Lecture 1:
Efficiency Ratio:
Business Valn Definition: i) eco value of owner int in a biz ; ii) price that market
participants pay ; iii) A&L computation
FMV: Price at which willing buyer and seller neither under the compulsion and both
having knowledge.
FV(Business val)/Equitable Value: EV definition: Definition of FMV + reflects the
respective interest of the parties. Fair Value is the one which is just and equitable. This
definition within itself contains the concept of adequate compensation (indemnity).
FV (Financial Reporting): Price to sell an asset or xfer liab between mkt participants at
measurement date. (GAAP)
IV: Value that investor believes is true or real and will become price when other people
start thinking same.
Investment value: Value based on particular investor based on individual requirements
and estimations for inv or opr.
VIU: PV of future CF from asset or CGU. CGU is the small independent group of asset
that generate CF that are independent from other assets or group of assets.
Liquidation Value: Value when assets are sold in piecemeal basis. Takes into acc the
costs involved in getting it into saleable condition as well as disposal activity. Two diff
premises of value: i) orderly transact with mkting period ; ii) forced transact with short
mkt period.
Business Value: Eco value of firm + societal, emp value, etc
Value Driver: Anything that can increase value of product and pay premium for it
Methods in diff situations: M&A: fmv, mv, inv value ; restructuring: fmv, mv ; inv
decision: IV, mv, inv ; tax: fmv mv ; judicial: fv , mv ; Fin Reporting: FV, viu,
replacement, reproduction cost new ; Winding down: Liq Value
Economic Analysis: General analysis, GDP, Infl, capital mkt conditions, money market
conditions (forex trend of LC and FC, govt bont yield, money and credit mkt condition)
Life Cycle Analysis:
Intro Growth Maturity Decline
PESTID: Pol, Eco, Soc, Tech, Innovation, Demo
SWOT: Opp and threat arise from ext organisations
How to create value for all the stakeholders?:
1) Increase sustaining business value through the good governance and risk
management mechanism to ensure effective use of these capitals:
Financial capital – e.g. shares, bonds, cash and cash equivalents ; Manufactured
capital – e.g. machines, buildings, non-current assets ; Human capital – e.g. people
and their knowledge, skills, motivation ; Intellectual capital – e.g. brands, intellectual
properties, patents ; Natural capital; and – e.g. environment related renewable and non-
renewable resources and processes ; Social capital – e.g. human relationships, co-
operation, networks, families, schools, social media
2) Improve sustainability practices and triple bottom lines: Economics,
Environmental, Social (EES)
9 value Drivers: 1) Next-Level Management Operating Systems Demonstrated to
Increase Sustainability of Cash Flows 2) Diversified Customer Base (i.e. not too
concentrated) 3) Proven Growth Strategy 4) Recurring Revenue That Is Sustainable and
Resistant to “Commoditization” 5) Good and Improving Cash Flow 6) Demonstrated
Scalability 7) Competitive Advantage 8) Financial Foresight and Controls
UNDERSTANDING VALUE DRIVERS
1- Understated Value Driver: Cash and cash flow management:
1) Role of Cryptocurrency (e.g. Bitcoin)? 2) Bank relationship and credit facilities
management- Multi-bank approach or focus on small number of bankers? 3) Treasury
management- Centralized treasury management – e.g. centralized cash management
including foreign currencies OR Use bank’s treasury management services? 4) Money
market funds and financial instruments: For profits or cash management and ST
investments using financial instruments
2- Regularly Understated Value Driver: WC Management:
1) Inventory and logistic management: i) Outsourcing (third party logistics),
insourcing or part of company’s daily operations? ii) Vendor inventory management and
Just-in-time/lean management 2) Accounts receivable management: i) Restructuring
of sales commission based on received rather sales ii) Factoring or invoice discounting
iii) Accounts receivable insurance iv) Incentives for on-time and prompt payments e.g.
