Chapter 13 - Advanced valuation methods

Question 1

A cash flow valuation may involve the following problems:

Answer 1

• Overseas taxation
• Foreign currency
• Selecting an appropriate cost of capital

Question 2

Overseas taxation as a complication to the cash flow valuation model:

Answer 2

1. Using the cash flows method, the post-tax cash flows of target will be discounted to calculate the NPV of target
2. In cross-border acquisitions, the cash flows may need to be adjusted to reflect the impact of withholding tax & double tax agreements

• Withholding tax = tax paid on remittances to an overseas investor (interest or dividend payments)
• Double tax agreement = agreement between two countries where tax paid on profits made by overseas subsidiary may be tax deductible against same profits in another country
• Group loss relief = group companies surrender both current period and brought forward losses to each other under group relief to reduce a company’s taxable profits

Question 3

Foreign currency as a complication to the cash flow valuation method:

Answer 3

1. PV of cash flows expected from an overseas acquisition will also be affected by expectations of future changes in the exchange rate
2. E.g. if the overseas currency is forecast to devalue - this will reduce the value of the cash flows
3. Overseas currency may devalue for many reasons, one of which is high inflation (lower purchasing power)

Question 4

Selecting an appropriate cost of capital as a complication in the cash flow valuation method:

Answer 4

• M&M theory can be used where an investment has differing levels of business risk (industry) and differing financial risk (capital structure)
• Therefore, a risk-adjusted cost of capital should be used (also known as project specific cost of capital)

Question 5

Business risk

Answer 5

risk relating to activities carried out by entity

Question 6

Financial risk

Answer 6

risk related to a company’s capital structure (level of debt fin in relation to equity finance)

Question 7

Risk-adjusted cost of capital

Answer 7

cost of capital reflecting the business and financial risk of an investment

Question 8

Cash flow valuation method to use when valuing specific divisions

Answer 8

1. The risk-adjusted cost of capital approach can also be used to estimate cost of capital for valuation of a specific division with differing risks or for valuing an unquoted company
2. Same approach for cash flow valuation method is used except a risk adjusted WACC or Ke should be used as the discount factor

Question 9

What is an equity beta?

Answer 9

1. Measure of market risk of a security, including its business risk and financial risk
2. Equity beta of a company will also be affected by its gearing; if the company has a high equity beta this may be because it has high gearing.

Question 10

What is an asset beta?

Answer 10

1. Ungeared beta, measuring business risk only (usually smaller than equity beta)
2. To understand the level of business risk of a company, an equity beta can be adjusted to show its value if the company was ungeared.

Question 11

How to calculate an asset beta:

Answer 11

1. Ungearing a beta:
   Beu =
   Beg (Ve / Ve+Vd(1-t)
   + Bd (Vd(1-t) / Ve + Vd(1-t))
2. If told the debt beta is zero:
   Beu = Beg (Ve / Ve + Vd(1-t)

Question 12

M&M formula for WACC

Answer 12

WACC = Keu [1 - (Vd t / Ve + Vd)]

Question 13

CAPM formula

Answer 13

Ke = Rf + (Rm - Rf) x B

Question 14

Different approaches to calculate appropriate cost of capital - approach 1: using M&M WACC formula if given a beta

Answer 14

Step 1 = Ungear the beta
Step 2 = Calculate Ke using CAPM formula
Step 3 = Use ungeared Ke to calculate the WACC using M&M WACC formula

Question 15

Different approaches to calculate appropriate cost of capital - approach 2: using M&M WACC formula if NO beta is given

Answer 15

Step 1a) = Strip out impact of debt levels from Ke
Keg = Keu + (Keu + Kd) x (Vd(1-t) / Ve)
1b) OR strip out impact of debt levels from WACC
WACC = Keu[1- (Vd t / Ve + Vd)]

Step 2 = Recalculate WACC using M&M formula & using divisions gearing

Question 16

Different approaches to calculate appropriate cost of capital - approach 3: Using M&M Ke formula (if valuing cash flow to equity)

Answer 16

Step 1 = Ungear the equity beta (approach 1) or the Ke or WACC (as approach 2) to obtain the ungeared beta or ungeared Ke

Step 2a) = Regear the beta using your company’s gearing
Beg= Beu + (Beu - Bd) x (Vd(1-t) / Ve)
and calculate the Ke geared (as approach 2)
Ke = Rf + (Rm - Rf) x B

Step 2b) OR regear the Ke using the following M&M formula:
Keg = Keu + (Keu - Kd) x (Vd(1-t) / Ve)

Question 17

Cost of capital for the dividend valuation model (DVM) - adjusting the betas for use in the DVM model

Answer 17

Step 1 = calculate the asset beta

Step 2 = Regear the beta using the unlisted company’s gearing
Beg = Beu + (Beu - Bd) x (Vd(1-t) / Ve)
to calculate its Ke geared (CAPM formula)

Step 3 = use this Ke geared to calculate the value of the company using:
P0 = d1 / Ke - g