Company Valuation -

Value, Structure, Risk

Marek Capiński and Wiktor Patena

University of Applied Sciences

Hof, Bavaria, Germany
 The Authors

Marek Capiºski is a professor at AGH University of Science and Technology,

Kraków, Poland (Faculty of Applied Mathematics).

Wiktor Patena is an associate professor at Wyższa Szkoła Biznesu – National-

Louis University, Nowy Sącz, Poland (College of Management and Business).

Editorial Committee:

Prof. Dr. Ulrich Enturp

Prof. Dr. Hans-Peter Sonnenborn
Dr. hab. Jacek Leskow

Cover design:

Janusz Bąk

Copyright © 2008

ISBN: 978-3-935565-23-3

University of Applied Sciences

Hof, Bavaria, Germany.
 Contents

List of Symbols................................................................................................... 5
Introduction....................................................................................................... 7
I. Value .......................................................................................................... 11
1.1 Basics of Company Valuation.............................................................. 11
1.1.1. Cash flows................................................................................... 14
1.1.2. Assets of a company – balance sheet.......................................... 15
1.1.3. Summary..................................................................................... 17
1.2. Valuation methods................................................................................ 19
1.2.1. Perpetuity, given capital structure............................................... 22
1.2.2. Perpetuity, given value of debt................................................... 26
1.2.3. One period – given capital structure ......................................... 29
1.2.4. One period – given debt ............................................................ 32
1.2.5. Three periods – given structure.................................................. 33
1.2.6. Growing perpetuity – given structure........................................ 37
1.2.7. Growing perpetuity – given debt................................................ 39
1.2.8. General case – given structure................................................... 40
1.2.9. APV – given structure................................................................. 41
1.2.10. Company valuation via iterations............................................. 44
1.3. Growth.................................................................................................. 46
1.3.1. Growth of value........................................................................... 46
1.3.2. Growth versus value................................................................... 47
1.3.3. Dividend policy and growth....................................................... 49
1.3.4. Growth versus cost of capital...................................................... 50
1.3.5. Residual value............................................................................. 52
1.4. Real options.......................................................................................... 53
1.4.1. Option to abandon....................................................................... 54
1.4.2. Option to abandon revisited........................................................ 56
1.4.3. Option to expand......................................................................... 57
1.5. Case study – documents pro forma...................................................... 59
II. Structure ................................................................................................... 64
2.1. How to determine the cost of capital................................................... 64
2.1.1. Equity........................................................................................... 64
 2.1.2. Structure – basics........................................................................ 65
2.2. Change of capital structure.................................................................. 72
2.2.1. Perpetuity.................................................................................... 72
2.2.2. Company as a project................................................................. 75
2.3. Applying options.................................................................................. 80
2.4. Branches............................................................................................... 83
2.4.1. Branches – cost of capital........................................................... 83
2.4.2. Branches – value......................................................................... 85
2.4.3. Debt being considered................................................................ 87
2.4.4. Valuing a branch – structural approach...................................... 89
2.5. Mergers and acquisitions .................................................................... 91
2.5.1. Basics of M&A........................................................................... 91
2.5.2. Reasons for M&A....................................................................... 93
2.5.3. Carrying out a merger ............................................................... 95
2.5.4. Hostile takeovers......................................................................... 96
2.5.5. Formal issues.............................................................................. 96
2.6. Case study – valuing a company......................................................... 99
III. Risk............................................................................................................ 104
3.1 Measures of risk.................................................................................. 104
3.1.1. Variance and the like................................................................. 104
3.1.2. Value at Risk............................................................................. 106
3.2. Risk management in a company........................................................ 109
3.2.1. Risk in a company..................................................................... 109
3.2.2. Risk management versus value.................................................112
3.2.3. Risk managements tools............................................................113
3.3. Case study – hedging exchange rate risk exposure............................114
Conclusions......................................................................................................119
Literature........................................................................................................ 120
 List of Symbols

APV............. adjusted present value

AR .............. accounts receivable
BV................ book value
C ................. Call premium
CAPM ........ Capital Assets Pricing Mode
CE................ certainty equivalent
CF................ cash flow (for shareholders)
D ................. debt
DCF ............ discounted cash flows
Div............... dividend
E . ................ equity (market value
EAT............. earnings after taxes
EBIT . ......... earnings before interest and tax
EPS.............. earnings per share
FCF ............ free cash flow (for shareholders and debt holders)
FTE ............ flow to equity (equity valuation method in which CFs are dis-
counted at kE)
FTF . ........... flow to firm (valuation method in which FCFs are discounted at
WACC)
FV ............... future value
G.................. present value of tax payments of a leveraged company
GU............... present value of tax payments of an unleveraged company
g................... growth rate
I.................... interest
Iterations..... method of solving logical loop via Excel application
K.................. strike price
kA................ WACC without tax shield
kD ............... cost of debt
kE ............... cost of equity
kM .............. required rate of return on a market portfolio
kU ............... cost of equity of an unleveraged company
MV............... market value
NWC .......... net working capital
OP................ operational profits
P................... put premium
p................... plowback ratio/investment ratio
P/E .............. price/earnings ratio
PV ............... present value
PVGO.......... present value of growth opportunities
PVTS........... present value of the tax shield
rRF ............. risk free rate of return
ROA............. return on assets
ROE . .......... return on equity
SML ........... Security Market Line
S................... stock price
T . ................ tax rate
TP ............... tax payments
TS ............... tax shield
V ................. value of a company (for shareholders and debt holders)
VU .............. value of an unleveraged company
WACC ........ weighted average cost of capital

6
 Introduction

DCF (discounted cash flows) valuation has had a long tradition that dates
back to early works of Miller, Modigliani, Gordon and Shapiro. Major contribu-
tions in the field of discounted cash flows valuation have been made by Cope-
land[1], Damodaran[2]and Fernandez[3].
In colloquial terms, DCF valuation, the concept first known for valuing
projects, is based on measuring the value of milk given by a cow (the market
value depends on future payment surpluses - the stream of cash flow is dis-
counted) instead of focusing on the price of the meat of a cow offered by a
butcher (the value of assets).
DCF method (sometimes called “intrinsic value method”) is mentioned in
the first line of this book not without a reason. This is without a doubt the major
valuation method used in most company valuations.
There is also the “peer comparison” [4] method (or multiple approach), where
a company is valued by analogy with other assets or companies of the same
type. This pragmatic approach assumes that markets are efficient, and the value
of one company should be measured by reference to another’s value. Speaking
of the market and its efficiency, it must be admitted that the market value (and
other methods referring to market values, just like the peer comparison method)
and present values of cash flows should converge.
In another approach (sum-of-the-parts method, or restated net asset value) a
company is valued as the sum of its assets less its net debt. There are numerous
variations of the method, starting with a crude one based on book values.
There are attempts to apply options theory – this seems a tempting theoreti-
cal concept, which may potentially represent a profound shift in the way equi-
ty capital is valued. At present, the structural approach is more often used for
credit risk estimation. Real options are more often in use, although after the dot
com craze (at the end of XX century) they have fallen out of fashion.

1 T.E. Copeland, Koller T., Murrin J., Valuation, Measuring and Managing the Value of Companies, John Wiley
and Sons, New York, 2000.
2 A. Damodaran, Investment Valuation, John Wiley & Sons, 2002.
3 P. Fernandez, Valuation and Shareholder Value Creation, Academic Press, San Diego 2002.
4 P. Vernimmen, Corporate Finance, John Wiley & Sons, 2005.

7
 Mixed methods, which usually boil down to being a weighted average of
DCF and restated net asset value, should be treated with caution. Some are
tempted to use them as the valuation results can be easily manipulated. Instead,
the differences stemming from using various methods should be analyzed, not
averaged.
This short review of valuation methods shows that there are three basic ap-
proaches: cash flow-based, market-based and asset-based. The methods will be
referred to again in Chapter 1.1.
The set of valuation methods that is actually in use in a given country is usu-
ally shaped by its history and economic environment[5]. Typically, the list may
include:
1. replacement method,
2. restated net asset value method,
3. liquidation value method,
4. multiple method,
5. DCF method.
Once the list is created, it often becomes a benchmark for company valu-
ations. The choice (with regard to methods) made by companies performing
company valuations depends on a number of factors.
1. If the financial markets are stable, market values may be used and then
the multiple method is preferred. However, the multiple method derived
value, being greater than DCF derived value, clearly shows that the com-
pany should go public.
2. The fact that a company is able to generate positive cash flows is an indi-
cation that the DCF method should be used. If this is the case, the DCF
derived value is typically higher than the values generated by any other
methods.
3. Companies that barely break even, but have a lot of marketable assets are
valuated with the use of restated net value method. The restated net value
being higher than the DCF value may be an indicator that the company
should gradually divest and liquidate its assets to boost profitability.
4. Those already in the red are bound to use the liquidation value method.
5. In most cases, as suggested by the applicable provision, at least two meth-
ods are utilized so that the brackets with the lowest and highest values
are formed and facilitate negotiations with potentials investors. If the fi-
nancial market is stable and a company generates positive cash flows,

5 In Poland for example, after the fall of communism in 1989, a lot of previously state-owned property started
to be commercialized and then privatized. One of the provisions of the Ministry of Treasury issued at that
time (3.06.1997) specified that at least two out of the five valuation methods that were listed there must
be used whenever any of the state-owned companies were to be privatized and sold. Since then, the five
methods have become a benchmark for company valuations even if they were done for purposes other than
commercialization and privatization.

8
 DCF and comparative methods are used in most cases. Some of the dif-
ferences in the values generated by the methods stem from the lifecycle
theory of company value[6]. For example, quite naturally if the company
enters a post-maturity phase, its profits decline and the cash flow value
slips below the restated net asset value.
The DCF method clearly dominates in most of the valuations of economi-
cally sound companies. Besides, other methods are quite straightforward, and
do not require sophisticated theories or mathematical models to support. DCF
does. The concepts of perfect market, time value of money, cost of capital, port-
folio theory and many others laid the foundation for DCF valuation. There are
certain standards that apply when DCF is used, some are the part of the com-
mon knowledge and are clearly codified, and others have to be presented in de-
tail.
This book is focused on the DCF method, the one that is most complicated
– hence needs special explanations, the one that is most sophisticated – hence
needs attention. Another reason is that the DCF method captures best the value
of profitable, economically sound companies. We believe it works for all firms
which have real expertise – this is the core of the economy, its salt of the earth.
The main purpose of this book is to explain the inner workings of the DCF
method, especially the variant in which capital structure constantly affects cost
of equity, as it does in reality.
The basic notion of the DCF method can be introduced with the following
valuation formula:

where subscripts 1, 2, … represent the first and further periods [7].

This is how the company’s value is determined: certain cash flows are dis-
counted with the cost of capital. There are three components involved: cash
flows, cost of capital and the model (or engine, technically speaking) explaining
how the first two are related and eventually put together into a coherent system.
In other words, one asks three questions.
1. What are cash flows?
2. What is the discount rate?
3. How to discount?
Consequently, the book revolves around these three issues. The three chap-
ters are devoted to the value of cash flows (modules A, B, C, see Figure 1 below),
the model focused on capital structure (modules G, H), and the cost of capital
6 P.Vernimmen. Corporate…, op.cit. p. 838.
7 Time dependent k will be introduced later.

9
that expresses risk (modules D, E, F). All of them are intertwined throughout
the whole book as they cannot be separated from other problems discussed.
The figure below shows a complete procedure for company valuation. The
book will focus on certain issues, and neglect others as in our view, there is
enough information on CAPM (Capital Assets Pricing Model) available else-
where.

10
 I. Value

The main goal of a company is to increase its value for the shareholders.
By the value we mean today’s value of future cash flows generated by the
company and discounted by a proper discount rate. The proper discount rate
is meant as a rate that reflects risk, and as suchis the cost of capital.
Let us justify this point of view on a company’s value. Obviously, it is not
based on book values and to some extent it ignores the company’s property,
which with DCF is treated as a means of generating cash flows and not an as-
set per se.

1.1 Basics of Company Valuation

In the case of companies listed and traded on a stock exchange, valuation

does not seem to be a problem – it is merely a question of multiplying the
number of shares in circulation by their price, and the market value (of equity)
is instantly obtained. Companies that are not listed may be offered for sale,
and the price from tenders can be used to estimate their value. Here we en-
counter the problem of a slight difference between price and value. The prime
difference stems from the fact that buyers and sellers look at the company
from two different points of view. For example, for a seller fixed assets may
seem to have the most value, whereas a buyer may be anxious to have access
to the market only, since he has better production potential himself. Or vice
versa, and the buyer is eager to get the assets. Each of the buyers may look at
the company from another angle; the same assets in various hands may rep-
resent a range of prices understood as potential to generate cash flows. Thus,
value is a relative concept and it is not identical to the market price. Whenever
dealing with the market price determined by a stock exchange or “peer com-
parison” methods of valuation (where a company is valued by analogy with
other assets or companies of the same type), one must remember that price
and value are different notions.

11
 P/E ratio is one of the best known profit-related indicators (often used in a
multiple method). As the name suggests (price to earnings ratio), it is the stock
price divided by profits generated by a company (attributable to one share, EPS
– earnings per share). The ratio would be useful, if it bore decent information.
We could value a company that is not listed on a stock exchange by using a P/E
ratio of a listed company and multiplying by the profit (E instead of EPS) of the
not-listed company. So the value of a not-listed company could be calculated us-
ing the following:

The problem however, is that the P/E ratio does not include debt, so the as-
sumption that the benchmark company is financed by equity only has to be
made. Still, the problem can be solved by making one simplifying assumption.
Suppose we know the following: the share price P, P/E ratio of a company that
is financed partially by debt whose value D is known (as well as the interest I
the company pays), the number of shares in circulation N, and that the company
pays tax rate T.

Example 1.

Suppose P/E = 6.1 and P = 32.50. Hence, EPS = 32.50/6.1 = 5.3279.

If the number of shares N = 10 000, EAT = 53.279. If D = 150 000 and the com-
pany pays an 8% interest rate, the amount of interest paid by the company equals
I = 12 000. Should the company have no debt (and the tax rate was 30%), the profit
would be:
53 279 + 1200(1-30%) = 61 679.

Having replaced debt by equity, the number of shares is increased by

15 000/32.5 =  4615, and the total number of shares now is 14 615. Hypothetical-
ly, we can calculate a new ratio for a company that is financed by equity only; the
share price should be divided by EPS = 61679/14615 = 4.22:
P/E = 32.50/4.22 = 7.7.

