Corporate Finance

Prof. Emiliano Pagnotta

Autumn 2017
Estimating Cash Flows
Which cash flow should I discount?
¨ Use Dividend Discount Model. (e.g., Deutsche Bank)
a) When you cannot estimate the free cash flows to equity or the firm, the only cash flow that you
can discount is dividends. For financial firms, it is difficult to estimate free cash flows
b) For firms which pay dividends (and repurchase stock) which are close to the Free Cash Flow to
Equity (over a extended period)

¨ Use Equity Valuation (e.g., Tata Motors)

(a) For firms which have stable leverage, whether high or not, and
(b) For firms which pay dividends which are significantly higher or lower than the FCFE
(c) For firms where dividends are not available (Example: Private Companies, IPOs)

¨ Use Firm Valuation (e.g., Disney and Vale)

(a) for firms which have leverage which is too high or too low, and expect to change the leverage
over time, debt payments and issues do not have to be factored in the cash flows and the discount
rate (cost of capital) does not change dramatically over time.
(b) for firms for which you have partial information on leverage (e.g.: interest expenses are
missing..)
(c) in all other cases, where you are more interested in valuing the firm than the equity. (Value
Consulting?)
The Steps and Ingredients in DCF calculations

1. Estimate the discount rate or rates to use in the valuation

1. Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital
(if valuing the firm)
2. Discount rate can be in nominal terms or real terms, depending upon whether the cash
flows are nominal or real
3. Discount rate can vary across time.
2. Estimate the current earnings and cash flows on the asset, to either equity
investors (CF to Equity) or to all claimholders (CF to Firm)
3. Estimate the future earnings and cash flows on the firm being valued, generally
by estimating an expected growth rate in earnings.
4. Estimate when the firm will reach “stable growth” and what characteristics (risk &
cash flow) it will have when it does.
5. Choose the right DCF model for this asset and value it.
Cost of Capital for Disney

• Values correspond to November 2013

• The T. bond rate at that time was 2.75%. The estimated equity risk premium of
5.76%
• The estimated cost of equity for Disney to be 8.52%:
• Disney s bond rating in May 2009 was A, and based on this rating, the estimated
pretax cost of debt for Disney is 3.75%. Using a marginal tax rate of 36.1, the after-
tax cost of debt for Disney is 2.40%.
After-Tax Cost of Debt = 3.75% (1 – 0.361) = 2.40%
• The cost of capital was calculated using these costs and the weights based on
market values of equity ($121,878m) and debt ($15.961m):

Cost of capital
The Right Tax Rate to Use

¨ Tax rates
¨ Effective tax rate in the financial statements= (taxes paid/Taxable income)
¨ Marginal Tax rate=Tax rate on the last dollar earned
¨ For the cost of capital calculation: always use the marginal tax rate. Interest
payments save you money on the last dollar paid in taxes.
¨ For after-tax operating income: the choice is between the effective and the
marginal tax rate. By using the marginal tax rate to compute after-tax operating
income, we tend to understate this value. So it is often better to use the effective
tax rate.
¨ A rule of thumb is to use the effective rate in the earlier years and the marginal tax
in later years, so you adjust the tax rate towards the marginal tax rate over time
(more conservative).
APV: VL=VU+PV(ITS)-PV(BC)
=EBIT(1-t(avg))/(ru-g)+t(marginal)D-PV(BC)
Estimating FCFF: Disney

q In the fiscal year ended September 2013, Disney reported the following:
• Operating income (adjusted for leases) = $10,032 million
• Effective tax rate = 31.02%
• Capital Expenditures (including acquisitions) = $5,239 million
• Depreciation & Amortization = $2,192 million
• Change in non-cash working capital = $103 million
q The free cash flow to the firm can be computed as follows:
After-tax Operating Income = 10,032 (1 -.3102) = $6,920
- Net Cap Expenditures = $5,239 - $2,192 = $3,629
- Change in Working Capital =$103
= Free Cashflow to Firm (FCFF) = $3,188
Estimating Fundamental Growth from new investments:
Three variations
Earnings Measure Reinvestment Measure Return Measure

