Valuation Slides Week4 1 - APV MPA

Valuation

MPA FIN 286 Alessandro Previtero

Slide Pack Week 4 Part 1 Company Valuation APV

Todays Content I. Announcements:

Review Session This Thursday 5.30-6.30pm HW3 Due this Wednesday (Feb. 10th) Case 1 due Monday Feb 15th.

II. APV

III. LBOs

IV. Problems

V. Assign Case 1 (AirThread)

Overview - 2

Recap: How to Value a Firm WACC

[ ]( )

= +=

0 1E

tt

tA WACC

FFCFV

CGTASCapexNWCtDAtEBITDAFFCF CC ++= )1(

)1()1( RRPDYTMPDrd =

)( fmefe rrrr +=

)(),(

m

mee rVar

rrCov=

If Public Company

CAPM

If NOT Public Company

E

D

e??

d

Ec3

Dc3

e_c3

d_c3

Ec2

Dc2

e_c2

d_c2

Ec1

Dc1

e_c1

Comparables

d_c1

A_c1

Unl

ever

ing

A_c1 A_c1

A_c A

Leve

ring

COMPARABLES

REGRESSION

ed rEDErT

EDDWACC

+

+

+

=**

)1(

Leverage

Firm

Val

ue

0 1 Optimal Leverage Ratio

TRADE-OFF THEORY

MVDNOAVMVE A +=

NMVEP =

Company Valua4on DCF Models WACC 3

Introduction Discounted Cash Flow (DCF) Models

Discount Rate No Friction Model WACC (Weighted Average Cost of Capital) APV (Adjusted Present Value)

Multiples Other topics: LBOs, M&A, etc.

I. Company Valuation

Intro on Adjusted Present Value (APV) The WACC Model assumes that the company continuously adjust its

leverage ratio to a constant optimal target ratio. This assumption is good for stable, mature companies

The Adjusted Present Value is a more flexible model, that is applicable to any company Young, new companies LBOs Mature

Company Valua4on DCF Models APV 5

t

Leve

rage

Optimal LR

Mature

D

E

BS

A TS

OA

A=OA+TS=D+E

Revenues - Costs (COGS & SG&A) =

EBITDA - Depreciation & Amortization (DA) =

EBIT - Interest =

EBT Taxes=

Earnings

IS

DA Tax Shield

Interest Payment Tax Shield

Stefanie_2Highlight

Stefanie_2Highlight

Stefanie_2Sticky NoteLeverage Buyout Firms:Firm that borrows heavily and use the proceeding to buy other firms.

Stefanie_2Sticky NoteTS: Present value of interest tax shield. OA: operating assets.

Stefanie_2Highlight

APV: Main Intuition The Adjusted Present Value takes the Value of the Operating Assets,

and adjusts it by adding the value of the tax shields and subtracting the costs of financial distress

Where:

FFCF = Firm Free Cash Flow IPTS= Interest Payment Tax Shield=IPT=DrdT FDC= Financial Distress Costs rOA = Discount Rate on Operating Assets rTS = Discount Rate on Tax Shields


[ ]( )

[ ]( )

)(1

E1

E

)()()(

00FDCPV

rIPTS

rFFCF

FDCPVIPTSPVFFCFPVVVVV

tt

TS

t

tt

OA

t

FDCTSOAA

+

++

=+=+=

=

=

Stefanie_2Sticky NoteNote: at optimal leverage ratio, the value of tax shield = value of costs of financial distress.However, if the firm is not at the optimal leverage structure, we need to use APV adjustment.

Levering/Unlevering with the APV The levering/unlevering formula now is slightly different:

The key choice to make in an APV model is to understand if the company is targeting a constant optimal capital structure (trade-off theory) or not.

1. If the company uses a targeting strategy, then the tax shields on interest payment have the same risk of the underlying operating assets. Why? Because the interest payment are a % of debt. In a targeting

strategy, the leverage is constant, therefore if the assets change value, so does the debt.

2. If the company does not use a targeting strategy, then the tax shields on interest payment have the same risk of the debt.


OATS =

dTS =

edTSOA EDE

EDD

TSOATS

TSOAOA

+

++

=+

++

Stefanie_2Sticky Note1. A= D+E = TS + OA2. Beta of assets = Lev * Beta of debt + (1-Lev)*Beta of equity. 3. Therefore, when optimal capital structure is not formed, the beta of assets is the weighted average of beta of OA and beta of TS.

