Enterprise Valuation

Overview

In this chapter we review the basics of business, or enterprise, valuation. Our focus is on the

hybrid valuation approach that combines DCF analysis (discussed in Chapters 2-5) with

relative valuation (introduced in Chapter 6). We decompose the enterprise valuation problem

into two steps: The first step involves the valuation of a business's planning period cash flows

spanning a 3- to 10-year period, and the second step involves the calculation of the terminal

value, which is the value of all cash flows that follow the planning period. Pure DCF

valuation models use DCF analysis to analyze the value of the planning period and terminal

value cash flows, whereas the hybrid valuation model we discuss utilizes DCF analysis to

value the planning period cash flows and an EBITDA multiple to estimate the terminal value.

7.1 INTRODUCTION

In this chapter we focus our attention on what is generally referred to as enterprise valuation,

which is the valuation of a business or going concern. The approach that we recommend,

which we refer to as the hybrid approach, recognizes that forecasting cash flows into the

foreseeable future poses a unique challenge since most enterprises are expected to stay in

business for many years. To deal with this forecasting problem, analysts typically make

explicit and detailed forecasts of firm cash flows for only a limited number of years (often

referred to as the planning period) and estimate the value of all remaining cash flows as a

terminal value, at the end of the planning period.

The terminal value can be estimated in one of two ways. The first method is a

straightforward a application of DCF analysis using the Gordon growth model. As we

discussed in earlier chapters, this approach requires an estimate of both a growth rate and a

discount rate. The second method applies the multiples approach we discussed in the last

chapter; typically, the terminal value is determined as a multiple of the projected end of

planning period earnings before interest, taxes, depreciation, and amortization (EBITDA). When this latter approach is used to evaluate terminal value and DCF is used to evaluate the planning period cash flows, the model is no longer a pure DCF model but becomes a hybrid approach to enterprise valuation.

The enterprise valuation approach described in this chapter is used in a number of

applications. These include acquisitions, which we consider in the example highlighted in

this chapter; initial public offerings, where firms go public and issue equity for the first time,

which we described in the previous chapter. Going private transactions (which we will

consider in the next chapter); spin-offs and carve-outs (where the division of a firm becomes

a legally separate entity); and finally, the valuation of a firms equity for investment

purposes.

In most applications, analysts use a single discount rate-the weighted average cost of

capital (or WACC) of the investment-to discount both the planning period cash flows and the

terminal value. This approach makes sense if the financial structure and the risk of the

investment are relatively stable over time. However, analysts frequently need to estimate the

enterprise value of a firm that is experiencing some sort of transition, and in these cases the

firms capital structure is often expected to change over time. Indeed, firms are often

acquired using a high proportion of debt, which is then paid down over time until the firm

reaches what is considered an appropriate capital structure. In these cases, the assumption of

a fixed WACC is inappropriate, and we recommend the use of a variant of the discounted

cash flow model known as the adjusted present value model, which we describe later in this

chapter.

Finally, it should be noted that when firms acquire existing businesses, they typically

plan on making changes in the businesss operating strategy. This requires that the potential

acquirer value the business given both its current strategy as well as the proposed new

strategy. Valuing the current strategy can be viewed as a reality check-if the business is not

valued appropriately given its current strategy, why not? One could then value scenarios

where the firms operating strategy is changed following the acquisition to determine whether

the new strategy creates additional value. To help answer this question, sensitivity analysis

can be deployed to determine the situations in which this additional value is indeed realized.

The chapter is organized as follows: Section 7.2 introduces the notion of estimating a

firms or business units enterprise value using the hybrid/multiples approach. Section 7.3

introduces the adjusted present value (APV) model, which is an alternative model that does

not require that the firms capital structure remain constant over the foreseeable future.

Finally, we close our discussion of enterprise valuation with summary comments in Section

7.4.

7.2 USING A TWO-STEP APPROACH TO ESTIMATE ENTERPRISE VALUE

We noted in the introduction that forecasting firm cash flows into the foreseeable

future is a challenging task, and for that reason analysts typically break the future into two

segments: a finite number of years known as the planning period, and all years thereafter.

(See the Practitioner Insight box. Enterprise Valuation Methods Used on Wall Street).

Consequently, the application of the DCF model to the estimation of enterprise value can best

be thought of as the sum of the two terms found in Equation 7.1. The first term represents the

present value of a set of cash flows spanning a finite number of years, referred to as the

planning period (PP).

PP Periodin Value

Terminal theof

ValuePresent

Term2

FlowsCash (PP) Period

Planning theof

ValuePresent

Term1ValueEnterprise

The second term is the present value of the estimated terminal value (TVpp) of the

firm at the end of planning period. As such, the terminal value represents the present value of

all the cash flows that are expected to be received beyond the end of the planning period. As

the following Technical Insight box on page 284 illustrates, the terminal value estimate is

generally quite important and can often represent over 50% of the value of the enterprise.

Example TATA Steel Ltd, Acquires Corus

To illustrate our enterprise valuation approach, consider the valuation problem in Tata Steels

acquisition or Corus in February 2007. Tata Steel Ltd, the largest steel company in India (5

million tons of steel), has often been cited as the lowest-cost producer of steel in the world. It

enjoys EBITDA margins of 30%-40%. Although Corus has been marred by financial

problems and lags behind in production efficiency with EBITDA margins of less than 10%,

the recent increase in global demand for steel has helped it turn around.

As discussed in Chapter 1, the Corus acquisition fits into Tata Steels overall business

strategy, which recognizes that the steel industry has undergone a significant transformation

in recent times and tee I can no longer be viewed as a homogeneous product. For instance,

Tata Steel specializes in the production of steel slabs, an intermediate form of steel because it

is closer to the source of raw materials (iron ore mines). In contrast, Corus: has a

comparative advantage in producing customized steel, which is a key requirement in several

industries (especially the automobile industry). Customized (or finished) steel can be sold at

a premium compared to steel slabs because of significant value-addition. Tata Steels overall

business strategy differentiates between steel slab capacity and finished steel capacity. It

involves acquiring each form of capacity in those geographic locations which offer the best

potential for value creation. The Corus acquisition highlights this aspect of their overall

business strategy.

The acquisition cost of 6172.31 million is 8.31 times Coruss 2006 EBITDA of 743

million (see Table 7.1). The acquisition cost of 6172.31 million along with a net debt

amount of 1798 million1, implies an enterprise value (EV) of 7970.31 million. Adjusting

for cash of 823 million, the EV/EBITDA ratio is 9.62. However, the standard metric for

valuation in the steel industry is EV per ton of steel. Corus produces about 18 million tons of

steel. This implies an EV of 397 per ton, or $767 per ton of steel (at the prevailing

exchange rate at the time of the transaction), which is close to the average of $747 per ton for

similar transactions in the recent past.

1 Liabilities in Corus include long-term debt and other obligations in the form of deferred tax

liabilities and pension liabilities. However, a major portion of the 1798 million liability is

in the form of long-term debt. In the interest of keeping the analysis as simple as possible, we

treat the entire liability amount of 1798 million as long-term debt.

PRACTITIONER INSIGHT:

Enterprise Valuation Methods Used on Wall Street - An Interview with Jeffrey Rabel*

In broad brush terms there are three basic valuation methodologies used throughout the

investment banking industry: trading or comparable company multiples, transaction

multiples, and discounted cash flows. Emphasis on a particular methodology varies

depending on the particular setting or type of transaction. For equity transactions such as the

pricing of an initial public offering (IPO), relative valuation based on multiples of market

comparables (firms in the same or related industries, as well as firms that have been involved

in recent similar transactions) is the preferred approach. The reason for the emphasis on this

type of valuation is that the Company will have publicly traded equity and thus investors will

be able to choose whether to buy said Company or any of the other companies that are

peers.

A key consideration in relative valuation analysis is the selection of a set of

comparable firms. For example, in the Hertz IPO we looked at not only the relative prices of

car rental firms (Avis, Budget, etc.) but also considered industrial equipment leasing

companies (United Rental, RSC Equipment, etc.) since this was a growing piece of Hertzs

business model. We also looked at travel related companies, as a large part of the Hertz

rental car business is driven by airline travel. Some also believed that Hertz, because of its

strong brand name recognition, should be compared to valuation multiples of a set of

companies with strong brand recognition including firms such as Nike or Coke. Obviously

selection of a comparable group of firms and transactions is critical when carrying out a

relative valuation because different comparable sets trade at different multiples and this

affects the valuation estimate.

In merger and acquisition (M&A) analysis involving a strategic buyer (typically

another firm in the same or a related industry) or a financial buyer such as a private equity

firm (see Chapter 8 for further discussion) the second type of relative valuation method,

transaction multiples, is used in combination with discounted cash flows (DCF). The reason

for the focus on a transaction multiple is the fact that transaction multiples represent what

other buyers have been willing to pay for similar companies or companies with related lines

of business. The transaction multiples are used in combination with the DCF approach as

DCF allows the buyers to value the acquisition based on their forecast of its performance

under their assumptions about how the business will be run.

