Chapter 3:the Actuarial or Income Approach: Approche Par Les Flux Actualises

CHAPTER 3:THE ACTUARIAL OR INCOME
APPROACH
APPROCHE PAR LES FLUX ACTUALISES
BASIC PRINCIPLE: DISCOUNTING OF FUTURE INCOMES OR FLOWS

GENERATED BY THE COMPANY
DIVIDENDS
FREE CASHFLOWS
A) INCOME OR FLOWS
CAPM
WACC
B) DISCOUNT RATES
DDM
GORDON SHAPIRO
C) VALUATION METHODS FISHER
DCF
APV
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THE INCOME APPROACH
A)INCOME STATEMENT REFRESHER
SIMPLIFIED PRESENTATION
SALES
-COGS AND OPERATING EXPENSES
= EBITDA
-DEPRECIATION AND AMORTIZATION
+EBIT
+/- FINANCIAL INCOME
=EBT
-CORP TAX
=EAT OR NET INCOME(NI)

N.B.:INCLUDES NON
RECURRENT ITEMS
GROUP
MINORITY
RESTATE NI AND CHECK PAYOUT
DIVIDEND POLICY
DIVIDEND PER SHARE
2
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THE INCOME APPROACH
A)VOCABULARY REFRESHER
NON CURRENT TANGIBLE AND

CAPEX = INTANGIBLE ASSETS
CAPITAL EXPENDITURE
BY ORIGIN: EQUITY + LONG TERM

LIABILITIES – NON CURRENT ASSETS
BY DESTINATION: CURRENTS ASSETS -

CURRENT LIABILITIES
WORKING CAPITAL(WC)
1) WORKING CAPITAL - NET CASH

NET CASH = CASH & CASH EQUIVALENTS -
BANKING FACILITIES (OVERDRAFT,ETC)
WORKING CAPITAL 2)( INVENTORIES + RECEIVABLES-
REQUIREMENT (WCR) PAYABLES) + (NON OPERATING
=NON CASH WORKING CAPITAL DEBTORS-NON OPERATING
CREDITORS) OTHER THAN CASH ITEMS

THE INCOME APPROACH
A)FREE CASH FLOWS FOR VALUE
EBITDA EBIT EAT OR NET INCOME
- ECONOMIC CORP TAX + DEPRECIATION & AMORT. + DEPRECIATION & AMORT.
ON EBIT - CORP TAX + CASH INTEREST x (1- CORP TAX)
- CHANGE IN WCR - CHANGE IN WCR - CHANGE IN WCR
- NET CAPEX - NET CAPEX - NET CAPEX
= FCFF (FREE CASH FLOW TO THE = FCFF (FREE CASH FLOW TO = FCFF (FREE CASH FLOW TO THE
FIRM) THE FIRM) FIRM)
NET FINANCIAL CHARGES AFTER NET FINANCIAL CHARGES AFTER NET FINANCIAL CHARGES AFTER
TAX SHIELD TAX SHIELD TAX SHIELD
+ REPAYMENT OF DEBT + REPAYMENT OF DEBT + REPAYMENT OF DEBT
- ISSUANCE OF NEW DEBT - ISSUANCE OF NEW DEBT - ISSUANCE OF NEW DEBT
=FCFD (FREE CASH FLOW TO THE =FCFD (FREE CASH FLOW TO THE =FCFD (FREE CASH FLOW TO THE
DEBT) DEBT) DEBT)
FCFF-FCFD= FCFE(FREE CASHFLOW FCFF-FCFD= FCFE(FREE FCFF-FCFD= FCFE(FREE CASHFLOW
TO EQUITY) CASHFLOW TO EQUITY) TO EQUITY)
-REPAYMENTS -REPAYMENTS -REPAYMENTS
+INCREASE IN EQUITY +INCREASE IN EQUITY +INCREASE IN EQUITY
= FCFS (FREE CASHFLOW FOR = FCFS (FREE CASHFLOW FOR = FCFS (FREE CASHFLOW FOR
SHAREHOLDERS) SHAREHOLDERS) SHAREHOLDERS)

THE INCOME APPROACH
B)DISCOUNT RATES:CAPM
CAPM CAPITAL ASSET PRICING MODEL(MEDAF IN FRENCH)
COST OF EQUITY = RISK-FREE RATE + b * MRP + (Pe)
EXTRA
PREMIA
PROFILE OF
COMPANY &
COUNTRY
GOVERNMENT BONDS OF SYSTEMATIC RISK OF MARKET RISK PREMIUM