The example shows how misleading the P/E ratio can be. When the compa-
ny is debt financed, EPS was higher and P/E was lower than when the company
was financed by equity only.
The simplifying assumption that was used for the calculations says that the
share price will not change after debt is exchanged for equity. However, this as-

12
sumption is not met, as we will see later: any change in capital structure will in-
fluence its share price. We should and we will try to acquire formulae that take
the change into account further on.

Value of a company that is calculated with P/E ratio may be faulty:

One problem can be attributed to the difference between price and value.
The other is referred to the book value of profit.

A modified ratio that takes cash flows into consideration would be of better
use than P/E. Still, mere cash flows do not contain any information about the
future or prospects of growth of a company. A part of net profits may be rein-
vested, the other paid out as dividends. The balance between paid out dividends,
growth that has been created, and risk may influence the company’s value. The
problem will be discussed later.
The menu of multiples is quite wide: P/NOPAT, P/EBIT, and P/EBITDA.
The ratios, such as price to sales, and price to EBIT, have the same drawbacks
as P/E. Any attempts to enhance any of these ratios in order to improve their
effectiveness are fruitless. One of the few sensible improvements that is often
tried is the use of the mean or median of the multiples of the sample of compa-
rable companies. The sample of several companies is better than one, but the
medians or means should not be applied mechanically. The multiple method
has to be used with extreme caution.
There are many more obstacles in using market prices. The current mar-
ket price does not reflect the actual value of a company, since any attempt to
buy a significant amount of shares may immediately affect the share price.
Market prices fluctuate, sometimes violently. The market price cannot be
ignored, but one should make an attempt to answer the question of how
much the company is really worth. In particular, in case of imperfect mar-
kets (low liquidity) the value of a company may be easily over or under es-
timated. Recognizing this fact is crucial for buyers, sellers, or investors tak-
ing any long-term positions. It may also be important for a company when
planning a new issue. Finally, when a company is a start-up, or exists but is
about to take a strategic decision that may appear to be a big leap, we are
devoid of market-based information, when estimating the value of a com-
pany is a must.
Setting the proper company value may also facilitate remuneration of man-
agers. Any system that is based on book values may be vulnerable to manipula-
tion. For example, the management may easily increase ROA of a company by
taking a decision to cease investing in fixed assets. As an investment in R&D
may mean losses that the company will incur for a few years, the management
that is rewarded based on net profit will never take such decisions. They will

13
ignore new technologies, avoid entering new markets or developing new prod-
ucts.
The competence in company valuation will provide us with a lot of insight
into the role of the components from the formula below:

1.1.1. Cash flows

It is clear that cash flows are a better indicator of the value of a company
than book profits as book values are often far from reality. Positive book prof-
its do not even exclude bankruptcy, let alone an increase in value. Moreover,
(book) profits may be difficult to exercise due to delayed or bad receivables. An
extreme case would be fictional profits generated by so-called creative account-
ing. The simple difference between book profit and cash flow that is a result of
depreciation is straightforward and must be taken into account. However, it (de-
preciation) is not related to our criticism concerning book profit as a company
value driver.
Going back to cash flows, they are the true proxy of the value of company.
Its value depends very much on how big the future cash flows might be, how
soon they will materialize, and how certain they are.
If the cash flows were certain, then valuation would be a piece of cake. The
certain cash flows would have to be discounted with the risk-free interest rate,
otherwise one would create a money machine (assuming short positions in CF
are available). It would also be against the notion of the well known free lunch
concept. Let’s assume we are considering buying a financial instrument that
will generate 105 in one year’s time (t = 1). If the risk free rate is 5%, then the
value of the purchase is 100 (assuming the asset is fully tradable):

This, however, is not the case of cash flows generated by a company. A com-
pany by definition is a risky asset. How to value under uncertainty? There are a
few theoretical concepts that may be applied.
1. Certainty equivalent is, in a nut shell, a payment that would be accept-
ed instead of any risky cash flows. Let’s assume we expect a cash flow
of 150 (if the market goes up), or 90 (if it goes down). We expect to get
150 or 90, both with the same probability of 50%. The expected value of

14
 the cash flow is then 120. The question however is: what cash flow (that
would be certain) shall we accept instead? If we are indifferent between
the certain payment of 105 and the risk of having either 150 or 90, then
105 is the certainty equivalent:

2. The risk adjusted discount rate method (cost of capital) is much more
practical. It assumes making some adjustments to the denominator,
such that the discount factor reflects the risk of the uncertain cash flows
(where E[FCF] representsmathematical expectations). The risk premium
kRP captures the risk. The cost of capital method dominates since we
find it easier to estimate appropriate discount rates than certainty equiva-
lent cash flows:

3. In the risk-neutral probabilities approach, the risk free rate is still used
for discounting. In the numerator, risk-neutral probabilities are used in-
stead of the subjective ones (the risk is removed). Such expectation is de-
noted by EM (for martingale probabilities)[8]. The relevant numbers here
have a risk-neutral (p) probability of 25% (up scenario), and (1-p) 75%
(down scenario):

where:

and u (50%) and d (-10%) are up and down scenario returns respectively.

1.1.2. Assets of a company – balance sheet

It is common practice to take the book value of assets as the value of a com-
pany. For this purpose, only fixed assets should be considered since in gen-
eral current assets are financed by current liabilities. Only net working capital
8 For more information about the martingale probabilities go to: M. Capinski, T. Zastawniak, Mathematics for
Finance, Springer Verlag, London, 2003

15
should be added to the value of fixed assets. However, the book value of as-
sets does not reflect the real value of a company – such an approach ignores a
number of critical factors. To name just a few:
• intangible assets,
• the role of environment,
• the role of management,
• the role of human resources.
The comments about the difference between book value and market value of
assets are still valid. For example, assets that are fully depreciated and have a
book value of zero can still be effectively used in the production process. Hence,
numerous attempts to use figures other than the book value of assets are made.
1. Restated net value.
When using the restated net value method, book values (which for many
reasons are far from reality) have to be restated and revalued before they
are able to represent a true asset’s value. Certain components of a bal-
ance sheet are adjusted: receivables that are past due are cancelled or
their value is reduced relative to the chance of having the invoices paid,
inventory value is adjusted by rejecting the items hard to sell and replac-
ing the book value with the market value, and the value of fixed assets
is adjusted on the basis of estimates by certified evaluators. In general,
each asset has to be valued, some at their market value (the assumption is
that we can sell the asset), while others at replacement cost (if the asset is
used in the company’s operations). The method is easy to use and the re-
sult is hardly ever questioned. However, one has to aware of the fact that
such a valuation only makes sense if the assets can be used independ-
ently of the company’s operations. If not, the result obtained through the
restated net value method seems meaningless.
2. Liquidation value.
When using the liquidation value method, book values are replaced with
market values based on the assumption that the business is to be liquidat-
ed and quickly sold off (usually) in pieces.The resulting number will be a
lower limit of a price estimate of a company that is close to bankruptcy.
In addition to that, costs of the liquidation process (bankruptcy proceed-
ings) must be taken into account, properly estimated and deducted from
the previously set value of a company.
3. Replacement value.
When using the replacement value method, we calculate a cost of build-
ing a company that has the same operational potential as the company
that is being analyzed. Components with no liquidation value should be
ignored. In fact (with the last statement) the method becomes a mixture
of other methods.

16
 However, none of the above adjustments are satisfactory, since they do not
solve the basic problem of the discrepancy between the value of assets and the
value of a business. On one hand, market value may be misleading since, for ex-
ample, expensive highly specialized machines that are difficult to relocate may
have low market value. On the other, replacement value may be too high – buy-
ing old equipment may pose a problem, since it is expensive and its efficiency is
doubtful. Finally, the liquidation value is typically very low.
What is sometimes discussed is the notion of economic value. The notion is
very unclear. The only estimate of such value that makes sense is to calculate
cash flows that may be potentially generated, and at the same time taking into
account proper costs of production and product quality.

Example 2.

Let us consider a business: a copying centre. Suppose that instead of buying a cop-
ying machine, we buy a scanner, computer and printer. The cost of buying all the
equipment is higher that the cost of a copying machine (and the quality is compara-
ble). The real value of the equipment if used for printing is low. We are not going to
be competitive, as the costs will be higher and delivery time longer, and the fact that
we can easily change the fonts, correct the spelling, or correct red eyes while copy-
ing will not be worth much.

There are a few other adjustment methods such as: book value of assets plus
certain percentage of revenues or turnover. They go in the right direction as an
attempt to recognize the ability of a company to generate cash, but they are ar-
bitrary and extremely subjective. Such valuations depend on the attitude of the
person that is doing the valuation and give extremely different results for com-
panies that are similar.

1.1.3. Summary

The discussion above on company valuation methods leads to a thought that

sometimes assets per se are not important but it is more important how the as-
sets are utilized, and all the organizational environment of a company is often
an essential component of the company’s value. Let us name a few factors:
• business idea,
• technology,
• licences,

17
 • staff, management,
• organizational structure,
• brand,
• market share.
Without these factors, equipment and machines themselves are not worth
much. They enable the production ofhigh quality, low cost products that are
sellable. Estimating their value without looking into the future is impossible.

The value of a company depends on cash flows

that the company may generate in the future.

The problem we are facing is to:

• estimate future cash flows
• determine a discount factor– cost of capital.
Let us admit that historical data are of little value. In order to prove the value
of this statement it is enough to imagine two companies having very different
backgrounds but sharing the same rosy prospects for the future. An argument
that the position on the market depends on the historical value can be rejected
by proving that expected cash flows should capture that. Risk is a factor of great
importance but this is included in the cost of capital.
Future expected cash flows will be calculated on the basis of strategic plans
and financial documents pro forma of a company. The starting point for such
calculations is sales predictions which are preceded by a macroeconomic analy-
sis. The prospects of economic growth of the economy affect the predicted in-
crease of purchasing power and demand. Such analysis should not ignore the
international environment, specifics of the region or a given industry. What fol-
lows, is the microeconomic analysis that may help calculate a unit price and the
level of sales. In practice, the sales from the previous period of time is accepted
as a starting point, then an increase of several basis or percentage points is as-
sumed. Costs can be predicted from analyzing company operations, but let us
not forget that they have to be viewed from a larger perspective, taking into ac-
count a number of other factors.For example, prices of materials may depend on
certain international factors such as exchange rates.
Such predictions are usually made for a period of 5 to 9 years. Further prog-
nosis poses a challenge as predicting sales 10 years from now is not likely to
be precise. Here, a simplifying assumption is made, where cash flows are pre-
dicted, then discounted to some point in the future and this number is called the
residual value.

18
 In practice, it is often assumed that future cash flows (e.g. after 5 years) be-
come a perpetuity or growing perpetuity. It significantly simplifies calcula-
tions of the residual value.

The planned future cash flows are only expected values. In practice, a cer-
tain amount risk is involved and there will always be some discrepancies be-
tween planned and realized values.
This fact is taken into account in choosing a discount rate (cost of capital)
that reflects the level of uncertainty that is risk.

1.2. Valuation methods

Once we have financial documents pro forma, we can calculate the cash
flows. There are two basic valuation methods, corresponding to two kinds of
cash flows.
1. FCF – Free Cash Flow (cash flow available for both shareholders and
debt holders)
FCF is cash that is generated by a company’s operational activity without
taking interest payments into account. We hypothetically assume a situation
where a company is equity financed only. The formula below is used in this
case:

The correction involves adding back depreciation and the value of actual in-
vestments made by a company in working capital and fixed assets. Using the
formula means that the tax shield is not taken into account. This however is not
true. The tax shield is not ignored but included in the calculations of cost of cap-
ital (WACC- weighted average cost of capital). The WACC is defined as:

Free Cash Flows are discounted and the value of a company is obtained.
Then, the market value of debt can be deducted and what is left is the value
of equity. The value of each share can be easily found then. In a nutshell:
E = V – D.

19
 The method is called Flow to Firm (FTF), or indirect method, since the val-
ue of equity is found indirectly – first the value of the whole company is found
and then equity.
2. CF – Cash Flow (Cash flow available for shareholders only).
We calculate cash flows CF available for shareholders:

Cash Flows (CF) are discounted by the cost of equity, which is the rate of return
required by shareholders. The value of debt is found independently and the sum of
these two gives the value of the whole company: V = E + D

The method is called Flow to Equity (FTE) or the direct method.

There is a clearly defined relationship between CF and FCF and the two
equalities:

It is worth emphasizing that Free Cash Flows are purely hypothetical and
(except for a company that is fully equity financed) are not cash flows that
are obtained in reality.

It is also worth mentioning that sometimes CCF (Capital Cash Flow) or DCF
(Debt Cash Flow) are defined. The latter is easy to calculate – it equals interest
plus principal payments or taking additional loans. Then CCF can be defined as
a sum of DCF and CF:

The appropriate discount rate for CCF is (according to the equality above
and the properties of the portfolio theory) a weighted average cost of capital
(without a tax shield) kA:

There is also the APV (Adjusted Present Value) method, where FCF is dis-
counted with the cost of capital kU (u stands for unleveraged) that does not in-
clude a tax shield (assuming that a company is equity financed), and then a cor-
rection including the current value of the tax shield, agency costs, etc. is added
or subtracted.

20
Example 3.

Here is the data concerning Hip Hop Inc.:

Balance sheet: (in millions)

Assets 2008 2009 Liabilities 2008 2009
Cash 96 160 Account payable 232 266
Accounts receivable 455 688 Tax liabilities 196 123
Inventory 553 555
Current assets 1104 1403 Current liabilities 428 389
Fixed assets 1644 1709 Debt 400 454
Equity 600 640
Retained earnings 1320 1629
Assets 2748 3112 Liabilities 2748 3112

Income statement: (in millions) 2009

Sales 1509
Cost of sales 750
Depreciation 65
EBIT 694
Interest 70
EBT 624
Tax (34%) 212
EAT 412
Dividend 103
Retained earnings 309

Here is the way to calculate the company’s cash flows:

21
 Let us check whether the formula that translates CF into FCF applies:

There are certain technical problems that are likely to appear in the calcula-
tions described so far.
1. One has to know the cost of capital WACC (and both its components:
cost of debt and cost of equity) in order to calculate the value of a com-
pany.
2. One has to know the capital structure, that is the value of debt and equity,
in order to calculate the cost of capital (cost of equity or WACC).
3. One has to know the value of interest payments, which is the value of
debt, in order to calculate cash flows.
The problems create a logical loop: step 1 needs step 2, but step 2 requires
step 1.In the next subsection we will show how to tackle the problem in a few
specific situations. By the way, the problem seems technical, but as a matter of
fact it is a profound shift in the way the value can be found.
Another problem with cash flows is that the term is not clearly defined.
We cannot rely on IFRS (International Financial Reporting Standards) or US-
GAAP (Generally Accepted Accounting Standards), or any of the local laws in
that respect. By no means are the two definitions of cash flows given above the
only ones that can be used. They are specific enough to justify the use of two
methods of company valuation, and general enough to allow further differences.
For example, cash is often treated as a non-operational asset and removed from
cash flow calculations. By the way, our view is that a certain amount of cash is
always needed for company operations. There are even models for optimizing
the amount of cash a company should hold (Baumol, Stone’s models) and there-
fore any decisions with regards to cash levels should definitely be treated as op-
erational ones. Thus, there a whole gamut of methods used for cash flow calcu-
lations – a good review of them is presented in Velez-Pareja’s paper[9] .

