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Valuation

MPA FIN 286


Alessandro Previtero
Slide Pack Week 4 Part 1
Company Valuation APV

Todays Content
I.

Announcements:

Review Session This Thursday 5.30-6.30pm

HW3 Due this Wednesday (Feb. 10th)

Case 1 due Monday Feb 15th.

II.

APV

III. LBOs
IV. Problems
V.

Assign Case 1 (AirThread)

Overview - 2

Recap: How to Value a Firm WACC


FFCF = EBITDA (1 tC ) + DA tC NWC Capex + AS CGT

E[FFCFt ]
VA =
t
(
)
1
+
WACC
t =0

rd = (1 PD)YTM PD(1 RR)


REGRESSION

e =
*

Firm Value

D
E
WACC =
(1 T ) rd +
re
D + E
D + E

Optimal Leverage
Ratio

1 Leverage

Cov (re , rm )
Var (rm )
If Public Company

re = rf + e (rm rf )

TRADE-OFF
THEORY

CAPM

Comparables

Unlevering

MVE
P=
N

e_c1

Ec
1

d_c1

Dc

e_c2

d_c2

A_c1

A_c1
A_c

e_c

Ec

Dc

d_c

Dc

Ec

e??

Levering

MVE = VA + NOA MVD

If NOT Public Company

A_c1
A

COMPARABLES

Company Valua4on DCF Models WACC 3

I. Company Valuation
Introduction
Discounted Cash Flow (DCF) Models
Discount Rate
No Friction Model
WACC (Weighted Average Cost of Capital)
APV (Adjusted Present Value)
Multiples
Other topics: LBOs, M&A, etc.

Intro on Adjusted Present Value (APV)

Leverage

The WACC Model assumes that the company continuously adjust its
leverage ratio to a constant optimal target ratio.
This assumption is good for stable, mature companies
The Adjusted Present Value is a more flexible model, that is
applicable to any company
Young, new companies
LBOs
Mature
Optimal
Mature
LR
t

BS

IS

DA Tax
Shield
Interest Payment
Tax Shield

Revenues Costs (COGS & SG&A) =


EBITDA Depreciation & Amortization (DA) =
EBIT Interest =
EBT
Taxes=
Earnings

TS

OA

A=OA+TS=D+E
Company Valua4on DCF Models APV 5

APV: Main Intuition


The Adjusted Present Value takes the Value of the Operating Assets,
and adjusts it by adding the value of the tax shields and subtracting
the costs of financial distress

VA = VOA + VTS VFDC = PV ( FFCF ) + PV ( IPTS ) PV ( FDC ) =


E[FFCFt ] E[IPTSt ]
+
PV ( FDC )

t
t
t = 0 (1 + rOA )
t = 0 (1 + rTS )

Where:
FFCF = Firm Free Cash Flow
IPTS= Interest Payment Tax Shield=IPT=DrdT
FDC= Financial Distress Costs
rOA = Discount Rate on Operating Assets
rTS = Discount Rate on Tax Shields

Company Valua4on DCF Models APV 6

Levering/Unlevering with the APV


The levering/unlevering formula now is slightly different:

OA
TS
D
E
OA +
TS =
d +
e
OA + TS
OA + TS
D+E
D+E
The key choice to make in an APV model is to understand if the company is
targeting a constant optimal capital structure (trade-off theory) or not.
1. If the company uses a targeting strategy, then the tax shields on
interest payment have the same risk of the underlying operating
assets. Why?

Because the interest payment are a % of debt. In a targeting


strategy, the leverage is constant, therefore if the assets change
value, so does the debt.

TS = OA
2.

If the company does not use a targeting strategy, then the tax shields
on interest payment have the same risk of the debt.

TS = d
Company Valua4on DCF Models APV 7

Discount Rates in APV


The discount rates are different as a function of the capital structure strategy

Targeting Strategy

Non-Targeting Strategy

OA
TS
D
E
OA +
TS =
d +
e
OA + TS
OA + TS
D+E
D+E

TS = OA = A

OA
TS
D
E
OA +
TS =
d +
e
OA + TS
OA + TS
D+E
D+E

TS = d

solving the algebra

solving the algebra


Levering/Unlevering Formula

OA =
rOA =

D
E
d +
e
D+E
D+E
D
E
rd +
re
D+E
D+E

rTS = rOA

OA =

D(1 T )
E
d +
e
D(1 T ) + E
D(1 T ) + E

rOA =

D(1 T )
E
rd +
re
D(1 T ) + E
D(1 T ) + E

rTS = rd

Company Valua4on DCF Models APV 8

How to Value a Firm APV with Targeting Strategy


FFCF = EBITDA (1 tC ) + DA tC NWC Capex + AS CGT
IPTS = D rd T
E[FFCFt ] E[IPTSt ]
VA =
+

t
t
rTS = rOA
t = 0 (1 + rOA )
t =0 (1 + rTS )

