Valuation Review

MBA1 Finance

Free Cash Flow to the Firm

FCFF represents cash flows to which all stakeholders

make claim

FCFF = EBIT  (1 - tax rate)

+ Depreciation and amortization
- Capital Expenditures
- Increase in Working Capital

Note: Working capital = Current Assets - Non-interest

Bearing Current Liabilities (e.g. A/P & Accrued liab.)
MBA1 Finance

DCFF Valuation
 Stage 1 FCFF
 You may be given projections for some (or all) of the items
needed to compute FCFF (at a minimum, sales)
 For other items, use historic ratios to sales (unless you
think the are not appropriate)
 Key: state and justify all assumptions!

 Stage 2 FCFF
 assume FCFF grow at a constant rate indefinitely into the
future
 Terminal growth (g)
 Nominal rate of “stable” growth in the economy

 Capital expenditures in stage 2 = depreciation

MBA1 Finance

Steps in Applying DCFF Valuation

 Discount projected FCFF at the firm’s WACC
 This gives the value of the operating assets of the
firm (Enterprise Value, or EV)
 Add to this the value of any non-operating assets
 “excess” cash, marketable securities, etc.
 Subtract the value of existing debt to obtain the value
of common stock
 Divide by shares outstanding to come up with price
per share
MBA1 Finance

Cost of Capital (WACC)

 After tax cost of capital is the weighted average of
required returns on different types of liabilities used to
finance the assets under consideration. Formally:

kc = (D/V ) * kd * (1-t) + (E/V ) * ke

kd = cost of debt D=value of debt

ke = cost of equity E=value of equity
kc = overall cost of capital V=D+E
t = firm’s marginal tax rate
MBA1 Finance

Capital Structure
 Use market rather than book values of debt and equity
if available

 “Target” capital structure:

 Estimate the firm’s current capital structure
 Review the capital structure of comparable firms
 Review management’s plans for future financing

 What if capital structure is expected to change over

time?
MBA1 Finance

Cost of Debt (kd)

 Match with term of projects (generally long-term)

 Focus on “permanent” debt (can include short term)
 Use same rate for all types of debt (short and long-
term)
 Use current as opposed to past yields
 Take government yields and add a risk “premium”
Historic spread for issuer (long-term best but use
short term spread if no better data)
Spread given bond rating, if available
1-3%, if no other information
MBA1 Finance

Cost of Equity (ke): the CAPM

 Relevant measure of risk:

 Contribution a stock makes to the risk of a well
diversified portfolio (the “market” portfolio)
 Formally, this contribution is given by an asset’s
“beta”

 The CAPM relates the cost of equity for an individual

stock to that asset’s beta (). Formally:

ke = rf +  RP
MBA1 Finance

The CAPM: Inputs

  - beta
 Beta for an asset of similar risk to the market portfolio = 1.
 Typical range of betas: 0.5 - 2.0
 If you cannot measure for firm, use beta of comparable firm(s).
Be consistent with capital structure assumptions (may need to
unlever / relever)

 rf - risk free rate

 Current yield on long-term government bonds

 RP - expected market risk premium

 Historic average of difference between the return on the
market (e.g. TSE300) and long-term government bonds
 4-6% if no better data available
MBA1 Finance

Relative Valuation Approaches

 Find “comparable firms”
 Similar industry, leverage (link to growth prospects,
risk)
 Industry average

 Assume that valuation multiple (P/E, EV/EBITDA, etc.)

for comparable(s) will be same as for firm in question
 Determine P or EV for firm such that this is true

 Merger method (comparable transaction)

 Principle is the same, just use transaction prices

rather than trading prices to come up with ratios

 Likely to have fewer “good” comparables

 Premium paid is important “psychologically”

MBA1 Finance

Special Cases in DCF Valuation

 Capital raising (e.g. IPO)
 Do cash flow projections account for capital raised?
 If so, value of existing equity equals total equity
value less amount raised in the IPO
 Share price for equity offering = value of existing
equity / number of existing shares
 If lower price, wealth transfers from original share
owners
 Private firms
 “Liquidity discount” ~40%
MBA1 Finance

M&A Valuation: The Process

Value
of
synergy
gain to Transaction
bidder Costs

Value Max.
of
Stand- target Bid
Min. alone with
target syner-
bid value gies

In most cases, we can just determine

this value
MBA1 Finance

M&A Valuation: Special Issues

 Competing bids
 Are there other potential bidders
 What would be their maximum bid (are we likely to lose
a bidding contest?)

 Cost of Capital
 Use target firm WACC when valuing the takeover target
(use target capital structure as stand alone firm)
 Use bidder WACC when valuing bidder
 Be wary of synergies due to reduced WACC!

 Private firm discounts

MBA1 Finance

M&A Valuation: Special Issues

 Deal financing
 Debt
What are key ratios on combined company?
Can combined company meet debt obligations?
 Equity
How many shares should be exchanged?
If selling new shares, are they fairly priced?
 Other considerations
Financial flexibility
Signals
MBA1 Finance

Valuation Case Process

 Size-up the firm being valued
 Do projections seem realistic (look at past growth
rates, past ratios to sales, etc.)?
 What are the key risks?

 What qualitative issues affect your purchase

interest?
 Valuation analysis
 Several approaches + sensitivities (tied to risks)

 Come up with a valuation range that is plausible

MBA1 Finance

Valuation Case Process

 Address case specific issues
 e.g. for M&A: what is fit (size-up bidder), any
synergies, bidding strategy, structuring the
transaction, etc.
 e.g. for capital raising: timing, deal structure, etc.

 Key: Respond to case specific questions

MBA1 Finance

UGG Grading Key

 Setup (alternatives / criteria) 5%
 UGG Size-up 25%
 Valuation
 Ratios 20%
 Base case DCF 20%
 DCF of synergies 13%
 Decision 17%

 Total 100%
MBA1 Finance

Empire Grading Key

 Setup (alternatives / criteria) 5%
 Oshawa Size-up 25%
 Valuation
 Ratios 15%
 Base case DCF 25%
 DCF of synergies 10%
 Decision 15%

 Total 100%