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Chapter 11 Theory Behind the Discounted Cash Flow approach

Chapter 11 Theory Behind the Discounted Cash Flow approach

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Page 1: Chapter 11 Theory Behind the Discounted Cash Flow approach

Chapter 11Theory Behind the Discounted

Cash Flow approach

Page 2: Chapter 11 Theory Behind the Discounted Cash Flow approach

The Market Value Balance Sheet

Enterprise value represents the left hand side

Page 3: Chapter 11 Theory Behind the Discounted Cash Flow approach

Who has a claim on the Enterprise

Value?

Either someone else (Debt and Preferred Stock) or owned by

the Equity Holders

Page 4: Chapter 11 Theory Behind the Discounted Cash Flow approach

What is Enterprise Value? The market value of the assets of the firm

Enterprise Value = Common Equity Value + Preferred

+ Market Value Debt – Excess Cash

Page 5: Chapter 11 Theory Behind the Discounted Cash Flow approach

The indirect method of equity valuation: DCF approach Calculate Enterprise value

Subtract out Market Value of Debt Preferred Stock

Add back excess Cash In practice, many analysts add back all cash to ensure

consistency across firms when performing comparable company analysis

Page 6: Chapter 11 Theory Behind the Discounted Cash Flow approach

How do we calculate Enterprise Value? Project future cash flows to capital

providers

Convert each cash flow to a Present Value equivalent

Sum these present value cash flows

Page 7: Chapter 11 Theory Behind the Discounted Cash Flow approach

How do we get the cash flows? Firms have infinite lives, so forecasting all

the cash flows is impossible

Forecast 5-10 years of cash flows

Calculate the TERMINAL VALUE of the remaining cash flows

Page 8: Chapter 11 Theory Behind the Discounted Cash Flow approach

Note on Terminal Value A common way to estimate the Terminal

Value of a firm is to assume that the business will grow at a particular rate in perpetuity

If you expect the business to grow at 10% per year forever, it will soon be worth more than an average-sized country!

Page 9: Chapter 11 Theory Behind the Discounted Cash Flow approach

The trick to a reasonable growth estimate Forecast the cash flows of the business for a long

enough period of time that you expect it to reach a "steady state", sustainable long term growth rate

Don't be surprised if your Terminal Value accounts for more than half of the total value of the business. DCF values are extremely sensitive to your assumption

of what the business is worth at the end of the forecast period.

Page 10: Chapter 11 Theory Behind the Discounted Cash Flow approach

Calculating the terminal Value Use the Gordon Growth Model

gWACC

gCFTV t

)1(

Page 11: Chapter 11 Theory Behind the Discounted Cash Flow approach

What do we need to do the DCF? Cash flows

What are the appropriate cash flows?

Discount Rate What is the appropriate discount rate?

Page 12: Chapter 11 Theory Behind the Discounted Cash Flow approach

Enterprise Value and Cash Flow Enterprise Value is the Market value of the assets All of the capital providers have a claim on this

market value

We are interested the cash flows available to pay all of the capital providers, not just the equity holders

We want the cash flows available to debt and equity holders

Page 13: Chapter 11 Theory Behind the Discounted Cash Flow approach

Unlevered Free Cash Flow Unlevered free cash flow is the total cash

available for distribution to owners and creditors after funding worthwhile investment activities

How do we get it? Two ways. 1. Use the statement of Cash Flows 2. Using only the Income Statement

Page 14: Chapter 11 Theory Behind the Discounted Cash Flow approach

Unlevered Free Cash Flow Using Cash Available for Debt Repayment Unlevered Free Cash Flow =

Cash Available for Debt Repayment + Interest Expense - Interest Tax Shield

Page 15: Chapter 11 Theory Behind the Discounted Cash Flow approach

Unlevered Free Cash Flow Using the Income Statement Unlevered Free Cash Flow =

EBITDA - Taxes on EBITA - Capital Expenditures - Changes in Working Capital

OrEBIT – Taxes on EBIT + Depreciation +

Amortization - Capital Expenditures - Changes in Working Capital

Page 16: Chapter 11 Theory Behind the Discounted Cash Flow approach

Year0 1 2 3 4

Purchase Machine (240.0)$ Net working capital (20.0)$

Revenues 210.0$ 220.5$ 231.5$ 243.1$ Expenses 126.0$ 132.3$ 138.9$ 145.9$ Depreciation 79.2$ 108.0$ 36.0$ 16.8$

EBIT 4.8$ (19.8)$ 56.6$ 80.4$ Tax 1.9$ (7.9)$ 22.6$ 32.1$

Operating Income 2.9$ (11.9)$ 34.0$ 48.3$ Plus Depreciation 79.2$ 108.0$ 36.0$ 16.8$

Operating Cash Flow 82.1$ 96.1$ 70.0$ 65.1$

Salvage Value (Cap Exp) 15.0$ Recovery of Net Working Cap 20.0$

Free Cash Flow (260.0)$ 82.1$ 96.1$ 70.0$ 100.1$

Page 17: Chapter 11 Theory Behind the Discounted Cash Flow approach

We have the cash flows, now we need:

the Discount Rate Weighted Average Cost of

Capital

Page 18: Chapter 11 Theory Behind the Discounted Cash Flow approach

Required rate of return on invested capital The appropriate Discount Rate is the rate

of return that can be earned on an investment of comparable risk.

The riskier an investment, the higher the expected return needs to be to justify an investment

It measures the Opportunity Cost of the Investors’ Capital

Weighted Average Cost of Capital: WACC

Page 19: Chapter 11 Theory Behind the Discounted Cash Flow approach

Intuition... WACC $1 debt and $1 equity, $2 total capital

Bank needs 10%, shareholder needs 20% Need to earn 10 cents to keep bank happy Need to earn 20 cents to keep stock happy

Total required earnings is 30 cents

$0.30/$2.00=15% required return on capital

Page 20: Chapter 11 Theory Behind the Discounted Cash Flow approach

If you earn more than 15%

Money is left over. Positive NPV. Everybody is happy!

