Topic 7: Alternative Valuation Models Flashcards
Criticism of textbook OFCF / WACC valuation model
Assumes that the ratio of D/V remains constant.
However, dividend payments and debt repayments may cause actual D/V to differ to target at any point in time
Debt adds value due to :
How is this incorporated into WACC?
What is the value of the tax benefit?
Debt adds value due to : tax deductibility of interest expense
How is this incorporated into WACC? in the Rd (1-T) term
What is the value of the tax benefit? V(ITS) = V(L) - V(U)
that is, Value of the interest tax shield - Value of levered firm less the value of the unlevered firm
Value of the Levered Firm (V(L)) = ? Discount V(U) flows by ?
V(L) = V(U) + PV(ITS)
(NOTE: it is the PRESENT VALUE of the ITS. Make sure it is discounted appropriately)
Discount V(U) flows by : Rho
Adjusted Present Value Method (APV Method)
- Describe method to get to Levered EV
- WACC vs APV
- Describe: calculate unlevered (all equity) EV; then add the incremental value arising from using Debt rather than equity to get the Levered EV
It is OFCF capitalised at the all equity rate
Project value = value of project with all equity financing, plus the value of any financing side effects (eg ITS) - WACC vs APV:
a) WACC & APV produce the same result
b)
Describe the similarities of the WACC, APV and Flow to Equity Methods (similarities, differences)
- All use Ungeared After Tax Cash Flows as a starting point
- Difference: how financing effects are incorporated
- All give same answer. Ensure consistency between how CFs are defined and the discount rate used to discount that flow.
- APV is more transparent but more work - you need a dollar value at each point. Can calculate $ value as the EV * D/E ratio
In order of risk:
Rf < Kd (after tax) < Kd (pre tax) < Rho < Ke (ie levered cost of equity)
Describe
- after tax vs pre tax debt - you are entitled to the income tax shield
- WACC < rho: otherwise why have debt.
- Levered cost of equity is higher: as you add debt, shareholders are in a riskier position as debt holders will have priority when a payout is required
Use Adjusted Present Value method when:
use when financing strategy is expressed in dollar terms rather than a ratio - eg fixed debt repayment schedule
Calculate Levered Equity Value (E(L)) using Flow to Equity
- Calc FCFE (ie after debt servicing)
- Discount at the cost of equity. (Ke)
- Cost of equity used must reflect risk of project and the assumed debt level
When to use WACC model
- ASsumes that D/V is kept constant
- commonly used in non financing companies where projects typically funded from corp pool of funds
- each division can have own WACC
When to use Adjusted Present Value
- Use APV when financing arrangements differ from long run target ratio - eg fixed term or subsidised debt
- Assumes level of debt is known over life of project
- use for projects with specific financing
When to use FTE
- FTE requires both a RATIO (to calculate Re) and a debt schedule (to calc CF to E)
- used for projects with specific financing
APV and FTE: error prone
- Changing project values over time - if assume perpetual debt or bullet payment, could overvalue PV(ITS)
- Displaced debt:
Structuring offshore project - 2 decisions
Focus for decisions (3)
- mix of debt & equity
- whose B/S gets the debt - domestic parent or offshore subsidiary
Decisions
- tax rates in different countries
- different borrowing margins
- cost of repatriation
Advantages of Adjusted Present Value in valuing offshore projects (2)
Advantages of APV in valuing offshore projects:
- analysis kept simple for each component of CF stream, avoid arbitrary adjustments to discount rate
- more information is created about the increase/decrease in value caused by taxation issues, concessional borrowing etc
Adjusted Present Value process for valuing offshore project (2 steps)
- Get worst case unlevered value: Value project without any debt finance in offshore location; repatriate all CFs to parent in home country in which case div withholding tax may be levied
- calculate PV(ITS): incremental amount of using debt vs equity; incl effect of debt on DWT. (ie double whammy: ITS & Div WHT rebate