Welcome, my name is Han Smit, I’m a professor of Corporate Finance at Erasmus School of Economics. In this webcast, we will introduce you to company valuation. The learning objective of this webcast is being able to calculate the free cash flows in the forecasting period and the discount factor. Determining the value of a company is critical to all parties in a transaction. First of all, the owners of a company need to know the value of assets in order to decide whether or not to sell and at what price to negotiate when evaluating the sale of a subsidiary. Interested buyers must determine the company's value in order to set up bidding limits and strategy. In leverage buyouts, where debt levels are a significant part of the purchase price, creditors need to ensure operating cash flows and projected asset sales are sufficient to cover future debt obligations. In all these cases, the DCF method is a useful tool. There are a variety of DCF related methods that can be applied. First: the Weighted Average Cost of Capital, or WACC method, is the best known of these DCF approaches. This method is appropriate for valuing transactions where the capital structure is expected to remain stable. The WACC valuation method involves first estimating the total value of the company, known as the enterprise value, by discounting the net free cash inflows at the Weighted Average Cost of Capital. Thereafter, you subtract the market value of any company debt to arrive at the value of its equity. Two: another approach is the Free Cash Flow to Equity (FCFE) method, often used to estimate the price of traded companies. It involves estimating equity value directly by discounting both the after-tax cash flows to equity and the terminal equity value at the cost of equity. Three: yet another approach is the Adjusted Present Value (APV) method. The APV method splits the value of a company into the discounted value of the company as an all-equity entity, plus the discounted value of the interest tax shields of the company's debt. This variant of the DCF method is appropriate when the debt-equity mix is changing over time, as for instance, in leveraged buyouts. In the assignments, you may use the adjusted present value procedure in valuing a leveraged buyout. We separate the company's expected cash flows into two periods: the explicit forecast period, which typically spans up to six years into the future, and the terminal or continuing value, which covers the period after the explicit forecast period, essentially into eternity. Hence, we define enterprise value as follows: enterprise value is the present value of free cash flows during the explicit forecast period, plus the present value of the terminal value. In this video, we will cover the WACC method. In part one, we will focus on calculating the discount factor and the free cash flows during the explicit forecast period. In part two, we will cover the calculations of the terminal value and determine the total company value. Before we start, let's first have a look at the company financials and the information that has been provided. We have actual realized financials for the year that we call t is zero, and forecasts for the years one up to six, for both the balance sheet and the profit and loss account. Furthermore, the company has a target debt-to-equity ratio of 0.5 and a BB+ bond rating. Its unlevered beta is equal to 0.8 and its profits are taxed at a rate of 25 percent. One: the WACC. Okay. Let's start by calculating the discount factor, known as the Weighted Average Cost of Capital or WACC. Company ABC is financed by both equity and debt and both types of capital providers require return on their invested capital. Therefore, the future free cash flows that the company generates must be discounted by the relative proportions of invested debt and equity, which are accounted for in the WACC. The official formula for the WACC is the cost of equity, denoted by Re, times the proportion of equity to firm value, plus the cost of debt, denoted by Rd, times the debt to firm value ratio, times one minus the tax rate. We adjust the cost of debt for the tax rate because interest payments are tax deductible. The cost of debt is equals the risk-free rate plus the credit spread on debt, depending on the risk of default. In this example, the cost of debt therefore equals two percent, plus three percent, which is five percent. We can readily plug in the tax shield, namely one minus 25 percent, to estimate the after-tax required return on debt. Next, we calculate the cost of equity, which arguably can be estimated using a variant of the Capital Asset Pricing Model or the market model. The cost of equity equals the risk-free rate plus the equity beta times the market risk premium, plus any additional firm-specific risk premiums. Given the provided numbers for the risk-free rate, market risk premium, and the small firm premium, we obtain a cost of equity of 11 percent. We can calculate the equity component of firm value using the target debt-to-equity ratio of 50 percent. The equity component then equals to ratio of equity to equity plus debt, which is two-thirds in this case. By the same reasoning, the debt component then equals one-third. Now we have all the components, we can fill them into the WACC formula, leaving us with a WACC of nine percent rounded to the nearest whole percentage. Two: the forecasting period. Let's move to step two: calculating the free cash flows during the explicit forecasting period. Recall from the previous webcast, the way to estimate the operating free cash flows: from both the forecasted income statement and balance sheet, which are based on forecasted fundamental value drivers. Typically, we explicitly forecast for the years one up to six, in the case of company ABC. We start with the EBIT. We multiply the EBIT with one minus the tax rate, to obtain the net operating profit after tax, in short, NOPAT. Beware: we do not simply subtract the tax reported on the income statement in this calculation, because those reported taxes are adjusted for the tax shield of debt. With the WACC method, the tax shield benefit is already accounted for in the discount factor. Next, we add the depreciation, for which we can simply use the values from the profit and loss account. Then we need to subtract the change in the operating provisions, which is simply the difference between the operating provisions of two years. Thus, five for each year, since each year the provisions increase with five million. Next, we subtract the change in net working capital. In this example, the operating short-term assets consist of inventories, accounts receivables, and operating short-term assets. We exclude cash when it's not part of the company's daily operation, and we exclude operating provisions, since we corrected already for provisions at another stage. The operating short-term liabilities consist of the accounts payables and other operating short-term liabilities. We can calculate the net working capital for each separate year. For instance, at t is zero, the calculation is as follows: 87 plus 165, plus 23, minus 152, minus 38, which equals 85 million. Following the same calculation, gives us the following values for the year t is one through six: 89, 95, 101, 105 million, 110 million, and 112 million. Then, the change in the net working capital is simply the difference between two years. So, for year one it's equal to 89 minus 85 yielding four. For the other years, this equals: 6, 6, 4, 5, and 2 respectively. Finally, we subtract the capital expenditures. To estimate capital expenditures from the balance sheet we take the change in the tangible fixed assets and add to this the depreciation. For t is one, this equals to 236 minus 225, plus 31, yielding 42. In such a calculation, do pay attention to the years from which we need to use the financials. Now that we have all the items, we can calculate the free cash flows. So let the numbers fly in! These values represent company ABC's free cash flows for each year of the planning period. By discounting them with the appropriate discount factor, equal to one divided by one plus the WACC to the power of time, using the nine percent WACC that we calculated earlier, we get the present value of our free cash flows during the planning period. In our example, this equals 398 million rounded to the closest whole number. To summarize this video: you now understand the first step of a DCF: how to estimate the WACC and the free cash flow during the forecasting period. In the next video we will continue our estimation of company ABC's value by calculating the terminal value and adding everything together. You will find the spreadsheet of this method and the other methods at our supporting site. So, you can try them out. Why don't you do that now? Hope to see you in the next webcast.