1.2.1. Perpetuity, given capital structure.

There is a range of problems in the valuation of companies. We will make

some simplifications in order to come up with a result. Here are a few examples
of applying both methods of company valuation. First, an infinite investment
horizon is assumed (the company will never terminate its operation).

9 I. Velez-Pareja, “Construction of Free Cash Flow”, Working Paper 1995/6, www.paper.ssrn.com

22
 Example 4.

Suppose, sales of 200[10] are generated every year. Costs are always 70% of sales.
The company is financed by debt of 20%, that is D/V = 20%. The cost of debt is
16% and the cost of equity 26%. The company pays 30% corporate income tax.

FTF method (based on FCF)[10]

An income statement for the years to come is drawn up. Hypothetically, it

assumed that there is no debt (in order to determine free cash flows).

Sales 200
Operational costs 140
EBIT 60
Interest 0
EBT 60
Tax 18
FCF 42

Now, it is easy to calculate the weighted average cost of capital:

The value of the whole firm is:

Debt is stipulated at 20% of the total value of the firm, so D = 36.46 and
E = 145.83.
The above income statement was calculated with no debt assumption.
The genuine profit can now be found, since interest can be found once debt is
known.

10 Money amounts in most of the examples and cases are expressed in thousands.

23
 Sales 200.00
Operationalcosts 140.00
EBIT 60.00
Interest 5.83
EBT 54.17
Tax 16.25
CF 37.92

We can also calculate the present value of cash flows by discounting them
with the cost of equity. The result is the same as before:

FTE method (based on CF)

Had we known both methods would give the same result, we could use the
above calculations (both), where the level of debt, interest and cash flows were
found. However, we did not know that and thecalculations had to be repeated. It
is good practice to use both methods and prove the result by executing the cal-
culations separately, otherwise we are in facing a tautology.
We have another series of relationships leading to a loop:
1. CF is calculated with the use of interest rates of 16% of debt – the value
of debt is not known yet.
2. The value of debt can be derived from a capital structure (D/E = 20%/
80% = 25%) – but this needs the value of equity as an input.
3. The value of E is equivalent to the value of cash flow discounted at the
cost of capital – the loop is complete, CF is not known yet.
The problem can be solved numerically, or by solving the set system of si-
multaneous equations:

24
 By substituting CF and D from the equations above to the last equation, it is
easy to solve and will generate E:

(25% is the D/E ratio that is derived from the implied capital structure.)

Once we know the value of equity, the value of debt can also be found: D/E
= 20%/80%, so debt is 5% of equity, hence D = 36.46 as before.
It has been proven that this method leads to the same result as before. It is
not a coincidence. Let us analyze the case again by reformulating the equation
for E:

It is worth emphasizing an existing flaw in assuming a fixed capital struc-

ture. If the value of equity changes, the capital structure changes too. It could
happen as a result of a change in risk or a change in expected cash flows. It is
worth bearing in mind that changing share prices may affect even the value of
companies that are not listed, let alone those that are traded. We should then
adjust the level of debt, so the capital structure is always as planned. Obviously,
this is difficult as the value of debt is determined at the very beginning, and the
changes may take place later. Besides, it is easier to assume that the level of debt
at a particular point in time is given. It does not exclude using the policy aimed
at obtaining a certain required capital structure.
The assumption that the capital structure is known brings (apart from sim-
plicity of calculations) a significant advantage. In most of the cases analyzed in
this chapter, it was assumed that cost of equity is given. However, the cost of eq-
uity depends on financial risk, which is also represented by the capital structure.
Relying on debt that is given and used to determine the capital structure leads to
a logical loop: structure determines cost of equity, cost of equity determines the
value of equity, and finally equity defines capital structure. The problem will
be taken care of in Chapter 2, which is devoted to capital structure only. Here,

25
in this section, it is assumed that the cost of equity is found independent of the
structure of financing, e.g. by using CAPM.

1.2.2. Perpetuity, given value of debt.

Taking for granted that the value of debt is given is reasonably realistic. The
capital structure is temporarily unknown and will be calculated as soon as the
value of equity is found.

Example 5.

Let’s assume that sales do not change and are 200 every year. Costs are 70% of
sales. The company is partly financed by debt of 50. Interest is a perpetuity of 8,
since the cost of debt is 16%. Cost of equity is 26%. The company pays corporate
tax of 30%.

Method based on FCF.

For FCF calculations, the same data as before are used:

Sales 200
Operational costs 140
EBIT 60
Interest 0
EBT 60
Tax 18
FCF 42

The following problem is encountered:

1. We need to know the weights (share of debt and equity in total financ-
ing), in order to calculate weighted average cost of capital.
2. We need to know the value of debt (this is given) and equity in order to
find the weights.
3. The sum of debt and equity gives the value of the company that we are
looking for.

26
 An analytical solution to the problem is fairly straightforward: we are facing
the following system of equations, where V is the value of a company and k the
cost of capital:

The first equation shows the value of the whole company as a perpetuity
with an annual payment of 42 and an unknown discount rate k. The other shows
the formula for WACC, where “V – 50” is the value of equity. The system can
be easily solved by entering k =42/V into the other equation. We get:

and then,

Thus, E = 140 after deducting the value of debt from the value of the com-
pany.
The problem can also be solved numerically. First, let us accept any cost of
capital, e.g. 10%. This would provide the value of equity as follows:

FCF 42
K 10%
V 420
D 50
E 370
The value is incorrect, since for such values for D and E, the resulting value
of WACC would be different from 10%.

27
 In order to make the necessary corrections, we should enter a formula for
WACC in the appropriate cell in Excel, replacing the k = 10% with the result
above. The loop is then complete and the final results, as shown below, are cor-
rect.

FCF 42
K 22.11%
V 190
D 50
E 140

The loop will work on one condition: a feedback loop must be activated in
Excel (go to Tools/Options/Calculations, tick Manual Calculation and Iteration
boxes)[11]. By setting the Maximal Number of Iterations to 1, it can be observed
how the computer gets closer and closer to the right answer. The computer will
only execute one loop and each following loop can be triggered by pressing the
F9 key.

Method based on CF.

The same result can be obtained by relying on CF. The income statement
looks as follows:
Sales 200
Operational costs 140
EBIT 60
Interest 8
EBT 52
Tax 15,6
EAT = CF 36,4

The value of equity can be easily found, once we know the cost of equity.
The result is identical to the one found before:

11 In more recent versions of MS Office, the path is slightly different.

28
 1.2.3. One period – given capital structure

The assumption that operations of a company are represented by a perpetu-

ity is an gross simplification. A one-period case is essential since later on it will
become a starting point for developing a multi-period case. It will be based on
repeating a single-period case.

Example 6.

Let us assume an investment horizon of one year. Starting the business involves in-
vesting 200, including working capital (say this is mostly land in order to avoid prob-
lems with depreciation). EBIT = 80 is generated at the end of the year, and the value
of assets does not change. The company pays 30% tax. The shareholders require
28% return on the money invested into the business. Cost of debt (that provides
40% of financing) is 10%.

Method based on FCF.

Let us calculate FCF: profit after taxation is 56, and so at the end of the year
200 is recovered:
FCF = 256.
Now, WACC can be found:

FCF can be discounted at WACC:

Finally, the values of E and D can be calculated:

We are able to determine how much has to be borrowed in order to finance

the business idea. The missing 114.38 must be invested by the shareholders.
Shortly afterwards, the value of the shares (if traded) grows to 128.43, as a re-
sult of the fact that the investment is characterized by a positive NPV of 14.05,
as shown below:
200 – 85.42 = 114.38

29
 This is exactly the difference between the principal initially invested and the
market value of equity:

Let us put the phenomenon into a wider context. The value of the company
V is its discounted value of future cash flows, so the relationship NPV = – I + V
holds. There are some more relationships that follow:

where (I – D) is the sum of money supplied by shareholders in order to fi-

nance the business. This is an illustration of the general fact that equity is typi-
cally increased by the NPV of a project.

Method based on CF.

Let us first find a solution to the problem by solving a system of equations.

In the first equation, the fact that debt has to be paid back and assets can be sold
is taken into account. The second one shows the implied capital structure. The
last one defines equity as the discounted cash flow available to shareholders:

E may be easily obtained by solving the last equation:

30
 D can be determined using the second equation. It also shows that the meth-
ods lead to the same result as before. To make sure this is not a single occur-
rence but a rule, let us reformulate the equation for E to see how both methods
(CF and FCF-based) are reconciled:

To complete the task, let us solve the problem numerically.

Here is the income statement (suppose D = 100):

EBIT 80
D 100
Interest 10
EBT 70
Tax 21
EAT 49
CF 149

Now, let us calculate E by discounting CF at cost of equity:

The loop may now be closed by entering the expression (0,4/0,6)E (implied
by the capital structure) instead of 100, and by executing iterations (F9). We
eventually get to the same result:

EBIT 80.00
D 85.62
Interest 8.56
EBT 71.44
Tax 21.43
EAT 50.01
CF 164.39
E 128.43

31
 1.2.4. One period – given debt

The calculations using the direct valuation method are facilitated using the
debt assumption,, since interest payments and cash flows (CF) can be easily
found. Applying the indirect method to the same set of data is more difficult
(compared to the situation with a given capital structure).

Example 7.

Let us assume that a business is carried out for one year, where the initial invest-
ment of 200 is financed 50% by shareholders and the other 50% by a loan. At the
end of the year EBIT of 80 is generated and the invested funds can be fully recov-
ered. The company pays corporate income tax of 30%, and the cost of equity is
28%.

Method based on FCF

In the same fashion as before, free cash flows are calculated (taking into ac-
count that the assets are sold at the end of the year).

EBIT 80
Tax 24
Net profit 56
FCF 256

We are dealing with a logical loop once again: WACC is still unknown, the
value of the company cannot be calculated without WACC, so we don’t know
the value of equity either, which means we do not know the capital structure of
the company, which we need to find the cost of capital (WACC).
The system of equations that permits to us to find the value of a company is
as follows:

32
 The system can be solved (using simple algebra), or the solution can be found
with the use of iterations in spreadsheets (the rules of using iterations have al-
ready been explained). Here is the solution we obtain:

Since the value of debt (loan) is 100, the value of equity becomes:

Please note, that the financing structure (market-value wise) is different from
the initial one (where 50% of the seed money came from a loan), since debt rep-
resents 46.21% of the company value.

Method based on CF

Let us calculate cash flow available to the shareholders:

EBIT 80
Interest 10
EBT 70
Tax 21
EAT 49
CF 149

This approach requires paying back the loan at the end of the year. The avail-
able cash flow (100) (left after selling the assets) discounted at 28%, generates
the same value of equity E as before (in the indirect method).

1.2.5. Three periods – given structure

The multi-period example will be limited to the method based on given cap-
ital structure. An approach which assumes a fixed level of debt, and that has
a  changing capital structure, will be presented in Chapter 2 together with meth-
ods of determining the cost of capital in such a context.
The general case will be illustrated by an example of a company with an in-
vestment horizon of three years. The example is general enough, since methods
used to cope with problems encountered here are helpful when dealing with
a three-period (and more) case as well.

33
 Example 8.

The company conducts operations for three years. Initially, 200 is invested in land.
At the end of each of the three years, EBIT of 80, 90 and 70 respectively is gener-
ated.
It is assumed that the value of land will not change and it can be sold as soon as the
company terminates its operations. The company is financed 40% by debt. Other
necessary parameters are as follows: T = 30%, kD = 10%, kE = 28%.

Method based on FCF

WACC has already been calculated (Example 6): WACC = 19.60%.

Let us proceed to calculating free cash flow for each of the years and dis-
counting it at WACC.

Year 1 2 3
EBIT 80.00 90.00 70.00
Tax 24.00 27.00 21.00
FCF 56.00 63.00 249.00
PV 46.82 44.04 145.55

The value of the whole company is obtained by summing the present values
of free cash flows: V = 236.41. The values of debt and equity can now easily be
found using the following formulae:

Now we can take advantage of the values and determine cash flow in the
first year. First, however, let us see what the value of company is each year.
The discounted cash flow from the end of year 3 represents the value of
the company at the end of year 2, and the discounted cash flows from years 2
and 3 represent the value of the company at the end of year 1. The same result
is obtained if cash flow and the value of company are discounted at the end of
year 2:

34
 There is also another way to show the present value:

For each of the years, let us split V into debt and equity according to the as-
sumed capital structure:

Year 0 1 2 3
FCF 56.00 63.00 249.00
V 236.41 226.75 208.19
D 94.57 90.70 83.28
E 141.85 136.05 124.92

Now, cash flows (CF) can be determined for each of the periods. They are
going to serve as data for a comparison analysis with the CF method that is to
follow. Net profits must be calculated first.

Year 1 2 3
EBIT 80.00 90.00 70.00
Interest 9.46 9.07 8.33
EBT 70.54 80.93 61.67
Tax 21.16 24.28 18.50
EAT 49.38 56.65 43.17

Finding the value of cash flow needs a great deal of attention. At the end of
year 3, the value of assets (after they are sold) must be added, and the debt (that
is paid back) can be deducted:

At the end of year 2, another correction has to be made: the value resulting
from a changed level of debt must be added. Debt diminishes, so every year
cash flow is lower than net profit.

