1. Fundamentals of Valuation P.V. Viswanath Partly based on Damodaran’s Corporate Finance

2. 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

3. P.V. Viswanath3 The Statement of Cash Flows

4. P.V. Viswanath4 Cash Flows: The Financial Analyst’s Approach  In financial analysis, we are much more 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.

5. P.V. Viswanath5 Present and Future Value  Present Value – earlier money on a time line  Future Value – later money on a time line 0235461 100  If a project yields $100 a year for 6 years, we may want to know the value of those flows as of year 1; then the year 1 value would be a present value.  If we want to know the value of those flows as of year 6, that year 6 value would be a future value.  If we wanted to know the value of the year 4 payment of $100 as of year 2, then we are thinking of the year 4 money as future value, and the year 2 dollars as present value.

6. P.V. Viswanath6 Rates and Prices  A rate is a “price” used to convert earlier money into later money, and vice-versa.  If $1 of today’s money is equal in value to $1.05 of next period’s money, then the conversion rate is 0.05 or 5%.  Equivalently, the price of today’s dollar in terms of next period money is 1.05. The excess of next period’s monetary value over this period’s value (1.05 – 1.00 or 0.05) is often referred to, as interest.  The price of next period’s money in terms of today’s money would be 1/1.05 or 95.24 cents.  This price reflects two elements: (1) Preference for current consumption (Greater =>Higher Discount Rate) (2) the uncertainty in the future cash flows (Higher Risk =>Higher Discount Rate)

7. P.V. Viswanath7 Rate Terminology  Interest rate – “exchange rate” between earlier money and later money (normally the later money is certain).  Discount Rate – rate used to convert future value to present value.  Compounding rate – rate used to convert present value to future value.  Cost of capital – the rate at which the firm obtains funds for investment.  Opportunity cost of capital – the rate that the firm has to pay investors in order to obtain an additional $ of funds.  Required rate of return – the rate of return that investors demand for providing the firm with funds for investment.

8. P.V. Viswanath8 Relation between rates  If capital markets are in equilibrium, the rate that the firm has to pay to obtain additional funds will be equal to the rate that investors will demand for providing those funds. This will be “the” market rate.  Hence this is the rate that should be used to convert future values to present values and vice-versa.  Hence this should be the discount rate used to convert future project (or security) cashflows into present values.

9. P.V. Viswanath9 Two essential concepts 1.Cash flows at different points in time cannot be compared and aggregated. All cash flows have to be brought to the same point in time, before comparisons and aggregations are made. 2.The concept of a Time Line:

10. P.V. Viswanath10 Discount Rates and Risk  In reality there is no single discount rate that can be used to evaluate all future cashflows.  The reason is that future cashflows differ not only in terms of when they occur, but also in terms of riskiness.  Hence, one needs to either convert future risky cashflows into certainty-equivalent cashflows, or, as is more commonly done, add a risk premium to the “certain-future-cashflows” discount rate to get the discount rate appropriate for risky-future- cashflows.

11. P.V. Viswanath11 Discounted Cashflow Valuation where, n = life of the asset CF t = cashflow in period t r = discount rate reflecting the riskiness of the estimated cashflows

12. P.V. Viswanath12 Cash Flow Types and Discounting Mechanics  There are five types of cash flows -  simple cash flows,  annuities,  growing annuities  perpetuities and  growing perpetuities

13. P.V. Viswanath13 I. Simple Cash Flows  A simple cash flow is a single cash flow in a specified future time period. Cash Flow:CF t ________________________________________|____ Time Period:t  The present value of this cash flow is- PV of Simple Cash Flow = CF t / (1+r) t  The future value of a cash flow is - FV of Simple Cash Flow = CF 0 (1+ r) t

