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Valuation: Cash Flow-Based Approaches

Valuation: Cash Flow-Based Approaches. Dr. Nancy Mangold California State University, East Bay. Valuation. Security Analyst and Investment Bankers Make buy, sell, or hold recommendations Right Price for IPO Price for a corporate acquisition. Valuation. Economic Theory

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Valuation: Cash Flow-Based Approaches

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  1. Valuation: Cash Flow-Based Approaches Dr. Nancy Mangold California State University, East Bay

  2. Valuation • Security Analyst and Investment Bankers • Make buy, sell, or hold recommendations • Right Price for IPO • Price for a corporate acquisition

  3. Valuation • Economic Theory • Value of any resource equals the present value of the returns expected from the resource, discounted at a rate that reflects the risk inherent in those expected returns

  4. Valuation

  5. Rationale for Cash-Flow Based Valuation • Cash is the ultimate source of value • Cash serves as a measurable common denominator for comparing the future benefits of alternative investment opportunities

  6. Cash Flow vs Earnings • Investors cannot spend earnings for future consumption • Accrual earnings are subject to numerous questionable accounting methods • Pooling vs purchase in acquisition valuation • Expensing of R & D costs • Earnings are subject to purposeful management by a firm

  7. Cash Flows vs Earnings • Earnings are not as reliable or meaningful as a common denominator for comparing investment alternatives as cash • $1 earnings (Firm 1) not equal to $1 earnings (Firm 2). • $1 Cash (Firm 1) = $1 Cash (Firm 2)

  8. Cash Flow-Based Valuation • Three elements needed • Expected periodic cash flows • Residual (Terminal) value - Expected cash flow at the end of the forecast horizon • Discount rate used to compute the present value of the future cash flows

  9. I. Periodic Cash Flows • Cash Flow to the Investor vs Cash Flow to the Firm • Cash Flow to the Investor: CF dividends expected to be paid to the investor • Cash Flow to the Firm (CF dividends + CF retained by firm) • If the rate of return of retained CF equals the discount rate, either CF will yield the same valuation • Use Cash Flow to the Firm

  10. Periodic Cash Flows: Relevant Firm Level Cash Flows • Which cash flow amounts from the projected statement of cash flows the analyst should use to discount to present value when valuing a firm • Unleveraged free cash flows • leveraged free cash flows

  11. Periodic Cash Flows: Relevant Firm Level Cash Flows • Unleveraged free CF is CF before considering debt vs equity financing • Unleveraged free cash flows = CFO + interest cost (net of tax) +(-) Cash flow for investing activities • This pool of cash flows is available to service debt, pay dividends and provide funds to finance future earnings

  12. Leveraged free cash flows • Leveraged free cash flows = CFO - Cash flow for investing activities +(-) net change in ST & LT borrowing +(-) Changes and dividends on on preferred stock • Cash flows available to the common shareholders after making all debt service payments to the lenders and paying dividends to preferred shareholders

  13. Unleveraged Free CF Cash Flow from Operations before subtracting Cash outflows for interest costs (net of tax savings) =Unleveraged CFO +(-) CF for Investing Act. = Unleveraged Free Cash Flow to All Providers of Capital Leveraged Free CF CFO before interest - Cash outflows for interest costs (net of tax savings) =leveraged CFO +(-) CF for Investing Act. +(-)CF for changes in ST&LT borrowing +(-)CF for changes in and Dividends on preferred stock = leveraged Free CF to Common Shareholders Measurement of Unleveraged and Leveraged Free Cash Flows

  14. Unleveraged Free Cash Flows • If the objective is to value the assets of a firm, then the unleveraged free cash flow is the appropriate cash flow • Discount rate should be weighted average cost of capital

  15. Leveraged Free Cash Flows • If the objective is to value the common shareholders’ equity of a firm, then the leveraged free cash flow is the appropriate cash flow • Discount rate should be the cost of equity capital

