Valuation and Mergers &

Acquisitions

OVERVIEW of VALUATION
FUNDAMENTALS
- Notes coverage begins with the very basics but
quickly builds to more developed concepts – we will
skim much of these slides in class
1
Valuation and M&A
►Valuation plays a key role in M&A as in all of finance. In valuation, we
wish to determine value (what something is worth today using the most
up-to-date information available) and make decisions based on that
value assessment. While M&A’s specific transaction context, execution
and source of value may differ from firms’ traditional individual capital
budgeting decisions, the objective remains the same => to obtain a +
NPV (Net Present Value) result.

►NPV represents the addition to the firm’s market value from

undertaking the M&A transaction and it corresponds with the objective of
traditional finance theory => i.e., “to maximize shareholder value.”

►But first, let’s review valuation, NPV, generating pro formas, etc.
2
Outline of Topics
• The Finance Function within the Firm
• Present Value, Discounted Cash Flows, NPV, WACC
• Review of Financial Statements
• Free Cash Flow – Estimation
• Valuing a Firm – using FCFs and WACC – a DCF method
• Building Pro Formas
• Issues to Keep in Mind with WACC, CAPM/SML
• Un-leveraging / Re-leveraging Betas
• APV Valuation – a DCF method
• FCFE – a DCF method
• Appendix: Financial Ratio Analysis 3
The Firm: Investment Vehicle Model - Flow of Cash

Firm's Operations
(2) Financial Manager (1) Financial
Investors

(4a)

(3) (4b)

(1) Cash raised from investors

(2) Cash invested in firm
(3) Cash generated by operations
(4a) Cash reinvested
(4b) Cash returned to investors
4
The Firm: Relating Value back to the Balance Sheet
Maximizing Value (Investment
Decision): The value of the firm can
be thought of as a pie. => The goal of Assets
the manager is to increase the size of
the pie via value maximization (+NPV
project selection).
Or Or...
Capital Structure (Financing 70%
25% 30%
Decision): The Capital Debt Debt Equity
Structure decision can be
75%
viewed as how best to slice up Equity
the pie. This can take on an
infinite range of possibilities. How we ‘slice up’ the pie, can in
turn affect the value of the pie. 5
Corporations: Two Main Sources of External
Financing - Equity & Debt
► DEBT
• Lenders – By lending money to the corporation, debt holders
become the corporation’s creditors and lenders.
• Relationship Determined by Contract - A debt contract is a legally
binding agreement. It specifies principal, interest, maturity date,
and specific protective covenants.
• Security and Seniority – In case of bankruptcy, debt holders collect
before equity holders. However, different debt holders have
different priority claims to the cash flows and assets of a bankrupt
firm, according to their respective debt contracts.
• Interest paid to debtors is tax deductible to the corporation.
6
Corporations: Two Main Sources of External
Financing - Equity & Debt
► EQUITY
• Shareholders’ Ownership Rights – by buying shares in the
corporation, shareholders become the owners of the firm.
Shareholders are the RESIDUAL claimants of the firm.
• Shareholders’ Payoffs – shareholders receive monetary
returns in the following ways:
– Dividend per share, paid to investors from the corporation’s
after-tax dollars.
– Capital gain from the sale of shares (ownership rights) at a
price higher than they were purchased for.
• Price/Share – this is equal to the total market value of equity
divided by the total number of equity shares outstanding.
7
Maximizing the Value of the Firm:
• Recall that shareholders are the residual claimants of the firm. They
collect after all other claims are satisfied.

• Share Prices reflect the market value of the residual claims – i.e., the
value of the remaining cash flow after all business costs have been
addressed. Thus they ultimately reflect the underlying firm’s ability
to generate cash flows. Accordingly, the goal of financial management
is to maximize share price as it is said to maximize the contributions of
the firm. When might this not be appropriate?

• We value that cash flow generating ability by examining:

– Amount of cash flows expected by shareholders
– Timing of the cash flow stream
– Riskiness of the cash flow stream 8
Cash Timing: Present Value and Future Value
Year 0 Year 1 Year 2

End of End of
Today year 1 year 2

Beginning Beginning Beginning

of year 1 of year 2 of year 3

0 1 2 3

• Present Value (PV) – the value of something today. On a timeline t = 0. Present

Value is also referred to as the market value today of a cash flow to be received
in the future. Translating a value that comes at some point in the future to its
value in the present is referred to as discounting.

• Future Value (FV) – the value of a cash flow sometime into the future. On a
timeline t > 0. Translating a value to the future is referred to as compounding.
9
Present Value
• Assume a stream of cash flows 𝐶𝐶1 , 𝐶𝐶2 , 𝐶𝐶3 , … where the subscripts denote time periods that
the cash flows are received, and r is the constant discount rate per period.
• The Present Value (PV: value at period 0) of the stream of cash flows is
𝐶𝐶1 𝐶𝐶2 𝐶𝐶3
𝑃𝑃𝑃𝑃 = + + +⋯
1+𝑟𝑟 1+𝑟𝑟 2 1+𝑟𝑟 3
• A perpetuity refers to a constant period cash flow C = 𝐶𝐶1 , 𝐶𝐶2 , 𝐶𝐶3 , …, and the first cash
flow occurs at the end of the first period,
𝐶𝐶
𝑃𝑃𝑃𝑃 =
𝑟𝑟
• For a perpetuity whose period cash flow increases at a steady rate g for every period in
perpetuity, and the first cash flow occurs at the end of the first period
𝐶𝐶
𝑃𝑃𝑃𝑃 = 𝑟𝑟−𝑔𝑔
1

• For an annuity where the payments are constant in amount C, made per period for a fixed
number of n periods and r is the constant discount rate per period
𝐶𝐶 1
𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 = 1− 10
𝑟𝑟 1+𝑟𝑟 𝑛𝑛
Direct Valuation of Bonds/Stocks
• When valuing a firm’s bonds, we use PV of an annuity and PV of an
individual cash flow, to value the fixed stream of periodic coupon
payments as well as the one-time return of principal payment at par
value. The cash flows are discounted at the firm’s required rate of
return on debt, i.e. its yield to maturity (sometimes referred to as
YTM or rD).

• We can directly value a firm’s stock by looking at cash flows going to

shareholders, as we discount all expected future dividends at the firm’s
required rate of return on equity. (Dividend Discount Model – DDM)
– Expected future dividends are often modelled using estimates of dividends for
the next several years and then a single sum terminal value estimate to
capture the present value estimate of all subsequent dividends to be paid by
the firm into perpetuity.
– The required rate of return on equity is found with reference to the
CAPM/SML
Valuing a Project: Seeking +NPV
Recall that managers’ objective is to maximize the value of the firm. Selecting all
positive NPV projects available to the firm increases (maximizes) the value of the
firm.

The Net Present Value (NPV) Decision Making Guideline:

1. Estimate the expected future cash flows:
• Amount and timing (Use a time-line)
2. Estimate the required return for projects of this risk level
• This is usually the firm’s WACC (weighted average cost of capital)
3. Find the present value of all cash flows of the project, including subtracting
the initial investment.
C1 C2 Cn
NPV = −CI 0 + + + ... +
1 + r (1 + r )2
(1 + r )n

NPV Rule: Accept the project If NPV > 0 12

Example: Computing Project NPV
• Drawing a time-line and using the formulas:
T=0 1 2 3
r = 12% 12% 12%

“Initial Cash Outflow” “Expected Annual Cash Inflows”

-165,000 63,120 70,800 91,080

56,357.14 PV12%,1
PV12%,2
56,441.32
PV12%,3
64,828.94
12,627.40
 NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = +12,627.40
 Relating NPV to an Acquirer: NPV + when Target B + ∆V > Target B + ∆P + C
What I’m Receiving > What I’m Paying 13
Estimating the Value of a ‘Stand Alone’ Firm
1) Forecast all relevant after tax expected free cash flows (FCFs) generated by
the project or firm. We estimate a firm or project’s free cash flow based on the
firm’s projected financial statements.

