Valuation_slides_Week2_1 - No Friction Model and Frictions_MPA

7/21/2019 Valuation_slides_Week2_1 - No Friction Model and Frictions_MPA

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Valuation

MPA FIN 286

Alessandro Previtero

Slide Pack Week 2 Part 1

Company Valuation – No FrictionModel and Frictions



Today’s Content

I. Announcements:

a. HW 1 due todayb. HW 2 due next classc. TA Review session this Thursday 5-6pm. Room TBA

II. DCF: No Friction Model

III.

Frictions: Taxes and Bankruptcy Costs

IV. Problems

!"#$"%#& ( )



• Introduction•

Discounted Cash Flow (DCF) Models – Discount Rate – No Friction Model –

WACC (Weighted Average Cost of Capital) –

APV (Adjusted Present Value)• Multiples•

Other topics: LBO’s, M&A, etc.

I. Company Valuation



No Friction Model

• We first study a valuation model with no frictions

!

No Corporate or Personal Taxes ! No Bankruptcy Costs ! No Transaction or Issuance Costs !

No Asymmetric Information

• We will then add back frictions, and understand how taxes and

bankruptcy costs affect firm value.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 =



Recap: How to Value a Firm – No Friction Model

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*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 >



Estimating the Cost of Debt (1/12)

•

Cost of debt (r d) depends on: – Rate on Treasury bonds with same maturity (risk-free rate) – Company’s systematic default risk

•

The cost of debt can be estimated in the following ways, orderedfrom most-preferred to least-preferred:

1. CAPM - We can use the CAPM to measure the cost of debt:

$ Unfortunately the majority of corporate debt obligations arenot traded. The few that are traded are not very liquid

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 ?

ed A r E D

E

r E D

D

r ++

+=

)( f md f d

r r r r !"+= #




2.

Yield-to-maturity of firm’s corporate bonds – requires that bonds aretraded in a liquid market (so price is informative) and knowledge ofthe underlying cash flows; adjustment for default probability andrecovery rates necessary for speculative-grade debt (or,alternatively, when probability of default is higher than 1%).

r d = (1-PD)·YTM – PD·(1-RR)

where YTM is the yield-to-maturity, RR is the recovery rate (% of facevalue) should default take place and PD the annualized probability of

default. – The yield-to-maturity (YTM) measures promised return to

bondholders. Therefore, when default risk is relevant, expectedreturn will be lower than YTM

– For speculative-grade debt (worse than Baa/BBB), default riskmay be significant.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 @

return if it pays return if it does not pay




• Table below (source: Moody’s) shows the ratings

characteristics.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 A




• Table below (source: Moody’s) shows the trend in default rates

over time.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 B




• Table below (source: Moody’s) shows the migration tables

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 CD




•

Table below (source: Moody’s) shows default probabilities byletter rating

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 CC




•

Table below (source: Moody’s) shows default probabilities byindustry.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 C)




•

Table below (source: Moody’s) shows recovery rates by debtseniority

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 CE




•

Table below (source: Moody’s) shows recovery rates

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 C=




•

Example: consider a corporate bond with 10 years’ maturity, B rating,and a 8% YTM. What is the cost of debt?o PD of B rated bond is 3.894%o

Recovery rate is 37%

r d = (1-PD)YTM - PD(1-RR)

= (1-0.03894)*0.08 - 0.03894* (1-0.37)= 5.2%

• If we used 8% as an estimate for the cost of debt we would bemissing by approximately 30% relative to the correct rate

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 C>




3.

Using a credit spread, which we add to the relevant Treasury rate – requires

knowledge of bond rating (or at least interest coverage ratio EBIT/Interest toconstruct synthetic rating) in order to obtain credit spread. Risk-free ratematurity should correspond to the average maturity of the company’s debt(detailed in next slide). Default adjustments in 1. still apply.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 C?

Date of Analysis: Data used is as of January 2015.http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ratings.htm

If interest coverage

ratio is

> " to Rating is Spread is

8.50 100000 F..GFFF DH@>I

6.5 8.499999 F.)GFF CHDDI

5.5 6.499999 FCGFJ CHCDI

4.25 5.499999 F)GF CH)>I

3 4.249999 FEGF( CH@>I

2.5 2.999999 K..)GKKK )H)>I

2.25 2.49999 K.CGKKJ EH)>I

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1.75

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1.25 1.499999 KEGK( @H>DI

0.8 1.249999 *..G*** BHDDI

0.65 0.799999 *.)G** C)HDDI

0.2 0.649999 *)G* C?HDDI

-100000 0.199999 6)G6 )DHDDI

For Large non-financial service companies with market cap > $5Billion




4. Inspecting the ratio expenses/debt in historical income statements

– this will provide an approximation, but it may be a bad one ifconditions significantly changed since the debt contracts were enteredinto (e.g. risk-free rate or firm’s credit conditions).

