Financial Management

Session 3
Valuation (I)

Jia, Ning (贾宁)

School of Economics and Management
Tsinghua University

Fall 2021
Today’s Agenda

1. Overview of Business Valuation

2. The Weighted Average Cost of Capital (WACC) Method

3. The Adjusted Present Value (APV) Method

4. The Flow-to-Equity (FTE) Method

2
Today’s Agenda

1. Overview of Business Valuation

2. The Weighted Average Cost of Capital (WACC) Method

3. The Adjusted Present Value (APV) Method

4. The Flow-to-Equity (FTE) Method

3
Business Valuation
 Business valuation is a process and a set of procedures used to
estimate the economic value of an owner’s interest in a business
 Investment Analysis
 Merger and Acquisition
 Financial Reporting and Tax
 Litigation

 Elements of Business Valuation

 Economic / Industry / Market Conditions
Valuation requires an opinion about the current and future national, regional
and local economic conditions, as well as the conditions of the industry and
market in which the subject business operates.

What is an example of a market where the price elasticity of demand is zero?

4
Business Valuation
 Firm’s Strategic Positioning and Competitive Advantages
How the subject company will compete, i.e., the SWOT analysis

 Financial Analysis
The financial statement analysis generally involves common size analysis,
ratio analysis (liquidity, turnover, profitability, etc.), trend analysis and
industry comparative analysis. This permits the valuation analyst to compare
the subject company to other businesses in the same or similar industry, and to
discover trends affecting the company and/or the industry over time.

By comparing a company’s financial statements in different time periods, the

valuation expert can view growth or decline in revenues or expenses, changes
in capital structure, or other financial trends. How the subject company
compares to the industry will help with the risk assessment and ultimately
help determine the discount rate and the selection of market multiples.

5
Valuation Method Paradigm

Valuation of
Operations
(assets-in-place)

Absolute/Intrinsic Relative
Valuation Valuation

Residual Discounted
Income Cash Flow Asset
Multiples
Accumulation
(EVA) (DCF)

Adjusted Flow-to-
WACC Present Value Equity
(APV) (FTE)

6
Absolute/Intrinsic vs. Relative Valuation
 Relative Valuation
 Market Approach, i.e., determines the value based on the market
prices of similar assets
 Attempts to use actual public valuations to infer value for a “similar”
company
 Generally applied to going concerns
 Easy to use, acts as a “sanity check”
 But relatively informal
 Hard to find comparables sometimes

 Absolute/Intrinsic Valuation
 Accounting (i.e., Income or Asset) Approach
 Computation intensive, more formal
 Accuracy depends heavily on the set of underlying assumptions

7
Valuation Method Paradigm

Valuation of
Operations
(assets-in-place)

Absolute/Intrinsic Relative
Valuation Valuation

Residual Discounted
Income Cash Flow Asset
Multiples
Accumulation
(EVA) (DCF)

Adjusted Flow-to-
WACC Present Value Equity
(APV) (FTE)

8
 Absolute/Intrinsic Valuation Methods
Asset Accumulation Economic Profit Discounted Cash
(EVA) Flow (DCF)
Value equals to… Difference between Present value of Present value of all
current value of all invested capital and future cash flows
assets and current future economic from owning the
value of all liabilities rents over the life of firm
the firm

Formula V0 = Assets - 
( ROEt  r )  Bt1
V0  B0  
Liabilities t 1 (1  r ) t

Valuation Approach Assets/Liabilities Economic Income / Accounting Income /

Residual Income Free Cash Flow

Value is a function Current value of Forecasted rates of Forecasted free cash

of… assets and Current return or residual flow
value of liabilities income

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 Absolute/Intrinsic Valuation Methods (Con’t)

Asset Accumulation Economic Profit (EVA) Discounted Cash

Flow (DCF)
Used • Liquidation • A firm has negative free • A firm whose cash
frequently • Companies with cash flow many years flows are currently
in… substantial tangible out, but is expected to positive and can be
assets generate positive cash estimated with
flow at some point in the
• High quality balance future (for example, a some reliability for
sheet young or rapidly future periods
• Future viability of growing firm where • Terminal value is
company is doubtful capital expenditures are relatively easy to
being made to fuel estimate
future growth)
• There is a great deal of
uncertainty in
forecasting terminal
values.

