Frameworks for Valuation Flashcards

Question

Why is the Debt Tax shield not just included FCF?

Answer 1

It allows us to assess performance as if the entire Firm was equity financed. Not looking at capital structure in this step makes it much easier to compare performance across companies and over time.

Answer 2

For example, when a company owns a minority stake in another company, it will not record the company’s revenue or costs as part of its own. Instead, the company will record only its proportion of the other company’s net income as a separate line item. Including net income from non-consolidated subsidiaries as part of the parent’s operating profit will distort margins, since only the subsidiaries’ profit is recognized and not the corresponding revenues. Consequently, non-consolidated subsidiaries are best analyzed and valued separately.

Answer 3

We subtract the value of debt and other non equity claims. Our goal is ultimately to find the intrinsic value per share and compare that to the share price on the market.

Answer 4

Debt - use market value for fixed and floating Leases - lease payments recorded as interest expense and not rental expense Unfunded retirement liabilities - unfunded obligations should be treated like debt Preferred Stock Employee options non controlling interest - important to realize that the minority interest holder does not have a claim on the company’s assets, but rather a claim on the subsidiary’s assets

Answer 5

each year’s cash flow provides little insight into the company’s competitive position and economic performance. Declining free cash flow can signal either poor performance or investment for the future. The economic-profit model highlights how and when the company creates value, yet properly implemented, it leads to a valuation that is identical to that of enterprise DCF. This makes them a strong duo when used together.

Answer 6

= Invested Capital * (ROIC - WACC) or = NOPAT - (Invested Capital * WACC)

Answer 7

When adding debt, we adjusted the weights, but we failed to properly increase the cost of equity. Since debt payments have priority over cash flows to equity, adding leverage increases the risk to equity holders. When leverage rises, they demand a higher return. Modigliani and Miller postulated that this increase would perfectly offset the change in weights. *This thought experiment is in a world without tax

Answer 8

The cost of equity would be, if the company had no debt

Answer 9

DCF as if all equity financed + add all debt benefits -> this will give you the value of its operations *remember to use the unlevered cost of equity to discount

Answer 10

1. Cost of Capital (or financing) depends on the risk of the capital employed 2. The WACC is fundamentally independent from the capital structure. 3. Shareholders are not sensitive to dividend policy Assumes no Tax benefits

Answer 11

As this equation indicates, the cost of equity depends on the unlevered cost of equity, or the cost of equity when the company has no debt, plus a premium for leverage, less a reduction for the tax deductibility of debt. Note that when a company has no debt (D = 0) and subsequently no tax shields (Vtxa = 0), ke equals ku. This is why ku is referred to as the unlevered cost of equity.

Answer 12

then the value of the tax shields will track the value of the operating assets. Thus, the risk of tax shields will mirror the risk of operating assets (k_txa = k_u). This leaves out the reduction term for the tax deductibility of debt. The unlevered cost of equity can now be reverse engineered using the observed cost of equity, the cost of debt, and the market debt-to-equity ratio.

Answer 13

We take net debt * interest rate to get our expected interest payment. We then apply the marginal tax rate to find our interest tax shield.

Answer 14

A company with significant leverage may not be able to fully use the tax shields (it may not have enough profits to shield). If there is a significant probability of default, you must model expected tax shields, rather than the calculated tax shields based on promised interest payments.

Answer 15

there is no need to separate free cash flow from tax shields when both flows are discounted by the same cost of capital.15 He combined the two flows and named the resulting cash flow (i.e., FCF plus interest tax shields) capital cash  flow (CCF)

Answer 16

WACC (tax shield valued in the cost of capital), APV (tax shield valued separately), and CCF (tax shield valued in the cash flow). Although FCF and CCF lead to the same result when debt is proportional to value, we believe FCF models are superior to CCF models. By keeping NOPAT and FCF independent of leverage, it is easier to evaluate the company’s operating performance over time and against competitors. A clean measure of historical operating performance leads to better forecasts.

Answer 17

Each of the preceding valuation models determined the value of equity indirectly by subtracting debt and other nonequity claims from enterprise value. The equity cash flow model values equity directly by discounting cash flows to equity (CFE) at the cost of equity, rather than at the weighted average cost of capital.

Answer 18

To value using cash flow to equity holders, discount projected equity cash flows at the cost of equity. Unlike enterprise-based models, this method makes no adjustments to the DCF value for nonoperating assets or debt. Rather, they are embedded as part of the equity cash flow.

Answer 19

Most of the times, capital structure changes are too complex, and you will make mistakes. It is not commonly used. One situation where the equity cash flow model leads to the simplest implementation is the analysis and valuation of financial institutions. Since capital structure is a critical part of operations in a financial institution, using enterprise DCF to separate operations and capital structure requires unnecessary assumptions.

Answer 20

Multiples. They are low effort and a great sanity check. Easy to communicate. It is hard to choose good comparables. It is hard to choose the correct multiple. It is easy to misinterpret.

Answer 21

The comparable companies not only should be in the same industry, but also should have similar performance, as measured by ROIC and growth

Answer 22

This might be a clue that there is something wrong with your DCF valuation model. Alternatively, it could be that the company you are valuing is expected to perform differently than the comparable companies. Finally, it could be that investors have a different outlook for the entire industry than you do (in which case the multiples of all the comparable companies would be out of line with their DCF value).

Answer 23

If a portfolio exists of traded securities whose future cash flows perfectly mimic the security you are attempting to value, the portfolio and security must have the same price. *powerful for stock options, hard for corporate valuation