Week 1: Intro

- Bad deal: overpaying, Price>NPV

- Market Efficiency: market prices give the best estimate of a project’s fair value
- Value comes from superior tech, info, access to cheaper inputs/resources
- M&M assumptions:

1. No transaction costs
2. No taxes
3. Firms in financial distress can be reorg without cost
4. Firms and investors can borrow/lend at the same rate
5. No information asymmetry
6. No agency problems
7. Investment decisions are independent of financing

- No taxes: The value of the firm is independent of its capital structure (leverage). Tax shield!
- Value creation in mergers: Target SE: 20-30% returns and the combined entity: 8%; acquirer
suffers -1% (acquirer pays the premium. You overpay for the target plus synergy value
- CAPM: asset returns depend on beta
- Max stakeholder value not only SE. There’s difficulty of gauging non-financial commitments with
the same accuracy and consistency as financial measures
- Corporate Social Responsibility caveat: it can allow executives to set their own criteria for
success and let them off the hook for poor financial performance
- ESG: overhyped. There are costs associated with being ‘good’ and they should not be ignored;
might not work for mass-market products, only for niche one targeting middle-upper class
- Key finance ideas: TVM and NPV, CAPM, EMH, M&M, BSM

Week 2: Cost of Capital

Cost of Capital paper

- “Best practice” cost of capital estimation: WACC is widely used but disagreements over the
CAPM implementation
- Ideally: weights should be based on market value mixes of D and E; after-tax cost of debt based
on statutory tax rates; using CAPM to get the cost of equity; using betas with long interval of
equity returns; matching the tenor of the risk-free rate with the CFs’; using MRP of about 6%;
annual testing of WACC, monitor financial markets continuously; WACC should be adjusted for
risk
- RFR, beta, equity market risk premium, and risk adjustments are major points of disagreements
- Ambiguity: few % point difference can result in billion-dollar difference
- Cost of capital: benchmark to compare to other investment opportunities
- Which default-free rate to use: T-bills or bonds (yield curve is generally flat after 10-year mark).
10-year Treasury. While the T-bills truly reflect the risk-free nature since they suffer less from
material loss in value due to interest rate movements, 10-year Treasuries reflect more closely
default-free holding period returns available on long lived investments and thus more closely
 mirror the types of investments made by companies (maturity to match the length of the
project/investment horizon)
- Ideally, want a forward-looking beta. Can run a regression model, beta is a slope coefficient of
the market model of returns (60-month covariance between the stock and the market)
- Another way: weighted average of business segment betas, segment betas are estimated using
pure-play firm betas of comparable companies)
- Risk adjustments: CFs or the discount rate?

Cost of Capital/Opportunity cost of capital

- Discount Rate depends on timing and risk but not who is the provider/source of capital
- Discount rate/cost of capital is project-specific
- WACC v unlevered cost of capital
- APV: using ru, when the leverage ratio changes over the life of the project
- Ru is fully determined by the physical characteristics of the asset
- WACC depends on capital structure
- When debt is issued at par, book value is close to market value; interest rate changes or credit
risk changes (market value could go up or down then)

M&M

- Firm’s value is independent of its capital structure. Firm’s value depends only on the CFs
generated by the operating assets
- Proposition 1: value of the unlevered firm=value of the levered firm
- Direct consequence of Proposition 1: cost of capital is also independent of leverage
(WACC=Ru); EBIT(1-t)/Ru
- Proposition 2: Re goes up linearly with D/E ratio (because equity becomes riskier; creditors get
the safest part of the CFs; equity absorbs all the residual risk; not because of default)
- Re=Ru + D/E(Ru-Rd)(1-t)
- Re determinants: business risk (beta) and financial risk (D/E)
- With low enough discount rates, some negative NPV projects can turn into positive NPV
projects. Alternatively, investing in other assets is no longer attractive as the returns are low
- Relaxing assumptions: incorporating taxes and debt tax shield (interest is tax deductible)
- Value of the levered firm is the value of the unlevered firm plus the value of PV(TS)
- Debt scenarios: permanent (same D) or constant leverage (same D/V) aka ME model
- Relaxing assumptions: incorporating taxes and debt tax shield (interest is tax deductible)
- WACC=E/(D+E)*rE + D/(D+E)*(1-t)rD 