DCF valuation methods vary slightly from one investment bank to another: however,

the typical approach to enterprise valuation is a hybrid approach consisting of forecasting

cash flows to evaluate near-term projections and relative valuation to estimate a terminal

value. The analysis typically involves a five-year forecast of the firms cash flows which are

discounted using an estimate of the firms weighted average cost of capital. Then the value

of cash flows that extend beyond the end of the planning period are estimated using a

terminal value that is calculated based on a multiple of a key firm performance attribute such

as EBITDA. The terminal value estimate is frequently stress tested using a constant growth

rate with the Gordon growth model to assess the reasonableness of the implied growth rate

reflected in the terminal value multiple.

The final valuation approach we use a variant of the DCF approach that is used where

a M & A transaction involves a financial sponsor (generally a private equity firm such as

Blackstone, Cerberus or KKR. Financial buyers are primarily driven by the rate of return

they earn on their investors money so the valuation approach they use focuses on the IRR of

the transaction. The basic idea is to arrive at a set of short-term cash flow forecasts that the

buyer is comfortable with, estimate a terminal value at the end of the forecast period

(typically 5 years), and then determining IRRRs by varying the acquisition price.

* Jeffrey Rabel is a CPA and a Vice President in the Global Financial Sponsors group at

Lehman Brothers in New York.

The acquisition cost of 6172.31 million to acquire Corus was too large an amount,

given the size of Tata Steel Ltd. The only feasible financing alternative for Tata Steel Ltd,

was to raise a significant portion of the acquisition cost in the form of debt. To safeguard the

interests of Tata Steels shareholders, the management of Tata Steel had hinted at the time of

the acquisition that the acquired assets and the associated debt would be placed in a separate

legal entity. This arrangement would effectively protect Tata Steels shareholders from the

risks associated with high debt. For the purpose of acquiring Corus, Tata Steel therefore

created a wholly owned subsidiary in the U.K. (Tata Steel Limited).

Table 7-1 Pre-and Post-Acquisition Balance Sheets for Corus (All Figures in Millions)

Pre-Acquisition

2006

Post-Acquisition

2006

Current Assets*

Net property, plant, and equipment

Other investments and assets

Goodwill

4,412.00

2,758.00

780.00

130.00

4,412.00

2,758.00

780.00

2,368.31

Total

Current liabilities

Long-term debt**

8,080.00

2,348.00

1,798.00

10,3180.31

2,348.00

4,526.39

Total liabilities

Paid-up capital

Premium

Retained earnings

Common equity

Total

4,146.00

1,725.00

389.00

1,820.00

3,934.00

8,080.00

6,874.39

1,725.00

1,718.93

0.00

3,443.93

10,318.31

* 2006 and 2007 Current Assets include Cash of 823 million

** Long term loans and other long-term liabilities have been clubbed together under the head

Long-term debt.

This type of transaction is a highly leveraged one and is frequently used by private

equity groups or corporate raiders to take over undervalued companies. We often hear about

such transactions-they go by the name of LBOs (leveraged buy-outs). The Tata Corus

acquisition, however, does not fit into the category of a standard private equity led LBO

transaction because Tata Steel has not entered into the transaction with an explicit intent to

divest Corus at a higher valuation in the future. In contrast, sponsors of LBO acquisition

strategies have very clearly defined goals of divesting the acquired assets within a five-to ten-

year time frame. We will examine the more general use of LBOs as part of an acquisition

strategy in Chapter 8.

Table 7.1 shows the pre- and post-acquisition balance sheets for Corus. The

acquisition cost of 6172,.31 million reflects a premium of 2238.31 million above Coruss

pre-acquisition book value of the equity of 3934 million. Note that this difference is

recorded as goodwill in the revised post-acquisition balance sheet.2

2 By including all of the purchase premium as Goodwill we are assuming that the appraised

value of the Coruss assets is equal to their book value.

We assume that Tata Steel UK is able to raise 60% of the acquisition cost of 6172.31

million in the form of long-term loans.3This amount is 3703.39 million. The long-term loans

come with legally structured agreements, which ensure that cash flow from Coruss

operations will be used to service these loans. Second, we also carry forward old debt in

the amount of 823 million.4This implies that the total debt amount post acquisition is

4526.39. Given an enterprise value of 7970.31 million, it follows that the remaining

amount of 3443.93 million has to be supplied by equity holders.

In summary, post acquisition, Tata Steel UK and Corus combination will have a total

of 7970.31 million in invested capital, of which 4526.39 million (56.79%) is debt and the

remaining 3443.93 million (43.21%) is equity. Current liabilities consist mostly of

payables, and therefore we treat this amount as a non-interest bearing liability.

We can decompose the synergies in the acquisition into two components. First, under

the new management, synergies arise in the operations of Corus. These synergies would be

reflected in the value of Tata Steel UK. As an equity holder in Tata Steel UK, Tata Steel Ltd

would therefore benefit from the synergies created in Corus. Second, Tata Steel Ltd. could

directly experience synergies in its own operations as a result of the Corus acquisition. The

valuation of the acquisition to Tata Steel should reflect both sources of synergy. In this

chapter, however, we focus only on the former source of synergy, i.e., we value the Corus

acquisition from the perspective of Tata Steel UK, rather than Tata Steel Ltd. (India).

To estimate these synergies, we will first examine Corus prior to the acquisition under

a status quo strategy. Then we will analyze the value of Corus under a growth strategy

that reflects the restructuring plans of Tata Steel UK. The comparison of the value of Corus

under these two strategies will help us estimate the synergies created in Corus under the new

management.

Our analysis of the status quo strategy shows that Corus has an enterprise value in the

range of 5 to 6 billion, which implies a share value in the range of 350 to 400 pence a

share. This is consistent with the share price of Corus during the six-month period prior to

the acquisition. Then we estimate the value of the growth strategy that Tata Steel UK is

likely to display after the acquisition. We find that cash flows under the growth strategy are

lower than those under the status quo strategy for the first few years. However, in later years,

when the synergies of the acquisition start kicking in, the cash flows arising from the growth

strategy become larger. We find that the enterprise value of Corus under the management of

Tata Steel UK could be in the range of 9 to 11 billion, depending on the method used for

valuation.

3The financing arrangement that was eventually adopted differed a slightly from this rough

breakup. According to a press release of Reuters LPC (Tata Steel launches 3.7 bln stg loan

for Corus buy, Friday July 6, 09:00 PM), the financing of Tata Steel UK has been structured

as a hybrid corporate-leveraged financing arrangement and will have no recourse to parent

company Tata Steel. The bankers to the deal are ABN AMRO, Citibank, and Standard

Chartered. The long-term loans amount to a total of 3670 million. The interest rates have

been set at LIBOR plus a spread ranging between 175 basis points and 225 basis points.

Further the report mentions that Tata Steel and Tata Sons would jointly invest 3500 million

as equity in Tata Steel UK. For our purposes, it makes sense to value the investment

opportunity based on the expected financing arrangement rather than the eventual financing

arrangement. At the time of making the acquisition offer, Tata Steel had only ballpark

estimates of the terms of financing based on discussions with their bankers. Our analysis is

therefore not constrained by this. lack of information.

4To keep matters as simple as possible, we assume that the old debt that is carried forward

bears the same interest rate as the new debt.

Valuing Corus using DCF Analysis

We follow the same three-step procedure discussed in Chapter 2 to perform the DCF analysis

for valuing the Corus acquisition: Step 1-estimate the amount and timing of the expected cash

flows; Step 2-estimate a risk-appropriate discount rate; and Step 3-calculate the present value

of the expected cash flows, or enterprise value.

Step 1. Estimate the amount and timing of the expected cash flows. We used information

gleaned from the annual reports of Corus prior to the acquisition to evaluate the status quo

strategy. Corus was well on its way in implementing Restoring Success, a key

restructuring initiative that had already resulted in incremental EBITDA of 680 million by

the end of 2006. The hallmark of this initiative was to divest from low-margin activities and

to consolidate in high-margin activities. As a result of such restructuring activities,

significant cost reductions were achieved every year both in terms of cost of goods sold and

general administrative expenditures. Going forward, we estimate that the total savings would

be 150 million in 2007, 225 mi1lion during 2008-2009 and would increase to 300

million annually during 2010-2012. These savings amount to 1500 million during the 2007-

2012 planning period. On C1l the expenditure side, Corus had committed to renewing

employer contribution to pension schemes by an amount of 50 million annually from 2006.

We also assume that no extraordinary capital expenditures arise in the status quo plan, other

than those required to offset depreciation.

The exact schedule of savings in costs and the additional pension expenditures are

shown in Panel a of Table7-2. These estimates of savings are reasonably conservative and

consistent with the stated plans of Corus management. Their impact is more obvious when

we look at the projected change in EBITDA margin over the period 2007-2012. As can be

inferred from proforma income statements in Table 7.2 (and more explicitly, in data stated in

Figure 7-1), these savings imply a relatively modest change in EBITDA margins from 7.63%

in 2006 to 8.15% in 2012.

In Panel b of Table 7.2 we present the pro forma financial statements and cash flow

projections for Corus that are required to complete Step 1 of a DCF analysis. The cash flow

projections consist of planning period cash flows spanning the period 2007-2012, and

terminal value estimates based on cash flow projections for 2013 and beyond. The pro forma

calculations reflect an assumed rate of growth in revenues of 3 % per year during the

planning period and a 1.5 % growth rate in firm free cash flows in the post planning period.

