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

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

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

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

5. 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

6. 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

7. 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

8. 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!

9. 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.

10. Calculating the terminal Value
Use the Gordon Growth Model

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

12. 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

13. 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

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

15. 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

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

18. 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

19. 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

20. 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...

21. 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)

22. 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

23. 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

24. 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

25. 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

26. 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%

27. 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

28. 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

29. 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%

30. 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.

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

32. 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

33. 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

34. 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

35. 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)]

36. 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

37. 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

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

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%

40. Now you have the cash flows and the discount rate
Calculate the Enterprise Value
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