Presented by:

presented to :

Dr. Parmjit Kaur

Akhil Kohli Bandeep Jaswal Deepika Mahajan Prabhjot Singh Ramneek Singh

Valuationy Economic theory teaches that VALUE of any resource

equals present value of returns expected from the resource, discounted at a rate that reflects the risk inherent in those expected returns. Thus: Valuet =t=1, t=n

Returnst ( 1 + Discount Rate)t

Rationale for Cash Flow-Based ValuationIt is two-fold: 1. Cash is the ultimate source of value. A resource has value because of its ability to provide future cash flows. 2. Cash serves as a measurable common denominator for comparing future benefits of alternative investment opportunities.

Cash Flow-Based ValuationValuation of any resource using Cash Flows involves 3 elements: 1. The expected periodic cash flows. 2. The expected cash flow at the end of the forecast horizon, referred to as residual or terminal value. 3. The discount rate used to compute the present value of the future cash flows.

Periodic Cash Flow1. Cash Flow to the Investor VS Cash Flows to the Firm: y Cash flows to the investor in the stock and cash flows generated by a firm each period will differ to the extent that the firm reinvests a portion (or all) of the cash flows generated during the period y It has been seen that the same valuation results whether analyst discounts a) Expected periodic and liquidating dividends to the investor b) The expected cash flows to the firm

2. Relevant Firm-Level Cash Flowsy Another issue is WHICH cash flow amounts from the

projected statement of cash flows the analyst should discount to a present value when valuing a firm. There are 2 types of free cash flows: a) Unleveraged Free Cash Flow b) Leveraged Free Cash Flows

Measuring Free Cash FlowsUnleveraged Free Cash Flow Cash Flow from operation before subtracting Cash outflows for Interest Costs Equals Unleveraged Cash Flow from operations Plus or Minus Cash flow for investing activities Leveraged Free Cash Flows Cash Flow from operation before subtracting Cash outflows for Interest Costs Minus Cash outflows for Interest Costs Equals Leveraged Cash Flow from operations Plus or Minus Cash flow for investing activities Plus/minus cash flows for changes in short and long term borrowing Plus/minus cash flows for changes in and Dividends on Preferred stock

Equals Unleveraged Free Cash Flow to Equals Leveraged Free Cash Flow to All providers of capital Common Shareholders

Which Cash Flow to UseThe appropriate cash flow measure depends on the RESOURCE TO BE VALUED 1. If the objective is to value the assets of a firm, then Unleveraged Free Cash Flow is used 2. If the objective is to value the common shareholder s equity of a firm, then the Leveraged Free Cash Flow is appropriate.

3. Nominal VS Real Cash Flowsy The question arises

Should the projected cash flows to be used in valuing a resource reflect nominal amounts, which includes inflationary or deflationary components OR real amounts, which filter out the effect of changes in general purchasing power.

y If projected cash flows ignore changes in general

purchasing power of the monetary unit, then discount rate should INCORPORATE an inflation component

y If projected cash flows filters out the effects of general

price changes, then discount rate should EXCLUDE the inflation component.

ExampleA firm owns a tract of land that it expects to sell one year from today for $115 million. The general price level is expected to increase 10% during this period. The real interest rate is 2 %.Nominal Cash Flows * $115 million * Real Cash Flow * Discount Rate Including Expected Inflation = 1/(1.02)(1.10) Discount Rate Excluding Expected Inflation = 1/(1.02) Value

$102.5 million Value

$115 million /1.10

= $102.5 million

PreTax VS After-Tax Cash Flowsy Same valuation does not arise if the analyst discounts

pretax cash flows at a pretax cost of capital and aftertax cash flow at an after tax cost of capital. y This difference arise because cash inflows from assets are taxed at 40%, and cash outflows to service debt gives rise to tax savings of 40% y Thus, we use After Tax Cash Flows at after tax cost of capital

Selecting a Forecast Horizony For how many future years should the periodic cash

flows be projected? For expected life of the resource to be valued y For resources with an infinite life (like portfolio of net assets of a firm), we calculate future periodic cash flows for some number of years, and then estimate the likely residual, or terminal, value at the end of this forecast horizon.

