DCF Review
Transcript of DCF Review
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Valuation Review
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MBA1 Finance
Free Cash Flow to the Firm
FCFF represents cash flows to which all stakeholders
make claim
FCFF = EBITv (1 - tax rate)
+ Depreciation and amortization
- Capital Expenditures
- Increase in Working Capital
Note: Working capital = Current Assets - Non-interest
Bearing Current Liabilities (e.g. A/P & Accrued liab.)
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DCFF Valuation
Stage 1 FCFF
You may be given projections for some (or all) of the itemsneeded to compute FCFF (at a minimum, sales)
For other items, use historic ratios to sales (unless youthink the are not appropriate)
Key: state and justify all assumptions!
Stage 2 FCFF
assume FCFF grow at a constant rate indefinitely into thefuture
Terminal growth (g)
Nominal rate of stable growth in the economy
Capital expenditures in stage 2 = depreciation
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Steps in Applying DCFF Valuation
Discount projected FCFF at the firms WACC
This gives the value of the operating assets of the
firm (Enterprise Value, or EV)
Add to this the value of any non-operating assets
excess cash, marketable securities, etc.
Subtract the value of existing debt to obtain the value
of common stock Divide by shares outstanding to come up with price
per share
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Cost of Capital (WACC)
After taxcost of capital is the weighted average of
required returns on different types of liabilities used to
finance the assets under consideration. Formally:
kc= (D/V) * kd*(1-t) + (
E/V) * ke
kd= cost of debt D=value of debtke = cost of equity E=value of equity
kc= overall cost of capital V=D+E
t = firms marginal tax rate
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Capital Structure
Use market rather than book values of debt and equity
if available
Target capital structure:
Estimate the firms current capital structure
Review the capital structure of comparable firms
Review managements plans for future financing
What if capital structure is expected to change over
time?
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Cost ofDebt (kd)
Match with term of projects (generally long-term)
Focus on permanent debt (can include short term)
Use same rate for all types of debt (short and long-
term)
Use current as opposed to past yields
Take government yields and add a risk premium
Historic spread for issuer (long-term best butuse short term spread if no better data)
Spread given bond rating, if available
1-3%, if no other information
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Cost of Equity (ke): the CAPM
Relevant measure of risk:
Contribution a stock makes to the risk of a well
diversified portfolio (the market portfolio)
Formally, this contribution is given by an assets
beta
The CAPM relates the cost of equity for an individual
stock to that assets beta (F). Formally:
ke = rf + F RP
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The CAPM: Inputs
F - beta
Beta for an asset of similar risk to the market portfolio = 1.
Typical range of betas: 0.5 - 2.0
If you cannot measure for firm, use beta of comparable firm(s).Be consistent with capital structure assumptions (may need to
unlever / relever)
rf - risk free rate
Current yield on long-term government bonds
RP - expected market risk premium
Historic average of difference between the return on the
market (e.g. TSE300) and long-term government bonds
4-6% if no better data available
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Relative Valuation Approaches
Find comparable firms
Similar industry, leverage (link to growth prospects,risk)
Industry averageAssume that valuation multiple (P/E, EV/EBITDA, etc.)
for comparable(s) will be same as for firm in question
Determine P or EV for firm such that this is true
Merger method (comparable transaction)
Principle is the same, just use transaction pricesrather than trading prices to come up with ratios
Likely to have fewer good comparables
Premium paid is important psychologically
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Special Cases in DCF Valuation
Capital raising (e.g. IPO)
Do cash flow projections account for capital
raised?
If so, value of existing equity equals total equity
value less amount raised in the IPO
Share price for equity offering = value of existing
equity / number of existing shares
If lower price, wealth transfers from original share
owners
Private firms
Liquidity discount ~40%
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M&A Valuation: The Process
Stand-
alonetarget
value
Value
of
target
withsyner-
gies
Value
of
synergy
gain to
bidder
Transaction
Costs
Min.bid
Max.
Bid
In most cases, we can just determine
this value
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M&A Valuation: Special Issues
Competing bids
Are there other potential bidders
What would be their maximum bid (are we likely to lose
a bidding contest?)
Cost of Capital
Use target firm WACC when valuing the takeover
target (use target capital structure as stand alone firm)
Use bidder WACC when valuing bidder
Be wary of synergies due to reduced WACC!
Private firm discounts
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M&A Valuation: Special Issues
Deal financing
Debt
What are key ratios on combined company?
Can combined company meet debt obligations?
Equity
How many shares should be exchanged?
If selling new shares, are they fairly priced?
Other considerations
Financial flexibility
Signals
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Valuation Case Process
Size-up the firm being valued
Do projections seem realistic (look at past growth
rates, past ratios to sales, etc.)?
What are the key risks?
What qualitative issues affect your purchase
interest?
Valuation analysis
Several approaches + sensitivities (tied to risks)
Come up with a valuation range that is plausible
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Valuation Case Process
Address case specific issues
e.g. forM&A: what is fit (size-up bidder), any
synergies, bidding strategy, structuring the
transaction, etc.
e.g. for capital raising: timing, deal structure, etc.
Key: Respond to case specific questions
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UGGGrading Key
Setup (alternatives / criteria) 5%
UGGSize-up 25%
Valuation
Ratios 20%
Base case DCF 20%
DCF of synergies 13%
Decision 17%
Total 100%
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Empire Grading Key
Setup (alternatives / criteria) 5%
Oshawa Size-up 25%
Valuation
Ratios 15%
Base case DCF 25%
DCF of synergies 10%
Decision 15%
Total 100%