Advanced Corporate Finance

Spring 2011
Review Of Valuation Methods
Brandon Julio
Advanced Corporate Finance. Spring 2011 – Brandon Julio
2
Plan of Attack


Important Assumptions


Traditional DCF vs. Risk-Neutral Valuation


Valuation Using Adjusted Present Value.


Comparing APV and WACC.


Discounted Cash Flow Valuation Methods.


Capital Cash Flow.


Equity Cash Flow.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
3
Plan of Attack (cont.)


Valuation by Multiples.


Valuation of Private Companies.


Appendix: Computing Asset Betas and Equity Betas.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
4
Overview of Assumptions


$ $


Corporate
Project

Financial
Market
Investment


Corporate
Manager
Risky Future Cash Flows
Risky Future Cash Flows
Investor
Let Manager
Invest For Me?
Invest Directly
On My Own?
• Investors are “rational”.
• Managers are “rational”.
• Financial Markets are “efficient”.
• Managers objective function:

Maximize shareholder wealth.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
5
Two Approaches to Valuing Cash Flows
Risky Cash Flows
{ }
1
t
Risk Adjusted
E CF
V
r
÷
=
+
{ }
1
t
Risk Free
E CF Risk Adjustment
V
r
÷
÷
=
+
{ }
*
1
t
Risk Free
E CF
V
r
÷
=
+
Adj ust discount
rat e for risk.
Adj ust cash flows
for risk.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
6
Example


Consider a project that pays an uncertain cash flow in one
year. The project pays £120 million in a ‘good’

state of
the world and £60 million in the ‘bad’

state of the world.
Suppose we know the probability of the good state is 0.70
and the appropriate risk-adjusted discount rate is 12%.
Assume the risk-free rate is 4%. Then:
07 . 91 £
) 12 . 0 1 (
102 £
102 £ ) 60 )(£ 70 . 0 1 ( ) 120 (£ 70 . 0 ) (
=
+
= ¬
= ÷ + =
V
CF E
This is the traditional DCF approach
Advanced Corporate Finance. Spring 2011 – Brandon Julio
7
Example, cont.


Alternatively, we could approach this in a different way.
Suppose we don’t know the right risk-adjusted discount
rate. Can we adjust the cash flows and discount by the risk-

free rate to get the same value?
V V
CF E
=
+
= =
+
= ¬
= ÷ + =
) 12 . 0 1 (
102 £
07 . 91 £
) 04 . 0 1 (
71 . 94 £
*
71 . 94 £ ) 60 )(£ 579 . 0 1 ( ) 120 (£ 579 . 0 ) ( *
Notice that I have solved for a different set of probabilities that sets
the value equal to the risk-adjusted value.
This is the risk-neutral approach to valuation
Advanced Corporate Finance. Spring 2011 – Brandon Julio
8
Objective for Today: DCF Methods


We know how to value a 100% equity financed project.


Now we want to take financing into account. Recall financing
matters through:


Tax shields


Costs of financial distress


Bankruptcy costs


Agency Costs


There are different techniques in the valuation world. Much
more than the ones we will cover in this course.


We want to review the basics of WACC, APV, Discounted Cash
Flows (DCF), Equity Cash Flows (ECF), Capital Cash Flows
(CCF) and Multiples/Comparables. Next time: Real Options.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
9
Two Different Methods
Two different methods for valuation with financing:


WACC (Weighted Average Cost of Capital).


APV (Adjusted Present Value).
Valuation Using APV
Advanced Corporate Finance. Spring 2011 – Brandon Julio
11
The Adjusted Present Value Method


An alternative approach to the WACC is to compute the
Adjusted Present Value (APV).


The two simple steps involved in computing the APV are:


Step 1: Value of the project as if all-equity financed: use the
after-tax cash flows and discount them at the cost of capital.
Remember that for an all-equity firm the cost of capital equals the
cost of equity.


Step 2: Add the present value of the tax shield (TS) generated by
the project.
APV ÷

NPV
all equity

+ PV(TS)


APV is also known as valuation by components.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
12
The Adjusted Present Value Method


This is simply MM Proposition I with taxes in action.
APV = V
L

= V
U

+ PV[TS]


We do this to separate the value of running the business from
the value created by financing.


Doing this allows us to identify the sources of value and to


discount different risks appropriately.


The APV method uses the value additivity

principle to evaluate
the contribution of both cash flows and increased debt tax
shields. It can easily be adapted to include other financing side
effects.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Important Caveat


In principle, financing should affect the value of a potential


project only if

the ability to use certain financing depends
directly on the decision to take the project.


Otherwise, if the firm can use the financing regardless of the
investment decision, the value of the financing is not
incremental to the project and should be ignored.


It follows that the tax benefits of debt (as well as the associated
costs) should be attributed to a project only if the project


increases the debt capacity

of the firm.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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APV: Basic Steps


Step 1: Value free cash flows as if the firm were 100% equity


financed.


Calculate free cash flows (we are estimating enterprise value).


Unlever

the equity beta and calculate the return on equity if the firm had
no debt using an asset pricing model.


Discount the cash flows with the unlevered cost of capital.


Do a terminal value calculation.


Step 2: Value the tax shields separately.


Calculate expected interest shields.


Discount the tax shields at the “appropriate”

rate.


Do a terminal value calculation for the tax shields related to the terminal
value of cash flows.


Let’s go through each of these steps in detail.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Step 1: Valuing the Cash Flows


Free Cash Flows are exactly what you need.


Get the FCF from running the business as an all-equity firm.


FCF = EBIT(1-

t
C

) + Change in Deferred Taxes + Depreciation –

Increase in NWC –

CAPX + Other.


We start with EBIT because this is what is available to be paid
to the owners –

regardless of the existing debt/equity mix . We
don’t want the tax consequences of capital structure to matter.


It is important to remember that getting the correct free cash
flow estimates will usually have a much larger impact on the
final value than obtaining the correct discount rate.


We typically have a forecast horizon of 5 years. Be careful
with cyclical industries and young growth firms.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
16
Some Remarks About Free Cash Flows


Be careful with non-cash expenses and income.


For example, deferred taxes.


Should be added back since it is a non-cash expense. This is
tax that we owe, but do not presently have to pay.


Bottom Line:


Non-cash expenses should be summed-up to the FCF.


Non-cash income should be subtracted from the FCF.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Which Discount Rate?


You need the rate that would be appropriate to discount the
firm’s cash flows if the firm were 100% equity financed.


This rate is the expected return on equity if the firm were 100%

equity financed.


To get it, you need to:


Find comparables, i.e., publicly traded firms in same business.


Employ an asset pricing model (usually CAPM) to translate risk
exposures into expected returns.


Estimate their expected return on equity if they were 100% equity
financed, by unlevering

the equity betas.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Which Discount Rate? (cont.)


Unlever each comp’s |
E

to estimate its asset beta (more on this
later)


D

and E

are historical market values. If no market value for D,
use book value.


In D only include interest bearing debt.


Exclude Account Payables and Pension Liabilities.


Include interest bearing short-term and long-term debt.


Deduct Excess Cash (only) from debt.


Bottom Line: Beta is not perfect, but it is the best we have.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Which Discount Rate? (cont.)


Use the comps’

|
A

to estimate the project’s |
A

(e.g. average).


Use the estimated |
A

to calculate the all-equity cost of capital r
A
r
A

= r
f
+ |
A

* Market Risk Premium


Here is an obvious place where judgment is required. How do
you pick the risk-free rate and the excess return on the market?


Short-term or long-term for r
f

? →Same horizon as the
investment.


There are plenty of estimates of risk premium of market over
Treasury Bonds.


Use r
A

to discount the project’s FCF.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
20
Estimates of the Equity Risk Premium


Historical Equity Risk Premium


There are plenty of estimates of risk premium of market over
Treasury Bonds. Historically 6%.


Ibbotson & Associates (2000): Realized average risk premium
over treasuries in 1999 was 9.32%.


Implied Equity Risk Premium


Fama

& French (2001): Risk premium implied by fundamentals
and stock prices over the 1872-2000 time period was between
2.55% and 4.32%.


Kaplan and Ruback

(1996): Risk premium implied by sample of
MBOs

was 7.8%


Equity Risk Premium –

Survey Estimates


Graham and Harvey (2001) survey of CFOs: 10-year risk
premium ranges between 3.6% and 4.7%.


Welch (2001) survey of finance professors: 1-year risk premium
averaged 3.4%, 30-year premium averaged 5.5%.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
21
Detour on the Discount Rate


Best check on the discount rate:


Sensitivity Analysis.


Re-do valuation with other discount rates (always!).


Getting “fancy”

with the discount rate is a low payoff activity.


Using “term structure”

(different risk-free rates for each period)
adds very little.


Using Fama-French (three-factor or four-factor) model instead of
CAPM makes no difference.


Instead better to calibrate.


How do we proceed with calibration?
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Detour on the Discount Rate (cont.)
Three Basic Steps on Calibration


Value Company as it is.


Use current forecasts.


Find the discount rates.


Is estimated value close to the market value?


No? Try to understand why.


Make adjustments to get the market value.


Apply discount rate/growth rate to:


Other companies/investments.


