The Match Game: Cap Rates and Cash Flows

Transcription

1 The Match Game: Cap Rates and Cash Flows 44 th Annual Wichita Program Appraisal for Ad Valorem Taxation Jay Fletcher Washington Department of Revenue Paul Simon Xcel Energy Robert Reilly Willamette Management Associates Presentation Outline Terminology: discount rates and capitalization rates Practical issues in selecting cap rates and income Procedural issues in selecting cap rates and income Conceptual issues in selecting cap rates and income Analyst caveats in selecting cap rates and income Illustrative examples matching (and mismatching) capitalization rates and income measures Summary and conclusions; questions and discussioni 1 1

2 Terminology: Discount Rates and Capitalization Rates For purposes of this discussion, let s agree on this terminology: Cap rates are also called direct capitalization rates Discount rates are also called yield capitalization rates There is a direct mathematical relationship between cap rates and discount rates (when derived for the same level of income): Discount rates LT growth rate = Capitalization rate Capitalization rate + LT growth rate = Discount rate 2 Terminology: Discount Rates and Capitalization Rates (cont.) 3 2

3 Terminology: Discount Rates and Capitalization Rates (cont.) When to use either valuation model Use the single period model when income is expected to change at a constant rate Use the multiperiod model when income is expected to change at a non-constant rate When the income change rate is constant (i.e., when g is constant), both models produce exactly the same value 4 Practical Issues in Selecting Cap Rates and Corresponding Income Follow the law Consider state statutory authority, judicial precedent, and administrative rulings Often, only tax assessors are required to comply with certain administrative rulings However, taxpayers and valuation analysts should consider the guidance provided by state administrative rulings 5 3

4 Practical Issues in Selecting Cap Rates and Corresponding Income (cont.) Taxpayers that operate in multiple jurisdictions should recognize that: different states may tax different bundles of taxpayer assets, different states may prefer different valuation approaches or methods, different states have their own procedures for measuring income, different states have their own procedures for measuring discount and capitalization rates, and some states develop their own capitalization rates for certain industries Taxpayers often prepare internal unit valuations that are appropriate for one state but may not be appropriate p for another state 6 Procedural Issues in Selecting Cap Rates and Corresponding Income Taxpayer income can be measured many different ways, including: EBITDA net income before tax EBIT net income after tax EBIT after tax net cash flow after tax Consider the following income components in each income measurement Income taxes Interest expense Depreciation expense Cash flow components (e.g., capx, working capital investments) 7 4

5 Procedural Issues in Selecting Cap Rates and Corresponding Income (cont.) Consider the following income influences in each income measurement: Growth rate Income growth from assets in place only Income growth from assets in place and replacement assets Income growth from assets in place and expansionary assets This growth rate decision affects income and cash flow (e.g., depreciation, capx, working capital additions) Normalization adjustments When analyzing historical income (however measured), consider nonrecurring, nonoperating, and extraordinary revenue and expense items The selected income measure should represent a normalized, stabilized, or typical level of income 8 Procedural Issues in Selecting Cap Rates and Corresponding Income (cont.) Consider the following income attributes in each income measurement Is the income measurement ex poste (historical)? Is the income measurement ex ante (expected)? However income is measured, is the measurement based on? last year 3-year average 5-year average weighted average historical average plus a growth rate expected next year provided by management provided by securities analysts provided by appraiser s estimate 9 5

6 Conceptual Issues in Selecting Cap Rates and Corresponding Income Different jurisdictions tax different bundles of taxpayer assets, such as: All taxpayer assets (including expected future assets) Tangible assets only All tangible and intangible assets in place All assets except specified intangible assets Is the objective of the selected valuation method to value? The taxpayer total assets (e.g., a direct capitalization method) The taxpayer total equity (e.g., a stock & debt method) These conceptual issues will influence: What level of income should be considered in the analysis What level of cap rate should be considered in the analysis 10 Consistency in Measuring Cap Rates and Corresponding Income The cap rate measurement should match up with the level of income selected: Income taxes Cash flow adjustments Interest expense Expected growth rate Depreciation expense Ex poste or ex ante basis The levels of the selected income variables should be consistent within the analysis; for example: Using an industry average tax rate in the cap rate and a company-specific tax rate in the income measurement will cause a mismatch Using an industry average growth rate in the cap rate and a company-specific growth rate in the income measurement will cause a mismatch 11 6

7 Consistency in Measuring Cap Rates and Corresponding Income (cont.) Analysts can measure the income first, then select a cap rate that corresponds to that income measure Or, analysts can measure the cap rate first, then select an income measure that corresponds to that cap rate But, the cap rate and the income should be measured consistently with jurisdictional requirements with other components of the valuation analysis with prior periods, if possible, to create transparency 12 Analyst Caveats When Selecting Cap Rates and Corresponding Income Comply with any applicable jurisdictional requirements Perform one component analysis first either cap rate or income measure then derive the second component consistently with the first Which component to select first is based on: is there more jurisdictional guidance for either component? are there better data sources to derive either component? Understand what valuation variables are implicit in your selected cap rate or income component data sources Be consistent with prior period analyses, if possible Specifically define the cap rate derivation procedures and the income measurement procedures 13 7