2) Estimate the opportunity cost of capital r (reflects the rate of return on a

similar maturity, similar market risk investment)

3) Evaluate using Discounted Cash Flows (DCF) analysis:

There are a number of DCF methods. We will focus on the first one:
- Free Cash Flow (FCF) using WACC
- Adjusted Present Value (APV) is often used for LBOs/MBOs
- Free Cash Flow to Equity (FCFE) is often used for banks and financial
institutions (this values the equity stake directly)
► A discussion of the factors that determine these inputs occupies a great deal of
valuation analysis.
► We use the DCF method in a similar manner (sometimes with adjustments) whether we are valuing the
entire firm, a subsidiary of a firm, or a project 14
Estimating the Value of a ‘Stand Alone’ Firm
Under the Free Cash Flow method, the value of a firm’s operating assets (i.e. enterprise
value) can be found using the formula below, (r =WACC):

Firm Value =
Year 1 Free Cash Flow Year 2 Free Cash Flow
+ +. . .
1 + 𝑟𝑟 1 + 𝑟𝑟 2
Year n Free Cash Flow + Termnal Value as of Year n
+
1 + 𝑟𝑟 𝑛𝑛
where D E
r = WACC = rD * (1 − TC ) * + rE
V V
►When estimating WACC, use market values for D (debt), E (equity) and V
(V=D+E), and essentially use the firm’s target D/V ratio.
►WACC stands for Weighted Average Cost of Capital. It is the average return that
the firm must generate per year on funds obtained from all investors.
►Free Cash Flow (FCF) is also called Unlevered Cash Flows and Free Cash Flows to the Firm (FCFF)
15
Re WACC Components: rD cost of debt
Lenders to the firm receive an annual return of rD (also
referred to as YTM, yield to maturity). They are
compensated for:

1. Real rate of interest

Term Structure of Interest Rates
2. Expected future inflation
3. Interest rate risk
4. Default risk
5. Taxability
6. Lack of liquidity
16
Re WACC Components: re cost of equity
re, the cost of equity, is derived from CAPM:

Required
Return on (re )
Equity SML

rM

= rM - rf = Slope of the line

rf
Y-intercept
𝛽𝛽𝑖𝑖
0 βm= 1 = β of the market portfolio Beta
17
Re WACC Components: re cost of equity
βe, the cost of equity, is derived from a regression of the firm’s stock returns on the market
index’s stock returns:
Cov(ri , rm )
βi =
1. Total risk = Stock i σ 2 (rm )
diversifiable risk + return
market risk
2. Market risk is
measured by beta, the beta
sensitivity to market
+10%
-10%
changes

- 10% +10%
Market
return
-10%
The resulting regression:
α + β r + ε
r =
i i i m i

βi- Sensitivity of a stock i’s return to the return on the market portfolio.
rm refers to the historical market portfolio return, ε refers to the “noise” or unique risk 18
The Financial Statements - Reminder
1. Balance sheet – provides a snapshot of a firm’s financial
position at a point in time.
2. Income statement – summarizes a firm’s revenues and
expenses over a given period of time.
3. Statement of retained earnings – shows how much of the
firm’s earnings were retained, rather than paid out as
dividends.
4. Statement of cash flows – reports the impact of a firm’s
activities on cash flows over a given period of time.
Essentially reconciles the beginning and ending cash
balances. 19
Sample “Balance Sheet” December 31, 20XX
ASSETS = LIABILITIES + EQUITY Numbers in thousands ($000s)
2023 2022 2023 2022
Cash & Equiv. 3,171 6,489 A/P 313,286 340,220
A/R 1,095,118 1,048,991 N/P 227,848 86,631

Inventory 388,947 295,255 Other CL 1,239,651 1,098,602

Other CA 314,454 232,304 Total CL 1,780,785 1,525,453

Total CA 1,801,690 1,583,039 LT Debt 1,389,615 871,851

Net FA 3,129,754 2,535,072 C/S 963,841 1,000,000

R/E 797,203 720,807
Total Assets 4,931,444 4,118,111 Total Liab. 4,931,444 4,118,111
& Equity
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Sample “Income Statement”
For Year Ending December 31, 20XX
Numbers in thousands ($000s)
Revenues $4,335,491 Profits vs. Cash Flows
Cost of Goods Sold 1,762,721
Operating Expenses 1,390,262
Depreciation 362,325
EBIT $820,183
Interest Expense 52,841
Taxable Income $767,342
Taxes 295,426
Net Income $471,916

“Statement of Retained Earnings”

 Net Income = Dividends + Change in Retained Earnings 21
Sample “Statement of Cash Flows”
Numbers in thousands ($000s)
Cash, beginning of year 6,489 Financing Activity
Operating Activity Increase in Notes Payable 141,217
Net Income 471,916 Increase in LT Debt 517,764
Plus: Depreciation 362,325 Decrease in Common Stock -36,159
Increase in Other CL 141,049 Dividends Paid -395,520
Less: Increase in A/R -46,127 Net Cash from Financing 227,301
Increase in Inventory -93,692 Net Decrease in Cash -3,318
Increase in Other CA -82,150 Cash End of Year 3,171
Decrease in A/P -26,934
Refer to Balance Sheet
Net Cash from Operations 726,387
Investment Activity
Fixed Asset Acquisition -957,007 - (Change in net fixed assets
Net Cash from Investments -957,007 + depreciation for the year)
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The Finance Concept of Cash Flow
• Cash flow is one of the most important pieces of information
that a financial manager can derive from financial statements.
• We will look at how cash is generated from utilizing assets and
how it is paid to those that finance the purchase of the assets.
• “Cash is King” in the study of finance. Finance professionals
are not concerned with accrual accounting, but rather whether
there is enough cash generated to pay bills, investors, etc.
• In finance, our concept of “cash flow from assets” is different
than the accounting “Statement of Cash Flows”. We care about
cash generated from operations over the period of interest.
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Free Cash Flow (FCF)
Free Cash Flow =
NOPAT* + Depreciation
– Net Capital Spending (NCS)
– Change in NOWC (Net Operating Working Capital)

• In any particular year:

Free Cash Flow (FCF) + Interest Tax Shield =
Cash Flow to Creditors + Cash Flow to Stockholders

*NOPAT (Net Operating Profit After Tax) = EBIT*(1 – Tax Rate)

24
Free Cash Flows
► OR, if our starting point is Net Income, then we can find FCF as follows:

Net Income
+ Depreciation
- Increase in operating current assets
Change in NOWC
+ Increase in operating current liabilities
- Increase in fixed assets at cost (Increase in NFA + Accum Depreciation)
+ After-tax interest paid on debt
= Free Cash Flow

*Note that if there are Deferred Taxes (we would add those back in)
**If Interest has been received on cash balances, we would subtract After-tax Interest Received.
25
Valuing a Firm Using the FCF Method
• The free cash flow method suggests that the value of the firm’s
operating assets (i.e., enterprise value) is equal to the present value
of the firm’s expected future free cash flows generated from those
assets.
• Free cash flows refer to the firm’s after-tax operating income less the
net capital investment in fixed assets and net increased investment in
operating working capital:

