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Valuation, discount rate, discount rate,
growth rate and project selection

      LECTURE 3



                     2   1
Learning Goal

                We know the
                    cost of
                everything but
                 the value of
Lecture outline

   Introduction
   Value creation
   Valuation models
   Discount rates
   Growth rates
   Project selection
Value creation

   Firms make various value-increasing decisions
       New venture
       New project
           Product innovation
           Process innovation
   Need to value those projects/ventures well for
    better management
   Lecture 5 looks at valuation of Technologies/IP
Valuation Framework

 1. Gather latest information/data
 2. Estimate expected revenue growth (past rates,
    mkt. rates, other factors )
 3. Sustainable operating margin (CVP analysis)
 4. Reinvestment (plough-back rate = g/ROC)
 5. Risk parameters (discount rates)
 6. Start-up valuation (EPS)
 7. Project selection
Many different valuation methods…….
              Valuation Measures
     Approach               Description
      Accounting Book
    Breakup Liquidation
             Fair Value
       Enterprise Value

  Many different valuation methods…….
                           Valuation Measures
   Approach                                 Description
Subjective/Personal   Based    on unique individual preferences
  Accounting Book     Historical   cost from the financial reporting model
      Replacement     Cost   to buy asset in the purchase market
           Deprival   Cost   to compensate for the loss of an asset
            Market    Equilibrium   price amongst actively traded parties
Breakup Liquidation   Net   realizable value in the sales market
         Fair Value   A   “reasonable” value given information at hand
 Intrinsic/Economic   A   estimate of value basing on earning potential
   Enterprise Value   The   intrinsic value of a firm’s operating assets

In general

   Cost approach (accounting book)
   Income approach (Present value or
    discounted cash flow (DCF);
   Market approach

   Example:
       Valuing a second hand car
           Accounting valuation vs. DCF valuation
1. Cost Approach

   measures the future benefits of ownership by
    quantifying the amount that would be
    required to replace the future service
    capability of the asset
   assumes that the cost of replacement
    commensurate with the value of the service
    that the asset can provide during its
    productive life
1. Cost Approach

1. Research and Development Expenditures:
   involves the capitalisation of R&D or product launch
   has the double effect of reducing expenses in the
    income statement and building up the asset side of
    the balance sheet
   capitalisation of R&D expenditure is to recognise its
    future benefit and therefore should be amortised
    against future sales
1. Cost Approach

Research and Development Expenditures:
   empirical evidence has failed to ‘find
   significant correlation between research
   and development expenditures and
   increased future benefits as measured by
   subsequent sales, earnings, or share of
   industry sales’.
1. Cost Approach

Research and Development Expenditures:
   The professional practice is to take a
   conservative approach to R&D expenses
   and to remove intangible assets unless
   there is a history of profits and sales as
   justification (i.e. brand names)
1. Cost Approach

2. Tobin’s q
   combines the market value and the replacement
    cost methods for valuing assets in a way very similar
    to the market-to-book (M/B) value ratio
   expectations of future profits are the basic
    determinant of investment activity and these
    expectations are supposed to be reflected in a firm’s
    market value
1. Cost Approach

2. Tobin’s q

                 V     MV (assets )
     Tobin' sQ  i 
                P K replacement cos ts

Compare Tobin’s Q with 1.
1. Cost Approach

Tobin’s q
   market value of the firm exceeds the value of its
    existing capital when investors’ perceive its
    expected earnings as high or increasing
   firm can be worth less than its existing capital when
    its prospects are considered uncertain or low
   investment in new real capital is profitable if q
    exceeds one
1. Cost Approach

Tobin’s q
   Firms with high q ratios are normally those with
    attractive investment opportunities or a significant
    competitive edge, as would the case with most
    technology start-ups
   Tobin’s q ratio differs from the M/B ratio
   q ratio utilises market value of the debt plus equity
   It also uses the replacement value of all assets
    instead of the historical cost value
1. Cost Approach
3. Adjusted Net Assets Method - One of the Cost Approaches

i. The balance sheet is restated from historical cost to market value
ii. A valuation analysis is performed for the fixed, financial, other
     assets, and liabilities
iii. The aggregate value of the assets is “netted” against the
     estimated value of existing and potential liabilities to estimate the
     value of the equity
iv. This value represents the minimum, or “floor,” value the
     company at liquidation
Income Approach:
Discounted cash flows method

   Focuses on the income-producing potential of
    the asset
   The value of the asset can be estimated from
    the present worth of the net economic benefit
    generated over the life of the asset
   The DCF approach captures the essence of
    the time value of money and risk.
Discounted cash flows method
        Value  
                t 1   i 
           The present value of all future cash flows
           discounted at a rate that reflects the time
       =   value of money and the
           certainty of cash flows.
Discounted cash flows method

                      t 1 1  WACC
                        t 
   Value of firm =
Nice Idea But…

      Who knows what          The complexity of
     future cash flow &      modeling an enterprise
    discounts rate to use?       is daunting!
Step 1: Estimate Cash flows

   Cash flows are pre-financing, i.e.,
    independent of the capital structure of the
       Do not take out interest expense from cash flows
Estimating Cash flows

CFt = EBITt*(1 - T) + DEPRt – CAPEX - WKt + othert

 CF = Cash flow;

 EBIT = Earnings before interest and taxes;

 T = Corporate tax rate;

 DEPR = Depreciation;

 CAPEX = Capital Expenditure;

 WK = Increase in working capital, and
 other = Increases in taxes payable, wages, payable, etc.
Industry based understanding
Cash                              Cash
flow                              flow


       Cash flow diagram for an          Cash flow diagram for a
       airline company                   newsletter company
Multiple cash flow curves
            Harvest                   This occurs when after the first
                                      project, the firm has options to
                                      introduce related products/services
                                      to the market.