8 Analyst Caveats When Selecting Cap Rates and Corresponding Income (cont.) Specifically state the treatment of income taxes, interest, depreciation, capx, growth rates, and historical/expected variables including the data sources relied upon Make the analyses replicable, transparent, and well-documented You can t just change one variable. If you have to change one valuation variable (e.g., to use that state s industry cap rate), you should review all other variables for internal consistency You can t assume away a cap rate or income variable (e.g., growth rate implicit in income or cap rate). By not making a decision about a variable, you ve made an implicit and probably inconsistent decision about that variable. 14 Illustrative Examples of Matching (and Mismatching) Cap Rates and Income Measures The following examples illustrate the importance of consistency (and inconsistency) in selecting valuation variables related to income tax rates income growth rates cost of capital components income measurement components 15 8

9 Example 1 Simple Direct Capitalization Example fact set: NCF net cash flow last period net cash flow is $1,000 k weighted average cost of capital is 10% g expected long-term growth rate in NCF is 3% Analyst caveats: Analyst has confirmed that both NCF and WACC are measured on a consistent basis; that is: 1. NCF is before interest expense but after tax if 2. WACC is after tax and 3. NCF is adjusted for capx and NWC investments consistent with a 3% growth rate Assignment: What is the entity value? 16 Example 1 Solution

10 Example 1 Solution 2 18 Example 1 Solution

11 Example 1 Solution 4 20 Example 1 Recommended Solution 21 11

12 Example 2 High Growth Rate Scenario Example fact set: NCF net cash flow last period net cash flow is $1,000 k weighted average cost of capital is 10% g expected long-term growth rate in NCF is 8% Analyst caveats: Management prepared a 5-year projection that incorporates an 8% supernormal growth rate. Management cannot predict how long that growth rate can be sustained. Last year NCF was $1,000. But, continued high growth will require extraordinary future expenditures on R&D, capx, and NWC investments. Sustainable long-term industry growth rate is probably in the 4% to 6% range (e.g., inflation rate + GNP growth rate + some industry-specific growth factor) Assignment: What is the entity value? 22 Example 2 Solution

13 Example 2 Solution 2 24 Example 2 Solution

14 Example 2 Solution 4 26 Example 2 Recommended Solution Solution 3 is the recommended solution In cases of supernormal (but unsustainable) growth, the analyst will often use a 2-stage or 3-stage DCF model to accommodate the varying future growth rates. The analyst should be careful to consider all extraordinary expenses and investments (capx, NWC) during the supernormal growth periods. Due to data constraints, this simplified example did not include extraordinary expenses or investments. Conceptually, solution 4 (adjusting the cost of equity component of the WACC for the risk of supernormal growth) is also a valid solution. However, practically, there are no empirical data sources or generally accepted formula for making this company-specific risk adjustment

15 Example 3 Calculate Various Cost of Capital Components Example fact set: Taxpayer net plant is $1,000,000 Capital structure is 75% equity and 25% debt Long-term growth rate is 2% Cost of equity capital is 15% Cost of debt capital is 8% Income tax rate is 40% After-tax WACC is 12.45% Depreciation rate = 10% of net plant Analyst caveats: Calculate net cash flow as follows: Net operating income + depreciation expense capital expenditure = net cash flow $124,500 + $100,000 $120,000 = $104,500 Assignment: Calculate the following: Overall yield capitalization rate Debt yield rate Equity yield rate 28 Example 3 Overall Yield Rate Calculation Alternatives Alternative Solutions Formula Used Calculation Concluded Rate 1 Net cash flow $104,500 = 10.45% Net plant $1,000,000 2 Net cash flow Net plant Plus long-term growth rate $104,500 $1,000,000 = % 2% 12.45% 3 Net cash flow Net plant Minus long-term growth rate $104,500 $1,000,000 = 10.45% 2% = 8.45% 29 15

16 Example 3 Overall Yield Rate Recommended Solution Recommended Solution Formula Used Result 2 Net cash flow + Long-term growth rate = Overall yield rate Net plant $104, % $1,000, % + 2% = 12.45% 30 Example 3 Debt Yield Rate Calculation Alternatives Alternative Solutions Formula Used Calculation Concluded Rate 1 Annual debt service $20, = 2.00% Net plant $1,000,000 2 Annual debt service Debt outstanding $20,000 $250,000 = 8.00% 3 After tax cost of debt $12,000 Debt outstanding $250,000 = 4.80% 31 16

17 Example 3- Debt Yield Rate Recommended Solution Solution Formula Used Result 2 Annual debt service Debt outstanding $20,000 $250,000 = 8% 32 Example 3 Equity Yield Rate Calculation Alternatives Alternative Solutions Formula Used Calculation Concluded Rate 1 Net cash flow $104,500 Net plant $1,000,000 = 10.45% 2 Net cash flow Debt service Equity investment $84,500 $750,000 = 11.27% 3 Net cash flow Debt service + Debt shield + Net debt $97,500 Equity investment $750,000 = 13.00% 33 17

