Advanced Valuation Lecture 2

Question 1

What are the FCF?

Answer 1

The CFs generated by the operating capital of the firm taking into account all investments in operating capital assuming the firm is 100% equity financed. In other words, FCF is on an unlevered basis.

Question 2

Give the FCF calculation

Answer 2

EBITDA
-/- depr. & amort.
EBIT
-/- operating tax expense
NOPAT
+/+ depr. & amort.
-/- capex in tangibles
-/- capex in intangibles
+/+ ∆ operating provision
+/+ ∆ deferred taxes
-/- investments in operating working capital
————
FCF

Question 3

What are the methods to calculate CV?

Answer 3

1. Liquidation approach > assuming liquidation at the end of the explicit forecast period. Determine the liquidation value of the tangible assets. Useful when valuing a JV.
   //
2. Multiples > based on EV-multiple. Should reflect steady state. But it is highly affected by growth (i.e., it’s high for growth companies)
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3. Perpetuity method > assuming an infinite cash flow of the firm growing at a constant rate. CV depends on CF in last forecast period, WACC and the growth rate.

Question 4

What’s a steady state? (according to lecturer)

Answer 4

1. company growth = industry growth
2. realistic long-term EBITDA margin
3. WC constant as % of sales
4. expansion capex needed to support the real growth on the long-term

Question 5

general comment on cyclicality:

Answer 5

End the forecast period MID-CYCLE. If you end at a peak or trough, and you base your terminal value on it, it will be over-/undervalued.
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Note: we do not care about SEASONALITY within a year, as we build annual statements

Question 6

Give the Gordon Growth model, and also a flaw. Propose 2 solutions

Answer 6

CV = FCF(CV) / (WACC - G(CV))
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Flaw: does not properly account for GROWTH. If your G increases, you must invest more in the business to facilitate that growth. So, your capex, which is reflected in the FCF, must also change. If capex increases, FCF decreases. And that’s not the case in this formula!!
//
Solutions:
1. McKinsey model
2. Bradley-Jarrel model

Question 7

What does the reinvestment rate mean?

Answer 7

How much of NOPAT are you reinvesting back into the business

Question 8

general comment on growth rate G:

Answer 8

It should never exceed the nominal growth rate of the economy or the industry and therefore should be lower than:
> real GDP growth + inflation
> real industry growth + inflation

Question 9

What is the RONIC? How does the RONIC relate to the CV period?

Answer 9

It reflects the nominal return that’s generated on expansion capex.
//
In competitive industries, the long-run RONIC == WACC, as it’s not possible to generate excess return (ie positive spread). The company only makes zero-NPV investments.
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If the firm has a competitive advantage till infinity, it’s possible to generate a positive spread (RONIC > WACC). Growth adds value.

Question 10

The McKinsey Model assumes depreciation = maintenance capex

Answer 10

But this may not be true, as the depreciation is based on historical prices. The maintenance capex is based on today’s prices which may be higher du to inflation. For assets with short useful lives it’s negligible. But for assets with long useful life, it’s important.
//
Note: prices may also decrease due to technological advancement

Question 11

Which CV model typically comes up with a lower terminal value?

Answer 11

The McKinsey model usually comes up with a lower terminal value, because they assume you need expansion capex to facilitate inflationary growth.

Question 12

Give the CV formula for McKinsey model and Bradley Jarrel model

Answer 12

McKinsey: (NOPAT * (1 - G/RONIC)) / (WACC - G)
G = RI * RONIC
—
BJ: (CBNI * (1 - RI)) * (WACC - G)
G = inflation + RI * (RONIC - inflation)

Question 13

What is the difference between end-period discounting and mid-period discounting?

Answer 13

(1 + WACC)^0,5 - 1 = WACC/2

Question 14

What discounting convention do you use when the CFs exhibit strong seasonal patterns?

Answer 14

Break the annual FCF down into a quarterly/monthly CF and discount these with the quarterly/monthly discount factor.

Question 15

How do you classify deferred taxes, and how do you value the non-operating deferred tax asset/liability

Answer 15

It could be operating or non-operating
- operating DTA/DTL > include in FCF (like DTL on PPE, DTL on intangibles, DTA on operating provisions)
- non-operating or financing DTA/DTL > value separately (like DTA on tax loss carry forward, pension deficits)
—
If the tax loss is 10mln and the tax rate is 25%, the DTA is 2,5mln on the balance sheet. But you need to forecast how you would realise it in the future. So, next year 0,5, 1mln year after etc. You need to discount it with COST OF EQUITY, as it contains equity risk!

