Valuation

Question 1

What is the formula for ROIC

Answer 1

(EBIT * (1-tax rate)) / avg operating capital

Question 2

4 types of non-recurring items

Answer 2

1. One-time expenses
2. Items that recur every year but change sign
3. Items that recur at regular intervals
4. Items that recur every year but are highly volatile

Question 3

3 types of investments

Answer 3

1. Minority passive investment
2. Minority active investment
3. Majority active investment (step 6 of DCF)

Question 4

EXCEL: what is the line item order of reinvestments (PPE)

Answer 4

1. Beginning
2. CapEx + increase in lease liabilities
3. Depr./Amor. + depreciation on lease asset
4. Acquisitions net of disposals
5. Revaluations
6. End + lease addition to PPE

Question 5

EXCEL: what is the line item order of reinvestments (tangibles)

Answer 5

1. Beginning
2. CapEx + current year R&D spending
3. Amortisation + amortisation on R&D asset
4. Acquisitions net of disposals
5. Revaluations
6. End + capitalised value of R&D expense

Question 6

What is the formula for Trade Receivable Days and Accounts Payable Days

Answer 6

TRD: trade and other receivables / operating capital * 365
APD: trade and other payables / revenue * 365

Question 7

Give the EBIT > FCFF overview

Answer 7

EBIT
- Taxes
NOPAT

+ Depreciation
+ Amortisation

• Reinvestment in PPE
• Reinvestment in Intangibles
• Change in ONWC

+ Proceeds assets held for sale (change in book value on BS)
+ Change in provisions
+ Change non-current operating liabilities
+ Change in DTL

FCFF

Question 8

3 lifecycle stages of firms

Answer 8

1. High revenue growth, high operating costs, and high reinvestment rate.
2. Slowing / declining revenue growth rate, stabilising operating costs, and slowing reinvestment rate.
3. Stable revenue growth, stable operating costs, stable reinvestment rate.

Question 9

Forecast period must be how long?

Answer 9

Long enough for the company to reach a steady state characterised by:
- constant reinvestment rate
- constant RONIC

Question 10

Calculate stable growth rate in Excel; procedure

Answer 10

1. New investment = NOPAT - FCFF
2. Reinvestment rate = New investment / NOPAT
3. RONIC = (NOPAT next year - NOPAT current year) / new investment
4. NOPAT growth rate = reinvestment rate * RONIC
5. ROIC = NOPAT / avg operating capital previous year and current year
6. Implied real RONIC = take out inflation of RONIC
7. Implied real growth rate = reinvestment rate * implied real RONIC
8. Implied nominal growth rate = add inflation to implied real growth rate

Question 11

Principles needed to calculate RF

Answer 11

1. Timing: CFs must be matched with discount rates
2. Currency consistency: CFs must be in the same currency as risk free rates
3. No default-risk: RF must really be risk-free, so no reinvestment risk > don’t use coupon bonds.

Question 12

4 ways to estimate the cost of debt

Answer 12

1. Historical interest costs
2. Traded bond yields
3. Synthetic bond yields
4. An asset pricing model / CAPM (requires liquid debt market)

Question 13

3 Determinants of the cost of debt

Answer 13

1. Risk-free rate
2. Credit spread (should always be higher than the EDL)
3. Expected default loss

Question 14

4 types of multiples

Answer 14

1. Earnings based
2. Revenue based
3. Book-value based
4. Sector multiple

Question 15

2 Key principles with choosing multiples

Answer 15

1. Uniformity = are the items defined in the same way?
   > time horizon
   > accounting standards
2. Consistency = numerator and denominator need to be to the same claim holders
   > e.g., net income cannot be compared to enterprise value
   > that’s why Price/Sales is also wrong

Question 16

Advantage and disadvantage of revenue multiples

Answer 16

Pro: cannot be zero and is less easy to manipulate
Con: high revenue doesn’t imply high profit. This is really firm dependent.

Question 17

Name the strengths and weaknesses of the APV method

Answer 17

+ it’s able to adjust for capital structure
+ takes into account the cost of financial distress
+ valuation of private companies without measurable D/E ratio

– requires a lot of uncertain inputs that make practical implementation poor
> synthetic credit ratings
> expected cost of financial distress
> rate to discount tax shields
> other effects of leverage on value besides the tax shield

Question 18

3 general assumptions for cost of equity for public companies

Answer 18

1. Diversified investors
2. Liquid markets
3. Powerful shareholders

Question 19

Explain the steps and inputs involved in calculating the IMPLIED ERP

Answer 19

The EPR is calculated by reverse-engineering the valuation of the index by using a DCF. That is, decide the forecast horizon, the expected CFs from the index (from for instance analyst reports) and the discount rate for each period. The current level of the index is the valuation of the index and you have information on cash flows as well as the risk-free part of the discount rate. If we assume that the CAPM is the appropriate discount model, the remaining unknown variable is the ERP. You can calculate this and get a forward looking measure of risk.

For this to work, we have to assume we’re using a similar model as the marginal market participant, that is, we have to assume that our choice of forces horizon is correct and that analyst estimates accurately proxy for the market’s growth expectations of CFs. We also have to assume the CAPM is the appropriate measure of risk.

Question 20

Give the steps of bottom-up beta

Answer 20

1. Determine a group of peer firms
2. Calculate regression betas for these firms for an appropriate time horizon (e.g. 1Y daily data)
3. Calculate the asset beta (industry beta) by unleveling these betas – that is, adjust for the capital structure of the peer firms
4. Take the unlettered beta and re-lever it for the expected capital structure of the firm

Question 21

You typically use the book value of debt to proxy for the market value of debt when calculating the D/E ratio. In what kind of firms does this approximation lead to large errors and what could be done to correct for them?

Answer 21

For distressed firms where the market value of debt is below the book value. Using book value to calculate D/E will lead to large errors.

In order to correct for these errors, some kind of discount must be applied to the book value of debt. Look for example at how the market value of similarly traded debt relative to its book value and apply a discount. Or, look at the YTM on similarly rated traded debt and calculate a market value of your firm’s debt using this.

Question 22

A student is valuing a privately-held firm. He is using the CAPM to calculate the asset beta of the firm’s publicly-traded peers and their average D/E (debt-to-equity) ratio (in market value terms) to calculate its cost of levered cost of equity. Explain why this is inappropriate

Answer 22

The CAPM assumes that the marginal investor holds a diversified portfiolio and therefore expects compensation for only non-diversifiable risk, which is captured by the beta measure of publicly-traded firms. The marginal investor (the owner) in a private firm does not hold a diversified portfolio and (s)he therefore expects compensation for firm-specific as well as non-diversifiable risk. The beta estimated based on publicly-listed peers understates the risk and hence the cost of equity of the privately-held firm.

Question 23

Explain the concepts of ‘discount for lack of diversification’, ‘illiquidity discount’, and ‘control premium’

Answer 23

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