14. P.V. Viswanath14 Application: The power of compounding - Stocks, Bonds and Bills  Between 1926 and 1998, Ibbotson Associates found that stocks on the average made about 11% a year, while government bonds on average made about 5% a year.  If your holding period is one year,the difference in end-of-period values is small: Value of $ 100 invested in stocks in one year = $ 111 Value of $ 100 invested in bonds in one year = $ 105

15. P.V. Viswanath15 Holding Period and Value

16. P.V. Viswanath16 The Frequency of Compounding  The frequency of compounding affects the future and present values of cash flows. The stated interest rate can deviate significantly from the true interest rate – For instance, a 10% annual interest rate, if there is semiannual compounding, works out to- Effective Interest Rate = 1.05 2 - 1 =.10125 or 10.25% The general formula is Effective Annualized Rate = (1+r/m) m – 1 where m is the frequency of compounding (# times per year), and r is the stated interest rate (or annualized percentage rate (APR) per year

17. P.V. Viswanath17 The Frequency of Compounding FrequencyRatetFormula Effective Annual Rate Annual10%1r10.00% Semi-Annual10%2(1+r/2) 2 -110.25% Monthly10%12(1+r/12) 12 -110.47% Daily10%365(1+r/365) 365 -110.52% Continuous10% e r -110.52%

18. P.V. Viswanath18 II. Annuities  An annuity is a constant cash flow that occurs at regular intervals for a fixed period of time. Defining A to be the annuity, AAAA |||| 01234

19. P.V. Viswanath19 Present Value of an Annuity  The present value of an annuity can be calculated by taking each cash flow and discounting it back to the present, and adding up the present values. Alternatively, there is a short cut that can be used in the calculation [A = Annuity; r = Discount Rate; n = Number of years]

20. P.V. Viswanath20 Example: PV of an Annuity  The present value of an annuity of $1,000 at the end of each year for the next five years, assuming a discount rate of 10% is -  The notation that will be used in the rest of these lecture notes for the present value of an annuity will be PV(A,r,n).

21. P.V. Viswanath21 Annuity, given Present Value  The reverse of this problem, is when the present value is known and the annuity is to be estimated - A(PV,r,n).

22. P.V. Viswanath22 Computing Monthly Payment on a Mortgage  Suppose you borrow $200,000 to buy a house on a 30-year mortgage with monthly payments. The annual percentage rate on the loan is 8%.  The monthly payments on this loan, with the payments occurring at the end of each month, can be calculated using this equation: Monthly interest rate on loan = APR/12 = 0.08/12 = 0.0067

23. P.V. Viswanath23 Future Value of an Annuity  The future value of an end-of-the-period annuity can also be calculated as follows-

24. P.V. Viswanath24 An Example  Thus, the future value of $1,000 at the end of each year for the next five years, at the end of the fifth year is (assuming a 10% discount rate) -  The notation that will be used for the future value of an annuity will be FV(A,r,n).

25. P.V. Viswanath25 Annuity, given Future Value  If you are given the future value and you are looking for an annuity - A(FV,r,n) in terms of notation - Note, however, that the two formulas, Annuity, given Future Value and Present Value, given annuity can be derived from each other, quite easily. You may want to simply work with a single formula.

26. P.V. Viswanath26 Application : Saving for College Tuition  Assume that you want to send your newborn child to a private college (when he gets to be 18 years old). The tuition costs are $16000/year now and that these costs are expected to rise 5% a year for the next 18 years. Assume that you can invest, after taxes, at 8%. Expected tuition cost/year 18 years from now = 16000*(1.05) 18 = $38,506 PV of four years of tuition costs at $38,506/year = $38,506 * PV(A,8%,4 years) = $127,537  If you need to set aside a lump sum now, the amount you would need to set aside would be - Amount one needs to set apart now = $127,357/(1.08) 18 = $31,916  If set aside as an annuity each year, starting one year from now - If set apart as an annuity = $127,537 * A(FV,8%,18 years) = $3,405

