Lecture 3 – February 4, 2021

ESTIMATING CONTINUING VALUE AND

COST OF CAPITAL
 Estimating the continuing value

 Firm value depends on FCFs in two periods:

 PV(FCFs) from explicit forecast period (Lecture 2)
 PV(FCFs) from years after explicit forecast period
 CV usually accounts for a significant portion of total firm value –
hence important how we estimate it and assumptions we use.
Generally,

 g 
NOPLATt 1 * 1  
CVt =  RONIC 
(WACC  g )
where RONIC = return on new (after explicit period) invested capital

 Use CV when company reaches a steady state

 Often RONIC = WACC
 g = growth rate of the economy
 Estimating the continuing value

 The length of the explicit forecast period should not

affect firm value
 It should affect only how value is distributed over time
 If you expect that RONIC>WACC, then extend the explicit
forecast period

 Is the firm’s competitive advantage gone after the

explicit forecast period?
 The ROIC on old invested capital will most likely continue to
be above the WACC
 If RONIC>WACC during the CV period, then make sure a
stable growth rate is selected

 FCFt+1 could be bigger than FCFt*(1+g)

 OWC and Capex will decrease because of slower growth
 Other approaches to estimating CV

 Growing perpetuity FCF approach

FCFt 1
CV =
(WACC  g )

where g = expected (stable) growth rate

 Convergence approach
NOPLATt 1
CV =
WACC
 Assumes that WACC=RONIC
 Other approaches to estimating CV

 Stable perpetuity FCF approach

 Assumes no growth in sales (Capex=depreciation)
 Results in substantial increase in FCFt+1 compared to FCFt
FCFt 1
CV = WACC
Other (non-CF) approaches to estimating CV

 Multiple of earnings approach

CV = NIt+1 * (Enterprise value/Earnings)

where
Enterprise value = market value of equity + debt

 Liquidation value approach

 CV = TAt+1 – TLt+1
 Liquidation value could be smaller/larger than value of
company as a going concern

 Replacement cost approach

 CV = Expected costs of replacing company’s TA in time t+1
 Some assets (e.g., intangibles) difficult to replace
 Estimating the WACC

 Must include the opportunity costs of all investors

 Common equity, debt, preferred equity, operating leases,
etc.

 Must be computed using market values of securities

 Any financing-related benefits (e.g., tax shields) or

costs must be incorporated into WACC
 If not possible, use the APV method

 Must be computed after taxes

 The duration of securities must match the duration of
CFs
Estimating the WACC – cost of equity

 Cost of equity is usually estimated using the CAPM

k E  rf   *  rM  rf 
 Risk-free rate (rf): use the yield on appropriate long-
term Treasury bonds (usually 10-year or 15-year
zero-coupon TBs)

 Market risk premium (rM- rf): Usually 5-6% is OK

 Could vary based on the time period of estimation
 Arithmetic average vs. geometric average
Estimating the WACC – cost of equity

 Estimate beta using historical returns and a

regression approach (historical beta):

Ri     * RM  
 How far back in time shall we go?
 Use 5 years of data

 What should the return frequency be?

 Use monthly returns; daily returns have problems

 What should be used as a proxy for the Market

portfolio?
 Estimating the WACC – cost of equity

 Use comparable firms to improve the beta estimate

 Why use comparables?
 Use industry means or medians (or the mean or median of a
sample of firms with similar size)

 Remember that beta is determined by three factors:

 Type of business (e.g., cyclical vs. noncyclical, discretionary
versus nondiscretionary products)
 Degree of operating leverage (fixed costs/total costs): can be
approximated by %change in Oper. Profit / %change in Sales, or
assume that it is correlated with firm size
 Degree of financial leverage

• Since firms in the same industry have different

leverage, need to unlever their betas
Estimating the WACC – cost of equity

Estimating comparable firm betas (bottom-up betas)

 Estimate the average (or median) beta for the publicly
traded comparable firms
 Estimate the average market value debt-to-equity ratio
of these comparable firms and calculate the unlevered
(operating) beta for the firm being valued

 unlevered   levered / 1  1  tm  *  Debt / Equity  Comp 

 Assumptions: Debt is risk-free and tax shields have the same risk
as debt
 Estimating the WACC – cost of equity

 Estimate the current (or some long-term, optimal)

Debt/Equity ratio for the firm being valued:

 firm   unlevered * 1  1  t m  *  Debt / Equity  firm 

 Estimate the cost of equity of the firm using βfirm

 Benefits compared to historical betas

 Challenges using the bottom-up beta approach

 Business Betas

 When we think comparable firms have

different operating leverage, we could adjust
the beta for differences in operating leverage
Business beta = Unlevered betaComp/[1+(Fixed
cost/Variable cost)Comp]

The unlevered beta of the firm would be:

Unlevered beta = Business beta*[1+(Fixed
cost/Variable cost)firm]
 Other asset pricing models

 Fama-French three-factor model

 Uses firm size and book-to-market ratio as additional
factors
k E  rf  1 *  rM  rf    2 *  rS  rB    3 *  rH  rL 

 APT model
k E  rf  1 * F1   2 * F2  ...   k * Fk
 Estimating the WACC – cost of debt

 Measures the current cost to the firm of borrowing

funds to finance projects
 Depends on the risk-free rate and the default risk (and
the associated default spread) of the company
 If the firm has traded outstanding bonds, use the yield
as cost of debt
 For below investment grade companies, not a good proxy
for expected bond return – use the APV method

 If the firm has credit rating, use it to determine the

default spread and add it to the risk-free rate
 Estimating the WACC – cost of debt

 What if the firm is not rated?