10
Which Valuation Method to Use?
 It is very important to note that valuation is more an art than a science
because it requires judgment:
 There are very different situations and purposes in which you value an asset
(e.g. company in distress, tax purposes, mergers & acquisitions, quarterly
reporting). In turn this requires different methods or a different interpretation
of the same method each time
 All valuation models and methods have their limitations (e.g., mathematical,
complexity, simplicity, comparability) and could be widely criticized. As a
general rule the valuation models are most useful when you use the same
valuation method as the "partner" you are interacting with. Mostly the method
used is industry or purpose specific
 The quality of some of the input data may vary widely (private vs. public
companies)
 In all valuation models there are a great number of assumptions that need to
be made and things might not turn out the way you expect. Your best way out
of that is to be able to explain and stand for each assumption you make

11
Valuation Method Paradigm

Valuation of
Operations
(assets-in-place)

Absolute/Intrinsic Relative
Valuation Valuation

Residual Discounted
Income Cash Flow Asset
Multiples
Accumulation
(EVA) (DCF)

Adjusted Flow-to-
WACC Present Value Equity
(APV) (FTE)

12
Today’s Agenda

1. Overview of Business Valuation

2. The Weighted Average Cost of Capital (WACC) Method

3. The Adjusted Present Value (APV) Method

4. The Flow-to-Equity (FTE) Method

13
DCF Method - WACC

Where

E = market value of equity

D = market value of debt
Tc = marginal corporate tax rate

rE = equity cost of capital

rD = debt cost of capital
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Capital Structure and the Cost of Capital

 In capital budgeting, we discount future free cash flows by the

project’s cost of capital, i.e., the return that be earned by
undertaking another project of the same risk level

 In business valuation, the discount rate (i.e., cost of capital)

depends on the firm’s capital structure (i.e., the mix of equity
and debt)

 WACC represents the average return the firm must pay to its
investors (both debt and equity holders)

15
Why Do Firms Use Debt Financing?

Let’s look at Ikea’s income with and without leverage

(Year 2005, in $million)

16
 Why Do Firms Use Debt Financing?

With Leverage Without Leverage

Interest paid to debt holders 400 0

Income available to equity 522 812

holders
Total available to all 952 812
investors

 Ikea is able to pay $140 million more to investors when taking

on debt
 Where does this $140 million come from?
 $140 million = 35% * $400 million  Interest Tax Shield
 Interest tax shield = Corporate Tax Rate * Interest Payments

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The Cash Flows of the Unlevered and Levered Firm

15-18
Interest Tax Shield and Firm Value
 For each period,
Cash Flows to Investors with Leverage = Cash Flows to Investors
without Leverage + Interest Tax Shield

 Firm can enhance its total values (to both shareholders and debt
holders) by using leverage to minimize the taxes it pays

 Effective after-tax borrowing rate =

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The Pecking Order of Financial Choices
1. Firms prefer internal finance.

2. They adapt their target dividend payout ratios to their investment

opportunities, while trying to avoid sudden changes in dividends.

3. Sticky dividend policies, plus unpredictable fluctuations in profitability

and investment opportunities, mean that internally generated cash flow is
sometimes more than capital expenditures and other times less. If it is
more, the firm pays off debt or invests in marketable securities. If it is less,
the firm first draws down its cash balance or sells its marketable securities.

4. If external finance is required, firms issue the safest security first. That is,
they start with debt, then possibly hybrid securities such as convertible
bonds, then perhaps equity as a last resort.

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The Pecking Order of Financial Choices

Internal
Debt Equity
Funds

21
Leverage Ratio - US

22
Leverage Ratio – China (Excluding Financial Institutions)

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

-10.00%

杠杆水平 杠杆水平变化率

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Leverage Ratio – G8 Countries
2008 2009 2010 2011

Canada 0.36 0.37 0.36 0.35

Germany 0.31 0.30 0.31 0.32

France 0.35 0.34 0.33 0.33

UK 0.36 0.34 0.30 0.29

Italy 0.35 0.37 0.39 0.39

Japan 0.26 0.27 0.26 0.26

Russia 0.26 0.27 0.32 0.30

US 0.38 0.36 0.33 0.33

Source: OSIRIS public companies worldwide

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Debt-to-Value Ratio Varies by Industry
The average debt
financing for all
U.S. stocks was
about 36%, but note
the large differences
by industry.

