Valuations of assets are subjective and when making an investment decision, you need to escape merely the financial. You need to use your own judgment, to find what is scarce and valuable to you, and suitable to your ends.
A. Setting Strategy
An investor outlays capital to produce an income. For an investment to be worthwhile it must meet strategic goals. An investor need decide on its focus by asking:
· What it is good at?
· How the market might change?
· How customer satisfaction can be delivered?
· What is the risk-return goals?
· Are the risks the kind that tend to result in a permanent loss of capital?
B. Rate of Return
There are different types of professional investor. Each investor will establish their required rate of return on an investment given their risk appetite. The more uncertain a project. The longer it ties up your money. The more it should deliver superior returns.
Risk Appetite | Investor Category | Rate of Return | Holding Period
Low | Pension Funds | 5% Yield/10% IRR | 20+ years
Balanced | Investment Managers | 10% Yield/15% IRR | 10+ years
High | Private Equity | 15%+ Yield/20%+ IRR | 5 to 10 years
C. Cost of Capital
Value is created by earning a return on the investment that is higher than the cost of capital. The cost is calculated by a weighted average, expressed as a percentage of the mix of equity and debt. In this scenario and ignoring tax it is 9%:
WACC = (cost of equity * % equity funding) + (cost of debt * % debt funding)
WACC = (15.0% x 40%) + (5.0% x 60%)
WACC = 9.00%.
Cost of Equity
The cost of equity is calculated by the Capital Asset Pricing Formula:
CoE = Risk Free Rate + Beta (Market Rate of Return - Risk-Free Rate)
CoE = 2.00% + 1.4 (11.00% - 2.00%)
CoE = 15.00%
The formula takes the risk-free rate of return. This is the return on an investment with zero risk, which is considered to be short term government debt. I have assumed here that if you owned government debt it would pay 2% per annum.
It then calculates the premium for making an investment in a risker market asset (credit risk). This is the stock market return less the 2% which gives a 9% premium.
The risk is evaluated with the Beta coefficient. This measure the volatility of the investment compared with the overall stock market. A value of 1 indicates it would move identically with the market.
For alternative investments, a public benchmark is found in the same sector such as a listed construction company, and a premium is added. For this evaluation the construction company ‘Sterling Construction Company Inc’ has a Beta of 1.36. In our our example we add a premium to get 1.4 and will require a 15.00% return.
Cost of Debt
The cost of debt is the interest rate on bank loans.
Debt is cheaper as it is secured against assets of a company and is a tax-deductible expense. Therefore, maximising the amount of debt should reduce the cost of capital and increase shareholder value. Too much debt however, increases the financial risk.
D. Evaluating the Investment
The owners of UPP, Barclays Capital, had two return metrics in evaluating their investment decisions.
Internal Rate of Return
The IRR evaluated the returns over the investment’s holding period. It indicates the effective ‘interest rate’ earned on the equity. It takes into account the timing and amounts of payments to the investor until all the funds are withdrawn.
The IRR at Reading was 14%. It required a detailed financial model showing the cash flow each year for 50 years.
The rationale behind IRR is if it is greater than WACC (IRR>WACC). The project’s rate of return will exceed its costs, and as a result should be accepted.
Cash Yield
Barclays also evaluated the cash return on the investment in its first year, with a net initial yield (NIY) calculation. This deducts all expenses from the annual rent in the first year. This net income is then divided by the property’s purchase price. For the University of Reading acquisition, the NIY was 6.5%.