Advanced Finance GEST-S402 Wrap-up session: company valuation and financing decision

Advanced Finance GEST-S402 Wrap-up session: company valuation and financing decision 2017-2018 Prof. Laurent Gheeraert

Objectives of the session BDM, 2013 reference: Chapter 18: Capital Budgeting and Valuation with Leverage 1. Understanding the key steps in company valuation 2. Being able to value a company using different valuation methods A. Discounted Cash Flow methods a) WACC (Weighted Average Cost of Capital) method b) APV (Adjusted Present Value) method c) CFE (Cash Flow to Equity) method d) CCF (Capital Cash Flow) method B. Other valuation methods a) Multiples method b) Net Asset Value method 3. Developing and challenging arguments in negotiation or valuation process 4. Making and justifying a financing decision

A) Discounted Cash Flow (DCF) valuation methods

DCF valuation 1. Company valuation: overall principle 2. Projecting Cash flows a. Free Cash Flows, Cash Flows to Equity holders, Cash Flows to Debt holders, Capital Cash Flows b. Projecting future expected Cash Flows c. Dealing with inflation in a consistent way 3. Dealing with never stopping cash flows: the terminal value a. Using our usual formulas with reasonable assumptions b. Need to know the discount rate! 4. Using the relevant Cash Flows and discount rates, in function of the valuation method chosen a. Adjusted Present Value (APV) method b. Weighted Average Cost of Capital (WACC) method c. Capital Cash Flow (CCF) method d. Cash Flow to Equity (CFE) method 5. Estimating the discount rates a. Using the beta and CAPM b. Considering the real activity (-ies) c. Taking into account leverage (e.g. to compute cost of equity or WACC) 6. Computing enterprise value and equity value a. The price to pay to buy a company is the market value of equity (not the enterprise value!) b. Price is not always value! c. Validating the result using alternative methods

Corporate Finance 101 Activities of the firm and related Cash Flows Investment Dividend Projects A B Z FIRM (or individual) Issuance of stock Issuance of debt (bond) Shareholders Debtholders CF from operations Interest / Debt payment

Company valuation What is the market value of the firm / company / enterprise? V ED What is the price to pay to buy a firm / company / enterprise? Determined based on: E V D where: E = market value of equity = market capitalization D = market value of debt V = firm / company / enterprise value (market value)

Market view of the firm Book value Market value Book value of Assets Book value of Equity Book value of Financial Debt Market Value of Assets Market Value of Equity Market Value of Financial Debt

Accounting From Accounting to Finance What happened? Historical cost Non cash expenses (depreciation, ) Realized gains (and realizable losses) useful for third parties (taxable income, ) Finance What will happen? Opportunity cost Only cash expenses Realizable gains and losses useful for the management (shareholders, )

Company valuation: general principle The company value is a present value! PV Risk Return analysis Which Cash Flows? Which discount rate? Terminal value t CF t (1 r) 1 Cash Flow Analysis t Time value of money Discounting techniques How to take into account the potential impact of the financial structure?

Dealing with uncertainty Risky Cash Flows are random variables, i.e., take different values ex-post, in function of the state of nature (not a number known with certainty!) Two possible approaches: 1. Discount the risk-adjusted expected cash flow using the risk-free interest rate Not in this course 2. Discount the expected cash flow using a risk-adjusted discount rate PV EC ( 1) 1 r Focus in this course CAPM : r r ( r r ) f m f

Company valuation Key questions What is the market value of the company? What price to pay to buy a company? FCFt Company value t1 (1 r) Company value ED E = Equity market value = market capitalization D = Debt market value Company Value = Company market value t Which price should you pay for a company? Which FCFs? Which discount rate (r)?

Value measurement and investment decision The company value is a Present Value! Terminal value Cash flow analysis PV t CF t (1 r) 1 t Risk Return analysis Time value and discounting techniques Which Cash Flows?

* Accounting-wise, interest income and interest expenses are generally accounted for as operating cash flows. Finance-wise, net interest (or alternatively, interest expenses) are excluded from the Free Cash Flows (= CF op + CF inv of the unlevered company). Taking into account the source of cash flows: IAS 7 CF op + CF inv = ΔCASH CF fin Operating cash flow: cash flows primarily derived from the principal revenue producing activities of the entity * Investment cash flow: expenditures that are made for resources intended to generate future income and cash flows Financing cash flow: claims on future cash flows by providers of capital to the entity (cash proceeds from issuing shares, debentures, loans, bonds, ST and LT borrowings, etc.)

Free Cash Flow of the unlevered company MAJOR CONCEPT (used throughout the course) Free Cash Flows of all-equity = unlevered firm (FCF = FCF U ) = Cash Flows from operations of the all-equity firm + Cash Flows from investments FCF = EBIT*(1-T C ) + non-cash expenses * ΔWCR** I EBIT*(1-T C ) = the NI the firm would have had if it were 100% equity financed EBIT*(1-T C ) is independent from the financial structure! EBIT*(1-T C ) is referred to as NOPAT (Net Operating Profit After Taxes) or EBIAT (Earnings Before Interest and After Taxes) or NOPLAT (Net Operating Profit Less Adjusted Taxes) FCF U = FCF L + Int*(1-T C ) * Mainly: depreciation and amortization charges, impairment charges (+ new provisions release of provisions). ** WCR = Working Capital Requirement = Inventory + Accounts Receivable (+ stricto sensu the cash necessary to the activity) Accounts payable; do not forget to consider the Δ, i.e., the change in WCR from a period to another.

