Lecture Notes - Week 8

Reading Material: BMA Chapter 9

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Valuation Under Risk (all equity firms)

! One of the more fruitful applications of CAPM (and other riskreturn models) is valuation (capital budgeting and firm valuation) ! Whenever a firm (or individual) evaluates an investment opportunity, there is a need to discount future cash flows. As these cash flows are generally risky, the choice of discount rate is not a trivial matter ! In general, the risk return trade-off for financial investments developed above (e.g. CAPM) also applies to investments in real projects ! IMORTANT: The correct discount rate reflects the risk of the project/firm that is to be acquired, NOT the risk of acquiring firm
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Valuation Under Risk (all equity firms)

! Suppose firm A wants to acquire project B. If B is a firm which was previously traded in the stock market, then the correct discount rate is the required return on equity of firm B (UNLESS the acquisition by firm A will change the risk of firm Bs assets) ! Hence, we can look at firm Bs stock returns over the last 5 years and estimate its Beta. The CAPM will then give us the discount rate Often, it will be a good idea to look also at some other firms in the same industry as firm B and use the average beta of several firms. While this means using the beta of firms which are slightly different from firm B, it will make estimation much more accurate (i.e. the beta estimate of just firm B might be subject to sever estimation error)
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Valuation Under Risk (all equity firms)

! Suppose firm A wants to acquire project B. If B is a firm which was not previously publicly traded (or firm B is really just a project that we would like to invest in, or the acquisition by firm A changes the nature of firm Bs business and hence its risk) ! Then we will have to find a publicly traded firm which does exactly the same thing as firm B (under As management), estimate its Beta, and use the CAPM to estimate the discount rate to use. ! Again, in general we will estimate the beta of several firms which do the same thing as B, in order to lower estimation error.
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Example
! Suppose A wants to acquire firm B. ! Firm B has had the following cash flows this past year Sales: $10M, Costs: $5M, Depreciation: $1M, Tax: 40% Sales and Costs are expected to grow at the rate of inflation (4%) Depreciation of existing machinery will decline by 3% each year If acquired by firm A, sales will grow by an additional 3% p.a. (costs will remain a constant proportion of sales in real terms) If M denotes the market portfolio, then we also have the following information from the securities markets: !A=30% !B=40% !M=20% E[rM]-rf=6% "AB=-0.3 "AM=-0.7 "BM=0.8 rf=6%
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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There are two ways of solving this

1)! We could project the firms net cash flows (Revenue minus costs plus depreciation tax shields) into the infinite future and then discount them 2) Given that the different cash flows grow at different rates maybe its easier to calculate their present values separately We will do 2) After Tax Operating profits (revenues minus costs) are a growing perpetuity with growth rate 7% (inflation plus acquisition synergies), with the first cash flow equal to $3.21 Depreciation tax shields are a declining perpetuity with growth rate -3% and first cash flow equal to $388K What is the correct discount rate?
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Example
The beta of firm B is given by

Cov(rM , rB ) " BM # B# M 0.8 ! 0.4 ! 0.2 !B = = = = 1.6 2 2 Var (rM ) #M (0.2)

Hence, the discount rate is 0.06 + 1.6 x 0.06=15.6% Thus the value of firm B to firm A is given by

$3.21M $388K V= + = $39.412 M 0.156 ! 0.07 0.156 + 0.03

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Another thing that matters: the capital structure (i.e. debt)

Debt matters for two reasons: 1)! Interest payments on debt are tax deductible. Since we only care about after tax cash flows, the cost of debt (the required return on debt) is best written as rD x (1-tc) where tc is the corporate tax rate 2)! Debt is less risky than equity, because debt holders get paid first. Thus, the cost of debt capital is lower than equity capital. Furthermore, leverage (debt) makes returns on equity more volatile (risky). Hence leverage will also affect the required return on equity.

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Valuation under Risk (firms with debt)

IMPORTANT: The correct discount rate reflects the risk and capital structure of the project/firm that is to be acquired, NOT the risk of the acquiring firm

D E WACC = rD (1 ! t ) + rE D+E D+E

If we know a firms capital structure, its required return on debt and its required return on equity, then we can determine its WACC If the investment under consideration looks just like the rest of the firm (e.g. expansion of capacity), then the WACC of the existing firm is the correct discount rate to use. If the investment is different from the existing firm, then we need to compute the WACC appropriate for the project under consideration (possibly firm comparable firms data)!
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Where do we get the information we need to estimate the WACC?

