Review of Valuation Methods PDF

CORPORATE FINANCE II
Review of Valuation Methods
Victor Torres
1
Corporate Finance II – 2019 1st Semester – Victor Torres
Topics
• Important Assumptions
• Traditional DCF vs. Risk-Neutral Valuation
• Valuation Using Adjusted Present Value.
• Comparing APV and WACC.
• Discounted Cash Flow Valuation Methods.

– Free Cash Flows, Capital Cash Flows, Equity Cash Flows
Corporate Finance II – 2019 1st Semester – Victor Torres 2

Topics (Cont.)
• Valuation by Multiples
• Valuation of Private Companies

Overview of Assumptions
• Investors are
“rational”.
• Managers are
“rational”.
• Financial Markets are
“efficient”.
• Managers objective
function: Maximize
shareholder wealth.

Two Approaches to Valuing Cash Flows

Example:
Consider a project that pays an uncertain cash flow in one year. The
project pays US$120 million in a ‘good’ state of the world and US$60
million in the ‘bad’ state of the world. Suppose we know the probability
of the good state is 0.70 and the appropriate risk-adjusted discount rate
is 12%. Then:
E(CF) = 0.70 (US$120) + (1-0.70) (US$ 60) = US$ 102 This is the
traditional DCF
𝑈𝑆$ 102 approach to
=> V = = US$ 91.07 valuation
(1+0.12)

Example (Cont.):
Alternatively, we could approach this in a different way. Suppose we
don’t know the right risk-adjusted discount rate. Assume the risk-free
rate is 4%. Can we adjust the cash flows and discount by the risk- free
rate to get the same value?
E*(CF) = 0.579 (US$120) + (1-0.579) (US$ 60) = US$ 94.71
This is the risk-
𝑈𝑆$ 94.71 𝑈𝑆$ 102 neutral
=> V* = = US$ 91.07 = =V approach to
(1+0.04) (1+0.12) valuation
Note that we have solved for a set of probabilities that

sets the value equal to the risk-adjusted value.

DCF Methods
Two different methods for valuation with financing:
• WACC (Weighted Average Cost of Capital)
• APV (Adjusted Present Value)

Valuation Using WACC

Free Cash Flow (FCF)
• FCF method uses WACC to discount FCFs in the future.
• Hence, FCF method includes the tax benefits of deductible
interest payments in the discount rate
• The more the tax advantages, the lower the discount rate.
• Because the tax advantages of debt are included in the discount
rate, the cash flows do not include the tax benefits of debt.
FCF = EBIT(1- tC) + Change in Deferred Taxes + Depreciation

– Increase in NWC – CAPX + Other

Valuation using WACC
Discount the Free Cash Flows to the present using the
Weighted Average Cost of Capital (WACC) as discount rate
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝐾𝑒 + 𝐾𝑑 (1 − 𝑡)
𝐷+𝐸 𝐷+𝐸
Tax benefits of interest expense included in the discount rate

Valuation Using APV

Adjusted Present Value Method
An alternative approach to the WACC is to compute the Adjusted Present
Value (APV).
The two simple steps involved in computing the APV are:

– Step 1: Value of the project as if all-equity financed: use the after-tax
free cash flows and discount them at the cost of capital. Remember that
for an all-equity firm the cost of capital equals the cost of equity
(assuming unlevered).
– Step 2: Add the present value of the tax shield (TS) generated by the
project.
APV = NPVAll Equity + PV(TS)
APV is also known as valuation by components.
Adjusted Present Value Method (Cont.)
This is simply MM Proposition I with taxes in action.
APV = VL = VU +PV[TS]
We do this to separate the value of running the business from the value
created by financing.
Doing this allows us to identify the sources of value and to discount

different risks appropriately.
The APV method uses the value additivity principle to evaluate the
contribution of both cash flows and increased debt tax shields. It can easily
be adapted to include other financing side effects.
Important Caveat
In principle, financing should affect the value of a potential project only if
the ability to use certain financing depends directly on the decision to take
the project.
Otherwise, if the firm can use the financing regardless of the investment
decision, the value of the financing is not incremental to the project and
should be ignored.
It follows that the tax benefits of debt (as well as the associated costs)
should be attributed to a project only if the project increases the debt
capacity of the firm.

