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Valuation - DCF

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Chapter 1

Valuation - DCF1This is only a summary. Please read the text book and assigned readings for details. Removal of errors and omissions, if any, in this ppt are your responsibility.ContentsBalance SheetValuationNumerical 1Estimating CFEstimating Growth RateEstimating Terminal ValueEstimating WACCValuation ApproachNumerical 2, 3, 4ReadingsSummary of Valuation Methods

2Accounting Balance Sheet

Balance Sheet

33Financial Balance Sheet

Balance Sheet

44Valuation

Firm Value - FCFFEquity Value - FCFENeed CF either to the firm or equity55Misconceptions about valuation1. It is an objective search for true valueValuations are biased by how much and in which directionSize and direction of bias depends on who pays you and how much! Basically understand the dynamics2. Valuation is preciseNote that the payoff to valuation is most when valuation is least precise!3. More quantitative the model, better the valuationUnderstanding of the model is inversely proportional to the number of inputsComplex models perform worse due to being unclear

Valuation66ValuationFirst principles of valuation

Never mix and match cash flows and discount rates

What happens when you discount equity cash flows with the WACC?

What happens when you discount firm cash flows with the cost of equity?77Numerical 18

Consider the 4-yr projection for XYZ Inc.After 2011, EBIT and deferred taxes are expected to grow at the nominal rate of 3%, capital expenditures will equal depreciation and net working capital will not change.In addition, the firms tax rate is 38%, its WACC is 11%, its current net debt amounts to $650 million and is projected to grow to $820 million by the end of 2011. The interest rate on debt is 8.5%. This rate is expected to apply to future borrowing as well. The firm has 35 million common shares outstanding.Consider the 4-yr projection for XYZ Inc.8Numerical 19

Estimate the free cash flows of the firm for the 5 years 2008 to 2012 and compute the enterprise value as of year-end 2007Estimate the value per share of the firms equity in 2007 endCompute the prospective (i.e., with respect to next year earnings) price-earnings multiplies implied by your valuation at year-end 2007 and year-end 2011For simplicity, assume that all debt financing for each year is raised at the beginning of the year such that beginning-of year debt and average debt are the same.9Estimating CFOperating Leases treated like operating expenses though it is more a financing expense

Adjustment to earningsAdj. operating earnings = operating earnings + lease expenses depreciation of the leased asset

R&D Acctg. Standards require you to treat it like operating expenses though it is more a capital expenditure

Adjustment to net capexAdj. net capex = net capex + current year R&D Amortization of R&D asset1010Estimating CFWhat about acquisition of other firms? captured in the capex

Adj. net capex = Net capex + acq. of firm amortization

Change in working capital: increase in workingcapital will reduce cash flow and vice versa1111Estimating CFTax rate marginal or average?

1212Estimating Growth RatePast estimatesThe historical growth in earnings per share is usually a good starting point for growth estimationAnalyst estimatesAnalysts estimate growth in earnings per share for many firms; it is useful to know what their estimates areBasic fundamentalsUltimately, all growth in earnings can be traced to two fundamentals - how much the firm is investing in new projects, and what returns these projects are making for the firm

1313Few other aspects..Growth rate incorporates current growth from investments and better utilization of assets in place may lead to high growth phaseLength of high growth phase important; terminal value computed using stable growth rateHow to deal with negative earningsHow to incorporate size changes through differential growth phases and rates

Estimating Growth Rate1414Estimating Terminal Value

1515Estimating Terminal ValueNormally firms are considered to have infinite life

Thus, estimate CF for a growth period and then terminal value which captures all future growth

If firms have differential growth rate then appropriately apply the growth rates

Stable growth rate cannot be greater than the growth rate for the economy (when a firm achieves this depends on size, market competition, current growth rate, entry barriers)

1616Estimating Terminal ValueIf the economy is composed of high growth and stable growth firms, the growth rate of the latter will probably be lower than the growth rate of the economyThe stable growth rate can be negative; then the terminal value will be lower and it implies that the firm will disappear over time

1717Estimating WACCDiscount rate should be consistent with the riskiness and type of CFVariables needed: risk free rate, market risk premium, beta, cost of equity, cost of debtRisk free rate: no default risk, no reinvestment riskNot all government securities are risk freeGenerally long term securities considered stable and default free are the proxy for risk free rate For MNCs which risk free rate?1818Market risk premiumHistorically what stocks have earned above the risk free rate how far back, t-bills or t-bonds as a proxy for risk free rate Longer the past greater the noise, what about unexpected events discard data? Survivorship bias more so in developing countriesMay need to incorporate country risk premium for multinationals

Estimating WACC1919Issues with betaStationary? Is beta stable over timeFor new firms sample size may be inadequateLeverage and business mix is over the period of estimation could be different today; need to correct for thatWhat is market index?Estimating WACC2020Concerns 1 and 2 can be mitigated by sophisticated statistical techniques

Concern 3 can be somewhat overcome by adjusting for changes in the firm-specific business risk (operational risk - % of FC in the companys cost structure) and financial risk (reliance on debt or D-E ratio)

