Transcript Financial Forecasting and Corporate Valuation

Corporate Valuation
Free cash flow approach
Firm Valuation—Disney

Disney has a normal valuation case….
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
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
The Strict View
Dividends + Buybacks
To Equity
The Broader View
Net Income
- Net Cap Exp (1-Debt Ratio)
- Chg WC (1 - Debt Ratio)
= Free Cash flow to Equity
Cash Flows
To Firm
EBIT (1-t)
- ( Cap Exp - Depreciation)
- Change in Working Capital
= Free Cash flow to Firm
The growth rates in cash flows
Net
Income
Operating
Income
Retention
ratio
Reinvestment
rate
ROE
ROC
g EPS
g EBIT
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)
D. Ret.
Earnings
(B-C)
20
C.
Dividend
(B*50%)
10
10
E.
End EQ
(A+D)
110
100
110
22
11
11
121
121
24.2
12.1
12.1
133.1
133.1
26.6
13.3
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
Reinvestment Rate 
Capital Expenditure - Depreciation   Non-cash WC
EBIT (1 - tax rate)
Firm Valuation—Disney
1996 Disney’s basic data
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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
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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
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The current growth rate for Disney
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Reinvestment Rate1996 =(1745-1134+617) /
5559*(1-36%) =34.5%
ROC1996= 5559*(1-36%) / (7663+11668) =18.69%
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Forecasted Reinvestment Rate=50%
ROC=20%

Expected Growth EBIT = 50% * 20% = 10%
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The firm Valuation
t=N
CFt
Terminal Value
Value = 
+
N
t
(1+r)
t=1 (1+r)
Terminal value n = FCFF n+1 / (Cost of Capital n+1 - g n )
How to determine a reasonable growth rate?
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The firm is in stable growth
The firm is in a relatively high growth, will
be in stable growth after certain years (2stage)
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
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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.
high
low
ROC
high
ROC is close to WACC
Leverage
Very low
high
Disney’s Firm Valuation
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Free Cash flows to Firm Approach
Three stages of growth
High Growth
length
Revenues
Pre-tax Margin
Tax Rate
ROC
Working capital
Reinvestment
Rate
Stable growth
5 years
5 years
11th to forever
1996: $18,739
Revenues grows at the same rate
as Operating earnings
Revenues grows at the same
rate as Operating earnings
Grows at a
stable growth
rate
29.67% of Revenues
EBIT of 1996 $5,559
Steadily increase to 32%
due to scale economy
32% of
Revenues
36%
36%
36%
20%, same as 1996
Steadily decrease to 16%
16%
5% of Revenues
5% of
Revenues
5% of Revenues
50%, $1,134 for 1996, assume
same growth rate as EBIT
Expected growth
ROC*Reinvestment Rate=10%
in EBIT
Debt /Capital
Transition
18%
Beta=1.25
k equity=13.88%
Risk Parameters
Cost of debt = 7.5%(before tax)
(Long Term Bond Rate=7%)
Steadily decrease to 31.25%, 31.25%
Steadily decrease to stable
growth 5%
5%
Steadily increase to 30%
30%
Beta decrease steadily to
1.00
Cost of debt remains 7.5%
Beta=1.00；
Cost of debt
remains 7.5%
Disney’s FCFF
Basic
year
Expected
Growth
1
2
3
4
5
6
7
8
9
10
10%
10%
10%
10%
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%
29.67%
29.67%
29.67%
29.67%
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
$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
20%
20%
20%
20%
20%
20%
19.2%
18.4%
17.6%
16.8%
16%
50%
50%
50%
50%
50%
46.88%
43.48%
39.77%
35.71%
31.25%
ROC
Reinv.
Rate
Disney’s Cost of Capital
Year
1
2
3
4
5
6
7
8
9
10
Cost of
Equity
13.88%
13.88%
13.88%
13.88%
13.88%
13.60%
13.33%
13.05%
12.78%
12.50%
Cost of Debt
(after tax)
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
4.80%
Debt Ratio
18.00%
18.00%
18.00%
18.00%
18.00%
20.40%
22.80%
25.20%
27.60%
30.00%
Cost of
Capital
(WACC)
12.24%
12.24%
12.24%
12.24%
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) (136%) (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%
12.24%
12.24%
12.24%
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?
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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）
6,000,000
6,000,000
6,000,000
6,000,000
(2,000,000)
(2,000,000)
(2,000,000)
(2,000,000)
Deprec.
2,000,000
2,000,000
2,000,000
2,000,000
OP CF
3,500,000
3,500,000
3,500,000
3,500,000
Initial invest.
(total cost)
(8,000,000)
Inc. rev.
Inc. cost
NOP CF
3,000,000
Project CF
(8,000,000)
Financing
8,000,000
Interest (AT)
3,500,000
3,500,000
3,500,000
6,500,000
(360,000)
(360,000)
(360,000)
(360,000)
Repay.
Fin. Rel. CF
Total CF
(8,000,000)
8,000,000
(360,000)
(360,000)
(360,000)
(8,360,000)
0
3,140,000
3,140,000
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
3,500,000
3,500,000
6,500,000
NPV (at 4.5%)
7,072,024
（t=1）
（t=2）
（t=3）
（t=4）
3,140,000
3,140,000
3,140,000
(1,860,000)
(t=3）
（t=4）
（t=0）
Total CF
0
NPV (at 4.5%)
Fin. Rel. CF
NPV (at 4.5%)
7,072,024
（t=0）
（t=1）
（t=2）
8,000,000
(360,000)
(360,000)
0
(360,000)
(8,360,000)
How do managers create value?
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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
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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
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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
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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
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APV = PV of asset flows + PV of side
effects associated with the financing
program.
Recall the M/M proposition I:
VL 
EBIT(1  t ) tk D D

 Vu  tD
k su
kD
Adjusted Present Value (APV)
Approach

Procedure:
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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
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Assume:
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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
40
Depreciation
20
22
24
26
28
Increase in NWC
20
22
23
25
27
FCF
30
32.8
35.6
38.4
41.4
Terminal Value
[email protected]%
Total PV
296.4
289.8
26.9
26.4
25.7
24.9
24.1
168.5
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
20
22
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.
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 40.0
no debt
43.2
46.4
49.6
53.6
Tax payments with 35.2
debt @ 8%
39.1
43.2
47.4
52.5
Tax savings
4.1
3.2
2.2
1.1
PV of tax savings
@ 8%
$13
4.8
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.