Market Risk Analysis Prof Ian Giddy Stern School of Business New York University LIB.
Investment Banking and The Private Firm Prof. Ian GIDDY Stern School of Business New York...
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Transcript of Investment Banking and The Private Firm Prof. Ian GIDDY Stern School of Business New York...
Topics:- Leveraged Buyouts and Venture Capital- Initial Public Offerings- Valuing a Business- Realizing Value from a Private Company
Copyright ©2003 Ian H. Giddy Introduction 4
Corporate Finance
CORPORATE FINANCE
DECISONS
CORPORATE FINANCE
DECISONS
INVESTMENTINVESTMENT RISK MGTRISK MGTFINANCINGFINANCING
CAPITAL
PORTFOLIO
M&ADEBT EQUITY
TOOLS
MEASUREMENT
Copyright ©2003 Ian H. Giddy Introduction 7
Leveraged Financing
Leveraged Finance is the provision of bank loans and the issue of high yield bonds to fund acquisitions of companies or parts of companies by
an existing internal management team (a management buy-out),
an external management team (a management buy-in), or
a third party (a leveraged acquisition).
Copyright ©2003 Ian H. Giddy Introduction 8
Leveraged Finance is For Companies with Unused Debt Capacity
Leveraged buyout?
Company has
unused debt
capacity Leveraged
recapitalization?
Takeover?
Copyright ©2003 Ian H. Giddy Introduction 9
Typical LBO Sequence
Company gets bloated or slack and stock price falls
LBO offer made
LBO completed
Restructuring Efficiencies Divestitures Financial
? years 3-9 months 5-7 years
IPO or sale of company
LBO financing lined up
Copyright ©2003 Ian H. Giddy Introduction 10
LBO: A Temporary Capital Structure
COST
OF
CAPITAL
DEBT
RATIO
Stage 1: Pre-LBO
Stage 4: Debt paydown
Stage 2: LBO financing
Stage 3: LBO refinancing
Copyright ©2003 Ian H. Giddy Introduction 11
12-Step Method
Evaluating cost of deal Estimating borrowing capacity Estimating cash costs of funding Estimating growth rates of sales, expenses,
etc Projecting cash flows (FCFF and FCFE) Projecting debt amortization Calculating terminal value of FCFE and FCFF Estimating costs of capital to find PV Making sense of the deal
Copyright ©2003 Ian H. Giddy Introduction 12
Cost of the Deal
Estimating cost of deal
Shares 10Price 45$ Premium 15%Equity cost 518$ Debt cost 55$ Fees 5% 29$ Capex & restructuring 10% 57$ Total cost of deal 658$
lbocapacity.xls
Copyright ©2003 Ian H. Giddy Introduction 13
Borrowing Capacity
Estimating borrowing capacity
Given:EBIT 95$ Min EBIT int coverage ratio 1.3Interest capacity 73$ Interest rate 16.00%Debt capacity 457$
From table
lbocapacity.xls
Copyright ©2003 Ian H. Giddy Introduction 14
Cost of Debt
Estimating the cost of debtEnter the type of firm = 2 (1 if large manufacturing firm, 2 if smaller or riskier firm)EBIT 95$ Current interest expenses = 73$ Current long term government bond rate = 0.06OutputInterest coverage ratio = 1.3Estimated Bond Rating = CCCEstimated Default Spread = 10%Estimated Cost of Debt = 16%
For large manufacturing firms For smaller and risk ier firmsIf interest coverage ratio is If interest coverage ratio is> ≤ Rating is Spread is > ≤ Rating is Spread is
-100000 0.199999 D 0.14 -100000 0.499999 D 0.140.2 0.649999 C 0.127 0.5 0.799999 C 0.127
0.65 0.799999 CC 0.115 0.8 1.249999 CC 0.1150.8 1.249999 CCC 0.1 1.25 1.499999 CCC 0.1
1.25 1.499999 B- 0.08 1.5 1.999999 B- 0.081.5 1.749999 B 0.065 2 2.499999 B 0.065
1.75 1.999999 B+ 0.0475 2.5 2.999999 B+ 0.04752 2.499999 BB 0.035 3 3.499999 BB 0.035
2.5 2.999999 BBB 0.0225 3.5 4.499999 BBB 0.02253 4.249999 A- 0.02 4.5 5.999999 A- 0.02
4.25 5.499999 A 0.018 6 7.499999 A 0.0185.5 6.499999 A+ 0.015 7.5 9.499999 A+ 0.0156.5 8.499999 AA 0.01 9.5 12.5 AA 0.018.5 100000 AAA 0.0075 12.5 100000 AAA 0.0075lbocapacity.xls
Copyright ©2003 Ian H. Giddy Introduction 15
Capital Structure
Preliminary capital structure
Debt 457$ Missing 177$ Mgt equity 25$ Total financing 658$
lbocapacity.xls
Copyright ©2003 Ian H. Giddy Introduction 16
LBO Financing
NEWCO
Cost of
purchasing
the
business Equity $25
Senior
debt $457 What securities?
