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1、Primer on Cash Flow Valuation,The greater danger for most of us is not that our aim is too high and we might miss it, but that it is too low and we reach it. Michelangelo,Learning Objectives,Primary learning objectives: To provide students with an understanding of business valuation using discounted
2、 cash flow valuation techniques and the importance of understanding assumptions underlying business valuations Secondary learning objectives: To provide students with an understanding of discount rates and risk as applied to business valuation; how to analyze risk; alternative definitions of cash fl
3、ow and how and when they are applied; the advantages and disadvantages of the most commonly used discounted cash flow methodologies; the sensitivity of terminal values to changes in assumptions; and adjusting firm value for non-operating assets and liabilities.,Required Returns: Cost of Equity (ke),
4、Capital Asset Pricing Model (adjusted for firm size): ke = Rf + (Rm Rf) + FSP Where Rf = risk free rate of return = beta (systematic/non-diversifiable risk) Rm = expected rate of return on equities Rm Rf = 5.5% (i.e., equity risk premium historical average since 1963) FSP = firm size premium,Estimat
5、es of Size Premium,Market Value (000,000) $21,589 $7,150 to $21,589 $2,933 to $7,150 $1,556 to $2,933 $687 to $1,556 $111 to $687 $111,Percentage Points Added to CAPM Estimate 0.0 1.3 2.4 3.3 4.4 5.2 7.2,Source: Adapted from estimates provided by Duff & Phelps, LLC.,Required Returns: Cost of Capital
6、,Weighted Average Cost of Capital (WACC):1,2 WACC = ke x E + i (1-t) x D + kpr x _PR_ (E+D+PR) (E+D+PR) (E+D+PR) Where E = the market value of equity D = the market value of debt PR = the market value of preferred stock ke = cost of equity kpr= cost of preferred stock i = the interest rate on debt t
7、 = the firms marginal tax rate,1To estimate WACC, use firms target debt-to-total capital ratio (TC). 2(D/E)/(1+D/E) = (D/E)/(E+D)/E = (D/E)(E/(E+D) = D/(E+D) = D/TC; E/TC = 1 D/TC.,Analyzing Risk,Risk consists of a non-systematic/diversifiable and systematic/non-diversifiable component Beta () is a
8、measure of non-diversifiable risk Beta quantifies a stocks volatility relative to the overall market Beta is impacted by the following factors: Degree of industry cyclicality Operating leverage refers to the composition of a firms cost structure (fixed plus variable costs) Financial leverage refers
9、to the composition of a firms capital structure (debt + equity) Firms with high ratios of fixed to total costs and debt to total capital tend to display highly volatility and betas,How Operating Leverage Affects Pretax Profits,How Operating Leverage Affects Financial Returns1,Key Point: High fixed t
10、o total cost ratios magnify fluctuations in financial returns. Why? Because of the large percentage of revenue in excess of fixed costs that flows to pretax profits.,How Financial Leverage Affects Financial Returns1,Key Point: High debt to total capital ratios magnify fluctuations in financial retur
11、ns. Why? Because equitys share of total capital declines faster than net income as debts share of total capital increases.,Leveraged versus Unleveraged Betas,In the absence of debt, the is called the unleveraged u, which is impacted by the firms operating leverage and the cyclicality of the industry
12、 in which the firm competes In the presence of debt, the is called the leveraged l If a firms shareholders bear all the risk of operating and financial leverage and interest is tax deductible, leveraged and unleveraged betas can be calculated as follows: l = u (1 + (1-t) (D/E) and u = l / (1 + (1-t)
13、 (D/E) where t, D, and E are the tax rate, debt and equity, respectively. Implications: -Increasing D/E raises firms breakeven and increases shareholder risk that firm will be unable to generate future cash flows sufficient to pay their minimum required returns. -Tax deductibility of interest reduce
14、s shareholder risk by increasing after-tax cash available for shareholders.,Estimating a Firms Beta,Regress percent change in firms share price plus dividends against percent change in a broadly defined stock index plus dividends for last 3-5 years. However, this assumes the historical relationship
15、between risk and return will hold in the future If we have reason to believe this is not true, the “bottoms-up” approach may be appropriate. In the “bottoms-up” approach, we use a sample of similar firms:1 Step 1: Select sample of firms with similar cyclicality and operating leverage (i.e., usually
16、in the same industry) Step 2: Calculate average unlevered beta for firms in the sample to eliminate the effects of their current capital structures on their betas u = l / (1 + (1-t) (D/E) Step 3: Relever average unlevered beta using the (D/E)* ratio and marginal tax rate t*of the firm whose beta you are trying to estimate (i.e., target firm) l = u (1 + (1-t*) (D/E)*),1This assumes the firms fu