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 C@




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L e v e r i n g

COMPARABLES

REGRESSION

MVD NOAV MVE A

!+=

N

MVE P =

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 CA




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*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 CB



Discount Rate and Leverage

• What happens to the firm cost of capital r A if a company increases itsleverage? $ r e increases because #e increases $ r d increases because #d increases $ r A ?

• Under a no friction model, if we increase the leverage, the discountrate r A remains constant, because even if r e and r d increase, the D/(D

+E) goes up and E/(D+E) goes down. $ We already knew that!

$ # A is not affected by leverage

ed A r E D

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*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 )D



Discount Rate and Leverage - Example

• Company XYZ has a leverage ratio of 20%, #e = 1.5 and #d

=0.2 .The company wants to restructure its capital structure, raisingthe leverage ratio to 30%, but it is concerned that a higher leveragemight increase its discount rate. Assuming that #d is not affected bythe leverage increase, r f =5% and r m =10% and no frictions: $ How much is the firm discount rate BEFORE the restructuring? $ How much is the firm discount rate AFTER the restructuring?

Before the Debt Restructuring After the Debt Restructuring

125.0)05.01.0(5.105.0)( =!+=!+= f me f e r r r r "

060.0)05.01.0(2.005.0)( =!+=!+= f md f d r r r r "

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*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 )C

Note: Many times we will assume that d does not change with leverage. That is agood assumption ONLY if the debt has very low risk for the leverages we areworking with. If debt becomes risky this assumption will not hold any more.




•

Previously, we have seen that in a world with no frictions (no taxes,bankruptcy costs, asymmetric information, transaction costs,%)

$ Firm’s cost of capital =

$ r A is independent of leverage (Modigliani and Miller Proposition

II)

$ The value of a firm does not depend on its capital structure(Modigliani and Miller Proposition I)

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** ))

ed A r

E D

E r

E D

Dr

+

+

+

=



• Introduction•

Discounted Cash Flow (DCF) Models – Discount Rate – No Friction Model –

WACC (Weighted Average Cost of Capital)

–

APV (Adjusted Present Value)• Multiples•

Other topics: LBO’s, M&A, etc.

I. Company Valuation




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ed A r

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COMPARABLES

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*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** )=



Intro on WACC

• The No-Friction Model assumes that there are no corporate taxes

and no costs of financial distress (bankruptcy)• The WACC (Weighted Average Cost of Capital) model relaxes theseassumptions. $ Corporations pay taxes at a marginal rate T $ Financial distress is costly for the firm

• Debt is good because interest on the debt is paid before taxes,generating a Tax Shield

•

How much Tax savings does Debt generate? $ Value of Debt Tax Shields = tcD

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** )>

Revenues -Costs (COGS & SG&A) =

EBITDA -

Depreciation & Amortization (DA) =

EBIT -

Interest =EBT –

Taxes=

Earnings

IS

DA Tax Shield

Interest Payment Tax Shield



Firms’ capital structure preferences (1/2)

Source: Berk and deMarzo, 2009, chapter 15.

• Debt-to-Value Ratio [D / (E + D)]

of U.S. Firms, 1975–2005

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** )?



Firms’ capital structure preferences (2/2)

Source: Berk and deMarzo, 2009, chapter 15.

• Interest Payments as a Percentage of EBIT for S&P

500 Firms, 1975–2005

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** )@



Trade-off Theory (1/3)

• Debt is good% up to a point. When debt is too big, companies enter

financial distress, that is costly to the firm

• We have seen before that the higher the leverage the higher isreturn on debt. Is higher return on debt another cost of debt? $ NO! Why?