Selecting a Forecast HorizonSelecting a forecast horizon involves trade-offs:y A relatively short forecast horizon (3-5 years) enhances the likely accuracy of the periodic cash flows. However, it causes a large portion of the total present value to be related to the lest detailed estimated residual value y A Longer period (10-15 years) reduces the influence of estimated residual value on the total present value. However the predictive accuracy of detailed cash flow is questionable. y Thus, security analysts typically select a forecast horizon in the range of 4-6 yrs.

Residual Valuey The expected cash flow at the end of the forecast

horizon. Also referred to as the terminal value. y In most cases it is the largest portion of the value of the firm. y Its size is directly dependent upon the assumptions made for the forecast horizon. y The analyst must project future periodic cash flows for some number of years, and then estimate the likely residual value at the end of this forecast horizon.

y Selecting a forecast horizon involves trade-offs. Using a relatively short forecast horizon, such as 3 to 5 years, enhances the likely accuracy of the projected cash flows. But this causes a large portion of the total present value to be related to the residual value. y Selecting a longer period in the forecast of periodic cash flows such as 10 to 15 years, reduces the influence of the estimated residual value on the total present value. However, the predictive accuracy of detailed cash flow forecasts this far into the future is likely to be questionable. y It is best to select as a forecast horizon the point at which a firm s cash flow pattern has settled into an equilibrium. This equilibrium position could be either no growth in future cash flows or growth at a stable rate. y Typically 4 to 7 years

Discounted cash flow (economic approach)y When a firm s cash flow pattern has settled into an equilibrium at the end of the forecast horizon: Residual Value at End of Forecast Horizon (n) = Periodic Cash Flow (n-1) * (1+g) (r-g) Where: n= forecast horizon; g= annual growth rate in periodic cash flows after the forecast horizon; and r= discount rate y If the final year s cash flow continues at the same level in perpetuity. Residual value = cash flow / r

Exampley An analysts forecasts that the leveraged free cash flow

of a firm in Year 5 is $ 30 million. This is a mature firm that expects zero growth in future cash flows. The residual value of the cash flow, assuming a 15 percent cost of equity capital, is computed as: Residual Value at End of Forecast Period = $30 million/ 0.15 = $200 million The present value at the beginning of Year 1 of this residual value = $99.4 million

(ii) If the analyst expects the cash flow after Year 5 to grow at 6 percent each year Residual Value at End of Forecast period= $30 million * (1+ 0.06) = $353.5 million (0.15 - 0.06) (ii) If the analyst expects the cash flow after Year 5 to grow at 6 percent each year Residual Value at End of Forecast period= $30 million * (1 - 0.06) = $134.3 million 0.15 - (-0.06) The cash flow of a firm in decline will eventually reach zero (or the firm will become bankrupt)

y Analysts frequently estimate a residual value using

multiples of six to eight times leveraged free cash flow in the last year of the forecast horizon to value the common stock of a firm y Table: Cash flow multiples using (1+g)/(r-g)Cash Flow Multiples Growth rate 2% Cost of Equity Capital 15% 18% 20% 7.8 6.4 5.7 9.5 7.4 6.5 11.8 8.8 7.6 4% 6%

Problems with the modely This residual valuation model does not work well when:

Discount rate and the growth rate are approximately equal => Denominator approaches zero and the multiple becomes exceedingly large Growth rate exceeds the discount rate => Denominator becomes negative and the resulting multiple is meaningless y These difficulties arise because the growth rate assumed is too high. y The model assumes that the growth rate will continue in perpetuity. But competition, technological change, new entrants and similar factors reduce growth rates.

