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Q: Determine and justify the required rate of return for Harley Davidson (HDI) ( Answered 5 out of 5 stars,   0 Comments )
Subject: Determine and justify the required rate of return for Harley Davidson (HDI)
Category: Business and Money
Asked by: mermer1033-ga
List Price: $25.00
Posted: 20 Apr 2005 15:26 PDT
Expires: 20 May 2005 15:26 PDT
Question ID: 511996
In order to complete the project I will need to use two different
techniques for the required rate of return:
a: the dividend disount model (constant growth model)
b: CAPM model

I need at least 5 years of dividends to determine Harley's growth, and
to predict future dividends. I also need to find the beta for my
company and I have no idea what the "beta" means? I then need to
determine the risk free rate of return and the market risk premium?? I
was told that the market risk return/premium is subjective but I'm not
sure it that's correct or what that number should be? I need to
"justify" how I derived each value! If anyone can help I would be
greatly appreciative!! Thank you!
Subject: Re: Determine and justify the required rate of return for Harley Davidson (HDI)
Answered By: omnivorous-ga on 21 Apr 2005 16:48 PDT
Rated:5 out of 5 stars
Mermer1033 --

There are a number of places that you can go to find data such as
historical earnings and dividends. One such place is Harley Davidson?s
own investor relations page; another is the SEC Edgar database:
SEC Edgar
?Harley Davidson?

Data is usually available for several years in the Form 10-K or annual
report.  For longer periods of data, it?s a good idea to use Standard
& Poor?s company reports or another service (like Value Line).   These
services are often better because they?ll have a ?beta? for the
company ? something I?ve never seen in a annual report for Form 10-K.


Beta is a measure of the volatility of the company as compared to the
market.  A beta of more than 1.0 means that as the stock market goes
up (or down) the firm will move MORE than the market average.  A beta
below 1.0 means a ?lower risk? firm that isn?t as dramatically
affected by economic changes.  Historically these have been food or
utility companies, where economic or market changes have less impact
on their businesses.

Here?s a good discussion of cost of capital and beta that?s quite to the point:

Actuarial Review
?The Risk Premium Project Releases Empirical Results,? (Francis, February 2004)

Note the key formula:

Rc = rf + c(rM - rf)


Rc is the company's expected return on capital 
rf is the risk-free return rate, usually a long-term U.S. Treasury bill rate 
rM is the expected return on the entire market of all investments. 
This is actually the toughest number, so often it?s the return on the
S&P500 over the past 5 or 10 years ? and some people suggest adding 3%
to the risk-free rate.
c is the company's Beta, based on its covariance with the market. 
Most commonly it?s measured as co-variance with the S&P500, as it?s
one of the broadest market indices.  However, even then you?ll see
slightly different numbers for a ?beta,? as some methods calculate it
over 1 year, others over 3 years and still others over 5 years.


Now let?s get you some hard data on the company and markets to use:


Rf is 4.31% on a 10-year Treasury bill according to today?s Wall
Street Journal.  It?s about 4.7% if you want to use a 25-year T-bill


ValueLine measured it at 1.1 in its most-recent report.


Before 1993 there were none.
1993  $0.02
1994  $0.04
1995  $0.05
1996  $0.06
1997  $0.07
1998  $0.08
1999  $0.09
2000  $0.10
2001  $0.12
2002  $0.14
2003  $0.20
2004  $0.41

So you?ve seen dividend growth of 1950% in 11 years or a compounded
growth rate of 31.6%.  Here?s your first choice in the ?future
dividend? model ? you can use that ?compounded growth rate? or perhaps
an average of the following numbers:


1994  100%
1995    25%
1996    20%
1997    16.7%
1998    14%
1999    12.5%
2000    11.1%
2001    20%
2002  16.7%
2003  42.9%
2004  105%

Before going on to market risk, I have to look at HDI earnings. 
Dividends have grown at a great rate but if earnings aren?t growing as
fast it would be a good idea to adjust downward the implied rate of
dividend growth.  Dividends can?t grow faster than earnings or at some
point they will begin liquidating the firm ? but that?s a whole
different question.

