BVCG | Summary
Business Valuation part
Lecture 1
A value has to do with perception, psychology, information and methods. One of the goals of
valuation is the ‘buy-sell-hold’ decision.
Valuation methods that don’t involve forecasting:
- Method of comparables
- Multiple screening
- Technical screening
- Asset-based valuation
Valuation methods that involve forecasting:
d1
V0
- Dividend discounting (value of equity = present value of expected dividends) r g
- Discounted cash flow (value of the firm – present value of expected FCF)
FCF1
V0 NetDebt
wacc g
Enterprise value = value of equity + value of debt
Market value (of equity) = market capitalization
Book value (of equity) = balance sheet
- Project Valuation: firms acquire productive capacity by assembling necessary assets
- Enterprise (Business) Valuation: acquisitions of entire businesses - acquiring the
productive assets of an existing firm
- Common valuation tools and underlying principles can be used for both types of analysis.
- The objective of a firm is to create value by initiating and managing investments that
generate future cash flows that are worth more than the amount invested.
- Effective valuation analysis involves a disciplined 3-phase investment evaluation process
NPV = value created in project: output - input
Potential causes of investments that destroy value:
- Managers “go with their gut”
- Managers invest in many risky projects that do not provide adequate returns
- Managers take decisions on the basis of incomplete information about uncertain future
events
Chapter 2
1
,The idea of DCF valuation:
- The value of an investment is determined by the magnitude and the timing of future cash
flows
- The DCF approach provides a basis for assessing the value of these cash flows
- It is a cornerstone of valuation analysis
Relevant cash flows = incremental cash flows > Cash flows directly generated by the
investment.
Incremental cash flows = projected revenues and costs of the new product. Potential
cannibalization of other existing products.
Sunk costs (expenditures that either have already been made or must be made regardless of
whether the firm proceeds with the investment) are not incremental cash flows and should be
ignored.
Conservative/optimistic cash flows
Conservatism: e.g. when cash flow forecast serves as future targets that will influence
bonuses
Optimism: if a manager gets a bonus for identifying a promising investment opportunity that
the firm initiated.
Hoped-for vs. expected cash flows are tightly linked to this.
Investment cash flow: the sum of cash inflows and outflows from the project
Equity free cash flow (EFCF): cash flow available for distribution to the firm’s common
shareholders
Free cash flow (FCF): amount of cash produced (by a project/firm) during a particular time
that is available for distribution to both the firm’s creditors and equity holders. D
FCF = EBIT*(1-T) + DA – NWC – CAPEX
NWC = change in net working capital, NWCt – NWCt-1
- Increase in trade receivables
o FCF decreases
- Decrease in gross margins
o FCF decreases
- Increase in property, plant, and equipment
o FCF decreases
- Increase in inventories
o FCF decreases
- Interest expense
o No influence on FCF
- Increase in prepaid expenses
o FCF decreases
- Increase in notes payable
o FCF increases
IRR = internal rate of return. Should be more than cost of capital (WACC)
2
, NPV = net present value, should be positive.
Lecture 2: Cost of capital
Book ch. 3
WACC: The weighted average of the expected after-tax rates of return of the firm’s various
sources of capital. It is the discount rate that should be used to discount the firm’s expected
free cash flows to estimate firm value. It can be viewed as its opportunity cost of capital.
Kd = cost of debt
Wd = weight of debt
T = tax rate
Kp = cost of preferred stock
Wp = weight of preferred stock
Ke = cost of equity > the rate of return investors expect from investing in the firm’s stock
We = weight of equity
Three steps in estimating WACC:
- Capital structure weights
- Cost of capital: debt, equity
- Calculating the weighted average cost of capital
CAPM = Capital Asset Pricing Model. Is used for estimating Ke
Krf = Risk free Rate, Be = Beta, Km = expected return on the market.
Risks
Systematic risk / Non-diversifiable risk:
- Variability that contributes to the risk of a diversified portfolio
- E.g. market factors such as changes in interest rates and energy prices that influence
almost all stocks.
- Stocks that are very sensitive to these sources of risk should have high required rates
of return.
Non-systematic risk / diversifiable risk:
- Variability that does not contribute to the risk of a diversified portfolio
- E.g. random firm-specific events such as lawsuits, product defects and various
technical innovations
- These sources of risk have almost no effect on required rates of return because they
contribute very little to the overall variability of diversified portfolios.
