Investment Banking
and The Private Firm
Prof. Ian GIDDY
Stern School of Business
New York University
Topics:
- Leveraged Buyouts and
Venture Capital
- Initial Public Offerings
- Valuing a Business
- Realizing Value from a Private
Company
Corporate Finance
CORPORATE FINANCE
DECISONS
INVESTMENT
FINANCING
PORTFOLIO
RISK MGT
MEASUREMENT
CAPITAL
DEBT
M&A
Copyright ©2003 Ian H. Giddy
EQUITY
TOOLS
Introduction 4
Leveraged Finance
Prof. Ian Giddy
New York University
Leveraged Financing
Leveraged Finance is the provision of
bank loans and the issue of high yield
bonds to fund acquisitions of companies
or parts of companies by
 an existing internal management team
(a management buy-out),
 an external management team (a
management buy-in), or
 a third party (a leveraged acquisition).
Copyright ©2003 Ian H. Giddy
Introduction 7
Leveraged Finance is For Companies
with Unused Debt Capacity
Company
has
unused
debt
capacity
Copyright ©2003 Ian H. Giddy

Takeover?

Leveraged
buyout?

Leveraged
recapitalization?
Introduction 8
Typical LBO Sequence
Company gets bloated or slack
and stock price falls
IPO or sale of
company
LBO financing lined up
LBO offer made
LBO completed
Restructuring

Efficiencies

Divestitures

Financial
? years
Copyright ©2003 Ian H. Giddy
3-9 months
5-7 years
Introduction 9
LBO: A Temporary Capital Structure
Stage 1: Pre-LBO
Stage 2: LBO
financing
COST
OF
CAPITAL
Stage 4: Debt
paydown
Stage 3: LBO
refinancing
DEBT
RATIO
Copyright ©2003 Ian H. Giddy
Introduction 10
12-Step Method









Evaluating cost of deal
Estimating borrowing capacity
Estimating cash costs of funding
Estimating growth rates of sales, expenses,
etc
Projecting cash flows (FCFF and FCFE)
Projecting debt amortization
Calculating terminal value of FCFE and FCFF
Estimating costs of capital to find PV
Making sense of the deal
Copyright ©2003 Ian H. Giddy
Introduction 11
Cost of the Deal
Estimating cost of deal
Shares
Price
Premium
Equity cost
Debt cost
Fees
Capex & restructuring
Total cost of deal
$
$
5% $
10% $
$
10
45
15%
518
$ 55
29
57
658
lbocapacity.xls
Copyright ©2003 Ian H. Giddy
Introduction 12
Borrowing Capacity
Estimating borrowing capacity
Given:
EBIT
Min EBIT int coverage ratio
Interest capacity
Interest rate
Debt capacity
$
95
1.3
$
73
16.00%
$
457
From table
lbocapacity.xls
Copyright ©2003 Ian H. Giddy
Introduction 13
Cost of Debt
Estimating the cost of debt
Enter the type of firm =
2 (1 if large manufacturing firm, 2 if smaller or riskier firm)
EBIT
$ 95
Current interest expenses =
$ 73
Current long term government bond rate =
0.06
Output
Interest coverage ratio =
1.3
Estimated Bond Rating =
CCC
Estimated Default Spread =
10%
Estimated Cost of Debt =
16%
For large manufacturing firms
If interest coverage ratio is
>
≤
Rating is
-100000 0.199999 D
0.2 0.649999 C
0.65 0.799999 CC
0.8 1.249999 CCC
1.25 1.499999 B1.5 1.749999 B
1.75 1.999999 B+
2 2.499999 BB
2.5 2.999999 BBB
3 4.249999 A4.25 5.499999 A
5.5 6.499999 A+
6.5 8.499999 AA
8.5
100000 AAA
Copyright ©2003 Ian H. Giddy
Spread is
0.14
0.127
0.115
0.1
0.08
0.065
0.0475
0.035
0.0225
0.02
0.018
0.015
0.01
0.0075
For smaller and risk ier firms
If interest coverage ratio is
>
≤
Rating is
-100000 0.499999 D
0.5 0.799999 C
0.8 1.249999 CC
1.25 1.499999 CCC
1.5 1.999999 B2 2.499999 B
2.5 2.999999 B+
3 3.499999 BB
3.5 4.499999 BBB
4.5 5.999999 A6 7.499999 A
7.5 9.499999 A+
9.5
12.5 AA
12.5
100000 AAA
Spread is
0.14
0.127
0.115
0.1
0.08
0.065
0.0475
0.035
0.0225
0.02
0.018
0.015
0.01
0.0075
lbocapacity.xls
Introduction 14
Capital Structure
Preliminary capital structure
Debt
Missing
Mgt equity
Total financing
$
$
$
$
457
177
25
658
lbocapacity.xls
Copyright ©2003 Ian H. Giddy
Introduction 15
LBO Financing
NEWCO
Cost of
purchasing
the
business
Copyright ©2003 Ian H. Giddy
Senior
debt $457
Mezzanine
What securities?
What returns?
What investors?
Equity $25
Introduction 16
Mezzanine








