19FV290320

CORPORATE FINANCE
19. Financing and Valuation

… Last year bearish commentators pointed out that lofty valuations mean optimistic
expectations for earnings need at the very least to be matched to avoid a major market
tantrum. Superficially, at least, it appears high hopes have been met. The FT reported last
week that with almost half the companies in the S&P 500 having reported second-quarter
earnings, 73 per cent have beaten analyst expectations, the highest level since FactSet began
tracking such data in late 2008. That will embolden optimists to point to a sustained US
earnings recovery that has unfolded since 2016. Don’t expect this to reassure those who have
sounded warnings about over exuberance in the US equity markets for years. They will note
that the S&P 500 is trading at a multiple of earnings near to the highest in its history, on both a
forward and cyclically adjusted basis. Based on the logic of mean reversion they argue a sharp
correction is likely. But as the debate rages on whether earnings will justify current valuations,
a critical point is lost: the accounting earnings which are used to construct the widely cited p/e
multiples that each camp employs fail to tell the whole story. There are reasons to be sceptical
about the apparent current earnings recovery, but not for the reasons that many bulls or bears
believe. Great attention is lavished on the earnings each company releases. Yet published
accounting earnings — used by the majority of the market to make their investment decisions
— can do a poor job of reflecting the true economic earnings power of a business.
Many highly respected investors instead argue that the returns a company makes on its
invested capital are the single most important factor dictating the performance of its shares.
As Charlie Munger of Berkshire Hathaway has put it, “Over the long term, it’s hard for a stock
to earn much better than the business which underlies it earns.” …
Miles Johnson, Financial Times, 31.07.2017
José A. de Azevedo Pereira 2019 Gestão Financeira II 2

19-1 Introduction
•Capital project adjustments to take into consideration

financing decisions (basic alternatives):
 Adjust the discount rate
• Modify to reflect capital structure, bankruptcy risk, other factors
 Adjust present value
• Start with a base case in which all equity financing is
assumed and afterwards adjust to take into consideration
financing decisions

19-1 Introduction
• Valuation Methods:
• The Discounted Cash-Flow Method
• Relative Valuation

19-1 Introduction
• Discounted cash flow methods:

• Non-adjusted cash flows:
• Valuation of the whole company (all stakeholders):
• Flow to firm, or WACC approach
• Equity valuation:
• Dividend discount model
• Flow to equity
• Adjusted cash flows:

• APV

19-1 Introduction
• Value of a financial asset is a function:

• Of the cash-flows it can generate;
• Of the expected timing of these cash flows;
• Of the risk associated with the realization of

these cash flows.

19-1 Introduction
 General valuation formulae:
Company Value =
1+
 Or,
FCF FCF FCF PV

PV = + +. . . + +
(1 + ) (1 + ) (1 + ) (1 + )
PV (free cash flows) PV (valor no horizonte)

19-1 After-tax weighted-average
cost of capital
•Tax-Adjusted Formula
D  E
WACC = rD × (1 − TC ) ×   +  rE × 
V   V

cost of capital
•Example: Sangria Corporation
• Firm has marginal tax rate of 35%. Cost of equity
is 12.4%, pretax cost of debt is 6%. Given book

and market-value balance sheets, what is tax-
adjusted WACC?
• Current stock price is $7.5 and the number of

shares outstanding is 100 million

cost of capital
•Example, Continued

19-1 after-tax weighted-average
cost of capital
• Debt ratio = (D/V) = 500/1,250 = .4, or 40%
• Equity ratio = (E/V) = 750/1,250 = .6, or 60%
WACC = .06 × (1 − .35)(.40) + .124(.60)

= .090
= 9 .0 %

cost of capital
• Sangria wants to invest in machine (Perpetual
Crusher) with cash flows of $1.731 million per

year pre-tax, in perpetuity. What is the value of
the machine, given initial investment of $12.5
million?

cost of capital
C1
NPV = C0 +
r−g
1.125
= −12.5 +
.09
=0

cost of capital

cost of capital
After tax interest = rD (1 − TC ) D = .06 × (1 − .35) × 5 = .195
Expected equity income = C − rD (1 − TC ) D = 1.125 − .195 = 0.93
expected equity income

