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Business Analysis and Valuation

PGP, IIM I Indore Campus


Term V - 2014
Deepak Kapur
tapak7@yahoo.com

Dec-14

Deepak Kapur

Changes in Schedule VI presentation of financial


statements
Applicable to financial statements prepared post April
1st, 2011
While presentation of financial statements is not a
subject matter of this course, changes introduced have
lead to a problem for analysts in comparing earlier year
statements with current years
Sheer numerical analysis may lead to incorrect
conclusions and hence all analysts must study and
understand the changes introduced in Schedule VI
before comparing financial data across year
Read the summary document sent as soft copy
Annual Reports most exciting reading genre
Is it fiction or non-fiction?
Dec-14

Deepak Kapur

The following two slides show how the


SAME data looks different under the old
and new format of classification
While balance sheet looks very different
there is no difference in reported net
profit

Dec-14

Deepak Kapur

OLD FORMAT

Dec-14

NEW FORMAT

Deepak Kapur

OLD FORMAT

Dec-14

NEW FORMAT

Deepak Kapur

What is Intrinsic Value


.. intrinsic value, an all-important concept that offers the only
logical approach to evaluating the relative attractiveness of
investments and businesses. Intrinsic value can be defined simply:
It is the discounted value of the cash that can be taken out of a
business during its remaining life. The calculation of intrinsic
value, though, is not so simple. As our definition suggests,
intrinsic value is an estimate rather than a precise figure, and it is
additionally an estimate that must be changed if interest rates
move or forecasts of future cash flows are revised. Two people
looking at the same set of facts, moreover - and this would apply
even to Charlie and me - will almost inevitably come up with at
least slightly different intrinsic value figures.
Warren Buffet
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Deepak Kapur

BAV is going to try to . link

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Deepak Kapur

Valuation - Reality
1. We can only estimate a likely range of fair value, never a
precise estimate an endless search for intrinsic value
2. A professional valuation report usually has inherent biases
depending on who is valuing and for whom
3. Uncertainty is a given in business valuation
4. High end quantitative techniques are not necessarily better
valuation models in fact simpler models give better
estimates
5. Herd mentality tends to reinforce biases and perceptions
which may be distant from reality
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Deepak Kapur

Living With Assumptions

BUT

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Deepak Kapur

Price is not Value : Price is NOT Value

Price is what you pay and Value if what you get


The stock market is filled with individuals who know the
price of everything, but the value of nothing."
Common Stocks And Uncommon Profits

DO NOT MIX BETWEEN VALUE AND


PRICE
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10

We dont want to know what the other guy will pay


Our aim is to put a fair value to the business we are valuing
and not second guess what someone else will pay

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PV Basics
1. PV of series of cashflows at time t 0

CFn
CF1
CF2

.
.
.

(1 r )1 (1 r ) 2
(1 r ) n

2. PV of a constantperpetuity at time t

CFt 1
r

(also called capitalising)

Note: its cash flow at END of


first year which should be
CFt 1
used
numerator. This
3. PV of a growing perpetuity at time t
........................................
....in.(I)
rg
formula can also be written
as [CF0*(1+g)]/(r-g) where
1 CF0 is the cash flow of just

(1 r) n completed year and which is


expected to grow by g
4. PV of a constant year end annuity; PV(A, n, r) A
r

percent each year

(1 g) n
1
n
(1

r)
5. PV of a growing year end annuity; PV(A, n, r, g) A(1 g)

r-g

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Deepak Kapur

....(II)

12

Testing PV Basics
A business currently earns $10mn and this is expected to grow at
5% per year for the next five years and thereafter remain constant
at $15mn per year for another 5 years. From the 11th year onwards
earnings are expected to grow at 5% till perpetuity. Find the value
of the business by discounting earnings at 10%
(1 (1.05 / 1.1) 5 )
1
(1 (1 / 1.1) 5 )
10 * (1.05 )

* 15

n
0.1 0.05
0
.
1
(1.1 )

1
(1.1

15 * (1.05 )
(0.1 0.05 )

10

What is the value of n? 5 or 6 (Ans: _5)


What is the value of m? 11 or 10 (Ans: 10_)
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Try these question use discount rate of 20%


A business earned Rs. 5 mn as free cash flow in the just
concluded financial year. What is the PV of a business if
cash flows are expected to be 10 mn each year from next
year onwards till perpetuity
For the above question, what would be the value of the
business if the business had earned 10 mn in the just
concluded financial year instead of 5 mn.
A business is expected to generate 10 mn in free cash
flow next year, 20 mn the year after that and thereafter
the free cash flows will grow at 10% perpetually. What
is the present value of the business?
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The Importance of Understanding a Business to do


justice to valuation
If I were teaching a course on investing, there would simply be one
valuation study after another with the students trying to identify the
key variables in that particular business and ... evaluating how
predictable they were. because that's the first step..
W.E.B

