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Valuation Tutorial

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Cash Flow Calculation – The Numerator. A) Cash Flows: Not Accounting Earnings. 1) Forecasting earnings. a) Forecast sales. Most pro-forms will start with a sales forecast, and then other variables will be functions of sales. What will cause the sales to rise or fall in our forecasts? b) Forecast profit margin. By specifying a profit margin or costs as a percent of sales, we can have costs move with sales. However, the profit margin may rise or fall with our forecasts. Why would you expect them to rise or fall? c) Equilibrium profit margin. At the end of your pro-forma, you must believe the market is in some form of equilibrium. What determines the long run equilibrium profit margin? d) Earnings before interest and taxes. EBIT is where we start. This is revenues minus costs minus depreciation. I want to separate out depreciation. Even though it is a cost, since it is a non-cash cost. A non-cash cost is a cost which is called a cost in the income statement, but does not represent cash flowing out of the firm today. 2) Taxes. Corporations pay taxes and thus we must subtract off these cash flows. The taxes you subtract off should be cash taxes, not accounting taxes. 3) Operating profit from operations. This is defined as EBIT minus taxes. If the tax rate is constant this is EBIT * (1-τ). 4) Interest expense.2 We are excluding interest payments from our calculation of cash flow to assets. Interest is cash flow to debt which comes from the

This is an abbreviated version of what is covered in corporate finance (441 – Finance II). It is designed to give you some of the language and some of the intuition prior to interviews. The long term key to successfully using these concepts is the ability to internalize them, integrate them into your thinking, and be able to explain them (teach them) in your own words. This is why it takes ten weeks in Finance II. One keys to valuation is to be consistent. Thus when discounting cash flows, you want to make sure the cash flow (in the numerator) and the discount rate (in the denominator) match. This means we discount the cash flow to assets at the asset discount rate, the cash flows to debt at the debt discount rate, and the cash flow to equity at the equity discount rates. CFA ' CFD % CFE A ' D % E ' CFA CFD CFE ' % 1 % rA 1 % rD 1 % rE

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The problem with subtracting off interest and not principal payments, is the resulting number is not the cash flow to assets (you have subtracted off interest), nor the cash flow to equity (you have not subtracted off principal payments).

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Copyright © 2005, Mitchell A. Petersen

a) No net working capital. Firm purchases a TV for $80 and sells it for $100 today. Both the purchase and the sale are cash transactions. The first is net working capital. Firm purchased a TV last year 2 Valuation Tutorial Today 100 80 20 Next Year Today 100 80 20 Next Year . you want the cash flow to assets. Consistency gets you a long way in finance. we transform earnings into cash flow. Examples. We will discuss two types of capital expenditure. The difference between cash flow and earnings is capital expenditures. Firm purchases a TV for $80 and sells it for $100. Net working capital is defined as current assets (excluding cash) minus current liabilities (excluding short term debt). Changes in Net Working Capital. 1) Definition. Last Year Revenue Cost EBIT 8 NWC Net Cash flow c) Accounts receivable and inventory. Last Year Revenue Cost EBIT 8 NWC Net Cash Flow b) Accounts receivable. By adjusting for changes in net working capital. The patients are given one year to pay.B) cash flow to assets. If you are valuing assets. Assets Liabilities 2) 3) Increases in net working capital are a negative cash flow. This example demonstrates where accounting earnings and actual cash flows can differ significantly.

Net working capital accounts to exclude. Mitchell A. One thing to look at is how the level of depreciation relates to the level of capital expenditure. We do not include cash because this is what we are trying to calculate. 4) Tax consequences of an asset sale or writeoff. The firm’s supplier was paid last year when the depressors were delivered. a) Short term debt is not included in current liabilities. When we sell an asset or write off and dispose of an asset. this is a negative cash flow. We want to value the assets of a firm. this is a positive cash flow. Thus we want to discount the cash flows to assets at the asset discount rate. Which basis should we use for this calculation? 5) Net investment. If we included cash as a current asset. Capital Costs. b) Cash is not included in current assets. When we sell the capital equipment at the end of the project. Net investment is annual capital expenditure minus depreciation. What is the logic behind this difference? 1) Initial capital expenditure. This is the net amount we must invest (if this is positive) to maintain our business and generate the predicted sales.for $80 and sells it for $100 today. We include almost all current assets and current liabilities when we calculate changes in net working capital. Accounting and finance recognize investment expenditure at different times. If we have to pay to have the equipment or land scrapped. this will have tax consequences if the sale price differs from our basis. plant and equipment. We calculate cash flow as follows: Today 100 80 20 Next Year C) D) 3 Copyright © 2005. Petersen . our calculated cash flow would be zero. 2) Depreciation. 3) Sale of asset at project’s completion. What does it mean if depreciation is larger than capital expenditure? Summary. The customer is given one year to pay. There are two exceptions. This refers to long-term capital expenditures: investments in property. but it is not a negative cash flow. Last Year Revenue Cost EBIT 8 NWC Net Cash flow 4) 5) Recapture of net working capital. Depreciation is treated as a cost for accounting and tax purposes.

