Corporate Finance & Risk Management 06 Financial Valuation

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1 Corporate Finance & Risk Management 06 Financial Valuation Christoph Schneider University of Mannheim Tel: +49 (621)

2 Topics covered After-tax WACC Valuing companies - Preparing cash flows - Valuation using the WACC - Valuation using the APV-method Issues - Checking values - Riskiness of tax shields 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 2

3 Valuation and intrinsic value We define intrinsic value as the discounted value of the cash that can be taken out of a business during its remaining life. Anyone calculating intrinsic value necessarily comes up with a highly subjective figure that will change both as estimates of future cash flows are revised and as interest rates move. Despite its fuzziness, however, intrinsic value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses. Warren E. Buffett, Chairman s Letter, Berkshire Hathaway Annual Report Ernst Maug Corporate Finance & Risk Management: Financial Valuation 3

4 Two ways to value a company First step: forecast future cash flows Method 1: Adjust discount rate (WACC) - Forecast cash flows for 100% equity-financed firm, not adjusted for financing effects - Discount these at WACC - WACC adjusts for tax shields Method 2: Adjust cash flows (APV) - Cash flows adjusted for financing effects - Discount at opportunity cost of capital (not adjusted for taxes) 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 4

5 Method 1: After-tax WACC Example: T-Offline AG - 6.5% cost of debt % cost of equity - Tax rate: 30% Market-value balance sheet: T-Offline AG (Market Values, millons) Asset value 2,000 1,500 Equity 500 Debt 2,000 2,000 Leverage (D/V) = 25% All calculations are documented in the Excel file 06_Financing_Valuation.xls. Note that the numbers displayed are based on exact calculations Ernst Maug Corporate Finance & Risk Management: Financial Valuation 5

6 Calculating after-tax WACC Apply the after-tax WACC-formula: r WACC E re V D rd 1T V 0.125(1 0.25) The after-tax WACC is 10.5% This is already adjusted for financing effects (tax advantage) Note: The tax effect is r D T(D/V)=0.065*0.3*0.25=0.005, or 0.5% - the opportunity cost of capital (r A, = pre-tax WACC) is therefore 11% Ernst Maug Corporate Finance & Risk Management: Financial Valuation 6

7 Cash is king! Analyzing free cash flows Free Cash Flow = Cash inflow - Cash outflow Cash inflow = Sales x Operating profit margin Cash outflow = Capital expenditure (CAPEX) + New investment in working capital + Taxes Note: Capital expenditure(t) = Change in PPE (= new PPE) + Depreciation (= replacement) 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 7

8 Forecasting cash flows Percentage of sales approach Steps: - Forecast sales growth of T-Offline immediate growth rate (years 1-3): 5.5% perpetual growth rate (year 4+): 4.0% - Express other cash flow items as a percentage of sales COGS / Sales = 90% Depreciation / Sales = 5.4% Net PPE /Sales = 10% Working capital / Sales = 10% - Assume: Sales = 5, Ernst Maug Corporate Finance & Risk Management: Financial Valuation 8

9 Cash flows Step 1: Calculate taxes Sales 5,000 - COGS 4,500 = EBITDA Depreciation 270 = EBIT 230 x Tax rate 30% = Taxes 69 Rule: Depreciation is subtracted to calculate earnings and taxable income, but all non-cash items are added back to calculate cash flows. 90% 5.4% Step 2: Calculate cash flows EBIT Taxes 69 = EBIAT Depreciation CAPEX (investment in PPE) Investment in WC 26 = FCF U (unlevered firm) 109 Change in net PPE is =26. CAPEX = Depreciation + Change in PPE = = 296 Change in WC is = Ernst Maug Corporate Finance & Risk Management: Financial Valuation 9

10 T-Offline: Cash flow forecasts Year (1) Sales 5,000 5,275 5,565 5,871 6,106 (2) EBITDA = (1) x margin (3) Depreciation (4) EBIT = (2) - (3) (5) Taxes = (4) x T (6) EBIAT = (4) - (5) (7) CAPEX (8) Investment in WC (9) Free cash flow (FCF U ) = (6)+(3)-(7)-(8) Net PPE Working Capital (7): Calculate PPE as percentage of sales each year. Then CAPEX = PPE(t) PPE(t-1) + depreciation (8): Calculate WC as percentage of sales each year. Then Investment in WC = WC(t) WC(t-1) Note: There might be errors from using rounded numbers. Estimations rely on exact calculations from the Excel file 06_Financing_Valuation.xls Ernst Maug Corporate Finance & Risk Management: Financial Valuation 10

11 T-Offline: Horizon value Assume that the cash flows grow after year 3 at a perpetual rate of 4.0%. Calculate horizon value as a growing perpetuity: V 3 r FCF WACC 4 U g ,298 Note: This is the present value as of year 3. Note: There might be errors from using rounded numbers. Estimations rely on exact calculations from the Excel file 06_Financing_Valuation.xls Ernst Maug Corporate Finance & Risk Management: Financial Valuation 11

12 T-Offline: Valuation Valuation with the WACC: V FCF FCF FCF U U U 1 2 t t 1 rwacc 1rWACC 1rWACC U U U FCF1 FCF2 FCF3 V rwacc 1rWACC 1rWACC , , Horizon value Year (10) Horizon value 2,298 (11) Present value of FCFs (12) Present value of horizon value 1,702 Value of firm = SPV(FCFs) 2,000 2,096 2,195 2, Ernst Maug Corporate Finance & Risk Management: Financial Valuation 12