INDUSTRIALIZED THE STOCK
COUNTRIES SUCH AS SENSITIVITY OF ITS MARKET INDEX
FRENCH OAT OVER 10 RETURN RETURN – RISK-FREE
YEARS TO THE CHANGE IN RATE
THE MARKET INDEX
INTEREST RATE DEPENDS RETURN MRP = [E(rm)- rf ]
ON:
b EXPECTED P, b= cov (rp, rm)/var EXAMPLE
b GOVERNMENT DEBT, (rm)
b BUDGET DEFICIT CAC 40 YIELD -
FRENCH OAT RATE
(3 MAASTRICHT CRITERIA) rp stock yield
rm market yield

THE INCOME APPROACH
EXPECTED
RETURN SECURITIES
MARKET LINE
INTERPRETATION OF THE b
HIGHER b WHEN…
HIGH SENSITIVITY TO
CONJONCTURE
STRONG OPERATING
LEVERAGE
HIGH DIFFICULTY TO
FORECAST FIGURES
E(rm)
HIGH GEARING
HIGH GROWTH RATE OF
MRP FUTURE INCOMES
RISK-FREE RATE
b=1 b
THE INCOME APPROACH

THE INCOME APPROACH
b OF PRIVATE COMPANIES? LIMITS OF THE FORMULA:
1. BENCHMARKING b OF SAMPLE COMPANIES - THE DEBT RATE IS THE RISK-FREE RATE
- THE VALUE OF ECONOMIC ASSETS OF THE

2. CALCULATION OF UNLEVERED b FOR THE INDEBTED COMPANY = THE VALUE OF THE
SAMPLE COMPANIES COMPANY WITHOUT DEBT + TAX SHIELD
:
UNLEVERED b = LEVERED b
UNLEVERED b ( b OF ECONOMIC ASSETS )=
[1+(1-CT)x D/E] [b E × E/(E+D)]+ [b D × D/(E+D)]
b D = [(COST OF DEBT ×(1-CT) - RISK-FREE

CT= CORP.TAX D= (MARKET)VALUE OF NET RATE) /MRP]
LIABILITIES E = (MARKET)VALUE OF EQUITY
OR FORMULA WITH CORP TAX EFFECT
3. CALCULATION OF THE AVERAGE UNLEVERED b E + [b D × (1-CT) × D/E]

BETA OF THE SAMPLE COMPANIES
1+(1-CT) × D/E
4. RELEVERAGING THE b WITH THE CURRENT
GEARING (FCFF) OR THE TARGET GEARING
(FCFE)FO THE TC ©SPOC Essec Buisson Reproduction 8
THE INCOME APPROACH
Risk-Free Rate
Pablo Fernandez
https://papers.ssrn.com/sol3/papers.
cfm?abstract_id=3861152
9
THE INCOME APPROACH
Market Risk Premium

Pablo Fernandez
https://papers.ssrn.com/sol3/papers.cfm
?abstract_id=3861152

THE INCOME APPROACH
B)DISCOUNT RATES:WACC(1)
WACC WEIGHTED AVERAGE COST OF CAPITAL(CMPC IN FRENCH)
WACC RATE= COST OF EQUITY * [E / (E + D)] + COST OF NET DEBT AFTER TAX * [D/(E+ D)]
E IS EQUITY
D IS DEBT
MARKET RATE OF TC’ S OUTSTANDING DEBT NET DEBT = NET

FINANCIAL DEBT AND
MARKET CAP DEBT RATE OF TC’S SECTOR ASSIMILATED (LATINE
CREDIT-BAIL, PENSION
DEBT RATE OF PEERS WITH SAME RATING LIABILITIES,
RNA FOR GW CONTINGENT CLAIMS)
RNA EURIBOR+ bD x (AVERAGE COST OF CREDIT-EURIBOR) MARKET VALUE
BOOK VALUE INTEREST RATE OF GOVIES + ESTIMATED DEFAULT

SPREAD (see Damodaran NYU Stern) PV OF FLOWS
BOOK VALUE

THE INCOME APPROACH
B)DISCOUNT RATES:WACC(2)
WACC = (VALUE OF EQUITY x COST OF EQUITY ) + NET LIABILITIES x ARAT

VALUE OF EQUITY + NET LIABILITIES
ARAT = AVERAGE INTEREST RATE FOR DEBT AFTER CORP. TAX
NET LIABILITIES = NET FINANCIAL LIABILITIES =

NON CURRENT AND CURRENT FINANCIAL DEBT
+ CONTINGENT LIABILITIES AND SPECIFIC PROVISIONS
+ CREDIT-BAIL
+ RETIREMENT ALLOWANCES
– CASH AND CASHABLE ITEMS (OR CASH AT HAND AND IN BANK +
MARKETABLE SECURITIES)
IF NET LIABILITIES ARE < 0 WACC= COST OF EQUITY

