Enterprise Valuation

Overview
In this chapter we review the basics of business, or enterprise, valuation. Our focus is on the
hybrid valuation approach that combines DCF analysis (discussed in Chapters 2-5) with
relative valuation (introduced in Chapter 6). We decompose the enterprise valuation problem
into two steps: The first step involves the valuation of a business's planning period cash flows
spanning a 3- to 10-year period, and the second step involves the calculation of the terminal
value, which is the value of all cash flows that follow the planning period. Pure DCF
valuation models use DCF analysis to analyze the value of the planning period and terminal
value cash flows, whereas the hybrid valuation model we discuss utilizes DCF analysis to
value the planning period cash flows and an EBITDA multiple to estimate the terminal value.
7.1 INTRODUCTION
In this chapter we focus our attention on what is generally referred to as enterprise valuation,
which is the valuation of a business or going concern. The approach that we recommend,
which we refer to as the hybrid approach, recognizes that forecasting cash flows into the
foreseeable future poses a unique challenge since most enterprises are expected to stay in
business for many years. To deal with this forecasting problem, analysts typically make
explicit and detailed forecasts of firm cash flows for only a limited number of years (often
referred to as the planning period) and estimate the value of all remaining cash flows as a
terminal value, at the end of the planning period.
The terminal value can be estimated in one of two ways. The first method is a
straightforward a application of DCF analysis using the Gordon growth model. As we
discussed in earlier chapters, this approach requires an estimate of both a growth rate and a
discount rate. The second method applies the multiples approach we discussed in the last
chapter; typically, the terminal value is determined as a multiple of the projected end of
planning period earnings before interest, taxes, depreciation, and amortization (EBITDA).
When this latter approach is used to evaluate terminal value and DCF is used to evaluate the
planning period cash flows, the model is no longer a pure DCF model but becomes a hybrid
approach to enterprise valuation.

The enterprise valuation approach described in this chapter is used in a number of

applications. These include acquisitions, which we consider in the example highlighted in
this chapter; initial public offerings, where firms go public and issue equity for the first time,
which we described in the previous chapter. Going private transactions (which we will
consider in the next chapter); spin-offs and carve-outs (where the division of a firm becomes
a legally separate entity); and finally, the valuation of a firms equity for investment
purposes.
In most applications, analysts use a single discount rate-the weighted average cost of
capital (or WACC) of the investment-to discount both the planning period cash flows and the
terminal value. This approach makes sense if the financial structure and the risk of the
investment are relatively stable over time. However, analysts frequently need to estimate the
enterprise value of a firm that is experiencing some sort of transition, and in these cases the
firms capital structure is often expected to change over time. Indeed, firms are often
acquired using a high proportion of debt, which is then paid down over time until the firm

reaches what is considered an appropriate capital structure. In these cases, the assumption of
a fixed WACC is inappropriate, and we recommend the use of a variant of the discounted
cash flow model known as the adjusted present value model, which we describe later in this
chapter.
Finally, it should be noted that when firms acquire existing businesses, they typically
plan on making changes in the businesss operating strategy. This requires that the potential
acquirer value the business given both its current strategy as well as the proposed new
strategy. Valuing the current strategy can be viewed as a reality check-if the business is not
valued appropriately given its current strategy, why not? One could then value scenarios
where the firms operating strategy is changed following the acquisition to determine whether
the new strategy creates additional value. To help answer this question, sensitivity analysis
can be deployed to determine the situations in which this additional value is indeed realized.
The chapter is organized as follows: Section 7.2 introduces the notion of estimating a
firms or business units enterprise value using the hybrid/multiples approach. Section 7.3
introduces the adjusted present value (APV) model, which is an alternative model that does
not require that the firms capital structure remain constant over the foreseeable future.
Finally, we close our discussion of enterprise valuation with summary comments in Section
7.4.
7.2

USING A TWO-STEP APPROACH TO ESTIMATE ENTERPRISE VALUE

We noted in the introduction that forecasting firm cash flows into the foreseeable
future is a challenging task, and for that reason analysts typically break the future into two
segments: a finite number of years known as the planning period, and all years thereafter.
(See the Practitioner Insight box. Enterprise Valuation Methods Used on Wall Street).
Consequently, the application of the DCF model to the estimation of enterprise value can best
be thought of as the sum of the two terms found in Equation 7.1. The first term represents the
present value of a set of cash flows spanning a finite number of years, referred to as the
planning period (PP).
Enterp riseValue

Term1
Present Value

Term2
Present Value

of the Planning

of the Terminal

Period (PP) Cash Flows

Value in Period PP

The second term is the present value of the estimated terminal value (TVpp) of the
firm at the end of planning period. As such, the terminal value represents the present value of
all the cash flows that are expected to be received beyond the end of the planning period. As
the following Technical Insight box on page 284 illustrates, the terminal value estimate is
generally quite important and can often represent over 50% of the value of the enterprise.
Example TATA Steel Ltd, Acquires Corus
To illustrate our enterprise valuation approach, consider the valuation problem in Tata Steels
acquisition or Corus in February 2007. Tata Steel Ltd, the largest steel company in India (5
million tons of steel), has often been cited as the lowest-cost producer of steel in the world. It

enjoys EBITDA margins of 30%-40%. Although Corus has been marred by financial
problems and lags behind in production efficiency with EBITDA margins of less than 10%,
the recent increase in global demand for steel has helped it turn around.
As discussed in Chapter 1, the Corus acquisition fits into Tata Steels overall business
strategy, which recognizes that the steel industry has undergone a significant transformation
in recent times and tee I can no longer be viewed as a homogeneous product. For instance,
Tata Steel specializes in the production of steel slabs, an intermediate form of steel because it
is closer to the source of raw materials (iron ore mines). In contrast, Corus: has a
comparative advantage in producing customized steel, which is a key requirement in several
industries (especially the automobile industry). Customized (or finished) steel can be sold at
a premium compared to steel slabs because of significant value-addition. Tata Steels overall
business strategy differentiates between steel slab capacity and finished steel capacity. It
involves acquiring each form of capacity in those geographic locations which offer the best
potential for value creation. The Corus acquisition highlights this aspect of their overall
business strategy.
The acquisition cost of 6172.31 million is 8.31 times Coruss 2006 EBITDA of 743
million (see Table 7.1). The acquisition cost of 6172.31 million along with a net debt
amount of 1798 million1, implies an enterprise value (EV) of 7970.31 million. Adjusting
for cash of 823 million, the EV/EBITDA ratio is 9.62. However, the standard metric for
valuation in the steel industry is EV per ton of steel. Corus produces about 18 million tons of
steel. This implies an EV of 397 per ton, or $767 per ton of steel (at the prevailing
exchange rate at the time of the transaction), which is close to the average of $747 per ton for
similar transactions in the recent past.
1

Liabilities in Corus include long-term debt and other obligations in the form of deferred tax
liabilities and pension liabilities. However, a major portion of the 1798 million liability is
in the form of long-term debt. In the interest of keeping the analysis as simple as possible, we
treat the entire liability amount of 1798 million as long-term debt.
PRACTITIONER INSIGHT:
Enterprise Valuation Methods Used on Wall Street - An Interview with Jeffrey Rabel*
In broad brush terms there are three basic valuation methodologies used throughout the
investment banking industry: trading or comparable company multiples, transaction
multiples, and discounted cash flows. Emphasis on a particular methodology varies
depending on the particular setting or type of transaction. For equity transactions such as the
pricing of an initial public offering (IPO), relative valuation based on multiples of market
comparables (firms in the same or related industries, as well as firms that have been involved
in recent similar transactions) is the preferred approach. The reason for the emphasis on this
type of valuation is that the Company will have publicly traded equity and thus investors will
be able to choose whether to buy said Company or any of the other companies that are
peers.
A key consideration in relative valuation analysis is the selection of a set of
comparable firms. For example, in the Hertz IPO we looked at not only the relative prices of
car rental firms (Avis, Budget, etc.) but also considered industrial equipment leasing
companies (United Rental, RSC Equipment, etc.) since this was a growing piece of Hertzs

business model. We also looked at travel related companies, as a large part of the Hertz
rental car business is driven by airline travel. Some also believed that Hertz, because of its
strong brand name recognition, should be compared to valuation multiples of a set of
companies with strong brand recognition including firms such as Nike or Coke. Obviously
selection of a comparable group of firms and transactions is critical when carrying out a
relative valuation because different comparable sets trade at different multiples and this
affects the valuation estimate.
In merger and acquisition (M&A) analysis involving a strategic buyer (typically
another firm in the same or a related industry) or a financial buyer such as a private equity
firm (see Chapter 8 for further discussion) the second type of relative valuation method,
transaction multiples, is used in combination with discounted cash flows (DCF). The reason
for the focus on a transaction multiple is the fact that transaction multiples represent what
other buyers have been willing to pay for similar companies or companies with related lines
of business. The transaction multiples are used in combination with the DCF approach as
DCF allows the buyers to value the acquisition based on their forecast of its performance
under their assumptions about how the business will be run.
DCF valuation methods vary slightly from one investment bank to another: however,
the typical approach to enterprise valuation is a hybrid approach consisting of forecasting
cash flows to evaluate near-term projections and relative valuation to estimate a terminal
value. The analysis typically involves a five-year forecast of the firms cash flows which are
discounted using an estimate of the firms weighted average cost of capital. Then the value
of cash flows that extend beyond the end of the planning period are estimated using a
terminal value that is calculated based on a multiple of a key firm performance attribute such
as EBITDA. The terminal value estimate is frequently stress tested using a constant growth
rate with the Gordon growth model to assess the reasonableness of the implied growth rate
reflected in the terminal value multiple.
The final valuation approach we use a variant of the DCF approach that is used where
a M & A transaction involves a financial sponsor (generally a private equity firm such as
Blackstone, Cerberus or KKR. Financial buyers are primarily driven by the rate of return
they earn on their investors money so the valuation approach they use focuses on the IRR of
the transaction. The basic idea is to arrive at a set of short-term cash flow forecasts that the
buyer is comfortable with, estimate a terminal value at the end of the forecast period
(typically 5 years), and then determining IRRRs by varying the acquisition price.
* Jeffrey Rabel is a CPA and a Vice President in the Global Financial Sponsors group at
Lehman Brothers in New York.
The acquisition cost of 6172.31 million to acquire Corus was too large an amount,
given the size of Tata Steel Ltd. The only feasible financing alternative for Tata Steel Ltd,
was to raise a significant portion of the acquisition cost in the form of debt. To safeguard the
interests of Tata Steels shareholders, the management of Tata Steel had hinted at the time of
the acquisition that the acquired assets and the associated debt would be placed in a separate
legal entity. This arrangement would effectively protect Tata Steels shareholders from the
risks associated with high debt. For the purpose of acquiring Corus, Tata Steel therefore
created a wholly owned subsidiary in the U.K. (Tata Steel Limited).

