CORPORATE VALUATION by liwenting

VIEWS: 516 PAGES: 47

									Management Control Financial Analysis and Shareholder Value

Dr. Michael Lamla 41 av. Felix Faure, 75015 Paris October 2009

Financial Analysis

I. II.

EBITDA, EBIT, EBT, Net earnings ROCE / ROE

III.
IV.

Case Study: Golf Club Phantasia
Leverage

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Summarized P&L
Sales -Costs of Goods sold -Selling, General & Admin. Expenses EBITDA + - depreciation and amortisation

Operating cycle

Capital expenditures
EBIT (Earnings before Interest and Taxes) + + financial income (expenses) Capital structure EBT (Earnings before taxes) + + extraordinary items - associated undertakings -taxes- minority interests Net earnings
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Non-recurrent items and tax

Summarized Balance Sheet

Capital Employed = Fixed assets + Working Capital


Fixed assets =

Tangible assets + Intangible assets

+ Investments.



Working Capital =

Inventories + Accounts Receivable

+ Other current assets (excluding cash)
- Accounts payable - Other current liabilities (excluding short-term borrowings)

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Summarized Balance Sheet


Capital Employed =

Shareholders’ equity + + + Minority Interests Provisions for Liabilities & Charges Net Debt Equity Retained earnings

Shareholders’equity

= +

Minority Interests Provisions for liabilities & charges =

Restructuring plans, retirements

Net Debt

= +

Long term debt Short term debt Cash & marketable securities

(more than 1 year) (less than 1 year)
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-

Capital Employed / Invested Capital

Fixed Assets Capital Employed (CE) Working Capital

Shareholders’ equity (E) MI PLC Invested Capital (IC)

Net Debt (D)

MI : Minority Interests

PLC : Provisions for liabilities & charges.

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ROCE / ROE


Income, assets and rate of return


EBIT stems from Capital Employed Net Income is allocated to Equity



Equity EBIT Return on capital employed (ROCE) Capital employed

Net earnings
Return on equity (ROE)

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ROCE


ROCE : Return on Capital Employed

EBIT (1-TR) ROCE = CE
EBIT : Earnings before interest & taxes TR : Corporate tax rate

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ROCE

EBIT (1-TR) ROCE

EBIT (1-TR)

Sales

=
CE

=
Sales
profit margin

x
CE
asset turnover ratio



High ROCE can derived from :


high margins, low asset turnover ratio (e.g. : luxury goods). low margins, high asset turnover ratio (e.g. : temporary work services).



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ROE


ROE : Return on Equity.

ROE

EBT (1 = E +

MI

TR)

EBT(1 or ROE =

-

TR)

after

MI

E

EBT : Earnings before Tax.
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Analysing a business plan

Sales plan

Cost estimates

Development of Net Working Capital

Investments and Depreciation

Financial structure

Balance sheet forecast

P&L forecast

Investment plan

Financing needs and financial result forecast

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Exercise: Case Study Golf Club Phantasia
Review the business plan and discuss it with management


Mistakes in the business plan  ...  ...  ...  ...  ...  ...  ...  ...  ...



Topics to be further explored  ...  ...  ...  ...  ...
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Exercise: Case Study Golf Club Phantasia


Topics to be further explored


... ... ... ... ... ... ... ... ... ...





















Conclusions to be drawn from the case study


A)



B)
C)
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

Financial Leverage

D L = Leverage = =

Net Debt

E + MI

Equity + Minority Interests

Leverage (gearing)

ROE = ROCE + (ROCE -

Kd ) L

Kd: : Book value cost of the debt (%) after tax.

If ROCE>Kd et L>0, then ROE>ROCE. but the level of risk is higher.