35
 Cash flows discounted at 28% generate the value of E = 141.85. We can also
find the value of equity each year (in the same fashion we did for the value of
company V) :

Year 0 1 2 3
CF 45.52 49.23 159.89
E 141.85 136.05 124.92

For example, 136.05 is calculated by discounting the sum of 45.52 and

124.92 using a 28% discount rate.
The convergence between the two methods is striking. Still, it does not prove
that the CF-based method will give the same result, since CFs were calculated
with the use of values obtained via FCF based method. Let us calculate the ap-
propriate values separately.

Method based on CF

Let us pore over the one-period example and use the experience to deal
with an investment horizon of many periods. This time, however, we will
limit ourselves to numerical solutions. Solving systems of equations for the
multi-period case is viable but it would involve very complicated notation. We
will relax these restrictions later and present graphically how such systems of
equations might work. For the time being, a numerical solution will do – it is
good enough to draw conclusions of a general nature.
Temporarily, debt is assumed to be fixed at 50 every year. The formula for
CF takes into account changes in the level of debt, although now it is irrelevant
since debt does not change.

Year 0 1 2 3
EBIT 80.00 90.00 70.00
D 50.00 50.00 50.00
Interest 5.00 5.00 5.00
EBT 75.00 85.00 65.00
Tax 22.50 25.50 19.50
EAT 52.50 59.50 45.50
CF 52.50 59.50 195.50
E 170.55 165.81 152.73

36
 The value of equity E each year is the discounted value of cash flow from
the years to follow, or a discounted sum of one cash flow and the value of equity
from the following year. It can be seen that the level of debt must be adjusted,
because the capital structure is different from the one that was assumed. The
assumed ratio of D/E is 2/3 and the adjustment are entered into the appropriate
cells:

Year 0 1 2 3
EBIT 80.00 90.00 70.00
D 94.57 90.70 83.28
Interest 9.46 9.07 8.33
EBT 70.54 80.93 61.67
Tax 21.16 24.28 18.50
EAT 49.38 56.65 43.17
CF 45.52 49.23 159.89
E 141.85 136.05 124.92

The order of putting the formulae into the spreadsheet also matters. Let us
begin with the debt at the end of year 2. The numbers in bold are safe in that re-
spect as their values are not related to other cells.
In conclusion, for the multi-period case and a fixed capital structure, both
methods (CF and FCF-based) give identical results. The case of fixed debt will
be considered in Chapter 2.

1.2.6. Growing perpetuity – given structure

On one hand, the assumption that a company receives cash flows represent-
ed as a growing perpetuity is often criticized as being a gross simplification. On
the other hand, in real life a more precise prognosis is not available. Surely, ac-
cepting the growing perpetuity is a mistake, as in practice there will never be
such a scenario. Still, the assumption is justified by its simplicity, realism and
the fact that part of the risk (divergence from the expected values) is reflected in
the cost of capital. The growth factor is not likely to be constant, but there is no
other reasonable alternative to use instead. Setting the value of the growth fac-
tor is a difficult task.

37
 Example 9.

Let us assume that the company’s operations will never terminate. Initially, 200 is
invested in land. At the end of the first year, EBIT of 80 is generated and then it will
grow at the pace of 5% every year. The company is financed 40% by debt. Other
necessary parameters are as follows: T = 30%, kD = 10%, kE = 28%.

Method based on FCF

Free cash flow at the end of the first year has already been calculated, so has
WACC = 19.60%.Both EBIT and FCF grow at 5% every year:

Let us calculate the present value of a growing perpetuity:

This is also the value of the whole company, which can be split into debt and
equity according to the assumed capital structure.

EBIT 80.00
Tax 24.00
FCF 56.00
V 383.56
D 153.42
E 230.14

Method based on CF

When using this method, we encounter the same logical loop leading to a
system of equations as many times before. Please note that because profit grows
at the g rate, equity grows accordingly and debt has to grow at the same rate
so the capital structure could be maintained. The initial level of debt D after
one year grows by gD to D(1+g). Consequently, CF (at the end of year 1) is in-
creased by gD. Substituting these values into formulae x and y, we obtain the
following:

38
 Here is the solution for E:

The numerical solution involves setting the value of debt at, say, D = 100, and
then calculating cash flow, discounting and finding D based on the assumed capi-
tal structure (first column below). Then, the loop has to be closed by referring the
100 cell (D) to the cell in the second column, including a proper formula for debt.

EBIT 80.00 80.00

D 100.00 153.42
Interest 10.00 15.34
EBT 70.00 64.66
Tax 21.00 19.40
EAT 49.00 45.26
CF 54.00 52.93
E 234.78 230.14
D 156.52 153.42
V 391.30 383.56
To sum up, the method based on FCF seems much simpler; though both
give the same results..

1.2.7. Growing perpetuity – given debt

To demonstrate this concept, we will assume an initial level of debt and then
assume that debt is growing at the same rate as profits. An alternative assump-
tion that debt and profits grow at a different rates leads to many technical prob-
lems and is of little practical use.
The case is quite simple to solve.

39
 Example 10.

Let us assume that operational profit (EBIT) at the end of the year is 60 (for simplic-
ity depreciation is ignored), kD = 6%, kE = 14%, and initially the value of debt is 100.
T = 30%. Profits and debt both grow at 4% a year.

Net profit can be found by deducting interest payment and tax. Then we
have to take into account the fact that growing debt means a positive cash flow
for the shareholders. Thus, the cash flow expected at the end of the year must be
increased by gD, that is, 4% of debt.

EBIT 60.00
I 6.00
EAT 37.80
CF 41.80
FCF 42.00

Now, Gordon’s model can be used to calculate the cost of equity (here origi-
nal S is replaced with E).

The same result is obtained if FCF is discounted at WACC (12.11%):

1.2.8. General case – given structure

What is often considered when performing real life company valuations is

operations that are not planned to terminate at any point of time, but cash flows
for the first, say, five years can be more or less precisely predicted, and then, it
is assumed the company will continue operations in a form of a growing per-
petuity. Such a situation is easy to analyze: in Example 8 the amount acquired
from selling the assets can be replaced by the amount representing continua-
tion.

40
 1.2.9. APV – given structure

A company can be treated as a portfolio of equity and debt. Then, the rate
of return for the company can be found, providing costs of debt and equity are
available:.

The APV method involves discounting FCF at this very cost of capital, and
then adding some adjustments, such as adding the value of a tax shield. Typi-
cally, other adjustments are also included, such as flotation costs, costs of fi-
nancial distress, etc. The APV method is more flexible than the methods where
such costs are only reflected in the discount factor. The tax shield adjustment
requires finding the value of the tax shield for each year, and then calculating its
present value. The problem that is encountered here relates to establishing the
proper value of the discount rate.

Example 11.

Company X generates EBIT = 200 (perpetuity), and pays 30% tax. It is financed
30% by debt. The cost of debt is 10% and cost of equity is 16%.

FCF (140) and cost of capital kA can be easily found:

In the next step, the basis for the further adjustment is calculated – it is the
present value of cash flows for a hypothetical situation in which the company is
fully financed by equity (then FCF = CF)

The final adjusted value of the company is denoted as APV. Debt is 30% of
the amount, and interest is 10% of the debt. Tax shield (TS) is 30% of the latter:

41
 However, APV is unknown so the calculations cannot be performed. Addi-
tionally, there is the question of how to discount the tax shield. The answer de-
pends on how we perceive the risk which is associated with the volatility of the
underlying instruments (mostly debt). Here are three different points of view.
1. If the structure is fixed, the value of debt will correspond to the changes
in the company value. Thus, we should discount at kA which reflects the
volatility of the value of the company.
2. Initially, the value of debt is known, so the first tax shield is less risky
and should be discounted at the cost of debt, and all the others to follow
at kA.
3. The cash flows are as risky as debt is (debt is the key component of the
tax shield), therefore they should be discounted at the cost of debt.
Some argue that a risk free rate could also be used.Let us present the conse-
quences of supporting the points of view number 1 and 2 above.

Approach 1.

Let us calculate the present value of a tax shield:

Let us correct the present value of cash flows and add the present value of
the tax shield:

Please note that we are facing a logical loop again: APV depends on TS,
and TS cannot be calculated without APV. Still, the system of equations can be
solved:

Interestingly enough, if the formula for kA is entered in the denominator, we

obtain a formula that looks familiar:

42
 Clearly, the method gives the same result as the ones used so far: the value
of the company is obtained by discounting FCF at WACC. Now, we can com-
plete the calculations:

Approach 2 (Miles-Ezzell)

According to this approach, discounting of the tax shield is done as follows:

Then, we take the same steps as previously in an attempt to find APV:

After solving the equation for APV we get:

The rate in the denominator replaced WACC. It is also a type of a weighted

average cost of capital that, in order to distinguish it from regular WACC and
appreciate the contribution of its authors, is marked as WACCME:

The calculations can now be completed:

43
 The result is different from that of approach 1, but the difference is not strik-
ing. The discounting factor that was used in the first period was lower (kD in-
stead kE), so the resulting number (APV) is obviously higher.
Admittedly, the formulae are slightly complicated. Let us then present a sim-
ple iteration-based method for finding the value of APV. First, the present value
of FCF must be found (FCF is discounted at kA =14.2% and, for the time being,
the value is accepted as APV). Then, the tax shield is to be found according to
the formula below:

Here is the result of the attempt:

FCF 140.00
PV(FCF) 985.92
APV 985.92
D 295.77
TS 8.87
PV(TS) 64.87
The loop is completed by replacing APV with PV(FCF)+PV(TS). Eventu-
ally, we obtain the same results as before:

FCF 140.00
PV 985.92
APV 1 055.36
D 316.61
TS 9.50
PV(TS) 69.44

1.2.10. Company valuation via iterations

In case of a company represented by a perpetuity (as shown in many cases

above) finding the company’s value by solving a system of equations is quite
viable. In a real life case, however, when one has to deal with numerous para-
meters and time periods, a numerical solution seems to be the only feasible ap-

44
proach. For example, in order to find the value V (for a given year t), one needs
to know the values of WACC, next E, and then kE. It is impossible to calculate
WACC without V (the one we look for), and E without kE. There appears to be
many logical loops in the formulae shown below. It is a chain of formulae that
becomes so integrated that the information between cash flows and cost of capi-
tal moves freely. The cost of capital “tracks” the capital structure and changes
accordingly, while CF is a reflection of future profits and also the level of debt
in the company. This is the value-add of the iteration-based method.

Similar loops will appear if one uses the FTE method (with CF) instead
of FTF (FCF-based). Depending on whether debt or capital structure is given,
loops will additionally run along columns (from V to WACC, and from E to k)
and lines (from one year to another). The valuation is recursive, going back-
wards in time. To conclude, calculating the value of a company without using
iterations is tantamount to applying the wrong weights to WACC and leads to an
inner contradiction.
In general, the recursive method of company valuation that has been shown
through many examples overcomes a fundamental problem that is often ignored
by many other methods: the fact that the cost of capital depends on the financial
structure. It creates additional technical problems in a form of a logical loop but
this was also remedied. Admittedly, there are also many simplifications: one is
that we often use perpetuities as the last resort, and second is the assumption
that the required rate of return is equal to the expected return (determined by
cash flows). However, the latter does not seem far from true; an expected return
that is higher than required would lead to a positive NPV, an opportunity which
when confronted with competitive markets quickly ceases to exist.

45
 1.3. Growth

1.3.1. Growth of value

It goes without saying that growth in value may take place, providing the
company carries out projects with a positive NPV. Let us illustrate the issue by
showing a company that is financed by equity only, and whose profits it gene-
rates are represented by a perpetuity. Let us suppose its cost of capital is 20%,
and the company generates cash flows of 300 every year. The value of the com-
pany is easy to find:

Now suppose the company can invest 150 in a project that additionally
generates 50 a year. The value of the project is:

Another way to calculate the value of the company is:

The result is in compliance with our prediction and the rule of additivity: the
value of two projects is the sum of their values, providing the cash flow of the
joined projects is the sum of their individual cash flows. This is not always the
case however, since the effect of the growth in units sold may be spoilt by re-
duction in prices. If the project brings a return that is lower than its cost of capi-
tal, the value of the company falls. Let us suppose the project earns only 25k a
year. Then:

Generating profits is not enough. Profits have to be above the hurdle set by
the cost of capital.
A question arises: how to find projects with a positive NPV. In nine out of
ten cases these are a result of a competitive advantage. Here are a few such situ-
ations:

46
 1. Technological advantage,
2. Organizational advantage,
3. Monopolistic position.
None of these advantages last long as the competition is quick to catch up.
Case (below) shows technical and numerical aspects of this phenomenon.

1.3.2. Growth versus value

Profits generated by a company are the basic source of funds that can be
reinvested in order for the company to grow. However, any reinvestment deci-
sions (which may trigger growth) and decisions involving paying out dividends
(which may satisfy shareholders) are contradictory. Let us analyze which deci-
sion is genuinely rewarding shareholders. It is obvious though that a positive
NPV is a sine qua non condition concerning all growth prospects.
We will consider equity financing first, so that we focus on one issue, putting
the debt versus value problem aside. The simplest situation imaginable is a com-
pany that does not grow: it generates a profit of 25 000 every year, all of which is
paid out to shareholders (cost of capital is 15%). Both the value of the company
and the share price (assuming that there are 1000 shares in circulation) can be
calculated as follows:

Suppose some investment opportunities appear at the end of year 1. The
whole profit can be reinvested and generate a profit in a form of a perpetuity
(for simplicity’s sake, in the following years we do not allow any investment).

Case 1

Suppose the return expected from the investment is the same as the cost of capi-
tal (15%). This means that the 25 000 that is to be invested will bring the profit of 3
750 every year. The expected net present value of the project is no surprise:

At the end of year 1, nothing will be paid out to the shareholders, but in the
years to come the company will generate profit of:

47
 The shareholders miss the dividend in the first year, but then the dividend
grows as shown below:

Dividend / year 1 2 3 ...

No reinvestment 25.00 25.00 25.00 ...
Reinvestment in year 1 0 28.75 28.75 ...
The value of the company is the present value of all future cash flows, shown
as follows:

To make the calculations easier, let us find the value at year 1, so the perpe-
tuity formula can be used.

The amount V(1) has to be discounted to year 0 to find V(0). Apparently, the
reinvestment decision did not affect the value of the company.

Case 2

Suppose now the return that is expected from the investment is 20%. It
means that the investment will bring an additional 5 000 a year, starting year 2.
The value of the project at year 1 is:

The table below shows the amount of dividends in both situations:

Dividend / year 1 2 3 ...

