lance young seba lecture 2

2. Valuation

3. Discounted Cash Flows Adjusted present value The adjusted present value method treats the value of the firm as the discounted value of the firm’s expected free cash flows, as if the firm was 100% equity financed, plus the value of interest tax shields from debt The interest tax shields reflect the additional value that debt financing adds to the firm APV = Present value of free cash flows + Present value of interest tax shields

4. Discounted Cash Flows What are “free cash flows” ? Free cash flow is the cash generated in a period, for which the firm has no other profitable investment opportunities Cash that could be paid out to equity or debt holders You can think of free cash flows as almost like ‘excess’ cash generated by the business

5. Discounted Cash Flows Free cash flow: Free cash flow in any period is the cash generated, after necessary investments in working capital and plant and equipment. This cash can be paid to equity holders (dividends) or debt holders (interest and principal)

6. Discounted Cash Flows Where: EBIT= Earnings before interest and taxes t=Tax rate DWC= Change in working capital Working Capital is the sum of required cash, accounts receivable, inventories less accounts payable and non-interest related accruals CAPEX= Capital expenditures

7. Discounted Cash Flows What is not deducted from free cash flows Interest Dividends Debt payments (principal) The point of free cash flows is to accumulate the entire amount of cash that could be used for debt service or returned to shareholders that period

8. Discounted Cash Flows Where do the discount rates come from for APV ? Interest tax shields are commonly discounted at the interest rate on the debt The expected free cash flows should be discounted at the opportunity cost of capital The cost of capital on an investment of similar systematic risk Often this can be estimated via the CAPM:

9. Discounted Cash Flows Where: Ra is the expected cost of capital for the firm Rm is the expected return on the market Rf is the risk free rate b or beta, is the measure of systematic risk Where do betas come from ? Often they come from comparable firms with publicly traded equity

10. Discounted Cash Flow Methods Theoretically, firms can have an infinite life We don’t want to have to forecast free cash flows for an infinite period, however Often, people employ a forecast horizon of 3 to 5 years (or whatever is appropriate) then compute the terminal value of the company One commonly used formula is:

11. Discounted Cash Flows Where: FCF is the free cash flow in the last year of the forecast horizon r=discount rate g=assumed growth rate This formula assumes that cash flows will continue in perpetuity, growing at g percent per year Be careful with g: Large values for g are not reasonable assumptions. Use a longer forecast horizon for a period of extraordinary growth Other values could be used based on price multiples, book values etc. These values may be better than blindly using the perpetuity formula

12. Discounted Cash Flows Adjusted present value What are interest tax shields ? Interest payments are tax deductible--dividends are not Interest tax shields are the reduction in a firm’s tax bill from interest payments Ex: A $1000 loan with 5% interest and a 35% tax rate provides a yearly interest tax shield of .05*1000*.35=18 APV = Present value of free cash flows + Present value of interest tax shields

13. Discounted Cash Flows Problems: Lack of information to produce reliable forecasts Difficult to account for “real options” Ability of the company to adapt to future conditions Questions about terminal values

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