Earnings per share Retention Ratio = % of Return on Equity = Net

net income retained by Income/ Book Value of
the company = 1 – Equity
Dividends/Net Income
Net Income Equity Reinv. Rate=(Net Return on Equity = Net
Cap Ex +Change WC – Income / Book value of
Change Debt)/(Net equity
Income)
(with constant DR)
Operating Income Reinvestment Rate = Return on Capital or
(Net Cap Ex + Change in ROIC = After-tax
non-cash WC)/ After-tax Operating Income/ (Book
Operating Income value of equity + Book
value of debt – Cash)
Reinvestment Rate for Disney

q The reinvestment and reinvestment rate for Disney are as follows:

• Reinvestment = $3,629 + $103 = $3,732 million
• Reinvestment Rate = $3,732/ $6,920 = 53.93%

q Note you can equivalently compute the FCFF as

Estimating Growth in EBIT: Disney

• We compute the return on capital, using operating income in 2013 and capital
invested at the start of the year:

Return on Capital2013 = EBIT (1-t) 10, 032 (1-.361)

= = 12.61%
(BV of Equity+ BV of Debt - Cash) (41,958+ 16,328 - 3,387)

• If Disney maintains its 2013 reinvestment rate and return on capital for the next
five years, its growth rate will be 6.80 percent.

Expected Growth Rate from Existing Fundamentals = 53.93% * 12.61% = 6.8%

Analysts’ Forecasts of Growth

¨ While the job of an analyst is to find under and over valued stocks in the sectors
that they follow, a significant proportion of an analyst’s time (outside of selling) is
spent forecasting earnings per share.
¤ Most of this time, in turn, is spent forecasting earnings per share in the next
earnings report
¤ While many analysts forecast expected growth in earnings per share over the
next 5 years, the analysis and information (generally) that goes into this
estimate is far more limited.
¨ Analyst forecasts of earnings per share and expected growth are widely
disseminated by services such as Zacks and IBES, at least for U.S companies.
How good are analysts at forecasting growth?

¨ Analysts forecasts of EPS tend to be closer to the actual EPS than simple time series
models, but the differences tend to be small
Study Group tested Analyst Time Series
Error Model Error
Collins & Hopwood Value Line Forecasts 31.7% 34.1%
Brown & Rozeff Value Line Forecasts 28.4% 32.2%
Fried & Givoly Earnings Forecaster 16.4% 19.8%

¨ The advantage that analysts have over time series models

¤ tends to decrease with the forecast period (next quarter versus 5 years)
¤ tends to be greater for larger firms than for smaller firms
¤ tends to be greater at the industry level than at the company level
¨ Forecasts of growth (and revisions thereof) tend to be highly correlated across
analysts.
Getting Closure in Valuation
¨ Since we cannot estimate cash flows forever, we estimate cash flows for a “growth
period” and then estimate a terminal value, to capture the value at the end of the
period: t=N CF
Value = ∑ t + Terminal Value
t (1+r) N
t=1 (1+r)

¨ When a firm’s cash flows grow at a “constant” rate forever, the present value of
those cash flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where, g~~rf

r = Discount rate (Cost of Equity or Cost of Capital)

g = Expected growth rate forever.
• If you estimate CF for 10 years, terminal value if computed using CF for year 11
¨ This “constant” growth rate is called a stable growth rate and cannot be higher than
the growth rate of the economy in which the firm operates.
Getting terminal value right…

