Valuation

Valuation
MPA FIN 286

Alessandro Previtero
Slide Pack Week 2 Part 1
Company Valuation No Friction
Model and Frictions
Todays Content
I.
Announcements:
a. HW 1 due today
b. HW 2 due next class
c. TA Review session this Thursday 5-6pm. Room TBA
II.
DCF: No Friction Model
III. Frictions: Taxes and Bankruptcy Costs

IV. Problems
Overview - 2
I. Company Valuation
Introduction
Discounted Cash Flow (DCF) Models
Discount Rate
No Friction Model
WACC (Weighted Average Cost of Capital)
APV (Adjusted Present Value)
Multiples
Other topics: LBOs, M&A, etc.
No Friction Model
We first study a valuation model with no frictions
No Corporate or Personal Taxes
No Bankruptcy Costs
No Transaction or Issuance Costs
No Asymmetric Information
We will then add back frictions, and understand how taxes and
bankruptcy costs affect firm value.
Company Valua4on DCF Models No Fric4on Model 4
Recap: How to Value a Firm No Friction Model

FFCF = EBIT (1 tC ) + DA NWC Capex + AS CGT
E[FFCFt ]
VA =
t
(
)
1
+
r
t =0
REGRESSION
rA =
D
E
rd +
re
D+E
D+E
e =
Cov (re , rm )
Var (rm )
If Public Company
re = rf + e (rm rf )
CAPM
Comparables
Unlevering
MVE
P=
N
e_c1
Ec
1
d_c1
Dc
e_c2
d_c2
A_c1
A_c1
A_c
e_c
Ec
Dc
d_c
Dc
Ec
e??
Levering
MVE = VA + NOA MVD
If NOT Public Company
A_c1
A
COMPARABLES
Estimating the Cost of Debt (1/12)

rA =
D
E
rd +
re
D+E
D+E
Cost of debt (rd) depends on:

Rate on Treasury bonds with same maturity (risk-free rate)
Companys systematic default risk
The cost of debt can be estimated in the following ways, ordered

from most-preferred to least-preferred:
1. CAPM - We can use the CAPM to measure the cost of debt:
rd = rf + d (rm rf )
Unfortunately the majority of corporate debt obligations are

not traded. The few that are traded are not very liquid

2. Yield-to-maturity of firms corporate bonds requires that bonds are
traded in a liquid market (so price is informative) and knowledge of
the underlying cash flows; adjustment for default probability and
recovery rates necessary for speculative-grade debt (or,
alternatively, when probability of default is higher than 1%).
rd = (1-PD)YTM PD(1-RR)
return if it pays
return if it does not pay
where YTM is the yield-to-maturity, RR is the recovery rate (% of face

value) should default take place and PD the annualized probability of
default.
The yield-to-maturity (YTM) measures promised return to
bondholders. Therefore, when default risk is relevant, expected
return will be lower than YTM
For speculative-grade debt (worse than Baa/BBB), default risk
may be significant.

Table below (source: Moodys) shows the ratings
characteristics.

Table below (source: Moodys) shows the trend in default rates
over time.

Table below (source: Moodys) shows the migration tables

Table below (source: Moodys) shows default probabilities by
letter rating

Table below (source: Moodys) shows default probabilities by
industry.

Table below (source: Moodys) shows recovery rates by debt
seniority

Table below (source: Moodys) shows recovery rates

Example: consider a corporate bond with 10 years maturity, B rating,
and a 8% YTM. What is the cost of debt?
o PD of B rated bond is 3.894%
o Recovery rate is 37%
rd = (1-PD)YTM - PD(1-RR)
= (1-0.03894)*0.08 - 0.03894* (1-0.37)
= 5.2%
If we used 8% as an estimate for the cost of debt we would be
missing by approximately 30% relative to the correct rate

3.
Using a credit spread, which we add to the relevant Treasury rate requires
knowledge of bond rating (or at least interest coverage ratio EBIT/Interest to
construct synthetic rating) in order to obtain credit spread. Risk-free rate
maturity should correspond to the average maturity of the companys debt
(detailed in next slide). Default adjustments in 1. still apply.
For Large non-financial service companies with market cap > $5Billion
If interest coverage
ratio is

