Mid Term Paper

DCF Method:

The Discounted Cash flow method also known as DCF method is used to estimate the value of

an investment opportunity. The method makes use of future cash flow projections to evaluate

the opportunity. The results are solely based on projected future cash flows and not on the

accounting earnings. Discounted cash flow tries to work out the value of a company today,

based on projections of how much money it's going to make in the future. DCF analysis says

that a company is worth all of the cash that it could make available to investors in the future. It

is described as “discounted" cash flow because cash in the future is worth less than cash

today. The basic equation of discounted future cash flow valuation is:

PV= FV/(1+i)n

Forecast Period:

Selecting the forecast period is critical for the discounted cash flow method. As the number of

years grow, the difficulty of projection and the chances of error grow as well. There is not set

standards for the period to be selected but periods from 5 to 7 years are a common choice. The

number of years may coincide with the period of projections used to obtain loan financing for

an acquisition. Another opinion is that forecasted cash flow should be projected to the time

when the business attains maturity and experiences steady-state growth and profitability

Some analyst have a view that the forecast period should be chosen keeping the type of

company and market situation in mind. According to this approach the selection should be

made using this table:

Debt Free (Financing Neutral) Method

In Debt Free or Financing Neutral method of discounted cash flow valuation, debt will be

subtracted or excess cash added. This method is for the valuation where no debt exists and

there is no interest to be amortized.

The cash flow begins with earnings before interest, taxes, depreciation and amortization

(EBITDA). Capital expenditures (CAPEX) and expected working capital changes (WCC) are then

subtracted from EBITDA. The formula used for the cash flow is:

CF = EBITDA – CAPEX = WCC

Equity (Leveraged) Method

In Equity method, debt exists so the valuation has to be done considering debt and interest.

The cash flow begins with net income after interest and taxes. Cash expenses of interest and

taxes are deducted. Non-cash charges depreciation, amortization and deferred taxes are added.

Maintenance capital expenditures are deducted. Working capital changes are added if there is

excess cash or subtracted if there is debt.

Discount Rate

Financing Neutral Method:

In the financing neutral or debt free method, the discount rate is determined by calculating

weighted average cost of capital (WACC). The discount rate is a weighted-average of the

returns expected by the different classes of capital providers (holders of different types of

equity and debt).

The capital funding of a company is made up of two components: debt and equity. Lenders and

equity holders each expect a certain return on the funds or capital they have provided. The cost

of capital is the expected return to equity owners (or shareholders) and to debt holders, so

WACC tells us the return that both stakeholders (equity owners) and lenders can expect. WACC,

in other words, represents the investor's opportunity cost of taking on the risk of putting money

into a company. The formula for calculating WACC is:

WACC = COE (%equity) + COD (% debt)

Equity (Leveraged) Method:

In the leveraged buyout method, the cost of equity is usually calculated using the capital asset

pricing model. Cost of equity is the actual cost of equity that the buyer has obtained to finance

an acquisition. The equity holders' required rate of return is a cost from the company's

perspective because if the company does not deliver this expected return, shareholders will

simply sell their shares, causing the price to drop.

The method used for calculating Capital Asset Pricing Model (CAPM)

Cost of Equity = Risk free rate + Beta * (Market Risk Premium – Risk Free Rate)

COE = Rf + β(Rm – Rf)

Risk Free Rate

Risk Free rate is generally considered to be the yield on a 10 or 20 year U.S. Treasury Bond. This

is a risk free investment so it is regarded as an alternate investment that the investor can make

getting a minimum return without risk.

Beta

Beta is the measure of the riskiness of a stock against the market. In other words it measures

how much a company’s share price reacts against the market as a whole. The basic unit is 1.0

for stocks that rise and fall at the same rate as a general market index. Companies that have a

beta in excess of one, their share is exaggerating the market's movements; less than one means

the share is more stable. So a stock with a Beta above 1 is perceived to be more risky than the

market and a stock with a Beta of less than 1 is perceived to be less risky. Some stocks have a

beta in negative. This shows that the stock moves in the opposite direction to the market. Gold

is an example of a stock having a negative beta.

To calculate the beta of a stock, we have to take the returns of the stock and the market for at

least 2 years. The returns are then regressed against each other and the value is our beta. Betas

are also provided by financial websites.

Equity Market Risk Premium

This is the value in the parenthesis in CAPM formula. This represents the returns investors

expect to compensate them for taking extra risk by investing in the stock market over and

above the risk-free rate. The newer the company, the more risky it would be and this value will

be larger. Riskier companies have a higher Equity Market Risk Premium because they have a

higher chance to fail and hence the investors want a bigger return for the extra risk they are

taking.

