Thus, it is necessary o study the firm or project’s operations, investments, and capital Structure, and to assess its potential for improvements and future growth. 19. 3 Building the Financial Model A financial model may be used to project the future cash flows from an investment. A pro formal income statement projects the firm’s future income statements based on a set of assumptions. The financial model should also consider future working capital needs and capital expenditures. Based on these estimates, future free cash flows as well as pro formal balance sheets and statements of cash flows can be forecast. 2011 Pearson Education Beer}Demeanor ; Corporate Finance, Second Edition 19. 4 Estimating the Cost of Capital To value an investment, the investment’s risk needs to be assessed and an estimate of the appropriate cost of capital must be determined. One method for estimating the equity cost of capital is to use the CAMP. The unlearned beta can be used in the CAMP to estimate the unlearned cost of capital to use in the APP method. The firm or comparison firm’s beta can be unlearned using: PU [E / (E * + [D / (E * z [E / .

For the WAC and FEET methods, the unlearned beta can be relieved to reflect the firm’s capital Truckee as: / – ;D)z;U [1 * (D / The levered beta can be used in the CAMP to determine the industry equity cost of capital, and then the firm’s WAC can be determined. I g. S Valuing the Investment For a firm or project With an infinite life, free cash flows are generally forecast for several years until a constant rate of growth is expected to begin in year T. These Pops are then discounted back to time zero individually as lump sums. Next, the firm’s continuation, or terminal, value at the end of the forecast horizon must be estimated.

One common method Of estimating the terminal value is to assume a constant expected growth rate, g, and a constant debt-equity ratio, to calculate the discounted cash flow value of the cash flows from time to infinity, valued at time T: Enterprise Value in Year T = VT = race – g Another method to determining the terminal value is to use a valuation multiple based on comparable firms, It is informative to use both the discounted cash flow approach and the multiples approach when estimating a realistic terminal value estimate, While the NP method is the most reliable approach for evaluating an investment, practitioners often use cash multiples as an alternative valuation method. The cash multiple for an investment is the ratio of the total cash received to the total cash invested: Cash Multiple = Total Cash Received Total Cash Invested The Obvious weakness Of the cash multiple approach is that it does not depend on the amount of time it takes to receive the cash, nor does it account for the risk Of the investment. It is therefore useful only for comparing deals With similar time horizons and risk. 19. Sensitivity Analysis Sensitivity analysis is useful for evaluating the uncertainty of estimates used in a valuation. Ay computing the value based on different variable estimates, the impact of this uncertainty on the value of the firm or project can be estimated. Geri/Demeanor ; Corporate Finance, Second Edition 225 Appendix: Compensating Management Firms may use a management incentive plan to reward management for good performance. This may be in the form of an equity stake that would be vested over a period of years Because the payment to the managers is an equity claim, to compute its present value we must use an equity cost of capital. To compute the equity cost of capital re, vie use CEQ. 18. 0, which applies when the debt levels of the firm follow a known schedule: E=our+ We then compute the cost of management’s equity share by discounting at this rate: Cost of Management’s Share t Cost of Management’s Share t -1 Once we have determined the cost of management’s equity share, it can be deducted from the total value of the equity. Selected Concepts and Key Terms Pro Formal Forecasts Projections of future income statements, balance sheets, or statements of cash flows for a firm or project based on a set Of assumptions. Cash Multiple, Multiple of Money, Absolute Return The ratio of the total cash received to the total cash invested. unlearned PIE Ratio A PIE ratio that is calculated by dividing continuing enterprise value by unlearned net income.

Concept Check Questions and Answers 19. 1. 1. What is the purpose of the valuation using comparable? The purpose of the valuation using comparable is to estimate the value of a firm by comparing it to firms in a similar line to business. I g, I If the valuation using comparable indicates the acquisition price is reasonable compared to other firms in the industry, does it establish that the acquisition is a good investment opportunity? No, the valuation using comparable ignores important differences among rims such as operating efficiency and growth prospects. The valuation using comparable should be used as a preliminary way to estimate the value of a firer 19. 21.