Prompt payment discount? 3) Accounts payable management: i) Vendor and supply
chain management ii) Obtain trade credit whenever possible iii) Compare days in
payable outstanding (creditor days) and days sales outstanding (debtor days) iv) Monitor
cash conversion cycle and net working capital position
3- Enhance Business Value through Organic Growth and Capital Investments
1) Expand through internal resources & capital (the six capitals mentioned earlier) 2)
Use of retained earnings and financing capital for investment, expansion and
diversification. 3) May use capital investment appraisal techniques (e.g. Discounted
Cash Flow) to help assess whether project or investment creating business value
4) Build on business’ existing strengths and tend to expand in services and products 6.
13) (EV/EBITDAR)
which the company has reasonable competency and resources to deal with 5) 14) EV / EBIT (EV/EBIT)
Diversifying into new products and new markets often seen as more difficult for 1) Operating Eff: Opr Ratio- (Opex+ COGS)/Net Sales 15) EV / Revenue (EV/R)
company with organic growth strategy due to lack of prior knowledge and experience of 2) Financial Eff: ICR ; 16) EV / Free Cash Flow (EV/FCF) (where FCF = EBITDA – Capital Expenditure +
the market 6) Allow business to grow at a sensible and manageable rate in the long run 3) Opr and Financial Eff= i) Asset Turnover (Activity Ratios or Asset Utilisation Decrease in Working Capital (– Increase in Working Capital)
7) Have lower risk than growing through mergers and acquisitions 8) Focus on these to Ratios): Total (Fixed) asset turnover)- Net Sales/Avg TA(Avg TFA) , WCT , ITR or
improve value: i) Brand and Promotion ii) Innovation and Product Development iii) DOI , ART or DSO ; ii) APT or DPO Pros and Cons of Different Valuation Ratios
Sales and Distribution iv) Customer Relationships v) Operations: Efficiency, Lecture 2-2 (CCC, Overtrading,Mkt Based Valn
Productivity and Quality P/E: Pros: Commonly used and data easily avail ; Cons: EPS manipulated easily, can’t
Approach): use for loss making, EPS can be high due to one off events ; Best use: except loss EPS
4- Enhance Business Value through Mergers PEG: Pros: Considers future potential ; Cons: Requires credible accurate forecasts,
Two “more or less equal size” companies merge together. Shareholders of the two CCC: Calculates the amount of time taken to pay for inv and receive the money back. requires sensible risk and growth assessment ; Best use: High g companies
companies retain equity interest of the combined entity and management share the Also measures the amount of time we have to finance the inventory. P/S: Pros: Can apply to loss-making companies, Data is relatively more objective, easy
responsibility of running the combined organisation. 1) Try to gain market share CCC is an impt short term financing metric that needs attention. to use ; Cons: EV/S is preferred to P/S ; Best use: Broad estimation
(Horizontal merger) . 2) Try to remain competitive when the market consolidate CCC increases when DSO or DIO increases or when DPO decreases P/B: Pros: Easy to use ; Cons: Asset values may be manipulated and not represent the
(Horizontal or Vertical merger). 3) Ensure supplies or distribution channels and There is a direct connection between CCC, a company’s profitability & stock true economic value ; Best use: Capital intensive industries and financial insti
strengthen its value chain position (Vertical merger) market performance. Total asset turnover (TAT) = Net Sales/TA is a useful measure P/D: Pros: as floor price, compare cash return with other types of inv ; Cons: Depends
and Lower cycle à lower investment in inventory & receivables à lower total assets on div policy which might be affected by tax legislation, constant growth assumed,
5- Enhance Business Value through Acquisition (or Takeovers) à higher TAT (assuming net sales remain constant)! and Higher TAT à Higher cannot be applied for non-div paying firms ; Best use: to set floor price
Friendly takeover normally termed as acquisition. Target company's management and ROE! P/CF: Pros: Data is more objective and less manipulable, Emphasizes CF instead of
board of directors agree to acquisition by the acquiring company. profit ; Cons: Must be assessed based on comparable companies to get the relative value
What is overtrading?
