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Attribution Non-Commercial (BY-NC)

- Damodaran - Solution Manual
- Valuation Models
- Aswath Damodaran Financial Statement Analysis
- DAMODARAN-ESTIMATE TERMINAL VALUE
- Damodaran on Valuation 1
- The Dark Side of Valuation (Slides)
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- financial_modelling_corporate.pdf
- Damodaran, A. - Capital Structure and Financing Decisions
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Basics

Aswath Damodaran

Aswath Damodaran 1

Discounted Cashflow Valuation: Basis for

Approach

t = n CF

Value = ∑ t

t

t = 1( 1 +r)

where CFt is the cash flow in period t, r is the discount rate appropriate

given the riskiness of the cash flow and t is the life of the asset.

Proposition 1: For an asset to have value, the expected cash flows

have to be positive some time over the life of the asset.

Proposition 2: Assets that generate cash flows early in their life will

be worth more than assets that generate cash flows later; the latter

may however have greater growth and higher cash flows to

compensate.

Aswath Damodaran 2

Equity Valuation versus Firm Valuation

n Value the entire business, which includes, besides equity, the other

claimholders in the firm

Aswath Damodaran 3

I.Equity Valuation

i.e., the residual cashflows after meeting all expenses, tax obligations and

interest and principal payments, at the cost of equity, i.e., the rate of return

required by equity investors in the firm.

t=n

CF to Equity t

Value of Equity = ∑ (1+ k )t

t=1 e

where,

CF to Equityt = Expected Cashflow to Equity in period t

ke = Cost of Equity

n The dividend discount model is a specialized case of equity valuation, and the

value of a stock is the present value of expected future dividends.

Aswath Damodaran 4

II. Firm Valuation

the firm, i.e., the residual cashflows after meeting all operating

expenses and taxes, but prior to debt payments, at the weighted

average cost of capital, which is the cost of the different components

of financing used by the firm, weighted by their market value

proportions.

t=n

CF to Firm t

Value of Firm = ∑

t = 1 ( 1 +WACC)

t

where,

CF to Firmt = Expected Cashflow to Firm in period t

WACC = Weighted Average Cost of Capital

Aswath Damodaran 5

Firm Value and Equity Value

n To get from firm value to equity value, which of the following would

you need to do?

o Subtract out the value of long term debt

o Subtract out the value of all debt

o Subtract the value of all non-equity claims in the firm, that are

included in the cost of capital calculation

o Subtract out the value of all non-equity claims in the firm

n Doing so, will give you a value for the equity which is

o greater than the value you would have got in an equity valuation

o lesser than the value you would have got in an equity valuation

o equal to the value you would have got in an equity valuation

Aswath Damodaran 6

Cash Flows and Discount Rates

n Assume that you are analyzing a company with the following cashflows for

the next five years.

Year CF to Equity Int Exp (1-t) CF to Firm

1 $ 50 $ 40 $ 90

2 $ 60 $ 40 $ 100

3 $ 68 $ 40 $ 108

4 $ 76.2 $ 40 $ 116.2

5 $ 83.49 $ 40 $ 123.49

Terminal Value $ 1603.0 $ 2363.008

n Assume also that the cost of equity is 13.625% and the firm can borrow long

term at 10%. (The tax rate for the firm is 50%.)

n The current market value of equity is $1,073 and the value of debt outstanding

is $800.

Aswath Damodaran 7

Equity versus Firm Valuation

n Cost of Equity = 13.625%

n PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 +

76.2/1.136254 + (83.49+1603)/1.136255 = $1073

Method 2: Discount CF to Firm at Cost of Capital to get value of firm

Cost of Debt = Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%

WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94%

PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 +

(123.49+2363)/1.09945 = $1873

n PV of Equity = PV of Firm - Market Value of Debt

= $ 1873 - $ 800 = $1073

Aswath Damodaran 8

First Principle of Valuation

n The key error to avoid is mismatching cashflows and discount rates,

since discounting cashflows to equity at the weighted average cost of

capital will lead to an upwardly biased estimate of the value of equity,

while discounting cashflows to the firm at the cost of equity will yield

a downward biased estimate of the value of the firm.