The asset levels found in the pro forma balance sheets reflect the assets that Corus

needs to support the projected revenues. Current assets are determined by a fixed current

asset-to-sales ratio of 45% (2006 actual), and current liabilities are determined by a fixed

current liabilities-to-assets ratio of 29% (2006 actual). Any additional financing requirements

are assumed to be raised by first retaining 95% of Coruss earnings (implying a dividend

payout ratio of 5%) and then taking recourse to long-term debt. A quick review of the pro

forma balance sheets found in Panel b of Table 7-2, however, indicates that under the status

quo strategy Coruss long-term debt actually declines from 1798 million at the end of 2006

to 186.50 million by 2012. This decrease reflects the fact that the firms retention of future

earnings is more than adequate to meet its financing needs, which allows the firm to retire its

long-term debt. Finally, Coruss estimated cash flows, found in Panel c, indicate that from

2007 through 2012 cash flows are expected to grow from 276.67 million to 438.87 million.

Estimating Coruss Enterprise Value using DCF Analysis (Status quo Strategy)

[All Figures in Millions]

Panel a. (Step 1) Estimate the Key Savings in Costs and Additional Expenditures

During Planning Period

Planning Period Pro Forma Financial Statements

2007 2008 2009 2010 2011 2012 Total

Change

(2007-

2012)

Reduction in

COGS

Reduction in

SG & A

Total Savings

Increase in

Pension

10%

90.00

10.00%

60.00

150.00

50.00

15%

135.00

15.00%

90.00

225.00

50.00

15%

135.00

15.00 %

90.00

225.00

50.00

20%

180.00

20.00 %

120.00

300.00

50.00

20%

180.00

20.00 %

120.00

300.00

50.00

20%

180.00

20.00 %

120.00

300.00

50.00

100%

900.00

100.00 %

600.00

1,500.00

300.00

Panel b. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Planning Period Pro Forma Balance Sheet

Corus Pro Forma Balance Sheets

2006 2007 2008 2009 2010 2011 2012

Current

assets

4,412.00

4,544.36

4,680.69

4,821.11

4,965.74

5,114.72

5,268.16

Net

property-

plant, and

equipment

2,758.00

2,758.00

2,758.00

2,758.00

2,758.00

2,758.00

2,758.00

Other

investments

and assets

780.00

780.00

780.00

780.00

780.00

780.00

780.00

Goodwill 130.00

130.00 130.00 130.00 130.00 130.00 130.00

Total

8,080.00

8,212.36

8,348.69

8,489.11

8,633.74

8,782.72

8,936.16

Current

liabilities

2,348.00

2,386.46

2,426.08

2,466.89

2,508.91

2,552.21

2,596.79

Long-term

debt

1,798.00

1,641.98

1,420.67

1,181.08

872.30 541.18 186.50

Total

liabilities

4,146.00

4,028.44

3,846.75

3,647.96

3,381.22

3,093.38

2,783.30

Paid-up

capital

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

1,725.00

Premium 389.00 389.00 389.00 389.00 389.00 389.00 389.00

Retained

earnings

1,820.00

2,069.92

2,387.94

2,727.15

3,138.53

3,575.33

4,038.86

Common

equity

3,934.00

4,183.92

4,501.94

4,841.15

5,252.53

5,689.33

6,152.86

Total

8,080.00

8,212.36

8,348.69

8,489.11

8,633.74

8,782.72

8,936.16

Continued

Table 7-2 Planning Period Pro Forma Income Statements

Corus Pro Forma Income Statements

2006 2007 2008 2009 2010 2011 2012

Revenue

9,733.00

10,024.99 10,325.74

10,635.51

10,954.58

11,283.21

11,621.71

Cost of goods

sold

-

6,275.00

- 6,325.99 - 6,473.47 - 6,671.73 - 6,380.93 - 7,041.26 - 7,257.90

Gross profit

3,458.00

3,699.00 3,852.27 3,963.78 4,123.65 4,241.96 4,363.82

General and

administrative

expense

-

2,715.00

- 2,997.50 - 3,057.72 - 3,150.65 - 3,216.37 - 3,314.96 - 3,416.51

EBITDA 743.00 701.50 -794.54 813.13 907.27 926.99 947.30

Depreciation

expense

- 286.00 - 275.80 - 275.80 - 275.80 - 275.80 - 275.80 - 275.80

Net operating

income

457.00 425.70 518.74 537.33 631.47 651.19 671.50

Other income 58.00 58.00 58.00 58.00 58.00 58.00 58.00

EBIT 515.00 483.70 576.74 595.33 689.47 709.19 729.50

Interest expense - 202.00 - 107.88 -- 98.52 - 85.24 - 70.86 - 52.34 - 32.47

Earnings before

taxes

313.00 375.82 478.23 510.09 618.61 656.85 697.03

Taxes - 119.00 - 112.75 - 143.47 - 153.03 - 185.58 - 197.06 - 209.11

After-tax profit

from continuing

operations

194.00 263.07 334.76 357.06 433.03 459.80 487.92

After-tax profit

from

discontinued

operations

35.00

Net Income 229.00

Table 7.2 Continued

Panel c. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Planning Period Projected Firm Free Cash Flows (FFCF)

Projected Firm Free Cash Flows

2007 2008 2009 2010 2011 2012

EDIT 483.70 576.74 595.33 689.47 709.19 729.50

Less: Taxes - 145.11 - 173.02 - 178.60 - 206.84 - 212.76 - 218.85

NOPAT 338.59 403.72 416.73 482.63 496.44 510.65

Plus:

Depreciation

275.80

275.80

275.80

275.80

275.80

275.80

Less: Capex - 275.80 - 275.80 - 275.80 - 275.80 - 275.80 - 275.80

Less:

Increases in

Net

Working

Capital

- 61.92

- 63.78

- 65.69

-67.66

- 69.69

- 71.78

Equals

FFCF

276.67 339.94 351.04 414.97 426.74 438.87

Panel d. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Terminal Value Cash Flow Estimate

Method #1 DCF Using the Gordon Growth Model Ration -

Terminal Value Multiples from the Gordon Model

Growth Rates (g)

Discount Rates 0.00% 1.00% 1.50% 2.00%

8.357% 11.97 13.73 14.80 16.05

8.857% 11.29 12.86 13.80 14.88

9.357% 10.69 12.09 12.92 13.87

9.857% 10.15 11.40 12.15 12.98

Terminal Value Estimates (for FFCFs received in 2013 and beyond)

Growth Rates (g)

Discount Rates 0.00% 1.00% 1.50% 2.00%

8.357% 5,251,77 6,025.31 6,496.70 7,042.24

8.857% 4,955.28 5,641.86 6,055.14 6,528.70

9.357% 4,690.48 5,304.29 5,669.79 6,084.97

9.857% 4,452.55 5,004.84 5,330.55 5,697.72

Method #2 Multiples Using Enterprise Value to EBITDA

Terminal Value Estimates

Enterprise Value / EBITDA Terminal Value

5.00

5.50

6.00

6.70

7.20

5,026.51

5,529.16

6,031.82

6,735.53

7,238.18

(Continued)

Panel e (Step 2) Estimate a Risk Appropriate Discount Rate

Cost of debt Estimated borrowing rate is 6.0% with a marginal tax of 30% results in

an after-tax cost of debt of 4.200%.

Cost of equity An average industry unlevered equity beta of .849 implies a levered

equity beta for Corus of 1.02 assuming a target debt ratio of 22% and a debt beta of

.255. Using the capital asset pricing model with a 10 year government security yield

of 4.60% and a market risk premium of 5.50% produces an estimate of the levered

cost of equity of 10.189%.

Weighted average cost of capital (WACC) Using the target debt to value ratio of

22% the WACC is approximately 8.857%.