AIM: To understand the risks and drivers in a business


and their effect on cash flow. This is the key to good
forecasting.
It is not possible to do justice to valuation without
understanding the basic characteristics of the business
Remember, firms are just an aggregate of securities and
projects
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Understanding Capital, Return on Capital


and various uses of the word value

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Book Value of Capital


Capital refers to amount invested to run a business.
It could be capital raised from owners (or equity
holders) or from lenders
Capital of Owners as shown in books of accounts also
referred to as: Networth / Shareholders Equity / Equity /
Book Value of Equity
Capital from lenders and owners combined as shown in
books of accounts referred to as: Invested Capital /
Total Capital / Book Value of Debt+Equity / Book Value
of Enterprise
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Capital
Networth (NW)*
If Calculated From Equity and Liability Side = Share Capital + Reserves
& Surplus
If Calculated from Asset Side = All assets Non-Current and Current
Liabilities
Capital Employed or Invested Capital**
If Calculated From Equity and Liability Side = Networth + Debt (Long
and Short Term) + Short term portion of Long term debt (we have to look
at details of other current liabilities to get this figure)

* Many analysts include deferred tax liability (DTL) as part of NW. This is true is cases
where DTL is expected to exist for a very long time. Otherwise DTL should be part of
Long Term Debt. But ensure it is treated as either debt or equity and not left out.
** When investors look to calculate return on total capital, the total capital they take is
equity plus interest bearing debt (including short term portion of long term debt).
Liabilities which arise in the course of business (long or short term) are not part of
invested capital. Hence Current Liabilities (CL) and other long term liabilities are not
included as part of it other than short term portion of long term debt.
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For Given Data


Calculate
1. Net worth
2. Invested Capital /
Total Capital
3. Assume: Short
Term Portion of
Long Term Debt is
zero unless
otherwise specified

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Solution (workings are in Millions)


Networth = 111 + 1126 = 1237
Invested Capital = 1237 + 289 + 854 + 0 = 2405
(in this course we will neglect DTL for the purpose of
calculating Total Capital)

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Market value of Capital


EQUITY:
As against Book Value of Equity which shows the amount of
equity (a.k.a. Networth )as recorded in the books of accounts,
market value of equity refers to how much the market is valuing
the equity if the company is listed.
Market value of equity = no. of shares * price per share
This is also known as market capitalization.
DEBT
Technically there is a difference between the market value of debt
and book value of debt - but in most cases the two values will be
similar and hence we use book value as proxy for market value
Market value of debt will be the value at which debt is traded if
the bonds of the company are listed.
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Intrinsic value of Capital


EQUITY:
Intrinsic Value of Equity this is the estimate of the true worth of
equity of a business. This is what an analyst seeks to evaluate so
that he can compare the same with market value and decide on
buying or selling. Discounting free cash flows to equity at cost of
equity is the most fundamental method to get the intrinsic value of
equity
DEBT
Intrinsic value of Debt : This can be calculated as the present
value of all future interest and principal payments discounted as
the cost of debt of the firm.
Again: for well run firms where there is no distress in debt; the
intrinsic value of debt will be close to the book value of debt and
hence the latter is used for practical reasons.
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Which Value does value of business refer to?


Always be careful of what is being valued
Value of company can mean either that of standalone or consolidated
company: & could refer to equity value or enterprise value [debt + equity]. It
could be the equity value or EV with or without non operating assets. The
person using this term value could be using could be referring to:

Intrinsic Value

Market Value

Book Value

Market Price

The terms market price and market value are interchangeably used we use the
term market value more when we talk of the value of the aggregate company and
use the term market price more when we talk of the price per share
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So
If someone asks you what is the value of company A, you
ask him/her which of the following value they are
referring to:

Book Value of Equity


Book Value of Enterprise
Market Value of Equity
Market Value of Enterprise
Intrinsic Value of Equity
Intrinsic Value of Enterprise

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Comparisons which matter in Valuation


Can we compare profit margins across industries (NP margin /
Gross Profit Margin)?
Can we compare Return on Investment (RoE or RoIC) across
industries?

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Comparisons which matter in Valuation


Can we compare profit margins across industries (NP margin /
Gross Profit Margin)? No, comparison of profit margins is
useful for comparing companies within an industry and not across
Can we compare Return on Investment (RoE or RoIC) across
industries? yes. Since ultimately investors and entrepreneurs
chase return on investments, it makes sense to compare them
across industries. However investments need not necessarily go
into the industires with highest RoE. Both RoE as well as the
quantum of capital that can be deployed have to be studied.

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Analysis of Capital in the Financial Statements

While analyzing Capital as shown in financial


statements we are interested in the following

Where has the capital come from owners or lenders?


Where is the capital invested?

The answer to first question lies on the liability side of


the balance sheet
The answer to the second question lies on the asset side
This asset side analysis in important in valuation
because this is what tells use whether the funds are
deployed in assets which are operating/core in nature
or non-operating/non-core in nature
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Return on Invested Capital (a.k.a Return on Total


Capital or simple Return on Capital
Choose the correct answer:
RoIC = EBIT / (Debt + Equity)
RoIC = EBIDTA / (Debt + Equity)
RoIC = EBIT(1-t) / (Debt + Equity)
RoIC = EBIDTA (1-t) / (Debt + Equity)

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Return on Invested Capital (a.k.a Return on Total


Capital or simple Return on Capital

Choose the correct answer:


RoIC = EBIT / (Debt + Equity)
RoIC = EBIDTA / (Debt + Equity)
RoIC = EBIT(1-t) / (Debt + Equity)
RoIC = EBIDTA (1-t) / (Debt + Equity)
Each of the above definitions used based on the purpose. However for standalone
calculation of Return on Capital, it is the third definition which is most often used.
The others are used more for comparative purposes. E.g. if two companies in the
same industry have different depreciation policies and operate in different tax
environments, it makes sense to use the second definition to compare their returns.
Always remember that the numerator and denominator have to be consistent
they should belong to the same group of stake holders
The earnings of the numerator should have been produced by the capital taken in
denominator
Return on Operating and Non Operating Earnings should be measured separately
This will also imply that cost of total capital should be compared to RoIC and cost of
equity to RoE and the two should not be mixed and matched

