Transcript Document

Managing for Value Creation
(Summer 2006)
1
Class #1b Outline
• Review—Class #1a
• Lecture—Overview of business valuation
• Class discussion—Eskimo Pie Corp. Case
Overview of Business Valuation
Basic Inc. Case—Business valuation
in a perfect world
Business Valuation
Valuation Method
Valuation Theories
Component (Equity) Method
Entity (Traditional WACC) Method
Adjusted Present Value (Method)
Equity FCF
Firm FCF
Unlevered (Firm) FCF
Interest Tax Savings
Cost of Levered Equity
WACC
Unlevered Cost of Equity
Cost of Debt
Appropriate Discount Rate
Relevant Cash flow
Valuation in Practice
Forecast FCFs
Trend Forecasting
Financial Forecasting
Estimate Required Rates of Return
Capital Market Theory
Estimation Problems
Basic, Inc. (the setup)
• Investors have raised $600m to
start Basic, Inc. ($317.44m in 9%
bonds and the balance in equity).
• Basic is expected to produce
$500m in sales annually with net
income of $50m forever.
• All the firm’s net income will be
paid in dividends.
• Annual Capex = depreciation
expense and NWC does not change.
• No debt is issued or retired.
Assumptions:
Cost of Equity
Cost of debt, Kd
CAPEX
Depreciation Expense
Tax Rate
Dividends = Net Income
$
15.00%
9.00%
10.00
10.00
30%
50.00
Assets
$
600.00
Debt
Equity
Debt + Equity
$
317.44
282.56
600.00
$
$
Balance Sheet
$
Income Statement
Revenues
less: COGS
Gross Profit
less Operating Expense
EBIT
less: Interest
EBT
less: Taxes
NI
$
$
500.00
(300.00)
200.00
(100.00)
100.00
(28.57)
71.43
(21.43)
50.00
Business Valuation
Valuation Theories
Component (Equity) Method
Entity (Traditional WACC) Method
Adjusted Present Value (Method)
Equity FCF
Firm FCF
Unlevered (Firm) FCF
Interest Tax Savings
Cost of Levered Equity
WACC
Unlevered Cost of Equity
Cost of Debt
Valuation in Practice
Forecast FCFs
Trend Forecasting
Financial Forecasting
Estimate Required Rates of Return
Capital Market Theory
Estimation Problems
Equity Free Cash Flow
Net Income
Plus: Depreciation Expense
Less: Debt Repayment
Plus: New debt issued
Less: Investment in Working Capital
Less: Capital Expenditures (Capex)
Equals: Equity Free Cash Flow (EFCF)
EFCF Calculation
Calculation of Equity Free Cash Flow
NI
plus: Depreciation Expense
less: CAPEX
Equity Free Cash Flow
$
$
50.00
10.00
(10.00)
50.00
Recall that there are no new debt issues nor is debt retired
and NWC does not change.
Security Valuation
• Debt value
Interest Expense
$28.57

