Scribd
Upload
39 views

Unit 3 Valuation of Firm With Different Valuation Techniques

This document discusses different techniques for valuing firms, including the adjusted present value (APV) approach, weighted average cost of capital (WACC) approach, and flow to equity (FTE) approach. It provides details on each approach, such as how to calculate unlevered and levered cash flows, tax shields, and discount rates. The approaches are compared, with guidelines for when each is most appropriate to use depending on whether the project's debt level is known or if the firm's target debt ratio applies. The WACC approach is noted as the most widely used in practice.

Uploaded by

Sudan Khadgi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
39 views

Unit 3 Valuation of Firm With Different Valuation Techniques

This document discusses different techniques for valuing firms, including the adjusted present value (APV) approach, weighted average cost of capital (WACC) approach, and flow to equity (FTE) approach. It provides details on each approach, such as how to calculate unlevered and levered cash flows, tax shields, and discount rates. The approaches are compared, with guidelines for when each is most appropriate to use depending on whether the project's debt level is known or if the firm's target debt ratio applies. The WACC approach is noted as the most widely used in practice.

Uploaded by

Sudan Khadgi
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
You are on page 1/ 21

Unit 3

Valuation of firm with different


valuation techniques

KUSOM
1
Course Contents

 Unit 2: Valuation of firm with different


valuation techniques 4.5 hrs
– NPV and Adjusted Present Value Approach
– WACC approach
– Flow to Equity Approach (ETF)
– Capital Cash Flow approach (CCF)
– A comparison of NPV, APV, FTE,CCF and WACC
– Valuation practice in Nepal

2
Misconceptions about Valuation

 Myth 1: A valuation is an objective search for “true” value


– Truth 1.1: All valuations are biased. The only questions are “how
much” and in which direction.
– Truth 1.2: The direction and magnitude of the bias in your valuation is
directly proportional to who pays you and how much you are paid.
 Myth 2.: A good valuation provides a precise estimate of value
– Truth 2.1: There are no precise valuations.
– Truth 2.2: The payoff to valuation is greatest when valuation is least
precise.
 Myth 3: . The more quantitative a model, the better the valuation
– Truth 3.1: One’s understanding of a valuation model is inversely
proportional to the number of inputs required for the model.
– Truth 3.2: Simpler valuation models do much better than complex
3 ones.
Approaches to Valuation

 1. Intrinsic valuation, relates the value of an asset to its intrinsic


characteristics: its capacity to generate cash flows and the risk in
the cash flows. In it’s most common form, intrinsic value is
computed with a discounted cash flow valuation, with the value of an
asset being the present value of expected future cash flows on that
asset.
 2. Relative valuation or Pricing, estimates the value of an asset by
looking at the pricing of 'comparable' assets relative to a common
variable like earnings, cashflows, book value or sales.
 3. Contingent claim valuation, uses option pricing models to
measure the value of assets that share option characteristics.

4
Basis for all valuation approaches

 The use of valuation models in investment decisions


(i.e., in decisions on which assets are under valued
and which are over valued) are based upon
– a perception that markets are inefficient and make mistakes
in assessing value
– an assumption about how and when these inefficiencies will
get corrected
 In an efficient market, the market price is the best
estimate of value. The purpose of any valuation
model is then the justification of this value.

5
Valuation of Levered Firm

 three approaches to valuation for the levered firm


 The analysis of these approaches is relevant for entire
firms as well as projects.
 Understand the effects of leverage on the value created
by a project
 Be able to apply Adjusted Present Value (APV), the
Flows to Equity (FTE) approach, and the WACC method
for valuing projects with leverage

6
Adjusted Present Value Approach

 The adjusted present value (APV) method


is best described by the following formula:
APV = NPV + NPVF
 (APV) is equal to the value of the project to
an unlevered firm (NPV) plus the net present
value of the financing side effects (NPVF).

7
Net present value of the financing
side effects (NPVF).

 There are four side effects of financing:


– The Tax Subsidy to Debt
– The Costs of Issuing New Securities
– The Costs of Financial Distress
– Subsidies to Debt Financing

8
APV Example
Consider a project of the Pearson Company. The timing and size
of the incremental after-tax cash flows for an all-equity firm are:
–$1,000 $125 $250 $375 $500

0 1 2 3 4
The unlevered cost of equity is R0 = 10%:

$125 $250 $375 $500


𝑁𝑃𝑉10% = −$1,000 + + + +
(1.10) (1.10)2 (1.10)3 (1.10)4
𝑁𝑃𝑉10% = −$56.50

The project would be rejected by an all-equity firm: NPV < 0.