what are we including? 1) Assets are a portfolio. When a firm pays dividends to its shareholders. Where do we get the debt and equity numbers? 1) Market ratios. We can think of a firm’s assets in the same way. Thus the cost of capital is: WACC ' (1 & τ) r D D E % rE D%E D%E (4) 3) B) This is often called the firm’s weighted average cost of capital (WACC). The assets of the firm are the sum of the values of the firm’s securities. The value of your portfolio is the sum of the value of all the stocks and bonds (or assets) in your portfolio. This will determine the firm’s cost of capital. When we say the firm’s assets. If we can calculate the expected return on the firm’s assets. stocks and bonds). D E % rE rA ' rD (3) D%E D%E Debt is tax favored. To know the correct discount rate for a project we need to know how what required rate of return investors will demand for purchasing the securities of a firm. Source of Capital: Debt and Equity.The first set of numbers we will get is the debt and equity ratios.Cashflow ' Revenue & Costs & Depreciation & Taxes[ R & C & D ] % Depreciation & Capital Expenditure & Increase in NWC % Salvage value & Taxes on salvage value % Recapture of NWC (1) II) Calculating the Project’s Cost of Capital. Book values are the amounts reported on a firm’s 4 Valuation Tutorial . and many other countries. how do we calculate the return on the firm’s assets? We use the same method. We want to calculate the cost of capital for a firm. A) Return on the Firm’s Assets. Thus we need to know where to look up or estimate all the numbers in the cost of capital formula (equation 5). Assets ' Debt % Equity 2) (2) Expected return on firm’s assets. this will be the firm’s cost of capital. does not treat debt and equity equally. When a firm pays interest to its debt holders. When you invest your personal or pension investments. Market values are the price at which you can buy or sell the securities in the open market. this comes out of after tax profits. The tax code in the US. 2) Book values as estimates. Since the firm’s assets are equal to its debt plus its equity. This is the fraction of the firm which is financed with debt and with equity.g. you allocate your investment portfolio across different assets (e. this comes out of pre-tax profits.

then the promised rate would be 13. The expected return on assets is a weighted average of the expected return on debt and the expected return on equity. In this case. If not. we just have more terms in our cost of capital expression. In this case. By this they mean the promised return. keep track of whether it is a promised or expected yield. we need to calculate the cost of the debt and the equity.3 This rate is not set by the firm. This means the bond was sold for face value.10 ) ' ' 97 1 % rpromised 100 (1 % 0. b) Promised rate. not the promised. the promised return and coupon rate are the same when firm’s issue debt. the higher the promised rate which the market will demand. a) Coupon rate. Mitchell A. When you use a bond yield. coupon rate of 10%. The firm decides with the help of their investment bankers what rate of interest the debt will pay. Petersen . Thus if the bond (face value of $100.C) balance sheet. return on debt. We will need one term for each source of capital. Thus if debt with a maturity of one year has a face value of $100 and a coupon rate of 10%. The cost of debt can be calculated from the rate we have to pay on the debt. and a one year maturity) sold for 97. There are three rates of return when it comes to debt. The higher the risk of default or the lower the credit rating. They have multiple types of debt (short term bank debt and long term bonds) or multiple types of equity (preferred and common). but by the market. 3 5 Copyright © 2005. Price ' FV (1 % rcoupon ) (5) 1 % rpromised 100 (1 % 0. It is based on the market’s assessment of how risky the debt is. Expected rate of return. 3) More complicated capital structures. then bond holders will receive and interest payment of $10 at the end of the year plus their principal ($100). The more likely the bond Traders usually refer to the yield on a bond. you might use the wrong one when valuing projects or firms. Once we know how much debt and equity we have. I will use return and yield interchangeable.4% ' 97 rpromised c) In many cases. the bond was issued at par.4%. Many firms have more complicated capital structures than the one here. Cost of Debt.10 ) & 1 ' 13. Thus the correct cost of debt is the expected. We are going to discount expected cash flows to assets at expected rate of return on assets. 1) Definitions of Debt Returns. This is the interest rate contractually set by the firm. It is essential they be clear in your mind.

Assets with more idiosyncratic risk do not have higher expected returns. Thus if our projects are riskier than our investors will demand a higher rate of return and our cost of capital will go up. The reason we care about risk is because it affects our firm’s cost of capital. a) Payment for risk: The math. First. Asset pricing models are financial models which explain what the expected return on assets should be. The risk of an assets is often measured as the variance of its return. equity in this case. Cost of Equity. is the capital asset pricing model (CAPM). This is the part of the variability in the return to a project which is correlated with. b) Idiosyncratic risk. I mean assets with more systematic risk have higher expected returns. economy wide risk. The risk of an asset can be divided into two sources of risk: systematic and firm-specific. 1) Decomposing Risk. The return on an asset can be divided into three components. The most common model/method which is used to estimate the risk of an asset and thus the cost of capital for an asset. the greater the difference between the expected and promised return. The first is the riskfree return. This is also called market risk. or related to. The second and third terms are the risky parts of the returns. It has two advantages.D) is to default and the worse the return if the bond does default. Risk( rEquity ) ' 0 % βEquity Risk ( rmarket ) % Risk( ε ) a) 2 (7) 3) Systematic risk. rEquity ' rriskfree % βEquity ( rmarket & rriskfree ) % ε (6) 2) Two Types of Risk: Definitions. Our investors don’t like risk. If you think of the entire economy as a pie. only the systematic risk is compensated. how well the economy is doing. By compensated. E[ rEquity ] ' rriskfree % βEquity E[ rmarket & rriskfree ] (8) 6 Valuation Tutorial . Although an investment can and in general will have both types. This is the part of the risk that is unrelated to how well the economy is doing. this is how the pie grows in booms and shrinks in recessions. This is also called firm specific risk. or diversifiable risk. the intuition behind the model makes a lot of sense and you can explain it to someone who doesn’t understand finance. unique risk. Compensation for Risk. This risk is how the pie is divided up. it is the most widely used model. and undiversifiable risk. More importantly.

