VALUATION
A.
Valuation steps
1.
2.
3.
B.
C.
Estimate future cash flows
Determine required rate of return (discount rate)
Find present value of cash flows
Valuation formulas
1.
n CF
t
Finite period: PV  
t
t 1 1  k 
2.
Infinite period: PV 
CF1
k g
Sources of risk or uncertainty
1.
2.
3.
Cash flow
Required rate of return
Growth rate
1
D.
Applications of valuation
1.
2.
3.
4.
Bonds and stocks
Capital budgeting
Leasing
Mergers and acquisitions
Methods of evaluating projects
1.
Net Present Value (NPV)
n CF
t (where the initial cash flow is usually negative)
 
t
t  0 1  k 
2.
Internal Rate of Return (IRR)
n
CFt
 CF0

t
t 1 1  IRR 
3.
Modified Internal Rate of Return (MIRR)
n
nt
 CFt 1  k 
t 1
 CF0
n
1  MIRR 
2
4.
Payback
= Year before full recovery + (Uncovered cost at start of year/Cash flow during year)
ex: CF0 = -2,000, CF1 = 1,800, CF2 = 500:
Payback = 1 
200
 1.4 years
500
CAPITAL BUDGETING CONCEPTS

In capital budgeting, you compute the incremental free cash flows (the cash flows available to
the investors):
Changes in operating cash flow
-Changes in capital spending
-Changes in net working capital
=Changes in free cash flow
3
1. Operating Cash Flow
 Revenues
 Operating costs (Be sure to include effects on revenues and operating costs in other
parts of the company and incremental overhead or administrative costs)
 Taxes (Include the tax effects of depreciation but not depreciation itself)
2. Investment (Capital Expenditures)
 Purchases and sales of assets
 Include any tax effects of sales
 Opportunity cost of assets already owned that are employed
3. Changes in net working capital include
 Sales and purchases on credit (accounts receivable and payable)
4
 Changes in inventories of materials and finished goods
 Reserves of cash
TAXES AND CAPITAL BUDGETING
 Taxes are the part of capital budgeting that makes things complicated.
 Because of tax laws, we have to worry about whether certain effects are taxable and how
much tax they incur.
 One example is depreciation, which is a charge to earnings (a quasi-expense), but not an
actual cash flow.
 Another example is the sale of an asset. Whenever you sell an asset, you pay taxes on any
"profit" from the sale. Uncle Sam defines profit as:
 Profit = Selling Price - Book Value (where Book Value = Installed Cost of Asset Accumulated Depreciation)
Ex: If you sell an asset for $10,000, the book value is $6,000, and your tax rate is 40%
then: Profit = $10,000-$6,000=$4,000 and your net cash inflow is:
$10,000-.40($4,000)=$8,400.
5
A Typical Profile of Cash Flows:
Initial outlays or cash flows
Purchase and installation of
assets
Intermediate cash flows
Revenues minus expenses
net of tax effects
Terminal cash flows
Proceeds from sale of assets net
of tax effects
Changes in net working capital
Changes in overhead
expenses net of tax effects
Costs of clean up or disposal
net of tax effects
Depreciation tax shields
Recovery of working capital
Training expenses net of tax
effects
Sale or disposal of replaced
assets net of tax effects
Most projects usually exhibit a normal cash flow pattern, meaning that the initial cash flow is
negative, followed by a series of cash inflows. A nonnormal cash flow pattern is one in which an
initial negative cash flow is followed by a series of inflows and outflows.
Note about net working capital:
Changes in net working capital frequently accompany capital expenditure decisions. The
recovery of working capital in the terminal cash flow occurs because at the end of the project’s
life the need for increased net working capital investment is assumed to end.
6
Always ask the "with vs. without" question!
 The "with vs. without" rule says to always ask whether a particular cash flow is different
with versus without the project. If the answer is "yes" then include it in your project
analysis; otherwise leave it out. Typical items that do not get included are sunk costs and
overhead expenses. However, incremental overhead expenses would be included.
Things to keep in mind when computing incremental cash flows:
 Include changes, not levels, of net working capital
 Include the recovery of net working capital at the termination of a project
 Ignore costs that are not incremental (i.e., sunk costs and pre-committed expenditures)