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Financial Leverage
Return on Equity (ROE) L=3 L=1 L = 1/2 14% 10% 9% 8% L=0

8%

Return on Capital Employed (ROCE)

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Shareholder Value

I. II.

Corporate Cost of Capital (WACC) Cost of Equity (CAPM)

III.
IV.

Cost of Debt
DCF Entity Method: An Overview

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Corporate Cost of Capital
A company‘s corporate cost of capital covers: a) cost view - debt: actual cost of providing funds to the company - equity: expected minimum return for investments under uncertainty b) revenue view - time value of money - risk premium debt: default risk equity: volatile residual claims

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Corporate Cost of Capital
Simplifying Assumptions • Company generates constant cash flow in every period • Cash Flow = CF

• Infinite time horizon

Value of the Firm

 A

V

CF k

V = value of the firm k = total cost of capital

Firm Value = present discounted value of future cash flows

B 

V ED

E = equity D = debt

Firm Value = sum of all financial claims against the company

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Corporate Cost of Capital
From (A):

Cost of Capital

(C ) k 
Plug in (B):

CF V

( D) k 
Value of Equity

CF ED

Value of Equity:

(E) E 

CF  k D  D  t  k D  D kE

kE = cost of equity kD = cost of debt before taxes t = tax rate

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Corporate Cost of Capital
Solve (E) for CF:
Interest expenses are typically tax-deductible!

( F ) CF  k E  E  (1  t )  k D  D
WACC = Weighted Average Cost of Capital

WACC

 E   D  After Taxes k    kE     kD  ED  ED After where k D Taxes  (1  t )  k D
also referred to as the tax-shield effect of debt

What to watch out for: Our ultimate objective is to determine the value of E. To do so, we need k – but k depends again on E (implied circular reasoning!).
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Cost of Equity: Capital Asset Pricing Model
The Capital Asset Pricing Model describes the expected return for all assets and portfolios of assets in the economy:
Required rate of return = Risk-free rate + risk premium
~ E(RI )

~ ~ E(RI )  Rf    E(RM )  Rf





I  1
~ E(RM )

M

 I  (0,1)
Rf

I  1

I  0

M  1

I 

 IM 2 M

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Cost of Equity
Consider an all-equity financed company which has the opportunity to invest in a project generating a constant cash flow forever out (“cash cow”). Investment expenditures are I. In general:

E (CFt ) NPV   I   1  RF    E( RM )  RF t t 1
With constant cash flow:

T

NPV   I 

CF RF    E ( RM )  RF 

Accept the project if NPV is non-negative.
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Cost of Equity

Investment Decisions with Different Beta Estimates I 80 CF 11 Beta-1 1.2 NPV-1 3.333333 Beta-2 1.3 NPV-2 -0.28986 Beta-3 1.4 NPV-3 -3.61111 RF 0.06 RM 0.12 (all Figures in USD bill.) kE-1 0.132 kE-2 0.138 kE-3 0.144

Working with the wrong beta estimate can imply huge value losses for the company... ...and leads to wrong investment decisions!
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Cost of equity
Which betas to use?

• Publicly Traded Company
• Use beta of your company if available • Cross-check with industry average to see whether assessment is fair (especially regarding risk profile)

• Non-Traded Company / Individual Investment in New Market
• Use company beta if risk profile comparable • Use benchmark portfolio • Use industry beta

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Cost of equity
Using company-wide hurdle rates to make decisions on individual projects implies error of judgement! Very common but faulty practice.
E (R )

Security Market Line

Project increases shareholder value! Using a general hurdle rate implies the rejection of the project!

Rf

Project

Firm


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Cost of Equity / Cyclicality
What to watch out for when using benchmarks! Cyclicality • stock prices depend on the overall business cycle • up-/downturns show up differently for different sectors • more cyclicality implies higher betas • benchmarks used must reflect differences in this regard Operating Leverage Financial Leverage

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Cost of Equity /Operating Leverage
Operating Leverage • refers to the technology mix chosen by the firm • has an impact on the relative importance of fixed vs. variable costs • technologies with higher fixed cost component (e.g. less labor intensive, more capital intensive) carry higher operating margins • (price – marginal cost) is higher • we say: firm has higher operating leverage • sales fluctuations have a larger impact

TC TVC MC   Q Q

• • • • • •

MC = Marginal cost TC = total cost TVC = total variable cost TFC = total fixed cost Q = output (volume) Delta = change

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Cost of Equity / Operating Leverage
EUR TC EUR TC

