Raising Equity Finance & Valuing a Business

2. Raising Equity Finance & Valuing a Business Prof. Ian GIDDY Stern School of Business New York University

3. Telkom South Africa • Why did South Africa follow its initial 30% privatization of Telkom with an initial public offering? What are the advantages and disadvantages of a public listing for a company? • What is an ADR? Why did Telkom use the ADR technique in conjunction with its Johannesburg IPO? • What does a company have to do to ensure a successful IPO? What makes shares attractive to investors? • Was the Telkom IPO priced correctly? How would you value a company in order to judge the price for an IPO?

4. Valuing a Firm with DCF Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF … Stable growth model or P/E comparable Discount to present using weighted average cost of capital (WACC) Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity

5. What’s a Company Worth? • Required returns • Types of Models • Balance sheet models • Comparables • Corporate cash flow models • Estimating Growth Rates • Applications • Option-based models

7. IBM’s Financials

8. Equity Valuation: From the Balance Sheet Value of Assets • Book • Liquidation • Replacement Value of Liabilities • Book • Market Value of Equity

9. Equity Valuation: From the Balance Sheet Value of Assets • Book • Liquidation • Replacement • Or what? A New York City study estimated that the 322 trees surveyed had an average value of $3,225 per tree and a total value of $1,038,458. The value was said to be the amount the city would have to pay to replace the tree. (New York Times, 12 May 2003)

10. Relative Valuation • In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include: • Price/Earnings (P/E) ratios • and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) • Price/Book (P/BV) ratios • and variants (Tobin's Q) • Price/Sales ratios

11. Comparables • Value Indicator • Earnings • Cash Flow • Revenues • Book • Average • Comparable • Industry • Firms • Deals Target Company Numbers or Projections Estimated Value of Target

12. IBM: Comparables

13. Corporate Cash Flow

14. Discounted Cashflow Valuation: Basis for Approach • where • n = Life of the asset • CFt = Cashflow in period t • r = Discount rate reflecting the riskiness of the estimated cashflows

15. Start with theWeighted Average Cost of Capital Choice Cost 1. Equity Cost of equity - Retained earnings - depends upon riskiness of the stock - New stock issues - will be affected by level of interest rates - Warrants Cost of equity = riskless rate + beta * risk premium 2. Debt Cost of debt - Bank borrowing - depends upon default risk of the firm - Bond issues - will be affected by level of interest rates - provides a tax advantage because interest is tax-deductible Cost of debt = Borrowing rate (1 - tax rate) Debt + equity = Cost of capital = Weighted average of cost of equity and Capital cost of debt; weights based upon market value. Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]

16. IBM’s Cost of Capital

17. Valuation: The Key Inputs • A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever. • Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:

18. Dividend Discount Models:General Model • V0 = Value of Stock • Dt = Dividend • k = required return

19. No Growth Model • Stocks that have earnings and dividends that are expected to remain constant • Preferred Stock

20. No Growth Model: Example • Burlington Power & Light has earnings of $5 per share and pays out 100% dividend • The required return that shareholders expect is 12% • The earnings are not expected to grow but remain steady indefinitely • What’s a BPL share worth? E1 = D1 = $5.00 k = .12 V0 = $5.00/0.12 = $41.67

21. Constant Growth Model • g = constant perpetual growth rate

22. Constant Growth Model: Example • Motel 6 has earnings of $5 per share. It reinvests 40% and pays out 60%dividend • The required return that shareholders expect is 12% • The earnings are expected to grow at 6% per annum • What’s an M6 share worth? E1 = $5.00 k = 12% D1 = $3.00 g = 6% V0 = 3.00 / (.12 - .06) = $50.00

23. Shifting Growth Rate Model • g1 = first growth rate • g2 = second growth rate • T = number of periods of growth at g1

24. Shifting Growth Rate Model: Example • Mindspring pays dividends $2 per share. The required return that shareholders expect is 15% • The dividends are expected to grow at 20% for 3 years and 5% thereafter • What’s a Mindspring share worth? D0 = $2.00 g1 = 20% g2 = 5% k = 15% T = 3 D1 = 2.40 D2 = 2.88 D3 = 3.46 D4 = 3.63 V0 = D1/(1.15) + D2/(1.15)2 + D3/(1.15)3 + D4 / (.15 - .05) ( (1.15)3 V0 = 2.09 + 2.18 + 2.27 + 23.86 = $30.40

25. Choosing a Growth Pattern: Examples Company Valuation in Growth Period Stable Growth PWC Nominal U.S. $ 10 years 6%(long term Firm (3-stage) nominal growth rate in the world economy DirecTV Nominal US$ 5 years 4%: based upon Equity: FCFE (2-stage) expected long term US growth rate Allianz Nominal Euro 0 years 3%: set equal to Equity: Dividends nominal growth rate in the European economy

26. Better Than Dividends:Free Cash Flows Revenue - Expenses - Depreciation = EBIT Adjust for tax: EBIT(1-T) + Depreciation - Capex - Ch working capital = Free Cash Flows to Firm

27. Deriving IBM’s Free Cash Flows IBMvaluation.xls

28. Equity Valuation in Practice • Estimating discount rate • Estimating cash flows • Estimating growth • Application with constant growth: Optika • Application with shifting growth: IBM

29. Valuing a Firm with DCF: The Short Version Historical financial results Projected sales and operating profits Adjust for noncash items Free cash flows to the firm (FCFF) Calculate weighted average cost of capital (WACC) Discount to present using constant growth model FCFF(1+g)/(WACC-g) Estimate stable growth rate (g) Present value of free cash flows - Market value of debt Value of shareholders equity

30. Optika: Facts • The firm has revenues of €3.125b, growing at 5% per annum. Costs are estimated at 89%, and working capital at 10%, of sales. The depreciation expense next year is calculated to be €74m. • Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%. • The market value of equity is €1.3b. • Is this firm fairly valued in the market? What assumptions might be changed?

31. Optika optika.xls

32. Optika WACC: ReE/(D+E)+RdD/(D+E) Value: FCFF/(WACC-growth rate) CAPM: 7%+1(5.50%) Equity Value: Firm Value - Debt Value = 2681-250 = 2431 Debt cost (7%+1.5%)(1-.35) optika.xls

33. Valuing a Firm with DCF: The Extended Version Historical financial results Adjust for nonrecurring aspects Gauge future growth Projected sales and operating profits Adjust for noncash items Projected free cash flows to the firm (FCFF) Year 1 FCFF Year 2 FCFF Year 3 FCFF Year 4 FCFF Terminal year FCFF … Stable growth model or P/E comparable Discount to present using weighted average cost of capital (WACC) Present value of free cash flows + cash, securities & excess assets - Market value of debt Value of shareholders equity

34. Case Study: IBM

35. Case Study: IBM IBMvaluation.xls

36. Mt CameroonEcotours

37. Case Study: Mt Cameroon Ecotours • What alternative financing sources are available to Mount Cameroon Ecotours? • How would foreign investors assess the risks of investing in this private venture in Cameroon? What could be done to reduce the risks to foreign investors? What might be their exit plan? • What is a reasonable estimate of the company's value? • How much of the company's equity shares would have to be given up in order to raise the required EUR5 million? 

38. Thursday: Structured Financing Korea Asset Funding Cap des Biches LBO Banpu Finance Co. Bhd