Takeover tends to refer to hostile takeover but not necessary in all cases as takeover ; Best use: Relative pricing comparison, Good for start-up evaluation
and acquisition are interchangeable nowadays.Target company's management and board When growth controls the business, rather than the business controlling growth, there EV/EBITDA: Pros: Is the most popular EV model, EBITDA is close to FCF, Is not
of directors reject the proposed acquisition. Acquiring company bypasses the rejecting may be trouble ahead. affected by accounting policies on non-cash items ; Cons: Ignores capex and value
parties and goes to shareholders directly by offering attractive premium so as to achieve Overtrading is where a business enters into commitments beyond its available short created by tax management and planning ; Best use: All except 0 or -ve EBITDA
sufficient shares to fight for replacement of the existing management and board of term resources. Typically, trying to make a profit with too little working capital EV/EBITDAR: Pros: use when companies rent assets instead of purchase them ; Cons:
directors; and/or take over the control underpinning the effort. Overtrading can be difficult to spot as it’s caused by time lags Same as ev/ebitda + rent may not be disclosed ; Best use: hotels, trans, and retail
within the business model, not easily discernible to outsiders EV/EBIT: Pros: Highlights/Differentiates companies with high capital commitments ;
6- Enhance Business Value through Spinoff and Management Buyout Worse is – a company might not be aware they’re overtrading. It may be expanding to Cons: affected by dep policy; Best use: except 0 or loss making ebit
A company makes an independent subsidiary by selling/distributing new shares of get their way out of some underlying financial trouble! EV/R: Pros: Apply to loss-making companies, Data is more objective, easy to use ;
existing company is called spinoff. Cons: Rev may not be the key driver ; Best use: Min price setting, professional firms
When managers acquire a large part of the company, it is called management buyout. Signs of Overtrading: such as acc and law firms (with high corr of earning with rev), new start-ups
EV/FCF: Pros: Can better normalize impact for companies with intensive capital
7- Enhance business valuation via early/diff stage venture or PE inv requirements, Is not affected by accounting policies on non-cash item ; Cons: Capital
A cheaper form of investment and acquisition due to cheaper valuation expenditure tends to be irregular items, leading to more difficult interpretation and lack
Risk Factors involved with different growth methods of consistency of figure. ; Best use: lower the ratio- more underval the company, start up
valuation
Organic: Too slow compared to merged company so loss of mkt cap and large
customer. Growth rate can be restricted by and dependent on overall g of market. Limitation of Rations:
M&A: Most M&A fail to achieve the estimated synergy. 1) Companies operate in different industries with diff market factors. There it might be
Venture & PE: High failure rate, constant change of direction and plans, constant misleading to compare ratios of companies in diff industries. 2) Diff accounting policies
request for new injection of funds by start-up, potential dilution effects used by different companies which might impair comparability and ratio analysis, 3)
Lecture 2-1 (Ratio Analysis): Ratio analysis in general explains relationships between past information while users
are more concerned about current & future information
1. Profitability Ratios:
!" *+,- #, #/"0- Lecture 4 (Asset & Income Based Valuation Approach)
GPM= OPM= NPM= ROIC=
#$% '()$' #$% .()$' #$% .()$' 012 ,31$'%$4 5(67%()
#/" 89 *+,- #, #,
ROCE= ROA= ROA= 1. Cost Approach (ABV):
012 ,31$'%$4 5(67%() 012 -0 012 .:(9$:8)4$9 *;
Meaning: Assume buyer will not pay more than the cost of assets for the business. It is
1) where Net Sales = Revenue after deducting: Sales Tax, Discounts & Sales Returns Signs of Overtrading:
2) where Capital Employed (CE) = TA – Current Liab Or CE = Eq + LT Debts 1) Inject new equity funding, if possible based on the BV (with suitable adj) of the assets: Net Asset Value Approach, also
known as Net Asset Backing Approach, Asset Accumulation Method, Asset Build-up
3) where NOPAT = EBIT * (1 - Tax) ; Invested Capital = CE – Non-operating assets 2) Manage supply chain (and suppliers) carefully and negotiate better payment terms
(e.g. cash, share investment) which can often make or break a business’s ability to meet demand, without running Method, Adjusted Book Value Method, Adjusted Net Asset Approach.
