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Primer on Cash Flow Valuation ElsevierDirect

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Primer on Cash Flow Valuation ElsevierDirect Powered By Docstoc
					Primer on Cash Flow
     Valuation
   The greater danger for most of
 us is not that our aim is too high
and we might miss it, but that it is
     too low and we reach it.
            —Michelangelo
                                    Course Layout: M&A & Other
                                      Restructuring Activities



 Part I: M&A        Part II: M&A           Part III: M&A         Part IV: Deal       Part V:
 Environment         Process               Valuation &           Structuring &     Alternative
                                            Modeling              Financing        Strategies

Motivations for      Business &          Public Company           Payment &        Business
     M&A             Acquisition            Valuation                Legal         Alliances
                       Plans                                     Considerations

 Regulatory        Search through            Private              Accounting &    Divestitures,
Considerations        Closing               Company                   Tax         Spin-Offs &
                     Activities             Valuation            Considerations   Carve-Outs

Takeover Tactics   M&A Integration          Financial              Financing      Bankruptcy &
 and Defenses                               Modeling               Strategies      Liquidation
                                           Techniques


                                                                                  Cross-Border
                                                                                  Transactions
               Learning Objectives
• Primary learning objectives: To provide students with an
  understanding of
   – business valuation using discounted cash flow valuation
     techniques and
   – the importance of understanding assumptions underlying business
     valuations
• Secondary learning objectives: To provide students with an
  understanding of
   – discount rates and risk as applied to business valuation;
   – how to analyze risk;
   – alternative definitions of cash flow and how and when they are
     applied;
   – the advantages and disadvantages of the most commonly used
     discounted cash flow methodologies;
   – the sensitivity of terminal values to changes in assumptions; and
   – Adjusting firm value for non-operating assets and liabilities.
                 Required Returns:
                 Cost of Equity (ke)
Capital Asset Pricing Model (3-factor model):

                ke = Rf + ß(Rm – Rf) + FSP

Where Rf       = risk free rate of return
     ß         = beta (systematic/non-diversifiable risk)
     Rm        = expected rate of return on equities
     Rm – Rf   = 5.5% (i.e., equity risk premium
                         historical average since
                         1963)
      FSP      = firm size premium
      Estimates of Size Premium

Market Value (000,000)           Percentage Points Added to
                                   CAPM Estimate
  >$18,600                                  0.0
  $7,400 to $18,600                          .6
  $2,700 to $7,400                          1.0
  $1,100 to $2,700.                         1.5
  $450 to $1,100                            2.3
  $200 to $450                              2.7
  $100 to $200                              5.8
  <$100 million                             9.2


Source: Adapted from estimates provided by Ibbotson Associates.
Required Returns: Cost of Capital
Weighted Average Cost of Capital (WACC):1,2

WACC = ke x                E    + i (1-t) x    D   + kpr x __PR__
                        (E+D+PR)            (E+D+PR)      (E+D+PR)

Where E = the market value of equity
      D = the market value of debt
     PR = the market value of preferred stock
      ke = cost of equity
      kpr= cost of preferred stock
       i = the interest rate on debt
       t = the firm’s marginal tax rate

1To   estimate WACC, use firm’s target debt-to-total capital ratio (TC).
2(D/E)/(1+D/E)  = [(D/E)/(E+D)/E] = [(D/E)(E/(E+D)] = D/(E+D) = D/TC; E/TC = 1 – D/TC.
                       Analyzing Risk
• Risk consists of a non-systematic/diversifiable and systematic/non-
  diversifiable component
• Equity beta (ß) is a measure of non-diversifiable risk
• Equity beta quantifies a stock’s volatility relative to the overall
  market
• Equity beta is impacted by the following factors:
   – Degree of industry cyclicality
   – Operating leverage refers to the composition of a firm’s cost
      structure (fixed plus variable costs)
   – Financial leverage refers to the composition of a firm’s capital
      structure (debt + equity)
• Firms with high ratios of fixed to total costs and debt to total capital
  tend to display high volatility and betas
                How Operating Leverage Affects
                     Financial Returns?1
                                        Case 1                  Case 2: Revenue               Case 3: Revenue
                                                                Increases by 25%              Decreases by 25%

