2 Firm Valuation—Disney Disney has a normal valuation case….Disney has positive earnings.Disney’s earning has a positive growth rate.Disney’s has sufficient financial information in estimating cost of capital.
4 Firm Valuation—Disney Cash FlowsTo FirmTo EquityEBIT (1-t)- ( Cap Exp - Depreciation)- Change in Working Capital= Free Cash flow to FirmThe Strict ViewDividends + BuybacksThe Broader ViewNet Income- Net Cap Exp (1-Debt Ratio)- Chg WC (1 - Debt Ratio)= Free Cash flow to Equity
5 The growth rates in cash flows Retention ratioROEg EPSReinvestment rateROCg EBITOperating IncomeNet Income
6 Dividend growth, retention ratio, and Return on Equity (ROE) g = retention * ROE Assume that ROE=20%, payout=50%, beginning equity = 100A.Beg. EQB. Earnings(A*ROE)C.Dividend(B*50%)D. Ret. Earnings(B-C)E.End EQ(A+D)1002010110221112124.212.1133.126.613.3146.4
7 The growth rates in cash flows Expected Growth EBIT = Reinvestment Rate * Return on CapitalReturn on Capital = EBIT (1-t) / Capital Invested
8 Firm Valuation—Disney 1996 Disney’s basic dataEBIT：$5,559 MillionCapital spending：$ 1,746 MillionDepreciation：$ 1,134 MillionNon-cash Working capital Change：$ 617 MillionBook value of Debt：$7,763 Million (MV$11,180)Book value of Equity：$11,668 Million (MV$50,880)Levered Beta：1.25Risk free rate：7.00%Risk Premium：5.50%Tax rate：36%
9 Cost of Equity• Cost of Equity ：k equity = 7.00% *5.50% = 13.88%• Market Value of Equity = $50,880 Million• Equity/(Debt +Equity ) = 82%
10 Cost of Debt•Cost of Debt for Disney = 7.50% (From Moody’s Bond Rating)• After-tax Cost of debt = 7.50% (1-36%) = 4.80%• Market Value of Debt = $ 11,180 Million• Debt/(Debt +Equity) = 18%
15 How to determine a reasonable growth rate? The firm is in stable growthThe firm is in a relatively high growth, will be in stable growth after certain years (2-stage)The firm is in a high growth period, will experience a period of transition period before it is in stable growth (3-stage)
16 The high growth rates and high growth period Very high growth rate in current time – long growth periodHigh entry barriers – long growth periodLarge size of firm – short growth period
17 Relationship between growth rates and other firm characteristics High growth firmsStable growth firmsRiskLargeMediumDividend payoutVery little or even zerohighNet Capital Exp.lowROCROC is close to WACCLeverageVery low
18 Disney’s Firm Valuation Free Cash flows to Firm ApproachThree stages of growth
19 Expected growth in EBIT High GrowthTransitionStable growthlength5 years11th to foreverRevenues1996: $18,739Revenues grows at the same rate as Operating earningsGrows at a stable growth ratePre-tax Margin29.67% of RevenuesEBIT of 1996 $5,559Steadily increase to 32% due to scale economy32% of RevenuesTax Rate36%ROC20%, same as 1996Steadily decrease to 16%16%Working capital5% of RevenuesReinvestment Rate50%, $1,134 for 1996, assume same growth rate as EBITSteadily decrease to 31.25%,31.25%Expected growth in EBITROC*Reinvestment Rate=10%Steadily decrease to stable growth 5%5%Debt /Capital18%Steadily increase to 30%30%Risk ParametersBeta=1.25k equity=13.88%Cost of debt = 7.5%(before tax)(Long Term Bond Rate=7%)Beta decrease steadily to 1.00Cost of debt remains 7.5%Beta=1.00；
21 Disney’s Cost of Capital Year12345678910Cost of Equity13.88%13.60%13.33%13.05%12.78%12.50%Cost of Debt (after tax)4.80%Debt Ratio18.00%20.40%22.80%25.20%27.60%30.00%Cost of Capital(WACC)12.24%11.80%11.38%10.97%10.57%10.19%
23 Disney：Net Present Value Year12345678910FCFF$1,966$2,163$2,379$2,617$2,879$3,370$3,932$4,552$5,228$5,957Terminal Value$120,521Present Value$1,752$1,717$1,682$1,649$1,616$1,692$1,773$1,849$1,920$42,167Cost of Capital12.24%11.80%11.38%10.97%10.57%10.19%Value of firm = $ 57,817 millionValue of equity = Value of firm –Value of debt= $ 57,817 -$ 11,180 = $ 46,637 millionNumber of Shares =675.13Value per share = 46637/ = $69.08
24 Why we do not consider the cash flows related to the financing? When you use the after-tax cost of capital to be the discount rate, you basically take in the effect of the financing.If you discount the project cash flows (without financing) by the after-tax cost of capital, you will get the exact net present value as you use it to discount the total cash flows (project cash flows plus the financing cash flows).That is, when you use the after-tax cost of capital to discount financing related cash flows, the net present value would be zero.