  16. Unleveraged vs Leveraged Free Cash Flows • The Valuation Difference = the value of total interest-bearing liabilities and preferred stock

  17. Unleveraged vs Leveraged Free Cash Flows • Value interest-bearing liabilities by discounting debt service costs (including repayments of principal) at the after tax cost of debt capital

  18. Unleveraged vs Leveraged Free Cash Flows • Valuing preferred stock by discounting preferred stock dividends at the cost of preferred equity

  19. Unleveraged vs Leveraged Free Cash Flows • Valuation for total assets (unleveraged Free CF) = • Valuation for common equity (leveraged Free CF) • + Value of interest-bearing liabilities • + Value of preferred stock

  20. Acquiring the operating assets of of another firm • Acquiring firm will replace with its own financing structure • Price to pay for the division’s assets?

  21. Acquiring the operating assets of of another firm • CF these assets will generate • Use unleveraged free cash flows (Operating cash flows - cash outflow for investing) • Discount these projected cash flows at the weighted average cost of capital of the new division

  22. Engage in a leveraged buy out (LBO) of a firm • Managers offer to purchase the outstanding common shares of the target firm at a particular price if current shareholders will tender them • The managers invest their own funds for a portion of the purchase price (usualy 20% - 25%) and borrow the remainder from various lenders

  23. Engage in a leveraged buy out (LBO) of a firm • The managers use the equity and debt capital raised to purchase the tendered shares • After gaining voting control of the firm, the managers direct the firm to engage in sufficient new borrowing to repay the bridge loan obtained to execute LBO

  24. Engage in a leveraged buy out (LBO) of a firm • The lenders have a direct claim on the assets of the firm • Managers shift any personal guarantees they made on the bridge loans to the firm

  25. Price of LBO • Use Valuation of common equity • Leveraged free cash flows discounted at the cost of common equity capital

  26. Price of LBO • Or Use Valuation of total assets and subtract the market value of the debt raised to execute the LBO. • PV of unleveraged free cash flows using the weighted average cost of debt and equity capital

  27. Price of LBO • The projected debt service costs after the LBO will differ significantly • Valuation of the equity must reflect the new capital structure and the related debt service cost • The cost of equity capital will increase as a result of the higher level of debt in the capital structure

  28. Nominal Vs Real Cash Flows • Nominal cash flows include inflationary or deflationary components • Real cash flows filter out the effect of changes in general purchasing power • Valuation should be the same whether one uses nominal cash flow amounts or real cash flow amounts, as long as discount rate used is consistent with CF

  29. Nominal Vs Real Cash Flows • If projected cash flows ignore changes in the general purchasing power of the monetary unit • Then the discount rate should incorporate an inflation component • Nominal CF 1.15 million (land price) • Discount rate s/b 1/1.02 /1.1 • Interest rate 2% and inflation rate 10% • Value 102.5

  30. Nominal Vs Real Cash Flows • If projected cash flows filter out the effects of general price changes • Then the discount rate should exclude the inflation component • Real CF 1.15 million (land price)/1.1 (inflation rate) • Discount rate s/b 1/1.02 • Land Value 102.5

  31. Nominal Vs Real Cash Flows • A firm owns a tract of land that it expects to sell one year from today for 115 million • The selling price reflects a 15% increase in the selling price of the land • General price level is expected to increase 10% • The real interest rate is 2%

  32. The Value of Land Discount rate including expected inflation 115m x 1/(1.02)(1.1)= 102.5 million Discount rate excluding expected inflation (115 million/1.10) x 1/1.02 = 102.5 million

  33. PreTax vs After-Tax Cash Flows • Discount pretax cash flows at a pretax cost of capital • Discount after-tax cash flows at an after-tax cost of capital • Valuation will be the same

  34. Selecting a Forecast Horizon • For how many future years should the analyst project periodic cash flows? • Theoretically: the expected life of the resource to be valued (machine, building ) • To value the equity claim on the portfolio of net assets of a firm, the resource has indefinite life • Analyst must project the years of CF and residual value at the end of forecast horiz.

