6.14 Appendix: The MCPM Model
We briefly summarize the model first presented by
What's Your Real Cost of
Capital? By James J. McNulty, Tony D. Yeh, William S.
Shulze, and Michael H. Lubatkin, Harvard Business Review,
October 2002.
The objective of this measure is to estimate cost of equity
capital by examining the minimum return that would be acceptable
to stockholders.
Consider corporate debt. By comparing the price of the
corporate debt to the price of the equivalent Treasury debt it
is possible to infer the default risk premium from the relative
values. MCPM extends this idea to the risk of equity.
1. Calculate the Forward Break-Even Price of the Stock.
This is defined as the minimal price an investor requires to be
compensated for holding a stock as opposed to a bond.
Operationally, the return on equity equals
Calculate
the minimal capital gains that stock investors require, which
MCPM defines from the corporate debt yield.
From dividend policy and the observed corporate debt
yield, the minimal capital gain rate is defined as follows:
And the forward break-even price is computed as follows:
Here P0 equals the stock price and t is the
investment time horizon in years.
2.
Estimate
the Stock’s Return Volatility for the Given Time Horizon
This can be estimated using implied volatility from an
at-the-money option price (if available) or past price data.
The implied volatility is preferred as it provides an ex
ante estimate for volatility.
3.
Calculate the Cost of Downside
Insurance
By combining the stock with a put option you can insure against
downside losses.
MCPM computes the cost of the downside insurance by calculating
the value of a put option with the life equal to the time
horizon and strike equal to the forward break-even price.
Note:
In this step if you apply an option calculator to
calculate the put option value, the inputs into this calculation
are the following:
·
underlying asset price= current market price of the stock
·
strike price =
forward break-even price (step 1 above)
·
time to maturity = investment horizon
·
volatility = stock’s volatility
·
risk free rate = the corporate debt rate for the time to
maturity
·
dividend yield= dividend yield on the stock
The Black-Scholes put
option price is the estimate of the cost of insuring downside
risk.
4.
Derive the annualized excess
equity return
This step re-expresses the dollar cost of the insurance
calculated in step 3 as an annualized rate.
This rate is the Excess Equity Return that will be added
to the company’s bond rate to provide the volatility based
estimate of the cost of equity capital.
The step is expressed as follows:
The intuition behind the above formula is as follows. The Option
Price/Stock Price is proportion of the stock price that an
investor would be willing to pay to buy out of the downside risk
of earning a lower rate than the bond.
The Excess Equity Return is merely the re-expression of
this proportion as an ordinary annuity using the standard
annuity formula and solving for “C” when the PV of the annuity
equals the Option Price/Stock Price.
Here, C is the Excess Equity Return and is obtained by solving
this equation.
5. The last step then combines the corporate debt rate with excess equity premium to provide the MCPM estimate of the cost of equity capital.
In
Valuation Tutor, you can see the details of this calculation and
also compare the CAPM and MCPM.
After downloading the Current FTS Dataset, select
Discount Rates under the Dividend Model and then MCPM:
You can see
we have selected the stock CMS Energy (CMS) to analyze.
This stock has a low beta (0.58 at the time of this
writing) and a BBB credit rating.
The yield on its bonds with an average maturity of 10
years is 9.59%.
With an equity premium of 5.1%, the CAPM discount rate is
6.848%. This is
below the bond yield.
The MCPM discount rate as you can see is over 11%.