Fundamentals of Valuation P.V. Viswanath Based on Damodaran’s Corporate Finance

P.V. Viswanath2 Cash Flows: The Accountant’s Approach  The objective of the Statement of Cash Flows, prepared by accountants, is to explain changes in the cash balance rather than to measure the health or value of the firm

P.V. Viswanath3 The Statement of Cash Flows This is a historical approach. We will modify this to create a model of cashflows for valuation

P.V. Viswanath4 Cash Flows: The Financial Analyst’s Approach  In financial analysis, we are concerned about Cash flows to Equity: These are the cash flows generated by the asset after all expenses and taxes, and also after payments due on the debt. Cash flows to equity, which are after cash flows to debt but prior to cash flows to equity Cash flow to Firm: This cash flow is before debt payments but after operating expenses and taxes. This looks at not just the equity investor in the asset, but at the total cash flows generated by the asset for both the equity investor and the lender.  These cash flow measures can be used to value assets, the firm’s equity and the entire firm itself.

P.V. Viswanath5 Free Cashflows to the Firm  Free Cashflows to the firm (FCFF) are defined as cashflows available for distribution to (all) the stakeholders of the firm without impairing the long-run profitability of the firm. Free Cash Flow to Firm = EBIT (1-t) – Net Reinvestment where Net Reinvestment = Incr in Non-cash Working Cap + Cap Exp – Depreciation  Alternatively, FCFF = Net Income + Interest (1-t) + Net Reinvestment  Note that we do not take into account the tax benefit of interest in computing FCFF because the tax benefit of interest is accounted for in the discount rate.

P.V. Viswanath6 Free Cashflows to the Firm  We can compute historical, i.e. ex-post FCFF by using information in the Statement of Cashflows: FCFF = Cashflow from Operations + Interest (1-t) – Capital Expenditures Note that Cashflows from Operations already include changes in working capital so we do not need to subtract this out again. However, They also include interest as a negative flow, so we add it back  For valuation purposes, we need forecasts of these quantities and the disaggregated model is more useful.  The value of the firm is the discounted present value of cashflows to the firm + Any cash position that the firm might have. Cash is considered separately because it is usually interest bearing and its present value is simply its current value.

P.V. Viswanath7 Cashflows to Equity  Free Cash Flow to Equity (FCFE) is another cashflow measure that focuses on cash flows to equityholders alone.  FCFE = Net Income + Depreciation – (Change in noncash Working Capital) – Capital Expenditures – Net Debt Paid.  FCFE can also be computed (as an historical quantity) from the statement of cashflows as FCFE = Cashflow from Operations – Capital Expenditures – Net Debt paid (short-term and long-term)  If there are other non-common stock securities, cashflows associated with them, such as preferred dividends are also subtracted.  The value of common equity is the discounted present value of free cashflows to equity.

P.V. Viswanath8 Two Measures of Discount Rates  Cost of Equity: This is the rate of return required by equity investors on an investment. It will incorporate a premium for equity risk -the greater the risk, the greater the premium. This is used to value equity.  Cost of capital: This is a composite cost of all of the capital invested in an asset or business. It will be a weighted average of the cost of equity and the after-tax cost of borrowing. This is used to value the entire firm.

P.V. Viswanath9 Equity Valuation

P.V. Viswanath10 Valuing Equity in a Finite Life Asset  Assume that you are trying to value the Home Depot’s equity investment in a new store.  Assume that the cash flows from the store after debt payments and reinvestment needs are expected will be $850,000 a year, growing at 5% a year for the next 12 years.  In addition, assume that the salvage value of the store, after repaying remaining debt will be $ 1 million.  Finally, assume that the cost of equity is 9.78%.

P.V. Viswanath11 Firm Valuation Note that the tax benefits of debt are not included in FCFF because they are taken into account in the firm’s cost of capital.

P.V. Viswanath12 Valuing a Finite-Life Asset  Consider the Home Depot's investment in a proposed store. The store is assumed to have a finite life of 12 years and is expected to have cash flows before debt payments and after reinvestment needs of $ 1 million, growing at 5% a year for the next 12 years.  The store is also expected to have a value of $ 2.5 million at the end of the 12 th year (called the salvage value).  The Home Depot's cost of capital is 9.51%.

P.V. Viswanath13 Expected Cash Flows and present value

P.V. Viswanath14 Valuation with Infinite Life

P.V. Viswanath15 Valuing the Home Depot’s Equity  Assume that we expect the free cash flows to equity at Home Depot to grow for the next 10 years at rates much higher than the growth rate for the economy. To estimate the free cash flows to equity for the next 10 years, we make the following assumptions: The net income of $1,614 million will grow 15% a year each year for the next 10 years. The firm will reinvest 75% of the net income back into new investments each year, and its net debt issued each year will be 10% of the reinvestment. To estimate the terminal price, we assume that net income will grow 6% a year forever after year 10. Since lower growth will require less reinvestment, we will assume that the reinvestment rate after year 10 will be 40% of net income; net debt issued will remain 10% of reinvestment.

P.V. Viswanath16 Estimating cash flows to equity: The Home Depot New Investments = Change in Working Capital + Capital Expenditures – Depreciation Hence FCFE = Net Income – Reinvestment needs – Net Debt Paid

P.V. Viswanath17 Terminal Value and Value of Equity today  FCFE 11 = Net Income 11 – Reinvestment 11 – Net Debt Paid (Issued) 11 = $6,530 (1.06) – $6,530 (1.06) (0.40) – (-277) = $ 4,430 million  Terminal Price 10 = FCFE 11 /(k e – g) = $ 4,430 / ( ) = $117,186 million  The value per share today can be computed as the sum of the present values of the free cash flows to equity during the next 10 years and the present value of the terminal value at the end of the 10 th year. Value of the Stock today = $ 6,833 million + $ 117,186/(1.0978) 10 = $52,927 million

P.V. Viswanath18 Valuing Boeing as a firm  Assume that you are valuing Boeing as a firm, and that Boeing has cash flows before debt payments but after reinvestment needs and taxes of $ 850 million in the current year.  Assume that these cash flows will grow at 15% a year for the next 5 years and at 5% thereafter.  Boeing has a cost of capital of 9.17%.

P.V. Viswanath19 Expected Cash Flows and Firm Value  Terminal Value = $ 1710 (1.05)/( ) = $ 43,049 million YearCash FlowTerminal Value Present Value 1$978$895 2$1,124$943 3$1,293$994 4$1,487$1,047 5$1,710$43,049$28,864 Value of Boeing as a firm =$32,743