Check whether assumptions seem sensible in other valuations.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
23
Terminal Values
There are generally two ways to proceed to compute TV


Take cash flow (that presumably you already calculated earlier)
and do a perpetuity calculation.


Assume that you can sell the firm using a simple rule involving
P/E’s –

i.e. price will equal x

times earnings.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Terminal Values: Perpetuity Calculation


If you do a perpetuity calculation you probably will use the last
free cash flow and divide it by r
A

- g.


Terminal FCF in Last Year T. The main issue is to determine the
FCF in steady-state situation.


Careful with high-growing companies, cyclical industries.


Get FCF
T

and then apply formula:


Where do we get g?


Careful here: valuation is typically very sensitive to this.
T
FCF (1 )
TV =
A
g
r g
+
÷
Advanced Corporate Finance. Spring 2011 – Brandon Julio
25
Terminal Values: Perpetuity Calculation (cont.)


To get PV(TV), need to discount back: PV(TV) = TV / (1 + r
A

)
T


Make sure FCF
n

used to get TV reflects g:


Adjust capital expenditures and depreciation.


Bottom Line: Are depreciation, NWC and other flows you
have in the cash flow estimate consistent with the g that you
choose?
Advanced Corporate Finance. Spring 2011 – Brandon Julio
26
Terminal Values: Multiples of Earnings


If you use a multiple of earnings to calculate the sale price, then
you need to calculate earnings –

not free cash flows.


Where do you get the multiple from?


Another place where you can manipulate the answer.


Presumably you pick the multiple using comparable firms.


More on Valuation with Multiples later.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
27
Step 2: Add PV[Tax Shield of Debt]


Need to account for the debt tax shields, including any
associated with the terminal value and discount these at the
appropriate interest rate.


These deductions depend on the interest payments and the tax
rate. Often the interest payments will appear on the financial
statements. If so use them.


If only the debt levels appear you need to translate them into
implied levels of interest payments.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
28
What Interest Rate Do We Use to Discount TS?


The choice of the discount rate depends on the risk. What is the

risk of the tax shield? We don’t actually know…


In general the tax shield will have its own risk, which will
depend also on the probability that the government will change
its tax policy, and similar issues.


Estimating the risk of the tax shield would be very cumbersome
(and not worthwhile), thus typically we choose among two
assumptions: the risk of the tax shield is equal to the risk of the
debt

or the risk of the assets.


Since these are assumptions there is no absolute right or wrong
answer. However, one may claim that one criteria will probably
be closer the truth, depending on circumstances.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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A Suggestion


If debt is predetermined or has a low level, risk of tax shields

similar to risk of repayments to debtholders; so r
D

is correct
discount rate.


If high level of debt (e.g. LBOs), or if level of debt varies with
firm value, then riskiness of tax shields similar to that of
operating assets and tax shields should be discounted at r
A
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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For example, in the article by Kaplan and Ruback, several LBOs

are considered. The level of debt is very high.


When leverage is 80-90% of the value of the firm, the risk of the
debt is close to the risk of the assets.


Then we might as well assume that the risk of the tax shield is
also equal to the risk of the assets for firms with very high
leverage.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
31


Whatever assumption you make about the risk of the tax shield,
you have to take care to be consistent throughout the valuation.


In particular, remember that the assumption you make about the
risk of the tax shield also affects the equation you will use to

lever and unlever the beta.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
32
Two Possible Scenarios
SCENARIO 1 – Using r
A


Debt in the future is not fixed.


Debt and interest expense are tied to FCF.


Model when big changes in capital structure,


LBOs

(more highly leveraged transactions).


Bankruptcy.


In those cases, the ability to use tax shields has more systematic
risk than the ability to pay debt.


Int
t

comes from debt repayment schedule and interest rates.
1 2 T
2 T
Int Int Int
TS = Tax Rate * ...
(1 ) (1 ) (1 )
A A A
r r r
(
+ + +
(
+ + +
¸ ¸
Advanced Corporate Finance. Spring 2011 – Brandon Julio
33
Two Possible Scenarios (cont.)
SCENARIO 2 – Using r
D


You expect a predictable, stable and low level of debt.


Ability to use tax shield has the same systematic risk as the
ability to pay debt. Generally in less highly leveraged situations.


For permanent debt with the same risk as interest:
TS = Permanent Debt * Tax Rate = t * D
1 2 T
2 T
Int Int Int
TS = Tax Rate * ...
(1 ) (1 ) (1 )
D D D
r r r
(
+ + +
(
+ + +
¸ ¸
Advanced Corporate Finance. Spring 2011 – Brandon Julio
34
Just to Check Things Are Clear


Remark 1: If debt is predetermined (D is constant) and has a
low level, risk of tax shield equal to risk of payments to debt
holders; so r
D

is the correct discount rate.


Remark 2: If high level of debt or if level of debt varies with
firm value (D/V is constant), then the risk of the tax shield is

similar to that of operating assets and tax shields should be
discounted at r
A

.


Remark 3: Some firms have high leverage or maintain a target
leverage ratio while maintaining an investment grade rating on
their debt. For these firms, the correct discount rate is probably
closer to r
D.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
35
How Leverage Affects the Betas?


Whatever assumption you make about the risk of the tax shield,
you have to take care to be consistent throughout the valuation.


In particular, remember that the assumption you make about the
risk of the tax shield also affects the equation you will use to

lever
and unlever

the beta.


If the risk of the tax shield is equal to the risk of the debt

(D is
constant), then such equation is:


If instead the risk of the tax shield is equal to the risk of the
assets (D/V

is constant), then such equation is:
C
C C
(1 )
(1 ) (1 )
A D E
D t E
E D t E D t
| | |
÷
= +
+ ÷ + ÷
A D E
D E
E D E D
| | | = +
+ +
Advanced Corporate Finance. Spring 2011 – Brandon Julio
36
What About the TS Associated with the TV?


If you do a perpetuity calculation for the TV and the firm is
expected to have some debt then this matters!


Remember that you have to add any debt tax shields on NPV that
accrue beyond the terminal date.


There are “many”

ways to compute the terminal value of the tax
shields.


Again you do not have to get fancy. Common sense matters!


They are obviously short-cuts. The main thing is to recognize that
you are going to get some tax shields beyond

T and then do
something sensible.


Let’s see 2 different ways…
Advanced Corporate Finance. Spring 2011 – Brandon Julio
37
What About the TS Associated with the TV?
1.

If D stabilizes at a permanent (and low) level, D
T
.
2.

If (D/V) stabilizes at some level, γ

(D
T

= γ

* V
T

):
T C
D t TS TV * ) ( =
g r
r D t
TS TV
A
D T C
÷
=
* *
) (
Advanced Corporate Finance. Spring 2011 – Brandon Julio
38
Comments on Step 2 (cont.)


For many projects, neither D nor D/V is expected to be stable.


Need to be careful and creative.


Firms on average tend to rebalance leverage towards a target, but
they do so slowly (at an average rate of 30% per year).


For instance, LBO debt levels are expected to decline.


In general you can estimate debt levels using:


Repayment schedule if one is available.


Financial forecasting.
and discount by a rate between r
D

and r
A

.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
39
Extending the APV Method


You could also take care of the costs to financing that come
from financial distress, any issue costs, etc. Once again you
find the present value and subtract it.


You could also add the PV of the costs of financial distress.
How?


Write scenarios and include costs of distress in bad scenarios.


Often people omit PV(costs of distress) because it is difficult to
quantify.
APV vs. WACC
Advanced Corporate Finance. Spring 2011 – Brandon Julio
41
Pros and Cons of APV


Pros:


Implicit assumptions are very clear. No contamination.


Works even if debt is not permanent.


Is very easy if the level

of future debt is known.


Clearer: Puts the spot light on what is creating value. Beautiful!
Easier to track down where value comes from.


Assists in the decision of how to structure financing for projects.


More flexible: Just add other effects as separate terms.


Cons:


Requires explicitly calculating future debt levels.


It is increasingly used, but still less well known than WACC.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
42
Pros and Cons of WACC
Pros:


Most widely used.


The inputs are easy to get.


If you have a precise debt to value policy, then it is easy and
relative accurate.


But this seems to be highly restrictive.


Less computations needed. It is very simple tool.


Only when project is similar to rest of the firm.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
43
Pros and Cons of WACC (cont.)
Cons:


Mixes up the effects of assets and liabilities.


Errors/approximations in effect of liabilities contaminate the whole
valuation.


Does not reveal where the value is coming from.


Not very flexible. Cannot easily allow for changes in:


Other effects of financing (e.g., costs of distress, issue costs)


Non-constant debt ratios


Changes in tax rates
Advanced Corporate Finance. Spring 2011 – Brandon Julio
44
Practical Implications


In principle we can always use either WACC or APV. As long
as you follow all the steps and you are careful in making the
same assumptions you should obtain (approximately) the same
solution.


In practice, however, one of the two will be much simpler to
use depending on the situation.


For complex, changing or highly leveraged capital structure (i.e.
LBOs) APV is much better.


Otherwise, it does not matter much which method you use.


Lets consider two cases:


Debt is rebalanced.