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Return on Equity
Choose the correct answer:
RoEt = PATt / Net Wortht
RoEt = PATt / Net Wortht-1
RoEt = PATt / Average Net Worth(t,t-1)

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Return on Equity
Choose the correct answer:

RoEt = PATt / Net Wortht


RoEt = PATt / Net Wortht-1
RoEt = PATt / Average Net Worth(t,t-1)
It Depends on the purpose but in absence of other information
it is the last definition which is most used. However there may
be instances where the second definition is most ideal e.g. a
company has done an IPO towards the year end and hence its
reserves and surplus as well as equity capital has shot up
because of this fund raising. In this instance, if we use average
net worth we would be underestimating the true RoE since this
new capital has not yet been put to use and hence the PAT does
not reflect returns from this capital.

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Financial Analysis for Valuation


On the B/S
We study the asset side to separate the core and non-core
assets
We then analyze to see how the core and non-core assets are
financed

On the P/L
We want to make adjustments for:
Non recurring items
Separate out the core and non-core income, expenses and
taxes.
Also to reflect average normal income from the assets of the
company, we may adjust for capacity utilisation, business
cycle etc.
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What what RoE and RoIC in


2012?
What is networth in 2011 and
2012?

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Infosys RoE
From Database

Actual
Even though the above nos of RoE from a database seem to indicate that infosys RoE is
about 27% that is actually its blended RoE of operating and non operating income. In the
balance sheet of Infosys in year 2011 there was almost 16666 crore cash and
equivalents. Out of this total of cash and cash equivalents lets consider about 1666
crores as cash required for operation. So the balance 15,000 crore was excess cash.
Total Networth in 2011 was 25976 crores. So operating networth will be only about
10976 crores after subtracting excess cash. Also PAT of infosys for year 2012 was 8332
crores. Other income was 1904 crores (mostly interest income from excess cash) and
hence post tax other income would be just 1904*(1-0.3) or 1332 crores. Hence operating
PAT is (8332-1332) = 7000 crores. Hence true operating RoE on opening equity capital
is 7000/10976 or almost 63% !! Infosys has no debt so RoIc = RoE
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Infosys RoE

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Infosys Restructured BS and P&L

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36

Normalizing the income statement Some of the


Reasons
Business cycle effects Sukhjit Starch, Jindal Poly etc.
To know how much to adjust study historic gross margins or average RoE
To know how long an abnormal period can last study industry demand and
competitive position; industry dynamics in terms of time required to set up new
capacities

Expense treatment to be corrected Apollo Hospitals


One time income / expense
Should be eliminated

Financing Effects Infrastructure Companies / Real Estate companies today


Capacity Utilization Effects
New capacities on stream so depreciation/ other expenses on books but capacities
not fully utilized and scale effects not fully reflected in current statements

Other income will not sustain at current levels Reliance Power


Companies which raise fresh cash will have other income till the cash is deployed

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Hawkins Cooker Normalization Example


In 2011 2012 : worker unreast at one of its cooker factories and
pollution control issues at another: result was a fall in production.
Supply not enough to meet demand.
Hence FY 2012 PAT does not reflect normal level of PAT and is
underestimating normal PAT.
A quick way to adjust this would be apply average net margins of
last few years to the value of lost sales estimated and add this
figure to reported PAT.
Reported PAT: 30 crores
Sales lost: about 15% of previous year sales ( prev yr sales = 350
cr) = 52 cr.
Average Net Margins: 10%
Adjusted PAT = 30 + 0.1*52 = 35.2 cr.
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Normalizing Earnings One time item example


The reported PAT of a company is 500 mn. An analyst is trying to normalize
this PAT. The tax rate on ordinary profits is 50%. He notices that the P&L
statement had a one time income of 100 mn on which the tax rate was only 20%
and he has to adjust the reported PAT for this line item in order to calculate
normalized PAT. Apart from this all others items on the income statement were
normal in nature and need no further adjustment. What is the normalized
PAT of the company?

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Solution
The reported PAT of a company is 500 mn. An analyst is trying to normalize
this PAT. The tax rate on ordinary profits is 50%. He notices that the P&L
statement had a one time income of 100 mn on which the tax rate was only 20%
and he has to adjust the reported PAT for this line item in order to calculate
normalized PAT. Apart from this all others items on the income statement were
normal in nature and need no further adjustment. What is the normalized
PAT of the company?
Solution:
One time item to be excluded: 100 mn
Tax on this item: 100*0.2 = 20 mn

Hence contribution of this one time item in reported PAT = 80 mn


Normalised PAT = 500 80 = 420 mn

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Normalized Earnings Expense side adjustment


Example
In 2006 Apollo Hospitals Ltd reported a PAT of 50 crores. As part of operating
expenses it showed an expenses of 15 crores on accreditation. In notes to
accounts it mentioned that such accreditation was valid for 3 years and the
company will look to renew it after 3 years. This is a tax deductible expense.
The marginal tax rate of AHL is 30%. What should be normalised PAT for
2006?

