week 9 (module 12) - cost of capital measures, dcf

Question 1

in what situations does valuation play a central role in?

Answer 1

merger decision based on estimated fair value of target company

share price of ipo depends on business valuation by issuer as well as by potential investors

identifying stocks/bonds that are over/under-valued

Question 2

what is cost of capital?

Answer 2

discount rate to value future payoffs and reflects return the investor expects

Question 3

what are future payoffs

Answer 3

involve dividends, free cash flows, or residual earnings

Question 4

what can we use valuation techniques to do?

Answer 4

compare stock price estimate to observed trading price and decide whether to buy/sell/hold

set share price in IPO

determine curr price of a bond/financial instrument

Question 5

in what issues is the valuation process useful in?

Answer 5

deciding whether a plant/division should be expanded/closed

determining hwo much should be paid in a merger/acquisition

evaluating an offer to acquire a company

Question 6

if a bond holder is entitled to interest payments and the repayement of principal when the bond matures, what is that for stockholders?

Answer 6

future cash flows come from dividends and cash from selling the stock

Question 7

what is the valuation framework?

Answer 7

cost of debt capital - used for payoffs to debt holders

cost of equity capital - used for payoffs to equity holders

wacc - used for payoffs to entire firm

matching cost of capital with payoffs

Question 8

why do we need to use discount rates?

Answer 8

time value of money:
- forgone interest from investing in an instrumenet with future payoffs
- RISK FREE component

cost of risk:
- investor’s compensation for bearing risk associated with uncertainty of payoff
- RISK PREMIUM component

Question 9

what is the cost of debt capital?

Answer 9

borrowing rate vs cost of debt
- lenders vs borrower’s perspective

detrminants of borrowing rate:
- how much debt investors ask for: time value + risk premium

determinants of risk prem:
- comp’s perceived level of risk by lenders
- factors considered by lenders include
- ST liquidity
- LT solvency

Question 10

what is the formula for cost of debt capital?

Answer 10

rd = pretax borrowing rate for debt * (1 - tax rate)

pretax borrowing rate for int-bearing debt = interest expense / avg. int bearing debt

income tax rate = tax savings due to interest reducing taxes

Question 11

how to calculate borrowing rate?

Answer 11

interest expenses in i/s
current portion of debt/finance leases, debt and finance leases (net of current portion), other long term liabilities

other long term liabilities: no interest expenses for operating lease liabilities as the rent is recorded as rental expenses not interest expenses

interest expense
interest bearing debt
current portion of debt and finance lease
debt and finance lease, net of current portion
total debt ending balance
avg debt balance
pre-tax borrowing rate

pretax borrowing rate for int-bearing debt = interest expense / avg. int bearing debt

Question 12

what does cost of equity relate to if cost of debt relates to what debt investors ask for?

Answer 12

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

Question 13

what is capm and how do we caluclate it

Answer 13

cost of equity capital

re = rf + [beta * (rm - rf)]

expected return (re):
- expected return for security e

risk free rate (rf):
- commonly based on return on ten year us treasury bills

market risk premium (rm - rf):
- difference between expected market return (rm) and expected risk free rate

market beta (beta):
- sensitivity of assets’ return to overall market

Question 14

what are criticisms of capm?

Answer 14

• variation in beta should track changes in systematic risk of firm, whereas in practise time period (weeks vs months) and methodology used in estimation have big effects
• market portfolio should include all assets in economy, not just publicly traded equity (debt, private equity, real estate, human cpaital)
• market risk premium changes over time and changes are difficult to capture (no consensus on what it is and how to measure)

Question 15

what is wacc?

Answer 15

weight average cost of capital

valuation models that assume payoffs are distributed to both equity holders and debt holders

rw = (rd * (iv debt/iv firm)) + (re * (iv equity/iv firm))

iv firm = iv debt + iv equity

where:
iv firm = intrinsic value of comp
iv debt = intrinsic value of comp liabilities
iv equity = intrinsic value of comp equity

Question 16

what 2 camps do equity valuation models fall into?

Answer 16

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

market multiples:
- earnings, book value

Question 17

how do you do valuation with market multiples?

