Study notes of Valuation

Chapter 1: introduction
The nature of major investment decision
Firms grow and expand in two ways:

1. They acquire productive capacity by assembling the necessary assetsproject

valuation

2. They acquire existing business enterprise valuation

Important issues to think when making a major investment

1. Does the ‘story’ make sense?

a. The investment story, strategy must be plausible to decision makers

b. The potential gain is large enough to warrant initial investigation

c. Comparative advantages: does the firm have an advantage due to

specialized knowledge or circumstances that allow it to capture the benefits
of the investment?

d. Does the firm, and does this project, provide any comparative advantages
relative to those of other firms and existing projects?

e. Are the firm’s comparative advantages sufficient to deter competitors from

making similar investment?

2. What are the risks involved in undertaking the investment?

a. What are the underlying risks associated with investment?

b. How should these risks be incorporated into the project analysis?

c. Do the investment risks affect the rate of return that should be used in
evaluating whether to undertake the investment?

d. Are there governmental programs (domestic or foreign) that can insure the
investment in the event of political instability?

e. How does the ability of the firm to transfer investment risk affect the
financing of the project and the project’s valuation?

3. How can the investment be financed?

4. How does the investment affect near-term earnings?

a. A project’s effect on earnings can be important for a variety of reasons in

determining whether managers are willing to initiate an investment.

b. Management performance measures

5. Does the investment have inherent flexibilities that allow the firm to modify it in
response to changing circumstances?
 a. Can be investment be staged?  real option

b. Does the investment offer the opportunity for follow-on investment?

c. Does the investment provide production or marketing synergies with

existing products?

Three-phase investment evaluation process-covering all the bases

Phase 1: investment (idea) Origination and Analysis-
1. : conduct a strategic assessment
2. : estimate the investment’s value (valuation model)
3. : prepare an investment evaluation report and recommendation to
management
Phase 2: managerial review and recommendation (control function)
4. : evaluate the investment’s strategic assumptions
5. : review and evaluate the methods and assumptions used to estimate the
investment’s NPV
6. :adjust for inherent estimation errors induced by bias, and formulate a
recommendation regarding the proposed investment
Phase 3: managerial decision and approval
7. Make a decision
8. Seek final managerial and possibly board approval

Broad set of factors:

 Cash flow estimation

 Risk assessment

 Financing opportunities

 The effects on the firm’s near-term earnings

 Staged investments

 ‘follow-on’ investment opportunities

Chapter 2: Project Analysis using Discounted Cash Flow (DCF)

The three-step DCF process
Steps Investment valuation
Step 1: forecast the amount and timing of Forecast free cash flow (FCF)
future cash flows. How much cash is the
project expected to generate and when?
Step 2: estimate a risk-appropriate Combine the debt and equity discount rate
discount rate. How risky are the future (weighted average cost of capital)
cash flows, and what do investors
currently expected to receive for
investment of similar risk?
Step 3: discount the cash flows. What is Discount the FCF using WACC to estimate
the present value ‘equivalent’ of the the value of the project as a whole.
investment’s expected future cash flows?
Defining cash flows:
What cash flows are relevant to the valuation of a project or investment?
 Only incremental cash flows are relevant which includes the direct effect generated
by investment and the indirect effect on the existing business lines.

 Sunk cost are irrelevant

Conservative or optimistic cash flows?

 Assumes the cash flows being ‘expected’ cash flows

 Forecast bias: overconfidence, hoped-for cash flow rather than expected CF which
need adjusted for higher discount rate

Equity versus Projected Free Cash Flow

FCF (free cash flow) is the amount of cash flow that is available for distribution to the various
claimants (debt and equity) after paying all the firm’s expenses and investing in new
projects.

Equity FCF refer to the amount of cash flow that is available for distribution to the firm’s
equity holder. FCFE= FCFF – after tax interest exp. + net debt issue

Free refers to the fact that the cash flow is no needed for any particular purpose.

Calculating Projected Free Cash Flow (FCF)

FCFF = (EBIT – tax expense) + D&A – CAPEX – increase in NWC

= NOPAT + D&A – CAPEX – increase in NWC

= EBIT*(1-Tc) + D&A – CAPEX – increase in NWC

EBIT = Sales – COGS – operating expenses

= Gross profit – operating expenses

FCFF= (EBITDA)*(1-t) + D&A*t – CAPEX – increase in NWC

= (EBITDA-DA)*(1-Tc) + D&A – CAPEX – increase in NWC

Depreciation and amortisation expense:

They are non-cash accounting expenses, the relevant cash flow is the tax benefit generated
by D&A since they are tax deductable.

