FM414 LN 6 Master Copy Presentation Solutions - Valuation - 2024 Color

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Lecture 6:
Valuation
Outline 2
0. Motivation
1. Economic Framework
2. In Practice
Motivation
Problem: The valuation of firms is a central problem facing capital market
participants (i.e. buyers and sellers) 3
Motivation 4
There are many questions we want to answer:
• What do we mean by “value”? Can different market participants value the same
asset differently?
• How do we estimate the market value of a company?
• What methods for value estimation are best?
• What are the key drivers of value for a given company?
Why should I care about answering these questions?

1. Relevant for many careers
 Operations / Consulting – often evaluate operational improvements in terms of
the value added
 Buy side (equity, debt analyst, private equity) – constantly valuing companies
and trading their securities
 Sell side (banking) – Valuing firms and selling securities
2. Helpful for forming your own views on many world events
- for example, how do world events impact firm valuations, and vice versa?
Motivation 5
There are many questions we want to answer:
• What do we mean by “value”? Can different market participants
value the same asset differently?
• How do we estimate the market value of a company?
• What methods for value estimation are best?
• What are the key drivers of value for a given company?
Can we answer these questions using intuition alone?

 Intuition is helpful though clearly insufficient due to its imprecision and
susceptibility to bias
Can we rely on statistical approaches to estimating discount rates?

 Statistics are helpful for providing benchmarks, but statistics doesn’t tell
us how much to deviate from benchmarks and why. Moreover, some
assets don’t have comparables.
Economic Approach
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Because intuition and statistics are helpful, but not fully

sufficient for valuing companies, we will use economics to
help guide us.
We will develop a theoretical framework to think about firm

valuation.
We will then apply this framework in practical settings. You

have covered this topic in FM422, but we will go more in
depth to discuss important strengths and limitations of
implementing various valuation frameworks in practice.
Valuation using APV:
Adjusted Present Value 7
 The method of writing the PV of a levered project as the sum of the PV of the unlevered
project and the PV of “financing side effects” is known as “Adjusted Present Value” (APV)
method.
 Besides tax shields we can also include other “financing side effects” such as issuance costs,
loan subsidies and (if we can measure them) expected costs of financial distress.
Value of levered project = Value of unlevered project
+ PV tax shields
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 Using the APV formula we can compute the NPV of a levered project (with
constant leverage ratios) as follows:
 
Ct TrD D
NPVlevered   ,
1  r  t 11 rA
t 0   A
t t
"Base case NPV" PV tax shields
where Ct denotes the unlevered project cash flows, T is the corporate tax rate, and
D is the (incremental) amount of debt raised because the project is undertaken.
Note that if the firm does not target a constant leverage ratio, but instead targets
a constant level of debt, we discount the tax shields by the cost of debt: r d
Weighted Average Cost of Capital (WACC)
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Method
 The “Weighted Average Cost of Capital” (WACC) method
incorporates the tax benefits of debt by discounting the unlevered cash
flows at a rate called rWACC
 The WACC method is essentially a specific case of APV. Since the tax
benefits of debt are fully incorporated in the discount rate (r WACC),
there is no need to separately consider the debt tax shield.
 A key assumption when using this formula is that firms will maintain a
constant D/V (or D/E) ratio over time.
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Specifically, using the WACC method, we can compute the value of a firm as
follows:

Ct
Vlevered  ,
t  0 1  rWACC 
t
where
E D
rWACC  rE  rD (1  T )
ED ED
is the weighted average cost of capital (or “WACC”).