Debt is predetermined.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Practical Implications (cont.)


If debt is rebalanced (i.e. the firm has a target debt/asset ratio):


Computing WACC is much easier.


APV is much more complex since you do NOT know D.


Bottom Line: In this case of rebalanced debt use WACC.


If debt is predetermined (i.e. firm knows the evolution of D):


APV is easy to compute by discounting future expected interest
payments.


WACC instead has a problem, because if the debt is not
rebalanced then D/V changes over time and so does WACC.


Bottom Line: In this case of predetermined debt use APV.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
46
Two Remarks


Remark 1: In principle, you can always forecast D/V values,
compute a different WACC for each year and discount back by
using a different WACC every year. This is a headache!


Remark 2: For non-constant debt-ratios, could use different
WACC for each year but this is heavy and defeats the purpose.
Discounted Cash Flow Valuation Methods
Advanced Corporate Finance. Spring 2011 – Brandon Julio
48
Three Cash Flow Valuation Methods


The three methods differ in their measure of cash flows and the
discount rate applied to those cash flows.


The names for the three methods correspond to the type of cash
flow that is used in the valuation:


Capital Cash Flow (CCF) –

Provides Enterprise Value.


Free Cash Flow (FCF) –

Provides Enterprise Value.


Equity Cash Flow (ECF) –

Provides Equity Value.


The three methods provide consistent valuations when applied
correctly.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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FCF and CCF


CCF method includes the benefits of the tax shields as cash
flows.


The more the tax advantages, the higher the capital cash flow.


The discount rate for this method is the return on assets.


FCF method includes the tax benefits of deductible interest
payments in the discount rate as it uses WACC


The more the tax advantages, the lower the discount rate.


Because the tax advantages of debt are included in the discount
rate, the cash flows do not include the tax benefits of debt.


The difference between the FCF and the CCF is in the Interest
Tax Shield:
Capital Cash Flow = FCF + Interest Tax Shield
Advanced Corporate Finance. Spring 2011 – Brandon Julio
50
CCF and APV


Note that the expression of the CCF is close and resembles to
the APV expression we studied before.


In fact, when we use r
A
as the discount rate of both terms:


Thus, APV = NPV(CCF) discounted at r
A

. It is also called
“Compressed APV”.
FCF FCF ITS CCF
APV
C D
A A A A A
t r D
r r r r r
= + = + =
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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CCF and APV (cont.)


CCF uses actual taxes (projected tax payments).


Hence, you should always compute it starting from Net Income
because Net Income is already net of actual taxes.


CCF from a net income version:


CCF = Net-after tax income (NI) + Interest Expense (I) + Dep



Capx



Change in NWC + Other
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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When Should We Use CCF?


CCF valuation is generally useful for:


Highly Leveraged Transactions.


Firms in Financial Distress.


Bankruptcy.


In these cases we would have discounted the tax shield with r
A


However, we recommend using APV instead of CCF. Why?
Advanced Corporate Finance. Spring 2011 – Brandon Julio
53
Equity Cash Flow


ECF measures the cash flow available to stockholders after
payment to debt holders are deducted from operating cash
flows.


Payment to debt holders are sometimes called “Debt Cash
Flows”

(DCF), and they include interest and principal


payments.
ECF = CCF –

DCF


As DCF are paid out of operating cash flows before equity cash
flows, debt cash flows are safer than equity cash flows.


ECF are riskier than cash flow measures that combine DCF and
ECF. And riskier cash flows have higher discount rates.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
54
Equity Cash Flow (cont.)


ECF are calculated by subtracting taxes, interest and debt
repayments from operating cash flows and adding debt
additions.
ECF = Net Income + Dep



Capx



Change in NWC + Other +
Change in Debt


Notice that Increases in Debt help to finance increases in capital
expenditures and net working capital.


Alternatively, ECF can be calculated as CCF less DCF.


The discount rate used in the ECF is the return on equity and
the value we obtain is the equity value of the firm.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
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Equity Cash Flow (cont.)


ECF is extremely useful for:


Valuing financial institutions. Very difficult to use APV or
WACC in banks. Why?


Debt is part of the business of most financial institutions.


Very difficult to have an “all equity bank”.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
56
Pros and Cons of ECF


In general, we prefer both APV and WACC to ECF.


APV is preferred to the ECF for many of the same reasons that
APV is superior to WACC.


The use of one discount rate for ECF requires that the firm have

a
constant debt to total capital ratio. If the debt to total capital ratio
varies over time, we need to calculate a different discount rate

for
the equity for each year.


It is much easier to make mistakes using the ECF. In particular, it
is critical to include increases in debt in the cash flows,
particularly in the terminal value calculation.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
57
Pros and Cons of ECF


ECF tend to calculate equity values that are too low.


The method values equity as the discounted value of the expected

ECF. This is accurate as long as there is no probability that the
equity value will be less than or equal to 0.


Expected Debt Payments ≤

Promised Debt Payments.
Valuation Using Multiples
Advanced Corporate Finance. Spring 2011 – Brandon Julio
59
Valuation Using Multiples


Valuation by multiples is a fancy name for market prices

divided by some measure of performance.


It assesses the value based on that of other (publicly-traded)

firms:
[Value/Key Characteristic]
Ind.Average

* Key Characteristic of Firm


Numerator of multiple is typically the total value of the firm.


Denominator of multiple is the characteristic that is important
for that industry:


clicks or subscribers for web site


paid miles flown for airlines


number of patents for a hi-tech firm.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
60
Valuation by Multiples: Implicit Assumptions
1.

Comparable companies assumed to have expected cash
flows growing at the same rate

and have the same level of
risk

as the company being valued.
2.

The value of the company is assumed to vary in direct
proportion

with changes in the performance measure; i.e.
if expected EBITDA increases by 8%, expected firm value
also increases by 8%.
¬

If these assumptions are valid, valuing by multiples
will be more

accurate than the DCF approach because it
incorporates current market expectations of cash flows
and discount rates.
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61
Types of Multiples


Cash-flow-based Value

multiples:


MV of firm/Earnings, MV of firm /EBITDA, MV of firm /FCF.


Cash-flow-based Price

multiples:


Price/Earnings (P/E), Price/EBITDA, Price/FCF.


Asset-based Value

multiples:


MV of firm/BV of assets, MV of equity/BV of equity.


Industry-specific Value

multiples:


MV of firm/Hospital Beds, MV of firm/Number of Customers.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
62
Procedure
Hope: Firms in the same business should have similar multiples.


Step 1: Identify firms in same business as the firm you wish to
value. Be careful not to induce a selection bias.


Step 2: Calculate multiple for comparable firms.


Step 3: Calculate average for the set of comparable firms. In
doing this we are coming up with an estimate of the multiple we
wish to use in valuing our firm. Equal-weighting vs. Distance-

weighting.


Step 4: Multiply average with the value of the characteristic for
the firm you wish to value.


Step 5: Often different multiples give you different answers:
you need to reflect what is economically reasonable.
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63
Important Remarks


When choosing comparable firms you face a trade-off: too
many firms requires to select firms that are not truly
comparable; too few firms means that your average will reflect
idiosyncracies of those firms.


For firms with no earnings or limited asset base (e.g. hi-tech),


Price-to-patents multiples.


Price-to-subscribers multiples.


Or even price-to-Ph.D. multiples!


For transactions, can also use multiples for comparable


transactions.


Similar transaction values.


But be aware, everyone might be over/underpaying!
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64
Important Remarks (cont.)


For similar public traded companies:


Use trading multiples.


They tell you what market thinks about the value.


Multiples based on equity value (or stock price, e.g., P/E) as
opposed to total firm value ignore effect of leverage on the cost
of equity (or assume the firms have similar leverage)


Beware if comparables have very different leverage.
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65
Motivation for Multiples?


Firms in the same business should have similar multiples.


If the firm’s actual FCF is a perpetuity:
MV firm = FCF/(WACC-g) =>

MV firm/FCF = 1/(WACC-g)


Comparables will have a similar MV firm/FCF provided they:


Have the same WACC (requires similar D/(D+E)).


And are growing at a similar rate.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
66
Bottom Line on Multiples


Multiples complement APV/DCF methodology:


Check on valuation; market based perspective.


Extremely useful when you do not have cash flow projections.


EBITDA or cash-flow multiples are preferable to (net) earnings
multiples.


More consistent treatment of leverage.


Companies with different leverage will have different P/E


multiples, even tough same business risk and growth.


Less ability to manipulate


Easier to manipulate net earnings through accountings than
EBITDA or cash flow.
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67
Pros and Cons of Multiples
Pros:


Incorporates simply a lot of information from other valuations in a
simple way.


Embodies market consensus about discount rate and growth rate.


Free-ride on market’s information.


Can provide discipline in valuation process by ensuring that your
valuation is in line with other valuations.


Sometimes, what you care about is what the market will pay, not
the fundamental value.
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Pros and Cons of Multiples (cont.)
Cons:


Difficult to find true

comparables. Implicitly assumes all
comparables are alike in growth rates, cost of capital, and
business composition. Hard to find true comparables in real life.


Hard to incorporate firm-specific information. Particularly
problematic if operating changes are going to be implemented.