Other approachesy Alternative approach to estimate residual value is to

use the free cash flow multiples for comparable firms that currently trade in the market. Provides a degree of market validation for the theoretical model. Analysts identifies comparable companies by studying growth rates in free cash flows, profitability levels, risk characteristics and similar factors. y Analysts also use earnings-based models such as priceearnings ratios or market to book value ratios to estimate a residual value.

Definitiony To a firm, it is the cost of obtaining funds y To an investor, it is the minimum rate of return

expected by it without which the market value of shares would fall.y In accounting sense, it is the weighted average cost of

various sources of finance used by a firm.

Definition (Contd..)y According to James C Van Horne It is the cut off rate

for the allocation of capital to investments of projects. It is the rate of return on a project that will leave unchanged the market price of the stock.y According to John J. Hampton Cost of Capital is the

rate of return the firm requires from the investment in order to increase the value of the firm in the market place

WACCy Company typically has several options for raising

capital including :

Issuing Equity Issuing Debt Issuing Preferred Stocks.

y

y y

Each Selected source becomes a component of company's cost and may be called as a Component cost of capital. The weighted average of all these costs is called Weighted average cost of capital or WACC. It is also called Marginal cost of capital.

WACC = wp rp +Wherenew funds.

we r e

+ Wd Rd (1-t)

y wp = the proportion of preferred stock that the company uses to raisey Rp = the marginal cost of preferred stock.

y we = the proportion of equity that the company uses to raise newfunds.

y Re = the marginal cost of equity.

y wd

= the proportion of debt that the company uses to raise new funds.

y Rd = the before tax marginal cost of debt. y T= company s marginal tax rate.

Significance Of Cost Of Capitaly The acceptance criterion in capital budgeting (in NPV,

as a discounting factor and in IRR it is used as a cut off rate to compare with)y The determinant of optimal capital mix in the capital

structure decision (i.e., the mix that minimizes the overall cost of capital)y A basis of evaluating the financial performance( i.e.

EVA = capital employed (ROI-COC)

y Firms employ several types of capital, called capital

components, with common and preferred stock, along with debt, being the three most frequently used types with one thing in common The investors who provide the funds expect to receive a return on their investmenty However, because of varying risks, these different

securities have different required rate of return.

Cost Of Debty The first step is to determine the rate of return debt

holders require i.e. rd y A calculated estimate, because it is difficult to project the type of debt used over a period. y Now, we calculate the after-tax cost of debt After Tax Cost of Debt = Interest Rate Tax Savings = rd - rd T = rd (1 - T)

E.g.: Incorporating the effects of Taxes on the Cost of CapitalJorge Richard , A financial Analyst is estimating the cost of capital for ABC company. Richard has calculated the before tax costs of capital for ABC s debt and equity as 4% and 6% respectively. What would be the after tax costs of debt and equity if the marginal tax rate is :30% 2. 48%1.

SolutionMarginal Tax After Tax Cost of Rate Debt Solution to 1 Solution to 2 30% 48% .04(1-.30 ) = 2.80 % .04(1-.48 ) =2.08 % After Tax Cost of Equity 6% 6%

Calculating the Cost of Debt (Yield to maturity approach )YTM is the annual return that an investor earns if the investor purchases a bond today and holds it until maturity.

P0= PMT1/(1+rd/2) + PMTn/(1+rd/2) + FV/ (1+rd/2)Where: P0= the current market price of the bond. PMT t = interest payment in the period t.

rd=the yield to maturity. n= no of periods remaining to maturity FV the maturity value of the bond.

Calculating the Cost of Debt (Debt Rating Approach)y When reliable current market price for a company s

debt is not available Debt rating approach is used. y Based on a company s debt rating, we estimate the before tax cost of debt by using the yield on comparably rated bonds for maturities that closely match that of the company s existing debt.