Asset-backed or cash flow-backed debt
Senior debt
Subordinated debt with high yield
Subordinated debt with upside
participation
Subordinated debt with equity option
Preferred equity with warrants or
conversion options
Restricted shares
Common stock
Copyright ©2003 Ian H. Giddy
Introduction 17
Why Venture Capitalists Prefer Preferred
Senior status in bankruptcy
 Does not put a value on the shares
 Is convertible into common stock before
the IPO
 Conversion price is set such that if there
is a liquidation all the money goes to the
preferred shareholders (equity is worth
zero)

Copyright ©2003 Ian H. Giddy
Introduction 18
Cash Flows and Debt Repayment
Cash Flows and debt repayment
0
1
EBIT
$
110
Borrowed $
437
Interest
61
Tax
35%
17
Add depr - Capex
30
Cash avail to repay debt
62
Remaining debt
375
Copyright ©2003 Ian H. Giddy
2
117
3
124
4
131
5
135
52
22
30
72
303
42
28
30
83
220
31
35
30
95
125
18
41
30
106
19
Introduction 19
Exit
IPO or sale of
company
Company gets bloated or slack
and stock price falls
LBO financing lined up
LBO offer made
0
IPO @ 6xEBIT
VCs take
Managers $
IRR
1
2
3
4
0
0
0
0
0
0
LBO completed
(135)
(15)
40%
0
0
5
810
729
81
Restructuring

Efficiencies

Divestitures

Financial
? years
Copyright ©2003 Ian H. Giddy
3-9 months
5-7 years
Introduction 20
Case Study: Cap des Biches




Bank debt and equity-linked structured
financing in the context of leveraged buyout
financing, including valuation and exit
strategies. Mezzanine and VC financing.
What financial structure enables the acquiring
group to retain control?
What is the cost of financing?
“How much equity should/must our client give
up in order to get the funding we need?”
Copyright ©2003 Ian H. Giddy
Introduction 21
Case Study: Cap des Biches (B)
The LBO Proposal
 Devise a recommended financing plan

GTI (owner)
Buyers
Copyright ©2003 Ian H. Giddy
Other Investors
Introduction 22
Financing Sources
Bank loans
 Loan from seller
 Private equity investors
 Family money

Copyright ©2003 Ian H. Giddy
Introduction 23
Financing a Growing Company
Prof. Ian Giddy
New York University
Financing a Growing Company
How fast can we grow? How should we
finance our growth?
 What kind of equity financing? What’s our
exit plan? A public offering?
 Do we want money, management, or
more?
 What’s our company worth?
How can we make it worth more?

Copyright ©2003 Ian H. Giddy
Introduction 26
Corporate Financing Life-Cycle
Leverage
Growth companies
Copyright ©2003 Ian H. Giddy
Mature companies
Introduction 27
First, Why Equity?

