1. Corporate Valuation Free cash flow approach

2. Firm Valuation—Disney
Disney has a normal valuation case….
Disney has positive earnings.
Disney’s earning has a positive growth rate.
Disney’s has sufficient financial information in estimating cost of capital.

4. Firm Valuation—Disney
Cash Flows
To Firm
To Equity
EBIT (1-t)
- ( Cap Exp - Depreciation)
- Change in Working Capital
= Free Cash flow to Firm
The Strict View
Dividends + Buybacks
The Broader View
Net Income
- Net Cap Exp (1-Debt Ratio)
- Chg WC (1 - Debt Ratio)
= Free Cash flow to Equity

5. The growth rates in cash flows
Retention ratio
ROE
g EPS
Reinvestment rate
ROC
g EBIT
Operating Income
Net Income

6. Dividend growth, retention ratio, and Return on Equity (ROE) g = retention * ROE Assume that ROE=20%, payout=50%, beginning equity = 100 A.
Beg. EQ
B. Earnings
(A*ROE) C.
Dividend
(B*50%)
D. Ret. Earnings
(B-C) E.
End EQ
(A+D)
100 20 10
110 22 11
121
24.2
12.1
133.1
26.6
13.3
146.4

7. The growth rates in cash flows
Expected Growth EBIT = Reinvestment Rate * Return on Capital
Return on Capital = EBIT (1-t) / Capital Invested

8. Firm Valuation—Disney
1996 Disney’s basic data
EBIT：$5,559 Million
Capital spending：$ 1,746 Million
Depreciation：$ 1,134 Million
Non-cash Working capital Change：$ 617 Million
Book value of Debt：$7,763 Million (MV$11,180)
Book value of Equity：$11,668 Million (MV$50,880)
Levered Beta：1.25
Risk free rate：7.00%
Risk Premium：5.50%
Tax rate：36%

9. Cost of Equity
• Cost of Equity ：k equity = 7.00% *5.50% = 13.88%
• Market Value of Equity = $50,880 Million
• Equity/(Debt +Equity ) = 82%

10. Cost of Debt
•Cost of Debt for Disney = 7.50% (From Moody’s Bond Rating)
• After-tax Cost of debt = 7.50% (1-36%) = 4.80%
• Market Value of Debt = $ 11,180 Million
• Debt/(Debt +Equity) = 18%

11. WACC
WACC = 13.88% * % * 0.18 = 12.24%

12. 1996 Free Cash Flow to the Firm
FCFF= EBIT (1 - tax rate)
– (Capital Expenditures - Depreciation)
– Change in Non-cash Working Capital
=$5,559 (1-36%) – ($1,746-$1,134) –$617
=$2,329

13. The current growth rate for Disney
Reinvestment Rate1996 =( ) / 5559*(1-36%) =34.5%
ROC1996= 5559*(1-36%) / ( ) =18.69%
Forecasted Reinvestment Rate=50%
ROC=20%
Expected Growth EBIT = 50% * 20% = 10%

14. The firm Valuation

15. How to determine a reasonable growth rate?
The firm is in stable growth
The firm is in a relatively high growth, will be in stable growth after certain years (2-stage)
The firm is in a high growth period, will experience a period of transition period before it is in stable growth (3-stage)

16. The high growth rates and high growth period
Very high growth rate in current time – long growth period
High entry barriers – long growth period
Large size of firm – short growth period

17. Relationship between growth rates and other firm characteristics
High growth firms
Stable growth firms
Risk
Large
Medium
Dividend payout
Very little or even zero
high
Net Capital Exp.
low
ROC
ROC is close to WACC
Leverage
Very low

18. Disney’s Firm Valuation
Free Cash flows to Firm Approach
Three stages of growth

19. Expected growth in EBIT
High Growth
Transition
Stable growth
length
5 years
11th to forever
Revenues
1996: $18,739
Revenues grows at the same rate as Operating earnings
Grows at a stable growth rate
Pre-tax Margin
29.67% of Revenues
EBIT of 1996 $5,559
Steadily increase to 32% due to scale economy
32% of Revenues
Tax Rate
36%
ROC
20%, same as 1996
Steadily decrease to 16%
16%
Working capital
5% of Revenues
Reinvestment Rate
50%, $1,134 for 1996, assume same growth rate as EBIT
Steadily decrease to 31.25%,
31.25%
Expected growth in EBIT
ROC*Reinvestment Rate=10%
Steadily decrease to stable growth 5% 5%
Debt /Capital
18%
Steadily increase to 30%
30%
Risk Parameters
Beta=1.25
k equity=13.88%
Cost of debt = 7.5%(before tax)
(Long Term Bond Rate=7%)
Beta decrease steadily to 1.00
Cost of debt remains 7.5%
Beta=1.00；