Used for cross checking and setting a floor pice. Valn Adjs depends on: 1) Going
4) When companies are from different tax regimes- use ROCE ; else, ROIC itself dry
3) Obtain short term business loans and more favourable credit terms from suppliers concern: MV of assets and liabilities as a going concern business and 2) Liquidation
(break-up basis): MV of A&L in liquidation ; NRV (incl tax impli) ; liqui cost
2. ROE Decomposition: 4) Replenish funds as fast as possible by offering early and prompt payment discounts
ROE= NPM x Assets Turnover x Equity Multiplier to incentivize customers to make payment early or promptly allowance
#$% 73<8=$ #$% .()$' 012.-0
ROE= x x 5) Manage working capital carefully, especially on inventory, accounts receivable, and
#$% .()$' 012. -0 012.-*
cash Choosing a valuation base for assets: 1) Historical Cost: Appropriate for CAs with
1) NPM- Measure of opr eff ; TAT- Asset use eff; EM- Measure of LT solvency fast turnover, trade receivables (subject to allowance for doubtful debts) ; 2)
2) Only invest more in A when the TAT & PM is greater than B. But if it is only Mkt Based Valuation Ration: Replacement Cost: Assets are used continually within the business (e.g. Raw material
because of EM, then we would not cus we are exposing ourselves to bankruptcy risks inventories) ; 3) Net Replacement Cost: Non-current assets carrying at net book
3. Mkt Based Ratios Prev already stated ratios: 1) EPS= (NI-Pref Div)/wtd avg, 2) Div yield= DPS/Price, 3) values in the financial statements (eg: equipment & machinery). It is just the full
#$% ,3<8=$?"9$@$99$4 47174$34' 5C99$3% .:(9$ "97<$
EPS= P/E Ratio= BV/share, 4) MV/share, 5) CF/share, 6) P/E (ttm and ntm) replacement cost minus allowance for depreciation to recognise the age of the asset. 4)
A$72:%$4 012 58==83 .:(9$ //. *(93732' 6$9 .:(9$
58==83 ':(9$:8)4$9'!*;C7%D E". FG% 5(6
NRV: Apt for assets have readily available markets such as properties, motor vehicles,
BV Per Share= ; Div yield= MV/share= "
Normal New: commodities held as inventory
58==83 .:(9$' /C%'%(34732 5F" 58==83 .:(9$' #
FH- 50" 5I/?"9$@ E71 7) PEG: PE/EPS growth (or PE/{[(EPSn-EPS0)^(1/n) – 1]*100)} ; 8) PS: MP/Sales per
P/B= CF Per Share = P/CF= Under Going Concern: Value of 100% Eq= Net assets + Inc mkt value of the property
-8%() 58==83 .:(9$:8)4$9 *; A%4.012.#8.8@ ':(9$' sh ; 9) P/B ; 10) P/D= MP/Div per sh ; 11) P/CF: MP/CF per sh
.:(9$ "97<$ - income tax on the sale of property
5I 6$9 .:(9$
EV= Mkt Cap + NET Debt + Minority Sh (or minority interest) + Pref Shares – C&CE Under Liq: First calc NAV by doing (BV +- any value adj) and getting the mkt value.
1) Trailing (ttm) PE: MP/EPS0 ; Leading PE: CMP/EPS1 ; Jus PE: payout ratio/ (req Then adding it to get NAV. Then subtract liq cost to ger the 100% eq value.