Benefits of Equity
Flexibility:
cannot afford to have fixed
obligations
Strategic partners
Interventionist partners

Disadvantages
No
tax shield
Expensive!
Copyright ©2003 Ian H. Giddy
Introduction 28
What Kind of Equity?

Sources of Equity
Private
investors
Strategic investors
Interventionist investors
Public market

And Kinds
Common
stock
Stock with restricted voting rights
Hybrids, including convertibles
Copyright ©2003 Ian H. Giddy
Introduction 29
messageclick




Started in September 1997, messageclick enables
users to send faxes and receive faxes over the
internet at a low cost.
By June 1998 the company had expanded its
services and was signing up subscribers at the rate
of 100,000 a day.
Initial funding was “Angel” finance, but now the
expansion was exceeding the company’s financial,
physical and managerial capacity. On two occasions
it had literally run out of money.
What form of equity financing would be appropriate
for messageclick?
Copyright ©2003 Ian H. Giddy
Introduction 30
Pre-IPO Equity Financing
Friends and family
 Angel
 Venture capital
 Strategic partners

Copyright ©2003 Ian H. Giddy
Introduction 31
Private Equity Funds
Private equity funds are generally
structured as partnerships specializing
in venture capital, leveraged buyouts,
and corporate restructuring.
 The private equity fund mobilizes funds,
selects and monitors investments,
eventually exiting the investment and
paying back the investors.

Copyright ©2003 Ian H. Giddy
Introduction 32
Silipos Inc
Copyright ©2003 Ian H. Giddy
Introduction 33
Silipos Inc, 1999
Debt?
Where do
you want
to go?
IPO?
Acquisition?
Sell?
Copyright ©2003 Ian H. Giddy
Introduction 34
IntraLinks
Copyright ©2003 Ian H. Giddy
Introduction 35
IntraLinks’ Choices




Issue debt, either by borrowing from one of the big
New York banks keen to get more involved in
promising Internet businesses, or by means of a
private placement of debt notes, possibly with
“sweeteners” such as warrants to attract a lender.
Seek out one or more private equity investors,
ones who believed in the company’s product and
its management.
Do an initial public offering (IPO).
Find another corporation who would be willing to
acquire IntraLinks.
Copyright ©2003 Ian H. Giddy
Introduction 36
Initial Public Offerings:
Underwriting, Distribution
and Pricing
Prof. Ian Giddy
New York University
Investment Banking: Organizarion
Banking
“Coverage”
•Corporate Finance
•Mergers &
Acquisitions
•Investment
Banking
Fixed Income
Equity
Debt Capital Markets
Equity Capital Markets
(DCM)
•Syndicate
•Marketing
(ECM)
•Sales
•Trading
•Research
Sales
•Institutional
•Retail
Trading (proprietary)
•Risk
•Profits
Structured Finance
Credit Research
Private Placement
Loan Syndication
Copyright ©2003 Ian H. Giddy
Introduction 41
Investment Banking: Organization
New Deal Pitch Team
 Coverage/
Investment banking
 Product (DCM or
ECM)
Copyright ©2003 Ian H. Giddy
Commitment Committee
 Investment banking
 ECM/DCM
 Senior sales/trading
 Research
Introduction 42
Underwriting Sequence





Engagement: Mandate
signed by issuer
engaging lead manager
Due Diligence:
Conducted by Lead
manager
Documentation: Loan
agreement, Prospectus
Signing: Underwriting
agreement signed and
issue priced
Closing: Settlement of
the offering
Copyright ©2003 Ian H. Giddy
“Beauty Contest”
Engagement
Due Diligence and
Documentation
Signing and Pricing
Closing
Introduction 43
The Beauty Contest
Criteria for Selecting a Lead Manager 1
 Experience with similar transactions (sector,
market, currency, maturity, high or low-quality
issuers)
 Ranking in League Tables
 Placement power with institutional and/or
retail investors
 Standing in secondary market as “market
maker” and commitment to secondary market
trading
Copyright ©2003 Ian H. Giddy
Introduction 44
The Beauty Contest (Cont.)
Criteria for Selecting a Lead Manager 2
 Quality/reputation of research
 Proposed marketing strategy (pricing,
timing, issue size, etc.)
 Proposals for “Roadshow”
 Relationships with potential comanagers
 Senior management commitment to
backing issue with people and capital
Copyright ©2003 Ian H. Giddy
Introduction 45
The Roadshow
Organized by global coordinator and
lead managers
 Informal presentation by management
to potential investors
 Attendance limited to professional
intermediaries and investing institutions
 Content must be consistent with
information in draft version of
prospectus or offering circular.