REGRESSION

rd = (1 PD)YTM PD(1 RR)

rOA =

D
E
rd +
re
D+E
D+E

e =

Cov (re , rm )
Var (rm )
If Public Company

re = rf + e (rm rf )
CAPM

Comparables

Unlevering

MVE
P=
N

e_c1

Ec
1

d_c1

Dc

e_c2

d_c2

OA_c1

OA_c1
OA_c

e_c

Ec

Dc

d_c

Dc

Ec

e??

Levering

MVE = VA + NOA MVD

If NOT Public Company

OA =

D
E
d +
e
D+E
D+E

OA_c1
OA

COMPARABLES

Company Valua4on DCF Models APV 9

How to Value a Firm APV with Targeting Strategy


FFCF = EBITDA (1 tC ) + DA tC NWC Capex + AS CGT

E[FFCFt ] E[IPTSt ]
VA =
+
t
t
t = 0 (1 + rOA )
t =0 (1 + rTS )

IPTS = D rd T
rTS = rOA

rOA = rf + OA (rm rf )

Comparables

MVE = VA + NOA MVD

P=

Unlevering

MVE
N

e_c1

Ec
1

d_c1

Dc

e_c2

d_c2

OA_c1

OA_c1
OA_c

e_c

Ec

Dc

d_c

Dc

Ec

OA_c1
OA

COMPARABLES

Company Valua4on DCF Models APV 10

Capital Cash Flow Model


If the company is adopting a targeting strategy, we can add together the
FFCF and the IPTS
Defining CCF = Capital Cash Flow = FFCF+IPTS

E[FFCFt ] E[IPTSt ] E[FFCFt + IPTSt ] E[CCF ]


VA =
+
=
=
t
t
t
t
(1 + rOA )
t =0 (1 + rOA )
t = 0 (1 + rOA )
t =0
t = 0 (1 + rOA )

rOA = rf + OA (rm rf )
Comparables

Unlevering

e_c1

Ec
1

d_c1

Dc

e_c2

d_c2

OA_c1

OA_c1
OA_c

e_c

Ec

Dc

d_c

Dc

Ec

OA_c1
OA

COMPARABLES

Company Valua4on DCF Models APV 11

How to Value a Firm APV with Non-Targeting Strategy


FFCF = EBITDA (1 tC ) + DA tC NWC Capex + AS CGT
IPTS = D rd T
E[FFCFt ] E[IPTSt ]
VA =
+

t
t
t = 0 (1 + rOA )
t =0 (1 + rTS ) rTS = rd = (1 PD)YTM PD(1 RR)

D(1 T )
E
rd +
re
D(1 T ) + E
D(1 T ) + E

rOA =

REGRESSION

e =

Cov (re , rm )
Var (rm )
If Public Company

re = rf + e (rm rf )
CAPM

Comparables

Unlevering

MVE
P=
N

e_c1

Ec
1

d_c1

Dc

e_c2

d_c2

OA_c1

OA_c1
OA_c

e_c

Ec

Dc

d_c

Dc

Ec

e??

Levering

MVE = VA + NOA MVD

If NOT Public Company

OA =

D(1 T )
E
d +
e
D(1 T ) + E
D(1 T ) + E

OA_c1
OA

COMPARABLES

Company Valua4on DCF Models APV 12

How to Value a Firm APV with Non-Targeting Strategy


FFCF = EBITDA (1 tC ) + DA tC NWC Capex + AS CGT

E[FFCFt ] E[IPTSt ]
VA =
+
t
t
t = 0 (1 + rOA )
t =0 (1 + rTS )

IPTS = D rd T
rTS = rd = (1 PD)YTM PD(1 RR)

rOA = rf + OA (rm rf )

Comparables

MVE = VA + NOA MVD

P=

Unlevering

MVE
N

e_c1

Ec
1

d_c1

Dc

e_c2

d_c2

OA_c1

OA_c1
OA_c

e_c

Ec

Dc

d_c

Dc

Ec

OA_c1
OA

COMPARABLES

Company Valua4on DCF Models APV 13

WACC vs APV

CONS

PROS

APV

WACC

Highly Flexible
Applicable also to
cases where capital
structure is not
stationary through time
(LBOs, IPOs,)