Revenue                                   100                           125                             75

Fixed                                      48                            48                             48
Variable2                                  32                            40                             24
  Total Cost of Sales                      80                            88                             72

Earnings Before Taxes                      20                            37                              3

Tax Liability @ 40%                        8                            14.8                           1.2

After-Tax Earnings                         12                           22.2                           1.8

Firm Equity                               100                           100                            100

Return on Equity (%)                       12                           22.2                           1.8
1All figures are in millions of dollars unless otherwise noted. All cases have same fixed expenses and firm equity but
differ by revenue.
2In Case 1, variable costs represent 32% of revenue. Assuming this relationship is maintained, variable costs in Cases

2 and 3 are estimated by multiplying total revenue by .32.


       Key Point: High fixed to total cost ratios magnify fluctuations in financial returns.
        How Financial Leverage Affects
             Financial Returns1
                                        Case 1: No Debt       Case 2: 25% Debt to      Case 3: 50% Debt to
                                                                 Total Capital            Total Capital

Equity                                         100                      75                      50

Debt                                            0                       25                      50

Total Capital                                  100                     100                      100

Earnings before Interest and                   20                       20                      20
Taxes

Interest @ 10%                                  0                      2.5                       5

Income before Taxes                            20                      17.5                     15

Less income Taxes @ 40%                         8                       7                        6

Net Income                                     12                      10.5                      9

After-Tax Return on Equity (%)                 12                       14                      18
1All   figures are in millions of dollars unless otherwise noted. Total capital and EBIT same in all cases.


        Key Point: High debt to total capital ratios magnify fluctuations in financial returns.
    Leveraged versus Unleveraged Equity Betas
• In the absence of debt, the equity ß is called the unleveraged ßu,
  which is impacted by the firm’s operating leverage and the cyclicality
  of the industry in which the firm competes
• In the presence of debt, the equity ß is called the leveraged ßl
• If a firm’s shareholders bear all the risk of operating and financial
  leverage and interest is tax deductible, leveraged and unleveraged
  betas can be calculated as follows:

ßl = ßu (1 + (1-t) (D/E)) and ßu = ßl / (1 + (1-t) (D/E))

where t, D, and E are the tax rate, debt and equity, respectively.

Implications:
--Increasing D/E raises firm’s breakeven and increases shareholder risk
    that firm will be unable to generate future cash flows sufficient to pay
    their minimum required returns.
--Tax deductibility of interest reduces shareholder risk by increasing
    after-tax cash available for shareholders.
      Estimating a Firm’s Equity Beta
• Regress percent change in firm’s share price plus
  dividends against percent change in a broadly defined
  stock index plus dividends for last 3-5 years.
   – However, this assumes the historical relationship
     between risk and return will hold in the future
• Alternatively, use a sample of similar firms:
   – Step 1: Select sample of firms with similar cyclicality
     and operating leverage (i.e., usually in the same
     industry)
   – Step 2: Calculate average unlevered beta for firms in
     the sample to eliminate the effects of their current
     capital structures on their betas
   – Step 3: Relever average unlevered beta using D/E
     ratio and marginal tax rate of firm whose beta you are
     trying to estimate (i.e., target firm)
                    Estimating Abbot Labs’ Equity Beta
Step 1: Select sample of firms having similar              Step 2: Compute            Step 3: Relever
cyclicality and operating leverage                         average of firms’          average unlevered
                                                           unlevered betas            beta using target’s
                                                                                      debt/equity ratio
         Firm              Levered           Debt /          Unlevered Equity              Abbot Labs’
                            Equity           Equity1              Beta2                  Relevered Equity
                            Beta1                                                             Beta3
Abbot Labs                   .2900            .2662                 .2501                        NA
Johnson & Johnson            .6000            .0762                 .5738                        NA
Merck                        .6600            .3204                 .5536                        NA
Pfizer                       .6800            .3044                 .5750                        NA
                                                             Average = .4881                    .4209
1Yahoo    Finance (1/29/2011). Beta estimates are based on historical relationship between the firm’s share
price and a broadly defined stock index.
2ß = ß / (1 + (1-t) (D/E)), where ß and ß are unlevered and levered betas; marginal tax rate is .4.
  u     l                             u      l
 Abbot Labs (ßu ) = .2900 / (1 + (1 - .4).2662)) = .2501
 Johnson & Johnson (ßu ) = .6000 / (1 + (1 - .4).0762)) = ..5738
 Merck (ßu) = .6600 / (1 + (1 - .4).3204)) = .5536
 Pfizer (ßu) = .6800 / (1 + (1 - .4).3044)) = .5750
3ß = ß (1 + (1-t) (D/E)) using the target firm’s (Abbot Labs) debt/equity ratio and marginal tax rate.
  l    u
 Abbot Labs’ relevered beta = .4881 (1 + (1 - .4).2662)) = .4209
                 Valuation Cash Flow
• Valuation cash flows represent actual cash flows available to reward
  both shareholders and lenders
• Cash flow statements include cash inflows and outflows from:
    – operating,
    – investing, and
    – financing activities
• GAAP cash flows are adjusted for non-cash inflows and outflows to
  calculate valuation cash flow. Examples include the following:
    – Adding depreciation back to net income
    – Deducting gains from and adding losses to net income resulting
      from asset sales since such gains or losses are changes in book
      values only with the actual cash flows from the sale shown in the
      cash flow statement as cash from investing activities.
• Valuation cash flows include free cash flows to equity investors or
  equity cash flow and free cash flows to the firm or enterprise cash
  flow
           Calculating Free Cash Flow
to Equity Investors or Equity Cash Flow (FCFE)
 FCFE (equity cash flow)1 represents cash flow available for
   paying dividends or repurchasing common equity, after
   taxes, debt repayments, new issues, and all
   reinvestment requirements.