APV: Basic Steps
Step 1: Value free cash flows as if the firm were 100% equity financed.
– Calculate free cash flows (we are estimating enterprise value).
– Unlever the equity beta and calculate the cost of equity if the firm had no debt using
an asset pricing model.
– Discount the cash flows with the unlevered cost of capital.
– Do a terminal value calculation.
Step 2: Value the tax shields separately.

– Calculate expected interest shields.
– Discount the tax shields at the “appropriate” rate.
– Do a terminal value calculation for the tax shields related to the terminal value of cash
flows.
APV: Step 1 – Valuing the Cash Flows
Need to consider Free Cash Flows
– Get the FCF from running the business as an all-equity firm.
FCF = EBIT(1- tC) + Change in Deferred Taxes

+ Depreciation – Increase in NWC – CAPX + Other.
We start with EBIT because this is what is available to be paid to the

owners – regardless of the existing debt/equity mix . We don’t want the tax
consequences of capital structure to matter.

APV: Step 1 – Valuing the Cash Flows (Cont.)
It is important to remember that getting the correct free cash flow

estimates will usually have a much larger impact on the final value than
obtaining the correct discount rate.
We typically have a forecast horizon of 5 years. Be careful with cyclical

industries and young growth firms.

APV: Step 1 – Valuing the Cash Flows (Cont.)
It is important to remember that getting the correct free cash flow

estimates will usually have a much larger impact on the final value than
obtaining the correct discount rate.
We typically have a forecast horizon of 5 years. Be careful with cyclical

industries and young growth firms.

APV: Step 1 – Which Discount Rate?
You need the rate that would be appropriate to discount the firm’s cash
flows if the firm were 100% equity financed.
This rate is the expected cost of equity (expected return on equity) if the
firm were 100% equity financed.
To get it, you need to:

– Find comparables, i.e., publicly traded firms in same business.
– Employ an asset pricing model (usually CAPM) to translate risk exposures into
expected returns.
– Estimate their expected return on equity if they were 100% equity financed, by
unlevering the equity betas.

APV: Step 1 – Which Discount Rate? (Cont.)
• Unlever each comp’s βE to estimate its asset beta (more on this later)
• D and E are historical market values. If no market value for D, use book
value.
• In D only include interest bearing debt.

– Exclude Account Payables and Pension Liabilities.
– Include interest bearing short-term and long-term debt.
• Deduct Excess Cash (only) from debt.
• Bottom Line: Beta is not perfect, but it is the best we have

• Use the comps’ βA to estimate the project’s βA (e.g. average).
• Use the estimated βA to calculate the all-equity cost of capital rA

rA = rf + βA * Market Risk Premium
• Judgement required. How do you pick the risk-free rate and the excess
return on the market?
– Short-term or long-term for rf ? →Same horizon as the investment.
– There are plenty of estimates of risk premium of market over Treasury
Bonds.
• Use rA to discount the project’s FCF.
• Use the comps’ βA to estimate the project’s βA (e.g. average).
• Use the estimated βA to calculate the all-equity cost of capital rA

rA = rf + βA * Market Risk Premium
• Judgement required. How do you pick the risk-free rate and the excess
return on the market?
– Short-term or long-term for rf ? →Same horizon as the investment.
– There are plenty of estimates of risk premium of market over Treasury
Bonds.
• Use rA to discount the project’s FCF.
APV: Step 1 – Estimates of the Market Risk Premium
• Historical Equity Risk Premium
– There are plenty of estimates of risk premium of market over Treasury Bonds. Historically 6%.
Damodaran: http://pages.stern.nyu.edu/~adamodar/
• Implied Equity Risk Premium

– Fama & French (2001): Risk premium implied by fundamentals and stock prices over the 1872-2000
time period was between 2.55% and 4.32%.
– Kaplan and Ruback (1996): Risk premium implied by sample of MBOs was 7.8%
• Equity Risk Premium – Survey Estimates

– Graham and Harvey (2001) survey of CFOs: 10-year risk premium ranges between 3.6% and 4.7%.
– Welch (2001) survey of finance professors: 1-year risk premium averaged 3.4%, 30-year premium
averaged 5.5%.

APV: Terminal Value
There are generally two ways to proceed to compute Terminal Value (TV)
• Take cash flows (that presumably you already calculated earlier) and do a
perpetuity calculation.
• Assume that you can sell the firm using a simple rule involving P/E’s – i.e.
price will equal x times earnings.

