Pre-Workshop Reading The Structure of Value

Analyze Cost of Capital

H istoricals

Initial Pricing
Analysis

Choose
Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Reject Calculate &

Interpet

Value!

Accept

C onsider C ost of
Analy ze C apital
V aluation
Historicals
Dy nam ics

Initial Pricing
Analy sis The value proposition is a systemic
structure, which reflects the circular
nature of the valuation process.
At any time, the valuer needs to be able
C hoose to go backwards, forwards and around
V aluation within the model, in order to be informed
M odels of the impact of value drivers on the
overall E stim ate
S teprocess.
ve S h a w & R ic h a rd S to k e s - 2 0 0 1
Forecast C ontinuing
Only when the valuer has been around V alue
Performance
Market value is defined as the price at the model enough times to have
which shares would change hands between concluded within the required precision
a willing buyer and a willing seller, neither on the value of the firm, can he then exit
being under compulsion to buy or sell, and the model and accept the resulting value
both having reasonable knowledge of within the parameters of the valuation
relevant facts and market conditions at the engagement.
time.

R eject C alculate &

The value of a firm is the present value of Interpet
its expected cash flows, discounted back at
a rate that reflects both the riskiness of the
project and the financing mix used to V alue!
finance it.
Accept

ABCD - Pre-Reading 6 -
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Pre-Workshop Reading
Analyze Cost of Capital
H istoricals

Initial Pricing
Analysis

Choose
Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Reject Calculate &

Interpet

Calculating the Cost of Capital

Value!

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Capital asset pricing model

„ The cost of equity capital (Ke) is usually calculated using the capital asset pricing
model, which uses the following formula:

Ke = Risk-free rate + (Equity risk premium x Beta)

„ The firm’s beta is 1.20, the risk-free rate is 5.25% and the equity risk premium is
5.00%. The cost of capital is calculated as 5.25 + (5.00 x 1.20) = 11.25%

WACC
„ The weights are based on the market values of debt and equity using D/(D+E).
„ The cost of debt is post-tax (31%) because interest is tax deductible. Equity is not
tax deductible!

WACC calculation % $ million % of funds Post tax Weighted

Debt 7.75% 26.0 8.12% 5.35% 0.43%
Equity 11.25% 294.0 91.88% 11.25% 10.34%
-------- --------- --------
Total funds 320.0 100.00% 10.77%
===== ======= ======
ABCD - Pre-Reading 9 -
KPMG Corporate Finance
Global CF – M & A 1 © KPMG and Stokes & Shaw Associates – Version 2002.01 STOKES & SHAW
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Pre-Workshop Reading
Analyze Cost of Capital
H istoricals

Initial Pricing
Analysis

Choose
Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Reject Calculate &

Interpet

Choosing Valuation Methods

Value!

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There are basically three valuation methods (market, asset-

based and economic methods) which contain many models.
MarketMethods
Market Methods
For example, under economic methods, there are three main
models - DCF, Economic Profit (EVA, ROIC and CFROI) and
option pricing models.
Within DCF models there are further sub-models depending
on whether you are discounting dividends, FCFE or FCFF.
Even within each sub-model, further choices can be made as
to whether 2-stage, 3-stage or multi-stage explicit growth
periods are used.
Asset-BasedMethods
Asset-Based Methods

Dividend
Discount

FCFE DCF Models

APV Model

Economic Economic EconomicMethods

Methods
FCFF
Methods Economic
Profit

Option Pricing

ABCD - Pre-Reading 20 -
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Pre-Workshop Reading
Analyze Cost of Capital
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Analysis

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Valuation
M odels
Estimate
Continuing
Forecast
Value

Choosing DCF Valuation Models

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Value!

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Dividend discount models

„ Basically, shares only do one thing; they pay dividends. The problem is that only about 11% of the value of the top 100 companies in the
Fortune 500 is represented by dividends which will be paid within the next five years. The market obviously only looks at dividends for
plodders, and even the established plodders, such as the utilities companies, are changing their spots these days! The DDM is often
used to value whole stock markets.

