Ten Badly Explained Topics In Most Corporate Finance Books
University of Navarra - IESE Business School
November 17, 2015
Abstract:
This paper addresses 10 corporate finance topics that are not well treated (or not treated at all) in many Corporate Finance Books. The topics are:
- Where the WACC equation comes from.
- The WACC is not a cost.
- How is the WACC equation when the value of debt is not equal to its nominal value.
- Textbooks differ a lot on their recommendations regarding the equity premium.
- The term equity premium is used to designate four different concepts.
- Which Equity Premium do professors and practitioners use?
- Calculated (historical) betas change dramatically from one day to the next.
- Why many professors continue using calculated (historical) betas in class?
- EVA does not measure Shareholder value creation.
- The relationship between the WACC and the value of the tax shields (VTS).
Ten Badly Explained Topics In Most Corporate Finance Books - Introduction
The term equity premium is used to designate four different concepts
The equity premium (also called market risk premium, equity risk premium, market premium and risk premium), is one of the most important and discussed, but elusive parameters in finance. Part of the confusion arises from the fact that the term equity premium is used to designate four different concepts:
- Historical equity premium (HEP): historical differential return of the stock market over treasuries.
- Expected equity premium (EEP): expected differential return of the stock market over treasuries.
- Required equity premium (REP): incremental return of a diversified portfolio (the market) over the risk-free rate required by an investor. It is used for calculating the required return to equity.
- Implied equity premium (IEP): the required equity premium that arises from assuming that the market price is correct.
The equity premium designates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium (IEP). Although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors.
There is a kind of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors look for a unique discount rate. It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship.
A unique IEP requires assuming homogeneous expectations for the 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 Expected and Required equity premium and 82 identify Expected and Historical equity premium. This is also explained in chapter 12 “Equity Premium: Historical, Expected, Required and Implied”, downloadable in http://ssrn.com/abstract=933070
Textbooks differ a lot on their recommendations regarding the 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 recommendations regarding the equity premium range from 3% to 10%, and that 51 books use different equity premia in different pages. Figure 1 contains the evolution of the Required Equity Premium (REP) used or recommended by 150 books, and helps to explain the confusion that many students and practitioners have about the equity premium. The average is 6.5%.
Which 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 the one 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 the ones of companies (2.0%) and professors (1.6%).
Which 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 the one 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 the ones of companies (2.0%) and professors (1.6%).
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