What returns?
What investors?Mezzanine
Copyright ©2003 Ian H. Giddy Introduction 17
Mezzanine
Asset-backed or cash flow-backed debt Senior debt Subordinated debt with high yield Subordinated debt with upside
participation Subordinated debt with equity option Preferred equity with warrants or
conversion options Restricted shares Common stock
Copyright ©2003 Ian H. Giddy Introduction 18
Why Venture Capitalists Prefer Preferred
Senior status in bankruptcy Does not put a value on the shares Is convertible into common stock before
the IPO Conversion price is set such that if there
is a liquidation all the money goes to the preferred shareholders (equity is worth zero)
Copyright ©2003 Ian H. Giddy Introduction 19
Cash Flows and Debt Repayment
Cash Flows and debt repayment0 1 2 3 4 5
EBIT 110$ 117 124 131 135Borrowed 437$ Interest 61 52 42 31 18 Tax 35% 17 22 28 35 41 Add depr - Capex 30 30 30 30 30Cash avail to repay debt 62 72 83 95 106 Remaining debt 375 303 220 125 19
Copyright ©2003 Ian H. Giddy Introduction 20
Exit
Company gets bloated or slack and stock price falls
LBO offer made
LBO completed
Restructuring Efficiencies Divestitures Financial
? years 3-9 months 5-7 years
IPO or sale of company
LBO financing lined up
0 1 2 3 4 5IPO @ 6xEBIT 810VCs take (135) 0 0 0 0 729Managers (15)$ 0 0 0 0 81IRR 40%
Copyright ©2003 Ian H. Giddy Introduction 21
Case Study: Cap des Biches
Bank debt and equity-linked structured financing in the context of leveraged buyout financing, including valuation and exit strategies. Mezzanine and VC financing.
What financial structure enables the acquiring group to retain control?
What is the cost of financing? “How much equity should/must our client give
up in order to get the funding we need?”
Copyright ©2003 Ian H. Giddy Introduction 22
Case Study: Cap des Biches (B)
The LBO Proposal Devise a recommended financing plan
GTI (owner)
Buyers Other Investors
Copyright ©2003 Ian H. Giddy Introduction 23
Bank loans Loan from seller Private equity investors Family money
Financing Sources
Copyright ©2003 Ian H. Giddy Introduction 26
Financing a Growing Company
How fast can we grow? How should we finance our growth?
What kind of equity financing? What’s our exit plan? A public offering?
Do we want money, management, or more?
What’s our company worth?
How can we make it worth more?
Copyright ©2003 Ian H. Giddy Introduction 27
Corporate Financing Life-Cycle
Growth companies Mature companies
Leverage
Copyright ©2003 Ian H. Giddy Introduction 28
First, Why Equity?
Benefits of EquityFlexibility: cannot afford to have fixed
obligationsStrategic partnersInterventionist partners
DisadvantagesNo tax shieldExpensive!
Copyright ©2003 Ian H. Giddy Introduction 29
What Kind of Equity?
Sources of EquityPrivate investorsStrategic investorsInterventionist investorsPublic market
And KindsCommon stockStock with restricted voting rightsHybrids, including convertibles
Copyright ©2003 Ian H. Giddy Introduction 30
messageclick
Started in September 1997, messageclick enables users to send faxes and receive faxes over the internet at a low cost.
By June 1998 the company had expanded its services and was signing up subscribers at the rate of 100,000 a day.
Initial funding was “Angel” finance, but now the expansion was exceeding the company’s financial, physical and managerial capacity. On two occasions it had literally run out of money.
