Chapter 19 Financing and Valuation

1. Chapter 19Financing and Valuation • Recall that there are three questions in corporate finance. • The first regards what long-term investments the firm should make (the capital budgeting question). • The second regards the use of debt (the capital structure question). • This chapter is the nexus of these questions.

2. The 3 Methods for Valuation • After Tax WACC • Flow of Equity Method • Adjusted Present Value

3. Method 1 After Tax WACC Tax Adjusted Formula

4. After Tax WACC Example - Sangria Corporation The firm has a marginal tax rate of 35%. The cost of equity is 12.4% and the pretax cost of debt is 6%. Given the book and market value balance sheets, what is the tax adjusted WACC?

5. After Tax WACC Example - Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine?

6. Remember with WACC Approach ! • Since tax shield is accounted for in the cost of capital, calculate cash flows as if the company is all equity financed. • WACC approach values the assets and operations of the company. If you are interested in equity value, do not forget to subtract the value of the company’s debt.

7. Capital Budgeting Valuing a Business or Project • The value of a business or Project is usually computed as the discounted value of FCF out to a valuation horizon (H). • The valuation horizon is sometimes called the terminal value.

8. Valuing a Business Example: Rio Corporation OCF=Profit After Tax + Depreciation

9. Valuing a Business Example: Rio Corporation – continued - assumptions Capital spending Investment in NWC

10. Valuing a Business Example: Rio Corporation – continued FCF = Profit after tax + depreciation - investment in fixed assets - investment in working capital FCF = 8.7 + 9.9 – (109.6 - 95.0) – (11.6 - 11.1) = $3.5 million PV (FCF) = 3.5/(1.09) + 3.2/(1.09^2) + 3.4/(1.09^3) + 5.9/(1.09^4) + 6.1/(1.09^5) + 6.0/(1.09^6)= 20.3

11. Valuing a Business Example: Rio Corporation – continued

12. Things to Consider • Don’t value mechanically – for terminal value it might be wise to use knowledge about mature firms in the industry. • Liquidation value.

13. In Practice How are costs of financing determined? • What is included in debt? • What if there are other securities? • How do we determine debt return? • How do we determine preferred stock return? • What if project has a different leverage ratio? • How do we determine equity return for a firm that is not yet traded, or (and) had a different leverage than what we observe in the stock market?

14. Project with Different Leverage Perpetual Crusher project at 20% D/V • rD is constant at 6% (at all debt levels up to 40%) • At 40%: rE=12.4% ; Tc=35%  WACC = 9% • Step 1: unlever the firm to find rA, the cost of capital (WACC) in an all equity firm. • Step 2: Find rE when Debt is 20% (note D/E = 0.2/0.8=25%) • Step 3: Recalculate WACC

15. Example : Calculating WACC • World-Wide Enterprises (WWE) is planning to enter into a new line of business (widget industry) • American Widgets (AW) is a firm in the widget industry with an estimated beta of 1.5. • WWE has a D/E of 1/3, AW has a D/E of 2/3. • Borrowing rate for WWE is10 % Borrowing rate for AW is 12 % • Given: Market risk premium = 8.5 %, Rf = 8%, Tc= 40% • What is the appropriate discount rate for WWE to use for its widget venture?

16. Example : Calculating WACC A four step procedure to calculate discount rates: • Determining AW’s cost of Equity Capital (rE) • Determining AW’s Hypothetical All-Equity Cost of Capital. (rA) • Determining rE for WWE’s Widget Venture • Determining rWACC for WWE’s Widget Venture.

17. Beta and Leverage: No Corp.Taxes • In a world without corporate taxes, and with riskless corporate debt, it can be shown that the relationship between the beta of the unlevered firm (beta of assets) and the beta of levered equity is: • In a world without corporate taxes, and with risky corporate debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

18. Since must be more than 1 for a levered firm, it follows that Beta and Leverage: with Corp. Taxes • In a world with corporate taxes, and riskless debt, it can be shown that the relationship between the beta of the unlevered firm and the beta of levered equity is:

19. Beta and Leverage: with Corp. Taxes • If the beta of the debt is non-zero, then:

20. Method 2 Flow to Equity Approach • Discount the cash flow from the project to the equity holders of the levered firm at the cost of levered equity capital, rE. • There are three steps in the FTE Approach: • Step One: Calculate the levered cash flows • Step Two: Calculate rE. • Step Three: Valuation of the levered cash flows at rE.

21. Flow to Equity Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine? Remember: rE = 12.4%, D=$5million (40% of project’s cost), rD = 6%, TC=35%.

22. Method 2Adjusted Present Value APV = Base Case NPV+ PV Impact • Base Case = All equity finance NPV – Discount unlevered cashflow by unlevered cost of equity (rA), assuming not tax world. • PV Impact = all costs/benefits directly resulting from project - Discount all cost/benefits of financing according to their particular risk.

