Topic 3: Special Topics in Valuation

Question 1

To check whether NPV is realistic use: sensitivity analysis

• factors checked
• advantages
• disadvantages

Answer 1

1. sensitivity analysis (what-if; bop (best, optimistic, pessimistic))
2. factors checked:
   - revenues - what are they dependent on
   - costs - fixed, variable
3. advantages:
   can show where more work is required to refine estimates
4. disadvantages
   - can increase false sense of security (knowing so-called worst scenario)
   - variables are treated in isolation rather than in reality - different variables are likely to be related. To counter - use SCENARIO ANALYSIS

Question 2

Break even analysis

1. define
2. Calculate BE in what terms?
3. Comment on before or after tax usage when calculating BE

Answer 2

1. define: determine sales required to break even
2. Calculate BE in what terms? Accounting Profit and Present Value
3. Tax: Trick in exercise - use pre tax to determine BE; because a pretax profit of $0 will also be after tax profit of $0

Question 3

Break even analysis:

Present Value - discuss Equivalent Annual Cost

Answer 3

Equivalent Annual Cost:
- EAC = Initial Investment / (annuity factor)
- EAC puts costs on a per year basis. This way you can compare costs with different lifespans, rather than just NPV’ing each on a different basis.
- EAC implies that the initial investment could have been invested at the rate of interest
EAC BE is different to accounting BE. Accounting BE subtracts depreciation. Depreciation understates true cost of recovering initial investment (initial investment could have been invested at the interest rate; ie this is an opportunity cost)

Question 4

Monte Carlo simulation - steps

Answer 4

1. Specify the basic model
2. Specify a distribution for each variable in the model (probability vs factor)
3. Computer draws one outcome
4. repeat the procedure (Monte Carlo simulation repeats the steps again and again)
   5, Calculate NPV

Question 5

Risk management - methods that give insight into potential variation of project’s revenue (8)

Answer 5

1. ratio analysis (eg vs other projects, vs competitors)
2. multiples (vs comparables, also can reconcile DCF with multiples through backward engineering to reconcile any differences)
3. sensitivity analysis (alter key inputs one at a time and observe change in value)
4. scenario analysis (alternate scenarios that might affect all key inputs; check resulting value)
5. monte carlo simulation (probability distributions for key inputs in a project; then prepare scenarios using random drawings to calc CF & project NPV. Generate prob distn)
6. recognise strategic flexibility in the project
7. breakeven analysis
   - accounting BE: at what level of sales does the project show accounting profit
   - PV BE: At what level of sales does the project reach NPV = 0; ie PV = initial investment. PV BE is higher as project must earn enough profit to provide required return on capital
8. Equivalent annual cost (EAC): EAC is the annuity cashflow whose PV is equal to the PV of the after tax outlays, both operating and capital, for a project.

Question 6

Standardizing Statements (for comparison)

1. Common Size Balance Sheets
2. Common Size Income Statements

Answer 6

1. Common Size Balance Sheets - express as a percentage of total assets
2. Common Size Income Statements - express each item as a percentage of sales

Question 7

Commonly Used Measures of Earnings:

1. Net Income
2. EPS
3. EBIT
4. EBITDA

Answer 7

1. Net Income:
   - bottom line; = Total Revenue - Total Expenses.
   - reflects differences in cap structure & taxes as well as op income.
   - div payout & revenue are closely linked to net income
2. EPS
   - Net income / total shares outstanding
3. EBIT
   - Income from operations; ie before unusual items, discontinued operations or extraordinary items
   - Total operations revenue - Total operating expenses.
   - Cap structure is considered separately
4. EBITDA
   - = EBIT - D&A
   - add back the two non cash items (D&A) to get a better measure of before tax operating CF

Question 8

Why use Financial Analysis with our valuation?

Answer 8

1. measure quality of results (ratio calcs allow us to measure quality of profits
2. check how robust our forecasts are
3. diagnose historical performance
4. forecast relationships (calc ratios to allow us to forecast variables based on relationships between variables)

Question 9

Financial Analysis Toolkit - 4 STEPS

1. ADJUST
2. ANALYSE
3. RATIOS
4. BENCHMARK

Answer 9

1. ADJUST
   - adjust raw financial numbers
   - reorganise to be compatible with valuation metrics
   - normalise for non recurring items
   - adjust for items not included in Income Statement and BS
2. ANALYSE
   - analyse movements in key line items to understand what is driving results
3. RATIOS
   - common size financial statements
   - calculate key financial ratios and use drill down analysis to understand key changes
4. BENCHMARK
   - benchmark results against history, targets, peers/ competitors

Question 10

Book Value of Assets:

Net Operating Assets; Value of Operations - describe

Answer 10

Net Operating Assets

• BV of co’s operations
• usually bulk of co’s value
• may contain several divisions or segments
• “net” - include operating liabiltiies

Question 11

Book Value of Assets:

Non Operating Assets- describe

Answer 11

Non Operating Assets

• surplus assets or assets that are not wholly owned or operated
• distinguish between operating and non operating by asking if asset is CORE, CONTINUING AND CONTROLLABLE.