Free Cash Flows = NOPAT + Depreciation – Net Capital

Spending – Increases in Net Operating Working Capital

• We find projected FCFs from projected Balance Sheet and Income

Statements.
Note: Interest is Tax Deductible
• Recall from the Income Statement that any interest payments are deducted
from EBIT (Earnings Before Interest and Tax) before the calculation of Taxes.
– This means that interest payments function to reduce the amount of taxes
paid. Thus although interest payments are paid out in cash, they result in
the company paying less tax than it otherwise would. The reduction in the
amount of tax paid is referred to as the Interest Tax Shield.
– Dividend payments are not tax deductible and do not reduce the amount of
taxes paid. Thus dividend payments are paid out in cash, with no offsetting
tax shield.
 When determining FCF “free cash flow” we do not take into account the
interest tax shield. We separate operations from financing. Thus we
consider the Interest Tax Shield separately. And we note that the Tax Shield
increases the amount of cash flow available to Creditors and Shareholders – it
has an impact on cash flows and that impact will simply be dealt with
separately.
“Operating Working Capital”:
• Business operations generally require investment in net operating
working capital.
– We may need operating cash on hand
– Inventory
– Accounts receivable
– But we may also enjoy increases in Accounts Payable from our
suppliers
• Funds are required for the above items to support sales although the related
cash has not yet been collected from any sale.
• Note that we only consider operating working capital. Thus we exclude
non-operating working capital such as Notes Payable from our calculation
of changes in Net Operating Working Capital
Example Info:
BIZ Corporation
2022 and 2023 Balance Sheets
(in $ Millions)
Assets Liabilities & Stockholder's Equity
2022 2023 2022 2023
Current Assets Cuurent Liabilities
Cash $104 $160 A/P $232 $266
A/R 455 688 N/P 196 123
Inventory 553 555 Total $428 $389
Total $1,112 $1,403
Long-term Debt $408 $454
Fixed Assets
Net PP&E $1,644 $1,709 Stockholder's Equity
Common Stock and
Pain-in Surplus $600 $640
Retained Earnings 1320 1629
Total $1,920 $2,269
Total Liabilities &
Total Assets $2,756 $3,112 Stockholder's Equity $2,756 $3,112
29
Example Info Continued:
BIZ Corporation
Income Statement
For Year Ending December 31, 2023
(in $ Millions)

Net Sales $1,509

Cost of Goods Sold 750
Depreciation 65
Earnings Before Interest and Taxes $694
Interest Paid 70
Taxable Income $624
Taxes (34%) 212
Net Income $412
Dividends $103
Addition to Retained Earnings $309
30
Example: Part I
FCF = NOPAT + Depreciation – NCS – Change in
NOWC
• NOPAT + Depreciation = EBIT (1 – Tax Rate) +
Depreciation = 694 *(1 - 0.34)+ 65 = 523
• Net Capital Spending (NCS) = Ending Net Fixed
Assets – Beginning Net Fixed Assets + Depreciation =
1709 – 1644 + 65 = $130
• Change in NOWC = Ending NOWC – Beginning
NOWC = (160 + 688 + 555 – 266) - (104 + 455 +553 -
232) = $257
• FCF = 523 – 130 – 257 = $136 31
Example: Part II

Interest Tax Shield

= Cash generated from the reduction in the amount
of taxes paid due to tax deductibility of interest
= $70 * 34% = $70 * 0.34
= $24 (rounded)

32
Example: Part III
• Cash Flow to Creditors (info from B/S and I/S) =
interest paid – net new borrowing (LT Debt and Notes
Payable) = $70 – [(123+454) – (196+408)] = $70 – -
$27 = $97
• Cash Flow to Stockholders (info from B/S and I/S) =
dividends paid – net new equity raised = $103 – ($640 -
$600) = $63

For The Year 2023:

Cash flow to Creditors and Stockholders = $97 + $63
= $160 = FCF + Interest Tax Shield = 136 + 24 = $160 33
Example: Part IV – FCF via NI
OR we can calculate FCF as follows:
If our starting point is Net Income, then we can find FCF as follows:

412 Net Income

+65 + Depreciation
-291 - Increase in current assets used for operations
+34 + Increase in current liabilities from operations
-130 - Increase in fixed assets at cost (Increase in net fixed assets + depreciation)
+46 + After-tax interest paid on debt
136 = FCF

34
Review: Identifying Relevant Cash Flow Inputs:
1) Depreciation is not a cash flow, but results in a positive tax flow by reducing taxes paid. As
well, increases in deferred taxes arise when a higher tax is computed for reporting purposes
than is actually owed (e.g., a result of using accelerated depreciation for tax purposes but not
for reporting purposes).

2) Include capital investment in fixed assets

3) Include investment in net operating working capital:

Include only changes in operating working capital. Short-term debt, excess cash and
marketable securities should not be accounted for.

4) Estimate cash flows as if entirely equity financed (separate investment and financing
decisions).

5) Estimate cash flows on an incremental basis:

Forget sunk costs: cost incurred in the past and irreversible
Include all externalities - the effects of the project on the rest of the firm - e.g.,
cannibalization or erosion, enhancement

6) Include opportunity costs

35
Review: Identifying Relevant Cash Flow Inputs:
7) Include firm’s continuing value (residual or terminal value):
=> Operational estimates are made by period up until a certain horizon period (until
operations “stabilize” and/or future is too unclear). A terminal value is then added to the
cash flows in the last horizon year. The terminal value is the present value of all project
operating cash flows from the last horizon year and beyond. This can be a large proportion of
the total value estimate and care should be taken in its estimate.
Liquidation value (if the firm will not continue as a going concern): Estimate the proceeds
from the sale of assets after the explicit forecast period. (Recover working capital, tax-
shield on un-depreciated fixed assets, salvage values realized, but excludes intangibles
and value of on-going business). Liquidate if liquidation value exceeds going concern
value
Terminal Value – No growth or perpetual growth: Assumes firm continues as going
concern but cash flows are expected to be constant or grow at a constant rate perpetually
Cn+1
Terminal Value TVn =
(r−g)

Terminal Value – Multiples method: Again assumes going concern. E.g. EBITDA Multiple
– comparing relative values to obtain market value. 36
Valuing the Firm – a note on Terminal Val and growth:
⇒ When a firm’s continuing value expectations after time t are such that it is not
expected to grow but rather maintain market share, then the firm pays out its
entire earnings and does not reinvest in the firm. Thus the firm’s entire earnings
available to stakeholders FCFn+1 are in fact NOPATn+1 (because there is no
further adjustment for additional investment in working capital or capital
expenditure [investment = depreciation], etc., beyond existing operations).
⇒While it is common practice to value these cash flows as:
NOPATn+1
Continuing Value [at time n] (with 𝑔𝑔 = 0) Often Estimated as =
WACC

⇒This estimation is flawed when inflation exists, as it results in a significantly

reduced terminal value due to the fact that it does not reflect the FCFs and thus
NOPATs expected growth at the rate of inflation (thus implies that real FCFs and
NOPAT decrease at the rate i). This can be corrected as follows:
NOPATn+1
Continuing Value 𝑎𝑎𝑎𝑎 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝑛𝑛 (with 𝑔𝑔 = 0, but 𝑖𝑖 > 0) =
WACC − 𝑖𝑖
37
Identifying Relevant Cash Flow Inputs:
8) Be consistent in your treatment of inflation
Nominal cash flows (reflect inflation) – discount with a nominal cost of capital r
Real cash flows (exclude inflation) – discount with a real cost of capital r
Let rnominal be the nominal interest rate
rr be the real interest rate
ri be the expected inflation rate
1 + rnominal = (1 + rr)×(1 + ri)
Adjust sales, costs and capital expenditures to reflect expected changes in both
product prices and input prices. For terminal values, keep in mind if nominal or
real growth rate.