Table 7-1 Pre-and Post-Acquisition Balance Sheets for Corus (All Figures in Millions)
Pre-Acquisition

Post-Acquisition

2006

2006

Current Assets*

4,412.00

4,412.00

Net property, plant, and equipment

2,758.00

2,758.00

Other investments and assets

780.00

780.00

Goodwill

130.00

2,368.31

Total

8,080.00

10,3180.31

Current liabilities

2,348.00

2,348.00

Long-term debt**

1,798.00

4,526.39

Total liabilities

4,146.00

6,874.39

Paid-up capital

1,725.00

1,725.00

389.00

1,718.93

Retained earnings

1,820.00

0.00

Common equity

3,934.00

3,443.93

Total

8,080.00

10,318.31

Premium

* 2006 and 2007 Current Assets include Cash of 823 million

** Long term loans and other long-term liabilities have been clubbed together under the head
Long-term debt.
This type of transaction is a highly leveraged one and is frequently used by private
equity groups or corporate raiders to take over undervalued companies. We often hear about
such transactions-they go by the name of LBOs (leveraged buy-outs). The Tata Corus
acquisition, however, does not fit into the category of a standard private equity led LBO
transaction because Tata Steel has not entered into the transaction with an explicit intent to
divest Corus at a higher valuation in the future. In contrast, sponsors of LBO acquisition
strategies have very clearly defined goals of divesting the acquired assets within a five-to tenyear time frame. We will examine the more general use of LBOs as part of an acquisition
strategy in Chapter 8.
Table 7.1 shows the pre- and post-acquisition balance sheets for Corus. The
acquisition cost of 6172,.31 million reflects a premium of 2238.31 million above Coruss

pre-acquisition book value of the equity of 3934 million. Note that this difference is
recorded as goodwill in the revised post-acquisition balance sheet.2
2

By including all of the purchase premium as Goodwill we are assuming that the appraised
value of the Coruss assets is equal to their book value.
We assume that Tata Steel UK is able to raise 60% of the acquisition cost of 6172.31
million in the form of long-term loans.3This amount is 3703.39 million. The long-term loans
come with legally structured agreements, which ensure that cash flow from Coruss
operations will be used to service these loans. Second, we also carry forward old debt in
the amount of 823 million.4This implies that the total debt amount post acquisition is
4526.39. Given an enterprise value of 7970.31 million, it follows that the remaining
amount of 3443.93 million has to be supplied by equity holders.
In summary, post acquisition, Tata Steel UK and Corus combination will have a total
of 7970.31 million in invested capital, of which 4526.39 million (56.79%) is debt and the
remaining 3443.93 million (43.21%) is equity. Current liabilities consist mostly of
payables, and therefore we treat this amount as a non-interest bearing liability.
We can decompose the synergies in the acquisition into two components. First, under
the new management, synergies arise in the operations of Corus. These synergies would be
reflected in the value of Tata Steel UK. As an equity holder in Tata Steel UK, Tata Steel Ltd
would therefore benefit from the synergies created in Corus. Second, Tata Steel Ltd. could
directly experience synergies in its own operations as a result of the Corus acquisition. The
valuation of the acquisition to Tata Steel should reflect both sources of synergy. In this
chapter, however, we focus only on the former source of synergy, i.e., we value the Corus
acquisition from the perspective of Tata Steel UK, rather than Tata Steel Ltd. (India).
To estimate these synergies, we will first examine Corus prior to the acquisition under
a status quo strategy. Then we will analyze the value of Corus under a growth strategy
that reflects the restructuring plans of Tata Steel UK. The comparison of the value of Corus
under these two strategies will help us estimate the synergies created in Corus under the new
management.
Our analysis of the status quo strategy shows that Corus has an enterprise value in the
range of 5 to 6 billion, which implies a share value in the range of 350 to 400 pence a
share. This is consistent with the share price of Corus during the six-month period prior to
the acquisition. Then we estimate the value of the growth strategy that Tata Steel UK is
likely to display after the acquisition. We find that cash flows under the growth strategy are
lower than those under the status quo strategy for the first few years. However, in later years,
when the synergies of the acquisition start kicking in, the cash flows arising from the growth
strategy become larger. We find that the enterprise value of Corus under the management of
Tata Steel UK could be in the range of 9 to 11 billion, depending on the method used for
valuation.
The financing arrangement that was eventually adopted differed a slightly from this rough
breakup. According to a press release of Reuters LPC (Tata Steel launches 3.7 bln stg loan
for Corus buy, Friday July 6, 09:00 PM), the financing of Tata Steel UK has been structured
as a hybrid corporate-leveraged financing arrangement and will have no recourse to parent
company Tata Steel. The bankers to the deal are ABN AMRO, Citibank, and Standard
3

Chartered. The long-term loans amount to a total of 3670 million. The interest rates have
been set at LIBOR plus a spread ranging between 175 basis points and 225 basis points.
Further the report mentions that Tata Steel and Tata Sons would jointly invest 3500 million
as equity in Tata Steel UK. For our purposes, it makes sense to value the investment
opportunity based on the expected financing arrangement rather than the eventual financing
arrangement. At the time of making the acquisition offer, Tata Steel had only ballpark
estimates of the terms of financing based on discussions with their bankers. Our analysis is
therefore not constrained by this. lack of information.
To keep matters as simple as possible, we assume that the old debt that is carried forward
bears the same interest rate as the new debt.
4

Valuing Corus using DCF Analysis

We follow the same three-step procedure discussed in Chapter 2 to perform the DCF analysis
for valuing the Corus acquisition: Step 1-estimate the amount and timing of the expected cash
flows; Step 2-estimate a risk-appropriate discount rate; and Step 3-calculate the present value
of the expected cash flows, or enterprise value.
Step 1. Estimate the amount and timing of the expected cash flows. We used information
gleaned from the annual reports of Corus prior to the acquisition to evaluate the status quo
strategy. Corus was well on its way in implementing Restoring Success, a key
restructuring initiative that had already resulted in incremental EBITDA of 680 million by
the end of 2006. The hallmark of this initiative was to divest from low-margin activities and
to consolidate in high-margin activities. As a result of such restructuring activities,
significant cost reductions were achieved every year both in terms of cost of goods sold and
general administrative expenditures. Going forward, we estimate that the total savings would
be 150 million in 2007, 225 mi1lion during 2008-2009 and would increase to 300
million annually during 2010-2012. These savings amount to 1500 million during the 20072012 planning period. On C1l the expenditure side, Corus had committed to renewing
employer contribution to pension schemes by an amount of 50 million annually from 2006.
We also assume that no extraordinary capital expenditures arise in the status quo plan, other
than those required to offset depreciation.
The exact schedule of savings in costs and the additional pension expenditures are
shown in Panel a of Table7-2. These estimates of savings are reasonably conservative and
consistent with the stated plans of Corus management. Their impact is more obvious when
we look at the projected change in EBITDA margin over the period 2007-2012. As can be
inferred from proforma income statements in Table 7.2 (and more explicitly, in data stated in
Figure 7-1), these savings imply a relatively modest change in EBITDA margins from 7.63%
in 2006 to 8.15% in 2012.
In Panel b of Table 7.2 we present the pro forma financial statements and cash flow
projections for Corus that are required to complete Step 1 of a DCF analysis. The cash flow
projections consist of planning period cash flows spanning the period 2007-2012, and
terminal value estimates based on cash flow projections for 2013 and beyond. The pro forma
calculations reflect an assumed rate of growth in revenues of 3 % per year during the
planning period and a 1.5 % growth rate in firm free cash flows in the post planning period.

The asset levels found in the pro forma balance sheets reflect the assets that Corus
needs to support the projected revenues. Current assets are determined by a fixed current
asset-to-sales ratio of 45% (2006 actual), and current liabilities are determined by a fixed
current liabilities-to-assets ratio of 29% (2006 actual). Any additional financing requirements
are assumed to be raised by first retaining 95% of Coruss earnings (implying a dividend
payout ratio of 5%) and then taking recourse to long-term debt. A quick review of the pro
forma balance sheets found in Panel b of Table 7-2, however, indicates that under the status
quo strategy Coruss long-term debt actually declines from 1798 million at the end of 2006
to 186.50 million by 2012. This decrease reflects the fact that the firms retention of future
earnings is more than adequate to meet its financing needs, which allows the firm to retire its
long-term debt. Finally, Coruss estimated cash flows, found in Panel c, indicate that from
2007 through 2012 cash flows are expected to grow from 276.67 million to 438.87 million.

Estimating Coruss Enterprise Value using DCF Analysis (Status quo Strategy)
[All Figures in Millions]
Panel a. (Step 1) Estimate the Key Savings in Costs and Additional Expenditures
During Planning Period
Planning Period Pro Forma Financial Statements
2007

Reduction in
COGS
Reduction in
SG & A

Total Savings
Increase in
Pension

2008

10%

2009

2010

2011

2012

20%

20%

Total
Change
(20072012)

15%

15%

20%

90.00

135.00

135.00

180.00

180.00 180.00

900.00

10.00%

15.00%

15.00 %

20.00 %

20.00 %

100.00 %

60.00

90.00

90.00

120.00

120.00 120.00

600.00

150.00

225.00

225.00

300.00

300.00 300.00

1,500.00

50.00

50.00

50.00

50.00

50.00

20.00 %

50.00

100%

300.00

Panel b. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Planning Period Pro Forma Balance Sheet
Corus Pro Forma Balance Sheets
2006

2007

2008

2009

2010

2011

2012


4,412.00

4,544.36

4,680.69

4,821.11

4,965.74

5,114.72

5,268.16

Net

property2,758.00
plant, and
equipment

2,758.00

2,758.00

2,758.00

2,758.00

2,758.00

2,758.00

Other
investments
and assets

780.00

780.00

780.00

780.00

780.00

780.00

780.00

Goodwill

130.00 130.00

130.00

130.00

130.00

130.00

130.00

Total

8,080.00 8,212.36

8,348.69

8,489.11

8,633.74

8,782.72

8,936.16

Current
liabilities

2,348.00 2,386.46

2,426.08

2,466.89

2,508.91

2,552.21

2,596.79

Long-term
debt

1,798.00 1,641.98

1,420.67

1,181.08

872.30

541.18

186.50

Total
liabilities

4,146.00 4,028.44

3,846.75

3,647.96

3,381.22

3,093.38

2,783.30

Paid-up
capital

1,725.00 1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

Premium

389.00 389.00

389.00

389.00

389.00

389.00

389.00

Retained
earnings

1,820.00 2,069.92

2,387.94

2,727.15

3,138.53

3,575.33

4,038.86

Common
equity

3,934.00 4,183.92

4,501.94

4,841.15

5,252.53

5,689.33

6,152.86

Total

8,080.00 8,212.36

8,348.69

8,489.11

8,633.74

8,782.72

8,936.16

Current
assets

Continued
Table 7-2 Planning Period Pro Forma Income Statements
Corus Pro Forma Income Statements
2006

2007

2008

2009

2010

2011

2012


9,733.00

10,024.99

10,325.74

10,635.51

10,954.58

11,283.21

11,621.71

-
6,275.00

- 6,325.99

- 6,473.47

- 6,671.73

- 6,380.93

- 7,041.26

- 7,257.90

Gross profit

3,458.00

3,699.00

3,852.27

3,963.78

4,123.65

4,241.96

4,363.82

General
and
administrative
expense

-
2,715.00

- 2,997.50

- 3,057.72

- 3,150.65

- 3,216.37

- 3,314.96

- 3,416.51

EBITDA

743.00

701.50

-794.54

813.13

907.27

926.99

947.30

Depreciation
expense

- 286.00

- 275.80

- 275.80

- 275.80

- 275.80

- 275.80

- 275.80

Net
operating
income

457.00

425.70

518.74

537.33

631.47

651.19

671.50

Other income

58.00

58.00

58.00

58.00

58.00

58.00

58.00

EBIT

515.00

483.70

576.74

595.33

689.47

709.19

729.50

Interest expense

- 202.00

- 107.88

-- 98.52

- 85.24

- 70.86

- 52.34

- 32.47

Earnings before
taxes

313.00

375.82

478.23

510.09

618.61

656.85

697.03

Taxes

- 119.00

- 112.75

- 143.47

- 153.03

- 185.58

- 197.06

- 209.11

After-tax profit
from continuing
operations

194.00

263.07

334.76

357.06

433.03

459.80

487.92

After-tax profit
from
discontinued
operations

35.00

Net Income

229.00

Revenue

Cost
sold

of

goods

Table 7.2 Continued

Panel c. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Planning Period Projected Firm Free Cash Flows (FFCF)
Projected Firm Free Cash Flows

EDIT
Less: Taxes

2007

2008

2009

2010

2011

2012

483.70

576.74

595.33

689.47

709.19

729.50

- 145.11

- 173.02

- 178.60

- 206.84

- 212.76

- 218.85

NOPAT
Plus:
Depreciation
Less: Capex
Less:
Increases in
Net
Working
Capital
Equals
FFCF

338.59

403.72

416.73

482.63

496.44

510.65

275.80

275.80

275.80

275.80

275.80

275.80

- 275.80

- 275.80

- 275.80

- 275.80

- 275.80

- 275.80

- 61.92

- 63.78

- 65.69

-67.66

- 69.69

- 71.78

276.67

339.94

351.04

414.97

426.74

438.87

Panel d. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Terminal Value Cash Flow Estimate
Method #1 DCF Using the Gordon Growth Model Ration Terminal Value Multiples from the Gordon Model
Growth Rates (g)
Discount Rates

0.00%

1.00%

1.50%

2.00%

8.357%

11.97

13.73

14.80

16.05

8.857%

11.29

12.86

13.80

14.88

9.357%

10.69

12.09

12.92

13.87

9.857%

10.15

11.40

12.15

12.98

Terminal Value Estimates (for FFCFs received in 2013 and beyond)

Growth Rates (g)
Discount Rates

0.00%

1.00%

1.50%

2.00%

8.357%

5,251,77

6,025.31

6,496.70

7,042.24

8.857%

4,955.28

5,641.86

6,055.14

6,528.70

9.357%

4,690.48

5,304.29

5,669.79

6,084.97

9.857%

4,452.55

5,004.84

5,330.55

5,697.72

Method #2 Multiples Using Enterprise Value to EBITDA

Terminal Value Estimates
Enterprise Value / EBITDA

Terminal Value

5.00

5,026.51

5.50

5,529.16

6.00

6,031.82

6.70

6,735.53

7.20

7,238.18

(Continued)
Panel e (Step 2) Estimate a Risk Appropriate Discount Rate

Cost of debt Estimated borrowing rate is 6.0% with a marginal tax of 30% results in
an after-tax cost of debt of 4.200%.

