1 LECTURE 09 Valuation Berk, De Marzo Chapter 18
2 Overview of Key Concepts Assumptions in this chapter The project has average risk. The firm s debt-equity ratio is constant. Corporate taxes are the only imperfection Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm) Estimate the discount rate or rates to use in the valuation Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm)
3 Method-01: Company Valuation The Weighted Average Cost of Capital (FCF) The WACC can be used throughout the firm as the companywide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm s debt-equity ratio. For now, it is assumed that the firm maintains a constant debt-equity ratio and that the WACC remains constant over time. E D rwacc = re + rd (1 τ c ) E + D E + D This method takes the interest shield in account by using the after-tax cost of capital as the discount rate. Because the WACC incorporates the tax savings from debt, we can compute the levered value of an investment, by discounting its future free cash flow using the WACC. L F C F1 F C F 2 F C F 3 V 0 = + + + L 2 3 1 + rw a c c (1 + rw a c c ) (1 + rw a c c ) PV of FCF is the total value of the company. Value of equity is PV of FCF minus the market value of outstanding debt.
4 CASE-01 Method-01: Company Valuation-WACC (FCF) Assume Avco is considering introducing a new line of packaging, the RFX Series. Avco expects the technology used in these products to become obsolete after four years. However, the marketing group expects annual sales of $60 million per year over the next four years for this product line. Manufacturing costs and operating expenses are expected to be $25 million and $9 million, respectively, per year. Developing the product will require upfront R&D and marketing expenses of $6.67 million, together with a $24 million investment in equipment. The equipment will be obsolete in four years and will be depreciated via the straight-line method over that period. Avco expects no net working capital requirements for the project. Avco pays a corporate tax rate of 40%. 1. Determine the free cash flow of the investment. 2. Compute the weighted average cost of capital. 3. Compute the value of the investment, including the tax benefit of leverage, by discounting the free cash flow of the investment using the WACC.
CASE-01 Method-01: Company Valuation-WACC (FCF) Spreadsheet Expected Free Cash Flow from Avco s RFX Project 5
CASE-01 Method-01: Company Valuation-WACC (FCF) 6
CASE-01 Method-01: Company Valuation-WACC (FCF) Avco intends to maintain a similar (net) debt-equity ratio for the foreseeable future, including any financing related to the RFX project. Thus, Avco s WACC is E D 300 300 rwacc = re + rd (1 τc) = (10%) + (6%)(1 0.40) E + D E + D 600 600 = 6.8% Note that net debt = D=320-20=$300 million. The value of the project, including the tax shield from debt, is calculated as the present value of its future free cash flows. L 18 18 18 18 V 0 = + + + = 2 3 4 1.068 1.068 1.068 1.068 7 $61.25 million The NPV of the project is $33.25 million $61.25 million $28 million = $33.25 million
CASE-01 Method-01: Company Valuation-WACC (FCF) 8
CASE-01 Method-01: Company Valuation-WACC (FCF) 9
10 CASE-01 Method-01: Company Valuation-WACC (FCF) Implementing a Constant Debt-Equity Ratio: By undertaking the RFX project, Avco adds new assets to the firm with initial market value $61.25 million. Therefore, to maintain its debt-to-value ratio, Avco must add $30.625 million in new debt. 50% 61.25 = $30.625 Avco can add this debt either by reducing cash or by borrowing and increasing debt. Assume Avco decides to spend its $20 million in cash and borrow an additional $10.625 million. Because only $28 million is required to fund the project, Avco will pay the remaining $2.625 million to shareholders through a dividend (or share repurchase). $30.625 million $28 million = $2.625 million
CASE-01 Method-01: Company Valuation-WACC (FCF) The market value of Avco s equity increases by $30.625 million. $330.625 $300 = $30.625. Adding the dividend of $2.625 million, the shareholders total gain is $33.25 million.$30.625 + 2.625 = $33.25,Which is exactly the NPV calculated for the RFX project. Debt Capacity: The amount of debt at a particular date that is required to maintain the firm s target debt-to-value ratio. The debt capacity at date t is calculated as: D = d V t Where d is the firm s target debt-to-value ratio and V L t is the levered continuation value on date t. V = F C F + L t t } L V V alu e o f F C F in year + 2 an d b eyo n d L t + 1 t + 1 t 1 + rw a cc 11
Table 18.4 Spreadsheet Continuation Value and Debt Capacity of the RFX Project over Time
Method-02: Company Valuation-APV (The Adjusted Present Value Method) Adjusted Present Value (APV):A valuation method to determine the levered value of an investment by first calculating its unlevered value and then adding the value of the interest tax shield. L U V = APV = V + PV (Interest Tax Shield) The first step in the APV method is to calculate the value of the free cash flows using the project s cost of capital if it were financed without leverage. Unlevered Cost of Capital: The cost of capital of a firm, were it unlevered: for a firm that maintains a target leverage ratio, it can be estimated as the weighted average cost of capital computed without taking into account taxes (pre-tax WACC). E D ru = re + rd = E + D E + D Pretax WACC As the firm s leverage choice doesn t change the overall risk of the firm, the pretax WACC must be the same whether the firm is levered or unlevered. This argument relies on the assumption that overall risk of the firm is independent of the choice ofleverage. 13
14 Method-02: Company Valuation-APV (The Adjusted Present Value Method) The APV method; we proceed as follows 1. Determine the investment s value without leverage. 2. Determine the present value of the interest tax shield. a. Determine the expected interest tax shield. b. Discount the interest tax shield. 3. Add the unlevered value to the present value of the interest tax shield to determine the value of the investment with leverage..