Relies on accounting measures being comparable too.


Differences in accounting practices can affect earnings and
equity-based multiples. Therefore better to use FCF and EBITDA
multiples.
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69
Pros and Cons of Multiples (cont.)


Cons:


Book values can vary across firms depending on age of PPE.


If market is overpaying, you will too!
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70
Bottom Line On Multiples


Because of the many limitations, never rely on just a single

multiple or on valuation based only on multiples.


Best to use multiples only as a check for the valuation based

on
discounted cash-flows.


After you have done a throughout

valuation, you can compare
your predicted multiples, such

as P/E and market-to-book, to
representative multiples of

similar firms.


If your predicted multiples are out of line then

you have to
convince yourselves (and your clients) that your

model is
reasonable.
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71
Bottom Line On Multiples (cont.)


Because of accounting differences, be careful in using multiples

to compare firms across industries, and especially,

across
countries.


As a rule of thumb when choosing the basis for multiples,

remember that:


The higher up the basis is in the income

statement (e.g. sales) the
less it is subject to changes in

the accounting method.


On the other hand, the less it

reflects differences in operating
efficiency across firms (e.g. firm’s pricing policies, production
efficiency, etc.).
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72
After Valuation is Done!


Three possible answers:


NPV >> 0

=

GO!!


NPV << 0

=

No Go*


NPV = 0

=

Think More.


*Are there future options in project?


Try to incorporate these in cash flows.


Are we overpaying?


Have we properly accounted for financial / capital structure
effects on real cash flows:


changes in incentives?


costs of financial distress?
Advanced Corporate Finance. Spring 2011 – Brandon Julio
73
Takeaways


It is important to separate the value created by underlying assets
and those coming from financing.


APV does this directly and is a very flexible tool. Sometimes it

can be difficult because you need to know the future levels of
debt.


Both WACC and APV force you to get the asset beta, so you
have to be able to do this!


If applied correctly, both give the same answer.


APV is aesthetically cleaner in terms of the source of the value

generation. APV does not mix the valuation of operation with
the effects of financing.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
74
Takeaways (cont.)


For APV we need to know the level of debt outstanding each
year –

more suitable for LBOs.


For WACC we need to know the D/V ratio each year.


You should understand the conceptual differences between
these two methods and why in principle we prefer APV.


Remember there are other cash flows methods you should bear
in mind. Go through the examples and be sure you are capable
of computing each of the cash flows.


Best to use multiples only as a check for the valuation based

on
discounted cash-flows.
Example (Be Sure To Go Through It!)
Valuation Of Private Companies
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84
Valuing Private Companies


There are three major complications in the case of a private
company:


We have much less information available.


Estimating Cost of Equity.


Estimating Cost of Debt.


Estimating Cash Flows.


Effect of Illiquidity on Value.


Control Issues.
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85
I. Less Information: Cost of Equity
The problem with a private company is that there are no past
prices to estimate risk parameters (betas).
Two Possible Solutions
1.

Estimate β

of a comparable traded firm.


Remember to correct for different capital structure.


A simple test to see if the group of comparable firms is truly
comparable is to estimate a correlation between the revenues or
operating income of the comparable firms and the firm being
valued.


Even after we compute the β
A
from comparable companies, we
do not have a market value of debt and equity to compute
leverage.
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86
I. Less Information: Cost of Equity (cont.)
2.

Assume that the private firm will move to the industry average
debt ratio.


The β

for the private firm will then also converge on the industry
average beta.


Might not happen immediately but over the long term.


Alternatively you may try to estimate the optimal debt ratio for

the company, based upon its operating income and cost of
capital.
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87
I. Less Information: Cost of Debt


The main problem is that private firms generally do not access
public debt markets, and are therefore not rated.


This problem might also happen with public companies.


Most debt on the books is bank debt, and the interest expense
on this debt might not reflect the rate at which they can borrow.


One possible solution is to assume that the private firms can
borrow at the same rate as similar firms in the industry.


Alternatively, you can estimate the appropriate bond rating for
the company, based upon financial ratios, and use the interest
rate related to the estimated bond rating.
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88
I. Less Information: Cost of Debt (cont.)


Finally, if the debt on the books of the company is long-term
and recent, the cost of debt can be calculated using the interest
expense and the debt outstanding.


Caveat: If the firm borrowed the money towards the end of the
financial year, the interest expenses for the year will not reflect
the interest rate on debt.
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89
I. Less Information: Cash Flows
There are special problems associated with estimating cash


flows for a private firm:


Shorter History


Private firms often have been around for much shorter time
periods than most publicly traded firms.


There is less historical information available on them.


Different Accounting Standards.


The accounting statements for private firms are often based upon

different accounting standards than public firms, which operate
under much tighter constraints on what to report and when to
report.
Advanced Corporate Finance. Spring 2011 – Brandon Julio
90
I. Less Information: Cash Flows (cont.)


Mix of Personal and Business Expenses.


In the case of private firms some personal expenses may be
reported as business expenses.


Separating Salaries from Dividends.


It is difficult to tell where salaries end and dividends begin in a
private firm, since they both end up with the owner.


Rules of Thumb –

Dealing With Special Problems.


Re-state earnings using consistent accounting standards.


If any of the expenses are personal, estimate the income without

these expenses.


Estimate a reasonable salary based upon the services the owner
provides the firm.
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91
II. Effect of Illiquidity on Value


There is a general agreement that the value of the company
should be lower because of illiquidity.


The problem is by how much? Lots of disagreement!


Some recent studies suggest that the liquidity discount is
between 20-30% for private firms.


Adjust subjectively for size.


Make the discount smaller for larger firms.


Some Facts:


Discounts should be reduced by:
1.

Roughly 6% for a firm with $100M in revenue.
2.

Up to 11% for a company with $1B in revenue.


If earnings are negative, increase the discount.
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92
III. Effects of Control


Purchasers pay a premium for control positions.


Many studies show that control block trade at a premium for
public companies.


This is because once you have control you can improve the
company.


It is almost like a takeover.


There is no guideline on how to compute the control premium
in DCF.


You should take into account in your projections what you think
you can accomplish with control!


Alternatively, you can use transaction multiples.


However, trying to find comparables both in terms of transaction

and firm is difficult.
Appendix:
Computing Asset and Equity Betas
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94
Computing Asset Betas and Equity Betas
How to Measure |
A

?


The value of the levered firm is given by V
L

= D + E.


Since, V
L

= V
U
+ PV(TS), then V
U

= D + E -

PV(TS).


And therefore:


Which we can be re-written as:
U U U
D E PV(TS)
V V V
A D E TS | | | | = + ÷
U
V D E PV(TS) A D E TS | | | | ÷ = +
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95
Computing Asset Betas and Equity Betas (cont.)


Now we need to assume something about |
TS

.


Assumption 1: The risk of the tax savings is the same as the
risk of the debt that generates it (|
TS
= |
D

).


Then the previous equation becomes:


And since V
U

= V -

PV(TS), we have:
D - PV(TS) E
V - PV(TS) V - PV(TS)
Α D E | | | = +
U U U
D E PV(TS)
V V V
A D E D | | | | = + ÷
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96
Computing Asset Betas and Equity Betas (cont.)


This formula simplifies under some special cases.


If D is constant:


If, in addition, the debt is riskless (|
D

= 0):
D(1 ) E
V D V D
C
Α D E
C C
t
t t
| | |
÷
= +
÷ ÷
D
1 (1 )
E
( )
E
C
A
t
|
| =
+ ÷
Advanced Corporate Finance. Spring 2011 – Brandon Julio
97
Computing Asset Betas and Equity Betas (cont.)


Assumption 2: The risk of the tax savings is the same as the
risk of the existing assets (|
TS
= |
A

).


Then we are left with,


And since, V
L

=V
U

+ PV(TS) we have that:


Conclusion: We can compute |
A

just using the values from the
levered firm in the Finance I formula.
U (V PV(TS)) D E
A D E
| | | + = +
D E
V V
Α D E | | | = +

Plan of Attack
• • • • • Important Assumptions Traditional DCF vs. Risk-Neutral Valuation Valuation Using Adjusted Present Value. Comparing APV and WACC. Discounted Cash Flow Valuation Methods.
– Capital Cash Flow. – Equity Cash Flow.

Advanced Corporate Finance. Spring 2011 – Brandon Julio

2

Plan of Attack (cont.)
• • • Valuation by Multiples. Valuation of Private Companies. Appendix: Computing Asset Betas and Equity Betas.

Advanced Corporate Finance. Spring 2011 – Brandon Julio

3

Advanced Corporate Finance. • Managers are “rational”.Overview of Assumptions Let Manager Invest For Me? Corporate Manager Risky Future Cash Flows Corporate Project $ $ Risky Future Cash Flows Investor Invest Directly On My Own? Financial Market Investment • Investors are “rational”. • Managers objective function: Maximize shareholder wealth. Spring 2011 – Brandon Julio 4 . • Financial Markets are “efficient”.

Adjust cash flows for risk.Two Approaches to Valuing Cash Flows Risky Cash Flows Adjust discount rate for risk. E CFt  V 1  rRisk  Adjusted E CFt   Risk Adjustment V 1  rRisk  Free E * CFt  V 1  rRisk  Free Advanced Corporate Finance. Spring 2011 – Brandon Julio 5 .

