Valuation: Theory and Practice

Lance Young SEBA Lecture 2/2/10

Valuation
There are multiple ways to value a business:
Discounted cash flows (DCF) Price multiples Venture capital method Real options

We will focus on DCF methods, in particular the Adjusted Present Value method

Discounted Cash Flows

Adjusted present value
The adjusted present value method treats the value of the firm as the discounted value of the firms expected free cash flows, as if the firm was 100% equity financed, plus the value of interest tax shields from debt
The interest tax shields reflect the additional value that debt financing adds to the firm

APV = Present value of free cash flows + Present value of interest tax shields

Discounted Cash Flows

What are free cash flows ?
Free cash flow is the cash generated in a period, for which the firm has no other profitable investment opportunities
Cash that could be paid out to equity or debt holders

You can think of free cash flows as almost like excess cash generated by the business

Discounted Cash Flows

Free cash flow:
FCF = EBIT *(1 t ) + Dep + Amort WC CAPEX

Free cash flow in any period is the cash generated, after necessary investments in working capital and plant and equipment. This cash can be paid to equity holders (dividends) or debt holders (interest and principal)

Discounted Cash Flows

Where: EBIT= Earnings before interest and taxes t=Tax rate WC= Change in working capital
Working Capital is the sum of required cash, accounts receivable, inventories less accounts payable and non-interest related accruals

CAPEX= Capital expenditures

Discounted Cash Flows

What is not deducted from free cash flows
Interest Dividends Debt payments (principal)

The point of free cash flows is to accumulate the entire amount of cash that could be used for debt service or returned to shareholders that period

Discounted Cash Flows

Where do the discount rates come from for APV ?
Interest tax shields are commonly discounted at the interest rate on the debt The expected free cash flows should be discounted at the opportunity cost of capital
The cost of capital on an investment of similar systematic risk Often this can be estimated via the CAPM:

Ra = r f + ( Rm r f

Discounted Cash Flows

Where:
Ra is the expected cost of capital for the firm Rm is the expected return on the market Rf is the risk free rate or beta, is the measure of systematic risk - Where do betas come from ?
Often they come from comparable firms with publicly traded equity

Discounted Cash Flow Methods

Theoretically, firms can have an infinite life
We dont want to have to forecast free cash flows for an infinite period, however Often, people employ a forecast horizon of 3 to 5 years (or whatever is appropriate) then compute the terminal value of the company
One commonly used formula is:

FCF (1 g ) + T= rg

Discounted Cash Flows

Where:
FCF is the free cash flow in the last year of the forecast horizon r=discount rate g=assumed growth rate

This formula assumes that cash flows will continue in perpetuity, growing at g percent per year
Use a longer forecast horizon for a period of extraordinary growth

Be careful with g: Large values for g are not reasonable assumptions.

Other values could be used based on price multiples, book values etc.

These values may be better than blindly using the perpetuity formula

Discounted Cash Flows

Adjusted present value
What are interest tax shields ?
Interest payments are tax deductible--dividends are not
Interest tax shields are the reduction in a firms tax bill from interest payments Ex: A $1000 loan with 5% interest and a 35% tax rate provides a yearly interest tax shield of .05*1000*.35=18

APV = Present value of free cash flows + Present value of interest tax shields

Discounted Cash Flows

Problems:
Lack of information to produce reliable forecasts Difficult to account for real options
Ability of the company to adapt to future conditions

Questions about terminal values

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