Primer on Cash Flow Valuation

1
Primer on Cash Flow Valuation
2
The greater danger for most of us is not that our
aim is too high and we might miss it, but that it
is too low and we reach it. Michelangelo
3
Cross-Border Transactions
4
Learning Objectives

• Primary learning objectives To provide students
  with an understanding of
• business valuation using discounted cash flow
  valuation techniques and
• the importance of understanding assumptions
  underlying business valuations
• Secondary learning objectives To provide
  students with an understanding of
• discount rates and risk as applied to business
  valuation
• how to analyze risk
• alternative definitions of cash flow and how and
  when they are applied
• the advantages and disadvantages of the most
  commonly used discounted cash flow methodologies
• the sensitivity of terminal values to changes in
  assumptions and
• Adjusting firm value for non-operating assets and
  liabilities.

5
Required Returns Cost of Equity (ke)

• Capital Asset Pricing Model (3-factor model)
• ke Rf ß(Rm Rf) FSP
• Where Rf risk free rate of return
• ß beta (systematic/non-dive
  rsifiable risk)
• Rm expected rate of return on
  equities
• Rm Rf 5.5 (i.e., equity risk
  premium
• historical
  average since
• 1963)
• FSP firm size premium

6
Estimates of Size Premium

• Market Value (000,000)
• gt18,600
• 7,400 to 18,600
• 2,700 to 7,400
• 1,100 to 2,700.
• 450 to 1,100
• 200 to 450
• 100 to 200
• lt100 million

• Percentage Points Added to CAPM Estimate
• 0.0
• .6
• 1.0
• 1.5
• 2.3
• 2.7
• 5.8
• 9.2

Source Adapted from estimates provided by
Ibbotson Associates.
7
Required Returns Cost of Capital

• Weighted Average Cost of Capital (WACC)1,2
• WACC ke x E i (1-t) x D
  kpr x __PR__
• (EDPR)
  (EDPR) (EDPR)
• Where E the market value of equity
• D the market value of debt
• PR the market value of preferred
  stock
• ke cost of equity
• kpr cost of preferred stock
• i the interest rate on debt
• t the firms marginal tax rate

1To estimate WACC, use firms target
debt-to-total capital ratio (TC). 2(D/E)/(1D/E)
(D/E)/(ED)/E (D/E)(E/(ED) D/(ED)
D/TC E/TC 1 D/TC.
8
Analyzing Risk

• Risk consists of a non-systematic/diversifiable
  and systematic/non-diversifiable component
• Equity beta (ß) is a measure of non-diversifiable
  risk
• Equity beta quantifies a stocks volatility
  relative to the overall market
• Equity beta is impacted by the following factors
• Degree of industry cyclicality
• Operating leverage refers to the composition of a
  firms cost structure (fixed plus variable costs)
• Financial leverage refers to the composition of a
  firms capital structure (debt equity)
• Firms with high ratios of fixed to total costs
  and debt to total capital tend to display high
  volatility and betas

9
How Operating Leverage Affects Financial
Returns?1
Case 1 Case 2 Revenue Increases by 25 Case 3 Revenue Decreases by 25
Revenue 100 125 75
Fixed Variable2 Total Cost of Sales 48 32 80 48 40 88 48 24 72
Earnings Before Taxes 20 37 3
Tax Liability _at_ 40 8 14.8 1.2
After-Tax Earnings 12 22.2 1.8
Firm Equity 100 100 100
Return on Equity () 12 22.2 1.8
1All figures are in millions of dollars unless otherwise noted. All cases have same fixed expenses and firm equity but differ by revenue. 2In Case 1, variable costs represent 32 of revenue. Assuming this relationship is maintained, variable costs in Cases 2 and 3 are estimated by multiplying total revenue by .32. 1All figures are in millions of dollars unless otherwise noted. All cases have same fixed expenses and firm equity but differ by revenue. 2In Case 1, variable costs represent 32 of revenue. Assuming this relationship is maintained, variable costs in Cases 2 and 3 are estimated by multiplying total revenue by .32. 1All figures are in millions of dollars unless otherwise noted. All cases have same fixed expenses and firm equity but differ by revenue. 2In Case 1, variable costs represent 32 of revenue. Assuming this relationship is maintained, variable costs in Cases 2 and 3 are estimated by multiplying total revenue by .32. 1All figures are in millions of dollars unless otherwise noted. All cases have same fixed expenses and firm equity but differ by revenue. 2In Case 1, variable costs represent 32 of revenue. Assuming this relationship is maintained, variable costs in Cases 2 and 3 are estimated by multiplying total revenue by .32.
Key Point High fixed to total cost
ratios magnify fluctuations in financial returns.
10
How Financial Leverage Affects Financial Returns1
Case 1 No Debt Case 2 25 Debt to Total Capital Case 3 50 Debt to Total Capital
Equity 100 75 50
Debt 0 25 50
Total Capital 100 100 100
Earnings before Interest and Taxes 20 20 20
Interest _at_ 10 0 2.5 5
Income before Taxes 20 17.5 15
Less income Taxes _at_ 40 8 7 6
Net Income 12 10.5 9
After-Tax Return on Equity () 12 14 18
1All figures are in millions of dollars unless otherwise noted. Total capital and EBIT same in all cases. 1All figures are in millions of dollars unless otherwise noted. Total capital and EBIT same in all cases. 1All figures are in millions of dollars unless otherwise noted. Total capital and EBIT same in all cases. 1All figures are in millions of dollars unless otherwise noted. Total capital and EBIT same in all cases.
Key Point High debt to total capital
ratios magnify fluctuations in financial returns.
11
Leveraged versus Unleveraged Equity Betas