Cost Of Preferred Stocky Because, Preferred Stock are not tax deductible, not tax adjustment is used when calculating the cost of preferred stock y The component cost of preferred stock rps is the preferred dividend, Dps divided by the net issuing price, Pn , which is the price the firm receives after deducting floatation costs:

COMPONENT COST OF PREFERRED STOCK = rps = Dps / Pn

Cost Of Common Stocky A company can raise common equity in 2 ways : (1)

directly issuing new shares (2) indirectly, by retaining earnings y When, new shares issued, shareholders require a return, rs . y Also, retained earnings have a cost known as opportunity cost - the earnings could have been paid out as dividends which could have been reinvested in other investments.

y Thus, the firm should earn on its reinvested earnings

at least as much as its stockholders themselves could earn on alternate investments of equivalent risks, which is rs y Thus rs is the cost of common equity raised internally by reinvesting earnings

y Whereas, debt and Preferred Stock are contractual

obligations that have easily determined costs, it is more difficult to estimate rsy 3 Methods are typically used :-

(a) The CAPM (b) Discounted Cash Flow Method (c) The Bond-Yield-Plus-Risk-Premium Approach

The CAPM ApproachSTEP 1 . Estimate the risk free Rate, rRF STEP 2. Estimate the current market Risk premium, RPm, which is expected market return minus the risk free rate. STEP 3. Estimate the stock s beta coefficient, bi, and use it as an index of the stock s risk

STEP 4. Substitute the preceding values into the CAPM equation to estimate the required rate of return in: rs = rRF + (RPM)biy Risk free rate is taken as the return from the long term

Treasury securities.y The Risk Premium is the result of investor risk

aversion.

y The Risk Premium is estimated on the basis of (1)

Historical Data (2) Forward looking data y Beta I the relevant risk of an individual stock, it contributes to the market portfolio ( or well diversified portfolio)

DIVIDEND-YIELD-PLUS-GROWTHRATE, OR DCF APPROACHy If dividends grow at g rate, then expected price is

P0 = D1 /(rs - g) where P0 is the current price; D1 is the dividend expected to be paid, and rs is the required ROR on common equity Hence rs = (D1 / P0 ) +Expected g

y The investors expect to receive a dividend yield plus a

capital gain as expected return. The method of estimating the cost of equity is called Discounted Cash Flow method.y Growth rates calculated either as historical growth

rates, or retention growth model, or by forecasts.y RETENTION GROWTH MODEL

g = ROE(Retention Ratio)

BOND-YIELD-PLUS-RISK-PREMIUM Approachy Subjective, adhoc procedure y Adding a judgmental risk premium to the interest

rates on firm s own long term debt.y ASSUMPTION Firms with risky, low rated, and high

interest-rate debt will also have risky, high-cost equity rs = Bond Yield + Bond risk premium

WEIGHTED AVERAGE COST OF CAPITALy The weighted average cost of capital (WACC) is the

rate that a company is expected to pay on average to all its security holders to finance its assets. y It is the weighted sum of cost of all the sources used to finance the investments. If a firm uses preferred stock, common equity and debt, the WACC will be WACC = wd rd (1-T) + wps rps + wce rs

FACTORS AFFECTING WACCy The cost of capital is affected by a number of factors.

Some are beyond the firm s control, but others are influenced by its financing and investment policies.y FACTORS THE FIRM CANNOT CONTROL 1. The Level of interest Rates

If IR increases, cost of debt increases and equity cost increases. 2. Market Risk Premium 3. Tax Rates

FACTORS the FIRM CAN CONTROL 1. Capital Structure Policy The amount of debt used in capital structure depends on the policies of the firm 2. Dividend Policy The amount of payout depends on the management 3. Investment Policy

Referencesy CFA Level-I book y Financial Reporting and Statement Analysis: A

Strategic Perspective- Clyde P. Stickney and Paul R. Brown y Financial Management: Text and Cases- Brigham and Ehrhardt