chapter 9 - from slides

Question 1

what’s the role of valuation

Answer 1

1. merger decision dependson teh estimated fair value of the target company
2. the share price of an initial public offering depends on the business valuation by the issuer + potential investors
3. identifying stocks or bonds that re over or undervalued

Question 2

define cost of capital and future payoffs

Answer 2

cost of capital = discount rate to value the future payoffs and reflects the return the investor expects

future payoffs = dividends, free cash flows, residual earnings

Question 3

what can we use valuation techniques for

Answer 3

compare stock price estimate to the observed trading price and then decide whether to buy, sell or hold the stock

set a share price in an initial public offering

determine the current price of a bond or other financial instruments

Question 4

what are valuations useful in addressing?

Answer 4

deciding whether a plant or division should be expanded or closed
determining how much should be paid in a merger or acquisition

evaluating an offer to acquire the company

Question 5

what are the payoffs from equity and debt intruments

Answer 5

equity = dividends and cash form selling the stock in the future

debt = interest payments and repayment of principal when the bond matures

Question 6

what’s the valuation model formula

Answer 6

valuation = sum of (projected future payoffs)/(1+disount rate)^t

Question 7

what’s the components of discount rate

Answer 7

time value of money - forgone interest from investing in an instrument with future payoffs - risk-free component

cost of risk - investor’s compensation for bearing the risk associated with the uncertainty of the payoff - risk-premium component

Question 8

what determines the risk premium

Answer 8

a company’s perceived level of risk by lenders - short term liquidity and long-term solvency

Question 9

what’s the pretax borrowing rate for interest-bearing debt

Answer 9

pretax borrowing rate for debt = interest expense/average interest-bearing debt

Question 10

what’s the cost of debt capital (after tax)

Answer 10

rate = pretax borrowing rate for debt x (1 - tax rate)

Question 11

what’s the income tax rate

Answer 11

tax savings due to interest reducing taxes

Question 12

what’s included in the interest bearing debt

Answer 12

current portion of debt + finance lease
dent + finance lease, net of current portion

pretty much total leases

Question 13

what’s the percentage of the cost of debt/equity

Answer 13

cost of debt = how much the debt investors ask for: time value (risk free rate) + debt risk premium

cost of equity = how much equity investors ask for: time value (risk free rate) + equity risk premium

Question 14

how have researchers estimate expected returns

Answer 14

capital assets pricing model

Question 15

what’s the component of CAPM

Answer 15

re = rf + [B x (rm-rf)]

re = expected return - expected return for security e

rf = commonly based on the return on 10-year US treasury bills

market risk premium = difference between the expected market return (rm) and the expected risk free rate

market beta (B) = sensitivity of the asset’s return to the overall market

Question 16

what are the criticisms of CAPM

Answer 16

variation in beta should track changes in systematic risk of firm - whereas in practice time period and methodology used in estimate have big effects

market portfolio should include all assets in the economy not just publicly traded equities

market risk premium changes over time and these changes are difficult to capture - no consensus on what it is and how to measure it

Question 17

what’s the formula for WACC

Answer 17

WACC = ((IVdebt/IVfirm) x cost of debt) + (cost of equity x (IVequity/IVfirm))

IVfirm = intrinsic value of the company
IVdebt = intrinsic value of company liabilities
IVequity = intrinsic value of company equity

Question 18

what’s wrong with the WACC

Answer 18

there’s a circularity problem in estimating WACC as we are using the market value as the intrinsic value of equity to find the intrinsic value of equity

if the purpose is to value equity, we do not need to estimate WACC

Question 19

what’s an alternative to WACC

Answer 19

match the cost of equity with the future payoffs to equity holders

Question 20

cost of debt vs cost of equity

Answer 20

COE = very difficult to estimate, should be higher than cost of debt - can adjust estimates based on understanding of the firm’s past

Question 21

what are the 2 camps of equity valuation models

Answer 21

fundamental firm-specific data; dividends, cash flows, residual income

market multiples; earnings, book value

Question 22

what’s the process of using market multiples

Answer 22

select relevant summary performance measure for a target company

identify companies that are comparable to the target company

compute the ratio of market value to the selected summary performance measure

average of ratios = market multiple

value of target company = summary of performance measure x market multiple

Question 23

how to select a equity or company value with market multiple

Answer 23

depends on the performance measure selected to get the value of either equity or company value

if an equity performance measure is selected - output will be an equity value (earnings, book value)

if a company performance measure is selected = output will be an enterprise value (sales, EBIT, EBITDA, NOPAT, NOA)

Question 24

what’s the limitations of using industry based multiples

Answer 24

multiple focuses on sales rather than profitability

e.g retail industry sales per square foot of selling space is common
airline industry focuses on revenue, expenses or profits per mile

Question 25

what are the key assumptions of market multiples-based valuation

Answer 25

• the performance measure chosen = summary statistic of intrinsic value
• the comparable firms we choose re truly comparable for valuation purpose, similar growth, risk, profitability, etc
• comparable firms are efficiently priced