Note: Depreciation is based on historical costs and therefore does not grow with
inflation.

Common Mistake: Nominal discount rate used to discount real cash flows. Thus,
good projects are rejected.
Review: Identifying Relevant Cash Flow Inputs:
Year 1 Year 2 Year 3 Year 4 Year 5 . . . Terminal
FCF1 FCF2 FCF3 FCF4 FCF5 FCFn+1/(r-g)

Non – Operating Sources of Value/Debt:

PV of the Firm’s Operating Cash Flows Any asset/liability that has no cash-flow
consequences registered in the projections
+ Excess cash balance is missed by the DCF valuation. Study the
+ Excess marketable securities balance sheet for assets (unused land,
patents, etc.) or unreported debts (legal
+ Excess real estate liability claims, etc.) that do not produce a
- Under-funded pension cash flow in the projection – you will
- Stock option obligations want to add back the market value of
those assets or debts.
Firm’s Total Value = Market Value of Equity + Debt
9) Note that the DCF of the FCFs and TVn cash flow gives the Enterprise Value, i.e, the
value of the firm’s operating asset. In order to obtain total firm value, one must
additionally include excess cash, excess real estate, unfunded (over-funded) pension
funds, large stock option obligations 39
“Enterprise Value”
• The enterprise value of a firm assesses the value of the underlying
business assets (however financed), and separate from the value of
any non-operating cash (i.e., “excess cash”) and other non-operating
assets (e.g., unused land owned by firm, etc.) or liabilities that the
firm may have.
• Generally,
Enterprise Value = PV of all FCFs and Terminal Value = Market Value of Equity
(which is equal to Stock Price * Shares Outstanding) + Debt – Excess Cash
– Other Non Operating Assets + Other Non Operating Liabilities

• In theory, the cost of a company if someone were to acquire ONLY its

operating assets. Note though that, in reality, a buyer purchasing
ownership of a firm will pay shareholders the market value of equity,
which is the shareholders’ ownership rights in all assets, operating and
non-operating. 40
Valuing a Firm: Using FCFs and WACC
• Projected FCFs are free cash flows expected to be generated by the firm
and belonging to all the firm’s providers of capital. Thus they are to be
discounted back by the firm’s cost of capital WACC (weighted average
cost of capital). WACC value-weights the firm’s after-tax cost of equity rE
as well as its after-tax cost of debt rD)
25%
Debt
Assets
75%
Equity

These FCFs belong to all

Assets generate FCFs
FCFs the providers of capital

FCFs are the cash flows generated by a firm’s operating assets for a given period, after taking into account
investment needed in fixed assets and working capital. Thus it is cash available to the providers of capital
Basic Example: Corporate Valuation
The below timeline indicates the firm’s projected FCFs (in
$Millions): FCF1 = -5, FCF2 = 10, FCF3 = 20. After year three, the firm is
expected to have a long-run constant gFCF = 6%. It has a weighted
average cost of capital (WACC) of 10%. Use the FCF DCF model to
find the firm’s value today.

0 r = 10% 1 2 3 4
g = 6%
...
-5 10 20 21.20
-4.545
8.264
15.026 21.20
398.197 530 = 0.10 - 0.06
416.942 TV3
Basic Example: Corporate Valuation
If the firm has no non-operating assets or liabilities, has $40
million in debt and has 10 million shares of stock, what is
the firm’s value per share?
• MV of equity = MV of firm – MV of debt
D
= $416.94 - $40
= $376.94 million Equity

• Value per share = MV of equity / # of shares

= $376.94 / 10
= $37.69
■ In this specific example, what is ‘Enterprise Value’? Is it the same as
the total Market Value of the Firm? Why?
Basic Pro Formas for Company Valuation:

Creating a complete set of pro-forma (forecast)

financial statements ensures that assumptions about the
individual line items of the forecast are consistent with
each other.

=>Thus it is preferable to obtain free cash flow

estimates in this way rather than by directly estimating
them by projecting FCF’s individual components
(operating income, depreciation, capital expenditure)

44
Basic Pro Formas for Company Valuation:
• Some Points
- For the purposes of building pro forma financial statements,
operating “current assets” refers only to those current assets used
in the firm’s operations. This would include: A/R, Inventories,
Pre-paid Expenses. Pro forma “current assets” does not include
Cash and Marketable Securities THAT are NOT required for the
firm’s operations (i.e., it does not include ‘excess cash’).
- Concurrently, when building pro formas, operating “current
liabilities” also refers only to those current liabilities used in the
firm’s operations. Included would be: A/P, Taxes Payable. Short-
term debt and the current portion of long term debt are not
included.
45
Projecting Cash Flows - Overview:
• A Basic Financial Planning Model has 3 Major Components:
i. The Model Parameters/Value Drivers: These reflect the basic
assumptions of the model. More often than not, financial-
statement models are sales-driven – accordingly, once a sales
estimate is made, many of the other financial statement accounts are
expressed as a function (percentage) of the firm’s sales.
ii. Financial Policy Assumptions: How will the firm finance
operating cash shortfalls in the future? If there is instead a cash
surplus generated, will the firm’s excess operating cash generated
go to its cash account or is it used to pay down debt.
iii. Creation of Pro Forma Financial Statements: Once the above
components have been determined, a firm’s pro formas can be
created in line with their business strategy, financial policy and
expected performance. 46
Building Pro Formas – Basic Overview:
Extending the Model to Years 2 and Beyond:

►When valuing firms and creating pro formas, the forecast period is
selected so as to incorporate all non-smooth foreseeable changes in
expected cash flow patterns (lumpy capital expenditures, asset
disposals, reductions in expenses, atypical growth, cyclical effects,
etc.).

► “Terminal value” captures subsequent cash flows, usually by

making a simplifying assumption about future operations (although
due to competition, imitation and technological convergence, it is not
out of order to assume that a firm will regress to the industry norm).
Sometimes, a reasonable assumption may be that the firm’s nominal
growth rate will approach that of the economy as a whole. 47
Building Pro Formas – Estimating FCF

• Free Cash Flows: Once we have our pro-formas, we

can produce a Free Cash Flow calculation. The FCF
measures the cash produced by the firm’s operating
activities. Ultimately, investors are most interested in
this value, i.e., the cash a firm is able to produce and
that is free to be distributed to its shareholders and debt
holders.

48
Sensitivity Analysis:
• By varying the model’s assumptions, we can use the financial planning model
to analyze different scenarios of the firm’s future performance. This allows for
a review of the project’s strengths, weaknesses, and the consequences of mis-
estimating variables. In enterprise valuation, there is no substitute for a
careful analysis of the possible cash flow scenarios.
• While the pro-formas will be produced for the expected operating results (most
likely scenario), it is also important to acknowledge and comment on the effect
of varying financial assumptions on NPV and value.
- Determining the impact of changing certain assumptions on the financial
statements and the free cash flows can easily be done with Excel, by
changing the values of the cells containing the revenue growth
assumptions or the discount rates for valuation
- However to more broadly see the range of impact of changing
assumptions on the financial statements we can use Excel’s Data
Table feature. 49
Sensitivity Analysis:
• Two Dimensional Data Tables (Under Excel ‘What If Analysis’): Below we
vary our example with respect to both the interest rate and the initial deposit.