20. Disney’s FCFF Basic year 1 2 3 4 5 6 7 8 9 10 Expected Growth Revenues
10% 9% 8% 7% 6% 5%
Revenues
$18,739
$20,613
$22,674
$24,942
$27,436
$30,179
$32,895
$35,527
$38,014
$40,295
$42,310
Operating Margin
29.67%
30.13%
30.60%
31.07%
31.53%
32.00%
EBIT
$5,559
$6,115
$6,726
$7,399
$8,139
$8,953
$9,912
$10,871
$11,809
$12,706
$13,539
EBIT(1-t)
$3,558
$3,914
$4,305
$4,735
$5,209
$5,730
$6,344
$6,957
$7,558
$8,132
$8,665
+Dep.
$1,134
$1,247
$1,372
$1,509
$1,660
$1,826
$2,009
$2,210
$2,431
$2,674
$2,941
-Capital Exp.
$1,754
$3,101
$3,411
$3,752
$4,128
$4,540
$4,847
$5,103
$5,313
$5,464
$5,548
-△WC
$94
$103
$113
$125
$137
$136
$132
$124
$114
$101
=FCFF
$1,779
$1,966
$2,163
$2,379
$2,617
$2,879
$3,370
$3,932
$4,552
$5,228
$5,957
ROC
20%
19.2%
18.4%
17.6%
16.8%
16%
Reinv. Rate
50%
46.88%
43.48%
39.77%
35.71%
31.25%

21. Disney’s Cost of Capital
Year 1 2 3 4 5 6 7 8 9 10
Cost of Equity
13.88%
13.60%
13.33%
13.05%
12.78%
12.50%
Cost of Debt (after tax)
4.80%
Debt Ratio
18.00%
20.40%
22.80%
25.20%
27.60%
30.00%
Cost of Capital
(WACC)
12.24%
11.80%
11.38%
10.97%
10.57%
10.19%

22. Terminal Value
FCFF11 = EBIT11 *(1-t) – EBIT11* (1-t) *Reinvestment Rate
= $ 13,539 (1.05) (1-36%) - $ 13,539 (1.05) (1-36%) (31.25%)
= $ 6,255 million
Terminal Value = $ 6,255/(10.19 %- 5%)
= $ 120,521 million

23. Disney：Net Present Value
Year 1 2 3 4 5 6 7 8 9 10
FCFF
$1,966
$2,163
$2,379
$2,617
$2,879
$3,370
$3,932
$4,552
$5,228
$5,957
Terminal Value
$120,521
Present Value
$1,752
$1,717
$1,682
$1,649
$1,616
$1,692
$1,773
$1,849
$1,920
$42,167
Cost of Capital
12.24%
11.80%
11.38%
10.97%
10.57%
10.19%
Value of firm = $ 57,817 million
Value of equity = Value of firm –Value of debt
= $ 57,817 -$ 11,180 = $ 46,637 million
Number of Shares =675.13
Value per share = 46637/ = $69.08

24. Why we do not consider the cash flows related to the financing?
When you use the after-tax cost of capital to be the discount rate, you basically take in the effect of the financing.
If you discount the project cash flows (without financing) by the after-tax cost of capital, you will get the exact net present value as you use it to discount the total cash flows (project cash flows plus the financing cash flows).
That is, when you use the after-tax cost of capital to discount financing related cash flows, the net present value would be zero.