THE INCOME APPROACH
B)SUMMARY
KIND OF PROFILE OF NATURE OF GEARING CORP TAX DISCOUNT

TRANSACTION FLOWS FCF RATE
PORTFOLIO OR FINANCIAL DIVIDENDS COST OF
SHORT TERM EQUITY
INDUSTRIAL AND ECONOMIC FCFF CURRENT ECONOMIC WACC RATE
STRATEGIC GEARING CORP TAX
TRANSACTION
FINANCIAL FINANCIAL OR FCFE TARGET REAL CORP COST OF
TRANSACTION LEVERAGED GEARING TAX EQUITY
FOCUSED ON
CONTROL
MINOR FINANCIAL OR FCFS TARGET REAL CORP COST OF
OPERATIONS LEVERAGED GEARING TAX EQUITY

THE INCOME APPROACH
C) DIVIDEND DISCOUNT MODEL(DDM) REFRESHER
1. PV OR PRICE P0 OF STOCK SOLD AFTER n YEARS
𝑫𝒕 𝑷𝒏
P0 = σ𝒏𝒕=𝟏 + Pn sale price end of year n Dt expected dividend year t r discount rate
(𝟏+𝒓)^𝒕 (𝟏+𝒓)^𝒏
2. PV OR PRICE OF STOCK HELD WITHOUT SPECIFIC LIMITATION

𝑫𝒕
P0 = σ∞
𝒕=𝟏 (𝟏+𝒓)^𝒕
3. IF DIVIDENDS HAVE A CONSTANT GROWTH RATE g FOR ∞: GORDON & SHAPIRO
D0 𝒙(𝟏+𝒈)^𝒕 𝐷0(1+𝑔) 𝐷1
P0 = σ∞
𝒕=𝟏 = = 𝑤𝑖𝑡ℎ 𝑟 > 𝑔 HOW TO ASSESS THE GROWTH RATE g?
(𝟏+𝒓)^𝒕 𝑟−𝑔 𝑟−𝑔
1) RELY ON HISTORICAL GROWTH RATE
2) ADJUST THE GDP OF THE COUNTRY

4.IF GROWTH RATE OF DIVIDENDS=0
3) ESTIMATE g g = ROE * (1- dividend pay out ratio)
𝐷 𝐷 𝐷 𝐷
P0 = + + ⋯.+ =
1+𝑟 (1+r)^2 1+𝑟 𝑛 𝑟

THE INCOME APPROACH
D) FISHER VALUATION
FISHER VALUATION IS FOCUSED ON FINANCIAL INVESTORS

IT IS BASED ON THE DIVIDEND DISCOUNT MODEL(DDM)
VALUE OF TC =SUM OF PV OF DIVIDENDS OVER 5 YEARS + PV OF TERMINAL

(EXIT)VALUE
5
𝐷𝑛 𝐷 5 (1+𝑔) 𝐷𝑛 𝐸𝑋𝐼𝑇
σ5𝑛=1 + [ ] ෍ +
(1+𝑟)^𝑛 (𝑟−𝑔) (1 + 𝑟)^𝑛 (1 + 𝑟)^5
𝑛=1
(1+r)^5
OTHER EXIT
GORDON SHAPIRO EXIT

THE INCOME APPROACH
D) FISHER VALUATION
EXAMPLE
DIVIDENDS = 40% OF RNI FISHER RATE(COST OF EQUITY) r = 8% g=2% FOR ∞
M EUR 1 2 3 4 5
RNI 70 76 82 90 104
DIVIDENDS 28 30.4 32.8 36 41.6
DISCOUNTED 28/1.08 30.4/1.08^2 32.8/1.08^3 36/1.08^4 41.6/1.08^5
DIVIDENDS
SUM OF DISCOUNTED DIVIDENDS =132.80
1. GORDON SHAPIRO EXIT 2. PER AT THE END OF YEAR 5 = 12

EXIT= 41.6(1+2%)/(8%-2% )=707.2
EXIT VALUE =12*104= 1248
PV OF EXIT =707.2/1.08^5=481.31
PV OF EXIT = 1248//1.08^5=849.4
VALUE=132.80 +481.31= 614.11 M EUR
VALUE=132.80 +849.4= 982.2 M EUR

THE INCOME APPROACH
E) THE DCF METHOD
INTRINSIC VALUE OF TARGET COMPANY BASED ON THE PROJECTIONS OF

ECONOMIC FREE CASHFLOWS
FREE CASH FLOWS (FCFF)
INDIRECT DCF VALUE FOR A STANDARD GROWTH TO MATURITY=
SUM OF PV OF FCFF OVER 5 YEARS + PV OF TERMINAL VALUE – NET
LIABILITIES (NL) OUTSTANDING AT THE END OF YEAR 0 – MINORITY(M)
𝐹𝐶𝐹 𝐹𝐶𝐹5 (1+𝑔) 𝐹𝐶𝐹 𝐸𝑋𝐼𝑇