¨ Exceptional growth and Competitive Advantage. It is not growth per se that creates
value but growth with excess returns. For growth firms to continue to generate value
creating growth, they have to be able to keep the competition at bay.
¨ Proposition 1: The stronger and more sustainable the competitive advantages, the longer a
growth company can sustain “value creating” growth.
q Proposition 2: Growth companies with strong and sustainable competitive advantages are rare.
q Risk and costs of equity and capital: Stable growth firms tend to
¤ Have betas closer to one
¤ Have debt ratios closer to industry averages (or mature company averages)
¤ Country risk premiums should evolve over time
¨ Investment Returns. The excess returns at stable growth firms should approach (or
become) zero. ROC -> Cost of capital and ROE -> Cost of equity
¨ Consistent reinvestment measures. The reinvestment needs and dividend payout ratios
should reflect the lower growth and excess returns:
¤ Stable period payout ratio = 1 - g/ ROE
¤ Stable period reinvestment rate = g/ ROC
Firms with Prolonged Periods of High Growth the Exception
Sources of Economic Moats
From firm value to equity value per share
Approach used
Discount dividends per share at the cost
of equity
Discount aggregate FCFE at the cost of
equity
Discount aggregate FCFF at the cost of
capital
To get to equity value per share
Present value is value of equity per share
Present value is value of aggregate equity.
Subtract the value of equity options given
to managers and divide by number of
shares.
PV is Value of operating assets (or EV)
+ Cash & Near Cash investments
+ (Value of minority cross holdings
-Value of minority interests)
-Debt outstanding
= Value of equity
-Value of equity options
=Value of equity in common stock
Remarks 1: From firm value to equity value per share

q DCF of FCFF = EV. Why not FV? (EV+cash)

qWe are discounting a CF based on operating income. Financial investments income
appear down the road in the income statement.
q Cross-holdings
qMinority cross holdings. Reference firm has less than 50% ownership. They
appear on the asset side of the balance sheet
qExample: Disney owns 30% of Hulu (American subscription video on
demand). Rest is owned by 21st Century Fox (30%), Comcast (30%), Time
Warner (10%)
qControlling Interest. Reference firm has controlling power (>=50% ownership).
In most countries these will appear as part of the consolidated balance sheet.
qDisney owns 80% of ESPN
qMinority interest: the portion (less than 50%) that is not owned by the
reference firm. Appears as a liability on the balance sheet.
Valuing Disney
Estimating Stable Period Inputs after a high growth period:
Disney
q Respect the cap: The growth rate forever is assumed to be 2.5. This is set lower than the
riskfree rate (2.75%).
q Stable period excess returns: The return on capital for Disney will drop from its high
growth period level of 12.61% to a stable growth return of 10%. This is still higher than
the cost of capital of 7.29% but the competitive advantages that Disney has are unlikely
to dissipate completely by the end of the 10th year.
q Reinvest to grow: Based on the expected growth rate in perpetuity (2.5%) and expected
return on capital forever after year 10 of 10%, we compute a stable period reinvestment
rate of 25%:
Reinvestment Rate = Growth Rate / Return on Capital = 2.5% /10% = 25%
q Adjust risk and cost of capital: The beta for the stock will drop to one from years 5 to 10,
reflecting Disney s status as a mature company.
q The debt ratio for Disney will rise to 20%. Since we assume that the cost of debt remains
unchanged at 3.75%, this will result in a cost of capital of 7.29%

Cost of capital = 8.51% (.80) + 3.75% (1-.361) (.20) = 7.29%

But costs of equity and capital can and should change over
time…
After-tax
Cost of Cost of
Year Beta Equity Debt Debt Ratio Cost of capital
1 1.0013 8.52% 2.40% 11.50% 7.81%
2 1.0013 8.52% 2.40% 11.50% 7.81%
3 1.0013 8.52% 2.40% 11.50% 7.81%
4 1.0013 8.52% 2.40% 11.50% 7.81%
5 1.0013 8.52% 2.40% 11.50% 7.81%
6 1.0010 8.52% 2.40% 13.20% 7.71%
7 1.0008 8.51% 2.40% 14.90% 7.60%
8 1.0005 8.51% 2.40% 16.60% 7.50%
9 1.0003 8.51% 2.40% 18.30% 7.39%
10 1.0000 8.51% 2.40% 20.00% 7.29%
Disney: Inputs to Valuation