Aswath Damodaran 9

The Effects of Mismatching Cash Flows and

Discount Rates

PV of Equity = 50/1.0994 + 60/1.09942 + 68/1.09943 + 76.2/1.09944 +

(83.49+1603)/1.09945 = $1248

Value of equity is overstated by $175.

Error 2: Discount CF to Firm at Cost of Equity to get firm value

PV of Firm = 90/1.13625 + 100/1.136252 + 108/1.136253 + 116.2/1.136254 +

(123.49+2363)/1.136255 = $1613

PV of Equity = $1612.86 - $800 = $813

Value of Equity is understated by $ 260.

Error 3: Discount CF to Firm at Cost of Equity, forget to subtract out debt, and

get too high a value for equity

Value of Equity = $ 1613

Value of Equity is overstated by $ 540

Aswath Damodaran 10

Discounted Cash Flow Valuation: The Steps

• Discount rate can be either a cost of equity (if doing equity valuation) or a

cost of capital (if valuing the firm)

• Discount rate can be in nominal terms or real terms, depending upon

whether the cash flows are nominal or real

• Discount rate can vary across time.

n Estimate the current earnings and cash flows on the asset, to either

equity investors (CF to Equity) or to all claimholders (CF to Firm)

n Estimate the future earnings and cash flows on the firm being

valued, generally by estimating an expected growth rate in earnings.

n Estimate when the firm will reach “stable growth” and what

characteristics (risk & cash flow) it will have when it does.

n Choose the right DCF model for this asset and value it.

Aswath Damodaran 11

Generic DCF Valuation Model

Expected Growth

Cash flows Firm: Growth in

Firm: Pre-debt cash Operating Earnings

flow Equity: Growth in

Equity: After debt Net Income/EPS Firm is in stable growth:

cash flows Grows at constant rate

forever

Terminal Value

CF1 CF2 CF3 CF4 CF5 CFn

Value .........

Firm: Value of Firm Forever

Equity: Value of Equity

Length of Period of High Growth

Discount Rate

Firm:Cost of Capital

Aswath Damodaran 12

EQUITY VALUATION WITH DIVIDENDS

Net Income Retention Ratio *

* Payout Ratio Return on Equity

Firm is in stable growth:

= Dividends

Grows at constant rate

forever

Dividend 1 Dividend 2 Dividend 3 Dividend 4 Dividend 5 Dividend n

Value of Equity .........

Forever

Discount at Cost of Equity

Cost of Equity

Riskfree Rate :

- No default risk Risk Premium

- No reinvestment risk Beta - Premium for average

- In same currency and + - Measures market risk X

risk investment

in same terms (real or

nominal as cash flows

Type of Operating Financial Base Equity Country Risk

Business Leverage Leverage Premium Premium

Aswath Damodaran 13

Financing Weights EQUITY VALUATION WITH FCFE

Debt Ratio = DR

Net Income Retention Ratio *

- (Cap Ex - Depr) (1- DR) Return on Equity

Firm is in stable growth:

- Change in WC (!-DR)

Grows at constant rate

= FCFE

forever

FCFE1 FCFE2 FCFE3 FCFE4 FCFE5 FCFEn

Value of Equity .........

Forever

Discount at Cost of Equity

Cost of Equity

Riskfree Rate :

- No default risk Risk Premium

- No reinvestment risk Beta - Premium for average

- In same currency and + - Measures market risk X

risk investment

in same terms (real or

nominal as cash flows

Type of Operating Financial Base Equity Country Risk

Business Leverage Leverage Premium Premium

Aswath Damodaran 14

VALUING A FIRM

EBIT (1-t) Reinvestment Rate

- (Cap Ex - Depr) * Return on Capital

Firm is in stable growth:

- Change in WC

Grows at constant rate

= FCFF

forever

FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn

Value of Operating Assets .........

+ Cash & Non-op Assets Forever

= Value of Firm

Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity))

- Value of Debt

= Value of Equity

(Riskfree Rate Based on Market Value

+ Default Spread) (1-t)

Riskfree Rate :

- No default risk Risk Premium

- No reinvestment risk Beta - Premium for average

+ - Measures market risk X

- In same currency and risk investment

in same terms (real or

nominal as cash flows

Type of Operating Financial Base Equity Country Risk

Business Leverage Leverage Premium Premium

Aswath Damodaran 15

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