Equity Valuation DCF, WACC and APV

8/22/2019 Equity Valuation DCF, WACC and APV

1/64

Financial Statement Analysis

Equity Valuation:

DCF, WACC and APV

Business 30130

Christian Leuz


2/64

2

ValuationReview

Valueofafirm

o Thesum

of

the

present

values

of

Netdebt(akaNetfinancialobligations)

Interestpayments Principalrepayments

Equity

Dividends

Repurchases

(Includesthe

terminal

dividend/repurchase,

i.e.,capitalappreciationcomponent)

Enterprisevalueif

yourdefinitionof

Netdebttreats

Cash/Equivalentsas

negativedebt


3/64

Equityvalue=PVoffuturecashashareholdergetsbackfromtheir

investmentinthecommonstock

Let:

o AnnualfuturecashberepresentedbyD1,D2,o Costofequityberepresentedbyre

Then,

Or,

t=0 t=1 t=2 t=3

3

Dividenddiscountmodel(DDM)

...)()()(

valueEquity 0

3

3

2

2

1

1

111 eee r

D

r

D

r

D

1 1tt

e

t

r

D

)(valueEquity 0


4/64

4

TheissuewithDDM

-

10,000

20,000

30,000

40,000

50,000

60,000

DP=

0%

0%


5/64

OverviewofcommonmethodsValuation:

1 (1 )

t

tt e

D

r

CashFlows Earnings

Multiples

WACC

Method

APV

Method

Cashflows

toequity

Method

Abnormal

Op.Earnings

Abnormal

Earnings

Abnormal

ROE

P/E,etc.

M/B

PEG,other


6/64

Discountedcashflowvaluationmethods

6


7/64

7

Overviewof

WACC

and

APV

methodsDiscount Fair

Method Flows Rate Value Adjustments4 Result

WACC Free WACC1 NOA3 +Finassets Finoblig. = CommonEquity

Cash &Int.tax

Flows shield

APV Free Ru2 NOA3 +Int.taxshield

Cash +Finassets Finoblig. = CommonEquityFlows

1 WACCistheWeightedAverageCostofCapital (alltypesofinvestedcapital,weightedbylongruntargetedproportionsoftotalinvestedcapitalinmarketvalueterms)

2 Ru istheunleveredcostofequitycapital,reflectingtheriskofthenetoperatingassets

3 NOAvalueisthefairvalueofthebundleofnetoperatingassetswhichgeneratestheFCF

4 Theseadjustmentsaremadeintermsofthefairvalue ofthefinancialassetsandfinancialobligations(otherthancommonstock)atthevaluationdate


8/64


WACCMethod

8


9/64

9

WACCMethod

Overview

1. ForecastFCF overforecasthorizon

2. Estimateweightedaveragecostofcapital(WACC)

3. UseWACCtoestimatePV ofFCFduringforecasthorizon

4. Estimateterminal(akacontinuing)value asofthevaluationdate

5. AddPVofFCFduringforecasthorizonandterminalvalue

i.e.,Fair

value

of

net

operating

assets

and

tax

shield

on

interest

6. Addfairvalueoffinancialassets onvaluationdate

7. Subtractfairvalueoffinancialobligations (otherfinancialclaims)on

valuationdate

8. Divideby#ofsharesoutstandingonvaluationdatetoestimatepershare

value


10/64

10

WACCmethod

Two

key

assumptions

1. Capitalstructureisexpectedtobestable

2. Taxsavingsoninterestexpenseswillberealizedwithoutdelay

i.e., adequatetaxableincometoabsorbinterestdeductionsandrealizethetax

benefits

of

the

deductibility

of

interest

Ifcapitalstructureisnotexpectedtobestable,youneedtoestimateadifferentWACCeachtimethecapital

structureisforecastedtochange

o OnealternativeistousetheAPVmethodinsteadbecausetheAPVdiscountrateistheunleveredcostofequity

(i.e.,unaffectedbycapitalstructure)

If thereareNOLcarryforwardsnoworinthefuture,estimatedWACCwillbetoolow(andhence,estimated

valuewillbetoohigh),becausetheWACCpresumestaxsavingsarerealizedwithoutdelay

o OnealternativeistousetheAPVmethodinstead

ExampleofanimproperuseofWACCmethod: LBOs

o ForLBOsthereisaclearchangeinexpectedcapitalstructureintheneartermandLBOsarefrequently

associatedwithNOLs


11/64

11

WACCMethod

NOPLAT

in

McKinsey

Book Whenestimatingcashflowsfromfinancialstatementinformation,youcanstartin

multipleplaces: Netincome,EBITDA,EBITorCFO

Oneissueyoumustdealwithishowtaxesaretreated;EasiesttoseethisinthinkingaboutNOPAT

NOPAT

o Bottomupcalculation

= NetIncomeplusaftertaxinterestexpenseminusaftertaxfinancialincome

o Topdowncalculation

=

Operatingincome

(EBIT)

minus

tax

expense

on

EBIT

ThereisalsoasimilarmeasureusedintheMcKinseyvaluationbook:

o NOPLAT(NetOperatingProfitLessAdjustedTaxes)

o NOPLATisjustlikeNOPATexceptfortwothings:

1)adjusts

for

cash

taxes

on

operating

income

2)treatsdeferredtaxitemsasnonoperating(financial)items

o Aslongaswetreattaxexpenseanddeferredtaxitemsconsistently,wellgetthesameresultsusingNOPLATaswewouldusingNOPAT. IntheseslideswewilluseNOPAT


12/64

12

WACCMethod

Step1:

Illustration

of

free

cash

flows

calculationIncomeStatement 2006 2007

Sales 2,663 2,830

COGS

SG&A

Deprec.&amort.

Interestexpense

+Financialincome 87 184

Incometaxexpense

Netincome 403 349

CashFlowStatement

Netincome 349

PlusDeprec&amort 117

netdefdtaxliab

Minus:

A/R

Inventory

Prepaidexp

Plus: A/P 74

Taxespayable

Otheraccexp 108

Otherncliab 12

Cashfrom

Ops

432

LTinvestments

Capitalexpenditures

Otherinvestments

CashfromInvesting

indebt 739

Dividends

Cashfrom

Financing

557

BalanceSheet

Assets 2006 2007

Cash 144 486

A/R 409 593

Inventories 286 289

Prepaidexpenses 13 38

Total

current

assets

852 1,406

GrossPP&E 1,851 2,467

Accumulateddepreciation

NetPP&E 1,263 1,768

Longterminvestments 390 402

Otherassets(includingintangibles) 150 163

Totalassets 2,655 3,739

Liabilities&Stockholders'equity

CurrentportionofLTD 29 39

Notespayable 102 40

Accountspayable 151 225

Taxespayable 48 45

Otheraccruedexpenses 84 192

Total

current

liabilities

414 541

Longtermdebt 390 1,181

Deferredincometaxes 221 208

Othernoncurrentliabilities 39 51

Totalliabilities 1,064 1,981

Stockholders'Equity 1,591 1,758

TotalLiab&Stockholders'eq. 2,655 3,739


13/64

13

WACCMethod

Step

1:

