Corporate Valuation
Session 8
Shobhit Aggarwal
25 July 2021
IIM Udaipur
Cost of Debt
Market Value of Debt
• Sandstorm Inc. is incorporated in Spain. It has a book
value of debt of 100 mn. It paid 9.5 mn as interest
expense last year. The average maturity of the debt is
4 years. The Spanish government bonds have a ytm
of 9%. Sandstorm has a rating of BB which has a
default spread of 3%. Find the market value of
Sandstorm’s debt.
• PV of an annuity of 9.5 mn for 4 years + PV of 100
mn 4 years later
• 28.86 + 63.55 = 92.41 mn
Cost of Capital
Q. It is always recommended to use market
value weights for cost of capital. Why?
a) Because market is usually right
b) Because market values are easier to obtain
c) Because book values are meaningless
d) None of the above
― Answer: Because market value is what you have to
pay to get control and the DCF value is normally
assuming 100% control (acquisition value)
Cost of Capital
• To convert a USD cost of capital to a rupee cost of
capital, use the inflation rates in the two
countries
• Rupee cost of capital = Dollar cost of capital *(1 +
India inflation rate)/(1 + US inflation rate)
Convertible Debt
• Should we consider convertible debt (or other
hybrids) as debt or equity?
― Answer: Separate it into conventional debt and
equity (option to convert). Basically value the straight
debt part (by discounting coupons and maturity
value at the cost of debt) and the remaining value is
equity
Preferred stock is a kind of hybrid which should be
treated separately
Convertible Debt
• Q. Assume that you have convertible debt with face
value of 125 mn, a coupon rate of 4% and maturity of
10 years. The market value of the convertible debt is
140 mn. The rating for the firm is A- and the going
ytm for A- rated bonds is 8%. How do you treat this
debt?
– Estimate the value of debt
– 10 yr annuity of 5 mn + 125 mn 10 years later
discounted at 8% = 91.45 mn
– Equity portion = 140 mn – 91.45 mn = 48.55 mn
Recap
• Cost of Equity
• Risk-free rate = Govt. Bond - Default Spread for country rating
• Beta
– Business
– Financial Leverage
– Operating Leverage (if needed)
– Cash
• Market Risk Premium
– Historical Risk Premium
– Use implied equity premiums
• Lambda
– Ratio of domestic earning of firm/Domestic Earnings of average firm
• Country Risk Premium
– Default Spread
– Mature market Risk premium * Stdd. Dev of market index where firm belongs/Stdd. Dev of
market Index in mature market –Mature MRP
– Default Spread * Stdd. Dev of Equity Index/Stdd. Dev of Bonds
Recap
• Cost of Capital
– Cost of Equity
– Cost of Debt
• YTM of traded bond
• Risk-free rate + Default Premium for rating
• Risk-free rate + Default Premium for Synthetic rating
– Market Value weights of Debt and Equity
– If there is preferred stock, then cost and weight of
preferred stock
Project Part 2 (16 marks)
• Detailed revenue forecast
• Financial statement forecasts and linking
• Cost of equity and WACC estimation
• Restatements of disguised Cap Ex
Project Part 2
• Financial statement forecasts
– Focus on detail
– Proper linking of statements
– Clearly mentioned assumptions
– First sheet in excel should explain the assumptions
and why a particular number was chosen
Project Part 2
• Cost of Equity and WACC
– Use forward looking risk premium if the company
is in a single country primarily
– Estimate CRP and lambda yourself if the
revenue/operating income from a country is more
than 10% of the company’s revenue/operating
income
– Use the CRP from the excel sheet sent otherwise
– Use CRP for regions from the excel sheet
Project Part 2
• Cost of Equity and WACC (….continued)
– Estimate beta yourself
– If you intend to value the company in parts, then
you will need multiple cost of equity estimations –
one for each part
• Adjust R&D, Training and Recruitment,
Advertising etc. if they are a critical part of
how your company does business before
taking weights on WACC
Valuing Country Stock Markets
Estimating Cash Flows
CASH FLOWS
• Three steps:-
– How much are the net earnings
• For Equity start with Net Income
• For firm, start with EBIT * (1 – t)
– How much does the business reinvest
• Capital Expenditures
• Working Capital
• Restatements of capital expenditures stated as expenses
– If we are estimating cash flows to only equity
holders, what are the net cash effects of debt
CASH FLOWS
• FCFE
• Net Income + Depreciation – Capital Expenditure –
Change in non-cash working capital + Debt Issues –
Debt Repayments – Preferred Dividends
• FCFF
• EBIT * (1-t) + Depreciation – Capital Expenditure –
Change in non-cash Working Capital
• Is the Interest tax saving being ignored?