TFC
TFC Q EBIT EBIT Q

Q

Q
Lower MC implies bigger EBIT variations on the margin
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Cost of Equity / Financial Leverage

k 20%

CP

15%

k 10%

k 5%

D

V 0% 0 0,1 0,2 0,3 0,4 0,5 0,6 0,7 0,8 0,9

D

/V



Increasing leverage leads to higher risk for the shareholders and thus to an increase of beta. Moreover, financial structure does not have any impact on the WACC, since increasing leverage leads to increasing cost of equity. ße





Unlevered beta = 1+(1-T) x

VD VE

(assuming that ßd = 0)
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Cost of Debt
• Cost of Debt = • Time Value of Money (Value of Liquidity) + • Default Risk Premium + • Adjustments for Specific Contract Features + • Adjustment for „Tax Shield“ Effect

GENERAL RULE

•
PRINCIPLE • •

opportunity cost principle (market rates vs. historical/contractual rates)
evaluate cost of debt on the basis of target capital structure (implication for maturity and type of debt considered?) credit rating of firm vs. bond issue

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DCF-Entity-Method
Planning Horizon „Perpetuity"

CF
1

CF
2

CF
3

CF
4

CF
5

CF
x

Average (permanent) CF

t

Investment

Discounting
Residual Value = Capitalized „Perpetuity" CF1 CF2 CF3 CF4 CF5

t
PV of the Residual Value



Investment

Sum of PV of Future Cash Flows

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DCF-Entity-Method
Market Value of Debt

Terminal Value

Gross Value of the Company

Real world betas

Present Value of Cash Flows during Planning Period

Market Value of Equity = Company Value from a Shareholder Perspective

Shareholder Value

Non-operating Assets

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Outline for different steps
1. 2. 3. 4. 5. Determine the corporate cost of capital (WACC) Determine the planning horizon Project cash flows for the planning horizon (+ 1 Period) Determine the residual value Discount future cash flows with WACC to obtain firm value net of non-operating assets Determine the value of non-operating assets to obtain firm value Determine the market value of debt

6. 7.

8.

Subtract the market value of debt from firm value to obtain shareholder value

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1. Beta: An Example
Beta 1 0,88 0,92 1,08 1,31 1,39 0,43 Debt to Equity 607% 300% 340% 176% n.a. 46% Sales Sales margin 85.554 EUR 2,41% 35.356 EUR 2,90% 162.384 EUR 1,53% 4.441 EUR 6,09% 11.581 EUR 9,14% 81.422 EUR 6,85%

Volkswagen BMW DaimlerChrysler Porsche LVMH Nestlé
1

Measured against the Dow Jones Euro Stoxx 50

 How can we explain LVMH‘s company beta? Divisions
€ 14.611m € 60,95 489,90m € 34.535m Wines & Spirits Fashion & Leather Perfumes & Cosmetics e.g. Hennessy, Veuve, Pommery, Moet e.g. Kenzo, DKNY, LV e.g. Christian Dior, Givenchy

Financial Data
Debt Stock Price # of Shares MktCap (2001)

Selective Retailing
Watches & Jewelry

e.g. DFS, Le bon Marché
e.g. TAG Heuer, Fred

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1. Beta: An Example (continued)
Sales 2.232 3.612 2.231 3.475 679 12.229 Income 676 1.274 149 -194 -345 1.560 Industry Beta 0,7 0,5 1,0 1,5 --0,94

Wines & spirits Fashion & Leather Perfumes & Cosmetics Selective Retailing Other TOTAL

Industry Beta chosen to fit the example by Farag Professional Research

 The weighted average of division betas is 0,94!

ßequity

 Debt  1    ßasset *    Equity 

 The levered company beta is 1,40!

 14611m  ßequity  0,94 * 1   60,95 * 489,90m    
ßequity  0,94 * 1  0,4893  1,40
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2. Planning Horizon

Planning horizon must capture an entire business cycle, otherwise systematic valuation bias! Company should reach steady state within planning horizon!