Week 3: International Valuation

Discount Rates in Emerging Markets: Four Models and An Application

- Valuing investment opportunities: NPV, IRR, Real Options

- EM: uncertainty in political, economic climates, stability of institutions, systems
- How to account for the additional risk? General practice is to increase the discount rate
- Currently, no standard model for EM
- Variation of CAPM: R = Rf + MRP·SR + A; All four models share Rf and MR, SR and A differ
 - The Lessard Approach: SR=βp ·βc, A=0
- The Godfrey-Espinosa Approach: SR= (0.60)·(σc /σW) and A=the yield spread of a country
relative to the U.S. (YSc ); R = (Rf +YSc ) + MRP·{(0.60)·(σc /σw)}
- GS: SR = (1–ρSB)·(σc /σW); R = (Rf +YSc ) + MRP·{(1–ρSB)·(σc /σW)}; captures the risk reflected
by both the stock market and the bond market without double counting sources of risk
- The SalomonSmithBarney Approach: accounting for the risk of investing in a specific industry
(βp), for the risk of investing in a specific country, and for some characteristics of both the
project and the company considering the investment
- A = {(γ1 +γ2 +γ3 )/30}·YSc; adjusting this political risk premium by three factors: A company’s
access to capital markets, the susceptibility of the investment to political risk, and the financial
importance of the project for the company; R = Rf + MRP· f βp + {(γ1 +γ2 +γ3 )/30}·YS

SSB paper

- With the globalization of most product and service markets, international capital allocation has
gained in importance in all industries
- Establish a foothold in emerging markets to generate growth rates that would lead to attractive
valuations and enhanced shareholder value.
- Developed Markets: discount rate= industry hurdle rate, adjusted for the unique financial
leverage of the investment; Cost of equity = long-term risk-free rate + leverage adjusted beta
(the industry risk measure) * the overall equity market risk premium
- EM: adjust CFs or the discount rate t account for political risk premium
- When adjusting CFs, the discount rate will incorporate business and financial risk but not
political to avoid double-counting
- How to price political risk: sovereign bond spreads, S&P country sovereign debt ratings, country
ratings from Institutional Investor and Euromoney magazines, and macroeconomic variables
- Consider the following: (1) the investment’s susceptibility to political risk, (2) the investor’s
access to global capital markets (and correspondingly the diversification of its investor base),
and (3) the relative size of the investment
- Segmented v Integrated CAPM
- Against using local betas: small equity markets are usually dominated by a handful of large
corps, screws the correlation; capital is raised from worldwide investors at globally competitive
rates of return; local equity markets have limited sectoral representation
- Adjusting CFs makes sense because that’s where the diversifiable risk adjustments are made;
discount rate should reflect non-diversifiable risks
- Minority stakes, start with a small “toehold”

Voiceover for the summary slide

 Why should companies care about international capital allocation in the first place? To
remain competitive, capture greater market share and generate attractive return rates
by unlocking new and high-growth markets which all enhance shareholder value and
attract new investoes&capital

 However, many companies are scaling down their EM investments and are struggling to
correctly price them
  There is currently no consensus on the ‘standard pricing model” amongst the academic
world or industry practitioners

 What makes it so challenging to evaluate investment opportunities in developing

countries? Often, unstable Economic and political con

 Frequently observed Unstable economic and political conditions in emerging markets

introduce a challenge in assigning project betas and country or industry risk premiums

 Currently, we have 4 models to estimate the cost of equity in Ems which are all a version
of the standard CAPM. starting with the Lessard model which the most elegant and
simple one to and ending with the most robust SalomonSmithBarney model which

Week 4: Multiples

- Multiples Valuation is rooted in the concept of LOP: identical assets must have identical prices
- Estimate the value of the subject company by observing prices paid for similar companies
relative to some benchmark
- The accuracy of the result depends on the skill and diligence of the practitioner and the quality
and availability of data
- Multiples is a “market approach” in contrast to DCF which is considered an “income approach”
- Trading multiples or transaction multiples

The process: 1) search and select, 2) adjust and compute, and 3) apply and conclude

1) Finding the right comps: Comparability is established by matching key business attributes of the
subject with those of another group of firms

- Requires thorough understanding of the business

- Unbiased selection process: begin by being inclusive and then progressively exclude; document
- Trade-off between degree of comparability and sample size

2) Adjust and Compute

- EV=market value of invested capital (MVIC)

- Normalize data (LIFO v FIFO), adjust for nonrecurring items (discontinued operations, extraordinary
gains or losses, unusual taxes or shields); adjust for nonoperating items (excess cash)

- Backward-looking (trailing)/LTM or forward-looking operating metrics

- Using equal-weighted (median or mean) or value-weighted

3) apply and conclude

- Adjust for excess cash, control premium, illiquidity

Caveats: sample size, unreliable market data, leverage, seasonality/cyclicality

McKinsey article re multiples

 - Companies in the same industry, can have different expected growth rates, returns on invested
capital (ROIC), and capital structures
- Even when companies with identical prospects are compared, the P/E ratio itself is subject to
problems, since net income commingles operating and nonoperating items
- To choose the right companies, you have to match those with similar expectations for growth
and ROIC
- Growth alone doesn’t drive P/E, has to be combined with a healthy ROIC
- Four basic principles can help companies apply multiples properly: the use of peers with similar
ROIC and growth projections, forward-looking multiples, EV multiples, as well as the adjustment
of EV multiples for nonoperating items
- P/E flaws: systematically affected by capital structure (P/E ratios rise with leverage);P/E ratio is
based on earnings, which include many nonoperating items, such as restructuring charges and
write-offs

