f nce 207 review sheet final

7/31/2019 f Nce 207 Review Sheet Final

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I. The valuation processa. Identify the companys direct, indirect, and potential competitorsb. Analyze historical performance, strategy, and sources of competitive advantagec. Calculate the value of the firm and equity using a discounted cash flow or excess flow method

i. Forecast relevant FCF or excess flows and financial statementsii. Measure the business risk of the company and the relevant cost of capital

d. Calculate the value of the firm and its common equity using market multiple valuation methodsi. Using publicly traded companies

ii. Using comparable transactionse. Consider alternative valuation methods, e.g. LBO

II. Creating and measuring value: value comes when a company earns above their risk-adjusted rate of return.a. Value comes from two sources

i. Industry-wide factors (porters) or competitive advantage.b. FCF of the unlevered firm

i. Represent the cash flows available for distribution to all of the firms claimbholders, aftermaking all required investments in the business, but excluding the tax savings from interest.

1. Tax savings excluded bc we will account for the financial strategy later, by valuing taxsavings in the discount rate or separately.

c. Porters 5 forces

i. Extend Porters: what is the competitive advantage??a. Cost Leadershipb. Product Differentiation

2. Is it sustainable??3. How to challenge a competitor who has a competitive advantage

a. Product price reductionsb. Product innovationsc. Product delivery innovationsd. Lower production costse. Imitation

III. Analyzing Financial Statementsa. Primary uses of ratio analysis

i. Gain a general understanding of firm & industry


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ii. Forecastingiii. Choosing comps for market multiplesiv. Choosing comps for estimating the cost of capitalv. Bank covenants

vi. Compensation contractsb. Decomposing ROE

i. ROE = [NI-pref. div.]/ Avg. Common Equity = [(NI-pref.div.)/Revenues]*[Revenues / avg. Totalassets]*[Avg. Total assets / avg. common equity] = profit margin * asset turnover * leverageratio

ii.

IV. FCF Basics and the statement of cash flowsa. Statement of cashflows

i. Operating cash flows measure the cash flows produced by operations after interest and taxes,but before investments.

ii. Investing activities indicate purchases and sales of long-lived assets.iii. Financing activities indicate transactions with the firms claimholders, except for interest

payments.

iv. CFO by indirect method


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V. Forecasting and creating a simple financial modela. Step 1: Forecast horizon, forecast drivers, aggregation level: go til steady state

i. In practice, the midyear convention is quite popular1. (end value)*(1+r)1/2

b. Step 2: forecasting revenuesc. Step 3: forecasting operating expenses

i. Operations vs excess assets: both included in value of the unlevered assets.ii. Required cash vs excess cashd. Step 4: structure of modele. Step5: checking modelf. Step 6: reasonableness of modelg. Step 7: forecast capital structure

i. Interest is tax deductible


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iii. Effective vs federal tax rate.b. Equity-based compensation

i. Adjustments1. Adjust valuation for the equity-based compensation contracts outstanding as of the

date of valuation.

2. Adjust FCF forecasts for the equity-based compensation contracts we expect thecompany to grant in the future.

ii. Warrant (issued by company and has a dilutive effect) vs option (traded by 3rd party)iii. Option:

1. From issuance, amortize the deferred compensation over the vesting period. This is taxdeductible.

2. The company needs to repurchase shares of stock so that it can reissue those shares tosettle the equity-based compensation contract.

a. Approximation: total effect of call option of FCF at exercise date is pretty much(1 taxrate)*(Sactual-Koption)

b. Use option value at issuance as a cash compensation expense for a simplesolution.

c. Discounts and premiums on debti. Firms seldom sell their bonds exactly at par.

ii. If they issue the bond for less (more) than the face, the effective interest rate is higher (lower)than the coupon rate.

iii. Accountants amortize discount or premium to zero over the life of the bond, which affects theeffective interest expense.