Free Cash Flow to Equity and Debt holders Cash Flow to Equity holders (CFE) = cash flow that could be distributed to equity owners (= dividends plus cash build-up) CFE = FCF Int*(1-T C ) + Net Borrowing * = NI + Dep ΔWCR I + D t D t-1 = DIV ΔK + ΔCASH Secondary concepts Attention: NI, and hence CFE, depend on the financial structure! Cash Flow to Debt holders (CFD) CFD = Int Net Borrowing * = Int (D t D t-1 ) Capital Cash Flow (CCF**) = capital available to all holders of company securities (Equity holders and Debt holders) NB1: FCF U = FCF L + Int * (1-T C ) NB2: CFE + CFD = FCF L + Int = FCF U + Int*T C * Net borrowing = Debt amortization ** Ruback, 2000 *** Tax shield = Int*T C CCF = CFE + CFD = NI + Dep ΔWCR I + Int = FCF + tax shield ***

In practice, how to retrieve the FCF from the statements of CF? Consolidated statement of CF (found in financial statements) Operating CFs Calculation of FCF (using information from statement of CF) Operating CFs + Investment CFs + Investment CFs (CFs related to operations only exclude investments and divestments of securities) = FCF L + Financing CFs = Δ CASH + Net Interest * (1-T C ) = FCF (= FCF U )

Making projections of future expected Cash Flows Rely on market knowledge / experts to estimate the possible future Cash Flows If necessary, use different scenarios (.e.g, inflation rises, stays stable, decreases) Compute the expected value of Cash Flows (attention: not necessarily the most likely scenario, or even one of your possible scenarios!!) N E( CF) p CF Expected cash flow = i i with p i = probability of scenario i (N scenarii in total) i1 Example: Cash flows Scenario Probability Year 1 Year 2 Years 3 to Optimistic 10% 100 150 200 Realistic 60% 100 120 140 Pessimistic 30% 100 50 0 Expected cash flows 100 102 104

Be consistent: discount nominal (real) Cash Flows with a nominal (real) discount rate In practice, Cash Flow projections are made in nominal terms, i.e., they include inflation forecasts In this case, a nominal discount rate should be used and the resulting present value will be expressed in euros of today Sometimes, real cash flow projections are used, those exclude inflation, i.e., cash flows are expressed in euros of a given year (for example: projections «in euros of 2015») Beware of the tax impact from depreciation and amortization (which is expressed in nominal terms) Beware of the computation of the change in Working Capital Requirement In this case, a real discount rate should be used and the resulting present value will be expressed in euros of the chosen year Both approaches, when used correctly, can be reconciled and should lead to the exact same value, however the nominal approach is generally less prone to error

Real and nominal interest rate Investment opportunity 2011 2012 You invest 100 EUR You receive 110 EUR Nominal interest rate = 10% Inflation rate = 2% A hamburger sells for 5 EUR 5,1 EUR Your purchasing power (# hamburgers) 20 units 21,5686 units Real interest rate = 7.84 % (1 + Nominal interest rate) = (1 + Real interest rate) (1 + Inflation rate) Real interest rate Nominal interest rate Inflation rate (= only an approximation of the right formula above!)

Be consistent : Dealing with inflation Example Discount nominal cash flows with a nominal discount rate (preferred method) Discount real cash flows with real discount rate (generally a riskier method!) Both approaches lead to the exact same value Example: real CFs in year 3 = 100 (based on the level of prices in year 0) Inflation rate = 5% Real discount rate = 10% Discount real CFs with real discount rate Real Cash Flow =? Real rate =? PV =? Discount nominal CFs with nominal discount rate Nominal Cash Flow =? Nominal rate =? PV =? Same Present Value!

How to deal with never stopping Cash Flows? The company value is a Present Value! Terminal value Cash flow analysis PV t CF t (1 r) 1 t Risk Return analysis Time value and discounting techniques What to do when Cash Flows run until infinity? Computing the terminal value (TV) in company valuation

Reminder Discounting techniques: common patterns Constant cash flows Growing cash flows (at perpetual growth rate g *** ) g Perpetuity * Constant perpetuity: C t = C for all t Growing perpetuity: C t = C 1 (1+g) t-1 for all t g Annuity ** Constant annuity: C t = C for t = 1 to T Growing annuity: C t = C 1 (1+g) t-1 for t = 1 to T * CF from t = 1 to t = ** CF from t = 1 to t = T *** g = perpetual Cumulative Annual Growth Rate (perpetual CAGR)