σ5𝑛=1 +[ (𝑟−𝑔) ] -NL -M σ5𝑛=1 + (1+𝑟)^5 - NL - M
(1+𝑟)^𝑛 (1+𝑟)^𝑛
(1+𝑟)^5
(1+r)^5
GORDON SHAPIRO EXIT OTHER EXIT

THE INCOME APPROACH
E) THE DCF METHOD
DCF AND THE VALUATION BRIDGE

(1) PARTIAL NETTING
𝐹𝐶𝐹 𝐹𝐶𝐹5 (1+𝑔)
EQUITY VALUE = σ5𝑛=1 +[ ] + RESIDUAL FINANCIAL ASSET - NL - M
(1+𝑟)^𝑛 (𝑟−𝑔)
(1+r)^5
EV
FV
(2)TOTAL NETTING
𝐹𝐶𝐹 𝐹𝐶𝐹5 (1+𝑔)
EQUITY VALUE = σ5𝑛=1 +[ ] - NL - M
(1+𝑟)^𝑛 (𝑟−𝑔)
(1+r)^5
EV=FV

THE INCOME APPROACH
E) THE DCF METHOD
CALCULATION OF FREE CASH FLOWS OVER 5 YEARS

YEAR 1 2 3 4 5
RESTATED OPERATING INCOME
- ECONOMIC CORP TAX

= ADJUSTED EBIT
NORMATIVE
CORP TAX + DEPRECIATION AND ITEMS
CONSIDERED AS NON CASH
- CHANGE IN WCR(WORKING
CAPITAL REQUIREMENT)
NORMATIVE
WCR - NET CAPEX
= FREE CASH FLOWS
DISCOUNTED FCF(DCF)
DISCOUNT
2 BUSINESS MODELS: 2 FCFF 2 WACC RATES
RATE ?
2 ACTIVITIES: 2 FCF 1 WACC RATE
19
THE INCOME APPROACH
E) THE DCF METHOD
EXAMPLE IN M EUR WACC = 6% g=2% NET(FINANCIAL)LIABILITIES = 5

YEAR 1 2 3 4 5
RESTATED OPERATING INCOME 100 110 122 134 148
- ECONOMIC CORP TAX (35) (38.5) (42.7) (46.9) (51.8)
= ADJUSTED EBIT 65 71.5 79.3 87.1 96.2
+ DEPRECIATION AND NON CASH ITEMS 8 8 10 10 10
- CHANGE IN WCR(WORKING (2) (3) (4) (4) (6)
CAPITAL REQUIREMENT)
- NET CAPEX (10) (10) (12) (12) (12)
= FREE CASH FLOWS 61 66.5 73.3 81.1 88.2
DISCOUNTED FCF(DCF) 308.3 57.5 59.2 61.5 64.2 65.9
GORDON SHAPIRO EXIT = FCFF year 5(1+g)/(r-g)=88.2 (1+2%)/(6%-2%) =2 249.1
PV= 2249.1/1.06^5=1680.66 DCF VALUE = 308.3 + 1680.66 -5 = 1 983.96
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SUMMARY: VALUATION METHODS
VALUATIO MAIN FINANCIAL EXIT DISCOUNT RATE COMMENTS

N METHOD STATEMENTS
RNA BALANCE-SHEET NO DIFFERENT PAST HISTORY AND UNDERVALUATION
NOTES ONES RECONCILIATION OF STAND ALONE AND
CONSOLIDATED ACCOUNTS
LEGAL VALUE IN THE SPA
REFERENCE VALUATION FOR HOLDINGS AND
COMPANIES WITH MANY ASSETS
RNA AND BALANCE-SHEET NO GOODWILL RATE IMPROVES RNA
GW NOTES AVERAGE ROE BUT GOODWILL IS CALCULATED EXANTE
INCOME COST OF EQUITY
STATEMENTS
PER SE INCOME NO MARKET BASED AND ANALOGICAL
STATEMENTS SHORT TERM
FISHER INCOME YES COST OF EQUITY LIMITED VALUATION
STATEMENTS IMPACTED BY ASSUMPTION ON DIVIDEND
PAY OUT AND ON EXIT
DCF CASHFLOW YES WACC OR COST INTRINSIC VALUE
STATEMENTS OF EQUITY FOCUSED ON FUTURE
INCOME IMPACTED BY ASSUMPTIONS => USE OF A
STATEMENTS SENSITIVITY MATRIX
21
SUMMARY:SOME EXIT VALUES
EXIT OR TERMINAL VALUE METHOD