No reinvestment 25.00 25.00 25.00 ...
Reinvestment in year 1 0 30.00 30.00 ...
The value of the company is the present value of all future cash flows, so we
follow the calculation procedure from the previous case (Case 1):

48
 The reinvestment positively affects the value of the company and share
price:

The present value of the company has grown by 7 246.38, (that is 7.25 per
share) thanks to some growth opportunities. The amount (7.25) is denoted by
PVGO (present value of growth opportunities). The example can be a start-
ing point for analyzing PVGO in a wider context. It is clear that growth higher
than zero (investment with the rate of return that is equal to the cost of capi-
tal also generates zero growth) increases the share price. This growth potential
(denoted by PVGO) can be defined as:

The formula can be rewritten so that it provides a more natural definition of

a share price:

The share price is broken into two components: value without growth and an
additional component derived from the growth potential.

1.3.3. Dividend policy and growth

Let us check how dividend policy (or reinvestment policy – both are two
sides of the same coin) influences growth and value of a company.

Example 12.

An evaluator analyses a firm that is fully financed by equity (100 book value), that
generates cash flow in a form of perpetuity with ROE = 30%. The cost of capital is
25%. There is an option to reinvest part of the profit (30 a year) into a project that
may yield 30% return.

49
 If the firm does not take the opportunity[12], 30 will be distributed among the
shareholders every year, and the value of the firm will reach 120. If, however,
the firm decides to take advantage of the (5%) growth opportunity, they will
have to reinvest 16.67% of the profit, increase assets to 105 and pay out only
25 to the shareholders. Technically speaking, growth is defined as a product of
ROE and plow-back ratio (reinvestment ratio - p).

Another year will bring a profit of 31.5, out of which 83.33% (100% –
16.67%) will be paid out to shareholders (5% more than previously). The growth
can be sustained and then the value of the company will reach 125 (using Gor-
don’s model). At 10% growth, the value of the company will reach 133.3, at
15% 150. Speaking of PVGO, at different levels of growth (respectively 0%,
5%, 10% and 15% its value (per share) is:
PVGO = 0
PVGO = 5.00
PVGO = 13.33
PVGO = 30.00.
Companies with a high PVGO can be defined as growth companies. From
the point of view of an investor who is considering buying the shares, pro-
fits may be delayed: we swap high dividends now for even higher dividends
promised to be paid out in a distant future. The delay involves risk: if the growth
is not sustained, the promise may never materialize.
In practice, high growth cannot be sustained in the long run. The market
will not be insatiable forever, and so we will eventually have a lower the return
from selling our product. The model can be used to simulate moderate growth
only (related to GDP, or population growth). Dynamic growth must be analyzed
separately.

1.3.4. Growth versus cost of capital.

Let us consider the problem of finding the cost of capital for a public compa-
ny (listed on the stock exchange). In a zero-growth scenario, the cost of capital
can be easily found.

and all the dividends are equal to EPS:

12 cf: A. Damodaran, Damodaran on Valuation, John Wiley & Sons, New York 1994, p. 86.

50
 Hence,

In a scenario with given growth, the formula looks as follows:

However, the growth is usually unstable – it is hardly possible to express it

through only one rate. Let us then go back to the PVGO formula:

Let us suppose the share price is 50, PVGO is 50, and profit per share is 10:

Now, the cost of capital can be found by solving the equation:

Computing the PVGO remains the main problem, of course.

It is extremely educational to use spreadsheets in order to analyze the rela-
tionship.
In practice, P/E ratio (price/earnings) is easily available:

In the example, the P/E ratio is 5. The flipped ratio gives the cost of capital
for a zero-growth scenario. In other words, in a zero-growth scenario, P/E =
1/k.Hence we are able to determine the cost of capital. In this example it equals
20%. Thanks to growth opportunities, the cost of capital grows too. The larger
the contribution of the share price that comes from PVGO, the higher the share
price is. For example, (ceteris paribus) suppose:

Then,

51
 It goes in line with our understanding of the cost of capital as a risk-related
required rate of return. For a company, in which a large share of its value is
based on growth, the level of risk is understandably higher.
What if a company generates losses? The only justification of a positive mar-
ket price is faith (of the market) in future profits and PVGO is then higher than
share price. The classic example (dated 2000) might be IT companies. Sup-
pose:

Then,

which obviously is more than the share price of 50.

To conclude, investment pays off (it initiates growth), providing the rate of
return on the projects is higher than the cost of capital of the company. Such
opportunities are difficult to find and due to competition’s activity, hard to sus-
tain.

1.3.5. Residual value

Expected cash flows are the foundation of the model of company valuation.
Unfortunately, predicting value of cash flows for 7, 9, or 15 years from now is
problematic. Working under the assumption that a company has a finite lifespan
would mean that beyond a certain point in time, cash flow is no longer gener-
ated, and the company would not have any value at that point.This is contro-
versial, since companies are usually set up for the long run. Should we suggest
that companies live infinitely. A reasonable approach requires setting a certain
finite investment horizon (and then predicting cash flows with a great deal of
precision). Beyond that point in time, it should be assumed that the company
is still active and has some residual value. The residual value concept typically
involves simplifying cash flows generated by a company to a perpetuity. Let us
discuss some specific assumptions made for the residual value.
1. Assumption that after some time T a company will generate cash flows
in theform of a growing perpetuity.
Once this assumption has been accepted, one has to estimate the growth fac-
tor, cost of capital, and first cash flow after time T. Next, Gordon’s model can
be applied. There are pros and cons to this approach. Its simplicity is the biggest

52
advantage, with the disadvantage being a high sensitivity of the results with re-
spect to the assumed (estimated) growth factor.
2. Comparison with another company that has reached a phase of develop-
ment our company is planning to reach at time T.
Once we find such a company, some of the ratios that refer to the market
value can be used. Suppose the company has P/E ratio that equals 8. The ratio
can be applied to our prediction with respect to the level of profits at time T. The
profit can be multiplied by 8 to obtain the value of the company.
Or suppose that the company’s MV/BV is 2. We should be able to predict the
book value of our company at time T, and multiply it by 2 to obtain the residual
value of the company.
3. Estimating the length of the competitive advantage phase.
Once the competitive advantage phase ends,the growth opportunities will
vanish, which, on one hand, is bad news, but on the hand makes valuation much
easier (we can completely ignore one of the parameters, namely the growth fac-
tor). The residual value can be calculated with the use of a perpetuity only.

1.4. Real options

Expected cash flows are the foundation of the model of company valuation.
The uncertainty related to future cash flows cannot eliminated, hence we tend
to underline the expression “expected”. During the life of a project, the cash
flows may be lower or higher than the expected ones. When the cash flows are
lower e.g. due to diminished demand, we might have a chance to abandon the
project. In case of success, we might be able to increase production. This type
of flexibility, which is unique to some projects, is not captured by traditional
methods of valuation.
Both decisions; to withdraw after failure or expand after success, have some
financial consequences and depend on future events that are highly uncertain.
The similarity with options theory seems obvious. A buyer of a “put” may ex-
ercise the option if the price of underlying asset goes down, likewise buyer of a
“call” may benefit from a situation when the price of an underlying instrument
goes up. The analogies are actually much deeper than it seems at first glance.
Hence, the expression “real options” is often used whenever referring to an op-
tion whose underlying assets are not financial instruments.
Hence, here is a brief presentation of the basic ideas demonstrating the con-
cept of a real option. If a company conducts market research, it in fact buys an
option: if the research is fruitful the company will launch the product. The ex-
penses incurred during the market research phase represent the option premi-

53
um, and the cost of further investment incurred at some future time T is the ex-
ercise price. The payoff depends on the success of the new product and it is the
difference between the value of the future expected cash flows (discounted to
time T) and the investment. The payoff is then given by the following formula:
max(0,R(T)-K), where K is the value of the investment and R (T) is the value
of the generated cash flows at time T (a situation known in the world of finance
under the name“call option”). Obviously, it is zero when the result of the market
research is negative and the company does not invest. As another example, con-
sider production facilities allowing for expansion, which will be employed only
in case of success. Classical cases here are also concerned with oil-drilling and
research and development. On the other hand, “put options” may provide insur-
ance against risk a company may face in case of a failure and a necessity to re-
duce the production facilities.
Such options as they appear in real business activities are very specific, as
the examples above show. They can be rarely written or sold, we cannot hedge,
nor can we replicate them using the underlying assets and bonds. These features
distinguish them sharply from financial options. This raises the question: how
to valuate real options?
If the real option can be related to a financial option, which is the case when
there is a financial asset perfectly correlated with the underlying asset of the
real option, then applying the valuation tools developed for financial options is
justified. However, we face a danger of mispricing if the correlation is not per-
fect [13].

1.4.1. Option to abandon

The first example below deals with the additional value resulting from an
option to abandon a project.

Example 13.

A project requires an investment of 100. Two future scenarios are conceivable: cash
flows of 60 (success), or 10 (flop) for three years. The probability of each scenario
materializing is 50%. At any time the operation may be terminated (assets can be
sold) for 80. The cost of capital is 30%.

13 Capiński M., Patena W. “Real Options – Realistic Valuation”, Journal of Business and Society, 2006/3

54
A classic approach suggests finding the expected cash flows. Here, the cash
flows are as follows:

NPV of the project is negative (- 0.02). However, we make a mistake by ig-

noring thepossibility to abandon the project. The previous calculations are cor-
rect if the abandonment option is not available. Let us make the calculations
again. The operations should be terminated after one year, if the pessimistic
scenario materializes (the cash flow is 90 then). NPV of the project now chang-
es significantly and is 7.31.
Financial options use specific terminology, which we will apply here in or-
der to help us identify crucial components of the real option (option to aban-
don):

1. Maturity – the end of year 1.

2. Underlying asset: the value of project. At time 1, it is the value of cash
flows as shown below:

It is clear that in the pessimistic scenario we are better off by terminating
the project and selling the assets, as the cash flow is 90 then (instead of
70.95).
3. Exercise price – 90 (underlying instrument includes abandoning the
project and selling the assets).

55
 4. Put option payoff – max(0,K - R(T)), 0 in a optimistic scenario and(90 –
70.95) = 19.05 in a pessimistic one.
5. Option premium – price of the option (present value of cash flows calcu-
lated usingthe cost of capital) is 7.33.
The project with the option to abandon is worth 7.33 more than the same
project without the option. The difference is simply the value of the option (op-
tion premium). Please note that the suggested method of valuing the option is
based on physical probabilities and as such is not the classic one.Typically, fi-
nancial options valuation involves the replication method or the use of mar-
tingale probabilities. It is important to notice that (because the option is worth
7.33) it is worth investing 105 (including 5 for the option), instead of 100 to have
the extra opportunity to abandon the project.

1.4.2. Option to abandon revisited

Example 14.

A project requires an investment of 100 and will generate cash flows of 130 (suc-
cess), or 95 (flop) after one year. The probability of each scenario materializing is
50%. At any time, the operation may be terminated and assets can be sold for 100
provided the infrastructure is up to the buyer’s needs. The cost of capital is 30% and
the risk-free rate is 5%. How much to invest in order to have the option?

The option can be valued with the use of physical probabilities, using the
same technique as before. Comparing the values with (4.54) and without (2.27)
the option gives an idea of how much the option itself is worth (2.27).
However, it would be tempting to use financial options theory to valuate the
real options. The technique relies on replication. One needs to create a portfolio
that would generate the same payoffs as the option. The number below (denoted

56
as delta) will be helpful (difference in the option payoffs divided by the differ-
ence in the project’s payoffs):

The portfolio composed of the stock (bought in proportion implied by the

delta) and bond generates the same payoff as the option (0, 5). Delta is the po-
sition in the underlying asset which completed in cash position replicates the
payoff.

Scenario up down
Stock -18.57 -13.57
Bond 18.57 18.57
Total 0 5

The payoffs of the portfolio and option are the same and hence their present
values must be equal too.

The option is then worth 3.40. The discrepancy (2.27 versus 3.4) between
the values given by the two methods stems from the fact that both approaches
have flaws. In the first approach, the physical probabilities have been arbitrarily
chosen, while in the second, replication is hardly possible if the real business is
at stake (how to short sell the business that is not publicly traded).

1.4.3. Option to expand

Another example illustrates the benefits from having an option to expand.

When starting a business, we can build a bigger warehouse or buy more effi-
cient (than necessary) machines, which may allow a business to increase pro-
duction in case of larger demand without having to incur additional investments
later on.

57
 Example 15.

A project requires an investment of 100 and will bear cash flows of 80 (success),
or 20 (flop) for three years. The probability of each scenario materializing is 50%.
Sales in years 2 and 3 may be doubled if an investment of 70 is made at the end of
year 1. The cost of capital is 30%.

NPV of the success and flop scenarios (without the option to expand) are
45.29 and – 63.68, respectively. It means that NPV of the project is negative
( –9.19). Exercising the option to expand generates cash flows (in the optimis-
tic scenario) of 10, 160, 160 in the three subsequent years. NPV of the project
becomes 75.19 and the option is worth 5.76. Here are the components of the op-
tion:
1. Maturity T: the end of year 1.
2. Underlying instrument: value of cash flows, 108.88 or 27.22 that is.
3. Exercise price K: 70.
4. Payoff of the call option: max(0,R(T) - K); 38.88 in a positive and0 in a
negative scenario.
5. Call premium: price of the option (present value of cash flows at the cost
of capital) is 14.95.
Options of that kind are often used in projects concerned with oil-drilling
and research and development, where significant amounts of money have to be
invested into research and the eventual building of a well depends on the re-
search results.