Copyright ©2003 Ian H. Giddy
Introduction 46
Distribution
Lead Manager
Book-Runner
“International Coordinator
Joint Co-Lead
Joint Co-Lead
Manager
Joint Co-Lead
Manager
Managers
Lead
Lead
Manager
Lead
Manager
Managers
Manager
Manager
Managers
Copyright ©2003 Ian H. Giddy
Co-Lead Manager
Question:
Which banks are
involved with an IPO,
and what are their
roles?
Selling Agent
Introduction 47
Issuing Equity: Key Players
SELLING
GROUP
Copyright ©2003 Ian H. Giddy
UNDERWRITERS
MANAGERS
Introduction 48
Securities Underwriting: Relationships
Issuer
Agents
Debt: Fiscal agent
Equity:
Depositary institution
Investment Bankers
Lead manager/Bookrunner
Registered offering: Underwriting Agreement
Unregistered: Purchase Agreement
Co-managers
Agreement Among Underwriters
Prospectus/Offering Circular
Institutional Buyers
Copyright ©2003 Ian H. Giddy
Retail Buyers
Introduction 49
Subscription or Underwriting
Agreement





Between issuer, global coordinator and all managers
Signed after pricing when “book-building” completed
Firm commitment to underwrite, subject to delivery of
certain confirmatory certificates and no “material
adverse change” or “force majeure”
Indemnity: By the issuer in favor of Global Coordinator
and Managers against liability arising as a breach of
warranty, material inaccuracy or omission
Lock up: Issuer will not offer other securities for a
period of time (eg six months)
Copyright ©2003 Ian H. Giddy
Introduction 50
Underwriting Economics
Underwriting
Fee
20%
Management
Fee
20%
Underwriting Fee:
Based on
underwriting
commitment (often
less expenses of
offering)
Management Fee:
Normally shared
equally among
managers (may be
subject to a
praecipium for
Global Coordinator
or Lead Manager)
Selling
Concession
60%
Copyright ©2003 Ian H. Giddy
Selling Concession:
Payable as a
percentage of
allocation
(determined by
book-runner)
Introduction 51
Pricing
Debt Instruments




Bonds priced according
to yield over benchmark
(spread)
Yield too low – issue
does not sell
Yield too high – too
much given away
Generally syndicate
holds price for a day; in
a successful issue
yields gradually tighten
Copyright ©2003 Ian H. Giddy
Equity


Mature issue: based on
current market price and
market conditions, small
premium for dilution;
comparables
IPO: comparables and
discounted cash flow
analysis
Introduction 52
Pricing and Fees
The Issuer
The Business
 Telecoms
 Dot-Coms
 Avons
(How much volatility?)
Copyright ©2003 Ian H. Giddy
Fees
Pricing
Debt
0.15%
to
1.5%
T+Spread
L+Spread
Equity
5% to
7%
Comparables/Ratios
The market
Future cash flow
valuation
Introduction 53
Valuing a Business
Prof. Ian Giddy
New York University
Valuing a Firm with DCF
Historical
financial
results
Adjust for
nonrecurring
aspects
Gauge
future
growth
Projected sales
and operating
profits
Adjust for
noncash
items
Projected free cash flows
to the firm (FCFF)
Year 1
FCFF
Year 2
FCFF
Year 3
FCFF
Year 4
FCFF
Discount to present using weighted
average cost of capital (WACC)
Present
value of free
cash flows
Copyright ©2003 Ian H. Giddy
+ cash,
securities &
excess assets
- Market
value of
debt
…
Terminal year FCFF
Stable growth model
or P/E comparable
Value of
shareholders
equity
Introduction 56
What’s a Company Worth?
Required returns
 Types of Models