Stefanie_2Highlight

Stefanie_2Highlight

Stefanie_2Sticky NoteWhen assets increase/decrease, the firm can still keep the debt level unchanged. Therefore, the riskness of the tax shield equals the riskness of debt.

solving the algebra solving the algebra

Discount Rates in APV The discount rates are different as a function of the capital structure strategy


AOATS ==

edTSOA EDE

EDD

TSOATS

TSOAOA

+

++

=+

++

edOA EDE

EDD

+

++

=

edOA rEDEr

EDDr

++

+=

dTS =

edTSOA EDE

EDD

TSOATS

TSOAOA

+

++

=+

++

edOA ETDE

ETDTD

+

++

=

)1()1()1(

OATS rr = dTS rr =

Targeting Strategy Non-Targeting Strategy

edOA rETDEr

ETDTDr

++

+

=

)1()1()1(

Levering/Unlevering Formula

Stefanie_2Sticky NoteAPV valuation steps:1. Is the firm targeting on optimal leverage? --> Yes. WACC2. If NO. --> adjust for interest tax shield.

How to Value a Firm APV with Targeting Strategy


edOA rEDEr

EDDr

++

+=

)1()1( RRPDYTMPDrd =

)( fmefe rrrr +=

)(),(

m

mee rVar

rrCov=

If Public Company

CAPM


E

D

e??

d

Ec3

Dc3

e_c3

d_c3

Ec2

Dc2

e_c2

d_c2

Ec1

Dc1

e_c1

Comparables

d_c1

OA_c1

Unl

ever

ing

OA_c1 OA_c1

OA_c OA

Leve

ring

COMPARABLES

REGRESSION

MVDNOAVMVE A +=

NMVEP =

[ ]( )

[ ]( )

=

= ++

+=

00 1E

1E

tt

TS

t

tt

OA

tA r

IPTSr

FFCFVTrDIPTS d =

OATS rr =


edOA EDE

EDD

+

++

=

How to Value a Firm APV with Targeting Strategy


Ec3

Dc3

e_c3

d_c3

Ec2

Dc2

e_c2

d_c2

Ec1

Dc1

e_c1

Comparables

d_c1

OA_c1

Unl

ever

ing

OA_c1 OA_c1

OA_c OA

COMPARABLES

MVDNOAVMVE A +=

NMVEP =

[ ]( )

[ ]( )

=

= ++

+=

00 1E

1E

tt

TS

t

tt

OA

tA r

IPTSr

FFCFV

)( fmOAfOA rrrr +=

TrDIPTS d =

OATS rr =


If the company is adopting a targeting strategy, we can add together the FFCF and the IPTS

Defining CCF = Capital Cash Flow = FFCF+IPTS

Capital Cash Flow Model

[ ]( )

[ ]( )

[ ]( )

[ ]( )

=

=

=

= +=

+

+=

++

+=

0000 1E

1E

1E

1E

tt

OAtt

OA

tt

tt

OA

t

tt

OA

tA r

CCFrIPTSFFCF

rIPTS

rFFCFV

Ec3

Dc3

e_c3

d_c3

Ec2

Dc2

e_c2

d_c2

Ec1

Dc1

e_c1

Comparables

d_c1

OA_c1

Unl

ever

ing

OA_c1 OA_c1

OA_c OA

COMPARABLES

)( fmOAfOA rrrr +=


How to Value a Firm APV with Non-Targeting Strategy


edOA rETDEr

ETDTDr

++

+

=

)1()1()1(

)( fmefe rrrr +=

)(),(

m

mee rVar

rrCov=

If Public Company

CAPM


E

D

e??

d

Ec3

Dc3

e_c3

d_c3

Ec2

Dc2

e_c2

d_c2

Ec1

Dc1

e_c1

Comparables

d_c1

OA_c1

Unl

ever

ing

OA_c1 OA_c1

OA_c OA

Leve

ring

COMPARABLES

REGRESSION

MVDNOAVMVE A +=

NMVEP =

[ ]( )

[ ]( )

=

= ++

+=

00 1E

1E

tt

TS

t

tt

OA

tA r

IPTSr

FFCFVTrDIPTS d =

)1()1( RRPDYTMPDrr dTS ==


edOA ETDE

ETDTD

+

++

=

)1()1()1(

How to Value a Firm APV with Non-Targeting Strategy


Ec3

Dc3

e_c3

d_c3

Ec2

Dc2

e_c2

d_c2

Ec1

Dc1

e_c1

Comparables

d_c1

OA_c1

Unl

ever

ing

OA_c1 OA_c1

OA_c OA

COMPARABLES

MVDNOAVMVE A +=

NMVEP =

[ ]( )

[ ]( )

=

= ++

+=

00 1E

1E

tt

TS

t

tt

OA

tA r

IPTSr

FFCFV

)( fmOAfOA rrrr +=

TrDIPTS d =

)1()1( RRPDYTMPDrr dTS ==


The WACC assumes that the company is targeting a stationary capital structure, therefore the value using the WACC should be equal to the value using the APV with a targeting strategy

