Presentation on theme: "Theory Behind the Discounted Cash Flow approach"— Presentation transcript:
1 Theory Behind the Discounted Cash Flow approach Chapter 11Theory Behind the Discounted Cash Flow approach
2 The Market Value Balance Sheet Enterprise value represents the left hand side
3 Who has a claim on the Enterprise Value? Either someone else (Debt and Preferred Stock) or owned by the Equity Holders
4 What is Enterprise Value? The market value of the assets of the firmEnterprise Value =Common Equity Value + Preferred+ Market Value Debt – Excess Cash
5 The indirect method of equity valuation: DCF approach Calculate Enterprise valueSubtract outMarket Value of DebtPreferred StockAdd back excess CashIn practice, many analysts add back all cash to ensure consistency across firms when performing comparable company analysis
6 How do we calculate Enterprise Value? Project future cash flows to capital providersConvert each cash flow to a Present Value equivalentSum these present value cash flows
7 How do we get the cash flows? Firms have infinite lives, so forecasting all the cash flows is impossibleForecast 5-10 years of cash flowsCalculate the TERMINAL VALUE of the remaining cash flows
8 Note on Terminal ValueA common way to estimate the Terminal Value of a firm is to assume that the business will grow at a particular rate in perpetuityIf you expect the business to grow at 10% per year forever, it will soon be worth more than an average-sized country!
9 The trick to a reasonable growth estimate Forecast the cash flows of the business for a long enough period of time that you expect it to reach a "steady state", sustainable long term growth rateDon't be surprised if your Terminal Value accounts for more than half of the total value of the business.DCF values are extremely sensitive to your assumption of what the business is worth at the end of the forecast period.
10 Calculating the terminal Value Use the Gordon Growth Model
11 What do we need to do the DCF? Cash flowsWhat are the appropriate cash flows?Discount RateWhat is the appropriate discount rate?
12 Enterprise Value and Cash Flow Enterprise Value is the Market value of the assetsAll of the capital providers have a claim on this market valueWe are interested the cash flows available to pay all of the capital providers, not just the equity holdersWe want the cash flows available to debt and equity holders
13 Unlevered Free Cash Flow Unlevered free cash flow is the total cash available for distribution to owners and creditors after funding worthwhile investment activitiesHow do we get it? Two ways.1. Use the statement of Cash Flows2. Using only the Income Statement
14 Unlevered Free Cash Flow Using Cash Available for Debt Repayment Cash Available for Debt Repayment + Interest Expense - Interest Tax Shield
15 Unlevered Free Cash Flow Using the Income Statement EBITDA - Taxes on EBITA - Capital Expenditures - Changes in Working CapitalOrEBIT – Taxes on EBIT + Depreciation + Amortization - Capital Expenditures - Changes in Working Capital
17 We have the cash flows, now we need: the Discount Rate Weighted Average Cost of Capital
18 Required rate of return on invested capital The appropriate Discount Rate is the rate of return that can be earned on an investment of comparable risk.The riskier an investment, the higher the expected return needs to be to justify an investmentIt measures the Opportunity Cost of the Investors’ CapitalWeighted Average Cost of Capital: WACC
19 Intuition... WACC $1 debt and $1 equity, $2 total capital Bank needs 10%, shareholder needs 20%Need to earn 10 cents to keep bank happyNeed to earn 20 cents to keep stock happyTotal required earnings is 30 cents$0.30/$2.00=15% required return on capital
20 Money is left over. Positive NPV. Everybody is happy! If you earn more than 15%Money is left over. Positive NPV. Everybody is happy!But, if you earn less...
21 How do we calculate the WACC WACC=(1-t)kd(D/V) +ke(E/V)where…D and E are the market value of debt and market value of equityMarket value of debt is difficult to obtain, so analysts usually use the book value (reasonable assumption for solvent firms)
22 Should we include short-term debt? Only include short-term debt if you believe that it will be a permanent component of the capital structure
23 How to get the market value of equity? Multiply number of shares outstanding by the price per shareFor a private firm, things are more difficult, since the equity does not have a “price”You might want to use liquidation value of the assets minus the value of the debtBETTER PROXY: use industry P/E multiple
24 Actual or target weights for debt and equity? We are interested in the required rate of return in the future, so today’s ratios are irrelevantWhat matters is our expectation of the future
25 How to get the cost of debt? Calculate yields to maturity using bond market pricesThese reflect what bondholders expect to earn over the life of their investmentUse yields for firms with similar bond ratingsImpute a bond rating using TIE, D/A, and liquidity ratiosLook in footnotes to annual reportCall the firm directly
26 Getting the firm’s cost of debt The firm has the following long-term bond outstanding15 year maturity, Par=1000, Coupon payments are 9% semi-annual. Price is $1,080. Solve your effective annual yield to maturity.8.24%
27 What about the cost of equity? Use CAPMkreq= krf+ (L)(km-krf)So, we need beta, the risk-free rate, and the market risk premium
28 The risk-free rate - Krf This is easy, just take the rate of return for a risk-free bond with the same maturity as the firm’s assets.In this case, use the rate of return on 30-year government debt 4.75% on April 1, 2007
29 The market risk premium Km-KrfThis is NOT the difference between the current rate of return on the market and the current risk free rate of return.This reflects expected investor risk-aversion. Current premium is 6.4%
30 Beta - systematic risk Remember, beta is a backwards-looking measure. If you expect historical values to prevail, then use the firm’s current beta.You can get this from Bloomberg, Yahoo.FinanceIf there is a systematic change in either the firm’s business or financial risk, then the historical beta is useless.
31 Deconstruction of risk Total risk = Business risk + Financial RiskBusiness riskRisk of product market/assetsFinancial riskUse of leverage
32 Risk: Our old friend beta Intro to Finance beta is a levered beta.Also called the equity betaIt reflects the historical sensitivity of a stock’s rate of return to that of the marketBut, the stock’s rate of return depends on the amount of debt in the capital structure, so...Beta reflects both the business and financial risk
33 You calculate the firm’s historical beta to be 1 You calculate the firm’s historical beta to be 1.11, but expect is capital structure to changeWhy is this beta unacceptable?The firm’s target debt ratio is 60%But, current market value of debt to total capital was only 41%Beta has to be adjusted for the difference between the actual and target debt ratio
34 How do we do this?Strip away the effects of the existing capital structure (leverage) to get the business riskRe-lever to reflect the future capital structure
35 Unlevered Beta - Asset Beta Reflects only the firm’s business riskL = U [1+(D/E)(1-t)]orU= L / [1+(D/E)(1-t)]
36 Check this out… CAPM kreq= krf+ (L)(km-krf) substitute levered beta into CAPM to getkreq= krf+ (U)(km-krf) + (U)(D/E)(1-t)(km-krf)Return= risk-free rate + premium for business risk + premium for financial risk
37 Unlevering & relevering the beta Bu=1.11 / [1+(.41/.59)(1-.34)] = 0.76Re-lever with 60% leverageBLnew=0.76[1+(0.6/0.4)(1-.34)] = 1.514
38 Firm’s cost of equity capital Krequired = Risk free rate + beta(risk premium)4.75% + (1.514)(6.4%) = 13.39%
39 Putting it all together WACC WACC= (D/V) kd (1-t) + (E/V)ke0.6(8.24%)(1-.34) + (0.4)(13.39%)=Firm’s WACC is 8.62%
40 Now you have the cash flows and the discount rate Calculate the Enterprise ValueNext Chapter