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Methods of Valuation

Valuation of levered firm


Weighted average cost of capital method

 Adjusted Present Value approach

 Flow to equity approach


Equity versus Project free cash flow
 Equity free cash flow: Focuses on the CF that is available for
distribution to the firm’s common shareholders

EFCF levered firm = (EBIT-I) (1-T) + DA – WC – CAPEX-P+NP


= EBIT(1-T) + DA –I(1-T) –WC – CAPEX –P + NP
Where P : Principal payments on the firm’s outstanding debt
NP: Net proceeds from the issuance of debt

 Project free cash flow: Focuses on the CF available for distribution to


both the firm’s creditors and equity holders

PFCF levered firm = EFCF levered firm + I (1-T) + P –NP


Creditors CF are I + P –NP. Tax savings from govt. Equals I x T
Hence, CF to creditors net of tax saving I-IxT + P – NP

PFCF levered firm = EBIT (1-T) + DA – WC – CAPEX =OCF – WC-


CAPEX =UCF = EBIT(1-T) + DA – WC - CAPEX
Weighted Average Cost of capital
method

 Calculate the Project Free Cash flow :


PFCF levered firm = EBIT (1-T) + DA – WC – CAPEX =
UCF

 Calculate the WACC: the information regarding capital structure is


present in WACC.
 Used when the capital structure is constant for the firm

 Value of a levered firm = Discount PFCF by WACC as the


discount rate
S B
RWACC  RS  RB (1  TC )
SB SB
Weighted Average Cost of capital
method drawback
 What happens in case of say LBO?
A leveraged buyout (LBO) is a method of acquiring a company
with money that is nearly all borrowed. The basic idea behind an
LBO is that the acquirer purchases the target with a loan
collateralized by the target's own assets.

Very high leveraged transactions .


 Debt levels have to be brought down with time.
Capital structure is not constant with time.

Can we use single WACC?


No. Since for WACC, the capital structure used is a
constant.

Hence, use Adjusted Present Value method for Valuation.


LBO and India
LBO and India
Following table shows the list of successful LBO by Indian company. The first being done by Tata Tea in 2000 for UK based
Tetley.

Target Indian
Company Country Company Value Type
United 271 million
Tetley Kingdom Tata Tea pounds LBO
United 550 million
Whyte & Mackay Kingdom UB Group pounds LBO
United $11.3
Corus Kingdom Tata Steel billion LBO
Hansen
Transmissions Netherlands Suzlon Energy 465 million LBO
American Axle USA Tata Motors $2 billion LBO
Zoom Auto $225
Lombardini Italy Ancillaries million LBO
Adjusted Present Value method

Value of the levered firm is the sum of the values of :

APV = NPV (all equity)+ NPV of Financing side effects

 The unlevered equity cash flows (with discount rate as cost


of equity for unlevered firm; R0) and

 Financing side effects


 Interest tax savings (with discount rate as COST OF DEBT; RB)
 Costs of issuing new securities – floatation costs (fees to the
investment banker for their work on the public issuance of debt)
 Costs of financial distress
 Subsidies to debt financing (say subsidy obtained by govt.)
Flow to equity method
Value of the levered firm is :
 Discounting EFCF (i.e. Cash flow from project to equity
holders of a levered firm) by cost of levered equity (Rs)
From, Session 12, EFCF levered firm = (EBIT-I) (1-T) + DA –
WC – CAPEX-P+NP

Rs = Ro + B/S (1-tc)(R0 – RB)

Again, use Flow to equity method only if the capital


structure is constant.
Steps to Flow to equity method
Calculate the Levered Cash Flow or Equity free cash flow for a
levered firm or cash flow to the equity holders of a levered firm
 Calculate Rs – COST OF EQUITY CAPITAL
Summary: APV, FTE, and WACC
APV WACC FTE
Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

PV of financing
effects Yes No No

When to use Changing


If & Constant Constant Constant
Capital structure
Problem on APV with floatation costs
Gemini Inc. is an all equity firm, is considering a 1.7 million dollar
investment that will be depreciated according to the straight line
method over its four year life. The project is expected to generate
EBITDA of $595,000 per year for four years. The investment will not
change the risk level of the firm. The co. can obtain a 4 year, 9.5% loan
to finance the project from a local bank. All principal will be repaid in
one balloon payment at the end of the fourth year. The bank will charge
the firm $45,000 in floatation fees, which will be amortized over the
four year life of the loan. If co. financed the project entirely with
equity, firm’s cost of capital would be 13%. The corporate tax rate is
30%. Using the APV method, determine whether the co. should
undertake the project.
Refer to Excel.
Addition to the problem : If subsidized debt was issued at rate below
9.5%, (say at 5%) all interest payments will be calculated based on 5%
but the cost of debt (hence rate at which interests are discounted will be
9.5%)
Problem on APV, FTE
Seger , Inc., is an unlevered firm with expected annual earnings before taxes of
$21 million in perpetuity. The current required return on the firm’s equity is 16
percent, and the firm distributes all of its earnings as dividends at the end of
each year. The company has 1.3 million shares of common stock outstanding
and is subject to a corporate tax rate of 35 percent. The firm is planning a
recapitalization under which it will issue $30 million of perpetual debt and use
the proceeds to buy back shares.
a. Calculate the value of the company before the recapitalization plan is
announced. What is the value of equity before the announcement? What is
the price per share?
b. Use the APV method to calculate the company value after the
recapitalization plan is announced . What is the price per share?
c. How many shares will be repurchased? What is the value of equity after
repurchase has been completed?
d. Use the flow to equity method to calculate the value of the company’s
equity after the recapitalization.

Refer to Excel.