Free cash flows to equity

„ The major difference between FCFE and the DDM lies in the openness of the market for corporate control. As changes in corporate
control become more difficult, the value from the DDM will provide a more appropriate benchmark for comparison. DDM will equal
FCFE when all of the firm’s cash flows are paid out in dividends, and when the excess cash (FCFE – Dividends) is invested in projects
with a NPV of zero. FCFE will be higher than DDM where the excess cash is invested in projects with a negative NPV, and where too
small dividends are paid, resulting in lower than optimum leverage. FCFE is also widely used for banks, since a bank's changing liability
structure forms an integral part of its income-generating capacity.
„ Equity Cash Flow methods (as opposed to FCFF) are most useful when leverage is high, but not too high (i.e. when debt is clearly risky,
but the firm is clearly solvent). For firms within this range, ECF methodology is a good way to obtain a lower bound for the value of
equity. When leverage is extremely high, ECF methods can still be counted on to underestimate equity value, but in this range, the
underestimation is so severe, that the estimate cannot be useful, and option pricing should be considered. It is well known that holders
of highly leveraged equity essentially own a call on the assets of the firm. They can exercise the call by paying off the outstanding debt.
They will do so if, when the debt comes due, the assets are worth more than the face amount of the debt. Unfortunately, in reality the
structure of long-term debt creates a series of nested options which makes option pricing less feasible. FCFE is particularly useful for
LBOs, and is the basis for most venture capital MBO models. It is also used for banks, since a bank’s changing liability structure forms
an integral part of its cash-generating capacity.

Free cash flows to the firm

„ This is the default method. It assumes that debt is rebalanced, and is thus not so good for changing leverage situations. FCFF will equal
FCFE if consistent assumptions are made about growth (i.e. not the same assumptions, since the growth rates, especially in the
continuing period, may have to be adjusted for the effects of leverage). FCFF will also equal FCFE if debt is properly valued.

Adjusted present value

„ APV is most useful when leverage is high, or when it is changing. A great advantage of APV is that it is transparent, and it effectively
unbundles operating cash flows from financing and other side effects. Another advantage of APV over WACC is that the discount rate is
only calculated once (unleveraged cost of equity), whereas for WACC the cost of equity and the cost of debt change with the level of
leverage, and this leads to many interperiod recalculations of beta, cost of equity and WACC. The disadvantage of APV is that the costs
of bankruptcy need to be estimated.
ABCD - Pre-Reading 21 -
KPMG Corporate Finance
Global CF – M & A 1 © KPMG and Stokes & Shaw Associates – Version 2002.01 STOKES & SHAW
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Pre-Workshop Reading
Analyze Cost of Capital
H istoricals

Initial Pricing
Analysis

Choose
Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Cost of Capital Reject Calculate &

Interpet

Accept
Value!

„ Cost of capital is the expected rate of return that the market requires in order to
attract funds to a particular investment.
Cost of
„ Cost of capital is Equity
ƒ a function of the investment not the investor Arbitrage
ƒ forward-looking and represents investors' expectations Pricing
ƒ based on market value not book value Theory
ƒ usually stated in nominal terms Capital
ƒ equal to the discount rate which is not the same as capitalization rate Asset Risk-Free
Pricing Rate
„ The Capital Asset Pricing Model measures risk in terms of non-diversifiable Model
variance, and relates expected returns to this risk measure. It is based on several
assumptions: that investors have homogeneous expectations about asset returns
and variances, that they can borrow and lend at a risk-free rate, that all assets are Beta
marketable and perfectly divisible, that there are no transaction costs, and that Equity
there are no restrictions on short sales. Risk
Premium
„ The principal factors which influence the risk-free rate, equity risk premium and
level of the beta are as follows:

ƒ Risk-free rate
• maturity
• implied inflation Gearing
• liquidity premium
ƒ Equity risk premium
• underlying economy
• political risk
• market structure
Optimal
ƒ Betas Gearing W ACC
Modify
• cyclical nature of the business Level
Beta
• operating leverage
• financial leverage
• size
• company-specific factors
Cost of
Debt

ABCD - Pre-Reading 25 -
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Pre-Workshop Reading
Analyze Cost of Capital
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Initial Pricing
Analysis

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Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Reject Calculate &

Interpet

Swordfish Division
Value!