What form of equity financing would be appropriate for messageclick?
Copyright ©2003 Ian H. Giddy Introduction 31
Pre-IPO Equity Financing
Friends and family Angel Venture capital Strategic partners
Copyright ©2003 Ian H. Giddy Introduction 32
Private Equity Funds
Private equity funds are generally structured as partnerships specializing in venture capital, leveraged buyouts, and corporate restructuring.
The private equity fund mobilizes funds, selects and monitors investments, eventually exiting the investment and paying back the investors.
Copyright ©2003 Ian H. Giddy Introduction 34
Silipos Inc, 1999
Where do you want
to go?
Debt?Debt?
Acquisition?Acquisition?
IPO?IPO?
Sell?Sell?
Copyright ©2003 Ian H. Giddy Introduction 36
IntraLinks’ Choices
Issue debt, either by borrowing from one of the big New York banks keen to get more involved in promising Internet businesses, or by means of a private placement of debt notes, possibly with “sweeteners” such as warrants to attract a lender.
Seek out one or more private equity investors, ones who believed in the company’s product and its management.
Do an initial public offering (IPO). Find another corporation who would be willing to
acquire IntraLinks.
Copyright ©2003 Ian H. Giddy Introduction 41
EquityBanking Fixed Income
Investment Banking: Organizarion
“Coverage”
•Corporate Finance•Mergers & Acquisitions•Investment Banking
Debt Capital Markets (DCM)
•Syndicate•Marketing
Sales•Institutional•Retail
Trading (proprietary)•Risk •Profits
Structured FinanceCredit ResearchPrivate PlacementLoan Syndication
Equity Capital Markets (ECM)
•Sales•Trading•Research
Copyright ©2003 Ian H. Giddy Introduction 42
Investment Banking: Organization
New Deal Pitch Team Coverage/
Investment banking Product (DCM or
ECM)
Commitment Committee Investment banking ECM/DCM Senior sales/trading Research
Copyright ©2003 Ian H. Giddy Introduction 43
Underwriting Sequence
Engagement: Mandate signed by issuer engaging lead manager
Due Diligence: Conducted by Lead manager
Documentation: Loan agreement, Prospectus
Signing: Underwriting agreement signed and issue priced
Closing: Settlement of the offering
EngagementEngagement
Due Diligence and
Documentation
Due Diligence and
Documentation
Signing and PricingSigning and Pricing
ClosingClosing
“Beauty Contest”“Beauty Contest”
Copyright ©2003 Ian H. Giddy Introduction 44
The Beauty Contest
Criteria for Selecting a Lead Manager 1 Experience with similar transactions (sector,
market, currency, maturity, high or low-quality issuers)
Ranking in League Tables Placement power with institutional and/or
retail investors Standing in secondary market as “market
maker” and commitment to secondary market trading
Copyright ©2003 Ian H. Giddy Introduction 45
The Beauty Contest (Cont.)
Criteria for Selecting a Lead Manager 2 Quality/reputation of research Proposed marketing strategy (pricing,
timing, issue size, etc.) Proposals for “Roadshow” Relationships with potential co-
managers Senior management commitment to
backing issue with people and capital
Copyright ©2003 Ian H. Giddy Introduction 46
The Roadshow
Organized by global coordinator and lead managers
Informal presentation by management to potential investors
Attendance limited to professional intermediaries and investing institutions
Content must be consistent with information in draft version of prospectus or offering circular.
Copyright ©2003 Ian H. Giddy Introduction 47
Distribution
Lead ManagerBook-Runner
“International Coordinator
Joint Co-Lead
ManagerJoint Co-Lead
ManagerJoint Co-Lead
Managers
Lead
ManagerLead
ManagerLead
Managers
ManagerManagerManagers Selling Agent
Co-Lead Manager
Question:Which banks are involved with an IPO, and what are their roles?