Answer 17

• simple and success

1. select relevant summary performance measures (earning, book values, cash flows, sales) for a target company
2. identify comps that are “comparable”
3. for comparable comp, compute ratio of market value to selected summary performance measures
4. average of ratios is market multiple
5. multiply summary performance measure for target comp by the market multiple to estimate value of target company

value = summary performance measure * market multiple

Question 18

how do you know if market multiple approach is calculating equity or company value

Answer 18

more common: equity
if an equity performance measure is selected:
output will be an equity value
(ex. earnings, book vlaue)

if company performance measure is selected:
output will be an enterprise vlaue
(ex. sales, ebit, ebitda, nopat, noa)

Question 19

how to determine valuation using price to book (PB) multiple?

Answer 19

for 2 comparable comps:
market cap (equity value) / book vlaue of common equity

take average of it for 2 companies to determine PB market multiple

EQUITY intrinsic value

Question 20

how to complete valuation using net income multiple

Answer 20

NI market multiple = avg of (market cap/net income available to common shareholders)

EQUITY intrinsic value

Question 21

how to complete valuation using industry based multiples

Answer 21

some industries have specific measures related to industry characteristics that are closesly watchd by investors/analysts

retail -> sales per square foot selling space
airline -> revenues, expenses, profits per mile (one aircraft seat flown one mile whether occupied or not)

Question 22

what are key assumptions underlying the market multiples based valuation?

Answer 22

performance measure chosen is a summary statistic of intrinsic value

comparable firms are truly comparable for valuation purpose, similar growth/risk/profitability/etc

comparable firms are efficiently priced

Question 23

what are weaknesses of the multiples based valuation

Answer 23

no right measure

no right companies to use for comparison

no right way to combine comparable comp data to product multiple

despite deficiencies in valuing comps using market multiples, it is commonly applied in practise

Question 24

what 3 features do equity valuation models share?

Answer 24

1. assume that a particular fundamental variable determines equity value
2. forecast fundamental variable for remainder of comp’s life
   - estimate over horizon period (4-8 years)
   - make simplifying assumptions about terminal period
   - assume that fundamental variables continue into perpetuity
3. use time value of money techniques to determine pv of future estimated amounts

Question 25

what is ddm?

Answer 25

dividend discount model

equates value of company equity with pv of all future dividends

dividends are viewed similar to coupon payments on debt

use cost of equity capital

Question 26

how to calculate ddm?

Answer 26

2 methods:
perpetuity method or constant growth method

IV0 = D1/(1+re) + D2/(1+re)^2 + ….

Question 27

how to do ddm with constant perpetuity?

Answer 27

dividends stabilize at some point in the future and remain constant

perpetuity: ordinary annuity with infinite horizon

pv of a constant perpetuity:

IV0 = D1/re

Question 28

how to do ddm with increasing perpetuity

Answer 28

dividends grow at some constant rate in the future

“gordon growth model”

pv of a n increasingly perpetuity:

IV 0 = D1/(re-g)

** long term growth rate must be less than cost of equity

Question 29

what are some issues in applying the ddm

Answer 29

large % of publicly traded comps do not issue dividends
- zero payout may cont indefinitely

some comps have unusually high dividend payouts given profit levels
- sustaining may not be possible

difficult to find analysts forecasts of dividends to use in model

Question 30

what is the dcf?

Answer 30

discounted cash flow model

widely used and theoretically sound

focuses on operating/investing activities - ability to generate cash

fundamental input variable -> fcf to the firm

estimates value of comp (enterprise value) as pv of expected fcf and then subtracts comp’s debt to determine the equity value (shareholder’s portion of enterprise value)

Question 31

how do we measure free cash flows?

Answer 31

all capital providers (fcff) or common equity holders only (fcfe)

depends on objective:
if it is to value net operating assets (all debt/equity capital), use fcf for all capital providers (fcff) - valuing an asset acquisition

if it is to value common equity, using fcf for common stockholders (fcfe) - valuing equity shares

Question 32

what is fcff?

Answer 32

cash flow avail to comp’s suppliers of debt and equity capital after all operating expense (including income taxes) and necessary investments in working capital and fixed capital

Question 33

what are the different versions of fcff?

Answer 33

1. fcff = nopat - increase in noa
2. fcff = ocf - capex
3. fcff = ocf - capex + Int(1 - tax rate)

Question 34

how does dcf define firm value?