GORDON SHAPIRO 1) X = DIVIDEND OF YEAR 5 x (1+ GROWTH RATE)
WITH DIVIDENDS FISHER RATE - GROWTH RATE
2)EXIT VALUE = X/(1+ FISHER RATE)^5

GORDON SHAPIRO WITH FCF 1) X= FCF OF YEAR 5 x (1+ GROWTH RATE)
WACC OR FISHER RATE - GROWTH RATE
2) EXIT VALUE = X/(1+ WACC OR COST OF EQUITY)^5
RNA 1) X= RNA OF YEAR 5 = RNA OF YEAR 0 + RETAINED EARNINGS
2) EXIT VALUE =X/(1+ WACC OR COST OF EQUITY)^5

EXIT MULTIPLE METHOD 1) X = RNI OF YEAR 5 x P/E IN YEAR 5
2) EXIT VALUE = X/(1+ WACC OR FISHER RATE)^5

1) X=FOR EXAMPLE 8 TIMES THE EBITDA OF YEAR 5(…)
2) EXIT VALUE=X/(1+ WACC OR FISHER RATE)^5

SUGGESTED COMMENTS ON VALUATIONS
NB: figures for ratios are indicative because it depends on the nature of the business
and on the main characteristics of what you get in the numerator and in the
denominator
RNA VALUE
• Traditional activity, high tech activity?
• Light, heavy or intermediate industry?
Ratio = gross fixed assets / value added
Ratio <0.50 for light industry

Ratio >1.75 for heavy industry
Ratio in between = intermediate industry
• Old assets or new assets?
Ratio = Cumulated depreciation /gross fixed assets

Getting old if > 50% and too old/to late to replace if >80%
• Level of capex?
Ratio = capex/sales
RNA VALUE
Financial situation and level of liabilities(1)
• Level of gearing?
Leverage ratio = net financial liabilities /equity

It must be <1
Net financial liabilities = financial liabilities - cash at hand and in bank
• Level of autonomy?
Ratio= equity / total assets

It must be >30% or at least >20%
See also Plow back ratio = retained earnings / earnings

= earnings (or net income)- dividends / net income = 1- payout ratio
Pay out ratio = dividends /net income
• Global capacity to borrow?
Ratio = (net) financial liabilities / total assets

RNA VALUE
Financial situation and level of liabilities(2)
• Capacity to borrow in the long term?
Ratio = equity / equity + long term liabilities

It must be > 50%
• Liquidity and ability to meet short-term commitments?
Global liquidity ratio = net working capital / total assets
Current ratio = current assets/current liabilities It must be = > 1 but it is

better when it is 2 to 1
quick ratio or acid test = (receivables + marketable securities + cash) /

current liabilities It must be = or> 1
Cash ratio =( cash + marketable securities) / current liabilities
RNA + GW VALUE
• Why is there a low goodwill or a high goodwill?
• Why is there a badwill?
Some ratios to take into account
Ratio of net profit margin = net income /sales(10% is excellent! But the situation is
already very good with 6% or 7% for instance)
• Ratio of financial profitability = current income/Equity
• Ratio of interest charges = interest paid/EBITDA ,or interest paid/sales figure(3% is

high!)
• ROE Return on equity= net income/average equity

PER VALUE
• Family company? Listed or not listed? Sufficient number of samples?
• Any gap between average PER in N and N+1 for instance? Why this gap?
• Problems pertaining to the sample companies? Problems pertaining to the field of activity?
• Discrepancies between market value and fundamentals? Why?
• If N is chosen does it penalize the TC? Then you may take into account future synergies for
the restatement of the income of N
• If N+1 is chosen, is it too optimistic or too pessimistic (projections)?
• Appraisal with a PE beyond N+1 must be careful

PER VALUE
• The better the visibility of the future incomes, the higher the PER
• A high gearing means a lower PER
• The more liquid a value, the higher the PER
• The PER of a company reflects the growth of incomes expected by the SE
• PER of a company must be compared with the SE/market average
1) if PER is higher than the SE/market average, it means that the market expects a growth
more important than the average. Purchase is more risky and bad news will generally have a
stronger impact on a high price
2) if PER is lower than the SE/market average, it means that the market expects a slow growth
or a decrease of incomes .It may mean that the company is going to encounter difficulties or is
recovering from difficulties

PER VALUE
Value of share year N = anticipated dividend of year N+1/(t – g)

g being the constant growth rate and t the cost of equity
Since anticipated dividend D = earning per share for N x d

where d is pay-out ratio
Value of share= (earning per share for N x d)/ (t - g)
Value of share/ earning per share for N=PER of year N = d / (t - g)
PER is higher when pay out rate of dividends (d) is high, when risk is low
(so t is low) and when growth rate (g) is high

DCF VALUE
For a very high or a very low DCF, analyse:
• ROI
• Level of depreciation (high or low?)
• Level of capex (high or low?)
• Relation between depreciation and capex
• Change in working capital requirement (increase, decrease, why?)
• Discount rate (low one, high one, why?)

