Theory Behind the Discounted Cash Flow approach Chapter 11 Theory Behind the Discounted Cash Flow approach

The Market Value Balance Sheet Enterprise value represents the left hand side

Who has a claim on the Enterprise Value? Either someone else (Debt and Preferred Stock) or owned by the Equity Holders

What is Enterprise Value? The market value of the assets of the firm Enterprise Value = Common Equity Value + Preferred + Market Value Debt – Excess Cash

The indirect method of equity valuation: DCF approach Calculate Enterprise value Subtract out Market Value of Debt Preferred Stock Add back excess Cash In practice, many analysts add back all cash to ensure consistency across firms when performing comparable company analysis

How do we calculate Enterprise Value? Project future cash flows to capital providers Convert each cash flow to a Present Value equivalent Sum these present value cash flows

How do we get the cash flows? Firms have infinite lives, so forecasting all the cash flows is impossible Forecast 5-10 years of cash flows Calculate the TERMINAL VALUE of the remaining cash flows

Note on Terminal Value A common way to estimate the Terminal Value of a firm is to assume that the business will grow at a particular rate in perpetuity If you expect the business to grow at 10% per year forever, it will soon be worth more than an average-sized country!

The trick to a reasonable growth estimate Forecast the cash flows of the business for a long enough period of time that you expect it to reach a "steady state", sustainable long term growth rate Don't be surprised if your Terminal Value accounts for more than half of the total value of the business. DCF values are extremely sensitive to your assumption of what the business is worth at the end of the forecast period.

Calculating the terminal Value Use the Gordon Growth Model

What do we need to do the DCF? Cash flows What are the appropriate cash flows? Discount Rate What is the appropriate discount rate?

Enterprise Value and Cash Flow Enterprise Value is the Market value of the assets All of the capital providers have a claim on this market value We are interested the cash flows available to pay all of the capital providers, not just the equity holders We want the cash flows available to debt and equity holders

Unlevered Free Cash Flow Unlevered free cash flow is the total cash available for distribution to owners and creditors after funding worthwhile investment activities How do we get it? Two ways. 1. Use the statement of Cash Flows 2. Using only the Income Statement

Unlevered Free Cash Flow Using Cash Available for Debt Repayment Cash Available for Debt Repayment + Interest Expense - Interest Tax Shield

Unlevered Free Cash Flow Using the Income Statement EBITDA - Taxes on EBITA - Capital Expenditures - Changes in Working Capital Or EBIT – Taxes on EBIT + Depreciation + Amortization - Capital Expenditures - Changes in Working Capital

We have the cash flows, now we need: the Discount Rate Weighted Average Cost of Capital

Required rate of return on invested capital The appropriate Discount Rate is the rate of return that can be earned on an investment of comparable risk. The riskier an investment, the higher the expected return needs to be to justify an investment It measures the Opportunity Cost of the Investors’ Capital Weighted Average Cost of Capital: WACC

Intuition... WACC $1 debt and $1 equity, $2 total capital Bank needs 10%, shareholder needs 20% Need to earn 10 cents to keep bank happy Need to earn 20 cents to keep stock happy Total required earnings is 30 cents $0.30/$2.00=15% required return on capital

Money is left over. Positive NPV. Everybody is happy! If you earn more than 15% Money is left over. Positive NPV. Everybody is happy! But, if you earn less...

How do we calculate the WACC WACC=(1-t)kd(D/V) +ke(E/V) where… D and E are the market value of debt and market value of equity Market value of debt is difficult to obtain, so analysts usually use the book value (reasonable assumption for solvent firms)

Should we include short-term debt? Only include short-term debt if you believe that it will be a permanent component of the capital structure

How to get the market value of equity? Multiply number of shares outstanding by the price per share For a private firm, things are more difficult, since the equity does not have a “price” You might want to use liquidation value of the assets minus the value of the debt BETTER PROXY: use industry P/E multiple

Actual or target weights for debt and equity? We are interested in the required rate of return in the future, so today’s ratios are irrelevant What matters is our expectation of the future

How to get the cost of debt? Calculate yields to maturity using bond market prices These reflect what bondholders expect to earn over the life of their investment Use yields for firms with similar bond ratings Impute a bond rating using TIE, D/A, and liquidity ratios Look in footnotes to annual report Call the firm directly

Getting the firm’s cost of debt The firm has the following long-term bond outstanding 15 year maturity, Par=1000, Coupon payments are 9% semi-annual. Price is $1,080. Solve your effective annual yield to maturity. 8.24%

What about the cost of equity? Use CAPM kreq= krf+ (L)(km-krf) So, we need beta, the risk-free rate, and the market risk premium

The risk-free rate - Krf This is easy, just take the rate of return for a risk-free bond with the same maturity as the firm’s assets. In this case, use the rate of return on 30-year government debt 4.75% on April 1, 2007

The market risk premium Km-Krf This is NOT the difference between the current rate of return on the market and the current risk free rate of return. This reflects expected investor risk-aversion. Current premium is 6.4%

Beta - systematic risk Remember, beta is a backwards-looking measure. If you expect historical values to prevail, then use the firm’s current beta. You can get this from Bloomberg, Yahoo.Finance If there is a systematic change in either the firm’s business or financial risk, then the historical beta is useless.

Deconstruction of risk Total risk = Business risk + Financial Risk Business risk Risk of product market/assets Financial risk Use of leverage

Risk: Our old friend beta Intro to Finance beta is a levered beta. Also called the equity beta It reflects the historical sensitivity of a stock’s rate of return to that of the market But, the stock’s rate of return depends on the amount of debt in the capital structure, so... Beta reflects both the business and financial risk

You calculate the firm’s historical beta to be 1 You calculate the firm’s historical beta to be 1.11, but expect is capital structure to change Why is this beta unacceptable? The firm’s target debt ratio is 60% But, current market value of debt to total capital was only 41% Beta has to be adjusted for the difference between the actual and target debt ratio

How do we do this? Strip away the effects of the existing capital structure (leverage) to get the business risk Re-lever to reflect the future capital structure

Unlevered Beta - Asset Beta Reflects only the firm’s business risk L = U [1+(D/E)(1-t)] or U= L / [1+(D/E)(1-t)]

Check this out… CAPM kreq= krf+ (L)(km-krf) substitute levered beta into CAPM to get kreq= krf+ (U)(km-krf) + (U)(D/E)(1-t)(km-krf) Return= risk-free rate + premium for business risk + premium for financial risk

Unlevering & relevering the beta Bu=1.11 / [1+(.41/.59)(1-.34)] = 0.76 Re-lever with 60% leverage BLnew=0.76[1+(0.6/0.4)(1-.34)] = 1.514

Firm’s cost of equity capital Krequired = Risk free rate + beta(risk premium) 4.75% + (1.514)(6.4%) = 13.39%

Putting it all together WACC WACC= (D/V) kd (1-t) + (E/V)ke 0.6(8.24%)(1-.34) + (0.4)(13.39%)= Firm’s WACC is 8.62%

Now you have the cash flows and the discount rate Calculate the Enterprise Value Next Chapter