The net result is that we add an amount back to FCF equal to the tax savings on the
depreciation expense.

Capital expenditure (CAPEX)

CAPEX = changes in the net PPE

= Net PPE (t) – Net PPE (t-1) + Depreciation Exp. (t)

Changes in the NWC

Changes in the NWC = increase in CA – increase in CL

CA increase, cash decrease

CL increase, cash increase

Valuing investment cash flows

 NPV

 IRR

 Payback period

 Discount payback period

 Accounting rate of return

Mutually exclusive project: highest NPV

IRR VS NPV: NPV profile, when cash flow are not conventional (multiple signs)multiple IRR

Chapter 3: Project risk analysis

Estimated NPV value or IRR figure is not guaranteed, since it involves a lot of assumptions
and estimations.

 Need project risk analysis

 Understand the key value drivers of the project

 Sensitivity analysis (scenario analysis, breakeven analysis, simulation analysis)

Scenario analysis
The sensitivity of an investment’s value under different situations or scenarios that might
arise in the future.

Scenario refers to different sets of assumptions about the realised values of each of the
value drivers.

Advantages: management be prepared for different situations in the future

Disadvantages:

Although scenario analysis is very helpful, there is no systematic way to define the scenarios.
The number of possible scenarios is limited only by the imagination of the analyst
performing the analysis. One approach that is often used to systematize the sensitivity
analysis is something called breakeven sensitivity analysis.

Breakeven sensitivity analysis

What is the critical value that drives the NPV to zero?

Method:

1. Trial and error

2. Goal seek function in Excel to perform what-if type problems

3. Solver: maximisation, minimisation, breakeven problems in the presence of multiple

constrains.

Limitations:
 1. This type of analysis considers only one value driver at a time, while holding all
others equal to their expected values. This can produce misleading results if two or
more of the critical value drivers are correlated with one another.

2. We don’t have any idea about the probabilities associated with exceeding or droping
below the breakeven value drivers. It would be helpful to have some idea as to the
likelihood of missing the key driver targets

3. We do not have a formal way of incorporating consideration for interrelationships

among the variables.

Then we turn to simulation analysis which overcomes all three shortcomings.

Simulation analysis
Monte Carlo analysis:

Define the key driver distribution: triangle and uniform distribution.

The result evaluation can use Tornado Diagram to sum up the key drivers changes.

Reflection of using simulation analysis:

o It is difficult to make distribution assumption

o The fact is that the analyst who fails to address the underlying complexities of an
investment’s cash flows explicitly is simply making the assumptions implicit in
analysis.

Valuing project flexibility – decision trees

Project flexibilityreal option in financeeffect the expected cash in DCF analysis

The expected cash that incorporated the real option is the weighted average expected cash
flow from different situations. Without consider the option, we implicitly assumes the
project will continue in light of the new information.

Summary:
Determining the value of an investment opportunity is straightforward when future cash
flows are known. However, we live in a very uncertain world, and very few investments
generate cash flows that can be predicted with any degree of precision.

While uncertainty clearly complicates the valuation process, a number of tools help the
analysis deal with this complexity more effectively.

All three tools provide information that the analyst can use to understand the key factors
that drive a project’s success or failure. This information helps the analyst develop a better
understanding of how confident the firm should be in the project’s prospects.

Chapter 4: Cost of capital

To value those cash flows, we need a cost of capital or a discount rate to reflect the risks of
the cash flows.

The idea of an investment’s opportunity cost of capital.

Weighted average cost of capital (WACC) provides the appropriate discount rate for valuing
an entire firm.

WACC is not appropriate for valuing individual project, if the project risk is significantly differ
from the firm-wide risk. Moreover, firm might be consider multiple discount rates.

WACC Introduction
WACC (‘whack’) is the weighted average of the expected after-tax rates of return of the
firm’s various sources of capital.

Usefulness:

1. Provide the appropriate discount rate

2. Benchmark for determining the appropriate discount rate for new investment
projects

3. For valuing acquisition candidates

4. For evaluating their own performance

Value, Cash flow, and discount rate

Important: cash flow calculation and discount rate calculation must be properly aligned.

 Equity cash flow matched with the cost of equity.

 FCFF (free cash flow to firm) matched with WACC.

 Conservative cash flow discount at a lower discount rate.

 Estimated cash flows are ‘hoped-for’ or optimistic discount at higher discount rate.

Firm valuation
Invested capital as capital raised through the issuance of interest-bearing debt and equity
(both preferred and common).

