1

VALUATION: THE VALUE OF CONTROL

Control is not always worth 20%.

Set Up and Objective

1: What is corporate finance
2: The Objective: Utopia and Let Down
3: The Objective: Reality and Reaction
The Investment Decision
Invest in assets that earn a return
greater than the minimum acceptable
hurdle rate
Hurdle Rate

4. Define & Measure Risk

5. The Risk free Rate
6. Equity Risk Premiums
7. Country Risk Premiums
8. Regression Betas
9. Beta Fundamentals
10. Bottom-up Betas
11. The "Right" Beta
12. Debt: Measure & Cost
13. Financing Weights

The Financing Decision

Find the right kind of debt for your
firm and the right mix of debt and
equity to fund your operations

Financing Mix
17. The Trade off
18. Cost of Capital Approach
19. Cost of Capital: Follow up
20. Cost of Capital: Wrap up
21. Alternative Approaches
22. Moving to the optimal
Financing Type
23. The Right Financing

Investment Return
14. Earnings and Cash flows
15. Time Weighting Cash flows
16. Loose Ends

36. Closing Thoughts

The Dividend Decision

If you cannot find investments that make
your minimum acceptable rate, return the
cash to owners of your business

Dividend Policy
24. Trends & Measures
25. The trade off
26. Assessment
27. Action & Follow up
28. The End Game

Valuation
29. First steps
30. Cash flows
31. Growth
32. Terminal Value
33. To value per share
34. The value of control
35. Relative Valuation

Disney: Inputs to ValuaCon

3

High Growth Phase

Transition Phase

5 years

5 years

Length of Period
Tax Rate

Stable Growth Phase

Forever after 10 years

31.02% (Effective)

31.02% (Effective)

31.02% (Effective)

36.1% (Marginal)

36.1% (Marginal)

36.1% (Marginal)

Return on Capital

12.61%

Declines linearly to 10%

Stable ROC of 10%

Reinvestment Rate

53.93% (based on normalized Declines gradually to 25% 25% of after-tax operating

acquisition costs)

as ROC and growth rates income.

drop:

Reinvestment rate = g/ ROC

= 2.5/10=25%

Expected

Growth ROC * Reinvestment Rate = Linear decline to Stable 2.5%

Rate in EBIT

0.1261*.5393 = .068 or 6.8%

Growth Rate of 2.5%

Debt/Capital Ratio

11.5%

Rises linearly to 20.0%

20%

Risk Parameters

Beta = 1.0013, ke = 8.52%%

Beta changes to 1.00;

Beta = 1.00; ke = 8.51%

Pre-tax Cost of Debt = 3.75%

Cost of debt stays at 3.75% Cost of debt stays at 3.75%

Cost of capital = 7.81%

Cost of capital declines Cost of capital = 7.29%

gradually to 7.29%

Current Cashflow to Firm

EBIT(1-t)= 10,032(1-.31)= 6,920
- (Cap Ex - Deprecn)
3,629
- Chg Working capital
103
= FCFF
3,188
Reinvestment Rate = 3,732/6920
=53.93%
Return on capital = 12.61%

Disney - November 2013

Reinvestment Rate
53.93%

Return on Capital
12.61%
Expected Growth
.5393*.1261=.068 or 6.8%

Growth declines
gradually to 2.75%

First 5 years
Op. Assets 125,484
+ Cash:
3,931
+ Non op inv 2,849
- Debt
15,961
- Minority Int 2,721
=Equity
113,582
-Options
869
Value/Share $ 62.26

Terminal Value10= 9,086/(.0729-.025) = 189,738

1
2
3
4
5
6
7
8
9
10
EBIT/*/(1/2/tax/rate) $7,391 $7,893 $8,430 $9,003 $9,615 $10,187 $10,704 $11,156 $11,531 $11,819
/2/Reinvestment
$3,985 $4,256 $4,546 $4,855 $5,185 $4,904 $4,534 $4,080 $3,550 $2,955
FCFF
$3,405 $3,637 $3,884 $4,148 $4,430 $5,283 $6,170 $7,076 $7,981 $8,864

Cost of Capital (WACC) = 8.52% (0.885) + 2.40% (0.115) = 7.81%

Cost of Debt
(2.75%+1.00%)(1-.361)
= 2.40%
Based on actual A rating

Cost of Equity
8.52%

Riskfree Rate:
Riskfree rate = 2.75%

Stable Growth
g = 2.5%; Beta = 1.00;
Debt %= 20%; k(debt)=3.75
Cost of capital =7.29%
Tax rate=36.1%; ROC= 10%;
Reinvestment Rate=2.5/10=25%

Beta
1.0013

Unlevered Beta for

Sectors: 0.9239

Weights
E = 88.5% D = 11.5%

ERP for operations

X 5.76%

D/E=13.10%

Cost of capital declines

gradually to 7.29%

In November 2013,
Disney was trading at
$67.71/share

Term Yr
12,114
3,029
9,086

Strategic investments determine length of growth

period

Investment decision affects risk of assets being finance and financing decision affects hurdle rate

The Investment Decision

Invest in projects that earn a
return greater than a minimum
acceptable hurdle rate
Existing
Investments
ROC = 12.61%
Current EBIT (1-t)
$ 6,920

The Dividend Decision

If you cannot find investments that earn
more than the hurdle rate, return the
cash to the owners of the businesss.

New Investments
Return on Capital
12.61%

Reinvestment Rate
53.93%

Expected Growth Rate = 12.61% *

53.93%= 6.8%

The Financing Decision

Choose a financing mix that
minimizes the hurdle rate and match
your financing to your assets.

