Topic 2: Valuation Principles

Question 0

Nominal cash flow vs Real cashflow

Answer 0

Nominal cashflow: expressed in terms of monetary value applying at time of transaction
Real cashflow: expressed in terms of time zero.

NOTE: ensure that nominal cash flows are discounted by the nominal exchange rate; and that real cashflows are discounted by the real cash rate. ALSO: watch the depreciation tax shield - eg discount real cFs at real rate and deprec tax shields at nominal rate.

Question 1

Inflation affects the value of an investment project in 2 ways:

Answer 1

Inflation impacts:

1. Project’s cashflows
2. Company’s cost of funds and hence the projects discount rate

Question 2

Valuing CFs in foreign currency:

Answer 2

If CFs are in a foreign currency, ensure that discount rate is the foreign currency. Match the discount rate to the cashflows.

Question 3

Determining inputs to Terminal Value formula (3)

Answer 3

1. Ensure CF used in numerator of perpetuity formula is consistent w/ terminal growth rate assumption
2. Ensure level of CF assumed in 1st year of TV calc s normalised for replacement capital, taxes, etc
3. Ensure level of CF assumed in 1st year of TV calc is sustainable and not at unsustainably high level. TO do this, can check that ROIC assumed at TV is reasonable (eg compare with industry)
   - - Most companies have ROIC levels that are within WACC levels +/- 5%; and
   - long term ROIC has a mean reverting tendency

Question 4

Absolute purchasing power parity =

Relative purchasing power parity =

Answer 4

Absolute purchasing power parity = commodity costs same regardless of which currency it is in. P(uk) = S x P(us)
- assumes zero transaction costs; no barriers to trade; goods are identical
Relative purchasing power parity = tells us the change in exchange rate over time; not the absolute level.
- determined by differences in inflation rate between the 2 countries

Question 5

Covered interest arbitrage

Answer 5

• -covered in the event of a change in exchange rate because we lock in the forward today
• consider arbitrage if available from locking in a forward and investing cash into specific currency (earning interest) then converting it back.

Question 6

Unbiased forward rate

Answer 6

The forward rate is equal to the expected future spot rate

Question 7

International Fisher Effect

Answer 7

• real rates are equal across countries

Question 8

Foreign currency in cash flow forecasts:

- forecast cashflows are converted at foreward exchange rates (ie on fully hedged basis). Why

Answer 8

If only partially hedged; you are taking a view on currency. ie confusing 2 opportunities - the opportunity to invest and the opportunity to speculate on currency

Question 9

Interest rate parity

Answer 9

difference in national interest rates would be equal to, but opposite in sign to, the forward rate discount or premium for the foreign currency (excl transaction costs)

Question 10

Fisher effect

Answer 10

Nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation

Question 11

Notes to assist Growth rates used in terminal values (4)

Answer 11

1. Ensure growth rate is consistent with strategic and competitive position of project or business being valued
2. Ensure growth rate is consistent with stage of life cycle
3. Ensure cashflow is consistent with growth rate by including necessary expenditure (working cap etc) to support growth for the term of the TV period
4. be careful of growth rates that assume continuing supply of growth opportunities

Question 12

Net Present Value of Growth Opportunities

• Two conditions must be met in order to increase value
• Growth in earnings and dividends vs growth opportunities

Answer 12

1. earnings must be retained so that projects can be funded
2. the projects must have positive net present value

Note: growth in earnings & divs vs growth opps:

• negative NPV projects lower the value of the firm (projects with rates of return below the discount rate will lower the firm value)
• both the earnings and dividends of a firm will grow in terms of earnings and dividends, but will destroy firm value

Question 13

Terminal Value Guidelines (6)

Answer 13

1. Make explicit assumptions about growth rate, term & growth options, don’t just use arbitrary multiple
2. Benchmark assumptions against competitors market values - reverse engineer valuations
3. If using a multiple, make sure its implicit assumptions line up with stage of life cycle
4. Make sure that CF forecast is based on the LT growth rate g used in the perpetuity formula
5. Make sure that value impact of growth projects is transparent

Question 14

5 steps for using multiples

Answer 14

1. find comparable companies (need to be similar - eg profitability, growth, capex)
2. standardise financial data (reorganise, normalise for non recurring items, adjust for items not in Inc Statement or B/S)
3. for each comparable company, calculate the relevant multiple
4. the average of a group of comparable companies is then estimated
5. target is then valued :
   Value Metric (tgt) = Acctg Metric (tgt) x average of group

Question 15

Valuation Models (3)

Answer 15

1. OFCF / WACC
2. Residual Income
3. Multiples

Question 16

Advantages of the 3 valuation models:

1. OFCF / WACC
2. Residual Income
3. Multiples

Answer 16

1. OFCF / WACC
   - based off cashflows
2. Residual Income
   - based off ROIC; allows analysis of forecast using DuPont analysis, therefore allowing detailed analysis of assumptions underlying the forecasts
3. Multiples
   - based on market valuations of comparables, can interpret as the market’s expectation of future CFs discounted at the mkt’s required return. Therefore can compare results of our own forecasts (OFCF and RI models) with external valuations)

Question 17

Profit After Tax refers to xxxxxx
while
EBITDA refers to xxxx

Answer 17

Profit After Tax refers to value of ordinary equity
while
EBITDA refers to value of operating assets

Question 18

Consistency Principles (11)

Answer 18

1. Multiples: match right perf metric with right value metric
2. Multiples: use perf metrics from the same time frame
3. Nominal cashflows - use nominal discount rates
4. nominal cashflows - ensure inflation assumption is consistent w/ infl rate embedded in mkt rates
5. For forecast CFs, use forward curve or discount curve that matches the same time frame
6. Use discount rate consistent with risk of the CFs
7. Use discount rate consistent with financing strategy used
8. When discounting foreign currency CFs converted to home currency at forward rate; use home mkt disc rate
   9, When discounting foreign currency CFs, use foreign currency disc rate
9. When using ratios, make sure numerator and denominator (perf metric, investment base) are consistent
10. When valuing V(L) make sure you only include CFs related to the operating asset.

Question 19

Convert cashflow statement from Accountant Style to Corporate Finance:

Answer 19

1. Embedded in NPAT is INTEREST. Can’t start a corp finance CF statement with NPAT
2. Need to get NOPAT

Question 20

Note for EXAM

What is value / do you proceed with project?`

Answer 20

1. Value is NOT NPV and NOT MVA
2. Value is the ENTERPRISE VALUE
3. Enterprise Value minus cost = MVA
4. MVA positive -> proceed. But this is not the VALUE
   eg What is shareholder value = value of the equity, their claim. What is equity : amt leftover, operational minus claims, EV minus claims
   eg what is the value: answer is a dollar value

Question 21

Invested Capital

Answer 21

• this comes from the B/S; ie total of LHS and RHS of balance sheet.
• on the accountant’s balance sheet = debt + equity MINUS CASH