What are the different operational improvements KIP plans to make? KIP plans to cut administrative costs immediately and redirect resources to new product development, sales, and marketing. Beer,’Demeanor ; Corporate Finance, Second Edition 19. 22. Why is it necessary to consider these improvements to assess whether the acquisition is attractive? Whether the acquisition is attractive and is a successful investment for KIP upends on Diode’s post-acquisition performance. Thus, it is necessary to look in detail at Diode’s operation, investments, and capital structure, and to assess its potential for improvements and future growth. What is a pro formal income statement?

A pro formal income statement is an income statement that is not based on actual data but, instead, depicts the firm’s financial under a given set of hypothetical assumptions. 19. 3. 2. How do we calculate the firm’s free cash flow, and the free cash flow to equity? To compute free cash flow, we first adjust net income by adding back the after-tax interest payments associated with the et debt in its capital structure, adding back depreciation, and then deducting increases in net working capital and capital expenditures. To calculate the free cash flow to equity, we add net borrowing (increases to net debt) to the free cash flow of firm, and then deduct the after-tax interest expense. 134. 1. What is a standard approach to estimate an equity beta?

The standard approach to estimating an equity beta is to determine the historical sensitivity of the stocks return to the market’s returns by using linear regression to estimate the slope coefficient of the straight line. 19. 4. 2. HOW do we estimate a firm’s unlearned cost Of capital using data from comparable publicly traded firms? To estimate a firm’s unlearned cost of capital using data from comparable publicly traded firms, we first estimate the equity cost of capital for the comparable firms, and then estimate the unlearned cost of capital for each firm based on its capital structure. The unlearned costs of capital of the comparable firms are next used to estimate the unlearned cost of capital for the target firm. What are the main methods of estimating the continuation value of the firm at the end of the forecast horizon?

The main methods of estimating the continuation value of the firer at the end of the tortoise horizon are the multiples approach and the discounted cash flow valuation approach using the WAC method, 19. 5. 2. What are the potential pitfalls of analyzing a transaction like this one based on its AIR or cash multiple? There are potential pitfalls with the AIR and cash multiple methods. First, there is no single cost of capital to compare to the AIR because the firm’s leverage ratio changes over time, which will also change the risk of its equity. Besides, the cash multiple does not depend on the amount of time it takes to receive the cash, or does it account for the risk of the investment. It is therefore useful only for comparing deals with similar time horizons and risks. 19. 6. 1.

What is the purpose of the sensitivity analysis? The purpose Of using sensitivity analysis is to evaluate the uncertainty Of estimates used for valuation, and the impact of this uncertainty on the value of the deal. Beer/Demeanor ; Corporate Finance, Second Edition 19. 6. 2. Table 19. 20 shows the sensitivity analysis for Kip’s investment in Ideas. Given this information, do you recommend the acquisition of Ideas? Yes, we recommend the acquisition of Ideas. With an assumption of an exit EBITDA multiple of 9. 1, KIP will have a good profit on its SSE million investment in Ideas, and the AIR of 33. 3% is very high. Even with a very low exit multiple of 6. , KIP will approximately break even on its investment in Ideas, Examples with Step-by-Step Solutions Solving Problems All of the problems in this chapter relate to the Ideas case study discussed in the chapter, and generally involve applications that require the use of the Ideas spreadsheet. Most problems involve varying the assumptions used in a discounted cash flow valuation using the APP and PET methods, With five years f forecasted data and a growing perpetuity or EBITDA multiple terminal value. The problems generally require manipulating the original spreadsheet used in the chapters case study by changing one or more of the variables to achieve some specific result. Problem 1 below provides an example of what this process is like.

Problems may also involve using comparable valuation multiples to value a project or firm. Problem 2 below provides an example of calculating and using valuation multiples. Examples 1. In the valuation of Ideas, direct labor is estimated as SIB per unit in the base ear and growing at 4% in 2006-2010. New information suggests that labor costs should be $22 per unit and grow at How does this affect the valuation using the WAC method? Step 1. Determine what needs to be changed. The assumption affects the forecasted income statements, which affect the unlearned free cash flow calculations. Once these are updated with the new assumptions, the valuation can be revised, Step 2. Revise the pro formal income statements for 2006-2010.