>

8.50

6.5

5.5

4.25

3

2.5

2.25

2

1.75

1.5

1.25

0.8

0.65

0.2

-100000

to

100000

8.499999

6.499999

5.499999

4.249999

2.999999

2.49999

2.2499999

1.999999

1.749999

1.499999

1.249999

0.799999

0.649999

0.199999

Rating is

Aaa/AAA
Aa2/AA
A1/A+
A2/A
A3/A-
Baa2/BBB
Ba1/BB+
Ba2/BB
B1/B+
B2/B
B3/B-
Caa/CCC
Ca2/CC
C2/C
D2/D
Spread is

0.75%
1.00%
1.10%
1.25%
1.75%
2.25%
3.25%
4.25%
5.50%
6.50%
7.50%
9.00%
12.00%
16.00%
20.00%
Date of Analysis: Data used is as of January 2015.

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

4. Inspecting the ratio expenses/debt in historical income statements
this will provide an approximation, but it may be a bad one if
conditions significantly changed since the debt contracts were entered
into (e.g. risk-free rate or firms credit conditions).

E[FFCFt ]
VA =
t
(
)
1
+
r
t =0
rd = (1 PD)YTM PD(1 RR)

REGRESSION
rA =
D
E
rd +
re
D+E
D+E
e =
Cov (re , rm )
Var (rm )
If Public Company
CAPM
Comparables
Unlevering
MVE
P=
N
e_c1
Ec
1
d_c1
Dc
e_c2
d_c2
A_c1
A_c1
A_c
e_c
Ec
Dc
d_c
Dc
Ec
e??
Levering
MVE = VA + NOA MVD
A_c1
A
COMPARABLES

FFCF = EBITDA (1 tC ) + DA tC NWC Capex + AS CGT
E[FFCFt ]
VA =
t
(
)
1
+
r
t =0
rA = rf + A (rm rf )
Comparables
MVE = VA + NOA MVD
P=
Unlevering
MVE
N
e_c1
Ec
1
d_c1
Dc
e_c2
d_c2
A_c1
A_c1
A_c
e_c
Ec
Dc
d_c
Dc
Ec
A_c1
A
COMPARABLES
Discount Rate and Leverage

rA =
D
E
rd +
re
D+E
D+E
What happens to the firm cost of capital rA if a company increases its

leverage?
re increases because e increases
rd increases because d increases
rA ?
Under a no friction model, if we increase the leverage, the discount
rate rA remains constant, because even if re and rd increase, the D/(D
+E) goes up and E/(D+E) goes down.
We already knew that!
rA = rf + A (rm rf )
A is not affected by leverage

Discount Rate and Leverage - Example

Company XYZ has a leverage ratio of 20%, e = 1.5 and d
=0.2 .The company wants to restructure its capital structure, raising
the leverage ratio to 30%, but it is concerned that a higher leverage
might increase its discount rate. Assuming that d is not affected by
the leverage increase, rf =5% and rm =10% and no frictions:
How much is the firm discount rate BEFORE the restructuring?
How much is the firm discount rate AFTER the restructuring?
Before the Debt Restructuring
After the Debt Restructuring
re = rf + e (rm rf ) = 0.05 + 1.5(0.1 0.05) = 0.125
rd = rf + d (rm rf ) = 0.05 + 0.2(0.1 0.05) = 0.060

rA =
D
E
rd +
re = 0.2 0.06 + 0.8 0.125 = 0.112
D+E
D+E
A =
D
E
d +
e = 0.2 0.2 + 0.8 1.5 = 1.240
D+E
D+E
e =
A LEV d 1.24 (0.3)0.2

=
= 1.686
1 0.3
(1 LEV )
re = rf + e (rm rf ) = 0.05 + 1.686 (0.1 0.05) = 0.134

rA =
D
E
rd +
re = 0.3 0.06 + 0.7 0.134 = 0.112
D+E
D+E
Note: Many times we will assume that d does not change with leverage. That is a
good assumption ONLY if the debt has very low risk for the leverages we are
working with. If debt becomes risky this assumption will not hold any more.