15-25
Leverage Ratio Varies by Industry - China

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

制造业 电力、热力、燃气及水生产和供应业 建筑业

批发和零售业 交通运输、仓储和邮政业 信息传输、软件和信息技术服务业
房地产业 平均值

26
Leverage Ratio – by Ownership Type

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

非国有企业 地方国企 中央国企

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Debt-to-Value Ratio Also Varies by Firm
Rajan and Zingales (1995) published a study of debt vs. equity choice by large
firms in Canada, France, Germany, Italy, Japan, UK, and US.
They found that the debt ratios of individual companies depend on four main
factors:
1. Size
Large firms tend to have higher debt ratios

2. Tangible assets
Firms with high ratios of fixed assets to total assets have higher debt ratios

3. Profitability
More profitable firms have lower debt ratios

4. Market-to-Book
Firms with higher ratios of market-to-book value have lower debt ratios

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Questions

If debt provides a tax advantage that lowers a firm’s weighted

average cost of capital and increases firm value, why does debt
make up less than half of the capital structure of most firm?

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Potential Explanations
 Limits to the tax benefits of debt
 A firm receives a tax benefit only if it is paying taxes in the first place,
that is, the firm must have taxable income.
 This constraint may limit the amount of debt needed as a tax shield

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Potential Explanations
 Increasing the level of debt increases the probability of bankruptcy
 Aside from taxes, another important difference between debt and equity
financing is that debt payments must be made to avoid bankruptcy,
whereas firms have no similar obligation to pay dividends or realize
capital gains.

 If bankruptcy is costly, which it is, these costs might offset the tax
advantages of debt financing.

 We will come back to this issue later in week 9 and 10

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Predicting Bankruptcy
 Can we predict the probability of bankruptcy based on a firm’s financial
measures?

 Prior studies have examined the following variables

 Size = log (total assets) (-)
 Total Liability/Total Assets (+)
 Working Capital/Total Assets (-)
 Current Liability/Current Assets (+)
 Net Income/Total Assets (-)
 Operating Cash flow/Total Liabilities (-)
 Previous two-year NI = 1 if negative for two years (+)

 What affects the ability of financial ratios to predict bankruptcy?

 Financial reporting standards – fair value accounting?
 Earnings management
 Intangible assets
 Off-balance sheet items (financial derivatives etc.)
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Predictor of Bankruptcy – Chinese Companies

ROE
0.50

0.00
0 1 2 3 4 5
-0.50

-1.00
Pre-bankcruptcy Year
Predictor of Bankruptcy – Chinese Companies

Debt Ratio
0.70
0.65
0.60
0.55
0.50
0.45
0.40
0 1 2 3 4 5
Deriving the WACC Method

Where

E = market value of equity

D = market value of debt
Tc = marginal corporate tax rate

rE = equity cost of capital

rD = debt cost of capital
35
Deriving the WACC Method (Con’t)
 Consider an investment that is financed by both debt and equity.
Because equity holders require an expected return of rE on their
investment and debt holders require a return of rD, the firm will
have to pay investors a total of

next year.

 What is the value of the investment next year? The project

generates free cash flows of FCF1 at the end of the year. In
addition, the interest tax shield of the debt provides a tax savings
of Tc * (interest on debt). Finally, if the investment will continue
beyond next year, it will have a continuation value of V1(L).

36
Deriving the WACC Method (Con’t)
 To satisfy investors, the project cash flows must be such that

 Because V0 = E+D, we can express rwacc as

 Rewrite the top equation as

37
Deriving the WACC Method (Con’t)
 If the WACC is the same next year, then

 By repeatedly replacing each continuation value, and assuming

the WACC remains constant, we get:

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Implementing a Constant Debt-Equity Ratio
 The notion of Debt Capacity

We define an investment’s debt capacity, Dt, as the amount of debt at

date t that is required to maintain the firm’s target debt-to-value ratio, d.

Given the project’s levered continuation value on date t, that is, the
levered value of its free cash flow after date t,

Then debt capacity equals

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In Class Exercise: Lucent Technology
 Suppose Lucent Technology has an equity cost of 10%, market
capitalization of $10.8 billion, and an enterprise value of $14.4 billion.
Suppose Lucent’s debt cost of capital is 6.1% and its marginal tax rate is
35%.

(a) What is Lucent’s WACC?

(b) If Lucent maintains a constant debt-equity ratio, what is the value of the
following project?
Year 0 1 2 3
FCF -100 50 100 70

(c) If Lucent maintains its debt-equity ratio, what is the debt capacity of the
project in part (b)?