3
Business Valuation part
Lecture 1
A value has to do with perception, psychology, information and methods. One of the goals of
valuation is the ‘buy-sell-hold’ decision.
Valuation methods that don’t involve forecasting:
- Method of comparables
- Multiple screening
- Technical screening
- Asset-based valuation
Valuation methods that involve forecasting:
d1
V0
- Dividend discounting (value of equity = present value of expected dividends) r g
- Discounted cash flow (value of the firm – present value of expected FCF)
FCF1
V0 NetDebt
wacc g
Enterprise value = value of equity + value of debt
Market value (of equity) = market capitalization
Book value (of equity) = balance sheet
- Project Valuation: firms acquire productive capacity by assembling necessary assets
- Enterprise (Business) Valuation: acquisitions of entire businesses - acquiring the
productive assets of an existing firm
- Common valuation tools and underlying principles can be used for both types of analysis.
- The objective of a firm is to create value by initiating and managing investments that
generate future cash flows that are worth more than the amount invested.
- Effective valuation analysis involves a disciplined 3-phase investment evaluation process
NPV = value created in project: output - input
Potential causes of investments that destroy value:
- Managers “go with their gut”
- Managers invest in many risky projects that do not provide adequate returns
- Managers take decisions on the basis of incomplete information about uncertain future
events
Chapter 2
1
,The idea of DCF valuation:
- The value of an investment is determined by the magnitude and the timing of future cash
flows
- The DCF approach provides a basis for assessing the value of these cash flows
- It is a cornerstone of valuation analysis
Relevant cash flows = incremental cash flows > Cash flows directly generated by the
investment.
Incremental cash flows = projected revenues and costs of the new product. Potential
cannibalization of other existing products.
Sunk costs (expenditures that either have already been made or must be made regardless of
whether the firm proceeds with the investment) are not incremental cash flows and should be
ignored.
Conservative/optimistic cash flows
Conservatism: e.g. when cash flow forecast serves as future targets that will influence
bonuses
Optimism: if a manager gets a bonus for identifying a promising investment opportunity that
the firm initiated.
Hoped-for vs. expected cash flows are tightly linked to this.
Investment cash flow: the sum of cash inflows and outflows from the project
Equity free cash flow (EFCF): cash flow available for distribution to the firm’s common
shareholders
Free cash flow (FCF): amount of cash produced (by a project/firm) during a particular time
that is available for distribution to both the firm’s creditors and equity holders. D
FCF = EBIT*(1-T) + DA – NWC – CAPEX
NWC = change in net working capital, NWCt – NWCt-1
- Increase in trade receivables
o FCF decreases
- Decrease in gross margins
o FCF decreases
- Increase in property, plant, and equipment
o FCF decreases
- Increase in inventories
o FCF decreases
- Interest expense
o No influence on FCF
- Increase in prepaid expenses
o FCF decreases
- Increase in notes payable
o FCF increases
IRR = internal rate of return. Should be more than cost of capital (WACC)
2
, NPV = net present value, should be positive.
Lecture 2: Cost of capital
Book ch. 3
WACC: The weighted average of the expected after-tax rates of return of the firm’s various
sources of capital. It is the discount rate that should be used to discount the firm’s expected
free cash flows to estimate firm value. It can be viewed as its opportunity cost of capital.
Kd = cost of debt
Wd = weight of debt
T = tax rate
Kp = cost of preferred stock
Wp = weight of preferred stock
Ke = cost of equity > the rate of return investors expect from investing in the firm’s stock
We = weight of equity
Three steps in estimating WACC:
- Capital structure weights
- Cost of capital: debt, equity
- Calculating the weighted average cost of capital
CAPM = Capital Asset Pricing Model. Is used for estimating Ke
Krf = Risk free Rate, Be = Beta, Km = expected return on the market.
Risks
Systematic risk / Non-diversifiable risk:
- Variability that contributes to the risk of a diversified portfolio
- E.g. market factors such as changes in interest rates and energy prices that influence
almost all stocks.
- Stocks that are very sensitive to these sources of risk should have high required rates
of return.
Non-systematic risk / diversifiable risk:
- Variability that does not contribute to the risk of a diversified portfolio
- E.g. random firm-specific events such as lawsuits, product defects and various
technical innovations
- These sources of risk have almost no effect on required rates of return because they
contribute very little to the overall variability of diversified portfolios.
3