Question 16

What are the 2 pension plans?

Answer 16

1. Defined contribution plan = employer pays cash out immediately > no separate adjustments are necessary
2. Defined benefit plan = company invests money on behalf of the client and promises a return
   a. funded plan: separate fund > surplus/deficit on balance sheet
   b. unfunded plan: pension obligation is on the company’s balance sheet

Question 17

Explain how you would adjust for pensions in a funded plan

Answer 17

Tax rate = 25%
Fund 1: deficit = 100
Fund 2: surplus = 10
—
deficit = 100&raquo_space; DTA = 25
surplus = 10&raquo_space; DTL = 2,5
—
when you realise the surplus, you have to pay taxes on it > DTL
when you realise the deficit, it is tax deductible > DTA
—
net deficit = 75
net surplus = 7,5
—
total pension adjustment = 7,5 - 75 = -67,5
formula: (1 - Tc) * (assets - liabilities)
—
SO ADJUST ON AN AFTER-TAX BASIS

Question 18

How do you adjust for employee stock options?

Answer 18

Outstanding options: value it as of the valuation date with BS model or other model
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Future options: this will dilute existing shareholders, but no need to account for it as there is already a cost for this incorporated in the labour costs for future options.
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instead of deducting the outstanding option value from the equity value, you could also add the number of outstanding options to the current outstanding shares to capture the dilutive effect of the ESO

Question 19

How do you account for Associates and JVs?

Answer 19

To value: use a multiple or dividend discount model

Question 20

How do you value a subsidiary?

Answer 20

it’s a company you control, so you consolidate the financial statements and do not have to value them separately. But if you own 80% instead of 100%, you have to subtract a minority stake in the EV-Equity bridge.

Question 21

How do you account for difference between book value of debt and fair value of the debt?

Answer 21

Only the existing debt at the valuation date should be valued. If possible, value the debt per valuation date based on a DCF analysis as the book value may significantly differ from economic value for:
1. Fixed rate debt raised in the past as interest rates have changed a lot
2. Large changes in the creditworthiness of the company as historical credit spreads reflected in the coupon may not reflect current credit risk profile.
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Expected debt CFs: (1-DP)CF + DPCF*(1-LGD)

Question 22

Example working capital adjustment: at completion date, the WC is higher than average WC level. Will this result in a positive or negative value adjustment for the buyer?

Answer 22

I think positive, as the buyer does not have to invest a lot himself to increase working capital. It is already there, so you increase the purchase price to reflect that value.

Question 23

What are the shortcomings of the WACC? Propose a solution

Answer 23

1. ## it assumes a fixed D/E ratio. But if it is now below/above the target, you assume it will jump to the target from one year to the other.
2. ## it neglects tax issues such as limits on tax deductibility of interest costs, tax carry forwards, and changing corporate tax rates, as a constant tax rate is used in the WACC.
3. the WACC copes with an implicit circularity: D/E weight > WACC > value > D/E weight > ……
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   Solution: APV

Question 24

What are the financing side effects of debt financing?

Answer 24

1. value of interest tax shield
2. value loss of potential distress
3. costs of raising the debt financing > fixed fees when you raise it

Question 25

Give 2 ways to calculate Unlevered Cost of Capital

Answer 25

Hamada: when the debt is constant absolute amount and debt holders do not bear systematic risk
unlevered beta = equity beta / (1 + (1-Tc) * D/E)
—
Harris Pringle: when the debt is a constant portion of the firm value and debt holders do not bear any systemic risk
unlevered beta = equity beta / (1 + D/E)

Question 26

How do you value the interest tax shield?

Answer 26

During explicit forecast: Tc * D * rD
Which discount rate to use is not clear. If the tax shields are dependent on firm value, use rU. If they are independent on firm value, use rD.
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During CV period
- fixed absolute debt level: Tc * D
- debt that grows with a constant rate: (Tc * D * rD) / (rU - G)

Question 27

How do you estimate the value loss of potential distress?

Answer 27

1. Probability of distress > failure to meet debt service obligations
2. loss when in distress > depends on asset specificity, seniority, collateral, legal regime

Question 28

Give 4 ways to estimate default probabilities

Answer 28

1. implied by corporate ratings
2. KMV model: based on option models for deriving default probabilities implied by the market value of equity. It is based on the principle that straight equity can be viewed as a call option on the value of the firm, with strike price D.
3. simulation models: simulate CF to determine the probability of a breach in financial covenants
4. Altman Z-Score: measure of a company’s financial strength that uses a weighted sum of several factors.