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In Class Exercise: Lucent Technology - Answer
(a) 10.8 14.4  10.8
rwacc  10%  6.1%(1  0.35)  8.49%
14.4 14.4

(b) 50 100 70
VL   2
 3
 185.86
1.0849 1.0849 1.0849
NPV(WACC) = 185.86-100 = 85.86

(c) Lucent’s debt-to-value ratio is d = (14.4 – 10.8) / 14.4 = 0.25. The

project’s debt capacity is equal to d times the levered value of its
remaining cash flows at each date:
Year 0 1 2 3
FCF –100 50 100 70
VL 185.86 151.64 64.52 0
D = d*VL 46.47 37.91 16.13 0.00

41
The WACC Method – Limitations
 The practical virtue of WACC is that it keeps calculations used in
discounting to a minimum
 But WACC’s virtue comes with a price
 It is suitable only for the simplest and most static of capital
structures. In using WACC, we made the following two
assumptions:
(1) The firm’s debt-equity ratio is constant

(2) Corporate taxes are the only market imperfection

 In practice, valuation needs to be adjusted for other things such as

issue costs and dynamic capital structures
 The more complicated a company’s capital structure, tax position, or
fund-raising strategy, the more likely it is that mistakes will be made
in using WACC

42
Today’s Agenda

1. Overview of Business Valuation

2. The Weighted Average Cost of Capital (WACC) Method

3. The Adjusted Present Value (APV) Method

4. The Flow-to-Equity (FTE) Method

43
A More “Trendy” Valuation Method - APV
 Both WACC and APV (and other DCF methodologies) involve
forecasting future cash flows and then discounting them to their
present value at a rate that reflects their riskiness

 But the methodologies differ in the details of their execution, most

particularly in how they account for the value created (or destroyed)
by financial maneuvers, as opposed to operations

 Two major kinds of cash flows:

 Real Cash Flows associated with the business operation (e.g., revenues,
cash operating costs, and capital expenditures)
 “Side Effects” Cash Flows associated with the financial maneuvers
(e.g., the values of interest tax shields, government subsidy, issue costs)

44
A More “Trendy” Valuation Method - APV
 WACC’s approach is to adjust the discount rate (the cost of capital)
to reflect financial enhancements. In contrast, the Adjusted Present
Value (APV) method applies the basic DCF relationship to each cash
flow component separately and then add up the present values –
“Divide and Conquer”
 APV always works when WACC does, and sometime when WACC
doesn’t, because it requires fewer restrictive assumptions. APV is
also less prone to serious errors than WACC

 APV is flexible. The basic framework can be highly refined or

customized according to the tastes and circumstances

45
 APV – The Fundamental Idea
 APV unbundles components of value and analyzes each one separately
 The power of APV lies in the added managerially relevant information
it can provide. APV can help managers analyze not only how much an
asset is worth but also where the value comes from
Value of All Financing Side Effects
Base-case Value Interest Tax Shields

Costs of Financial Distress

Value of the
project as if it were
APV = financed entirely + Subsidies
with equity
Issue Costs

Other Costs

46
Five Steps in a Basic APV Analysis

 Step 1: Prepare performance forecasts and base-case incremental

cash flows for the business

 Step 2: Discount base-case cash flows to present value

 Step 3: Evaluate financing side effects

 Step 4: Add the pieces together to get an initial APV

 Step 5: Tailor the analysis to fit manager’s needs

47
APV - An Acquisition Case Study
 IBEX Inc. is contemplating an acquisition deal of Acme Filters, a
division of SL Corporation. Acme is a mature business that has
underperformed in its industry for the past six years.

 After an internal campaign to boost performance fell short of senior

executives’ expectations, SL Corporation resolved to sell Acme.

 The acquisition scenario and performance forecasts are given in the

hand-out

 SL Corporation is currently asking for no less than the book value

($307 million), is this a good deal?

48
Step 1: Prepare Performance Forecasts

Year 1 Year 2 Year 3 Year 4 Year 5

EBIT 22.7 29.8 37.1 40.1 42.1
- Taxes @ 34% 7.7 10.1 12.6 13.6 14.3
=EBIT (1-t) <- Net Income 15.0 19.6 24.5 26.4 27.8
+Depreciation 21.5 13.5 11.5 12.1 12.7
=Operating Cash Flow 36.5 33.1 36.0 38.5 40.4
- Change in NWC 21.3 5 -0.8 -5.2 -6.1
- CapEx -10.7 -10.1 -10.4 -11.5 -13.1
= FCF 47.0 28.1 24.8 21.8 21.3

49
Step 2: Discount Base-Case Cash Flows and
Terminal Value to Present Value
What is the discount rate? 13.5%

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

FCF 47 28.1 24.8 21.8 21.3
Terminal Value 263.4
Discount Factor 0.8811 0.7763 0.6839 0.6026 0.5309
Present Value 41.4 21.8 17.0 13.1 151.1
Base-case Value 244.5
(Total)