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Solution
In 2006 Apollo Hospitals Ltd reported a PAT of 50 crores. As part of operating
expenses it showed an expenses of 15 crores on accreditation. In notes to
accounts it mentioned that such accreditation was valid for 3 years and the
company will look to renew it after 3 years. This is a tax deductible expense.
The marginal tax rate of AHL is 30%. What should be normalised PAT for
2006?
Solution:
The 15 crores should be spread over 3 years and hence only 5 crores should
have been expense for this year.
Hence normalised PAT = 50 + 15*(1-0.3) 5*(1-0.3) = 57 crores or 14% higher
than reported

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Conventions to follow for studying the valuation


models
For estimating Return on Equity (RoE) or Return on
Invested Capital (RoIC) always use the opening (or
previous years closing) Networth or Invested capital in the
denominator for the purpose of studying valuation models
in this course.
RoE 2012 = PAT 2012 / NW 2011
RoIC 2012 = EBIT(1-t) 2012 / IC 2011
Remember IC = Networth + Long Term Loans (including
Short Term Portion of Long Term Loans) + Short Term
Loans
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Fundamental Growth Rates

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Fundamental Growth Rate Limits to Growth


Growth will depend on

Future opportunities
Amount retained out of earnings
Additional investments
The return generated on these investments
Part growth may be due to inflationary effects zero value growth
Part growth may be due better utilization of existing assets - not sustainable

any analyst should ensure that when forecasting financial statements


he cannot forecast all three variable - growth rate, return on capital
and retained earnings independently. When any two are forecasted
the third is fixed as can be seen from formulae linking the 3 variables.
This kind of check should also be done after valuation is done.
We could measure the growth rate in net earnings, EPS or operating
profits.
Remember - Growth can create value only if RoC is greater than CoC
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Earning Per Share growth Case of constant ROE


Expected Long Term Growth in EPS If RoE remains constant
change in earnings = Reinvestment Rate * RoE
Divide both sides by current earnings
gEPS = b*RoE

b = Reinvestment rate = Retention ratio = retained earnings / total earnings


RoE = PAT / BV of Equity

We can see from above formula that Growth rate cannot exceed
RoE since maximum retention ratio is one (assuming no external
capital brought in). Hence if a company wishes to grow at a rate
faster than its sustainable RoE it needs to keep raising and
investing capital in excess of its PAT i.e. raise new funds
Limitations of EPS growth formula
Focuses on per share number
Assumes reinvestments will generate returns at RoE
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EPS growth changing RoE


If RoE expected to change and future RoE is RoEt+1 then:
Change in earnings (i.e EPS of next yr EPS of this year) = new
invst*RoEt+1 + existing invst*change in RoE
i.e. the additional EPS can come from two sources: 1.) the new
retained capital earning the RoEt+1 2) the old capital earning a
some additional (delta) RoE than it was earning before.
Divide both sides by current EPS
gEPS= b *RoEt+1 +[(RoEt+1 RoEt)/ RoEt]
The formula shows how small improvements in RoE can translate
into big growth
A company cannot sustain growth simply by improvements in RoE
So the higher the RoE today or more the competition lesser the likelihood of
improvement in RoE

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Growth in Net Income When RoE is Stable


Growth in Net Income
Use real investments instead of retention ratio
Real investment for total firm = (change in net Long Term Assets + change in
WC) : Part of this is funded by equity holders and balance by debt
So, Reinvestment Rate for Net Income = [(net change in PPE + change in WC)
funded by equity holders / PAT]
In case of linear growth model where D/E remains stable : for every 100
invested in company 100*(1 - D/(D+E)) will be the amount equity holders have
to finance and the balance will be finance by debt holders.
If D/E ratio is 2:1 then if total reinvestment is 600 equity holders share will be
600* ( 1-2/3) = 200
Hence,
Equity Reinvestment Rate = [(Net Capex + Change in WC) (1 D/IC)] / Net
Income, where IC = D+E
gnet income = Equity reinvestment rate * RoE

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Growth in Net Income When RoE is Changing

Change in PAT = new investment*RoEt+1 + existing


investment*change in RoE ( A )
Remember investment means equity investment or networth
since we are interested in growth of PAT
Divide both sides of (A ) by current PAT
Gnet income= equity reinvestment rate *RoEt+1 +[(RoEt+1 RoEt)/
RoEt]

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Growth in Operating Income


Stable RoC :
gNOPLAT = reinvestment rate*RoC
Reinvestment rate = [net change in LTA + change in WC]/NOPLAT
RoIC = NOPLAT / [Invested Capital]

Changing RoC :
gNOPLAT = reinvestment rate*RoNIC + [(RoNIC RoIC) / RoIC]
When the return on capital is changing, there will be a second component to
growth, positive if the return on capital is increasing and negative if the return
on capital is decreasing.
If the change is over multiple periods the second component should be spread
over each period
RONIC this is the new overall RoIC after new capital is invested

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Example
Data : Current year is 2012

PAT 2012 = 100


RoE 2012 = 0.2
Change in Networth between 2011 and 2012 = 50
Company will maintain its reinvestment rate in future

Question 1: What is growth rate of PAT in 2013 if RoE


can be maintained in future
Question 2: What is growth rate of PAT in 2013 and
2014 if RoE next year and beyond can be maintained at
30%
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Question 1
Question 1: What is growth rate of PAT in 2013 if RoE
can be maintained in future
Solution: Method 1 using formula
RoE 2012 = PAT 2012 / NW 2011 = 0.2; hence NW 2011 = 500
Since additional NW in 2012 is 50 the reinvestment rate is
50/100 = 50% or 0.5
Since this is a case of stable future RoE
expected growth rate in earnings = 0.5 * 0.2 = 10