Here are the earnings for the same period, expressed in Earnings Per
Share (EPS), along with a growth in percent:

1993:  $0.24, 26.3%
1994:  $0.34, 41.7%
1995:  $0.37,   8.8%
1996:  $0.48,  29.7%
1997:  $0.57,  18.8%
1998:  $0.69,  21.1%
1999:  $0.87,  26.1%
2000:  $1.13,  29.9%
2001:  $1.43,  26.6%
2002:  $1.90,  32.9%
2003:  $2.50,  31.6%
2004:  $3.00,  20.0%

You can use the average of these growth rates ? or the 25.8%
compounded growth rate from 1993 to 2004 ? but as you can see it?s
less than the dividend growth rate.  So, it would be unwise to use the
dividend growth rate in your Dividend Discount Model, unless you
forecast Harley Davidson to go out of business in the next 10 years.

rM or market returns are most-often used against a broad-based index
and most-often against the Standard & Poor?s 500 index, as it
represents a heavy percentage of the equity value in the U.S. markets.
 The following are annual returns to the S&P500.  Again you can use
the compound number or an average.  Remember that costs of capital are
an ESTIMATE and that there are arguments for using either:


1993:    466.5,  7.1%
1994:    459.3, -1.5%
1995:    615.9, 34.1%
1996:    740.7, 20.3%
1997:    970.4, 31.0%
1998:  1,229.2, 26.7%
1999:  1,469.3, 19.5%
2000:  1,320.3, -10.1%
2001:  1,148.1, -13.0%
2002:     879.8, -23.4%
2003:  1,111.9, 26.4%
2004:  1,211.9,   9.0%

Compounded, that?s about 9.1% annual growth in the S&P500 over the 11-year period.

So, there you go: plug the numbers of your choice into your growth
model and estimate the price for HDI.  (Here?s a hint: it closed at
$47.46 today, up $2.04.)

Google search strategy:
CAPM + beta + WACC
?Capital asset pricing model? + beta

Best regards,


Request for Answer Clarification by mermer1033-ga on 21 Apr 2005 23:31 PDT
Hello, and thank you for your excellent response. I am still a little
confused about how you came to your calculations.... you came to the
growth rate of 31.6%, yet how did you calculate that? I also was a
little fuzzy on "So, there you go: plug the numbers of your choice
into your growth
model and estimate the price for HDI.  (Here?s a hint: it closed at
$47.46 today, up $2.04.)" Which model am I using for this? And which
numbers should I use??

You also mentioned that "people suggest adding 3% to the risk-free rate." why?

Thanks again!

Clarification of Answer by omnivorous-ga on 22 Apr 2005 06:04 PDT
Mermer1033 --

COMPOUNDED GROWTH: We have 11 years of dividend data, so you can use
beginning and ending numbers to calculate a dividend growth rate. 
Here's how you do it:

2 cents * (1.316 ^ 11) = 41 cents

The terms here are: 
1.  beginning dividend
2.  the growth factor -- with the number to the right of the decimal
being percentage
3.  ^ 11 is 1.316 multiplied by itself 11 times -- or 1.316 to the
11th power.  If you want to do these calculations yourself (for
earnings or other measures), just set the terms up in a spreadsheet.
4.  41 cents: the ending dividend

I cited the obviously problems with this -- the low base -- and that
fact that earnings aren't growing that fast.  But you'll probably make
big points with the professor if you mention the calculation, then
explain why you DID NOT use that number.

WHY 3%?  Capital returns are important within financial markets but in
evaluating a firm or in making business decisions, one percent or two
makes little difference, as other factors will outweigh a 10% or 20%
change in capital.  I believe that it was Warren Buffett, certainly
one of the most-astute investors of modern times, who said "we just
add 3% to the interest rate."  In 'normal' years you'll see interest
rates of 5%-8% and corporate returns of 8% - 12% and so it's a good
rule of thumb.

FINALLY, PRICE: The closing price today indicates the votes of
thousands (millions?) of investors as to:
  *  future rf
  *  future rm
  *  future dividend growth of HDI

As you plug-and-chug different numbers and get widely different
valuations, I'd always remember that HDI traded between $45.20 and
$63.80 in the past year.  If you come up with values outside that
range, I'd change my statistical assumptions.  Markets are efficient
and all that.

Harley Davidson is a good case model: it's considered to be a
well-managed company with good earnings predictabiity.  By the way, if
you want some additional data to work with, I'd strongly suggest
picking up the one-page Value Line summary.  It's in virtually any
public library and the last analysis was written Feb. 18, 2005.

Best regards,

mermer1033-ga rated this answer:5 out of 5 stars
Excellent researcher! What a wonderful asset to have on! Thank you!

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