• In the absence of debt, the equity ß is called
  the unleveraged ßu, which is impacted by the
  firms operating leverage and the cyclicality of
  the industry in which the firm competes
• In the presence of debt, the equity ß is called
  the leveraged ßl
• If a firms shareholders bear all the risk of
  operating and financial leverage and interest is
  tax deductible, leveraged and unleveraged betas
  can be calculated as follows
• ßl ßu (1 (1-t) (D/E)) and ßu ßl / (1
  (1-t) (D/E))
• where t, D, and E are the tax rate, debt and
  equity, respectively.
• Implications
• --Increasing D/E raises firms breakeven and
  increases shareholder risk that firm will be
  unable to generate future cash flows sufficient
  to pay their minimum required returns.
• --Tax deductibility of interest reduces
  shareholder risk by increasing after-tax cash
  available for shareholders.

12
Estimating a Firms Equity Beta

• Regress percent change in firms share price plus
  dividends against percent change in a broadly
  defined stock index plus dividends for last 3-5
  years.
• However, this assumes the historical relationship
  between risk and return will hold in the future
• Alternatively, use a sample of similar firms
• Step 1 Select sample of firms with similar
  cyclicality and operating leverage (i.e., usually
  in the same industry)
• Step 2 Calculate average unlevered beta for
  firms in the sample to eliminate the effects of
  their current capital structures on their betas
• Step 3 Relever average unlevered beta using D/E
  ratio and marginal tax rate of firm whose beta
  you are trying to estimate (i.e., target firm)