 FCFE = (Net Income + Depreciation – Δ Net Working
   Capital2)3 – Gross Capital Expenditures4 + (New
   Preferred Equity Issues – Preferred Dividends + New
   Debt Issues – Principal Repayments)5
 1PV of equity cash flows is the equity value of the firm.
 2Excludes cash in excess of normal operating requirements.
 3Cash from operating activities.
 4Cash from investing activities.
 5Cash from financing activities.
         Calculating Free Cash Flow
to the Firm or Enterprise Cash Flow (FCFF)

 FCFF (enterprise cash flow)1 is cash flow available to repay
   lenders and/or pay common and preferred dividends and
   repurchase equity, after taxes and reinvestment
   requirements but before debt repayments.

 FCFF = (Earnings before interest & taxes (1-tax rate) +
   Depreciation – Δ Net Working Capital2)3 – Gross Capital
   Expenditures4

 1PV of enterprise cash flows is the enterprise value of the firm
 2Excludes cash in excess of normal operating requirements.
 3Cash from operating activities.
 4Cash from investing activities.
        Comparing Free Cash Flow
         to the Firm and to Equity

                      Free Cash Flow   Free Cash Flow
                      to the Firm      to Equity
Cash from Operating         40              40
Activities
Cash from Investing        (22)             (22)
Activities
Cash from Financing                         (10)
Activities
Total Cash Flow             18               8
          Discussion Questions
1. How does the size of the firm affect its
   perceived risk? Be specific?
2. How would you estimate the beta for a
   publicly traded firm? For a private firm?
3. Explain the difference between equity
   and enterprise cash flow?
4, What is the appropriate discount rate to
   use with equity cash flow? Why? With
   enterprise cash flow? Why?
Commonly Used Discounted Cash Flow
        Valuation Methods

• Zero Growth Model

• Constant Growth Model

• Variable Growth Model
             Zero Growth Model

• Free cash flow is constant in perpetuity.

  P0 = FCFF0 / WACC, where FCFF0 is free cash
       flow to the firm and WACC is the weighted
       average the cost of capital

  P0 = FCFE0 / ke where FCFE0 is free cash flow
       to equity investors and ke is the cost of
       equity
     Zero Growth Model Example

• What is the value of a firm, whose annual
  FCFF0 of $1 million is expected to remain
  constant in perpetuity and whose weighted
  average cost of capital is 12%.

