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Firm Valuation A Discounted Cash Flow Approach

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Title: Firm Valuation A Discounted Cash Flow Approach


1
Firm ValuationA Discounted Cash Flow Approach
2
A General Valuation Model
  • The basic components of the valuation are
  • An estimate of the future cash flow stream from
    owning the asset
  • The required rate of return for each period based
    upon the riskiness of the asset
  • The value is then found by discounting each cash
    flow by its respective discount rate and then
    summing the PVs (Basically the PV of an Uneven
    Cash Flow Stream)

3
The Formal Model
  • The value of any asset should then be equal to

4
Applying the general valuation formula to a firm
  • The only question is what to use as the future
    cash flows when valuing the firm.
  • Free Cash Flow
  • The cash flow from operations that is actually
    available for distribution to investors
    (stockholders, bondholders and preferred
    stockholders)

5
Free Cash Flow
  • Net Operating Profit After Taxes
  • depreciation
  • -Gross Capital Expenditure
  • -Change in net operating working capital
  • Free Cash Flow

6
NOPAT
  • NOPAT EBIT(1-Tax Rate)
  • NOPAT is the amount of profit a firm would earn
    if it had no debt and held no financial assets.

7
FCF
  • Five good uses of FCF
  • Pay interest to debtholders (cost to firm is
    after tax interest expense)
  • Repay debt
  • Pay dividend to shareholders
  • Repurchase stock from shareholders
  • Buy marketable securities or other nonoperating
    assets.

8
Developing estimates of free cash flow
  • To develop the estimates of future cash flows you
    need to forecast the future income of the firm.
  • This will be a result of your financial plan and
    proforma financial statement.

9
Financial Planning
  • Establish an outline of the process by which the
    firms goals are to be realized

10
Goals of the Plan
  • Examining interactions
  • Exploring Options
  • Avoiding Surprises
  • Evaluating Feasibility

11
Elements of a Financial Plan
  1. Forecasting What future assets will be needed
    and how will they be obtained
  2. Capital Structure Policy How will the assets be
    financed
  3. Dividend Policy What portion of earnings will
    be returned to shareholders
  4. Working Capital The amount of liquidity needed
    for the firm to conduct daily operations

12
Main issues addressed
  • Corporate Purpose Overview of long run mission
    of firm
  • Corporate Scope Geographic location and main
    business line
  • Corporate Objectives Specific Goals for the
    firm ( targets)

13
Main Issues
  • Corporate Strategy A plan to obtain the firms
    objectives
  • Operating Plans Five year horizon each year
    less specific

14
Steps in the process
  1. Pro Forma Financial Statements
  2. Determine the funds needed to support the plan
  3. Forecast the funds available
  4. Establish controls
  5. Plan for other contingencies
  6. Establish a performance based compensation plan

15
A simple model
  • Assume that all variables are directly tied to
    sales If sales increases so do the other
    entries on the balance sheet and income statement
    (by the same )
  • As sales increase so do assets why?
  • (Assume total capacity utilization)

16
Simple Income Statement
  • Sale 1,000
  • Costs 800
  • Net income 200
  • Sale 1,250
  • Costs 1,000
  • Net income 250

17
Simple Balance Sheet
  • Assets 500 Debt 250
  • Equity 250
  • 500 500
  • Assets 625 Debt 325
  • Equity 325
  • 625 625

18
Percentage of Sales Approach
  • Two categories those that vary directly with
    sales and those that do not.
  • Income Statement
  • Costs remain a set of sales
  • Dividend Payout Assume it remains constant
  • Balance Sheet
  • Find of sales for LHS, on the RHS not for L-T
    Debt or retained earnings or equity (only CL)
  • Retained Earnings use dividend payout

19
Income Statement
  • Sales 1,250
  • Costs 1,000
  • Taxable income 250
  • Taxes 85
  • Net Income 165
  • Addition to Ret Earn
  • .6667(165) 110
  • Sales 1,000
  • Costs 800
  • Taxable income 200
  • Taxes 68
  • Net Income 132
  • Dividends 44
  • Addition to Ret E 88
  • RetRate88/13266.67