13 Horizon value: Issues In the valuation of T-Offline - the horizon value contribute 1,702 = 85% - the cash flows in years 1 3 contribute 15% of the total value of the firm Check that this makes sense! - Valuation of firm to total value of assets (PPE + WC) in year 3: 2, Valuation of firm to sales in year 3: 2, ,871 - Compare these numbers to industry peers Ernst Maug Corporate Finance & Risk Management: Financial Valuation 13

14 T-Offline s expansion project T-Offline's R&D network service proposes investing in a perpetual license for a STMU-network: - capital expenditure: million - network never depreciates - generates a perpetual stream of pre-tax cash flows of 50 million p. a. Should T-Offline invest? 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 14

15 T-Offline s expansion project Step 1: Analyze cash flows: Investment Pretax cash flow 50.0 Tax 15.0 After-tax cash flow 35.0 Step 2: Calculate NPV using WACC: 35 NPV Ernst Maug Corporate Finance & Risk Management: Financial Valuation 15

16 Project returns and security returns NPV=0 means that investors recover exactly their opportunity costs Assume debt capacity of project = leverage of T-Offline - actual source of financing is irrelevant! Balance sheet of project: Perpetual STMU-License (Market Values, millons) Asset value Equity 83.2 Debt Ernst Maug Corporate Finance & Risk Management: Financial Valuation 16

17 Project returns and security returns Pre-tax interest is 6.50% of 83.2 = 5.4 Tax shield is 30% of 5.4 = 1.6 After-tax interest is = 3.8 Income of equityholders is = 31.2 Return to equityholders on equity of 249.7: Return to equityholders % Ernst Maug Corporate Finance & Risk Management: Financial Valuation 17

18 Adjusted present value (APV) WACC is restrictive: - need to assume constant capital structure - leverage and risk cannot change over time Alternative: Adjusted present value (APV) Steps: - calculate cash flows of unlevered firm (FCF U ) - forecast explicit schedule for debt issues and debt repayments - calculate tax shields and all other financing implications APV-Value = PV(FCF's) + PV(Tax shields) 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 18

19 APV-Valuation of T-Offline APV (1) Debt (2) Interest Payment = Debt(t-1) x r D (3) Tax shield = (2) x T (4) Horizon value tax shield 160 (5) Present value tax shields (6) Free cash flow (FCF U ) (7) Horizon value cash flows 2,138 (8) Present value cash flows ,657 Discount tax shields and free cash flows at r A = 11%. APV-Value = PV(FCF's) + PV(Tax shields) = 1, = 2, Ernst Maug Corporate Finance & Risk Management: Financial Valuation 19

20 Are APV and WACC the same? WACC assumes a constant capital structure Assume this also in your APV calculations, use growing perpetuity model: V APV 0 FCF U 1 D 0 r A r D T g Multiply through by r A - g and rearrange: V r g r D T FCF APV 0 U 0 A D APV 1 V0 Divide by the term in brackets and use definition of WACC: V APV 0 FCF D U 1 0 ra rd T g V Ernst Maug Corporate Finance & Risk Management: Financial Valuation r FCF WACC U 1 g WACC V0 20

21 The flexibility of APV The case of LBO valuation Assume Locust Brothers, a private equity boutique, want to purchase T-Offline. Locust would conduct an LBO (leveraged buyout), issue more debt so total debt would be 1800 in year 0. The average cost of debt would increase to 8%. In years 1, 2, and 3 only 100 of the debt would be repaid in each year. In year 4 debt would revert to the same level of 597 as under the current management Ernst Maug Corporate Finance & Risk Management: Financial Valuation 21

22 LBO Valuation LBO (1) Debt 1,800 1,700 1,600 1, (2) Interest Payment = Debt(t-1) x r D (3) T ax shield = (2) x T (4) Horizon value tax shield 166 (5) Present value tax shields (6) Free cash flow (FCF U ) (7) Horizon value cash flows 2,138 (8) Present value cash flows ,657 Tax shields in years 1-4 discounted at r D =8%. Tax shields in years 5+ discounted at r A =11%. APV-Value = PV(FCF's) + PV(Tax shields) = 1, = 2, Ernst Maug Corporate Finance & Risk Management: Financial Valuation 22

23 How risky are tax shields? Assumption 1: Leverage stays constant as % of value - Debt level (in Euros) fluctuates with the value of the firm - Tax shields are proportional to interest payments, which are proportional to debt level - Risk of tax shields is similar to that of the firm - discount tax shields at r A Assumption 2: Leverage is constant in Euros - Debt level (in Euros) is constant - Risk of tax shields is similar to that of debt - discount tax shields at r D 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 23

24 APV for T-Offline s STMU-license Szenario I: Rebalance debt, discount at r A : U NPV ( FCF ' s) PV ( Tax shields) We obtain the same NPV=0 result as before. Szenario II: Hold debt constant, discount at r D : 1.6 PV ( Tax shields) NPV is = 10.2 now Ernst Maug Corporate Finance & Risk Management: Financial Valuation 24

25 Summary Fundamental value of firms: how much cash can you take out of a firm over its remaining life? - Determine free cash flows Consider tax shields - Method 1: Adjust the discount rate WACC - Method 2: Adjust cash flows APV Never mix these two methods! Check your valuations - Your strategic scenario has to make sense - Benchmark against multiples from peers 2016 Ernst Maug Corporate Finance & Risk Management: Financial Valuation 25

Ozymandias LTM revenue is $800 million, and it has achieved EBITDA margins of 30% historically.

Ozymandias LTM revenue is $800 million, and it has achieved EBITDA margins of 30% historically. Paper LBO Model 30 Minutes ABQ Capital is considering a leveraged buyout of Ozymandias, a leading provider of generic pharmaceuticals, with distribution in all 50 states of the U.S. ABQ plans to purchase