 $317.44
Debt Yield  to  maturity
.09
• Equity value
EFCF $50

 $333.33
Ke
.15
Firm Value
Firm Value = Debt Value + Equity Value
$650.77 = $317.44 + $333.33
Business Valuation
Valuation Theories
Component (Equity) Method
Entity (Traditional WACC) Method
Adjusted Present Value (Method)
Equity FCF
Firm FCF
Unlevered (Firm) FCF
Interest Tax Savings
Cost of Levered Equity
WACC
Unlevered Cost of Equity
Cost of Debt
Valuation in Practice
Forecast FCFs
Trend Forecasting
Financial Forecasting
Estimate Required Rates of Return
Capital Market Theory
Estimation Problems
Firm Free Cash Flow (FFCF)
• Net Operating Income (NOI)
Less: Taxes on Incremental NOI
• Equals: Net Operating Profit after Tax
Plus: Depreciation Expense
Less: Investment in Working Capital
Less: Capital Expenditures (Capex)
• Equals: (Firm) Free Cash Flow
How does FFCF compare to payments
made to financial claimants?
Financial Claimant:
Creditors
Stockholders
Payment:
After-tax interest plus
principal payments
less new debt issued.
Common dividends
plus share repurchases
less new shares issued.
Free Cash Flow Calculations
• Firm Free Cash Flow
(FFCF)
Used to value a levered firm or “entity”
value and the equity of an unlevered firm.
• Equity Free Cash
Flow (EFCF)
Used to value the “common equity” of a
levered firm.
Calculation of Firm Free Cash Flow
Net Operating Income (NOI)
less: Taxes
NOPAT
plus: Depr.
less: CAPEX
Firm Free Cash Flow (FFCF)
$
$
100.00
(30.00)
70.00
10.00
(10.00)
70.00
Calculation of Equity Free Cash Flow
Net Income (NI)
plus: Depreciation Expense
less: CAPEX
Equity Free Cash Flow (EFCF)
or
EFCF
plus: Int(1-T)
FFCF
$
$
$
$
50.00
10.00
(10.00)
50.00
50.00
20.00
70.00
Basic, Inc.’s WACC
K wacc
Debt
Equity
 K d (1  Tax Rate)
 Ke
Value
Value
Source of Capital
Debt
Equity
Proportion
0.4878
0.5122
After-tax Cost
0.0630
0.1500
WACC
Financing proportions are based on
market values calculated earlier!
Product
0.0307
0.0768
10.76%
Entity Valuation
Firm ( Entity)Value 
FFCF
K wacc
$70
Firm Value 
 $650.78
.107562
EVA, MVA and Firm Value
Economic Value Added (EVA)
EVA = NOPAT - Kwacc x Invested Capital
= $70 - .1076 x $600 = $70.00 - 64.54 = $5.46
Market Value Added (MVA) = PV(EVAs)
MVA = $5.46/.1076 = $50.78
Firm Value = MVA + Invested Capital
= $50.78 + 600.00 = $650.78
NPVfirm=Firm Value - Invested Capital = MVA
Business Valuation
Valuation Theories
Component (Equity) Method
Entity (Traditional WACC) Method
Adjusted Present Value (Method)
Equity FCF
Firm FCF
Unlevered (Firm) FCF
Interest Tax Savings
Cost of Levered Equity
WACC
Unlevered Cost of Equity
Cost of Debt
Valuation in Practice
Forecast FCFs
Trend Forecasting
Financial Forecasting
Estimate Required Rates of Return
Capital Market Theory
Estimation Problems
Adjusted Present Value Model
Value
of the
Value

of the
Value

of the
Levered Firm Unlevered Firm Interest Tax Savings
Value
of the
Unlevered Firm