1. In both cases, interest expense does not equal cash interest paid.a. Discount amortizations are added back to NI since interest expense = cash

interest + discount amortization

b. Premium amortizations are deducted from net income since interest expense =cash interest premium amortization.

d. Post-retirement benefitse. R&D

i. Expense legally, capitalized otherwise.VII. APV and WACC discounted CF valuation models

a. APV method


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i. Value of the firm is obtained by discounting the forecasted FCF of the unlevered firm at theunlevered cost of capital (100% equity financed) adding the present value of the interest tax

shields at the appropriate discount rate, rITS.

ii. What you need:1. UFCF, ITS, discount rate for tax shields, CV of the levered firm or continuing value of

unlever + continuing value of ITS.

iii. Unlevered cost of capital, rUA: reflects the risk of CFs from the companys assets. Assume fornow, that ITS have same risk as firms operations:

iv. APV easier to implement when debt amount is relatively constant, or at least predictable,because need to know the amount of ITS.

b. WACC methodi. Value of the firm is obtained by discounting the forecasted UFCF at the weighted average cost of

capital:

ii. WACC: weighted average of the after-tax cost of each of the securities that the firm issues:

iii. WACC is easier to implement if capital structure is realtively constant over the forecast periodbecause .

iv. WACC is less reliable when ITS varies over time due to NOLS bc effective IR is not constant.c. Valuing Equity

i. = value of the firm minus market value of debt, preferred stock, and all other non-commonequity securities. NOT current operating liabilities (eg AP) bc already incorporated into UFCF.

ii. Discounted FCF to equity1. Difficult

a. Bc need to forecast the leverage ratio (to estimate the cost of equity capital:levering beta) and the actual magnitude of the debt (to estimate the FCFE:

interest expense).

VIII. Excess Earnings Valuation Method: algebraically equivalent to DCFa. Allows for a better understanding of the value created excess flow.


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j. USES of the 3 excess earnings formsi. WACC form will be directly implementable when the firm pursues a target capital structure

policy (constant D/V)

ii. APV form will be implementable when the future amounts of debt that will be outstanding areknown and managed independent of firm value.

iii. The Equity form will not be directly implementable.IX. Measuring Continuing Value using the constant growth perpetuity model

a. Assuming constant growth and risk is a common method for estimating continuing value:

b. Choosing a CV datei. Need a base-year CF to be positive and expected to grow at a constant rate in perpetuity.

1. Tied to inflation and perhaps real population growth or real productivity gains.ii. Need a constant discount rate.

iii. The base-year FCF should have the firm earning modest or zero returns in excess of its cost ofcapital, unless we think it has a competitive advantage that lasts forever.

iv. The base-year FCF should imply a sensible long-run capex to depreciation ratio.c. Constraints on stable growth rate

i. First growth < nominal growth of economyii. A stable growth firm can generate a return on capital very close to industry average or cost of

capital.

iii. Expected growth rate of FCF should be close to: reinvestment rate * return on capitald. Present value weighted average growth rate (PVWAGR)

i. A useful computation to summarize yoru assumptions about a company value is using PVWAGR;need to know the value of the firm and the base year cash flow has to be positive.

X. Estimating the COST OF EQUITYa. Four methods to get equity cost of capital

i. CAPM1. rE=RF + Beta*MRP

a. Beta: Shows how far up and down a security moves with the overall market.b. A measure of relative risk in a portfolio


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iii. BE CONSISTENT with what you choose for MRP.g. Substitute estimates in CAPM equation and solve for cost of equity capital

ii. CAPM with size adjustment1. This is disappearing2. rE=Rf+ Beta*MRP + adjustment for size mispricing

a. only an empirical finding.iii. Fama/French 3 factor model

1. rE=Rf+ Beta*MRP + Small/big coefficient*(small-big premium) + high/low coefficient*(high-low premium).

a. Small-big premium is premium earned on small-cap stocks vs large-cap stocksbased on difference in average annual returns between the two portfolios and

high-low premium is the difference in annual returns between high book-to-

market and low book-to-market firms.

iv. Dividend Discount Model1. P = DIV/(rE-g) rE=g+DIV/P

v. Private firms1. No problem to use CAPM if private company being valued as public entity, but

problematic if we want to value as private company.a. Normally value as public company, thenn apply a discount for non-marketability

i. Restricted stock studiesii. Discounts of sales before IPO show median disconts of 43% to 66%

depending on the study

iii. Tax courts often allow discounts in the 35%-50% rangeXI. Cost of Debt

a. Depends on probability of default, recovery rate, and on general interest rates in economy.b. Estimating cost of publicly traded debt.

i. Sometimes past returns are unreliable because so thinly traded. However, we can use creditrating and then assess standard yield for similar debt (same rating, same industry, and similarmaturity).

c. Promised vs expected yieldsi. Promised yield is the YTM. Does not incorporate expected default losses.

ii. YTM is not cost of debt: IT IS ALWAYS HIGHER THAN THE TRUE COST OF DEBT IF THERE IS ANYPROBABILITY OF DEFAULT.