High Growth Phase Transition Phase Stable Growth Phase

Length of Period 5 years 5 years Forever after 10 years
Tax Rate 31.02% (Effective) 31.02% (Effective) 31.02% (Effective)
36.1% (Marginal) 36.1% (Marginal) 36.1% (Marginal)
Return on Capital 12.61% Declines linearly to 10% Stable ROC of 10%
Reinvestment Rate 53.93% (based on normalized Declines gradually to 25% 25% of after-tax operating
acquisition costs) as ROC and growth rates income.
drop: Reinvestment rate = g/ ROC
= 2.5/10=25%
Expected Growth ROC * Reinvestment Rate = Linear decline to Stable 2.5%
Rate in EBIT 0.1261*.5393 = .068 or 6.8% Growth Rate of 2.5%
Debt/Capital Ratio 11.5% Rises linearly to 20.0% 20%
Risk Parameters Beta = 1.0013, ke = 8.52%% Beta changes to 1.00; Beta = 1.00; ke = 8.51%
Pre-tax Cost of Debt = 3.75% Cost of debt stays at 3.75% Cost of debt stays at 3.75%
Cost of capital = 7.81% Cost of capital declines Cost of capital = 7.29%
gradually to 7.29%
overvalue

margin of safety 20%

Details on the calculations

Value of non-operating assets:

q At the end of September 2013, Disney reported holding $3,931 million in cash and marketable
securities.

q In addition, Disney reported a book value of $2,849 million for minority investments in other
companies, all in the entertainment business. In the absence of detailed financial statements
for these investments, we will assume that the book value is roughly equal to the market
value.

q Disney consolidates its holdings in a few subsidiaries in which it owns less than 100%. The
portion of the equity in these subsidiaries that does not belong to Disney is shown on the
balance sheet as a liability (minority interests) of $2,721 million. As with its holdings in other
companies, we assume that this is also the estimated market value and subtract it from firm
value to arrive at the value of equity in Disney.
 Computing terminal value and Value of Equity

q Number of shares= 1,800m. Then price per share=$112,713/1,800=$62.26, about 10%

below market price of $67.71
 Investment decision affects risk of assets being finance and financing decision affects hurdle rate

The Investment Decision The Dividend Decision The Financing Decision

Invest in projects that earn a If you cannot find investments that earn Choose a financing mix that
return greater than a minimum more than the hurdle rate, return the minimizes the hurdle rate and match
Strategic investments determine length of growth

acceptable hurdle rate cash to the owners of the businesss. your financing to your assets.

Existing New Investments Financing Choices

Investments Return on Capital Reinvestment Rate Financing Mix Mostly US $ debt
ROC = 12.61% 12.61% 53.93% D=11.5%; E=88.5% with duration of 6
years
Current EBIT (1-t) Expected Growth Rate = 12.61% *
$ 6,920 53.93%= 6.8%
Cost of capital = 8.52% (.885) + 2.4% (.115) = 7.81%

Year Expected+Growth EBIT+(15t) Reinvestment FCFF Terminal+Value Cost+of+capital PV

1 6.80% $7,391 $3,985 $3,405 7.81% $3,158
2 6.80% $7,893 $4,256 $3,637 7.81% $3,129
3 6.80% $8,430 $4,546 $3,884 7.81% $3,099
period

4 6.80% $9,003 $4,855 $4,148 7.81% $3,070

5 6.80% $9,615 $5,185 $4,430 7.81% $3,041
6 5.94% $10,187 $4,904 $5,283 7.71% $3,367
7 5.08% $10,704 $4,534 $6,170 7.60% $3,654
8 4.22% $11,156 $4,080 $7,076 7.50% $3,899
9 3.36% $11,531 $3,550 $7,981 7.39% $4,094
10 2.50% $11,819 $2,955 $8,864 $189,738 7.29% $94,966
Value of operating assets of the firm = $125,477
Value of Cash & Non-operating assets = $6,780
Value of Firm = $132,257
Market Value of outstanding debt = $15,961
Minority Interests $2,721
Market Value of Equity = $113,575
Value of Equity in Options = $972
Value of Equity in Common Stock = $112,603
Market Value of Equity/share = $62.56

