Project-Based Cost of Capital

What if the project changes either the leverage of the firm or its risk or both? We cannot anymore use the firms cost of capital (or beta to evaluate the project!

Problems "ith using the firms cost of capital

Project IRR
Wrongly accepted projects Wrongly rejected projects

SML

Rfirm RF

RF + FIRM ( R M RF )

Firms risk (beta)

F IR M

#aking into account the projectspecific risk

We need to compute $ssume r% is kno"n! #hen "e need to compute r& $ssuming constant %'& policy(

But ho" to compute r)? *Pure-play techni+ue,! -ind firms in the market (comparables "hose "hole business is similar to your project. and take their r)

#hese firms may be levered. then you have to find their r) first! $ssuming they follo" a constant %'& policy(

&/ample(

Comparable 0( r&1023. r%143. %'(&5% 1673 r)18!43 Comparable 2( r&107!93. r%1:!:3. %' (&5% 12:3 r)18!63 $verage r)18!:3

$ssume %'& of the firm before the project "as 0. and its cost of debt "as 1 43 (see last lecture ! ;f "e assume that both things stay the same. "e obtain

D rE = rU + ( rU rD ) = 9.5% + 1 (9.5% 6%) = 13.0% E

rwacc E D = rE + rD (1 c ) = 0.5 13% + 0.5 6%(1 0.4) = 8.3% E+D E+D

;nstead "e could directly use (from the t"o formulas above "here d is %'(&5% < the projects debt-to-value ratio

=ote( if you dont kno" r& and r% of the comparable firms. but kno" their >& and >% . then you simply use C$P? to find r& and r%. or you can directly compute

E D U = E + D E+D E+D
$nd then use C$P? to determine r)! =ote( the above formula holds only for constant %'& policy ;n general. your project may have %'(&5% different from the rest of your firm! #hen in the formulas in the previous slide you need to use the projects %'(&5% ! @ee e/ample (ne/t t"o slides

%etermining a projects %'(%5& (incremental leverage of a project

Aet dp1%p'(%p5&p is the debt-to-value ratio you "ant for your project Compute the projects PB using W$CC (assuming you kno" the projects risk. i!e! r). and r%. you can al"ays find its r& &p 1 PBp < %p and dp1%p'PBp %p such that you achieve your desired dp ;f you need to achieve certain target %'(%5& for your firm. then you need to solve simultaneously(

(%old 5%p '(%old 5%p5&old 5&p 1 %'(%5& %p5&p C PBp 1 discounted -C- using W$CC W$CC is determined by dp1%p'(%p5&p

Baluing Business
?ethods of valuation

%C- valuation (*income, approach Delative valuation (*market, approach Cost-based valuation

Delative valuation (valuation using comparables

Based on comparison "ith similar firms on the market

)ses ratios (multiples of similar firms to estimate the share price or &B of a given firm &arnings multiples
P'& < price to earnings ratio (share price ' earnings per share C ?arket Cap ' =et ;ncome &B'&B;#%$

?ost commonly used multiples(

Devenue multiples
P'@ < price to sales ratio &B'@ < enterprise value to sales ratio

Book (or replacement Balue multiples

P'BB < price to book value ratio &B'BB

#heoretical rationale for using multiples

;f cash flo"s gro" at constant rate g( PV 1 CF0'(r-g 1 cash flow multiple CF0 =et ;ncome or &B;#%$ are not cash flo"s. but the implicit assumption is that they are either close or roughly proportional to C(the same logic of *proportionality, applies to using sales multiples or customer multiples

&/ample! Baluing ;deko Corporation (B%?. ch! 08

Aine of business( designing and manufacturing sports eye"ear &stimated 277: ;ncome @tatement and Balance @heet(

@ales 1 9:.777 &B;#%$ 1 04.2:7 =et ;ncome 1 4.8E8 %ebt 1 6.:77 ;magine you are considering ac+uiring this company at a price of F0:7 mln! ;s it a fair price? $t this price(

P'& 1 20!4 &B 1 & 5 % < cash! $ssume you estimate that ;deko holds F4!: mln in cash in e/cess of its "orking capital needs (i!e! invested at a market rate of return &B 1 0:7 5 6!: < 4!: 1 F06G mln &B'@ales 1 2 &B'&B;#%$ 1 8!0

;deko -inancial Datios Comparison

Prices based on multiples averaged across the three comparable firms(

P'& 1 2E!9 P 1 046!2 &B'@ales 1 2!79 &B 1 0:: P 1 &B < % 5 e/cess cash 1 0:9 &B'&B;#%$ 1 00!G &B 1 080 P 1 08E

Hence. 0:7 looks like a good price. though the conclusion is not clear-cut if "e look at the industry multiples!