Cost of equity An average industry unlevered equity beta of .849 implies a levered
equity beta for Corus of 1.02 assuming a target debt ratio of 22% and a debt beta of
.255. Using the capital asset pricing model with a 10 year government security yield
of 4.60% and a market risk premium of 5.50% produces an estimate of the levered
cost of equity of 10.189%.

Weighted average cost of capital (WACC) Using the target debt to value ratio of
22% the WACC is approximately 8.857%.

Panel f. (Step 3) Calculate the Present Value of Future Cash Flows

Present Value of Expected Future Cash Flows
Terminal Value

Enterprise Value

Discount
Rate

Planning
Period FFCF

Method #1

Method #2

Method #1

Method #2

7.857%
8.857%
9.857%

1,706.31
1,651.65
7,599.60

4,451.40
3,639.11
3,302.60

4,278.50
4,048.02
3,831.90

6,157.70
5,290.76
4,632.20

5,984.80
5,699.67
5,431.50

Status Quo Strategy

2006

2007

2008

2009

2010

2011

2012

Total liabilities / Total assets

51.3%

49.1%

46.1%

43.0%

39.2%

35.2%

31.1%

Long-term debt/Total assets

22.3%

20.0%

17.0%

13.9%

10.1%

6.2%

2.1%

Growth Strategy Strategy

2006

2007

2008

2009

2010

2011

2012

Total liabilities / Total assets

66.6%

67.7%

67.7%

66.7%

63.7%

59.2%

53.5%

Long-term debt/Total assets

43.9%

44.9%

44.9%

43.9%

40.9%

36.5%

30.8%

EBITDA margins
2006

2007

2008

2009

2010

2011

2012

Status quo case

7.63%

7.00%

7.69%

7.65%

8.28%

8.22%

8.15%

Growth strategy case

7.63%

5.35%

6.93%

8.22%

10.99%

12.68%

13.97%

Growth minus Status quo

0.00%

-1.64%

-0.76%

0.57%

2.70%

4.47%

5.82%

Terminal Values, Expected Growth Rates, and the Cost of Capital

When estimating value using a planning period and a terminal value, how much of the value
can be attributed to each of these components? To answer this question, consider the
situation where a firms free cash flows are expected to grow at a rate of 12% per year for a
period of five years, followed by a 2% rate of growth thereafter. If the cost of capital for the
firm is 10%, then the relative importance of the planning period cash flows and the terminal
value cash flows for different planning periods is captured in the upper figure:
If the analyst uses a five-year planning period, then the present value of the planning
period cash flows in this setting constitutes 27.45 % of the value of the enterprise, leaving
over 72.55 % of enterprise value in the terminal value. Similarly, if a three-year planning
period is used, then the terminal value constitutes 83.83% of the enterprise value estimate,
leaving only 16.17% for the planning period. The key observation we can make from this
analysis is that the terminal value is at least 50% of the value for the firm for all commonly
used planning periods (i.e., three to 10 years).
The previous example was obviously a very high-growth firm. It stands to reason,
then, that the terminal value may be less important for more stable (low-growth) firms. It
turns out (as the lower figure indicates) that even for a very low- and stable-growth firm
whose cash flows grow at 2% per year forever, the terminal value is still the dominant
component of the enterprise value estimate for the typical three- to 10-year planning period.
In this case where the firm has a constant rate of growth of 2% per year for all years, a five
year planning period results in 31.45% of the enterprise value coming from the cash flows in
the planning period, which leaves 68.55 % of enterprise value in the terminal value.
The message is very clear. The analyst must spend significant time estimating the
firms terminal value. In fact, even for a long (by industry standards) planning period of 10
years, the terminal value for the slow-growth firm above is still roughly half (47%) of the
firms enterprise value.
How important should the terminal value be to the enterprise value of your firm? As
the examples weve used above suggest, the answer will vary with the firms growth
prospects and the length of the planning period used in the analysis. In general, terminal

value increases in importance with the growth rate in firm cash flows and decreases with the
length of the planning period.
Panel d includes two analyses of the terminal value of COTUS evaluated in 2012.
The first method (Method #1) uses the Gordon growth model (introduced in Chapter 2) to
estimate the present value of the firm free cash flows (FFCFs) beginning in 2013 and
continuing indefinitely. Specifically, we estimate the terminal value in 2012 using Equation
7.2:

Terminal Value 2012

FFCF2012 1 Terminal Growth Rate (g)

Cost of Capita (kWACC) Terminal Growth Rate (g)

To estimate the terminal value using this method, we assume that the cash flows the firm is
expected to generate after the end of the planning period grow at a constant rate (g), which is
less than the cost of capital (Kwacc) Recall from our discussion of multiples in Chapter 6 that
Equation 7.2a can be interpreted as a multiple of FFCF2012 where the multiple is equal to the
ratio of one plus the terminal growth rate divided by the difference in the cost of capital and
the growth rate, i.e.:

Gordon Growth
1 g

FFCF 2012x
Terminal Value 2012 FFCF 2012
kWACC g
Model Multiple
In Panel d of Table 7-2 we report a panel of Gordon growth model multiples that
correspond to a reasonable range of values of the discount rate and rate of growth in future
cash flows. For example, for the cost of capital of 8.857% and a 1.5% terminal growth rate,
1 g
,is 13.80.
the multiple for terminal value based on the Gordon Growth Model,
kWACC g
Based on the estimated FFCF2012 of 438.87 million, this produces an estimate of the
terminal value at the end of 2012 of 6055.14 million.
In addition to the DCF analysis of the terminal value, Panel d of Table 7-2 provides
an analysis that uses EBITDA multiples (Method #2), as shown in Equation:
Terminal
Value 2012 EBITDA 2012 x EBITDA Multiple

Multiples ranging from 5 to 7 are reported in Panel d of Table 7-2. The average multiple for
similar transactions that have recently occurred in the steel industry is 6.70.
Using this multiple of 6.70 times EBITDA2012 (which equals 1005.30) produces an
estimated terminal value for Corus in 2012 of 6735.53 million = 6.70 x 1005.30 million. It
should be noted that the EBITDA multiple and the free cash flow multiple generate very
similar terminal value estimates when there are no extraordinary capital expenditures or
investments in net working capital. If this were not the case, the analyst would want to
double-check his or her assumptions and attempt to reconcile the conflicting terminal value
estimates.

Step 2. Estimate a risk-appropriate discount rate. Under the status quo strategy, we
compute the cost of capital for Corus based on a 22% debt to enterprise value ratio (2006
actual). We assume that this 22% ratio is the target capital structure under the status quo
strategy. We also assume that the cost of debt of 6%. Details supporting the calculation are
provided in Panel e of Table 7-2. The analysis implies an estimated cost of capital for Corus
of 8.857%.
Step 3. Calculate the present value of the expected cash flows, or enterprise value. In Panel
f of Table 7-2 we estimate the enterprise value of Corus using the free cash flow estimates
from Panel c and discounting them with the estimated cost of capital for Corus from Panel e
plus and minus one percent-8.857% (the estimated WACC), 7.857%, and 9.857%. The result
is an array of enterprise value estimates reflecting each of the methods used to estimate the
terminal value and the range of cost of capital estimates. With the 8.857% estimated cost of
capital, the estimate of enterprise value is in the range of 5,291 million to 5700 million.
These numbers imply that the owners equity is in the range of 3493 million to 3902
million, or equivalently 344 pence to 384 pence per share. The actual market price of Corus
shares in the six-month period prior to the acquisition also varied around this range.
Based on this analysis, we can see that the acquisition is not worth pursuing at a cost
of 608 pence a share unless there are synergies that compensate for the premium paid in the
acquisition. The acquisition, therefore, makes sense only if Tata Steel is confident of making
changes in the operating strategy of Coruss business. As we discussed in Chapter 1 and at
the beginning of this chapter, the Tata Steel-Corus combination offers significant
opportunities of creating synergies. Tata Steel is one of the lowest cost producers of slab
steel, which is a key raw material for customized steel products sold by Corus. Corus will
thus be able to reduce its cost of goods sold. At the same time, Corus will be in a position to
divest from its low margin plants (or at least reduce the scale of such plants), thereby saving
on administrative expenses. In addition, Corus will be able to gain access to the increasing
demand for customized steel products in the high-growth emerging market of India.
Valuing Corus under Tata Steels Growth Strategy
To evaluate the Corus acquisition under the management of Tata Steel, we repeat the earlier
analysis keeping in mind the synergies of the acquisition. The results of this analysis are
contained in Table 7-3. Panel a shows that the potential savings under the growth strategy
over the planning period (2007-2012) are 3000 million which is twice the total savings
under the status quo strategy. However, it can also be expected that Tata Steel UK will incur
more cash outflows due to capital expenditures under the more ambitious growth strategy. In
addition to these costs. Tata Steel has also agreed to put more resources into the pension
scheme at Corus. Projections related to these item are shown in detail in Panel a of Table
7.3.
It should be noted that Tata Steel had very little surplus steel slab capacity in 2006 but
was confident about increasing capacity in the next two to three years. This meant that there
would be a gestation period of two or three years before the synergies arising in Corus due to
lower cost steel slabs start having a significant effect. The pattern of savings in Panel a of
Table 7-3 reflects this situation. These estimates of savings are reasonably conservative and
consistent with the stated plans of Tata Steel. As can be inferred from proforma income
statements in Table 7.3 (and more explicitly, in data stated in Figure 7-1), these savings imply

a change in EBITDA margin from 7.63% in 2006 to 13.97% in 2012. Tata Steel
management has often said that it would be able to increase EBITDA margins in Corus up to
20%.
Panel b of Table 7-3 presents proforma financial statements (2007-2012) for Corus
under the growth strategy. The growth strategy involves increased capital expenditures on
upgrading and restructuring of manufacturing capacity. Specifically, the plan calls for
spending an additional 50 million each year on aggressive marketing plans and capital
equipment throughout the six-year planning period.
We predict that the combined effect of these actions is to increase the planning period
rate of growth in sales to 5% per year, compared to only 3% under the status quo strategy.
After achieving the higher target market share in 2012, capital expenditures and marketing
expenditures are expected to return to the status quo levels, and the expected rate of growth in
firm free cash flow for 2013 and beyond is assumed to be 2%, slightly higher than the 1.5%
growth rate in. the status quo case.
Comparing the cash flow projections for the status quo strategy found in Panel c of Table 7-2
with those or the growth strategy in Panel c of Table 7-3, we see that the growth strategy has
the initial effect of reducing cash flows below status quo levels for 2007-2009. However,
beginning in 2010 the growth strategy cash flows will exceed those of the status quo strategy
(577 million for the growth strategy as compared with 415 million for the status quo
strategy). Moreover, for all subsequent years we expect the growth strategy to maintain a
higher level of FFCF. As can be seen in Panel f of Table 7-3, the enterprise value estimates,
are dramatically higher under the growth strategy than under the status quo strategy. Using a
cost of capital of 8.420% (Panel e of Table 7-3), it can be shown that the enterprise value is
11,037 million when the Gordon growth model is used to estimate the terminal value and
9,754 million when a 6.7 times EBITDA multiple (the average EBITDA multiple in recent
transactions) is used to estimate the terminal value. These enterprise values imply a value of
614 ($1185) per ton of steel under the Gordon method and a value of 542 ($1047) per ton
of steel under the EBITDA multiple approach. After subtracting the long term debt of 1798,
the owners equity is equal to 9239 million and 7956 million under Method # 1 and
Method # 2, respectively. Given the acquisition cost of 6172.31 million, the NPV of the
acquisition from the point of view of Tata Steel UK is 3067 million and 1784, respectively.
Table 7.3