Balance
sheet models
Comparables
Corporate cash flow models
Estimating Growth Rates
 Applications
 Option-based models

Copyright ©2003 Ian H. Giddy
Introduction 57
Copyright ©2003 Ian H. Giddy
Introduction 58
IBM’s Financials
Copyright ©2003 Ian H. Giddy
Introduction 59
Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
Value of
Liabilities
 Book
 Market
Value of Equity
Copyright ©2003 Ian H. Giddy
Introduction 60
Equity Valuation:
From the Balance Sheet
Value of Assets
 Book
 Liquidation
 Replacement
 Or what?
A New York City study estimated that the 322 trees surveyed had an
average value of $3,225 per tree and a total value of $1,038,458. The
value was said to be the amount the city would have to pay to
replace the tree. (New York Times, 12 May 2003)
Copyright ©2003 Ian H. Giddy
Introduction 61
Relative Valuation

In relative valuation, the value of an asset is derived
from the pricing of 'comparable' assets, standardized
using a common variable such as earnings, cashflows,
book value or revenues. Examples include:
• Price/Earnings (P/E) ratios
 and variants (EBIT multiples, EBITDA multiples,
Cash Flow multiples)
• Price/Book (P/BV) ratios
 and variants (Tobin's Q)
• Price/Sales ratios
Copyright ©2003 Ian H. Giddy
Introduction 62
Comparables





Value Indicator
Earnings
Cash Flow
Revenues
Book
Copyright ©2003 Ian H. Giddy





Average
Comparable
Industry
Firms
Deals
Target
Company
Numbers or
Projections
Estimated
Value of
Target
Introduction 63
IBM: Comparables
Copyright ©2003 Ian H. Giddy
Introduction 64
Corporate Cash Flow
Prof. Ian Giddy
New York University
Discounted Cashflow Valuation:
Basis for Approach
t = n CF
t
Value = 
t
t =1 (1+ r)
where

n = Life of the asset
 CFt = Cashflow in period t
 r = Discount rate reflecting the riskiness of
the estimated cashflows
Copyright ©2003 Ian H. Giddy
Introduction 67
Equity Valuation in Practice
Estimating discount rate
 Estimating cash flows
 Estimating growth
 Application with constant growth: Optika
 Application with shifting growth: IBM

Copyright ©2003 Ian H. Giddy
Introduction 68
Start with the
Weighted Average Cost of Capital
Choice
Cost
1. Equity
- Retained earnings
- New stock issues
- Warrants
Cost of equity
- depends upon riskiness of the stock
- will be affected by level of interest rates
Cost of equity = riskless rate + beta * risk premium
2. Debt
- Bank borrowing
- Bond issues
Cost of debt
- depends upon default risk of the firm
- will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity =
Capital
Cost of capital = Weighted average of cost of equity and
cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Copyright ©2003 Ian H. Giddy
Introduction 69
IBM’s Cost of Capital
IBM
Cost of Capital
Cost
Amount
Weight
Debt
10-year bond yield
Tax rate
After-tax cost
4.95%
29%
3.5%
61.9
31%
Risk-free Treasury
Beta
Market Risk Premium
From CAPM
4.50%
1.47
5.50%
12.6%
137.4
69%
9.77%
199.3
Equity
Total
Source: IBMfinancing.xls
Copyright ©2003 Ian H. Giddy
Introduction 70
Valuation: The Key Inputs

A publicly traded firm potentially has an infinite life.
The value is therefore the present value of cash flows
forever.
t =  CF
t
Value = 
t
t = 1 (1+ r)

