EMGT 386
Mergers, Acquisitions and Valuation
Fourth Lecture
Part 1
Discounting and Cashflow
Discounting
The operating premise ..
The financial value of something today is typically
regarded as the future payment stream, however
calculated, discounted by some acceptable rate of
discount, to a present value.
For example, the value of a bond is equal to the value
of all future cash payments (interest and principal
redemption) discounted to the future the yield on
equivalent bonds.
This discount rate is typically some “opportunity cost”
yield.
The slides that follow explain the concept of discounting.
The Compounding Formula
What is the formula for calculating the future
value X f of the present value X pinvested at
interest rate r (compounded, annual) for n
years??
X p (1 + r) n = X f
An example ...
$10 invested for 10 years at 8% compounded
annually will be worth:
10
10 (1.08)
= 21.59
Present Value Formula
What is the present value X p of some
guaranteed future value X f , assuming the
opportunity to invest money today at some
compounded interest rate r??
Xp =
Xf
(1 + r)
n
Present Value Formula
What is the present value X p of some
guaranteed future value X f , assuming the
opportunity to invest money today at some
compounded interest rate r??
Xp =
Xf
(1 + r)
n
A question ...
What is the present value of a promise to pay
two payments of $ 100 each at a date 5 years
in the future and again 10 years in the future,
if money today can be expected to earn 12%
between now and then??
The California Lottery
What is the true present value of winning $10
million in the California lottery (paid in 20
equal and annual payments) assuming an
interest rate of 8%??
19

Value =
i=0
500k
(1.08)
i
= ???
The California Lottery
(continued)
Would would be today's value of the last
lottery payment made (in 19 years)??
19
$500,000 / (1.08)
= $115,856
WHY??
Because $115,856 invested at 8% per year
compounded for 19 years would accrue to
exactly $500,000.
A question ...
How would you evaluate the present market
value of a note or bond which had been
issued at some given coupon rate c if
prevailing market rates r are higher or
lower??
For example, what would be today's value of
a 30-year bond issued 10 years ago at 10% if
20-year bonds today yield only 6%?
Some partial answers ..
What would be the present market value of the
redemption value of this bond ($100 in 20
years)?
100
= $31.18
20
(1.06)
What would be the present market value of the
interest payment that will be received in 5
years??
10
= $7.47
5
(1.06)
Simple Bond Valuation Formula
.. for annual compound interest and annual payments
MV =
where:
{
n

C
(1 + r)i
}
+
Par
(1 + r)n
i=1
MV = Market value
n = # of years (or periods) to maturity
C = Coupon payment (par X rate)
r = prevailing market rate for equivalent
Present Discounted Cashflow
.. pro forma calculation
The true present value of a corporation today equals
the present discounted value of the cashflow stream
generated by that corporation.
Ultimately, value is increased by increasing that
cashflow stream.
Look at cashflow, the cashflow stream (estimates),
and the value drivers.
The two primary components
1. The near-term value
... generally uses some variation of the discount formula
2. The perpetuity
... uses some variation of the perpetuity formula
Some basics
Discounting
n
CF
PV  
i
i  1 (1  r )
CF1
CF2
CF3
PV 

2 
3
(108
. ) (108
. )
(108
. )
Some basics (cont)
Value of a perpetuity cashflow
Constant cashflow:
CF 100
PV 

 $1250
r
.08
Cashflow growing at rate g:
CF (1  g ) 100(105
. )
PV 

 $3500
r g
.08 .05
The spreadsheet/proforma model
Variables:
PV: present value
FCF: free cashflow estimate from the proforma model
g: growth rate of FCF, estimated over the years of the
proforma forecast
FCFE: FCF estimate for the first year past the proforma
forecast, estimated by multiplying g times FCF in
the last forecast year.
r: discount rate (weighted average cost of capital or
long-bond plus X%)
The proforma formula
The proforma component:
5
FCFi

i
i  1 (1  r )
The perpetuity component:
1
FCFE6 (1  g )
6 X
(1  r )
r g
Part 2
Cashflow, free cashflow, and
cashflow analysis
Why cashflow matters
• Modern valuation techniques use
discounted present value free cashflow
• Cashflow prior to debt use represents the
true strength of the company
• To survive, a company must have sufficient
cashflow to meet amortized debt and similar
obligations
Why cashflow differs from earnings
• Some business activities contribute to
earnings or constitute expenses, but
corresponding cash payments are delayed
– payables, receivables, inventory
• Some business activities are expensed, but
there never is a related cash payment
– depreciation, amortization, amortization of
goodwill
Why cashflow differs (cont)
• Borrowing and the servicing of debt involve
expense and revenue entries that do not
correspond to concurrent cash transfers
– borrowing immediately adds cash but is not
directly expensed
– loan payments reduce cash, but only the interest
component is expensed
Debt and Buying Assets
When using debt to buy GFA:
• Borrowing increases cash at the time of the loan
• Buying the asset decreases cash at the time of the purchase
• The cost of the loan is expensed only as each payment is
made, and then only interest is expensed as interest
expense, principal reduction is not expensed.
• The fixed asset is not expensed at time of acquisition, but
is depreciated slowly over time.
Debt financing GFA
Activity
Borrow the money
Impact upon Impact upon
cash
earnings
None
+
Buy the equipment
-
None
Make loan payment
-
Expense interest
only
Expense
depreciation
Depreciate
equipment
None
Depreciation schedules .. 1st five years
Year
3
5
7
10
15
20
1
33.33
20.00
14.29
10.00
5.00
3.75
2
44.45
32.00
24.49
18.00
9.50
7.22
3
14.81
19.20
17.49
14.40
8.55
6.68
4
7.41
11.52
12.49
11.52
7.70
6.18
11.52
8.93
9.22
6.93
5.71
5
What is Goodwill??
When one company acquires another, it always does so
for more than the book value of the target company.
Because the assets and liabilities of the target company
are directly absorbed by the parent, the failure to adjust
for this premium would cause a discrepancy in the
books and would not represent the true value of new
assets acquired.
Therefore the difference between book value and
amount paid for the target is (more or less) recorded
as an asset under Goodwill. This amount is then
amortized over the years. Amortization of Goodwill is
not a cashflow outlay.
Components of cashflow
• Cashflow from operations
– adjustments for accruals and amortization
• Cashflow from financing
– new debt adds, debt payment substracts
• Cashflow for investment (GFA usually)
– theoretically seen as basis for future value
Adjustments to EBIT for cashflow
Accounts Receivable
Deferred Income Taxes
(-)
(+)
(-)
(-)
Depreciation
(+)
Amortization
(+)
(+)
Accounts Payable
Inventories
Amortization of Goodwill
Free Cashflow
... derivation from Gross Cashflow
• Gross Cashflow
–
–
–
–
less: Capital Expenditures
less: Financing
less: Notes Payable (t-1)
equals
• Free Cashflow
Cashflow Problems and
Solutions
Introductory Overview
Debt payments excessive
• Possible causes
–
–
–
–
paid too much for the property
leverage ratios too high (LBOs, junk bonds)
poor business
debt terms unacceptable
• Solutions
– arrange refinancing
– bankruptcy
Cashflow (ops) low relative to income
• Possible causes
– inventories too high
– days receivable too long
– days payable too short
• Solutions
– shorten days receivable or extend days payable
– get inventories under control
– don’t use receivables to inflate quarterly profits