Corporate Valuation Free cash flow approach

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.

Firm Valuation—Disney Cash Flows To Firm To Equity EBIT (1-t) - ( Cap Exp - Depreciation) - Change in Working Capital = Free Cash flow to Firm The Strict View Dividends + Buybacks The Broader View Net Income - Net Cap Exp (1-Debt Ratio) - Chg WC (1 - Debt Ratio) = Free Cash flow to Equity

The growth rates in cash flows Retention ratio ROE g EPS Reinvestment rate ROC g EBIT Operating Income Net Income

Dividend growth, retention ratio, and Return on Equity (ROE) g = retention * ROE Assume that ROE=20%, payout=50%, beginning equity = 100 A. Beg. EQ B. Earnings (A*ROE) C. Dividend (B*50%) D. Ret. Earnings (B-C) E. End EQ (A+D) 100 20 10 110 22 11 121 24.2 12.1 133.1 26.6 13.3 146.4

The growth rates in cash flows Expected Growth EBIT = Reinvestment Rate * Return on Capital Return on Capital = EBIT (1-t) / Capital Invested

Firm Valuation—Disney 1996 Disney’s basic data EBIT：$5,559 Million Capital spending：$ 1,746 Million Depreciation：$ 1,134 Million Non-cash Working capital Change：$ 617 Million Book value of Debt：$7,763 Million (MV$11,180) Book value of Equity：$11,668 Million (MV$50,880) Levered Beta：1.25 Risk free rate：7.00% Risk Premium：5.50% Tax rate：36%

Cost of Equity • Cost of Equity ：k equity = 7.00% + 1.25*5.50% = 13.88% • Market Value of Equity = $50,880 Million • Equity/(Debt +Equity ) = 82%

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%

WACC WACC = 13.88% * 0.82 + 4.80% * 0.18 = 12.24%

1996 Free Cash Flow to the Firm FCFF= EBIT (1 - tax rate) – (Capital Expenditures - Depreciation) – Change in Non-cash Working Capital =$5,559 (1-36%) – ($1,746-$1,134) –$617 =$2,329

The current growth rate for Disney Reinvestment Rate1996 =(1745-1134+617) / 5559*(1-36%) =34.5% ROC1996= 5559*(1-36%) / (7663+11668) =18.69% Forecasted Reinvestment Rate=50% ROC=20% Expected Growth EBIT = 50% * 20% = 10%

The firm Valuation

How to determine a reasonable growth rate? The firm is in stable growth The 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)

The high growth rates and high growth period Very high growth rate in current time – long growth period High entry barriers – long growth period Large size of firm – short growth period

Relationship between growth rates and other firm characteristics High growth firms Stable growth firms Risk Large Medium Dividend payout Very little or even zero high Net Capital Exp. low ROC ROC is close to WACC Leverage Very low

Disney’s Firm Valuation Free Cash flows to Firm Approach Three stages of growth

Expected growth in EBIT High Growth Transition Stable growth length 5 years 11th to forever Revenues 1996: $18,739 Revenues grows at the same rate as Operating earnings Grows at a stable growth rate Pre-tax Margin 29.67% of Revenues EBIT of 1996 $5,559 Steadily increase to 32% due to scale economy 32% of Revenues Tax Rate 36% ROC 20%, same as 1996 Steadily decrease to 16% 16% Working capital 5% of Revenues Reinvestment Rate 50%, $1,134 for 1996, assume same growth rate as EBIT Steadily decrease to 31.25%, 31.25% Expected growth in EBIT ROC*Reinvestment Rate=10% Steadily decrease to stable growth 5% 5% Debt /Capital 18% Steadily increase to 30% 30% Risk Parameters Beta=1.25 k equity=13.88% Cost of debt = 7.5%(before tax) (Long Term Bond Rate=7%) Beta decrease steadily to 1.00 Cost of debt remains 7.5% Beta=1.00；

Disney’s FCFF Basic year 1 2 3 4 5 6 7 8 9 10 Expected Growth Revenues 10% 9% 8% 7% 6% 5% Revenues $18,739 $20,613 $22,674 $24,942 $27,436 $30,179 $32,895 $35,527 $38,014 $40,295 $42,310 Operating Margin 29.67% 30.13% 30.60% 31.07% 31.53% 32.00% EBIT $5,559 $6,115 $6,726 $7,399 $8,139 $8,953 $9,912 $10,871 $11,809 $12,706 $13,539 EBIT(1-t) $3,558 $3,914 $4,305 $4,735 $5,209 $5,730 $6,344 $6,957 $7,558 $8,132 $8,665 +Dep. $1,134 $1,247 $1,372 $1,509 $1,660 $1,826 $2,009 $2,210 $2,431 $2,674 $2,941 -Capital Exp. $1,754 $3,101 $3,411 $3,752 $4,128 $4,540 $4,847 $5,103 $5,313 $5,464 $5,548 -△WC $94 $103 $113 $125 $137 $136 $132 $124 $114 $101 =FCFF $1,779 $1,966 $2,163 $2,379 $2,617 $2,879 $3,370 $3,932 $4,552 $5,228 $5,957 ROC 20% 19.2% 18.4% 17.6% 16.8% 16% Reinv. Rate 50% 46.88% 43.48% 39.77% 35.71% 31.25%