The APV using a targeting strategy should give a lower valuation than the APV using a non-targeting strategy, because the tax shields are discounted at a higher discount rate

WACC vs APV

Highly Flexible Applicable also to

cases where capital structure is not stationary through time (LBOs, IPOs,)

APV WACC

More complex Not as popular

Applicable only when capital structure is stationary (mature, stable companies)

PR

OS

C

ON

S

Easy to use Widely used


Mixed Approach Companies might not be able to adopt a targeting strategy in the interim

period, but they are planning to adopt a targeting strategy when they mature (in the terminal value)

In these cases, we can use a mixed approach, where the company is not targeting for a few years, and then targeting in perpetuity afterwards

Use APV with no targeting in the interim period Use WACC for the terminal value


Introduction Discounted Cash Flow (DCF) Models

Discount Rate No Friction Model WACC (Weighted Average Cost of Capital) APV (Adjusted Present Value)

Multiples Other topics:

Other Valuation Techniques M&A LBOs Control and Liquidity Premium VC

I. Company Valuation

Leverage BuyOuts

LBOs represent a business acquisition strategy whereby an investor group acquires all the equity of a firm and assumes its debts The investment is predominantly financed with

debt; typically 50-80% of total capital structure The idea is that the leveraged nature of the

acquisition structure forces management to run operations at maximum efficiency to service debt

The lure of leveraged returns attract investors Tax shields may also be high Called MBO if firm Management is involved and

incentivized with their own equity stake in the deal

Company Valua4on Other Topics - 17

Stefanie_2Highlight

LBO capital structures

Common Equity Preferred Stock Junior Subordinated Debt (8-12 yr. maturity) Senior Subordinated Debt (8-12 yr. maturity) Bank Debt (5-8 yr. maturity)

Sweat Equity for management Management Capital Former Owner Equity Provided by Financial Investors (LBO Firm)

Typical Range

Equity 20-50% Debt 50-80%

Typical Range

8-15% 0-5% 5-30% 50-87%

Typical LBO Capital Structure

Typical Equity Ownership Structure


LBO acquisition strategies Bust-up strategy

Take control of company and sell off assets to repay debt used to finance the acquisition

Objective is to increase efficiency in operations and sell for more than you paid for it

Tax shields also a consideration Very popular in the 1980s (Movie Wall Street)

Build-up strategy Objective is to create a large public company,

sometimes through the purchase of a platform company upon which further acquisitions are made

Gained popularity in the 1990s Company Valua4on Other Topics - 19

APV model for LBOs Mixed Strategy

where PP is the last planning period

The firm is assumed to adopt a constant leverage ratio after time PP, and have pre-determined debt and interest payments before time PP

( ) ( )

( ) PP

OA

PP

PP

tt

d

PP

tt

OA

t

rgWACCgFFCF

rIPTS

rFFCFEV

+

++

++

++

= ==

111

11 11


Stefanie_2Highlight

Example of Build-Up Strategy Textbook

Hokie Partners LP are considering the acquisition of PMG Foods Inc.

PMG has current EBITDA of $100 million; expected purchase price equal to 5x the current level of EBITDA, or $500 million.

The acquisition of PMG is financed with 75% debt with an interest rate of 14% (thats high!), and a 25% equity piece put up by the equity group Hokie

The debt has covenants that require that all excess cash be used to retire principal (cash sweep debt covenants), which means that the equity investors will not receive any cash flow from their investment until year 5 when the firm is sold.


Stefanie_2Sticky Note1. Outstanding debt = $500 million * 75% = 375million

Example: Assumptions

Equity group projects EBITDA growth of 10% per year for 5 years, then sell the firm for 6x EBITDA

Firms outstanding debt will be repaid at sale and remaining funds distributed to the equity investors


Earnings Estimates Annual Capex 50.00$ Current year EBITDA (millions) 100.00$ Planning Period EBITDA growth rate 10% Acquisition and sale EBITDA multiplesPlanned holding period 5 years Purchase multiple - Platform Company (PMG) 5 Corporate tax rate 35% Purchase multiple - Add-on Company (Centex) 3 Depreciable life of assets 10 years Company sale (harvest) multiple 6 Depreciation expense (Year 0) 40.00$

LBO Capital StructureDebt/Assets 75%Interest cost 14%

Example: APV Projections with LBO


Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 TV EBITDA $ 110.00 $ 121.00 $ 133.10 $ 146.41 $ 161.05

Less: Depreciation $ (45.00) $ (50.00) $ (55.00) $ (60.00) $ (65.00) EBIT $ 65.00 $ 71.00 $ 78.10 $ 86.41 $ 96.05 Less: Taxes $ 22.75 $ 24.85 $ 27.34 $ 30.24 $ 33.62 EBIT(1-T) $ 42.25 $ 46.15 $ 50.77 $ 56.17 $ 62.43