DCF VALUE
For ROI you can focus on some ratios:
• Ratio of operating profit margin = (net income+ interest) /sales
• Other ratios that you can find in your self assessment with their
interpretation in the suggested answers for your self assessment :
• VA ratio = VA/production or VA/ sales
• EBITDA/VA
• Ratio of economic profitability = EBITDA /invested capital where

invested capital= non current assets + working capital
requirement
CHAPTER 4:VALUES, PRICE AND REAL OPTIONS
A) VALUES AND PRICE

VALUES, PRICE AND REAL OPTIONS
A) VALUES AND PRICE
RNA
RNA PER DCF
& GW
100 180C 200
VALUATION SCOPE 130
SOCCER FIELD OR FOOTBALL FIELD
https://corporatefinanceinstitute.com/resources/templates/excel-modeling/football-field-chart-template/
A) VALUES AND PRICE
STANDARD SITUATION :
RNA < RNA&GW < TRADING MULTIPLES <TRANSACTION MULTIPLES <DCF
HIGHEST VALUATION A SOLUTION FOR INTERPRETATION

RNA PAST HISTORY
MANY ASSETS
FEW LIABILITIES
➔ HIGH CAPEX INDUSTRY
➔ WINES, CHAMPAGNE
YOU CAN SELL ON RNA BASIS
DCF ➔ RNA IS VERY LOW YOU CAN SELL BUT TC IS ATTRACTIVE SO DCF VALUE
SHOULD TAKE INTO ACCOUNT COMPETITION RISK
➔ RNA AND PER ARE CLOSE, PER INCLUDES CREATION OF VALUE ONLY FOR
ONE OR TWO YEARS IT IS BETTER TO SELL LATER
PER GAP BETWEEN BUSINESS PLAN AND MARKET ANTICIPATIONS
IF TC IS NOT LISTED IT CAN GO FOR IPO IN ORDER TO SELL PARTIAL OR
TOTAL NUMBER OF SHARES

A) VALUE AND PRICE
– c
WALK AWAY
BATNA PRICE
(BUY SIDE)
ZOPA OR
ZONE OF
BATNA POSSIBLE
AGREEMENT
CONTROL WALK AWAY

PREMIUM PRICE
(SELL SIDE)
STAND STOCK
ALONE EXCHANGE
PRICE
36
©SPOC Essec Buisson Reproduction & distribution are forbidden
A) VALUE AND PRICE
STAND ALONE VALUE WALK AWAY PRICE(WAP) BATNA

VALUE OF THE TARGET ➔ MAXIMUM PRICE FOR BEST ALTERNATIVE TO
COMPANY ALONE THE BUYER
(WITHOUT TAKING NEGOTIATED AGREEMENT
SYNERGIES INTO ➔ MINIMUM PRICE FOR A STRONG BATNA GIVES
ACCOUNT) THE SELLER WEIGHT IN NEGOTIATIONS
PREMIUMS AND DISCOUNTS

PREMIUM = EXCESS OVER MARKET TRADING VALUE PRICE
HIGHER IN STRATEGIC DEALS THAN IN FINANCIAL
DEALS
- SYNERGIES
- TAKING CONTROL
- CONVINCING RELUCTANT SHAREHOLDERS IN THE TC
DISCOUNT = PRICE UNDER MARKET TRADING VALUE
STAND ALONE VALUE +VALUE
- PRIVATE COMPANY
OF SYNERGIES + CONTROL
- STOCK IS NOT LIQUID PREMIUM + OTHER ITEMS OF
- BLOCK OF NON CONTROLLING INTEREST THE DEAL
- CONGLOMERATE

VALUE, PRICE AND REAL OPTIONS
B) REAL OPTIONS
REAL OPTIONS CAN BE USED REFRESHER ON OPTIONS
4WITH FLEXIBLE PROJECTS AND OPTIONS WITH UNDERLYING ASSET = SHARE

MUTUALLY EXCLUSIVE PROJECTS EUROPEAN CALL OPTION MATURITY 6 MONTHS
STRIKE=10
4 WHEN THERE IS A HIGH LEVEL OF
UNCERTAINTY AND RISK IF AT MATURITY:
4 WHEN THERE IS THE POSSIBILITY TO A) PRICE IS 14 YOU EXERCISE THE OPTION TO