Reminder Useful formulas Constant cash flows Growing cash flows r > 0 (at perpetual growth rate g) r > g Perpetuity* PV C r PV r C 1 g Constant perpetuity: C t = C for all t Growing perpetuity: C t = C 1 (1+g) t-1 for all t Annuity** PV C r (1 1 (1 r) T ) Constant annuity: C t = C for t = 1 to T Growing annuity: C t = C 1 (1+g) t-1 for t = 1 to T * CF from t = 1 to t = ** CF from t = 1 to t = T *** g = perpetual Cumulative Annual Growth Rate (perpetual CAGR)

Terminal value (1/4) In company valuations, Free Cash Flows generally do not stop after a given period of time In practice, Free Cash Flow projections generally involves at least two distinct projection periods 1. Detailed projection horizon: over a first period (e.g., 5-15 years), detailed cash flow projections are made, in order to factor in detailed information available about the firm / project (e.g., sales projections, new projects, potential synergies)

* Formulas are given here for an estimate of the terminal value based on FCFs; the terminal value for other types of CFs can easily be obtained by analogy. Terminal value (2/4) 2. After the detailed projections horizon, the formula of a growing perpetuity can be used to estimate a terminal value at the end of the detailed projection horizon 3. Simplifying assumptions need to be made, commonly*: a) Assuming that FCF grow (for ever) at constant growth rate g where: TV t FCFt 1 FCFt(1 g) r g r g g = long-term growth rate of the FCF you need to know the discount rate r!

Terminal value (3/4) b) Assuming that in the long-run: I = DEP (i.e., FA are stable over time) TV where: TV t t g = long-term growth rate of the FCF FCF = NOPAT ΔWCR (due to the assumption: I = DEP) you need to know the discount rate r! c) Assuming that in the long-run, FA and WCR grow at perpetual growth rate g: where: FCFt 1 ( NOPAT WCR) t(1 g) r g r g FCFt 1 NOPATt (1 g) ( WCR FA) t g r g r g g = long-term growth rate of the FCF you need to know the discount rate r!

Terminal value (4/4) The terminal value is very sensitive to the chosen value of the parameters, in particular the perpetual growth rate don t be over-optimistic in your estimate of the perpetual growth rate (for example, one could use as a proxy the GDP growth rate in a mature economy) Handle carefully the timing of each component Don t forget that the terminal value obtained is expressed at time t (still needs to be discounted to time 0 to obtain a present value!)

What relevant discount rate? The company value is a Present Value! Terminal value Cash flow analysis PV t CF t (1 r) 1 t Risk Return analysis Time value and discounting techniques Which discount rate should be used with which cash flows?

Possible cash flows 1. Cash flows from Operations, CF op 2. Cash flows from Investments, CF inv 3. Cash flows from Financing, CF fin 4. Free Cash Flows (= Free Cash Flows of the unlevered firm), FCF or FCF U 5. Free Cash Flows of the levered firm, FCF L 6. Cash flow to Equity holders, CFE 7. Cash flow to Debt holders, CFD 8. Cash flows to Equity and Debt holders = Capital Cash Flow, CCF* 9. Which cash flows should be used? With which discount rate? 32 * Ruback, 2000

33 Possible discount rates 1. Risk-free rate, r f 2. Cost of equity, r E 3. Cost of debt, r D 4. Weighted Average Cost of Capital, WACC E D WACC re rd (1 TC ) V V where: V = E + D r E and r D are weighted by the relative market values of equity (E/V) and debt (D/V) 5. Cost of equity of the all-equity firm, r A 6. Which discount rate should be used? With which cash flows?

34 1 APV Method (Adjusted Present Value) Generic method V VU NPV (financing) FCFt t (1 r ) NPV (financing) t1 A where: V = market value of the levered firm V U = market value of the all-equity firm FCF t = Free Cash Flows at time t r A = cost of equity of the all-equity firm NPV(financing) = net present value of from the financial structure of the company

2 WACC method (Weighted Average Cost of Capital) where: V t FCF 1 (1 WACC) V = Present Value of the levered firm FCF t = Free Cash Flows at time t WACC = Weighted Average Cost of Capital t t Generic method 35 with: where: E = market value of equity D = market value of debt E D WACC re rd (1 TC ) V V V = market value of the levered firm (= E + D) r E = cost of equity r D = cost of debt T C = marginal corporate tax rate

36 3 CFE method (Cash Flows to Equityholders) Generic method E t CFE 1 (1 r ) E t t where: E = market value of equity CFE t = Cash Flows to Equityholders au temps t r E = cost of equity

37 4 CCF method (Capital Cash Flows) Generic method V t CCF 1 (1 r ) A t t where: V = market value of the levered firm CCF t = Capital Cash Flows (= Cash Flows to equity and debt holders) at time t r A = cost of equity of all-equity firm

What relevant discount rate? The company value is a Present Value! Terminal value Cash flow analysis PV t CF t (1 r) 1 t Risk Return analysis Time value and discounting techniques How to estimate the discount rate?