APV: Terminal Value – Perpetuity Calculation
If you do a perpetuity calculation you probably will use the last free cash
flow:
– Terminal FCF in Last Year T. The main issue is to determine the FCF in
steady-state situation.
Careful with high-growing companies, cyclical industries.
– Get FCFT and then apply formula:
𝐹𝐶𝐹𝑇 (1 + 𝑔)
𝑇𝑉 =
𝑟𝐴 − 𝑔
– Where do we get g?
Careful here: valuation is typically very sensitive to this
(https://www.mef.gob.pe/contenidos/pol_econ/marco_macro/MMM_2018_2021.p
df)
APV: Terminal Value – Perpetuity Calculation (Cont.)
• To get PV(TV), need to discount back:
𝑇𝑉
𝑃𝑉(𝑇𝑉) =
(1 + 𝑟𝐴 )𝑇
• Make sure FCFT used to get TV reflects g:

– Adjust capital expenditures and depreciation.
• Bottom Line: Depreciation, NWC and other flows you have in the cash
flow estimate should be consistent with the g that you choose.

APV: Terminal Value – Multiples of Earnings
• If you use a multiple of earnings to calculate the sale price, then you need
to calculate earnings – not free cash flows.
• Where do you get the multiple from?

– Another place where you can manipulate the answer.
– Presumably you pick the multiple using comparable firms.
– More on Valuation with Multiples later.

APV: Step 2 – Add PV (Tax Shield of Debt)
• Need to account for the debt tax shields, including any associated with
the terminal value and discount these at the appropriate interest rate.
• These deductions depend on the interest payments and the tax rate.
Often the interest payments will appear on the financial statements. If so
use them.
– If only the debt levels appear you need to translate them into implied
levels of interest payments.
• KPMG: https://home.kpmg.com/xx/en/home/services/tax/tax-tools-and-
resources/tax-rates-online/corporate-tax-rates-table.html

APV: Step 2 – Interest Rate to Discount Tax Shield
• The choice of the discount rate depends on the risk. What is the risk of
the tax shield?
• In general the tax shield will have its own risk, which will depend also on
the probability that the government will change its tax policy, and similar
issues.
• Estimating the risk of the tax shield would be very cumbersome (and not
worthwhile), thus typically we choose among two assumptions: the risk
of the tax shield is equal to the risk of the debt or the risk of the assets.
– Since these are assumptions there is no absolute right or wrong answer. However,
one may claim that one criteria will probably be closer the truth, depending on
circumstances.
• If debt is predetermined or has a low level, risk of tax shields similar to

risk of repayments to debtholders; so rD is correct discount rate.
• If high level of debt (e.g. LBOs), or if level of debt varies with firm value,
then riskiness of tax shields similar to that of operating assets and tax
shields should be discounted at rA.

• Whatever assumption you make about the risk of the tax shield, you have
to take care to be consistent throughout the valuation.
• In particular, remember that the assumption you make about the risk of
the tax shield also affects the equation you will use to lever and unlever
the beta. (More on that later)

APV: Step 2 – TS – Two Scenarios
SCENARIO 1 –Using rA
• Debt in the future is not fixed.

– Debt and interest expense are tied to FCF.
• Model when big changes in capital structure,

– LBOs (more highly leveraged transactions).
– Bankruptcy.

SCENARIO 1 –Using rA
• In those cases, the ability to use tax shields has more systematic risk than
the ability to pay debt.
𝐼𝑛𝑡2 𝐼𝑛𝑡1 𝐼𝑛𝑡𝑇

𝑃𝑉 𝑇𝑆 = 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 ∗ + 2
+ ⋯+
(1 + 𝑟𝐴 ) (1 + 𝑟𝐴 ) (1 + 𝑟𝐴 )𝑇
• Intt comes from debt repayment schedule and interest rates.

SCENARIO 2 –Using rD
• You expect a predictable, stable and low level of debt.
• Ability to use tax shield has the same systematic risk as the ability to pay
debt. Generally in less highly leveraged situations.
𝐼𝑛𝑡2 𝐼𝑛𝑡1 𝐼𝑛𝑡𝑇

𝑃𝑉 𝑇𝑆 = 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 ∗ + 2
+ ⋯+
(1 + 𝑟𝐷 ) (1 + 𝑟𝐷 ) (1 + 𝑟𝐷 )𝑇