Disney: Corporate Financing Decisions and Firm Value

Ways of enhancing value…
Enhancing value

Suppose that you take over Disney

q Enhance the efficiency of investments: ROC increases to 14% from 12.7%. You
become a bit more selective on projects, so the reinvestment rate drops to 50%.

q Move the debt to capital ratio to 40% (optimum)

q Resulting price per share = $74.91

q So we can raise the value per share from $62.56 to $74.91. The difference of $11.35
can be viewed as the value of control.

q In general, the better managed a firm is, the lower will be the value of control.
Current Cashflow to Firm Disney (Restructured)- November 2013
EBIT(1-t)= 10,032(1-.31)= 6,920 Reinvestment Rate More selective Return on Capital Stable Growth
- (Cap Ex - Deprecn) 3,629 50.00% acquisitions & 14.00% g = 2.75%; Beta = 1.20;
- Chg Working capital 103 payoff from gaming Debt %= 40%; k(debt)=3.75%
= FCFF 3,188 Cost of capital =6.76%
Reinvestment Rate = 3,732/6920 Expected Growth Tax rate=36.1%; ROC= 10%;
=53.93% .50* .14 = .07 or 7% Reinvestment Rate=2.5/10=25%
Return on capital = 12.61%

First 5 years
Growth declines Terminal Value10= 9,206/(.0676-.025) = 216,262
gradually to 2.75%
Op. Assets 147,704 1 2 3 4 5 6 7 8 9 10
+ Cash: 3,931 Term Yr
EBIT * (1 - tax rate) $7,404 $7,923 $8,477 $9,071 $9,706 $10,298 $10,833 $11,299 $11,683 $11,975 12,275
+ Non op inv 2,849
- Reinvestment $3,702 $3,961 $4,239 $4,535 $4,853 $4,634 $4,333 $3,955 $3,505 $2,994 3,069
- Debt 15,961 Free Cashflow to Firm $3,702 $3,961 $4,239 $4,535 $4,853 $5,664 $6,500 $7,344 $8,178 $8,981
- Minority Int 2,721 9,206
=Equity 135,802
Cost of capital declines
-Options 972 Cost of Capital (WACC) = 8.52% (0.60) + 2.40%(0.40) = 7.16% gradually to 6.76%
Value/Share $ 74.91

In November 2013,
Cost of Debt Disney was trading at
Cost of Equity (2.75%+1.00%)(1-.361) Weights $67.71/share
10.34% = 2.40% E = 60% D = 40%
Based on synthetic A rating
Move to optimal
debt ratio, with
higher beta.
ERP for operations
Beta X
Riskfree Rate: + 1.3175
5.76%
Riskfree rate = 2.75%

Unlevered Beta for D/E=66.67%

Sectors: 0.9239
26

The Magnitude of R&D Expenses

R&D as % of Operating Income

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Market Petroleum Computers
27

R&D Expenses: Operating or Capital Expenses

¨ Accounting standards require us to consider R&D as an operating expense

even though it is designed to generate future growth. It is more logical to
treat it as capital expenditures.
¨ To capitalize R&D,
¤ Specify an amortizable life for R&D (2 - 10 years)
¤ Collect past R&D expenses for as long as the amortizable life
¤ Sum up the unamortized R&D over the period. (Thus, if the amortizable
life is 5 years, the R&D “research asset” can be obtained by adding up
1/5th of the R&D expense from five years ago, 2/5th of the R&D
expense from four years ago...:
28

Capitalizing R&D Expenses: SAP

R & D was assumed to have a 5-year life.
Year R&D Expense Unamortized Amortization this year
Current 1020.02 1.00 1020.02 € 0.00
-1 993.99 0.80 795.19 € 198.80
-2 909.39 0.60 545.63 € 181.88
-3 898.25 0.40 359.30 € 179.65
-4 969.38 0.20 193.88 € 193.88
-5 744.67 0.00 0.00 € 148.93=R&D EXPENSE/5
FOR THE CURRENT YEAR

