Firm valuation

Question 1

What are some different valuation techniques?

Answer 1

Earnings mutliples, after tax profit, DCF

Question 2

Is the value of a something the same as the price?

Answer 2

No we want to find the value of something such that we can negotiate a price.

Question 3

When we do a valuation for our companies, how can we use the output?

Answer 3

1) Sensitivity analysis of outputs to variation in inputs ) sales growth +/- 5%, rising debt/operating costs etc
2) Compute statistical ratios
3) Compare valutions across various methods ( DCF vs multiples vs historical)

Question 4

Remind yourself what the value of a levered company is?

Answer 4

Question 5

The method of writing the PV of a levered project as the sum of the PV of the unlevered project and the PV of “financing side effects” is known as

Answer 5

Adjusted present value ( APV)
Besides tax shields we can also include “financing side effects” such as
▶ Issuance costs
▶ Loan subsidies
▶ Expected costs of financial distress (if we can measure them)

Question 6

What is the APV formula for a levered project with a constant leverage ratio? what does it separate?
If the firm doesn’t target a constant leverage ratio what do we do?

Answer 6

APV separates the impact of debt in comparison WACC.

2) We discount the tax shields by the cost of debt.

Question 7

So rather than calculating the net benefits of debt using the APV, wacc forgets that and just adjusted discount rate as a way to capute the effects. Show the formula? Show the value of a levered firm using WACC.
Also what is a key assumption of this formula?

Answer 7

Key assumption is that the firm will maintain a constant leverage ratio ( D/V) over time, if we want to maintain a constant rwacc over time. Because if not then different levels of debt risk for our shareholders, coming from different tax shields, so if a company changes there debt consistently applying the wacc will compute the value of tax shields incorrectly.

Question 8

When leverage ratio is 0, what is the return on assets equal to and why? What happens when we increase leverage ratio?

Answer 8

It is the same as return on equity and WACC because shareholders only face risk of assets but when debt increases there is financial risk to shareholders in addition to risk on the assets, show shareholders ask for a higher Re, hence wacc doesn’t equal ra

Question 9

Why does WACC go down when we increase leverage?
Why also is the expected rate of return for debt is usually lower than equity?

Answer 9

As a company increases its debt, the tax shield grows, effectively making the cost of debt cheaper after accounting for taxes. Since this after-tax cost of debt is lower than the cost of equity, the overall cost of capital (WACC) decreases as the company increases its leverage.

As bondholders are always ahead of the queue than shareholders, but less risk for them.

Question 10

ABC Corporation is considering an expansion. It maintains a constant debt-to-value ratio of 40% with an equity beta of 0.75 and a zero debt beta. The expansion costs $1 million
today and generates unlevered after-tax cash flows of $300,000 per year in perpetuity. The risk of the expansion project is the same as that of the firm’s existing business and ABC intends to continue with the same debt-to-value ratio after the expansion. The risk-free rate is 5%, the market risk premium is 10%, and the corporate tax rate is 25%.
Now firstly because this is an expansion project, in order to discount our cash flows related to this expansion, if i want to use the same numbers as my current company, we need to be sure of 2 things, which are what? What does it tell us about our WACC?

Answer 10

1) the risk of that expansion is the same for the current company ( e.g. if my current company sells ice cream and im thinking of expanding my production of ice cream, that means the risk is the same
2) Capital structure: The firm maintains the same debt-to-value ratio (in this case, 40%) after the expansion.

So before tells us the rank of my expansion is the same as current one?

Question 11

ABC Corporation is considering an expansion. It maintains a constant debt-to-value ratio of 40% with an equity beta of 0.75 and a zero debt beta. The expansion costs $1 million
today and generates unlevered after-tax cash flows of $300,000 per year in perpetuity. The risk of the expansion project is the same as that of the firm’s existing business and ABC intends to continue with the same debt-to-value ratio after the expansion. The risk-free rate is 5%, the market risk premium is 10%, and the corporate tax rate is 25%.
What is the value of expansion using WACC method?

Answer 11

As asset beta is 0, the expected cost of debt = risk free rate.
Using CAPM we can calculate cost of equity.

Question 12

ABC Corporation is considering an expansion. It maintains a constant debt-to-value ratio of 40% with an equity beta of 0.75 and a zero debt beta. The expansion costs $1 million
today and generates unlevered after-tax cash flows of $300,000 per year in perpetuity. The risk of the expansion project is the same as that of the firm’s existing business and ABC intends to continue with the same debt-to-value ratio after the expansion. The risk-free rate is 5%, the market risk premium is 10%, and the corporate tax rate is 25%.
What is the value using the APV formula ( potentially tricky, read question properly)?

Answer 12

Tax shields = tax rate x cost of debt x amount of debt, the amount of debt in this case ( we are told the company wants to target the same amount of debt forever, so debt will be 40% of our value of our company.

Then solve equation with one unknown.

Question 13

ABC Corporation is considering an expansion. It maintains a constant debt-to-value ratio of 40% with an equity beta of 0.75 and a zero debt beta. The expansion costs $1 million
today and generates unlevered after-tax cash flows of $300,000 per year in perpetuity. The risk of the expansion project is the same as that of the firm’s existing business and ABC intends to continue with the same debt-to-value ratio after the expansion. The risk-free rate is 5%, the market risk premium is 10%, and the corporate tax rate is 25%.
Now what is the PV of our tax shields ( HINT use APV and Wacc to compute this?
What would happen if the company would want to do the expansion using a different portion of debt and equity?

Answer 13

V(unlevered firm using APV) was 300/0.095 = 3157.89.
V(levered firm) using WACC = 3,333.33.

So present value of tax shields is the difference
175.439 ( so the added value of debt) .