Expected equity return = rE =
equity value
0.93
= = .124, or 12.4%
7.5

19-1 Crucial assumptions in the Sangria example
• The project’s business risks are the same as those of
Sangria’s other assets and remain so for the life of the
project;
• The project supports the same fraction of debt to value
as in Sangria’s overall capital structure, which remains
constant for the life of the project

19-1 Common mistakes using WACC
• Temptation to increase debt level without taking into
consideration the corresponding impact on the cost of
debt;
• WACC works properly only for projects that are carbon copies
of the firm;
• Any advantage from financing any project with more debt will
come from the existing assets;
• It is not possible to increase the debt ratio without increasing
financial risk for stockholders and the corresponding cost.

19-2 Valuing businesses
•Business value usually computed as discounted

value of future cash flows (FCF) to a valuation
horizon (H)
• Valuation horizon is also called terminal value

A. Valuing the whole business (WACC or FCFF):
FCF1 FCF2 FCFH PVH

PV = 1
+ 2
+ ... + H
+ H
(1 + r ) (1 + r ) (1 + r ) (1 + r )
PV (free cash flows) PV (horizon value)
In this case, r = WACC

Table 19.1b Free-cash-flow projections,
Rio corporation ($ Millions)
Latest year Forecast
Assumptions: 0 1 2 3 4 5 6 7
Sales growth (percent) 6,7 7 7 7 4 4 4 3
Costs (percent of sales) 75,5 74 74,5 74,5 75 75 75,5 76
Working capital (percent of sales) 13,27 13 13 13 13 13 13 13
Net fixed assets (percent of sales) 79,2 79 79 79 79 79 79 79
Depreciation (percent of net fixed assets) 4,99 14 14 14 14 14 14 14
Tax rate, percent 35
Cost of debt, percent (rD) 6
Cost of equity, percent (rE) 12,4

Debt ratio (D/V) 0,4
WACC, percent 9
Long-term growth forecast, percent 3

Table 19.1A free-cash-flow projections,
Rio corporation ($ Millions)
• Sangria is considering the possibility of buying Rio corporation
• In order to assess the deal it will need to start by projecting Rio’s FCFs
• Determine a terminal value in the horizon year (add to the corresponding FCF)
• Those FCFs can be discounted using WACC
0 1 2 3 4 5 6 7
1. Sales 83,6 89,5 95,8 102,5 106,6 110,8 115,2 118,7

2. Cost of goods sold 63,1 66,2 71,3 76,3 79,9 83,1 87,0 90,2
3. EBITDA (1 - 2) 20,5 23,3 24,4 26,1 26,6 27,7 28,2 28,5
4. Depreciation 3,3 9,9 10,6 11,3 11,8 12,3 12,7 13,1
5. Profit before tax (EBIT) (3 - 4) 17,2 13,4 13,8 14,8 14,9 15,4 15,5 15,4
6. Tax 6,0 4,7 4,8 5,2 5,2 5,4 5,4 5,4
7. Profit after tax (5 - 6) 11,2 8,7 9,0 9,6 9,7 10,0 10,1 10,0
8. Investment in fixed assets 11,0 14,6 15,5 16,6 15,0 15,6 16,2 15,9
9. Investment in working capital 1,0 0,5 0,8 0,9 0,5 0,6 0,6 0,4
10. Free cash flow (7 + 4 - 8 - 9) 2,5 3,5 3,2 3,4 5,9 6,1 6,0 6,8
PV Free cash flow, years 1-6 20,3 (Horizon value in year 6)

PV Horizon value 67,6 113,4
PV of company 87,9

•Example: Rio Corporation
• Free cash flow = profit after tax + depreciation - ∆(fixed
assets) - ∆(working capital)
• FCF = 8.7 + 9.9 – (109.6 – 95) – (11.6 – 11.1) = $3.5
million
PV(FCFF)
3.5 3.2 3.4 5.9 6.1 6.0
= + + + + +
1.09 1.09 1.09 % 1.09 & 1.09 ( 1.09 )
= 20.3