Earnings before taxes

Valuation Date

End of Planning Horizon

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3. Free Cash Flow calculation (direct approach)
– COGS – SG&A – Depreciation / amortization + Adjustments: operating leases retirement liab. – (Adjusted) Taxes on EBIT + Change in deferred Taxes

Free Cash Flows (FCF) are all cash flows available for satisfying the claims of all investors (i.e. equity and debt holders)

Net Sales

+ Depreciation / amortization

EBIT NOPLAT Gross CF from Operations

– Change in net working capital – CapEx – Investments in Goodwill

FCF
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3. Free Cash Flow calculation (indirect approach)
(Accounting) Earnings non-cash costs non-cash revenues Interest payments EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization) Depreciation and Amortization EBIT (Earnings before Interest and Taxes) Taxes on EBIT (incl. change in deferred tax asset) NOPLAT (Net Operating Profit Less Adjusted Taxes) Depreciation and Amortization Operating Cash Flow Investments in Net Working Capital Investments in long-term assets (capital expenditures & goodwill)

+ + = = = + = -

= Free Cash Flow
Interest payments (+ Increase in debt) = Cash Flow to equity holders
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4. Residual Value

according to the investment level !

ROCE
30 %

TVn

=

FCFFn+1

wacc - g

WACC 10 %

TV = _ _ _ _ _ (EBIT multiple of _ _ )

time
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4. Residual Value

Gordon-Growth Formula

RVT 

FCFT 1 kg

FCFt+1 = normalized free cash flow after planning horizon g k RVT = expected growth rate = WACC = residual value at the end of the planning horizon

RVT RV0  (1  k )T
•

present value of RV

alternatives: liquidation value, simple perpetuity

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4. RESIDUAL VALUE – SOLUTION

Free Cash Flows  In the long run, net investments and DA have to cancel out.  It’s essential to question whether planning data for T is representative for future years Growth Rate  In the long run, growth rates will generally not be larger than inflation.

 Short term, there is no reason, why company should not reach industry average growth.

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6. NON-OPERATING ASSETS – PRACTICE PROBLEM

A German soccer club operates various pieces of real estate as listed in the table below:
Stadium Merchandise Stores Practice Facility Player Condominiums Hotel & Conference C. FCF Book Value 50.000 100 2.500 7.500 10.000 70.100 Market Value 250.000 1.000 25.000 10.000 20.000 306.000 Net Income 0 10.000 -15.000 -2.000 2.500 -4.500

 Which of these assets are considered non-operating?

 How much are these assets worth?

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6. NON-OPERATING ASSETS – SOLUTION
Hotel and conference center; primarily used for non-team related events. As further information was not given, a number of assumptions have to be made in order to assess the value of this estate: • The company’s cost of capital is estimated at 10% p.a. • Net Income is assumed to equal cash flows from operations • Necessary “replacement” investments average 25% of net income

 PV 

FCF r



PV 

(1  0,25) * 2500  18750 0,1

Present Value of Cash flows < Market Value, however, liquidation costs need to be taken into account (in this case assumed to be zero).  max (PV; MV-LC)
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7. ARRIVING AT THE MARKET VALUE OF DEBT
Market Prices • If available

• Without market prices, approximation requires four steps:: Equivalents 1. Identifying contractual payments 2. Identifying credit rating of instrument 3. Estimation of market prices through comparable instruments with equal coupon, duration, rating etc. 4. Calculating present value of debt payments using effective interest on equivalent instruments • If neither market prices nor equivalents exist, (discounted) book values have to be used Complex instruments (e.g. convertible debt consisting of regular debt and option to switch to equity) Approach: Separating into individual components and valuing each using specific methods (i.e. option component using adequate option pricing model)
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Book Values

Hybrid Debt

• •

8. SHAREHOLDER VALUE
Any financial policy or strategy measure must be evaluated on the basis of its impact on shareholder value:

SV  
t 0

T

1  k 

E (CFt )
t

 RV  NOA  D

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SHORTCOMINGS OF DCF

• DCF captures expected outcomes and not the spread (how bad could it be; how well could things turn out) • implicitly assumes that company operates on auto pilot, i.e., management does not play an active role in responding to changes in the economic environment • constant WACC is likely not to reflect reality

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Presentation of results

not :

VALUE = 109.85

...but :

VALUE = 100 to 120

-

+
You should ALWAYS talk about ranges - and describe what assumptions are they linked to
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