From Accounting to Finance: Value creation Accountant Based on PAST information Based on FUTURE expectations Capital market ROE Return on Equity r E Expected return on equity ROE Net Income Stockholders' equity r E Div Capital gain (loss) Initial equity investment The capital employed by the firm has an opportunity cost The opportunity cost of capital is the expected / required rate of return (r E ) offered by equivalent investments in the capital market

Source : Graham, J. and Harvey R., 2002, How Do CFOs Make Capital Budgeting and Capital Structure Decisions?, Journal of Applied Corporate Finance, 15:1 The message from CFOs: cost of equity How do you determine your firm's cost of equity capital? CAPM Arithmetic average historical return Multibeta CAPM Dividend discount model Investor expectations Regulatory decisions Based on a survey of 392 CFOs 0.00% 10.00% 20.00% 30.00% 40.00% 50.00% 60.00% 70.00% 80.00% % always or almost always

Risk premium and systematic risk (beta) Starting point: the expected return of a security is linked to the risk premium of that security E( r ) r E(risk premium ) i f i Insight from the CAPM: definition (and quantification) of the risk premium E( r ) r ( E( r ) r ) i f M f i CAPM: the expected return of a security is positively linked to its beta, and equals: Risk-free rate* + Excess return from the market (= market risk premium**) X Beta of the security * The risk-free rate can be proxied by the yield-to-maturity observed on a risk-free bond (e.g., German Bund, US government bond) ** The market risk premium is generally estimated to be between 4 and 6%

CAPM: Risk-return relationship CAPM relationship: E( r ) r ( E( r ) r ) i f M f i Expected return E(r M ) E(r i ) r f β i 1 Beta (i) = measure of the (systematic) risk of security i

Portfolio standard deviation Diversification 35,00% Risk reduction of equally-weighted portfolios 30,00% 25,00% Unique risk 20,00% 15,00% 10,00% 5,00% Market risk 0,00% # stocks in portfolio

Correlation (close to 1) Value Security A+B Security A Security B time

Correlation (close to -1) Value Security A+B Security B Security A time

Return on asset The beta in practice The beta of a security* = the correlation between the returns of that security and those of the market**, normalized: Beta = 1 the security reacts to a market shock, on average, like the market (systematic) risk equal to the one of the market Beta > 1 the security, on average, magnifies market shocks high (systematic) risk Beta < 1 the security, on average, softens market shocks low (systematic) risk Beta < 0 the security, on average, softens market shocks and moves in opposite direction compared to the market low (systematic) risk, and "protection" against negative market shocks How to estimate a beta in practice? 30 25 20 15, 25 20, 27.5 15 15, 15 10 5 Slope = Beta = 1.5 0-15 -10-5 0 5 10 15 20 25-5, -5-5 -10-10, -17.5 Return on market * The beta of a portfolio follows the same principle. ** The market portfolio is defined as the best diversified portfolio (the "optimal portfolio"), which is obtained by combining all available risky securities, in proportion corresponding to their respective market capitalizations; in practice, it is proxied by a welldiversified index, such as S&P500 (Standard & Poor s), or MCSI World (Morgan Stanley Capital International). -5, -15-15 -20

In practice: how to estimate a company / project s opportunity cost of capital (using a sample of listed firms) Use the CAPM relationship: E( r ) r ( E( r ) r ) i f M f i 1 r f = expected return on the risk free asset (e.g., 10-year yield-to-maturity on a US or German bond; information from the yield curve can be used) 2 E(r M ) r f = expected market risk premium (generally between 4 and 6%) 3 β i = measure of the systematic risk of activity i 1) Identify a group of listed companies with similar business risk (i.e., similar activity) 2) Compute the periodic returns on the stock price over a recent period* (e.g., weekly returns over a 2-5 year period) 3) Compute the beta for each stock (levered beta) 4) Unlever each beta, based on each company s leverage ratio, using one leveraging formula (e.g., Harris-Pringle hypothesis) and average the unlevered betas to get a proxy for the beta assets for your company / project 5) Relever the beta assets, based on the optimal leverage ratio of your company / project, using one leveraging formula** * The time period chosen for the computation of the beta should be a long enough period over which the company (activity) stayed relatively stable (sound judgment is necessary) ** E.g., Harris-Pringle hypothesis

Impact of leverage: summary of the implications of three common hypotheses 1) MM 58 = Modigliani-Miller in perfect market (no tax) 2) MM in perfect market with corporate taxes 3) Harris-Pringle (HP) in perfect market with corporate taxes Hypotheses: - Debt - Tax shield discount rate (none) (n/a) Perpetual debt r D Constant leverage ratio r A PVTS 0 T C X D. t D r T t 1 (1 r ) t D C A Formulas for: - Relevering - Unlevering WACC 49 (assuming β D = 0) D. E A ( A D) E E D. A E D V V WACC = r A (independent of financial structure) D. E A ( A D)(1 TC ) E E D. A E D V V U Subject to change each year (whenever the leverage ratio changes)! U D. E A ( A D) E E D. A E D V V E E E A A A D D D 1 1 (1 TC ) 1 E E E WACC = r A r A T C D/V WACC = r A r D T C D/V L Constant (as per hypothesis the leverage ratio is constant) L

Interpretation of the discount rate Reminder and deepening Opportunity cost of capital The opportunity cost of capital is the expected return of an equivalent investment on the financial markets Which return can we expect from an investment of the same risk Which risk exactly are we talking about? Knowing it is easy for an investor to diversify, the relevant risk for the investor is the systematic risk (i.e., non diversifiable) Interpretation of a zero-npv investment? Interpretation of the IRR?