Since we cannot estimate cash flows forever, we
estimate cash flows for a “growth period” and then
estimate a terminal value, to capture the value at the
end of the period:
t = N CFt
Terminal Value
Value = 

N
t
(1
+
r)
(1
+
r)
t =1
Copyright ©2003 Ian H. Giddy
Introduction 71
Finding Free Cash Flows
Revenue
- Expenses
- Depreciation
= EBIT
Adjust for tax: EBIT(1-T)
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
81.20
(67.99)
(4.95)
8.26
5.90
4.95
(4.31)
(0.90)
5.64
+ Depreciation
- Capex
- Ch working capital
= Free Cash Flows to Firm
Copyright ©2003 Ian H. Giddy
Introduction 72
Deriving IBM’s Free Cash Flows
Data
Sales, ttm
Operating costs
Depreciation
EBIT
Tax
Cap Ex
Change in WC
Interest expense
4Q02ttm
$ 81.20
$ 67.99
$ 4.95
$ 8.26
$ 2.36
$ 4.31
$ 0.90
$ 0.15
Free Cash Flows
84%
29%
$b
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
Copyright ©2003 Ian H. Giddy
billion
billion
billion
billion
billion
billion
billion
billion
81.20
(67.99)
(4.95)
8.26
5.90
4.95
(4.31)
(0.90)
5.64
Interest
$
0.15
FCFE
$
5.49
IBMvaluation.xls
Introduction 73
Choosing a Growth Pattern: Examples
Company
PWC
Valuation in
Nominal U.S. $
Firm
DirecTV
Nominal US$
Equity: FCFE
Allianz
Nominal Euro
Equity: Dividends
Copyright ©2003 Ian H. Giddy
Growth Period Stable Growth
10 years
6%(long term
(3-stage)
nominal growth rate
in the world economy
5 years
4%: based upon
(2-stage)
expected long term
US growth rate
0 years
3%: set equal to
nominal growth rate
in the European
economy
Introduction 74
Valuing a Firm with DCF:
The Short Version
Historical
financial
results
Projected sales
and operating
profits
Adjust for
noncash
items
Free cash flows to the firm
(FCFF)
Discount to present using
constant growth model
FCFF(1+g)/(WACC-g)
Present
value of free
cash flows
Copyright ©2003 Ian H. Giddy
- Market
value of
debt
Calculate weighted
average cost of
capital (WACC)
Estimate stable
growth rate (g)
Value of
shareholders
equity
Introduction 75
Constant Growth Model
CFo(1  g )
Vo 
rg
g
= constant perpetual growth rate
Copyright ©2003 Ian H. Giddy
Introduction 76
Constant Growth Model: Example

CFo(1  g )
Vo 
rg


Motel 6 has cash flows
available to shareholders of
$3 per share. The required
return that shareholders
expect is 12%
The earnings are expected
to grow at 4% per annum
What’s an M6 share worth?
CF0 = $3.00 r = 12% g = 4%
V0 = 3.12/(.12 - .04) = $39.00
Copyright ©2003 Ian H. Giddy
Introduction 77
Optika: Facts