2) We would have to recompute the whole thing, having to change discount rates for wacc and so on..

Question 14

You are considering setting up a candy company. The project costs $1,000 today and generates unlevered after-tax cash flows of $600 one year from now and $700 two years from now. You plan to maintain a constant (optimal) debt-to-value ratio of 30%. At this ratio your cost of debt is 8%. The corporate tax rate is 35%. A comparable candy company maintains a constant debt-to-value ratio of 20%, cost of equity of 13%, and cost of debt of 8%. Should you undertake the project? notice anything?

Answer 14

Yes

Question 15

The Singer Corporation has a debt-to-value ratio of 10%. The firm’s revenues are $500,000 per year forever and its operating costs are $360,000 per year forever. The firm’s cost of debt is 10% and its cost of equity is 21%. The firm has 100,000 shares outstanding. The corporate tax rate is 34%.
What is the firm’s value? Its stock price?

Answer 15

We calculate the numerator.
Then calculate the discount rate, using wacc.
Then find whole value.
Then find equity value, by finding 90% of whole value.
Then we divide by the amount of shares outstanding.

Question 16

Complicated question now. Lets take this slowly, immediately eye balling this question, what will have to do?

Answer 16

We will need to find the incremental value to shareholders of this optimal capital structure, then divide by shares outstanding to behind premium.
First of all we have to adjust our WACC formula, as re changes, because we are changing the capital structure of the company to find firm value.

Question 17

Now lets solve this ( hint calculate incremental debt and assume this debt issued, is used to pay shareholders a dividend)

Answer 17

Question 18

Now lets suppose their is a sharebuy back….

Answer 18

….

Question 19

We are now going to look at valuation using multiples?

Answer 19

1) find other companies that are similar to you.
2) then use the value of comparable companies as a proxy for us.

Question 20

Lets say we are looking to rent a 1 bedroom house in holborn and we have been quoted a £2000 per month, how do we know if its a fair price or not?

Answer 20

We look at comparable flats with similar characteristics such as size, location but each flat might have different sizes and might have same size but one has more bedrooms for example. So lets say we want to compare flats but they have different sizes hence different prices, so we can calculate the ratio between rent/size ( this is the multiple, based on size )

Question 21

What does our mutiples tell us?

Answer 21

The value of our company is based on a multiple of a company x from our peers x X for our company, where x is a characteristic such as size, profit, earnings, ebitda. ( so we are trying to forecast the future based on the past)

Question 22

What is a pro and con of multiples?

Answer 22

PRO = very simple to explain then DCF
CON = we assume our comparable firms have the same risk, cost of capital etc, so finding similar companies is very difficult.

Question 23

To summarise what are the 3 main discounted, recipes or methods we wil see in exam what is the cash flows, discount rate and answer?

Answer 23

Question 24

Calculate comparable company and Industry P/E, ratio ( essentially find different prices of apple using 2 different EPS?

Answer 24

Comps P/E is the. average of Dell, HP and Microsoft, then set that equal to what we see.

Question 25

So when we are valuating a business we have valued it at end of cycle, so no Terminal value = Terminal value assumes a business will grow at a set growth rate forever after the forecast period. So now we are going to assume terminal value, what are 2 ways of calculating it?

Answer 25

Mx ( multiple of a certain characteristic) x value of X for our firm at time t.

Question 26

There is going to be a specific way we calculate the long term growth rate, for terminal value, which is what?

Answer 26

Estimate our growth rate based on the amount of our profits we reinvest x return on the money.

Question 27

Summarise the Volkswagen case.

Answer 27

There was an acquisition by Porsche for Volkswagen ( Porsche way smaller than Volkswagen but they acquired shares in Volkswagen by borrowing money to pay for the shares.

Question 28

So porsche had around 7.47 billion in sales ( very small) but if you look at their net income it is 6.29, so a 80% margin on their cars, that is ridiculous, so why were porsche so profitable?

Answer 28

This is because as the share-price of the asset they owned (volkswagen, kept going up, the value of porsche kept going up too

Question 29

What is funny is that porsche spent a long time trying to buy volkswagen, but due to financial crisis, share price went down and couldn't repay loan back so what did they do?

Answer 29

So what porsche did was try to sell their company back to volkswagen, so that they can use the company to pay the loans

Question 30

Volkswagen’s P/E multiple is 16.3, while the industry average is 7.58. Mr. Klaus Farra wants to multiply the industry’s P/E ratio by Volkswagen’s EPS to find the fair valuation of Volkswagen’s shares. Is this the right way to proceed? Does this imply that Volkswagen is over-valued, under-valued or correctly priced in December 2008? Is there a better measure than industry average? Data based on 2008 BTW?

Answer 30

It is better to use median, because even if there is an outlier, we still look for middle position, so results not screwed?

Question 31

Next question, now we know that Volkswagen, have a huge portfolio of different cars, thus this must mean that one company might have a higher EPS, earnings etc because they have have an expenisive car in their portfolio. What should be the comparable firms’ set for the P/E analysis? Think about the factors affecting your choice. What is the value of Volkswagen stock using P/E multiples valuation?

Answer 31

There are no fixed rule in terms of the characteristics, so lets take the companies that are known globally (SIZE) , have a similar capital structure ( LEVERAGE) and ROIC. Now the crisis expected to hit in 2009 thats why analyst Expected EPS are volitaile. In 2010, the crisis was much less and the dispersion was less .

Question 32

Next question, when we compute the price earnings ratio, earnings is the same thing as net income, if im comparing Volkswagen to companies of very different places in the world, them places might have different accounting standards, hence people like to use EBITDA as a measure of profit, because its less affected by manipulation of companies then NET income are. Also firms have different capital structures, hence the effect of interest payments and tax deductions are not included.

Answer 32