Broadly, consider average beta estimates of comparable firms in the industry and adjust for firm-specific risk bottoms up beta (levering-unlevering)Estimating WACC2121For the firm under consideration, identify the various lines of business, financial leverage and operating leverageFind other publicly traded firms in these specific business and obtain the beta (regression), the financial leverage and operating leverage of each comparable firmFor the publicly traded firms Compute the average beta (market weighted, equal weight?) Compute the average D-E ratio Compute the average FC/VC ratioEstimating WACC2222Estimate the unlevered beta for publicly traded firms by first unlevering for average financial leverage and then average operating leverageEstimate the beta for the firm under consideration by beginning with the above betaThen first relever using the firm-specific operating leverage and then the financial leverage of the firm under considerationEstimating WACC2323Rating agencies rate the debt of firm reasonable estimate of debt spread

Cost of debt = risk free rate + default spread

Factor in country spread if and when needed

Need to incorporate tax shield when computing WACCEstimating WACC2424Estimating CF

Discount at WACCDiscount at Ke2525Valuation ApproachVarious approaches to valuation

FCFF is independent of the leverageFinancing is a reality and has to be taken into considerationSpecifically, the interest tax shield (ITS) has to be incorporated in some mannerThere are several approaches and each differs in the way the ITS is incorporated2626Valuation ApproachWe will consider four techniquesFCFFThe impact of interest expense is incorporated in the computation of the WACCAll financing side effects are assumed to be captured in the WACC (blend of costs)Implicitly assumes constant rebalancing of D-EAPV Unbundles all CF or sources of value and treats them separatelySide effects considered separately2727Valuation ApproachWe will consider four techniquesThe Capital Cash Flow (CCF) Incorporates the ITS in the cash flows itselfHas to be discounted at cost of the asset (Ra)FCFE Considers only cash flow to owners of the firmDoes not provide information on the sources of value creationEquity value may be ve2828Valuation ApproachMiles and Ezzell propose discounting the ITS in the first year at the cost of debt and then at the cost of the unlev firm for the future years into perpetuity (for rebalancing once at the beginning of the year)In the first year the size of the ITS is known and so can be discounted at the cost of debtHowever in the future ITS being an estimate, the D-E ratio being constant and a part of the firm it should be discounted at the cost of the unlev firm 2929Numerical 2As an analyst you are asked to evaluate Smith Co. (the target) using DCF methodology. Long term interest rates are currently at 8.15% and the market risk premium is 6%. In its last attempt about 6 months ago the firm was able to raise debt at the rate of 9.25%. The market conditions and the firms performance have remained consistent, meeting expectations over this period. The firms financial information is shown below. In the last three years the EBIT growth has been over 10% and is expected to be similar for the next two years and then tapering off to industry standards. Your analysis estimates ABC Corp., a 30-year old firm in this industry to have a growth potential of 2%. Smith Co. internal data analysts have provided you with suitable data that shows XYZ. Ltd. a key competitor with over 35 years experience has been growing steadily at 4% per annum over the last 8-10 years. Beta 3030Numerical 2There is not much information with respect to capital expenditure. Your analysis reveals that with the growth that the company will be experiencing over the next ten years, a new machine will have to be installed in three years. The machine is projected to cost $2 million with a depreciation rate of 30% per year. There are no other capital expenses anticipated. Smith Co. plans to retain its capital base now and in the future. Working capital in the past three years has increased proportionately with increases in sales. The firm plans to keep its % of debt around the same. Smith and Co. has a tax rate of 45%.Set up the cash flow projections for the next five years and value the target using FCFF.3131Numerical 232

32Numerical 2a33The CEO of your company asks you to use only first year CF projection of Smith Co., the target and value it using FCFF, CCF, and FCFE approaches assuming a 5% stable growth rate33Valuation ApproachTo summarize the approaches:FCFF discounted at after tax WACCFCFE discounted at KeCapital CF (includes ITS in the CF) discounted at cost of unlev firm KaAPV Discounting ITS at KaDiscounting ITS at Kd 5. Discounting using M&E (at times referred to as WACC approach using M-E)3434Numerical 3Given Firm has to be valued over a 5-year periodEBIT is growing at 5% and currently = 100,000Depreciation, Capex and change in NWC is constant (D = 50,000, Capex = 60,000 and increase in NWC = 10,000)Tax rate = 40%Rf = 5%, mkt risk prem = 7%, asset beta = 1.2Capital structure is changing Current debt = 100,000, debt is being repaid at 50% per year on the outstanding amountCurrent debt = 61.3%, changing to 35.2%, 21.5%, 14.7%, and 13.3% in the following yearsCurrent debt beta = 0.4, declining by 0.05 per yearValue the firm using FCFF, APV, CCF3535Numerical 4Consider a company with the followingExpected EBIT is $1000 next yearGrowth rate is 3% into perpetuityTax rate is 35%Return on the asset is 11%The firm rebalances its capital structure once a year in the beginningRiskless debt = 2000Cost of debt 5%Maintains a constant proportion of debt

Value the firm using various approaches3636Alibaba YahooGo through the readings3737Readings38What is the central idea in the Luehrman articles?Which CFOther adjustments to the CFDiscount rate useFormulaCaveats38


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