Suppose we know the probability of the good state is 0. The project pays £120 million in a ‘good’ state of the world and £60 million in the ‘bad’ state of the world. Then: E (CF )  0. Assume the risk-free rate is 4%.70)(£60)  £102 £102 V   £91.12) This is the traditional DCF approach Advanced Corporate Finance.07 (1  0.70 and the appropriate risk-adjusted discount rate is 12%. Spring 2011 – Brandon Julio 6 .70(£120)  (1  0.Example • Consider a project that pays an uncertain cash flow in one year.

579 )(£ 60 )  £ 94 . 71 £ 102  £ 91 . 04 ) Notice that I have solved for a different set of probabilities that sets the value equal to the risk-adjusted value. 07  V (1  0 . Suppose we don’t know the right risk-adjusted discount rate. 579 (£ 120 )  (1  0 . Can we adjust the cash flows and discount by the riskfree rate to get the same value? E * ( CF )  0 .Example. 71  V* £ 94 . Spring 2011 – Brandon Julio 7 . cont. 12 ) (1  0 . This is the risk-neutral approach to valuation Advanced Corporate Finance. we could approach this in a different way. • Alternatively.

Much more than the ones we will cover in this course. Discounted Cash Flows (DCF). Advanced Corporate Finance. Recall financing matters through: – – – – Tax shields Costs of financial distress Bankruptcy costs Agency Costs • There are different techniques in the valuation world. Next time: Real Options. Spring 2011 – Brandon Julio 8 . Now we want to take financing into account. – We want to review the basics of WACC.Objective for Today: DCF Methods • • We know how to value a 100% equity financed project. Equity Cash Flows (ECF). APV. Capital Cash Flows (CCF) and Multiples/Comparables.

Advanced Corporate Finance. APV (Adjusted Present Value). Spring 2011 – Brandon Julio 9 .Two Different Methods Two different methods for valuation with financing: • • WACC (Weighted Average Cost of Capital).

Valuation Using APV .

The two simple steps involved in computing the APV are: – Step 1: Value of the project as if all-equity financed: use the after-tax cash flows and discount them at the cost of capital. Spring 2011 – Brandon Julio . – Step 2: Add the present value of the tax shield (TS) generated by the project.The Adjusted Present Value Method • An alternative approach to the WACC is to compute the Adjusted Present Value (APV). Remember that for an all-equity firm the cost of capital equals the cost of equity. • APV  NPVall equity + PV(TS) • APV is also known as valuation by components. 11 Advanced Corporate Finance.

It can easily be adapted to include other financing side effects. Spring 2011 – Brandon Julio 12 . Doing this allows us to identify the sources of value and to discount different risks appropriately. • • Advanced Corporate Finance.The Adjusted Present Value Method • This is simply MM Proposition I with taxes in action. APV = VL = VU + PV[TS] • We do this to separate the value of running the business from the value created by financing. The APV method uses the value additivity principle to evaluate the contribution of both cash flows and increased debt tax shields.

Important Caveat • In principle. if the firm can use the financing regardless of the investment decision. financing should affect the value of a potential project only if the ability to use certain financing depends directly on the decision to take the project. the value of the financing is not incremental to the project and should be ignored. • It follows that the tax benefits of debt (as well as the associated costs) should be attributed to a project only if the project increases the debt capacity of the firm. • Otherwise. Advanced Corporate Finance. Spring 2011 – Brandon Julio 13 .

– Discount the tax shields at the “appropriate” rate. – Calculate expected interest shields. – Unlever the equity beta and calculate the return on equity if the firm had no debt using an asset pricing model. – Do a terminal value calculation for the tax shields related to the terminal value of cash flows. – Calculate free cash flows (we are estimating enterprise value).APV: Basic Steps • Step 1: Value free cash flows as if the firm were 100% equity financed. Spring 2011 – Brandon Julio 14 . • Step 2: Value the tax shields separately. • Let’s go through each of these steps in detail. – Do a terminal value calculation. Advanced Corporate Finance. – Discount the cash flows with the unlevered cost of capital.

tC) + Change in Deferred Taxes + Depreciation – Increase in NWC – CAPX + Other. Spring 2011 – Brandon Julio . – Get the FCF from running the business as an all-equity firm.Step 1: Valuing the Cash Flows • Free Cash Flows are exactly what you need. Be careful with cyclical industries and young growth firms. – FCF = EBIT(1. 15 • • Advanced Corporate Finance. We don’t want the tax consequences of capital structure to matter. It is important to remember that getting the correct free cash flow estimates will usually have a much larger impact on the final value than obtaining the correct discount rate. We typically have a forecast horizon of 5 years. • We start with EBIT because this is what is available to be paid to the owners – regardless of the existing debt/equity mix .

deferred taxes. – For example. This is tax that we owe. – Non-cash income should be subtracted from the FCF. Advanced Corporate Finance. but do not presently have to pay.Some Remarks About Free Cash Flows • Be careful with non-cash expenses and income.  Should be added back since it is a non-cash expense. • Bottom Line: – Non-cash expenses should be summed-up to the FCF. Spring 2011 – Brandon Julio 16 .

– Employ an asset pricing model (usually CAPM) to translate risk exposures into expected returns. – Estimate their expected return on equity if they were 100% equity financed. you need to: – Find comparables. by unlevering the equity betas. This rate is the expected return on equity if the firm were 100% equity financed.e. To get it.Which Discount Rate? • You need the rate that would be appropriate to discount the firm’s cash flows if the firm were 100% equity financed. • • Advanced Corporate Finance. i. publicly traded firms in same business. Spring 2011 – Brandon Julio 17 ..

Spring 2011 – Brandon Julio 18 . Advanced Corporate Finance. • • Deduct Excess Cash (only) from debt. In D only include interest bearing debt.) • • • Unlever each comp’s E to estimate its asset beta (more on this later) D and E are historical market values.Which Discount Rate? (cont. – Exclude Account Payables and Pension Liabilities. use book value. If no market value for D. – Include interest bearing short-term and long-term debt. but it is the best we have. Bottom Line: Beta is not perfect.

How do you pick the risk-free rate and the excess return on the market? – Short-term or long-term for rf ? →Same horizon as the investment.) • • Use the comps’ A to estimate the project’s A (e.g. – There are plenty of estimates of risk premium of market over Treasury Bonds.Which Discount Rate? (cont. • Use rA to discount the project’s FCF. Use the estimated A to calculate the all-equity cost of capital rA rA = rf + A * Market Risk Premium • Here is an obvious place where judgment is required. 19 Advanced Corporate Finance. average). Spring 2011 – Brandon Julio .

6% and 4.7%. • Implied Equity Risk Premium – Fama & French (2001): Risk premium implied by fundamentals and stock prices over the 1872-2000 time period was between 2. – Ibbotson & Associates (2000): Realized average risk premium over treasuries in 1999 was 9.5%. – Kaplan and Ruback (1996): Risk premium implied by sample of MBOs was 7. Spring 2011 – Brandon Julio 20 . Advanced Corporate Finance.4%.55% and 4.32%. – Welch (2001) survey of finance professors: 1-year risk premium averaged 3. 30-year premium averaged 5.8% • Equity Risk Premium – Survey Estimates – Graham and Harvey (2001) survey of CFOs: 10-year risk premium ranges between 3. Historically 6%.32%.Estimates of the Equity Risk Premium • Historical Equity Risk Premium – There are plenty of estimates of risk premium of market over Treasury Bonds.

– How do we proceed with calibration? Advanced Corporate Finance. • Getting “fancy” with the discount rate is a low payoff activity. – Re-do valuation with other discount rates (always!). – Using Fama-French (three-factor or four-factor) model instead of CAPM makes no difference.Detour on the Discount Rate • Best check on the discount rate: – Sensitivity Analysis. – Using “term structure” (different risk-free rates for each period) adds very little. Spring 2011 – Brandon Julio 21 . – Instead better to calibrate.

– Make adjustments to get the market value.) Three Basic Steps on Calibration • Value Company as it is. – Use current forecasts. • Is estimated value close to the market value? – No? Try to understand why.Detour on the Discount Rate (cont. – Find the discount rates. • Apply discount rate/growth rate to: – Other companies/investments. – Check whether assumptions seem sensible in other valuations. Spring 2011 – Brandon Julio 22 . Advanced Corporate Finance.

Spring 2011 – Brandon Julio 23 . price will equal x times earnings.Terminal Values There are generally two ways to proceed to compute TV • Take cash flow (that presumably you already calculated earlier) and do a perpetuity calculation. • Assume that you can sell the firm using a simple rule involving P/E’s – i.e. Advanced Corporate Finance.

Terminal Values: Perpetuity Calculation • If you do a perpetuity calculation you probably will use the last free cash flow and divide it by rA . Advanced Corporate Finance. cyclical industries. – Get FCFT and then apply formula: TV = FCFT (1  g ) rA  g – Where do we get g?  Careful here: valuation is typically very sensitive to this.  Careful with high-growing companies. The main issue is to determine the FCF in steady-state situation. Spring 2011 – Brandon Julio 24 . – Terminal FCF in Last Year T.g.