SCENARIO 2 –Using rD
• For permanent debt with the same risk as interest:
𝑃𝑉 𝑇𝑆 = 𝑃𝑒𝑟𝑚𝑎𝑛𝑒𝑛𝑡 𝐷𝑒𝑏𝑡 ∗ 𝑇𝑎𝑥 𝑅𝑎𝑡𝑒 = 𝑡 ∗ 𝐷

APV: Step 2 – TS – Remarks
Remark 1: If debt is predetermined (D is constant) and has a low level, risk
of tax shield equal to risk of payments to debt holders; so rD is the correct
discount rate.
Remark 2: If high level of debt or if level of debt varies with firm value (D/V
is constant), then the risk of the tax shield is similar to that of operating
assets and tax shields should be discounted at rA.
Remark 3: Some firms have high leverage or maintain a target leverage

ratio while maintaining an investment grade rating on their debt. For these
firms, the correct discount rate is probably closer to rD .

APV: Step 2 – How Leverage Affects Betas?
• Whatever assumption you make about the risk of the tax shield, you have
to take care to be consistent throughout the valuation.
– In particular, remember that the assumption you make about the risk of the tax
shield also affects the equation you will use to lever and unlever the beta.
• If the risk of the tax shield is equal to the risk of the debt (D is constant),
then such equation is:
𝐷(1−𝑡𝑐 ) 𝐸
β𝐴 = β𝐷 + β𝐸
𝐸+𝐷(1−𝑡𝑐 ) 𝐸+𝐷(1−𝑡𝑐 )

APV: Step 2 – How Leverage Affects Betas?
• If instead the risk of the tax shield is equal to the risk of the assets (D/V is
constant), then such equation is:
𝐷 𝐸
𝐸+𝐷 𝐸+𝐷

APV: Step 2 – What about TS associated with TV?
If you do a perpetuity calculation for the TV and the firm is expected to
have some debt then this matters.
– Remember that you have to add any debt tax shields on NPV that
accrue beyond the terminal date.
There are “many” ways to compute the terminal value of the tax shields.
– They are obviously short-cuts. The main thing is to recognize that you
are going to get some tax shields beyond T and then do something
sensible.
Let’s consider 2 different ways:

APV: Step 2 – What about TS associated with TV?
1. If D stabilizes at a permanent (and low) level, DT.
𝑇𝑉 𝑇𝑆 = 𝑡𝐶 ∗ 𝐷𝑇
2. If (D/V) stabilizes at some level, γ (DT = γ * VT):
𝑡𝐶 ∗ 𝐷𝑇 ∗ 𝑟𝐷
𝑇𝑉 𝑇𝑆 =
𝑟𝐴 − 𝑔

APV: Step 2 – Comments
For many projects, neither D nor D/V is expected to be stable.
– Need to be careful and creative.
– Firms on average tend to rebalance leverage towards a target, but they do so
slowly
For instance, after an LBO, the debt levels are expected to decline.
In general you can estimate debt levels using:

– Repayment schedule if one is available.
– Financial forecasting.
and discount by a rate between rD and rA.

Computing Asset and Equity Betas

Computing Asset Betas and Equity Betas
How to Measure βA?
The value of the levered firm is given by VL = D + E.
Since, VL= VU + PV(TS), then VU = D + E - PV(TS).
And therefore:
𝑉𝑈 β𝐴 = 𝐷β𝐷 + 𝐸β𝐸 − 𝑃𝑉(𝑇𝑆)β 𝑇𝑆
which we can be re-written as:

𝐷 𝐸 𝑃𝑉(𝑇𝑆)
β𝐴 = β𝐷 + β𝐸 − β 𝑇𝑆
𝑉𝑈 𝑉𝑈 𝑉𝑈
Now we need to assume something about βTS.
Assumption 1: The risk of the tax savings is the same as the risk of the debt
that generates it (βTS = βD).
Then the previous equation becomes:

𝐷 𝐸 𝑃𝑉(𝑇𝑆)
β𝐴 = β𝐷 + β𝐸 − β𝐷
𝑉𝑈 𝑉𝑈 𝑉𝑈
And since VU = VL - PV(TS), we have:

𝐷 − 𝑃𝑉(𝑇𝑆) 𝐸
𝑉𝐿 − 𝑃𝑉(𝑇𝑆) 𝑉𝐿 − 𝑃𝑉(𝑇𝑆)
This formula simplifies under some special cases.
– If D is constant:
𝐷(1 − 𝑡𝑐 ) 𝐸
𝑉𝐿 − 𝑡𝑐 𝐷 𝑉𝐿 − 𝑡𝑐 𝐷
– If, in addition, the debt is riskless (βD = 0):
1 Hamada´s
β𝐴 = β𝐸 Equation
𝐷
1 + (1 − 𝑡𝑐 )
𝐸
• Assumption 2: The risk of the tax savings is the same as the risk of the
existing assets (βTS = βA).
• Then we are left with,