        P0 = $1 / .12 = $8.3 million
        Constant Growth Model

  • Cash flow next year (i.e., FCFF1, the first year of the
    forecast period) is expected to grow at a constant rate.

                    FCFF1=FCFF0(1+g)

P0 = FCFF1 / (WACC-g), where g is the expected rate of
     growth of FCFF1.

P0 = FCFE1 / (ke –g), where g is the expected rate of
     growth of FCFE1.
    Constant Growth Model Example

• Estimate the value of a firm (P0) whose cost of
  equity is 15% and whose cash flow in the prior
  year is projected to grow 20% in the current year
  and then at a constant 10% annual rate
  thereafter. Cash flow in the prior year is $2
  million.

  P0 = ($2 x 1.2)(1.1) / (.15 - .10) = $52.8 million
            Variable Growth Model
• Cash flow exhibits both a high and a stable growth
  period.
• High growth period: The firm’s growth rate exceeds a
  rate that can be sustained long-term.
• Stable growth period: The firm is expected to grow at a
  rate that can be sustained indefinitely (e.g., industry
  average growth rate).
• Discount rates: Reflecting the slower growth rate during
  the stable growth period, the discount rate during the
  stable period should be lower than doing the high growth
  period (e.g., industry average discount rate).
Variable Growth Model Cont’d.
                 n
      P0,FCFF = Σ FCFF0 x (1+gt)t +         Pn
                t=1 (1+ WACC)t           (1+WACC)n

 Where


 Pn = FCFFn x (1 + gm)
        (WACCm – gm)
 FCFF0 = free cash flow to the firm in year 0
 WACC = weighted average cost of capital through year n
 WACCm = Weighted average cost of capital beyond year n
             (Note: WACC > WACCm)
 Pn = value of the firm at the end of year n (terminal value)
 gt = growth rate through year n
 gm = stabilized or long-term industry average growth rate beyond year n
       (Note: gt > gm)
    Variable Growth Model Example

• Estimate the value of a firm (P0) whose
  cash flow is projected to grow at a
  compound annual average rate of 35% for
  the next five years and then assume a
  more normal 5% annual growth rate. The
  current year’s cash flow is $4 million. The
  firm’s weighted average cost of capital
  during the high growth period is 18% and
  then drops to the industry average rate of
  12% beyond the fifth year.
Variable Growth Model Example Solution

  PV1-5 = $4 x 1.35 + $4 x (1.35)2 + $4 x (1.35)3 +
            (1.18)      (1.18)2        (1.18)3

          $4 x (1.35)4 + $4 x (1.35)5
            (1.18)4        (1.18)5

        = $30.5

  PV5   = (($4 x (1.35)5 x 1.05)) / (.12 - .05) = $117.65
                        (1.18)5

  P0    = PV1-5 + PV5 = $30.5 + $117.65 = $148.15
      Solving Variable Growth Model Example
             Using A Growing Annuity
P0,FCFF = High Growth Period       +      Terminal Period
           (Growth Annuity)             (Constant Growth Model)

P0,FCFF = FCFF0(1 + g) x {1 – [(1 + g)/(1 + WACC)]n } + FCFFn x (1 + g)/(WACC - g)
           (WACC – g)                                      (1 + WACC) n


       = $4.00 (1.35) x {1 – [(1.35/1.18)]5} + [($4.00 x 1.355 x 1.05]/(.12 - .05)
          (.18 - .35)                                       1.185

        = -.91.8 x -.96 + $117.65

        = $30.50 + $117.65

        = $148.15
         Determining Growth Rates
• Key premise: A firm’s value can be approximated by the
  sum of the high growth plus a stable growth period.
• Key risks: Sensitivity of terminal values to choice of
  assumptions about stable growth rate and discount rates
  used in both the terminal and annual cash flow periods.
• Stable growth rate: The firm’s growth rate that is
  expected to last forever. Generally equal to or less than
  the industry or overall economy’s growth rate. For
  multinational firms, the growth rate is the world
  economy’s rate of growth.
• Length of the high growth period: The greater the current
  growth rate of a firm’s cash flow relative to the stable
  growth rate, the longer the high growth period.
                     Choosing the Correct Tax Rate
                        (Marginal or Effective)

