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I.
Announcements:
II.
APV
III. LBOs
IV. Problems
V.
Overview - 2
E[FFCFt ]
VA =
t
(
)
1
+
WACC
t =0
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
A_c1
A
COMPARABLES
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.
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
TS
OA
A=OA+TS=D+E
Company
Valua4on
DCF
Models
APV
5
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
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?
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
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
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
t
t
rTS = rOA
t = 0 (1 + rOA )
t =0 (1 + rTS )
REGRESSION
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
OA =
D
E
d +
e
D+E
D+E
OA_c1
OA
COMPARABLES
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
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
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
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
OA =
D(1 T )
E
d +
e
D(1 T ) + E
D(1 T ) + E
OA_c1
OA
COMPARABLES
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
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
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
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
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
Typical LBO
Capital Structure
Equity
20-50%
Common Equity
Preferred Stock
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
PP
FFCFt
IPTS
EV =
+
+
t
t
t =1 (1 + rOA )
t =1 (1 + rd )
FFCFPP (1 + g ) 1
+
WACC g 1 + rOA
PP
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
5
3
6
75%
14%
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
IP
IPTS
$
(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
75%
10%
6.00
41.75%
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
$
(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%
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
IP
IPTS
$
(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
75%
4%
3.00
-22.35%
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
$
(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%
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