Panel f. (Step 3) Calculate the Present Value of Future Cash Flows

Present Value of Expected Future Cash Flows

Terminal Value Enterprise Value

Discount

Rate

Planning

Period FFCF

Method #1 Method #2 Method #1 Method #2

7.857%

8.857%

9.857%

1,706.31

1,651.65

7,599.60

4,451.40

3,639.11

3,302.60

4,278.50

4,048.02

3,831.90

6,157.70

5,290.76

4,632.20

5,984.80

5,699.67

5,431.50

Status Quo Strategy 2006 2007 2008 2009 2010 2011 2012

Total liabilities / Total assets 51.3% 49.1% 46.1% 43.0% 39.2% 35.2% 31.1%

Long-term debt/Total assets 22.3% 20.0% 17.0% 13.9% 10.1% 6.2% 2.1%

Growth Strategy Strategy 2006 2007 2008 2009 2010 2011 2012

Total liabilities / Total assets 66.6% 67.7% 67.7% 66.7% 63.7% 59.2% 53.5%

Long-term debt/Total assets 43.9% 44.9% 44.9% 43.9% 40.9% 36.5% 30.8%

EBITDA margins

2006 2007 2008 2009 2010 2011 2012

Status quo case 7.63% 7.00% 7.69% 7.65% 8.28% 8.22% 8.15%

Growth strategy case 7.63% 5.35% 6.93% 8.22% 10.99% 12.68% 13.97%

Growth minus Status quo 0.00% -1.64% -0.76% 0.57% 2.70% 4.47% 5.82%

Terminal Values, Expected Growth Rates, and the Cost of Capital

When estimating value using a planning period and a terminal value, how much of the value

can be attributed to each of these components? To answer this question, consider the

situation where a firms free cash flows are expected to grow at a rate of 12% per year for a

period of five years, followed by a 2% rate of growth thereafter. If the cost of capital for the

firm is 10%, then the relative importance of the planning period cash flows and the terminal

value cash flows for different planning periods is captured in the upper figure:

If the analyst uses a five-year planning period, then the present value of the planning

period cash flows in this setting constitutes 27.45 % of the value of the enterprise, leaving

over 72.55 % of enterprise value in the terminal value. Similarly, if a three-year planning

period is used, then the terminal value constitutes 83.83% of the enterprise value estimate,

leaving only 16.17% for the planning period. The key observation we can make from this

analysis is that the terminal value is at least 50% of the value for the firm for all commonly

used planning periods (i.e., three to 10 years).

The previous example was obviously a very high-growth firm. It stands to reason,

then, that the terminal value may be less important for more stable (low-growth) firms. It

turns out (as the lower figure indicates) that even for a very low- and stable-growth firm

whose cash flows grow at 2% per year forever, the terminal value is still the dominant

component of the enterprise value estimate for the typical three- to 10-year planning period.

In this case where the firm has a constant rate of growth of 2% per year for all years, a five

year planning period results in 31.45% of the enterprise value coming from the cash flows in

the planning period, which leaves 68.55 % of enterprise value in the terminal value.

The message is very clear. The analyst must spend significant time estimating the

firms terminal value. In fact, even for a long (by industry standards) planning period of 10

years, the terminal value for the slow-growth firm above is still roughly half (47%) of the

firms enterprise value.

How important should the terminal value be to the enterprise value of your firm? As

the examples weve used above suggest, the answer will vary with the firms growth

prospects and the length of the planning period used in the analysis. In general, terminal

value increases in importance with the growth rate in firm cash flows and decreases with the

length of the planning period.

Panel d includes two analyses of the terminal value of COTUS evaluated in 2012.

The first method (Method #1) uses the Gordon growth model (introduced in Chapter 2) to

estimate the present value of the firm free cash flows (FFCFs) beginning in 2013 and

continuing indefinitely. Specifically, we estimate the terminal value in 2012 using Equation

7.2:

(g) RateGrowth Terminal )(k Capita ofCost

(g) RateGrowth Terminal1FFCFValue Terminal

WACC

20122012

To estimate the terminal value using this method, we assume that the cash flows the firm is

expected to generate after the end of the planning period grow at a constant rate (g), which is

less than the cost of capital (Kwacc) Recall from our discussion of multiples in Chapter 6 that

Equation 7.2a can be interpreted as a multiple of FFCF2012 where the multiple is equal to the

ratio of one plus the terminal growth rate divided by the difference in the cost of capital and

the growth rate, i.e.:

Multiple Model

GrowthGordon x FFCF

gk

g1 FFCF Value Terminal 2012

WACC

20122012

In Panel d of Table 7-2 we report a panel of Gordon growth model multiples that

correspond to a reasonable range of values of the discount rate and rate of growth in future

cash flows. For example, for the cost of capital of 8.857% and a 1.5% terminal growth rate,

the multiple for terminal value based on the Gordon Growth Model,

gk

g 1

WACC

,is 13.80.

Based on the estimated FFCF2012 of 438.87 million, this produces an estimate of the

terminal value at the end of 2012 of 6055.14 million.

In addition to the DCF analysis of the terminal value, Panel d of Table 7-2 provides

an analysis that uses EBITDA multiples (Method #2), as shown in Equation:

MultipleEBITDA EBITDA Value

Terminal

x 20122012

Multiples ranging from 5 to 7 are reported in Panel d of Table 7-2. The average multiple for

similar transactions that have recently occurred in the steel industry is 6.70.

Using this multiple of 6.70 times EBITDA2012 (which equals 1005.30) produces an

estimated terminal value for Corus in 2012 of 6735.53 million = 6.70 x 1005.30 million. It

should be noted that the EBITDA multiple and the free cash flow multiple generate very

similar terminal value estimates when there are no extraordinary capital expenditures or

investments in net working capital. If this were not the case, the analyst would want to

double-check his or her assumptions and attempt to reconcile the conflicting terminal value

estimates.

Step 2. Estimate a risk-appropriate discount rate. Under the status quo strategy, we

compute the cost of capital for Corus based on a 22% debt to enterprise value ratio (2006

actual). We assume that this 22% ratio is the target capital structure under the status quo

strategy. We also assume that the cost of debt of 6%. Details supporting the calculation are

provided in Panel e of Table 7-2. The analysis implies an estimated cost of capital for Corus

of 8.857%.

Step 3. Calculate the present value of the expected cash flows, or enterprise value. In Panel

f of Table 7-2 we estimate the enterprise value of Corus using the free cash flow estimates

from Panel c and discounting them with the estimated cost of capital for Corus from Panel e

plus and minus one percent-8.857% (the estimated WACC), 7.857%, and 9.857%. The result

is an array of enterprise value estimates reflecting each of the methods used to estimate the

terminal value and the range of cost of capital estimates. With the 8.857% estimated cost of

capital, the estimate of enterprise value is in the range of 5,291 million to 5700 million.

These numbers imply that the owners equity is in the range of 3493 million to 3902

million, or equivalently 344 pence to 384 pence per share. The actual market price of Corus

shares in the six-month period prior to the acquisition also varied around this range.

Based on this analysis, we can see that the acquisition is not worth pursuing at a cost

of 608 pence a share unless there are synergies that compensate for the premium paid in the

acquisition. The acquisition, therefore, makes sense only if Tata Steel is confident of making

changes in the operating strategy of Coruss business. As we discussed in Chapter 1 and at

the beginning of this chapter, the Tata Steel-Corus combination offers significant

opportunities of creating synergies. Tata Steel is one of the lowest cost producers of slab

steel, which is a key raw material for customized steel products sold by Corus. Corus will

thus be able to reduce its cost of goods sold. At the same time, Corus will be in a position to

divest from its low margin plants (or at least reduce the scale of such plants), thereby saving

on administrative expenses. In addition, Corus will be able to gain access to the increasing

demand for customized steel products in the high-growth emerging market of India.

Valuing Corus under Tata Steels Growth Strategy

To evaluate the Corus acquisition under the management of Tata Steel, we repeat the earlier

analysis keeping in mind the synergies of the acquisition. The results of this analysis are

contained in Table 7-3. Panel a shows that the potential savings under the growth strategy

over the planning period (2007-2012) are 3000 million which is twice the total savings

under the status quo strategy. However, it can also be expected that Tata Steel UK will incur

more cash outflows due to capital expenditures under the more ambitious growth strategy. In

addition to these costs. Tata Steel has also agreed to put more resources into the pension

scheme at Corus. Projections related to these item are shown in detail in Panel a of Table

7.3.

It should be noted that Tata Steel had very little surplus steel slab capacity in 2006 but

was confident about increasing capacity in the next two to three years. This meant that there

would be a gestation period of two or three years before the synergies arising in Corus due to

lower cost steel slabs start having a significant effect. The pattern of savings in Panel a of

Table 7-3 reflects this situation. These estimates of savings are reasonably conservative and

consistent with the stated plans of Tata Steel. As can be inferred from proforma income

statements in Table 7.3 (and more explicitly, in data stated in Figure 7-1), these savings imply

a change in EBITDA margin from 7.63% in 2006 to 13.97% in 2012. Tata Steel

management has often said that it would be able to increase EBITDA margins in Corus up to

20%.

Panel b of Table 7-3 presents proforma financial statements (2007-2012) for Corus

under the growth strategy. The growth strategy involves increased capital expenditures on

upgrading and restructuring of manufacturing capacity. Specifically, the plan calls for

spending an additional 50 million each year on aggressive marketing plans and capital

equipment throughout the six-year planning period.

We predict that the combined effect of these actions is to increase the planning period

rate of growth in sales to 5% per year, compared to only 3% under the status quo strategy.

After achieving the higher target market share in 2012, capital expenditures and marketing

expenditures are expected to return to the status quo levels, and the expected rate of growth in

firm free cash flow for 2013 and beyond is assumed to be 2%, slightly higher than the 1.5%

growth rate in. the status quo case.