Three

ways

to

compute

free

cash

flows

(FCF)

Way#1: StartwithEBIT

Way#2: StartwithCashflowfromoperations

Way#3: StartwithNOPAT


14/64

14

WACCMethod

Way

#1:

Begin

with

EBITEBIT (i.e.includesallpretaxearningsclassifiedasoperating)

TaxesonEBIT

= NOPAT

+ Depreciation&amortization

=

GrossCash

Flows

Increaseinoperatingworkingcapital(includingoperatingcash)

Capitalexpenditures(netofdisposals)

Netexpendituresforotheroperatingassets(netofchangesinoperatingliabilities)

= FreeCashFlows(FCF)

EBIT = Operatingearningsbeforeinterestandtax= Sales COGS SG&A Otheroperatingexpenses depreciation&amortization

(ifdepreciation&amortizationarereportedseparatelyontheincomestatement)

TaxexpenseonEBIT = Totalincometaxexpense+ Interestexpensexmarginaltaxrate(t) [ort*EBIT]

Financialrevenuesxappropriatetaxrate(t*)

Increase inoperating

= Increase

in

operating

cash

workingcapital + increaseinA/R

+ increaseinInventory

+ increaseinPrepaidexpenses

increaseinA/P

increaseinTaxespayable

increaseinAccruedexpenses

increaseinOtheroperating(noninterestbearing)noncurrentliabilities


15/64

15

Way#1illustration

Calculating

free

cash

flows

from

EBITASSUMPTIONS: 1.Financialincomeistaxedatthemarginaltaxrate(t)of.36 (i.e.t*=t)2.Noproperty,plant,orequipmentissoldorretiredduring2007

2007

Sales 2,830 2006 2007 Change

COGS

(1,993) Current Assets:

SG&A (281) Cash 144 486 342

Depreciation&amortization (117) A/R 409 593 184

=EBIT 439 Inventory 286 289 3

Less: Prepaidexpen 13 38 25

EBITtaxes (160) Totalcur.asset 852 1,406 554

=

NOPAT

279

Op.

liab:

+Depreciation&amortization 117 A/P 151 225 74

=Grosscashflows 396 Taxespayable 48 45 (3)

Operatingworkingcapital (376) Otheraccr.exp 84 192 108

Netcapex (616) OtherliabilitiesDeferredtaxes

39

221

51

208

12

(13)

Investmentsinothoperasset (19) Totalopliab 543 721 178

=FREECASHFLOW Changeop.w.c 376

EBITtaxes= [totaltaxexp + (Interestexpense)xt (financialincome)xt*]

= [ 199 + (75 x.36) (184x.36) ]

= 160


16/64

16

Way#1illustration

Calculating

free

cash

flows

from

EBIT

(cont.) Net capex = Capitalexpenditures cashproceedsfromsaleofPP&E= NetPP&E + depreciationexpense + loss(gain)ondisposalPP&E= 17681263 + 111 + 0= 616

YoucanuseGross PP&Etogetnetcapex:

o Netcapex =GrossPPE +Accum deprec onassetssold/retired +Loss(Gain)ondisposal

o IfnoPP&Esoldorretired Netcapex =ChangeingrossPP&E

Investmentsinotherop. assets =Changeinotherop.assets+amortizationexpense= 163 150 + 6= 19

(Note:Amort exp=Deprec &Amort exp Deprec exp=117 111=6)

NetPPE

06 1263

07 1768

Accum

Dep

06 588

07 699

Onassetssold sold/retired 0 111 Deprecexp {Plug}

111 Depexp 0 sold/retCapexp616


17/64

17

Way#2illustration

Calculating

free

cash

flows

from

the

cash

flow

statement Freecashflows = Cashfromoperations"(fromcashflowstatement) 432 Increaseinoperatingcashbalance 342+ Interestexpensex(1 t) + 75(1.36) Cashflowfromfinancialincomex(1 t*) 184(1.36) Capex(netofdisposals) 616 Netexpendituresforotheroperatingassets 19

=

Theaddbackofinterestexpensenetoftaxisintendedtoremovealleffectsofinterestthatwereincludedinoperatingcashflowsfromthefreecashflowcalculation. Thisisoftenwellapproximatedby: interestexpx(1t).However,ifbondswereissuedatadiscountorpremiumsothataportionoftheprojectedinterestexpenseisanoncashitem,onlytheeffectsofinterestwithincashfromoperations (netoftax)shouldbeaddedback. Forexample,supposeafirmhasapurediscountbondoutstanding,withanaftertaxinterestexpenserecognizedontheincomestatementof100x(1.36)=64.Cashflowsfromoperatingactivitiesonthecashflowstatementwouldincludethefollowing:

EffectsofaftertaxinterestonNetincome includedonincomestatementAddback: Amortizationofbonddiscount 100 oncashflowstatementEffectofinterestoncashflowsfromoperations 36

(i.e.,thetaxbenefitof$36istheonlyeffectofinterestexpensewithincashflowsfromoperations)

HencetheinterestexpenseonthepurediscountbondincreasesCFOby36duetotaxsavings.Wewouldsubtractthe36fromCFOinourFCFcalculation.

NotethatcapitalizedinteresthasnoeffectonCFO,sonoaddbackisneededforthisinterest.

However,technicallytheamountofinterestcapitalizedduringtheperiodshouldbeeliminatedfromprojectedcapitalexpendituressinceinterestpaymentsarenonoperating.


18/64

18

Way#3illustration

Calculating

free

cash

flows

using

NOPAT

and

NOA ThesimplestmethodtocalculateFCFistotakeNOPATandsubtractthechangeinnetoperatingassets(NOA):

NOA2006 = OA2006 OL2006= 2,265 543= 1,722

NOA2007 = OA2007 OL2007= 3,337 721= 2,616

Thus,

Freecashflows = NOPAT ChangeinNOA= NOPAT (NOA2007 NOA2006)= 279 (2,616 1,722)= 279 894=

Theintuitionhereisfreecashflowequalsincomeminusinvestment. AlthoughNOPATisanaccrualnumber,anynoncashitemsinNOPAT(suchasdepreciation)canceloutwhenthechangeinnetoperatingassetsissubtractedfromNOPAT. Forexample,ifdepreciationis$100,then,allelseequal,netoperatingassetsdecreaseby$100andNOPATdecreasesby$100.