Copyright ©2003 Ian H. Giddy Introduction 48
Issuing Equity: Key Players
MANAGERSUNDER-
WRITERS
SELLING
GROUP
Copyright ©2003 Ian H. Giddy Introduction 49
Securities Underwriting: Relationships
Issuer
Agents Investment Bankers
Debt: Fiscal agent
Equity:
Depositary institution
Lead manager/Bookrunner
Registered offering: Underwriting Agreement
Unregistered: Purchase Agreement
Co-managers
Agreement Among Underwriters
Prospectus/Offering Circular
Institutional Buyers Retail Buyers
Copyright ©2003 Ian H. Giddy Introduction 50
Subscription or Underwriting Agreement Between issuer, global coordinator and all managers Signed after pricing when “book-building” completed Firm commitment to underwrite, subject to delivery of
certain confirmatory certificates and no “material adverse change” or “force majeure”
Indemnity: By the issuer in favor of Global Coordinator and Managers against liability arising as a breach of warranty, material inaccuracy or omission
Lock up: Issuer will not offer other securities for a period of time (eg six months)
Copyright ©2003 Ian H. Giddy Introduction 51
Underwriting Economics
Selling Concession
60%
Underwriting Fee20%
Management Fee20%
Management Fee: Normally shared equally among managers (may be subject to a praecipium for Global Coordinator or Lead Manager)
Selling Concession: Payable as a percentage of allocation (determined by book-runner)
Underwriting Fee: Based on underwriting commitment (often less expenses of offering)
Copyright ©2003 Ian H. Giddy Introduction 52
Pricing
Debt Instruments Bonds priced according
to yield over benchmark (spread)
Yield too low – issue does not sell
Yield too high – too much given away
Generally syndicate holds price for a day; in a successful issue yields gradually tighten
Equity Mature issue: based on
current market price and market conditions, small premium for dilution; comparables
IPO: comparables and discounted cash flow analysis
Copyright ©2003 Ian H. Giddy Introduction 53
Pricing and Fees
The Business Telecoms Dot-Coms Avons(How much volatility?)
Debt
Equity
Fees
0.15%
to
1.5%
5% to
7%
PricingT+Spread
L+Spread
Comparables/Ratios
The market
Future cash flow valuation
The Issuer
Copyright ©2003 Ian H. Giddy Introduction 56
Valuing a Firm with DCF
Historical financial results
Adjust for nonrecurring aspects
Gauge future growth
Adjust for noncash items
Projected sales and operating profits
Projected free cash flows to the firm (FCFF)
Year 1 FCFF
Year 2 FCFF
Year 3 FCFF
Year 4 FCFF
Terminal year FCFF
Stable growth model or P/E comparable
Present value of free cash flows
+ cash, securities & excess assets
- Market value of debt
Value of shareholders equity
…
Discount to present using weighted average cost of capital (WACC)
Copyright ©2003 Ian H. Giddy Introduction 57
What’s a Company Worth?
Required returns Types of Models
Balance sheet modelsComparablesCorporate cash flow models
Estimating Growth Rates Applications Option-based models
Copyright ©2003 Ian H. Giddy Introduction 60
Equity Valuation: From the Balance Sheet
Value of AssetsBookLiquidationReplacement
Value of Liabilities
BookMarket
Value of Equity
Copyright ©2003 Ian H. Giddy Introduction 61
Equity Valuation: From the Balance Sheet
Value of AssetsBookLiquidationReplacementOr what?
A New York City study estimated that the 322 trees surveyed had an average value of $3,225 per tree and a total value of $1,038,458. The value was said to be the amount the city would have to pay to replace the tree. (New York Times, 12 May 2003)
Copyright ©2003 Ian H. Giddy Introduction 62
Relative Valuation
In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cashflows, book value or revenues. Examples include:
• Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples,
Cash Flow multiples)
• Price/Book (P/BV) ratios and variants (Tobin's Q)
• Price/Sales ratios
Copyright ©2003 Ian H. Giddy Introduction 63
Comparables
Value Indicator Earnings Cash Flow Revenues Book
Value Indicator Earnings Cash Flow Revenues Book
Average Comparable Industry Firms Deals
Average Comparable Industry Firms Deals
Target
Company
Numbers or
Projections
Target
Company
Numbers or
Projections
Estimated
Value of
Target
Estimated
Value of
Target
Copyright ©2003 Ian H. Giddy Introduction 67
Discounted Cashflow Valuation: Basis for Approach
where n = Life of the asset CFt = Cashflow in period t r = Discount rate reflecting the
riskiness of the estimated cashflows
Value = CFt
(1+ r)tt =1
t = n
Copyright ©2003 Ian H. Giddy Introduction 68
Equity Valuation in Practice
Estimating discount rate Estimating cash flows Estimating growth Application with constant growth: Optika Application with shifting growth: IBM
Copyright ©2003 Ian H. Giddy Introduction 69
Start with theWeighted Average Cost of Capital
Choice Cost1. Equity Cost of equity
- Retained earnings - depends upon riskiness of the stock
- New stock issues - will be affected by level of interest rates
- Warrants
Cost of equity = riskless rate + beta * risk premium
2. Debt Cost of debt
- Bank borrowing - depends upon default risk of the firm
- Bond issues - will be affected by level of interest rates
- provides a tax advantage because interest is tax-deductible
Cost of debt = Borrowing rate (1 - tax rate)
Debt + equity = Cost of capital = Weighted average of cost of equity and
Capital cost of debt; weights based upon market value.
