Valuation Fundamentals Questions and Answers

Valuation Fundamentals Questions and Answers WACC Formula [Ke x E / (D+E)] + [ Kd x (1 - T) x D/ D + E)] Ke = cost of equity Kd = cost of debt E = market value of equity D = market value of debt T = marginal tax rate Cost of Equity / CAPM Ke = Rf + [β * (Rm - Rf)] Ke = cost of equity Rf = Risk-free rate β = Beta Rm = market rate of return Rm - Rf = market risk premium Ke = required annual rate of return that a company's equity investors expect to receive Risk-Free Rate Rate on a "zero-risk" investment 10-year treasury note is used as a proxy Market Risk Premium Difference between expected return in equity markets and the frisk-free rate Additional return an investor needs for added risk of investing in equity Beta Measures a stock's reaction to movements in the equity market Beta of 1: expected return on stock = return on market portfolio Beta 1: expected return on stock return on market portfolio Beta 1: expected return on stock return on market portfolio Terminal Value Details Captures value of a company's steady state CF's after forecast period (60-80% of company value) Exit multiple method: -Assumes company is worth a multiple of an operating metric (typically EBITDA) - Use LTM Perpetuity Growth method: - Assumes company's FCF in last forecast year grows at a constant rate indefinitely - growth rate typically in 2-4% range. Should not exceed growth rate of the economy Calculating Terminal Value Exit Multiple: Multiple * Financial Metric n Perpetuity Growth: FCFn * (1+g) / (WACC - g) FCF = unlevered free cash flow n = terminal year of projection period g = perpetuity growth rate WACC = Weighted Average cost of capital IRR for LBO [( FV / PV)^1/n] -1