The firm has revenues of €3.125b, growing at
5% per annum. Costs are estimated at 89%,
and working capital at 10%, of sales. The
depreciation expense next year is calculated
to be €74m.
Optika’s marginal tax rate is 35%, and the
interest on its €250m of debt is 8.5%.
The market value of equity is €1.3b.
Is this firm fairly valued in the market? What
assumptions might be changed?
Copyright ©2003 Ian H. Giddy
Introduction 78
Optika
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
Treasury bond rate
Debt Spread
Market risk premium
Revenues next year
-COGS
-Depreciation
=EBIT
EBIT(1-Tax)
+Depreciation
-Capital Expenditures
-Change in WC
-Free Cash Flow to Firm
Cost of Equity (from CAPM)
Cost of Debt (after tax)
WACC
Firm Value
5%
35%
3125
89%
10%
1300
250
1
7%
1.50%
5.50%
T+1
3281
2920
74
287
187
74
-74
-16
171
12.50%
5.53%
11.38%
2681
optika.xls
Equity Value
Copyright ©2003 Ian H. Giddy
2431
Introduction 79
Growth
Tax rate
Initial Revenues
COGS
WC
Equity Market Value
Debt Market Value
Beta
WACC:
Treasury bond rate
Debt Spread
ReE/(D+E)+RdD/(D+E)
Market risk premium
Optika
Revenues next year
Value:
-COGS
-Depreciation
FCFF/(WACC-growth
rate)
=EBIT
EBIT(1-Tax)
+Depreciation
-Capital Expenditures
Equity Value:
-Change in WC
Firm Value - Debt Value
-Free Cash Flow to Firm
Cost of Equity (from CAPM)
= 2681-250 = 2431 Cost of Debt (after tax)
WACC
Firm Value
5%
35%
3125
89%
10%
1300
250
1
7%
1.50%
5.50%
T+1
3281
2920
74
287
187
74
-74
-16
171
12.50%
5.53%
11.38%
CAPM:
7%+1(5.50%)
Debt cost
(7%+1.5%)(1-.35)
2681
optika.xls
Equity Value
Copyright ©2003 Ian H. Giddy
2431
Introduction 80
Valuing a Firm with DCF:
The Extended Version
Historical
financial
results
Adjust for
nonrecurring
aspects
Gauge
future
growth
Projected sales
and operating
profits
Adjust for
noncash
items
Projected free cash flows
to the firm (FCFF)
Year 1
FCFF
Year 2
FCFF
Year 3
FCFF
Year 4
FCFF
Discount to present using weighted
average cost of capital (WACC)
Present
value of free
cash flows
Copyright ©2003 Ian H. Giddy
+ cash,
securities &
excess assets
- Market
value of
debt
…
Terminal year FCFF
Stable growth model
or P/E comparable
Value of
shareholders
equity
Introduction 81
Shifting Growth Rate Model
(1  g1)
CFT (1  g 2)
Vo  CFo

t
T
(r  g 2)(1  r )
t 1 (1  r )
T
t
 g1
= first growth rate
 g2 = second growth rate
 T = number of periods of growth at g1
Copyright ©2003 Ian H. Giddy
Introduction 82
Shifting Growth Rate Model: Example

CF0 = $2.00
g1 = 20% g2 = 5%
r = 15% T = 3
V0 = CF1/(1.15)+CF2/(1.15)2+CF3/(1.15)3
+ CF4/(15%-5%)(1.15)3
= 2.40/(1.15)+2.88/(1.15)2+3.46/(1.15)3
+ 3.63/(.15-.05)(1.15)3


Mindspring
pays cash flows
of $2 per share.
The required
return that
shareholders
expect is 15%
The dividends
are expected to
grow at 20% for
3 years and 5%
thereafter
What’s a
Mindspring
share worth?
= $30.40
Copyright ©2003 Ian H. Giddy
Introduction 83
Case Study: IBM
Copyright ©2003 Ian H. Giddy
Introduction 84
Case Study: IBM
Constant growth model valuation:
FCFF
5.64
WACC
9.77%
Growth rate
5.70%
Firm Value
less debt
Equity value
146.51 billion
-61.86 billion
84.65 billion
divided by
1.69 gives
$ 50.09 per share
2-stage growth model valuation
Stage 1
10%
Stage 2
5.70%
End of year
Revenue
-Expenses
-Depreciation
EBIT
EBIT(1-t)
+Depreciation
-CapEx
-Change in WC
FCFF
Total
PV
Total PV
less debt
Equity value
2002
81.20
-67.99
-4.95
8.26
5.90
4.95
-4.31
-0.90
5.64
2003
89.32
-74.79
-5.45
9.09
6.49
5.45
-4.74
-0.99
6.20
2004
98.25
-82.27
-5.99
9.99
7.14
5.99
-5.22
-1.09
6.82
2005
108.08
-90.49
-6.59
10.99
7.85
6.59
-5.74
-1.20
7.51
2006
118.88
-99.54
-7.25
12.09
8.64
7.25
-6.31
-1.32
8.26
6.20
5.65
6.82
5.66
7.51
5.68
8.26
5.69
176.00
-61.86 billion
114.13 billion
divided by
1.69 gives
2007
130.77
-109.50
-7.97
13.30
9.50
7.97
-6.94
-1.45
9.08
235.25
244.34
153.32
2008
138.23
-115.74
-6.94
15.55
11.10
6.94
-6.94
-1.53
9.57
$ 67.53 per share
IBMvaluation.xls
Copyright ©2003 Ian H. Giddy
Introduction 85
Application to a Private Firm: “Argus”



