# On Valuation

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```					An overview on valuation methods
ON VALUATION

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Asset Valuation Model: can we
find the true value of a
project using DCF?
Discounted Cash Flow methods
Multiples: Price/earning Ratio, Market to book ratio
valuation.
Option pricing model
Piece meal approach: evaluate firm part by part

Sources of Uncertainty in Asset valuation:
 the asset being valued, and
 the valuation model itself and the analyst
 Hard to quantify managerial skill, human factors.
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Discounted Cash Flow
Valuation

where n = Life of the asset
CFt = Cash flow in period t
r = Discount rate reflecting the riskiness of the
estimated cash flows
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2 steps of the DCF methods

 Estimating the expected cash flows for
the firm
 discounting the cash flows at an interest
rate that reflects the default risk

 Some projects are easier to evaluate than others:
companies with substantial uncertainties are
harder to evaluate but more rewarding.

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Book Valuation versus DCF
Valuation
Calculate the Value of firm X at end of year 10
(required rate of return = 10 %)
Balance sheet 31. Dec. 09
Fixed Assets      50,000   Equity        10,000

Current Assets    60,000   Liabilities   100,000

110,000                 110,000

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Determination of Free Cash
Flows: Equity Value
Revenues
-operating expenses
= Earnings before interest, taxes and depreciation
(EBITDA)
-depreciation
= EBIT (= Earnings before interest and taxes)
-Interest expenses
= Earnings before taxes
-Taxes
= Net income
+ depreciation
-preferred dividends
-capital spending *
-working capital needs*
= Free Cash Flow to equity
-                                                    6
Determination of Free Cash
Flows: the equity value
In the table,
the capital expenditures is :
 reinvestment: capital expenditures in high-
growth phases exceed depreciation.
Working capital needs is:
the difference between its current assets and
current liabilities. Increases in working capital
needs are cash outflows.
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I.Equity Valuation
 The value of equity is obtained by discounting expected
cash flows to equity, i.e., the residual cash flows after
meeting all expenses, tax obligations and interest and
principal payments, at the cost of equity, i.e., the rate of
return required by equity investors in the firm.

where,
CF to Equityt = Expected Cash flow to Equity in period t
ke = Cost of Equity

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II. Firm Valuation
1. Cost of capital approach:
The value of the firm is obtained by
discounting expected cash flows to the
firm, i.e., the residual cash flows after
meeting all operating expenses and
taxes, but prior to debt payments, at the
weighted average cost of capital.

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approach
2. APV approach: The value of the
firm can also be written as the sum
of the value of the unlevered firm
and the effects of debt.
Firm Value = Unlevered Firm Value
+ PV of tax benefits of debt
- Expected Bankruptcy Cost

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More on APV Model
 In the adjusted present value approach, the value
of the firm is written as the sum of the value of
the firm without debt (the unlevered firm) and
the effect of debt on firm value
 The unlevered firm value can be estimated by
discounting the free cash flows to the firm at the
unlevered cost of equity
 The tax benefit of debt reflects the present value of
the expected tax benefits.
Tax Benefit = Tax rate × Debt (1+ rd )
 The expected bankruptcy cost is a function of the
probability of bankruptcy and the cost of bankruptcy
(as a percent of firm value).
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III. Using Multiples
the underlying belief of the multiple method is :
The value of any asset can be estimated by
looking at how the market evaluates “similar” or
‘comparable” assets.

Equity versus Firm Value
1. Equity multiples (Price per share or Market value
of equity) e.g. 6 times Book value
2. Firm value multiplies

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III. Valuation using                      Multiples
 The multiple method usees
Earnings (EPS, Net Income, EBIT, EBITDA)
e.g. 8 times EBITDA.
Book value (Book value of equity, Book
value of assets, Book value of capital)
Revenues
Sector specific variables
 Relative valuation is much more likely to reflect market
perceptions and moods than discounted cash flow
valuation.
 Relative valuation generally requires less information than
discounted cash flow valuation
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Estimate the Cost of Equity:
Competing Models
Model          Expected Return                   Inputs Needed
Riskfree Rate; Beta;
CAPM           E(R) = Rf + b (Rm- Rf)            Market Risk Premium
Riskfree Rate;
# of Factors;
APM            E(R) = Rf + Sj=1..n bj (Rj- Rf)   Betas; Factor risk
Riskfree Rate; Macro
Multi-factor   E(R) = Rf + Sj=1,,n bj (Rj- Rf)   factors; Betas; Macro