NWC and other flows you have in the cash flow estimate consistent with the g that you choose? Advanced Corporate Finance.Terminal Values: Perpetuity Calculation (cont. need to discount back: PV(TV) = TV / (1 + rA)T Make sure FCFn used to get TV reflects g: – Adjust capital expenditures and depreciation.) • • To get PV(TV). Spring 2011 – Brandon Julio 25 . • Bottom Line: Are depreciation.

Terminal Values: Multiples of Earnings • If you use a multiple of earnings to calculate the sale price. Advanced Corporate Finance. – Presumably you pick the multiple using comparable firms. then you need to calculate earnings – not free cash flows. – More on Valuation with Multiples later. Spring 2011 – Brandon Julio 26 . • Where do you get the multiple from? – Another place where you can manipulate the answer.

If so use them. Advanced Corporate Finance.Step 2: Add PV[Tax Shield of Debt] • Need to account for the debt tax shields. – If only the debt levels appear you need to translate them into implied levels of interest payments. including any associated with the terminal value and discount these at the appropriate interest rate. Spring 2011 – Brandon Julio 27 . Often the interest payments will appear on the financial statements. • These deductions depend on the interest payments and the tax rate.

However. Spring 2011 – Brandon Julio • • 28 . Estimating the risk of the tax shield would be very cumbersome (and not worthwhile). depending on circumstances. one may claim that one criteria will probably be closer the truth.What Interest Rate Do We Use to Discount TS? • The choice of the discount rate depends on the risk. What is the risk of the tax shield? We don’t actually know… In general the tax shield will have its own risk. – Since these are assumptions there is no absolute right or wrong answer. and similar issues. Advanced Corporate Finance. thus typically we choose among two assumptions: the risk of the tax shield is equal to the risk of the debt or the risk of the assets. which will depend also on the probability that the government will change its tax policy.

• If high level of debt (e. LBOs).A Suggestion • If debt is predetermined or has a low level. Spring 2011 – Brandon Julio 29 . risk of tax shields similar to risk of repayments to debtholders. or if level of debt varies with firm value.g. so rD is correct discount rate. then riskiness of tax shields similar to that of operating assets and tax shields should be discounted at rA Advanced Corporate Finance.

Spring 2011 – Brandon Julio 30 . several LBOs are considered. • Then we might as well assume that the risk of the tax shield is also equal to the risk of the assets for firms with very high leverage. in the article by Kaplan and Ruback. The level of debt is very high. Advanced Corporate Finance.• For example. the risk of the debt is close to the risk of the assets. • When leverage is 80-90% of the value of the firm.

Advanced Corporate Finance. Spring 2011 – Brandon Julio 31 . you have to take care to be consistent throughout the valuation. • In particular.• Whatever assumption you make about the risk of the tax shield. remember that the assumption you make about the risk of the tax shield also affects the equation you will use to lever and unlever the beta.

• In those cases. – LBOs (more highly leveraged transactions)..  TS = Tax Rate *   (1  rA ) (1  rA ) 2 (1  rA ) T   • Intt comes from debt repayment schedule and interest rates.  Int1 Int 2 Int T    . 32 Advanced Corporate Finance. – Bankruptcy.Two Possible Scenarios SCENARIO 1 – Using rA • Debt in the future is not fixed.. – Debt and interest expense are tied to FCF. • Model when big changes in capital structure. the ability to use tax shields has more systematic risk than the ability to pay debt. Spring 2011 – Brandon Julio .

Two Possible Scenarios (cont.)
SCENARIO 2 – Using rD • • You expect a predictable, stable and low level of debt. Ability to use tax shield has the same systematic risk as the ability to pay debt. Generally in less highly leveraged situations.
 Int1 Int 2 Int T    ...  TS = Tax Rate *   2 (1  rD ) T   (1  rD ) (1  rD )

For permanent debt with the same risk as interest: TS = Permanent Debt * Tax Rate = t * D

Advanced Corporate Finance. Spring 2011 – Brandon Julio

33

Just to Check Things Are Clear

Remark 1: If debt is predetermined (D is constant) and has a low level, risk of tax shield equal to risk of payments to debt holders; so rD is the correct discount rate. Remark 2: If high level of debt or if level of debt varies with firm value (D/V is constant), then the risk of the tax shield is similar to that of operating assets and tax shields should be discounted at rA. Remark 3: Some firms have high leverage or maintain a target leverage ratio while maintaining an investment grade rating on their debt. For these firms, the correct discount rate is probably closer to rD.
34

Advanced Corporate Finance. Spring 2011 – Brandon Julio

How Leverage Affects the Betas?
• Whatever assumption you make about the risk of the tax shield, you have to take care to be consistent throughout the valuation.
– In particular, remember that the assumption you make about the risk of the tax shield also affects the equation you will use to lever and unlever the beta.

If the risk of the tax shield is equal to the risk of the debt (D is constant), then such equation is:
 A  D
D(1  tC ) E  E E  D(1  tC ) E  D(1  tC )

If instead the risk of the tax shield is equal to the risk of the assets (D/V is constant), then such equation is:
 A  D
D E  E ED ED
35

Advanced Corporate Finance. Spring 2011 – Brandon Julio

What About the TS Associated with the TV?
• If you do a perpetuity calculation for the TV and the firm is expected to have some debt then this matters!
– Remember that you have to add any debt tax shields on NPV that accrue beyond the terminal date.

There are “many” ways to compute the terminal value of the tax shields.
– Again you do not have to get fancy. Common sense matters! – They are obviously short-cuts. The main thing is to recognize that you are going to get some tax shields beyond T and then do something sensible.

Let’s see 2 different ways…

Advanced Corporate Finance. Spring 2011 – Brandon Julio

36

What About the TS Associated with the TV?
1. If D stabilizes at a permanent (and low) level, DT.

TV (TS )  tC * DT
2. If (D/V) stabilizes at some level, γ (DT = γ * VT):

TV (TS ) 

tC * DT * rD rA  g

Advanced Corporate Finance. Spring 2011 – Brandon Julio

37

– Financial forecasting. Spring 2011 – Brandon Julio 38 .) • For many projects. In general you can estimate debt levels using: – Repayment schedule if one is available. LBO debt levels are expected to decline. Advanced Corporate Finance.Comments on Step 2 (cont. but they do so slowly (at an average rate of 30% per year). and discount by a rate between rD and rA. • • For instance. – Need to be careful and creative. – Firms on average tend to rebalance leverage towards a target. neither D nor D/V is expected to be stable.

Extending the APV Method • You could also take care of the costs to financing that come from financial distress. You could also add the PV of the costs of financial distress. Spring 2011 – Brandon Julio 39 . • Advanced Corporate Finance. – Often people omit PV(costs of distress) because it is difficult to quantify. How? – Write scenarios and include costs of distress in bad scenarios. etc. Once again you find the present value and subtract it. any issue costs.

WACC .APV vs.

Is very easy if the level of future debt is known. – More flexible: Just add other effects as separate terms.Pros and Cons of APV • Pros: Implicit assumptions are very clear. Beautiful! Easier to track down where value comes from. – – – – • Cons: – Requires explicitly calculating future debt levels. Works even if debt is not permanent. Spring 2011 – Brandon Julio 41 . Clearer: Puts the spot light on what is creating value. but still less well known than WACC. No contamination. – Assists in the decision of how to structure financing for projects. – It is increasingly used. Advanced Corporate Finance.

 Only when project is similar to rest of the firm. – Less computations needed. – If you have a precise debt to value policy. then it is easy and relative accurate. – The inputs are easy to get.  But this seems to be highly restrictive. It is very simple tool. Spring 2011 – Brandon Julio 42 .Pros and Cons of WACC Pros: – Most widely used. Advanced Corporate Finance.

Pros and Cons of WACC (cont.g. Spring 2011 – Brandon Julio 43 . costs of distress.  Does not reveal where the value is coming from.) Cons: – Mixes up the effects of assets and liabilities.  Errors/approximations in effect of liabilities contaminate the whole valuation. Cannot easily allow for changes in:  Other effects of financing (e.. – Not very flexible. issue costs)  Non-constant debt ratios  Changes in tax rates Advanced Corporate Finance.

it does not matter much which method you use. As long as you follow all the steps and you are careful in making the same assumptions you should obtain (approximately) the same solution.e. LBOs) APV is much better. Advanced Corporate Finance. • • Lets consider two cases: – Debt is rebalanced. changing or highly leveraged capital structure (i. one of the two will be much simpler to use depending on the situation. however. – Debt is predetermined. Spring 2011 – Brandon Julio 44 . – For complex. – Otherwise. In practice.Practical Implications • In principle we can always use either WACC or APV.

firm knows the evolution of D): – APV is easy to compute by discounting future expected interest payments.e. • If debt is predetermined (i. – Bottom Line: In this case of rebalanced debt use WACC. the firm has a target debt/asset ratio): – Computing WACC is much easier. Spring 2011 – Brandon Julio 45 . because if the debt is not rebalanced then D/V changes over time and so does WACC.e. – APV is much more complex since you do NOT know D. – Bottom Line: In this case of predetermined debt use APV. – WACC instead has a problem.Practical Implications (cont.) • If debt is rebalanced (i. Advanced Corporate Finance.