* Treasury bills (or T-bills ) are short-term obligations (with a term of 1 year of less, usually zero coupon); notes are medium-term (duration between 2 and 10 years); bonds are long-term obligations (over 10 years) ** Not appropriate when the credit risk (risk of default) is sizeable, as cost of debt is an expected yield to maturity (vs. a promised yield to maturity) *** Using market values of equity (E) and debt (D) = market value of Debt; company value V = D + E Conclusion on the main discount rates Definition and estimation method in practice Discount rate Notation Possible proxies / computation Beta Risk-free rate r f US government bond YTM (T-bill / note / bond*) 0 Cost of debt r D Average YTM on corporate debt** YTM of corporate bonds of similar rating and similar maturity (imperfect proxy) Cost of equity r E Required return on equity of listed companies with same activity and same leverage (estimate the β and use the CAPM) Relevered cost of assets (see next) β D β E (sometimes also noted β L ) (After-tax) Weighted Average Cost of Capital E D WACC re rd (1 TC ) V V WACC *** β WACC Cost of equity of an allequity firm (or, cost of assets) r A Required return on equity of listed companies with same activity and no leverage (estimate the β and use the CAPM) Unlevered cost of equity (see next) β A (sometimes also noted β U )

53 With leverage, company value differs from equity value! Company value t1 FCF (1 WACC) t t Company value t1 FCF t (1 r ) A t PV (financing) Company value ED E V D

How to treat cash in valuation? Excess (or, idle) cash (i.e., cash not necessary to the business) can be treated as: 1) A value to be deducted from the debt in this case, company valuation is done using the classical methods, taking into account net debt instead of financial debt (net debt = financial debt excess cash) or 2) A value to be added to the enterprise value in this case, company valuation is done ignoring excess cash (i.e., assuming that excess case is fully distributed), and excess cash is added to the enterprise value In both cases, excess cash increases the market value of equity (indeed, the shareholder can decide to pay off the excess cash, e.g., through a dividend or capital reduction) * Stricto sensu, Enterprise Value does not include idle or excess cash

What price should I pay to buy a company? Value is not price! If the acquirer pays the full value to buy a company, (s)he does not create any value (NPV = 0)! Example: M&A (Merger & Acquisition) Typically, two valuations of the target company are done Valuation of the stand-alone company Valuation of the synergies Where should the transaction price be? (ZOPA = Zone of Possible Agreement ) Last tips: Perform sensitivity analyses on the key parameters influencing the value ("key value drivers ) Always double check your estimates using alternative methods

Conclusion on company valuation methods using discounted cash flows

Company value, relevant CF and discount rates with taxes 2 1 3 V L = V U + PVTS = E + D 2 WACC method: discount FCF (all-equity firm) with the WACC FCF WACC FCF r A Value of all-equity firm (V U ) Value of equity (E) CFE r E TS r TS * Value of tax shield (PVTS) Value of debt (D) CFD r D 1 APV method: compute V U and PVTS, then make the sum of the parts Reminder: all values are in market values (not book values!) 57 * MM hypothesis (debt = perpetuity): r TS = r D Harris-Pringle hypothesis (D/E = constant): r TS = r A

* Assuming r TS = r A ** Ruback, 2000 Discount relevant cash flows with the relevant discount rate If you discount the following cash flows using as a discount rate (associated with its Beta), you obtain as a present value FCF Cost of assets (cost of equity of the allequity firm): r A β A = β U V U FCF Weighted Average Cost of Capital: WACC = r E * E/V + r D * (1 T C ) * D/V β WACC V L Interest Tax Shield (TS) Discount rate of the tax shield: r TS β TS PV(TS) CFE Cost of equity: r E β E = β L E CFD Cost of debt: r D β D D CCF (Capital Cash Flows)** Cost of assets (cost of equity of the allequity firm): r A β A = β U V L * There are several ways to perform company valuation If you make consistent hypotheses, all methods should all lead to the same value (principle of the sum of the parts) The choice of the method depends on the valuation situation faced

Common methods for company valuation (1/2) 1 2 The APV (Adjusted Present Value) method 1) Project FCF of the all-equity firm 2) Discount them using r A 3) Result = V U 4) Value the PV(TS) using explicit hypotheses* V L = V U + PV(TS) 5) To obtain E, deduct D from V L (+ add idle cash, if any) The WACC method 1) Project FCF of the all-equity firm 2) Discount them using the WACC** 3) Result = V L 4) To obtain E, deduct D from V L (+ add idle cash, if any) * See, e.g., Myers (1974) or Luehrman (1997), who assume that the level of debt, and hence also the tax shields, are a fixed dollar amount, and therefore discount the interest tax shields at the cost of debt ** This method is particularly adapted to the cases where a constant leverage ratio is assumed and is realistic (otherwise, the WACC needs to be adapted each time the leverage ratio changes); it does however yield only a single global value (assets + financing)