20
Balance Sheet
  • Assets
  • Current Assets 160 16
  • Accts Rec 440 44
  • Inventory 600 60
  • Total 1200 120
  • Fixed Assets 1800 180
  • Total Assets 3000 300
  • Liabilities
  • Current Liab 300 30
  • Notes Pay 500 na
  • Total 400 na
  • L-T debt 800 na
  • Ret Earn 1000 na
  • Total Liab 3000 300

21
Proforma Balance SheetSales increase by 25
  • Assets
  • Current Assets 200 16
  • Accts Rec 550 44
  • Inventory 750 60
  • Total 1500 120
  • Fixed Assets 2250 180
  • Total Assets 3750 300
  • Laibilitess
  • Current Liab 375 30
  • Accts Pay 500 na
  • Total 875 na
  • LT Debt 800 na
  • Ret Earn 1110 na
  • Total Liab 2785 300

They do not balance! The difference is the
EFN EFN 3750 2785 965
22
External Financing Needed
  • Should be equal to Change in Assets Change in
    Liabilities
  • Represents the amount of cash that needs to be
    raised to finance the assets.

23
Internal Growth Rate
  • The rate of growth where the amount of external
    financing needed is equal to zero. This would
    mean that the additional assets required are
    equal to the increase in retained earnings
  • Internal Growth Rate (ROA)b/1-(ROA)b
  • b retention rate

24
Sustainable Growth Rate
  • The firm wants to maintain a constant debt equity
    ratio (not increase its financial leverage).
    This implies that the firm will raise funds only
    in the form of debt, not external equity.
  • sustainable growth rate (ROE)b/1-(ROE)b

25
Problems
  • Financial Planning models that depend upon the
    financial statements leave out important
    financial relationships such as cash flows, risk
    ,and timing

26
The Formal Model Again
  • The value of any asset should be equal to

27
Value of Operations
  • After forecasting the free cash flows it is then
    possible to find the value of operations for the
    firm.
  • Notice, this depends upon a forecast of future
    free cash flow which much like dividends are not
    certain.

28
Cost of Capital
  • What required return should be used in the
    formula?
  • Weighted average measure of the returns required
    by the providers of capital (debt, preferred
    stock, common stock) to the firm.
  • The weight corresponds to the amount of financing
    that comes from each source.
  • We will calculate it in more detail soon.

29
Weighted Average Cost of Capital (WACC)
  • Pacific corporation is considering a new project.
    It wants to issue debt for 75 of the funding,
    investors will require an 8 return on the debt.
    The other 25 would come from new equity,
    investors require a 12 return on the equity.
  • The WACC would then be
  • (.75)(.08) (.25)(.12) .09

30
Constant Growth in FCF
  • Just like the constant growth in dividend model
    if constant growth in free cash flow is assumed
    you can shorten the equation.

31
  • This is the PV of the FCF from time N to time
    Infinity (think about the last part of a
    nonconstant dividend valuation)
  • We will call it the terminal value or horizon
    value or continuing value.
  • If the firm had constant growth forever N would
    be today.

32
Value of operations
  • Generally we will not assume that the firm has
    constant growth in Free Cash Flow.
  • Instead you want to forecast the future free cash
    flows for the firm over a reasonable period (5 to
    10 years).
  • Then calculate the terminal value for the firm
    from the end of the forecast period to infinity.
    (the process is very similar to finding the PV of
    a nonconstant growth dividend stream.

33
Estimating price per share of stock
  • The PV of all the future free cash flows provides
    an estimate of the total value of the firm
  • We need to subtract the total amount of debt and
    claims by the owners of preferred stock.
  • Divide the remaining amount by the number of
    shares outstanding to get the value of one share
    of outstanding stock.
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