We can get a further idea by looking at the range of prices implied by the range of multiples for comparable firms(

Price range implied by P'&( 024!E to 086!E Price range implied by &B'@ales( 079 to 276!: Price range implied by &B'&B;#%$( 0:E!0 to 2E4

Problems "ith relative valuation

%ifficult to find truly good matches (even if they do the same business. your firm may be at a different stage of development. have different gro"th prospects. different business risk. different capital structure. etc! Current earnings and sales may not accurately reflect the firms prospects What if the market is inefficient and incorrectly values your matches? (i!e! the "hole industry can be overpriced

Correcting for Iro"th Date

$ssume firms similar to yours have different earnings per share (or =et ;ncome gro"th rates! #"o firms "ith the same current earnings but different e/pected gro"th rates should have different prices (a firm "ith a higher gro"th rate should be priced higher Jou should use gro"th-adjusted P'& ratio to value your firm( P&I1(P'& 'g. "here g is the e/pected gro"th in &P@ =ote( P&I does not have a strong theoretical rationale(

P 1 CF0'(r-g ! $ssuming C- K =; and dividing by g. "e obtain( (P'& 'g 1 0'((r-g g ! DH@ depends on gL But its true that. at least for gMr. 0'((r-g g is less sensitive to g than 0'(r-g ! ;n particular. at g1r'2 its derivative "!r!t! g e+uals 7!

;magine a firm in the ;# industry. ;nfo@oft. "ith =et ;ncome 1 F899.E77

Based on $verage P& its e+uity value (?Cap should be 899.E77N2G!60 1 F29!94: mln

But imagine ;nfo@ofts =et ;ncome e/pected gro"th rate is 29!7E3! #hen a more correct estimate of its e+uity value 1 899.E77N0!67N29!7E 1 F E4!8GE mln

#ransaction vs! #rading ?ultiples

#rading multiples( based on stock prices of publicly traded comparable firms #ransaction multiples( based on ac+uisition prices of comparable firms $re transaction multiples normally higher or lo"er than trading multiples? )sually higher! Why?

Control premium @ynergies Operational improvements

$t the same time( discount for illi+uidity can lo"er transaction multiple

&/ample! Dadio One ;nc!

)@ company! Aargest radio group targeting $fro-$mericans! ;n 2777 Dadio One got a chance to ac+uire 02 urban radio stations #hat "ould double Dadio Ones siPe and help build its national platform What should the price be?

Baluation using trading multiples

BC- 1 O; before depreciation. amortiPation and corporate e/penses!

@ource( HB@ case 8-270-72:

Dationale for using Dadio One multiples(

ne" stations are similar to Dadio Ones e/isting stations even if not very similar initially. after ac+uisition they "ill be operated by Dadio Ones management Current multiples may reflect the e/pectation of ac+uisition

Problems "ith using Dadio One multiples(

Baluation using transaction multiples

@hortly before. ;nfinity Broadcasting ac+uired 0G stations from the same company that Dadio One is going to ac+uire stations from! #he price "as 20!: 2777 BC-! ;f "e use this multiple and BC- forecast for 2770. "e get 20!:N94.6E4 1 0!46 billion! ;f "e use actual 2777 BC-. "e get 20!:N4:.760 1 0!6 billion! =ote( %C- analyses yielded 0!2-0!: billion! What happened( the actual ac+uisition price "as 0!6 billion

Why "e need relative valuation? Why not al"ays use %C-?
Jou may need to get a +uick estimate Jou may not have enough data to build a financial model of the firm

;nformation is undisclosed #he company is too young (start-up to have a history of operations

;t may be impossible to do accurate predictions of -C- for a long term

?ultiples are often used to estimate a terminal value

)seful to verify an estimate obtained by %C-