Easy to use
Widely used

More complex
Not as popular

Applicable only when


capital structure is
stationary (mature,
stable companies)

The WACC assumes that the company is targeting a stationary capital


structure, therefore the value using the WACC should be equal to the value
using the APV with a targeting strategy
The APV using a targeting strategy should give a lower valuation than the
APV using a non-targeting strategy, because the tax shields are discounted
at a higher discount rate
Company Valua4on DCF Models APV 14

Mixed Approach
Companies might not be able to adopt a targeting strategy in the interim
period, but they are planning to adopt a targeting strategy when they
mature (in the terminal value)
In these cases, we can use a mixed approach, where the company is not
targeting for a few years, and then targeting in perpetuity afterwards
Use APV with no targeting in the interim period
Use WACC for the terminal value

Company Valua4on DCF Models APV 15

I. Company Valuation
Introduction
Discounted Cash Flow (DCF) Models
Discount Rate
No Friction Model
WACC (Weighted Average Cost of Capital)
APV (Adjusted Present Value)
Multiples
Other topics:
Other Valuation Techniques
M&A
LBOs
Control and Liquidity Premium
VC

Leverage BuyOuts
LBOs represent a business acquisition strategy
whereby an investor group acquires all the
equity of a firm and assumes its debts
The investment is predominantly financed with
debt; typically 50-80% of total capital structure
The idea is that the leveraged nature of the
acquisition structure forces management to run
operations at maximum efficiency to service debt
The lure of leveraged returns attract investors
Tax shields may also be high
Called MBO if firm Management is involved and
incentivized with their own equity stake in the deal
Company Valua4on Other Topics - 17

LBO capital structures


Typical
Range

Typical LBO
Capital Structure

Equity
20-50%

Common Equity
Preferred Stock

Sweat Equity for


management

8-15%

Debt
50-80%

Junior Subordinated
Debt (8-12 yr. maturity)

Management Capital

0-5%

Former Owner

5-30%

Equity Provided by
Financial Investors
(LBO Firm)

50-87%

Senior Subordinated
Debt (8-12 yr. maturity)
Bank Debt
(5-8 yr. maturity)

Typical Equity
Ownership Structure

Typical
Range

Company Valua4on Other Topics - 18

LBO acquisition strategies


Bust-up strategy
Take control of company and sell off assets to repay
debt used to finance the acquisition
Objective is to increase efficiency in operations and
sell for more than you paid for it
Tax shields also a consideration
Very popular in the 1980s (Movie Wall Street)
Build-up strategy
Objective is to create a large public company,
sometimes through the purchase of a platform
company upon which further acquisitions are made
Gained popularity in the 1990s
Company Valua4on Other Topics - 19

APV model for LBOs Mixed Strategy


PP

PP
FFCFt
IPTS
EV =
+
+
t
t
t =1 (1 + rOA )
t =1 (1 + rd )

FFCFPP (1 + g ) 1

+
WACC g 1 + rOA

PP

where PP is the last planning period


The firm is assumed to adopt a constant leverage ratio
after time PP, and have pre-determined debt and
interest payments before time PP

Company Valua4on Other Topics - 20

Example of Build-Up Strategy Textbook


Hokie Partners LP are considering the acquisition of
PMG Foods Inc.
PMG has current EBITDA of $100 million; expected
purchase price equal to 5x the current level of
EBITDA, or $500 million.
The acquisition of PMG is financed with 75% debt with
an interest rate of 14% (thats high!), and a 25% equity
piece put up by the equity group Hokie
The debt has covenants that require that all excess
cash be used to retire principal (cash sweep debt
covenants), which means that the equity investors will
not receive any cash flow from their investment until
year 5 when the firm is sold.
Company Valua4on Other Topics - 21

Example: Assumptions
Equity group projects EBITDA growth of 10% per year
for 5 years, then sell the firm for 6x EBITDA
Firms outstanding debt will be repaid at sale and
remaining funds distributed to the equity investors
Earnings Estimates
Current year EBITDA (millions)
Planning Period EBITDA growth rate
Planned holding period
Corporate tax rate
Depreciable life of assets
Depreciation expense (Year 0)
LBO Capital Structure
Debt/Assets
Interest cost