But, if you earn less...

Page 21: Chapter 11 Theory Behind the Discounted Cash Flow approach

How do we calculate the WACC

WACC=(1-t)kd(D/V) +ke(E/V)

where…

D and E are the market value of debt and market value of equity

Market value of debt is difficult to obtain, so analysts usually use the book value (reasonable assumption for solvent firms)

Page 22: Chapter 11 Theory Behind the Discounted Cash Flow approach

Should we include short-term debt?

Only include short-term debt if you believe that it will be a permanent component of the capital structure

Page 23: Chapter 11 Theory Behind the Discounted Cash Flow approach

How to get the market value of equity?

Multiply number of shares outstanding by the price per share

For a private firm, things are more difficult, since the equity does not have a “price”

You might want to use liquidation value of the assets minus the value of the debt

BETTER PROXY: use industry P/E multiple

Page 24: Chapter 11 Theory Behind the Discounted Cash Flow approach

Actual or target weights for debt and equity?

We are interested in the required rate of return in the future, so today’s ratios are irrelevant

What matters is our expectation of the future

Page 25: Chapter 11 Theory Behind the Discounted Cash Flow approach

How to get the cost of debt? Calculate yields to maturity using bond market

prices These reflect what bondholders expect to earn over the life of

their investment

Use yields for firms with similar bond ratings

Impute a bond rating using TIE, D/A, and liquidity ratios

Look in footnotes to annual report Call the firm directly

Page 26: Chapter 11 Theory Behind the Discounted Cash Flow approach

Getting the firm’s cost of debt The firm has the following long-term bond

outstanding 15 year maturity, Par=1000, Coupon

payments are 9% semi-annual. Price is $1,080. Solve your effective annual yield to maturity.

8.24%

Page 27: Chapter 11 Theory Behind the Discounted Cash Flow approach

What about the cost of equity? Use CAPM

kreq= krf+ (L)(km-krf)

So, we need beta, the risk-free rate, and the market risk premium

Page 28: Chapter 11 Theory Behind the Discounted Cash Flow approach

The risk-free rate - Krf

This is easy, just take the rate of return for a risk-free bond with the same maturity as the firm’s assets.

In this case, use the rate of return on 30-year government debt 4.75% on April 1, 2007

Page 29: Chapter 11 Theory Behind the Discounted Cash Flow approach

The market risk premium Km-Krf

This is NOT the difference between the current rate of return on the market and the current risk free rate of return.

This reflects expected investor risk-aversion. Current premium is 6.4%

Page 30: Chapter 11 Theory Behind the Discounted Cash Flow approach

Beta - systematic risk Remember, beta is a backwards-

looking measure. If you expect historical values to prevail,

then use the firm’s current beta. You can get this from Bloomberg, Yahoo.Finance

If there is a systematic change in either the firm’s business or financial risk, then the historical beta is useless.

Page 31: Chapter 11 Theory Behind the Discounted Cash Flow approach

Deconstruction of risk Total risk = Business risk + Financial Risk

Business riskRisk of product market/assets

Financial riskUse of leverage

Page 32: Chapter 11 Theory Behind the Discounted Cash Flow approach

Risk: Our old friend beta Intro to Finance beta is a levered beta.

Also called the equity beta It reflects the historical sensitivity of a stock’s rate of

return to that of the market But, the stock’s rate of return depends on the

amount of debt in the capital structure, so...

Beta reflects both the business and financial risk

Page 33: Chapter 11 Theory Behind the Discounted Cash Flow approach

You calculate the firm’s historical beta to be 1.11, but expect is capital structure to change

Why is this beta unacceptable? The firm’s target debt ratio is 60% But, current market value of debt to total

capital was only 41%

Beta has to be adjusted for the difference between the actual and target debt ratio

Page 34: Chapter 11 Theory Behind the Discounted Cash Flow approach

How do we do this? Strip away the effects of the existing

capital structure (leverage) to get the business risk

Re-lever to reflect the future capital structure

Page 35: Chapter 11 Theory Behind the Discounted Cash Flow approach

Unlevered Beta - Asset Beta Reflects only the firm’s business risk

L = U [1+(D/E)(1-t)]

or

U= L / [1+(D/E)(1-t)]

Page 36: Chapter 11 Theory Behind the Discounted Cash Flow approach

Check this out… CAPM kreq= krf+ (L)(km-krf)

substitute levered beta into CAPM to get

kreq= krf+ (U)(km-krf) + (U)(D/E)(1-t)(km-krf)

Return= risk-free rate + premium for business risk + premium for financial risk

Page 37: Chapter 11 Theory Behind the Discounted Cash Flow approach

Unlevering & relevering the beta Bu=1.11 / [1+(.41/.59)(1-.34)] = 0.76

Re-lever with 60% leverage

BLnew=0.76[1+(0.6/0.4)(1-.34)] = 1.514

Page 38: Chapter 11 Theory Behind the Discounted Cash Flow approach

Firm’s cost of equity capital

Krequired = Risk free rate + beta(risk premium)

4.75% + (1.514)(6.4%) = 13.39%

Page 39: Chapter 11 Theory Behind the Discounted Cash Flow approach

Putting it all together WACC WACC= (D/V) kd (1-t) + (E/V)ke

0.6(8.24%)(1-.34) + (0.4)(13.39%)=

Firm’s WACC is 8.62%

Page 40: Chapter 11 Theory Behind the Discounted Cash Flow approach

Now you have the cash flows and the

discount rate

Calculate the Enterprise ValueNext Chapter