                                      This presents new growth
                      Growth          opportunity to the company.
Projection vs. reality                      Scenario 1
Cash                                 Cash
flow                                 flow                Scenario 2 More
       projection                                        time & money,


                    Time                                     Time

                                                         Scenario 3: More
                                                         time & money,
Need to understand the industry

   Group discussion exercise
       The following common sized Financial statements
        were taken from 4 companies in 4 different
        industries. Could you please match the numbers
        to the companies?
           Utility
           Banking
           Grocery
           Pharmaceutical
Step 2:
Estimate growth rate and discount rate
   Using CAPM to work out the cost of equity
               ra  r f   * ( rm  r f )

       Need risk free rate (note the matching principle)
       Firm beta (leveraged vs. unlevered)
       Market risk premium
       Note on beta.
       Use this as the discount rate for all equity firm
Estimating accounting beta
The private firm’s accounting earnings can be used to regress
against changes in earnings for a market equity index such as
the S&P/ASX 200 to estimate an accounting beta.

Earningsf =  + S&P/ASX200 + 

Earningsf = the change in earnings of the firm;
 = the intercept or constant;
 = the beta of the market equity index;
S&P/ASX200 = the market equity index, and
 = the random error term.
Bottom-up Betas
  This method involves breaking down betas into their business
  risk and financial leverage components to enable us to estimate
  betas without having to rely on past prices on a technology start-

  Unlevered Betas (u): The systematic risk of a firm assuming
  that it is 100% equity financed and has no debt.

               U =
                       [1 + (D/E)]
Bottom-up Betas
   Levered Betas (u): Where the firm’s capital structure
    consists of both equity and debt financing.

                L = U [1 + (D/E)]

   The use of operating income (i.e. EBIT) would yield an
    unlevered beta while using the net income would yield the
    equity or levered beta.
   The limitations with this type of beta are the distortion of
    data caused by accounting adjustments and the lack of a
    long time series for earnings given the short history of most
    technology start-ups
Cost of Debt

   The best practices for estimating the cost of
    debt are to use the marginal borrowing rate
    and a marginal tax rate or the current
    average borrowing rate and the effective tax
   The after-tax cost of debt, Kd(1 – T), is used
    to calculate the weighted average cost of
WACC as the discount rate

   rWACC  wE * r  wD * (1   ) * rD

  Weight of Debt and Weight of Equity are based on Market value
Venture Capital Rates of Return
 The required rates of return for venture capital
 at different development stages are illustrated
 below (Smith and Parr 2000):
 Venture Capital Rates of Return

 Stage of Development       Required
                         Rate of Return (%)
 Start-up                       50
 First Stage                    40
 Second Stage                   30
 Third Stage                    25
Venture Capital Rates of Return
The pharmaceutical industry provides a
specific industry example, Hambrecht & Quist
(Smith and Parr 2000)
Development Stage          Required Rate of Return (%)
Discovery                             80
Pre-Clinical                          60
Clinical Trials – Phase I             50
                – Phase II            40
                – Phase III           25
New Drug Application                  20
Product Launch                     17.5 – 15
Growth Rates

Damodaran (2002) suggests three ways of
estimating growth for any firm as follows:

    Historical growth rate
    Market analysts’ estimates
    Firm’s fundamentals
Valuing cash flows with the CCF method

   All equity (unlevered firm)

        CF1     CF2               CFT  TVT
 PVU                     ... 
       1  ra (1  ra ) 2
                                   (1  ra )T

                                            CFT * (1  g )
                                      TVT 
                                               ra  g
Valuing cash flows with the CCF
method (cont.)
   Leveraged firm
       Tax shield advantage when debt is taken as
        interest payment are tax deductible.
       Value of tax shield, TS (time period t)
             TS t   * rd * D
Valuing cash flows with the CCF
method (cont)
     The tax shields are discounted to PV to get PVTS

          * rd * D1        * rd * D2                 * rd * DT  TV ( * rd * D)T
PVTS                                       ... 
           1  ra           (1  ra )   2
                                                                (1  ra )T

                                                                       * rd * DT
                                    TV ( * rd * D )T 

     Assuming D stays constant for simplicity
     WACC can be used as a discount rate
Valuing cash flows with the CCF
method (cont)


 NPVCCF  PV  Investment
Practice with NSK case

   Please work out the value of NSK company
    basing on the information of NSK and
    comparable companies provided in the case.
Next class

   Valuation with market based approach.
   Case: Tutor Time (A) (p. 131)

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