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

1
Q

in what situations does valuation play a central role in?

A

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

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2
Q

what is cost of capital?

A

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

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3
Q

what are future payoffs

A

involve dividends, free cash flows, or residual earnings

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4
Q

what can we use valuation techniques to do?

A

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

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5
Q

in what issues is the valuation process useful in?

A

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

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6
Q

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

A

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

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7
Q

what is the valuation framework?

A

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

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8
Q

why do we need to use discount rates?

A

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

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9
Q

what is the cost of debt capital?

A

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

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10
Q

what is the formula for cost of debt capital?

A

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

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11
Q

how to calculate borrowing rate?

A

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

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12
Q

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

A

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

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13
Q

what is capm and how do we caluclate it

A

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

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14
Q

what are criticisms of capm?

A
  • 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)
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15
Q

what is wacc?

A

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

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16
Q

what 2 camps do equity valuation models fall into?

A

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

market multiples:
- earnings, book value

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17
Q

how do you do valuation with market multiples?

A
  • 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

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18
Q

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

A

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)

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19
Q

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

A

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

20
Q

how to complete valuation using net income multiple

A

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

EQUITY intrinsic value

21
Q

how to complete valuation using industry based multiples

A

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)

22
Q

what are key assumptions underlying the market multiples based valuation?

A

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

23
Q

what are weaknesses of the multiples based valuation

A

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

24
Q

what 3 features do equity valuation models share?

A
  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
25
what is ddm?
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
26
how to calculate ddm?
2 methods: perpetuity method or constant growth method IV0 = D1/(1+re) + D2/(1+re)^2 + ....
27
how to do ddm with constant perpetuity?
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
28
how to do ddm with increasing perpetuity
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
29
what are some issues in applying the ddm
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
30
what is the dcf?
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)
31
how do we measure free cash flows?
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
32
what is fcff?
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
33
what are the different versions of fcff?
1. fcff = nopat - increase in noa 2. fcff = ocf - capex 3. fcff = ocf - capex + Int(1 - tax rate)
34
how does dcf define firm value?
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
35
what is the difference between nopat - increase in noa and ocf - capex
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
36
how to apply dcf model?
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
37
what does the dcf look like
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
38
how is wacc computed
weighted cost of debt, cost of common equity, cost of preferred stock wacc = sumof(cost of capital) * weight
39
how is pretax cost of debt computed
short term debt long term debt leases all them (rates) multiplied by rate, determining their weighted rate
40
how to do sensitivity analysis
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
41
how to perform sensitivity analysis for sensitivity to wacc and terminal growth rate
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)
42
how does the discounted free cash flow model measure equity value?
the pv of future free cahs flows vo = sigma(n, t=1) fcfe/(1+re)^t
43
what is fcfe?
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
43
what are strengths and weaknesses of ddm?
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
44
what are strengths and weaknesses of dcf?
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
45
what are the strengths and weaknesses of multiples based models?
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?)