Annual Capex
$ 100.00
10%
5 years
35%
10 years
$ 40.00

$ 50.00

Acquisition and sale EBITDA multiples


Purchase multiple - Platform Company (PMG)
Purchase multiple - Add-on Company (Centex)
Company sale (harvest) multiple

5
3
6

75%
14%

Company Valua4on Other Topics - 22

Example: APV Projections with LBO


EBITDA

Year 0

Year 1
Year 2
Year 3
Year 4
Year 5
$ 110.00 $ 121.00 $ 133.10 $ 146.41 $ 161.05

Less: Depreciation
EBIT
Less: Taxes
EBIT(1-T)

$ (45.00)
$ 65.00
$ 22.75
$ 42.25

Plus :
Depreciation
Less: CAPEX
FFCF

$ 45.00 $ 50.00 $ 55.00 $ 60.00 $ 65.00


$ (50.00) $ (50.00) $ (50.00) $ (50.00) $ (50.00)
$ 37.25 $ 46.15 $ 55.77 $ 66.17 $ 77.43 $ 966.31

IP
IPTS

$ 52.50 $ 52.06 $ 50.34 $ 47.11 $ 42.14


$ 18.38 $ 18.22 $ 17.62 $ 16.49 $ 14.75

$ (50.00)
$ 71.00
$ 24.85
$ 46.15

$ (55.00)
$ 78.10
$ 27.34
$ 50.77

$ (60.00)
$ 86.41
$ 30.24
$ 56.17

TV

$ (65.00)
$ 96.05
$ 33.62
$ 62.43

Outstanding Loan $ 375.00 $ 371.88 $ 359.57 $ 336.52 $ 300.98 $ 250.93


Cash to Equity
Holders $ (125.00) $ - $ - $ - $ - $ 715.37
Input Variables
% Financing
Growth
EBITDA Multiple
Output V ariables
IRR

75%
10%
6.00

41.75%

Company Valua4on Other Topics - 23

Example: APV Projections without Leverage


Year 0
EBITDA

Year 1
Year 2
Year 3
Year 4
Year 5
$ 110.00 $ 121.00 $ 133.10 $ 146.41 $ 161.05

Less: Depreciation
EBIT
Less: Taxes
EBIT(1-T)

$ (45.00)
$ 65.00
$ 22.75
$ 42.25

Plus :
Depreciation
Less: CAPEX
FFCF

$ 45.00 $ 50.00 $ 55.00 $ 60.00 $ 65.00


$ (50.00) $ (50.00) $ (50.00) $ (50.00) $ (50.00)
$ 37.25 $ 46.15 $ 55.77 $ 66.17 $ 77.43 $ 966.31

$ (50.00)
$ 71.00
$ 24.85
$ 46.15

$ (55.00)
$ 78.10
$ 27.34
$ 50.77

$ (60.00)
$ 86.41
$ 30.24
$ 56.17

TV

$ (65.00)
$ 96.05
$ 33.62
$ 62.43

Cash to Equity
Holders $ (500.00) $ 37.25 $ 46.15 $ 55.77 $ 66.17 $ 1,043.74
Input Variables
% Financing
Growth
EBITDA Multiple
Output V ariables
IRR

0%
10%
6.00

22.46%

Company Valua4on Other Topics - 24

Example: APV Projections with LBO 4% Growth & 4x


EBITDA Multiple
Year 0
EBITDA

Year 1
Year 2
Year 3
Year 4
Year 5
$ 104.00 $ 108.16 $ 112.49 $ 116.99 $ 121.67

Less: Depreciation
EBIT
Less: Taxes
EBIT(1-T)

$ (45.00)
$ 59.00
$ 20.65
$ 38.35

Plus :
Depreciation
Less: CAPEX
FFCF

$ 45.00 $ 50.00 $ 55.00 $ 60.00 $ 65.00


$ (50.00) $ (50.00) $ (50.00) $ (50.00) $ (50.00)
$ 33.35 $ 37.80 $ 42.37 $ 47.04 $ 51.83 $ 365.00

IP
IPTS

$ 52.50 $ 52.61 $ 52.10 $ 50.91 $ 48.96


$ 18.38 $ 18.41 $ 18.24 $ 17.82 $ 17.14

$ (50.00)
$ 58.16
$ 20.36
$ 37.80

$ (55.00)
$ 57.49
$ 20.12
$ 37.37

$ (60.00)
$ 56.99
$ 19.95
$ 37.04

TV

$ (65.00)
$ 56.67
$ 19.83
$ 36.83

Outstanding Loan $ 375.00 $ 375.78 $ 372.17 $ 363.67 $ 349.72 $ 329.71


Cash to Equity
Holders $ (125.00) $ - $ - $ - $ - $ 35.28
Input Variables
% Financing
Growth
EBITDA Multiple
Output V ariables
IRR