Unlevered FCF
Unlevered Cost of Equity
Value
of the
Interest Tax Savings

Interest Expense x Tax Rate
Cost of Debt
Calculating Unlevered EFCF
Firm Free Cash Flow (FFCF)
• Net Operating Income (NOI)
Less: Taxes on Incremental NOI
• Equals: Net Operating Profit after
Tax
Plus: Depreciation Expense
Less: Investment in Working
Capital
Less: (Capex)
• Equals: (Firm) Free Cash Flow
Unlevered Firm’s EFCF
•
•
•
Net Operating Income (NOI)
Less: Taxes on Incremental NOI
Equals: Net Operating Profit after
Tax and firm Net Income
Plus: Depreciation Expense
Less: Investment in Working Capital
Less: (Capex)
Equals: (Unlevered) Free Cash Flow
Note that for the unlevered
firm there is no new debt
issued or retired.
APV Valuation for Basic Inc.
Analysis of the Unlevered Cost of Equity:
1.00
Levered Equity Beta
0.14
Debt Beta
333.33
Levered Equity Value
317.46
Debt Value
30%
Corporate tax rate
9%
Cost of debt financing
8%
Risk free rate
7%
Market risk premium
Unlevered Beta
Unlevered Cost of Equity
0.66
12.60%
.09 = .08 + bd(.07)
bd = .14
bu 
b e S e  b d D (1  T )
S e  D (1  T )
b u  .66
ku  r f  b u (MRP)
ku  .08  .66(.07)
APV Estimate of Firm Value
Value of Unlevered Cash Flows
Value of Interest Tax Savings
Firm Value
Kd=rf+bd(Market Risk Premium)
ku  .126 or 12.6%
555.56
95.24
650.79
Vu = $70/.126 = $555.56
VITS = ($28.57 x .3)/.09 = $95.24
Compressed APV
Unlevered FCF
Interest tax savings
Capitalized Cash Flow
$
70.00
8.57
78.57
$
Firm Value
623.58
Value of Unlevered Cash Flows
Value of Interest Tax Savings
Firm Value
555.56
68.03
623.58
Approximation of firm value—Interest tax savings
discounted using the unlevered cost of equity.
Eskimo Pie Corporation
Business valuation in practice
Revised FCF—1991
($ thousands)
Projected Net Income
$
plus: After-tax interest expense
1991
Explanation
4,000
Revised estimate by Wheat First Securities of
1991 revenues found on page 5.
32
$52.5 (1 - .40) -- from Exhibit 6 for 1991.
4,032
NI + I(1 – T)
Plus: Depreciation expense
1,400
Exhibit 2—Depreciation expense for 1990 =
$1,352
Less: Capital expenditures
(1,000)
Page 5—estimate by Wheat First Securities
NOPAT = NOI(1 - T)
Less: Change in working capital
Free cash flow (unadjusted)
$
less: After-tax interest income
Free cash flow (adjusted)
4,432
(396)
$
Netting out cash NWC appears to decline with
increasing sales.
4,036
$13.191m x 5% x (1 - .40)—one-time cash
dividend.
Cost of Capital Estimate
Company
Book Value
Market
Total
of Equity Value of Equity Debt
Equity
Beta
Equity Value/
Firm Value
Asset
Beta
26.3
110.1
2.8
1.2
0.98
1.170
113.1
534.0
44.3
1.4
0.92
1.293
Empire of Carolina, Inc.
45.1
51.4
89.8
0.3
0.36
0.109
Steve's Homemade Ice Cream
11.1
37.4
3.1
2.5
0.92
2.309
1,335.3
4,002.5
282.9
1.0
0.93
0.934
152.8
728.8
-
1.0
1.00
1.000
Average
1.2
0.85
1.136
Ben & Jerry's
Dreyer's Grand Ice Cream
Hershey Foods Corp
Tootsie Roll Inds.
Kunlevered = risk-free rate + Betaunlevered(Market Risk Premium)
Kunlevered = .0742 + 1.136 (.075) = .1594 or 15.94%
Firm and Equity Value
(Compressed APV Model)
FCF (1991)
Interest Tax Savings (1991)
FCF (1991) + Interest Tax Savings (1991) =
$
$
$
4,035.77
21.00
4,056.77
Interest (1991)
Tax Rate
Interest Tax Savings
$ 52.50
40%
$ 21.00
Firm Value excluding excess cash
Discount Rates
15%
16%
17%
0%
27,045
25,355
23,863
2%
31,830
29,556
27,586
Growth Rates in FCF
4%
6%
38,355 47,780
35,159 43,002
32,454 39,093
8%
62,590
54,766
48,681
10%
89,249
74,374
63,749
12%
151,453
113,590
90,872
2%
44,830
42,556
40,586
Growth Rates in FCF
4%
6%
51,355 60,780
48,159 56,002
45,454 52,093
8%
75,590
67,766
61,681
10%
102,249
87,374
76,749
12%
164,453
126,590
103,872
2%
44,086
41,812
39,842
Growth Rates in FCF
4%
6%
50,611 60,036
47,415 55,258
44,710 51,349
8%
74,846
67,022
60,937
10%
101,505
86,630
76,005
12%
163,709
125,846
103,128
Plus Excess Cash = $ 13,000.00
Firm Value including excess cash
Discount Rates
15%
16%
17%
Less Debt (1990) = $
0%
40,045
38,355
36,863
744.00
Equity Value
Discount Rates
15%
16%
17%
0%
39,301
37,611
36,119
Firm Value (DCF)
Value of Free Cash Flows (excluding excess cash)
Growth Rates in FCF
Discount Rates
0%
2%
4%
6%
8%
15%
26,905
31,665
38,156 47,532 62,266
16%
25,224
29,403
34,977 42,779 54,483
17%
23,740
27,443
32,286 38,890 48,429
FCF (1991)
$ 4,035.77
Excess Cash
$ 13,000.00
10%
88,787
73,989
63,419
12%
150,669
113,002
90,401
10%
101,787
86,989
76,419
12%
163,669
126,002
103,401
Total Value including excess cash
Discount Rates
15%
16%
17%
0%
39,905
38,224
36,740
2%
44,665
42,403
40,443
Growth Rates in FCF
4%
6%
8%
51,156 60,532 75,266
47,977 55,779 67,483
45,286 51,890 61,429
Ignoring debt financing (all equity firm)
Firm Value (Comparables)
Company
Ben & Jerry's
Dreyer's Grand Ice Cream
Empire of Carolina, Inc.
Steve's Homemade Ice Cream
Hershey Foods Corp
Tootsie Roll Inds.
Firm Value to Equity Value
Cash Flow
to Net Income
16.85
29.76
24.00
33.58
8.40
5.84
15.00
20.78
14.66
18.23
22.42
28.58
Firm Value
to Sales
1.16
1.63
0.58
1.15
1.48
3.51
Average multiple (less max and min)
17.23
24.34
1.36
Estimate for Eskimo Pie--1991
4,432
4,000
61,000
Implied Firm Value
Excess cash in 1991
Total Value including excess cash
$
$
$
76,373
13,000
89,373
$
$
$
97,350
13,000
110,350
$
$
$
82,737
13,000
95,737
Preparation for BumbleBee
•
•
•
•
The Compressed APV model.
Cash flow estimation
Estimating the unlevered cost of equity.
Estimating the value of subsidized debt
Compressed APV Model and
Equity Value
Firm
Value
PV of Firm
PV of Interest
 FreeCash Flow  Tax Savings 
( Kunlevered equity )
Equity
Value