The most common adjustments

- Excess cash and other nonoperating assets. Since EBITA excludes interest income from excess
cash, the enterprise value shouldn’t include excess cash. Nonoperating assets must be evaluated
separately.
- Operating leases. Companies with significant operating leases have an artificially low enterprise
value (because the value of lease-based debt is ignored) and an artificially low EBITA (because
rental expenses include interest costs). Although both affect the ratio in the same direction, they
are not of the same magnitude. To calculate an enterprise-value multiple, add the value of
leased assets to the market value of debt and equity. Add the implied interest expense to EBITA.
- Employee stock options. To determine the enterprise value, add the present value of all
employee grants currently outstanding. Since the EBITAs of companies that don’t expense stock
options are artificially high, subtract new employee option grants (as reported in the footnotes
of the company’s annual report) from EBITA.
- Pensions. To determine the enterprise value, add the present value of pension liabilities. To
remove the nonoperating gains and losses related to pension plan assets, start with EBITA, add
the pension interest expense, deduct the recognized returns on plan assets, and adjust for any
accounting changes resulting from changed assumptions (as indicated in the footnotes of the
company’s annual report).

McKinsey article: All P/Es are not created equal

- Growth rates and multiples don’t move in lockstep

IRR article

- Multiple roots issue; ranking issues (crossover point of NPV and IRR; conflict when the NPV
hurdle rate is to the left of the crossover point); scaling issue in risk&return decisions. Just use
NPV

Video lecture notes

- Real Options: accounting for flexibility in decision-making

 - Have the right but not the obligation if the market conditions are not favourable just like with
the financial options (calls/puts)
- Such flexibility is especially important in natural resources

Multiples

- Select a set of publicly traded comparable comps, scale the value by some measure of size
(assets or CFs). Some size characteristic that is proportional to value; divide the value by this size
measure, get the ratio that is similar across the firms; find an average and compute the subject
firm’s EV
- Consistency is key
- Start with the same industry and then apply filters
- EV-based multiples: EV/FCF – difficult to compute FCF, easier to get EBITDA; however, if it’s
negative, better to use Sales
- EQ-based ratios: P/E=market cap/NI; sensitive to capital structure

DCF v Comps

- DCF is your view of the company v comps is the market views of the entire industry or sector.
Relative valuation methodology: it’s right when the market is right; supplemental to DCF
- Criteria: geography, industry, “financial” size (projected revenue); ideally 5-10 comps. Want
them to have the same discount rates. Comp Value=CF/(Discount rate-g); want CF and Discount
Rate to be the same, so that differences in multiples can be explained by g

Week 5: DCF

- EV=D+EQ
- Net D=LT D + D in CL + Cap Leases – Excess Cash
- 5–10-year CF projections, until CF growth stabilizes/reaches steady-state and TV
- We use unlevered CFs
- Estimating TV: 3 methods
- Salvage value, multiples, and perpetuity (constant growth rate)
- How to incorporate tax shields? 2 approaches: adjust CF (APV) or the discount rate (WACC)
- Can’t use WACC when the leverage changing

APV article

APV v WACC

- APV works when WACC doesn’t because of the less restrictive assumptions; less prone to
serious errors; managerial insight into where the value comes from

Week 6: Financial Distress

- Hertz article: planning to issue shares instead of senior debt loan

- Such a sale is highly unusual for a company going through Chapter 11 bankruptcy proceedings
since common shareholders, who are last in line when assets are allocated during court
proceedings, may be left with worthless stock.
- Taking advantage of the opportunity created by the retail investors in the market
 - Court approved 500mln worth of shares issuance
- Equity is costless and no restrictive liens/covenants involved
- The cruder empirical measure of the cost of equity is the reciprocal of the price-to-earnings
ratio: the earnings yield
- The higher the stock price relative to earnings, the lower the earnings yield and the cost of
equity
- Hertz wanted to use the sale to leverage interest in its stock, which had seen volatile trading in
the wake of its bankruptcy filing. The company felt it was a better option than obtaining so-
called debtor-in-possession financing. DIP financing is a loan that the company would need to
pay back. However, if it were to sell stock, the funds it raises would not need to be reimbursed.
- What happened: $6 billion revised proposal from Knighthead Capital Management LLC, Certares
Opportunities LLC and Apollo Capital Management to provide the equity capital needed to fund
its reorganization plan.
- Hertz’s chapter 11 plan will be funded using direct stock investments from the group of $2.781
billion, the issuance of $1.5 billion of new preferred stock to Apollo, and a fully backstopped
rights offering to the company’s existing shareholders to purchase $1.635 billion of additional
common stock
- Symptoms of distress:

