with market integration --- some variables (e.g., profitability and net issuance) that explain equity returns do not explain corporate bond returns, and for others the cross-sectional return premia in the bond market are too large relative to those implied by contingent claims pricing. These discrepancies in the relative premia covary with aggregate investor sentiment and are concentrated on the short side of long-short portfolios, thus suggesting that market segmentation is severe when noisy investor demand is stronger and short sale impediments are present. >more

Consumption CAPM

### DOES MONEY HELP TO RESCUE THE CONSUMPTION-CAPM?

Paulo F. Maio, and Andre C. Silva

2014

This paper offers a simple macroeconomic asset pricing model that extends the consumption model by adding the growth in real money balances as a risk factor. The results from Euler equations estimation show that the monetary model improves significantly the baseline model in terms of pricing errors. Yet, the parameter estimates are economically implausible in most cases. Specifically, the estimates for the share of money in the utility function are very large in economic terms. The results for a linear version of the monetary model show that it cannot outperform the standard CCAPM in explaining cross-sectional risk premia. >more

Sales Method

### DETERMINANTS AND SHAREHOLDER WEALTH EFFECTS OF THE SALES METHOD IN M&A

Frederik P. Schlingemann, and Hong Wu

2014

We analyze the sales method for a sample of 575 M&A deals announced between 1998 and 2012 and find that targets use auctions to increase the probability of finding bidders that can relax their financial constraints rather than to create operational synergies. Auctions, compared to negotiated deals, are associated with significantly higher target announcement returns, especially for relatively small targets. Bidder returns are positively related to auctions for bidders acquiring relatively small targets, not for the full sample. Taking into account size differences, we find that auctions, decrease target gains and increase bidder gains expressed in dollars. >more

Asset Pricing Models

### ASSESSING ASSET PRICING MODELS USING REVEALED PREFERENCE

Jonathan Berk, and Jules H. Van Binsbergen

2014

We propose a new method of testing asset pricing models that relies on using quantities rather than prices or returns. We use the capital flows into and out of mutual funds to infer which risk model investors use. We derive a simple test statistic that allows us to infer, from a set of candidate models, the model that is closest to the true risk model. Using this methodology, we find that of the models most commonly used in the literature, the Capital Asset Pricing Model is the closest. Given our current state of knowledge, we argue that the Capital Asset Pricing Model is the appropriate method to use to calculate the cost of capital of an investment opportunity. Despite the Capital Asset Pricing Model's success, we also document that a large fraction of mutual fund flows remain unexplained by existing asset pricing models. >more

Equity Premium

### MAXIMUM LIKELIHOOD ESTIMATION OF THE EQUITY PREMIUM

Efstathios Avdis, and Jessica A. Wachter

2013

The equity premium, namely the expected return on the aggregate stock market less the government bill rate, is of central importance to the portfolio allocation of individuals, to the investment decisions of firms, and to model calibration and testing. This quantity is usually estimated from the sample average excess return. We propose an alternative estimator, based on maximum likelihood, that takes into account information contained in dividends and prices. Applied to the postwar sample, our method leads to an economically signicant reduction from 6.4% to 5.1%. Simulation results show that our method produces tighter estimates under a range of specications. >more

Risk Premium

### TIME-VARYING RISK PREMIUM IN LARGE CROSS-SECTIONAL EQUITY DATASETS

Patrick Gagliardini, Elisa Ossola, and O. Scaillet

2011

We develop an econometric methodology to infer the path of risk premia from large unbalanced panel of individual stock returns. We estimate the time-varying risk premia implied by conditional linear asset pricing models through simple two-pass cross-sectional regressions, and show consistency and asymptotic normality under increasing cross-sectional and time series dimensions. We address consistent estimation of the asymptotic variance, and testing for asset pricing restrictions. Our approach also delivers inference for a time-varying cost of equity. The empirical illustration on over 12,500 US stock returns from January 1960 to December 2009 shows that conditional risk premia and costs of equity are large and volatile in crisis periods. They exhibit large positive and negative strays from standard unconditional estimates and follow the macroeconomic cycles. The asset pricing restrictions are rejected for the usual unconditional four-factor model capturing market, size, value and momentum effects but not for its conditional version using scaled factors. >more

Market Efficiency

### HAVE FINANCIAL MARKETS BECOME MORE INFORMATIVE?

Jennie Bai, Thomas Philippon, and Alexi Savov

2013

The finance industry has grown. Financial markets have become more liquid. Information technology has been revolutionized. Have market prices become more informative? We use stock and bond prices to forecast earnings and find that the information content of market prices has not increased since 1960. We use a model with information acquisition and investment to link financial development, price informativeness, and investment. As information costs fall, the predictable component of future earnings should rise and hence improve capital allocation and enhance welfare. We find that this component has remained stable in the data. Our model also allows us to decompose price informativeness into two components, one produced in markets, the other reflected by markets. Both are unchanged. Prices have become stronger predictors of R&D investment, but this has not translated into stronger earnings predictability. >more