58
 1.5. Case study – documents pro forma

A firm’s value is determined by its ability to generate cash flow, both now
and in the future. When approaching a company valuation, a considerable
amount of time must be spent on estimating future cash flows.
Let us analyze the case of Tea.dot company – it is a successful but new com-
pany which reinvests most of its earnings. The company’s performance has to
be predicted for, at least, the next five years so the free cash flows and then
horizontal value of the company were calculated. However, pro forma financial
statements, such as income statements, balance sheets and cash flow statements
could not be produced, if we did not make a number of assumptions.
Before doing so, however, let us have a look at the financial situation of the
company to see how it is doing. As investment analysts, we are mainly interest-
ed in assessing the future performance of the company. The basis of traditional
analysis is comparison, as absolute numbers carry little information value. The
framework for comparison should be:
1. The company’s own performance in other years (trend)
2. An industry average (benchmarking)
Let us do the benchmarking first and compare the ratios for the relevant in-
dustry (Bakery Products) with those of the company:

Industry Tea.dot (2008)

Quick ratio 1,0 2,39 OK
Current ratio 1,6 2,64 OK
Liabilities/equity 99,7% 358% high/risky
DSO 24,1 79,56 poor
Total assets turnover 33,4% 93% OK
ROA 7,4% 11% OK
ROE 16,5% 48% OK

The company’s liquidity position is very strong. However, it also means that
it has a lot of money tied up in nonproductive assets (cash). The company should
pay more attention to cash management as well as to inventory control. The
average collection period is very long – the company has to wait 80 days af-
ter making a sale before receiving cash. This suggests that some steps should
be taken to expedite the collection of accounts receivables or at least monitor
the receivables position to start with. The turnover of all the firm’s assets is
high which means that the company is generating a sufficient volume of busi-
ness given its total assets investment. The analysis raises a few questions about

59
the company’s gearing and its investment strategy. Tea.dot is highly leveraged.
Creditors may be reluctant to lend the firm more money and the management is
subjecting the firm to the risk of bankruptcy if it still seeks to increase the debt
ratio by borrowing additional funds. Both profitability ratios are fine, although
it is obvious that its significantly better result in ROE is due to the company’s
great use of debt.
Now let us have a look at the trends at Tea.dot over the last 3 years.

Ratios -2 -1 0
Liquidity Ratios
current ratio 3.44 2.46 2.64
quick ratio 3.26 2.24 2.39
cash ratio 1.69 0.76 0.94
Asset Management Ratios
inventory turnover 9.32 3.47 3.76
DSO 74.16 78.84 79.56
Evaluating Assets
fixed asset turnover 1.94 1.51 1.73
total asset turnover 0.91 0.90 0.93
Debt Management Ratios
debt ratio 0.26 0.71 0.78
debt to equity 0.35 2.49 3.58
times interest earned 9.76 1.66 1.44
Profitability Ratios
profit margin on sales 0.21 0.13 0.11
basic earning power 0.26 0.19 0.20
return on assets 0.19 0.12 0.11
return on equity 0.26 0.41 0.48
The company has gone through a major expansion over the last 3 years
(fixed assets increased by almost 200% every year) which was financed largely
by an increase in debt. This has resulted in increased sales, but at the same time
decreased margins on sales. The company was lucky not to have been hit by
higher interest costs. The company does not seem to use internal cash flow to
finance investment sensibly (fixed assets increase but not as dynamically as the
debt). The debt ratio moved from an unremarkable 26% to a much more danger-

60
ous 71% and then 78 %. Overall impressions are that the company set up a very
ambitious expansion plan, financed mainly by borrowing. However, it is lucky
since demand is not slowing down. It should be able to operate successfully
provided bad times do not come soon. They have to generate a lot of profit to
reduce gearing. The company’s profitability has not improved, even though the
sales sky rocketed. ROE is the only ratio that grew significantly, but that was
mainly due to more and more debt the company used to finance its operations.
Thus, debt was used to increase the rate of return on equity.
Having analyzed the company’s financial situation, we can make a set of
assumptions for the next few years a savvy manager would make, being in the
shoes of Tea.dot. Here is a set of assumptions for the most likely scenario. The
country’s economy is not booming any more and recession is much more likely,
thus we can not expect sales to grow at more than 9% and then 5%, 2%, over
the next 3 years, and eventually no growth is expected. The debt has to be han-
dled and the company should not take more long term loans. The quick ratio is
definitely too high, as there is no point in having so much cash, although in this
kind of business it may be justified to some extent. The company should try to
be a bit more efficient and reduce administration costs and overheads to at most
30% of sales. Interest rates in the country will gradually fall which is in line
with the recent tendency and the central bank’s policy. The company should
have a stable dividend policy.

Balancesheet 1 2 3 4 5
1 Cash and cash equivalents 7605 7453 6516 6516 10270
2 Accounts receivable 11154 11712 11946 11946 11946
3 Inventory 2028 2129 2172 2172 2172
4 Prepaid expenses 2535 2662 2715 2715 2715
5 Current assets 23322 23956 23349 23349 27103
6 Property and equipment
7 Property at cost 35489 36199 36923 36923 36923
Less accumulated
8 -9065 -12614 -16234 -19926 -23618
depreciation
Net property
9 26425 23586 20690 16997 13305
and equipment
10 Total assets 49746 47541 44038 40346 40408
11 Accounts payable 9126 9582 9774 9774 9774
12 Income taxes payable 13 35 44 36 36

61
 Balancesheet 1 2 3 4 5
13 Other current liabilities 507 532 543 543 543
14 Current liabilities 9646 10149 10361 10353 10353
15 Long-term debt 23858 18175 11448 1988 0
16 Total liabilities 33503 28324 21808 12341 10353
17 Common stock 6243 6243 6243 6243 6243
18 Retained earnings 10000 12974 15987 21762 23812
19 Stockholders' equity 16243 19217 22230 28005 30055
20 Total liabilities and equity 49746 47541 44038 40346 40408

A complete set of assumptions now should be incorporated in a balance

sheet and income statement and linked sensibly with the most recent financial
documents. This is relatively easy.However, the main problem that is faced is
that the balance sheet is not in balance automatically. Due to the new assump-
tions, almost all the components are changed. The common practice then is to
use debt (for example short term debt) as a plug. It simply means that the differ-
ence between assets and liabilities that stems from the set of assumptions and
the internal mechanics of the balance sheet lands in the debt entry. The issue
seems technical, but it is crucial in the process of smooth preparation of a pro
forma balance sheet. Let us go into the details.
In the simplified balance sheet above, long-term debt is an offset (plug). In
the columns 1 to 4, the assets and liabilities are in equilibrium, because debt
(line 15) is given by the formula:

The approach has a handicap – some of the liabilities (retained earnings for
example) may grow to the extent that the debt (calculated according to the for-
mula) becomes negative, which (in terms of accounting rules) is absurd.
The formula must be changed into the following:

Now the debt never becomes negative, but the assets and liabilities are still
not in balance. The excess of money (from line 15) must be transferred (for ex-
ample) to the cash and cash equivalents entry (line 1). The formula there must
be altered too (f stands for the cash forecasted):

62
 In real life cases, we follow the same procedure, although the number of en-
tries in the formulae is much larger. Once the pro forma financial documents
are ready, the cash flows can be calculated according to the rule presented in
Section 1.2.

63
 II. Structure

Structure, as used in this book, is understood as the capital structure which is

the proportion in which a company is financed by equity and debt. What is di-
rectly related to the issue of structure is mergers and valuation of the company
branches. An analysis of a company with respect to the options theory may also
be helpful in the process of solving the riddle of company valuation. Before we go
any further, let us once again consider the problem of changes in capital structure
– the discussion will be complementary with the one from the previous chapter.

2.1. How to determine the cost of capital.

2.1.1. Equity.

Determining the cost of capital is a difficult task. Two aspects have to be

taken into account: risk and a reference point (prospects for the future).

1. Risk has numerous components, the most important ones being:

a) Market risk
b) Operational risk
c) Financial risk
Market risk reflects general prosperity or lack of it. It is extremely difficult
to succeed in a crisis while it is reasonably easy to conduct business during a
bull market. High tide raises all the boats – as technicians tend to say.There are
no good methods that may be used as a hedge against a global change affecting
individual companies. This risk is partially captured by CAPM, according to
which the required rate of return is given by the formula:

where rRF is risk-free rate of return, kM is the required rate of return on a market
portfolio, and the beta coefficient is the measure of the contribution of a single as-

64
set to the risk of portfolio. The idea is that the required rate of return as given by
the formula will compensate investors for bearing that risk (as measured by beta).
Operational risk deals with the uncertainty of forecasting. Estimates of
future prices of products, materials, levels of sales, or cost structure may be
wrong, hence cash flows become random. Expected values of cash flows are
used in budgeting, whereas information about the probability distribution (un-
certainty) of the cash flows is reflected in the cost of capital.
Debt financing increases riskiness as a company faces fixed interest payments
it has to incur, which in an extreme case may lead to bankruptcy. Quantitative re-
lationships between the level of debt and the required rate of return for sharehold-
ers will be referred to later in Chapter 2.2.

2. Reference point and prospects for the future.

This reflects a simple observation that the required rate of return depends on
the share price. The higher the share price is, the lower is the rate demanded by
investors. For example, high profits generated by a company will be sooner or lat-
er reflected in its share price, and eventually cashed in by the shareholders, which
may partially satisfy the shareholders’ demands with regard to their rate of return.
If the generated profits are initially low, due to, for example, weak expertise in
a new field, or unexpected failures, the shareholders tend to raise their demand
through a higher expected rate of return. The problem can be illustrated by the
cost of capital formula (derived from Gordon’s model):
The lower S(0), the higher k and vice versa. Div(1) represents (together with
the growth factor g) prospects of the future profits and, if positive, increases k. To
be honest, the cost of capital derived from Gordon’s model is usually interpreted
as an expected rate of return, but on the other hand both notions: required and ex-
pected rates are inseparable. Most of the markets for most of the time are in equi-
librium – the high expected rate of return inevitably becomes a high required rate
of return too. Otherwise, this would lead to projects with positive NPVs, which is
an anomaly in fact. It also coincides with the general idea of risk. High planned
inflows are typically riskier than lower ones and a drop in a share price signals
higher risk.

2.1.2. Structure – basics

Finding factors that are immanently important is the key to a successful

analysis of company’s value with respect to its capital structure. Cash that is
generated by a company finds its way to one of three groups:
• shareholders

65
 • debt holders
• government
The cash flows can be denoted as:
• dividends
• interest payments
• tax payments
The present value of the cash flows will be denoted as:
• E
• D
• G
The sum of the three gives an amount that is not affected by either the
level of tax, or changing proportions between equity and debt. If the tax
rates are altered (the government changes its fiscal policy), a different pro-
portion of profits generated by a company goes to the government. If the tax
rate is increased, the first two groups will receive less, but the total amount
will not change. The change in capital structure will influence the amount
of paid tax, because debt is closely related to the tax shield. Tax shield is a
result of a law that enables companies to deduct interest before calculating
the amount of tax owed. Thus, the higher the debt is, the lower the tax to be
paid. The sum of the three streams of cash flows is constant, but the change
in one component is likely to affect the other two. Let us denote the sum
asV T (total):

The value of equity is the present value of cash flow for shareholders (CF),
and tax payments (TP) are (we temporarily ignore depreciation and assume that
the level of debt does not change):

We already know that:

This implies:

The same is true as far as the present values of dividends, CF and tax pay-
ments are concerned (assuming perpetuities). G in the formula below is the
present value of tax payments and E is the present value of cash flows.

66
 The formula for the total value of a company can be rewritten as follows:

.
Let us suppose now that we are dealing with an unleveraged (hence sub-
script u) company, devoid of the tax shield effect. The value of such a company
can be shown as the sum of two components: the value of equity (no debt) and
the value of tax payments (no tax shield):

The values are given by:

This implies:

The same is true with regard to the present values (assuming perpetuities):

The relationships yield the following:

Please note that a change in T does affect Vu, since it does not affect the to-
tal value of a company. A comparison of the two formulae for the total value of
a company generates the following:

Hence:

Let us denote the cost of capital of an unleveraged company (financed by

debt only) by ku. From the portfolio theory we get the following important re-
lationship:

67
 The cost of capital does not depend (by definition) on the level of debt, so
it is assumed that it is not related to any changes in the capital structure either.
Debt, cost of equity, and equity will change in a way that the right side of the
formula is unaffected.
Whenever the capital structure changes, the cost of debt, equity, and
obviously the value of equity and debt will change too. For simplicity, let us as-
sume that the cost of debt remains the same. The formula may be now rewritten
with respect to the cost of equity:

There is a slight problem with applying the formula to real life calculations.
It gives us some idea of how E affects the cost of equity, but on the other hand
the very cost of capital is needed to determine the value of equity. However, we
went through the chore of solving many such problems (logical loops) in the
previous chapter.
It is worth emphasizing that in the case of a company that is partly financed
by debt, the value of the company (D + E) is bigger than the value of the com-
pany that is financed by equity only (Vu). The difference can be attributed to the
tax shield effect. For a perpetuity, it is TD (a product of tax rate and the value
of debt).
The formulae developed so far in this section were obtained for perpetui-
ties. Still, they are precise enough for any other situations and are widely used
in literature. Even more precise solutions can be found in M.Capinski, “A New
Method of DCF Valuation”, Nowy Sacz Academic Review, 2005/2 – they are
based on the same idea: cash flows that flow to the government, sharehold-
ers and debt holders. Using a spreadsheet and the “goal seek” tool makes it
easy to find the final values, whereas an analytic formula, though possible to
derive, would be very complicated. Here we only present the solution for a single-
period case.
The crucial relationship is concerned with two ways of decomposing the to-
tal value of the firm (which is the present value of the total generated cash). The
company may contribute to debt holders, shareholders and the government and
on the other hand to shareholders and the government in a hypothetical situa-
tion of an unleveraged firm with the same operations:

68
 We then compute the value of all components at time t on the basis of known
expected cash flows and the values at the end of year t +1. For notational sim-
plicity we sett=0 and the general relationship is as before:

We assume that the cost of debt kD(0) and the cost of an unleveraged com-
pany ku(0) are given. The formula for the cost of equity ke(0) will be derived be-
low. We assume that the values Vt(1), D(1), E(1), G (1), Vu(1), Gu (1) are known.
We identify some groups of cash flows at the end of year one, including:
1. Ct(1) – the total cash flow composed of the cash generated by the compa-
ny together with the terminal value Vt(1), discounted by ku(0) and giving
Vt(0) ,
2. CD – the cash for debt holders composed of the interest, change of debt,
and the value of debt D(1), discounted atkD(0),
3. Ce – the cash for the shareholders composed of the cash flow at the end
of the year and the value E(1), discounted by kE(0),
4. CG – the cash for the government (taxes) including the value G(1) also
discounted by kE(0) (the taxes are proportional to the cash flow to the
shareholders so the returns are the same and so is the risk).
The inclusion of the terminal value in the cash available is justified since,
for instance, the shareholders can sell the shares and debt holders can sell the
bonds, except for the government that is regarded as an investor in an abstract
sense.
Application of the basic idea of portfolio theory, regarding the company as a
portfolio of debt, equity and government, results in the following relationship:

In this formula the only unknown quantity is the cost of equity (kE ), and so
it can be calculated.
To complete the analysis, it is now sufficient to give the formulae for the nu-
merators as:

In the example below, we limit ourselves to showing the perpetuity case.