13
Estimating Abbot Labs Equity Beta
Step 1 Select sample of firms having similar cyclicality and operating leverage Step 1 Select sample of firms having similar cyclicality and operating leverage Step 1 Select sample of firms having similar cyclicality and operating leverage Step 2 Compute average of firms unlevered betas Step 3 Relever average unlevered beta using targets debt/equity ratio
Firm Levered Equity Beta1 Debt / Equity1 Unlevered Equity Beta2 Abbot Labs Relevered Equity Beta3
Abbot Labs .2900 .2662 .2501 NA
Johnson Johnson .6000 .0762 .5738 NA
Merck .6600 .3204 .5536 NA
Pfizer .6800 .3044 .5750 NA
Average .4881 .4209
1Yahoo Finance (1/29/2011). Beta estimates are based on historical relationship between the firms share price and a broadly defined stock index. 2ßu ßl / (1 (1-t) (D/E)), where ßu and ßl are unlevered and levered betas marginal tax rate is .4. Abbot Labs (ßu ) .2900 / (1 (1 - .4).2662)) .2501 Johnson Johnson (ßu ) .6000 / (1 (1 - .4).0762)) ..5738 Merck (ßu) .6600 / (1 (1 - .4).3204)) .5536 Pfizer (ßu) .6800 / (1 (1 - .4).3044)) .5750 3ßl ßu (1 (1-t) (D/E)) using the target firms (Abbot Labs) debt/equity ratio and marginal tax rate. Abbot Labs relevered beta .4881 (1 (1 - .4).2662)) .4209 1Yahoo Finance (1/29/2011). Beta estimates are based on historical relationship between the firms share price and a broadly defined stock index. 2ßu ßl / (1 (1-t) (D/E)), where ßu and ßl are unlevered and levered betas marginal tax rate is .4. Abbot Labs (ßu ) .2900 / (1 (1 - .4).2662)) .2501 Johnson Johnson (ßu ) .6000 / (1 (1 - .4).0762)) ..5738 Merck (ßu) .6600 / (1 (1 - .4).3204)) .5536 Pfizer (ßu) .6800 / (1 (1 - .4).3044)) .5750 3ßl ßu (1 (1-t) (D/E)) using the target firms (Abbot Labs) debt/equity ratio and marginal tax rate. Abbot Labs relevered beta .4881 (1 (1 - .4).2662)) .4209 1Yahoo Finance (1/29/2011). Beta estimates are based on historical relationship between the firms share price and a broadly defined stock index. 2ßu ßl / (1 (1-t) (D/E)), where ßu and ßl are unlevered and levered betas marginal tax rate is .4. Abbot Labs (ßu ) .2900 / (1 (1 - .4).2662)) .2501 Johnson Johnson (ßu ) .6000 / (1 (1 - .4).0762)) ..5738 Merck (ßu) .6600 / (1 (1 - .4).3204)) .5536 Pfizer (ßu) .6800 / (1 (1 - .4).3044)) .5750 3ßl ßu (1 (1-t) (D/E)) using the target firms (Abbot Labs) debt/equity ratio and marginal tax rate. Abbot Labs relevered beta .4881 (1 (1 - .4).2662)) .4209 1Yahoo Finance (1/29/2011). Beta estimates are based on historical relationship between the firms share price and a broadly defined stock index. 2ßu ßl / (1 (1-t) (D/E)), where ßu and ßl are unlevered and levered betas marginal tax rate is .4. Abbot Labs (ßu ) .2900 / (1 (1 - .4).2662)) .2501 Johnson Johnson (ßu ) .6000 / (1 (1 - .4).0762)) ..5738 Merck (ßu) .6600 / (1 (1 - .4).3204)) .5536 Pfizer (ßu) .6800 / (1 (1 - .4).3044)) .5750 3ßl ßu (1 (1-t) (D/E)) using the target firms (Abbot Labs) debt/equity ratio and marginal tax rate. Abbot Labs relevered beta .4881 (1 (1 - .4).2662)) .4209 1Yahoo Finance (1/29/2011). Beta estimates are based on historical relationship between the firms share price and a broadly defined stock index. 2ßu ßl / (1 (1-t) (D/E)), where ßu and ßl are unlevered and levered betas marginal tax rate is .4. Abbot Labs (ßu ) .2900 / (1 (1 - .4).2662)) .2501 Johnson Johnson (ßu ) .6000 / (1 (1 - .4).0762)) ..5738 Merck (ßu) .6600 / (1 (1 - .4).3204)) .5536 Pfizer (ßu) .6800 / (1 (1 - .4).3044)) .5750 3ßl ßu (1 (1-t) (D/E)) using the target firms (Abbot Labs) debt/equity ratio and marginal tax rate. Abbot Labs relevered beta .4881 (1 (1 - .4).2662)) .4209
14
Valuation Cash Flow

• Valuation cash flows represent actual cash flows
  available to reward both shareholders and lenders
• Cash flow statements include cash inflows and
  outflows from
• operating,
• investing, and
• financing activities
• GAAP cash flows are adjusted for non-cash inflows
  and outflows to calculate valuation cash flow.
  Examples include the following
• Adding depreciation back to net income
• Deducting gains from and adding losses to net
  income resulting from asset sales since such
  gains or losses are changes in book values only
  with the actual cash flows from the sale shown in
  the cash flow statement as cash from investing
  activities.
• Valuation cash flows include free cash flows to
  equity investors or equity cash flow and free
  cash flows to the firm or enterprise cash flow

15
Calculating Free Cash Flow to Equity Investors
or Equity Cash Flow (FCFE)

• FCFE (equity cash flow)1 represents cash flow
  available for paying dividends or repurchasing
  common equity, after taxes, debt repayments, new
  issues, and all reinvestment requirements.
• FCFE (Net Income Depreciation ? Net Working
  Capital2)3 Gross Capital Expenditures4 (New
  Preferred Equity Issues Preferred Dividends
  New Debt Issues Principal Repayments)5
• 1PV of equity cash flows is the equity value of
  the firm.
• 2Excludes cash in excess of normal operating
  requirements.
• 3Cash from operating activities.
• 4Cash from investing activities.
• 5Cash from financing activities.

16
Calculating Free Cash Flow to the Firm or
Enterprise Cash Flow (FCFF)

• FCFF (enterprise cash flow)1 is cash flow
  available to repay lenders and/or pay common and
  preferred dividends and repurchase equity, after
  taxes and reinvestment requirements but before
  debt repayments.
• FCFF (Earnings before interest taxes (1-tax
  rate) Depreciation ? Net Working Capital2)3
  Gross Capital Expenditures4
• 1PV of enterprise cash flows is the enterprise
  value of the firm
• 2Excludes cash in excess of normal operating
  requirements.
• 3Cash from operating activities.
• 4Cash from investing activities.