Capital Structure: market values if available, book value of debt generally OK Cost of Debt: debt ratings if available, debt beta less good Cost of Equity: CAPM, estimated from comparable firms Taxes: marginal tax rate if known

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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So what is remaining?
The problem is that we only observe the equity beta of levered firms 1)! If a firm changes its leverage, its beta will change. That means that we cannot use the (unadjusted) past beta if the future calls for a different capital structure. In fact, if the amount of debt used to finance a project is different from that of the overall firm, then the (unadjusted) beta of the overall firm cannot be used. 2)! If we want to use the average beta of several firms in an industry, we cannot simply use the beta estimated from their stock prices, because this beta will be distorted by all sorts of different capital structures. Only the asset risk of all the companies is comparable (i.e. the risk that remains when all the capital structure effects are stripped away)
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The strategy (I - RETURNS)

1)! Estimate the equity beta from equity prices. See what equity return this implies. This is distorted by leverage. 2)! Strip the equity return of its leverage effect (un-lever) 3)! The un-levered return (which only depends on the riskiness of the assets) can be compared across firms i.e. it can be averaged 4)! Use the forward looking capital structure of the project/firm under consideration, and the un-levered return from above, to come up with the (re-levered) required return on equity 5)! The re-levered required return of equity, as well as the forward looking capital structure and the expected required return of debt (from the expected debt rating) can be used to compute the WACC
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The strategy (I - RETURNS)

UNLEVERING

D(1 ! t ) E rU = rD + rE D(1 ! t ) + E D(1 ! t ) + E

RELEVERING

D(1 ! t ) rE = rU + [ rU ! rD ] E
If you are interested in derivation of this formula contact me by email.
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The strategy (II - BETAS):

1)! Estimate the equity beta from equity prices. This is distorted by leverage. 2)! Strip the equity beta of its leverage effect (un-lever) 3)! The un-levered beta (which only depends on the riskiness of the assets) can be compared across firms i.e. it can be averaged 4)! Use the forward looking capital structure of the project/firm under consideration, and the un-levered beta from above, to come up with the (re-levered) beta of equity. See what equity return this implies 5)! The re-levered required return of equity, as well as the forward looking capital structure and the expected required return of debt (from the expected debt rating) can be used to compute the WACC
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The strategy (II - BETAS):

Remember, that since CAPM is a linear relationship between returns and betas, we can equivalently write UNLEVERING and RELEVERING Equations in terms of Betas:

D(1 ! t ) E !U = !D + !E D(1 ! t ) + E D(1 ! t ) + E

D(1 ! t ) ! E = rU + [ !U ! ! D ] E
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The strategy (II - BETAS):

Often Debt Beta is taken as Zero i.e. it is assumed it has 0 correlation with the Equity Market (is it correct?) and then formulae simplify to:

E !U = !E D(1 ! t ) + E
D(1 ! t ) E + D(1 ! t ) EV ! Dt ! E = !U + !U = !U = !U E E E Where EV is Enterprise Value
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Use of WACC
The easy case: if the firm is traded, and had the same capital structure in the past as it will have in the future, and there is little worry about estimation risk 1)! Estimate the equity beta 2)! Estimate the forward looking cost of debt (probably from the debt rating, or from very recently issued debt) 3)! Plug the into the WACC formula, using the target capital structure and the forward looking marginal tax rate

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Use of WACC
The more difficult case: if our own firms past risk or capital structure is not applicable for the valuation at hand (or you want to look at more than one firm to avoid estimation error), we will have to look at comparable companies 1)! Find a few companies with the same beta risk (i.e. in the same line of business) as the project/acquisition under consideration. 2)! Measure these comparables rE, rD, t, and D/E 3)! Use these data to compute a WACC

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Use of WACC IMPORTANT!

If you used comparable firms, then there is a wrong ways to proceed and a right way The wrong way: average all rDs and rEs of comparable firms to get an average rE and rD. Then use your own firms D/E ratio to compute the WACC. Why it is wrong? What can reasonably be assumed constant among comparable firms is the operational risk. However, rE and rD will differ depending on the firms leverage ratios (i.e. their financial risk). The right way un-levers comparable firms returns to get at a return that only depends on their assets, and then re-levers them at our target capital structure to reflect financial risk
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Use of WACC
Once we have computed the un-levered cost of capital rU, we can average it among all comparable firms