Question 12

Book Value of Assets:

Surplus Cash - describe

Answer 12

Surplus Cash

• cash over and above that required to support operations
• would distort CF from ops, so separate it.

Question 13

Book Value of Financial Claims:
ie claims from financial markets or coinvestors

Interest Bearing Debt

Answer 13

Interest Bearing Debt

• external borrowings used to finance the company, ST & LT
• generally is BV (amt raised at time of issue) but may include mkt adjustments - eg swaps

Question 14

Book Value of Financial Claims:
ie claims from financial markets or coinvestors

Minority Interests

Answer 14

Minority Interests

• If a company owns 50.1% to 100% of a subsidiary, then it is fully consolidated even if not fully owned
• need to recognise that someone has a partial claim - the minority shareholders and non controlling interests
• minorities’ share of interest of retained earnings in consolidated subsidiaries.

Question 15

Book Value of Financial Claims:
ie claims from financial markets or coinvestors

Ordinary Equity

Answer 15

Ordinary Equity

• residual claim on the value of the assets
• calculate as residual after deducting all prior claims

Question 16

NOPAT =

Answer 16

NOPAT = EBIT x (1 - T)

Question 17

Adjust financial statements into a form that aids analysis - steps

Answer 17

1. Reorganise measures to be compatible with valuation metrics (eg Invested Capital, the BV equiv of MV)
2. Adjust for any non recurring items
3. Adjust for items not included in financial statements (eg capitalisation of operating leases)

Question 18

Adjustments for Non Recurring Items

Answer 18

Published profit
- p/l on sale of assets
- p/l on discontinued assets
\+ restructuring costs
\+ impairment writeoffs

Other ; eg omitted liabitilities such as capitalisation of operating leases, proper recognition of pension fund liabilities. Add to both sides - eg for the leases, add to liab & fixed assets

Question 19

Analyse Key Line Items:

Revenue

Answer 19

Analyse Key Line Items:
Revenue
- industry volume growth
- market share gains
- price growth
- currency movements
- new products
- impact of business bought / sold

Question 20

Analyse Key Line Items:

Costs - eg COGS or cost per unit

Answer 20

Analyse Key Line Items:
Costs - eg COGS or cost per unit
- impact of fixed / variable cost mix on cost results
- volume changes
- changes in labour and raw material costs
operational / productivity improvements

Question 21

Difference between NOPAT and NOPLAT

Answer 21

…“less adjusted taxes”

• NOPLAT deducts Ungeared Tax Paid instead of Ungeared Tax Expense
• volatile nature of tax paid means NOPAT preferred
• If using NOPLAT, ensure Invested Capital definition is adjusted. NOPLAT -> do not deduct net tax provisions from total assets

Question 22

Compare key performance measures with valuation results

Name 3 possible benchmarks

Answer 22

1. History
   - trend analysis
   - compare history vs forecast
2. Competitors
   - key financial metrics (eg ROIC, productivity and efficiency measures)
3. Financial or performance benchmarks
   - compare return on shareholder’s funds to cost of equity
   - compare ROIC to WACC
   - days sales ratios - compare with mgmt. targets or terms of trade
   - calculate sustainable growth rate

Question 23

Imputation
Gamma =
Gamma is determined by:
Timing (?)

Answer 23

Gamma = market value of imputation tax credit, values between 0 and 1
Gamma is determined by:
1. the rate at which companies actually distribute credits to shareholders
2. the actual value of these credits in the hands of shareholders
Timing is important: can be considerable time between tax pmt by co and time shareholder receives rebate or offset

Question 24

Name 3 complications to calculating Invested Capital

Answer 24

1. Surplus Cash
2. Non Operating Assets
3. Other equity claims & minority interests

Question 25

Typical valuation methodology (2)

Answer 25

1. value each operating business using DCF, possibly RI or multiples; AND
2. value non operating assets using estimated MV.