Common methods for company valuation (2/2) 3 4 The Cash Flow To Equity (CFE) method 1) Project CFE (CF to Equity holders of the levered firm) 2) Discount them using r E 3) (add idle cash, if any) 4) Result = E 5) To obtain V L, add D to E (+ deduct idle cash, if any) The Capital Cash Flow (CCF) method* (Ruback, 2000**) 1) Project the Capital Cash Flow (CCF) = CFE (CF to Equity holders of the levered firm) + interest on debt 2) Discount them using the cost of capital of the all-equity firm (r A ) 3) Result = V L 4) To obtain E, deduct D from V L (+ add idle cash, if any) * Sometimes also called the Compressed APV method (Myers) ** The Capital Cash Flow method (Ruback, 2000) assumes r TS = r A ; which implies nice properties, a.o., and is equivalency with the WACC method using the corresponding un- / releveraging methods E D ra re rd pre taxwacc V V

Practice: wrap-up case

62 CASE (reading): Sampa Video

Case questions "Sampa Video" 1. What is the value of the project assuming the firm was entirely equity financed? What are the annual projected Free Cash Flows (FCF)? What discount rate is appropriate? 2. Value the project using the Adjusted Present Value (APV) approach assuming the firm raises $750 thousand of debt to fund the project and keeps the level of debt constant in perpetuity. 3. Value the project using the Weighted Average Cost of Capital (WACC) approach assuming the firm maintains a constant 25% debt-to-market value ratio in perpetuity. 4. What are the end-of-year debt balances implied by the 25% target debt-to-value ratio? 5. Using the debt balances from question 4, use the Capital Cash Flow (CCF) approach to value the project. 6. How do the values from the APV, WACC, and CCF approaches compare? How do the assumptions about financial policy differ across the three approaches? 7. Given the assumptions behind APV, WACC and CCF, when is one method more appropriate or easier to implement than the others?

64 CASE (solution): Sampa Video

B) Valuation methods through multiples

Multiples valuation (1/3) Method of comparables, consisting in estimating the value of the firm based on known values of other, comparable firms or investments ( benchmarks ), such as the market value of listed companies, or transaction prices (e.g., the buying price of a company) Valuation multiple: ratio of the value (oftentimes: company or equity value) to some measure of a comparable firm Two types of multiples Trading multiples: based on comparable listed companies Transaction multiples: based on comparable transactions

Multiples valuation (2/3) Commonly used ratios: Enterprise value multiples EV / EBITDA EV / EBIT EV / CF OP EV / Sales Industry-specific ratios (e.g., value per subscriber in telecom) Equity multiples P/E = Price-Earnings Ratio (the forward P/E, based on expected earnings for the year ahead, is generally preferred to the trailing P/E, based on last realized earnings) P/B = Price to book value of equity (e.g., for firms with substantial tangible assets) P / CF = Price to cash flow Div / P = Dividend yield

Multiples valuation (3/3) Advantages: Simple Based on actual prices of real firms or transactions Disadvantages: Differences between the company to value and comparable firms can be significant and not accounted for in the multiples Multiples do not enable to incorporate specific information about the firm to value There can be a wide dispersion of multiples values across comparables (even within an industry) Accounting conventions, or exceptional items, can influence the value of the multiples (+ in some cases multiples are impossible to compute, e.g., what if the EBITDA is negative?) The multiples yield a valuation relative to a comparison set, but do not help to determine if an entire industry is under- / overvalued In the case of several divisions within a company: value the divisions separately with appropriate multiples for each!

Financial structure: Making a financing decision (financial structure decision)

What if we add taxes and bankruptcy costs? Trade-off theory Firm market value PV(costs of financial distress) PV(Tax Shields) Value of all-equity firm Leverage ratio

Finance theory and capital management Why bother to worry about financing or any risk management? Modigliani-Miller (1958) Miller (2001): if financing does matter, it must be because of one or several market imperfections, such as: Tax effects Transaction costs Costs of financial distress: potential bankruptcy and agency costs (cost of inefficiencies; effects on future investment decisions)

Still a puzzle If PV(Tax Shield) > 0, why not 100% debt? Counterbalancing forces: costs of financial distress 1. Cost of potential bankruptcy As debt increases, probability of financial problems increases 2. Agency costs Conflicts of interest between shareholders and debtholders

Gambling and agency costs Agency relationship: contract whereby the principal engage the agent to carry out work on behalf of him delegation of decision-making powers to the agent (Jensen and Meckling, 1976) Example 1: manager (e.g., CEO) = agent when different from the shareholder Example 2: shareholder = agent when he borrows money Moral hazard: the parties to the agreement engages in actions that the other party cannot observe, even though these actions influence the benefits accrued to both parties Thus conflicts of interests may arise, leading to a poor allocation of resources. This inefficiency is subsumed under the concept of agency costs (increase when financial distress is incurred)

Costs of financial distress Increasing debt increasing risk and increasing likelihood of distress, which has costs associated with it, such as: Costs of potential bankruptcy Agency costs associated with potential conflict shareholders-bondholders 1. Costs associated with the inability to operate efficiently, examples: a. Incentive to take large risks b. Incentive toward underinvestment 2. Other costs, example: a. Milking the property b. Costs of bond provisions / compliance

