Hi, Trying to value a firm using DCF method and the question is iff the firm is employing debt thus has periodic principal and interest payments as well as employment of new debt within the valuation period how would the FCF be calculated? I tried a few different approaches one of them was to value the EV through EBIT*(1-tax rate) and then no-cash adjustments (CAPEX, Cahnge WC, deprc) so no reflection of interest or principal payments. I used a WACC with a 30% D/D+E ratio constant. This one worked (of course) however not sure if this is the right way of doing the discounting since no debt activity (principal or interest) is being reflected. What would you say if I want to start with NOPAT, then adjust for non-cash items and CAPEX and WC and then adjust for any principal payments or new debt coming in (just like in the cash from financing of a cash flow statement) and then discount the CFs using a WACC but this WACC would be lower due to the inreased amount of debt in the capital structure thus increasing the EV of the firm. Last question I have is whether to deduct the Net Debt in year 0 from the EV or not? Casue I am thinking if I have acounted for all the principal portion of the debt activity in the casf flows and the interest portion of the debt employed is already being accounted in the WACC maybe I need not to deduct the Net debt to get to NEV but instead assume my NEV is the sum of all the DCF? I know it is lenghty question guys and I know there is never one right way to deal with such an approach like DCF but try to help me out if anyone can basically just looking for a few key advise that would allow me to spit another model to give a more multi-faceted view. Thanks,
If this is a question for your job, best to ask someone at your company for advice. The point of AF is not to earn your salary for you. That said, it might help you to differentiate between FCFE and FCFF.
This actually is for a certificate exam I ahve to take soon and everyone says something different. ~I am just trying to find the best aprroach to get a good grasp of the methodology. That said, the way I have calculatd already was the FCFF (but not I want to come up with the FCFE whcih woulod wssentially mean to adjust for the cash flows due to debt employment. Thanks
If you’re posting to L3 forum here the assumption is you’ve passed L1 and L2. I believe FCFF calculation is covered therein. Do you have your old textbooks? if you’re calculating fcff why do you care about P&I debt payments?
Regarding the effect of capital structure on debt on EV This was covered in LII. The text referenced the work of two authors whose names began with “M.” (Miller & Maglioni, or something). There are a few ways of looking at this, but here’s one take. Increasing the weight of debt in the capital structure makes the equity shareholder’s investment more risky, thereby increasing the cost of capital. Increasing the debt load will also increase the cost of debt – the new debt will likely be richer. The increased cost of equity and more expensive new debt will negate the tax effect of debt financing, resulting in an unchanged WACC and EV. Another take is that capital structure decisions alter uses of cash, but not intrinsic value. When I valued companies, I ignored the company’s WACC and capital structure entirely. The capital structure will change in a buyout. The firm’s value will not. I always used the optimal industry cost of capital (involving un- and re- levering the company’s comparables) to calculate the proper discount rate. This approach was taken straight out of the SBBI Valuation textbook. Regarding your valuation method. If you’re adding/subtracting P&I to NOPAT (EBIT(1-T)) then you are discounting FCF to the equity shareholder at the firm’s projected WACC. This is incorrect. FCF to Equity should be discounted at the cost of equity. To answer last your question: do not deduct debt from EV when using the FCF to equity method. That’s done when you discount FCF to the firm. You need to review LII before you do this project Now, here’s how I would value the firm. Calculate the DR based on the firm’s comparables using the approach detailed by SBBI. Ignore P&I and Discount the FCF to the firm at the DR to calculate EV. Remove the MV of debt and any minority interest or preferred to determine the equity vale. Also back it with a market approach valuation. Get a range of values by applying ebitda and revenue multiples.
Mostly pretty good, but… joemontana Wrote: ------------------------------------------------------- > There are a few ways of looking at this, but > here’s one take. Increasing the weight of debt in > the capital structure makes the equity > shareholder’s investment more risky, thereby > increasing the cost of capital. Increasing the > debt load will also increase the cost of debt – > the new debt will likely be richer. The increased > cost of equity and more expensive new debt will > negate the tax effect of debt financing, resulting > in an unchanged WACC and EV. Additional D will indeed cost more. I believe every other sentence in that paragraph is wrong.