Theitems

in

the

red

boxes

onthefinancialstatements

(severalslidesback)


19/64

19

WACCMethod

Step

2:

Estimating

WACC

Ideal

vs.

practical TobetruetothetheoreticalfoundationofDCF,

WACC=weightedaveragecostofeverycomponentofinvestedcapital(i.e.allfinancialclaimsnetoffinancialassets),whereweightsarebasedon

expected

(targeted) capitalstructure

in

future

in

terms

of

market

value

proportions

o Capitalstructurescanbecomplex,complicatingcomputationofWACC

Notethecircularity: ForecastingWACCpresumesyouknowmarketvaluesofbothdebt

andequity

for

periods

>time

t(which

is

what

you

are

trying

to

value

at

time

t)

Inpractice,

EstimatesofWACCareimprecise,sowecankeepthecomputationsimple,anduse

sensitivityanalysisasasanitychecko Estimatingtargetedcapitalstructure:

1. Pastcapitalstructureforthefirmexpectedtocontinue?

2. Capitalstructureofsimilarfirmsintheindustry?

3. Specificknowledgeoffuturedebtpolicy?


20/64

20

WACCMethod

Step

2:

Estimating

WACC

Calculation Forillustrationpurposes,assumesimplecapitalstructurewithstraightdebt(D)andcommonstock(E)only(i.e.,nootherfinancialclaimsandimmaterialfinancialassets)

WACC=[Wd xRd x(1t)] + [We xRe]

Wd = targetedproportionofinterestbearingdebtincapitalstructure(marketvalues)

= D/(D+E)

We = targetedproportionofcommonstockincapitalstructureinfuture(marketvalues)

= E/(D+E)=1 Wd

t

=

marginal

corporate

tax

rate Rd = expectedcostofdebtcapital(pretax)

Re = costofequitycapital

Comments:

o IncludecapitalleaseswithinD

o DonotincludeoperatingleaseswithinDunlessyouadjustNOPATbyaddingbackimplied

interestexpense(netoftax)associatedwithPVofoperatinglease (consistency!)

o DonotincludepensionorpostretirementliabilitiesunlessyoualsoadjustNOPATtoexclude

thesecostsforimpliedinterestexpense(netoftax)andpensionassetreturns

Iffirmhascomplexcapitalstructure,APVmethodmaybepreferable,whereyouunlever betasofcompetitorstoestimatediscountrate,Ru


21/64

21

WACCMethod

Step

2:

Estimating

WACC

Interest

tax

shield

WACC=[Wd xRd x(1t)] + [We xRe]

WACCMethodreducesthediscountratetoreflecttaxsavingsoninterest

ByusingthisreduceddiscountratetoestimatethePVoffuturefreecashflows,

o TheWACCmethodcomminglesthevalueoftheNOAwiththevalueofthetaxsavingsfrom

interestondebtfinancing:

PVoffuturefreecashflows = FairvalueofNOA + Valueofinteresttaxshield

Incontrast,theAPVMethodseparatelyestimatesthevalueofNOAandtheinteresttaxshieldby

usingunleveredcostofequity(Ru)todiscountfreecashflows

o Ru reflectsriskoffreecashflowsstreamfromNOA

o PVoffreecashflows= pureestimateoffairvalueofNOA


22/64

22

Usingobservableyields:

o 1.Ifpubliclytraded:Rd =Yieldtomaturityonlongtermdebt(IRRsuchthatbondprice=PVofpromisedfutureinterestandprincipalpayments)

o 2.If

not

publicly

traded,

but

rated:

Yieldoncorporatedebtwithsimilarrating

o 3.Ifnotpublicandnotrated:Estimatewhatratingwouldbe(e.g .,basedonfinancialriskratios)andthenuse2.

Alternatives:o UsedebtbetaandCAPMtodeterminecostofdebt

Rd =Rf +[d*(E(Rm) Rf)] (usingCAPM)

d 0.4ifhighyielddebt (d 0.3ifinvestmentgradedebt)

o

Use

yield

on

BBB

debt

(lower

yield

than

junk

bonds)

as

anchor,

and

then

use

CAPMmerelytoadjustyield,i.e.,add(0.4 0.3)*[E(Rm) Rf]

o Iftheprobabilityoffinancialdistressishigh,thenWACCisproblematic

Valueofinteresttaxshieldislikelyoverstated considerAPV

WACCMethod

Step

2:

Estimating

WACC

Rd (cost

of

debt

capital)


23/64

23

WACCMethod

Step

2:

Estimating

WACC

Re (cost

of

equity

capital) Re =Expectedreturndemandedbyshareholders,givenriskoffirmscommonequity NouniversallyacceptedassetpricingmodelorapproachforestimatingRe

Widelyusedinpractice: CAPM

o Re =

Rf +[*(E(Rm)

Rf)]

(if

using

CAPM)

Rf = Riskless"(zerobeta)return

E(Rm)Rf = Expectedequityriskpremiumonthemarketportfolio

Noagreementonbestmethodsforestimating Rf and E(Rm)Rf Rangesofequityriskpremiumestimatesfrom1%to8%arecommon

Recommendationforthisclass:

o Rf = Currentyieldonlongterm(e.g.10year)USTreasurybonds andE(Rm)Rf=5%

(canuse4.0% 6.0%forsensitivityanalysis,consistentwithmanypractitioners)

o = Betaofcommonstock(levered)

Recommendationforelsewhere:

o Dowhatyourbossorfinancialbackersdo

Note:Ideally,geographiclocationofRf shouldmatchlocationoffreecashflowsbecauseexpectedinflationaffectsRf andfuturecashflows(bothareinnominalterms).


24/64

24

WACCMethod

Step

2:

Estimating

WACC

Changes

in

capital

structure Note: Ifanewtargetcapitalstructurewillbeadopted...WACCshouldreflectthenewcapitalstructure

o i.e.,newRd,Re,Wd andWe Forexample,Rd shouldreflectdefaultriskassociatedwithnewcapitalstructureand

coverageratios

o Cancomparefinancialriskratiosbasedonproformafinancialstatementsreflectingfuturecapitalstructurewithpublishedmedianratiovaluesfordebtratingcategoriestoapproximatewhatdebtratingwouldbe

o Re

canbeestimatedbyunlevering basedonoldcapitalstructureandrelevering

to

reflect

future

(new)

capital

structure

o AlternativelyuseAPVMethodinsteadofWACCMethod

==============================================================

Note: ManyacademicsandpractitionersnowuseFamaFrench3factormodelinsteadofCAPM

o Wewillcoverthisintheregularclasssession

o FFfactorsareavailableat:http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html


25/64

25

WACCMethodStep3: UseWACCtodiscountfreecashflows(forecasthorizon)

PV(FH) = FCF1/(1+WACC)1 +FCF2/(1+WACC)

2 +... + FCFT/(1+WACC)T

where

PV(FH) = Presentvalueoffreecashflowsduring ForecastHorizon

T = #ofyearsinforecasthorizon

Note: ThisformulaassumesFCFoccuratendofeachyear

WellillustratemidyearadjustmentinStep5


26/64

26

WACCMethodStep4: Estimateterminalvalue Constantgrowthmethod

Terminalvalue(presentvalue) = FCFT+1 /(WACC g)