Estimating Corus's Enterprise Value using Analysis (Growth Strategy)

(All Figures in Millions)

Panel a. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Planning Period Pro Forma Financial Statements

2007

2008

2009

2010

2011

2012

Total
change
20072012

Reduction in
COGS

2%

5%

10%

20%

28%

35%

100%

42.00

105.00

210.00

420.00

588.00

735.00

2,100.00

2%

5%

10%

20%

28%

35%

100%

18.00

45.00

90.00

180.00

252.00

315.00

900.00

Total
savings

60.00

150.00

300.00

600.00

840.00

1,050.00

3,000.00

New capital
expenditures

50.00

50.00

50.00

50.00

50.00

50.00

300.00

126.00

50.00

50.00

10.00

10.00

10.00

256.00

Reduction in
SG&A

Increase
Pension

in

Panel b. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Planning Period Pro Forma Balance Sheet

PreAcquisition

PostAcquisition

2006

2006

Pro Forma Balance Sheets

2007

2008

2009

2010

2011

2012

4,412.00

4,412.00

4,632.60

4,864.23

5,107.44

5,362.81

5,630.95

5,912.50

2,758.00

2,758.00

2,808.00

2,858.00

2,908.00

2,958.00

3008.00

3,058.00

780.00

780.00

780.00

780.00

780.00

780.00

780.00

780.00

130.00

2,368.31

2,368.31

2,368.31

2,368.31

2,368.31

2,368.31

2,368.31

Total

8,080.00

10,318.31

10,870.54

10,588.91

10,870.54

11,163.76

11,787.27

12,118.82

Current
Liabilities

2,348.00

2,348.00

2,473.66

2,473..66

2,540.39

2,609.88

2,682.27

2,757.72

Long-term
debt

1,798.00

4,526.39

4,882.52

4,882.52

4,904.44

4,691.66

4,297.55

3,731.72

Total
liabilities

4,146.00

6,874.39

7,356.18

7,356.82

7,444.82

7,301.53

6,979.82

6,489.44

Current
assets
Net
property,
plant, and
equipment
Other
investments
and assets
Goodwill

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

Premium

389.00

1,718.93

1,718.93

1,718.93

1,718.93

1,718.93

1,718.93

1,718.93

Retained
earnings

1,820.00

0.00

- 22.91

- 70.43

275.01

723.67

1,363.52

2,185.45

Common
equity

3,934.00

3,443.93

3,421.01

3,514.36

3,718.93

4,167.59

4,807.45

5,629.38

Total

8,080.00

10,318.31

10,558.91

10,870.54

11,163.76

11,469.13

11,787.27

12,118.82

Paid-up
capital

Planning Period Pro Forma Income Statements

PreAcquisition

PostAcquisition

2006

2006

Revenue

9,733.00

Cost of goods sold

Pro Forma Balance Sheets

2007

2008

2009

2010

2011

2012

9,733.00

10,219.65

10,730.63

11,267.16

11,830.52

12,442.05

13,043.15

- 6,275.00

- 6,275.00

-
6,498.58

-
6,762.60

-
7,000.99

-
7,151.53

-
7,362.11

-
7,612.62

Gross profit

3,458.00

3,458.00

3,721.07

3,968.03

4,266.18

4,678.99

5,059.94

5,430.53

General
and
administrative
expense

- 2,715.00

- 2,715.00

-
3,173.90

-
3,224.19

-
3,340.15

-
3,379.16

-
3,484.61

-
3,607.95

EBITDA

743.00

743.00

547.18

743.84

926.03

1,299.83

1,575.32

1,822.59

Depreciation
expense

- 286.00

- 286.00

- 275.80

- 280.80

- 285.80

- 290.80

- 295.80

- 300.80

Net
operating
income

457.00

457.00

271.38

463.04

640.23

1,009.03

1,279.52

1,521.79

Other income

58.00

58.00

58.00

58.00

58.00

58.00

58.00

58.00

EBIT

515.00

515.00

329.38

521.04

698.23

1,067.03

1,337.52

1,579.79

Interest expense

- 202.00

- 202.00

- 362.11

- 380.67

- 390.60

- 392.35

- 375.33

- 343.80

Earnings
taxes

313.00

313.00

- 32.73

140.37

307.63

674.68

962.19

1,235.99

Taxes

- 119.00

- 119.00

9.82

- 42.11

- 92.29

- 202.40

- 288.66

- 370.80

After-tax profit
from continuing
operations

194.00

194.00

- 22.91

98.26

215.34

472.27

675.53

865.19

After-tax profit
from
discontinued
operations

35.00

35.00

Net Income

229.00

229.00

before

(continued)
Panel c. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Planning Period Cash Flow Estimates
Projected Firm Free Cash Flows
2007

2008

2009

2010

2011

2012

EBIT

329.38

521.04

698.23

1,067.03

1,337.52

1,579.79

less: Taxes

- 98.81

- 156.31

- 209.47

- 320.11

- 401.26

- 473.94

NOPAT

230.57

364.73

488.76

746.92

936.27

1,105.85

Plus:
Depreciation

275.80

280.80

285.80

290.80

295.80

300.80

less: Capex

- 325.80

- 330.80

- 335.80

- 340.80

- 345.80

- 350.80

less:
Increases in
Net Working
Capital

- 103.20

- 108.36

- 113.78

- 119.47

- 125.44

- 131.71

Equals FFCF

77.37

206.37

324.98

577.46

760.83

924.14

Panel d. (Step 1) Estimate the Amount and Timing of Future Cash Flows
Terminal Value Cash Flow Estimate
Method #1 DCF Using the Gordon Growth Model
Terminal Value Multiples from the Gordon Model
Growth Rates (g)
Discount Rates

0.00%

1.00%

1.50%

2.00%

7.920%

12.63

14.60

15.81

17.23

8.420%

11.88

13.61

14.67

15.89

8.902%

11.21

12.72

13.68

14.74

9.420%

10.62

12.00

12.82

13.75

Terminal Value Estimates (for FFCFs received in 2013 and beyond)

Growth Rates (g)

Discount Rates

0.00%

1.00%

1.50%

2.00%

7.920%

11,668.99

13,488.90

14,611.48

15,923.69

8.420%

10,976.02

12,579.90

13,555.68

14,683.45

8.920%

10,360.75

11,785.68

12,642.18

13,622.45

9.420%

9,810.79

11,085.78

11,844.02

12,704.45

Method #2 Multiples Using Enterprise Value to EBITDA

Terminal Value Estimates
Enterprise Value / EBITDA

Terminal Value

5.00

9,402.95

5.50

10,343.24

6.00

11,283.53

6.70

12,599.95

7.20

13,540.24

Panel e (Step 2) Estimate a Risk Appropriate Discount Rate

Cost of debt Estimated borrowing rate is 8.0% with a marginal tax of 30% results in
an after-tax cost of debt of 5.600%.

Cost of equity An average industry unlevered equity beta of .849 implies a levered
equity beta for Corus of 0.97 assuming a target debt ratio of 35% and a debt beta of
.618. Using the capital asset pricing model with a 10 year government security yield
of 4.60% and a market risk premium of 5.50% produces an estimate of the levered
cost of equity of 9.938%.

Weighted average cost of capital (WACC) Using the target debt to value ratio of
35% the WACC is approximately 8.420%.

Panel f. (Step 3) Calculate the Present Value of Future Cash Flows

Present Value of Expected Future Cash Flows
Terminal Value

Enterprise Value

Discount
Rate

Planning
Period FFCF

Method #1

Method #2

Method #1

Method #2

8.420%
10.000%
12.000%

1,996.66
1,873.52
1,731.80

9,040.26
6,651.08
4,775.62

7,757.49
7,112.34
6,383.53

11,036.92
8,524.60
6,507.42

9,754.15
8,985.86
8,115.33

Since the growth strategy initially has lower cash flows than the status quo strategy
but later generates much higher cash flows, its incremental value will depend on the discount
rate that is used to evaluate the strategy. In Panel e of Table 7-3 we show that the cost of
capital for the growth strategy is 8.420%, which is slightly lower than under the status quo
strategy (8.857%) because we assume a higher target capital structure (debt to enterprise
value ratio of 35% versus 22% under the status quo strategy). Although the cost of debt (8%)
is higher under the growth strategy, the net effect is a slightly lower cost of capital.
However, the growth strategy is almost certainly more risky than the status quo
strategy and should require a higher cost of capital. To evaluate how a higher cost of capital
will affect the value of the growth strategy, Panel f of Table 7-3 presents alternative values of
the growth strategy cash flows where the cost of capital is as high as 12%. Under the Gordon
growth method (Panel f, Table 7-3), the imputed enterprise value of 6507 million is well
below the EV of 7970.31 million. The EBITDA multiple method, however, yields an
enterprise value of 8115 million, which is slightly greater than the EV of 7970.31.
Sensitivity Analysis
The acquisition of Corus is a risky endeavor just like any investment proposal, so it is
important that we perform a sensitivity analysis of the proposal. In this instance, we will
limit ourselves to the use of breakeven sensitivity analysis although, as we illustrated in
Chapter 3, it is often helpful to construct a simulation model based on making estimates
concerning the random nature of the key value drivers.
We consider three important value drivers for the Corus acquisition under the growth
strategy: (i) to the cost of capital for the acquisition, (ii) the planned increase in EBITDA
margins due to savings in costs of goods sold and administrative costs during the planning
period and (iii) the terminal value multiple used to value the post-planning period cash flows.
If there is a slump in global steel prices, the effect on EBTIDA margins would be the same as
not realizing potential costs savings. Hence, item (ii) can be viewed as a representation of two
alternative forms of risk-one due to risk in steel prices and the other due to risk in realization
of potential cost savings. Both these factors can adversely affect EBITDA margins. Finally,
in the risk analysis that follows we focus our attention solely on the valuation that uses the
EBITDA multiple (Method #2) to estimate the terminal value.
Sensitivity analysis - Cost of Capital
The cost of capital, like all the value drivers, is always estimated with some error. However,
in this instance we have another reason to be concerned about the cost of capital estimate.
The growth strategy is a more risky strategy than the status quo strategy, which means that
the growth strategy cash flows should require a higher discount rate - but how much higher?
One approach we can take to addressing this issue is to explore the importance of the
discount rate to the valuation of Corus under the growth strategy. To do this, we can
calculate the internal rate of return (IRR) of the investment and ask whether it is plausible
that the appropriate discount rate exceeds the IRR.
We calculate the IRR for the acquisition based on the projected cash flows found in
Panel b in Table 7-3 (and a terminal value for 2012 equal to 6.7 times EBITDA2012) and the
7970.31 million in invested capital reflected in the asking price. The result is an estimated