because they don’t bear the risk. The bribe is the higher expected return they receive from a risky project opposed to a riskfree project. Mitchell A. For example. 1) Investors are risk averse. you still have a risky portfolio. Once you own all firms. You will often hear in classrooms and in finance discussions outside of classrooms that you don’t get paid (compensated) for bearing firm specific (idiosyncratic) risk. how do you avoid the risk that one firm loses market share and another firm gains market share? 3) Systematic risk must be borne by investors. 2) Firm specific risk need not be borne by investors. The argument is that if investors are well diversified. This is not an assumption.b) Payment for risk: The intuition. Petersen . if we want them to give us capital to invest in a risky project on their behalf. Thus. It is a conclusion. we have to bribe them for bearing the risk. they don’t get compensated for bearing firm specific risk. How do you avoid bearing this risk? 4) Assumptions versus conclusions. 7 Copyright © 2005.

This is the expected amount by which the (stock) market will beat the riskfree rate (E[ rMarket . shortterm T-bills. Equity β.e.E) Calculating the Cost of Equity. we use the Capital Asset Pricing Model (CAPM) formula from above. Sara Lee's Beta 30% Sara Lee's Return 20% 10% 0% -10% -20% -10% -5% 0% Market Return 5% 10% 8 Valuation Tutorial . i.rRiskfree ]). rEquity ' rriskfree % βEquity E[ rmarket & rriskfree ] 1) (9) Risk free rate. as our proxy for the risk-free rate. We can obtain this from data vendors or estimate it ourselves. the firm’s equity beta. Term Structure of Govt Bond Yields 6 5 4 3 2 1 0 0 5 10 15 20 25 30 2) 3) Market price of risk. Thus we need to calculate or look up three numbers: The riskfree rate. To calculate the cost of equity. and the market price of risk. We will use the return on government securities.

III) Terminal Value Valuation. (10) (1%r) (1%r)2 (1%r)3 4 C (1%g)t&1 C ' ' j t r & g t' 1 (1%r) B) Exit Value. Terminal valueT ' E[ FCF T%1 ] r & g r & g 1 % g ' E[ FCF T ] r & g ' ( Exit Multiple ) E[ FCF T ] ' E[ FCF T (1 % g) ] (11) C) Choosing the growth rate. we can estimate the expected cash flow in the next year... we know the expected cash flow is in the final year (T). This is the way to value the cash flows that the project will generate after year T. We saw this in a previous session. The value of the cash flows in the years after year T can be valued by using the expression for a growing annuity. This is the value of a perpetuity that pays a cash flow of C next year and then grows at g percent forever. We forecast the cash flows for a fixed number of years (T). Mitchell A. From our forecasts. Thus the only additional assumption which is required is the long term (in perpetuity) growth rate.. Given our assumed long term growth rate (g). C1 C2 C3 PV ' % % . A) Value of a growing perpetuity. (1%r) (1%r)2 (1%r)3 C C (1%g) C (1%g)2 ' % % . Petersen . 9 Copyright © 2005. We already have the discount rate which we used to discount the first T years of cash flows. First we need the formula for the value of a growing perpetuity.. Then apply the formula for a growing perpetuity is straight forward.

Since leverage alter’s most equity value multiples. 2) Denominator. I have a preference for asset value multiples. B) Hierarchy of Multiples. Different multiples contain different assumptions. 1) Numerator: Equity or Asset Value. One challenge is to figure out which mutiple to use. Multiples is not a valuation technique – unless your MBA is from the University of Chicago. multiples have the advantage that you only need to make one assumption – that the firm you are valuing and the firms you are using as comparables are the same in the relevant dimensions. even when there is no change in the value of the firm. There are an infinite number of multiples. There are many more choices here. Unlike discounted cash flow. 10 Valuation Tutorial . C) Valuation versus Pricing. Thus your choice of multiple is driven in part on how many assumptions you want to make. Most (reasonable) multiples are based on a flow variable which can range from sales through income (with many definitions) to cash flow.IV) Multiples Valuation. One challenge of A) Grocery Store Comparison. spinn off or sale. This is particularly appropriate if you are valuing the firm – for example for an aquisition.

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