18 Example 3 Equity Yield Rate Recommended Solution Recommended Solution Formula Used Result 3 Net cash flow Debt service + Debt shield + New debt Equity investment $104,500 $20,000 + ($20,000 40%) + ($1,000,000 2% 25%) $1,000,000 75% $104,500 - $20, $8,000 + $5,000 $750,000 $97,500 = 13% $750,000 Check: 13% yield rate + 2% long-term growth rate = 15% cost of equity capital 34 Example 4 Direct Capitalization Rates Extracted from Pricing Multiples Assignment Which of these market-derived pricing multiples provide valid indicators of value? Direct Capitalization Rates/Market Multiples 1. Equity price / a. Net income to equity b. NOI c. Net cash flow of the firm 2. Enterprise value / a. Net income to equity b. EBITDA c. Dividends to equity 3. Invested capital / a. Gross (operating) cash flow of the firm b. Net cash flow of the firm c. EBITDA 35 18

19 Example 4- Direct Capitalization Rate Recommended Solution Direct Capitalization Rate/ Market Multiple Recommended Applicable Income Measure 1. Equity price Net income to equity 2. Enterprise value EBITDA 3. Invested capital Gross cash flow of the firm or Net cash flow of the firm or EBITDA (it could be any of these three income measures; although, of course, the selected multiples will change accordingly) 36 Example 5 Discounted Cash Flow Analysis with Calculation Errors Example fact set: Cash flow of $1,000 in first year, growing at 5% annually for 10 years Cash flow growth rate after year 10 is 2% per year Weighted average cost of capital is 10% Analyst caveats: The analyst prepared the following DCF method valuation analysis: Year Net cash flow $1,000 $1,050 $1,103 $1,158 $1,216 $1,276 $1,340 $1,407 $1,477 $1,551 $1,629 Residual value $16,289 Present value of cash flow $950 $948 $945 $943 $941 $938 $936 $933 $931 $929 $9,265 Present value discount rate 5% Direct capitalization rate (going-in) 10% Direct capitalization rate (going-out) 8% Present value of net cash flow $18,659 Assignment: Identify any errors associated with this DCF analysis 37 19

20 Example 5 Discounted Cash Flow Analysis Recommended Corrections Recommended errors identified in the DCF valuation analysis: 1. The direct capitalization rate and the discount rate were reversed. 2. Residual value was calculated with the going-in direct cap rate rather than the going-out direct cap rate. 3. The residual value is received at the end of year 10, not at the end of year 11. Corrected DCF valuation analysis: Year Net cash flow $1,000 $1,050 $1, $1, $1,216 $1,276 $1,340 $1,407 $1,477 $1,551 Residual value $20,361 Total cash flow $21,913 Present value of cash flow $900 $851 $804 $760 $718 $678 $641 $606 $572 $7,640 Present value discount rate 10% Direct capitalization rate (going-in) 5% Direct capitalization rate (going-out) 8% Present value of net cash flow $14, Example 6 Extracting a Direct Capitalization Rate from Noisy Data Example fact set: NCF net cash flow the last period net cash flow was $2,000 k weighted average cost of capital is 10% g management s expected long-term annual growth rate in NCF is 5% for the next 10 years and 1.5% thereafter Independent market analysts say that a 1% to 2% growth rate is good for this industry over the foreseeable future One analyst says that growth in the industry can reach 5% if certain legislation occurs Analyst caveats: This is a fairly new company and, over the next 10 years, management expects its share of the market to grow The long-term growth rate from year 11 on reflects inflation only growth Your state has used the data source with the one positive analyst for several years The other analysts come from a very trusted source that is used by many analysts in the property tax profession Assignment: What is the correct direct capitalization rate? 39 20

21 Example 6 Extracting a Direct Capitalization Rate Recommended Solution Formula used Direct cap rate = WACC long-term growth rate Recommended application Direct cap rate = 10% - 1.5% Recommended conclusion Direct cap rate = 8.5% 40 Summary and Conclusion There is no absolutely correct (or absolutely incorrect) procedure for measuring cap rates and corresponding income All parties should be aware of the provisions of relevant statutory authority, judicial precedent, and administrative rulings All parties should be concerned about internal consistency in the cap rate and income measures with regard to income tax capital expenditures interest expense growth rate assumptions depreciation expense ex poste/ex ante variables All cap rate and income analyses should strive for internal consistency consistency with jurisdictional requirements replicability transparency 41 21

22 Summary and Conclusion (cont.) All cap rate and income analyses should be well supported well documented based on the best available data Assessors, valuation analysts, and taxpayers should consider practical issues, procedural issues, and conceptual issues when measuring cap rates and income We considered several examples to illustrate the importance of consistency in the application of capitalization rate variables and income measurement variables Questions and discussion 42 22