(1+WACC)T

where

o FCFT+1 = Normalized"FCFinthefirstyearaftertheforecasthorizon

o g = ExpectedconstantgrowthrateinFCFandNOPATbeyondyearT+1

Distortions/misunderstandings

o FCFT+1 = FCFT x(1+g)

Likelytounderstate normalizedFREECFT+1 andfirmvalueiftherewerelargeinvestments

duringyear

Tto

support

higher

revenue

growth

rate

during

year

T(no

longer

need

such

large

investmentsbeyondforecasthorizonifgrowthratebeginninginT+1


27/64

27

RationaleforFCFT+1

inconstantgrowthmodelEBIT

taxesonEBIT

=NOPAT

+Depreciation&amortization

=GROSSCASHFLOW Increaseinoperatingworkingcapital

Capitalexpenditures(netofdisposals) GROSSINVESTMENTSINNETOPERATINGASSETS

Expendituresforotheroperatingassets (i.e.toreplaceassetsplusincreaseassets)

=FREECASHFLOW

RecallFCFT+1 = GrossCashFlowT+1 GrossInvestmentsT+1

= [NOPAT+deprec &amort]T+1 [Netinvestment+deprec &amort]T+1

= NOPATT+1 NetinvestmentT+1

where:

1)NetInvestmentistoexpandscopeorscaleofops.=NOA2) Investmentstoreplaceexistingassetsareapproximatedbydeprec &amortizationexpenses


28/64

28

RationaleforFCFT+1

inconstantgrowthmodel(cont.) Thenuseestimatesofgandreturnonnewinvestedcapitalbasedoncompetitiveenvironmentto

computeFCFT+1

FCFT+1 = NOPATT+1 NOAT+1

= NOPATT+1 (1 NOAT+1)NOPATT+1

= NOPATT+1 (1 g )RONIC

where

RONIC = Returnonnewinvested capitaltoexpandscaleand/orscopeofoperations

= NOPATs+1 NOPATs foranyfutureyearsNOAs

g = ExpectedlongrungrowthrateinNOPATandFCF

NOAT+1 = g/RONIC = ConstantinvestmentrateNOPATT+1

(Seenextslidetoseewhytheconstantinvestmentrate= g/RONIC)


29/64

29

RationaleforFCFT+1

inconstantgrowthmodel(cont.)

Illustrationofwhy NOAT+1 = NETINVESTMENTT+1 = g/RONICNOPATT+1 NOPATT+1

FCF = NOPAT NETINVESTMENT

= NOPATx(1 NETINVESTMENT )NOPATinvestmentrate

IfinvestmentrateisconstantbeyondforecasthorizonANDRONICisconstant FCFwillgrowatthesameconstantrateasNOPATLetg=growthrateinNOPAT (andFCF)

g = NOPATNOPAT

Foranyfutureyears (multiplyanddividebyNETINVESTMENT):

g = NETINVESTMENTS

X NOPATS+1

NOPATS

NOPATS

NETINVESTMENTS

RONIC

g = NETINVESTMENTS X RONIC NOPATS g/RONIC= NETINVESTMENTSNOPATS


30/64

30

WACCMethodStep4: Estimateterminalvalue Perpetuitymethod

Terminalvalue(presentvalue) = [NOPATT+1 /WACC](1+WACC)T

where

o NOPATT+1 = Normalized"NOPATinthefirstyearaftertheforecasthorizon

Distortions/misunderstandings

o Perpetuitymethodimpliesnogrowthbeyondforecasthorizon

FALSE!!! Theperpetuity

method

does

notassume

that

there

is

no

growth

beyond

the

forecast

horizon.

It

assumesthatthegrowthbeyondtheforecasthorizonistheresultofincrementalinvestmentsthatearnthe

costofcapital,therebyhavingnoeffectonfirmvalue(0NPV). Itdoesimplythatrealcashflowsonassetsin

placewilldeclineovertimebecauseWACChasbuiltininflationaryexpectations,butNOPATisassumedtobe

constantinnominal$.

o UsingNOPATabandonsFCF,andusesaccountingbasedprofitsinstead

FALSE!!!NOPATT+1 is theestimateofFCFT+1 givenunderlyingassumptions:

Incrementalinvestmentsare0NPVprojectsandcanbeignored. TheonlyinvestmentsinnetoperatingassetsthatneedtobesubtractedfromgrossCFT+1 toget

FCFT+1 areinvestmentstoreplaceassetswearingout. Depreciationandamortizationexpensesapproximateexpendituresrequiredtoreplaceassets

wearingout


31/64

31

WACCMethodStep4: Estimateterminalvalue Perpetuitymethod(cont.)

Toshowthelastpointonthelastslide

(re:NOPATbeingequivalenttoFCFintheterminalvalueyear

undertheperpetuitymethodtoestimatingtheterminalvalue):

FCFT+1

=NOPATT+1 +deprec &amortT+1 InvestmentstoreplaceassetsT+1 InvestmentstoNOAT+1=NOPATT+1 +deprec &amortT+1 deprec &amortT+1 0(nogrowth)

=NOPATT+1


32/64

32

WACCMethodStep5: EstimatetotalPVofFCF

TotalPVofFCF = PV(FH) + PV(TV)

(step3) (step4)

BecausethesecalculationsassumeFCFoccuratendofeachyear,some

valuationexpertsapplyamidyearadjustmentfactor:

o TotalPV

of

FCF

(above)

x

(1+WACC)0.5 =

Value

of

operations

(includestaxshield)


33/64

33

WACCMethodStep6: Addfairvalueoffinancialassets Examples:

o Excessmarketablesecurities(Note:interestonoperatingcashisincludedinFCF)

o Longterminvestmentsindebtorequitysecurities

MakesurethecashflowsoftheseassetsareNOTinyourFCFestimates

Examples:

o Shortterminterestbearingdebt(notespayable)

o LTinterestbearingdebt(includingcurrentportionandcapitalleases)

o Minorityinterest

o

Preferred

stocko Employeestockoptions

o Note: DonotsubtractPVofoperatingleases,orpensionandpostretirementliabilitieson

thebalancesheetunless youconsistentlytreattheseitemsasinterestbearingdebt

throughout(whichmeansyouexcludetheircashflowsfromFCF,i.e.,youaddthemback)

WACCMethodStep7: Subtractfairvalueoffinancialobligations


34/64

34

WACCMethodStep8: Divideby#sharesoutstanding

Valueofequity= PVFCF(FH) + PVFCF(TV) + FVFA FVFO

Valuepershare

= Valueofequity / #sharesofcommonstockoutstanding

#Issued #inTreasury

(fromrecentbalancesheet)

Becareful

about

dilutive

securities

and

their

effects

on

shares

outstanding.