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** )A

•

Interest Payment Tax Shield• Management Incentives•

Concessions from Stakeholders

•

Direct Financial Distress Costs $ Legal and consultant fees $ Managerial time dedicated to

bankruptcy proceedings

•

Indirect Financial Distress Costs $ Asset Substitution Problem $ Debt Overhang Problem $ Stakeholders Problem

Benefits of Debt Costs of Debt



Financial Distress Costs: Direct Costs

• The direct costs are really all fees related to the Chapter 11 re-

organization process in the bankruptcy court. These fees are paidby both the firm and the creditors trying to get the firm to pay them. $ UAL re-org – $8.6 million/month $ Enron BK - $30 million/month $ Lehman total BK cost > $100 million as of April 2009

•

An early finance paper (Warner, 1977) estimated direct bankruptcycosts at 5% of the value of the assets being argued over, and this5% then has to be multiplied by the probability the firm even ends upin BK (which is usually low) to get expected direct bankruptcy costs $ Tax savings from debt seem to simply swamp this 5% estimate

(5% IFF you end up in BK)

$ e.g., asset is worth $100, E(BK) costs $5 at most $ Tax Savings = tcD > $5 with tc = 35 at any D > ~$15, or 15%

debt•

Something is missing from this 5% estimate, or we’d see a lot moredebt out there to get the tax savings

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** )B



Financial Distress Costs: Indirect Costs (1/3)

1.

Asset Substitution Problem: When the company is infinancial distress (Value of the firm < value of the debt) themanagers have an incentive to significantly increase theriskiness of the investments•

Managers try to maximize shareholders’ equity. If valueof the firm is less than value of the debt, equity value is

zero (limited liability) and thus managers have nothing tolose in taking on risky projects.

•

Equity is an option-like payoff where the underlyingsecurity is the value of the firm, and the strike price is the

value of the debt.

• It is called asset substitution because substituting lowrisky assets with high risky investments transfers from afirm’s bondholders to its shareholders

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** ED




2.

Debt Overhang Problem: When the company is infinancial distress (Value of the firm < value of the debt)it is very hard to raise external funding because anyextra value created goes first to the existing debt-holders

•

Example: Company XYZ $ is in financial distress (D=100, V=50) $ has a positive NPV Project (NPV=20) $ Needs to raise 10 to start the project $ New bondholders or shareholders would not get

anything back, because the entire expected NPVwould go to the existing bondholders.

$ Only the existing bondholders could finance theproject, but often unwilling to increase the debtexposure to a company in financial distress

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** EC




3.

Stakeholders Problem: Suppliers and customers arewary of dealing with firms that look like they are aboutto go bankrupt (warranty, account payables, investmentin a short term relationship, quality control,% )

•

Because of this worry by customers, the firm losesmoney through lost sales.

•

Usually it is a self-fulfilling prophecy

•

It is one of the most severe cost of financial distress

•

What are some characteristics of firms that might suffermore when customers fear the firm may be in financialdistress? Firms that sell which type of products?

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** E)



Recap: Trade-off Theory

• There is a trade off between the benefits and the costs of debt.

• Companies should target an optimal leverage ratio thatmaximizes firm value (Targeting Strategy) balancing the benefits andcosts of debt

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** EE

Leverage

F

i r m V

a l u e

0 1Optimal Leverage

Ratio

• Interest PaymentTax Shield

• Management

Incentives

• Concessions fromStakeholders

• Direct Financial DistressCosts

• Indirect Financial Distress

Costs $ Asset Substitution

Problem $ Debt Overhang

Problem $ Stakeholders

Problem

Benefits of Debt Costs of Debt



Trade-off Theory (3/3)

• The optimal leverage ratio is unique to each company/industry, as a

function of the relationship between tax advantages and financialdistress costs.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** E=



HOG Optimal Leverage Ratio

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** E>



Problem 1: No Friction Model

•

Consider the following forecasts regarding DFG, Inc. (‘000 of dollars):

•

Using a No-Friction Model, and assuming the FFCF will grow at a 4% rate inperpetuity after year 2 and a D/E target of 0.5, what is the value of DFG’sequity?

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 E?

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•

You also know:•

Asset Beta of DFG’s industry: 1.2;• DFG’s Cost of debt: 8%;•

Market Risk Premium: 6%;• Risk-free rate: 5%;•

DFG does not own non-operationalassets and has a zero excess cash

balance;•

Corporate tax rate: 30%.



Problem 2: No Friction Model

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*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 ;+ 7$%<4+/ 8+9#2 E@



Problem 3: Optimal Leverage Ratio

•

Company XYZ estimates that the value lost in case ofbankruptcy would be 30% of the firm’s value. Therelationship between financial distress costs andleverage is quadratic. Assuming that XYZ’s corporatetax rate is 40%, find the optimal leverage ratio.

*+,-./0 1.23.4+/ 5 6*7 8+9#2: 5 LF** EA

Documents

Valuation_slides_Week2_1 - No Friction Model and Frictions_MPA