Applied Corporate Finance
5-2 Method: Project-specific WACC: Project financing -Description: -Advantages (1): -Disadvantages (3): -When to Use (2):
-Description: Estimate WACC for each individual project, using the capital costs associated with the actual financing package for the project. Project is financed using non-recourse debt and the project is the sole source of collateral. -Advantages (1): 1) Provides a unique discount rate that reflects the risks and financing mix of the project. -Disadvantages (3): 1) Market proxies for project risk may be difficult to find. 2) Creates the potential for high influence costs as managers seek to manipulate to get their pet projects accepted. 3) Capital structure weights are problematic, as equity value of the project is unobservable. -When to Use (2): 1) The project is financied with nonrecourse debt. 2) The costs of administering multiple discount rates are not too great.
5-2 Method: Divisional WACC -Description: -Advantages (3): -Disadvantages (4): -When to Use (2):
-Description: Estimate WACC for individual business units or divisions of the firm. Use these estimates as the only discount rates within each division. Divisions defined either by geographical regions or industry lines of business. -Advantages (2): 1) Uses division-level risk to adjust discount rates for individual projects. Differences between divisions are based on the systematic risk within each division. 2) entails minimal influence costs within divisions 3) Minimizes time and effort. -Disadvantages (4): 1) does not capture intra-division risk differences in projects 2) does not account for differences in project debt capacities within divisions. Most investments are financed using corporate finance, which means that the debt used to finance the investment comes from corporate debt issues that are guaranteed by the corporation as a whole. Determining the appropriate discount rate for a project under these circumstances can be somewhat more challenging, as the cost of financing the project cannot be directly identified. 3) potential influence costs associated with the choice of discount rates across divisions 4) difficult to find single-division firms to proxy for divisions -When to Use (2): 1) individual projects within each division have similar risks and debt capacities 2) discount rate discretion creates significant influence costs within divisions but not between divisions
9-1 -What is the hybrid approach to enterprise valuation? -What are the 3 steps?
-Hybrid valuation combines DCF analysis with relative valuation -Steps: 1) The present value of planning period cash flows are discounted using the traditional DCF approach 2) Terminal value is calculated using an EBITDA multiple and end-of-planning period EBITDA 3) The present value of the terminal value is added to the present value of planning period cash flows to estimate enterprise value
5-1 Rationale for using multiple discount rates: -elaborate on project expected returns should be judged in comparison to returns that could be generated from investments in publicly traded stocks and bonds with equivalent risk.
-Less risky investments (cash flows resembling the cash flows of a portfolio of bonds) will have an opportunity cost of capital that is lower than more risky investments (cash flows resembling the cash flows of a portfolio of stocks).
9-1 -Most often way to find enterprise value is? -What are the steps? -What is the equation? -What are the two ways to estimate terminal value?
-The 2 step Approach -Steps are: 1) Company cash flows are forecasted for a limited number of years called the planning period and are discounted to present value 2) The estimate present value of all remaining cash flows is called the terminal value -Equation: Enterprise Value = PV of the Planning Period CFs + PV of Terminal Value There are two ways to estimate terminal value: 1) A perpetuity approach (using the Gordon growth model) 2) A multiples approach (using EBITDA multiples) Note: Terminal value often represents more than 50% of enterprise value
9-1 -How is using EBITDA to calculate terminal value beneficial? -When should the EBITDA multiple and Gordon growth model generage very similar terminal value estimates?
-Using EBITDA to calculate terminal value is beneficial because it ties the analysis of distant cash flows back to recent market transactions involving similar firms -EBITDA multiple and Gordon growth model should generate very similar terminal value estimates when there are no extraordinary capital expenditures or investments in net working capital
9-1 -what is one problem with using WACC based approaches to enterprise value? -What is another approach to enterprise value that solves this problem? This approach reveals how what influences what?
-WACC based approaches to enterprise value are widely used but do not take into consideration changes to capital structure over time -The adjusted present value (APV) approach provides an improvement over traditional WACC approaches because it reveals how the company's financing decisions influence enterprise value
5-1 Rationale for using multiple discount rates: -elaborate on Using a Single Discount Rate Results in Bias Towards Risk
-When a single discount rate (firm WACC) is used, the firm will tend to take on investment projects that are relatively risky (Project B), which appear to be attractive because they generate an IRR that exceed the firm's WACC. -The firm will tend to pass up investment projects that are relatively safe (Project A), but which generate an IRR that is less than the firm's WACC. -This bias in favor of high-risk projects will make the firm riskier over time.