EV= Net Debt + Equity – C&CE
RRoR –g) ; Subtract treasury stock from the O/S common shares in EPS formula
EV= Operating Assets= Fixed Assets + Intangible Assets + WC
and EV
10) EBITDA Multiple: EV/EBITDA
4. LT Solvency Ratio
-8%() J7(K7)7%7$' Pros
(89 -8%() E$K%) -8%() E$K% *+,- - This ratio does not consider tax therefore is useful for cross countries comparison
Debt ratio= D/E= ICR=
-8%() 0''$%' .:(9$:8)4$9' *;C7%D ,3% *N6 when companies under different tax regimes
-8%() E$K%(-E) -8%() (''$%'
Debt to Capital Ratio= Equity Multiplier= - This ratio explicitly considers the debt value and other funding sources therefore is
-EO.:(9$:8)4$9'!*;C7%D -8%() *;C7%D
good for mergers and acquisitions consideration to check the real value for the whole
Total debt here refers to interest-bearing debt (both ST and LT)
enterprise
Cons
5. ST Solvency Ratio
- It is not fair to use it for cross-industry analysis because different industry requires
different capital expenditure and working capital commitments. This ratio ignores
Formulas: WCT= Net Sales/Avg WC ; ITR= COGS/Avg Inv ; DOI= 365/ITR ; ART=
these factors. Similar to the PE ratio, the reasonable value is industry dependent
Net Cred Sale/Avg AR ; DSO= 365/ART ; APT= Credit Purch/Avg AP ; DPO= 365/AP
Current Ratio: Avg CA/Avg CL ; QR: (Avg. Cash + Avg Mkt Securities + Avg
AR)/Avg CL ; Cash Ratio= (Avg Cash+ Avg cash equivalents)/Avg CL ; CCC= 11) Earning Before Interest, Taxes, Depreciation and Amortisation multiple (EBITDA
DOI+DSO-DPO x)
= Enterprise Multiple
1) IF ITR>IND AVG= means that you might be selling goods at a discount = Enterprise Value / EBITDA (EV/EBITDA)
2) IF ART s high, it is good 12) EV/EBITDAR= EV/(EBITDA and Rental)
3) IF APT is high, do not pay too high

Additional requirements: Taxes on sale of capital assets such as properties and
investment ; Carry-forward tax losses? ; Discount (or Premium) on unquoted shares ;
Time left for sale of items ; Additional expenses ; Advertising and commission ;
Professional fees ; Redundancy and severance payments
2) Income Based Models (Div Disc)
Gordon Growth: P0= D1/(Re-g) …… => Re= (D1/P0) + g OR Div Yield + Capital
Gain Yield (Where Re is the expected return on the stock).
Q$ (ROS&) Q$ (S'(S))U
H Model: !P = "Q = + where gs= LT stable growth & gh means
T?S& T?S)
ST rate
Normal g abnormal g
H Model only works when the declining period is not long and stable g rate is not large
Problems with DDM: Suitable for min shareholders for companies with well
established div policy ; Very sensitive to g due to perpetual g assumption. Temp div g
can exceed the industry g but is not suitable in LT. the div g cannot exceed profit g in
LT. Also, div g must be smaller than E(Rate of return) or Re.
Estimating g: 1) Analyst forecast ; 2) Mgmt est ; 3) hist g ; 4) company’s fundamental
and prof trends ; 5) retention ratio (g= b*ROE OR g= b*ROI)(ROI is also denoted as
r)(b is based on NPAT not paid out as div OR b =(NI-Divs)/NI ; 6) g must be
sustainable. Significant change in the capital structure can affect such an assumption.
Terminal Value estimation: 1) Constant Growth: ; 2) H Model ; 3) Market Approach:
Price multiple (eg PE,PB) on some economic multiple (eg EBIT, NI) at the end of
explicit forecast period. It is a mix of mkt and income approach. Mkt condition at the
end of 4/5 yrs may not be the same as today. 4) Liq Value: If company will cease
operations and liquidate its assets at the end of the explicit forecast period.