Solution: Method 2 from basics


NW 2012 = 500+50 = 550
Since RoE is 20%, PAT 2013 = 550*0.2 = 110
Hence growth in PAT = [(PAT2013 PAT 2012) / PAT 2012 ]* 100
= (110 100)/100 = 0.1 or 10%
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Question 2
Question 2: What is growth rate of PAT in 2013 and
2014 if RoE next year and beyond can be maintained at
30%
Solution method 1 using formula
Gnet income= equity reinvestment rate *RoEt+1 +[(RoEt+1 RoEt)/
RoEt]
reinvestment rate in 2012 = additional investment / PAT = 50/100
= 0.5 or 50% - data says this will also be same in future
Hence g 2013 = 0.5*0.3 + (0.3-0.2/0.2) = 0.15 + 0.5 = 0.65 or 65%
In 2014 the RoE will be same as was in 2013, hence g 2014 =
RoE*RR = 0.3*0.5 = 0.15 or 15%
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Question 2
Question 2: What is growth rate of PAT in 2013 and 2014 if RoE
next year and beyond can be maintained at 30%
Solution method 2 from basics
NW 2011 = PAT 2012 / RoE 2012 = 500
reinvestment rate in 2012 = additional investment / PAT = 50/100 = 0.5 or
50% - data says this will also be same in future
NW 2012 = NW 2011 + change in NW = 500 + 50 = 550
RoE 2013 = 30% - given: hence PAT 2013 = 0.3*550 = 165
g 2013 = (165 100)/100 = 65%
Reinvestment in 2013 = PAT 2013 * reinvestment rate = 165*0.5 = 82.5
NW 2013 = NW 2012 + 82.5 = 632.5
PAT 2104 = RoE 2014 * NW 2013 = 0.3 * 632.5 = 189.75
Hence g 2014 = (189.75-165)/165 = 0.15 or 15%
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Will Value Depend on the Type of Investor?


1. Marginal Investors
2. Private Equity Investors
3. Buyers of Whole Businesses/New Management

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Will Value Depend on the Type of Investor?


1. Marginal Investors
Diversify Their risk
No say in corporate action

2. Private Equity Investors


Lesser Diversification of Risk
Part say in corporate action

3. Buyers of Whole Businesses/New Management


Concentrated Risk
Complete Control

Notice the two opposing effects on value more


concentration of risk could mean higher discount rate and
hence lower value; more control would require to pay
higher
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Is a Valuation Exercise Likely to be fruitful


especially in the context of listed securities?

Efficient Markets?
Rational Investors?
Inefficient Markets?
Irrational Investors?

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Is a Valuation Exercise Likely to be fruitful


especially in the context of listed securities?

Efficient Markets?
Rational Investors?
Inefficient Markets?
Irrational Investors?

Markets are a mix and match of all of the above at ANY given
point in time the purpose of valuation is to figure out how
investors and markets SHOULD be pricing securities as
against what they ARE pricing them at
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Does Valuation Matter in Investment?


Over time price of securities reflects the underlying intrinsic value

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Does Valuation Matter in Investment?


The previous graph shows the 100+ years chart of the Dow Jones
Industrial average on the log scale.
The other lines on the charts are trends in Earnings per unit of
index, Dividends per unit of index and the Book Value per unit of
index
As we know earnings, dividends, book value are all indicators of
value of underlying asset
The chart clearly shows that over time as these indicators of value
increase the Price of the asset also shows an increase albeit in a
very volatile manner
The following slide shows a similar chart for the NSE Nifty index
in India over a 11 year period
Notice in both charts as price trend diverges from underlying
value trends, sooner or later there is reversion to mean
Dec-14

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Ja
n9
Ju 9
n9
No 9
v9
Ap 9
r- 0
Se 0
p0
Fe 0
b01
Ju
l-0
De 1
c0
M 1
ay
-0
O 2
ct
-0
M 2
ar
-0
Au 3
g0
Ja 3
n0
Ju 4
n0
No 4
v0
Ap 4
r- 0
Se 5
p0
Fe 5
b06
Ju
l-0
De 6
c0
M 6
ay
-0
O 7
ct
-0
M 7
ar
-0
Au 8
g0
Ja 8
n0
Ju 9
n0
No 9
v0
Ap 9
r- 1
Se 0
p1
Fe 0
b11
Ju
l-1
1

Value
800

Index Vs Earnings and Dividend Yields

700
Div Yield

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index close

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Earnings
Book Balue

600

500

400

300

200

100

61

Sources of Value
And their link to the competitive
position of the firm

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Competitive Advantages

1.
2.

Contrary to popular belief examples of sustained competitive


advantages are rare
Some sources of such an advantage are
Exclusivity by regulations / license
Sales based : customer loyalty
1.
2.

3.

Comes from habit based products


High switching or searching costs products

Cost Based
1.

Production techniques, patents, know how

4. Economies of scale
1.
2.
Dec-14

High market share


reproducibility
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Q 1) What does Competitive Advantage Mean?