IRR of 12.36%. Consequently, if the higher cost of capital for the riskier growth strategy
exceeds 12.36%, the acquisition should not be undertaken. Although the appropriate
discount rate for this investment is likely to be higher than the discount rate for the status quo
investment, it is quite unlikely that it exceeds 12.36%. In Panel e of Table 7-3 we noted that
Coruss estimated equity beta was 0.97, which produced a cost of equity of 9.938% and a
weighted average cost of capital of 8.420%. To generate a cost of capital of 12.36%, Coruss
equity beta would have to rise to 2.07, which is highly unlikely.
Sensitivity Analysis - EBITDA margins
Next we consider a breakeven sensitivity analysis of the synergies of the acquisition that give
rise to savings in costs of goods sold and administrative expenses. While we focus on cost
savings as the source of the increase in EBITDA margins over the planning period, our
results on sensitivity to EBITDA margins can also be interpreted as sensitivity to global steel
prices. Our analysis reveals that if the costs savings of 3000 million over the six-year
planning period drop to 2100 million the NPV of the acquisition drops from 1783 million
to 52 million.5 For the acquisition to be positive NPV, the savings in costs is a critical
factor. If the costs savings drop by more than 30% (from 3000 to 2100), the acquisition
becomes unviable.
Sensitivity Analysis - Terminal Value EBITDA Multiple
The final value driver we consider is the terminal value multiple (i.e., enterprise value
divided by EBITDA) that is used to estimate the terminal value of Corus in 2012. In our
earlier analysis we used a multiple of 6.70, which was the average purchase price multiple in
similar transactions. However, if we reduce this terminal value EBITDA multiple to 5.15, the
NPV of the acquisition for Tata Steel drops below zero.
Scenario Analysis
Up to this point we have considered three value-drivers (the discount rate, the amount of cost
savings, and the EBITDA multiple at the terminal date one at a time. This discussion
suggests that our conclusion about the attractiveness of the investment is not likely to change
if we alter anyone of the value drivers individually. However, there are scenarios in which all
three value-drivers differ from their expected values such that the Corus investment does
have a negative NPV.
For example, although we argued that a 12.36% discount rate is very unlikely, a 10%
discount rate is plausible. Similarly, one might assume that the planning period cost savings
may be 2700 rather than 3000. If these changes are made, then the terminal value
EBITDA multiple only has to drop to 6.22 times before the enterprise value of Corus under
the growth strategy drops to a level that results in a negative NPV project at the acquisition
cost of 6172.31 million. As the following table indicates, there are a number of plausible
scenarios under which the acquisition and implementation of the growth strategy might not
be value-enhancing. We present three such breakeven scenarios.
Value Driver

Initial
Parameters

Breakeven Scenarios

Negative
NPV
Scenario

Cost of
Capital
Cost Savings
during the
planning
period

Terminal
value
EBITDA
multiple

Scenario #1

Scenario #2

Scenario #3

Scenario #4

8.420%

10.000%

10.066%

9.000%

10.000%

3000

2700

2850

2589

2500

million

million

million

million

million

6.70 times

6.218 times

6 times

6 times

6.40 times

We also present a negative NPV scenario. For example, with a slightly less favorable
6.40 EBITDA multiple for our terminal value calculation the acquisition has an enterprise
value of 7810 million (i.e., becomes a negative NPV investment) if we combine this with a
just slightly less favorable assumption about the discount rate (10%) but somewhat more
significant reduction in the cost savings for the planning period (500 million less). As we
learned earlier in Chapter 3, reviewing likely but less favorable scenarios, which can lead to a
negative NPV, is a very powerful tool for learning about a projects investment potential.
The set of scenarios reviewed above are far from exhaustive, and we can always find
scenarios under which almost any investment has either a positive or negative NPV. What
this means is that the tools that we have developed are just that-decision tools-they provide
support and background for the actual decision maker, but they do not actually make the
decision. In this particular case, as is often true, the numbers provide some justification for
whether or not Tata Steel should go ahead with the acquisition of Corus. However, the
numbers also suggest that there are significant risks and the success of the acquisition will
depend on how the future unfolds. This will generally be the case-the tools provide
management with valuable information, but ultimately management must use their judgment
to make the decision.
7.3 USING THE APV MODEL TO ESTIMATE ENTERPRISE VALUE
Up to this point we have been using the traditional WACC approach of enterprise
valuation, which uses a constant discount rate to value the enterprise cash flows. While this
approach makes sense for valuing Corus prior to its acquisition, the constant discount rate is
inconsistent with the projected changes in the firms capital structure after Coruss
acquisition. A quick review of the debt ratios found in Figure 7-l indicates that the capital
structure weights (measured here in terms of book values) are not constant over time for
either the status quo or growth strategy. In other words, the use of a single discount rate is
problematic.

In situations in which the firms capital structure is expected to substantially change

over time, we recommend that the Adjusted Present Value, or APV approach, be used.
Introducing the APV Approach
The APV approach expresses enterprise value as the sum of the following two components:

Value of the
Value of the

Enterprise Value (APV Approach) Unlevered Equity Interest

(7.4)

Free Cash Flows Tax Savings

The first component is the value of the firms operating cash flows. Since the operating cash
flows are not affected by how the firm is financed, we refer to these cash flows as the
unlevered equity free cash flows. The present value of the unlevered equity free cash flows
represents the value of the firms cash flows under the assumption that the firm is 100%
equity financed. The second component on the right hand side of Equation 7.4 is the present
value of the interest tax savings associated with the firms use of debt financing. The basic
premise of the APV approach is that debt financing provides a tax benefit because of the
interest tax deduction.6 By decomposing firm value in this way, the analyst is forced to deal
explicitly with how the financing choice influences enterprise value.
Using the APV Approach to Value Corus under the Growth Strategy
The APV approach is typically implemented using a procedure very similar to what we did to
estimate the enterprise value using the traditional WACC approach found in Equation 7.1 and
is described verbally in Equation 7.4a.

Value of the
Value of the
Unlevered Equity
Planning Period
Enterprise Value (APV Approach)

Free Cash Flows

Interest

for the Planning Period Tax Savings

Present Value

of the Estimated
Terminal Value

(7.4a)

That is, we make detailed projections of cash flows for a finite planning period and then
capture the value of all cash flows after the planning period in a terminal value. The principal
difference between the APV and traditional WACC approaches is that with the APV
approach we have two cash flow streams to value: the unlevered equity cash flows and the
interest tax savings.
Technically, the second term can be an amalgam that captures all potential side effects of
the firms financing decisions. In addition to the interest tax savings, the firm may also
realize financing benefits that come in the form of below market or subsidized financing. For
example, when one firm acquires assets or an operating division from another, it is not
uncommon for the seller to help finance the purchase with a very attractive loan rate.
6

Figure 7-2 summarizes the implementation of the APV approach in three steps: First, we
estimate the value of the planning period cash flows in two components: unlevered equity (or
operating) cash flows, and interest tax savings resulting from the firms use of debt financing.
In step two we estimate the residual or terminal value of the levered firm at the end of the
planning period, and finally, in Step 3, we sum the values of the planning period cash flows
and the terminal value to estimate the enterprise value of the firm.
Step 1: Estimate the value of the planning period cash flows
The planning period cash flows are comprised of both the unlevered equity free cash flows
and the interest tax savings. We value these cash flows for Corus using two separate
calculations. Equation (7.5) shows how we value the unlevered equity cash flows for the
planning period (PP):

Value of the
Planning Period
PP
FFCFt
Unlevered Equity
t 1 1 kUnlevered t

(7.5)

Free Cash Flows

Applying Equation 7.5 to the valuation of Coruss operating cash flows for the planning
period (2007 - 2012) summarized in Table 7.4 for the growth strategy case, we estimate a
value of 1929.15 million:

77.37
206.37
324.98
Value of theUnlevered Equity Free Cash Flows

1
2
3
1 .0927 1 .0927 1 .0927
577.46

760.83

1 .0927 4 1 .0927 5

924.14
1 .0927 6

This valuation is based on an estimate of the unlevered cost of equity equal to 9.27%. We
estimate the unlevered cost of equity in Figure 7-3 using the procedure described in Table 4-1
of Chapter 4 where we estimated the firms WACC and again in Chapter 5 to estimate a
projects cost of capital. The estimated unlevered beta for Corus is .849, which when
combined with a 10-year government security yield of 4.60% and a 5.50% market risk
premium, generates an unlevered cost of equity of 9.27%.
Next we calculate the value of the interest tax savings for the planning period as
follows:
Value of the
Planning Period

PP Interest Expenset X Tax Rate

1 r t
t 1

Interest Tax Savings

where r is the firms borrowing rate. Substituting Coruss interest tax savings for the growth
strategy (found in Table 7-4) into Equation 7.6 produces a 519.66 million estimate for the
value of its planning period interest tax savings.

Note that we are holding everything constant except the savings in cost in this analysis. For
instance, the growth rate in sales is still assumed to be 5% and the discount rate is still
assumed to be 8.420%.
Using the Adjusted Present Value (APV) Model to Estimate Enterprise
Step 1: Estimate the Value of the planning period cash flows
Evaluation of Operating (unlevered) Cash Flows
Definition: Unlevered Formula:Equity Free Cash
Flows = Firm or
Project Free Cash
Flows
Net
Income

Operating

Less: Taxes

PP

FFCF1
1
t 1 (1 kunlevered)

Value of Planning Period

Unlevered Equity
Cash Flows

Net Operating Profit

After
Taxes FFCF1 = Firm Free Cash Flow (equals equity
(NOPAT)
unlevered firm)

free cash flow for the

Plus:
Depreciation Kunlevered = Discount rate for project cash flows (unlevered equity)
Expense
PP = Planning Period
Less:
Capital
Expenditures (Capex)
Less: Increases in Net
Working Capital
Equals
Unlevered
Equity Free Cash
Flows (=FFCF)
Evaluation of the Interest Tax Savings
Definition : Interest Formulas:Tax Savings
Interest tax savings in
PP Intertest Expense x Tax Rate
Value
of
the
Interest
Tax
Savings

year t = Interest
(1 r )1
t 1

Expense in year t x
Tax Rate
PP = Planning Period
r = firms borrowing rate
Step 2: Estimate the value of the levered firm at the end of the planning period (i.e., the

terminal value)
Evaluation of the Terminal Value
Definition: Terminal
Value of firm is equal
to the enterprise value
of the levered firm at
the end of the planning
period

Formulas:Terminal Value of the Levered FirmPP

FFCFpp(1 g)
kwacc g

FFCFpp = firm free cash flow for the end of the planning period

Kwacc = weighted average cost of capital

Assumptions:- After
the planning period the g = rate of growth in FFCF after the end of the playing period in
firm
maintains
a perpetuity
constant proportion.1.
of debt in its capital
structure. The firms
cash flows grow at a
constant rate g which
is less than the firms
weighted average cost
of capital forever.

Step 3 : Sum the estimated values for the planning period and terminal period cash flows

pp
pp Interest Expense x Tax Rate
FFCF 1

APV model of Enterprise Value

1
t 1 (1 Kunlevered)1 t 1

(1 r)
pp
FFCF pp (1 g)
1

g
kwacc
1 kunleverred

Step 1 : Value of Planning Period Cash Flows

Step 2: Value of the Terminal Period cash

Flows

Figure 7-3
Coruss Cost of Capital Assumptions:
Assumptions:
1.

The risk free rate is 4.60%.

2.

The market risk premium is 5.50%. (Source: Elroy Dimson, Paul Marsh, and Mike
Staunton, Global Evidence on the Equity Risk Premium, Journal of Applied
Corporate Finance 15 (Fall 2003), pp. 27-38.)

3.

The corporate tax rate is 30%.

4.

The asset beta (or unlevered equity beta) is 0.849.

5.

Under the status quo strategy, the target capital structure is given by a debt to
enterprise value ratio of 22% and the cost of debt is 6%.

6.

Under the growth strategy, the target capital structure is given by a debt to enterprise
value ratio of 35% and the cost of debt is 8%.