Lecture 5 (FCFF, FCFE, Cost of Cap, CAPM)
1) FCFF= EBIT(1-tax on EBIT) + NCC – Capex – Change in WC
Note: 1) Disc at WACC, 2) EBIT(1-t) = NOPAT, 3) FCFF is an indicator of the firm
value. 4) Firm Value does not = Equity Value, 5) -ve values means cant cover cost and
inv.
2) FCFE= EBIT – Int – Tax + NCC – Capex – change in WC + New debt – Principal
repayment of old debt
Note: FCFE gives the value of equity; Disc using req return on eq (Re) (same as DDM)
3) Common Adj to CF: Opr Profit + Dep + Restructuring Exp (Accruals) --
Restructuring Income (which is write back of excessive accruals or prov) – Cap Gain +
Cap Loss – FX Gain + FX Loss
^^ because 1) acc and provs are non cash , 2) cap gains and losses are just acc adj and
cash flows are alr recorded based on receipts ; 3) FX also same logic: full amt of FX is
paid or received. The translation at record date create paper P/L.
4) Issues Concerning FCFE Modelling: 1) Suitable for major inv looking to control ;
2) better model than DDM when company pays no div/irregular pattern of div/irregular
div payout ratio ; 3) estimates CF from opr asset and ignores cash generated from non
opr assets (eg marketable securities). Therefore need to separately estimate. ; 4) FCFE
can be seen as the CF available for div and therefore same g can be used as DDM ; 5)
DDM tends to provide a lower valuation number since we use proportion of the retained
earning. FCFE provides higher valuation.
5) Pros of FCFE: 1) Not affected by discretionary div policy ; 2) good for valuing
companies with no/irregular div policy ; 3) measures cash flow generating ability ; 4)
controlling int companies ; 5) considering and incl more major assump and future
expectations ; 6) no need for comparable data and easy sensti and scenario analysis
6) Cons of FCFE: 1) requiring major CF estimation (extra for FCFE: net borrowing) ;
2) possible -ve CF when yrs with high g opportunities ; 3) complex and subjective
assump which causes change in answer ; 4) disc rate diff to know
7) Issues Concerning FCFF Modelling: 1) Calculates EV instead of equity value. Eq
Value= EV - Debt + C&C Equi + Value of non opr assets (Calc by income, mkt or asset
based approach. We only estimate CF form opr assets and therefore, separately estimate
value of non opr assets. 2) Estimation of reliable g. We use same as FCFE/DDM but
normally FCFF should be diff from FCFE due to presence of debt. Est g in levered firm
should be higher in FCFE than the FCFF g for the same firm as FCFF incl cash for both
eq and debtholders.
8) Pros & Cons of FCFF: Pros: 1) All points in FCFE ; 2) easier to estimate the opr
CF (without estimating the time and value of debt inflow or outflow) ; 3) Company’s
Opr CF g estimate is easier to estimate than the CF to eq shareholder only. Cons: All
points in FCFE.
9) FCFF vs FCFE: 1) FCFF provides firm value without debt CF ; 2) FCFF is useful in
valuing firms with confusing capital structure and firms with high leverage and being in
the process of reducing it to achieve its target capital structure. 3) Both should
theoretically provide the same value 4) Both is used to cross check 5) Disc rates are diff
to show risk
10) Mid-Year Discounting: Discount CF1 at 0.5, CF2 as 1.5….. To do this, you can
also.. DO FULL YEAR then multiply that number with (1+r)^(1/2)
11) Difference in Equity Value using Different Techniques (Discounted CF vs BS):
Discounting: Discounting based on operating cash flow to determine Enterprise Value.
Also, to determine equity value, need to add back Surplus Cash (not involved in the opr
CF. Balance Sheet: Equity Value from market value (if traded) or fair value (of Balance
sheet). Also, Enterprise Value is determined based on ALL Cash (in B/S)
NOTE FOR THIS LECTURE: Equity and Debts should be valued at their respective
Market Values. If they are traded, their respective market values will be used. If they
are not traded, they are assumed to be valued at fair value due to fair-value
accounting used.