1. The difference between YTM and the cost of debt is the expected default loss.


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Estimated default losses (as % of YTM spread over US GB).

d. Possible ways to adjust YTM given credit ratingi. Calculate the expected cash flows as we just did using data on cumulative default probabilities

and recovery rates

ii. Use historical data on the percentage of spreads that are expected default losses (above table)iii. Use the CAPM.


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e. Remember, FORECAST cost of debt. Without credit rating, two ways to pick comparablesi. Compare Ratios

1. Compare firms financials against credit rating statistics to get a sense of current debtrating. Changes in operations or capital structure can be anticipated and forecasted for

any changes in capital structure and operations and compared to the rating statistics.

2. Use Debt rating modelsa. These models attempt to mimic the ratings of rating agencies. Yields are highly

correlated with yields and default experience.

b. Potential usesi. Can determine likely rating and yield on a private company.

ii. Can determine likely rating and yield on a company thinking aboutchanging capital structure and/or operations.

3. Preferred stock Yields


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a. Preferred stock yields overstate the cost of capital if there is any chance ofdefault.

b. We can make similar adjustment to yields for preferred as we illustrated fordebt.

c. Differences are that non-payment of preferred dividends does not lead todefault, but dividends in arrears must be paid before shareholders receive

dividends.

4. Cost of capital for warrants, employee stock options didnt really go over this, but chp13 if necessary.

XII. The Effects of Financial Leverage on the Cost of Capitala. Why lever and unlever?

i. Sometimes we cannot estimate a companys cost of capital because it is private. Then we haveto rely on comparable companies with different capital structures.

ii. Sometimes we can estimate a companys costs of capital from tis own data, but we feel we canget more precise estimates of the cost of capital using comps.

iii. Sometimes we want to ask what would happen to a companys costs of capital if it changedfinancial leverage.

iv. Sometimes we are using the APV method and we need the unlevered cost of capital.1. IN ALL THESE CASES, we have to lever (to find rE) and/or unlever (to find rUA).

b. Everything comes from a single equation:

i. From this, one can isolate the equity cost of capital:

1. You can see that equity cost of capital is equal to the unlevered cost of capital plus apremium for each of the non-equity securities minus an adjustment for the existence of

an asset that is sometimes less risky than the companys underlying business risk (i.e.

ITS).

ii. Choosing discount rate for ITS1. Cost of debt

a. Intuition: use cost of debt if firm has fixed schedule of debt amounts unrelatedto firm value. Ability to use ITS mostly depends on whether firm can make

required debt payments cost of debt incorporates that risk well

2. Unlevered cost of capitala. Intuition: use Rua if amount of debt is tied to firm value (e.g. managers pursuing

constant D/V capital structure.

c. Scenariosi. Perpetual debt (In the long run, it is unlikely that any companys debt level should be thought to

be independent of firm value.)

1. ITS @ rd2.

ii. Continuous Refinancing


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1. ITS @ Rua2.

a. NEITHER OF THESE TWO ARE THAT ACCURATEd. Assume part ITS discounted at Rd, part Rua. This leads to:

i. Perpetual debt1.2.

ii. Continuous Refinancing1.

a. This is the same formula as if there was no tax deduction for interest (becausereturn on ITS = return on unlevered assets).

b. Even though the cost of equity capital does not depend on ITS in the continuousrefinancing scenario, the WACC and resulting firm value are affected by ITS

iii. Annual Refinancing1. We know the amount of debt the firm keeps in first year at date of valuation. Hence, the

risk of the first years ITS is given by the cost of debt at current time, but all future ITS

have risk of unlevered cost of capital at current time:

e. Lever/unlever Betas

f. WACC & ITS


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i. No cost of equity appears in this expressionii. No expression for preferred stock b/c it is not tax deductible and gets canceled out

iii. Only the value Vits@Rd will affect the WACC because it is less risky than UA whereas Vits@Ruais as risky.

g. Unlevering cost of capital


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h. Unlevering Betas

i. Two common practicioner mistakesi. Assuming zero debt and preferred betas

1. Implies that firms can issue debt and preferred at the risk free rate of interest.ii. Abuses of the M&M levering formula: use perpetual debt on growing company..

