FN428 : Investment Banking. Lecture 23 : Revision class

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1 FN428 : Investment Banking Lecture 23 : Revision class

2 Recap : Theory of Financial Intermediary An overview of Investment Banking Investment Bank vs. Commercial Bank Which are the various divisions of an Investment Bank? Scope of IB? (Advisory, Research, IPO, SEO, M&A, loan syndicate..etc) Glass-Steagall act 1933

3 Recap : Valuation models Dividend Discount Model Residual Income Model (and extensions) Free Cash Flow Model

4 The Basis of the DDM The basis of the DDM, then, is that the price to be paid for an equity in the market should reflect the future stream of dividend payments accruing to the equity investor. Lets start with the simplest case of an investor who is considering buying a share and holding it for one year before selling it again. What price should they pay for that share? Here: V 0 D (1 + r) P (1 + r) D1 + P (1 + r) V0 = + = = value of the share today (at t=0) P 1 = expected price that share could be sold for at time t+1 D 1 r = expected dividend for that share during the year = required rate or return on the share Equity value (Price today) = f Price next year + Dividend during year

5 A DDM Example Lets look at an example of this simplest of DDMs. Company DEF is expected to pay a dividend of 1.00 next year and is expected to sell for at the end of that period. The required rate of return for equity holders of DEF is 8 percent. What value should be placed on the share today? = D (1 + r) + P (1 + r) D1 + P (1 + r) V0 = D1 + P (1 + r) (1.08) 1 V0 = = = 14.81

6 The Gordon Growth Model However, very few shareholders buy a share with the intention of selling it in one year s time. Many investors and funds have the intention of buying a share to hold for a much longer time period, often as a key component of a retirement investment. How we deal with this fact is that we assume that we can make forecasts of dividends over some finite time horizon and then we estimate a terminal value thereafter. A model known as the Gordon Growth Model helps us with the problem of longer-term shareholdings. If we can observe the current dividend payment to shareholders, estimate the expected growth rate of those dividends into the future, and observe the required rate of return on that type of equity, then we can calculate the firm s equity value: = D0(1 + g) r g = D r g 1 V0 Note that an interesting shortcoming of this model is that the cost of equity, r, must always be greater than g, the growth rate of dividends. Otherwise, if r=g, the value of the equity is infinite or if r<g, the value of the equity is negative. Clearly, neither of these valuation outcomes is very useful!

7 A Gordon Growth Model Example Lets look at an example of a DDM valuation using the Gordon Growth Model. Company GHI has a required rate of return of 10 per cent, a fairly stable growth rate of dividends recently of 7 per cent and a current dividend of What is the value of a share in company GHI? D (1 + g) r g D r 0 1 V0 = = = D (1 + g) r g g 1.80(1.07) ( ) V0 = = = Clearly, using this type of model, an increase in the growth rate of dividends or a reduction in the cost of equity capital (the required rate of return) will increase the price paid for a share. The reason for this is that in former case, future cash flows to investors will be inflated for each year into infinity and in the latter case such cash flows will be discounted less harshly through time and thus their present value will increase. This demonstrates well the inverse relationship between the cost of capital of a firm and its intrinsic value. g = ROE * (1-payout ratio)

8 The Multiple Growth Rate Model Another extension to the DDM is needed to help us with real world valuation problems. How do we deal with a firm which is not expected to have a stable or constant growth rate into the indefinite future? Growth often falls into three stages for a company: 1. Growth Often during a growth phase, companies pay low dividends or even miss them. 2. Transition Once the growth phase has slowed and a firm s markets are maturing, free cash flows then become positive and the firm increases its dividends. 3. Maturity Here, once the firm s markets have matured and returns on equity approximate their costs, the path of dividends stabilises to a sustainable pattern. The Gordon Growth Model can be very useful for valuing firms in this phase. Dividends Per share Growth Transition Maturity Growth stage

9 A Multiple Growth Rate Example Arriving at an equity value for firms which will experience multiple growth rates into the future is perhaps a more difficult task, though the principles are simple. Lets look at an example firm. We expect the dividends of firm JKL to grow at 8 per cent for the next two years, 14 per cent for the following 4 years, and to settle at 10 per cent thereafter. The required rate of return for the company is 11 per cent. The company s current dividend is 0.75 per year. What is the value of an equity share in the company JKL? Three periods of growth for JKL: Dividend Growth Rate 15% 10% 5% Year

