wk 6 - FCFF and Negative earnings_2011s2

wk 6 - FCFF and Negative earnings_2011s2 - FINS3641...

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Prepared by Henry Yip 1 FINS3641 SECURITY ANALYSIS AND VALUATION PART 2 DISCOUNT CASH FLOW VALUATION MODELS Week 6 Free Cash Flow to the Firm Discount Valuation Models & Firms with Negative Earnings
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FINS3641 SAV Week 6: FCFF Discount Models and Valuing Firms with Negative Earnings 2 Week 6: FCFF Discount Valuation Models & Valuing Firms with –ve Earnings Topics: FCFF dividend discount models Reasons for negative earnings Ways to deal negative earnings in the context of valuation Learning Outcomes: Learn the input requirements for the FCFF models Learn how to normalise earnings when current earnings are negative Reading: Damodaran Chapters 15, 22 Damodaran Chapters 16 recmommended
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FINS3641 SAV Week 6: FCFF Discount Models and Valuing Firms with Negative Earnings 3 Valuation of Embraer in 2000 using a 2 stage FCFF Discount Valuation Model i) Reasoning: a) Unstable leverage (implying that the FCFE discount model will be less appropriate) Debt to capital ratio has been volatile Room to use more debt b) Past performance has been remarkable despite strong competition. This is indicative of sustainable growth for the next 10 years – 5 years of strong growth, then transition to reach stable growth in year 10 ii) Facts: Revenue 2000 = 4560 m; Operating income 2000 = 810.32 m; marginal tax rate = 0.33; Capital base 1999 = 1470 m Capex 2000 = 233.5 m; Dep n 2000 = 127.5 m; Nomalised Δ in NC WC 2000 = Δ revenue ࡺ࡯ ࢃ࡯ ૛૙૙૙ ࡾࢋ࢜ࢋ࢔࢛ࢋ ૛૙૙૙ = 239.59 m iii) Earnings growth rate during high growth period: reinvestment rate HG = [(Capex 2000 – dep 2000 ) + Δ in NC WC 2000 ] / [EBIT 2000 (1 tax rate) ] = [(233.5 – 127.5) + 239.59] / 810.32(1 – 0.33) = 0.6365 ROC 2000 = EBIT 2000 (1 tax rate) / (BV equity, 99 + BV debt, 99 ) = 810.32(1 – 0.33) / 1470 = 0.3694 g HG = reinvestment rate × ROC = 0.6365 × 0.3694 = 0.2351
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FINS3641 SAV Week 6: FCFF Discount Models and Valuing Firms with Negative Earnings 4 Valuation of Embraer in 2000 using a 2 stage FCFF Discount Valuation Model iv) WACC = ke[E/(D+E)] + kd(1 tax rate)[D/(D+E)] r f = 4.5%; US MRP = 4%; country MRK = 10.24% (default spread × σ C equity / σ C bond = 5.37%×32.6/17.1) bottom up beta = 0.88 (unlevered beta × [1 + (1–tax rate) × debt to equity ratio] = 0.87×[1+(1 0.33).0245)] Current k e,HG = 4.5% + 0.88(4% + 10.24%) = 17.03% Current pre tax cost of debt = (r f + country default spread + company default spread as implied by its credit rating) = 4.5% + 5.37% + 0.75% = 10.62% Market net debt to capital ratio = 2.4% (net debt = debt – cash & marketable securities; relevant when converting firm value into equity value) WACC HG = 17.03% × (1 0.024) + 10.62 × (1 0.33)(0.024) = 16.79% v) Assumptions for stable growth inputs (see the inputs and their usage for the transition period over the next 2 pages) Beta to rise to 0.9 in stable growth; Net debt ratio remains unchanged country MRK to drop to 5.37%; pre tax cost of debt to drop to 7.5% debt to capital ratio remains the same at 2.4% growth rate to drop to 3%; ROC to drop to 15% (average for mature firms) implying that: k e, ST = 4.5% + 0.9(4% + 5.37%) = 12.93% WACC ST = 12.93%*(1 0.024) + 7.5%*(1 0.33)(0.024) = 12.74% Reinvestment rate ST = g ST /ROC ST = 0.03/0.15 = 20%
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FINS3641 SAV Week 6: FCFF Discount Models and Valuing Firms with Negative Earnings 5 Valuation of Embraer in 2000 using a 2
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wk 6 - FCFF and Negative earnings_2011s2 - FINS3641...

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