8-5 To reflect differences in risk characteristics and growth opportunities, EBITDA multiples should be adjusted for (3): Examples: 1) Onetime transaction with a customer, which contributed to EBITDA but is not likely to be repeated in future years 2) Extraordinary write-offs Other possible nonrecurring items:
1) Variations in operating leverage; differences in profit margins 2) Differences between fixed and variable operating costs -Firms that incur higher levels of fixed operating costs but lower variable costs will experience more volatile swings in profits as their sales rise and fall over the business cycle. 3) Differences in expected growth rates Example 1: make a downward adjustment to EBITDA Example 2: make an upward adjustment -Asset write-downs -Restructuring charges -Start-up costs expensed -Profits & losses from asset sales -Change in accounting estimates or principles -Gain (loss) from discontinued operations -Strikes -LIFO liquidations -Catastrophes such as natural disasters or accidents -Product recalls
5-3 Hurdle rates influence corporate strategy in 5 ways:
1) choice of investments 2) capital structure 3) modes of growth 4) shareholder distribution policies 5) risk management
8-6 A high P/E ratio predicts that? Low P/E predicts that? Does size of company affect earnings?
A high P/E ratio predicts that the firm will have high growth in the future. Low P/E is a value stock—price is less about the future and more about where the company is today. Size affects earnings! When using P/E multiples, use similar-sized companies!
5-1 Benefits to using a single discount rate--because multiple discount rates may result in influence costs... What are these?
A manager who benefits personally from a project being accepted has incentives to put the investment proposal in the most favorable light possible (using optimistic CF forecasts and understating risk). When discount rates are discretionary, it opens up the possibility that "favored" or more persuasive managers will be able to use artificially low discount rates for their projects extra time and effort is spent: -Project advocate: justifying a lower discount rate -Managers evaluating the project: determining extent of the bias Using a single discount rate for all projects may increase perception of fairness, improve employee morale, and improve one source of influence cost.
8-2 What is the connection between DCF valuation and relative valuation?
Capitalization rate is the reciprocal of the multiple used to value the property. -Perpetual cash flow: $100 per year -Discount rate: 20% -The capitalization rate is 1/5 = .20 Value = 100/.2 = 500 Value = 100 x (1/.2) = 100 x (5) = 500 (1/.2=reciprocal) (5=multiple)
8-4 What is the most popular approach used by business professionals to estimate a firm's enterprise value? How do analysts generally view EBITDA?
EBITDA Multiples Analysts generally view EBITDA as a crude measure of a firm's cash flow, and thus view EBITDA multiples as roughly analogous to the cash flow multiples used in real estate. Sometimes viewing EBITDA as CF is good and sometimes it's not.
9-2 Enterprise Value (APV approach) equation:
Enterprise Value (APV Approach) = Value of the unlevered FCFs (planning period) + Value of Interest Tax Savings (planning period) + terminal value
5-3 Hurdle rates are what?
In practice firms tend to discount cash flow using discount rates, often referred to as hurdle rates, which exceed the appropriate cost of capital for the project being evaluated. -It's not unusual to see corporate hurdle rates as high as 15% for firms with WACCs, as well as project WACCs, as low as 10%. Firms generally require that accepted projects have a substantial NPV cushion, or margin of safety. -Most managers would consider an NPV cushion of 0.2% of the project's initial expenditure to be too small.
8-1 -What is the most common application of the relative valuation technique? What are the 3 key points necessary to consider in relative valuation?
Most common application of this method is the valuation of commercial and residential real estate. 1) Identification of appropriate comps is paramount. 2) The initial estimate must be tailored to the investment's specific attributes. 3) The specific metric used as the basis for the valuation can vary from one application to another.
5-1 Incentive problems that arise with managerial discretion can be mitigated how (2)?
Multiple discount rates should be used when risk attributes of projects varies widely: -Firms operating in different lines of business -Firms operating in different countries Incentive problems that arise with managerial discretion can be mitigated how? -Systematic and verifiable cost of capital estimation -Discount rates tied to outside market forces
8-1 What are the 4 steps in relative valuation?
Step 1: Identify similar or comparable investments and recent market prices for each. Step 2: Calculate a "valuation metric" for use in valuing the asset. Step 3: Calculate an initial estimate of value. Step 4: Refine or tailor your initial valuation estimate to the specific characteristics of the investment.
5-3 Managing the correct "buffer" in hurdle rates. 3 aspects to take into consideration.
The buffer should capture -The fact that new projects are riskier than the firm's assets in place today -The need to generate some return over the cost of capital to create value -The desire to compensate for "cash flow projection inflation"; that is, the fact that cash flow forecasts are often too high.