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You can show that the WACC method is a special case of APV, when the leverage
ratio is assumed to be constant.
 Example 1: ABC Corporation, which specializes in the furniture
business, is considering an expansion. ABC maintains a constant debt- 12
to-value ratio of 40%. The firm’s equity beta is 0.75 and its debt beta
is zero. The expansion costs $1 million today and generates unlevered
after-tax cash flows of $300,000 per year in perpetuity. The risk of the
expansion project is the same as that of the firm’s existing business.
Also, ABC intends to continue with the same debt-to-value ratio after
the expansion. The risk-free rate is 5%, the market risk premium is
10%, and the corporate tax rate is 25%.
Should ABC undertake the expansion? Value this firm using the APV
and WACC methods.
Solution (WACC): rwacc = (.6)(Re)+(.4)(Rd)(1-.25)

Rd = 5% = rf.
Re = rf + Be*(rm-rf) = 5% + .75*10% = 12.5%
Rwacc = 9%. NPV = 2,333.33 = -1,000 + 300/.09
Yes, undertake!
Solution (APV):
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ra=(.6)(re)+(.4)(rd)=9.5%. Let’s compute the value of future cash-flows
According to the APV: V(Levered)=V(Unlevered) + PVTS
V(Unlevered)=300/0.095= 3,157.89
Annual tax shields are: Tax rate*rd * D = Tax rate*rd * [0.4 * V(Levered)].
Thus, PVTS = Tax rate*rd * [0.4 * V(Levered)]/0.095
Finally, V(Levered) = V(Unlevered) + Tax rate*rd * [0.4 * V(Levered)]/0.095
V(Levered) = 3,157.89 + 25%*5% * [0.4 * V(Levered)]/0.095

V(Levered)= 3,333.33.
Hence NPV= PV(CF) – Investment = 3,333.33 – 1,000, just like the WACC method!
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 Example 2: You are considering setting up a firm to produce candy.
The project costs $1,000 today and generates expected unlevered
after-tax cash flows of $600 one year from now and $700 two years
from now. You are planning to maintain a constant (optimal) debt-to-
value ratio of 30%. At this ratio your cost of debt is 8%. The corporate
tax rate is 35%.
The Tucker Corporation, which also specializes in the production of

candy, maintains a constant debt-to-value ratio of 20%. The firm’s
cost of equity is 13% and its cost of debt is 8%.
Should you undertake the project? Please draw out the market value
balance sheet and describe the cash flows generated by the firm and
paid out to investors over time.
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 Example 2: You are considering setting up a firm to produce candy.
The project costs $1,000 today and generates expected unlevered
after-tax cash flows of $600 one year from now and $700 two years
from now. You are planning to maintain a constant (optimal) debt-to-
value ratio of 30%. At this ratio your cost of debt is 8%. The corporate
tax rate is 35%.
The Tucker Corporation, which also specializes in the production of

candy, maintains a constant debt-to-value ratio of 20%. The firm’s
cost of equity is 13% and its cost of debt is 8%.
Solution: ra = .8*.13+.2*.08 = 0.12

Our firm re = 0.13714. rwacc = 0.1116
NPV = -1,000 + 600/1.1116 + 700/1.1116^2 = 106.264 > 0.
Yes!
Summary
Economic methods for valuation are nothing more than applications of the16
NPV framework to the various assets that comprise the firm.
It is often times difficult to estimate the inputs required to perform corporate

valuations using DCF methods, which is why many people prefer relying on
intuition or statistics.
The methods are helpful, however, for organizing our thinking about the key
drivers of value and how various changes to the firm would impact
investors. The framework also provides common ground for different parties
to discuss and partake in value-adding transactions.

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1

Why should I care about answering these questions?

Can we answer these questions using intuition alone?

Can we rely on statistical approaches to estimating discount rates?

Because intuition and statistics are helpful, but not fully

We will develop a theoretical framework to think about firm

We will then apply this framework in practical settings. You

"Base case NPV" PV tax shields

is the weighted average cost of capital (or “WACC”).

Solution (WACC): rwacc = (.6)(Re)+(.4)(Rd)(1-.25)

Finally, V(Levered) = V(Unlevered) + Tax raterd [0.4 * V(Levered)]/0.095

V(Levered) = 3,157.89 + 25%5% [0.4 * V(Levered)]/0.095

The Tucker Corporation, which also specializes in the production of

The Tucker Corporation, which also specializes in the production of

Solution: ra = .8.13+.2.08 = 0.12

It is often times difficult to estimate the inputs required to perform corporate

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