FCFF 0 6.8
Horizon value = PV/ = = = 113.4
WACC − 4 .09 − .03
1
PV(horizon value) = × 113.4 = $67.6
1.09 )
PV(business) = PV(FCFF) + PV(horizon value)

= 20.3 + 67.6
= $87.9 million
If debt has a market value of $36.0 million, market value of equity will be:
PV business − PV debt = 87.9 − 36.0 = $51.9 million

B. Flow-to-Equity Method (Valuing Equity)

• Discount cash flows to equity at cost of equity
capital, after interest and taxes
• If firm has constant debt ratio over time, flow to

equity will give same answer as discounting total
cash flows at WACC and subtracting debt

B. Flow-to-Equity Method (Valuing Equity)
¨The Free Cashflow to Equity (FCFE) is a measure of how much cash is left in the
business after non-equity claimholders (debt and preferred stock) have been paid,
and after any reinvestment needed to sustain the firm’s assets and future growth.”
Net Income
+ Depreciation & Amortization
= Cash flows from Operations to Equity Investors
- Preferred Dividends
- Capital Expenditures
- Working Capital Needs
= FCFE before net debt cash flow (Owner’s Earnings)
+ New Debt Issues
- Debt Repayments
= FCFE after net debt cash flow
19-3 Using WACC in practice
•Tricks of the Trade

 What should be included with debt?
• Long-term debt
• Short-term debt (netting out acceptable only when temporary and
materially insignificant)
• Cash (netted out)
• Current liabilities (netted out)
• Receivables
• Deferred taxes (not exactly a source of financing,
consequently not taken into consideration in the cost
of capital formula)
•After-Tax WACC
• Preferred stock and other forms of financing must be
included in formula
D  P  E 
WACC = (1 − TC ) × rD  +  × rP  +  × rE 
V  V  V 

•Determining Costs of Financing

• Derive return on equity from market data
• Cost of debt set by market, rating of firm’s debt
• Preferred stock often has preset dividend rate

• Example, Continued (what happens if Perpetual Crusher
supports only 20% debt, as compared to Sangria’s 40%)
• Sangria Corporation at 20% D/V
• Step 1: unlevering the WACC r at current debt
Original _ rWACC = .06(.4)(1 − .35) + .124(.6) ≅ .09
• Step 2: Estimation of rA, based in the original capital structure:
C
.124 + .666 1 − .35 (.06) B + D 1 − EF G
> = = .104665 > =
1 + .666 1 − .35 C
1 + D 1 − EF
• Step 3: Estimation of the new cost of equity (D/V changes to 20%)

rE = .104665 + (.25)(.104665 − .06) 1 − .35 = .112 ( )
C
B = > + 1 − EF > − G
D
• Step 4: New WACC or rWACC
?>@@ = .06 1 − .35 .2 + .112 .8 = .09733 = 9.73%

Beta and Leverage: No Corporate Taxes
 In a world without corporate taxes, and with riskless
corporate debt (βDebt = 0), it can be shown that the
relationship between the beta of the unlevered firm and the
beta of levered equity is:
Debt Equity
βAssets = × βDebt + × βEquity
Assets Assets
LℎN N_PQQNRQ = CNSR + DTUVRW
 As in most of the cases, βDebt = 0

Equity
βAssets = × βEquity
Assets

Beta and Leverage: With Corporate Taxes
 In a world with corporate taxes, and riskless debt, it
can be shown that the relationship between the
beta of the unlevered firm and the beta of levered
equity is:
 Debt 
β Equity = 1 + × (1 − TC ) β Unleveredfirm
 Equity 
 Debt 
• Since 1 + × (1 − TC )  must be more than 1 for a
 Equity 
levered firm, it follows that βEquity > βUnlevered firm

Beta and Leverage: With Corporate
Taxes
 If the beta of the debt is non-zero, then:
D
β Equity = β Unleveredfirm + (1 − TC )(β Unleveredfirm − β Debt ) ×
EL

• Discounted cash flow methods:
• Non-adjusted cash flows:
• Valuation of the whole company (all stakeholders):
• Flow to firm, or WACC approach
• Equity valuation:
• Dividend discount model
• Flow to equity
• Adjusted cash flows:

• APV

19-4 Adjusted present value
•Adjusted Discount Rate

• Modify to reflect capital structure, bankruptcy risk, other
factors
•Adjusted Present Value
• Assume all-equity-financed firm, adjust value based on
financing

•APV = Base Case NPV + PV Impact

• Base case: All-equity-financed firm NPV
• PV impact: All costs/benefits directly resulting

from project

•Example
• Project A has $150,000 NPV. Firm must issue stock to
finance project, with $200,000 brokerage cost
• Project NPV = 150,000
• Stock issue cost = −200,000
• Adjusted NPV = −50,000
• Do not invest in Project A

•Example
• Project B has −$20,000 NPV. Firm can issue debt at
8% to finance project. New debt has PV tax shield of
$60,000. Assume Project B is only option
• Project NPV = −20,000
• Stock issue cost = 0,000
• Adjusted NPV = 40,000
• Invest in Project B

Table 19.2 Rio corporation APV ($ millions)
0 1 2 3 4 5 6 7
Free cash flow 2,48 3,46 3,22 3,45 5,88 6,12 5,99 6,80
PV Free cash flow, years 1-6 19,71 (Horizon value in year 6)

PV Horizon value 64,57 113,39
Base-Case PV of company 84,28
Debt 51 50,00 49,00 48,00 47,00 46,00 45,00

Interest 3,06 3,00 2,94 2,88 2,82 2,76
Interest tax shield 1,07 1,05 1,03 1,01 0,99 0,97
PV Interest tax shields 5,025808
APV 89,30
Assumptions:
Tax rate, percent 35,0
Opportunity cost of capital, percent (r) 9,84
Interest rate, percent 6,0

•Example
• Rio Corporation APV
APV = Base case NPV + PV(interest tax shields)

= 84.3 + 5.0 = $89.3 million

A Comparison of the APV, FTE, and
WACC Approaches
 All three approaches attempt the same task: valuation
in the presence of debt financing.
 Guidelines:
 Use WACC or FTE if the firm’s target debt-to-value ratio
applies to the project over the life of the project.
 Use the APV if the project’s level of debt is known over the
life of the project.

 In the real world, the WACC is, by far, the most widely
used.
Summary: APV, FTE, and WACC
APV WACC FTE

Initial Investment All All Equity Portion
Cash Flows UCF UCF LCF
Discount Rates RA RWACC RE
PV of financing
effects Yes No No
Summary: APV, FTE, and WACC
Which approach is best?

 Use APV when the level of debt is constant
 Use WACC and FTE when the debt ratio is
constant
 WACC is by far the most common
 FTE is a reasonable choice for a highly levered firm

19-5 Relative Valuation
 Prices can be standardized using a common variable such as earnings, cashflows,
book value or revenues.
 Earnings Multiples
• Price/Earnings Ratio (PE) and variants (PEG and Relative PE)
• Value/EBIT
• Value/EBITDA
• Value/Cash Flow
 Book Value Multiples
• Price/Book Value(of Equity) (PBV)
• Value/ Book Value of Assets
• Value/Replacement Cost (Tobin’s Q)
 Revenues
• Price/Sales per Share (PS)
• Value/Sales
 Industry Specific Variable (Price/kwh, Price per ton of steel ....)

 Different ways to use the method:

 Fundamentals:
• Relates multiples with values assumed by some key
indicators of the company to value
 Comparables:
• Estimation of multiples through the analysis of companies
identical to the company to be valued

 “Fundamentals"approach”:
G\]^
Gordon Model= Z[ =
_` ab
Dividing both members by earnings per share:
\c Payout ratio×( 0g n)
= ZD =
B\]c _` abe
Dividing both members by the equity book value:
Z[ ROE × Payout ratio × (1 + g n )

= Zfg =
fg[ j − 4k

 “Fundamentals“ approach:
CZl
Modelo de Gordon = Z[ =
mj − 4
Dividing both members by sales per share:
Z[ Profit Margin × Payout ratio × (1 + g n )

= Zl =
lnoNQ[ mj − 4k

We may develop the same reasoning in order to test the value of the company:
Gordon Model= g[ =
j − 4k
Dividing both members by the expected FCFF:
g[ 1
=
j − 4k
Since the free cash flow to the firm is given by net operating income minus capital
expenditures, plus depreciation and net additional NWC requirements, similar
multiples can be estimated for EBIT, EBIT (1-Tc) and EBITDA.