Previously, we have seen that in a world with no frictions (no taxes,
bankruptcy costs, asymmetric information, transaction costs,)
Firms cost of capital = rA =
D
E
rd +
re
D+E
D+E
rA is independent of leverage (Modigliani and Miller Proposition

II)
The value of a firm does not depend on its capital structure
(Modigliani and Miller Proposition I)
Company Valua4on DCF Models WACC 22
I. Company Valuation
Introduction
Discounted Cash Flow (DCF) Models
Discount Rate
No Friction Model
WACC (Weighted Average Cost of Capital)
APV (Adjusted Present Value)
Multiples
Other topics: LBOs, M&A, etc.

E[FFCFt ]
VA =
t
(
)
1
+
r
t =0
rd = (1 PD)YTM PD(1 RR)

REGRESSION
rA =
D
E
rd +
re
D+E
D+E
e =
Cov (re , rm )
Var (rm )
If Public Company
CAPM
Comparables
Unlevering
MVE
P=
N
e_c1
Ec
1
d_c1
Dc
e_c2
d_c2
A_c1
A_c1
A_c
e_c
Ec
Dc
d_c
Dc
Ec
e??
Levering
MVE = VA + NOA MVD
A_c1
A
COMPARABLES
Intro on WACC
The No-Friction Model assumes that there are no corporate taxes
and no costs of financial distress (bankruptcy)
The WACC (Weighted Average Cost of Capital) model relaxes these
assumptions.
Corporations pay taxes at a marginal rate T
Financial distress is costly for the firm
IS
DA Tax Shield
Interest Payment Tax Shield
Revenues Costs (COGS & SG&A) =

EBITDA Depreciation & Amortization (DA) =
EBIT Interest =
EBT
Taxes=
Earnings
Debt is good because interest on the debt is paid before taxes,

generating a Tax Shield
How much Tax savings does Debt generate?
Value of Debt Tax Shields = tcD
Firms capital structure preferences (1/2)

Debt-to-Value Ratio [D / (E + D)]
of U.S. Firms, 19752005
Source: Berk and deMarzo, 2009, chapter 15.

Firms capital structure preferences (2/2)

Interest Payments as a Percentage of EBIT for S&P
500 Firms, 19752005
Source: Berk and deMarzo, 2009, chapter 15.

Trade-off Theory (1/3)

Debt is good up to a point. When debt is too big, companies enter
financial distress, that is costly to the firm
Benefits of Debt
Interest Payment Tax Shield
Management Incentives
Concessions from Stakeholders
Costs of Debt
Direct Financial Distress Costs
Legal and consultant fees
Managerial time dedicated to
bankruptcy proceedings
Indirect Financial Distress Costs
Asset Substitution Problem
Debt Overhang Problem
Stakeholders Problem
We have seen before that the higher the leverage the higher is
return on debt. Is higher return on debt another cost of debt?
NO! Why?
Financial Distress Costs: Direct Costs

The direct costs are really all fees related to the Chapter 11 reorganization process in the bankruptcy court. These fees are paid
by both the firm and the creditors trying to get the firm to pay them.
UAL re-org $8.6 million/month
Enron BK - $30 million/month
Lehman total BK cost > $100 million as of April 2009
An early finance paper (Warner, 1977) estimated direct bankruptcy
costs at 5% of the value of the assets being argued over, and this
5% then has to be multiplied by the probability the firm even ends up
in BK (which is usually low) to get expected direct bankruptcy costs
Tax savings from debt seem to simply swamp this 5% estimate
(5% IFF you end up in BK)
e.g., asset is worth $100, E(BK) costs $5 at most
Tax Savings = tcD > $5 with tc = 35 at any D > ~$15, or 15%
debt
Something is missing from this 5% estimate, or wed see a lot more
debt out there to get the tax savings
Financial Distress Costs: Indirect Costs (1/3)