Cost of Debt

Cost of Debt is the actual rate at which the company can borrow. The rate applied to determine

the cost of debt should be the current market rate the company is paying on its debt. The

formula for calculating cost of debt is

Cost of Debt = Interest rate * (1 – Marginal Corporate Tax Rate)

COD = IR*(1 – TR)

Discounting Cash flow

Cash flows have to be discounted to the present value to know their value as current. The main

step in discounting the cash flows is to calculate a discount rate. Once we have the discount

rate we discount all the future cash flows using the annuity method. The formula for calculating

the present value of the projected cash flows is

PV = PCF1/(1+DR) + PCF2/(1+DR)……

Then we would have to calculate the remaining all cash flows till perpetuity. This would be

done using the Gordon growth method. The Residual Value is what we get using the Gordon

Growth Model. The formula is

Residual Value = Projected Cash flow (1 + Growth Rate)/(Discount Rate – Growth Rate)

This residual value is then discounted to present value using the same number of years as the

years included in the projection period. The Formula is

PV of Residual Value = RV/ (1+DR)n

The present values of the projected period and the residual value are added. This results in the

final value.

Adjustments

A fair market value of non operating assets is added to the Present value calculated. The debt

as of the valuaton date is also subtracted. These adjustments are made in the financing neutral

method.In a leverage buyout, the company is mostly new so the acquisition is taxable and the

buyer can obtain a stepped-up basis.

The debt-free (financing neutral) method depicts the intrinsic business value free of capital

structure choices. The equity (leveraged) method is used to determine fair market value based

on the seller’s capital structure and to determine investment value based on the buyer’s capital

structure. The debt held by the buyer is considered cheaper as compared to the seller in a debt

free method. This is because mostly the seller is in a bad economic position and that’s why it is

planning to sell. But in the case of a leveraged buyout as we have, the cost of capital for the

buyer is more because it is doing the acquisition based on debt. This makes the acquisition risky

and the cost of capital is high.

Calculating Cash flow

Cash flow is calculated using the debt free method.

CF = EBIT-pro forma taxes + DA –WCC -CAPEX

7-2.4+4.6-4.8-1.6-0-2.8

Discount Rate

WACC = COE (% equity) + COD (% debt)

Target Corp = 7.79% * (0.75) + 3.9% * (.25) = 6.82%

Newco = 7.79% * (0.30) + 9% * (0.70) = 8.63 %

Cost of Equity

COE = Rf + β(Rm – Rf)

COE = 1.72% + 1.0608*(7.44%-1.72%)

COE = 7.79%

Risk Free Rate

I have taken the risk free rate of US treasury at a maturity of 5 years. The rationale behind this

is that this is the return the investors can get risk free on investing their money instead of this

acquisition. The risk free rate therefore is 1.72%

Beta

-0.2 -0.15 -0.1 -0.05 0 0.05 0.1 0.15

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

0.15

0.2

0.25

f(x) = 1.06080285035133 x + 0.000139201187466443R² = 0.500661317110104

This is the beta plotted on the chart. I have calculated the beta using the stock returns of Target

Corp and S&P 500. I have used the returns for 8 years from 2006 to 2014. I chose this period to

incorporate the recession period in the value so that we can estimate how the company has

reacted to the recession as compared to the industry. Moreover an 8 year period gives a

sufficient data for an accurate calculation of beta.

The estimated beta is 1.0608. This represents that the company reacts a little more than the

industry in any given situation. The beta of more than 1 is an indication of somewhat risk but it

is marginally over 1 so the company could be regarded as a very stable and risk free company.

Market Return

The market return is the return on S&P index over a period of years. The market return is 7.44%

which is the return on S&P 500 for the last 10 years.

Cost of Debt

The cost of debt that I have calculated for the transaction is different for both the companies.

As we can read from the case, it is a leveraged buyout and the acquiring company is financing

the deal majorly by debt. These kind of acquisitions are regarded very risky because there is a

lot of debt. The investors therefore require a higher rate of return on the debt they offer. Hence

I have calculated two different cost of debts for the two cash flows.

Cost of Debt for Target Corp.

COD = 6.5% *(1-40%) = 3.9%

I am assuming a 6.50% interest rate for Target Corp. given its capital structure. The 75% equity

is a very healthy figure and shows the good standing of the company. This gives us the Cost of

debt as 3.9%.

Cost of Debt for Newco.

COD = 15% *(1-40%) = 9%

The interest rate for Newco has to be higher than Target Corp. I assume it to be in double

figures as it is going for a very risky acquisition. I am assuming an interest rate of 12%. This gives

us the cost of debt as 9%.

