Corporate Valuation

Marks Breakup
Internals (40 marks)
15 marks Viva Voce
20 marks Group Project / Presentation
05 marks Class Attendance

Semester End Examination (60

marks)

Books

What is Value ?

Price v/s Value

Bigger Fool Theory

Purpose of Valuation
The purpose of corporate valuation is
basically to estimate a fair market value of
a company.
Fair market value is the price at which the asset would
change hands between a willing buyer and a willing seller
when the former is not under any compulsion to buy and
the later is not under any compulsion to sell, both parties
having reasonable knowledge of relevant facts.

Caveats in Valuation
A valuation is an objective search for true value
All valuations are biased.

A good valuation provides a precise estimate of

value
There are no precise valuations (uncertainty)

The more quantitative model, the better valuation

Simpler valuation models do much better than the
complex ones

Bias in Valuation
Mitigation techniques
Avoid pre commitments
Delink valuation from reward /
punishment
Diminish institutional pressure
Increase self awareness

Uncertainty in Valuation
Sources of Uncertainty
Estimation uncertainty
Firm specific uncertainty
Macroeconomic uncertainty
Mitigation techniques
Better valuation models
Valuation ranges
Probabilistic Statements

Complexity in Valuation
The analysts can suffer from information
overload
Black box scenario The model becomes very
complex the analysts may not understand its
inner workings. They just feed input and get
the output.
.. if we can value an asset with three inputs we should not be
using five. If we can value a company with three years of cash
flow forecasts, forecasting 10 years cash flows is asking for
trouble. - Damodaran

Context of Valuation

Raising capital for a Nascent Venture

Initial Public Offering
Acquisitions
Disinvestment
Employee Stock Option Plans
Portfolio Management

Different Approaches to
Valuation
Intrinsic value approach (DCF)
Relative valuation approach
Option valuation approach

Discounted Cash Flow

Approach

Discounted Cash Flow

Valuation
The value of an asset is the present
value of the expected cash flows on
the asset, discounted back at the rate
that reflects the riskiness of these cash
flows.
E (CFn )
E (CF1 ) E (CF2 ) E (CF3 )
Value of asset

(1 r )

(1 r )

(1 r )

...

(1 r ) n

Classifying DCF Models

Going concern vs. Asset Valuation
Future Investments vs. Current
Investments

Equity valuation vs. Firm Valuation

Variations on DCF models
Excess returns
Adjusted present value

Inputs to DCF Models

Discount Rates
It should reflect the riskiness of cash flow
Cost of Equity
After tax cost of borrowing

Expected Cash Flows

Dividends
FCFE
FCFF

Expected Growth
Historical data
Management guidance
Reinvestments

Estimating Discount Rates

It represents a weighted average of the costs of
all sources of capital, as free cash flows reflects
the cash available to all providers of capital
It is calculated in post tax terms
It is based on market value weights of each
component
It reflects the risks borne by various providers
of capital
It is defined in nominal terms

Weighted average cost

of capital

WACC wE rE wD rD (1 T ) wP rP
where wE , wD and wP are the weights associated with equity, debt and preference
rE , rD and rP are the costs of equity , debt and preference.

Cost of Equity

Capital Asset Pricing Model Approach

Dividend Discount Model
Bond Yield plus risk premium
Earnings Price

CAPM

E(R i ) R f i [E(R m ) R f ]
where
E(R i ) is the exp ected return on sec urity i
R f is the risk free rate of return

i is the beta of sec urity i which reflects its sensitivity to market

E(R m ) is the exp ected returns on market

Risk Free Rate

Risk free rate is the return on a
security that is free from default risk
and is uncorrelated with returns from
anything else in the economy
In practice two ways are commonly
used
The rate on a short term government
security like the 364 day Treasury Bill
The rate on a long term government

Market Risk Premium

Value weighed equity index such as BSE Sensex and
Nifty are used as a proxy to market portfolios
The market risk premium is the difference between
the expected market returns and the risk free rate
of return
It can be estimated on the basis of historical data
(arithmetic mean vs. geometric mean) or forward
looking data (dividend yield + constant growth rate)

Beta
Beta measures the volatility of the
stock with respect to the market

Bond Yield Plus Risk Premium

Cost of equity = Yield on long term bonds +
Risk Premium
Firms that have risky and consequently high cost
debt will also have risky and consequently high
cost equity.
Risk premium is subjectively estimated by looking
at the operating and financial risks of the business

Dividend Discount Model

Dt
P0
t
t 1 (1 r )

D1
P0
rg
D0 (1 g)
D1
r
g
g
P0
P0
Growth rate (g) can be determined by
1. Analysts forecast
2. Historical Data
3. g = (retention rate)*(return on equity)

Earnings Price Ratio

E1
Cost of equity
P0
E1 exp ected earnings per share for the next year
P0 current market price per share

Cost of Debt
Cost of debt is nothing but the yield
to maturity of that instrument
Bank Loan
Debentures
n

P0
t 1

I
F

(1 rD )t (1 rD ) n

where
P0 is current market price of the debentureClose approximation can be given
I is the annual int erest payment
n is the number of years to maturity
F is the maturity value of debenture
rD is the cos t of debt

I ( F P0 ) / n
rD
0.6 P0 0.4 F

Cost of Debt
Commercial paper It is a short term
debt instrument which is issued at a
discount and redeemed at par. Hence
the cost of commercial paper is
simply is implicit interest rate.
Ex. The face value of a commercial paper
is 10,00,000 and it is traded in the market
at 9,65,000 with maturity of 6 months
Interest rate

10,00,000
1 0.0363 3.63%
9,65,000

Annualized int erest rate (1.0363) 2 1 0.0739 7.39%

Cost of Debt Example

Debt
Instrument

Face Value

Market
Value

Coupon
Rate

YTM

Non
Convertible
Debenture

100 cr

104 cr

12%

10.7%

Bank Loan

200 cr

200 cr

13%

12%

Commercial
Paper

50 cr

48.25 cr

N.A.

7.39%

352.25 cr

104
200
48.25

Average cost of debt

10.7%

12%

7.39% 10.98%
352.25
352.25
352.25

Post tax cost of debt 10.98%(1 0.30) 7.14%

Cost of Preference
Preference capital carries a fixed rate
of dividend and is redeemable in
nature
Preference stock will be considered
much like a bond with fixed
commitments. However preference
dividend unlike debt interest is not a
tax deductible expense and hence
does not produce any tax savings.

Weights to determine cost of

capital
Market value of the capital is to be
used while calculating the weights
Cost of capital is a forward looking
measure, it reflects the cost of
raising new funds to acquire the firm
today

WACC Example
Source of
capital

Proportion

Cost

Equity

0.60

16.0%

Preference

0.05

14.0%

Debt

0.35

12.0%

Tax Rate = 30%

Weighted
Cost

DCF Model Example

Year

CF to equity

Interest
Expense

50

40

60

40

68

40

76.2

40

83.49

40

Cost ofTerminal
Equity = 13.625% 1603
Cost of Debt
Value= 10%
Tax Rate = 50%
Total Debt = 800cr

CF to firm

2363