Corporate Finance Valuation Methods

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Questions and Answers

What is the formula for calculating the value of equity?

Value of Equity = Firm value - Debt value

How is the value of equity obtained using expected cash flows?

It is calculated by discounting expected cash flow to equity at the cost of equity.

Define the term 'weighted average cost of capital' (WACC).

WACC is the average rate of return a firm is expected to pay its security holders, weighted by the proportions of each source of financing.

What is meant by 'expected cash flow to the firm' (FCFF)?

FCFF refers to the residual cash flow after all operating expenses and taxes are paid, before any debt payments. Signup and view all the answers

Explain the concept of constant growth DCF models.

Constant growth DCF models assume that free cash flows will grow at a constant rate indefinitely. Signup and view all the answers

What role do expenses, tax obligations, interest, and principal payments play in calculating FCFE?

They must be met before determining the expected cash flows available to equity, which are used in FCFE calculations. Signup and view all the answers

In equity valuation, how is the cost of equity defined?

The cost of equity is the rate of return required by equity investors in the firm. Signup and view all the answers

What is the significance of discounting expected cash flows in firm valuation?

Discounting expected cash flows accounts for the time value of money and reflects the present value of future cash flows. Signup and view all the answers

What is the primary goal of the two-stage DCF model?

The primary goal is to estimate a firm's value by projecting free cash flows in two stages: an initial high-growth period followed by a stable growth phase. Signup and view all the answers

How can one forecast FCFF and FCFE using historical data?

By applying a constant growth rate to historical free cash flows, assuming that growth will remain constant and firm fundamentals will not change. Signup and view all the answers

What are two alternatives for a firm with positive FCFF?

Retain cash to increase balances of cash and marketable securities or use the cash for payments to providers of capital. Signup and view all the answers

Explain the role of growth rates in the two-stage FCFE model.

Growth rates in the FCFE model dictate how free cash flows are projected in both the high-growth and stable growth phases, influencing the calculated equity value. Signup and view all the answers

What is a key difference between FCFF and FCFE?

FCFF represents cash flows available to all capital providers, while FCFE represents cash flows available specifically to equity shareholders. Signup and view all the answers

Identify one option a firm has to cover negative cash flows.

A firm can draw down existing cash balances to cover negative cash flows. Signup and view all the answers

What components should be forecasted to estimate future FCFF?

Sales growth, future capital expenditures, depreciation expenses, and changes in working capital should be forecasted. Signup and view all the answers

Why might a firm choose to issue equity in response to negative cash flows?

A firm might issue equity to raise capital without taking on additional debt, thereby avoiding increased financial obligations. Signup and view all the answers

What formula is used to calculate the firm value when FCFF grows at a constant rate?

The firm value is calculated as $\frac{FCFF_1}{WACC - g}$. Signup and view all the answers

How is the weighted average cost of capital (WACC) calculated in this context?

WACC is calculated using the formula $0.25 \times 0.07 \times (1 - 0.30) + 0.75 \times 0.12$. Signup and view all the answers

What is the given tax rate in the provided data?

The tax rate is given as 30%. Signup and view all the answers

Calculate the firm's value if the current FCFF is $6,000,000$, WACC is approximately $10.23%$, and g is $5%$.

The firm's value is approximately $120.5$ million. Signup and view all the answers

What is the value of equity given a firm value of $120.5$ million and total debt of $30$ million?

The value of equity is $90.5$ million. Signup and view all the answers

How many shares are outstanding as mentioned in the data?

There are 2,900,000 shares outstanding. Signup and view all the answers

What is the required return on equity given in the data?

The required return on equity is 12%. Signup and view all the answers

What is the resulting equity value per share based on total equity value of $90.5$ million and $2,900,000$ shares?

The equity value per share is approximately $31.21$. Signup and view all the answers

Study Notes

Corporate Finance Lecture Notes

This lecture covers valuing businesses, focusing on the difference between value and price.
Valuation methods are discussed, including the DCF method.

Why Business Valuation?

Business valuation is crucial for evaluating strategic business decisions, communicating with analysts and shareholders, and appraising private businesses.
It's used to determine the impact of new strategies, understand how firm value is affected, and assess the value of private firms and equity compensation.
Corporate valuations are also essential for evaluating corporate events, including mergers.

Price vs. Value

Price represents the agreed market value of an asset.
Value is a subjective estimate of an asset's intrinsic worth.
Going-concern value assesses a firm's value assuming continued operation and optimal use of assets and financing.
Liquidation value is the worth of the firm's assets sold separately, assuming the business ceases operations.
Value usually exceeds market price, indicating potential undervaluation.
Value can be added through asset synergies or managerial skills.