If

theyaresubtractedinStep7,youdonotneedtoaccountfortheireffectsonthe

totalsharesoutstanding(thiswouldbedoublecounting)


35/64


APVMethod

35


36/64

36

AdjustedPresentValue(APV)Method

AdvantagesoverWACCmethod:

o SeparatesvaluationofFCFfromfinancingsideeffects(i.e.,interesttaxshield)

o Providespureestimateofvalueofnetoperatingassets,w/ocomminglingvalueofinteresttaxshield

TheAPVMethodcanmoreeasilyaccommodate:o Changingcapitalstructure

o Complexcapitalstructure

o Interestdeductionscarriedforward(NOLs)

o Financialdistress

o Appealingforvaluingdivisions,asyoudonotneedtoallocatecorporatedebttospecificdivisions,whichislikelywiththeWACCmethod


37/64

37

APVMethod Overview[DifferencesfromWACCMethodhighlightedinred anditalicized]

1. ForecastFCFoverforecasthorizon

2. Estimateunleveredcostofequitycapital(Ru)

3. UseRu todiscountFCFduringforecast horizon

4. Estimateterminalvalue(usingRu)asofthevaluationdate

5. AddPVofFCFduringforecasthorizonandterminalvalue

6. AddPVofinteresttaxshield

7. Addvalueoffinancialassets

8. Subtractvalueoffinancialobligations

9. Subtractcostsoffinancialdistress

10. Divideby#sharesoutstandingtoestimatevaluepershare


38/64

38

APVMethodStep1: ForecastFCF SameasWACCMethod

Ru =Rf +u *[E(Rm) Rf]where

o u =Unleveredbeta(i.e.foranallequityfinancedfirm)(assetbeta)

ReflectsriskofFCFgeneratedbyNetOperatingAssets

Formulaforu Dependsonassumptionaboutriskofthetaxshieldoninterest

APVMethodStep2:EstimatingRu Calculation


39/64

39

APVMethodStep2:EstimatingR

u

using u

Approach1: Assumetheriskofthetaxshieldoninterest=riskofthenetoperatingassets(u) UNLEVER:

o u = D *d + E *e Note:ifd =0, u= eD+E D+E (debtisriskfree) [1+(D/E)]

RELEVER:

o e =u +[(u d)*(D/E)] e =u *[1+(D/E)]

where

e = Leveredbetaoncommonequity

d =

Betaon

debt

D/E= capitalstructure(debtrelativetoequityinmarketvalueterms)

(Iffirmhaslotsofexcesscash,cansetD=netdebt=debt excesscash)

Reasonableifuncertaintyabouttaxshieldsismainlyassociatedwithgeneratingoperatingincome

AND/OR

Ifcapitalstructureexpectedtoremainstable AmountofdebtdependsonfuturevalueofNOA Themainuncertaintyaboutthefuturetaxshieldistheamountofdebtthatwillbeoutstanding

(whichisafunctionoftheNOAandcapturedbytheriskofthenetoperatingassets)


40/64

40


u

using u

(cont.)

Approach2: Assumetheriskofthetaxshield=riskonthedebt(d)ANDdebtisconstantindollars UNLEVER:

o u = D(1t) *d + E * e Note:ifd =0 u = eD(1t)+E D(1t)+E (debt&taxshield [1+(1t)(D/E)]

areriskfree)

RELEVER:

o e =u +[(u d)*(1t)(D/E)] e =u *[1+(1t)(D/E)]

where e = Leveredbetaoncommonequityd = BetaondebtD/E= Capitalstructure(inmarketvalueterms)

(aswithMethod1,canuseD=netdebtiflotsofexcesscash)

t = Marginaltaxrate

Reasonableifthemainsourceofuncertaintyiswhethertheinterestispaid,asreflectedintheriskofthedebt.

h d


41/64

41


u

Comments onunlevering Canbeadvantageoustounlever betasoffirmswithsimilarassetrisk,andtake

meanormedianasanestimateofunleveredbetaforthecompanyofinterest:

o Individualbetasareestimatedwitherror. Thehopeisthatbytakingaverage(ormedian),errorsinestimatesofindividualbetasarediversifiedaway,

producingamore

accurate

estimate

of

unlevered

beta

for

the

company.

o Forprivatecompanies,noequitybetaisavailabletounlever. Unlevering betasofpublicfirmswithsimilarassetriskisagoodwaytoestimateunleveredbetaofaprivatecompany.

o Ifunlevering betas

of

comparable companies

in

an

industry

with

heavy

relianceonoperatingleases,itcanbeusefultotreatoperatingleasesasdebt.Ifso,needtotreatoperatingleasesofthecompanyasdebtalso

o Ifafirmhasacomplexcapitalstructure (sosimplecapitalstructureassumedinunlevering formulasisntaccurate),youcanunlever betasoffirmswithsimilarassetriskbutwithsimplercapitalstructures,andusetheaverageormedianoftheseunleveredbetas(henceAPVmethodmakesiteasiertohandleacomplexcapitalstructurethanWACCmethod).

APV M h d


42/64

42


u

Examplesofunlevering betas

Firm

Equity

Beta Debt/EquityRatio

Debt

Beta

Southwest 1.13 0.15 0.00

AlaskaAir 1.80 1.06 0.15

SkyWest 1.69 1.05 0.15

Mesa 3.27 3.52 0.30

Continental 3.76 5.59 0.40

Source:Berk andDeMarzo

APV M th d


43/64

43


u

Examplesofunlevering betas(cont.)

Firm

Equity

Beta E/(E+D)

Debt

Beta D/(E+D)

UnLevered

Beta

Southwest 1.13 87% 0.00 13% 0.98

AlaskaAir 1.80 49% 0.15 51% 0.96

SkyWest 1.69 49% 0.15 51% 0.90

Mesa 3.27 22% 0.30 78% 0.95

Continental 3.76 15% 0.40 85% 0.90

X X+ =

APV M th d


44/64

44


u

Estimatingdebtbetas

Wheredowegetdebtbetas?

Inprinciple,debtbetascouldbeestimatedusingthesameregression

methodsthatwedevelopedforequitybetas Inpractice,however,datafor

thehistoricalreturnsofdebtsecuritiesaremuchmoredifficulttoobtain,

makingadirectcalculationofthebetafordebtproblematic. Asa

consequence,debtbetasareoftenapproximatedusingothermeans. Forexample,givenanexpectedreturnforthedebtrd (basedonitsyield,but

adjusteddownwardtoreflectthepossibilityofdefault),wecanestimatethe

betaofdebtusingthesecuritymarketlineoftheCAPM.