Comparing the cash flow projections for the status quo strategy found in Panel c of Table 7-2

with those or the growth strategy in Panel c of Table 7-3, we see that the growth strategy has

the initial effect of reducing cash flows below status quo levels for 2007-2009. However,

beginning in 2010 the growth strategy cash flows will exceed those of the status quo strategy

(577 million for the growth strategy as compared with 415 million for the status quo

strategy). Moreover, for all subsequent years we expect the growth strategy to maintain a

higher level of FFCF. As can be seen in Panel f of Table 7-3, the enterprise value estimates,

are dramatically higher under the growth strategy than under the status quo strategy. Using a

cost of capital of 8.420% (Panel e of Table 7-3), it can be shown that the enterprise value is

11,037 million when the Gordon growth model is used to estimate the terminal value and

9,754 million when a 6.7 times EBITDA multiple (the average EBITDA multiple in recent

transactions) is used to estimate the terminal value. These enterprise values imply a value of

614 ($1185) per ton of steel under the Gordon method and a value of 542 ($1047) per ton

of steel under the EBITDA multiple approach. After subtracting the long term debt of 1798,

the owners equity is equal to 9239 million and 7956 million under Method # 1 and

Method # 2, respectively. Given the acquisition cost of 6172.31 million, the NPV of the

acquisition from the point of view of Tata Steel UK is 3067 million and 1784, respectively.

Table 7.3 Estimating Corus's Enterprise Value using Analysis (Growth Strategy)

(All Figures in Millions)

Panel a. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Planning Period Pro Forma Financial Statements

2007 2008 2009 2010 2011 2012 Total

change

2007-

2012

Reduction in

COGS

2% 5% 10% 20% 28% 35% 100%

42.00 105.00 210.00 420.00 588.00 735.00 2,100.00

Reduction in

SG&A

2% 5% 10% 20% 28% 35% 100%

18.00 45.00 90.00 180.00 252.00 315.00 900.00

Total

savings

60.00 150.00 300.00 600.00 840.00 1,050.00 3,000.00

New capital

expenditures

50.00 50.00 50.00 50.00 50.00 50.00 300.00

Increase in

Pension

126.00 50.00 50.00 10.00 10.00 10.00 256.00

Panel b. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Planning Period Pro Forma Balance Sheet

Pre-

Acquisition

Post-

Acquisition

Pro Forma Balance Sheets

2006 2006 2007 2008 2009 2010 2011 2012

Current

assets

4,412.00 4,412.00 4,632.60 4,864.23 5,107.44 5,362.81 5,630.95 5,912.50

Net

property,

plant, and

equipment

2,758.00

2,758.00

2,808.00

2,858.00

2,908.00

2,958.00

3008.00

3,058.00

Other

investments

and assets

780.00

780.00

780.00

780.00

780.00

780.00

780.00

780.00

Goodwill 130.00 2,368.31 2,368.31 2,368.31 2,368.31 2,368.31 2,368.31 2,368.31

Total 8,080.00 10,318.31 10,870.54 10,588.91 10,870.54 11,163.76 11,787.27 12,118.82

Current

Liabilities

2,348.00 2,348.00 2,473.66 2,473..66 2,540.39 2,609.88 2,682.27 2,757.72

Long-term

debt

1,798.00 4,526.39 4,882.52 4,882.52 4,904.44 4,691.66 4,297.55 3,731.72

Total

liabilities

4,146.00 6,874.39 7,356.18 7,356.82 7,444.82 7,301.53 6,979.82 6,489.44

Paid-up

capital

1,725.00 1,725.00 1,725.00 1,725.00 1,725.00 1,725.00 1,725.00 1,725.00

Premium 389.00 1,718.93 1,718.93 1,718.93 1,718.93 1,718.93 1,718.93 1,718.93

Retained

earnings

1,820.00 0.00 - 22.91 - 70.43 275.01 723.67 1,363.52 2,185.45

Common

equity

3,934.00 3,443.93 3,421.01 3,514.36 3,718.93 4,167.59 4,807.45 5,629.38

Total 8,080.00 10,318.31 10,558.91 10,870.54 11,163.76 11,469.13 11,787.27 12,118.82

Planning Period Pro Forma Income Statements

Pre-

Acquisition

Post-

Acquisition

Pro Forma Balance Sheets

2006 2006 2007 2008 2009 2010 2011 2012

Revenue 9,733.00

9,733.00

10,219.65

10,730.63

11,267.16

11,830.52

12,442.05

13,043.15

Cost of goods sold - 6,275.00 - 6,275.00 -

6,498.58

-

6,762.60

-

7,000.99

-

7,151.53

-

7,362.11

-

7,612.62

Gross profit 3,458.00 3,458.00 3,721.07 3,968.03 4,266.18 4,678.99 5,059.94 5,430.53

General and

administrative

expense

- 2,715.00 - 2,715.00 -

3,173.90

-

3,224.19

-

3,340.15

-

3,379.16

-

3,484.61

-

3,607.95

EBITDA 743.00 743.00 547.18 743.84 926.03 1,299.83 1,575.32 1,822.59

Depreciation

expense

- 286.00 - 286.00 - 275.80 - 280.80 - 285.80 - 290.80 - 295.80 - 300.80

Net operating

income

457.00 457.00 271.38 463.04 640.23 1,009.03 1,279.52 1,521.79

Other income 58.00 58.00 58.00 58.00 58.00 58.00 58.00 58.00

EBIT 515.00 515.00 329.38 521.04 698.23 1,067.03 1,337.52 1,579.79

Interest expense - 202.00 - 202.00 - 362.11 - 380.67 - 390.60 - 392.35 - 375.33 - 343.80

Earnings before

taxes

313.00 313.00 - 32.73 140.37 307.63 674.68 962.19 1,235.99

Taxes - 119.00 - 119.00 9.82 - 42.11 - 92.29 - 202.40 - 288.66 - 370.80

After-tax profit

from continuing

operations

194.00 194.00 - 22.91 98.26 215.34 472.27 675.53 865.19

After-tax profit

from

discontinued

operations

35.00 35.00

Net Income 229.00 229.00

(continued)

Panel c. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Planning Period Cash Flow Estimates

Projected Firm Free Cash Flows

2007 2008 2009 2010 2011 2012

EBIT 329.38 521.04 698.23 1,067.03 1,337.52 1,579.79

less: Taxes - 98.81 - 156.31 - 209.47 - 320.11 - 401.26 - 473.94

NOPAT 230.57 364.73 488.76 746.92 936.27 1,105.85

Plus:

Depreciation

275.80 280.80 285.80 290.80 295.80 300.80

less: Capex - 325.80 - 330.80 - 335.80 - 340.80 - 345.80 - 350.80

less:

Increases in

Net Working

Capital

- 103.20 - 108.36 - 113.78 - 119.47 - 125.44 - 131.71

Equals FFCF 77.37 206.37 324.98 577.46 760.83 924.14

Panel d. (Step 1) Estimate the Amount and Timing of Future Cash Flows

Terminal Value Cash Flow Estimate

Method #1 DCF Using the Gordon Growth Model

Terminal Value Multiples from the Gordon Model

Growth Rates (g)

Discount Rates 0.00% 1.00% 1.50% 2.00%

7.920% 12.63 14.60 15.81 17.23

8.420% 11.88 13.61 14.67 15.89

8.902% 11.21 12.72 13.68 14.74

9.420% 10.62 12.00 12.82 13.75

Terminal Value Estimates (for FFCFs received in 2013 and beyond)

Growth Rates (g)

Discount Rates 0.00% 1.00% 1.50% 2.00%

7.920% 11,668.99 13,488.90 14,611.48 15,923.69

8.420% 10,976.02 12,579.90 13,555.68 14,683.45

8.920% 10,360.75 11,785.68 12,642.18 13,622.45

9.420% 9,810.79 11,085.78 11,844.02 12,704.45

Method #2 Multiples Using Enterprise Value to EBITDA

Terminal Value Estimates

Enterprise Value / EBITDA Terminal Value

5.00

5.50

6.00

6.70

7.20

9,402.95

10,343.24

11,283.53

12,599.95

13,540.24

Panel e (Step 2) Estimate a Risk Appropriate Discount Rate

Cost of debt Estimated borrowing rate is 8.0% with a marginal tax of 30% results in

an after-tax cost of debt of 5.600%.

Cost of equity An average industry unlevered equity beta of .849 implies a levered

equity beta for Corus of 0.97 assuming a target debt ratio of 35% and a debt beta of

.618. Using the capital asset pricing model with a 10 year government security yield

of 4.60% and a market risk premium of 5.50% produces an estimate of the levered

cost of equity of 9.938%.

Weighted average cost of capital (WACC) Using the target debt to value ratio of

35% the WACC is approximately 8.420%.

Panel f. (Step 3) Calculate the Present Value of Future Cash Flows

Present Value of Expected Future Cash Flows

Terminal Value Enterprise Value

Discount

Rate

Planning

Period FFCF

Method #1 Method #2 Method #1 Method #2

8.420%

10.000%

12.000%

1,996.66

1,873.52

1,731.80

9,040.26

6,651.08

4,775.62

7,757.49

7,112.34

6,383.53

11,036.92

8,524.60

6,507.42

9,754.15

8,985.86

8,115.33

Since the growth strategy initially has lower cash flows than the status quo strategy

but later generates much higher cash flows, its incremental value will depend on the discount

rate that is used to evaluate the strategy. In Panel e of Table 7-3 we show that the cost of

capital for the growth strategy is 8.420%, which is slightly lower than under the status quo

strategy (8.857%) because we assume a higher target capital structure (debt to enterprise

value ratio of 35% versus 22% under the status quo strategy). Although the cost of debt (8%)

is higher under the growth strategy, the net effect is a slightly lower cost of capital.