Marketing Prof
Q 2) What does Competitive Advantage mean?
Finance Prof
Asking the right questions, seeking the important
information, ability to overlook trivial data - are
very crucial to estimating fair value

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Q 1) What does Competitive Advantage Mean?


Marketing Prof
: I dont know
Q 2) What does Competitive Advantage mean?
Finance Prof
- It has to help the company earn a sustainable
return of capital in excess of its cost of capital

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Terminology
RCA
LV
EPV

Reproduction cost of Assets


Liquidation Value of Assets
Earning Power Value (without growth unless
otherwise mentioned)
EPVgrowth Earning Power Value with growth
r
Cost of Capital
RoIC
Returns on Invested Capital
IC
Invested Capital
g
growth rate

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Sources of Value

Every Valuation Model Explicitly or Implicitly goes about


finding a value based upon the fact that intrinsic value can
come from:
1. Existing Value of the Assets of the company
2. The existing sustainable Earning Power of the company
3. Growing Earning Power from Profitable growth - returns above
its cost of additional capital

Underlines the importance of being able to understand and


judge the competitive position of a company and its
sustainability

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1st Source of Value: Asset Value


Since assets of a company are in place, this is the most
certain of valuations for a company and is least corrupted
by forecasts.
Estimating the correct asset value requires a judgment of the
strategic situation of the firm
RULE ONE
For a Business in an Unviable Industry:
Asset Value = Liquidation Value

For a Business in a Viable Industry


Asset Value = Reproduction Cost
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1st Source of Value: Asset Value


RULE TWO For Viable Firms
In a viable industry:
The Intrinsic Value of Firm is at least equal to reproduction cost of
assets if competitive advantages (CA) exist
The Intrinsic Value of Firm is just equal to reproduction cost of assets
if NO competitive advantages exist
WHY is the above statement true?

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Reproduction Cost Value of Assets


RCA primarily represents the cost of the most efficient way
of reproducing the assets of the existing player
Includes investments required in recreating a sales and distribution set up
Includes the time value of money if starting from scratch

Start from Asset Side and Adjust value of all assets to


represent the amount a new entrant would need to invest in
the asset
Look at the liability side and estimate the spontaneous
liabilities the business generates. This effectively reduces
the investment required by new player
Calculate net asset value this is the reproduction cost
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Liquidation Value of Assets


Represent the best value a firm could fetch in a fire-sale or
staggered liquidation
Remember it will not be a going concern based value
Assets will fetch a value depending upon what best use they
can be put

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2nd Source of Value: Earning Power Value


Earning power means sustainable distributable earnings that may
reasonably be expected over a period of time in the future (almost
equivalent to distributable cash flows)
Earning Power Value no Growth = Present Value of current
sustainable earnings (E) capitalized at an appropriate rate (r)
EPV = [E / r]

Ignores future growth assumes earnings remain constant


The Earnings to Consider are Normalized earnings: These reflect
average sustainable free cash flow numbers based on no growth capex
assumptions
This approach is uncontaminated by forecasts of future
Since we are assuming no growth and sustainable earnings r would
be close to or slightly above risk free rate

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Intrinsic Value, RCA and EPV

Intrinsic value for a firm in a viable industry is going to be:

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its asset value (RCA), if no competitive advantage exists


its EPV, if competitive advantages exist (one can measure EPV
with growth also)

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Earnings Power Value and RCA

Three situations for economically viable industries


1.

EPV < RCA


Management not using assets optimally; Industry operating with excess capacity
Chance to unlock value?

2. EPV = RCA
No competitive advantages; average management
Ignored growth but in a situation with no comp adv growth doesnt add value
because RoIC = r !!

3. EPV > RCA


Strong barriers to entry or sustainable competitive advantages or great management
(is great management a sustainable comp adv?)
[EPV RCA] = value of franchise
The defining character of a franchise is that it enables a firm to earn more than it
needs to pay for the investments that fund its assets
One has to make a judgment about the sustainability and source of this value

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Estimating Equity EPV (no growth value)


The aim is to find normalised average sustainable FCFE from
existing assets, when there is no growth capex.
Start from Net Income and Adjust (on post tax basis) for
1.
2.
3.
4.
5.

Any one time expenses or income adjustment


Business Cycle adjustments
Capacity utilization adjustments
Maintenance capex adjustment
Leverage Adjustments ( is D/E too high or low than would in stable state?
If yes, then a) interest cost would accordingly have to be adjusted and b)
some cash kept aside to pay off excess debt over time this has the affect
of reducing FCFE OR some cash will come in from raising more debt over
time and this has the affect of increasing FCFE

If you want to estimate Enterprise EPV on no growth basis adjust


reported post tax EBIT for the above. (Leverage adjustments will
not
feature at Enterprise Level
valuation)
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3rd Source of Value: Value of Growth


put a value to growth separately in order not to corrupt other estimates
based on bird in hand value.
growth on a level economic playing field adds no value need moats
Growth requires new investments - Can Growth Come Without
Additional Investments?
Does Growth bring increase in value?
If RoIC = r : growth produces no value
If RoIC < r : growth will destroy value
If RoIC > r : growth will create value

Growth within a franchise creates value because it implies


sustainable competitive advantage leading to superior returns
This occurs when EPV >> RCA

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EPV with Growth: Simple Model


Balanced Growth
a change in revenues will imply a proportional change in profit
Assets and liabilities required to support this growth will also
grow proportionally
Implies capital required to support this growth grows
proportionally

EPVgrowth = IC * [RoIC - g] / [r-g] (this is just the perpetual


growth DCF formula re-written in terms of these variables)
RoIC = r => EPVgrowth = IC
RoIC < r => EPVgrowth <IC
RoIC > r => EPVgrowth >IC
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Growth Multiplier
M = EPVgrowth / EPV
= [1 (g/r)(r/RoIC)] / [1- (g/r)]
The higher the (g / r) and lower the (r / RoIC) greater the value of
growth

R/r

g/r

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1.5

2.5

0.25

1.11

1.17

1.2

1.22

0.5

1.33

1.5

1.6

1.67

0.75

2.5

2.8

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Three Sources of Value Summary


Discrepancies between RCA and
EPV represent both an
opportunity and caution

if EPV < RCA : will value unlock?

