Valuation Review

1. Valuation Review

2. Free Cash Flow to the Firm FCFF represents cash flows to which all stakeholders make claim FCFF = EBIT  (1 - tax rate) + Depreciation and amortization - Capital Expenditures - Increase in Working Capital Note: Working capital = Current Assets - Non-interest Bearing Current Liabilities (e.g. A/P & Accrued liab.)

3. DCFF Valuation • Stage 1 FCFF • You may be given projections for some (or all) of the items needed to compute FCFF (at a minimum, sales) • For other items, use historic ratios to sales (unless you think the are not appropriate) • Key: state and justify all assumptions! • Stage 2 FCFF • assume FCFF grow at a constant rate indefinitely into the future • Terminal growth (g) • Nominal rate of “stable” growth in the economy • Capital expenditures in stage 2 = depreciation

4. Steps in Applying DCFF Valuation • Discount projected FCFF at the firm’s WACC • This gives the value of the operating assets of the firm (Enterprise Value, or EV) • Add to this the value of any non-operating assets • “excess” cash, marketable securities, etc. • Subtract the value of existing debt to obtain the value of common stock • Divide by shares outstanding to come up with price per share

5. Cost of Capital (WACC) • After tax cost of capital is the weighted average of required returns on different types of liabilities used to finance the assets under consideration. Formally: kc = (D/V ) * kd * (1-t) + (E/V ) * ke kd = cost of debt D=value of debt ke = cost of equity E=value of equity kc = overall cost of capital V=D+E t = firm’s marginal tax rate

6. Capital Structure • Use market rather than book values of debt and equity if available • “Target” capital structure: • Estimate the firm’s current capital structure • Review the capital structure of comparable firms • Review management’s plans for future financing • What if capital structure is expected to change over time?

7. Cost of Debt (kd) • Match with term of projects (generally long-term) • Focus on “permanent” debt (can include short term) • Use same rate for all types of debt (short and long-term) • Use current as opposed to past yields • Take government yields and add a risk “premium” • Historic spread for issuer (long-term best but use short term spread if no better data) • Spread given bond rating, if available • 1-3%, if no other information

8. Cost of Equity (ke): the CAPM • Relevant measure of risk: • Contribution a stock makes to the risk of a well diversified portfolio (the “market” portfolio) • Formally, this contribution is given by an asset’s “beta” • The CAPM relates the cost of equity for an individual stock to that asset’s beta (b). Formally: ke = rf + b RP

9. The CAPM: Inputs • b - beta • Beta for an asset of similar risk to the market portfolio = 1. • Typical range of betas: 0.5 - 2.0 • If you cannot measure for firm, use beta of comparable firm(s). Be consistent with capital structure assumptions (may need to unlever / relever) • rf - risk free rate • Current yield on long-term government bonds • RP - expected market risk premium • Historic average of difference between the return on the market (e.g. TSE300) and long-term government bonds • 4-6% if no better data available

10. Relative Valuation Approaches • Find “comparable firms” • Similar industry, leverage (link to growth prospects, risk) • Industry average • Assume that valuation multiple (P/E, EV/EBITDA, etc.) for comparable(s) will be same as for firm in question • Determine P or EV for firm such that this is true • Merger method (comparable transaction) • Principle is the same, just use transaction prices rather than trading prices to come up with ratios • Likely to have fewer “good” comparables • Premium paid is important “psychologically”

11. Special Cases in DCF Valuation • Capital raising (e.g. IPO) • Do cash flow projections account for capital raised? • If so, value of existing equity equals total equity value less amount raised in the IPO • Share price for equity offering = value of existing equity / number of existing shares • If lower price, wealth transfers from original share owners • Private firms • “Liquidity discount” ~40%

12. M&A Valuation: The Process Value of synergy gain to bidder Transaction Costs Value of target with syner- gies Max. Bid Stand-alone target value Min. bid In most cases, we can just determine this value

13. M&A Valuation: Special Issues • Competing bids • Are there other potential bidders • What would be their maximum bid (are we likely to lose a bidding contest?) • Cost of Capital • Use target firm WACC when valuing the takeover target (use target capital structure as stand alone firm) • Use bidder WACC when valuing bidder • Be wary of synergies due to reduced WACC! • Private firm discounts

14. M&A Valuation: Special Issues • Deal financing • Debt • What are key ratios on combined company? • Can combined company meet debt obligations? • Equity • How many shares should be exchanged? • If selling new shares, are they fairly priced? • Other considerations • Financial flexibility • Signals

15. Valuation Case Process • Size-up the firm being valued • Do projections seem realistic (look at past growth rates, past ratios to sales, etc.)? • What are the key risks? • What qualitative issues affect your purchase interest? • Valuation analysis • Several approaches + sensitivities (tied to risks) • Come up with a valuation range that is plausible

16. Valuation Case Process • Address case specific issues • e.g. for M&A: what is fit (size-up bidder), any synergies, bidding strategy, structuring the transaction, etc. • e.g. for capital raising: timing, deal structure, etc. • Key: Respond to case specific questions

17. UGG Grading Key • Setup (alternatives / criteria) 5% • UGG Size-up 25% • Valuation • Ratios 20% • Base case DCF 20% • DCF of synergies 13% • Decision 17% • Total 100%

18. Empire Grading Key • Setup (alternatives / criteria) 5% • Oshawa Size-up 25% • Valuation • Ratios 15% • Base case DCF 25% • DCF of synergies 10% • Decision 15% • Total 100%