1) BETA measures the systematic risk of.a particular stock. It is sensitive to the time
interval taken and different sources can give you different betas for a company. Beta is
dependent of 2 factors: Business and Financial Risk. Higher these risks, higher will be
the beta. It is also the slope of the CAPM.
2) Market Risk Premium is forward looking expectation based, not directly
observable, country specific and can be calculated using historical analysis or surveys
with investors.
3) Equity Beta (also called geared beta) takes into consideration both, the business and
the financial risk. This is same as the betas of the company.
4) Asset Beta (also called ungeared beta) takes into account only the business risk of the
company or finds what the risk would be if company was fully financed with debt.
5) We also add a Size Premium or a Liquidity Premium to the normal CAPM. The
premium usually applies to forward-looking expected return only.
6) Alpha Value: There can be gap between the return of the stock and the return that we
got from the CAPM. This is mainly due to the unsystematic risk associated with the
stock. Over a long period of time, the alpha value should be equal to zero. Well-
diversified also 0.
7) Perpetual Cost of debt formula: (Coupon/CMP)*(1-t). For other cost of debt
computations, if no interest rates given, calculate the bond’s YTM using the financial
calculator.
8) Irredeemable preference share cost: (Div/CMP). REMEMBER NO TAX
REDUCTION.
Lecture 6 (MM Theorem and Hamada Equation)
1) MM1 (Without Taxes): Debt is risk-free and is freely available at the same cost as
to the equity investors. Therefore, capital structure is irrelevant and has no impact on the
wacc. In this case, the MV is determined by total earnings of the company and the level
of business risk of the company. NO financial risk. Proposition 1 states that the value
of a levered is same as the levered. Therefore, Vu=Vl. Proposition 2 says that the cost
E E * Whenever debt is mentioned, it always refers to the interest bearing debt. You would
of equity (Re) = %$ = %V + (%V - %4 ) . And WACC of the firm= & %4 ' + & %$ '. In MM1,
* W W have to not take A/C PAYABLE, TAX PAYABLE, OTHER PAYABLES from current
the Re increases but the Rd and WACC remains same.
2) MM2 (Without Transaction cost): In this, Rd remains the same but is lower due to
the tax benefit that the companies would get. The WACC reduces due to the tax benefit
and companies should borrow as much as possible till their Wd is next to a 100%. The
Re keeps rising in this case too. Proposition 1 states that the Vl= Vu + D*tax rate..
E
Proposition 2 says that the cost of equity (Re) = %$ = %V + (%V - %4 ) (1-t). And WACC
*
E * E
of the firm= & %4 (1 − ,)' + & %$ ' OR %A055* = %V ( 1 − . /< ) = %V (1 − / ).
W W W <
3) Weakness of MM: MM assumes that inv have the same info, react rationally and
borrow and lend at the Rf rate. It assumes that the prices reflect all info and no trans
cost.
4) In reality, Debt Capacity - Company has a borrowing limit mostly based on its
ability to provide collateral on the debt and its certainty in generating earnings and cash
flow. ; Asymmetric Information - Lenders may not provide the loans due to
reservation on assumptions and uncertainty on borrower’s ability to delivery the results
and repayments. It may be in the borrower’s interest not to provide full picture to the
lenders if it has problems to delivery the results. Share price may not reveal all
information about the company. ; Pecking order - Management may place higher
priority to funding sources that reveal the least amount of information. ; Cost of debt -
Cost of debt increases when more risk associates with the borrower as the lender would
require higher rate of return to justify the risk. ; Tax Benefits - If the borrower
continuous to borrow, its interest payments may eventually exhaust all profits turn into a
loss-making company which cannot utilise the tax benefit. ; Loan Covenants -
Lenders normally require borrower to restrict its borrowing to a limit as well as based
on interest payment coverage ratio. Therefore, the borrower may have a lot of loan on
interest payment coverage ratio. Therefore, the borrower may have a lot of loan
covenant conditions, restricting its borrowing ability. ; Transaction costs - Such cost
exists and can become significant if frequency of trading and transactions are high
5) Variability of return to the shareholders is generally much higher in levered firms,
proving that they have higher financial risk. Risk and variability is caused by the
changes in the capital structure, not from operations. This implies that geared companies
should have a higher beta as compared to the ungeared companies.