Answer 34

firm (enterprise) value = pv of expected fcf to the firm

cash flows arising from firm’s operating activities

fcf to the firm consists of cash flows arising from the operating side of business and exclude cash flows from financing activities

fcff = nopat - increase in noa

positive fcf: funds available for distributions to creditors/shareholders

negative fcf: firm requires additional funds from creditors/shareholders

Question 35

what is the difference between nopat - increase in noa and ocf - capex

Answer 35

net cash flow from operations uses net income which combines both operating and nonoperating components (selling expense and interest expense)

income tax includes effect of interest tax shield

net cash flow from operating activities includes nonoperating items in working capital (interest dividends payable) - noa focuses solely on operating activities

capex does not include increases in long term operating assets acquired via mergers/acquisitions

knowing other ways to define fcff aids us in using analyst research reports that might apply diff definitions of free cash flow

Question 36

how to apply dcf model?

Answer 36

1. forecast and discount fcff for the horizon period
2. forecast and discount fcff for terminal period
3. sum pv of horizon and terminal periods to yield firm value
4. to determine equity value subtract:
   - net nonoperating obligations (NNO)
   ** when nno < 0, we still subtract it but bc nno is negative, equity value will be greater than enterprise vlaue
   - preferred stock
   - noncontrolling interest (NCI)
5. divide firm equity value by number of shares outstanding to yield stock value per share

Question 37

what does the dcf look like

Answer 37

sales
nopat
noa

increase in noa
fcff (nopat - increase in noa)
discount factor (1/(1+wacc)^t]
pv of horizon fcff

** only calc for main year from here on

cumulative pv of horizon fcff
pv of terminal fcff = (tv/(1+wacc)^t)

total firm value
less nno
less preferred stock
less noncontrolling interest

firm equity value

shares outstanding

stock value per share

Question 38

how is wacc computed

Answer 38

weighted cost of debt, cost of common equity, cost of preferred stock

wacc = sumof(cost of capital) * weight

Question 39

how is pretax cost of debt computed

Answer 39

short term debt
long term debt
leases

all them (rates) multiplied by rate, determining their weighted rate

Question 40

how to do sensitivity analysis

Answer 40

horizon:
- reasonable to forecast growth for longer than 5 years
- down side to much longer horizon periods:difficult to accurately project growth
- more exact value estimate when an analyst can effectively use economic insights

sales growth rate:
- other alter sales growth rates over horizon and terminal periods

terminal growth rate:
- valuations are sensitive to variations in terminal growth rate
- ideally forecast horizon is sufficiently long to allow stead state to be achieved
- terminal growth can be positive or negative BUT NOT exceeding wacc

Question 41

how to perform sensitivity analysis for sensitivity to wacc and terminal growth rate

Answer 41

simultaneously varies terminal growth rate and wacc by one percentage point in 50 basis point increments

see what valuation is more sensitive to (growth rate or wacc)

Question 42

how does the discounted free cash flow model measure equity value?

Answer 42

the pv of future free cahs flows

vo = sigma(n, t=1) fcfe/(1+re)^t

Question 43

what is fcfe?

Answer 43

fcfe is cash flow available to comp’s stockholders after all operating expense and necessary investment in working capital and fixed capital borrowing costs (principal and interest)

adds up future cahs flows that could be paid to equity investors and discounts them back to the present

fcfe = ocf - capex + change in borrowing

Question 43

what are strengths and weaknesses of ddm?

Answer 43

strengths:
- simple, intuitive
- focus is on cash paid to shareholders

weaknesses
- many firms don’t pay dividends
- relies in large part on speculation
- very sensitive to changes in estimates

Question 44

what are strengths and weaknesses of dcf?

Answer 44

strengths:
- focuses on fcf
- more economically meaningful than earnings or abnormal earnings
- based on analysts projections of future operating/investing/financing decisions
- widely used in practise

weaknesses:
to naive users:
- penalizes firms for investing while fcf might be small/negative for good reasons
- treats new debt as increasing value but true only if proceeds are invested in projects that provide a return that is greater than cost of debt
- relies in large part on speculation and very sensitive to changes in estimates/errors

Question 45

what are the strengths and weaknesses of multiples based models?

Answer 45

strengths:
- quick and efficient
- implicitly incorporates market assumptions about cost of capital and growth rates that may be difficult to estimate directly and incorporate into formal models

weaknesses:
- competitor may differ significantly in key ways (growth, profitability, efficiency, capital structure, accounting policies, fiscal year)
- identifying appropriate competitors can be challenging (for tesla who? auto? tech? software? what is the mix now? what will it be in the future?)