However, the growth strategy is almost certainly more risky than the status quo

strategy and should require a higher cost of capital. To evaluate how a higher cost of capital

will affect the value of the growth strategy, Panel f of Table 7-3 presents alternative values of

the growth strategy cash flows where the cost of capital is as high as 12%. Under the Gordon

growth method (Panel f, Table 7-3), the imputed enterprise value of 6507 million is well

below the EV of 7970.31 million. The EBITDA multiple method, however, yields an

enterprise value of 8115 million, which is slightly greater than the EV of 7970.31.

Sensitivity Analysis

The acquisition of Corus is a risky endeavor just like any investment proposal, so it is

important that we perform a sensitivity analysis of the proposal. In this instance, we will

limit ourselves to the use of breakeven sensitivity analysis although, as we illustrated in

Chapter 3, it is often helpful to construct a simulation model based on making estimates

concerning the random nature of the key value drivers.

We consider three important value drivers for the Corus acquisition under the growth

strategy: (i) to the cost of capital for the acquisition, (ii) the planned increase in EBITDA

margins due to savings in costs of goods sold and administrative costs during the planning

period and (iii) the terminal value multiple used to value the post-planning period cash flows.

If there is a slump in global steel prices, the effect on EBTIDA margins would be the same as

not realizing potential costs savings. Hence, item (ii) can be viewed as a representation of two

alternative forms of risk-one due to risk in steel prices and the other due to risk in realization

of potential cost savings. Both these factors can adversely affect EBITDA margins. Finally,

in the risk analysis that follows we focus our attention solely on the valuation that uses the

EBITDA multiple (Method #2) to estimate the terminal value.

Sensitivity analysis - Cost of Capital

The cost of capital, like all the value drivers, is always estimated with some error. However,

in this instance we have another reason to be concerned about the cost of capital estimate.

The growth strategy is a more risky strategy than the status quo strategy, which means that

the growth strategy cash flows should require a higher discount rate - but how much higher?

One approach we can take to addressing this issue is to explore the importance of the

discount rate to the valuation of Corus under the growth strategy. To do this, we can

calculate the internal rate of return (IRR) of the investment and ask whether it is plausible

that the appropriate discount rate exceeds the IRR.

We calculate the IRR for the acquisition based on the projected cash flows found in

Panel b in Table 7-3 (and a terminal value for 2012 equal to 6.7 times EBITDA2012) and the

7970.31 million in invested capital reflected in the asking price. The result is an estimated

IRR of 12.36%. Consequently, if the higher cost of capital for the riskier growth strategy

exceeds 12.36%, the acquisition should not be undertaken. Although the appropriate

discount rate for this investment is likely to be higher than the discount rate for the status quo

investment, it is quite unlikely that it exceeds 12.36%. In Panel e of Table 7-3 we noted that

Coruss estimated equity beta was 0.97, which produced a cost of equity of 9.938% and a

weighted average cost of capital of 8.420%. To generate a cost of capital of 12.36%, Coruss

equity beta would have to rise to 2.07, which is highly unlikely.

Sensitivity Analysis - EBITDA margins

Next we consider a breakeven sensitivity analysis of the synergies of the acquisition that give

rise to savings in costs of goods sold and administrative expenses. While we focus on cost

savings as the source of the increase in EBITDA margins over the planning period, our

results on sensitivity to EBITDA margins can also be interpreted as sensitivity to global steel

prices. Our analysis reveals that if the costs savings of 3000 million over the six-year

planning period drop to 2100 million the NPV of the acquisition drops from 1783 million

to 52 million.5 For the acquisition to be positive NPV, the savings in costs is a critical

factor. If the costs savings drop by more than 30% (from 3000 to 2100), the acquisition

becomes unviable.

Sensitivity Analysis - Terminal Value EBITDA Multiple

The final value driver we consider is the terminal value multiple (i.e., enterprise value

divided by EBITDA) that is used to estimate the terminal value of Corus in 2012. In our

earlier analysis we used a multiple of 6.70, which was the average purchase price multiple in

similar transactions. However, if we reduce this terminal value EBITDA multiple to 5.15, the

NPV of the acquisition for Tata Steel drops below zero.

Scenario Analysis

Up to this point we have considered three value-drivers (the discount rate, the amount of cost

savings, and the EBITDA multiple at the terminal date one at a time. This discussion

suggests that our conclusion about the attractiveness of the investment is not likely to change

if we alter anyone of the value drivers individually. However, there are scenarios in which all

three value-drivers differ from their expected values such that the Corus investment does

have a negative NPV.

For example, although we argued that a 12.36% discount rate is very unlikely, a 10%

discount rate is plausible. Similarly, one might assume that the planning period cost savings

may be 2700 rather than 3000. If these changes are made, then the terminal value

EBITDA multiple only has to drop to 6.22 times before the enterprise value of Corus under

the growth strategy drops to a level that results in a negative NPV project at the acquisition

cost of 6172.31 million. As the following table indicates, there are a number of plausible

scenarios under which the acquisition and implementation of the growth strategy might not

be value-enhancing. We present three such breakeven scenarios.

Value Driver Initial

Parameters

Breakeven Scenarios Negative

NPV

Scenario

Scenario #1 Scenario #2 Scenario #3 Scenario #4

Cost of

Capital

8.420% 10.000% 10.066% 9.000% 10.000%

Cost Savings

during the

planning

period

3000

million

2700

million

2850

million

2589

million

2500

million

Terminal

value

EBITDA

multiple

6.70 times

6.218 times

6 times

6 times

6.40 times

We also present a negative NPV scenario. For example, with a slightly less favorable

6.40 EBITDA multiple for our terminal value calculation the acquisition has an enterprise

value of 7810 million (i.e., becomes a negative NPV investment) if we combine this with a

just slightly less favorable assumption about the discount rate (10%) but somewhat more

significant reduction in the cost savings for the planning period (500 million less). As we

learned earlier in Chapter 3, reviewing likely but less favorable scenarios, which can lead to a

negative NPV, is a very powerful tool for learning about a projects investment potential.

The set of scenarios reviewed above are far from exhaustive, and we can always find

scenarios under which almost any investment has either a positive or negative NPV. What

this means is that the tools that we have developed are just that-decision tools-they provide

support and background for the actual decision maker, but they do not actually make the

decision. In this particular case, as is often true, the numbers provide some justification for

whether or not Tata Steel should go ahead with the acquisition of Corus. However, the

numbers also suggest that there are significant risks and the success of the acquisition will

depend on how the future unfolds. This will generally be the case-the tools provide

management with valuable information, but ultimately management must use their judgment

to make the decision.

7.3 USING THE APV MODEL TO ESTIMATE ENTERPRISE VALUE

Up to this point we have been using the traditional WACC approach of enterprise

valuation, which uses a constant discount rate to value the enterprise cash flows. While this

approach makes sense for valuing Corus prior to its acquisition, the constant discount rate is

inconsistent with the projected changes in the firms capital structure after Coruss

acquisition. A quick review of the debt ratios found in Figure 7-l indicates that the capital

structure weights (measured here in terms of book values) are not constant over time for

either the status quo or growth strategy. In other words, the use of a single discount rate is

problematic.

In situations in which the firms capital structure is expected to substantially change

over time, we recommend that the Adjusted Present Value, or APV approach, be used.

Introducing the APV Approach

The APV approach expresses enterprise value as the sum of the following two components:

SavingsTax

Interest

the of Value

Flows Cash Free

Equity Unlevered

the of Value

Approach) (APV Value Enterprise (7.4)

The first component is the value of the firms operating cash flows. Since the operating cash

flows are not affected by how the firm is financed, we refer to these cash flows as the

unlevered equity free cash flows. The present value of the unlevered equity free cash flows

represents the value of the firms cash flows under the assumption that the firm is 100%

equity financed. The second component on the right hand side of Equation 7.4 is the present

value of the interest tax savings associated with the firms use of debt financing. The basic

premise of the APV approach is that debt financing provides a tax benefit because of the

interest tax deduction.6 By decomposing firm value in this way, the analyst is forced to deal

explicitly with how the financing choice influences enterprise value.

Using the APV Approach to Value Corus under the Growth Strategy

The APV approach is typically implemented using a procedure very similar to what we did to

estimate the enterprise value using the traditional WACC approach found in Equation 7.1 and

is described verbally in Equation 7.4a.

Value Terminal

Estimated the of

Value Present

SavingsTax

Interest

Period Planning

the of Value

Period Planning the for

Flows Cash Free

Equity Unlevered

the of Value

Approach) (APV Value Enterprise

(7.4a)

That is, we make detailed projections of cash flows for a finite planning period and then

capture the value of all cash flows after the planning period in a terminal value. The principal

difference between the APV and traditional WACC approaches is that with the APV

approach we have two cash flow streams to value: the unlevered equity cash flows and the

interest tax savings.