1. The formula is only an approximation for companies with low debt levels and very veryslow growth.

j. Financial Distress costs


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i. NOT incorporated into the calculated costs of capital.ii. Solution

1. For highly levered firms experiencing financial distress, you should try to use morehighly levered comps.

2. For firms with more modest leverage and no financial distress costs, you should not usehighly levered comps.

XIII. Further cost of capital issuesa. WACC: weighted average cost of capital (post taxes)

i. Useful when valuing the entire firm assuming that the investment policy of the firm will not varyand D/V will be predictable.

ii. Scale expansionsiii. Estimation tips

1. The weights should be based on forward-looking market values2. Debt weight should include short term debt like average balance of seasonal financing

and off balance sheet financing, but exclude non-interest bearing operating liabilities,

which are netted out when computing UFCF.

iv. WACC problems that it doesnt handle well:1. Effective interest rate at time of issuance doesnt equal the current cost of debt and the

old debt isnt being retired immediately. Problem is that the interest deductions (and

tax shields) are based on the effect rate of interest when the debt is issued.

2. Anything else that causes the timing of tax shields to differ from payment of interest orcauses amount of deductible for tax purposes to differ from cost of debt.

b. Interest Tax Shields Issuesi. Financial Distress Costs

1. Vf=Vua+Vits-Vfinancial distress costsa. 0-20% of firm value, depending on capital structure and situation.b. Note: if costs of capital incorporate financial distress costs, we dont get them

out through unlevering. Consequently, it is better to use comparable firms withthe same level of financial distress as the company we are valuing.

ii. Uncertainty of ITS1. Expected marginal tax rate ~24%.

iii. Personal taxes1. Debt has an interest tax shield only if:

a. 1-Tpersonal>(1-Tcorp)*(1-Tequity)2. ITS less valuable than often assumed bc

a. Financial distress costs reduce their value for aggressive capital structuresb. Use of top marginal tax rates for some companies may be too highc. Personal tax issues may reduce their value.

c. How to value a distressed Firmi. For a bankrupt firm

1. Equity value = 02. Debt value = whole firm3. Firm value= Vd

ii. If a firm loses a ton of money each year1. WACC method should have no interest tax shield.

iii. Valuation through simulations or scenario analysis are effective ways to value a distressed firm.


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iv. Off balance sheet financing1. Some leases are capitalized; meaning the present value of the lease payments is put on

the books as an asset and a liability. The asset is depreciated and the payments are

apportioned between interest expense and principal repayments.

a. If we use comps to help estimate the companys cost of capital, we must makesure leases are all on the same basis.

2. Summarya.

Ve is not affected by the treatment of the leases

b. UFCF are not the same under the two methods.c. Vf under the capitalized lease treatment is greater than the Vf under the

operating lease treatment by the value of the capitalized leases.

d. Rua is not the same!!! It is smaller under capitalized lease method bc it treatspart of the fixed payment as a financing activity.

XIV. Market Multiple Valuation Part 1: Introductiona. MM Overview

i. MM are used to value firm or common equityii. MM are used to assess current value as well as to estimate continuing value

iii. Sometimes based on publicly traded companies or transactionsb. Basic approachi. Value=Multiple*Firm characteristic

ii. Value equity=P/E multiple * Earningsiii. Essentially, it is an attempt to adjust for scale, but the technique makes the strong assumption

of direct proportionality of the value to the firms characteristic.

c. Role of the marketi. The market where the benchmark prices come from dictates value.

1. If you want to ask the question of what the market seems willing to pay for an asset, amultiple valuation can be informative.