25. （t=0）
（t=1）
（t=2）
（t=3）
（t=4）
Initial invest.
(total cost)
(8,000,000)
Inc. rev.
6,000,000
Inc. cost
(2,000,000)
Deprec.
2,000,000
OP CF
3,500,000
NOP CF
3,000,000
Project CF
6,500,000
Financing
8,000,000
Interest (AT)
(360,000)
Repay.
Fin. Rel. CF
(8,360,000)
Total CF
3,140,000
(1,860,000)

26. Assuming that financing totally comes from debt, and the before-tax
cost of capital is 6%, tax rate 25%, so the after-tax cost of capital 4.5%.
（t=0）
（t=1）
（t=2）
（t=3）
（t=4）
Project CF
(8,000,000)
3,500,000
6,500,000
NPV (at 4.5%)
7,072,024
（t=0）
（t=1）
（t=2）
（t=3）
（t=4）
Total CF
3,140,000
(1,860,000)
NPV (at 4.5%)
7,072,024
（t=0）
（t=1）
（t=2）
(t=3）
（t=4）
Fin. Rel. CF
8,000,000
(360,000)
(8,360,000)
NPV (at 4.5%)

27. How do managers create value?
Increase the cash flows generated by existing investments
Increase the expected growth rate in earnings
Increase the length of the high-growth period
Reduce the cost of capital that is applied to discount the cash flows.

28. Increasing the cash flows generated by existing investments
Managers can improve upon operating margin by improving operating efficiency and increase the returns to assets-in-place.
Tax management can also increase returns on existing assets.
Multinational firms can shift income across regions.
Net operating losses can shield future income. (Profitable firm acquires unprofitable firm)
Working capital management

29. Increasing the expected growth in FCFF or FCFE
Higher growth rates increase the value of the firm today.
The offsetting cost is that increasing the reinvestment rate can reduce costs today as it reduces FCFF and FCFE.
If reinvestment is NPV>0 project, then the benefits to growth outweigh the reduction on current cash flows.
Reinvest as long as EVA>0.
ROIC>rWACC

30. Reducing the cost of financing
Changing the financial mix of debt and equity can increase value.
Reduce tax liabilities by offsetting tax liabilities with interest payments.
Leads to an optimal capital structure for firm than lowers overall cost of capital and maximized firm value.

31. Adjusted Present Value (APV) Approach
APV = PV of asset flows + PV of side effects associated with the financing program.
Recall the M/M proposition I:

32. Adjusted Present Value (APV) Approach
Procedure:
1. Calculate PV of project (or enterprise) assuming it is all equity financed (i.e. no interest expense)
2. Calculate value of tax shield.
3. Total firm value = value of all equity firm + side effects of financing.

33. Calculate PV of project assuming it is all equity financed
Assume:
Asset (un-levered) beta = 0.7
Long Term T Bond Rate = 6%
Market Premium = 7.8%
From CAPM, Discount rate = *.078 = .1146
Also assume: Terminal value = (approx.) 7 x FCF

34. Year: 1 2 3 4 5
EBIT
100
108
116
124
134
40% 40
43.2
46.4
49.6
53.6
Capex 30 32 35 37
Depreciation 20 22 24 26 28
Increase in NWC 23 25 27
FCF
32.8
35.6
38.4
41.4
Terminal Value
289.8
26.9
26.4
25.7
24.9
24.1
168.5
Total PV

35. Calculate value of tax shield Assume: $150 of debt at 8% (pretax) remains outstanding
Year: 1 2 3 4 5
EBIT
100
108
116
124
134
Interest(=outstanding debt*.08)
12.0
10.2
8.0
5.6
2.8
Profit before tax
88.0
97.8
108.0
118.4
131.2
40%
35.2
39.1
43.2
47.4
52.5
Profit after tax
52.8
58.7
64.8
71.1
78.7
Capex 30 32 35 37 40
Depreciation 20 22 24 26 28
Increase in NWC 23 25 27
Net CF
22.8
26.7
30.8
35.1
39.7
Ending Debt = (beginning debt –net cash flow)
127.2
100.5
69.7
34.7
-5.1

36. Compare tax payments with vs. without debt
Compare tax payments with vs. without debt. The difference equals the tax savings available from the interest deduction (tax shield)
Discount tax savings at pre-tax rate of return on debt:
Tax payments with no debt
40.0
43.2
46.4
49.6
53.6
Tax payments with 8%
35.2
39.1
47.4
52.5
Tax savings
4.8
4.1
3.2
2.2
1.1
PV of tax 8% $13

37. Suppose in addition there is a tax loss carry-forward of $100 million
Suppose in addition there is a tax loss carry-forward of $100 million. This means that the first $40 million of taxes need not be paid.
Year
Tax savings
Taxable Income Used 1
35.2 88 2
4.8
100
PV of tax savings
@ 8% $37
Present value these savings at 8%, produces a value of 37 for the tax loss carry-forward.

38. APV - Conclusion
Total firm value = value of all equity firm (295) + side effects of financing ( ) = 345.