Tutorial 6

BUSI97318
Corporate Finance
Tutorial 6
MSc Finance and Accounting
Adrian Lam
y.lam16@imperial.ac.uk
Imperial College London
November 21, 2019

Logistics Tax Rates Free Cash Flows Practical Wrap Up
Plan for Today
1 Tips for coursework 3

Effective tax rates
Free cash flows
Practical
Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 1 / 29

Effective Tax Rates
Tax Rates and Stock Price Changes on Ex-dividend Date

How will stock price change around the ex-dividend date?

Dividends and Stock Price
What is the stock price implied by a discounted cash flow

model, excluding current dividends?
Discounted present value of all future cash flows
∞
X Dt
Pex =
t=1
(1 + r )t
What is the stock price implied by a discounted cash flow

model, including current dividends?
Add D0 back to Pex , i.e. starting the sum at t = 0 instead of t = 1
∞
X Dt
Pcum = D0 +
t=1
(1 + r )t
| {z }
= Pex

Effective Dividend Tax Rate
In a perfect world, would a rational investor care between

selling shares on the ex-dividend date?
No, if investors are rational, share price will only adjust for the dividend
payment and differences in capital gains tax and dividend tax rates
With dividend tax rate (td ) and capital gains tax rate (tg ), the price
adjustment relative to the dividend payment can be expressed as

Pcum − Pex 1 − td
=
D 1 − tg

Effective Capital Gains Tax Rate
Since capital gains taxes can be deferred, what is the effective

capital gains tax rate?
Assuming the stated capital gains tax rate (tgs ) is constant, with
duration of holding period (T ) and discount rate (r ), the effective
capital gains tax rate (tg∗ ) can be expressed as
tgs
tg∗ =
(1 + r )T
The new price-change per dividend equation can be re-written as

Pcum − Pex 1 − td
=
D 1 − tg∗
i.e. (Pcum − Pex ) will be smaller

Effective Dividend Tax Rate: An Example
Southern Rail
Southern Rail recently declared a dividend of $1. The dividend tax rate for
the average investor is 50%, which applies to dividends paid in the current
period. The capital gains tax rate is also 50%, but can be deferred until
the shares are sold. The stock price of Southern Rail closed at $10 one day
before the ex-dividend date. On the ex-dividend date, Southern Rail’s
share price fell to $9.2. Assuming a 10% discount rate, how many years is
the average investor deferring capital gains taxes?

Effective Dividend Tax Rate: An Example
What is the effective capital gains tax rate?

tgs 0.5
tg∗ = T
=
(1 + r ) 1.1T
Can we infer the differences in dividend and capital gains tax

rates from the share price reaction?
Yes, plugging in the numbers,
!
Pcum − Pex 10 − 9.2 1 − td 0.5
= = = 0.5
D 1 1 − tg∗ 1 − 1.1T
Solve for T

Valuation Using Discounted Cash Flow Models
Valuation Models Using FCFE and FCFF

How to get the right numbers to plug into our good old
annuity/perpetuity formulae

Valuation Using Discounted Cash Flow Models
Models valuing equity

Discounted dividend model: When cash flows cannot be estimated but
have information about dividends
Equity valuation: When dividend information is significantly different
from FCFE or dividend information is not available, and when leverage
is stable
Models valuing firm (or enterprise)
Firm valuation: When the discount rate does not change dramatically
over time but leverage is either too high, too low or expected to
change (e.g. after high growth)
Can use E = EV - D - C to retrieve equity value

Discounted Cash Flow Models: Ingredients
What do we need to use the discounted cash flow (DCF) model

to value a firm?
Which cash flows?
FCFE
FCFF
Growth rate in earnings?
High growth period
Stable growth period
Is it necessary for FCFF and FCFE to grow at the same rate?
Which discount rate?
Cost of equity vs cost of capital?
Nominal vs real?
Time varying?

Free Cash Flow to Equity (FCFE) and Potential Dividends

How do we calculate FCFE?
FCFE can also be written as the amount of cash flows from operations
after paying non-equity holders and after paying for any investments
and re-investments required to sustain operations and growth
FCFE = Cash Flows to Shareholders − Equity Reinvestment Needs
= Net Income − Net Investment − ∆WCNon-Cash + ∆Debt
= Net Income
− (CapEx − Depreciation & Amortisation)
− Change in Working Capital
+ (Proceeds from New Debt Issues
− Preferred Dividends − Principal Repayments)
How can we spend FCFE?
Think of it as potential dividends
FCFE = Payout + ∆Cash

FCFE: Boston Turkey Example
Boston Turkey
Boston Turkey, a publicly traded firm, is making projections for its
operations next year. It expects its revenues to grow by 10% and its
expenses to remain at 40% of revenues. The depreciation and interest
expenses will remain unchanged at $100,000. Working capital will increase
by $50,000. There are four projects available for Boston Turkey to choose
from, which will be financed by the funds from operations. Boston
Turkey’s most current income statement and the project profiles are in the
following slides.
Boston Turkey’s managers claim that the firm really should not be paying
dividends next year. If the Treasury bond rate is 6.25% and the ERP is
5.5%, evaluate the available projects and evaluate how much can the
company afford to pay in dividends next year.