EPV
Franchise
Value from
current
competitive
advantage

If EPV > RCA : will competitive


adv sustain?

Value of
Growth only
if growth
within
franchise

Asset value
Reproduction
Cost
Free entry
No comp adv

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Themes on Discounted Valuation Models


2+8=10
4+6=10
6=10-4

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Either Firm Value (Enterprise Value) or Equity


Value
Enterprise DCF
use free cash flows to firm (FCFF)
These are cash flows prior to debt payments but after meeting all
reinvestment needs for growth assets
The discount rate will reflect the cost of raising both debt and equity capital
in proportion to their use (Weighted Average Cost of Capital (WACC))

Equity DCF
Use free cash flows to Equity holders (FCFE)
These are cash flows from assets after debt payments and after meeting reinvestment needs
The discount rate would reflect the cost of equity (CoE)

Various data bases and books differ in the way they define Free
Cash Flows the essence rather than technical definition is
important
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Terminology for Firm Valuation Models


Invested Capital (IC)

Capital required for the operations =


NW + Long term Debt + Short Term
Debt
Operating Profit
Operating Revenues Cost of
Revenues = EBIT
NOPLAT
Operating profit less operating taxes
(NOPLAT = EBIT(1-t) ), where t is the
operating tax rate i.e. tax rate of a
completely equity financed firm
ROICt
NOPLATt/ICt-1
Investment Rate (IR)
Net Investment /NOPLAT
Net Investment
ICt+1 ICt (if measured from liability
side) or Change in Net long term assets
+ change in working capital (if
measured from asset side)
Growth in NOPLAT
g = ROIC*IR (when RoIC is stable)
Free Cash Flow Firm (FCFF) NOPLAT Net Investment
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Terminology for Equity Valuation Models


Networth (NW)

Equity = share cap + Reserves and


Surplus
Net Profit
PAT
RoEt
PATt/NWt-1
Reinvestment Rate (RR) Retained earnings / PAT
Net Equity Investment NWt+1 NWt = Retained earnings
Growth in PAT
g = RoE*RR (if RoE is stable)
Free Cash Flow (FCFE) PAT Net Equity Investment Net
Debt Repaid

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Linear Growth Models in Valuation Make it easy


to learn valuation modeling

Balanced Growth or Linear growth Models


a change in revenues will imply a proportional change in profit
Assets and liabilities required to support this growth will also grow
proportionally
Such an assumption makes it easy to study and apply valuation models
So if analyst projects profits to grow 10% then he will also project out capital
to grow 10% if RoC is expected to remain same

V = [FCFt=0* (1+g)] / ( CoC-g) (A) this equation inherently


assumes linear growth model!!
Since FCF is EBIT(1-t) reinvestment in capex and WC
WE can re-write equation (A) as
V = [Capitalt=0 *(RoCt+1 g)] / (CoCt+1 g)
Where Captial = Networth or Invested Capital depending on whether V
is value of equity or enterprise; similarly CoC will be either CoE or
WACC and RoC will be either RoE or RoIC
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Fundamental Model for firm value


For a Company with constant rate of growth of Free Cash Flow(FCF)
The formula below is also known as the value driver relationship,
because it shows the links between the various value drivers and the
value of future cash flows
Value

FCFt 1
(this is the PV formula for growing perpetuity whereFCF t 1 FCFt * (1 g) )
WACC g
NOPLATt 1 * (1 IR)
WACC g
g
)
RONIC
WACC g
This can be rewritten as ICt*(RONIC-g) / ( WACC-g),
where RONIC is the ROIC expected for next year

NOPLATt 1 * (1

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DCF or Economic Profit Model?


Value

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FCFt 1
WACC g
NOPLATt 1 * (1 IR)
WACC g
NOPLATt 1 * (1
WACC g

g
)
ROIC

g
)
ROIC IC ROIC g
0
WACC g
WACC g

IC0 (ROIC) * (1

IC0

ROIC WACC WACC - g


WACC g

IC0

ROIC WACC
IC0
WACC g
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86

Free Cash Flow Definitions


Free Cash Flow to Firm or FCFF
FCFF = NOPLAT + Dep Capex Change in WC >(A)
Capex = Change in Net Long Term Assets + Depreciation >(B)
Change in WC = WC of current year WC of previous year
Using (B) the expression ( A ) can be simplified to
FCFF = NOPLAT Change in Net LTA Change in WC

Free Cash Flow to Equity or FCFE


I) FCFE = FCFF Net debt repaid post tax interest payment
Net debt repaid = (opening debt closing debt)
Post tax interest payment = interest*(1-t)
II) FCFE = PAT + Dep Capex Change in WC Net Debt repaid > (C)
Using ( B ) expression ( C ) becomes
FCFE = PAT Change in Net LTA Change in WC Net Debt Repaid
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FCFE For a Debt Free Firm


For debt free company
FCFE = PAT + Dep (Change in net long term assets +
Depreciation) Change in WC
FCFE = PAT (change in net long term assets + change in
WC)

For a Debt Free Firm, under linear growth model


assumptions, any change in net worth will total the
change in net long term assets and working capital
Hence FCFE = PAT Change in networth

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1. Calculate FCFF for year 2011.