Example assumptions: D=150 Discount rate = 0% Agency costs 1. Incentive to take large risks (1/3) Low-risk project (market value) V = E + D Recession (p=0,5) 100 = 0 + 100 Boom (p=0,5) 200 = 50 + 150 Value 150 = 25 + 125

Example assumptions: D=150 Discount rate = 0% Agency costs 1. Incentive to take large risks (2/3) High-risk project (market value) V = E + D Recession (p=0,5) 20 = 0 + 20 Boom (p=0,5) 270 = 120 + 150 Value 145 = 60 + 85

Agency costs 1. Incentive to take large risks (3/3) Low-risk project: V=150 E=25 D=125 High-risk project: V=145 E=60 D=85 The low-risk project has a higher value than the high-risk project Shareholders choice? Shareholders expropriate value from the bondholders Other similar issues: Underinvestment Milking properties

Agency costs 2. Incentive toward underinvestment (1/3) Example assumptions: D=400 Discount rate = 0% Low-risk project (market value) V = E + D Recession (p=0,5) 240 = 0 + 240 Boom (p=0,5) 500 = 100 + 400 Value 370 = 50 + 320

Agency costs 2. Incentive toward underinvestment (2/3) Example assumptions: D=400 Discount rate = 0% Firm with new project: New shares issued 100 Euro V = E + D Recession (p=0,5) 410 = 10 + 400 Boom (p=0,5) 670 = 270 + 400 Value 540 = 140 + 400

Agency costs 2. Incentive toward underinvestment (3/3) 1) No project: V = 370 E = 50 D = 320 2) Project: V = 540 E = 140 D = 400 What will be the choice of shareholders, knowing they have to invest 100 for the new project? NPV = 170 E increases by 90 but shareholders invested 100 Positive NPV project could not be undertaken because of conflicts of interests

Agency costs 3. Milking the property When D is very risky, shareholders may: pay out extra dividends (no investments) new debt to pay extra dividends Protective covenants when debt is issued

Ways to mitigate agency costs Negative covenants prohibiting actions that the company may take Limitation of payout Firm may not pledge any of its assets to othe lender No sell or lease its major assets without approval No issue of additional debt Positive covenants specifies an action that a company agrees Maintain working capital at a minimum level Periodical reporting

Conclusion with taxes and bankruptcy costs? Trade-off theory Firm market value PV(costs of financial distress) PV(Tax Shields) Value of all-equity firm Optimal Debt ratio = ratio of debt which maximizes the company value Leverage ratio

The Belgian system of the notional interests Introduction and discussion

Notional interests: a Belgian specificity Description What? Tax break based on fictitious interests payments on corrected share capital, applicable to the corporate tax (Belgian and non-resident) The notional interest rate is based on the 10y rate for Belgian government bonds (OLO) and determined annually A higher rate is applicable to SMEs Rate: In revenue year 2012: 3% (3.5% for SMEs) In revenue year 2013: 2,74% (3,24% for SMEs) In revenue year 2014: 2,63% (3,13% for SMEs) In revenue year 2015: 1,63% (2,13% for SMEs) In revenue year 2016: 1,131% (1,631% for SMEs) In revenue year 2017: 0,237% (0,737% for SMEs) Aim: To compensate the tax shield of leverage (due to the deduction of interest payments from the corporate tax base), and to reestablish funding neutrality More details on the legislation: see SPF Finances FOD Financiën Website: http://finance.belgium.be/en/ondernemingen/vennootschapsbelasting/belastingvoordelen/notionele_interestaftrek Brochure: http://minfin.fgov.be/portail2/belinvest/downloads/fr/publications/bro_notional_interest.pdf Effect on the WACC?

Notional interests: Corrected share capital The corrected is obtained, by deducting from the accounting share capital, the following items: 1) Own shares (account 50) 2) Financial fixed assets (account 28) qualifying as participations and other shares 3) Shares issued by investment companies (when the income fulfils the conditions of the Belgian participation exemption: RDT ) 4) Net equity assigned to foreign permanent establishments or foreign real estate, when there is a double-taxation treaty with in Belgium (hence, tax exempt in Belgium) 5) Private tangible fixed assets (e.g., luxury car, jewelry, art work) 6) Tangible fixed assets considered as investment not acquired to produce a regular income 7) Real estate which is used by the directors of the company or their relatives 8) Tax-free revaluation gains (account 12) and capital subsidies (account 15)

Notional interests: Example Example: A company is 100% financed through equity and has a total capital of 10,000. The company s ROE before tax is 5%. Profit & Losses Without notional interest deduction With notional interest deduction Before tax profits 500 500 Notional interests (in 2012 for non SMEs: i = 3 %) / -300 Tax base 500 200 Corporate tax (t = 33.99 %) 169.95 67.98 Real corporate tax rate 33.99 % 13.6 %

Notional interest: impact on the corporate tax rate Real corporate tax rate depends on ROE and "corrected" share capital ROE Real corporate tax rate 3 % 0 % 4 % 8.5 % 5 % 13.6 % 8 % 21.2 %