8-7 -What approach plays an important role in the pricing of IPOs? -Are IPOs usually placed at a discount or premium?
The lead underwriter determines an initial estimate of a range of values for the issuer's shares. The estimate typically is the result of a comparables valuation analysis. Underwriters like to price the IPO at a discount, typically 10% to 25%, to the price the shares are likely to trade on the market. Underwriters argue that this helps generate good after-market support for the offering.
8-1 The method of comparables involves using a what? Doing this evaluates what?
The method of comparables involves using a price multiple to evaluate whether an asset is relatively fairly valued, relatively undervalued, or relatively overvalued in relation to a benchmark value of the multiple.
5-3 Mutually exclusive projects effect on cost of capital
For firms that have constraints limiting the number of projects that can be accepted, the opportunity cost of capital reflects the return on alternative investments that may have to be passed up. -For example, suppose a firm is choosing between two projects that are of equivalent risk. Suppose that the first project can generate an expected internal rate of return of 18%. If taking the second project precludes taking the first project, then the appropriate opportunity cost of capital that should be used to evaluate the second project is 18%, not the cost of capital.
8-2 How are operating leverage and investment risk related?
Investments with higher operating leverage will experience more volatility in its operating income in response to changes in revenues. Compare the fixed costs of an asset to its revenue: -Building B has higher fixed costs than Building A relative to revenues, so Building B's operating leverage is substantially higher than Building A; we expect its operating income to be more volatile in response to changes in rental revenues.
9-2 -By unlevering cash flow, the APV approach decomposes total enterprise value into what 2 types of values?
The APV approach decomposes total enterprise value into these 2 values: 1) value from unlevered equity FCF 2) value from financing This enables the impact of financing on enterprise value to become evident.
8-2 What is the Gordon Growth Model? How can you transform this into a multiple model and find the multiple?
The Gordon Growth Model formula is as follows: Value = [CF(0)x(1+g)] / (k-g) Example: Value = [100 x (1.05)]/(.2-.05) = 700 You can transform this into a multiple model and find the multiple by: Value = 100 x [1.05/(.2-.05)] = 100 x 7 = 700 Because the multiple is equal to 7, the cap rate is 1/7 or 14.29%, which is less than the 20% discount rate.
8-2 When is the cap rate larger than the discount rate? When is it smaller? When is the cap rate and discount rate the same? The difference between the discount rate and the capitalization rate increases with what?
the cap rate is less than the discount rate when cash flows are expected to grow, and it exceeds the discount rate when cash flows are expected to shrink or decline over time. Only when there is zero anticipated growth in future cash flows are the discount rate and the capitalization rate equal to one another. The difference between the discount rate and the capitalization rate increases with the growth rate anticipated in future cash flows.
8-1 The economic rationale underlying the method of comparables is what? What is the most widely used approach for analysts reporting valuation judgments on the basis of price multiples? If we may find that an asset is undervalued relative to a comparison asset or group of assets, and we may expect the asset to what?
the law of one price—the economic principle that two identical assets should sell at the same price. The method of comparables is perhaps the most widely used approach for analysts reporting valuation judgments on the basis of price multiples. If we may find that an asset is undervalued relative to a comparison asset or group of assets, and we may expect the asset to outperform the comparison asset or assets on a relative basis. -However, if the comparison asset or assets themselves are not efficiently priced, the stock may not be undervalued—it could be fairly valued or even overvalued (on an absolute basis).
5-2 Method: Project-specific WACC: Project financing -Description: -Advantages (1): -Disadvantages (4): -When to Use (1):
-Description: Estimate WACC for each individual project, using the capital costs associated with the debt capacity of the project. -Advantages (1): 1) Provides a unique discount rate that reflects the risks and financing mix of the project. -Disadvantages (4): 1) Market proxies for project risk may be difficult to find. 2) Creates the potential for high influence costs as managers seek to manipulate to get their pet projects accepted. 3) Capital structure weights are problematic, as equity value of the project is unobservable. 4) Project debt capacity must be allocated because it is not readily observed. -When to Use (1): 1) The project is of such significane that it has a material impact on the firm's debt capacity.