 If the debt on the books of the startup is long-term and recent, the
cost of debt can be calculated using the interest expense and the
debt outstanding.
Cost of debt = Interest expense / Debt outstanding

 Estimate a synthetic rating

 Synthetic rating
 Use financial ratios (e.g., interest coverage) of rated firms
and link them to rating classes (e.g., AAA, AA, etc.)
 Identify in which credit rating bin the firm falls based on its
ratios
 Use the firm’s synthetic credit rating to determine the
default spread
Estimating the WACC – cost of other debt-
equivalent claims

 If the company has operating leases and we adjust the

NOPLAT for lease payments, need to either include
them in the company debt or add them as another
claim in the WACC
 Capitalize the value of the operating lease using the following
formula:
Re ntal Expenset
Lease valuet-1 = 1
kd 
Asset life

 Preferred equity
 Kps = Dividend per share / Market price per share
 If special features, need to value them separately
Weighted average cost of capital method

 Once we find ke and kd, the WACC is calculated as:

E D
WACC  ke *  k d * (1  t ) *
DE DE

where E = market value of equity

D = market value of debt
t = marginal tax rate
 Need to use some stable, long-term target D/E ratio
when calculating the WACC
Weighted average cost of capital method

 Study the current capital structure of the firm

 Is the firm near its target capital structure?
 If not, how long would it take to converge to a target D/E?

 What is the capital structure of comparable firms?

 Could use an average (or median) industry D/E ratio
 It’s OK for a firm’s capital structure to be different than that of
the comparables or the industry, just need to understand why

 Review management’s historical financing philosophy

 If company is expected to undergo significant capital
structure changes, use other valuation methods
Weighted average cost of capital method

 Under the WACC approach, the value of a firm is

calculated as:
 CFN 1 
FCFN  wacc  g 
FCF1 FCF2
Value    ...   
1  wacc  1  wacc  2 1  wacc  N 1  wacc  N

 Consistency in assumptions: The debt ratio

assumptions used to calculate the beta, the cost of
debt, and the cost of capital weights should be
consistently selected
 Valuing nonoperating assets

 Cash and marketable securities

 Use their book value from the balance sheet

 Nonconsolidated subsidiaries
 For equity stakes between 20% and 50%, the equity holding is
reported in the parent’s balance sheet at historical cost plus
reinvested income. The parent firm’s portion of subsidiary’s profit
is shown below operating profit on the parent’s income
statement.
 For equity stakes below 20%, the equity holding is reported at
historical cost in the parent’s balance sheet. The parent firm’s
portion of subsidiary’s dividend is shown below operating profit
on the parent’s income statement.
 If subsidiary is public, use market value to determine the value of
the parent’s equity stake
 Valuing nonoperating assets

 Nonconsolidated subsidiaries
 If subsidiary is private, but you have access to its financials,
value it using DCF.
 If subsidiary is private and no financials are available, value it
using multiples or using the return on a tracking portfolio of the
stocks of similar firms.

 Financial subsidiaries
 Value those using multiples (P/E, P/BV)

 Discontinued operations
 Use the book value from the balance sheet
 Valuing nonoperating assets

 Excess real estate

 Value using most recent appraisal value, multiples, or DCF (cash
flows from rentals and appropriate discount rate)

 Tax loss caryforwards

 Tax credits generated by past losses, could be used to decrease
future taxes
 Forecast those by adding future losses and subtracting future
taxable profits. For each year in which TLCs are used to offset
taxable profit, discount the tax savings at the Kd.

 Excess pension assets

 Reported at market value on the balance sheet
 Valuing debt and debt equivalents
 Debt
 Use book value from balance sheet, unless the debt is traded
 For highly levered firms, value the company using other
approaches (derivative valuation)

 Operating leases
 Value using the approach in Lecture 2

 Unfunded pension funds

 The pension contributions are tax deductible
 Multiply unfunded pension liabilities by 1 minus the tax rate

 Provisions
 For long-term operating provisions (plant-decommissioning
costs) and nonoperating provisions (restructuring charges) use
the book value from the balance sheet
 Valuing debt and debt equivalents
 Convertible debt and convertible preferred stock
 Use market value if traded or option-based valuation if not traded
 Convert into equity

 Employee stock options

 Value of future stock options should be included in the FCFs as
part of the value of operations. The value of currently outstanding
stock options must be subtracted from enterprise value
 Use option-based valuation to value current employee stock
options, or assume they are exercised today

 Noncontrolling interests
 A controlled, but not fully owned subsidiary
 Value the portion not controlled by the parent firm in the same
way as you would value nonconsolidated subsidiaries