17
Comparing Free Cash Flow to the Firm and to
Equity
Free Cash Flow to the Firm Free Cash Flow to Equity
Cash from Operating Activities 40 40
Cash from Investing Activities (22) (22)
Cash from Financing Activities (10)
Total Cash Flow 18 8
18
Discussion Questions

• How does the size of the firm affect its
  perceived risk? Be specific?
• How would you estimate the beta for a publicly
  traded firm? For a private firm?
• 3. Explain the difference between equity and
  enterprise cash flow?
• 4, What is the appropriate discount rate to use
  with equity cash flow? Why? With enterprise cash
  flow? Why?

19
Commonly Used Discounted Cash Flow Valuation
Methods

• Zero Growth Model
• Constant Growth Model
• Variable Growth Model

20
Zero Growth Model

• Free cash flow is constant in perpetuity.
• P0 FCFF0 / WACC, where FCFF0 is free cash
• flow to the firm and WACC is the weighted
  
• average the cost of capital
• P0 FCFE0 / ke where FCFE0 is free cash flow
• to equity investors and ke is the cost of
  
• equity

21
Zero Growth Model Example

• What is the value of a firm, whose annual FCFF0
  of 1 million is expected to remain constant in
  perpetuity and whose weighted average cost of
  capital is 12.
• P0 1 / .12 8.3 million

22
Constant Growth Model

• Cash flow next year (i.e., FCFF1, the first year
  of the
• forecast period) is expected to grow at a
  constant rate.
• FCFF1FCFF0(1g)
• P0 FCFF1 / (WACC-g), where g is the expected
  rate of
• growth of FCFF1.
• P0 FCFE1 / (ke g), where g is the expected
  rate of
• growth of FCFE1.

23
Constant Growth Model Example

• Estimate the value of a firm (P0) whose cost of
  equity is 15 and whose cash flow in the prior
  year is projected to grow 20 in the current year
  and then at a constant 10 annual rate
  thereafter. Cash flow in the prior year is 2
  million.
• P0 (2 x 1.2)(1.1) / (.15 - .10) 52.8 million

24
Variable Growth Model

• Cash flow exhibits both a high and a stable
  growth period.
• High growth period The firms growth rate
  exceeds a rate that can be sustained long-term.
• Stable growth period The firm is expected to
  grow at a rate that can be sustained indefinitely
  (e.g., industry average growth rate).
• Discount rates Reflecting the slower growth rate
  during the stable growth period, the discount
  rate during the stable period should be lower
  than doing the high growth period (e.g., industry
  average discount rate).

25
Variable Growth Model Contd.
n
P0,FCFF S FCFF0 x (1gt)t
Pn t1 (1
WACC)t (1WACC)n
Where Pn FCFFn x (1 gm)
(WACCm gm) FCFF0 free cash
flow to the firm in year 0 WACC
weighted average cost of capital through year n
WACCm Weighted average cost of capital
beyond year n (Note
WACC gt WACCm) Pn value of the firm at
the end of year n (terminal value) gt
growth rate through year n gm
stabilized or long-term industry average growth
rate beyond year n (Note gt gt
gm)
26
Variable Growth Model Example

• Estimate the value of a firm (P0) whose cash flow
  is projected to grow at a compound annual average
  rate of 35 for the next five years and then
  assume a more normal 5 annual growth rate. The
  current years cash flow is 4 million. The
  firms weighted average cost of capital during
  the high growth period is 18 and then drops to
  the industry average rate of 12 beyond the fifth
  year.

27
Variable Growth Model Example Solution

• PV1-5 4 x 1.35 4 x (1.35)2 4 x (1.35)3
  
• (1.18) (1.18)2
  (1.18)3
• 4 x (1.35)4 4 x (1.35)5
• (1.18)4 (1.18)5
• 30.5
• PV5 ((4 x (1.35)5 x 1.05)) / (.12 - .05)
  117.65
• (1.18)5
• P0 PV1-5 PV5 30.5 117.65 148.15

28
Solving Variable Growth Model Example Using A
Growing Annuity

• P0,FCFF High Growth Period
  Terminal Period
• (Growth Annuity)
  (Constant Growth Model)
• P0,FCFF FCFF0(1 g) x 1 (1 g)/(1
  WACC)n FCFFn x (1 g)/(WACC - g)
  
• (WACC g)
  (1 WACC)n
• 4.00 (1.35) x 1 (1.35/1.18)5
  (4.00 x 1.355 x 1.05/(.12 - .05)
• (.18 - .35)
  1.185
  
