Advanced Corporate Finance Valuation I. Thomas J. Chemmanur Carroll School of Management Boston College

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1 Advanced Corporate Finance Valuation I Thomas J. Chemmanur Carroll School of Management Boston College

2 Valuation A variety of circumstances where value has to be established without using market value: 1. IPOs 2. Corporate control transactions: acquisitions, management buyouts, etc. 3. Valuing closely held business for gift & estate taxes, divorce settlements, etc.

3 Valuation techniques 1. Cash flow approaches 2. Valuation using comparable firm ratios or multiples 3. Asset-based approaches. Various advantages and disadvantages for each. Cash flow approaches best theoretical footing but difficult to estimate future cash flows and discounting rates in many situations.

4 Method of Comparables Works if and only if a truly comparable group is available. Can reduce the probability of mis-valuing a firm relative to others in the sector, but the whole sector may be undervalued or overvalued. Often used in many IPOs.

5 ASSET BASED APPROACHES Looks at the underlying value of a company s assets. Most useful when a significant portion of a company s assets can be liquidated readily at well-determined market prices. Not useful for most IPOs.

6 CASH FLOW BASED APPROACHES 1. Free cash flow (FCF) 2. Capital cash flow (CCF) 3. Equity cash flow (ECF) All based on the idea that price = PV of cash flow. We will value a simple firm using all three of the above approaches to illustrate their use, and their similarities and differences

7 * All start with EBIT (Earnings before interest and taxes). * Cash flow adjustments made to EBIT to transform accounting recognition of receipts and expenses to cash flow definitions. * EBIT - capital expenditure + depreciation - changes in working capital = operating cash flow

8 * The cash flow concepts differ in the discounting rate to be used (because they differ in riskiness). Numerical illustration: Assumptions Perpetual cash flow (either no growth or 5% growth). All cash flows proportional to sales, $5,000. EBIT margin: 40%

9 Depreciation: 10% of sales. Capital expenditure: depreciation + 10% of growth in sales Interest payment per period = $293 Change in working capital = 10% of growth in sales.

10 Table A: Capital Cash Flow Valuation Assumptions: Asset beta = 1 Riskfree = 10% Risk Premium = 8% Interest = $293 Interest = $395 Growth rate 0% 5% Sales 5,000 5,000 EBIT margin 40% 40% EBIT 2,000 2,000 Depreciation a Capital Expenditures b Change in Working Capital c 0 50 Operating Cash Flow 2,000 1,925 Tax at 40% of EBIT less interest d Capital Cash Flow e 1,317 1,283 Expected Asset Return f 18.0% 18.0% Capital Cash Flow Value g 7,317 9,868 a Depreciation is assumed to be 10% of sales. b Capital Expenditures are assumed to be equal to depreciation plus 10% of the change in sales. c Assumed to be 20% of the change in sales. d Debt is assumed to be riskfree with an interest rate equal to the riskfree rate. The amount of debt is computed using the debt-to-total value assumption of 40%. e Capital Cash Flow equals Operating Cash Flow less taxes. f Expected asset return is computed using the CAPM: Riskfree rate + [Asset Beta] [Risk Premium] = 10% + [1] [8%] = 18%. g Computed as growing perpetuity: CCF/[Expected Asset return Growth rate].

11 Capital Cash Flow (CCF) = Operating cash flow - taxes Riskiness of Capital Cash Flow (CCF) = Risk of firm assets. Let β D = 0, β A = 1, Rm - Rf = 8%, Rf = 10% Expected return: R A = Rf + β A [Rm - Rf] = (8) = 18%. No growth case: CCF VALUE OF FIRM = 1317/0.18 = % growth case: CCF VALUE = CCF/(r A - g) = 1283/( ) = 9868

12 Table B: Equity Cash Flow Valuation Assumptions: Asset beta = 1 Riskfree = 10% Risk Premium = 8% Interest = $293 Growth 0% Sales 5,000 EBIT margin 40% EBIT 2,000 Depreciation a 500 Capital Expenditures b 500 Change in Working Capital c 0 Operating Cash Flow 2,000 Tax at 40% of EBIT less interest d 683 Interest 293 Change in debt e 0 Debt Cash Flow 293 Equity Cash Flow f 1,024 Expected Equity Return g 23.3% Equity Cash Flow Value h 4,390 Debt Value i 2927 Equity Cash Flow and Debt Value (Firm Value) 7,317 Note: We focus only on the zero growth case in this example and the next (tables B and C).

13 Equity cash flow = Cash flow to equity = OCF - Taxes - Interest - Debt Repayments OR Equity cash flow = capital cash flow - debt cash flows Equity cash flows are discounted at the cost of equity to get equity value: E/V = 0.6, D/V = 0.4, β D = 0 β E = β A /(E/V) = 1/0.6 = 1.67 R E = Rf + β E (Rm - Rf) = (8) = 23.3%

14 Equity Value = ECF/ r e in no growth case = 1024/0.233 = 4390 CCF value = equity value + debt value Debt value = 293/0.1 = Interest/Rf = 2927 Firm value = equity value + debt value = 7317 (Same as before) Note: In both the Capital Cash Flow and the Equity Cash Flow methods, we account for tax effects only in the cash flow, not in the discounting rate (otherwise we would be double-counting).

15 Table C: Free Cash Flow Valuation Assumptions: Asset beta = 1 Riskfree = 10% Risk Premium = 8% Growth 0% Sales 5,000 EBIT margin 40% EBIT 2,000 Depreciation a 500 Capital Expenditures b 500 Change in Working Capital c 0 Operating Cash Flow 2,000 Tax at 40% of EBIT 800 Free Cash Flow d 1,200 Weighted Average Cost of Capital e 16.4% Free Cash Flow Value f 7,317

16 Free cash flow (FCF) = Does not include debt benefits (tax shield) in cash flows (i.e., in the numerator) Instead, tax benefits of debt are included in the discount rate (i.e., in the denominator) in the Free Cash Flow Valuation of a firm FCF = Operating cash flow - Notional (or hypothetical ) taxes WACC = (D/V)(1 - Tc)R D +(E/V)R E (1) From table B, we know that debt value = 2927, So: D/V = 2927/7317 = 0.4

17 E/V = 1 - D/V Therefore, Equity value/firm value = E/V = = 0.6 Tc = 0.4 or 40% From formula (1): WACC = 0.4(1-0.4)10% + 0.6(23.3%) Since r E = 23.3% From previous (Table- B) computation Therefore, WACC = 16.4%, which should be used to discount Free Cash Flow when valuing a firm using this technique

18 Therefore, firm value using Free Cash Flow method = Free cash flow/wacc for zero growth (perpetuity) case. = 1200/0.164 = 7317, which is the same as that we obtained using the CCF and the ECF methods.

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