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CF Multiple Questions > Lesson 6 > Flashcards

Lesson 6 Flashcards

1
Q

what is k_o?

A

cost of capital asset side / unlevered

the “pure” cost of operating capital, where the risk is determined by the dispersion of possible operating returns, and depends EXCLUSIVELY on OPERATING conditions EXTERNAL to the company (linked to the real market)

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2
Q

what is K_d?

A

cost of debt

depends on:
1. OPERATING risk
2. financial LEVERAGE
3. BC

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3
Q

what is k_e?

A

cost of equity capital

depends on
1.** OPERATING** risk
2. FINANCIAL** leverage**
3. VALUE of BC

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4
Q

how to find market values given k_o, k_e, and k_d

A

EV_unlevered = FCFO / k_o

EV_levered = FCFO / k_o + PV(tax shield)
or
EV_levered = FCFO / WACC

E = FCFE / k_e

D = OF / k_d

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5
Q

which are the components of market value of assets? what about market value of liabilities?

A

assets:

  1. assets in place (FA and NWC)
  2. growth assets (PVGO, if any)

liabilities:
1. market value of debt
2. market value of equity

!management has a significant role in mkt value of equity and **limited **or no intervention on mkt value of debt

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6
Q

what is the logic behing level of debt and shareholder’s wealth?

A

for debt to influence shareholder’s wealth, there must be TANGIBLE BENEFITS and COSTS

possibilities:
benefits > costs
benefits = costs
benefits < costs

!!!! if marginal benefits ALWAYS exceed costs the optimal financial structure would be 99% debt

!!! if marginal costs ALWAYS exceed benefits the optimal financial structure would be 100% equity

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7
Q

what is the definitio of optimal leverage?

A

leverage which maximizes the RELATIVE value of shareholders, the value of equity PER SHARE

! the ABSOLUTE value of equity because (all else equal) according to the accounting equation, as % of debt increases the % of equity decreases

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8
Q

what are the two components of shareholder wealth?

A
  1. accounting equity investment
  2. goodwill of equity
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9
Q

what is the formula for EV total goodwill?

A

EV total GW = GW_equity + tax shield - E[BC]

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10
Q

which are the 3 main methods for determining optimal financial leverage?

A
  1. cost of market capital (k_e, k_d, WACC)
  2. sector “benchmark”
  3. APV approach, !!!!!!! especially in the case of a STEADY STATE company !!!!!!!
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11
Q

what is the market value of tax shields over and INFINITE time horizon?

A

D_nom * t

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12
Q

what is the effect of tax shields on EV?

A

if benefits outweigh costs, value is created. EV increases by the present value of tax shields.

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13
Q

if debt has a natural maturity? why is the tax shield evaluated over an infinite horizon?

A

because we assume the financial structure remains constant, debt will be replaced by other debt (assuming same cost of capital)

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14
Q

in the event of bankruptcy the company does not repay the entire value of debt, why is the value of TS still D*t?

A

E[TS] = E[payoff_d] * t = Dnom * t

if debt is in equilibrium condition

E[payoff_d] = D_mkt = D_nom

and risk premium required by lenders already prices BC

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15
Q

why isn’t more debt always better?
prove it with a formula

A

two faces of the same coin

  1. advantage of tax shields
  2. as debt increases, E[BC] increase and this reduces EV

FORMULA

EV_lev,BC = EV + TS - E[BC]

where E[BC] = BC * P[default]

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16
Q

from the point of view of value estimation, where do bankruptcy costs occur?

A

while the value of tax shields appears directly in FCFE, BC are a LATENT negative value component and are
**not included in the yearly cash flows **
of a going concern company.

BC appear in
** k_d **
and in the interest rate on the debt, and CONSEQUENTLY in k_e

(basically
** implicit in the cost of equity and debt capital** )

17
Q

usually, what increases more EV_levered? adding risk free debt or risky debt?

assuming a “rational” financial structure

A

risky debt, given the deductibility of higher interest payments

18
Q

what is WACC? WACC formula

A

INVESTOR perspective: an asset side parameter (cost of capital), through which to discount the FCFO to determine the EV (levered, with the costs of bankruptcy)

MANAGER perspective: the cost of capital applicable to the evaluation of investment projects, ASSUMING they are FINANCED like a company’s financial structure.

