Brigham 173A 26
We valued the equity before... why a different method? Value of operations (from Day 7)
considers cash flows to ALL capital and is also known as Free Cash Flow to Firm (FCFF) Free Cash Flow to Equity (FCFE) considers cash flows to equity holders Adjusted Present Value (APV) separates operating cash flows and financing cash flows
Reminder
FCFF: FCF = NOPAT Net Investment in
Operating Capital FCFE = FCF Interest expense + Interest Tax Shield + Net Change in Debt APV = FCF + Interest Tax Shield When Using Income Statement and Balance Sheet forecasts this results in use of slightly different formats!
Reminder: FCF
NOPAT Net Investment in Operating
Capital EQUALS NOPAT + Depreciaton Gross Investment in Operating Capital WHERE Gross Investment = Net Investment + Depreciation
Estimating Future Cash Flows: Financials
Cash Flows To Equity To Firm
Revenue Minus COGS Minus OPEX Minus Depreciation/Amortization Minus Interest(debt service) Minus Tax Plus Depreciation/Amortization Minus Required Equity Retention for Growth
Revenue Minus COGS Minus OPEX Minus Depreciation/Amortization Minus Tax Plus Depreciation/Amortization Minus Gross Retention for Growth
APV Concept
APV separates operating cash flows and
financing cash flows... Value of Operations = Unlevered Value Of Operations + Value of Interest Tax Shield Value of Equity here is similar to FCFF Value of Equity = Unlevered VOPS + Non Operating Assets Value of Debt
Estimating Cash Flows: APV
Revenue Minus COGS Minus OPEX Minus Depreciation/Amortization Minus Tax Plus Depreciation/Amortization Minus Gross Retention for Growth Plus Interest Tax Shield
Horizon Value
All methodologies assume FCF to grow at
a constant rate after the final year Thus the constant growth formula Next FCF/(Required Rate Growth Rate) can be used to calculate the Horizon Value The discount rates differ between the methodologies
Discount Rate
FCFF uses WACC FCFE uses relevered Cost of Equity to
adjust for change in riskiness of the CF APV uses unlevered Cost of Equity
Unlevering and re levering Cost of Equity
I use the Hamada model rather than the
one in Brigham Ch 26 Bu = Beta/[1+(1OldTax%) (OldDebt/Equity)] BL = Bu* [1+(1NewTax%) (NewDebt/Equity)] BL will always be higher than Bu as increased leverage implies increased risk. It may not be higher than the original beta as it depends on the tax rate and D/E.
"Required Retention"?
Previously we deducted Investment in
Operating Capital from Operating Cash Flows Required Retention is just a way to say how much of the Firm's capital (debt + equity) or equity needs to be reserved for next year's growth In other words, either the full growth in OWC and new CAPEX OR just equity financed portion.
AVB Summary of Valuation Methods Also see Brigham p 910 & 912
Annual CF Project CF Changes in Rev -COGS -OPEX -Depr -Tax +Depr -Inc WC WACC or Risk Adjusted WACC a) After Tax Proceeds of Sale+Recovery of WC b) Other TV Working Capital if changing N/A N/A N/A NPV =PVFCF - Initial Investm FCFE Net income +Depreciation -EQ Ret: New WC(1-d) -Equity Ret: New Capex(1-d) Cost of Equity Re-levered for Risk Next CF Divided by (ke-LT growth) Equity Retention Included in WC No, unless OpWC definition used Advanced PV = Value of Equity (if OPWC add NO ded Debt) FCFF NOPAT +Depreciation -Ret New WC -Ret Capex New APV Op CF -Retention for new WC and CAPEX +Interest Tax Shield Cost of Equity Un-levered Next CF Divided by (WACC-LT growth) Gross Retention Yes Yes Advanced Equity Value =PV +Non-OPS -Debt/PS
Discounted at Terminal CF
WACC Next CF Divided by (WACC-LT growth) Gross Retention Yes Yes Advanced Equity Value =PV +Non-OPS -Debt/PS
Retention Deduction Add Non-ops Deduct Debt and Preferred Adjustment for R&D or leases Result
Compare to Holden
At a first glance Holden's methods may
look a bit different but for these 3 methods they are exactly the same as Brigham Just rearranging some elements That is why the Income Statement and partial Balance Sheet always works
Valuing a Target Firm
In acquisition valuation we must include
SYNERGIES in the cash flows Even when synergies are created within the buyer's operations they are attributed to the target firm (remember in Capital Budgeting we look at the "incremental cash flows" So what are synergies and how do you estimate them
Synergies
Operating Synergies (IS)
= Revenue synergies could be achieved = Cost of goods sold synergies could be achieved (more efficient plants, buying power = Operating Expense synergies are usually achieved as duplicate corporate functions are eliminated (sometimes there may be extra costs the old Starbucks...)
Synergies
Financial Synergies (IS, BS) can exist
= Lower rate due to lower risk of combined entity = Access to more capital markets Tax Synergies can exist (can also be negative) = Tax loss carry forwards have a lot of value = But, often the tax rate for the target goes up as it is merged to the larger entity
Synergies
Operating Efficiency synergies can often
be achieved = Consolidate plants/real estate = Implement "best practices" across combined entity for Accounts Receivable collection, Inventory management and the like
So, how do you estimate them
This is primarily for 173 B Revenue: Can they sell more products to more
customers if gaps in offering have been filled? Estimate a %. See if company says anything if an announced merger COGS: Are their plants sufficiently similar? Which company has lower %. Do they have buyer power viz their suppliers? See if company says anything or gradually bring COGS to the better company's %
Synergies
OPEX is fairly easy to estimate even if no
announcements have been made = See Executive Compensation Section for both companies and guess who will be gone = Add a % to that for lower level redundancy elimination
Synergies
Financial Synergies can reasonably be
estimated = Check out the ratings for both companies = Check out the rates they are paying for long term debt = Check out the diversity of sources of debt and equity (international? Institutional?)
Synergies
Tax Synergies may be easy to estimate
= Once you have a combined IS you can figure out what the tax bracket is! = If the acquired company has tax loss carry forwards you can value those (although in class we can only estimate so much)
Synergies
Operating Efficiency synergies are relatively
easy to estimate = If you ID redundant facilities, real estate, you can find market prices for those (sale of property adds to cash flows and reduces operating capital) = For current asset management efficiencies you can assume a 6 mo to 2 year implementation of the better companies systems