8/6/2019 DCF Review

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Valuation Review

8/6/2019 DCF Review

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MBA1 Finance

Free Cash Flow to the Firm

FCFF represents cash flows to which all stakeholders

make claim

FCFF = EBITv (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.)

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MBA1 Finance

DCFF Valuation

Stage 1 FCFF

You may be given projections for some (or all) of the itemsneeded to compute FCFF (at a minimum, sales)

For other items, use historic ratios to sales (unless youthink the are not appropriate)

Key: state and justify all assumptions!

Stage 2 FCFF

assume FCFF grow at a constant rate indefinitely into thefuture

Terminal growth (g)

Nominal rate of stable growth in the economy

Capital expenditures in stage 2 = depreciation

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MBA1 Finance

Steps in Applying DCFF Valuation

Discount projected FCFF at the firms 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

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MBA1 Finance

Cost of Capital (WACC)

After taxcost 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 debtke = cost of equity E=value of equity

kc= overall cost of capital V=D+E

t = firms marginal tax rate

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MBA1 Finance

Capital Structure

Use market rather than book values of debt and equity

if available

Target capital structure:

Estimate the firms current capital structure

Review the capital structure of comparable firms

Review managements plans for future financing

What if capital structure is expected to change over

time?

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MBA1 Finance

Cost ofDebt (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 butuse short term spread if no better data)

Spread given bond rating, if available

1-3%, if no other information

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MBA1 Finance

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 assets

beta

The CAPM relates the cost of equity for an individual

stock to that assets beta (F). Formally:

ke = rf + F RP

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MBA1 Finance

The CAPM: Inputs

F - 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

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Relative Valuation Approaches

Find comparable firms

Similar industry, leverage (link to growth prospects,risk)

Industry averageAssume 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 pricesrather than trading prices to come up with ratios

Likely to have fewer good comparables

Premium paid is important psychologically

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MBA1 Finance

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%

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MBA1 Finance

M&A Valuation: The Process

Stand-

alonetarget

value

Value

of

target

withsyner-

gies

Value

of

synergy

gain to

bidder

Transaction

Costs

Min.bid

Max.

Bid

In most cases, we can just determine

this value

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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

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MBA1 Finance

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

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MBA1 Finance

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

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MBA1 Finance

Valuation Case Process

Address case specific issues

e.g. forM&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

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MBA1 Finance

UGGGrading Key

Setup (alternatives / criteria) 5%

UGGSize-up 25%

Valuation

Ratios 20%

Base case DCF 20%

DCF of synergies 13%

Decision 17%

Total 100%

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MBA1 Finance

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%