10 A Multiple Growth Rate Example It is best to calculate the impact of the growth rate first and then discount to present value before summing these discounted cash flows: Time Dividend or terminal value Growth rate calculation Dividend or terminal value Present values (Discounte d at 11%) 1 D (1.08) D (1.08) D (1.08) 2 (1.14) D (1.08) 2 (1.14) D (1.08) 2 (1.14) D (1.08) 2 (1.14) V (1.08) 2 (1.14) 4 (1.10)/( ) Total 91.37

11 The Multiple Growth Rate Model Explained So how did we arrive at this equity value per share of for JKL? Our starting point is the current dividend. You will notice that we gradually inflate this by the growth rates applicable to each successive period. The inflator for each year is simply 1 plus the growth rate. Previous year dividend growth rates remain in the calculation to show that the future value is merely the current dividend inflated by a series of different growth rates through time. Employing this multiple growth rate model, then, using estimated data to determine the growth path of dividends over a horizon where we can reasonably estimate growth rates and then calculating a terminal value, we should be able to deal with any pattern of expected dividend growth.

12 Relative Merits of the DDM What are the advantages and disadvantages of this type of model then? The advantages of the dividend discount model are: 1. It is very simple to understand and apply 2. It focuses on the most visible form of returns to shareholders (dividends) 3. It relies on only a few parameters, requiring only the observation of the current dividend, the required rate or return on equity, and some projection of the future pattern of dividends The disadvantages of the model are, however: 1. It does not deal well with a required rate of return which is equal to or lower than the growth rate of dividends 2. It does not enable us to value firms which do not pay dividends 3. It concentrates on a very narrow range of parameters and may not capture the fundamental determinants of firm value 4. It focuses on the distribution of the firm s value, not the generation of the firm s value

13 Residual Income Models The following relationship can be used to value a firm s equity: Value of equity Book value = + of equity Present value of expected future abnormal earnings Residual income models were developed to correct a shortcoming of financial statements the fact that net income (profit) includes a charge for the cost of a firm s debt but not for the cost of its equity. The result of this is that it is left to shareholders to decide whether: The firm s earnings are greater than The cost of investment in equity If earnings are greater, then the firm is creating value, if they are less then the firm may even be destroying value for shareholders.

14 The Residual Income Model Expression Whether we wish to value a share in relation to residual income as calculated above or in relation to earnings per share, we can employ the following expression: V 0 = B 0 + RI t = B0 + t 1( 1+ r) t= t= 1 E t (1 + rb r) t 1 t V 0 = Value of share today (t=0) B 0 t = Book value of equity today B = Expected book value per-share at time t r = Equity cost of capital E t = Expected Earnings Per Share for period t RI t = Expected residual income per-share (Equals t rb) t 1 E

15 Calculating Net Income From an accounting viewpoint, lets calculate ABC s net income: EBIT 500,000 Less: Interest Expense (8%) (200,000) EBT 300,000 Less: Corporation Tax Expense (90,000) Net Income 210,000 So, clearly ABC is profitable from an accounting viewpoint. However, are its shareholders happy with this level of earnings? To answer this question, we need to deduct a charge for the opportunity cost of shareholders funds (or, put another way, an equity charge).

16 Residual Income Model and DDM Clean surplus relation: Beginning book value + Net income Dividends=Closing book value By substituting Dividends in the DDM as: Dividends= Beginning book value + Net income - Closing book value This equation state that the difference between the sum of Opening Book value plus Net Income and the closing book value are dividends. We obtain the Residual Income Model. DDM and Residual Income Model are equivalent as long as the clean surplus relation holds.