• What tax rate do we use in the formula
Estimating cash-flows
• Most updated earnings numbers
– Even if the time periods differ a bit
• If you are using a commodity firm, do not use last year’s
numbers as a base since earnings depend on commodity prices
• You need to normalize the earnings when past is not a good
predictor. Average over last 10 years does not always work since
operations of a firm and size keeps changing for most firms
– Trend Analysis may work
• You need to use a system depending on type of business (Price
*Qty, Size*Mkt Share, simple growth)
• Cleaning up accounting statements for accounting
Concept checker 15
• What is the most updated estimate of
earnings?
a) Most recent annual report
b) Last quarter results multiplied by 4
c) Adding together results from last 4 quarters
d) Taking reported earnings for current year and
adding expected earnings for remaining
quarters
― Answer: Adding together results from last 4 quarters.
What are the problems with other methods
Concept checker 16
• How do you value assets that are in extremely
short supply? E.g. Dhoni’s one year contract for
CSK/Ownership of KKR
― Answer: Valuing is doable since it is based purely on
cash flows.
― Find PV of cash-flows for the franchisee with Dhoni
― Find PV of cash-flows without Dhoni
― Pricing is very difficult because there is no active
market
Concept checker 17
• Which of the following should be considered as
capital expenditures?
a) R&D Expenses in a pharmaceutical company
b) Building a manufacturing plant
c) Advertising by a soft-drink company
d) Recruiting/Training at BPO/KPO/Consulting firms
e) All of the above
― Answer: All of the above
Concept checker 18
• Which tax rate will you use for estimating free
cash-flows? Marginal or Effective tax rates?
― Answer: Begin with effective and will slowly grow it
to marginal by the terminal growth year. Since
effective tax rates cannot remain low forever
Concept checker 19
• Why do we take marginal tax rate always in post-
tax cost of debt but effective tax rate in post-tax
cash flows?
― Answer: Because earnings are taxed on an effective
basis while tax benefits are accrued on the last rupee
(marginal)
Cleaning up accounting statements
• Financial Expenses disguised as operating
expenses
– Operating Leases (Used to be big problems in some sectors e.g.
restaurants, Retailers)
– Any other contractual commitments
• Capital Expenditures disguised as operating
expenses
– R & D Expenses
– Exploration costs
– Advertising Expenses where brand has huge value
– Training and Development if people drive value
Leases
• What are the two kinds of leases?
– Operating lease*
– Capital Lease
• Does either create an issue in terms of what it
economically is and how it is represented in
accounting terms?
* IFRS has changed this and if your company follows IFRS, it may
no longer be an issue
Leases
• What are the characteristics of a lease expense?
– Contractual commitments
– Interest deductible
– If you default, litigation with first right of lease holder
& bankruptcy/restructuring
• Is this any different from debt?
Capitalizing R&D Expense
• Assume an amortizable life for R&D. Average
gestation period
• Collect past R&D expenses for the amortizable
life
• Sum up the unamortized R&D portion over
the period
• Adjusted EBIT*(1-t) = Reported EBIT*(1-t) +
R&D Expense – R&D Amortization
Capitalizing R&D Expense
• Assume that the following R & D Expenses
were incurred
Year R & D Expense
-5 960
-4 1200
-3 1050
-2 845
-1 750
0 1600
• Estimate the readjustments