Topic 7: Alternative Valuation Models

Question 1

Criticism of textbook OFCF / WACC valuation model

Answer 1

Assumes that the ratio of D/V remains constant.

However, dividend payments and debt repayments may cause actual D/V to differ to target at any point in time

Question 2

Debt adds value due to :
How is this incorporated into WACC?
What is the value of the tax benefit?

Answer 2

Debt adds value due to : tax deductibility of interest expense
How is this incorporated into WACC? in the Rd (1-T) term
What is the value of the tax benefit? V(ITS) = V(L) - V(U)
that is, Value of the interest tax shield - Value of levered firm less the value of the unlevered firm

Question 3

Value of the Levered Firm (V(L)) = ?
Discount V(U) flows by ?

Answer 3

V(L) = V(U) + PV(ITS)
(NOTE: it is the PRESENT VALUE of the ITS. Make sure it is discounted appropriately)
Discount V(U) flows by : Rho

Question 4

Adjusted Present Value Method (APV Method)

1. Describe method to get to Levered EV
2. WACC vs APV

Answer 4

1. Describe: calculate unlevered (all equity) EV; then add the incremental value arising from using Debt rather than equity to get the Levered EV
   It is OFCF capitalised at the all equity rate
   Project value = value of project with all equity financing, plus the value of any financing side effects (eg ITS)
2. WACC vs APV:
   a) WACC & APV produce the same result
   b)

Question 5

Describe the similarities of the WACC, APV and Flow to Equity Methods (similarities, differences)

Answer 5

1. All use Ungeared After Tax Cash Flows as a starting point
2. Difference: how financing effects are incorporated
3. All give same answer. Ensure consistency between how CFs are defined and the discount rate used to discount that flow.
4. APV is more transparent but more work - you need a dollar value at each point. Can calculate $ value as the EV * D/E ratio

Question 6

In order of risk:
Rf < Kd (after tax) < Kd (pre tax) < Rho < Ke (ie levered cost of equity)
Describe

Answer 6

• after tax vs pre tax debt - you are entitled to the income tax shield
• WACC < rho: otherwise why have debt.
• Levered cost of equity is higher: as you add debt, shareholders are in a riskier position as debt holders will have priority when a payout is required

Question 7

Use Adjusted Present Value method when:

Answer 7

use when financing strategy is expressed in dollar terms rather than a ratio - eg fixed debt repayment schedule

Question 8

Calculate Levered Equity Value (E(L)) using Flow to Equity

Answer 8

1. Calc FCFE (ie after debt servicing)
2. Discount at the cost of equity. (Ke)
3. Cost of equity used must reflect risk of project and the assumed debt level

Question 9

When to use WACC model

Answer 9

• ASsumes that D/V is kept constant
• commonly used in non financing companies where projects typically funded from corp pool of funds
• each division can have own WACC

Question 10

When to use Adjusted Present Value

Answer 10

• Use APV when financing arrangements differ from long run target ratio - eg fixed term or subsidised debt
• Assumes level of debt is known over life of project
• use for projects with specific financing

Question 11

When to use FTE

Answer 11

• FTE requires both a RATIO (to calculate Re) and a debt schedule (to calc CF to E)
• used for projects with specific financing

Question 12

APV and FTE: error prone

Answer 12

• Changing project values over time - if assume perpetual debt or bullet payment, could overvalue PV(ITS)
• Displaced debt:

Question 13

Structuring offshore project - 2 decisions

Focus for decisions (3)

Answer 13

1. mix of debt & equity
2. whose B/S gets the debt - domestic parent or offshore subsidiary

Decisions

1. tax rates in different countries
2. different borrowing margins
3. cost of repatriation

Question 14

Advantages of Adjusted Present Value in valuing offshore projects (2)

Answer 14

Advantages of APV in valuing offshore projects:

1. analysis kept simple for each component of CF stream, avoid arbitrary adjustments to discount rate
2. more information is created about the increase/decrease in value caused by taxation issues, concessional borrowing etc

Question 15

Adjusted Present Value process for valuing offshore project (2 steps)

Answer 15

1. Get worst case unlevered value: Value project without any debt finance in offshore location; repatriate all CFs to parent in home country in which case div withholding tax may be levied
2. calculate PV(ITS): incremental amount of using debt vs equity; incl effect of debt on DWT. (ie double whammy: ITS & Div WHT rebate