69
 Example 16.

A company expects EBIT of 60 every year. The company is financed by debt of 100,
and the cost of debt is 6% (perpetuity too). The tax rate is 30%. We assume that the
depreciation each year is at the same level as the capital investment. We inquire
about the cost of equity and capital structure.

Calculating cash flows is quite straightforward:

Given equity

The value of equity may be estimated if the company is listed on a stock ex-
change. Suppose the value of equity is:
E = 300.
Then, from Gordon’s model (E is equivalent to S (0), zero growth) we get:

We also receive the financial structure:

Both, the rate of return and the value of the unleveraged company can be
calculated:

70
 We can also compute WACC and then find independently the value of the
company:

The difference (30) stems from the fact that the company uses financial lev-
erage and hence it is the present value of the tax shield.

Given cost of equity

Let us suppose the cost of equity (12%) was found using CAPM. The value
of equity (divide CF by kE) and the financial structure can now be easily deter-
mined:

Next, both the cost of capital and the value of an unleveraged company can
be found:

Given the cost of capital of an unleveraged company

Let us supposeku can be estimated (11%) for example as a result of a com-

parison with another company that is equity financed or historical data was
used for that purpose. Then:

71
 2.2. Change of capital structure

The change of capital structure may be a result of a number of different

events such as: issuing new stock, taking or paying off a loan, or stock repur-
chase. The key problem is to assess how restructuring may affect the costs of
capital, the value of the company and equity in particular. The change may also
be caused by some alterations in share prices or debt which may result from un-
dertaking certain investment projects.

2.2.1. Perpetuity

The usual practice is to begin with analyzing a company, whose profits

(EBIT) are in the form of a perpetuity. The question posed here is how changes
in capital structure influence the value of a company.

Example 17.

Company Wardrobe Ltd.: EBIT is 200 every year and we assume that the depre-
ciation each year is at the same level as the capital investment. The company pays
30% corporate income tax. The initial capital structure is made up of 50% debt fi-
nancing, at a cost of 10%. The cost of equity is 16.8%. Raising the debt share to
60% (or lowering it to 40%) is being considered.

We can easily calculate all the elements in the valuation scheme that have
been developed so far. Let us find the costs of capital:

and the value of the company, then equity and debt (according to the implied
capital structure):

We know already that using a direct valuation method will generate the
same result, as shown below:

72
 The main assumption is:

The cost of capital does not change when the financial structure is altered.

An analogy which justifies this assumption is that the efficiency of the

equipment used in the production process is not related to the kind of money
(debt or equity) used to buy it. It will affect the cash flows and then indirectly
the value of the equipment though.

Increasing debt to 60%

The assumption that the cost of debt remains at the same level is made, and
yet we know that if the increase in the level of debt is dramatic, the assumption
may turn out to be false. The increased level of debt is needed for stock repur-
chase. What follows (according to the formula below) is an increased risk for
the rest of the shareholders:

The new financial structure changes the weights and gives us the following:

The new WACC can also be calculated:

It is lower than the one calculated for the initial (50/50) capital structure
(11.90%), so the value of the company grows:

Once the debt is known, the income statement can be drawn up and CF can
be found:

73
 If we discount CF, we end up with the same value of equity as above:

The value of equity has predictably fallen, and so has the share price (as-
sume there are 50 shares in circulation):

One may be gullible enough to think that we should purchase 10 shares since
the proportion of equity has fallen from 50% to 40%, but it is misleading. Let us
first find out the incremental increase of debt:

It is exactly the amount we have at our disposal in order to buy back the
shares (at the current price of 11.76). Thus, we can buy back the following
number of shares:

It is a fraction, but the problem is negligible – it is good enough to assume

that there are actually 50 million shares. The share price after the change in
capital structure (we divide the new value of equity by the remaining number of
shares) is:

Surprisingly enough, the share price has grown from 11.76 to 12.90, the only
reason being the change in the financing structure. This case shows the benefits
from keeping an optimal capital structure. By the way, companies often have
other reasons to buy back their own shares, for example, it is a way to boost the
share price after it has been stagnant for some time.

Lowering debt to 40%

In this case, some new stock is issued in order to pay off a part of the loan
and diminish the loan’s share in the financial structure to 40%. Since the cost
of capital is already known (14%), all we need is the cost of equity and then the
new WACC (in the new capital structure):

74
 Next, the new value of the company (FCFs are discounted), and the values
of debt and equity (compliant with the new 40/60 capital structure) are found:

Debt is reduced by 133.69. Another question that needs urgent answering is

the price at which the new stock should be issued. The shareholders will have ac-
cess to the cash flows after the change, and consequently the share price should
change as well. We face another logical loop: the new price is needed to calcu-
late the number of shares to issue, and the number is necessary in order to set the
new price. One way to solve the problem is to solve a system of equations, where
C is the new share price and N is the number of shares after the change:

The solutions are as follows:

A numerical solution using iterations is also a possible approach.

2.2.2. Company as a project

This case presents a situation in which a company undertakes an invest-

ment project that affects its capital structure, cost of capital and eventually its
value. Hypothetically, the company is reduced to the project itself, where it
begins to carry out the project and closes after a few years, when the project is
complete. The change in capital structure is inevitable when a new project is
undertaken. This time the project (to remain realistic) cannot be reduced to a
perpetuity – different cash flows have to be allowed in different time periods;
what follows is the fluctuation in the value, structure and cost of capital. The
assumption that the cost of capital is constant throughout the life of a project
is unrealistic too. Debt would have to be constantly adjusted so the capital
structure is kept as planned. In practice, there are many technical restrictions
concerned with issuing new debt, new stock, huge volatility of the share pric-
es due to changes in interest rates, risk, etc. This makes the process undoable.

75
In the example below the level of debt, not the capital structure, will be given
every year.

Example 18.

Beginning an operation requires an investment of 120. The company takes 60 of

debt, and the remaining part is financed by shareholders. The debt (principal) is go-
ing to be paid off in equal installments (over the course of three years). A straight
depreciation system is used. The company forecasts operational profits (OP) of 60,
80, 70 at the end of the three years. Then, the operation is terminated (assets have
zero salvage value). The cost of debt = 6%, cost of the company (unleveraged)
= 11%, and T = 30%.

Let us begin with finding the cash flows (FCF) for the three consecutive
years. This requires deducting depreciation and tax payments, and then adding
back depreciation.

1 2 3
OP 60.00 80.00 70.00
Depreciation 40.00 40.00 40.00
EBIT 20.00 40.00 30.00
Tax 6.00 12.00 9.00
EAT 14.00 28.00 21.00
FCF 54.00 68.00 61.00

In order to determine cash flows to the shareholders, we are also re-

quired to additionally deduct interest payments and take into account the
level of debt. The debt diminishes at the pace of 20 every year, so the cor-
rection requires us to add the depreciation of 40 and deduct the change in
debt of 20.

1 2 3
OP 60.00 80.00 70.00
Depreciation 40.00 40.00 40.00
EBIT 20.00 40.00 30.00
Interest 3.60 2.40 1.20

76
 1 2 3
EBT 16.40 37.60 28.80
Tax 4.92 11.28 8.64
EAT 11.48 26.32 20.16
CF 31.48 46.32 40.16

As suspected, the valuation will be recursive. We will start with finding the
value of the company in the final year and then go backwards. The values at the
end of year 2 can be found in two ways: either CFs are discounted at the cost of
equity, or FCFs are discounted at WACC. The problem lies in a loop: the costs
of capital determine the value, the value determines structure, but the structure
needs values as inputs. We have already gone through such calculations. For the
cost of equity calculations, the following formula is to be used:

Below are the results for the CF-based method and the FCF-based method
at the end of year 2:

CF-based method

D 20.00
E 35.55
V 55.55
kD 6.00%
kE 12.97%
ku 11.00%
FCF-based method

V 55.55
D 20.00
E 35.55
kD 6.00%
kE 12.97%
ku 11.00%
WACC 9.81%

77
 Let us proceed to another year. At the end of year 1, proper CFs (or FCFs)
and previously calculated values of equity or company are discounted. For ex-
ample:

Below are the results for the CF-based method and the FCF-based method
at the end of year 1:

CF-based method

D 40.00 20.00
E 72.50 35.55
V 112.50 55.55
kD 6.00% 6.00%
kE 12.93% 12.97%
KU 11.00% 11.00%

FCF-based method

V 112.50 55.55
D 40.00 20.00
E 72.50 35.55
kD 6.00% 6.00%
kE 12.93% 12.97%
KU 11.00% 11.00%
WACC 9.83% 9.81%

Please note that the values of both costs of capital in use are changed and so
is the capital structure. The reference point for the calculations are ku, kE and
the relationship (with the current D and E values) is:

Let us proceed to finding the present value. The procedure as above is re-
peated.

78
 CF-based method

0 1 2
D 60.00 40.00 20.00
E 91.78 72.50 35.55
V 151.78 112.50 55.55
kD 6.00% 6.00% 6.00%
kE 13.29% 12.93% 12.97%
ku 11.00% 11.00% 11.00%

FCF-based method

0 1 2
V 151.78 112.50 55.55
D 60.00 40.00 20.00
E 91.78 72.50 35.55
kD 6.00% 6.00% 6.00%
kE 13.29% 12.93% 12.97%
KU 11.00% 11.00% 11.00%
WACC 9.70% 9.83% 9.81%

The present value of equity is then obtained by discounting the appropriate

cash flows at the different cost of capital for each year.

Similar calculations can be performed for the value of the company by dis-
counting FCFs at WACC.
The valuation can be easily applied to a company whose life span is infinite
(growing perpetuity after a period of dynamic growth). Then, the residual value
(the infinite tail of cash flows that follows the horizon date) must be incorpo-
rated at the end of the last finite period.
Finally, it is interesting to see how the APV method copes with this case.
The value of the company (unleveraged) is first calculated (FCFs are discount-
ed at ku) and then compared with the values obtained so far.

79
 V 151.78 112.50 55.55
Vu 148.44 110.77 54.95
PVTS 3.34 1.72 0.59

The present value of the tax shield is the difference between Vu and V.
Interestingly enough, the same amounts can be obtained by discounting kuxDxT
at ku.

2.3. Applying options

There are sophisticated models of a company’s financial structure based on

derivatives, namely options. Let us consider a company that is financed partly
by debt. The debt has a form of a zero-coupon bond with one year maturity T.
The nominal value of the bond is denoted by F. It means that shareholders are
obliged to pay F to the debt holders at time T, otherwise the company goes un-
der. Let us denote the value of a company at time T by V(T). Once the debt is
paid off (on the condition that the value of the company exceeds F ), the share-
holders are left with V(T) – F. Otherwise, the company goes bankrupt and will
be taken over by the debt holders. Here is a set of possible scenarios of what the
shareholders get:

It resembles payoffs of a call option. Hence, the present value of equity is the
same as a call premium. Shareholders have the right, but not obligation, to buy
back the company (from a bank or debt holders) at the nominal price of debt.
Another option-related concept that might be useful is a put call parity:

where S(0) is the present value of the underlying instrument, C and P are
call and put premiums respectively, K is the strike price, and r is a risk free rate
of return. The value of the underlying instrument is then:

There are obvious analogies with the value of the company, where the un-
derlying instrument represents the value of company V (0), known as:

80
 and a call option represents equity:

Both are entered into the put call parity and yield:

The present value of debt can be found as:

If there is no risk (the value of the company exceeds F at T), the call option
is worthless and the value of debt is represented by F. If there is some risk in-
volved, the value of the debt is decreased by the value of the put premium. In
a nutshell, it is possible that a bank will never recover the money loaned to the
company, and the bank’s exposure seems bigger than the value of assets. If the
option is deep in-the-money and volatility low, the value of the put is little.
In this context, the validity of Miller-Modigliani proposition (MM argue
that in a world without taxes, both the value of a firm and its WACC would be
unaffected by its capital structure) is worth emphasizing. It can be easily proved
that the right side of the equation below does not depend on K.

At first sight, it seems ridiculous since K is obviously there. However, there

is no contradiction because both put and call premiums change together with
the value of K and the changes balance each other out.
Seeing that the values of both options grow with risk, we are able to explain
the often observed conflict between shareholders and debt holders. The former
can be interested in carrying out risky projects, since it results in increased eq-
uity value at the expense of the value of debt (P grows too). Here is a short illus-
tration of this scenario.
Suppose a company is close to bankruptcy. At a nominal debt of 100, the
value of the company is below this number. Still, there is a chance to avoid
bankruptcy, since the debt is to be paid off in one year’s time. The owners have
the following scenarios to choose from:
1. To operate safely. The result of this is that the value of the company at
time T will reach 110. At maturity the shareholders are left with 10. If
the present value of debt is 100, then at a 10% risk free rate of return, the
value of debt will reach 100e-10%= 90.48, and the value of equity is 9.52.

81
 2. To take extreme risk. The risky activities are represented by two possi-
bilities: the value of the company may be 50 or 150 at the end of the year,
both with a 50% probability. Then, the company will either go bankrupt
(making debt holders very unhappy since then they will receive only half
of the money due), or survives and then shareholders get 50. Thanks to
the call option, the expected value for the shareholders is significantly
higher than in scenario 1.
The risky scenario may mean accepting a negative NPV project, which in
turn means a deterioration in the value of the company (high risk is reflected in
the high cost of capital, which lowers NPV). And yet, in spite of accepting bad
projects, the value of the company may skyrocket. Let us analyze a numerical
example.
Let us suppose a company is worth 100 today (out of which 80 can be allo-
cated to a risky project). The expected cash flows at the end of the year are 100.
When the cost of capital is higher than 25%, it clearly means a negative NPV. If
we let the cost of capital be 30%, then:

(we use continuous compounding to be in line with put call parity) and the
value of the company is 94.08. The value of equity can be represented as the
present value of expected cash flows:

Debt holders are left with 71.96. Let us compare the result with the safe sce-
nario: the value of the company has dropped, while at the same time the value
of equity has gone up (at the expense of debt holders though).
It is worth mentioning that the above is the structural approach to credit risk
estimation in the simplest possible case. It may also be, and often is, the starting
point for creating software used by the financial industry to value equity.

82
 2.4. Branches

We will consider a company that has a few branches specializing in very

different fields. We will inquire about the cost of capital and related problems:
the value of branches and the value of the company.

