Friday, January 3, 2014

Time Warner Cable's CAPM

As 2014 begins, Charter communications is still looking to buy Time Warner Cable.  This is a David and Goliath story with the smaller Charter trying to take over the larger Time Warner.

Having recently completed an Executive MBA program with a focus on corporate financing, I thought it would be interesting to value Time Warner and Charter to understand the deal.

There are a few steps to value a company and in this post, we'll start with figuring the CAPM for Time Warner (TWC).

The Capital Asset Pricing Model, or CAPM, is a way to value a security or investment.  Said another way, CAPM is the expected or needed return on an investment given it's risk.  CAPM can also be used to derive the Weighted Average Cost of Capital, or WACC, which is used in subsequent valuations of the company.

The formula for CAPM is simple... it is: Risk Free Rate + Beta x Market Risk Premium.  It is usually written as Rf + B (Rm).   The market risk premium has two components, the risk free rate and market required return.  In this case, professor Damodaran's 2013 numbers for the market risk premium (he is considered a credible source).

For Beta I used the Value Line number (beta differs depending on a lot of factors).

Beta = 1
Risk Free Rate = 1.76%
Market Risk Premium = 5.78%

CAPM = 1.76% + 1 x ( 5.78%)  = 7.54%.

This is the expected return on the TWC stock and also TWC's cost of equity which will be used in the next post to determine WACC.

Motley Fool article on the Time Warner deal

Damodaran's Website at NYU

CAPM explanation at Investopedia

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