(Berk andDeMarzo,page443)

APV Method


45/64

45

APVMethodStep3:UseRu todiscountFCF(forecasthorizon)

PV(FH) =FCF1/(1+Ru)1 +FCF2/(1+Ru)

2 +...+FCFT/(1+Ru)T

(sameasstep3forWACCMethod,exceptuseRu insteadofWACC)

(Sameasstep4forWACCMethod,exceptuseRu insteadofWACC)

APVMethod

Step

4:

Estimate

terminal

value

APV Method


46/64

46

APVMethodStep4: Estimateterminalvalue Constantgrowth = FCFT+1/(Ru g) = [NOPATT+1 (1 (g/RONIC))]/(Ru g)

(1+Ru)T (1+Ru)

T

where

o

FCFT+1 =

Normalized"

FCF

in

the

first

year

after

the

forecast

horizono NOPATT+1 = Normalized"netop.profitaftertaxin1

st yrafterforecasthorizon

o g = ExpectedconstantgrowthrateinFCFandNOPAT

o RONIC = Returnonnewinvestedcapitaltoexpandscaleofoperations

o

Ru =

Unlevered cost

of

equity

capital

= [NOPATT+1 /Ru]

(1+Ru)T

APVMethod

Step4(Alternative): Estimateterminalvalue Perpetuity

APV Method


47/64

47

APVMethodStep5:EstimatetotalPVofFCF

TotalvalueofFCF = [PV(FH)+PV(TV)]x(1+Ru)0.5

(sameasstep5ofWACCMethod,includingmidyearadjustmentfactorbasedonRu)

PVofinteresttaxshield = PVofinteresttaxshieldduring forecasthorizon

+ PVofinteresttaxshieldbeyondforecasthorizon

APVMethod

Step

6:

Add

PV of

interest

tax

shield

APV Method


48/64

48

APVMethodStep6: Estimatingthevalueoftheinteresttaxshield STEP6A:

o EstimatePVofinteresttaxshieldduring forecasthorizonperiod1:

[txinterestexp1]/(1+R)1 +...+[txinterestexpT]/(1+R)

T

whereRisthediscountratewhichreflectstheriskofthetaxshield

WhatisR?

o UseR=Ru ifriskofthetaxshield=riskofassets

o UseR=Rd ifriskofthetaxshield=riskofthedebt

Beconsistentwithmethodofestimatingunleveredbeta Whatist?

o Wewillusemarginalcorporatetaxrate(seeslidesinWeek3)

1 Thisexpressionassumesthattheinteresttaxdeductioncanbeusedintheyearinterestispaid. Ifnot(e.g.tax

losscarryforwards),reflecttheexpectedtimingoftherealizationofthetaxsavingsintheexpressiongivenforthe

PVoftaxshieldoninterest. Thisexpressionalsoassumesinterestrevenueonexcesscashisimmaterial.If

material,canusenetinterestexpenseintheformula=interestexp interestrevenueonexcesscash.

APV Method


49/64

49

APVMethodStep6: Estimatingthevalueoftheinteresttaxshield(cont.) STEP6B:

o EstimatePVofinteresttaxshieldbeyondforecasthorizon

Severalapproaches:

o Method1:

o Assumingcapital

structure

is

fixed

beyond

forecast

horizon:

o PVtaxshieldbeyondforecasthorizon= [terminalvalueusingWACC terminalvalueusingRu]/(1+R)

T

o EXAMPLE:

CONSTANT

GROWTH

IN

PERPETUITY

method

of

estimating

terminal

value:continuingvalueusingWACC =FCFT+1/ (WACC g)

continuingvalueusingRu =FCFT+1 /(Ru g)

PVoftaxshieldbeyondforecasthorizon={[FCFT+1 /(WACCg)] [FCFT+1/(Rug)]}/(1+R)

T

NOTE:R=Ru orRd dependingonassumedriskoftaxshield.

Beconsistentwithformulaforestimatingu MostcompellingtouseR=Ru ifdebtgrowingforeveratsamerateasFCF

(i.e.,stablecapitalstructurebeyondforecasthorizon)

APV Method


50/64

50

APVMethodStep6: Estimatingthevalueoftheinteresttaxshield(cont.) Method2:

o AssumeDT+1 (debtoutstandingatT+1)willgrowforeveratgrowthrateg.

o PVoftaxshieldbeyondforecasthorizon = [txRd xDT+1]/(Rg)/(1+R)T

o NOTE:R =Ru orRd dependingonassumedriskoftaxshield

BeconsistentwithformulaforestimatinguMostcompellingtouseR=Ru ifdebtgrowingforeveratsamerateasFCF(stablecapital

structurebeyondforecasthorizon)

Method3:

o AssumeDT+1 (debtoutstandingatT+1)willremainconstantin$beyondforecast

horizon

o PVoftaxshieldbeyondforecasthorizon = [txRd xDT+1]/R/(1+R)T

o NOTE: IfR=Rd PVoftaxshieldbeyondforecasthorizon=[txDT+1 ]/(1+Rd)T

================================================================

PVoftaxshield=6A+6B,assumingtaxsavingsoccuronlastdayofyear

Toadjusttaxsavingstomidyear: [6A+6B]x(1+R)0.5

APV Method


51/64

51

APVMethodStep7:Addfairvalueoffinancialassets SameasWACCMethod

SameasWACCMethod

Oftenignoredinpractice

o Duetoimprecisionofeverything,especiallyquantifyingcostsoffinancial distress

o Willhavemoreonthistopicnextclass

APVMethod

Step8: Subtract fairvalueoffinancialobligations

APVMethodStep9: Subtractcostsoffinancialdistress


52/64

52

APVMethod: SUMMARY

Valueofequity=

Totalvalueoffreecashflowstoallequityfinancedfirm

+ PVofinteresttaxshield

+ Fairvalueoffinancialassets

Fairvalueoffinancialobligations

Costsoffinancialdistress

Valuepershare

= Valueofequity / #sharesofcommonstockoutstanding

#Issued #inTreasury

APVMethodStep10: Divideby#sharesoutstanding


53/64

53

APPENDIX1

DCFVALUATION(WACCMETHOD)

AnIllustration:PepsiCo

From:

FinancialReportingandStatementAnalysis

Stickney,Brown,Wahlen[2004]

Assume:Allassetsareoperatingassets

Allsources

of

income

will

be

included

within

Free

Cash

Flows

EXHIBIT 10 3


54/64

54

Year+1 Year+2 Year+3 Year+4 Year+5

Projected Projected Projected Projected Projected

Salesa

28,841$ 30,890$ 33,094$ 35,464$ 38,013$

Costof

Goods

Sold

b

(11,450)

(12,202)

(13,006)

(13,866)

(14,825)

GrossMargin 17,391$ 18,688$ 20,088$ 21,598$ 23,188$

SellingandAdministrative Expensec

(12,429) (13,312) (14,262) (15,284) (16,382)

OtherRevenuesd

169 187 201 215 231

OtherExpensese

(58) (62) (66) (71) (76)

OperatingIncome 5,073$ 5,501$ 5,960$ 6,458$ 6,961$

InterestIncomef

73 80 86 92 99

InterestExpenseg

(189) (199) (194) (203) (216)

IncomebeforeIncomeTaxes 4,957$ 5,382$ 5,852$ 6,347$ 6,844$

IncomeTax

Expense

h

(1,586)