23. Adjusted Present Value Sangria Corporation - continued The company would like to invest in a perpetual crushing machine with cash flows of $1.731 million per year pre-tax. Given an initial investment of $12.5 million, what is the value of the machine? Remember: rE = 12.4%, D=$5million (40% of project’s cost), rD = 6%, TC=35%.

24. Side Effects in APV – Easy to Add Up Example: Project A has an NPV of $150,000. In order to finance the project we must issue stock, with a brokerage cost of $200,000. Project B has a NPV of -$20,000. We can issue debt at 8% to finance the project. The new debt has a PV Tax Shield of $60,000.

25. Summary: APV, FTE, and WACC APV WACC FTE Initial Investment All All Equity Portion Cash FlowsUnlevered Unlevered Levered Discount RatesrA rWACC rE PV of financing effects Yes No No Which approach is best? Use APV when the level of debt is constant Use WACC and FTE when the debt ratio is constant • WACC is by far the most common • FTE is a reasonable choice for a highly levered firm

26. A Comparison of the APV, FTE, and WACC Approaches • All three approaches attempt the same task: valuation in the presence of debt financing. • Guidelines: • Use WACC or FTE if the firm’s target debt-to-value ratio applies to the project over the life of the project. • Use the APV if the project’s level of debt is known over the life of the project. • In the real world, the WACC is the most widely used approach by far.

27. The Three Methods • The APV formula can be written as: • The FTE formula can be written as: • The WACC formula can be written as

28. Some Practical Issues • APV and NPV basically mean the same thing. • The three approaches will most likely yield different NPVs. • The APV is useful when special financing considerations are tied to the particular project. • WACC most common – has an intuitive appeal, a project should be accepted if its rate of return is higher than the weighted average cost of capital.

29. WACC Approach WACC approach is the most widely used because of its relative simplicity. WACC is only appropriate as a discount rate for a project when: The project has similar systematic business risk as the firm. The project and firm have the same debt capacity. The debt to equity ratio is presumed to stay constant throughout the life of the project.

30. Discounting Safe Cash Flows (for APV Approach) Safe (risk-free) cash flows are discounted by the after tax borrowing rate rD(1-TC). This may be applied for issues such as subsidized loans and depreciation tax shields. Example: The company is granted a one-year subsidized loan of $100k at 5%. The company’s borrowing rate is 13% and its tax rate 35%. What is the NPV of the loan?

31. PMM’s Project Valuation - APV Suppose PMM Inc. has an investment that costs $10,000,000 with expected EBIT (cash flows from operations) of $3,030,303 per year forever. The investment can be financed either with $10,000,000 in equity or with $5,000,000 of 10% debt and $5,000,000 of internally generated (equity) cash flows. The discount rate on an all‑equity-financed project with this kind of risk is 20%. The firm's marginal tax rate is 34%. • Using the APV approach – find whether the project should be pursued if financed with equity only. • Using the APV approach – find whether the project should be pursued if financed with 50% debt.

32. PMM’s Project Valuation with Subsidy Extension 1 : Subsidized (or below‑market‑rate) financing Suppose a municipal government decides that the investment is socially (and politically) desirable and agrees to raise the $5,000,000 debt financing as a municipal bond, or 'muni.' PPM Inc. can effectively borrow $5,000,000 at the municipality's borrowing rate, rD = 7%. (Interest income on a muni is exempt from Federal tax, so the muni rate is typically below the rate on corporate debt.) Using APV approach – find the effect of this subsidy on APV.

33. PMM’s Project Valuation with Subsidy Extension 2 : Flotation Costs When a company raises funds through external debt or equity, it must incur flotation costs. Assume that the municipal government no longer sponsored the project and PPM Inc. must obtain $5,000,000 with new debt at the market interest rate of 10%. Flotation costs are 12.5% of gross proceeds. Assume that the Canadian tax code allows this expense to be amortized over five years. Using APV approach – find the effect of flotation costs on APV.

34. PMM’s Project Valuation – Flow to Equity Suppose PMM Inc. has an investment that costs $10,000,000 with expected EBIT (cash flows from operations) of $3,030,303 per year forever. The investment can be financed with $5,000,000 of 10% debt and $5,000,000 of internally generated (equity) cash flows. The discount rate on an all‑equity-financed project with this kind of risk is 20%. The firm's marginal tax rate is 34%. Assume D/E = 50/67. Using the Flow to equity approach find whether the project should be pursued if financed with 50% debt.

35. PMM’s Project Valuation – WACC Suppose PMM Inc. has an investment that costs $10,000,000 with expected EBIT (cash flows from operations) of $3,030,303 per year forever. The investment can be financed with $5,000,000 of 10% debt and $5,000,000 of internally generated (equity) cash flows. The discount rate on an all‑equity-financed project with this kind of risk is 20%. The firm's marginal tax rate is 34%. Assume D/E = 50/67. Using the WACC approach find whether the project should be pursued if financed with 50% debt.