1. Asset Substitution Problem: When the company is in
financial distress (Value of the firm < value of the debt) the
managers have an incentive to significantly increase the
riskiness of the investments
Managers try to maximize shareholders equity. If value
of the firm is less than value of the debt, equity value is
zero (limited liability) and thus managers have nothing to
lose in taking on risky projects.
Equity is an option-like payoff where the underlying

security is the value of the firm, and the strike price is the
value of the debt.
It is called asset substitution because substituting low

risky assets with high risky investments transfers from a
firms bondholders to its shareholders

2. Debt Overhang Problem: When the company is in
financial distress (Value of the firm < value of the debt)
it is very hard to raise external funding because any
extra value created goes first to the existing debtholders
Example: Company XYZ

is in financial distress (D=100, V=50)
has a positive NPV Project (NPV=20)
Needs to raise 10 to start the project
New bondholders or shareholders would not get
anything back, because the entire expected NPV
would go to the existing bondholders.
Only the existing bondholders could finance the
project, but often unwilling to increase the debt
exposure to a company in financial distress

3. Stakeholders Problem: Suppliers and customers are
wary of dealing with firms that look like they are about
to go bankrupt (warranty, account payables, investment
in a short term relationship, quality control, )
Because of this worry by customers, the firm loses

money through lost sales.
Usually it is a self-fulfilling prophecy
It is one of the most severe cost of financial distress
What are some characteristics of firms that might suffer

more when customers fear the firm may be in financial
distress? Firms that sell which type of products?
Recap: Trade-off Theory

There is a trade off between the benefits and the costs of debt.
Benefits of Debt
Management
Incentives
Direct Financial Distress

Costs
Firm Value
Interest Payment
Tax Shield
Costs of Debt
Concessions from
Stakeholders
Optimal Leverage
Ratio
Leverage
Indirect Financial Distress

Costs
Asset Substitution
Problem
Debt Overhang
Problem
Stakeholders
Problem
Companies should target an optimal leverage ratio that

maximizes firm value (Targeting Strategy) balancing the benefits and
costs of debt
Trade-off Theory (3/3)

The optimal leverage ratio is unique to each company/industry, as a
function of the relationship between tax advantages and financial
distress costs.
HOG Optimal Leverage Ratio
Problem 1: No Friction Model

Consider the following forecasts regarding DFG, Inc. (000 of dollars):
Balance Sheet
Year 1
Year 2
Gross Fixed Assets
Income Statement
Year 1
Year 2
EBIT
500
520
Beginning-of-year
1,200
1,600
DepreciaBon
320
333
End-of-year
1,600
2,016
Interest
160
90
B-o-y
780
820
E-o-y
820
870
B-o-y
230
240
E-o-y
240
259
B-o-y
2,000
1,124
E-o-y
1,124
1,169
You also know:

Asset Beta of DFGs industry: 1.2;
DFGs Cost of debt: 8%;
Market Risk Premium: 6%;
Risk-free rate: 5%;
DFG does not own non-operational
assets and has a zero excess cash
balance;
Corporate tax rate: 30%.
Receivables
Payables
Financial debt
Using a No-Friction Model, and assuming the FFCF will grow at a 4% rate in
perpetuity after year 2 and a D/E target of 0.5, what is the value of DFGs
equity?
Problem 2: No Friction Model

Assume the CAPM holds, capital markets are perfect and there are no taxes. Exam Corp produces cars and has
a one-4me opportunity to expand produc4on of its exis4ng eet. New machinery will cost $60 million,
payable immediately. The machinery will be housed in a warehouse Exam currently rents to a clothing retailer
for $10 million per year. Expanding the eet will produce $25 million of revenues star4ng next year and
con4nuing for 5 years (at which point the project will be terminated). A]er a search on Yahoo Finance, you
nd the following informa4on from Exams balance sheet (in $ million):

Cash 200 ; Debt 100 ; Stockholders Equity 800

Moreover, you nd that Exams current stock price is $40, it has 50 million shares outstanding, a equity beta
of 1:4, and a AAA credit ra4ng. Finally, you nd the following informa4on on U.S. treasury yields and the
historical spread between S&P 500 returns and the yields of the various U.S. treasury securi4es:
Maturity
Yield
Spread
3 month
4.5%
14%
1 year

5%
11%
5 year

6%
10%
10 year

8%
7%
30 year

10%
6%

You have spent $1 million in labor costs to obtain the revenue projec4ons and market data.