- Under the same assumptions, all the DCF methods (FCFF discounted at the WACC, FCFE discounted at the cost of equity or my favourite, the APV, FCFF discounted at the cost of unlevered equity plus the present value of the interest tax shield) lead to the same result. If they do not, it is either because there is an inconsistency between the cash flows and the discount rate (e.g., FCFE discounted at the WACC), or because you use different assumptions (e.g., about the capital structure in the continuing value). 2. Back to the impact of the capital structure on the firm’s value: Step 1: M&M with no corporate taxes. The higher the debt, the higher the cost of equity. The capital structure has no impact on the cost of capital or the firm’s value. Step 2: M&M with corporate taxes. The higher the debt, the higher the cost of equity. Because this step only considers the advantage of debt, the interest tax shield, the higher the debt, the lower the cost of capital and the higher the firm’s value. Step 3: Static trade-off theory. The higher the debt, the higher the cost of equity. Because this step considers both the advantage of debt, the interest tax shield, and the disadvantage of debt, the cost of financial distress, there is an optimal capital structure which minimizes the cost of capital and maximizes the firm’s value. That’s really the theory thas is closest to the reality.
Make sure you know the difference between valuing cash flows to the firm (common way) vs cash flows to equity holders. Cash Flow to Firm EBIT(1-T)+D&A-CapEx-Changes in WC = Unlevered FCF Pick a forecast period (5-7 years) and discount these CF to t=0. Then for terminal value use multiple: (EBITDA x Mult) or perp growth (FCF * (1+g))/(k-g) and discount back to t=0. then subtract net debt at t=0. Regarding what WACC to use - Risk Free Rate - 10/20 year treasury Beta - Bloomberg/Barra/Whatever you use MRP - Ibottsons or whatever Firm guidance you ahve Cost of Debt - usually you employ a range based on yields on similar credits D/E - usually you employ a range around the targeted cap structure Thats it. For FCF to equity you would be discounting levered cash flows (after interest expense) at the cost of equity. Rarely used, except sometimes for utilities. hope that helps
DarienHacker Wrote: ------------------------------------------------------- > Mostly pretty good, but… > > joemontana Wrote: > -------------------------------------------------- > ----- > > There are a few ways of looking at this, but > > here’s one take. Increasing the weight of debt > in > > the capital structure makes the equity > > shareholder’s investment more risky, thereby > > increasing the cost of capital. Increasing the > > debt load will also increase the cost of debt – > > the new debt will likely be richer. The > increased > > cost of equity and more expensive new debt will > > negate the tax effect of debt financing, > resulting > > in an unchanged WACC and EV. > > Additional D will indeed cost more. I believe > every other sentence in that paragraph is wrong. Nah dude, that’s straight out of the Schweser LII text. T was one of a few theories thrown out by those authors (M&M was all I wrote in my notes). It’s not that I’m wrong. You just didn’t read that chapter As the weight of debt increases, the cost of equity increases. The increased cost of equity (and richer new debt) offsets the lower cost of debt. There was a graph as well. The graph in the text plotted return in the y axis and weight of debt – from 0% to 100% - in the x axis. As wd moves from 0 to 100%, the rE slopes upward. The WACC is perfectly flat – unchanging from 0% to 100%.
The fact that the cost of equity increases with the level of debt makes sense. But the fact that the WACC is flat is a special case, when the cost of financial distress exactly offsets the present value of the interest tax shield, no matter what the level of debt is. Works well in a textbook, not so well in reality. In reality, as the level of debt increases, the present value of the interest tax shield will increase and the cost of financial distress will increase too, but not by the exact same amount. Hence an optimal capital structure that minimizes the cost of capital and maximizes the firm’s value.
True. The text also discussed the (I think its called) the static tradeoff theory, wherein the firm WACC decreases and EV increases as wD increases up to a certain point. Eventually, increasing wD causes the opposite effect. It works intuitively. All else equal, would you demand a higher return from a firm with 40% debt or 98% debt?
Yep, the static trade-off theory is probably what works best in reality. Though the theory does not tell you exactly where the optimal point is. To determine it, the best thing is to use Monte Carlo simulations.