Step 1. Compute unlevered cost of equity: Substitute the unlevered equity beta into the
CAPM to estimate the unlevered cost of equity for the subject firm. Given a risk free
rate of 4.60% and a market risk premium of 5.50%, we get an estimated cost of equity
for an unlevered investment of 9.27%, i.e.,
Kunlevered equity = Risk-free rate + unlevered (Market-risk premium)
Kunlevered equity = .0460 + .849 x .0550 = .09727 or 9.27%
Step 2. Compute levered cost of equity and weighted average cost of capital: *Relever the
asset beta of 0.849 using the following equation**for levering and unlevering betas. For the
status quo case, the relevering is based on a target capital structure (debt to enterprise value
ratio of 22%) and a cost of debt of 6%. For the growth case, the debt to enterprise value
ratio is 35% and the cost of debt is 8%.

r
r

1 1 TX
L - 1 TX

L debt

levered
unlevered
1 r
1 r
(7.7)
where unlevered, levered, and debt are the betas for the firms unlevered and levered equity, plus
its debt. The cost of debt is r. T is the corporate tax rate, and L is the debt to equity ratio.
Finally,
one
can
find
the
weighted
average
cost
of
capital
as
L
L
kWACC
Lr 1 T
Ke
1 L
1 L

Status Quo Strategy

levered equity beta

Growth Strategy
1.02

0.97

levered cost of equity (CAPM)

10189%

9.938%

WACC

8.857%

8.857%

The weighted average cost of capital and the levered cost of equity can also be related to the
unlevered cost of equity capital by using the following relationships (L denotes the debt to
equity ratio, r is the cost of debt):

L 1 kunlevered
r

k
k
rT
and k k
k
r 1 T
L
WACC
unlevered
e
unlevered
unlevered
1 L
1 r
1 r

This relationship captures the effects of financial leverage on the firms beta coefficient. It
is a more general version of a similar formula discussed in Chapter 4 and Chapter 5. It
applies in the setting where the firm faces uncertain perpetual cash flows, corporate are taxed,
corporate debt is risky (i.e., debt betas are greater than zero), and the firms use of financial
leverage (i.e., the debt to equity ratio, L) is reset to a constant level every period. For a
derivation of this equation see E. Arzac and L. Glosten, A Reconsideration of Tax Shield
Valuation, Unpublished Manuscript, 2004.
**

Coruss Operating and Financial Cash Flows for the Planning Period
[All figures in millions]
Panel a. Unlevered Equity Free Cash Flows (same as FFCF)
Unlevered Equity Free Cash Flows

2007

2008

2009

2010

2011

2012

Status Quo Case

276.67

339.94

351.04

414.97

426.74

438.87

Growth Strategy Case

77.37

206.37

324.98

577.46

760.83

924.14

2007

2008

2009

2010

2011

2012

Status Quo Case

32.26

29.56

25.57

21.26

15.70

9.74

Growth Strategy Case

108.63

114.20

117.18

117.71

112.60

103.14

Panel b. Interest Tax Savings

Interest Tax Savings

108.63 114.20 117.18

Value of thePlannin g Period Interest Tax Savings

1
2
3
1 .08 1 .08 1 .08
117.71

1 .08

112.60

1 .08

103.14
1 .08 6
519.66

The combined value of operating cash flows and interest tax savings for the planning period
under the growth strategy, then, is 2448.81 million ( = 1929.15 + 519.66).
Step 2: Estimate Coruss Term of Value
The terminal value calculation for the APV approach is identical to the calculation we made
for our WACC analysis. As we previously stated, at the terminal date. Coruss cash flows
are assumed to grow at a constant rate of 2% per year and its capital structure will revert to a
constant mix of debt and equity such that the debt to value ratio would be 35%. Therefore,
we can use the Gordon Growth Model to estimate the terminal value of the levered firm at the
end of the planning period (pp) as follows:
Terminal Value of the Levered Firm pp

FFCFpp(1 g)
g
kWACC

(7.7)

Coruss FFCFpp in 2012 (which is the end of the planning period) is equal 924.14 (see Table
7-4) and this FFCF is expected to grow at a rate of 2% in perpetuity, and the weighted
average cost of capital (kwacc) is 8.420%.7 Using Equation 7.7 we estimate the terminal value
for Corus in 2012 as follows:
Terminal Value of
the Levered Firm

2012

924.14 1.02
14683.50
.0842 .02

We have one remaining calculation to make in order to value Coruss terminal value.
We need to discount the terminal value estimated in Equation 7.7 back to the present using
the unlevered cost of equity, i.e.,
Present Value of the
Terminal Value 2006

924.14 1 .02
1

.0842 .02 1 .0927 6

$8626.50

To complete the valuation of Corus using the APV method we now sum the value of the
planning period and terminal value in the final step.
Step 3. Summing the Values of the Planning Period and Terminal Period
Using the APV approach we estimate the enterprise value of the firm as the following sum:

PP
PP
Interest Expenset X Tax Rate
FFCF1
Enterprise Value (APV Approach)

t
1 r t

t 1 1 kUnlevered t 1
pp
FFCF 1 g

1
PP

K wacc g 1 kUnlevered
Step 1: Value of Planning Period Cash Flows

Step 2 :Value of the Terminal Period Cash Flows

(7.4a)

Substituting for the two components, we estimate Coruss enterprise value using the APV
model to be 11,075.31 million, i.e.,
Enterprise Value (APV Approach) = 1929.15 + 519.66 + 8626.50 = 11,075.31
This estimate is very nearly equal to the estimates of Coruss enterprise value found in Panel
c of Table 7-3 using the traditional WACC model (at 11037 million). However, for those
cases where the capital structure of the firm is expected to change dramatically over the
planning period, the APV model provides a preferred method for estimating enterprise value.
7

The weighted average cost of capital can also be related to the unlevered cost of equity
capital by using the following relationship:

L 1 kUnlevered
k
k
r TaxRate
WACC
Unlevered d

1 L
1 r

.35 1 .0927
k
0947 .08X.30X
X
.0842or8.420%
WACC
1 .35 1 .08
Where L is the ratio of debt to equity ratio.
Using an EBITDA Multiple to Calculate the Terminal Value
Using preceding application of the APV approach to the estimation of Coruss enterprise
value used the discounted cash flow (DCF) approach to value both the planning period value
and the post planning period terminal value. What typically happens in practice, however, is
that a market-based multiple is used to estimate the value of the post-planning period cash
flows. Equation 7.4b defines the APV approach of enterprise value as the sum of the present
values of the planning period cash flows (i.e., both the unlevered cash flows of the firm8 and
the interest tax savings) plus the terminal value of the firm which is estimated using the
EBITDA multiple,.

The values of the two planning period cash flow streams for Corus under the Growth Strategy
were estimated earlier in Table 7-4, and equal 924.15 for the operating cash flows and
519.66 for the interest tax savings. Using the 6.70 times multiple of EBITDA from our
previous analysis and the estimated EBITDA for 2012 (found in Table 7-3), we calculate
Coruss terminal value cash flow as follows:
EBITDA for 2012 is found in Table 7-3 by summing the 1822.59 million EBITDA from
operations, with the 58.00 million from other income to get 1880.59 million. Multiplying
this EBITDA estimate by 6.70 produces an estimate of the terminal value in 2012 of
12599.95 million. Discounting the terminal value back to the present using the unlevered
cost of equity we get 7402.44. To complete the estimate of enterprise value using the hybrid
APV we simply substitute our estimates of the values of the cash flow streams into Equation
7.4b as follows:
This value is slightly lower than our earlier estimate because in this case the EBITDA
multiple provided a more conservative estimate of Coruss terminal value.
Table 7-5 summarizes the APV estimates of enterprise value for the status quo and growth
strategies using our two methods for estimating terminal value.
8

Recall from Chapter 2 that the unlevered cash flows of a firm are simply the cash flows that
the firm would realize if it uses no debt financing. Furthermore, these unlevered cash flows
are the same as the firm free cash flows (FFCF) calculated earlier to value the firm using the
traditional WACC model. However, in the APV model we discount the FFCFs using the
unlevered cost of equity capital (i.e., the equity discount rate appropriate for a firm that uses
no debt financing) and then account for the value of the firms interest tax savings as a
separate present value calculation.
Table 7-5

APV Valuation Summary for Corus for Status Quo and Growth Strategies [All Figure in
Millions]
Panel a. Status Quo Case
APV Estimate of Enterprise Value
APV Calculation
of Planning
Period Cash
Flow
Unlevered equity free cash
flow

1,629.85

Interest Tax Savings

1,743.60

Total

5,187.23
113.75

3,557.38

5,300.98

of
APV Calculation
of Planning
Period Cash
Flow

Unlevered equity free cash

flow

1,629.85

Interest Tax Savings

EBITDA Multiple
Terminal Value

3,957.11

113.75

Total
Hybrid APV Estimate
Enterprise Value

3,557.38

113.75

Total
Hybrid APV Estimate
Enterprise Value

DCF Estimates of
Terminal Value

1,743.60

Total

5,586.96
113.75

3,957.11

5,700.71

of

Panel b. Growth Strategy Case

APV Estimate of Enterprise Value

APV Calculation
of Planning
Period Cash
Flow
Unlevered Equity free cash
flow
Interest Tax Savings

1,929.15
519.66

DCF Estimates of
Terminal Value

8,626.50

Total

10,555.65
519.66

Total

2,448.81

8,626.50

11,075.31

Hybrid APV Estimate of Enterprise Value

APV Calculation
of Planning
Period Cash
Flow
Unlevered Equity free cash
flow
Interest Tax Savings

EBITDA Multiple
Terminal Value

1,929.15

Total

7,402.44

9,331.59

519.66

Total

2,448.81

519.66
7,402.44

9,851.25

Comparing the WACC and APV Estimates of Coruss Enterprise Value

Table 7-6 combines our estimates of Coruss enterprise value using both the traditional
WACC approach and the APV approach. Although the estimates are not exactly the same,
they are surprisingly similar. The growth strategy clearly dominates the status quo strategy.
Also, the acquisition price of 6172.31 million cannot be justified under the status quo
strategy. It is only under the growth strategy that such a high acquisition price can be
acceptable.
Summary of WACC and APV Estimates f Corus's
Enterprise Value [All figures in millions]
Status quo strategy

Traditional WACC

APV

Terminal Value
* Gordon Growth Model

5,290.76

5,300.98

* EBITDA Multiple

5,699.67

5,700.71

Growth strategy

Traditional WACC

APV

Terminal Value
* Gordon Growth Model
* EBITDA Multiple

11,036.92

11,075.31

9,754.15

9,851.25

In this particular application of the WACC and APV valuation approaches the results are for
all practical purposes the same. In practice, the capital structure changes much more
dramatically in an LBO transaction because debt levels have to be brought down within a
short span of time. Even in the Tata-Corus transaction, the final terms of loan agreements
mandated that about a third of the debt amount should be paid back on an annual amortized
basis within five years. The effects caused by very dramatic changes in debt financing over
the life of the investment can lead to meaningful differences in the results of the two

valuation approaches. and in these instances the APV approach has a clear advantage in that
it can more easily accommodate the effects of changing capital structure.
The EBTTDA multiple used in the valuation of Corus produced results that were very similar
to the DCF estimate and this is purely an artifact of the particular choices made in carrying
out this valuation. Due to the importance of the terminal value to the overall estimate of
enterprise value we recommend that both approaches be used and that when selecting an
EBITDA multiple. close attention be paid to recent transactions involving closely comparable
firms. The advantage of the EBITDA multiple in this setting is that it ties the analysis of more
distant cash flows back to a recent market transaction. However, the EBITDA multiple
estimate or terminal value should be compared to a DCF estimate using the analysts
estimates of reasonable growth rates as a test or the reasonableness of the terminal value
estimate based on multiples.
A Brief Summary of the WACC and APV Valuation Approaches
The following grid provides a summary of the salient features of the traditional WACC and
APV approaches. As we have discussed, the traditional WACC method is the approach that
is used in practice. However, when the capital structure of the firm being valued is likely to
be changing over time the APV is the preferred approach.

Object of the
Analysis

Cash Flow
calculation

Discount Rate(s)

How Capital Structure

Effects Are Dealt withDiscount Rates, Cash
Flows, or Both

Adjusted Present Value

(APV Method
Enterprise value as the sum
of the values of:

The unlevered equity

cash flows, and

Financing
side
effects

Unlevered
equity
free cash flows (i.e. firm free
cash flows), plus

Interest tax savings

Unlevered
equity
cash flows-cost of equity for
unlevered firm, and

Interest tax savingsthe yield to maturity on the

firm's debt
Cash flows Capital
structural affects the present
value of the interest tax
savings only. The value of
the unlevered firm is not
affected by the firm's use of
debt financing.