5-2 Method: Firm WACC -Description: -Advantages (3): -Disadvantages (2): -When to Use (2):
-description: Estimate the WACC for the firm as an entity and use it as the discount rate on ALL projects. Approximately 6 out of 10 firms use a single, companywide discount rate to evaluate investment projects. -Advantages (3): 1) is a familiar concept ot most business executives 2) Minimizes estimation costs, as there is only one costs of capital calculation for the firm 3) does not create influence cost issues -Disadvantages (2): 1) does not adjust discount rates for differences in project risk 2) does not provide for flexibility in adjusting for differences in project debt capacities -When to Use (2): 1) projects are similar in risk to the firm as a whole 2) when using multiple discount rates creates significant influence costs
8-6 1) What is a stable-growth firm? 2) How to value a stable-growth firm? Equation?
1) A stable-growth firm is one that is expected to grow indefinitely at a constant rate. 2) use Gordon growth model: P(0) = Div(1+g)/(k-g) =[(EarningsPerShare)(1-b)(1+g)] / (k-g) b: retention ratio, or the fraction of firm earnings that the firm retains, implying that (1 - b) is the fraction of firm earnings paid in dividends g: growth rate of these dividends k: the required rate of return on the firm's equity.
5-1 Rationale for using multiple discount rates (3):
1) Discount rates should reflect the opportunity cost of capital/the risk of the investment. 2) project expected returns should be judged in comparison to returns that could be generated from investments in publicly traded stocks and bonds with equivalent risk. 3) Using a Single Discount Rate Results in Bias Towards Risk
8-6 drawbacks to the P/E ratio (3):
1) EPS can be negative. The P/E ratio does not make economic sense with a negative denominator. 2) The components of earnings that are on-going or recurrent are most important for this method. -Earnings often have volatile, transient components, making application of this method difficult. 3) Management can "manage earnings" and distort earnings per share. -Distortions can affect the comparability of P/E ratios across companies.
5-3 Why has lower cost of debt not led to more investment (2)?
1) Low cost of debt =/= low cost of capital -Cost of equity has remained stable. If firms are primarily capitalized with equity, as in U.S., WACC has not dropped. 2) Low cost of capital =/= low hurdle rates -Firms maintain hurdle rates that are materially higher than their estimated cost of capital. -Many firms believe that interest rates are artifically low and likely to rebound soon.
9-1 -Using the traditional WACC approach to enterprise valuation requires some assumptions which are difficult to justify, specifically (2):
1) Risks of cash flows do not change over time 2) Company maintains a steady capital structure -Often a constant discount rate is inconsistent with projected changes to capital structure -Examples: LBO's, Planned M&A activity, future stock buy-back plans
8-3 How do you decompose an NOI into revenue and maintenance cost multipliers?
Building Vallue = NOI x NOI multiple = (Rental Rev. x Rev. Mult.) - (Maint. Costs x Maint. Mult.) Building Value = NOI / NOI cap rate = (Rental Rev./Rev. cap rate) - (Maint Costs/Maint Cap rate) Get the cap rates by finding the invesrse of the multiples in the first equation. Since both buildings cost the same to maintain, it seems reasonable to use identical cap rates for the maintenance costs. Moreover, since we have assumed that rent revenues for each building are similar in terms of both growth and risk, a single revenue cap rate is reasonable to apply to the rents from both buildings. If the ratio of rents to expenses were the same for both buildings (resulting in identical operating leverage), then these assumptions would imply that cap rates for each building would also be identical. However, as we will show, when two buildings differ in their operating leverage, they will generally differ in their overall cap rates, even when they have the same revenue and maintenance cap rates. The decomposition method we illustrate here allows the analyst to compare buildings that differ only in their operating leverage. If Buildings A and B differ on more than this dimension, additional analysis is required.
8-4 1) Difference between EBITDA and FCF is? 2) Why is FCF oftentimes more volatile than EBITDA? 3) Why not use a FCF multiple? 4) So then under what circumstances is EBITDA a good measure of FCF?
EBITDA is not always a good estimate of free cash flow: 1) EBITDA is a before-tax measure and does not include expenditures for new capital equipment (CAPEX) and does not account for changes in working capital (NWC). 2) FCF is often more volatile than EBITDA because it includes consideration for new investments in CAPEX and NWC, which are discretionary to varying degrees and vary over the business cycle. -In years when large capital investments are being made, EBITDA significantly overstates the firm's free cash flow, and vice versa. 3) Why not use a FCF Multiple? Too volatile since it reflects discretionary expenditures for capital investments and working capital that can change dramatically from year to year. However, EBITDA only measures the earnings of the firm's assets already in place, it ignores the value of the firm's new investments. 4) Good for mature companies with CFs that are easy to predict and that stay relatively stable. Enterprise value won't work well for a high growth, unpredictable company. If CAPEX is bouncing all over the place, you want to go back to firm free CF because it picks up the day to day changes
8-4 What is enterprise value? What is Firm Value? Enterprise Value formula
Enterprise value of a firm is defined as the sum of the values of the firm's interest-bearing debt and its equity minus the firm's cash balance on the date of the valuation. Firm Value is all debt + the market value of common equity Enterprise Value = Owner's Equity + (InterestBearing Debt - Cash)
8-3 If two buildings are not perfectly comparable, is it possible to use comparable analysis?