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2. This will include market bubbles and mispricingsd. What drives variations in multiples:

i. Mispricingsii. Growth

iii. Riskiv. Reinvestmentv. Profitability

vi. Different accounting techniquesvii. Controlling for size

viii. Transitory shocks1. Short term shocks to FCF, earnings, or some other denominator.

e. Risk and growthi. Present value weighted average growth rate: g=r-FCF/Vf,0

1. We can then get the value of the firm as a growing perpetuity which gives rise to theprice/FCF multiple:

a. MM=V/FCF=1/(r-g)i. .: risk and growth are determinants of any multiple

f. FCF multiplesi. The problem with free cash flows is that, for many firms, investment is lumpy. Hence observed

FCF are not based on some normalized amount of investment. This difference impacts growth

rates.

ii. In addition, FCF are negative for many firms. If the denominator is negative, you cant use it tovalue the firm. So.. not practical or popular.

g. Revenue multiplesi. Do not control for differences in operating costs

h. EBIT & EBITDA multiplesi. Partially, but not totally, control for differences in operating costs. At least, they control much

better for these differences than revenue multiples.i. PEG ratio

i. P/E divided by expected growth in earnings per share. Some say a PEG ratio significantly greaterthan 1 might indicate an overvalued stock wrong

j. Enterprise or Firm Valuei. Market value minus cash & securities. This implies that they assume that all cash is available to

pay off debt (i.e. no required cash).

k. Choosing COMPSi. Want to find comps in the same line of business and are similar in terms of:

1. Growth2. Risk3. Reinvestment requirements/profitability4. Leverage5. Accounting Techniques

l. Continuing Value in DCFi. Continuing value should be consistent with the entity being valued.

ii. Avoid using high growth multiples, which might be okay for now,iii. In cyclical industries, pick multiples from middle of cycle.iv. Multiples used for current valuation are different from multples for CV


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ii. Non-mgmt with significant stake increases board effectivenessiii. Advantages to being private no filings!iv. Tax benefits from higher debtv. Transfer wealth from other stakeholders in the firm such as employees and bondholders

1. Not good evidence for wealth transfer from employees2. Bondholders lose some wealth ~2%

XVII. Valuing Financial Institutionsa. Similar to non-finacial firms, but a few key differnecesb. Categories of financial services

i. Banksii. Insurance companies

iii. Investment banksiv. Investment firms

c. Difference due to:i. Regulatory constraints

1. Capital ratio requirements2. Constrained as to where they can invest their funds.3. Need to be approved by State banking and insurance commissions before a new firm

can enter the market.

ii. Accounting rules1. Mark-to-market accounting applies (accountants record and update assets and liabilities

at their fair market value.

2. Loan loss provisions smooth out earningsiii. Use of debt

1. Debt of a financial firm cannot be separated from its operatings DCF and WACC aredifficult because they use unlevered FCF!

2. Leverage is high (before crisis, Vf/Ve = 30, so a 1% error in firm value leads to a 30%error in equity value. So estimating equity value by first valuing the firm is dangerous.

iv. Reinvestment that affects free cash flows1. To forecast FCF, we need to forecast reinvestments in regulatory capital (requirement

depends on type of institution).

2. Some analysts just forecast and value the dividend stream instead of FCF streambecause dividends tend to be stable for financial firms.

a. Only need to knowi. Cost of equity capital

1. Skip unlevering and levering bc capital structures amongfinancial firms in the same sector are often homogenous due to

regulations and a financial firms debt and capital structure are

difficult to measure. Hence, even if we wanted to unlever and

lever the cost of capital, it would be a shitty estimate.

ii. Expected growth rate in dividends1. Need to check how retained earnings are reinvested. For a

stable firm

a. E[Gdiv]=(1-Payout)*ROEiii. Payout policy.

1. Similarly Payout = 1-{E[Gdiv]/ROE}


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XVIII. Insider Tradinga. Def: information about the value of a security that is not publicaly available and that would causes

prices to change if publicly known.

Questions:

High ROA can be good or bad. Why? Is high Advertising/Revenue bad, or a source of competitive advantage? In model, what should you do with excess cash? Trade cash-cycle? Provision for bad-debts ratio increases, FCF increases. Why? How do you go from year-end to mid-year valuation? Specifically for debt? What do you do with excess cash in your financial model?? Equity-based compensation causes dilution. Why??? Are options dilutive? How does Rwacc account for how we value tax shields?

f nce 207 review sheet final

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