• Straight debt = (4% of $125 million) (PV of annuity, 10 years, 8%) + 125 million/ 1.08 10 = $91.45 million • Equity portion = $140 million - $91.45 million = $48.55 million
Aswath Damodaran 90 Recapping the Cost of Capital Cost of Capital = Cost of Equity (Equity/(Debt + Equity)) + Cost of Borrowing (1-t) (Debt/(Debt + Equity)) Cost of borrowing should be based upon (1) synthetic or actual bond rating (2) default spread Cost of Borrowing = Riskfree rate + Default spread Marginal tax rate, reflecting tax benefits of debt Weights should be market value weights Cost of equity based upon bottom-up beta
Aswath Damodaran 91 II. Estimating Cash Flows DCF Valuation
Aswath Damodaran 92 Steps in Cash Flow Estimation Estimate the current earnings of the firm • If looking at cash flows to equity, look at earnings after interest expenses - i.e. net income • If looking at cash flows to the firm, look at operating earnings after taxes Consider how much the firm invested to create future growth • If the investment is not expensed, it will be categorized as capital expenditures. To the extent that depreciation provides a cash flow, it will cover some of these expenditures. • Increasing working capital needs are also investments for future growth If looking at cash flows to equity, consider the cash flows from net debt issues (debt issued - debt repaid)
Aswath Damodaran 93 Measuring Cash Flows Cash flows can be measured to All claimholders in the firm EBIT (1- tax rate) - ( Capital Expenditures - Depreciation) - Change in non-cash working capital = Free Cash Flow to Firm (FCFF) Just Equity Investors Net Income - (Capital Expenditures - Depreciation) - Change in non-cash Working Capital - (Principal Repaid - New Debt Issues) - Preferred Dividend Dividends + Stock Buybacks
Aswath Damodaran 94 Measuring Cash Flow to the Firm EBIT ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital = Cash flow to the firm Where are the tax savings from interest payments in this cash flow?
Aswath Damodaran 95 From Reported to Actual Earnings Update - Trailing Earnings - Unofficial numbers Normalize Earnings Cleanse operating items of - Financial Expenses - Capital Expenses - Non-recurring expenses Operating leases - Convert into debt - Adjust operating income R&D Expenses - Convert into asset - Adjust operating income Measuring Earnings Firm ʼ s history Comparable Firms
Aswath Damodaran 96 I. Update Earnings When valuing companies, we often depend upon financial statements for inputs on earnings and assets. Annual reports are often outdated and can be updated by using- • Trailing 12-month data, constructed from quarterly earnings reports. • Informal and unofficial news reports, if quarterly reports are unavailable. Updating makes the most difference for smaller and more volatile firms, as well as for firms that have undergone significant restructuring.
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