Traditional WACC Method

Enterprise value equal to the
present value of the firm's
capital cash flows discounted
using the after-tax WACC

Firm free cash flows (FFCF)

After tax weighted average

cost of capital (WACC)

Discount rate The debtequity mix in the firm's

capital structure affects the
firm's WACC. However, the
mix of debt and equity is
assumed to be constant
throughout the lift of the
investment.

Valuation
Models

Enterprise Value
Enterprise Value
Enterprise Value = Value of the
FFCF
00
t
Unlevered Firm + Value of Interest EnterpriseValue
t
t 1 1 k
Tax Savings
WACC
Unlevered
Where
oo EFCFt

t
t 1 1 k
FFCFt = firm free cash flow for yeart
Unlevered
oo InterestxTaxRate

kWACC = the firm's weighted average
t
t 1 1 k
cost of capital
Debt
Where
EFCFtUnlevered = equity free cash
flows for an unlevered firm (same as
FFCFt).
Ku = cost of equity for an unlevered
firm
User's Guide

Choosing Although not as popular as the

the Right traditional WACC method, this
Model
approach is gaining support and is
particularly attractive when valuing
highly leveraged transactions, such
as LBOs where capital structure is
not stationary through time.

Most widely used methodology for

valuing
individual
investment
projects (capital budgeting) and entire
firms. Since the discount rate (the
WACC) assumes constant weights for
debt and equity, this method is not
well suited for situations where
dramatic changes in capital structure
are anticipated (e.g., LBOs).

Estimating the value of subsidized Debt Financing

In our preceding example, financing affects firm value only through its effect on interest tax
savings. However, it is not uncommon for the seller of a business to offer an incentive to the
buyer in the form of below-market-rate debt financing. To illustrate how we might analyze
the value of below-market financing consider the $40 million loan offer outlined in Table 77. Although the current market rate for such a loan is 6.5%, the loan carries an interest rate of
5%, which implies a 1.5% reduction in the rate of interest charged on the loan. The loan
requires that the firm pay only interest, and no principal is due until maturity. Consequently,
the required payments consist of $2 million per year in interest payments over the next five
years and, in the fifth year (the year in which the loan matures) the full principal amount of
$40 million is due and payable.
To value the subsidy associated with the below-market rate financing, we calculate that the
present value of the payments, using the current market rate of interest, is only $37,506,592,
which indicates that the financing provides the borrower with a subsidy worth $2,493,407! In
essence, the seller has reduced the selling price of the firm or asset being sold by two and a
half million dollars as an incentive to the buyer.

Summary
Using discounted cash flow analysis (DCF) to value s firm is a straightforward extension of
its use in project valuation. The added complexity of firm valuation comes largely from the
fact that the time horizon of firm cash flows is indefinite while project cash flows are
typically finite. In most cases, analysts solve this problem by estimating the value of cash
flows in what is referred to as a planning period using standard DCF analysis, and then using
the method of comparables or multiples (as introduced in Chapter 6) to calculate what is
generally referred to as the terminal value of the investment. In most cases, the planning
period cash flows and terminal value estimates are discounted using the investments
weighted average cost of capital.

Table 7-7

The Value of Subsidized Debt Financing

Given:
Loan amount

$ 40,000,000

Current market rate

6.5%

Cost of debt (Subsidized)

5.0%

Term of loan

Type of loan

Interest only
2007

Interest
Payments
Principal
payment

$ 2,000,000

2008

2009

$ 2,000,000

$ 2,000,000

Present value of
payments
Value of loan
subsidy

$ 2,000,000

2011
$ 2,000,000
$ 40,000,000

$ 2,000,000 $ 2,000,000
Total
Evaluation of Subsidized Loan:

Cash received

2010

$ 2,000,000

$ 2,000,000

$ 42,000,000

$ 40,000,000
37,506.592
2,493.407

As we have noted, the WACC approach that we described in the first half of this chapter is
widely used throughout industry to value businesses. However, it should be emphasized that
this approach requires a number of implicit assumptions, which may be difficult to justify in

most applications. In particular, the analysis assumes that the risks of the cash flows do not
change over time and that the firms financial structure does not change. For this reason we
would again like to add our usual caveat that the tools that we present are imperfect and
should be viewed as providing support for management and not a substitute for management
judgment.
The second half of the chapter considered the case where the debt ratio of the acquired
business changes over time. When this is the case, the APV approach provides an
improvement over the WACC approach. Although this approach is not frequently used by
industry practitioners, we expect that over time it will become more popular.
PROBLEMS
7.1 ENTERPRISE VALUATION-TRADITIONAL WACC MODEL
Canton Corporation is a privately owned firm that engages in the production and sale of
industrial chemicals primarily in North America. The firms primary product line consists of
organic solvents and intermediates for pharmaceutical, agricultural, and chemical products.
Cantons management has recently been considering the possibility of taking the company
public and has asked the firms investment banker to perform some preliminary analysis of
the value of the firms equity.
To support its analysis, the investment banker has prepared pro forma financial statements for
each of the next four years under the (simplifying) assumption that firm sales are flat (i.e.,
have a zero rate of growth), the corporate tax rate equals 30%, and capital expenditures are
equal to the estimated depreciation expense. In addition to the financial information on
Canton, the investment banker has assembled the following information concerning current
rates of return in the capital market
Canton Corporation Financials

Current assets
Property, plant and
equipment
Total
Accruals and payables
Long-term debt
Equity
Total

0
$ 15,000
40,000
$ 55,000
$ 5,000
25,000
25,000
$ 55,000

Pro Forma Balance Sheets ($000)

1
2
3
4
$ 15,000 $ 15,000 $ 15,000 $ 15,000
40,000
$ 55,000
$ 5,000
25,000
25,000
$ 55,000

40,000
$ 55,000
$ 5,000
25,000
25,000
$ 55,000

40,000
$ 55,000
$ 5,000
25,000
25,000
$ 55,000

40,000
$ 55,000
$ 5,000
25,000
25,000
$ 55,000

Pro Forma Income Statements ($ 000)

Sales
Cost of goods sold
Gross profit
Operating expenses (excluding
Depreciation)

1
$ 100.00
(40,000)
$ 60,000
(30,000)

2
$100,000
(40,000)
$ 60,000
(30,000)

3
$ 100,000
(40,000)
$ 60,000)
(30,000)

4
$100,000
(40,000)
$ 60,000)
(30,000)

Depreciation expenses
Operating Income (earnings before
Interest and taxes)
Less: Interest expense
Earnings before taxes
Less: taxes
Net Income

(8,000)
$ 22,000

(8,000)
$ 22,000

(8,000)
$ 22,000

(8,000)
$ 22,000

(2,000)
$ 20,000
(6,000)
$ 14,000

(2,000)
$ 20,000
(6,000)
$ 14,000

(2,000)
$ 20,000
(6,000)
$ 14,000

(2,000)
$ 20,000
(6,000)
$ 14,000

The current market rate of interest on 10-year Treasury bonds is 7%, and the market
risk premium is estimated to be 5%.
Canton's debt currently carried a rate of 8%, and this is the rate the firm would have to
pay for any future borrowing as well.
Using publicity traded firms as proxies, the estimated equity beta for Canton is 1.60.

a. What is Canton's cost of equity capital? What I the after-tax cost of debt for the firm?
b. Calculate the equity free cash flows for Canton for each of the next four year. Assuming that
equity free cash flows are a level perpetuity for Years 5 and beyond, estimate the value of
Canton's equity. (Hint: Equity value is equal to the present value of the equity free cash
flows discounted at the levered cost of equity.) If the market rate of interest on Canton's
debt is equal to the 8% coupon, what is the current market value of the firm's debt? What
is the sum of the estimated values of the firm's interest-bearing debt plus equity.)
c. Using the market values of Canton's debt and equity calculated in part b above, calculate the
firm's after-tax weighted average cost of capital Hint:

WACC

1 Tax
Cost of Debt
Rate

Debt Value

Enterprise Value

Equity Value

Cost of Levered Equity

Enterprise Value
d. What are the firm free cash flows (FFCFs) for Canton for years 1 through 4?
e. Estimate the enterprise value of Canton using the traditional WACC model based on your
previous answers and assuming that the FFCFs after Year 4 are a level perpetuity equal to

the Year 4 FFCF. How does your estimate compare to your earlier estimate using the sum
of the values of the firms debt and equity?
f. Based on your estimate of enterprise value, what is the value per share of equity for the
firm if the firm has two million shares outstanding (remember that your calculations to
this point have been in thousands of dollars.)
ENTERPRISE VALUATION APV MODEL This problem uses the information from
Problem 7-1 about Canton Corporation to estimate the firms enterprise value using the APV
model.
a.
What is the firm's unlevered cost of equity ?
b.
What are the unlevered equity free cash flows for Canton for Years 1 through 4?
(Hint: The unlevered equity free cash flows are the same as the firm free cash flows.)
c.
What are the interest tax savings for Canton Corp. for Years 1 through 4 ?
d.
Assuming that the firms future cash flows from operations (i.e., its FFCFs) and its
interest tax savings are level perpetuities for Years 5 and beyond that equal their Year 4
values, what is your enterprise value of Canton Corp ?

e.
Based on your estimate of enterprise value, what is the value per share of equity for
the firm if the firm has two million shares outstanding? (Remember that your calculations to
this point have been in thousands of dollars.)
7-3 APV VALUATION The following information provides the basis for performing a
straightforward application of the adjusted present value (APV) model.
Years
Firm free cash flows
Interest-bearing debt
Interest expense
Interest tax savings

4 & Beyond

$100.00
200.00
16.00
4.80

$120.00
150.00
12.00
3.60

$180.00
100.00
8.00
2.40

$200.00
50.00
4.00
1.20

Legend
Unlevered cost of equity the rate of return required by stockholders in the company, where
the firm has used only equity financing.
Borrowing rate the rate of interest the firm pays on its debt. We also assume that this rate
is equal to the current cost of borrowing for the firm or the current market rate of interest.
Tax rate the corporate tax rate on earnings. We assume that this tax rate is constant fr all
income levels.
Current debt outstanding - Total interest-bearing debt excluding payables and other forms of
non interest bearing debt, at the time of the valuation.
Firm free cash flows-Net operating earnings after tax ( OPAT). plus depreciation (and other
noncash charges), less new investments in net working capital less capital expenditures
(CAPEX) for the period. This is the free cash flow to the unlevered firm since no interest or
principal are considered in its calculation.
Interest-bearing debt-Outstanding debt at the beginning of the period, which carries an
explicit interest cost.
Interest expense-Interest-bearing debt for the period times the contractual rate of interest that
the firm must pay.
Interest tax savings-Interest expense for the period times the corporate tax rate.
a.
What is the value of the unlevered firm, assuming that its free cash flows for Years 5
and beyond are equal to the Year 4 free cash flow?
b.
What is the value of the firms interest tax savings, assuming that they remain
constant for Years 4 and beyond?
c.
What is the value of the levered firm?
d.
What is the value of the levered firms equity (assuming that the firms debt is equal
to its book value)?

