- 170 Views
- Uploaded on

Download Presentation
## Session 9: Valuation

**An Image/Link below is provided (as is) to download presentation**

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -

Presentation Transcript

### Session 9: Valuation

C15.0008 Corporate Finance Topics

Outline

- Valuation with leverage
- WACC
- APV
- FTE
- Valuation using multiples

Approaches to Valuation

There are 3 equivalent (but not identical) approaches to valuation (of projects or firms)

- WACC: weighted average cost of capital
- APV: adjusted present value
- FTE: flow to equity

Formulas

WACC:

V = t UCFt / (1+rWACC)t

APV:

V = t UCFt / (1+r0)t + PV(financing effects)

FTE:

S = t LCFt / (1+rS)t

Cash Flows

- UCF--unlevered cash flows
- Cash flows available to all security holders (equity, debt, etc.)
- UCF = EBIT(1-T) + depr - capex - NWC = (1-b)EBIT(1-T)
- Gives V
- LCF--levered cash flows
- Cash flows available to equity holders (dividends)
- LCF = UCF - int exp(after-tax) - pref divLCF = (EBIT-int exp)(1-T) - pref div + depr - capex - NWC = (1-b)[(EBIT-int exp)(1-T) – pref div]
- Gives S

Discount Rates

- WACC--weighted average cost of capital
- Market value weights of permanent financing
- After-tax
- r0--required return on (cost of) unlevered equity
- Asset required return
- Can be backed out of rS
- rS--required return on (cost of) equity
- Dependent on financing

The Problem

Firm

- No growth, UCF of 60 in perpetuity

- Debt and equity financed

0 1 2 3 …

60 60 60 …

What is the value of the firm?

WACC Approach

V = t UCFt / (1+rWACC)t

UCF -- expected, after-tax, unlevered cash flow

rWACC = wB rB(1-T)+wS rS

Key assumption -- the weights are constant

Inputs: (1) leverage ratio (weights), (2) component costs of capital, (3) cash flows

WACC Valuation

0 1 2 3 …

60 60 60 …

rS = 11.2%, rB = 8%, wB = wS = 0.5, T = 40%

rWACC = 0.5(8%)(1-0.4) + 0.5(11.2%) = 8%

V = 60/0.08 = 750

APV Approach

V = t UCFt / (1+r0)t + PV(financing effects)

PV(financing effects) = PV(tax shield) + PV(subsidies) - PV(fin. distress/agency costs) – PV (other side-effects)

UCF -- expected, after-tax, unlevered cash flow

r0 -- required return on unlevered equity

Key assumption -- $ amount of debt known

Inputs: (1) financing effects, (2) cost of unlevered equity, (3) cash flows

WACC and APV

Why did the WACC approach and APV approach yield the same answer?

B = 375, V = 750 wB= 0.5

r0 = 10%, rS = 11.2%, rB = 8%

Because rS = r0 + (1- TC)(B/S)(r0 - rB)

MM w/ corporate taxes!

FTE Approach

S = t LCFt / (1+rS)t

LCF -- expected, after-tax, levered cash flow

rS -- required return on levered equity

Key assumptions -- debt cash flows known, rS constant

Inputs: (1) cost of levered equity, (2) cash flows

FTE Cash Flows

0 1 2 3 …

UCF 60 60 60 …

Int. exp. -30 -30 -30 …

After-tax -18 -18 -18 …

LCF 42 42 42 …

Or reconstruct income statement!

Issues

- Theoretically equivalent
- Assumptions/inputs determine applicability
- Constant leverage ratio WACC
- $ value of debt APV
- Both WACC, APV, FTE
- In practice all methods are approximations

WACC Approach

Consider a firm with expected EBIT next year of 100, a payout ratio of 75%, an expected perpetual growth rate of 5%, a tax rate of 40%, a WACC of 10%, and current market value of debt of 250.

What is the value of the equity?

The Solution

V = [(1-b)EBIT(1-T)]/(WACC-g)

= [(0.75)100(1-0.4)]/(10%-5%) = 900

S = V - B = 900 - 250 = 650

Assumptions

- Fixed leverage ratio, i.e., the debt will grow with firm value
- b(EBIT) = capex + NWC - depr

APV Approach

Consider a firm with a single 1 year project, that requires 1000 in financing, will generate expected UCF of 2200, and has a required return of 10%. The financing will come from equity and 400 in subsidized debt. The cost of debt is 6%, but the government is offering a low interest loan of 2% in return for an origination fee of 5. Assume a tax rate of 40%.

What is the NPV of the project?

The Solution

NPVU = -1000 + 2200/1.1 = 1000

Financing:01

400 -400

Int .exp -8

After-tax -4.8

CF 400 -404.8

PV(financing effects) = PV(tax shield) + PV(subsidy) – PV(financing costs) =

0.4(8)/1.06 + (24-8)/1.06 – 5 = 13.11

NPV = 1000 + 13.11 = 1013.11

FTE Approach

Consider a firm with expected EBIT next year of 100, interest expense of 25, a payout ratio of 40%, an expected perpetual growth rate of 3%, a tax rate of 40%, and a cost of equity of 13%.

What is the value of the equity?

The Solution

S = [(1-b)(EBIT-Int. Exp.)(1-T)]/(rS-g)

= [(0.40)(100-25)(1-0.4)]/(13%-3%)

= 180

Assumptions

- Fixed leverage ratio
- Interest expense growing with value

Terminal Values

- Usually, cash flows and tax shields can be forecasted only for a certain number of years into the future.
- Beyond that, you have to consider some terminal value of cash-flows and tax-shields, usually at a fixed or zero growth rate
- Applicable to all DCF methods

Example

- Spreadsheet..

Multiple-Based Valuation

- Value target as a multiple of earnings, cash flows, revenues (sales), etc.
- Multiple from comparable companies
- Choice of multiple depends on industry and motivation

Logic

- DCF is truth!
- Multiple-based valuation will give the correct answer if
- The variable (e.g., sales) translates into cash flows (current and future) the same way in both companies
- The discount rate (risk, capital structure) is the same for both companies

Implicit Assumptions

- UCF = EBIT(1-T) + depr – cap ex. – NWC
- Sales
- Same margin
- Same WC management
- Same growth (reinvestment rate, ROE)
- Same WACC (risk, leverage)
- EBITDA
- No margin assumption needed but more calculations required

Advantages

- Easy
- Correct if required assumptions are valid
- Uses market-based expectations
- Works even if firms are (consistently) mispriced

An Example: P/E Ratios

- Valuing the equity
- For comparable firms, P/E = 15 For firm to be valued P = 15 EPS
- Assumptions:P/E = (1-b)/(rS-g) g = b ROE
- Same cost of equity (risk, leverage)
- Same growth (reinvestment rate, investment opportunities, ROE)

Multiples

SalesP/SalesP/EM/B

Wal-Mart 256 0.86 23.97 5.33

H.D. 65 1.35 19.56 3.99

Lowes 31 1.25 21.92 4.00

Target 48 0.96 23.07 3.70

Sears 41 0.31 21.12 1.98

Kmart 17 0.43 20.52 2.85

Assignments

- Chapter 29.1-29.10
- Case: USG

Download Presentation

Connecting to Server..