1. What is Exams opportunity cost of capital?
2. Should Exam undertake the expansion?
3. Would your analysis change if Exam also planned to increase its leverage ra4o to 15% by issuing debt and
using the proceeds to repurchase shares? Why or why not. You may assume that the addi4onal debt will not
change Exams credit ra4ng.

Problem 3: Optimal Leverage Ratio
Company XYZ estimates that the value lost in case of

bankruptcy would be 30% of the firms value. The
relationship between financial distress costs and
leverage is quadratic. Assuming that XYZs corporate
tax rate is 40%, find the optimal leverage ratio.

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MPA FIN 286

DCF: No Friction Model

III. Frictions: Taxes and Bankruptcy Costs

Company Valua4on DCF Models No Fric4on Model 4

Recap: How to Value a Firm No Friction Model

MVE = VA + NOA MVD

If NOT Public Company

Company Valua4on DCF Models No Fric4on Model 5

Estimating the Cost of Debt (1/12)

Cost of debt (rd) depends on:

The cost of debt can be estimated in the following ways, ordered

Unfortunately the majority of corporate debt obligations are

Company Valua4on DCF Models No Fric4on Model 6

Estimating the Cost of Debt (2/12)

return if it does not pay

where YTM is the yield-to-maturity, RR is the recovery rate (% of face

Estimating the Cost of Debt (3/12)

Company Valua4on DCF Models No Fric4on Model 8

Estimating the Cost of Debt (4/12)

Company Valua4on DCF Models No Fric4on Model 9

Estimating the Cost of Debt (5/12)

Company Valua4on DCF Models No Fric4on Model 10

Estimating the Cost of Debt (6/12)

Company Valua4on DCF Models No Fric4on Model 11

Estimating the Cost of Debt (7/12)

Company Valua4on DCF Models No Fric4on Model 12

Estimating the Cost of Debt (8/12)

Company Valua4on DCF Models No Fric4on Model 13

Estimating the Cost of Debt (9/12)

Company Valua4on DCF Models No Fric4on Model 14

Estimating the Cost of Debt (10/12)

Company Valua4on DCF Models No Fric4on Model 15

Estimating the Cost of Debt (11/12)

Date of Analysis: Data used is as of January 2015.

Company Valua4on DCF Models No Fric4on Model 16

Estimating the Cost of Debt (12/12)

Company Valua4on DCF Models No Fric4on Model 17

Recap: How to Value a Firm No Friction Model

rd = (1 PD)YTM PD(1 RR)

MVE = VA + NOA MVD

If NOT Public Company

Company Valua4on DCF Models No Fric4on Model 18

Recap: How to Value a Firm No Friction Model

MVE = VA + NOA MVD

Company Valua4on DCF Models No Fric4on Model 19

Discount Rate and Leverage

What happens to the firm cost of capital rA if a company increases its

A is not affected by leverage

Discount Rate and Leverage - Example

After the Debt Restructuring

re = rf + e (rm rf ) = 0.05 + 1.5(0.1 0.05) = 0.125

rd = rf + d (rm rf ) = 0.05 + 0.2(0.1 0.05) = 0.060

A LEV d 1.24 (0.3)0.2

re = rf + e (rm rf ) = 0.05 + 1.686 (0.1 0.05) = 0.134

Recap: How to Value a Firm No Friction Model

rA is independent of leverage (Modigliani and Miller Proposition

Company Valua4on DCF Models WACC 22

Recap: How to Value a Firm No Friction Model

rd = (1 PD)YTM PD(1 RR)

MVE = VA + NOA MVD

If NOT Public Company

Company Valua4on DCF Models WACC 24