B C D E F G H
9 $2,334.93 0% 5% 10% 15% 20% 25%
10 50 500.00 660.34 876.56 1,167.46 1,557.52 2,078.31
11 100 1,000.00 1,320.68 1,753.12 2,334.93 3,115.04 4,156.61
12 150 1,500.00 1,981.02 2,629.68 3,502.39 4,672.56 6,234.92
13 200 2,000.00 2,641.36 3,506.23 4,669.86 6,230.08 8,313.23
14 250 2,500.00 3,301.70 4,382.79 5,837.32 7,787.60 10,391.53
15 300 3,000.00 3,962.04 5,259.35 7,004.78 9,345.13 12,469.84
50
More WACC Valuation Issues: Project vs. Firm
We use a firm’s after-tax WACC on a project/transaction when its business risk is the same as
that of the firm’s other assets and it is expected to remain so for the life of the project.
However, when that is not the case, firm WACC should not be used. For example, consider a
conglomerate firm composed of four business divisions, but which uses the firm’s overall
WACC to evaluate projects.

r Good Projects Rejected Bad Projects Accepted

Pharma

12.74% Overall Firm’s

Professional Services After-Tax WACC
Food Staples
Railroads
5%
β
0.97
The β of the firm is a weighted average of the βs of the four component divisions.
51
More WACC Valuation Issues: Financing
►When there are more sources of financing – e.g. Preferred Stock:

D E P
WACC = rD × (1 − Tc ) × + rE × + rP ×
V V V
Where Value = Debt + Equity + Preferred Equity

► Industry WACCs are sometimes more useful b/c they are less exposed
to random noise and estimation errors. But this assumes company and
industry have same business risk and financing risk (capital structure).

52
More WACC Valuation Issues: Financing
►We use a firm’s after-tax WACC on a project when the project supports the same
fraction of debt to value as the firm’s overall capital structure. However note that the
immediate source of funds has no necessary connection with what the project’s
overall contribution to/ effect on the firm’s borrowing power / debt ratio. We are
concerned with the latter.
• Small or temporary fluctuations in the debt ratios can be ignored because
changes in the tax shield over time tend to offset each other. This does not apply
to large and persistent movement from the target debt ratio.
►Note: Recall that when using the WACC Valuation method, the free cash flows
composing the numerator, have to be projected as if the company were all equity
financed. Again, these cash flows are then discounted at the after-tax cost of capital
thereby incorporating the value of the interest tax shield in the valuation calculation
rendered.
►Note: When using the WACC Valuation method, the value estimate obtained
represents the total value of the firm’s entire operations (excluding non operating
assets which have to be added to this calculation) – this includes all debt and equity.
53
Recall WACC Components
Return on Equity derived from: CAPM => SECURITY MARKET LINE

Expected Return E(rE)= rf + βE ( rm - rf )

Cov(ri , rm )
βi =
σ 2 (rm )
Market Return = rm .
Market Portfolio
Risk Free
Return = rf
1.0 BETA

⇒ The SML describes the risk return relationship between the β of a security and its
expected rate of return. =>The most common method of estimating return on equity 54
Recall Beta and Diversifiable Risk
Cov(ri , rm )
1. Total risk =
βi =
σ 2 (rm )
diversifiable risk Stock i
+ market risk return
2. Market risk is
measured by beta, beta
the sensitivity to +10%
-10%
market changes

-10% +10%
Market
-10% return
The resulting regression:
α + β r + ε
r =
i i i m i

βi- Sensitivity of a stock’s return to the return on the market portfolio.

rm refers to the historical market portfolio
55
ε refers to the “noise” or unique risk
CAPM: QUALIFICATIONS
• What is the market portfolio?
• What is the choice of rf?
• What is the market risk premium?
• Should we apply a historical market risk premium? A forward
looking market risk premium?
• How should we measure β? Using data regarding returns going how
far back in time? Using daily, weekly, monthly data? Using returns
based on arithmetic means or geometric means?
• Thus, beyond the issues listed above, we must understand that CAPM
only provides a guideline for estimating the cost of equity and is not
definitive and unquestionable in its result.
56
SML and β Measurement
EXCESS RETURNS, NASDAQ vs S&P 500
May 1990 - August 2003
25%

Nasdaq
20%
y = 1.4346x + 0.0025
R2 = 0.6433 15%

10%

5%

0%
-20% -15% -10% -5% 0% 5% 10% 15%
-5% S&P 500

-10%

-15%

-20%

-25%

-30%

57
SML and β Measurement
EXCESS RETURNS, NASDAQ vs S&P 500
December 1999 - August 2003

25%

Nasdaq
20%

15%
y = 1.6865x + 0.0036
R2 = 0.6255 10%

5%

0%
-15% -10% -5% 0% 5% 10% 15%
-5%
S&P 500

-10%

-15%

-20%

-25%

-30%

58
Estimating Betas:
• We can use historical equity return data to estimate a firm’s equity β if
the firm’s past market sensitivity is assumed to be a good indication of
its future.

• Have there been technology changes, deregulation, changes in

product/service offerings, changes in debt ratio, etc.? Also, usually
the industry’s average β has a lower standard error than any
individual firm, but is it appropriate to use in the circumstances?

• Moreover, how far back in the past we look (2 years, 5 years, 30 years,
etc.) depends, on our assumptions about the stationarity of the
distribution of returns and the validity of the pricing model. A firm’s
sensitivity to the market may change. Usually β is estimated based on
more recent data (e.g., 3-5 years).

• The market index selected used will affect the estimated β

59
Applying CAPM: Leading rf
• During inflationary periods (e.g., early 1980s) characterized by inverted yield
curves, then basing a cost of capital estimate for a medium term or longer
project on the Treasury bill rate and then a beta weighted historic risk
premium over bills, could lead to an overestimation of the cost of capital and
an underestimation of value.
• => During a recession, where monetary policy is usually characterized
by an easing of interest rates, Treasury bill rates could result in an
underestimation of the cost of capital and overestimation of value.
• => Treasury bill rates are good for estimating next year’s cost of
capital, but not a long-term cost of capital.
• ►Most commonly used approach: The choice of the Treasury security
used depends on the length of the cash flows discounted. For longer-term
projects or firm valuation, some prefer to use 10 year T-Bond as 30 year
bonds are less traded (i.e., have lower liquidity).
60
Applying CAPM: Historical Market Risk Premium?
• Historic Risk Premium: The average difference between the realized (i.e., past)
returns on the market index used and a corresponding US Treasury security (bill
or bond) is usually used as the measure of the market risk premium.
• T-bill or T-bond: choice depends on maturity and interpretation. Some match the
leading rf with the rf to be used in the risk premium. Others use only T-bills to
measure the long run historical market risk premium, for example because of
the belief that the measured Beta will reflect whether or not any liquidity issues
are relevant.
• How far back to go? Arbitrary? Is it best to estimate the historical market risk
premium by including periods characterized by bubbles, crashes, depressions,
wars, inflations, stagflation, etc.?
• Use arithmetic average or geometric average market risk premium? Simple
compounding of historical rates may produce upward biased estimates of the
long-term expected return. Continuously compounded rates may produce
downward biased estimates…
61
Applying CAPM: Market Risk Premium in Conclusion
• An upsurge/decline in the equity premium?
• Both a review of the long-term historical analysis of the equity
market risk premium, and attempts at prospective estimates of the
equity market risk premium, have lead to estimates that the US
market risk premium (as well as other developed capital markets
according to a number of academic studies) is between 3% and 6%.
• At different times, it can be much lower and/or higher.
• Conclusion: the required return on equities varies over time
depending on changes in interest rates, return volatility and
attitudes toward risk.
62
Applying CAPM: Small Company (Liquidity) Premium?
• Studies testing CAPM, in spite of their differences, suggest that market
beta is not the only factor determining cost of capital. In practice, one of
the most common adjustments appears to be a modest company size
effect, even among public companies
• Studies of liquidity and expected returns have found that less liquid
stocks provide higher average returns than more liquid stocks. Measured
liquidity via bid-ask spread. A correction for higher transaction costs?
Liquidity: time, price, quantity?
• A large strategic buyer (e.g., GE, Google, etc) may not need a size
premium as the acquiring firm’s liquidity matters when discounting the
cash flows of the target. BUT, a private equity (financial) buyer will
most likely add an illiquidity premium when discounting the same cash
flows. 63
Valuation & After-Tax WACC Valuation
One reason financing and investment decisions interact is due to taxes and the
tax deductibility of debt’s interest expense. This tax deductibility reduces a
firm’s effective after-tax weighted average cost of capital. Thus all else equal, the
use of debt or leverage effectively increases the value of an unleveraged firm.