36. Pearson Company Project Valuation Consider a project of the Pearson Company, the timing and size of the incremental after-tax cash flows for an all-equity firm are: -$1,000 $125 $250 $375 $500 0 1 2 3 4 The unlevered cost of equity of Pearson is rA = 10%. The firm plans to finance the project with $600 of debt carrying an 8% interest. The overall debt to equity target ratio of the firm is 1.5 and the corporate tax rate is TC=40%. Calculate the NPV of the project according to (1) APV, (2) Flow to equity, (3) WACC.

37. CF4 = $500 -28.80 -600 CF3 = $375 -28.80 CF2 = $250 -28.80 CF1 = $125-28.80 $96.20 $221.20 $346.20 -$128.80 0 1 2 3 4 Pearson’s - Flows to Equity Approach Switching from unlevered to levered cash flows. -$400

38. Example: Worldwide Trousers Worldwide Trousers, Inc. is considering a $5 million expansion of their existing business. The initial expense will be depreciated straight-line over five years to zero salvage value. The pretax salvage value in year 5 will be $500,000. The project will generate pretax earnings (EBDIT) of $1,500,000 per year, and not change the risk level of the firm. The firm can obtain a five-year $3,000,000 loan at 12.5% to partially finance the project. If the project were financed with all equity, the cost of capital would be 18%. The corporate tax rate is 34%, and the risk-free rate is 4%. The project will require a $100,000 investment in net working capital. Calculate the NPV using the APV, WACC, and flow to equity approaches.

39. Relative Valuation Valuing a company relative to another company

40. Relative vs. Fundamental Valuation The DCF (WACC, FTE, APV) model of valuation is a fundamental method. • Value of firm (equity) is the PV of future cash flows. • Ignores the current level of the stock market (industry). • Appropriate for comparing investments across different asset classes (stocks vs. bond vs. real estate, etc). • In the long run, fundamental is the correct way of value any asset.

41. Relative vs. Fundamental Valuation Relative valuation is based on P/E ratios and a host of other “multiples”. • Extremely popular with the press, CNBS, Stock brokers • Used to value one stock against another. • Can not compare value across different asset classes (stocks vs. bond vs. real estate, etc). • Can not answer the question is the “stock market over valued?” • Can answer the question, “I want to buy a tech stock, which one should I buy?” • Can answer the question, “Which one of these overpriced IPO’s is the best buy?”

42. Relative vs. Fundamental Valuation You are investing for your retirement. You are planning to take a buy and hold strategy which involves picking some fairly priced stocks and holding them for several years. Which valuation approach should you use? Relative or fundamental?

43. Relative vs. Fundamental Valuation You are a short term investor. You trade several times a week on your E-trade account, and rarely hold a stock for more than a month. Which valuation technique should you use? Relative or fundamental?

44. Relative Valuation Prices can be standardized using a common variable such as earnings, cashflows, book value, or revenues. • Earnings Multiples • Price/Earning ratio (PE) and variants • Value/EBIT • Value/EBDITA • Value/Cashflow • Enterprise value/EBDITA • Book Multiples • Price/Book Value (of equity) PBV • Revenues • Price/Sales per Share (PS) • Enterprise Value/Sales per Share (EVS) • Industry Specific Variables (Price/kwh, Price per ton of steel, Price per click, Price per labor hour)

45. Multiples Relative valuation relies on the use of multiples and a little algebra. For example: house prices. Average $65.51 What is the price of a 1,650 sq ft house? Answer: 1650 × 65.51 = $108,092

46. Multiples can be misleading To use a multiple intelegantly you must: • Know what are the fundamentals that determine the multiple. • Know how changes in these fundamentals change the multiple. • Know what the distribution of the multiple looks like. • Ensure that both the denominator and numerator represent claims to the same group • - OK: P/E – Price  equityholders, EPS  equityholders • - Not OK: P/EBIT – Price equityholders, EBIT  All claimants • Ensure that firms are comparable.

47. Price Earnings Ratios PE – Market price per share / Earnings per share There are a number of variants of the basic PE ratio in use. They are based on how the price and earnings are defined. • Price - current price - or average price for the year • Earnings - most recent financial year - trailing 12 months (Trailing PE) - forecasted eps (Forward PE)

48. PE Ratio: Understanding the Fundamentals To understand the fundamental start with the basic equity discounted cash flow model. • With the dividend discounted model • Dividing both sides by EPS

49. PE Ratio: Understanding the Fundamentals Holding all else equal • higher growth firms will have a higher PE ratio than lower growth firms. • higher risk firms will have a lower PE ratio than low risk firms. • Firms with lower reinvestment needs will have a higher PE ratio than firms with higher reinvestment needs. Of course, other things are difficult to hold equal since high growth firms, tend to have high risk and high reinvestment rates.

50. Graph PE ratio (Amir Rubin)