Two Remarks • Remark 1: In principle. compute a different WACC for each year and discount back by using a different WACC every year. Advanced Corporate Finance. you can always forecast D/V values. This is a headache! • Remark 2: For non-constant debt-ratios. could use different WACC for each year but this is heavy and defeats the purpose. Spring 2011 – Brandon Julio 46 .

Discounted Cash Flow Valuation Methods .

• • The three methods provide consistent valuations when applied correctly. Advanced Corporate Finance. – Equity Cash Flow (ECF) – Provides Equity Value.Three Cash Flow Valuation Methods • The three methods differ in their measure of cash flows and the discount rate applied to those cash flows. The names for the three methods correspond to the type of cash flow that is used in the valuation: – Capital Cash Flow (CCF) – Provides Enterprise Value. Spring 2011 – Brandon Julio 48 . – Free Cash Flow (FCF) – Provides Enterprise Value.

– The discount rate for this method is the return on assets. – Because the tax advantages of debt are included in the discount rate. – The more the tax advantages. the cash flows do not include the tax benefits of debt. the lower the discount rate. • The difference between the FCF and the CCF is in the Interest Tax Shield: Capital Cash Flow = FCF + Interest Tax Shield Advanced Corporate Finance. Spring 2011 – Brandon Julio 49 . • FCF method includes the tax benefits of deductible interest payments in the discount rate as it uses WACC – The more the tax advantages.FCF and CCF • CCF method includes the benefits of the tax shields as cash flows. the higher the capital cash flow.

CCF and APV • Note that the expression of the CCF is close and resembles to the APV expression we studied before. It is also called “Compressed APV”. APV = NPV(CCF) discounted at rA. Spring 2011 – Brandon Julio 50 . when we use rA as the discount rate of both terms: FCF tC rD D FCF ITS CCF     APV  rA rA rA rA rA • • Thus. Advanced Corporate Finance. In fact.

Spring 2011 – Brandon Julio 51 .) • • CCF uses actual taxes (projected tax payments). CCF from a net income version: – CCF = Net-after tax income (NI) + Interest Expense (I) + Dep – Capx – Change in NWC + Other • Advanced Corporate Finance. you should always compute it starting from Net Income because Net Income is already net of actual taxes.CCF and APV (cont. Hence.

Spring 2011 – Brandon Julio 52 . – Bankruptcy. • • In these cases we would have discounted the tax shield with rA However.When Should We Use CCF? • CCF valuation is generally useful for: – Highly Leveraged Transactions. we recommend using APV instead of CCF. Why? Advanced Corporate Finance. – Firms in Financial Distress.

Payment to debt holders are sometimes called “Debt Cash Flows” (DCF). Spring 2011 – Brandon Julio . ECF are riskier than cash flow measures that combine DCF and ECF. ECF = CCF – DCF • As DCF are paid out of operating cash flows before equity cash flows.Equity Cash Flow • ECF measures the cash flow available to stockholders after payment to debt holders are deducted from operating cash flows. 53 • • Advanced Corporate Finance. And riskier cash flows have higher discount rates. debt cash flows are safer than equity cash flows. and they include interest and principal payments.

) • ECF are calculated by subtracting taxes. The discount rate used in the ECF is the return on equity and the value we obtain is the equity value of the firm. ECF can be calculated as CCF less DCF.Equity Cash Flow (cont. Alternatively. 54 • • Advanced Corporate Finance. interest and debt repayments from operating cash flows and adding debt additions. Spring 2011 – Brandon Julio . ECF = Net Income + Dep – Capx – Change in NWC + Other + Change in Debt • Notice that Increases in Debt help to finance increases in capital expenditures and net working capital.

Very difficult to use APV or WACC in banks. Why?  Debt is part of the business of most financial institutions.Equity Cash Flow (cont. Advanced Corporate Finance.  Very difficult to have an “all equity bank”.) • ECF is extremely useful for: – Valuing financial institutions. Spring 2011 – Brandon Julio 55 .

– It is much easier to make mistakes using the ECF. it is critical to include increases in debt in the cash flows. If the debt to total capital ratio varies over time. – The use of one discount rate for ECF requires that the firm have a constant debt to total capital ratio. In particular. particularly in the terminal value calculation.Pros and Cons of ECF • • In general. APV is preferred to the ECF for many of the same reasons that APV is superior to WACC. we prefer both APV and WACC to ECF. we need to calculate a different discount rate for the equity for each year. Spring 2011 – Brandon Julio 56 . Advanced Corporate Finance.

Advanced Corporate Finance. Spring 2011 – Brandon Julio 57 .Pros and Cons of ECF • ECF tend to calculate equity values that are too low. – Expected Debt Payments ≤ Promised Debt Payments. – The method values equity as the discounted value of the expected ECF. This is accurate as long as there is no probability that the equity value will be less than or equal to 0.

Valuation Using Multiples .

It assesses the value based on that of other (publicly-traded) firms: [Value/Key Characteristic]Ind. Denominator of multiple is the characteristic that is important for that industry: – clicks or subscribers for web site – paid miles flown for airlines – number of patents for a hi-tech firm. Spring 2011 – Brandon Julio 59 .Average* Key Characteristic of Firm • • Numerator of multiple is typically the total value of the firm.Valuation Using Multiples • • Valuation by multiples is a fancy name for market prices divided by some measure of performance. Advanced Corporate Finance.

The value of the company is assumed to vary in direct proportion with changes in the performance measure. 2.Valuation by Multiples: Implicit Assumptions 1.e. Comparable companies assumed to have expected cash flows growing at the same rate and have the same level of risk as the company being valued. Advanced Corporate Finance. expected firm value also increases by 8%.  If these assumptions are valid. if expected EBITDA increases by 8%. i. Spring 2011 – Brandon Julio 60 . valuing by multiples will be more accurate than the DCF approach because it incorporates current market expectations of cash flows and discount rates.

Advanced Corporate Finance. MV of firm /EBITDA. Spring 2011 – Brandon Julio 61 . MV of firm /FCF.Types of Multiples • Cash-flow-based Value multiples: – MV of firm/Earnings. MV of equity/BV of equity. MV of firm/Number of Customers. Price/FCF. • Asset-based Value multiples: – MV of firm/BV of assets. Price/EBITDA. • Industry-specific Value multiples: – MV of firm/Hospital Beds. • Cash-flow-based Price multiples: – Price/Earnings (P/E).

Step 3: Calculate average for the set of comparable firms. Spring 2011 – Brandon Julio . Equal-weighting vs. Step 2: Calculate multiple for comparable firms. 62 • • Advanced Corporate Finance. • • • Step 1: Identify firms in same business as the firm you wish to value. In doing this we are coming up with an estimate of the multiple we wish to use in valuing our firm. Distanceweighting. Step 4: Multiply average with the value of the characteristic for the firm you wish to value. Be careful not to induce a selection bias.Procedure Hope: Firms in the same business should have similar multiples. Step 5: Often different multiples give you different answers: you need to reflect what is economically reasonable.

g. – Price-to-patents multiples. too few firms means that your average will reflect idiosyncracies of those firms. multiples! • • For transactions. – Price-to-subscribers multiples.Important Remarks • When choosing comparable firms you face a trade-off: too many firms requires to select firms that are not truly comparable. – But be aware.D. – Similar transaction values. For firms with no earnings or limited asset base (e. can also use multiples for comparable transactions. – Or even price-to-Ph. Spring 2011 – Brandon Julio 63 . everyone might be over/underpaying! Advanced Corporate Finance. hi-tech).

Important Remarks (cont.. • Multiples based on equity value (or stock price.g. Advanced Corporate Finance. Spring 2011 – Brandon Julio 64 . – They tell you what market thinks about the value. P/E) as opposed to total firm value ignore effect of leverage on the cost of equity (or assume the firms have similar leverage) – Beware if comparables have very different leverage. e.) • For similar public traded companies: – Use trading multiples.

Advanced Corporate Finance. If the firm’s actual FCF is a perpetuity: MV firm = FCF/(WACC-g) => MV firm/FCF = 1/(WACC-g) • Comparables will have a similar MV firm/FCF provided they: – Have the same WACC (requires similar D/(D+E)). Spring 2011 – Brandon Julio 65 . – And are growing at a similar rate.Motivation for Multiples? • • Firms in the same business should have similar multiples.

– More consistent treatment of leverage. Spring 2011 – Brandon Julio 66 . • EBITDA or cash-flow multiples are preferable to (net) earnings multiples. – Extremely useful when you do not have cash flow projections. – Less ability to manipulate  Easier to manipulate net earnings through accountings than EBITDA or cash flow. Advanced Corporate Finance. even tough same business risk and growth.Bottom Line on Multiples • Multiples complement APV/DCF methodology: – Check on valuation. market based perspective.  Companies with different leverage will have different P/E multiples.