APV Example

 Now, imagine that the firm finances the project with $600 of debt
at RB = 8%.
 Pearson’s tax rate is 40%, so they have an interest tax shield
worth TCBRB = .40×$600×.08 = $19.20 each year.

 The net present value of the project under leverage is:


APV = NPV + NPV debt tax shield
4
$19.20
𝐴𝑃𝑉 = −$56.50 + ෍
(1.08)𝑡
𝑡=1

𝐴𝑃𝑉 = −$56.50 + 63.59 = $7.09


 So, Pearson should accept the project with debt.
Flow to Equity Approach

 Discount the cash flow from the project to the


equity holders of the levered firm at the cost
of levered equity capital, RS.
 There are three steps in the FTE Approach:
– Step One: Calculate the levered cash flows
(LCFs)
– Step Two: Calculate RS.
– Step Three: Value the levered cash flows at RS.
Step One: Levered Cash Flows

 Since the firm is using $600 of debt, the equity


holders only have to provide $400 of the initial
$1,000 investment.
 Thus, CF0 = –$400
 Each period, the equity holders must pay
interest expense. The after-tax cost of the
interest is:
B×RB×(1 – TC) = $600×.08×(1 – .40) = $28.80
Step One: Levered Cash Flows

CF3 = $375 – 28.80 CF4 = $500 – 28.80 – 600


CF2 = $250 – 28.80
CF1 = $125 – 28.80
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4
Step Two: Calculate RS
𝐵
𝑅𝑆 = 𝑅0 + (1 − 𝑇𝐶 )(𝑅0 − 𝑅𝐵 )
𝑆
B B
To calculate the debt to equity ratio, , start with
4 S V
$125 $250 $375 $500 19.20
𝑃𝑉 = + + + + ෍
(1.10) (1.10)2 (1.10)3 (1.10)4 (1.08)𝑡
𝑡=1

P V = $943.50 + $63.59 = $1,007.09


B = $600 when V = $1,007.09 so S = $407.09.

$600
𝑅𝑆 = .10 + (1 − .40)(.10 − .08) = 11.77%
$407.09
Step Three: Valuation

 Discount the cash flows to equity holders at RS =


11.77%
–$400 $96.20 $221.20 $346.20 –$128.80

0 1 2 3 4

$96.20 $221.20 $346.20 $128.80


𝑁𝑃𝑉 = −$400 + + + −
(1.1177) (1.1177)2 (1.1177)3 (1.1177)4
𝑁𝑃𝑉 = $28.56
WACC Method
𝑆 𝐵
𝑅𝑊𝐴𝐶𝐶 = 𝑅 + 𝑅 (1 − 𝑇𝐶 )
𝑆+𝐵 𝑆 𝑆+𝐵 𝐵

 To find the value of the project, discount the


unlevered cash flows at the weighted average
cost of capital.
 Suppose Pearson’s target debt to equity ratio is
1.50
WACC Method

𝐵
1.50 = ∴ 1.5𝑆 = 𝐵
𝑆

𝐵 1.5𝑆 1.5 𝑆
= = = 0.60 = 1 − 0.60 = 0.40
𝑆 + 𝐵 𝑆 + 1.5𝑆 2.5 𝑆+𝐵

𝑅𝑊𝐴𝐶𝐶 = (0.40) × (11.77%) + (0.60) × (8%) × (1 − .40)


𝑅𝑊𝐴𝐶𝐶 = 7.58%
WACC Method

 To find the value of the project, discount the


unlevered cash flows at the weighted average
cost of capital
$125 $250 $375 $500
𝑁𝑃𝑉 = −$1,000 + + 2
+ 3
+
(1.0758) (1.0758) (1.0758) (1.0758)4

NPV7.58% = $6.68
A Comparison of the APV, FTE,
and WACC Approaches

 All three approaches attempt the same task:


valuation in the presence of debt financing.
 Guidelines:
– Use WACC or FTE if the firm’s target debt-to-value
ratio applies to the project over the life of the project.
– Use the APV if the project’s level of debt is known
over the life of the project.
 In the real world, the WACC is, by far, the most
widely used.
Summary: APV, FTE, and WACC

APV WACC FTE


Initial Investment All All Equity Portion

Cash Flows UCF UCF LCF

Discount Rates R0 RWACC RS

PV of financing
effects Yes No No
Summary: APV, FTE, and WACC

Which approach is best?


 Use APV when the level of debt is not
constant
 Use WACC and FTE when the debt ratio is
constant
– WACC is by far the most common
– FTE is a reasonable choice for a highly levered
firm

You might also like