Notional interests: financial structure neutrality Alternatives to achieve funding neutrality Not allowing deduction of interest payments Rationale: interest payments are part of the cost of capital, like dividend payments and should be seen as an allocation of profit rather than a deductible cost Removing corporate taxes Rationale: corporate taxes (combined to income taxes) are a form of double taxation

CONCLUSIONS

Value measurement The Company Value is a Present Value! PV t CF t (1 r) 1 Cash flow analysis t Risk Return analysis Time value Discounting techniques Terminal value

93 (Levered) Company valuation Company value t1 FCF (1 WACC) t t Company value t1 FCF t (1 r ) A t PV (financing) Company value ED

Key takeaways from the course 1. Accounting is a valuable source of information and can help making management decisions, but in finance and for investment decisions: CASH IS KING! 2. Never again compare cash flows (CFs) at different points in time: capitalize or discount! 3. Only relevant CFs should be considered in your investment decision calculations 4. The market value of a company is a PV of future expected free cash flows (FCFs) 5. Discount the future expected free cash flows at a rate equal to the opportunity cost of capital 6. If a company has several divisions, value them separately (they may not have the same risks, hence the discount rates should be different!)

Thank you for your attention! Prof. Laurent Gheeraert Laurent.Gheeraert@ulb.ac.be

APPENDIX

Unlevering an estimated beta Remember that betas are estimated using stock price, yielding beta equity Beta equity depends on both: Activity Leverage In order to get rid of the leverage effect, we need to compute beta assets (which only depends on company activity) An unlevering formula* can be used to estimate beta assets where: β A, β E, and β D are the betas of, respectively, assets, equity and debt E A E D VL V L, E and D are the market values of, respectively, the levered company, equity and debt Once a reliable estimate of beta assets is obtained, if relevant the beta assets can be D relevered to a beta equity based on the same formula E A ( A D) E * This formula assumes either perfect capital markets (Modigliani-Miller), or perfect markets with corporate tax and constant leverage ratio (Harris- Pringle). Alternative formulas, assuming perfect markets with corporate tax and perpetual debt (Modigliani-Miller with debt), are sometimes also E D D used. In this case: unlevering formula: A E D ; relevering formula: ( )(1 ) (with V U = unlevered E A A D TC company value; T = marginal corporate tax rate). VU VU E D V L

98 * Identify companies with a similar activity, estimate the β E and use the CAPM 2 Summary MM II (no tax) MM II assume perfect capital markets (no taxes) r Expected return on equity is an increasing function of leverage The WACC is independent from leverage 3 1 D/E r E are observable on the market for different levels of leverage * r D is assumed to be known and fixed (depends on the borrowing risk) r A = a "given by nature", determined by the activity of the company and revealed through r E (constant) UN- & RE-LEVERING FORMULA: ( ) E A A D E D A E D V V D E r E Additional cost of equity due to leverage WACC = r A UNLEVER r D 1 2 RELEVER 2 3 E D ra re rd V V D re ra ( ra rd ) E r D < WACC r A r E with (by definition of the WACC): E D WACC re rd V V ra WACC WACC r A

2 99 Summary MM with corporate taxes To analyze the tax impact of debt, MM assume capital markets which are perfect, with the sole exception of corporate taxes; in such a world: Expected return on equity is an increasing function of leverage The WACC is a decreasing function of leverage They assume a perpetual debt, hence r TS = r D and V U = V T C D r 3 D/E r E are observable on the market for different levels of leverage * r D is assumed to be known and fixed (depends on the borrowing risk) r A = a "given by nature", determined by the activity of the company and revealed through r E (constant) UN- & RE-LEVERING FORMULA: D E A ( A D) (1 TC ) E E D V A E D VU U * Identify companies with a similar activity, estimate the β E and use the CAPM r E 1 Additional cost of equity due to leverage UNLEVER WACC<r A r D r A 1 2 RELEVER 2 3 r D < WACC r A r E with (by definition of the WACC): E D WACC re rd (1 TC ) V V E D r A r E rd (1 TC ) V U VU D re ra ( ra rd ) (1 TC ) E WACC ra D 1TC V D WACC ra ra TC V

2 100 Summary Harris Pringle Harris Pringle still assume that capital markets which are perfect, with the sole exception of corporate taxes; in such a world: Expected return on equity is an increasing function of leverage The WACC is a decreasing function of leverage They assume a constant debt to equity ratio, hence r TS = r A and V U = V T C D r D /r A r 3 1 D/E r E are observable on the market for different levels of leverage * r D is assumed to be known and fixed (depends on the borrowing risk) r A = a "given by nature", determined by the activity of the company and revealed through r E (constant) UN- & RE-LEVERING FORMULA: ( ) E A A D E D V A E D VL L D E * Identify companies with a similar activity, estimate the β E and use the CAPM r E Additional cost of equity due to leverage UNLEVER WACC<r A r D r A 1 2 RELEVER 2 3 r D < WACC r A r E with (by definition of the WACC): E D WACC re rd (1 TC ) V V E D ra re rd V V D re ra ( ra rd ) E D ra WACC rd TC V D WACC ra rd TC V