 VL = Value of the firm when leveraged (=VU + PV (Tax Shields))

 VLvalue FCF1 FCF2 FCF5 Year -5 Terminal Value
Enterprise
= + + + +
(1 + WACC ) (1 + WACC ) (1 + WACC ) (1 + WACC )
1 2 5 5

Recall the formula for a firm’s weighted average cost of capital WACC is given
below (tc represents the firm’s marginal corporate tax rate).
VL − tC DL DL EL
WACCA
WACC = r ( = ) = (1 − t C ) rD + rE
VL VL VL
►When estimating WACC, use projected D/V in market values
►What would WACC be if the firm were unleveraged?
64
Valuation & After-Tax WACC Valuation
VL − tC DL DL EL
WACC= rA (
WACC =V ) = (1 − t C )
VL
rD +
VL
rE
L

As the debt ratio increases, we know that the cost of equity also
increases, due to the increasing financial risk borne by equity holders.
However, the WACC declines. The decline is due to the tax shields on
debt’s interest payments. Were it not for this tax deductibility, the WACC
would be constant and equal to the firm’s cost of capital when it is
unleveraged (denoted rA) at all debt ratios and VL would be equal to VU.

The WACC reflects the after-tax cost of debt. It is via this adjusted
discount rate that the value of interest tax shields are taken into account
under WACC Valuation. The increased firm value gained through interest
tax shields is reflected not through higher after-tax cash flows (we use
unleveraged FCFs in the numerator), but in a lower after-tax discount
rate. 65
 Valuation & After-Tax WACC Valuation

Risk-free Debt Increasing Debt Risk

r r
rE
rE

rA
rA

WACC
rA (1 − tC ) rA (1 − tC ) WACC

rD rD

D/E Risk free debt Risky debt D/E

66
Unleveraged Firm’s Cost of Capital is rA
Company cost of capital rA is the opportunity cost of capital for
investment in the firm’s assets as a whole. If the firm were
unleveraged, its cost of capital would equal rA. When interest is NOT
tax deductible, then rA is also the company’s overall cost of capital
(regardless of its debt level) as illustrated in the below formula:

Company Cost of Capital DL EL

when interest notWACC
tax == rA = rD + rE
VL VL
deductible

D and E are the market values of the firm’s debt and equity and V is
the total market value of the leveraged firm (V = D + E).
67
Un-leveraging & Re-leveraging Issues
• In estimating asset values we don’t always have the required component
estimates of expected return. For example, sometimes we have a firm’s
βE or rE and really want its βA or rA(as in the case of APV Valuation, to be
discussed).

• Other times we have the βE or rE of a firm of similar business risk to the

firm of interest (as when trying to value a private company or a new type
of project), but the two firms’ debt/equity ratios differ.

 In these cases, we need to un-lever and re-lever the βE or rE to

obtain an appropriate estimate of the correct business and financial
risk of the firm of interest.

68
Un-leveraging & Re-leveraging Issues
There are a number of ways to approach un-leveraging and re-leveraging.

 1st: When working directly with the CAPM framework, then the focus of
un-leveraging and re-leveraging should be β.

 2nd: There are slightly different formulas for un-leveraging and re-
leveraging depend on the underlying assumptions about the patterns of firm
cash flows and the discount rate used to discount the tax shields (depending on
debt policy) (all formulas derive from the relationship VL = VU + PV (Tax
Shields)). We will focus on one of these formulas

***Fortunately the results of the different formulas are not too different and
estimates essentially are driven by the measurement error in estimating β s and
risk premiums rather than in the method of un-leveraging and re-leveraging. 69
Un-leveraging and Re-leveraging Betas – when rebalance
debt ratio continuously at a constant level
We can use the structure of the CAPM to un-lever and re-lever equity beta
directly. Once the beta of equity at the new debt ratio is calculated, the new
cost of equity rE is determined by plugging the new βE into the CAPM.
WACC is then recalculated.

First, we use the existing βD and βE to find the firm’s βA

βA = βD(D/V) + βE(E/V)

Then, using the new (D/E)* ratio, the βE is recalculated as follows:

βE = βA + (βA – βD)(D/E)*
**If the βD changes with the new D/E. this also is adjusted above.
***This derives from the Harris-Pringle formula (the Hamada formula assumes fixed D) 70
Adjusted Present Value (APV) Valuation Method
Adjusted Present Value (APV): Under APV, the value of a leveraged
project/firm is equal to the value of that project/firm when unleveraged plus
the net present value of all financing effects (if any).

APV = Base-Case NPV + Sum of PVs of Financing Side-Effects

VL = VU + PV (Tax Shields)

Base-Case NPV consists of the value of the firm or project as if it were an

all-equity financed business. Thus the discount rate rA (the firm’s opportunity
cost of capital when excluding the effect of the tax deductibility of interest),
is used to discount the total firm free cash flows as they would be under an
all-equity firm.
Financing effects, interest tax shields in particular, are taken into account
separately. Thus the interest tax shield is explicitly calculated and then
discounted at the pre-tax cost of debt rD. 71
Adjusted Present Value (APV) Valuation Method

►The APV valuation method is easily adjusted to different financing

strategies. Under APV there is no necessary requirement to
maintain a constant target debt ratio as with the WACC method.
As well, there is no calculation requirement to un-lever and re-lever
the expected return on equity rE for different leverage strategies, as rA
is always used to find the Base Case Value

► As we’ll see when we look at LBOs, APV is particularly useful

when a firm’s debt load has to be repaid according to a fixed
schedule (whereby the firm’s debt ratio is thus changing every
period).
72
APV Valuation: Basic Example
Example:
A firm is considering undertaking a project that would cost
$200M upfront. It would then generate free cash flows, on
an all-equity basis, of $65M annually for the next five
years. Given the project’s risk characteristics, the cost of
unlevered equity rA = 18%. The firm is to fund the project
via $100M in debt which is to be repaid in equal annual
installments over the next 5 years. The cost of such debt rD
is 10%. The applicable marginal tax rate is 46%.
►What is the value of the project?
73
APV Valuation: Basic Example

APV = Base-Case NPV + Sum of PVs of Financing Side-Effects

Here the Base-Case NPV is determined as follows:

= -$200M + $65M/(1.18) + $65M/(1.18)2 + $65/(1.18)3 + $65/(1.18)4
+$65/(1.18)5
= -$200M + $203.266M = $3.266M

PV of Financing Side Effects = PV of Annual Tax Shields

Note: If the discount rate rD was not also equal to the loan rate of 10%
(for example, in the case of government subsidy/incentive), then we
would also have to determine the PV of the principal receipt, the annual
interest payments and the eventual return of principal using the rate rD.
74
APV Valuation: Basic Example

The tax shields were determined from the loan repayment

schedule whereby the annual interest payment was multiplied by
the marginal tax rate.PVwithofPVan=Annuity
100,000,
interest = 10%, n = Column A * 10% Column B – Column A –
5 years Interest Rate Column C Column D

75
APV Valuation: Basic Example
YR1: $10,000 Interest Payment*46% Tax Rate = 4,600

PV of the Annual Tax Shields: YR2: $8,362 Interest Payment*46% Tax Rate = 3,847

= $ 4.600 /1.1 + $ 3.847/1.12 + $3.017/1.13 + $ 2.106/1.14 +

$ 1.103/1.15 = $11.751M

APV = Base-Case NPV + Sum of PVs of Financing Side-Effects

APV = $3.266 M + $11.751 M = $15.018 M

► APV shows us where the sources of value are coming from.