6 Technically, the second term can be an amalgam that captures all potential side effects of

the firms financing decisions. In addition to the interest tax savings, the firm may also

realize financing benefits that come in the form of below market or subsidized financing. For

example, when one firm acquires assets or an operating division from another, it is not

uncommon for the seller to help finance the purchase with a very attractive loan rate.

Figure 7-2 summarizes the implementation of the APV approach in three steps: First, we

estimate the value of the planning period cash flows in two components: unlevered equity (or

operating) cash flows, and interest tax savings resulting from the firms use of debt financing.

In step two we estimate the residual or terminal value of the levered firm at the end of the

planning period, and finally, in Step 3, we sum the values of the planning period cash flows

and the terminal value to estimate the enterprise value of the firm.

Step 1: Estimate the value of the planning period cash flows

The planning period cash flows are comprised of both the unlevered equity free cash flows

and the interest tax savings. We value these cash flows for Corus using two separate

calculations. Equation (7.5) shows how we value the unlevered equity cash flows for the

planning period (PP):

Flows Cash Free

PP

1tt

kUnlevered1

FFCFtEquity Unlevered

Period Planning

the of Value

(7.5)

Applying Equation 7.5 to the valuation of Coruss operating cash flows for the planning

period (2007 - 2012) summarized in Table 7.4 for the growth strategy case, we estimate a

value of 1929.15 million:

654

321

.0927 1

924.14

.0927 1

760.83

.0927 1

577.46

.0927 1

324.98

.0927 1

206.37

.0927 1

77.37 Flows Cash FreeEquity edtheUnlever of Value

This valuation is based on an estimate of the unlevered cost of equity equal to 9.27%. We

estimate the unlevered cost of equity in Figure 7-3 using the procedure described in Table 4-1

of Chapter 4 where we estimated the firms WACC and again in Chapter 5 to estimate a

projects cost of capital. The estimated unlevered beta for Corus is .849, which when

combined with a 10-year government security yield of 4.60% and a 5.50% market risk

premium, generates an unlevered cost of equity of 9.27%.

Next we calculate the value of the interest tax savings for the planning period as

follows:

SavingsTax Interest

PP

1 ttr1

Rate Tax X Expense Interest Period Planning

the of Value

t

where r is the firms borrowing rate. Substituting Coruss interest tax savings for the growth

strategy (found in Table 7-4) into Equation 7.6 produces a 519.66 million estimate for the

value of its planning period interest tax savings.

5 Note that we are holding everything constant except the savings in cost in this analysis. For

instance, the growth rate in sales is still assumed to be 5% and the discount rate is still

assumed to be 8.420%.

Using the Adjusted Present Value (APV) Model to Estimate Enterprise

Step 1: Estimate the Value of the planning period cash flows

Evaluation of Operating (unlevered) Cash Flows

Definition: Unlevered

Equity Free Cash

Flows = Firm or

Project Free Cash

Flows

Formula:-

Net Operating

Income

Less: Taxes

Net Operating Profit

After Taxes

(NOPAT)

Plus: Depreciation

Expense

Less: Capital

Expenditures (Capex)

Less: Increases in Net

Working Capital

Equals Unlevered

Equity Free Cash

Flows (=FFCF)

Flows Cash

Equity Unlevered

)k(1

FFCF1 Period Planning of Value

PP

1t1

unlevered

FFCF1 = Firm Free Cash Flow (equals equity free cash flow for the

unlevered firm)

Kunlevered = Discount rate for project cash flows (unlevered equity)

PP = Planning Period

Evaluation of the Interest Tax Savings

Definition : Interest

Tax Savings

Formulas:-

Interest tax savings in

year t = Interest

Expense in year t x

Tax Rate

)r(1

Rate Tax x Expense Intertest SavingsTax Interest the of Value

PP

1t1

PP = Planning Period

r = firms borrowing rate

Step 2: Estimate the value of the levered firm at the end of the planning period (i.e., the

terminal value)

Evaluation of the Terminal Value

Definition: Terminal

Value of firm is equal

to the enterprise value

of the levered firm at

the end of the planning

period

Assumptions:- After

the planning period the

firm maintains a

constant proportion.1.

of debt in its capital

structure. The firms

cash flows grow at a

constant rate g which

is less than the firms

weighted average cost

of capital forever.

Formulas:-

gkwacc

g)FFCFpp(1FirmPP Levered the of Value Terminal

FFCFpp = firm free cash flow for the end of the planning period

Kwacc = weighted average cost of capital

g = rate of growth in FFCF after the end of the playing period in

perpetuity

Step 3 : Sum the estimated values for the planning period and terminal period cash flows

pp

dkunleverre1

1g

k

g)(1FFCF

pp

1t

pp

1t 1r)(1

Rate Tax xExpense Interest

1)K(1

FFCFValue Enterprise of model APV

wacc

pp

unlevered

1

Step 1 : Value of Planning Period Cash Flows Step 2: Value of the Terminal Period cash

Flows

Figure 7-3

Coruss Cost of Capital Assumptions:

Assumptions:

1. The risk free rate is 4.60%.

2. The market risk premium is 5.50%. (Source: Elroy Dimson, Paul Marsh, and Mike

Staunton, Global Evidence on the Equity Risk Premium, Journal of Applied

Corporate Finance 15 (Fall 2003), pp. 27-38.)

3. The corporate tax rate is 30%.

4. The asset beta (or unlevered equity beta) is 0.849.

5. Under the status quo strategy, the target capital structure is given by a debt to

enterprise value ratio of 22% and the cost of debt is 6%.

6. Under the growth strategy, the target capital structure is given by a debt to enterprise

value ratio of 35% and the cost of debt is 8%.

Step 1. Compute unlevered cost of equity: Substitute the unlevered equity beta into the

CAPM to estimate the unlevered cost of equity for the subject firm. Given a risk free

rate of 4.60% and a market risk premium of 5.50%, we get an estimated cost of equity

for an unlevered investment of 9.27%, i.e.,

Kunlevered equity = Risk-free rate + unlevered (Market-risk premium)

Kunlevered equity = .0460 + .849 x .0550 = .09727 or 9.27%

Step 2. Compute levered cost of equity and weighted average cost of capital: *Relever the

asset beta of 0.849 using the following equation**for levering and unlevering betas. For the

status quo case, the relevering is based on a target capital structure (debt to enterprise value

ratio of 22%) and a cost of debt of 6%. For the growth case, the debt to enterprise value

ratio is 35% and the cost of debt is 8%.

debt L

r1

rTX1 - L

r1

rTX11

unlevered

levered

(7.7)

where unlevered, levered, and debt are the betas for the firms unlevered and levered equity, plus

its debt. The cost of debt is r. T is the corporate tax rate, and L is the debt to equity ratio.

Finally, one can find the weighted average cost of capital as

eKL1

LT1rL

L1

LWACCk

Status Quo Strategy Growth Strategy

levered equity beta

levered cost of equity (CAPM)

WACC

1.02

10189%

8.857%

0.97

9.938%

8.857%

* The weighted average cost of capital and the levered cost of equity can also be related to the

unlevered cost of equity capital by using the following relationships (L denotes the debt to

equity ratio, r is the cost of debt):

Lr1

rT1r

unleveredk

unleveredk

ek and

r1

unleveredk1

L1

LrT

unleveredk

WACCk

** This relationship captures the effects of financial leverage on the firms beta coefficient. It

is a more general version of a similar formula discussed in Chapter 4 and Chapter 5. It

applies in the setting where the firm faces uncertain perpetual cash flows, corporate are taxed,

corporate debt is risky (i.e., debt betas are greater than zero), and the firms use of financial

leverage (i.e., the debt to equity ratio, L) is reset to a constant level every period. For a

derivation of this equation see E. Arzac and L. Glosten, A Reconsideration of Tax Shield

Valuation, Unpublished Manuscript, 2004.

Coruss Operating and Financial Cash Flows for the Planning Period

[All figures in millions]

Panel a. Unlevered Equity Free Cash Flows (same as FFCF)

Unlevered Equity Free Cash Flows 2007 2008 2009 2010 2011 2012

Status Quo Case 276.67 339.94 351.04 414.97 426.74 438.87

Growth Strategy Case 77.37 206.37 324.98 577.46 760.83 924.14

Panel b. Interest Tax Savings

Interest Tax Savings 2007 2008 2009 2010 2011 2012

Status Quo Case 32.26 29.56 25.57 21.26 15.70 9.74

Growth Strategy Case 108.63 114.20 117.18 117.71 112.60 103.14

519.66

.08 1

103.14

.08 1

112.60

.08 1

117.71

.08 1

117.18

.08 1

114.20

.08 1

108.63 SavingsTax Interest Period gthePlannin of Value

654

321

The combined value of operating cash flows and interest tax savings for the planning period

under the growth strategy, then, is 2448.81 million ( = 1929.15 + 519.66).