Value of research asset = € 2,914 million

Amortization of research asset in 2004 = € 903 million
Increase in Operating Income = 1020.02 - 903 = € 117 million

q Assuming that R&D expenses are spent at the end of each year, that
is why there is no amortization of the current year s expense.
29
The Effect of Capitalizing R&D at SAP
! Conventional!Accounting!
Income!Statement!
EBIT&&R&D&&&=&&3045&
.&R&D&&&&&&&&&&&&&&=&&1020&
EBIT&&&&&&&&&&&&&&&&=&&2025&
EBIT&(1.t)&&&&&&&&=&&1285&m&
Balance!Sheet!
Off&balance&sheet&asset.&Book&value&of&equity&at&
3,768&million&Euros&is&understated&because&
biggest&asset&is&off&the&books.&
Capital!Expenditures!
Conventional&net&cap&ex&of&2&million&
Euros&
Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&1285&&
.&Net&Cap&Ex&&&&&&=&&&&&&&&2&
FCFF&&&&&&&&&&&&&&&&&&=&&1283&&&&&&
Return&on&capital&=&1285/(3768+530)&
Return on Capital (%): Conventional=29.9%
R&D!treated!as!capital!expenditure!
!Income!Statement!
EBIT&&R&D&=&&&3045&
.&Amort:&R&D&=&&&903&
EBIT&&&&&&&&&&&&&&&&=&2142&(Increase&of&117&m)&
EBIT&(1.t)&&&&&&&&=&1359&m&
Ignored&tax&benefit&=&(1020.903)(.3654)&=&43&
Adjusted&EBIT&(1.t)&=&1359+43&=&1402&m&
(Increase&of&117&million)&
Net&Income&will&also&increase&by&117&million&&
Balance!Sheet!
Asset&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&&Liability&
R&D&Asset&&&&2914&&&&&Book&Equity&&&+2914&
Total&Book&Equity&=&3768+2914=&6782&mil&&
Capital!Expenditures!
Net&Cap&ex&=&2+&1020&–&903&=&119&mil&
Cash!Flows!
EBIT&(1.t)&&&&&&&&&&=&&&&&1402&&&
.&Net&Cap&Ex&&&&&&=&&&&&&&119&
FCFF&&&&&&&&&&&&&&&&&&=&&&&&1283&m&
Return&on&capital&=&1402/(6782+530)&
Capitalizing R&D = 19.17%
30

Capitalizing R&D Expenses: Apple 2017

¨ Apple: 3 years amortizable life seems reasonable. Need to use 2016 10-k to obtain
2014 R&D expense
Process of Valuing Private Companies

¨ The process of valuing private companies is not different from the process of
valuing public companies. You estimate cash flows, attach a discount rate based
upon the riskiness of the cash flows and compute a present value.
¨ As with public companies, you can either value
¤ The entire business, by discounting CF to the firm at the cost of capital.
¤ The equity in the business, by discounting CF to equity at the cost of equity.

¨ Three important considerations:

1. There is not market value for either debt or equity
2. The financial statements for private firms are likely to go back fewer years, have
less detail and have more holes in them.
3. Big difference: the value can be different, depending upon who you do the
valuation for.
Motive matters

¨ You can value a private company for

¤ Show valuations
n Curiosity: How much is my business really worth?
n Legal purposes: Estate tax and divorce court
¤ Transaction valuations
n Sale or prospective sale to another individual or private entity.
n Sale of one partner s interest to another
n Sale to a publicly traded firm
¤ As prelude to setting the offering price in an initial public offering
¨ You can value a division or divisions of a publicly traded firm
¤ As prelude to a spin off
¤ For sale to another entity
¤ To do a sum-of-the-parts valuation to determine whether a firm will be worth more
broken up or if it is being efficiently run.
 Measuring Risk for non-diversified Investor: Total Betas
Private Owner versus Publicly Traded Company Perceptions of Risk in an Investment