TERMINAL VALUE ANALYSIS Terminal value refers to the valuation attached to the
end of the planning period and which captures the value of all subsequent cash flows.
Estimate the value today for each of the following sets of future cash flow forecasts:
a.
Claymore Mining Company anticipates that it will earn firm free cash flows (FFCFs)
of $r million per year for each of the next five years. Moreover, beginning in Year 6, the firm
will earn WACCs of $5 million per year for the indefinite future. If Claymore's cost of
capital is 10%, what is the value of the firm's future cash flows?
b.
Shameless Commerce Inc. has no outstanding debt and is being evaluated as a
possible acquisition. Shamelesss FFCFs for the next five years are projected to be $1 million
per year and beginning in Year 6, the cash flows are expected to begin growing at the
anticipated rate of inflation which is currently 3% per annum. If the cost of capital for
Shameless is 10%, what is your estimate of the present value of the FFCFs?
c.
Dustin Electric Inc. is about to be acquired by the firms management from the firms
founder for $15 million in cash. The purchase price will be financed with $ 10 million in
notes that are repaid in $2 million increments over the next five years. At the end of this fiveyear period, the firm will have no remaining debt. The FFCFs are expected to be $3 million a
year for the next five years. Beginning in Year 6, the FFCFs are expected to grow at a rate of
2% per year into the indefinite future. If the unlevered cost of equity for Dustin is
approximately 15% and the firms borrowing rate on the buyout debt is 10% (before taxes at
a rate of 30%) what is your estimate of the value of the firm?
7-5. ENTERPRISE VALUATION TRADITIONAL WACC VERSUS APV
Answer the following questions for the Canton Corporation described in Problem 7-1 where
firm revenues grow at a rate of 10% per year during Years 1 through 4 before leveling out at
no growth for Years 5 and beyond. You may assume that Canton maintains equal dollar
amounts of long-term debt and equity to finance its growing needs for invested capital.
Also assume that the cost of unlevered equity in this case is 13.84% and the cost of levered
equity is 15.28%. The cost of debt remains at 8%. The corporate tax rate is 30%.
a. Calculate the enterprise value using the adjusted present value method.
b. From part a, calculate the value of equity after deducting the value of debut from
enterprise value. Use these market values as weights to compute the weighted
average cost of capital.
c. Value the firm's free cash flows using the WACC approach.
d. Compare your enterprise value estimates for the two discounted cash flow models.
Which of the two models do you feel suits the valuation problem posed for Canton?
7-6 TERMINAL VALUE AND THE LENGTH OF THE PLANNING PERIOD The
Prestonwood Development Corporation has projected its cash flows (i.e. firm free cash
flows) for the indefinite future under the following assumptions: (1) Last year the firm's
FFCF was $1 million and the firm expects this to grow at a rate of 20% for the next 8 years;
(2) beginning Year 9, the firm anticipates that its FFCF will grow at a rate of 4%
indefinitely; and (3) the firm estimates its cost of capital to be 12%. Based on these
assumptions, the firm's projected FFCF over the next 20 years is the following:

Years

Cash Flows (millions)

1.2000

1.4400

1.7280

2.0736

2.4883

2.9860

3.5832

4.2998

4.4718

10

4.6507

11

4.8367

12

5.0302

13

5.2314

14

5.4406

15

5.6583

16

5.8846

17

6.1200

18

6.3648

19

6.6194

20

6.8841

a.
Based on the information given and a terminal value estimate for the firm of $89.4939
million for Year 20, what is your estimate of the firm's enterprise value today (in 2006)?
b.
If a three-year planning period is used to value Prestonwood, what is the value of
planning period cash flows and the present value of the terminal value at the end of year 3?
c.
Answer part b for planning periods of 10 and 20 years. How does the relative
importance of the terminal value change as you lengthen the planning period?
7-7 MINI-CASE APV VALUATION
Flowmaster Forge Inc. is a designer and manufacturer of industrial air handling equipment
that is a wholly owned subsidiary of Howden Industrial Inc. Howden is interested in selling
Flowmaster to an investment group formed by company CFO Gary Burton.

Burton prepared a set of financial projections revenues were estimated to be $160

ownership. For the first year of operations, firm revenues were estimated to be $ 160
million, variable and fixed operating expenses (excluding depreciation expense) were
projected to be $ 80 million, and depreciation expense was estimated to be $15 million.
Revenues and expenses were projected to grow at a rate of 4% year in perpetuity.
Flowmaster currently has $125 million in debt outstanding that carries an interest rate of 6%.
The debt trades at par (i.e., at a price equal to its face value). The investment group intends
to keep the debt outstanding after the acquisition is completed, and the level of debt is
expected to grow by the same 4% rate as firm revenues.
Projected income statements for the first three years of operation of Flowmaster following
the acquisition are as follows ($millions):
Pro Forma Income Statements
Year 1

Year 2

Year 2

Revenues

$160.00

$166.40

$173.06

Expenses

(80.00)

$(83.20)

$ (86.53)

Depreciation (note 1)

(15.00)

$ (15.60)

$ (16.22)

Earnings before interest and taxes

$ 65.00

$ 67.60

$ 70.30

(7.50)

(7.80)

(8.11)

Earnings before taxes

$ 57.50

$ 59.80

$ 62.19

Taxes (34%)

(19.55)

(20.33)

(21.15)

Net Income

$ 37.95

$ 39.47

$ 41.05

Interest expense (note 2)

Note 1 Property, Plant, and equipment grow at the same rate as revenues such that
depreciation expenses grow at 4% per year.
Note 2 The initial debt level of $ 125 million is assumed to g row with firm assets at a rate
of 4% per year.
This problem was written and contributed by Professor Scott Gibson, College of William and
Mary, Williamsburg, Virgina.
Burton anticipates that efficiency gains can be implemented that will allow Flowmaster to
reduce its needs for net working capital. Currently Flowmaster has net working capital equal
to 30% of anticipated revenues for Year 1. He estimates that for Year 1, the firms net
working capital can be reduced to 25% of Year 2 revenues, then 20% of revenues for all
subsequent years. Estimated net working capital for Years 1 through 3 is as follows ($
millions):
Current

Pro Forma

Net working capital (t - 1)/Revenues (t)

Net working capital

30%

25%

20%

20%

$ 48.00

$ 41.60

$34.61

$ 36.00

To sustain the firms expected revenue growth, Burton estimates that annual capital
expenditures will be required that equal the firms annual depreciation expense.
Gary Burton had been thinking for some time about whether to use Howdens corporate cost
of capital of 9% to value Flowmaster and had come to the conclusion that an independent
estimate should be made. To make the estimate, he collected the following information on
the betas and leverage ratios for three publicly traded firms with manufacturing operations
that are very similar to Flowmasters:
Company

Leveraged

Debt Beta

Equity

Leverage
Ration*

Revenues**
($ millions)

Beta
Gopher Forge

1.61

0.52

0.46

$400

Alpha

1.53

0.49

0.44

380

Global
Diversified

0.73

0.03

0.15

9,400

a.
Calculate the unlevered equity cash cash flows (i.e. the firm free cash flows for
Flowmaster for Years 1-3).
b.
Calculate the unlevered cost of equity capital for Flowmaster. The risk free rate of
interest is 4.5% and the market risk premium is estimated to be 6%.
c.
Calculate the value of Flowmasters unlevered business.
d.
What is the value of Flowmasters interest tax savings, based on the assumption, that
the $125 million in debt remains outstanding (i.e., the investment group assumes the debt
obligation) and that the firms debt and consequently its interest expenses grow at the same
rate as revenues?
e.
What is your estimate of the enterprise value of Flowmaster based on your analysis to
this point? How much is the equity of the firm worth today, assuming the $125 million in
debt remains outstanding?
f.
In conversations with the investment banker who was helping the investment group
finance the purchase, Mr. Burton learned that Flowmaster has sufficient debt capacity to issue
additional debt that would have a subordinate claim to the present debt holders carrying an
8.5 % rate. The amount of new debt is constrained by the need to maintain an interest
coverage ratio (i.e., earnings before interest, taxes, and depreciation divided by interest
expense) of five to one. Assuming that Flowmasters $125 million of 6% senior debt remains
in place (and grows at a rate of 4% per year going forward), what is the maximum amount of
subordinated debt that can be issued to help finance the purchase of Flowmaster?
g.
If the investment group decides to raise the additional subordinated debt (from part f),
Gary Burton, CFO, anticipates that Flowmasters unsecured suppliers will grant less
favorable credit terms (note that the amount of subordinated debt that Flowmaster can
support will continue to increase along with Flowmasters EBITDA growth). In fact, he
estimated that the decrease in accounts payable will result in an increase in the required net
working capital in perpetuity by 20% of anticipated revenues per year. Consequently, the

current net working capital balance would increase from 30% of revenues to 50%, or from
.3X$160 million = $48 million to .50 X $160 million = $80 million. Similarly, the projected
net working capital balance for the end of Year 1 would increase from 25% to 45% of
revenues. For Years 2 and beyond, working capital will increase from the 20% projected
earlier to 40% of revenues. Use the APV approach to estimating Flowmasters enterprise
value to determine whether the additional subordinated debt should be issued
PROBLEM 7-8 MINI-CASE TRADITIONAL WACC VALUATION10
Setting: It is early January 2007 and as the Chief Financial Officer of TM Toys Inc. you are
evaluating a strategic acquisition of Toy Co. Inc. (the target).
Industry Overview: The toys and games industry consists of a select group of global
players. The $60 billion industry (excluding videos) is dominated by two US toy makers:
Martel (Barbie, Hot Wheels, Fisher-Price) and Hasbro (G.I. Joe, Tonka, Playskool).
International players include Japans Bandai Co. (Digimon) and Sanrio (Hello Kitty), as well
as Denmarks LEGO Holding. Success in this industry is dependent on creating crossculturally appealing brands backed by successful marketing strategies. Toy companies
achieve success through scoring the next big hit with their target consumers and unveiling the
must-have toys (i.e. 2006 Mattels T.M.XTM Elmo, LEGOs Harry Potter and the Chamber
of Secrets, and Bratz Dolls from MGA Entertainment). Historically we have seen significant
merger and acquisition activity and consolidation among brands in this industry.
Target Company Description: Toy Co. Inc. is a multi-brand company that designs and
markets a broad range of toys and consumer products. The product categories include:
Action Figures, Art Activity Kits, Stationery, Writing Instruments, Performance Kites, Water
Toys, Sports Activity Toys, Vehicles, Infant/Pre-School, Plush, Construction Toys,
Electronics, Dolls, Dress-Up, Role Play, and Pet Toys and Accessories. The products are
sold under various brand names. The target designs, manufactures and markets a variety of
toy products worldwide through sales to retailers and wholesalers and directly to consumers.
Its stock price closed on 12/31/06 at $19.49 per share.
10This

problem was contributed by Professor Julia Plotts, University of Southern California

Exhibit P7-8.1 Planning Period Cash Flow Estimates

Toy Co.Inc. ($ Millions)

Projected Firm Free Cash

Flows

Fiscal Year Ended

12/31/07

12/31/08

12/31/09

12/31/10

12/31/11

$733.16

$757.63

$783.64

$799.32

$815.30

201.27

207.98

235.09

239.80

244.50

$531.90

$549.65

$548.55

$559.52

$570.71

183.58

186.21

191.80

195.64

199.55

(180.00)

(212.82)

(219.20)

(223.59)

(228.06)

(50.37)

43.54

(27.68)

(19.82)

(20.21)

Equals FCFF

$485.11

$566.59

$493.47

$511.76

$521.99

EBITDA

$916.74

$943.84

$975.45

$994.95 $1,014.85

Net Operating Income

Less: Taxws
NOPAT
Plus : Depreciation
Less : Capital Expenditures
(Increase) in Working Capital

Valuation Assignment: Your task is to estimate the intrinsic value of Toy Co. Inc.s equity
(on a per share basis) at 12/31/06 using the Enterprise DCF Model; this will assist you with
the determining what per share offer to make to Toy Co. Inc's shareholders. Treat all of the
results/forecasts for the fiscal year ended 2007-2011 as projections. Your research on various
historical merger and acquisition transactions suggest that comparable toy companies have
been acquired at Enterprise Value/EBITDA multiples of 10.5 x-11.5x. This is your
assumption for a terminal value exit multiple at the end of the forecast period, 2011. Exhibit
1 includes the targets planning period cash flow estimates and Exhibit 2 provides market and
other data for calculation of a weighted average cost of capital (WACC) for a discount rate.
Exhibit P7-8.2 Estimate a "Risk Appropriate" Discount Rate

Cost of debt-Estimated borrowing rate is 6.125% with a marginal tax of 27.29%

results in an after-tax cost of debt of 4.5%

Cost of equity-Levered equity beta for Toy Co. is .777; using the capital asset pricing
model with a 10-year Treasury Bond yield of 4.66% and a market risk premium of 7.67%
produces an estimate of the levered cost of equity of 10.57%.

Other-Diluted Shares of Common Equity outstanding at 12/31/06: $422,040,500,

Closing Stock Price $19.49; Debt Value Outstanding 12/31/06 $618,100,000

Weighted average cost of capital (WACC)- Using the target debt to value ratio of
6.99% the WACC is approximately 10.14%.
***********