Even though the two buildings are not perfectly comparable, it is still possible to use an adjusted comparable analysis, based on the sale price of Building A, to value Building B. -Dig more deeply into the determinants of their cash flows. --Decomposition of each building's NOI into revenue and maintenance-cost multipliers; this helps us analyze how each component of NOI influences the values of the two buildings.
8-6 Well-positioned firms with competitive advantages, intellectual property, patents, and managerial expertise are able to generate both higher rates of return on new investment, as well as opportunities to reinvest more of their earnings. Equation to calculate P/E multiple:
It is the combination of the amount by which r exceeds k, and the fraction of firm earnings that can be profitably reinvested each year (1 - b) that determines the firm's P/E ratio. Under these assumptions, we can express a firm's dividend growth rate as the product of its retention rate, b, and the rate of return it can provide on newly invested capital, r. P/E Multiple =[(1-b)(1+g)] / (k-g) =[(1-b)(1+br)] / (k-br) g turns into (b)(r), because it is based on its retention rate, b, and the rate of return it can provide on newly invested capital, r.
8-4 What is net Debt? Once you calculate a firm's Enterprise Value, what next?
Net debt refers to the firm's interest-bearing liabilities less cash. Compare the firm's enterprise value to its EBITDA to get an EBITDA multiple. -On August 1, 2005, Airgas's EBITDA was $340 million and its enterprise value was $2,955,995,000; this results in an EBITDA multiple for Airgas of 8.69x.
8-4 When a firm is a potential acquistion candidate and is privately owned, what is the thought process about valuing it (given that we know the firm's EBITDA). After our initial valuation, what next?
Once firms express interest in buying a company, they have to sign a confidentiality agreement. At that point, the private company can release its EBITDA and other financial information to the interested firms. Because it is privately owned, a potential acquirer cannot observe its market value. However, the acquirer can use similar firms that are publicly traded to infer an enterprise value for Helix by using the appropriate EBITDA valuation ratio. Once an enterprise value is estimated, we can then back out the equity value using the Enterprise Value formula. After our initial valuation, what next? -careful assessment of our valuation and refining our value to the specific firm we are examining. In other words, we consider the need to make adjustments to both the EBITDA and the EBITDA multiple used in Step 1.
5-3 How do high hurdle rates provide incentives to project sponsors?
Requiring high hurdle rates may signal that firms have good investment opportunities, which may have the side benefit of motivating project sponsors to find better projects. -For example, if top management sets a corporate hurdle rate at 12%, project sponsors may be happy to propose a project with an internal rate of return of 13%. However, with a 15% hurdle rate, the project sponsor will need to put in more effort and negotiate harder with suppliers and strategic partners to come up with an investment plan that meets the higher hurdle. -J.P. Morgan estimates that the current median WACC of S&P 500 firms is 8.5%. -Median reported hurdle rate of S&P 100 companies: 18%.
8-1 Relative valuation is what? The reliability of this method relies solely on what? DCF models estimate what kind of value of a firm compared to price multiples?
Uses market comparables: It is a technique used to value businesses, business units, and other major investments. -Assumes similar assets should sell at similar prices. -Relative valuation should be used to complement DCF analysis The reliability of this method of valuation depends on the ability to identify publicly traded stocks that are "comparable" to the company we are valuing. DCF models estimate the "intrinsic" value of a firm. Price multiples value a firm "relative" to how similar firms are valued by the market at the moment. An asset expensive on an intrinsic value basis may be "cheap" on a price multiple basis.
8-5 Adjusting for liquidity discounts and control premiums:
What price will a buyer will be willing to pay for a company? It depends. 1) A purely financial buyer (a private equity investor or hedge fund) is likely to expect a liquidity discount. -20-30% liquidity discount for privately held firms: -Private companies often sell at a discount to their publicly traded counterparts since they cannot be sold as easily. 2) A strategic buyer that can realize synergies by acquiring and controlling the investment may be willing to pay a control premium. -30%+ control premium for strategic acquisition -When there are benefits (or synergies) from control valuations often feature control premiums, which can enhance the value of an acquisition target by 30% or more.