Week 3 Flashcards
How to calculate Beta_levered when you also have a Beta_debt next to an unlevered Beta?
𝛽𝐿 = 𝛽𝑈*1+(1−𝜏)𝐷/𝐸 −𝛽𝐷(1−𝜏)𝐷/𝐸
How to estimate a Beta bottom up? (6 steps)
- Find the businesses the firm operates in
- Find publicly traded firms in each of these businesses
- Estimate betas for these firms and unlever these betas
- Choose weights for each line of business (typically revenues or operating income, could also be asset values)
- Compute a weighted average of the unlevered betas to obtain an estimate for the unlevered beta of the company
- Compute the levered beta of the company
Explain 2 methods how to get to the value of equity
Method 1: Discount CF to Equity at Cost of Equity to get value of equity
* Cost of Equity = 13.625%
* Value of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253 + 76.2/1.136254 + (83.49+1603)/1.136255 = $1073
Method 2: Discount CF to Firm at Cost of Capital to get value of firm Cost of Debt =
Pre-tax rate (1- tax rate) = 10% (1-.5) = 5%
WACC = 13.625% (1073/1873) + 5% (800/1873) = 9.94% PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 + 116.2/1.09944 + (123.49+2363)/1.09945 = $1873
Value of Equity = Value of Firm - Market Value of Debt = $ 1873 - $ 800 = $1073
Name the (4) steps of DCF valuation
- Estimate the discount rate or rates to use in the valuation
–>Discount rate can be either a cost of equity (if doing equity valuation) or a cost of capital (if valuing the firm) - Estimate the current earnings and cash flows on the asset, to either equity investors (CF to Equity) or to all claimholders (CF to Firm)
- Estimate the future earnings and cash flows on the firm being valued, generally by estimating an expected growth rate in earnings.
- Estimate when the firm will reach “stable growth” and what characteristics (risk & cash flow) it will have when it does.
What are the 2 steps in cashflow estimation?
- Estimate current earnings * Cash flows to equity: Net income (after interest expenses) * Cash flows to the firm: EBIT (before interest expenses)
- Consider investment in future growth * Capital Expenditures (net of depreciation) * Investments in Net Working Capital
An investment in a couple of new sowing machines allows for an expansion of clothing repair shop Patches. The investment has projected sales of €90000. Variable costs are 40 per cent of sales and fixed costs are €20000. Depreciation is €10000. What is Patches’s additional operating cash flow assuming a tax rate of 28 per cent?
27280
What are 3 ways of estimating growth in earnings?
Look at the past
* The historical growth in earnings per share is usually a good starting point for growth estimation
Look at what others are estimating
* Analysts estimate growth in earnings per share for many firms. It is useful to know what their estimates are
Look at fundamentals
* Ultimately, all growth in earnings can be traced to two fundamentals how much the firm is investing in new projects, and what returns these projects are making for the firm
How to estimate the growth rate if earnings are negative (3 ways)?
- Use the higher of the two numbers as the denominator (0.30/0.25 = 120%)
- Use the absolute value of earnings in the starting period as the denominator (0.30/0.05=600%)
- Use a linear regression model and divide the coefficient by the average earnings per share
(When earnings are negative, the growth rate is meaningless. Thus, while the growth rate can be estimated, it does not tell you much about the future)
What are the 3 grains of salt regarding analysts?
Grain of salt 1: There may be far less private information and far more public information in most analyst forecasts than is generally believed
Grain of salt 2: The biggest source of private information for analysts is the company itself which might explain
* Why there are more buy recommendations than sell recommendations (information bias and the need to preserve sources)
* Why there is such a high correlation across analysts forecasts and revisions
Grain of salt 3: There is value to knowing what analysts are forecasting as earnings growth for a firm. There is, however, danger when they agree too much and when they agree too little (in which case the information that they have is so noisy as to be useless)
What are the fundamentals underlying in this formula: 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑔𝑟𝑜𝑤𝑡ℎ 𝑖𝑛 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒 = 𝑅𝑒𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 ×𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐶𝑎𝑝𝑖𝑡𝑎𝑙?
- Growth depends on how much capital a firm re-invests
- Growth depends on how productive the re-invested capital is
Titan Cement has EBIT of €232 million and faces a 25.47% tax rate. Its book value of debt is €399 million and its book value of equity is €445 million. What is Titan Cement’s return on capital?
0.205
Titan Cement has EBIT of €232 million, faces a 25.47% tax rate. It has capital expenditures of €110 million, depreciation of €60 million, and a change in working capital of €52 million. What is Titan Cement’s reinvestment rate?
0.59
So, Titan Cement has a 20.5% return on capital, and a 59% reinvestment rate at a 25.47% tax rate. What is the expected growth rate?
0.12
Name the (3) growth dettermants
Size of the firm
* As firms become larger, it becomes more difficult to maintain high growth rates
Current growth rate
* There is correlation between current growth and future growth. A firm growing at 30% currently probably has higher growth and a longer expected growth period than one growing 10% a year now
Barriers to entry and differential advantages
* Ultimately, high growth comes from high project returns, which, in turn, comes from barriers to entry and differential advantages
* The question of how long growth will last and how high it will be can therefore be framed as a question about what the barriers to entry are, how long they will stay up and how strong they will remain