27. P.V. Viswanath27 Valuing a Straight Bond  You are trying to value a straight bond with a fifteen year maturity and a 10.75% coupon rate. The current interest rate on bonds of this risk level is 8.5%. PV of cash flows on bond = 107.50* PV(A,8.5%,15 years) + 1000/1.085 15 = $ 1186.85  If interest rates rise to 10%, PV of cash flows on bond = 107.50* PV(A,10%,15 years)+ 1000/1.10 15 = $1,057.05 Percentage change in price = -10.94%  If interest rate fall to 7%, PV of cash flows on bond = 107.50* PV(A,7%,15 years)+ 1000/1.07 15 = $1,341.55 Percentage change in price = +13.03%

28. P.V. Viswanath28 III. Growing Annuity  A growing annuity is a cash flow growing at a constant rate for a specified period of time. If A is the current cash flow, and g is the expected growth rate, the time line for a growing annuity looks as follows –

29. P.V. Viswanath29 Present Value of a Growing Annuity  The present value of a growing annuity can be estimated in all cases, but one - where the growth rate is equal to the discount rate, using the following model:  In that specific case, the present value is equal to the nominal sums of the annuities over the period, without the growth effect.

30. P.V. Viswanath30 The Value of a Gold Mine  Consider the example of a gold mine, where you have the rights to the mine for the next 20 years, over which period you plan to extract 5,000 ounces of gold every year. The price per ounce is $300 currently, but it is expected to increase 3% a year. The appropriate discount rate is 10%. The present value of the gold that will be extracted from this mine can be estimated as follows –

31. P.V. Viswanath31 IV. Perpetuity  A perpetuity is a constant cash flow at regular intervals forever. The present value of a perpetuity is-

32. P.V. Viswanath32 Valuing a Consol Bond  A consol bond is a bond that has no maturity and pays a fixed coupon. Assume that you have a 6% coupon console bond. The value of this bond, if the interest rate is 9%, is as follows - Value of Consol Bond = $60 /.09 = $667

33. P.V. Viswanath33 V. Growing Perpetuities  A growing perpetuity is a cash flow that is expected to grow at a constant rate forever. The present value of a growing perpetuity is - where CF 1 is the expected cash flow next year, g is the constant growth rate and r is the discount rate.

34. P.V. Viswanath34 Valuing a Stock with Growing Dividends  Southwestern Bell paid dividends per share of $2.73 in 1992. Its earnings and dividends have grown at 6% a year between 1988 and 1992, and are expected to grow at the same rate in the long term. The rate of return required by investors on stocks of equivalent risk is 12.23%. Current Dividends per share = $2.73 Expected Growth Rate in Earnings and Dividends = 6% Discount Rate = 12.23% Value of Stock = $2.73 *1.06 / (.1223 -.06) = $46.45

35. P.V. Viswanath35 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.

36. P.V. Viswanath36 Equity Valuation Free Cash Flow to Equity = Net Income – Net Reinvestment – Net Debt Paid (or + Net Debt Issued), where Net Reinvestment = Incr in Working Capital + Cap Exp – Depreciation

37. P.V. Viswanath37 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%.

38. P.V. Viswanath38 Firm Valuation Free Cash Flow to the Firm = Earnings before Interest and Taxes (1-tax rate) – Net Reinvestment Net Reinvestment is defined as actual expenditures on short-term and long-term assets less depreciation. The tax benefits of debt are not included in FCFF because they are taken into account in the firm’s cost of capital.

39. P.V. Viswanath39 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%.

40. P.V. Viswanath40 Expected Cash Flows and present value

41. P.V. Viswanath41 Valuation with Infinite Life

42. P.V. Viswanath42 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.

43. P.V. Viswanath43 Estimating cash flows to equity: The Home Depot

44. P.V. Viswanath44 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 / (.0978 -.06) = $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

45. P.V. Viswanath45 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%.

46. P.V. Viswanath46 Expected Cash Flows and Firm Value  Terminal Value = $ 1710 (1.05)/(.0917-.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