WACC allows us to define an EV which, net to the value of debt, defines the market value of equity (including operating GW, tax shield, and BC)

19
Q

how do you compute equity GW? how is this related to “optimal financial structure”?

A

GW_e = EV - CIN

consider EV = FCFO / WACC
>
GW_e = (FCFO/WACC) - CIN
>
optimal financial structure maximizes GW_e

20
Q

how is calculating WACC different from k_e, k_d, or k_o?

what are the 2 ways of computing WACC?

A

WACC is NOT a “PURE” cost of capital.

  • k_e can be derived directly from the market
  • k_d can be estimated on the basis of standard parameters
  • k_o is a result of delevering process

2 methods for estimating the WACC

a. reconstruction of WACC STARTING from MARKET/COMPARABLES data leveraging k_e, k_d and financial structure

b. APV method (“build-up”):
k_0 > EV_unlevered > add PV(TS) and subtract E[BC] > INDIRECTLY derive WACC from EV/FCFO
!!!!!! this leads to DIFFERENT RESULTS from method a. especially in case of GROWTH of the company !!!!!!

21
Q

what is an issue in the process of estimating the WACC through the USE OF market data?
how do you overcome it?

A

it requires the analytical determination of the level of financial leverage of the target company

3 solutions:

  1. use “market” financial structure (however, most of the times listed companies enjoy access to capital not shared by unlisted companies and the market structure could be UNREALISTIC [US listed companies have very low levels of financial leverage)
  2. use “target” financial structure (however the choice is always subjective and arbitrary)
  3. APV method allows to determine EV without requiring estimates of financial leverage
22
Q

what is the APV method?

A

a valuation approach that separates tax benefits associated with the tax deductibility of interests and “adds” them to the value of the unlevered company (calculated with k_o) and subtracts expected bankruptcy costs

EV_lev = EV_unl + TS - E[BC]

!!! the unlevered approach can obviously be applied to companies partly financed with debt by ignoring the effects of the latter (in unlevered situations k_e = k_o) !!!

23
Q

APV steps

A
  1. EV_unlevered (growing perpetuity)
    - !!! k_o = i_rf + B_asset*MRP
    - !!! unlever B_equity
  2. valuation of tax shields at time 0 (Dt)
    where D    t is the simplification of “sum of tax benefits arising from financial interest payments discounted by the cost of debt”
  3. determine E[BC]
    E[BC] = P[default] * PV[BC]
24
Q

what is the typical forecasting time horizon?

A

3 - 5 years in case of companies in mature sectors and **8-10 **years in case of companies with stable cashflows and competitive conditions.

! starting from the last year of the business plan it is necessary to determine the terminal value of the company

25
Q

2 ways in which the probability of bankruptcy can be estimated indirectly

A
  1. debt rating (i.e, interest coverage ratio)
  2. statistical method based on each possible level of default given each possible level of debt
25
Q

statistic on recovery rates for positions NOT sold for bank debts in italy

A

rate has decreased especially for secured credits

RR for guaranteed credits is steadily higher

RR decreases as seniority of the credit increases (older credits have lower recovery)
mmmm check, is it “seniority” or “maturity”?

26
Q

typical bankruptcy cost figures?

A

while indirect costs as a % of GROSS EV vary a lot from company to company (potentially higher in the case of unlisted and small companies) but between 25 and 30%

mmm check

27
Q

how do WACC approach and APV differ?

A
  1. they consider BC very differently, the APV provides more FLEXIBILITY in considering INDIRECT BC. Those costs do not appear adequately in the pre-tax k_d
    !!! APV produces a more CONSERVATIVE estimate of value
  2. APV only considers benefits associated with EXISTING debt, WACC assumes** capital structure** to remain CONSTANT on INCREASING CFs over time (implying the company increases level of debt in the future)

!!! in steady state hypothesis results should however be the **same **!!!

28
Q

APV flaws and one point in favour

A

CONS
1. most of the time E[BC] are partially ignored

  1. APV neglects the value of growth from the perspective tax shield

PROS
especially in the Italian system (within which most companies are not listed)
there is no need to resort to either market values or “target” structure, but with reference to a structure specific to the company being evaluated

29
Q

APV relevant formulas

A

slide 39

CF Multiple Questions (12 decks)

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