17 An ROE Expression for Residual Valuation We can simplify our understanding of residual income model valuation by using the following expression in real world valuations:- V 0 = B 0 + ((ROE r) / (r g)).b 0 Where V 0 = Value of a share in the firm B 0 = Opening book value of firm s equity ROE = Return on equity r = Cost of equity g = Growth rate of earnings The importance of this is that it uses an easy to estimate financial ratio, return on equity, and thus all we then need to know is the firm s opening book value of equity, its equity cost of capital and the growth rate of earnings (zero if all of earnings are paid out as dividends). net income available to common shareholders Return on common equity = average common equity

18 Free Cash Flow Valuation Models Free cash flow (FCF) valuation models will not be discussed in detail in this lecture as they are covered elsewhere. The basis for the technique is that we project financial statements, use them to calculate free cash flows and then use these as the basis for equity valuation. FCF measures the cash that is available to the shareholders of the firm and it is a finance free measure. More precisely: Free cash flow = Profit after taxes + Depreciation + Net after-tax interest payments - Increase in current assets + Increase in current liabilities - Increase in fixed assets at cost

19 Calculating Enterprise Value To arrive at the present value, we simply have to discount all of the FCFs and the terminal value by the WACC: EV = (1.14) (1.14) (1.14) (1.14) 15,232 5 (1.14) Thus the enterprise value for XYZ is calculated as: , = 8,681,010 So the EV of XYZ is 8,681,970. We then need to add back cash and marketable securities and subtract debt balances. Thus: Enterprise value 8,681,010 Add initial cash 80,000 Subtract initial debt (400,000) Equity value of XYZ 8,361,010

20 Price Multiples Models Comparable Companies Approach The basis for multiples valuation is that we judge what to pay for an equity share by looking to see what investor cash will buy for similar firms in terms of: Scale (P/B) Activity (P/S) Earnings ability (P/E, P/CF) Important: Compare your firm s multiple ratio with the peer group s multiple ratios. The basis for the technique is that similar companies should sell for similar prices. We should therefore calculate multiples for a group of similar companies. Lets illustrate with an example.

21 The relation between P/E and P/B ratio P/E=(P/B)/ROE Remember that the Price to Book ratio (P/B) is determined by the sustainable level of ROE in the future. In the above relation, P/E is affected by both the current and the sustainable level of ROE. High P/E and high P/B: The firm is expected to generate higher ROE in the future. Low P/E and high P/B>1: The firm is expected to generate high ROE but the current level is not sustainable.

22 Recap : Beta Estimation But the firm s beta cannot be estimated using regression method. Thus, we must find a work around to estimate beta of a private firm. In this case, we could utilize unlevered beta of the peer firms to estimate company unlevered beta.(more on this later) Levered Beta is the Beta that contains the effect of capital structure i.e. Debt and Equity both. The beta that we calculated above is the Levered Beta. Unlevered Beta is the Beta after removing the effects of the capital structure. As seen above, once we remove the financial leverage effect, we will be able to find the Unlevered Beta. Hamada s Equation :

23 A Reminder on the Cost of Capital Capital Asset Pricing Model to calculate the cost of equity: E (R i ) = R F + β i [E(R M ) R F ] Where: E (R i ) R F E(R M ) β I = expected return on asset i given its beta = risk-free rate of return = expected return on the market portfolio = asset s sensitivity to returns on the market portfolio To calculate the cost of debt: by dividing Interest expense (value) / Total debt of the company To calculate the weighted average cost of capital (WACC): Calculate the cost of components, compute the proportions of each and substitute into the following expression: WACC = D D + E r D (1 T C ) + E D + E r E

24 Recap : IPO What is IPO, IPO underpricing Initial Returns, Long-run returns Dutch auction vs Book Building Sabanes-Oxley Act 2002 IPO Technical Terms : Quite period, Lock-up period

25 Recap : Capital Structure represents the mix of claims against a firm s assets and free cash flow Some characteristics of financial claims Payoff structure (e.g. fixed promised payment) Priority (debt paid before equity)..etc leverage (debt vs. equity) and how it can affect firm Optimal capital structure & MM theory

26 Recap : M&A Reasons for mergers Estimating M&A gain and cost Take over defenses Technical Terms

27 Recap : Dividend Policy MM proposition and optimal dividend policy Information content, Dividend signaling Clientele Effect Bird-in-hand fallacy

28 Last but not least Analyze the question where applicable 3hr for final exam. (21 Dec ). Use it wisely. One dictionary is allowed. (No electronic dictionary) Good luck!. But above all, hopefully you won t need any luck to do it.

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