Cost of capital = kd [D/(D+E)] + ke [E/(D+E)]
Copyright ©2003 Ian H. Giddy Introduction 70
IBM’s Cost of Capital
IBM
Cost of Capital Cost Amount Weight
Debt10-year bond yield 4.95%Tax rate 29%After-tax cost 3.5% 61.9 31%
EquityRisk-free Treasury 4.50%Beta 1.47Market Risk Premium 5.50%From CAPM 12.6% 137.4 69%
Total 9.77% 199.3
Source: IBMfinancing.xls
Copyright ©2003 Ian H. Giddy Introduction 71
Valuation: The Key Inputs
A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.
Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:
Value = CF
t
(1+ r)tt = 1
t =
Value = CFt
(1 + r)t
Terminal Value
(1 + r)N
t = 1
t = N
Copyright ©2003 Ian H. Giddy Introduction 72
Finding Free Cash Flows
Revenue- Expenses- Depreciation
= EBITAdjust for tax: EBIT(1-T)
+ Depreciation- Capex- Ch working capital
= Free Cash Flows to Firm
Revenue 81.20
-Expenses (67.99)
-Depreciation (4.95)
EBIT 8.26
EBIT(1-t) 5.90
+Depreciation 4.95
-CapEx (4.31)
-Change in WC (0.90)
FCFF 5.64
Copyright ©2003 Ian H. Giddy Introduction 73
Deriving IBM’s Free Cash Flows
Data 4Q02ttmSales, ttm 81.20$ billionOperating costs 67.99$ billion 84%Depreciation 4.95$ billionEBIT 8.26$ billionTax 2.36$ billion 29%Cap Ex 4.31$ billionChange in WC 0.90$ billionInterest expense 0.15$ billion
Free Cash Flows $bRevenue 81.20
-Expenses (67.99)
-Depreciation (4.95)
EBIT 8.26
EBIT(1-t) 5.90
+Depreciation 4.95
-CapEx (4.31)
-Change in WC (0.90)
FCFF 5.64
Interest 0.15$
FCFE 5.49$ IBMvaluation.xls
Copyright ©2003 Ian H. Giddy Introduction 74
Choosing a Growth Pattern: Examples
Company Valuation in Growth Period Stable Growth
PWC Nominal U.S. $ 10 years 6%(long term Firm (3-stage) nominal growth
rate in the world economy
DirecTV Nominal US$ 5 years 4%: based upon Equity: FCFE (2-stage) expected long term
US growth rate
Allianz Nominal Euro 0 years 3%: set equal to Equity: Dividends nominal growth
rate in the Europeaneconomy
Copyright ©2003 Ian H. Giddy Introduction 75
Valuing a Firm with DCF: The Short Version
Historical financial results
Adjust for noncash items
Projected sales and operating profits
Free cash flows to the firm (FCFF)
Calculate weighted average cost of capital (WACC)
Estimate stable growth rate (g)
Present value of free cash flows
- Market value of debt
Value of shareholders equity
Discount to present using constant growth model
FCFF(1+g)/(WACC-g)
Copyright ©2003 Ian H. Giddy Introduction 76
Constant Growth Model
gr
gCFVo
o
)1(
gr
gCFVo
o
)1(
g = constant perpetual growth rate
Copyright ©2003 Ian H. Giddy Introduction 77
Constant Growth Model: Example
gr
gCFVo
o
)1(
gr
gCFVo
o
)1(
CF0 = $3.00 r = 12% g = 4%
V0 = 3.12/(.12 - .04) = $39.00
Motel 6 has cash flows available to shareholders of $3 per share. The required return that shareholders expect is 12%
The earnings are expected to grow at 4% per annum
What’s an M6 share worth?