Project Profile
Project Equity Investment CF to Equity RoE Beta CoE
A 100,000 12,500 12.5% 1 11.75%
B 100,000 14,000 14% 1.5 14.50%
C 50,000 8,000 16% 1.8 16.15%
D 50,000 12,000 24% 2 17.25%

What is the real question here?

Is FCFE equal to or lower than zero after Net CapEx and ∆WCNon-Cash ?
Which project should Boston Turkey take?
By the NPV rule, we accept projects with positive NPV (i.e. RoE ≥
CoE)
Boston Turkey should take Projects A and D
Equity investment is $150,000 (= $100,000 + $50,000)

How will the income statement look like next year?
Income Statement
This Year Adjustment Projection
Revenue 1,000,000 10% Growth 1,100,000
Expense (400,000) 40% of Revenue 4,400,000
Depreciation (100,000) No Change (100,000)
EBIT 500,000 – 560,000
Interest Expense (100,000) No Change (100,000)
Taxable Income 400,000 – 460,000
Tax (160,000) – (184,000)
Net Income 240,000 – 276,000

What is Boston Turkey’s projected FCFE?
FCFE = Cash Flows to Shareholders − Equity Reinvestment Needs

= Net Income − Net CapEx − ∆WCNon-Cash + ∆Debt
= 276, 000 − (150, 000 − 100, 000) − 50, 000 + 0
= $176, 000
Based on the above, Boston Turkey should be able to pay dividends

totalling $176,000 next year

Comparing FCFF and FCFE
What are the differences between FCFF and FCFE?

FCFF is the amount of free cash flows available to all financial
claimholders
FCFF = EBIT(1-t) − Net Investment − ∆WCNon-Cash

| {z } | {z }
Operating earnings Reinvestment Needs
attributable to
all claimholders
FCFE is the amount of free cash flows available to common

shareholders
FCFE = |Net Income

{z }
Operating earnings
attributable to
common shareholders
− Net Investment − ∆WCNon-Cash + ∆Debt
| {z }
Equity Reinvestment Needs

Free Cash Flow to Firm
How to calculate FCFF?

Method 1: Adjusting FCFE
FCFF = FCFE + (1 − t)(Interest Payment) − ∆Debt
Method 2: Adjusting EBIT
FCFF = (1 − t) EBIT − Net CapEx − ∆WCNon-Cash
Method 2’: Adjusting EBIT (assuming a constant reinvestment rate γ,

i.e. (Net CapEx + ∆WCNon-Cash ) is a constant proportion of after-tax
operating income)
FCFF = (1 − t) EBIT − Net CapEx − ∆WCNon-Cash

| {z }
=γ×(1−t)EBIT
= (1 − t)(1 − γ)EBIT

Valuation Using the Firm Valuation Model
Suppose we want to use the firm valuation model to value a

rapidly growing firm and its equity. What do we have to do?
T
X FCFFt Terminal Value
EV = t +
(1 + WACC ) (1 + WACC )T
t=1
Estimate FCFF in high growth and stable growth periods

Compute WACC for high growth period using current beta and WACC
for stable growth period using new beta
Compute equity value by subtracting debt and adding cash, since
EV = E + D - C =⇒ E = EV - D + C

DCF Model: Labqi Inc. Example
Labqi Inc.
Labqi Inc., some company that does X, Y, and Z, reported a net income of $849M
in 1992, after interest expenses of $356M. The corporate tax rate was 36%. It
reported depreciation of $1B that year, and capital spending was $1.4B. The firm
also had $2.096B in debt outstanding by book value, rated at AA (carrying a
yield to maturity of 8%), trading at par. The beta of the stock is 1.05 and there
were 200 million shares outstanding trading at $60 per share with a book value of
$4 billion. Labqi Inc. paid 70% of its earnings as dividends and working capital
requirements are negligible. The Treasury bond rate at the time was 7%.
1 Estimate the free cash flow to the firm in 1992

2 Estimate the value of the firm at the end of 1992, assuming that the firm
will grow at the implicit rate of growth in perpetuity
3 Estimate the value of equity at the end of 1992 and the value per share,
using the FCFF approach

Labqi Inc.: Question 1
Labqi Inc.
Estimate the free cash flow to the firm in 1992.
What is the free cash flow to the firm in 1992?
FCFF = FCFE + (1 − t)(Interest Payment) − ∆Debt

= [Net Income − (Net Invesetment) − ∆WCNon-Cash + ∆Debt]
+ (1 − t)(Interest Payment) − ∆Debt
= 849 − (1400 − 1000) + (1 − 36%) × 356
= $676.84M

Labqi Inc.
Estimate the value of the firm at the end of 1992, assuming that the firm
will grow at the implicit rate of growth in perpetuity.
What is the growth rate of FCFF (gFCFF )?
gFCFF = Reinvestment Rate × RoC
How much is EBIT?