(1,722)

(1,873)

(2,031)

(2,190)

NetIncome 3,371$ 3,660$ 3,980$ 4,316$ 4,654$

PreferredDividendsi

(4) (4) (4) (4) (4)

CommonDividendsj

(1,600) (1,692) (1,572) (2,395) (1,920)

ChangeinRetainedEarnings 1,767$ 1,964$ 2,404$ 1,917$ 2,730$

ProFormaStatementsofIncomeandRetainedEarningsforPepsiCo

(amountsin

millions;

allow

for

rounding

errors)

EXHIBIT10.3

a Sales projected sing e pected gro th rates for the three primar prod ct market

Exhibit10.3 notes:


55/64

55

a Salesprojectedusingexpectedgrowthratesforthethreeprimaryproductmarket

segments. 7.1%yrs+1to+3,7.2%inyrs+4and+5b COGSprojectedassumingasteadydeclinefrom39.7percentto39.0percentofsales

(39.7%,39.5%,39.3%,39.1%,39.0%)

c SG&Aprojectedassuming43.1percentofsales.

d Otherrevenuesprojectedassuming5.5percentreturnoninvestments.

e Otherexpensesprojectedassuming0.2percentofsales.

f Interestincomeprojectedassuminganinterestrateof4.2percentearnedonaveragecash

&short

term

investments.

g Interestexpenseprojectedassuminganinterestrateof6percentonaverageshortterm

borrowing,currentmaturitiesoflongtermdebt,&longtermdebt.

h Incometaxexpenseprojectedassuminganeffective&marginaltaxrateof32.0%.

(federalstatutory

+state

&

local

+foreign

in

recent

years

effective

rate

also)

i Preferreddividendsprojectedassumingaconstantpreferredstockdividend.

j Commondividendsprojectedassumingadividendpayoutrateof38.0percentofnet

income,plusanynecessaryadjustmenttobalancethebalancesheet.

ProFormaBalanceSheetsforPepsiCo

(amountsinmillions;allowforroundingerrors)

EXHIBIT10.4


56/64

56



Assets

Cash 790$ 846$ 907$ 972$ 1,041$

ShorttermInvestments 1,057 1,133 1,215 1,302 1,397

AccountsReceivable 2,291 2,454 2,629 2,818 3,020

Inventories 1,316 1,402 1,495 1,594 1,704

OtherCurrentAssets 822 881 945 1,013 1,086

TotalCurrentAssets 6,276$ 6,716$ 7,191$ 7,699$ 8,248$

Investments 3,287 3,524 3,779 4,052 4,346

Property,Plant,andEquipment(cost) 13,598 15,117 16,744 18,488 20,357

AccumulatedDepreciation (6,207) (7,174) (8,210) (9,320) (10,510)

OtherAssets 6,526 6,990 7,489 8,025 8,602

TotalAssets 23,481$ 25,173$ 26,993$ 28,944$ 31,043$

LiabilitiesandShareholder'sEquityAccounts

Payable 1,287$

1,380$

1,471$

1,569$

1,678$

ShorttermBorrowings 117 126 135 145 155

CurrentMaturitiesofLongtermDebt 485 441 167 602 310

OtherCurrentLiabilities 3,647 3,906 4,185 4,484 4,807

TotalCurrentLiabilities 5,536$ 5,853$ 5,958$ 6,800$ 6,950$

LongtermDebt 2,700 2,769 2,834 2,894 3,104

DeferredIncomeTaxes 1,602 1,716 1,838 1,970 2,111

OtherNoncurrent

Liabilities 4,150

4,445

4,762

5,103

5,470

TotalLiabilities 13,989$ 14,782$ 15,394$ 16,768$ 17,636$

PreferredStock 26$ 26$ 26$ 26$ 26$

CommonStock 43 43 43 43 43

RetainedEarnings 13,286 15,251 17,655 19,572 22,302

OtherEquityAdjustments (1,646) (1,646) (1,646) (1,646) (1,646)

TreasuryStock (2,217) (3,283) (4,479) (5,819) (7,318)

Total

Shareholders'

Equity 9,492$

10,391$

11,599$

12,176$

13,407$

TotalLiabilities andShareholders'Equit 23,481$ 25,173$ 26,993$ 28,944$ 31,043$

Exhibit10.4 notes:

Cashprojectedassuming10daysofsalesincash=endingcash/(sales/365)


57/64

57

Marketablesecurities(STinvestments)projectedtobe4.5%oftotalassets

A/Rprojectedassuming29daysofsalesinA/R=endingA/R/(sales/365)

Inventoryprojectedassuminginventoryturnoverof8.7

(usingyrendbalancesonlyinturnoverratio)

Othercurrentassetsprojectedtobe3.5%oftotalassets

Investmentsin

securities

projected

to

be

14.0%

of

total

assets

NetPP&EcomputedasbeginningNetPP&E+CAPEX depreciation,assumingCAPEX

growsanddepreciationexpgrowatsamerateassales,noassetssoldorretired.

Otherassetsgrowatsamerateassales

Toprojectamountsthatarespecified%oftotalassets,notewehave:

Assetsas%ofTotalAssets: AssetsPredictedDirectly(year+1)

Marketablesecurities 4.5% Cash 790

Othercurrentassets 3.5% A/R 2291

Investments

14.0%

Inventory

1316

Total 22.0% NetPP&E 7391

Otherassets 6526

Subtotal 18,314

Hence18,314=78%oftotalassets Totalassets+1 =18,314/.78=23,481

Exhibit10.4 notes:(cont.)


58/64

58

A/Pprojectedassumingaccountspayableperiod=41days(usingyrendbalanceofA/PonlyinA/P

turnoverratio)

Shorttermborrowingsprojectedtobe0.5%oftotalassets

CurrentmaturitiesofLTDprojectedusinginfoindebtnoteaboutfuturematurities

(Beyondyear+5assumedtobe10%ofLTD)

Othercurrentliabilitiesassumedtogrowatsamerateassales

LTDdeclinesto10%oftotalassets(11.5%inyear+1,11%inyear+2,10.5%inyear+3, 10.0%in

year+4andbeyond)

Deferredtaxesgrowassamerateassales

Othernoncurrentliabilitiesgrowatsamerateassales

Preferredstock

remains

the

same

Commonstockremainsthesame(usesthetreasurystockaccounttoreflectstockbuybacksand

reissuances)

Retainedearnings=Beginningbalance+netincome implieddividends

(Implied

div=

constant

pref.

dividends

($4

M)

+

38%

net

income

plus

plug

to

balance

bal

sheet) Otherequityadjustments=0(followrandomwalk,sopredictedchangeiszero)

Treasurystock:neteffectofassumedstockrepurchasesof1,$1,700Minyear+1,increasingby

10%ayeartoyear+5,andstockreissuanceforexerciseofstockoptionsof$751Minyear+1,and

growingatsamerateassalethru+5. Beyondyear+5treasurystockwillgrowat10%.