Liquidity crisis/cash shortage/equity insolvency (don’t use this term): could be nothing serious, all the
assets are LT, just a mismatch of maturities between A and L

Insolvency/B/S insolvency: serious, TA<TL, negative book equity: firm accumulates losses over several
years or write downs

- Financial distress: can’t pay the creditors, the result of the financing choices/borrowing
- Economic distress: business is going downhill; market conditions, industry-wide issues, firm
issues, investment choices, nothing to do with borrowing
- Default (disrupting CF pattern): failure to meet contractual obligations like missing a payment
- Technical default: covenant breach
- Workout: renegotiating out of court (bank v public, the latter is difficult, usually done via bond
exchange offer)
- Bankruptcy (Chapter 11): more serious; formal reorg; may or may not result in liquidation; very
expensive and long; pre-packaged deals
- Liquidation (Chapter 7): selling the assets; APR
- Going concern: firm still operates
- Distress is a very loose term
- Restructuring A or L

Bond default 3 ways according to rating agencies (D-rating downgrade): missing payments, bankruptcy
filing, distressed bond exchange

- Debt overhang: wealth transfer from shareholders to the creditors; SE are not willing to provide
funds
- Raising senior debt could be a solution in financial distress
- Avoiding the hold out issue: offer more senior debt, cash or ST
- How to deal with existing covenants? Exit consent; don’t need unanimous agreement
Week 7: Optimal capital structure

- Perfect world: M&M

- Market leverage ratio: D/D+E
- Some firms have zero debt. Why? Aversion to borrowing or not getting the full benefits of debt
- Capital intensive companies have higher levels of debt
- Benchmark leverage (non-fin firms): 30%
- Sometimes it’s not the firm’s choice
- 3 ways to compare leverage ratios: across different industries; firms within the same industry,
time series analysis of the same firm
- M&M: capital structure decisions don’t affect the firm’s value
- Fallacies: max debt to lower WACC (too much debt makes equity more expensive); EPS goes up
but not the firm’s value (riskier)
- Pecking order theory: asking a different question: how do we finance; focus is on incremental
financing decisions not on leverage ratio

Week 8: Project Finance

- Org form and fin structure choices

- Sponsors create legally distinct entities to develop, manage, and finance the project
- Non-recourse nature: repayment based on project’s cash flows rather than on the assets or
sponsors’ creditworthiness
- Misconceptions about why project finance: isolate project risk, increase equity returns, preserve
debt capacity, mitigate sovereign risk

The decision to use project finance involves an explicit choice of organizational form as well as financial
structure. With project finance, sponsoring firms create legally distinct entities to develop, manage, and
finance the project. These entities borrow on a limited or non-recourse basis, which means that loan
repayment depends on the project's cash flows rather than on the assets or general credit of the
sponsoring organizations. Despite the non-recourse nature of project borrowing, projects are highly
leveraged entities, with debt to total capitalization ratios averaging 60–70%. 

Petrozuata, a $2.4 billion oil field development project in Venezuela, is a recent example of the effective
use of project finance for several reasons. First, the analysis shows a typical setting where project
finance is likely to create value, that of a large-scale investment in Greenfield assets (in this case, wells,
pipelines, and upgrader) that can function as a stand-alone economic entity and support a high leverage
ratio. Given the nature of this investment, one can think of project finance as venture capital for fixed
assets, except that the investments are 100 to 1000 times larger and financed primarily with debt rather
than equity. 

Besides highlighting the types of assets appropriate for project finance, this article illustrates the
sizeable transactions costs associated with structuring a deal as well as the full range of benefits
accruing to project sponsors. The structure allows sponsors to capture tax benefits not otherwise
available, reduces information costs for creditors and other investors, and lowers the overall cost of
financial distress. The combination of high leverage, concentrated equity ownership, and direct control
in project finance also addresses a wide range of incentive problems that destroy value in diversified
companies. 
Analysis of the explicit contractual terms of the deal reveals a careful allocation of project risks in an
attempt to elicit optimal behavior by each of the participants. As illustrated in the Petrozuata case,
limiting completion and operating risks are important undertakings. But project finance is most valuable
as an instrument for managing sovereign risks. Indeed, the ability of project finance to limit sovereign
risk is the one feature that cannot be replicated under conventional corporate financing schemes. 

Valuation issues in PF

- Discount rate estimation: changing leverage and using multiple discount rates