Firm
Value
( Kunlevered equity )
 Liabilities
PV of
Subsidized
Debt Financing
Cash flows
1986
NOI (1-T) (Exhibit 8 & 15% tax rate)
$12.4
Plus: depreciation (Exhibit 7)
0.3
Less: CAPEX (Exhibit 7)
(1.0)
Less: Additions to WC (Exhibit 7)
(4.0)
Firm Free Cash Flow
$7.7
Tax Rate (Implied Exhibit 8 taxes)
Interest Expense (Exhibit 8)
Interest Tax Savings
15%
$
8.4
1.26
Estimating “Unlevered Betas”
Campbell Soup
Ralston Purina
H.J. Heinz
Average
Levered Debt to
Unlevered
Beta
Equity Tax Rate Beta
0.70
0.13
0.38
0.65
0.85
0.29
0.38
0.72
0.75
0.08
0.38
0.72
0.70

b Levered  b unlevered 1 

Debt to market value equity
ratio. Market value of equity =
Book Equity x Mkt/Book Ratio.

Debt
(1  Tax Rate) 
Equity

or
b unlevered 
b Levered


Debt
1  Equity (1  Tax Rate) 


b unlevered  b Levered
Equity
Debt
 b Debt
Equity  Debt (1  Tax Rate)
Equity  Debt (1  Tax Rate)
Valuing debt subsidies
Example—5 year (interest only) loan with interest rate of
10% for a borrower that would otherwise have to pay 13%.
In year 5 the borrower repays the $1,000 principal amount.
Subsidized interest rate
Market rate
Principal amount
Maturity (years)
10%
13%
$ 1,000.00
5
Principal and Interest
$
100.00
$
100.00
$
100.00
$
100.00
$
1,100.00
Year
1
2
3
4
5
Value of Note (10%)
Value of Note (13%)
Value of Subsidy
$1,000.00
$894.48
$105.52
What have we learned?
• There are multiple “DCF” models of firm value.
• The APV model offers significant advantages
over alternative methods in some applications but
is “not the standard” DCF model (yet).
• Subsidized financing is valuable and the value
can be quantified.
• Unlevering beta coefficients can be very
confusing.