Corporate Valuation Free cash flow approach

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Corporate ValuationFree cash flow approach
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Firm ValuationDisney

• Disney has a normal valuation case.
• Disney has positive earnings.
• Disneys earning has a positive growth rate.
• Disneys has sufficient financial information in
  estimating cost of capital.

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(No Transcript)
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Firm ValuationDisney
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The growth rates in cash flows
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Dividend growth, retention ratio, and Return on
Equity (ROE)g retention ROEAssume that
ROE20, payout50, beginning equity 100
A. Beg. EQ B. Earnings (AROE) C. Dividend (B50) D. Ret. Earnings (B-C) E. End EQ (AD)
100 20 10 10 110
110 22 11 11 121
121 24.2 12.1 12.1 133.1
133.1 26.6 13.3 13.3 146.4
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The growth rates in cash flows

• Expected Growth EBIT Reinvestment Rate Return
  on Capital
• Return on Capital EBIT (1-t) / Capital Invested
  

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Firm ValuationDisney

• 1996 Disneys basic data
• EBIT5,559 Million
• Capital spending 1,746 Million
• Depreciation 1,134 Million
• Non-cash Working capital Change 617 Million
• Book value of Debt7,763 Million (MV11,180)
• Book value of Equity11,668 Million (MV50,880)
• Levered Beta1.25
• Risk free rate7.00
• Risk Premium5.50
• Tax rate36

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Cost of Equity

• Cost of Equity k equity 7.00 1.255.50
  13.88
• Market Value of Equity 50,880 Million
• Equity/(Debt Equity ) 82

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Cost of Debt

• Cost of Debt for Disney 7.50 (From Moodys
  Bond Rating)
• After-tax Cost of debt 7.50 (1-36) 4.80
• Market Value of Debt 11,180 Million
• Debt/(Debt Equity) 18

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WACC

• WACC 13.88 0.82 4.80 0.18 12.24

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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

• Reinvestment Rate1996 (1745-1134617) /
  5559(1-36) 34.5
• ROC1996 5559(1-36) / (766311668) 18.69
• Forecasted Reinvestment Rate50
• ROC20
• Expected Growth EBIT 50 20 10

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The firm Valuation
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How to determine a reasonable growth rate?

• The firm is in stable growth
• The firm is in a relatively high growth, will be
  in stable growth after certain years (2-stage)
• The firm is in a high growth period, will
  experience a period of transition period before
  it is in stable growth (3-stage)

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The high growth rates and high growth period

• Very high growth rate in current time long
  growth period
• High entry barriers long growth period
• Large size of firm short growth period

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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
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Disneys Firm Valuation

• Free Cash flows to Firm Approach
• Three stages of growth

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High Growth Transition Stable growth
length 5 years 5 years 11th to forever
Revenues 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
Pre-tax Margin 29.67 of Revenues EBIT of 1996 5,559 Steadily increase to 32 due to scale economy 32 of Revenues
Tax Rate 36 36 36
ROC 20, same as 1996 Steadily decrease to 16 16
Working capital 5 of Revenues 5 of Revenues 5 of Revenues
Reinvestment Rate 50, 1,134 for 1996, assume same growth rate as EBIT Steadily decrease to 31.25, 31.25
Expected growth in EBIT ROCReinvestment Rate10 Steadily decrease to stable growth 5 5
Debt /Capital 18 Steadily increase to 30 30
Risk Parameters Beta1.25 k equity13.88 Cost of debt 7.5(before tax) (Long Term Bond Rate7) Beta decrease steadily to 1.00 Cost of debt remains 7.5 Beta1.00 Cost of debt remains 7.5
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Disneys FCFF
Basic year 1 2 3 4 5 6 7 8 9 10
Expected Growth 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
ROC 20 20 20 20 20 20 19.2 18.4 17.6 16.8 16
Reinv. Rate 50 50 50 50 50 46.88 43.48 39.77 35.71 31.25
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Disneys 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
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Terminal Value

• FCFF11 EBIT11 (1-t) EBIT11 (1-t)
  Reinvestment Rate
• 13,539 (1.05) (1-36) - 13,539 (1.05)
  (1-36) (31.25)
• 6,255 million
• Terminal Value 6,255/(10.19 - 5)
• 120,521 million

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DisneyNet 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
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Why we do not consider the cash flows related to
the financing?

• 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.

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(t0) (t1) (t2) (t3) (t4)
Initial invest. (total cost) (8,000,000)
Inc. rev. 6,000,000 6,000,000 6,000,000 6,000,000
Inc. cost (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
NOP CF 3,000,000
Project CF (8,000,000) 3,500,000 3,500,000 3,500,000 6,500,000
Financing 8,000,000
Interest (AT) (360,000) (360,000) (360,000) (360,000)
Repay. (8,000,000)
Fin. Rel. CF 8,000,000 (360,000) (360,000) (360,000) (8,360,000)
Total CF 0 3,140,000 3,140,000 3,140,000 (1,860,000)
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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.
(t0) (t1) (t2) (t3) (t4)
Project CF (8,000,000) 3,500,000 3,500,000 3,500,000 6,500,000
NPV (at 4.5) 7,072,024
(t0) (t1) (t2) (t3) (t4)
Total CF 0 3,140,000 3,140,000 3,140,000 (1,860,000)
NPV (at 4.5) 7,072,024
(t0) (t1) (t2) (t3) (t4)
Fin. Rel. CF 8,000,000 (360,000) (360,000) (360,000) (8,360,000)
NPV (at 4.5) 0
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How do managers create value?

• 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.

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Increasing the cash flows generated by existing
investments

• 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

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Increasing the expected growth in FCFF or FCFE

• 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 NPVgt0 project, then the
  benefits to growth outweigh the reduction on
  current cash flows.
• Reinvest as long as EVAgt0.
• ROICgtrWACC

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Reducing the cost of financing

• 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.

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Adjusted Present Value (APV) Approach

• APV PV of asset flows PV of side effects
  associated with the financing program.
• Recall the M/M proposition I

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Adjusted Present Value (APV) Approach

• Procedure
• 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.

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Calculate PV of project assuming it is all equity
financed

• Assume
• 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

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Year 1 2 3 4 5
EBIT 100 108 116 124 134
Tax _at_ 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 289.8
PV_at_11.46 26.9 26.4 25.7 24.9 24.1 168.5
Total PV 296.4
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Calculate value of tax shieldAssume 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 _at_ 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
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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 no debt 40.0 43.2 46.4 49.6 53.6
Tax payments with debt _at_ 8 35.2 39.1 43.2 47.4 52.5
Tax savings 4.8 4.1 3.2 2.2 1.1
PV of tax savings _at_ 8 13
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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 _at_ 8 37
Present value these savings at 8, produces a
value of 37 for the tax loss carry-forward.
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APV - Conclusion

• Total firm value value of all equity firm
  (295) side effects of financing (13 37) 345.