76
Finding the Value of a Highly Levered Firm
APV = Base-case NPV (Value as an all-equity financed firm)
+ Sum of PVs of all financing side effects

APV: Calculates value in parts: (i) the value of a firm as if it was all equity
financed (i.e., the value generated by a firm’s operating assets excluding any
financing effects), plus (ii) incremental value gained from leverage (value
gained from reduced tax outflow via the tax deductibility of interest), plus
(iii) any other value effects (other financing aspects, issuance costs, distress
costs, etc.). APV is ideal to use when the debt/equity ratio is not constant,
but the reduction in debt is systematic and/or predictable.
LBOs – Initially a heavy debt load, but debt/equity ratio falls over
time, as debt is repaid (both the cost of equity and the WACC change as
debts are paid!). The book value of the debt can be easily forecast
given a pre-specified financing payment schedule.

77
A Reminder About WACC DCF Valuation:

D E
WACC = (1 − Tc )rD + ( )rE
VL VL

DCF using WACC: Estimates a company’s value by discounting the firm’s

unleveraged free cash flows using a constant weighted average cost of
capital.

• Thus the WACC valuation method is ideal to apply when a firm has a
constant target debt/equity ratio (in terms of market values) (and by target
we mean ‘aspirational’ , i.e., a D/E that the firm aims to maintain) and the
firm’s asset risk (i.e., project business risk profile) is also maintained.

78
Free Cash Flows to Equity – FCFE – Valuing
Equity Directly (often used for financing firms)
• Free cash flow available to equity holders (FCFE)
NI
𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹
= 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 − 𝐼𝐼𝐼𝐼𝐼𝐼 1 − 𝑡𝑡 + 𝐷𝐷𝐷𝐷𝐷𝐷 − 𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 – Δ𝑁𝑁𝑁𝑁𝑁𝑁
+ 𝑁𝑁𝑁𝑁𝑁𝑁 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵

• FCFE must be discounted at required rate of return on equity (𝑟𝑟𝐸𝐸 ) as

they are cash flows that go only to Equity holders
• Also 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 = 𝐹𝐹𝐹𝐹𝐹𝐹 − 1 − 𝑇𝑇 𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 + 𝑁𝑁𝑁𝑁𝑁𝑁 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵
• FCFE does not refer to actual dividends paid out to shareholders. But
rather, it is the cash flows that have been generated by the firm during a
particular period, that are available to shareholders.
=> We will use FCFE valuation in our insurance industry case
79
 APPENDIX:

Financial Ratio Analysis –

Basic Overview

80
The 5 Major Categories of Ratios
1. Liquidity ratios (Short-Term Solvency) measure the firm’s
ability to pay bills in the short run.
• Can we make required payments as they fall due?

2. Long-Term Solvency (Financial Leverage) ratios show how

heavily the company is in debt.
• Do we have the right mix of debt and equity?

3. Asset management (Turnover / Efficiency) ratios measure how

productively the firm is using its assets
• Do we have the right amount of assets for the level of sales?
81
The 5 Major Categories of Ratios
4. Profitability ratios measure the firm’s return on its
investments:
• Do sales prices exceed unit costs, and are sales high
enough as reflected in PM, ROE, and ROA?

5. Market value ratios provides indications on the

firm’s prospects and how the market values the firm:
• Do investors like what they see as reflected in
Price-Earning (P/E) and Market-to-Book (M/B)
ratios?
82
Example: D’Leon’s Financial Statements
Balance Sheet: Assets

2023 2022
Cash 85,632 7,282
A/R 878,000 632,160
Inventories 1,716,480 1,287,360
Total CA 2,680,112 1,926,802
Gross FA 1,197,160 1,202,950
Less: Dep. 380,120 263,160
Net FA 817,040 939,790
Total Assets 3,497,152 2,866,592
83
Example: D’Leon’s Financial Statements
Balance Sheet: Liabilities and Stockholder’s Equity
2023 2022
Accts payable 436,800 524,160
Notes payable 300,000 636,808
Accruals 408,000 489,600
Total CL 1,144,800 1,650,568
Long-term debt 400,000 723,432
Common stock 1,721,176 460,000
Retained earnings 231,176 32,592
Total Equity 1,952,352 492,592
Total L & E 3,497,152 2,866,592
84
Example: D’Leon’s Financial Statements
Income Statement 2023 2022
Sales 7,035,600 6,034,000
COGS 5,875,992 5,528,000
Other expenses 550,000 519,988
EBITDA 609,608 (13,988)
Depr. & Amort. 116,960 116,960
EBIT 492,648 (130,948)
Interest Exp. 70,008 136,012
EBT 422,640 (266,960)
Taxes 169,056 (106,784)
253,584 (160,176)
Net income 85
Example: D’Leon’s Financial Statements
Additional Data
2023 2022
No. of shares
250,000 100,000
EPS
DPS $1.014 -$1.602
Stock price $0.220 $0.110
$12.17 $2.25

86
1. Liquidity Ratios
• Liquidity is the “ability to convert assets to cash quickly without a
significant loss in value.”
• Liquidity Ratios indicate a firm’s ability to meet its maturing short
term obligations.
• Is high liquidity always good? Kirk Kerkorian’s takeover bid for
Chrysler in April, 1995, is an example of investor dissatisfaction with
excess liquidity. At the time, Chrysler’s management had accumulated
$7.3 billion in cash and marketable securities as a cushion against an
economic downturn. Mr. Kerkorian instigated a takeover bid because
Chrysler’s management refused to pay this cash to stockholders.

87
D’Leon’s Current & Quick Ratios for 2023:
Current ratio = Current assets / Current liabilities
= $2,680 / $1,145 = 2.34x

Quick Ratio = (CA – Inventory) / CL

= ($2,680 - $1,716)/$1,145 = 0.84x

2023 2022 2021 Ind.

Current Ratio 2.34x 1.20x 2.30x 2.70x
Quick Ratio 0.84x 0.39x 0.94X 1.28x

• Seemingly improving but still below the industry average.

• Liquidity position is weak. 88
Other Liquidity Ratios

• Cash Ratio = Cash / CL

86/1,145= .075x

• NWC to Total Assets = NWC / TA

(2,680 – 1,145) / 3,497 = 0.439x

• Interval Measure = CA / average daily operating costs

2,680 / ((5,876 + 550)/365) = 152.2 days

89
2. Long-term Solvency
• Also known as financial leverage ratios. Financial leverage relates to the
extent that a firm relies on debt financing rather than equity. Generally, the more
debt a firm has, the more likely it is the firm will become unable to fulfill its
contractual obligations.
Total Debt Ratio = Total Debt / Total Assets
VARIATIONS:
Debt/Equity Ratio = (total assets – total equity) / total equity
Equity Multiplier = total assets/total equity
= 1 + debt/equity ratio
Long-Term Debt Ratio = long-term debt / (long-term debt + total equity)
COVERAGE RATIOS:
Times Interest Earned Ratio = EBIT / interest
Cash Coverage Ratio = (EBIT + depreciation) / interest
90
D’Leon’s Long-Term Solvency Ratios
Total Debt Ratio = Total debt / Total assets
= ($1,145 + $400) / $3,497
= 0.442 or 44.2%
Times Interest Earned = EBIT / Interest expense
= $492.6 / $70 = 7.0x

2023 2022 2021 Ind.

