BANK 3009 CVRM Introduction and Topic 1 2011

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BANK 3009 Corporate Valuation and Risk Management 2011 1

BANK 3009 Corporate

Valuation and RiskManagement

IntroductionTopic 1Review of the discountedcash flow approach


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Structure ofIntroduction/Topic 1

Introduction

Course structure

Assumed background

Share valuation (revision)

Capital budgeting (revision)Does the valuation story makesense?


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ReadingTitman S, and Martin J, 2011, Valuation:The Art and Science of Corporate

Investment Decisions(Second Edition),United States of America:Pearson/Prentice Hall, Chapters 1 & 2

As this is/or should be largely revision, youshould be able to skim-read most material


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The structure of the courseReview of thediscounted cash

flow approachAnalysing projectrisk

Cost of capitalFinancialstatements andvaluation

Enterprisevaluation

Risk mapping andhedging

Futures, options

and the valuationand riskassessment ofreal investments


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What you should know about already

Toolkit andbackground

Ideas ApplicationsPreviousstudies



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Ideas

Marketefficiency Equilibriumpricing Arbitrage Portfolioconcepts




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Applications

Financialmathematics

Risk &return

Valuation




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Risk & return

Forecast/

expectedreturns

Portfoliotheory

Systematic

versus nonsystematicrisk

CAPM and

fair/expectedreturns



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Valuation

Capitalprojects Bonds Stocks Derivatives



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1012BANK 3009 Corporate Valuation and Risk Management 2011

Finance

Business Finance/Finance & Investment

Derivative &Securities Markets

International Currency& Banking Markets

Portfolio & FundManagement



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Other studies

Economics Accounting

Law Statistics



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Statistics

AveragesStandard deviation/

Variance

Skewness Kurtosis

Regression



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Revision

Security valuationDDMs and FCFF(Note: can also apply most DDMstructures to FCFF valuation)


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Security valuationBasis of value is cash flow

In the case of dividend-discountmodels, cash flows come in the formof dividends (per share), which are aproportion of earnings (per share)

In the case of free cash flow-basedvaluation, free cash flows to thefirm/project (or equity) are used toderive value


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CALCULATING FCFF

Free cash flow to the firm (or project)



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Free Cash Flow (defined)Free cash flow to the firm for any time period(FCFFt) is the sum of free cash flow to equity (FCFEt)and cash flow to debt (CFDt), the latter beingreduced by the tax-shield benefit associated with

the interest cash flow to debt given the tax ratepaid by the firm (tt)FCFFt= FCFEt+ CFDt Itxtt

FCFEtrepresents the after-tax cash flow to equityCFDt Itxttis the after-tax cash flow to debt, whichrecognises the tax-shield benefits that the interestcash flow to debt producesFCFFtis the total cash flows available and paid toinvestors (equity and debt) in the firm

Note that the firm's free cash flows are also equal tothe firms financing cash flows


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Calculating FCFFFCFF for any time period equals after-tax cashflows from operations less incrementalinvestments in operating assetsRequires consideration of the following

Earnings before interest, taxes, depreciation andamortization (EBITDA)[i.e. operating income non-cash charges fordepreciation and amortization]Cash tax payments [i.e. paid not accrued taxes]

Investment in net operating working capital[i.e. the change in (non-interest bearing currentassets non-interest-bearing current liabilities)]Investment in fixed (capital) and other long-termassets (i.e. change in net property, plant andequipment depreciation)


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LetRt= operating revenue (e.g. sales)

DBt= net debt issued (i.e. new borrowing

less repayment of existing debt)

Ot= cash operating costs (not includinginterest)

It= net interest paid (i.e. interest payments

on debt lessinterest income earned)Tt= total tax paid

DKt= net non-current asset investment(i.e. net of the sales of assets)


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DWCt= net investment in working capital(generally excludes cash and marketablesecurities, unless these are required forgrowth)

tt= tax rateNPATt= net profit after tax

EBITt= earnings before interest and tax

The tsubscript is an index of time,associating each cash flow with aspecific time period


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tttttt

ttttttt

ttt

tttt

tttttt

ttttt

IBt][IB]WCK[]Dep)TIDepO[(RFCFF

]B[ICFD

B]WCK[]Dep

)TIDepO[(RFCFE

ICFDFCFEFCFF

t

t

D

DDD


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ttttt

tttttt

ttt

tttttttt

WCKDepEBITWCKDepINPAT

WCKDep

ITIDepORFCFF

DDDD

DD

t

t

t

11

1

So how is this different to the cash flow that you have

calculated in earlier Finance courses for singleprojects? It isnt! It is just a generalisation of CF.A firms cash flows are derived from a set of multiple/overlapping projects (i.e. CAPEX may occur each year).