Financing Mix
D=11.5%; E=88.5%

Financing Choices
Mostly US $ debt
with duration of 6
years

Cost of capital = 8.52% (.885) + 2.4% (.115) = 7.81%

Year Expected+Growth EBIT+(15t) Reinvestment FCFF Terminal+Value Cost+of+capital

1
6.80%
$7,391
$3,985
$3,405
7.81%
2
6.80%
$7,893
$4,256
$3,637
7.81%
3
6.80%
$8,430
$4,546
$3,884
7.81%
4
6.80%
$9,003
$4,855
$4,148
7.81%
5
6.80%
$9,615
$5,185
$4,430
7.81%
6
5.94%
$10,187
$4,904
$5,283
7.71%
7
5.08%
$10,704
$4,534
$6,170
7.60%
8
4.22%
$11,156
$4,080
$7,076
7.50%
9
3.36%
$11,531
$3,550
$7,981
7.39%
10
2.50%
$11,819
$2,955
$8,864
$189,738
7.29%
Value of operating assets of the firm =
Value of Cash & Non-operating assets =
Value of Firm =
Market Value of outstanding debt =
Minority Interests
Market Value of Equity =
Value of Equity in Options =
Value of Equity in Common Stock =
Market Value of Equity/share =

PV
$3,158
$3,129
$3,099
$3,070
$3,041
$3,367
$3,654
$3,899
$4,094
$94,966
$125,477
$6,780
$132,257
$15,961
$2,721
$113,575
$972
$112,603
$62.56

Disney: Corporate Financing Decisions and Firm Value

Ways of changing value

6

Are you investing optimally for
future growth?
How well do you manage your
existing investments/assets?

Cashflows from existing assets

Cashflows before debt payments,
but after taxes and reinvestment to
maintain exising assets

Are you building on your

competitive advantages?

Are you using the right

amount and kind of
debt for your firm?

Growth from new investments

Growth created by making new
investments; function of amount and
quality of investments

Efficiency Growth
Growth generated by
using existing assets
better

Expected Growth during high growth period

Is there scope for more

efficient utilization of
exsting assets?

Stable growth firm,

with no or very
limited excess returns

Length of the high growth period

Since value creating growth requires excess returns,
this is a function of
- Magnitude of competitive advantages
- Sustainability of competitive advantages

Cost of capital to apply to discounting cashflows

Determined by
- Operating risk of the company
- Default risk of the company
- Mix of debt and equity used in financing

Current Cashflow to Firm

EBIT(1-t)= 10,032(1-.31)= 6,920
- (Cap Ex - Deprecn)
3,629
- Chg Working capital
103
= FCFF
3,188
Reinvestment Rate = 3,732/6920
=53.93%
Return on capital = 12.61%

Disney (Restructured)- November 2013

Reinvestment Rate More selective
acquisitions &
50.00%
payoff from gaming
Expected Growth
.50* .14 = .07 or 7%

1
EBIT * (1 - tax rate)
$7,404
- Reinvestment
$3,702
Free Cashflow to Firm $3,702

2
$7,923
$3,961
$3,961

4
$9,071
$4,535
$4,535

Cost of Debt
(2.75%+1.00%)(1-.361)
= 2.40%
Based on synthetic A rating

Beta
1.3175

Unlevered Beta for

Sectors: 0.9239

3
$8,477
$4,239
$4,239

5
$9,706
$4,853
$4,853

6
$10,298
$4,634
$5,664

7
$10,833
$4,333
$6,500

Cost of Capital (WACC) = 8.52% (0.60) + 2.40%(0.40) = 7.16%

Cost of Equity
10.34%

Riskfree Rate:
Riskfree rate = 2.75%

Terminal Value10= 9,206/(.0676-.025) = 216,262

Growth declines
gradually to 2.75%

First 5 years
Op. Assets 147,704
+ Cash:
3,931
+ Non op inv 2,849
- Debt
15,961
- Minority Int 2,721
=Equity
135,802
-Options
972
Value/Share $ 74.91

Stable Growth
g = 2.75%; Beta = 1.20;
Debt %= 40%; k(debt)=3.75%
Cost of capital =6.76%
Tax rate=36.1%; ROC= 10%;
Reinvestment Rate=2.5/10=25%

Return on Capital
14.00%

Weights
E = 60% D = 40%

8
$11,299
$3,955
$7,344

9
$11,683
$3,505
$8,178

Cost of capital declines

gradually to 6.76%

In November 2013,
Disney was trading at
$67.71/share
Move to optimal
debt ratio, with
higher beta.

ERP for operations

5.76%

D/E=66.67%

10
$11,975
$2,994
$8,981

Term Yr
12,275
3,069
9,206

The value of control

8

We have two values for Disney.

The status quo value per share, run by exisCng

management with its current policies in place, is $62.56.

The opCmal value, with changes to invesCng, nancing
and dividend policy yields a value per share of $74.91

The dierence between the two values can

legiCmately be called the value of control.
Value of control = $74.91 - $62.56 = $ 12.35/share

ImplicaCons
9

The value of control should be greater at poorly managed

rms than well run rms.
The market price of a company should reect the expected
value of control, which incorporates the probability that
management will change.

1.
2.

a.

b.

If corporate governance is so weak that there is no chance of

management change, the expected value of control should go to
zero and the stock price should converge on the status quo value.
In the event of a control change (an acquisiCon or an acCvist investor
waging a control bacle), the likelihood of management change will
increase and the stock should trade at close to its opCmal value.

Task
EsCmate the
status quo &
opCmal values
for your rm,
and the value of
control

10

Read
Chapter 12