Special Cases in Valuation

Valuation of Banks
 Problems

Conceptually difficult from outside

1. Quality of portfolio

2. Impact of interest rate mismatch

3. Which business units are driving profits

Problem for the insider transfer pricing

 Business Unit Structure of a
Bank

Head Quarters
Cost Structure

Treasury and Trading

Assets : Loans to wholesale bank, trading assets
Liabilities : Borrowings from retail bank, trading liabilities
Equity

Wholesale Bank Retail Bank

Assets: reserves, external loans Assets: Reserves and lending to Treasury
Liabilities: deposits, borrowing from treasury Liabilities: Deposits
Equity Equity

Trf pricing
problem
 FCF to Equity Holders Part 1

Interest Income
1. + Fee Income; + Non interest revenue; + FX
incomes
2. - Interest expenses; - provision for credit losses; -
Non interest expenses; - Taxes

= Net Income
1. + extraordinary items + depreciation

= Cash from Operations
 Balance Sheet

Sources
Uses

Gross Loans Due
New Loans
1. -Provisions and 1. +inc in sec. Held; + inc
unearned income = in accounts
Net Loans Paid receivables; + inc in
2. +inc. in deposits; +inc net tangible assets; +
in external debt; + inc inc in other assets; -
in other liabilities; =inc decrease in deposits; -
in accounts payables decrease in external

All sources debt

Uses

FCFE = Cash from Operations + Sources - Uses

 Financial Statement of ABC

Balance Sheet
Income Statement

Assets
Interest income @ 12%
1. Cash reserves 120 (933) 111.96
2. Loans 933
Interest expenses @ 5%
3. Total 1,053 (1,000) -50.00

Liabilities
Other exp -48.00
1. Deposits 1,000
NPBT 13.96
2. Equity 53
Taxes @ 40% -5.58
3. Total 1,053
Net Income 8.38
 Spread Model of Income
Money rate (8%)
Definitions Calculations

Spread on Loans x loan (12-8) x (933) = 37.12

balance
+ Spread on deposits x (8-5) x (1,000) = + 30.00
deposits balance
Equity Credit x equity (8) X 53 = + 4.24

- Reserve debit x reserves (8) X (120) = -9.60

- Expenses -48.00

Net profit Before Tax 13.96

Taxes 40% hence net Income 8.38

 Mismatch Illustration

A bank lends Rs.1 million of 3 year fixed rate
money and borrows 900,000 of 1 year CDs which
are rolled over each year for 3 years
Maturity Yield 1 year Fwd Rate
1 year 8.0% 8.0%
2 year 9.0 10.0%
3 years 9.5 10.5
 Financial Statement Wholesale
Bank
Assets:
Income Statement
Loans: 1000.00 1. Yr1 Yr2 Yr3
Intt Inc 95.00 95.00 95.00
Liabilities
Borrowing from Treasury Intt Exp 90.25 90.25 90.25
950.00
Equity 50.00 Profit 4.75 4.75 4.75
Total 1000.00 The wholesale bank is match
funded with 3 year money
that costs 9.5% and earns
9.5% no spread
 Retail Bank

Assets Yr1 Yr2 Yr3

Loan to Treasury 950.00
Int Inc 76.00 95.00 99.75

Intt Ex 72.00 90.00 94.50

Liabilities
Profit 4.00 5.00 5.25

CDs 900.00

Equity 50.00
The retail Bank is

Total 950.00 forecasted to earn the one
year spot rate (8:10:10.5)
with no spread
 Treasury

Assets Yr1 Yr2 Yr3

Loan to Wholesale Bank
Int Inc 90.25 90.25 90.25
950.00
Intt Ex 76.00 95.00 99.75

Profit 14.00 - 4.75 -9.50

Liabilities

Loan from Retail Bank
Since Wholesale and
950.00 Retail Bank are match
funded the mismatch
appears in Treasury
 Total Bank

Assets Yr1 Yr2 Yr3

Loans 1,000.00
Int Inc 95.00 95.00 95.00

Intt Ex 72.00 90.00 94.50

Liabilities
Profit 23.00 5.00 0.50

CDs 900.00

The mismatch profits of

Equity 100.00 Treasury are reflected in

Total 1,000.00 the Bank as a whole

If the first year profit is

used for building a model
the forecasts will be wrong
Understanding Mismatch Gains
and losses