2. Calculate FCFE for year 2011.

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Calculations

Tax rate2011 = Tax / PBT = 4680/15600 = 0.3 or 30%


NOPLAT2011 = (PBT+I)*(1tax rate) = (20100(*0.7) = 14070
Depreciation for year = 6500
Change in Net LTA = 82500 77000 = 5500
Change in WC = 20300 15800 = 4500
FCFF = 14070+6500 (5500 + 6500) - 4500 =4070
FCFE = FCFF net debt repaid post tax int payment = FCFF net debt repaid post tax int payment = 4070 - ( 55000 - 60000)
4500*0.7 = 5920

FCFE (method 2) = PAT + Dep capex WC change - net debt


paid = 10920 + 6500 (5500 + 6500) 4500 (-5000) = 5920
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Terminology
Economic
Profit

The excess earned on the entire operating capital


over the cost of capital. Similar to EVA for firm.

Residual
Earnings

Economic Profitt = ICt-1* (ROICt WACCt)


The excess earned on the Book Value over the Cost of
Equity. Similar to EVA for Equity.
Residual Earningst = BVt-1*(RoE-CoE)

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1. Calculate Economic Profit (EP) for year 2011. WACC = 10%, t=30%
2. Calculate Residual Earnings (RE) for year 2011. CoE = 12%,

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Solution process
Step 1 calculate NOPLAT
Step 2 calculate RoIC and RoE
Step 3 calculate Economic Profit and Residual
Earnings

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Solution
EBIT 2011 (PBT+ interest)

20100

NOPLAT 2011

14070

IC 2010

92800

WACC

0.1

RoIC on opening capital

0.151616

Economic profit for 2011

PAT 2011

10920

Networth 2010

37800

CoE

0.12

RoE on opening networth

0.288889

Residual Earnings for 2011


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4790

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6384
94

Unlevered and Levered CoE


Levered CoE Cost of equity for a company as usually
calculated . If the company has debt, the risk and
benefits of debt will reflect in the CoE.
Unlevered CoE The cost of equity for a company
adjusted for risk and benefits of leverage. In other
words unlevered cost of equity is the cost of equity for a
company HAD it been totally equity financed.

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Frameworks for Discounted Valuation Models


Model

What is
Valued

Discount
Rate

Basis

What to
Discount

Enterprise DCF
(FCFFM)

Entire Firm WACC

Cash Flows (CFs)

Operating CFs

Equity DCF
(FCFEM)

Equity

Cash Flows

CFs to Equity

Economic Profit
(EPM)

Entire Firm WACC

Accrual Accounting

Economic Profit

Residual Earnings
(REM)

Equity

Levered
CoE

Accrual Accounting

Residual
Earnings

Dividend Discount
(DDM)

Equity

Levered
CoE

Cash Flows

Dividends

Adjusted Present
Value (APVM)

Entire Firm Unlevered


CoE

Cash Flows

Operating CFs

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Levered
CoE

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Discounted Cash Flow Based Valuation Models


FCFF

t n

FCFFt
FirmValue
t
t 1 (1 WACC )
t n

FCFE

FCFE t
Equity Value
t
(
1

CoE
)
t 1
t n

DDM

APV (MM
Theorem)

Div t
EquityValue
t
(
1

CoE
)
t 1
APV = PV of FCFF + PV of tax shields PV of bankruptcy cost =
FCFF (for FCFF use unlevered CoE as discount rate / for tax shields
its cost of debt or unlevered CoE)

All Models (other than DDM) will give the same value. Equivalence will hold IFF you make
consistent
assumptions
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Kapur
97

Interest Tax Shield


Interest is a genuine business expense and is hence tax deductible.
This means that tax is calculated only after deducting interest
from operating profits. So if an equity financed firm has PBIT of
100 and tax rate is 30% it pays 30 as tax since its PBT = PBIT. If
the same firm had debt and interest was 20 then PBT would 80
and tax would be 24. hence tax savings due to interest = 6 which
nothing but tax rate* interest = 20*0.3 = 6. This is also known as
interest tax shield. Since it reduces tax outgo its increasing cash
flows and hence adds value.
Enterprise DCF and APV give the same value but only differ in
the way they calculate the PV of interest tax shields
Where in Enterprise DCF are we accounting for the interest tax
shield?
In the WACC remember we use post tax cost of debt
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Discounted Accounting Based Valuation Models


Discounted
Economic
Profit Value

IC t ( ROIC t 1 WACC t 1 )
FirmValue IC 0
t 1
(
1

WACC
)
t 0

Residual
Earnings
Model

BVt ( ROE t 1 CoEt 1 )


EquityValue BV0
t 1
(
1

CoE
)
t 0

t n

t n

Accrual Accounting Models Should give same value at Cash Flow models if assumptions are
consistent
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