50
Step 3: Evaluate Financing Side Effects

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Interest Tax 7.4 6.5 6.1 5.6 5.4
Shields
Terminal Value 126
Discount Factor 0.9132 0.8340 0.7617 0.6956 0.6352
Present Value 6.7 5.4 4.6 3.9 83.5
Base-case Value 104.1
(Total)

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Step 4: Add the Pieces Together to Get APV

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Base-case value 244.5
Tax shields 104.1
APV 348.6

 Thus, if the purchase price is $307, then value created for IBEX
from this acquisition deal is $348.6-$307 = $41.6 million

52
Step 5: Tailor the Analysis to Fit Managers’
Needs – Value-creation Initiatives
 Baseline performance

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

FCF 20.3 17.1 18.9 19.2 18.5
Terminal Value 172.8
Discount Factor 0.8811 0.7763 0.6839 0.6026 0.5309
Present Value 17.8 13.2 13.0 11.5 101.6
Base-case Value 157.2
(Total)

53
Step 5: Tailor the Analysis to Fit Managers’
Needs – Value-creation Initiatives
 Margin Improvement

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Incremental EBIT 2.3 3.0 3.7 4.0 4.2
Taxes @ 34% -0.8 -1.0 -1.3 -1.4 -1.4
Cash Increment 1.5 2.0 2.4 2.6 2.8
Increment to 34.6
Terminal Value
PV (@13.5%) 1.3 1.5 1.7 1.6 19.9

Value of Margin 26.0

Improvement

54
Step 5: Tailor the Analysis to Fit Managers’
Needs – Value-creation Initiatives
 Net-working-capital Improvement

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Incremental Cash 25.3 9.0 3.4 0.0 0.0
Flow
Present Value (@ 22.3 7.0 2.3 0.0 0.0
13.5%)
Value of NWC 31.6
Improvement

55
Step 5: Tailor the Analysis to Fit Managers’
Needs – Value-creation Initiatives
 Higher steady-state growth

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Incremental 56.0
Terminal Value
Value of Growth 29.7

56
Step 5: Tailor the Analysis to Fit Managers’
Needs – Value-creation Initiatives
 Summing Up
Year 0
Baseline Value (Prior to Acquisition) 157.2
Increments:
Margin Improvement (Long-term Initiative) 26.0
Net-working-capital Improvement (Short-term) 31.6
Higher Steady-state Growth (Long-term) 29.7
Sum of Baseline and Increments 244.5
Plus Value of Interest Tax Shields 104.1
APV 348.6

57
 Step 5: Tailor the Analysis to Fit Managers’
Needs – Value-creation Initiatives
APV: $348.6 APV: $348.6

Value Created NPV: $41.6

(contributed by (captured by buyer)
Higher Growth: $29.7
buyer)
Margin Improve: $26 Financial
Maneuvers
(contributed by
Interest Tax Shield: buyer)
$104.1 Purchase Price: $307
Pre-existing (retained by seller)
Value
(contributed by
Baseline Value: seller)
$157.2

58
If We Use the WACC Method..
 WACC Calculations

Amount Percentage After-tax Weighted

of Funds Cost Cost
Debt
Revolving Credit @ 7.5% 13.0 4.2% 0.050 0.2%
Bank Debt @ 8.0% 80.0 26.1% 0.053 1.4%
Subord. Debt @ 9.5% 150.0 48.9% 0.063 3.1%
Equity @ 24% 64.0 20.8% 0.240 5.0%
Total Funds 307 100.0% 9.7%
(WACC)

59
If We Use the WACC Method…
 Discounting FCF at WACC
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
FCF 47.0 28.1 24.8 21.8 21.3
Terminal Value 476.6
Discount Factor @ 9.7% 0.9116 0.8310 0.7575 0.6905 0.6295
Present Value 42.8 23.4 18.8 15.1 313.4
Asset Value (Total) 413.5

 Value (APV) = $348.6 million

 Value (WACC) = $413.5 million
 What if the buyer asks for a price higher than $348.6 million?

60
Pitfalls of Using WACC
 We assume the cost of equity capital is 24%, using a comparable
company in the same business with about 50% debt in its capital
structure. However, IBEX does not achieve a debt/capital ratio of
50% until year 5, and in the meantime IBEX’s leverage is
substantially higher

 We used book values instead of market values to generate the

weights in the WACC

 Weights change every year as the capital structure changes

61