Motel 6 has cash flows available to shareholders of $3 per share. The required return that shareholders expect is 12%
The earnings are expected to grow at 4% per annum
What’s an M6 share worth?
Copyright ©2003 Ian H. Giddy Introduction 78
Optika: Facts
The firm has revenues of €3.125b, growing at 5% per annum. Costs are estimated at 89%, and working capital at 10%, of sales. The depreciation expense next year is calculated to be €74m.
Optika’s marginal tax rate is 35%, and the interest on its €250m of debt is 8.5%.
The market value of equity is €1.3b. Is this firm fairly valued in the market? What
assumptions might be changed?
Copyright ©2003 Ian H. Giddy Introduction 79
Growth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt Spread 1.50%Market risk premium 5.50%
T+1Revenues next year 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187+Depreciation 74-Capital Expenditures -74-Change in WC -16-Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%
Firm Value 2681
Equity Value 2431
Optika
optika.xls
Copyright ©2003 Ian H. Giddy Introduction 80
Growth 5%Tax rate 35%Initial Revenues 3125COGS 89%WC 10%Equity Market Value 1300Debt Market Value 250Beta 1Treasury bond rate 7%Debt Spread 1.50%Market risk premium 5.50%
T+1Revenues next year 3281-COGS 2920-Depreciation 74=EBIT 287EBIT(1-Tax) 187+Depreciation 74-Capital Expenditures -74-Change in WC -16-Free Cash Flow to Firm 171Cost of Equity (from CAPM) 12.50%Cost of Debt (after tax) 5.53%WACC 11.38%
Firm Value 2681
Equity Value 2431
Optika
CAPM:
7%+1(5.50%)
Debt cost
(7%+1.5%)(1-.35)
WACC:
ReE/(D+E)+RdD/(D+E)
Value:
FCFF/(WACC-growth rate)
Equity Value:
Firm Value - Debt Value
= 2681-250 = 2431
optika.xls
Copyright ©2003 Ian H. Giddy Introduction 81
Valuing a Firm with DCF: The Extended Version
Historical financial results
Adjust for nonrecurring aspects
Gauge future growth
Adjust for noncash items
Projected sales and operating profits
Projected free cash flows to the firm (FCFF)
Year 1 FCFF
Year 2 FCFF
Year 3 FCFF
Year 4 FCFF
Terminal year FCFF
Stable growth model or P/E comparable
Present value of free cash flows
+ cash, securities & excess assets
- Market value of debt
Value of shareholders equity
…
Discount to present using weighted average cost of capital (WACC)
Copyright ©2003 Ian H. Giddy Introduction 82
Shifting Growth Rate Model
T
TT
tt
t
oorgr
gCF
r
gCFV
)1)((
)1(
)1(
)1(
2
2
1
1
T
TT
tt
t
oorgr
gCF
r
gCFV
)1)((
)1(
)1(
)1(
2
2
1
1
g1 = first growth rate
g2 = second growth rate
T = number of periods of growth at g1
Copyright ©2003 Ian H. Giddy Introduction 83
Mindspring pays cash flows of $2 per share. The required return that shareholders expect is 15%
The dividends are expected to grow at 20% for 3 years and 5% thereafter
What’s a Mindspring share worth?
Mindspring pays cash flows of $2 per share. The required return that shareholders expect is 15%
The dividends are expected to grow at 20% for 3 years and 5% thereafter
What’s a Mindspring share worth?