Question 26

what are the weaknesses of multiples-based valuation

Answer 26

• no right measure to use - bc company value depends on future performance
• no right companies to use for comparison - as different companies can be very different in critical ways, could be over or under valued
• no right way to combine comparable company data to produce a multiple - median, equal-weighted average, value-weighted average or other average
• despite deficiencies in valuing companies using market multiples, it’s commonly applied in practice - wide discretion might also help with its popularity

Question 27

what’s the dividend discount model

Answer 27

DDM equates the value of company equity with the present value of all future dividends - using cost of equity capital to discount

2 methods to forecast future dividends - perpetuity or constant growth method

Question 28

what’s the DDM with constant perpetuity

Answer 28

dividends stabilize at some point in the future and remain constant thereafter
perpetuity: ordinary annuity with an infinite horizon

PV of constant perpetuity - IV = D1/re??

Question 29

what’s the DDM of increasing perpetuity

Answer 29

dividends grow at some constant rate in the future - present value of an increasingly perpetuity

IV = D1/ (re-g)

where long term growth must be less than cost of equity

Question 30

issues with DDM

Answer 30

lots of companies don’t issue dividends
some companies have high dividend payouts given their profit levels - sustaining may not be possible
difficult to find analysts’ forecasts of dividends to use in the model

Question 31

tell me about the DCF

Answer 31

DCF model focuses on company’s operating and investing activities - ability to generate cash - makes the model more practical than DDM

DCF model estimates the value of the company (enterprise value) as the PV of the expected free cash flows then subtracts teh company’s debt to determine the equity value (the shareholders’ portion of the enterprise value)

Question 32

FCFF vs FCFE

Answer 32

FCFF - free cash flows for all capital providers - use to value asset acquisition if objective is to value net operating assets

FCFE - free cash flows for common equity holders only after all operating expense and necessary investment in working capital and fixed capital and borrowing costs (principal + interest) - use to value common equity/equity shares, FCFE = OCF - CapEx + Change in borrowing

Question 33

what the formulas to finding FCFF why are there different formulas

Answer 33

FCFF = NOPAT - increase in NOA
FCFF = OCF - Capex
FCFF = OCF - Capex + int(1-tax rate)

if there’s positive FCF - funds = available for distributions to creditors/shareholders

if there’s negative free cash flows - firms requires additional funds from creditors

Question 34

FCFF = OCF - CAPEX vs FCFF = NOPAT - increase in NOA

Answer 34

net cash flow from operations uses net income which comingles both operating and nonoperating components (selling + interest expense)
- income tax includes the effect of the interest tax shield
- net cash flow from operating activities includes nonoperating items in working capital such as interest + dividends payable - NOA focuses only on operating activities
- CAPEX doesn’t include increases in long-term operating assets acquired via mergers + acquisitions

Question 35

steps in DCF model

Answer 35

1. forecast + discount FCFF for the horizon period
2. forecast + discount FCFF for terminal period
3. sum the present values for the horizon and terminal periods to yield firm (enterprise value)
4. to determine equity value subtract; net nonoperating obligations (NNO), preferred stock, noncontrolling interest (NCI)
5. divide firm equity value by the number of share outstanding to yield stock value per share

note: if NNO is negative, we still subtract it, but bc NNO is negative the equity value will be greater than enterprise value

Question 36

types of sensitivity analysis on DCF model

Answer 36

horizon period - forecast growth longer than 5 years but it’s difficult to accurately project growth, more exact value estimate when an analyst can effectively use economic insights

sales growth rate - alter sales growth over horizon + terminal periods

terminal growth rate - valuations are sensitive to variations in terminal growth rate, the forecast horizon is sufficiently long to allow steady state to be achieved, terminal growth rate can be positive or negative but not exceeding WACC*

Question 37

DCF model strengths + weaknesses

Answer 37

strengths: focuses on free cash flows (more economically meaningful than earnings?), based on analyst’s projections of future operating, investing and financing decision, widely used in practice

weaknesses: “penalizes” firms for investing while FCF might be small or negative for good reasons, treats new debt as increasing value but it’s only true if proceeds are invested in projects that provide a return that’s greater than the cost of debt, relies in large part on speculation, and is very sensitive to change sin estimates and errors

Question 38

multiples-based model strengths vs weaknesse

Answer 38

strength: quick + efficient, implicitly incorporates market assumption about cost of capital and growth rates that may be difficult to estimate directly and incorporate into formal models

weakness: competitors may differ significantly in key wats, identifying appropriate competitor firms can be challenging

Question 39

how does stock-based compensation affect valuation

Answer 39

can treat SBC as cash expense if there’s a lot - as SBC is a combination of operating activity (paying cash to employees) and financing activity (issuing stocks to employees)

is SBC is a one-time deal, will need to be reflected in forecasts of future FCFE - more cash expense would be needed for compensation

if SBC is continuously being issued, will need to account for future dilution effect - forecast the increased shares outstanding every year cause by dilution which is complicated