Net Income
EBIT = + Interest Expense
(1 − τ )
849
= + 356
1 − 0.36
= $1685.5625M

What is the reinvestment rate?

Net CapEx + ∆WCNon-Cash
Reinvestment Rate =
(1 − t) × EBIT
1400 − 1000 + 0
=
(1 − 0.36) × 1685.5625
= 37.1457227%
What is the return on capital (RoC )?

With book value of debt (BVD ) and book value of equity (BVE )
(1 − t) × EBIT
RoC =
BVD + BVE − Cash
(1 − 0.36) × 1685.5625
=
2096 + 4000
= 17.6646982%

What is the growth rate of FCFF?
gFCFF = Reinvestment Rate × RoC

= 37.1457227% × 17.6646982%
= 6.5616798%

What is the cost of equity (rE )?
rE = rf + β × ERP = 7% + 1.05 × 5.5%

=12.775%
What is the cost of capital (rC )?
E D
rC = × rE + (1 − t) × × rD
E +D E +D
12000 2096
= × 12.775% + (1 − 0.36) × × 8%
2096 + 12000 2096 + 12000
= 11.6367423%

What is the enterprise value (EV )?

Using the perpetuity formula,
FCFFt × (1 + gFCFF )
EV =
rC − gFCFF
= $14211.68836M

Labqi Inc.
Estimate the value of equity at the end of 1992 and the value per share,
using the FCFF approach.
What is the value of equity (VE )?
VE = EV − VD + Cash
= 14211.68836 − 2096 + 0
= $12115.68836M
What is the value per share (VPS )?

VE 12115.68836
VPS = =
N 200
= $60.57844181

Practical Advice: General
What should you do?

Follow the lecture slides! There is a fully worked-out Disney example
Illustrate you know what you are doing by properly signposting
appropriately
Mention your sources
Justify your assumptions and calculations
Write down your answers clearly and professionally
How to go above and beyond?
Well, hard to tell (it’s going above and beyond after all)
Highlight parts that you think you have added value to your work

Wrap Up
Coursework submission
28th November, 2019
Properly typed-up document
Highlight final answers in colour
Next week: Solutions for Coursework 3

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BUSI97318

MSc Finance and Accounting

Imperial College London

November 21, 2019

Plan for Today

1 Tips for coursework 3

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 1 / 29

Effective Tax Rates

Tax Rates and Stock Price Changes on Ex-dividend Date

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 2 / 29

Dividends and Stock Price

What is the stock price implied by a discounted cash flow

What is the stock price implied by a discounted cash flow

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 3 / 29

Effective Dividend Tax Rate

In a perfect world, would a rational investor care between

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 4 / 29

Effective Capital Gains Tax Rate

Since capital gains taxes can be deferred, what is the effective

The new price-change per dividend equation can be re-written as

i.e. (Pcum − Pex ) will be smaller

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 5 / 29

Effective Dividend Tax Rate: An Example

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 6 / 29

Effective Dividend Tax Rate: An Example

What is the effective capital gains tax rate?

Can we infer the differences in dividend and capital gains tax

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 7 / 29

Valuation Using Discounted Cash Flow Models

Valuation Models Using FCFE and FCFF

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 8 / 29

Valuation Using Discounted Cash Flow Models

Models valuing equity

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 9 / 29

Discounted Cash Flow Models: Ingredients

What do we need to use the discounted cash flow (DCF) model

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 10 / 29

Free Cash Flow to Equity (FCFE) and Potential Dividends

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 11 / 29

FCFE: Boston Turkey Example

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 12 / 29

FCFE: Boston Turkey Example

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 13 / 29

FCFE: Boston Turkey Example

What is the real question here?

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 14 / 29

FCFE: Boston Turkey Example

How will the income statement look like next year?

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 15 / 29

FCFE: Boston Turkey Example

What is Boston Turkey’s projected FCFE?

FCFE = Cash Flows to Shareholders − Equity Reinvestment Needs

Based on the above, Boston Turkey should be able to pay dividends

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 16 / 29

Comparing FCFF and FCFE

What are the differences between FCFF and FCFE?

FCFF = EBIT(1-t) − Net Investment − ∆WCNon-Cash

FCFE is the amount of free cash flows available to common

FCFE = |Net Income

Adrian Lam (Imperial College) Tutorial 6 November 21, 2019 17 / 29

Free Cash Flow to Firm

How to calculate FCFF?

FCFF = FCFE + (1 − t)(Interest Payment) − ∆Debt

Method 2: Adjusting EBIT