GET EXTRA INFORMATION THAT COULD BUY AT 10 AND SELL AT 14 VALUE OF OPTION
CHANGE THE EXPECTED FLOWS IS 4
KINDS OF OPTIONS
B) PRICE IS 10 SITUATION IS NEUTRAL
4OPTION TO DELAY
C) PRICE IS 8 YOU DO NOT EXERCISE THE
4OPTION TO EXPAND OPTION VALUE OF OPTION IS 0
4OPTIONS TO REDUCE
4OPTION TO ABANDON EUROPEAN OPTIONS HAVE A LOWER VALUE THAN
AMERICAN OPTIONS
VALUATION MODELS: VALUE OF OPTIONS DEPENDS ON 6 PARAMETERS
1) BLACK AND SCHOLES
(SEE NEXT SLIDE)
2) THE BINOMIAL MODEL

B) REAL OPTIONS
SUMMARY OF CHANGE IN VALUE OF OPTION

CHANGE IN PARAMETER PUT CALL
VALUE OF UNDERLYING ASSET (SHARE) INCREASES DECREASE INCREASE
VALUE OF ASSET DECREASES INCREASE DECREASE
VARIANCE OF THE VALUE OF THE ASSET INCREASES INCREASE INCREASE
VARIANCE DECREASES DECREASE DECREASE
HIGHER STRIKE INCREASE DECREASE
LOWER STRIKE DECREASE INCREASE
THE MORE YOU COME CLOSER TO MATURITY DATE DECREASE DECREASE
INTEREST RATES INCREASE DECREASE INCREASE
INTEREST RATES DECREASE INCREASE DECREASE
HIGHER DIVIDENDS INCREASE DECREASE
LOWER DIVIDENDS DECREASE INCREASE

B) REAL OPTIONS
BLACK AND SCHOLES EXAMPLE : OPTION TO DELAY
EUROPEAN OPTIONS Choice of decisions : to open a new store now or to

NO DIVIDENDS wait 1 year?
S PRICE OF UNDERLYING ASSET
K STRIKE
r = RISK-FREE RATE Investment cost I0 is supposed to be the same now and
t= TIME REMAINING UNTIL MATURITY next year I0 = EUR 3 Million
s =STANDARD DEVIATION OF STOCK
RETURN Net income expected for year 1 = 450 000 EUR
After the first year expected growth rate of net income
N (d) PROBABILITY FOR A CENTERED
REDUCED is 3%
VARIABLE TO HAVE A VALUE < OR
EQUAL TO d Cost of equity is 10%
PUT = K x 𝒆−𝒓𝒕 x N (-d2) - S x N (-d1) Present Value if no deferment = 450 000/(10%-3%) =

EUR 6 428 571
CALL =S x N (d1) – K x 𝒆−𝒓𝒕 x N (d2) NPV of project = EUR 6 428 571- EUR 3 000 000=
EUR 3 428 571
d1= {log (S/K) + [ r + s2/2] x t }/s √t
d2= d1- s√t
B) REAL OPTIONS
Deferment of project = European call
Maturity T = one year
Underlying asset=new store=S0= price of Stock price S0 EUR 6 428 571

share =market value of store= EUR 6 428 Strike K EUR 3 million
571
strike K = I0= EUR 3 000 000 Maturity T 1 year
Assumptions Risk-free rate rf 2%
If deferment of one year loss of Div=net
income of EUR 450 000
Volatility s 50%
No other cost of deferment Dividend Div EUR 450 000
risk-free rate rf= is 2%
Volatility of project s is 50%

C is the price of the call option

B) REAL OPTIONS
C= S1 *N(d1)-PV(K)*N(d2)
C= (S0- PV (Div) ) *N(d1)-PV(K)*N(d2)
C= {(S0- PV (Div) ) *N[(ln(S1/PV(K))/s√T) + (s√T)/2)]}-[PV(K)*N(d1- s√T)]

S1= S0- PV (Div)= EUR 6 428 571 – (450 000/1.10)= EUR 6 019 480
PV (K) = 3 000 000/1.02 = EUR 2 941 176
d1= (ln(S1/PV(K))/s√T) + (s√T/2) =ln(2.04662)/0.5 + 0.5/2 =1.682
d2= d1- s√T =1.682 -0.5=1.182
C= S1 *N(d1)-PV(K)*N(d2)= 6 019 480* 0,954 - 2 941 176* 0,881= EUR 3 151 408
For N(d) on excel, choose f x statistics, normal distribution (standard or unit normal distribution
with μ=0,s=1,cumulative=TRUE)
The present value of the deferment option is EUR 3 151 408
This value is lower than the NPV of the immediate opening of the goodies store. Invest now or not? Yes if the
NPV of the project is very high or if the call option is very much in-the-money
42
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Chapter 3:the Actuarial or Income Approach: Approche Par Les Flux Actualises