– Embodies market consensus about discount rate and growth rate. Spring 2011 – Brandon Julio 67 . what you care about is what the market will pay.Pros and Cons of Multiples Pros: – Incorporates simply a lot of information from other valuations in a simple way. – Free-ride on market’s information. – Can provide discipline in valuation process by ensuring that your valuation is in line with other valuations. Advanced Corporate Finance. – Sometimes. not the fundamental value.

Pros and Cons of Multiples (cont. Spring 2011 – Brandon Julio 68 . – Differences in accounting practices can affect earnings and equity-based multiples. Particularly problematic if operating changes are going to be implemented. Advanced Corporate Finance. Therefore better to use FCF and EBITDA multiples.) Cons: – Difficult to find true comparables. Implicitly assumes all comparables are alike in growth rates. cost of capital. – Relies on accounting measures being comparable too. – Hard to incorporate firm-specific information. Hard to find true comparables in real life. and business composition.

you will too! Advanced Corporate Finance. Spring 2011 – Brandon Julio 69 .) • Cons: – Book values can vary across firms depending on age of PPE.Pros and Cons of Multiples (cont. – If market is overpaying.

such as P/E and market-to-book. you can compare your predicted multiples. • Best to use multiples only as a check for the valuation based on discounted cash-flows. to representative multiples of similar firms. – If your predicted multiples are out of line then you have to convince yourselves (and your clients) that your model is reasonable. Advanced Corporate Finance. – After you have done a throughout valuation.Bottom Line On Multiples • Because of the many limitations. never rely on just a single multiple or on valuation based only on multiples. Spring 2011 – Brandon Julio 70 .

firm’s pricing policies. the less it reflects differences in operating efficiency across firms (e. sales) the less it is subject to changes in the accounting method.g.g. and especially.) • Because of accounting differences. be careful in using multiples to compare firms across industries.). Spring 2011 – Brandon Julio 71 . production efficiency.Bottom Line On Multiples (cont. – On the other hand. remember that: – The higher up the basis is in the income statement (e. • Advanced Corporate Finance. etc. across countries. As a rule of thumb when choosing the basis for multiples.

Spring 2011 – Brandon Julio 72 . • *Are there future options in project? – Try to incorporate these in cash flows. – Are we overpaying? – Have we properly accounted for financial / capital structure effects on real cash flows:  changes in incentives?  costs of financial distress? Advanced Corporate Finance.After Valuation is Done! • Three possible answers: – NPV >> 0 – NPV << 0 – NPV = 0 = = = GO!! No Go* Think More.

Takeaways • • It is important to separate the value created by underlying assets and those coming from financing. Sometimes it can be difficult because you need to know the future levels of debt. 73 • • • Advanced Corporate Finance. so you have to be able to do this! If applied correctly. APV does this directly and is a very flexible tool. Spring 2011 – Brandon Julio . Both WACC and APV force you to get the asset beta. APV is aesthetically cleaner in terms of the source of the value generation. both give the same answer. APV does not mix the valuation of operation with the effects of financing.

Takeaways (cont. You should understand the conceptual differences between these two methods and why in principle we prefer APV.) • • • • For APV we need to know the level of debt outstanding each year – more suitable for LBOs. Go through the examples and be sure you are capable of computing each of the cash flows. Best to use multiples only as a check for the valuation based on discounted cash-flows. • Advanced Corporate Finance. For WACC we need to know the D/V ratio each year. Spring 2011 – Brandon Julio 74 . Remember there are other cash flows methods you should bear in mind.

Example (Be Sure To Go Through It!) .

Valuation Of Private Companies .

– Effect of Illiquidity on Value.Valuing Private Companies • There are three major complications in the case of a private company: – We have much less information available.  Estimating Cost of Equity. Advanced Corporate Finance.  Estimating Cost of Debt. – Control Issues.  Estimating Cash Flows. Spring 2011 – Brandon Julio 84 .

Less Information: Cost of Equity The problem with a private company is that there are no past prices to estimate risk parameters (betas). Two Possible Solutions 1. we do not have a market value of debt and equity to compute leverage. A simple test to see if the group of comparable firms is truly comparable is to estimate a correlation between the revenues or operating income of the comparable firms and the firm being valued. – – Remember to correct for different capital structure. Estimate β of a comparable traded firm.I. • Even after we compute the βA from comparable companies. 85 Advanced Corporate Finance. Spring 2011 – Brandon Julio .

Spring 2011 – Brandon Julio 86 . Less Information: Cost of Equity (cont.  Might not happen immediately but over the long term.) 2.I. Advanced Corporate Finance. • Alternatively you may try to estimate the optimal debt ratio for the company. Assume that the private firm will move to the industry average debt ratio. – The β for the private firm will then also converge on the industry average beta. based upon its operating income and cost of capital.

• • Advanced Corporate Finance. and the interest expense on this debt might not reflect the rate at which they can borrow. and are therefore not rated. Spring 2011 – Brandon Julio 87 .I. Alternatively. • Most debt on the books is bank debt. you can estimate the appropriate bond rating for the company. – This problem might also happen with public companies. and use the interest rate related to the estimated bond rating. Less Information: Cost of Debt • The main problem is that private firms generally do not access public debt markets. based upon financial ratios. One possible solution is to assume that the private firms can borrow at the same rate as similar firms in the industry.

the interest expenses for the year will not reflect the interest rate on debt. Spring 2011 – Brandon Julio 88 .I. Less Information: Cost of Debt (cont. Caveat: If the firm borrowed the money towards the end of the financial year. if the debt on the books of the company is long-term and recent. the cost of debt can be calculated using the interest expense and the debt outstanding. • Advanced Corporate Finance.) • Finally.

Less Information: Cash Flows There are special problems associated with estimating cash flows for a private firm: • Shorter History – Private firms often have been around for much shorter time periods than most publicly traded firms. Advanced Corporate Finance. which operate under much tighter constraints on what to report and when to report. • Different Accounting Standards.  There is less historical information available on them. – The accounting statements for private firms are often based upon different accounting standards than public firms. Spring 2011 – Brandon Julio 89 .I.

– If any of the expenses are personal. estimate the income without these expenses. – Estimate a reasonable salary based upon the services the owner provides the firm. – It is difficult to tell where salaries end and dividends begin in a private firm. • Separating Salaries from Dividends. • Rules of Thumb – Dealing With Special Problems.I. Spring 2011 – Brandon Julio 90 . Less Information: Cash Flows (cont. – Re-state earnings using consistent accounting standards. Advanced Corporate Finance. – In the case of private firms some personal expenses may be reported as business expenses.) • Mix of Personal and Business Expenses. since they both end up with the owner.

2. Advanced Corporate Finance. • Some Facts: – Discounts should be reduced by: 1. Up to 11% for a company with $1B in revenue. increase the discount. – If earnings are negative. Effect of Illiquidity on Value • There is a general agreement that the value of the company should be lower because of illiquidity. Roughly 6% for a firm with $100M in revenue. – Make the discount smaller for larger firms.II. Spring 2011 – Brandon Julio 91 . – The problem is by how much? Lots of disagreement! • Some recent studies suggest that the liquidity discount is between 20-30% for private firms. – Adjust subjectively for size.

you can use transaction multiples. • This is because once you have control you can improve the company. – Many studies show that control block trade at a premium for public companies. • There is no guideline on how to compute the control premium in DCF. – It is almost like a takeover.III. Effects of Control • Purchasers pay a premium for control positions. – You should take into account in your projections what you think you can accomplish with control! • Alternatively. Advanced Corporate Finance. – However. trying to find comparables both in terms of transaction and firm is difficult. Spring 2011 – Brandon Julio 92 .

Appendix: Computing Asset and Equity Betas .

then VU = D + E . Since. Spring 2011 – Brandon Julio 94 . And therefore: VU  A  D  D  E  E  PV(TS) TS • Which we can be re-written as: D E PV(TS) A D E  TS VU VU VU Advanced Corporate Finance. VL= VU + PV(TS).PV(TS).Computing Asset Betas and Equity Betas How to Measure A? • • • The value of the levered firm is given by VL = D + E.

) • • Now we need to assume something about TS.PV(TS). we have: D .PV(TS) V .Computing Asset Betas and Equity Betas (cont. Spring 2011 – Brandon Julio 95 .PV(TS) E Α D E V .PV(TS) Advanced Corporate Finance. Then the previous equation becomes: • D E PV(TS) A D E D VU VU VU • And since VU = V . Assumption 1: The risk of the tax savings is the same as the risk of the debt that generates it (TS = D).

) • This formula simplifies under some special cases. the debt is riskless (D = 0): A   E (1  (1  t ) D ) E C Advanced Corporate Finance. Spring 2011 – Brandon Julio 96 .Computing Asset Betas and Equity Betas (cont. in addition. – If D is constant:    Α D D (1  t C )   V  tCD E E V  tCD – If.

) • Assumption 2: The risk of the tax savings is the same as the risk of the existing assets (TS = A). (V U  PV(TS))  A  D  D  E E • • And since. VL=VU + PV(TS) we have that:   Α D D E E V V • Conclusion: We can compute A just using the values from the levered firm in the Finance I formula.Computing Asset Betas and Equity Betas (cont. Advanced Corporate Finance. Spring 2011 – Brandon Julio 97 . Then we are left with.

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