Multiple Consistency

### DOES CONSISTENCY IMPROVE MULTIPLE QUALITY?

Alberto Chullen, Hannes Kaltenbrunner and Bernhard Schwetzler

2013

In this paper we analyze the impact of consistency upon the accuracy of corporate values estimates provided by multiple-based valuation methods. Based on a sample with more than 6,000 firm years from German firms we find consistent multiple definitions generally to outperform inconsistent ones. The first layer consistency requirement of properly matching entity figures and equity figures increases the valuation accuracy in all cases. In a deeper analysis with respect to consistent enterprise value definitions, in the vast majority of cases consistent definitions still outperform inconsistent ones. We find that consistent treatment of financial leases, pensions, preferred stocks and minority interest generally increases the valuation accuracy. However for two balance sheet variables we find mixed evidence: For accounts payables, the inclusion results in a higher valuation accuracy for all enterprise value multiples, whereas under our hypothesis it should only do so for the EV/sales multiplier. For investments in associates and joint ventures, we also get opaque results with respect to consistency. Within the class of consistently defined multiples EBITDA multiples have the highest valuation performance followed by EBIT, net income and sales based multiples. >more

Risk Premium

### RISK PREMIUMS OVER VARYING MARKET CONDITIONS: FURTHER EVIDENCE

Praveen K. Das

2012

Bhardwaj and Brooks (1992) and Kim and Burnie (2002) look at the size effect during expansion and recession but come to different conclusions. While Bhardwaj and Brooks report reversal of size effects, Kim and Burnie show that the size effect is strong during economic expansion. A possible reason for these conflicting conclusions might be model misspecification. Both studies use a single-factor CAPM model to calculate the average returns. In this paper, I use the Fama-French three-factor model with betas conditioned on the market states. I find that the reverse size effect is limited to growth stocks. The size effect among value stocks is observed in expansion as well as recession. Furthermore, regression results using the three-factor model with time-varying betas show that there is a negative book-to-market premium. >more

Predictability of Discount Rates

### MARKET EXPECTATIONS IN THE CROSS SECTION OF PRESENT VALUES

Bryan T. Kelly, and Seth Pruitt

AFA 2013 San Diego Meetings Paper

Returns and cash flow growth for the aggregate U.S. stock market are highly and robustly predictable. By drawing upon a single factor extracted from the cross section of book- to-market ratios, the authors reveal an out-of-sample return forecasting R-squared as high as 13% at the annual frequency (0.9% monthly). Also, they document similar out-of-sample predictability for returns on value, size, momentum and industry-sorted portfolios. The paper furthermore implies a model linking aggregate market expectations to disaggregated valuation ratios in a dynamic latent factor system. The results point at spreads in growth and value portfolios’ exposures to economic shocks being key to identifying predictability and being consistent with duration-based theories of the value premium. These findings suggest that discount rates are far less persistent, and their shocks far more volatile, than implied by leading asset pricing models. >more

Risk Premium

### EQUITY PREMIUM USED IN 2011 FOR THE USA BY ANALYSTS, COMPANIES AND PROFESSORS: A SURVEY

Pablo Fernandez, Javier Aguirreamalloa, and Luis Corres Avendaño

Midwest Finance Association 2012 Annual Meetings Paper

The results of this survey reveal that professors used a higher average equity premium or market risk premium (MRP) for the USA in 2011 (5.7%) compared to companies (5.6%) and analysts (5.0%). Also, the survey reports the applied standard deviation of the MRP. Contrary to previous surveys, this survey asks about the required MRP and not about the expected MRP. >more

Leverage

### The Impact of Credit Rating and Frequent Refinancing on Firm Value

Sven Arnold, Alexander Lahmann and Bernhard Schwetzler

SSRN Working Paper

Rating affects corporate credit costs and leverage choices. Therefore, we develop a corporate valuation model where the choice of leverage is consistent with the implied cost of debt of the rating class. We explicitly model the trigger, the consequences, and the analytical probability of bankruptcy. Further, we develop a financing policy where the firm refinances with a predefined frequency. To conclude, we develop value implications of rating and financing policy which are in line with the trade-off theory in capital structure theory. >more

German Firms on Nyse and Nasdaq

### THE LISTING AND DELISTING OF GERMAN FIRMS ON NYSE AND NASDAQ: WERE THERE ANY BENEFITS?

Wolfgang Bessler, Fred R. Kaen, Philipp Kurmann and Jan Zimmermann

Midwest Finance Association 2012 Annual Meetings Paper

The authors examine the NYSE and NASDAQ listing and delisting decisions of German companies in the context of the market segmentation and bonding theories, both explicitly or implicitly assuming that cross listing resulted in lower costs of capital and higher market valuations for the firms. Using the same or similar research methods employed by those who have investigated and tested these theories, however, the authors do not observe systemic evidence that the German companies experienced reductions in their cost of capital or increases in their market values as a result of the cross listings. The authors conclude that no significant valuation benefits were associated with the cross listings and that once Rule 12h-6 was adopted that enabled firms to delist without continuing to be subject to SEC regulations, many did so. Contributing to these decisions were changes in German corporate governance laws and the emergence of alternative trading platforms. >more