Enterprise value = equity + interest-bearing liabilities (?????)

WACC = 𝑘𝑑 (1 − 𝑡)𝑤𝑑 + 𝑘𝑝 𝑤𝑝 + 𝑘𝑒 𝑤𝑒

 Use market weights rather than book weights

 Use market-based opportunity cost (should reflect the current rate of return)

 Use forward-looking weights and opportunity costs

𝑁 𝐸(𝐹𝐶𝐹𝐹𝑡 )
𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒0 = ∑ 𝑡
𝑡=1 (1 + 𝑊𝐴𝐶𝐶)

 FCFF excludes interest expenses tax saving

 But the tax deduction is not ignored, it is included in the WACC calculation
Equity valuation
FCFF = FCFE + FCFD

FCFD (free cash flow to debt holder) = (interest expense- interest tax saving) + (principal
payment – New debt issue proceeds)

= After-tax interest expense + Net debt proceeds

FCFE = FCFF – (after-tax interest expense+ Net debt proceeds)

 Be careful for the signs of net debt proceeds

 If principal payment > new debt issue proceeds, cash outflows to firm

 If principal payment < new dent issue proceeds, cash inflows to firm

Estimating the WACC

The cost of debt:
1. Promised or contractual yields to maturity on corporate bonds (YTM), when the
market price, term to maturity and coupon rate is available.
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙
𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒 =
1 + 𝑌𝑇𝑀
2. If the debt is privately, the above information is not available, using the credit rating
approach, rf + credit spread for similar credit rating

3. YTM is only appropriate if it is default-free. The expected cash flows is not equal to
promised cash flows. For investment grade bond the spread is modest, but for
bonds below investment grade (BBB), there is a significant difference between YTM
and Rd

If the probability of default is high, cost of debt should be adjusted:

𝑏𝑜𝑛𝑑 𝑝𝑟𝑖𝑐𝑒
(𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙) ∗ 𝑃 + (𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 + 𝑝𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙) ∗ 𝑃𝑑 ∗ 𝑅𝑒𝑐𝑜𝑣𝑒𝑟𝑦 𝑟𝑎𝑡𝑒
=
1 + 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡
4. Estimating cost of convertible bond=weighted average cost of debt and equity
conversion option.

Cost of preferred equity

It typically pays the holder a fixed dividend each period, forever.
𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑
𝑘𝑝𝑠 =
𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑚𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠ℎ𝑎𝑟𝑒
It should be note that here, it assumes the promised dividend equal to the expected
dividend.

Cost of Common Equity

There is no promised cash flow for common equity holders. The relevant cost of common
equity is simply the rate of return investors expect from investing in the firm’s stock.

1. Asset pricing model

 a. The traditional CAPM: Re=Rf + beta*(Rm-Rf)

i. Selecting Rf: what is the risk-free security? domestic risk-free rate

to capture the inflation difference. And what maturity should we
use? We want to match the maturity of the risk-free rate the
maturity of the cash flows being discounted.

ii. Estimating beta:

1. regress excess stock return over excess market return.

Important: match the maturity of Rf and Rm

2. computing average of equity betas of comparable firms with

similar operating risk characteristics, then adjusting
difference in financial leverage. Unlever and relever beta

3. BARRA model also considers the fundamental variables such

as an industry variables

4. Bloomberg model:
Bloomberg adjusted beta=0.33+0.67(unadjusted historical beta)

iii. estimating market risk premium requires prediction of the future

spread between the rate of return on the market portfolio and the
risk-free rate.

1. In boom: MRP tends to narrow

2. In the recession: MRP tends to expend

3. Using DDM model apply to general market MRP=Rm-Rf

b. The sized-adjusted CAPM

c. Multifactor models: three factor model

i. Re=Rf+B*MRP+S*(SMBP)+H*(HMLP)

2. DDM approach (forward-looking model)

a. Re=D1/P + g

Capital structure
What liabilities should be included in defining the firm’s capital structure?

include only those liabilities that have an explicit interest cost associated with them.
Specially, exclude non-interest-bearing liabilities such as accounts payable.

How should the various sources of capital in the capital structure being weighted?

weights should reflect the current importance of sources of financing, which in turn, is
reflected in current market values. However, large private corporate debt does not have
observable market value, book value is used instead.
Chapter 5: estimated required rates of return for projects
Intro: the most widely used approach for choosing the discount rate for new investment is
to use firm’s WACC.

Two methods for customizing or tailoring the discount rate to the specific attributes of the
project:

1. Divisional WACC

2. Hurdle rate