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DIVIDEND DISCOUNTMODELS (DDM)

Valuation Models



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gk

gDV

)1(00

Constant growth model

V0= present value of all future dividends

D0

= most recent dividend paid

g= constant perpetual growth rate fordividends

k= risk adjusted required return on cash flows


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T

TT

t

t

t

kgk

gD

k

gDV

)1)((

)1(

)1(

)1(

2

2

1

100

Shifting growth rate model

g1= first growth rate

g2= second growth rate

T= number of periods of growth at g1


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ROEbg

EbD

00

1

Estimating dividends and

growth (self-sustaining rate)

b= retention rate on earnings

(1b)= payout ratio on earnings (E)

ROE= return on equity


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Why does business and

industry analysis matter?Provides inputs into valuationmodels

Dividend-discount model (DDMFree cash flow to the firm (FCFF)model

Common features to DDMs andFCFF modelsGrowth rates (g)

Capitalisation rates (k)


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Where do we get information onthese variables?

Capitalisation rates (k) CAPM

Monetary policy

Gearing (M&M)

Growth rates (g) Business cycle analysis

Industry analysis

Maturity of firm (life cycle analysis)


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UNDERSTANDING ROE

Valuation Models



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Determining ROERequires financial analysis ofcompanys accounting data

Helps us to estimate intrinsic valueWe use financial indicators(financial ratios)

Explore sources of firms profitability

and evaluate the value relevance ofits earnings Popular breakdown via use of the

Du Pont system


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The Du Pont system

LeverageROAburdenInterestburdenTaxROEso

AssetsSales

SalesEBITROA

Equity

Debt1

Equity

Assets

EBIT

Interest-EBIT

EBIT

profitPretax

but

Equity

Assets

Assets

Sales

Sales

EBIT

EBIT

profitPretax

profitPretax

profitNetROE

Source: Derived from Bodie, Kane & Marcus (2008), pp. 657-659


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Revision

Capital budgeting/Project evaluation


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Capital budgeting processalternatives and issues

NPV PI IRR

Discounted cash flow

AROR Payback period

Non-discounted cash flow

Methodologies

Time disparity Unequal lives

Capital rationing

Cash flows Discount rates

Risk adjustment

Project choice and risk

WACC WACC and Risk

Cost of capital

Operating Financial

Leverage

Limitations of DCF Options concepts in capital budgeting

Capital budgeting


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Guidelines on where NPV

comes from in projectsUse the NPVmethod for evaluation andranking of all potential investment

projects based on cash flows generatedby the project

Cash flows must be incremental- these arenew cash flows that will occur as a directresult of the project

Compare cash flows with and withoutproject


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Sources of cash flowInitial outlaysSynergistic effects

Working capitalrequirementsAdditionsto overhead costs andexpensesCost reductions

Additionsto revenuesTax effectsnon imputation firmsOpportunity costs


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Items which are notproject cash

flows

Existing overheads

Sunk costs

Tax effectsfull imputation firm

Other issuesInflation

Sources of value added


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Size disparity in capital budgeting

Mutually exclusive projects ofdiffering capital values

Must compare total NPV that canbe generated with funds

Consider use of marginal funds (eg,

IRR of incremental investment, orNPV of incremental investment onlarger project)


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Unequal livesNPV and IRR provide different rankingsas projects are not comparable

Implicitly reject future possibleinvestments on project with shorter lifeincluding

replacementoption to proceed to a dependent project

Use equivalent annualannuity/equivalent annual cost method(EAA/EAC)


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EAA/EAC

T

r

j

j

A

NPVEAA

Calculate NPV for each project

Calculate annuity factor for each project

Provides information on the annualannuity cash flow that would providethe same NPV as each project

Annuity

factor, Ttime

periods, atrater


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BANK 3009 C t V l ti d Ri k M t 2011 39

Next TopicAnalysing project risk

BANK 3009 CVRM Introduction and Topic 1 2011

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