 Ignore financing cash flows such as interest payments and dividends
 Include only overhead costs that are incremental to the project
 Include the opportunity cost of owned assets that are employed in a project
 Include the tax effects of the sale of assets
7
 Include effects on the sales and costs of production of related products or services of the
company
 Ignore depreciation charges, but include the tax effects of depreciation
 Treat inflation consistently (i.e., discount nominal cash flows by nominal discount rates)
Inflation adjustments
1.
2.
Real versus nominal cash flows
Real versus nominal discount rates
Is inflation neutral?
a.
Depreciation is invariant to inflation
b. Price inflation
c.
Cost inflation
8
COMPUTING THE DISCOUNT RATE
1. If the project is a scale expansion of the existing business, then the WACC is usually sufficient:
WACC  w dk d 1  T  w pk p  w sk s (d= debt, p=pfd. stock, and s=common stock)
2. If the risk of the project is different from the risk of the firm then you should use a risk-adjusted
discount rate (RADR). One way of doing this is with the CAPM:
 Assign a beta to the project
 Establish risk classes within the firm and assign betas accordingly
 Look at companies with similar projects (may need to unlever beta--see
M&A discussion)
 Use CAPM to compute the discount rate:
k i  k RF  i (k M  k RF )
9
OTHER PROJECT RISK ISSUES
1. Stand-alone risk: measures the risk the project would have it if were the firm's only asset. It is
measured by the variability of the asset's expected return.
 Sensitivity Analysis
 Simulation
 CV as a measure of risk:
 NPV
ENPV 
2. Within-firm risk: reflects the effects of a project on the firm's risk, and it is measured by the
project's effect on the firm's earnings variability.
3. Market risk: reflects the effects of a project on the riskiness of stockholders, assuming they hold
diversified portfolios. It is measured by the project's effect on the firm's beta coefficient.
10
MERGERS AND ACQUISITIONS
A.
Sources of synergy
1.
2.
3.
4.
Operating economies of scale
Financial economies of scale
Differential managerial efficiency
Increased market power
B.
Friendly versus hostile merger
C.
Cash flows
1.
2.
D.
Capital budgeting – all cash flows (to both equity and debt holders)
Mergers and acquisitions – equity cash flows
Discount rate
1.
2.
Capital budgeting – weighted average cost of capital
Mergers and acquisitions – cost of equity
11
VALUING THE TARGET FIRM
1. Discounted cash flow analysis
a. Pro forma cash flow statement
2006
2007
$4,000,000
$6,000,000
$7,500,000
$8,500,000
2,000,000
3,000,000
3,750,000
4,250,000
Depreciation
400,000
450,000
500,000
550,000
S&A expense
300,000
400,000
500,000
600,000
Interest expense
200,000
300,000
300,000
400,000
$1,100,000
$1,850,000
$2,450,000
$2,700,000
440,000
740,000
980,000
1,080,000
$660,000
$1,110,000
$1,470,000
$1,620,000
400,000
450,000
500,000
550,000
Cash flow
$1,060,000
$1,560,000
$1,970,000
$2,170,000
Retentions
0
500,000
400,000
300,000
$1,060,000
$1,060,000
$1,570,000
$1,870,000
Net sales
Cost of goods sold
EBT
Taxes
Net income
Add depreciation
Available CF
2008
2009
12
b. Estimating the discount rate (Hamada Equation)
bU 
bL
 D
1  1  T  
S

 D 
b L  b U 1  1  T   
 S 

 Assume the target firm's beta is 1.20, its capital structure consists of 40% debt, and the
corporate tax rate is 30%. The acquisition will increase the debt ratio to 50% and the tax
rate to 40%. The risk-free rate is 6% and the market return is 15%:
bU 
1.20
 .40 
1  1  .30

 .60 
 0.82 (asset beta of target firm)

 .50  
b L  0.821  1  .40
   1.31 (relevered beta w/new capital structure)
.
50



k s  .06  1.31.15  .06  0.1779
13
c. Valuing the cash flows
Estimating the terminal value: This can be done using the Gordon (constant growth) model
or market multiples (see pg. 115 in text--section 3.5.1)
 We'll assume a 5% annual growth rate after 2009:
TV2009 
CF0
CF1
CF2
CF3
CF4
I
NPV
=
=
=
=
=
=
CF2009 1  g  1,870,0001  .05

 $15,351,837
.1779  .05
ks  g
$0
$1,060,000
$1,060,000
$1,570,000
$1,870,000 + $15,351,837 = $17,221,837
=
17.79%
$11,570,917
d. Setting the bid price: If there are 1,000,000 shares outstanding then:
P
$11,570,917
 $11.57
1,000,000
14