 Applications:
 Ideally, data from a large number of companies
available to provide the basis for the calculation of the
desired multiples.
 Limitations:
 Definition of "comparable" is subjective;
 Multiplies errors, if any.

Thank You

19FV290320

Uploaded by

Copyright:

Available Formats

You might also like

19FV290320

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

19FV290320

Uploaded by

Copyright:

Available Formats

CORPORATE FINANCE

19. Financing and Valuation

Miles Johnson, Financial Times, 31.07.2017

José A. de Azevedo Pereira 2019 Gestão Financeira II 2

•Capital project adjustments to take into consideration

José A. de Azevedo Pereira 2019 Gestão Financeira II 3

• The Discounted Cash-Flow Method

José A. de Azevedo Pereira 2019 Gestão Financeira II 4

• Discounted cash flow methods:

• Adjusted cash flows:

José A. de Azevedo Pereira 2019 Gestão Financeira II 5

• Value of a financial asset is a function:

• Of the expected timing of these cash flows;

• Of the risk associated with the realization of

José A. de Azevedo Pereira 2019 Gestão Financeira II 6

 General valuation formulae:

FCF FCF FCF PV

PV (free cash flows) PV (valor no horizonte)

José A. de Azevedo Pereira 2019 Gestão Financeira II 7

José A. de Azevedo Pereira 2019 Gestão Financeira II 8

is 12.4%, pretax cost of debt is 6%. Given book

• Current stock price is $7.5 and the number of

José A. de Azevedo Pereira 2019 Gestão Financeira II 9

José A. de Azevedo Pereira 2019 Gestão Financeira II 10

WACC = .06 × (1 − .35)(.40) + .124(.60)

José A. de Azevedo Pereira 2019 Gestão Financeira II 11

Crusher) with cash flows of $1.731 million per

José A. de Azevedo Pereira 2019 Gestão Financeira II 12

José A. de Azevedo Pereira 2019 Gestão Financeira II 13

José A. de Azevedo Pereira 2019 Gestão Financeira II 14

Expected equity income = C − rD (1 − TC ) D = 1.125 − .195 = 0.93

expected equity income

José A. de Azevedo Pereira 2019 Gestão Financeira II 15

José A. de Azevedo Pereira 2019 Gestão Financeira II 16

José A. de Azevedo Pereira 2019 Gestão Financeira II 17

•Business value usually computed as discounted

José A. de Azevedo Pereira 2019 Gestão Financeira II 18

FCF1 FCF2 FCFH PVH

PV (free cash flows) PV (horizon value)

In this case, r = WACC

José A. de Azevedo Pereira 2019 Gestão Financeira II 19

Tax rate, percent 35

Cost of debt, percent (rD) 6

Cost of equity, percent (rE) 12,4

José A. de Azevedo Pereira 2019 Gestão Financeira II 20

1. Sales 83,6 89,5 95,8 102,5 106,6 110,8 115,2 118,7

PV Free cash flow, years 1-6 20,3 (Horizon value in year 6)

José A. de Azevedo Pereira 2019 Gestão Financeira II 21

José A. de Azevedo Pereira 2019 Gestão Financeira II 22

PV(business) = PV(FCFF) + PV(horizon value)

PV business − PV debt = 87.9 − 36.0 = $51.9 million

José A. de Azevedo Pereira 2019 Gestão Financeira II 23

B. Flow-to-Equity Method (Valuing Equity)

• If firm has constant debt ratio over time, flow to

José A. de Azevedo Pereira 2019 Gestão Financeira II 24

•Tricks of the Trade

José A. de Azevedo Pereira 2019 Gestão Financeira II 27

•Determining Costs of Financing