Plus : Depreciation $ 45.00 $ 50.00 $ 55.00 $ 60.00 $ 65.00 Less: CAPEX $ (50.00) $ (50.00) $ (50.00) $ (50.00) $ (50.00) FFCF $ 37.25 $ 46.15 $ 55.77 $ 66.17 $ 77.43 $ 966.31

IP $ 52.50 $ 52.06 $ 50.34 $ 47.11 $ 42.14 IPTS $ 18.38 $ 18.22 $ 17.62 $ 16.49 $ 14.75

Outstanding Loan $ 375.00 $ 371.88 $ 359.57 $ 336.52 $ 300.98 $ 250.93

Cash to Equity Holders $ (125.00) $ - $ - $ - $ - $ 715.37

Input Variables% Financing 75%Growth 10%EBITDA Multiple 6.00

Output VariablesIRR 41.75%

Example: APV Projections without Leverage





Cash to Equity Holders $ (500.00) $ 37.25 $ 46.15 $ 55.77 $ 66.17 $ 1,043.74



Stefanie_2Sticky NoteIRR decreases because now we assume 100% of equity. We invested more (500>125). We have to pay 4 times more money upfront, which cannot be compensated by the higher return we get at year 5. The amount we get and amount we spent generates the IRR. - Leverage up: interest rate is fixed, which does not depends on firm value. - Leverage doesn't help: firms have set payments to make-->possibly get bankrupt

Example: APV Projections with LBO 4% Growth & 4x EBITDA Multiple





IP $ 52.50 $ 52.61 $ 52.10 $ 50.91 $ 48.96 IPTS $ 18.38 $ 18.41 $ 18.24 $ 17.82 $ 17.14

Outstanding Loan $ 375.00 $ 375.78 $ 372.17 $ 363.67 $ 349.72 $ 329.71

Cash to Equity Holders $ (125.00) $ - $ - $ - $ - $ 35.28


Output VariablesIRR -22.35%

Stefanie_2Sticky NoteIn bad state: return becomes negative.

Example: APV Projections without Leverage 4% Growth & 3x EBITDA Multiple





Cash to Equity Holders $ (500.00) $ 33.35 $ 37.80 $ 42.37 $ 47.04 $ 416.83



Where is the value in a build-up LBO strategy?

Synergies: Economies of scale, scope, Combined company can be more diversified Higher debt capacity Perhaps a higher sales multiple for

diversification Those are the upside, but also need to

consider How risky is the strategy? Is the projected equity IRR worth the risk?


HOG Valuation with APV


Next Monday AirThread Case Download AirThread case from the HBS website link in the syllabus Form groups of max 4 people. Answer questions posted on Canvas Prepare a 3-pages report as a deliverable. Be ready to discuss the case

in class.


Stefanie_2Sticky NoteBring name tag for next week class.

Problem Your private equity rm has iden4ed a good acquisi4on candidate. The target rm has been poorly managed and has a very conserva4ve debt policy rela4ve to its debt capacity. The target also has non-core assets that can be sold in one year which would generate $5 billion aRer taxes. The target has been inves4ng too much in these non-core assets and you believe you can increase the growth in the core businesses by re-alloca4ng investment expenditures. Your forecasts are below (in millions of dollars). All gures are in nominal terms. Note that the deprecia4on expense reported above already incorporates the deprecia4on on the new capital expenditures. The growth rate is expected to slow down considerably aRer Year 5. Currently, the enterprise value (debt plus equity) of mature compe4tors in the target rms industry is ten 4mes EBITDA (trailing twelve months). You found one rm that was comparable to the target in business risk. This rm was consistently protable and had a A bond ra4ng. The rm had a debt-equity ra4o of 0.5 (market values) and an es4mated equity beta of 1.2. The risk-free rate is 7% and assume the market risk premium is 6%. The corporate marginal tax rate is 34%. You will use substan4al debt to nance the acquisi4on. In the high-growth phase of the business (up to Year 5) you believe the debt capacity is $3 billion and in the mature phase (aRer Year 5) you believe the debt capacity is $4 billion. With this nancing plan, you expect your bonds will be rated BBB and will have to oer a promised yield of 10%. Bonds in this ra4ng class have historically had annual default rates of 4% and the recovery rate is 50% in the event of default. Compute the value of the target. Jus4fy all assump4ons.


Year 1 Year 2 Year 3 Year 4 Year 5

Sales ($Mil) 5000 6000 7200 7920 8712

COGS ($mil) 4000 4800 5760 6336 6970

SGA ($mil) 500 600 720 792 871

DA ($mil) 300 350 400 450 500

Capex ($mil) 300 350 400 450 500

Documents

Valuation Slides Week4 1 - APV MPA