• -.91.8 x -.96 117.65
• 30.50 117.65
• 148.15
  

29
Determining Growth Rates

• Key premise A firms value can be approximated
  by the sum of the high growth plus a stable
  growth period.
• Key risks Sensitivity of terminal values to
  choice of assumptions about stable growth rate
  and discount rates used in both the terminal and
  annual cash flow periods.
• Stable growth rate The firms growth rate that
  is expected to last forever. Generally equal to
  or less than the industry or overall economys
  growth rate. For multinational firms, the growth
  rate is the world economys rate of growth.
• Length of the high growth period The greater the
  current growth rate of a firms cash flow
  relative to the stable growth rate, the longer
  the high growth period.

30
Choosing the Correct Tax Rate(Marginal or
Effective)

• Effective rates are those a firm is actually
  paying after allowable deductions (e.g.,
  investment tax credits) and deferrals (e.g.,
  accelerated depreciation)
• Marginal tax rates are those paid on the last
  dollar of income earned
• Zero and Constant Growth Models In calculating
  valuation cash flows, use marginal tax rates1
• Variable Growth Model In calculating valuation
  cash flows,
• Use effective rates to calculate annual cash
  flows when effective rates are less than marginal
  rates and
• Use marginal rates in calculating terminal period
  cash flows.1
• 1The use of effective tax rates during the
  terminal or an indefinite growth period implies
  the firm will defer
• the payment of taxes indefinitely.

31
Practice Exercise

• Free cash flow to equity last year was 4
  million. It is expected to grow by 20 in the
  current year, at a 15 rate annually for the next
  five years, and then assume a more normal 4
  growth rate thereafter. The firms cost of
  equity is 10 and weighted average cost of
  capital is 8 during the high growth period and
  then drop to 8 and 6, respectively, during the
  normal growth period. What is the present value
  of the firm to equity investors (equity value)?
  If the market value of the firms debt is 10
  million, what is the present value of the firm
  (enterprise value)?

32
Variable Growth Model Example Solution

• PV1-5 4 x 1.2 x 1.15 4 x 1.2 x (1.15)2 4
  x 1.2 x (1.15)3
• (1.10)
  (1.10)2 (1.10)3
• 4 x 1.2 x (1.15)4 4 x 1.2 x
  (1.15)5
• (1.10)4
  (1.10)5
• 27.47
• PV5 ((4 x 1.2 x (1.15)5 x 1.04)) / (.08 -
  .04) 155.86
• (1.10)5
• P0 PV1-5 PV5 27.47 155.86
  183.33 (equity value)
• P0 183.33 10 193.33 (enterprise
  value)1
• 1Recall that the enterprise value of a firm is
  equal to the sum of the value of its equity and
  debt.

33
Adjusting Firm Value

• Generally, the value of the firms equity is the
  sum of the present value of the firms operating
  assets and liabilities plus terminal value (i.e.,
  enterprise value) less market value of firms
  long-term debt.
• However, value may be under or overstated if not
  adjusted for present value of non-operating
  assets and liabilities assumed by the acquirer.
• PVFCFE PVFCFF (incl. terminal value) PVD
  PVNOA PVNOL
• where PVFCFE PV of free cash flow to
  equity investors
• PVFCFF PV of free cash flow to
  the firm (i.e., enterprise
• value)
• PVD PV of debt
• PVNOA PV of non-operating
  assets
• PVNOL PV of non-operating
  liabilities

34
Adjusting Firm Value Example

• A target firm has the following characteristics
• An estimated enterprise value of 104 million
• Long-term debt whose market value is 15 million
• 3 million in excess cash balances
• Estimated PV of currently unused licenses of 4
  million
• Estimated PV of future litigation costs of 2.5
  million
• 2 million common shares outstanding
• What is the value of the target firm per common
  share?

35
Adjusting Firm Value Example Contd.
Enterprise Value 104
Plus Non-Operating Assets Excess Cash Balances PV of Licenses 3 4
Less Non-Operating Liabilities PV of Potential Litigation 2.5
Less Long-Term Debt 15
Equals Equity Value 93.5
Equity Value Per Share 46.75
36
Things to Remember

• Zero growth model Cash flow is expected to
  remain constant in perpetuity.
• Constant growth model Cash flow is expected to
  grow at a constant rate.
• Variable growth model Cash flow exhibits both a
  high and a stable growth period.
• Total present value represents the sum of the
  discounted value of the cash flows over both
  periods.
• The terminal value frequently accounts for most
  of the total present value calculation and is
  highly sensitive to the choice of growth and
  discount rates.