26 Assuming that financing totally comes from debt, and the before-tax cost of capital is 6%, tax rate 25%, so the after-tax cost of capital 4.5%.（t=0）（t=1）（t=2）（t=3）（t=4）Project CF(8,000,000)3,500,0006,500,000NPV (at 4.5%)7,072,024（t=0）（t=1）（t=2）（t=3）（t=4）Total CF3,140,000(1,860,000)NPV (at 4.5%)7,072,024（t=0）（t=1）（t=2）(t=3）（t=4）Fin. Rel. CF8,000,000(360,000)(8,360,000)NPV (at 4.5%)
27 How do managers create value? Increase the cash flows generated by existing investmentsIncrease the expected growth rate in earningsIncrease the length of the high-growth periodReduce the cost of capital that is applied to discount the cash flows.
28 Increasing the cash flows generated by existing investments Managers can improve upon operating margin by improving operating efficiency and increase the returns to assets-in-place.Tax management can also increase returns on existing assets.Multinational firms can shift income across regions.Net operating losses can shield future income. (Profitable firm acquires unprofitable firm)Working capital management
29 Increasing the expected growth in FCFF or FCFE Higher growth rates increase the value of the firm today.The offsetting cost is that increasing the reinvestment rate can reduce costs today as it reduces FCFF and FCFE.If reinvestment is NPV>0 project, then the benefits to growth outweigh the reduction on current cash flows.Reinvest as long as EVA>0.ROIC>rWACC
30 Reducing the cost of financing Changing the financial mix of debt and equity can increase value.Reduce tax liabilities by offsetting tax liabilities with interest payments.Leads to an optimal capital structure for firm than lowers overall cost of capital and maximized firm value.
31 Adjusted Present Value (APV) Approach APV = PV of asset flows + PV of side effects associated with the financing program.Recall the M/M proposition I:
32 Adjusted Present Value (APV) Approach Procedure:1. Calculate PV of project (or enterprise) assuming it is all equity financed (i.e. no interest expense)2. Calculate value of tax shield.3. Total firm value = value of all equity firm + side effects of financing.
33 Calculate PV of project assuming it is all equity financed Assume:Asset (un-levered) beta = 0.7Long Term T Bond Rate = 6%Market Premium = 7.8%From CAPM, Discount rate = *.078 = .1146Also assume: Terminal value = (approx.) 7 x FCF
34 Year:12345EBIT10010811612413440%4043.246.449.653.6Capex30323537Depreciation2022242628Increase in NWC232527FCF32.835.638.441.4Terminal Value289.826.926.425.724.924.1168.5Total PV
35 Calculate value of tax shield Assume: $150 of debt at 8% (pretax) remains outstanding Year:12345EBIT100108116124134Interest(=outstanding debt*.08)12.010.28.05.62.8Profit before tax88.097.8108.0118.4131.240%188.8.131.52.452.5Profit after tax52.858.764.871.178.7Capex3032353740Depreciation2022242628Increase in NWC232527Net CF22.826.730.835.139.7Ending Debt = (beginning debt –net cash flow)127.2100.569.734.7-5.1
36 Compare tax payments with vs. without debt Compare tax payments with vs. without debt. The difference equals the tax savings available from the interest deduction (tax shield)Discount tax savings at pre-tax rate of return on debt:Tax payments with no debt40.043.246.449.653.6Tax payments with 8%184.108.40.2062.5Tax savings220.127.116.11.21.1PV of tax 8% $13
37 Suppose in addition there is a tax loss carry-forward of $100 million Suppose in addition there is a tax loss carry-forward of $100 million. This means that the first $40 million of taxes need not be paid.YearTax savingsTaxable Income Used135.28824.8100PV of tax savings@ 8% $37Present value these savings at 8%, produces a value of 37 for the tax loss carry-forward.
38 APV - ConclusionTotal firm value = value of all equity firm (295) + side effects of financing ( ) = 345.