Price vs. Value (continued)

Market price may not always reflect the intrinsic value of an asset.
Analyst estimations of intrinsic value can identify overvaluation or undervaluation compared to the market price.

"Value" and "Price" Differences

Price-earning ratios can be useful for stock return predictions.
However, adjustments might require waiting for several years to reflect actual value.

Principles in Valuing Businesses

Understanding the business involves industry and competitive analysis, and financial statement analysis.
Forecasting company performance includes projecting sales, earnings, dividends, and financial position.
Selecting the appropriate valuation model depends on the characteristics of the company.
Valuation models include present value models (dividend discount models, free cash flow to equity/firm), asset-based models, and residual income models.

Valuation Models

Absolute valuation models, like present value models, dividend discount models, and residual income models provide an estimated value based on discounted future cash flows.
Relative valuation models, like price ratios (price-to-earnings, price-to-book-value, price-to-cash-flow), and enterprise value multiples, assess value by comparing the company to market benchmarks.

Cashflow Discounting Models

Discounted cash flow (DCF) valuation uses time value of money to determine the present value of future cash flows.
The formula for calculating present value is Vo = Σ (CFt / (1 + r)t), where CFt = cash flow in period t, r = discount rate, and n = the asset's lifespan.

Present Value of Future Cash Flows - Example

Calculation examples are provided showing an asset generating future cash flows.

Dividend Discount Model

The dividend discount model values a stock based on the present value of future dividends.
The formula is Vo = Σ (Dt / (1 + r)t) + Pn / (1 + r)n.

Dividend Discount Model - Example

Numerical examples of calculating the value of a stock based on expected future dividends and terminal value are detailed.

Gordon Growth Model

The Gordon growth model calculates the present value of a stock by assuming constant dividend growth rate.
The formula for the valuation of the stock is Vo = D1 / (r − g).

Gordon Growth Model - Example

Uses the example of Sonoco Products Company to demonstrate the application of the Gordon growth model.

Estimating Growth Rate

Different ways to estimate the growth rate include industry averages, macroeconomic averages, and the Dupont formula.

Sustainable Growth Rate

The sustainable growth rate for a stock considers the dividend growth rate, earnings retention rate, and return on equity.
The sustainable growth rate is calculated as: g = b × ROE

Business Life Cycle and Division Growth Sustainability

The business life cycle phases (growth, transition, maturity) are considered to determine the dividend and growth rate sustainability of the business model.

Two-stage Dividend Discount Model

It accounts for varying dividend growth rates, enabling accurate estimation of value during transition phases.
Specific equations for firm value and equity value are provided which incorporate the appropriate time value factors.

Forecasting FCFF and FCFE

The underlying components of free cash flow are forecasts using historical data and applying growth rates to project future values.

Uses of Free Cash Flows

Positive FCFF can be used for retaining cash, covering debt payments, or equity payments.
Negative FCFF might require drawing down cash reserves, borrowing funds, or issuing equity.

Which Cashflow? Choice of DCF Models

Different DCF models are suitable for different types of firms, with dividend discount models suitable for firms with consistent dividend history, free cash flow models preferable for firms with sizable and positive cash flows, and residual income models ideal for firms with uncertain cash flows.

Criticism of DCF Models

DCF models, while useful, have limitations in a world with very low risk-free rates. Specifically, there is difficulty projecting values further out in time.
Accurately projecting future cash flows accurately and dealing with the implications when discount rates are extremely low presents a problem for valuation modeling.

Main Readings

The provided slides list resources such as chapters in BM EA (or similar financial management texts) and BD (or similar finance texts) for further study.

Equity Valuation

Equity value is derived by subtracting the value of debt from the firm's total value.
Equity valuation can also be obtained by discounting expected cash flow to equity at the cost of equity.

Firm Valuation

Firm value is determined by discounting expected cash flow to the firm at the Weighted Average Cost of Capital (WACC).

Constant Growth DCF Models

Applying constant growth rates to free cash flows assists in calculating firm and equity value within the present value model.
Relevant equations and formulas are provided.

Single-Stage DCF Model

This model demonstrates a single-stage calculation of firm and equity values, and includes an example with specific financial values inputted.

Two-Stage DCF Models

Two-stage models adjust for different growth phases, calculating firm value and equity value based on differing expected growth forecasts.

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Description

This quiz explores crucial concepts in corporate finance, particularly the methodologies for valuing businesses. Emphasizing the distinction between price and value, it reviews various valuation techniques, including the DCF method. By understanding these principles, you will grasp the importance of business valuation in decision-making and strategic planning.