6) Hamada Equation:
Y!
Asset Beta = Beta (U) = !X = "
[[O # ([?-$)]
E
Equity Beta = Beta L = 0J = 0X [1 + (1 − /< )]
*
Lecture 3 (Market-Based Approach)
Methods of doing market based analysis: CTM method: Suppose a company’s
NPAT is 10m and we know that other firms was sold at x of NPAT and there is a
control premium of equity, then value would be just me x*NPAT since the control
premium is already included in the sale. Comparable Company Method (for majority
stake): Suppose a company’s NPAT is x m and we know that other firms have a P/E of
yx and there is a control premium of a for full equity. Therefore, we would say that the
value of this part of the equity is y*x+a(y*x). Comparable Company Method (for
minority stake): Same example as above, just assume that the stake we are buying is
less than 50%, then no prem required.
Best use of the market approach is when the subject company has an identifiable
earnings trend and has the capability to generate earnings that can warrant a higher
value as compared to its underlying net tangible assets. For companies that are at the
infancy of its development, the market approach using revenue and net assets as the
financial metrics is also commonly adopted.
If EBITDA is negative , just use EV/Revenue or something to counter this.
Adjust for, one off, non-operating assets, goodwill or intangible writeoffs, income
and exp arising from non-arms length transactions, extraordinary items
Factors to consider: Which profit margin to use? ; Implication of dep/amort, capital
structure, size effect: use p/b, p/s or p/e? ; potential growth in revenue/profit: p/cf or p/s
; Comparable Products or Customer Portfolios – PEG, P/CF or P/E? ; Historical vs
Future earnings: based on quality of forecast ; Prem or Dis embedded in the transaction
multiples ; company reputation, goodwill, etc ; valuation range and expected rates of
returns
Types of earnings to be used: Business is mature: Historical and Current earnings ; No
Significant changes envisaged: hist, curr and forecasted earnings ; ongoing changes in
products and services: Forecasted ; Volatility in earnings: Avg Earnings
Weighted avg earnings: Basically rate last 5 yr’s earnings from 1 to 5. And then
multiply the relevant earning for the one with rating ‘1’ with 1/15. Do this for all to
come to an avg.
Trailing PE or EPS is used when forecasted returns cannot be estimated. Forward P/E
or NTM EPS is used when prev earnings are not reflective of the future.
For Monthly EPS COMPUTATION, do 1/12*Current yr EPS + 11/12*next yr EPS
MID TERM PAPER NOTES
liab. Bank loans, Overdrafts are included.
THE ABOVE IS EVEN TRUE FOR CALCULATING EV. REMOVE NON
RECURRING ITEMS FROM EBITDA COMPUTATIONS.
IN D/E CALCULATIONS, use the above mentioned debt and the equity is just the BV
of equity found.
CHECK FOR SIZE AND LIQUIDITY PREMIUM
INTANGIBLE LAST PART:
iii) With or without method: This is also called Comparative income differential
method, Income increment/cost decrement method, Comparative business valuation
method, Differential value method. Similar to the incremental cash flow method.
Comparing present value of cash flows of a business having the intangible asset with the
same business without the intangible asset. Steps: i) Establish the after-tax cash flows
generated by an entity owning the intangible asset over its economic life and discount
such cash flows (FCFF) to the valuation date using the risk-adjusted discount rate
specific to the intangible asset (i.e. With) ii) Repeat the same considering without the
intangible. Iii) Calculate the difference between the two scenarios (the differential
value) iv) Apply a probability factor, if any, for the estimation of the possibility and
likelihood of the without scenario to the differential value v) Add TAB, if any