(𝑉𝑈 + 𝑃𝑉(𝑇𝑆))β𝐴 = 𝐷β𝐷 + 𝐸β𝐸
• And since, VL=VU + PV(TS) we have that:

𝐷 𝐸
𝑉𝐿 𝑉𝐿

APV s. WACC

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CORPORATE FINANCE II

Review of Valuation Methods

• Traditional DCF vs. Risk-Neutral Valuation

• Valuation Using Adjusted Present Value.

• Comparing APV and WACC.

• Discounted Cash Flow Valuation Methods.

Corporate Finance II – 2019 1st Semester – Victor Torres 2

• Valuation of Private Companies

Corporate Finance II – 2019 1st Semester – Victor Torres 3

Corporate Finance II – 2019 1st Semester – Victor Torres 4

Corporate Finance II – 2019 1st Semester – Victor Torres 5

Corporate Finance II – 2019 1st Semester – Victor Torres 6

Note that we have solved for a set of probabilities that

Corporate Finance II – 2019 1st Semester – Victor Torres 7

• WACC (Weighted Average Cost of Capital)

• APV (Adjusted Present Value)

Corporate Finance II – 2019 1st Semester – Victor Torres 8

Corporate Finance II – 2019 1st Semester – Victor Torres 9

FCF = EBIT(1- tC) + Change in Deferred Taxes + Depreciation

Corporate Finance II – 2019 1st Semester – Victor Torres 10

Tax benefits of interest expense included in the discount rate

Corporate Finance II – 2019 1st Semester – Victor Torres 11

Corporate Finance II – 2019 1st Semester – Victor Torres 12

The two simple steps involved in computing the APV are:

Doing this allows us to identify the sources of value and to discount

Corporate Finance II – 2019 1st Semester – Victor Torres 15

Step 2: Value the tax shields separately.

FCF = EBIT(1- tC) + Change in Deferred Taxes

We start with EBIT because this is what is available to be paid to the

Corporate Finance II – 2019 1st Semester – Victor Torres 17

It is important to remember that getting the correct free cash flow

We typically have a forecast horizon of 5 years. Be careful with cyclical

Corporate Finance II – 2019 1st Semester – Victor Torres 18

It is important to remember that getting the correct free cash flow

We typically have a forecast horizon of 5 years. Be careful with cyclical

Corporate Finance II – 2019 1st Semester – Victor Torres 19

To get it, you need to:

Corporate Finance II – 2019 1st Semester – Victor Torres 20

• In D only include interest bearing debt.

• Deduct Excess Cash (only) from debt.

• Bottom Line: Beta is not perfect, but it is the best we have

• Use the estimated βA to calculate the all-equity cost of capital rA

• Use the estimated βA to calculate the all-equity cost of capital rA

• Implied Equity Risk Premium

• Equity Risk Premium – Survey Estimates

Corporate Finance II – 2019 1st Semester – Victor Torres 24

Corporate Finance II – 2019 1st Semester – Victor Torres 25

• Make sure FCFT used to get TV reflects g:

Corporate Finance II – 2019 1st Semester – Victor Torres 27

• Where do you get the multiple from?

Corporate Finance II – 2019 1st Semester – Victor Torres 28

Corporate Finance II – 2019 1st Semester – Victor Torres 29

• If debt is predetermined or has a low level, risk of tax shields similar to

Corporate Finance II – 2019 1st Semester – Victor Torres 31

Corporate Finance II – 2019 1st Semester – Victor Torres 32

• Debt in the future is not fixed.

• Model when big changes in capital structure,

Corporate Finance II – 2019 1st Semester – Victor Torres 33

𝐼𝑛𝑡2 𝐼𝑛𝑡1 𝐼𝑛𝑡𝑇

• Intt comes from debt repayment schedule and interest rates.

Corporate Finance II – 2019 1st Semester – Victor Torres 34

• You expect a predictable, stable and low level of debt.

𝐼𝑛𝑡2 𝐼𝑛𝑡1 𝐼𝑛𝑡𝑇