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Chapter 3:the Actuarial or Income Approach: Approche Par Les Flux Actualises

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CHAPTER 3:THE ACTUARIAL OR INCOME

BASIC PRINCIPLE: DISCOUNTING OF FUTURE INCOMES OR FLOWS

©SPOC Essec Buisson Reproduction 1

-DEPRECIATION AND AMORTIZATION

=EAT OR NET INCOME(NI)

NON CURRENT TANGIBLE AND

BY ORIGIN: EQUITY + LONG TERM

BY DESTINATION: CURRENTS ASSETS -

1) WORKING CAPITAL - NET CASH

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CAPM CAPITAL ASSET PRICING MODEL(MEDAF IN FRENCH)

COST OF EQUITY = RISK-FREE RATE + b * MRP + (Pe)

GOVERNMENT BONDS OF SYSTEMATIC RISK OF MARKET RISK PREMIUM

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b OF PRIVATE COMPANIES? LIMITS OF THE FORMULA:

1. BENCHMARKING b OF SAMPLE COMPANIES - THE DEBT RATE IS THE RISK-FREE RATE

- THE VALUE OF ECONOMIC ASSETS OF THE

b D = [(COST OF DEBT ×(1-CT) - RISK-FREE

3. CALCULATION OF THE AVERAGE UNLEVERED b E + [b D × (1-CT) × D/E]

Market Risk Premium

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WACC WEIGHTED AVERAGE COST OF CAPITAL(CMPC IN FRENCH)

MARKET RATE OF TC’ S OUTSTANDING DEBT NET DEBT = NET

RNA EURIBOR+ bD x (AVERAGE COST OF CREDIT-EURIBOR) MARKET VALUE

BOOK VALUE INTEREST RATE OF GOVIES + ESTIMATED DEFAULT

©SPOC Essec Buisson Reproduction 11

WACC = (VALUE OF EQUITY x COST OF EQUITY ) + NET LIABILITIES x ARAT

ARAT = AVERAGE INTEREST RATE FOR DEBT AFTER CORP. TAX

NET LIABILITIES = NET FINANCIAL LIABILITIES =

IF NET LIABILITIES ARE < 0 WACC= COST OF EQUITY

©SPOC Essec Buisson Reproduction 12

KIND OF PROFILE OF NATURE OF GEARING CORP TAX DISCOUNT

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1. PV OR PRICE P0 OF STOCK SOLD AFTER n YEARS

2. PV OR PRICE OF STOCK HELD WITHOUT SPECIFIC LIMITATION

3. IF DIVIDENDS HAVE A CONSTANT GROWTH RATE g FOR ∞: GORDON & SHAPIRO

2) ADJUST THE GDP OF THE COUNTRY

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FISHER VALUATION IS FOCUSED ON FINANCIAL INVESTORS

VALUE OF TC =SUM OF PV OF DIVIDENDS OVER 5 YEARS + PV OF TERMINAL

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SUM OF DISCOUNTED DIVIDENDS =132.80

1. GORDON SHAPIRO EXIT 2. PER AT THE END OF YEAR 5 = 12

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INTRINSIC VALUE OF TARGET COMPANY BASED ON THE PROJECTIONS OF

𝐹𝐶𝐹 𝐹𝐶𝐹5 (1+𝑔) 𝐹𝐶𝐹 𝐸𝑋𝐼𝑇

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DCF AND THE VALUATION BRIDGE

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CALCULATION OF FREE CASH FLOWS OVER 5 YEARS

- ECONOMIC CORP TAX

EXAMPLE IN M EUR WACC = 6% g=2% NET(FINANCIAL)LIABILITIES = 5

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VALUATIO MAIN FINANCIAL EXIT DISCOUNT RATE COMMENTS

EXIT OR TERMINAL VALUE METHOD

2)EXIT VALUE = X/(1+ FISHER RATE)^5

2) EXIT VALUE = X/(1+ WACC OR COST OF EQUITY)^5

RNA 1) X= RNA OF YEAR 5 = RNA OF YEAR 0 + RETAINED EARNINGS

2) EXIT VALUE =X/(1+ WACC OR COST OF EQUITY)^5

2) EXIT VALUE = X/(1+ WACC OR FISHER RATE)^5

2) EXIT VALUE=X/(1+ WACC OR FISHER RATE)^5