Key to Managing the Problem
1. Good Forecasts so that
1. Spreads change with changing interest rate
environments
2. Account for inflow of funds from loans being
paid and new loans made
3. Account for substitution of interest bearing and
non interest bearing deposits as environments
change
 Understanding Money Rate

Normal Choice of Transfer Price – Market Price

Usual choice is to use a money rate which

eliminates fluctuations in net interest income

Preferred choice a rate which stabilises

Shareholder Value
 Example

Retail bank has deposits that pay no interest and
needs to be repaid in 5 years

Reserves at RBI will be recovered at the same
time

Market rate is 10% and loans to treasury earn 10%
1. => MV = BV

Reserves and Deposits are zero coupon notes so
their market value is less than book value
 How choice of Money Rate
Affects stability of Net Income
vs. Equity Value

Reserves and Deposits
Market Value Balance
Paid off in 5 years Sheet

Current Interest rate 10%
Reserves 149.02

Loans to Treas 1,888.00

Book Value Balance Sheet

Total 2,037.02

Reserves 240.00

Loans to treas 1,888.00

Deposits 1,241.84

Total 2,128.00

Equity 795.14

Deposits 2,000.00
Total 2,037.02

Equity 128.00

Total 2,128.00
 Match Fund Deposits with 5
year Loan
Interest Rises to 15%

Market Value Balance
Year Net Income
Sheet
1 188.80

Reserves 119.32
2 188.80

Loans to treasury 1,571.54
3 188.80

Total 1,690.86
4 188.80

5 188.80

Deposits 944.36 Result

Equity 696.50 Net Income Constant Equity

Total 1,690.86 Value has declined
 Match Fund Deposits with 3
year Loan
Interest Rises to 15%

Market Value Balance
Year Net Income
Sheet
1 188.80

Reserves 119.32
2 188.80

Loans to treasury 1,672.46
3 188.80

Total 1,791.78
4 283.20

5 283.20

Deposits 994.36 Result

Equity 797.42 Net Income Varies

Total 1,690.86 Value of equity constant
Valuation

Special Case
 Cyclical Firms

Volatile; dependent on economy;

Base Year Earnings
1. Adjust base year for cyclical effects
2. Adjust expected growth rate to reflect economic
cycle
3. Used normalised earnings for base year

Volatility
1. Handle volatility through the discount rate
 Firms in Financial Distress

Characteristics
1. Negative cash flows
2. inability to meet debt payments
3. no dividends
4. high debt equity ratios

Is the firm terminal
1. Hope
2. No Hope
 Firm’s in Distress

Hope
1. Use normalised earnings from happier terms
2. Make detailed cash flow estimates for transition
period - from illness to health

No Hope
1. Liquidation Value = Liquidation value of Assets -
Value of Debt
2. Option Pricing Model . In Firms with high leverage
where the value of the firm is lower than the debt
equity can be considered as out of money call
option on the underlying firm and can be so valued.
 Firms with Product Options

Value = Value of assets in place + future
possibilities

Three approaches
1. Value the product option in the open market and
add it to the DCF valuation.
2. Use a higher growth rate capturing the impact of the
product option
3. Use option pricing models

Beware double counting
 Private Firms

Estimating Discount Rate
1. comparable firms

2. accounting betas
1. estimate the beta by regressing earnings with
the market index of earnings

3. use financial fundamentals

 Private Firms - Cash Flows

Cash Flows
1. Difficulty in estimating management compensation
and return on capital
2. Substantially less information
3. Past history unreliable

Estimating Cash Flows
1. Management Expenses
2. Tax Rates
3. Increase in expenses, legal, record keeping etc
 Valuation of Public Enterprises

Monopolies
1. Prelude to introduction of competition in the field

Special Status helps access markets

Manpower
1. Productivity
2. Size and Efficiency
3. Middle Management Strong/ Top Management
Weak

Technical Manpower Quality High

Benefits and Hidden liabilities

Real Estate

Access to Markets