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023EBIT $7.00 $7.20 $7.40 $7.60 $7.80 $8.00 $8.20 $8.40 $8.60 $8.80 $9.00 Taxes $2.40 $2.47 $2.54 $2.61 $2.67 $2.74 $2.81 $2.88 $2.95 $3.02 $3.09 Interest $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 $1.00 Add:Depriciation $4.60 $4.60 $4.60 $4.60 $4.60 $4.60 $4.60 $4.60 $4.60 $4.60 $4.60 Less: CAPEX $4.80 $4.80 $4.80 $4.80 $4.80 $4.80 $4.80 $4.80 $4.80 $4.80 $4.80 Less: Discretionary CAPEX $1.60 $1.60 $1.60 $- $- $- $- $- $- $- $- Add/Less: Changes in working Cap $- $0.20 $0.20 $1.80 $1.80 $1.80 $1.80 $1.80 $1.80 $1.80 $1.80 Free Cash Flow $1.80 $2.13 $2.26 $5.59 $5.73 $5.86 $5.99 $6.12 $6.25 $6.38 $6.51 Cost of capital 6.82% 6.82% 6.82% 6.85% 6.85% 6.85% 6.85% 6.85% 6.85% 6.85% 6.85%

Discount factor  0.936

2 0.8764 0.8197 0.7672 0.7180 0.6720 0.6289 0.5886 0.5508 0.5155PV(FCFF)   $2.00 $1.98 $4.59 $4.39 $4.21 $4.02 $3.85 $3.68 $3.52 $3.36

Target Corp Free Cash Flow (In the hands of Target)

Terminal cash flow $ 6.60 Terminal cost of capital 6.85%Terminal growth rate 1.80%Terminal value $130.69 PV(Terminal value) $ 67.38 PV (CF over next 10 years) $ 35.59

Sum of PV $102.97

I have taken the modest growth rate for the EBIT to grow each year. Target is a mature

company so it will grow at a low growth rate. I increased the EBIT by 0.2 Million each year. The

tax rate for 2013 was 34.29. This is the tax rate calculated from the data given in the case. So I

used the same tax rate for the next 10 years. I have maintained the interest rate constant at 1

Million. I have estimated the depreciation to rise to 6.8 Million and stay at that rate for the rest

of the years. Capital Expenditures will remain the same throughout the projection period. I

have limited the discretionary Capex payments to 3 years so because these have short pay back

periods as given in the case.

The Cost of capital will decrease at a very minor rate till it reaches 6.85%. this is due to the good

health of the business and the capital structure that has 75% equity

The terminal cost of capital I took is also 6.85%. the terminal growth rate I took is more

conservative than the growth rate in the projected period. I have estimated it to be 1.80%.

Target being a mature company is expected to grow at a low rate.

I have come to a terminal value of $67.38. The sum of the PVs is $117.81 which is the intrinsic

value of the business I have calculated in the hands of Target Corp.

Target Corp Free Cash Flow (In the hands of Newco)

2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023EBIT $7.00 $7.20 $7.40 $8.20 $9.00 $9.80 $10.60 $11.40 $12.20 $13.00 $13.80 Taxes $ 2.40 $ 2.47 $2.54 $2.81 $3.09 $3.36 $ 3.63 $ 3.91 $ 4.18 $ 4.46 $ 4.73 Interest $ 1.00 $ 1.00 $1.00 $1.00 $1.00 $1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00 $ 1.00 Add:Depriciation $ 4.60 $ 6.00 $6.00 $6.00 $6.00 $4.60 $ 4.60 $ 4.60 $ 4.60 $ 4.60 $ 4.60 Less: CAPEX $ 4.80 $ 4.80 $4.80 $4.80 $4.80 $4.80 $ 4.80 $ 4.80 $ 4.80 $ 4.80 $ 4.80 Less: Discretionary CAPEX $ 1.60 $ 1.60 $1.60 $ - $ - $ - $ - $ - $ - $ - $ - Add/Less: Changes in working Cap $ - $8.00 $1.20 $2.30 $2.30 $2.30 $ 2.30 $ 2.30 $ 2.30 $ 2.30 $ 2.30 Free Cash Flow $ 1.80 $11.33 $4.66 $7.89 $8.41 $7.54 $ 8.07 $ 8.59 $ 9.12 $ 9.64 $10.17 Cost of capital 6.82% 8.64% 8.50% 8.35% 8.20% 8.05% 7.50% 7.50% 7.25% 7.25% 7.00%Discount factor   0.9205 0.8495 0.7862 0.7296 0.6790 0.6480 0.6028 0.5712 0.5326 0.5083PV(FCFF)   $10.43 $3.96 $6.20 $6.14 $5.12 $ 5.23 $ 5.18 $ 5.21 $ 5.14 $ 5.17

Terminal cash flow $ 10.50 Terminal cost of capital 7.00%Terminal growth rate 3.25%Terminal value $ 280.00 PV(Terminal value) $ 142.34 PV (CF over next 5 years) $ 57.77 Sum of PV $ 200.11