CASE-02 Method-02: Company Valuation-APV (The Adjusted Present Value Method) For Avco, its unlevered cost of capital is calculated as: r = 0.50 10.0% + 0.50 6.0% = 8.0% U The project s value without leverage is calculated as: U 18 18 18 18 V = + + + = 2 3 4 1.08 1.08 1.08 1.08 $59.62 million
Method-02: Company Valuation-APV (The Adjusted Present Value Method) Valuing the Interest Tax Shield:The value of $59.62 million is the value of the unlevered project and does not include the value of the tax shield provided by the interest payments on debt. Interest paid in year t = rd Dt The interest tax shield is equal to the interest paid multiplied by the corporate tax rate. 1
Table 18.5 Spreadsheet Expected Debt Capacity, Interest Payments, and Tax Shield for Avco s RFX Project
Method-02: Company Valuation-APV (The Adjusted Present Value Method) The next step is to find the present value of the interest tax shield. When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project s cash flows, so they should be discounted at the project s unlevered cost of capital. 0.73 0.57 0.39 0.20 PV (interest tax shield) = + + + = $1.63 million 2 3 4 1.08 1.08 1.08 1.08
Method-02: Company Valuation-APV (The Adjusted Present Value Method) The total value of the project with leverage is the sum of the value of the interest tax shield and the value of the unlevered project. L U V = V + PV (interest tax shield) = 59.62 + 1.63 = $61.25 million The NPV of the project is $33.25 million $61.25 million $28 million = $33.25 million This is exactly the same value found using the WACC approach.
20 Comparison between WACC and APV Method It can be easier to apply than the WACC method when the firm does not maintain a constant debt-equity ratio. The APV approach also explicitly values market imperfections and therefore allows managers to measure their contribution to value. APV is more complicated than WACC because we must compute two separate valuations: the unlevered project and the interest tax shield. We also need to know the debt level to compute the APV but with a constant debt-equity ratio we need to know the project s value to compute debt level. It results that implementing APV requires solving for the project s debt and value simultaneously.
CASE-02 Method-02: Company Valuation-APV (The Adjusted Present Value Method) EX-18.3 21
22 CASE-02 Method-02: Company Valuation-APV (The Adjusted Present Value Method) EX-18.3
Method-03: Company Valuation- Flow to Equity Method (FTE) 23 Flow-to-Equity: valuation method that calculates the free cash flow available to equity holders taking into account all payments to and from debt holders. The cash flows to equity holders are then discounted using the equity cost of capital. First step of FTE method is to calculate the project s free cash flow to equity (FCFE). FCFE is the cash flow remaining after adjusting for interest payments, debt issuance and debt repayment. FCFE = FCF (1 τ c ) (Interest Payments) + (Net Borrowing) N et B o rro w in g at D ate t = D t D t 1. Determine the free cash flow to equity of the investment. 1 2. Determine the equity cost of capital. 3. Compute the equity value by discounting the free cash flow to equity using the equity cost of capital
24 Method-03: Company Valuation-(FTE) Table 18.6 Spreadsheet Expected Free Cash Flows to Equity from Avco s RFX Project
Method-03: Company Valuation- Flow to Equity Method (FTE) Spreadsheet Computing FCFE from FCF for Avco s RFX Project 25
Method-03: Company Valuation- Flow to Equity Method (FTE) Spreadsheet Computing FCFE from FCF for Avco s RFX Project Because the FCFE represent payments to equity holders, they should be discounted at the project s equity cost of capital. Given that the risk and leverage of the RFX project are the same as for Avco overall, we can use Avco s equity cost of capital of 10.0% to discount the project s FCFE. 9.98 9.76 9.52 9.27 NPV ( FCFE ) = 2.62 + + + + = $33.25 million 2 3 4 1.10 1.10 1.10 1.10 26 The value of the project s FCFE represents the gain to shareholders from the project and it is identical to the NPV computed using the WACC and APV methods.
