LESSON 4

Lecturer: MBA, MBF BUI QUOC KHANH

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 BUSINESS VALUATION
4.1 – ASSEST METHOD
• The persons or institutions that buy debt from the
firm are creditors.
• The holders of the equity shares are shareholders.
The size of the company’s balance sheet will
determine how well the company has made its
investment decisions. The size of the firm is its
value in the financial markets:
Value of company = Value of debt + Value of equity
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4.1 – ASSEST METHOD
The formula of assest value:

VE = VA – VD
Where:
VE: Market value of Equity
VA: Market value of Total assets
VD: Market value of Debt
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4.1 – ASSEST METHOD
Example of the effect of gearing in factory
purchase
• Factory is purchased for £100,000
• The growth rate in factory prices is 20 per cent
• 70 per cent is borrowed on mortgage
• The interest rate on the mortgage is 10 per cent p.a.
• The factory is sold after 1 year
1. What is the Value of Equity after 1 year?
2. What is the Value of Equity if you borrow 50 per
cent?
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4.1 – ASSEST METHOD
1. Sale price £120,000
(Market value of Total assets)
Less Mortgage £70,000
Plus Interest £7,000
Value of Debt £77,000

Value of Equity £43,000

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4.1 – ASSEST METHOD
2. Sale price £120,000
Less Mortgage £50,000
Plus Interest £5,000
Value of Debt £55,000
Value of Equity £65,000
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4.1 – ASSEST METHOD
Debt or equity
• The distinction between debt and equity
depends on whether the money is borrowed
(debt).
• Borrowed money needs to be repaid, and
interest will be paid on the outstanding
amount until the debt is repaid. The equity
return for the person who puts up the money
is determined by the success of the
enterprise.
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4.1 – ASSEST METHOD
4.1.1 Measuring Asset Value
The financial statement in which accountants summarize
and report asset value is the balance sheet. To examine
how asset value is measured, let us begin with the way
assets are categorized in the balance sheet. First, there
are the fixed assets, which include the longterm assets
of the firm, such as plant, equipment, land and buildings.
Next, we have the short-term assets of the firm,
including inventory (including raw materials, work in
progress and finished goods), receivables (summarizing
moneys owed to the firm) and cash; these are
categorized as current assets.
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4.1 – ASSEST METHOD
4.1.1 Measuring Asset Value
We then have investments in the assets and
securities of other firms, which are generally
categorized as financial investments. Finally, we
have what is loosely categorized as intangible
assets. These include assets, such as patents and
trademarks that presumably will create future
earnings and cash flows, and also uniquely
accounting assets such as goodwill that arise
because of acquisitions made by the firm.
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4.1 – ASSEST METHOD
• Fixed Assets
Generally accepted accounting principles (GAAP) in the
United States require the valuation of fixed assets at
historical cost, adjusted for any estimated gain and loss in
value from improvements and the aging, respectively, of
these assets.
• Current Assets
Current assets include inventory, cash and accounts
receivables. It is in this category that accountants are most
amenable to the use of market value, especially in valuing
marketable securities.
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4.1 – ASSEST METHOD
• Accounts Receivable
Accounts receivable represent money owed by
entities to the firm on the sale of products on
credit. The accounting convention is for accounts
receivable to be recorded as the amount owed to
the firm, based upon the billing at the time of the
credit sale. Firms can set aside a portion of their
income to cover expected bad debts from credit
sales, and accounts receivable will be reduced by
this reserve.
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4.1 – ASSEST METHOD
• Investments (Financial) and Marketable Securities
In the category of investments and marketable securities,
accountants consider investments made by firms in the
securities or assets of other firms, and other marketable
securities including treasury bills or bonds. Accounting
principles require that these assets be sub-categorized into
one of three groups: investments that will be held to
maturity, investments that are available for sale and trading
investments.
• Intangible Assets
Intangible assets include a wide array of assets ranging
from patents and trademarks to goodwill. The accounting
standards vary across intangible assets.
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4.1 – ASSET METHOD
4.1.2 Measuring the Value of Liabilities and Equities
Accountants categorize liabilities into current liabilities,
long-term debt, and long-term liabilities which are neither
debt nor equity. Next, we will examine the way they
measure each of these.
• Current Liabilities
Current liabilities categorize all obligations that the firm has
coming due in the next accounting period.
• Long Term Debt
Accountants measure the value of long-term debt by
looking at the present value of payments due on the loan or
bond at the time of the borrowing.
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4.1 – ASSEST METHOD
4.1.2 Measuring the Value of Liabilities and
Equities
• Other Long Term Liabilities
Firms often have long-term obligations that are not
captured in the long-term debt item. These include
obligations to lessors on assets that firms have
leased, to employees in the form of pension funds
and health care benefits yet to be paid, and to the
government in the form of taxes deferred.
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4.1 – ASSEST METHOD
• Measuring Liabilities and Equity: The
Home Depot Co.
Table below summarizes the accounting
estimates of liabilities and equity at The
Home Depot Co. for the 1998 financial year:
` Unit: USD