Step 2: Estimate Coruss Term of Value

The terminal value calculation for the APV approach is identical to the calculation we made

for our WACC analysis. As we previously stated, at the terminal date. Coruss cash flows

are assumed to grow at a constant rate of 2% per year and its capital structure will revert to a

constant mix of debt and equity such that the debt to value ratio would be 35%. Therefore,

we can use the Gordon Growth Model to estimate the terminal value of the levered firm at the

end of the planning period (pp) as follows:

gkWACC

g)FFCFpp(1ppFirm Levered the of Value Terminal

(7.7)

Coruss FFCFpp in 2012 (which is the end of the planning period) is equal 924.14 (see Table

7-4) and this FFCF is expected to grow at a rate of 2% in perpetuity, and the weighted

average cost of capital (kwacc) is 8.420%.7 Using Equation 7.7 we estimate the terminal value

for Corus in 2012 as follows:

14683.50.02.0842

1.02 924.142012

Firm Levered the

of Value Terminal

We have one remaining calculation to make in order to value Coruss terminal value.

We need to discount the terminal value estimated in Equation 7.7 back to the present using

the unlevered cost of equity, i.e.,

$8626.506.09271

1

.02.0842

.02 1 924.14Value Terminal

the of Value Present

2006

To complete the valuation of Corus using the APV method we now sum the value of the

planning period and terminal value in the final step.

Step 3. Summing the Values of the Planning Period and Terminal Period

Using the APV approach we estimate the enterprise value of the firm as the following sum:

pp

Unleveredwacc

PP

PP

1tt

tPP

1tt

Unlevered

k1

1

gK

g1FFCF

r1

Rate Tax X Expense Interest

k1

FFCF1Approach) (APV Value Enterprise

Step 1: Value of Planning Period Cash Flows

Step 2 :Value of the Terminal Period Cash Flows (7.4a)

Substituting for the two components, we estimate Coruss enterprise value using the APV

model to be 11,075.31 million, i.e.,

Enterprise Value (APV Approach) = 1929.15 + 519.66 + 8626.50 = 11,075.31

This estimate is very nearly equal to the estimates of Coruss enterprise value found in Panel

c of Table 7-3 using the traditional WACC model (at 11037 million). However, for those

cases where the capital structure of the firm is expected to change dramatically over the

planning period, the APV model provides a preferred method for estimating enterprise value.

7 The weighted average cost of capital can also be related to the unlevered cost of equity

capital by using the following relationship:

20%.0842or8.4.081

.09271X

.351

.35.08X.30X0947

WACCk

r1

Unleveredk1

L1

LTaxRate

dr

Unleveredk

WACCk

Where L is the ratio of debt to equity ratio.

Using an EBITDA Multiple to Calculate the Terminal Value

Using preceding application of the APV approach to the estimation of Coruss enterprise

value used the discounted cash flow (DCF) approach to value both the planning period value

and the post planning period terminal value. What typically happens in practice, however, is

that a market-based multiple is used to estimate the value of the post-planning period cash

flows. Equation 7.4b defines the APV approach of enterprise value as the sum of the present

values of the planning period cash flows (i.e., both the unlevered cash flows of the firm8 and

the interest tax savings) plus the terminal value of the firm which is estimated using the

EBITDA multiple,.

The values of the two planning period cash flow streams for Corus under the Growth Strategy

were estimated earlier in Table 7-4, and equal 924.15 for the operating cash flows and

519.66 for the interest tax savings. Using the 6.70 times multiple of EBITDA from our

previous analysis and the estimated EBITDA for 2012 (found in Table 7-3), we calculate

Coruss terminal value cash flow as follows:

EBITDA for 2012 is found in Table 7-3 by summing the 1822.59 million EBITDA from

operations, with the 58.00 million from other income to get 1880.59 million. Multiplying

this EBITDA estimate by 6.70 produces an estimate of the terminal value in 2012 of

12599.95 million. Discounting the terminal value back to the present using the unlevered

cost of equity we get 7402.44. To complete the estimate of enterprise value using the hybrid

APV we simply substitute our estimates of the values of the cash flow streams into Equation

7.4b as follows:

This value is slightly lower than our earlier estimate because in this case the EBITDA

multiple provided a more conservative estimate of Coruss terminal value.

Table 7-5 summarizes the APV estimates of enterprise value for the status quo and growth

strategies using our two methods for estimating terminal value.

8 Recall from Chapter 2 that the unlevered cash flows of a firm are simply the cash flows that

the firm would realize if it uses no debt financing. Furthermore, these unlevered cash flows

are the same as the firm free cash flows (FFCF) calculated earlier to value the firm using the

traditional WACC model. However, in the APV model we discount the FFCFs using the

unlevered cost of equity capital (i.e., the equity discount rate appropriate for a firm that uses

no debt financing) and then account for the value of the firms interest tax savings as a

separate present value calculation.

Table 7-5

APV Valuation Summary for Corus for Status Quo and Growth Strategies [All Figure in

Millions]

Panel a. Status Quo Case

APV Estimate of Enterprise Value

APV Calculation

of Planning

Period Cash

Flow

DCF Estimates of

Terminal Value

Total

Unlevered equity free cash

flow

1,629.85 3,557.38 5,187.23

Interest Tax Savings 113.75 113.75

Total 1,743.60 3,557.38 5,300.98

Hybrid APV Estimate of

Enterprise Value

APV Calculation

of Planning

Period Cash

Flow

EBITDA Multiple

Terminal Value

Total

Unlevered equity free cash

flow

1,629.85 3,957.11 5,586.96

Interest Tax Savings 113.75 113.75

Total 1,743.60 3,957.11 5,700.71

Hybrid APV Estimate of

Enterprise Value

Panel b. Growth Strategy Case

APV Estimate of Enterprise Value

APV Calculation

of Planning

Period Cash

Flow

DCF Estimates of

Terminal Value

Total

Unlevered Equity free cash

flow

1,929.15 8,626.50 10,555.65

Interest Tax Savings 519.66 519.66

Total 2,448.81 8,626.50 11,075.31

Hybrid APV Estimate of Enterprise Value

APV Calculation

of Planning

Period Cash

Flow

EBITDA Multiple

Terminal Value

Total

Unlevered Equity free cash

flow

1,929.15 7,402.44 9,331.59

Interest Tax Savings 519.66 519.66

Total 2,448.81 7,402.44 9,851.25

Comparing the WACC and APV Estimates of Coruss Enterprise Value

Table 7-6 combines our estimates of Coruss enterprise value using both the traditional

WACC approach and the APV approach. Although the estimates are not exactly the same,

they are surprisingly similar. The growth strategy clearly dominates the status quo strategy.

Also, the acquisition price of 6172.31 million cannot be justified under the status quo

strategy. It is only under the growth strategy that such a high acquisition price can be

acceptable.

Summary of WACC and APV Estimates f Corus's

Enterprise Value [All figures in millions]

Status quo strategy Traditional WACC APV

Terminal Value

* Gordon Growth Model

* EBITDA Multiple

5,290.76

5,699.67

5,300.98

5,700.71

Growth strategy Traditional WACC APV

Terminal Value

* Gordon Growth Model

* EBITDA Multiple

11,036.92

9,754.15

11,075.31

9,851.25

In this particular application of the WACC and APV valuation approaches the results are for

all practical purposes the same. In practice, the capital structure changes much more

dramatically in an LBO transaction because debt levels have to be brought down within a

short span of time. Even in the Tata-Corus transaction, the final terms of loan agreements

mandated that about a third of the debt amount should be paid back on an annual amortized

basis within five years. The effects caused by very dramatic changes in debt financing over

the life of the investment can lead to meaningful differences in the results of the two

valuation approaches. and in these instances the APV approach has a clear advantage in that

it can more easily accommodate the effects of changing capital structure.

The EBTTDA multiple used in the valuation of Corus produced results that were very similar

to the DCF estimate and this is purely an artifact of the particular choices made in carrying

out this valuation. Due to the importance of the terminal value to the overall estimate of

enterprise value we recommend that both approaches be used and that when selecting an

EBITDA multiple. close attention be paid to recent transactions involving closely comparable

firms. The advantage of the EBITDA multiple in this setting is that it ties the analysis of more

distant cash flows back to a recent market transaction. However, the EBITDA multiple

estimate or terminal value should be compared to a DCF estimate using the analysts

estimates of reasonable growth rates as a test or the reasonableness of the terminal value

estimate based on multiples.

A Brief Summary of the WACC and APV Valuation Approaches

The following grid provides a summary of the salient features of the traditional WACC and

APV approaches. As we have discussed, the traditional WACC method is the approach that

is used in practice. However, when the capital structure of the firm being valued is likely to

be changing over time the APV is the preferred approach.

Adjusted Present Value

(APV Method

Traditional WACC Method

Object of the

Analysis

Enterprise value as the sum

of the values of:

The unlevered equity cash flows, and

Financing side effects

Enterprise value equal to the

present value of the firm's

capital cash flows discounted

using the after-tax WACC

Cash Flow

calculation

Unlevered equity free cash flows (i.e. firm free

cash flows), plus

Interest tax savings

Firm free cash flows (FFCF)

Discount Rate(s) Unlevered equity cash flows-cost of equity for

unlevered firm, and

Interest tax savings-the yield to maturity on the

firm's debt

After tax weighted average

cost of capital (WACC)

How Capital Structure

Effects Are Dealt with-

Discount Rates, Cash

Flows, or Both

Cash flows Capital

structural affects the present

value of the interest tax

savings o