27 Comparison of the Flow-to-Equity Method The FTE method offers some advantages. It may be simpler to use when calculating the value of equity for the entire firm, if the firm s capital structure is complex and the market values of other securities in the firm s capital structure are not known. It may be viewed as a more transparent method for discussing a project s benefit to shareholders by emphasizing a project s implication for equity. The FTE method has a disadvantage. One must compute the project s debt capacity to determine the interest and net borrowing before capital budgeting decisions can be made.
Method-03: Company Valuation- Flow to Equity Method (FTE) The next step is to find the present value of the interest tax shield. When the firm maintains a target leverage ratio, its future interest tax shields have similar risk to the project s cash flows, so they should be discounted at the project s unlevered cost of capital. 28 0.73 0.57 0.39 0.20 PV (interest tax shield) = + + + = $1.63 million 2 3 4 1.08 1.08 1.08 1.08 The total value of the project with leverage is the sum of the value of the interest tax shield and the value of the unlevered project. The NPV of the project is $33.25 million L U V = V + PV (interest tax shield) = 59.62 + 1.63 = $61.25 million $61.25 million $28 million = $33.25 million This is exactly the same value found using the WACC approach.
Method-03: Company Valuation- Flow to Equity Method (FTE) 29 FCF valuation is most suitable when: the company is not dividend-paying. the company is dividend paying but dividends significantly differ from FCFE. The company s FCF s align with company s profitability within a reasonable time horizon. the investor has a control perspective. FCF valuation is very popular with analysts.
30 Method-04: Company Valuation Project-Based Costs of Capital In the real world, a specific project may have different market risk than the average project for the firm. In addition, different projects will may vary in the amount of leverage they will support. Suppose Avco launches a new plastics manufacturing division that faces different market risks than its main packaging business. The unlevered cost of capital for the plastics division can be estimated by looking at other single-division plastics firms that have similar business risks.
Method-04: Company Valuation Project-Based Costs of Capital Assume two firms are comparable to the plastics division and have the following characteristics: 31
Method-04: Company Valuation Project-Based Costs of Capital Estimating the Unlevered Cost of Capital: Assuming that both firms maintain a target leverage ratio, the unlevered cost of capital for each competitor can be estimated by calculating their pretax WACC. 32 Competitor 1: r = 0.60 12.0% + 0.40 6.0% = 9.6% U Competitor 2: r = 0.75 10.7% + 0.25 5.5% = 9.4% U
Method-04: Company Valuation Project-Based Costs of Capital Based on these comparable firms, we estimate an unlevered cost of capital for the plastics division is approximately 9.5%. With this rate in hand we can use APV approach. To use WACC or FTE method we need to estimate the project s equity cost of capital, which depends on the incremental debt the company will take on as a result of the project. A project s equity cost of capital may differ from the firm s equity cost of capital if the project uses a target leverage ratio that is different than the firm s. The project s equity cost of capital can be calculated as: re = ru + D ( ru rd ) E 33
Method-04: Company Valuation Project-Based Costs of Capital Now assume that Avco plans to maintain an equal mix of debt and equity financing as it expands into plastics manufacturing, and it expects its borrowing cost to be 6%. Given the unlevered cost of capital estimate of 9.5%, the plastics division s equity cost of capital is estimated to be: 0.50 r E = 9.5% + (9.5% 6%) = 13.0% 0.50 The division s WACC can now be estimated to be: r = 0.50 13.0% + 0.50 6.0% (1 0.40) = 8.3% WACC An alternative method for calculating the division s WACC is: r = r d τ r w a c c w a c c c D r = 9.5% 0.50 0.40 6% = 8.3% wacc 34
35 Method-04: Company Valuation Project-Based Costs of Capital
36 Method-04: Company Valuation Project-Based Costs of Capital18.5
37 Growth Estimation A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. In general, we can make one of two assumptions: there is no high growth, in which case the firm is already in stable growth there will be high growth for a period, at the end of which the growth rate will drop to the stable growth rate (2-stage). Some advocate a smoother drop in growth between the first and second stages. Need to determine the growth rates in each period as well as the length of the different periods if a 2-stage model is used.