If I want to VALUE a company, I look at the company from the Outside In. As an investor, how much would I pay for the company given the way it’s run? That’s VALUATION.
In corporate FINANCE, I look at the same company from the Inside Out. If I were running this company, how would I run it differently?
— Aswath Damodaran
Aswath Damodaran, is known as the “Dean of Valuation”, says: “This is all the Corporate Finance you need to know if you’ve never taken a finance class.”
The Three Business Decisions
There’s the Investment Principle…
There’s the Finance Principle…
There’s the Dividend Principle…
The Investment Principle
The principle that governs how you invest is a very simple one. Go out and make investments that earn more than the minimally accepted hurdle rate.
Find the mix of Debt and Equity that minimizes your hurdle rate.
The Hurdle Rate
To calculate a hurdle rate, you add a risk premium to the weighted average cost of capital (WACC), which represents the company's overall cost of raising money. The formula is Hurdle Rate = WACC + Risk Premium. The WACC is the blended cost of a company's debt and equity, and the risk premium is added to account for the specific uncertainties and risks of a particular investment.
Steps to Calculate the Hurdle Rate
1. Determine the Weighted Average Cost of Capital (WACC):
This involves calculating the cost of a company's equity and the cost of its debt.
It considers the proportion of each financing source (equity vs. debt) in the company's capital structure.
A company can use tools or complex financial models to find its WACC.
2. Add a Risk Premium:
Assess the specific risks associated with the potential investment project.
A riskier project will require a higher risk premium to justify the investment.
This premium can be based on factors like project volatility, market conditions, and the overall industry.
3. Combine for the Hurdle Rate:
Add the risk premium to the WACC.
The resulting hurdle rate is the minimum acceptable rate of return that a project must generate to be considered viable.
Example
If a company's WACC is 7% and the risk premium for a specific investment is 3%, the hurdle rate would be 10% (7% + 3%).
The investment would need to offer a potential return of at least 10% to be acceptable.