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Case Study

„ You are the business development manager of Rapier Plc. (a metal saw-making group) and your CEO, who has recently been appointed,
has asked you to prepare a quick valuation as of January 1, 2002 of the Swordfish division, which is run as a standalone division and
which specializes in hydraulic crane parts.

„ You have obtained the five-year projections of free cash flows to the firm for the years ending December 31, 2002, 2003, 2004,2005 and
2006 (in €million) from the company’s strategy and planning department.

2002 2003 2004 2005 2006

Free cash flows (€million) 36.5 33.1 36.0 38.5 40.4

„ Other information available on Swordfish is as follows:

ƒ Statutory tax rate 32%

ƒ Effective tax rate 34%
ƒ Projected growth rate after 2006: 2.5%
ƒ Risk-free rate: 5.25%
ƒ Equity risk premium: 5.00%
ƒ Group beta: 1.30
ƒ Divisional beta: 2.32

„ Debt - Equity structure (based on market values) % of Equity

• Revolving credit @ 9.5% 20.19%
• Bank debt @ 10.0% 125.48%
• Subordinated debt @ 10.5% 235.10%

„ Assume that the division’s gearing structure will remain the same after the change in ownership

Please answer this question and be prepared to share your answers during the
session which will take place on the first day of the workshop.
ABCD - Pre-Reading 26 -
KPMG Corporate Finance
Global CF – M & A 1 © KPMG and Stokes & Shaw Associates – Version 2002.01 STOKES & SHAW
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Pre-Workshop Reading
Analyze Cost of Capital
H istoricals

Initial Pricing
Analysis

Choose
Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Reject Calculate &

Interpet

Adjusted Present Value

Value!

Accept

How Does the Model Work?

„ APV unbundles WACC

ƒ APV unbundles components of value and treats each one separately
ƒ In contrast, WACC bundles all financing side effects into the discount rate

„ APV – the fundamental idea

Value of all financing side effects

interest tax shields

Base-case value
financial distress costs
Value of the project
APV = as if it were financed
+/- subsidies & guarantees
entirely with equity

hedges

issue costs

ABCD - Pre-Reading 33 -
KPMG Corporate Finance
Global CF – M & A 1 © KPMG and Stokes & Shaw Associates – Version 2002.01 STOKES & SHAW
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Pre-Workshop Reading
Analyze Cost of Capital
H istoricals

Initial Pricing
Analysis

Choose
Valuation
M odels
Estimate
Continuing
Forecast
Value
Perform ance

Reject Calculate &

Interpet

How Does the APV Model Work?

Value!

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APV model
„ Value the firm as if it were financed entirely with equity
ƒ Unlever beta and recalculate WACC at zero leverage (which is equal to the cost of equity).
ƒ Discount free cash flows to the firm to NPV using the unlevered WACC.
„ Evaluate the financing side effects of the interest tax shield
ƒ Model the tax advantages of financing with debt rather than an with all-equity structure.
ƒ Discount the tax shield to net present value using either the cost of debt (fixed debt assumption) or the zero-levered WACC
(rebalanced debt assumption).
„ Assess the costs of financial distress
ƒ Assess the probability of bankruptcy (eg. by using information from rating agencies).
ƒ Estimate the costs of bankruptcy (i.e. by suspending the going concern assumption).
ƒ Calculate the costs of financial distress by multiplying the costs of bankruptcy by the probability of going bankrupt.
„ Estimate the other financing side effects
ƒ Through interventionist policies, governments and quasi-governmental institutions introduce distortions which influence value.
These side effects include subsidies and guarantees. They are particularly in evidence in project finance situations.
ƒ There is much debate as to whether hedging increases shareholder value. In theory, hedging is designed to reduce cash flow
volatility, but in reality, the costs of hedging often exceed the benefits (cf. Copeland Valuation 3rd edition pp 346-351) .
ƒ Raising equity involves issue costs such as issue discounts, commissions, fees and underwriting costs. Although such costs are
usually disregarded when using APV for firm valuations, they are often taken into account where APV is used to evaluate separate
projects.
„ Aggregate the components to arrive at an enterprise APV value

ABCD - Pre-Reading 34 -
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