Shifting Growth Rate Model: Example
CF0 = $2.00
g1 = 20% g2 = 5%
r = 15% T = 3
V0 = CF1/(1.15)+CF2/(1.15)2+CF3/(1.15)3
+ CF4/(15%-5%)(1.15)3
= 2.40/(1.15)+2.88/(1.15)2+3.46/(1.15)3
+ 3.63/(.15-.05)(1.15)3
= $30.40
Copyright ©2003 Ian H. Giddy Introduction 85
Case Study: IBM
Constant growth model valuation:FCFF 5.64WACC 9.77%Growth rate 5.70%
Firm Value 146.51 billionless debt -61.86 billionEquity value 84.65 billion divided by 1.69 gives 50.09$ per share
2-stage growth model valuationStage 1 10%Stage 2 5.70%
End of year 2002 2003 2004 2005 2006 2007 2008Revenue 81.20 89.32 98.25 108.08 118.88 130.77 138.23-Expenses -67.99 -74.79 -82.27 -90.49 -99.54 -109.50 -115.74-Depreciation -4.95 -5.45 -5.99 -6.59 -7.25 -7.97 -6.94EBIT 8.26 9.09 9.99 10.99 12.09 13.30 15.55EBIT(1-t) 5.90 6.49 7.14 7.85 8.64 9.50 11.10+Depreciation 4.95 5.45 5.99 6.59 7.25 7.97 6.94-CapEx -4.31 -4.74 -5.22 -5.74 -6.31 -6.94 -6.94-Change in WC -0.90 -0.99 -1.09 -1.20 -1.32 -1.45 -1.53FCFF 5.64 6.20 6.82 7.51 8.26 9.08 9.57
235.25Total 6.20 6.82 7.51 8.26 244.34PV 5.65 5.66 5.68 5.69 153.32Total PV 176.00less debt -61.86 billionEquity value 114.13 billion divided by 1.69 gives 67.53$ per share
IBMvaluation.xls
Copyright ©2003 Ian H. Giddy Introduction 86
Application to a Private Firm: “Argus”
The company is in the advertising and public relations business. It is privately owned, but the other major competitors are publicly traded.
It has grown rapidly but growth is leveling off to about 3-6%. Interest on Argus’ €16 million debt is €2.4 million and EBITDA is €12 million.
How would you estimate the company’s Future growth rates? Beta? Cost of Equity? Cost of debt? Firm value?
Copyright ©2003 Ian H. Giddy Introduction 87
Source: www.damodaran.com
(Updated data)
Copyright ©2003 Ian H. Giddy Introduction 88
Analyzing a Private Firm
The approach remains the same with important caveats It is more difficult estimating firm value, since the
equity and the debt of private firms do not trade; we use comparables
Most private firms are not rated; we have to estimate a rating to get the cost of debt
If the cost of equity is based upon the market beta of comparable companies, it is possible that we might be underestimating the cost of equity, since private firm owners often consider all risk.
Copyright ©2003 Ian H. Giddy Introduction 91
Equity Valuation in an Acquisition
Estimating synergies Estimating business restructuring Estimating financial restructuring Application to Basix Valuation in a bidding context
Copyright ©2003 Ian H. Giddy Introduction 92
The Gains From an Acquisition
Gains from merger
Synergies Control
Top line Financial
restructuring
Business
Restructuring
(M&A)
Bottom line
Copyright ©2003 Ian H. Giddy Introduction 93
The Basics
IBM is considering the acquisition of Basix, Inc. The shares are trading at a P/E of 11, far below IBM’s P/E of 18. Based on past performance the company is expected to earn $2 per share next year, an increase from the current EPS of $1.93. If IBM acquires Basix, the long-run EPS growth rate could be raised to 5.5%. The Treasury bond yield is 4.5%, the company’s beta is 1.3 and the long run market return is 11.5%. Is the company worth buying at a P/E of 12? At how much of a premium should we say fugedaboudit?
Copyright ©2003 Ian H. Giddy Introduction 94
Basix
Use constant growth model
Before AfterEarnings 1.93$ 1.93$ Next year 2.00$ 2.00$ Growth rate 3.6% 5.5%Risk free rate 4.50% 4.50%Beta 1.3 1.30 Market return 11.50% 11.50%Req ret on equity 13.60% 13.60%Value 20.05$ 24.69$ P/E 10.4 12.8Price 21.23$ 16%
Source: basix.xls
Copyright ©2003 Ian H. Giddy Introduction 95
M&A and Leverage: Flexics
Leveraged buyout?
Company has
unused debt
capacity Leveraged
recapitalization?
Takeover?
Copyright ©2003 Ian H. Giddy Introduction 98
Contact
Prof. Ian Giddy
NYU Stern School of Business
44 West 4th Street
New York, NY 10012
Tel 212-998-0563; Fax 212-995-4233
www.giddy.org