D(1 ! t ) E rU = rD + rE D(1 ! t ) + E D(1 ! t ) + E

The normal average is preferred if you think that any one firm provides as much information about the beta risk as any other The weighted average is preferred if you think that the data from the larger (or otherwise weighted) firms contains more information (e.g. it is more accurately measured) Once we have the average rU in an industry we need to then establish the new cost of debt and the new level of leverage of our particular case
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Use of WACC
The new cost of debt comes from (i) an estimate, (ii) a guess as to what the firms credit rating will be, or (iii) the old cost od debt. Which is most appropriate depends on the situation and the firm The new cost of equity is determined as follows:

D(1 ! t ) rE = rU + [ rU ! rD ] E
Now that we have the new cost of equity and debt, we can compute the WACC from

D E WACC = rD (1 ! t ) + rE D+E D+E

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Example
You target a debt-to-equity ratio of 20%. The tax rate is 40%. Other firms in the industry are firms A & B. rf is 7%, (rm-rf)=5% Firm A: D/E=60%, rD=10%, #E=1.6 => rE=7%+1.6x5%=15% Firm B: D/E=100%, rD=12%, #E=2 => rE=7%+2x5%=17% Firm A: rU=0.265x10%+0.735x15%=13.675% Firm B: rU=0.375x12%+0.625x17%=15.125% (we average Firm A and Firm B rUs and get rU=14.4% Assume that your rD (with a 20% leverage) is 8%. Then you get D(1 ! t ) rE = rU + [ rU ! rD ] = 14.4% + 20% " 0.6 " (14.4% ! 8%) = 15.2% E WACC = 16.7% " 8% " (1 ! 40%) + 83.3% " 15.2% = 13.5%
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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WACC ingredients some comments:

1)! rE: use the CAPM 2)! rD: from the actual price of debt of the company, or the credit rating (if loan interest rate) 3)! t: marginal corporate tax rate 4)! E: market value of equity (market capitalisation divided by number of shares issued) 5)! D: market value of debt: two alternatives: a) Book value, if the value was recorded when (i) interest rates were similar to today, and (ii) the firms credit rating was similar. Otherwise, b) we take rD and apply it to the remaining debt payments if D is a loan from the bank, then remaining principal amount Example: 9% coupon, Maturity 10 years, $100 face value, rD=7%

$9 M 1 $100 M D= (1 ! )+ = $114.05M 10 10 7% (1 + 7%) (1 + 7%)

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The Cost of Debt

One of the more tricky issue is to estimate the cost of debt of a non-rated firm (or the cost of debt under some hypothetical target capital structure) In order to estimate the cost of debt under this scenario is to become ratings agency It is often not too difficult to estimate the credit rating that a particular firm would achieve under a particular debt scenario (actually, that is what banks do when estimating the interest rate on loan for corporates)

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Some numbers that ratings agencies look at

Median Ratios (Actual Numbers)

Firm Under Consideration

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The Cost of Debt

Once you have identified your likely credit rating, estimating the cost of debt is easy You can look up the current spread above the risk free rate for each ratings category Add this to the current risk-free rate and this is your estimated cost of debt (mostly done over long rate)

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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The Cost of Equity

Use the CAPM to get rE=rf + #E x (rm-rf)

Practical issues: For rf use the maturity matched generally long dated government yield minus liquidity premium, for #E use adjusted estimate, for (rm-rf) use market risk premium of the market which represents investment opportunities for the investors. Do everything in one currency

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Other Sources of Finance?

If firms have not only debt and equity, but also other securities, then we can generalise the WACC formula

D E PS WACC = rD (1 ! t ) + rE + rPS D + E + PS D + E + PS D + E + PS
This is the example when other source is Preferred Stock (PS). The cost of PS might be estimated as the required yield on the preferred securities

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Multiple Divisions?
If firms have multiple business lines, then their overall cost of capital is determined by weighted average risk of the divisions

Value Div1 Div1 Value Div 2 Div 2 Value DivN DivN ru = ru + ru + ... + ru FirmValue FirmValue FirmValue
Ideal Measure for Value is the market value of assets (i.e. present values of cash flows) However, because of difficulty to measure, sometimes, in practice, they use (i) Revenue Weights; (ii) Profit Weights; or (iii) Book Value of Assets Weights. Last is the best because we can adjust for industry market-tobook ratio.
Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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Recap of Basic Technique

1)! UNLEVER (old capital structure during estimation period)

D(1 ! t ) E rU = rD + rE D(1 ! t ) + E D(1 ! t ) + E

2) RELVER (future capital structure and cost of debt)

D(1 ! t ) rE = rU + [ rU ! rD ] E
3) Compute the WACC (future capital structure and cost of debt)

D E WACC = rD (1 ! t ) + rE D+E D+E

Advanced Corporate Finance, Vasil Revishvili, vrevishvili@cu.edu.ge

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