• Effective rates are those a firm is actually paying after
  allowable deductions (e.g., investment tax credits) and
  deferrals (e.g., accelerated depreciation)
• Marginal tax rates are those paid on the last dollar of
  income earned
• Zero and Constant Growth Models: In calculating
  valuation cash flows, use marginal tax rates1
• Variable Growth Model: In calculating valuation cash
  flows,
   – Use effective rates to calculate annual cash flows
      when effective rates are less than marginal rates and
   – Use marginal rates in calculating terminal period cash
      flows.1
   1The   use of effective tax rates during the terminal or an indefinite growth period implies the firm will defer
            the payment of taxes indefinitely.
               Practice Exercise

Free cash flow to equity last year was $4 million. It
  is expected to grow by 20% in the current year,
  at a 15% rate annually for the next five years,
  and then assume a more normal 4% growth rate
  thereafter. The firm’s cost of equity is 10% and
  weighted average cost of capital is 8% during
  the high growth period and then drop to 8% and
  6%, respectively, during the normal growth
  period. What is the present value of the firm to
  equity investors (equity value)? If the market
  value of the firm’s debt is $10 million, what is the
  present value of the firm (enterprise value)?
Variable Growth Model Example Solution

 PV1-5 = $4 x 1.2 x 1.15 + $4 x 1.2 x (1.15)2 + $4 x 1.2 x (1.15)3 +
             (1.10)              (1.10)2              (1.10)3

                 $4 x 1.2 x (1.15)4 + $4 x 1.2 x (1.15)5
                      (1.10)4              (1.10)5
             = $27.47

 PV5          = (($4 x 1.2 x (1.15)5 x 1.04)) / (.08 - .04) = $155.86
                                (1.10)5

 P0          = PV1-5 + PV5 = $27.47 + $155.86 = $183.33 (equity value)

 P0         = $183.33 + $10 = $193.33 (enterprise value)1
 1Recall   that the enterprise value of a firm is equal to the sum of the value of its equity and debt.
                   Adjusting Firm Value
• Generally, the value of the firm’s equity is the sum of the present
  value of the firm’s operating assets and liabilities plus terminal value
  (i.e., enterprise value) less market value of firm’s long-term debt.
• However, value may be under or overstated if not adjusted for
  present value of non-operating assets and liabilities assumed by the
  acquirer.

   PVFCFE = PVFCFF (incl. terminal value) – PVD + PVNOA – PVNOL

   where PVFCFE = PV of free cash flow to equity investors
         PVFCFF = PV of free cash flow to the firm (i.e., enterprise
                  value)
         PVD = PV of debt
         PVNOA = PV of non-operating assets
         PVNOL = PV of non-operating liabilities
    Adjusting Firm Value Example

• A target firm has the following characteristics:
   – An estimated enterprise value of $104 million
   – Long-term debt whose market value is $15 million
   – $3 million in excess cash balances
   – Estimated PV of currently unused licenses of $4
     million
   – Estimated PV of future litigation costs of $2.5 million
   – 2 million common shares outstanding

   What is the value of the target firm per common share?
Adjusting Firm Value Example Cont’d.
 Enterprise Value                  $104

 Plus: Non-Operating Assets
   Excess Cash Balances             $3
   PV of Licenses                   $4

 Less: Non-Operating Liabilities
  PV of Potential Litigation        $2.5

 Less: Long-Term Debt               $15

 Equals: Equity Value              $93.5

 Equity Value Per Share            $46.75
            Things to Remember…

• Zero growth model: Cash flow is expected to remain
  constant in perpetuity.
• Constant growth model: Cash flow is expected to
  grow at a constant rate.
• Variable growth model: Cash flow exhibits both a
  high and a stable growth period.
   – Total present value represents the sum of the
     discounted value of the cash flows over both
     periods.
   – The terminal value frequently accounts for most of
     the total present value calculation and is highly
     sensitive to the choice of growth and discount
     rates.

				
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posted:9/24/2012
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