Total Beta measures all risk

= Market Beta/ (Portion of the
total risk that is market risk)

80 units
Is exposed of firm
to all the risk specific
in the firm risk
Private owner of business
with 100% of your weatlth
invested in the business
Market Beta measures just
Demands a market risk
cost of equity
that reflects this
risk
Eliminates firm-
specific risk in
portfolio

20 units Publicly traded company

of market with investors who are diversified
risk
Demands a
cost of equity
that reflects only
market risk
Es#ma#ng a total beta

¨ Start with a market beta (unlevered) for the business or businesses that your
private company is in, just like you would for a public company.
¨ To get a measure of how much of the risk in the firm comes from the market and
how much is firm-specific, use the correlation of the publicly traded companies in
the business with the market.
¨ Since betas are based on standard deviations (rather than variances), we will take the
correlation coefficient (the square root of the R-squared) as our measure of the proportion
of the risk that is market risk.

¨ Total Unlevered Beta = Unlevered Beta/ Correlation with the market

Valuing a Private Business: Private to VC to Public offering
Assume that you have a private business operating in a sector, where publicly traded companies
have an average beta of 1 and where the average correlation of firms with the market is 0.25.
Consider the cost of equity at three stages (Risk-free rate = 4%; ERP = 5%):

Stage 1: The nascent business, with a private owner, who is fully invested in that business.
Perceived or Total Beta = 1/ 0.25 = 4
Cost of Equity = 4% + 4 (5% ) = 24%
Stage 2: Angel financing provided by specialized venture capitalist, who holds multiple
investments, in high technology companies. (Correlation of portfolio with market is 0.5)
Perceived or Total Beta = 1/0.5 = 2
Cost of Equity = 4% + 2 (5%) = 14%
Stage 3: Public offering, where investors are retail and institutional investors, with diversified
portfolios:
Perceived or Total Beta = 1
Cost of Equity = 4% + 1 (5%) = 9%
 Financing Choices across the life cycle

Revenues
$ Revenues/
Earnings

Earnings

Time

External funding High, but High, relative Moderate, relative Declining, as a

Low, as projects dry
needs constrained by to firm value. to firm value. percent of firm
up.
infrastructure value

Internal financing Negative or Negative or Low, relative to High, relative to More than funding needs
low low funding needs funding needs

External Owner’s Equity Venture Capital Common stock Debt Retire debt
Financing Bank Debt Common Stock Warrants Repurchase stock
Convertibles

Growth stage Stage 1 Stage 2 Stage 3 Stage 4 Stage 5

Start-up Rapid Expansion High Growth Mature Growth Decline

Financing
Transitions Accessing private equity Inital Public offering Seasoned equity issue Bond issues
31

Dealing with Negative or Abnormally Low Earnings

A Framework for Analyzing Companies with Negative or Abnormally Low Earnings

Why are the earnings negative or abnormally low?

Temporary Cyclicality: Life Cycle related Leverage Long-term

Problems Eg. Auto firm reasons: Young Problems: Eg. Operating
in recession firms and firms with An otherwise Problems: Eg. A firm
infrastructure healthy firm with with significant
problems too much debt. production or cost
problems.

Normalize Earnings

If firmʼs size has not If firmʼs size has changed

changed significantly
over time
Average Dollar
Earnings (Net Income
if Equity and EBIT if
Firm made by
the firm over time
over time
Use firmʼs average ROE (if
valuing equity) or average
ROC (if valuing firm) on current
BV of equity (if ROE) or current
BV of capital (if ROC)
Value the firm by doing detailed cash
flow forecasts starting with revenues and
reduce or eliminate the problem over
time.:
(a) If problem is structural: Target for
operating margins of stable firms in the
sector.
(b) If problem is leverage: Target for a
debt ratio that the firm will be comfortable
with by end of period, which could be its
own optimal or the industry average.
(c) If problem is operating: Target for an
industry-average operating margin.