  35. Selecting a Forecast Horizon • Prediction of CF requires assumptions for each item in the IS and BS and then deriving the related CF

  36. Selecting a Forecast Horizon • Using a relatively short forecast horizon (3-5 years) enhances the likely accuracy of the projected periodic cash flows • near term cash flows is often an extrapolation of the recent past • near term cash flows have the heaviest weight in the PV computation • But a large portion of the total PV will be related to the residual value

  37. Selecting a Forecast Horizon • The valuation is difficult when near-term cash flows are projected to be negative in rapidly growing firm that finances its growth by issuing common stock • All of the firm’s value relates to the less detailed estimation of the residual value

  38. Selecting a Forecast Horizon • Selecting a longer period in the forecast of periodic cash flows (10-15 years) • Reduces the influence of the estimated residual value on the total PV • Predictive accuracy of detailed cash flow forecasts this far into the future is likely to be questionable

  39. Selecting a Forecast Horizon • It is best to select as a forecast horizon the point at which a firm’s cash flow pattern has settled into an equilibrium • This equilibrium position could be either no growth in future cash flows or growth at a stable rate • Security analysts typically select a forecast horizon in the range of 4-7 years

  40. II. Residual Value • Residual Value at end of Forecast Horizon = Periodic Cash Flow n-1 x 1+g r-g • Where • n= forecast horizon • g= annual growth rate in periodic cash flows after the forecast horizon • r= discount rate

  41. Residual Value • Leveraged free cash flow of a firm in year 5 is 30 millions • 0 growth expected • Cost of equity capital = 15% • Residual value • = 30 x (1+0.0)/(.15-0.0) = 200 million • PV of RV (in Year 5)= 200 x 1/(1.15)5 = 99.4 million

  42. Residual Value • Add growth rate = 6% • Residual value = • 30 x (1+0.06)/(.15-0.06) = 353.3 million • PV = 353.3 x 1/(1.15)5 = 175.7 million

  43. Residual Value • Add growth rate = -6% • Residual value = • 30 x (1-0.06)/(.15 - (-0.06) = 134.3 million • PV = 134.3 x 1/(1.15)5 = 66.8 million • Analysts frequently estimate a residual value using multiples of 6-8 times leveraged free cash flows in the last year

  44. Difficulty in Using Residual Value • When the discount rate and growth rate are approximately equal • The denominator approaches zero and • The multiple becomes exceedingly large. • When the growth rate exceeds discount rate • The denominator becomes negative, the resulting multiple becomes meaningless

  45. Alternative Approach to Estimate Residual Value • Use free cash flow multiples for comparable firms that currently trade in the market • this model provides a market validation for the theoretical model • The analyst identifies comparable companies by studying growth rates in free cash flows, profitability levels, risk characteristics and similar factors.

  46. III. Cost of Capital • The analyst uses the discount rate to compute the present value of the projected cash flows • The discount rate equals the rate of return that lenders and investors require the firm to generate to induce them to commit capital given the level of risk involved

  47. Cost of Capital • Cost of debt capital equals the after-tax cost of each type of capital provided to a firm

  48. Cost of Debt Capital • Common practice excludes operating liability accounts from weighted average cost of capital • The present value of unleveraged free cash flows is the value of total assets net of operating liabilities which equals debt plus shareholders’ equity

  49. Cost of Debt Capital • The cost of debt capital equals • (1- marginal tax rate) x yield to maturity of debt • The yield to maturity is the rate that discounts the contractual cash flows on the debt to the debt’s current market value • The yield=coupon rate if the debt sells at par(face) value

  50. Cost of Debt Capital • Capitalized lease obligation have a cost equal to the current interest rate on collateralized borrowing with equivalent risk

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