59/64

EXHIBIT11.4

ValuationofPepsiCo:

PresentValueofFreeCashFlowstoAllDebtandEquityCapitalStakeholders


60/64

60

Year

+

1 Year

+

2 Year

+

3 Year

+

4 Year

+

5Projected Projected Projected Projected Projected

NETCASHFLOWFROMOPERATIONS $4,718.6 $5,079.9 $5,493.7 $5,940.4 $6,396.8

Addback:InterestExpenseaftertax(intexpx(1.32)) 128.7 135.4 132.0 138.3 147.1

Subtract:InterestIncomeaftertax 0.0 0.0 0.0 0.0 0.0

+/ Investmentinoperatingcash 107.2 56.1 60.4 64.9 69.8

FREECASHFLOWSFROMOPERATIONS 4,740.1 5,159.2 5,565.3 6,013.7 6,474.0

NETCASHFLOWFROMINVESTING 2,356.0 2,295.3 2,461.7 2,640.3 2,833.9

FREECASHFLOWS $2,384.1 $2,864.0 $3,103.6 $3,373.4 $3,640.1

PresentValueFactors(WACC=7.90%) 0.927 0.859 0.796 0.738 0.684

PVsofFreeCashFlows $2,209.6 $2,460.1 $2,470.8 $2,489.0 $2,489.2

SumofPVFreeCashFlowsYear+1throughYear+10 $24,317.6



NETCASHFLOWFROMOPERATIONS $6,863.2 $7,356.0 $7,884.8 $8,451.6 $9,061.5

Addback:InterestExpenseaftertax 151.0 161.9 173.7 186.3 199.8

Subtract:InterestIncomeaftertax 0.0 0.0 0.0 0.0 0.0

+/

Investmentin

operating

cash

74.9

80.2

86.0

92.2

99.0

FREECASHFLOWSFROMOPERATIONS 6,939.2 7,437.7 7,972.5 8,545.7 9,162.3

NETCASHFLOWFROMINVESTING 3,038.7 3,257.1 3,491.2 3,742.1 4,013.3

FREECASHFLOWS $3,900.6 $4,180.6 $4,481.3 $4,803.6 $5,149.0

PresentValueFactors(WACC=7.90%) 0.634 0.587 0.544 0.505 0.468

PVsofFreeCashFlows $2,472.1 $2,455.7 $2,439.6 $2,423.7 $2,407.8

Year+1throughYear+10

Beyondyear5,similarassumptionsto5(7.2%growthinsales,op.income,CFO,CFInvesting,FCF)

Aftertax Weighted

Value Cost of Average

WeightedAverageCostofCapital forPepsiCo


61/64

61

Value Costof Average

Capital Basis Amount Weight Capital Component

Debt Fair 3,266$ 0.0365 0.041 0.00150

Preferred Fair 50 0.0006 0.080 0.00005

Common Market 86,132 0.9629 0.080 0.07703

Total 89,448$ 1.0000 0.07858

Debt:

3,266fairvalueofdebtoutstandingdisclosedinnotestomostrecentfinancialstatements.

Aftertaxcosts=.06x(1.32)=.041.

Statedratesondebtexceedprevailingmarketratessince3,266exceedsbookvalueof3,005

However,prevailinglowratesnotexpectedtocontinue,souserecenteffectiverates

fromproformas

Preferredstock:

Assumeriskofpfdstock commonstocksosimilarcostofcapital.Impliesamarketvalueofpfdstockof4M/.08=50M

CommonStock:

Re =Rf + (ERm Rf) =.042+.76(.05)=.08 (Noteuses.05aspremiumonmarket)

86,132=$49.05stockpricex1,756Msharesoutstanding


62/64

62

WACC (cont.)

InitiallyusesactualmarketvalueofequityonvaluationdatetogetinitialWACC=.07858

Finalestimateofequityvalue(121,249.8million)suggestsinitialWACCcalculationabove

usestoolowaweightoncommonequity

Iterates,resultingin.079asthefinalestimateofWACC

Alternativeapproachthatavoidsiterationistoassumealongruntargetedcapitalstructure

EstimateofTerminalValue

Usesconstantgrowthmethod:


63/64

63

TerminalValue = FCFT+1 / (1+WACC)T

(WACC g)

FCF11 = $5,925.5million

Assumeg,longtermconstantgrowthrate=5%beginninginyear11.

Basedonexpectedlongtermgrowthofeconomyof 2%andlongterm

inflationof

3%

(1+.02)(1+.03)

=1.0506

Assumeallitemsofincomestatementgrowfromyear10to11by5%

Assumeassetsandliabilities(netoperatingassets)growby5%fromyear10to11

ComputeFCFinyear11fromprojectedincomestatementandbalancesheet

NoteifusedFCFinyear10x(1.05)=5406,wouldunderstateterminalvalue.

Reasonisthatsinceassumedterminalgrowthrateof5% 7.2%growthrateinyear+10, appropriatetoreduceCFusedforinvestinginyr+11belowyr10levels. (i.e.CF

frominvestingisnotgrowingat.05fromyr+10toyr+11)

FCFgrow

from

year

10

(5149)

to

year

11

(5925.5)

by

15%

Withg=.05 andWACC =.079

TerminalValue = FCFT+1 / (1+WACC)T = 5,925.5 / (1.079)10 95,642.4M(WACC g) (.079.05)

ValuationofPepsiCousingFreeCashFlowstoAllDebtandEquityCapital

EXHIBIT11.5


64/64

64

ValuationSteps Computations Amounts

PVFCFYear+1throughYear+10 SeeExhibit11.4 + 24,317.6$

PVFCFYears+11andBeyond Longrungrowthrateassumedtobe + 95,642.4$

5%;discountedat7.90%.

PVofAllDebtandEquityCapital = 119,960.0$

SubtractDebt

Capital Fair

Value

of

Debt

3,266.0$

SubtractPreferredStock FairValueofPreferredStock 50.0$

AddFinancialAssets AssumedtobeZero + $

PVofCommonEquity = 116,644.0$

AdjustforMidyearDiscounting Multiplyby1+(WACC/2) 1.0395

TotalPV

of

Common

Equity = 121,249.8$

DividebyNumberofSharesOutstanding Inmillionsofshares 1,756$

ValueperShareofCommonEquity = 69.05$

CurrentPriceperShare 49.05$

PercentDifference (Positivenumberindicatesunderpricing) 41%

Comments:

1. Canuse(1.079)0.5 =1.0387insteadof1.079/2=1.0395

2. If marketvaluesofdebtandpfdstockonvaluationdatearereadilyavailableinsteadof

estimatingfromfutureCF,donotneedtodomidyearadjustmentfortheseitems

Date post:	08-Aug-2018
Category:	Documents
Upload:	stf2x
View:	231 times
Download:	0 times

Equity Valuation DCF, WACC and APV

Documents