Book
Items Value Revalue
Net Fixed Assets 8,160
Goodwill 140
Investments and Notes Receivable 41
Deferred Income Taxes 0
Prepaid Pension Expense 0
Customer Financing 0
Other Assets 191
Current Assets
Cash 62
Short-term Marketable
Investments 0
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Accounts Receivables 469

Current Portion of
Customer Financing 0
Inventories 4,293
Other Current Assets 109
Total Current Assets 4,933
TOTAL ASSETS 13,465
 Unit: USD
Items Book Value Revalue
Current Liabilities
Accounts Payable & other liabilities 1,586
Accrued Salaries and Expenses 1,010
Taxes payable 247
Short term debt and Current LT debt 14
Other current payables 1,868
Total Current Liabilities 4,725
Non-current Liabilities
Other Long Term Liabilities 210
Deferred Income Taxes 83
Long-term Debt 1,566
Total Non-current Liabilities 1,859
TOTAL LIABILITIES 6,584
 Unit: USD
Book
Items Value Revalue
Shareholder's Equity
Par Value 37
Additional Paid-in Capital 2,891
Retained Earnings 5,812
Total Shareholder's Equity 8,740
TOTAL RESOURCES 13,465
 BUSINESS VALUATION
4.2 – INCOME METHOD
The value of the firm is obtained by
discounting expected cashflows to the firm,
i.e., the residual cashflows after meeting all
operating expenses, reinvestment needs and
taxes, but prior to any payments to either
debt or equity holders, at the weighted
average cost of capital, which is the cost of
the different components of financing used by
the firm, weighted by their market value
proportions.
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4.2 – INCOME METHOD
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4.2 – INCOME METHOD
• Applicability of DCF Valuation
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4.2 – INCOME METHOD
• Applicability of DCF Valuation
▪ Discounted cashflow valuation is based upon expected future
cashflows and discount rates. Given these informational
requirements, this approach is easiest to use for assets (firms)
whose cashflows are currently positive and can be estimated
with some reliability for future periods, and where a proxy for
risk that can be used to obtain discount rates is available.
▪ The further we get from this idealized setting, the more difficult
discounted cashflow valuation becomes. The following list
contains some scenarios where discounted cashflow valuation
might run into trouble and need to be adapted.
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4.2 – INCOME METHOD
• A discount rate converts all of the expected
future returns on investment (however defined)
to an indicated present value.
• Discount rate: A rate of return used to convert a
monetary sum, payable or receivable in the
future, into a present value
• Estimating a Weighted-Average Cost of Capital:
WACC = Percent Equity*Return on Equity +
Percent Debt *Cost of Debt*(1 - tax rate)
WACC = %E*e + %D*d*(1 - t)
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4.2 – INCOME METHOD
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4.2 – INCOME METHOD
• The Perpetual Economic Income Stream Model:
The basic discounted economic income formula would
value as follows:

where:
• n = The last period for which economic income
is expected; n may equal infinity (i.e., ∞) if the
economic income is expected to continue in
perpetuity.
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4.2 – INCOME METHOD
• Ei = The expected amount of economic income
in each ith period in the future
• kp = Rate of return
• i = The period (usually stated as a number of
years) in the future in which the prospective
economic income is expected to be received
• It can be shown mathematically that when the
expected economic income is a constant amount
in perpetuity, the above formula can be simplified
to:
Valuing a business opportunity:

What the business is worth

 BUSINESS VALUATION
4.2 – INCOME METHOD
❖Zero growth model
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4.2 – INCOME METHOD
• In the above formula, the divisor (k–g) represents
the capitalization rate, a relationship that can be
expressed as an formula as follows:
c=k–g
• c = Capitalization rate (a rate to be used as a
divisor to convert a return flow variable, such as
net cash flow, to an indication of value)
• g = Annually compounded rate of growth in the
economic income variable being capitalized over
the life of the investment
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4.2 – INCOME METHOD
• Projection scenario: $8,000,000 net cash flow to equity in
Year 1, a 5 percent perpetual annual growth rate from Year
1 forward, and a 25 percent present value discount rate.
Discounted Economic Income Method
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4.2 – INCOME METHOD
Capitalized Economic Income Method
• Projection period: Year 1
• Economic income to equity $8,000,000
• Present value discount rate minus __________
expected long-term growth rate 0.25 – 0.05
• Indicated value of business entity $40,000,000
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4.2 – INCOME METHOD
Illustration : Effects of mismatching cashflows
and discount rates Assume that you are analyzing
a company with the following cashflows for the
next five years. Assume also that the cost of equity
is 13.625% and the firm can borrow long term at
10%. (The tax rate for the firm is 50%.) The current
market value of equity is $1,073 and the value of
debt outstanding is $800.
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4.2 – INCOME METHOD
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4.2 – INCOME METHOD
• The cost of equity is given as an input and is
13.625%, and the after-tax cost of debt is
5%. Cost of Debt = Pre-tax rate (1 – tax
rate) = 10% (1-.5) = 5% Given the market
values of equity and debt, we can estimate
the cost of capital.
• WACC = Cost of Equity (Equity / (Debt +
Equity)) + Cost of Debt (Debt/(Debt+Equity))
= 13.625% (1073/1873) + 5% (800/1873) =
9.94%
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4.2 – INCOME METHOD
Method 1:
Discount CF to Equity at Cost of Equity to get value of
equity
We discount cash flows to equity at the cost of equity:
PV of Equity = 50/1.13625 + 60/1.136252 + 68/1.136253
+ 76.2/1.136254 + (83.49+1603)/1.136255 = $1073
Method 2:
Discount CF to Firm at Cost of Capital to get value of firm
PV of Firm = 90/1.0994 + 100/1.09942 + 108/1.09943 +
116.2/1.09944 + (123.49+2363)/1.09945 = $1873
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4.2 – INCOME METHOD
PV of Equity = PV of Firm – Market Value of
Debt = $ 1873 – $ 800 = $1073 Note that
the value of equity is $1073 under both
approaches. It is easy to make the mistake
of discounting cashflows to equity at the cost
of capital or the cashflows to the firm at the
cost of equity.
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4.2 – INCOME METHOD
• Illustration: Stable Growth rates and Excess
Returns
Alloy Mills is a textile firm that is currently reporting
after-tax operating income of $100 million. The firm
has a return on capital currently of 20% and
reinvests 50% of its earnings back into the firm,
giving it an expected growth rate of 10% for the
next 5 years:
Expected Growth rate = 20% * 50% = 10%
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4.2 – INCOME METHOD
Value of firm today =

Now consider the effect of lowering the growth rate

to 4% while keeping the return on capital at 10%
in stable growth:
Expected operating income in year 6
= 100 (1.10)5(1.04) = $167.49 million
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4.2 – INCOME METHOD
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4.2 – INCOME METHOD
Note that the terminal value decreases by $16
million but the cash flow in year 5 also increases
by $16 million because the reinvestment rate at
the end of year 5 drops to 40%.
The value of the firm remains unchanged at
$1,600 million.
In fact, changing the stable growth rate to 0% has
no effect on value:
Expected operating income in year 6
= 100 (1.10)5 = $161.05 million
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4.2 – INCOME METHOD
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4.2 – INCOME METHOD
• FREE CASH FLOW TO EQUITY DISCOUNT MODELS
• Free Cash Flows to Equity
To estimate how much cash a firm can afford to return to its
stockholders, we begin with the net income –– the accounting
measure of the stockholders’ earnings during the period ––
and convert it to a cash flow by subtracting out a firm’s
reinvestment needs.
• First, any capital expenditures, defined broadly to include
acquisitions, are subtracted from the net income, since they
represent cash outflows.
• Second, increases in working capital drain a firm’s cash
flows, while decreases in working capital increase the cash
flows available to equity investors.
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4.2 – INCOME METHOD
• Finally, equity investors also have to consider the effect of
changes in the levels of debt on their cash flows.
Repaying the principal on existing debt represents a cash
outflow; but the debt repayment may be fully or partially
financed by the issue of new debt, which is a cash inflow.
• Allowing for the cash flow effects of net capital
expenditures, changes in working capital and net changes
in debt on equity investors, we can define the cash flows
left over after these changes as the free cash flow to
equity (FCFE).
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4.2 – INCOME METHOD

This calculation can be simplified if we assume that the

net capital expenditures and working capital changes are
financed using a fixed mix1 of debt and equity.
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4.2 – INCOME METHOD
FCFE Valuation Models The free cash flow to
equity model does not represent a radical departure
from the traditional dividend discount model. In fact,
one way to describe a free cash flow to equity
model is that it represents a model where we
discount potential dividends rather than actual
dividends. Consequently, the three versions of the
FCFE valuation model presented in this section are
simple variants on the dividend discount model,
with one significant change - free cashflows to
equity replace dividends in the models.
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4.2 – INCOME METHOD
I. The constant growth FCFE model
The constant growth FCFE model is designed to
value firms that are growing at a stable rate and are
hence in steady state.
• The Model
• The value of equity, under the constant growth
model, is a function of the expected FCFE in the
next period, the stable growth rate and the
required rate of return.
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4.2 – INCOME METHOD

P0 = Value of stock today

FCFE1 = Expected FCFE next year
ke = Cost of equity of the firm
gn = Growth rate in FCFE for the firm forever
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4.2 – INCOME METHOD
II. The Two-stage FCFE Model
The two stage FCFE model is designed to value a
firm which is expected to grow much faster than a
stable firm in the initial period and at a stable rate
after that.
The Model The value of any stock is the present
value of the FCFE per year for the extraordinary
growth period plus the present value of the terminal
price at the end of the period.
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4.2 – INCOME METHOD

gn = Growth rate after the terminal year forever.

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