Disney’s Cost of Capital Year 1 2 3 4 5 6 7 8 9 10 Cost of Equity 13.88% 13.60% 13.33% 13.05% 12.78% 12.50% Cost of Debt (after tax) 4.80% Debt Ratio 18.00% 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%

Terminal Value FCFF11 = EBIT11 *(1-t) – EBIT11* (1-t) *Reinvestment Rate = $ 13,539 (1.05) (1-36%) - $ 13,539 (1.05) (1-36%) (31.25%) = $ 6,255 million Terminal Value = $ 6,255/(10.19 %- 5%) = $ 120,521 million

Disney：Net Present Value Year 1 2 3 4 5 6 7 8 9 10 FCFF $1,966 $2,163 $2,379 $2,617 $2,879 $3,370 $3,932 $4,552 $5,228 $5,957 Terminal Value $120,521 Present Value $1,752 $1,717 $1,682 $1,649 $1,616 $1,692 $1,773 $1,849 $1,920 $42,167 Cost of Capital 12.24% 11.80% 11.38% 10.97% 10.57% 10.19% Value of firm = $ 57,817 million Value of equity = Value of firm –Value of debt = $ 57,817 -$ 11,180 = $ 46,637 million Number of Shares =675.13 Value per share = 46637/675.13 = $69.08

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.

（t=0） （t=1） （t=2） （t=3） （t=4） Initial invest. (total cost) (8,000,000) Inc. rev. 6,000,000 Inc. cost (2,000,000) Deprec. 2,000,000 OP CF 3,500,000 NOP CF 3,000,000 Project CF 6,500,000 Financing 8,000,000 Interest (AT) (360,000) Repay. Fin. Rel. CF (8,360,000) Total CF 3,140,000 (1,860,000)

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) 3,500,000 6,500,000 NPV (at 4.5%) 7,072,024 （t=0） （t=1） （t=2） （t=3） （t=4） Total CF 3,140,000 (1,860,000) NPV (at 4.5%) 7,072,024 （t=0） （t=1） （t=2） (t=3） （t=4） Fin. Rel. CF 8,000,000 (360,000) (8,360,000) NPV (at 4.5%)

How do managers create value? Increase the cash flows generated by existing investments Increase the expected growth rate in earnings Increase the length of the high-growth period Reduce the cost of capital that is applied to discount the cash flows.

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

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

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.

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:

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.

Calculate PV of project assuming it is all equity financed Assume: Asset (un-levered) beta = 0.7 Long Term T Bond Rate = 6% Market Premium = 7.8% From CAPM, Discount rate = .06 + .7*.078 = .1146 Also assume: Terminal value = (approx.) 7 x FCF

Year: 1 2 3 4 5 EBIT 100 108 116 124 134 Tax @ 40% 40 43.2 46.4 49.6 53.6 Capex 30 32 35 37 Depreciation 20 22 24 26 28 Increase in NWC 23 25 27 FCF 32.8 35.6 38.4 41.4 Terminal Value 289.8 PV@11.46% 26.9 26.4 25.7 24.9 24.1 168.5 Total PV 296.4

Calculate value of tax shield Assume: $150 of debt at 8% (pretax) remains outstanding Year: 1 2 3 4 5 EBIT 100 108 116 124 134 Interest(=outstanding debt*.08) 12.0 10.2 8.0 5.6 2.8 Profit before tax 88.0 97.8 108.0 118.4 131.2 Tax @ 40% 35.2 39.1 43.2 47.4 52.5 Profit after tax 52.8 58.7 64.8 71.1 78.7 Capex 30 32 35 37 40 Depreciation 20 22 24 26 28 Increase in NWC 23 25 27 Net CF 22.8 26.7 30.8 35.1 39.7 Ending Debt = (beginning debt –net cash flow) 127.2 100.5 69.7 34.7 -5.1

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 debt 40.0 43.2 46.4 49.6 53.6 Tax payments with debt @ 8% 35.2 39.1 47.4 52.5 Tax savings 4.8 4.1 3.2 2.2 1.1 PV of tax savings @ 8% $13

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. Year Tax savings Taxable Income Used 1 35.2 88 2 4.8 100 PV of tax savings @ 8% $37 Present value these savings at 8%, produces a value of 37 for the tax loss carry-forward.

APV - Conclusion Total firm value = value of all equity firm (295) + side effects of financing (13 + 37) = 345.