D/A 44.2% 82.8% 54.8% 50.0%

TIE 7.0x -1.0x 4.3x 6.2x

• At this point, D/A and TIE appear to be better than the industry
average.
91
3. Asset Management Ratios
• Also known as activity ratios, they measure how effectively
the firm’s assets are being managed:
• Inventory ratios measure how quickly inventory is
produced and sold
• Receivable ratios provide information on the success of
the firm in managing its collection from credit
customers
• Fixed asset and total asset turnover ratios show how
effective the firm is in using its assets to generate sales
92
D’Leon’s Inventory turnover for 2023:
Inventory Turnover = COGS / Inventory = $5,876/$1,716 = 3.42x

2023 2022 2021 Ind.

Inventory
3.42x 4.30x 4.51x 4.82x
Turnover

• Inventory turnover below industry average. D’Leon might have old

inventory, or its control might be poor.
 Days’ Sales in Inventory = 365 / Inventory Turnover. For 2023,
Days’ Sales in Inventory = 365/3.42 = 106.7 days.
2023 2022 2021 Ind.

Days’ Sales in
106.7 days 84.9 days 80.9 days 75.7 days
Inventory
93
D’Leon’s Receivables Turnover for 2023:
Rec. turnover = Sales / Receivables = $7,036 / $878 = 8.01x

2023 2022 2021 Ind.

Receivables
8.01x 9.55x 9.76x 11.4x
Turnover

Days Sales Outstanding or Account Receivable Days or Average

Collection Period = The average number of days after making a sale
before receiving cash
Account Receivable
DSO =
Average Daily Sales Sales
or 365
DSO = 365/Receivables Turnover 94
D’Leon’s Days Sales Outstanding for 2023:
DSO = Account Receivable/ Average Daily Sales
= Receivables / Sales/365
= $878 / ($7,036/365)
= $878/$19.277
= 45.6 (Days)

2023 2022 2021 Ind.

DSO 45.6 38.2 37.4 32.0

• D’Leon collects on sales too slowly, and this is getting worse.

• D’Leon has a poor credit policy.
95
D’Leon’s Fixed Asset and Total Asset Turnover
Ratios for 2023:
FA Turnover = Sales / Net fixed assets = $7,036 / $817 = 8.61x
TA Turnover = Sales / Total assets = $7,036 / $3,497 = 2.01x

2023 2022 2021 Ind.

FA TO 8.6x 6.4x 10.0x 7.0x
TA TO 2.0x 2.1x 2.3x 2.6x

• FA turnover exceeded the industry average in 2023.

• TA turnover below the industry average. Caused by excessive
currents assets (A/R and Inv).
96
4. Profitability
• Measure how successfully a business earns a return on its investment
• Show the combined effects of liquidity, asset management, and debts on
operating results
Profit margin = Net income / Sales = $253.6 / $7,036 = 3.6%
BEP (Basic Earning Power) = EBIT/Total assets = $492.6 /$3,497 = 14.1%

2023 2022 2021 Ind.

PM 3.6% -2.7% 2.6% 3.5%
BEP 14.1% -4.6% 13.0% 19.1%
• Profit margin improving.
• BEP removes the effects of taxes and financial leverage, and is useful for
comparison. BEP has improved substantially, but still below the industry
average. Room for improvement. 97
D’Leon’s Other Profitability Ratios for 2023:
Return on Assets and Return on Equity
ROA = Net income / Total assets = $253.6 / $3,497 = 7.3%
ROE = Net income* / Total common equity = $253.6 / $1,952 = 13.0%

2023 2022 2021 Ind.

ROA 7.3% -5.6% 6.0% 9.1%
ROE 13.0% -32.5% 13.3% 18.2%

• Both ratios rebounded from the previous year, but are still below the
industry average. More improvement needed.
• Wide variations in ROE illustrate the effect that leverage can have on
profitability.
*If there is preferred dividend, you should deduct it from net income 98
Effects of Debt on ROA and ROE
• ROA is lowered by debt - interest expense lowers net income, which also
lowers ROA.
• However, the use of debt lowers equity, and if equity is lowered more than net
income, ROE would increase.

Problems with ROE

• ROE and shareholder wealth are correlated, but problems can arise when ROE
is the sole measure of performance
– ROE does not consider risk
– ROE does not consider the amount of capital invested
– Might encourage managers to make investment decisions that do not
benefit shareholders
• ROE focuses only on return. A better measure is one that considers both risk
and return.
99
5. Market Value Ratios
• A set of ratios that relate the firm's stock price to its earnings, cash flows and
book value per share:
1. P/E: How much investors are willing to pay for $1 of earnings.
2. M/B: How much investors are willing to pay for $1 of book value equity.
• For each ratio, the higher the number, the better.
D’Leon’s P/E = Price / Earnings per share = $12.17 / $1.014 = 12.0x
M/B = Mkt price per share / Book value per share = $12.17 / ($1,952 / 250) = 1.56x

2023 2022 2021 Ind.

P/E 12.0x -1.4x 9.7x 14.2x
M/B 1.56x 0.5x 1.3x 2.4x
100
The Dupont System
• Some profitability and efficiency measures can be linked in useful ways.
• These relationships are often referred to as the Du Pont system in
recognition of the chemical company that popularized them.
Deriving the Extended Du Pont Identity

• ROE = NI / TE
• Multiply by TA/TA (= 1) and then rearrange
• ROE = (NI / TE) (TA / TA)
• ROE = (NI / TA) (TA / TE) = ROA * EM
• Multiply by (Sales/Sales) and then rearrange
• ROE = (NI / TA) (TA / TE) (Sales / Sales)
• ROE = (NI / Sales) (Sales / TA) (TA / TE)
• ROE = PM * TA TO * EM 101
The Three Ratios of the Dupont Identity
ROE = PM * TA TO * EM
1. Profit margin (PM) is a measure of the firm’s operating
efficiency – how well does it control costs
2. Total asset turnover (TA TO) is a measure of the firm’s
asset use efficiency – how well does it manage its assets
3. Equity multiplier (EM) is a measure of the firm’s
financial leverage

102
D’Leon’s Extended DuPont Equation:
Breaking down Return on Equity
ROE = (Profit margin) x (TA turnover) x (Equity multiplier)
= 3.6% x 2 x 1.8
= 13.0%

PM TA TO EM ROE
2021 2.6% 2.3 2.2 13.3%
2022 -2.7% 2.1 5.8 -32.5%
2023 3.6% 2.0 1.8 13.0%
Ind. 3.5% 2.6 2.0 18.2%
103
Ratio Analysis: Potential Problems/ Limitations
• Comparison with industry averages is difficult if the firm operates
many different divisions (a diversified firm).
• “Average” performance is not necessarily good. Use the leader’s?
• Seasonal factors can distort ratios.
• Window dressing techniques can make statements and ratios look
better.
• Different accounting and operating practices can distort comparisons.
• Sometimes it is difficult to tell if a ratio value is “good” or “bad.”
• Often, different ratios give different signals, so it is difficult to tell, on
balance, whether a company is in a strong or weak financial condition.

104
Some Qualitative Factors
Additional considerations when evaluating a company’s future
financial performance:

• Are the company’s revenues tied to a single customer?

• To what extent are the company’s revenues tied to a single
product?
• To what extent does the company rely on a single supplier?
• What percentage of the company’s business is generated overseas?
• What is the competitive situation?
• What is the company’s legal and regulatory environment?

105