The company is in the advertising and public relations
business. It is privately owned, but the other major
competitors are publicly traded.
It has grown rapidly but growth is leveling off to about
3-6%. Interest on Argus’ €16 million debt is €2.4 million
and EBITDA is €12 million.
How would you estimate the company’s




Future growth rates?
Beta? Cost of Equity?
Cost of debt?
Firm value?
Copyright ©2003 Ian H. Giddy
Introduction 86
Source: www.damodaran.com
(Updated data)
Copyright ©2003 Ian H. Giddy
Introduction 87
Analyzing a Private Firm

The approach remains the same with
important caveats
 It
is more difficult estimating firm value, since the
equity and the debt of private firms do not trade;
we use comparables
 Most private firms are not rated; we have to
estimate a rating to get the cost of debt
 If the cost of equity is based upon the market beta
of comparable companies, it is possible that we
might be underestimating the cost of equity, since
private firm owners often consider all risk.
Copyright ©2003 Ian H. Giddy
Introduction 88
M&A Valuation
Prof. Ian Giddy
New York University
Equity Valuation in an Acquisition
Estimating synergies
 Estimating business restructuring
 Estimating financial restructuring
 Application to Basix
 Valuation in a bidding context

Copyright ©2003 Ian H. Giddy
Introduction 91
The Gains From an Acquisition
Gains from merger
Synergies
Top line
Copyright ©2003 Ian H. Giddy
Bottom line
Control
Financial
restructuring
Business
Restructuring
(M&A)
Introduction 92
The Basics
IBM is considering the acquisition of Basix, Inc.
The shares are trading at a P/E of 11, far
below IBM’s P/E of 18. Based on past
performance the company is expected to
earn $2 per share next year, an increase from
the current EPS of $1.93. If IBM acquires
Basix, the long-run EPS growth rate could be
raised to 5.5%. The Treasury bond yield is
4.5%, the company’s beta is 1.3 and the long
run market return is 11.5%. Is the company
worth buying at a P/E of 12? At how much of
a premium should we say fugedaboudit?
Copyright ©2003 Ian H. Giddy
Introduction 93
Basix
Use constant growth model
Earnings
Next year
Growth rate
Risk free rate
Beta
Market return
Req ret on equity
Value
P/E
Price
Before
$ 1.93
$ 2.00
3.6%
4.50%
1.3
11.50%
13.60%
$ 20.05
10.4
$ 21.23
After
$ 1.93
$ 2.00
5.5%
4.50%
1.30
11.50%
13.60%
$ 24.69
12.8
16%
Source: basix.xls
Copyright ©2003 Ian H. Giddy
Introduction 94
M&A and Leverage: Flexics
Company
has
unused
debt
capacity
Copyright ©2003 Ian H. Giddy

Takeover?

Leveraged
buyout?

Leveraged
recapitalization?
Introduction 95
Contact
Prof. Ian Giddy
NYU Stern School of Business
44 West 4th Street
New York, NY 10012
Tel 212-998-0563; Fax 212-995-4233
ian.giddy@nyu.edu
www.giddy.org
Copyright ©2003 Ian H. Giddy
Introduction 98