Corporate finance - Riassunti

Comparison of Methods

WACC: typically, the WACC method is the easiest to use when the firm will maintain a fixed debt to value ratio over the life of the investment.

APV: for alternative leverage policies, the APV method is usually the simplest approach.

FTE: the FTE method is typically used only in complicated settings where the values in the firm's capital structure or the interest tax shield are difficult to determine.

Project-Based Cost of Capital

For all these computations, we have assumed that the project has an average risk, as the other projects of the firm.

In the real world, a specific project may have different market risk than the average project for the firm.

In addition, different projects may vary in the amount of leverage they will support.

If the riskiness of the project is different from the riskiness of the firm, we cannot use the WACC or the unlevered cost of capital (r ).

In this case we have to look at another cost of capital, such as the one of the

The net effect will be close to 40%. So, when we evaluate this project we don't use the 90% but we use the 40%.

The following important concepts should be considered when determining a project's incremental financing:

• Cash is a negative debt
• A fixed pay-out policy implies 100% debt financing. A fixed pay-out policy implies that we have payments to the shareholders that do not depend by the FCF. The only source of financing is the debt itself and any requirement of the project will be founded using the firm's cash or with additional borrowing. If the project generates cash flows, this will be used to reduce this debt.
• Optimal leverage depends on project and firm characteristics
• Safe cash flows can be 100% Debt Financed

OTHER EFFECTS OF FINANCING

When a firm raises capital by issuing securities, the banks that provide the loan or underwrite the sale of the securities charge fees. These fees should be included as part of the project's required investment.

reducing the NPV of the project.

SECURITY MISPRICING

If management believes that the securities they are issuing are priced differently than their true value, the NPV of the transaction should be included in the value of the project.

The NPV of the transaction is the difference between the actual money raised and the true value of the securities sold.

If the financing of the project involves an equity issue, and if management believes that the equity will sell at a price that is less than its true value, this mispricing is a cost of the project for existing shareholders.

It should be deducted from the project NPV in addition to other issuance costs.

Example

Gap Inc. is considering borrowing 100 million to fund an expansion. Given investors' uncertainty regarding its prospects, Gap will pay a 6% interest rate on this loan. The firm's management knows that the actual risk of the loan is extremely low and that the appropriate rate on the loan is 5%. Suppose the loan is for 5 years, and the

principal is repaid in the 5 year. If Gap's marginal corporate tax rate is 40%, what is the net effect of the loan on the value of the expansion?

Fair Loan

We discount the cash flows using the 5%, so the NPV is 0

We calculate the interest tax shield knowing that the tax rate is 40% and we discount them at 5% as well.

The benefit of the loan on the project's value is 8,66 million

Actual Loan

As we have to pay 6%, we have higher cash flows, that we discount using the 5%, as it's the appropriate rate. So, we have a negative NPV.

We calculate the interest tax shield like before and, as we have higher cash flows, the tax shield is higher.

The benefit of the loan on the project's value is -4,33 + 10,39 = 6,06 million if we ignored the effect of the misprice, we would have overvalued the loan

FINANCIAL DISTRESS AND AGENCY COSTS

Financial distress and agency costs also impact the cost of capital.

The free cash flow estimates for a project should be adjusted to include expected financial

distress and agency costs.

VALUATION AND FINANCIAL MODELING – A CASE STUDY

Consider Ideko Corporation, a privately held firm. The owner has decided to sell the business.

Our job is to evaluate purchasing the company, implementing operational and financial improvements, and selling the business at the end of five years.

Estimated 2005 income statement and balance sheet

A price of $150 million for Ideko’s equity has been suggested.

The data in the previous slide provides some reassurance that the acquisition price of $150 million is reasonable as the ratios are about the same or better than the industry averages.

However, the cash flows need to be analysed.

Problem with P/E:

• the company is not listed, we are calculating it with the suggested price of 150 million
• when we have losses instead of incomes the ratio becomes meaningless

The difference between EV/Sales and EV/EBIDTA is that EV/Sales does not take into account the costs of the firm. We use EV/EBITDA only if we are confident.

About the information and estimations that we have about the cost structure of the firm. These 2 ratios are not affected by the capital structure. EBIDTA/Sales is called EBIDTA margin and shows the profitability of the firm. Our firm is efficient in translating sales into EBIDTA.

How can we select the group of comparables? We have many criteria:

• Sector: we select firm in the same sector
• Geography: this is irrelevant if the firm operates worldwide
• Size: we select firm with similar size
• Book Market / ROA: we select firms with similar B/M or ROA

Sector and Size are the most important. So, what kind of acquisition prices for Ideko is implied by the range of multiples for P/E, EV/Sales and EV/EBITDA? The range are quite large: this analysis does not provide us a precise value a DCF analysis is needed.

DISCOUNTED CASH FLOWS ANALYSIS

To implement this analysis, we need to make some assumptions, as we need estimates for the future cash flows. We create a business plan:

- By cutting administrative

Costs immediately and redirecting resources to new product development, sales, and marketing, we believe Ideko can increase its market share from 10% to 15% over the next five years. The increased sales demand can be met in the short run using the existing production lines. Once the growth in volume exceeds 50%, however, Ideko will need to undertake a major expansion to increase its manufacturing capacity. Ideko's average selling price is forecast to increase 2% each year. Raw materials are forecast to increase at a 1% rate. Labour costs are forecast to increase at a 4% rate.

Assumptions about the production volume:

Based on this forecast, production volume will exceed its current level by 50% in 2008, necessitating an expansion.

Assumption about the expenditure:

We can see the big investment in 2008.

WORKING CAPITAL MANAGEMENT

Ideko's accounts receivable days is:

This means that accounts receivable represents slightly less than 1/4 of our sales and we need 90 days to make sure that the

sales that we have generate the cash-in flowit takes a lot of time to get the cash from our customers.

The industry average is 60 days and we believe Ideko can tighten its credit policy to achieve the industry average without sacrificing sales.

Ideko's inventory figure on its balance sheet includes $2 million of raw materials.

Given raw material expenditures of $16 million for the year, Ideko currently holds 45.6 days worth of raw material inventory(2 / 16) * 365 = 45.6

We believe that, with tighter controls of the production process, 30 days worth of inventory will be adequate

CAPITAL STRUCTURE CHANGES

We believe Ideko is significantly underleveraged so you plan to increase the firm's debt. The debt will have an interest rate of 6.8% and Ideko will only pay interest during the next five years.

The firm will seek additional financing in 2008 and 2009 associated with the expansion

The forecasted interest expense each year is computed as: Interest in Year t = Interest Rate *

Ending Balance in Year (t - 1)6,8% D_t-1

Giving this particular debt schedule, the debt and the firm's value are not related → we cannot assume that the interest that we pay on the debt (and because of that the interest tax shield) has the same riskiness of the cash flow of the firm.

In addition to the $150 million purchase price for Ideko's equity, $4.5 million will be used to repay Ideko's existing debt. With $5 million in transaction fees, the acquisition will require $159.5 million in total funds.

KKP's sources of funds include the new loan of $100 million as well as Ideko's own excess cash (which KKP will have access to). Thus KKP's r