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Estimating Beta
The standard procedure for estimating betas is to
regress stock returns (Rj ) against market returns
(Rm ) :
Rj = a + b Rm
The slope of the regression b is the beta ( β ) of the
stock, and measures the riskiness of the stock.

This beta has three problems:
1. It has high standard error
2. It reflects the firm’s business mix over the period
of the regression, not the current mix
3. It reflects the firm’s average financial leverage
over the period rather than the current leverage.
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Two stage DCF Valuation:
Model   DISCOUNTED CASHFLOW VALUATION

Expe cte d Growth
Cash flows                                Firm: Growth in
Firm: Pre-debt cash                       Operating Earnings
flow                                      Equity: Growth in
Equity: After debt                        Net Income/EPS             Firm is in stable growth:
cash flows                                                           Grows at con stant rate
forever

Terminal Value
CF1          CF2      CF3        CF4           CF5          CFn
Value                                                                               .........
Firm: Value of Firm                                                                                           Fore ver
Equity: Value of Equity
Le ngth of Pe riod of High Growth

Disc ount Rate
Firm:Cost of Capital

Equity: Cost of Equity

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Stage 2: Stable Growth and Terminal
Value
When a firm’s cash flows grow at a “constant”
rate forever, the present value of those cash
flows can be written as:
Value = Expected Cash Flow Next Period / (r - g)
where,
r = Discount rate (Cost of Equity or Cost of
Capital)
g = Expected growth rate

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DDM: dividend discount model
Case study:
 ABN Amro: As a financial service institution,
estimating FCF to equity or FCFF is very difficult.
 The expected growth rate based upon the
current return on equity of 15.56% and a
retention ratio of 62.5% is 15.56%× .625 =9.73%.
 This is higher than what would be a stable
growth rate (roughly 5% in Euros)
Find more detail at:
qnotes/ddm.pdf
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 Market Inputs
Long Term Riskfree Rate (in Euros) = 5.02%
Current Earnings Per Share = 1.60 €; Current DPS = 0.60 €

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ABN Amro: Valuation

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Multinational Capital
Budgeting
Cross border mergers and acquisitions
 Improve economies of scale
 Cost reduction
 Get rid of your competitor
 Less risky than green-field ventures
 Improved financial power

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M&As – Reasons for failures

 Overoptimistic appraisal of market potential
 Overestimation of synergies (bad valuation
methods)
 Overlooking problems
 Overbidding
 Poor post-acquisition integration

23
CSR and firm value

 Is there such a thing as Corporate
Social Responsibility?
 How does it contribute to firm value?

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Important chapters for exam
 Exchange rate: the basic equations:
chapter 4, and 5.
 Theories of exchange rate movement:
chapter 7
 Economic exposure, transaction exposure, and
translation exposure : chapter 8
 Hedging technique, and management of
exposures: chapter 10, 11,12,13, 15
 FDI and international trade theory: chapter 20
 Capital budgeting models, NPV, APV, EVA,:
Chapter 22, 23, 24. Test bank 4 on the book.
Page 513.

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 From our experience, the first essential trait of
leadership is positive energy – the capacity to
go-go-go with healthy vigor and an upbeat
attitude through good times and bad. The
second is the ability to energize others, releasing
their positive energy, to take any hill. The third
trait is edge – the ability to make tough calls, to
say yes or no, not maybe. The fourth trait is the
talent to execute – very simply, get things done.
Fifth and finally, leaders have passion. They care
deeply. They sweat; they believe.

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 views: 16 posted: 10/2/2012 language: English pages: 26