75%
4%
3.00

-22.35%

Company Valua4on Other Topics - 25

Example: APV Projections without Leverage 4%


Growth & 3x EBITDA Multiple

Year 0
EBITDA

Year 1
Year 2
Year 3
Year 4
Year 5
$ 104.00 $ 108.16 $ 112.49 $ 116.99 $ 121.67

Less: Depreciation
EBIT
Less: Taxes
EBIT(1-T)

$ (45.00)
$ 59.00
$ 20.65
$ 38.35

Plus :
Depreciation
Less: CAPEX
FFCF

$ 45.00 $ 50.00 $ 55.00 $ 60.00 $ 65.00


$ (50.00) $ (50.00) $ (50.00) $ (50.00) $ (50.00)
$ 33.35 $ 37.80 $ 42.37 $ 47.04 $ 51.83 $ 365.00

$ (50.00)
$ 58.16
$ 20.36
$ 37.80

$ (55.00)
$ 57.49
$ 20.12
$ 37.37

$ (60.00)
$ 56.99
$ 19.95
$ 37.04

TV

$ (65.00)
$ 56.67
$ 19.83
$ 36.83

Cash to Equity
Holders $ (500.00) $ 33.35 $ 37.80 $ 42.37 $ 47.04 $ 416.83
Input Variables
% Financing
Growth
EBITDA Multiple
Output V ariables
IRR

0%
4%
3.00

3.39%

Company Valua4on Other Topics - 26

Where is the value in a build-up LBO strategy?


Synergies: Economies of scale, scope,
Combined company can be more diversified
Higher debt capacity
Perhaps a higher sales multiple for
diversification
Those are the upside, but also need to
consider
How risky is the strategy?
Is the projected equity IRR worth the risk?

Company Valua4on Other Topics - 27

HOG Valuation with APV

Company Valua4on DCF Models APV 28

Next Monday AirThread Case


Download AirThread case from the HBS website link in the syllabus
Form groups of max 4 people.
Answer questions posted on Canvas
Prepare a 3-pages report as a deliverable. Be ready to discuss the case
in class.

Company Valua4on DCF Models APV 29

Problem
Your private equity rm has iden4ed a good acquisi4on candidate. The target rm has been poorly
managed and has a very conserva4ve debt policy rela4ve to its debt capacity. The target also has non-
core assets that can be sold in one year which would generate $5 billion aRer taxes. The target has been
inves4ng too much in these non-core assets and you believe you can increase the growth in the core
businesses by re-alloca4ng investment expenditures. Your forecasts are below (in millions of dollars). All
gures are in nominal terms. Note that the deprecia4on expense reported above already incorporates
the deprecia4on on the new capital expenditures. The growth rate is expected to slow down considerably
aRer Year 5. Currently, the enterprise value (debt plus equity) of mature compe4tors in the target rms
industry is ten 4mes EBITDA (trailing twelve months). You found one rm that was comparable to the
target in business risk. This rm was consistently protable and had a A bond ra4ng. The rm had a debt-
equity ra4o of 0.5 (market values) and an es4mated equity beta of 1.2. The risk-free rate is 7% and
assume the market risk premium is 6%. The corporate marginal tax rate is 34%. You will use substan4al
debt to nance the acquisi4on. In the high-growth phase of the business (up to Year 5) you believe the
debt capacity is $3 billion and in the mature phase (aRer Year 5) you believe the debt capacity is $4
billion. With this nancing plan, you expect your bonds will be rated BBB and will have to oer a
promised yield of 10%. Bonds in this ra4ng class have historically had annual default rates of 4% and the
recovery rate is 50% in the event of default. Compute the value of the target. Jus4fy all assump4ons.
Year 1

Year 2

Year 3

Year 4

Year 5

Sales ($Mil)

5000

6000

7200

7920

8712

COGS ($mil)

4000

4800

5760

6336

6970

SGA ($mil)

500

600

720

792

871

DA ($mil)

300

350

400

450

500

Capex ($mil)

300

350

400

450

500

Company Valua4on DCF Models APV 30

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