2.4.1. Branches – cost of capital

Suppose that a company conducts operations in two fields (hardware and

software). Quite naturally questions appear about the cost of capital for each
of the branches and the company. The risk of creating software and the risk
of producing hardware are not identical, and hence the costs of capital should
differ too. On the other hand all the financing is provided by the company, so
the notion of the cost of capital is viewed only with respect to the whole com-
pany.
We will restrict ourselves to two branches only for simplicity’s sake, but
the same method could be used for many more. The method is based on
CAPM. Let us start with a general property: if portfolio P is composed of
two assets A and B in proportion given by the weights:

then, the simple formula for the beta of portfolio can be applied:

Let us denote the betas of the branches (the ones which we are searching for)
by ß1A, ß2A. A stands for assets and underlies the fact that the focus is on estimat-
ing the risk of the operational activity.
Suppose that market data can be used to determine betas of similar (in
terms of size, market position, and market share) companies. If we deal
with companies traded on a stock exchange, we have to be aware of the
fact that we actually found their equity betas, ßE . Betas of the assets can
be found from the relationship below (assume ßD =0):

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 Example 19.

Suppose that (based on data from a stock exchange) the betas of two companies
(twins of our two branches) are found (by running linear regressions). They are 1.2
and 0.8 for companies 1 and 2 respectively. The companies are financed by debt at
20% and 30% respectively.Their beta of debt is 0.1.

Betas of assets can be calculated:

The betas can also be found in a different way: ROA of the branch can be
used as a proxy of the branch’s returns and regressions can be run between the
ROAs and market returns.
Now, CAPM can be followed to find the costs of capital for both branches:

Suppose the risk free rate of return is 6%, and market premium is 8%.
Then:

The next step is to find the beta and the cost of capital that reflect opera-
tional activity of the company: ßA, kA. The formula for the beta of portfolio can
be applied:

where the weights correspond to each branch’s contribution to the compa-

ny’s financial standing. The weights can be based on book values (sales, opera-
tional profit), but comparing present value of expected cash flows seems to be
more adequate (at the branch level, without interest and tax payments).

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 2.4.2. Branches – value.

Valuation of branches does not differ from the company valuation. The task
is as difficult as before. First, future cash flows have to be determined, using
historical data as the starting point, but then some extraordinary events and
projects to be undertaken by the branch have to be considered. Volatility due to
the changing market prosperity is already included in the cost of capital.
For example, it is possible to take operational profit from the previous year,
separate for each of the branches, as the base for planning profits. The growth
rate must be estimated based on either historical data or prospect of the econo-
my growth for the specific industry in particular. Then, the time horizon has to
be determined. Dynamic growth (if predicted) cannot last too long; the period
of a few years can be split into a fast growth (acquiring new markets) and stable
growth phases (natural growth of the market). Generally, an infinite life span
for each of the branches is assumed, with the tail of cash flows beyond the hori-
zon date represented by a growing perpetuity. Still, we are not in the position to
find out how the capital structure affects the value of each of the branches.

Example 20.

Operational profits of 400 and 300 are predicted at the end of the year, and growth
rate is 3% for both branches. The cost of capital is 11% and 15% respectively. The
company pays 30% tax. Depreciation is ignored.

The value of growing perpetuities is as follows:

These numbers help to determine the value of the company (V = 5250) and
each branch’s share:

Now, the cost of capital of company can be calculated:

85
 The value of the company can be calculated again (the 3% growth rate is the
same for each branch, so it applies to the whole company as well):

Allowing different growth rates for each of the branches makes the situation
much more complicated, but more realistic too (different industries may natu-
rally grow at a different rates).

Example 21.

Suppose that the growth rate of the second branch is 5% instead of 3% (as before).
The growth of the first branch remains at 3%.

The value of the second branch is found (the branch is still financed by eq-
uity only):

then the value of the company V = 5600, new weights, and the cost of capital
become:

Here is an attempt to set the growth rate for the whole company. The first
step is to find the profits in the consecutive years. After the first year we get:

and after year two:

86
 Clearly the whole company does not grow monotonously, if the branches
grow at different speeds. Hence Gordon’s model cannot be used to calculate
its value. Another problem is that the share of each of the branches will change
too, and so will the cost of capital, . Having to analyze each of the branches sep-
arately seems inescapable – the financing issue is the exception (this is provided
for the company as a whole). The problem resembles the one related to allocat-
ing a part of the fixed costs of the company to specific products, commissions,
or production units. In the same spirit, financing can be proportionally allocat-
ed to different branches. Financing, however, affects the value of the company,
which creates a logical loop.

2.4.3. Debt being considered

The task of taking debt into account is simple on one condition: the capi-
tal structure is fixed. Then, the value of each of the branches can be calculated
separately (first the cost of equity, WACC, the total value of the company, and
then the values of equity and debt). The branches will grow as planned (with
3% and 5% rates), so the debt allocated to each of the branches will grow at the
same pace.
Let us consider the situation where debt is given– this will give us an oppor-
tunity to analyze the problem of allocating costs to branches.

Example 22.

Two branches are characterized by the costs of capital (unleveraged) of 11%, 15%
and growth rates of 3%, 5% respectively. They generate operational profits of 400
and 300 (zero depreciation is assumed, but if there is a need, it can be easily incor-
porated). The tax rate is still 30%. The company is financed by 1500 of debt, and
pays 7% APR to service the debt.

The values of the branches have already been calculated (without debt),
hence the weights are 62.5%, 37.5%. Let us accept them temporarily. It makes it
easy to calculate interest, net profits and CF.

87
 Branch 1 2 Total
ku 11% 15%
g 3% 5%
EBIT 400.00 300.00
FCF 280.00 210.00
Vu 3500.00 2100.00 5600.00
Weights 62.50% 37.50%
The amounts will be corrected as soon as the values of the branches (fi-
nanced by debt) are found.
First, the changing levels of debt must be taken into consideration when
calculating cash flows. In the growing perpetuity model, the debt grows every
year by g:

Branch 1 2 Total
D 937.50 562.50 1500.00
Interest 65.63 39.38
EAT 234.06 182.44
CF 262.19 210.56
3% of 937.50 is added to the net profit generated by the first branch. The same
procedure is applied to the other branch.
The values can be found by solving (numerically) a loop: D and E determine
the capital structure, so they are needed to calculate kE, but kE itself requires E
as an input. We still use the formula known from precious calculations:

Branch 1 2 Total
D 937.50 562.50
E 2 949.22 1 790.63
V 3 886.72 2 353.13 6 239.84
kE 11.89% 16.76%
Weights 62.29% 37.71%
Now, the new weights reflecting the value can be found. The weights are
used to split the 1500 debt between the branches. Consequently, all the oth-
er values will change. The alterations are not significant, as the initial weights
were close to the final ones.

88
 Branch 1 2 Total
ku 11% 15%
g 3% 5%
EBIT 400.00 300.00
Weights 62.26% 37.74%
D 933.96 566.04 1 500.00
Interest 65.38 39.62
EAT 234.24 182.26
CF 262.25 210.57
E 2 951.30 1 788.68
V 3 885.26 2 354.72 6 239.98
kE 11.89% 16.77%

2.4.4. Valuing a branch – structural approach

A company starting a new project is similar to adding a branch: what is

faced is not only specific operational risk but also common financing. In this
context, we have the basket option. Let us consider the following example. It
mimics the one from Chapter 2.3 and represents the structural approach to eq-
uity valuation.

Example 23.

Take a company that is financed partly by debt. The debt has the form of a zero-
coupon bond with one year maturity T. The nominal value of the bond (80) is de-
noted by F whichmeans that shareholders are obliged to pay F to the debt holders
at time T, otherwise the company goes under. Let us denote the value of the com-
pany at time T by V(T). Currently V is 100 and is expected to be 150 or 60 at the end
of the period. In addition to this, there is also a new project (branch) the company
is going to implement. The project requires an investment of 50 (denoted as B(0)),
but its value may be 80 or 30 at the end of the period. The project is partly financed
by debt with the face value (denoted as D) of 20. We are assuming that the project
(branch) cannot be a separate company, since the bank would not lend money for
such a venture.

89
 We will compare and contrast two ways of valuing the company: first the
company will be treated as the sum of two call options, and then second as the
call option on the sum (V + B). In terms of the value for the shareholders, here
are two sets of possible scenarios:

1.

versus:

2.

The hypothesis is that the call option on the sum is worth less than the sum
of the two call options.
We have demonstrated in Chapter 2.3 that the value of a company’s equity
is comparable to the value of a call option on the value of the company. The op-
tion’s strike price is the amount of debt to be repaid at maturity. This approach,
combined with the fundamental equality between put and call (known as put
call parity), yields:

where a call option (C) represents equity.The present value of debt can be found
as:

and the company value (represented by S) = the value of the call option + the
present value of debt at the risk-free rate – the value of the put option.
The value of equity for the two cases, calculated in accordance with the ap-
proach presented at the beginning of the chapter, is as follows: the values of the
two calls in scenario 1 are 35.5 and 31.9, whereas the value of the call in scenar-
io 2 is 59.9 (assuming a 10% risk-free rate and 30% cost of equity).
Interestingly enough, the call option on the sum is worth less than the sum
of the two call options. This means that for specific situations, when a project is
implemented within the company structure (i.e. as a branch), it adds less value
to a company than if the project was separate from the company structure (car-
ried out as a separate company). It is easier to finance, though. This is caused
by the fact that in the second scenario the risk of defaulting (the event when the
creditors find themselves the unwilling owners of the company) has been diver-
sified away.

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 2.5. Mergers and acquisitions

2.5.1. Basics of M&A

Before proceeding with a financial analysis of an M&A example, a crucial

difference between merger and acquisition terms need to be underlined. This
clarification is not only important to understand the core idea of these com-
plex concepts, but it also has implications for judicial and tax matters.
An acquisition can be compared to a development of an existing product
line or starting a completely new venture – it is the purchase of an existing,
well-formed company (i.e. the youtube.com purchase by google.com). Dur-
ing this process, assets of an offered company are transferred to the acquirer.
The purchasing organization takes actual control over the other company. In
M&A practice two kinds of acquisitions are observed – a friendly takeover –
when the seller, unforced and actively, participates in the whole process, and a
hostile takeover – when the change of ownership takes place against the will
of the owners.
A merger is a process of combining two or more entities into one, through
a purchase, acquisition or pooling of interests. The merger act is usually un-
dertaken between companies, which perform as partners. The word “part-
ners” should be crucial when discussing this form of business co-operation.
As partners, both companies involved in merger share common risk and pos-
sible gains.
Fusion and merger are two different categories due to legal provisions. Fu-
sion is a combination of two legal entities, often with similar potential. Com-
panies, which want to fuse, dissolve their legal identities in order to create a
new one – in practice, often the economically stronger company sustains its
legal body. In case of a merger both companies maintain their separate legal
identities.
Mergers and acquisitions are only two types of a wide range of corporate
marriages used in the modern business environment. These two forms are the
most distinctive and complex operations as the scope of changes in both par-
ties are significant in terms of organizational structures and human resources.
Most generally we can classify M&As as:
1. Strategic – carried out to take advantage of prospective synergy effects
and as a part of long-term development strategy.
2. Occasional – used as ad-hoc instrument of raising a company’s value
by purchasing undervalued companies.

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 Another typology includes:
1. Horizontal M&A – in which companies operating and competing in the
same sector (competitors) are combined to create a new entity. The fun-
damental objective of such integration is to have active influence on price
creation.
2. Vertical M&A – in which suppliers merge with buyers or distributors.
The basic reason is to eliminate costs of searching for prices, contract-
ing, payment collection and advertising – in simple terms, broadly under-
stood synergy effects. Unlike horizontal mergers, which have no specific
timing, vertical mergers take place when both firms plan to integrate the
production process and capitalise on the demand for the product.
3. Conglomerate M&A – in this type of merger both companies concerned
(usually operationally unrelated) usually maintain their autonomy and
have a large amount of sovereignty in their decision-making processes.

Vertical Mergers are divided into:

• Upstream – where companies integrate suppliers.
• Downstream – where a company expands its distribution channels with
the help of another specialized company.
Conglomerate mergers are divided in the majority of literature into:
• Financial conglomerates – where a stronger company focuses on finan-
cial flows within a conglomerate and participates in strategic decisions.
• Managerial conglomerates – where the management of a stronger com-
pany not only participates in the strategic decision-making process but
also actively controls decisions at the operational level. This is a so-called
deep integration.
• Concentric M&A – companies try to diversify the branch risk and
strengthen the internal development through this type of co-operation.
There are three basic types of concentric mergers: product-based (merger
of companies with substitute products or from similar branches), geo-
graphical-based (concentration of companies from one geographic area),
and varied concentric merger and acquisition (bargain-based merger of
unrelated companies).
Very seldom does only one type of fusion take place. Usually it is matrix of
several types, which is usually a function of the market situation and strategic
objectives.
The procedures and techniques that are currently known under the term
M&A are as old as the private sector. The first alliances occurred in XV and
XVI century but the peak of M&A activities was observed in XX century. The
examination of historical events and literature on the subject empirically proves
that, just as we observe waves of growth in the market, we can clearly notice

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ups and downs in integration processes – we refer to these events as mergers
waves. Researchers on the subject and practices observed five major waves in
last century.
First wave – called the century turn wave rose during 1893 – 1904. The
United States of America was a very specific market at this time because, due
to large amount of economical liberty, many companies undertook horizontal
acquisitions. This resulted in many monopolies (US Steel Corporation (now
USX), American Tobacco Company or Standard Oil of New Jersey (now Exx-
on)).
The second period of dynamic growth of M&As occurred from 1916 until
1929 and was a direct consequence of economical transformation after World
War I. This wave resulted in a new market form – oligopolies. Oligopolies con-
centrated market leaders’ capital in particular branches and sectors, which in
fact created impossible to overcome barriers of entry into the particular sector.
This second wave was stopped during the Great Depression of 1929.

During the nineteen sixties a new structural form was created in the shape
of conglomerates. This corporate identity became popular since it diversified
operational risk.
The fourth wave occurred during the early nineties. During this wave a large
number of transactions was completed compared to previous periods, but in
terms of capital flow it was characterised by small volume. A significant number
of acquisitions during this time were attributed to hostile takeovers.
Starting from the mid-nineties the fifth wave was observed. Its rise was
stimulated by globalization processes and became the impulse for the creation
of Multi National Companies (MNC). 2000 was the year of a historical peak of
mergers and acquisitions both in terms of number of transactions and their val-
ue. During this boom, the value of all M&A deals reached four billion dollars.
Due to the IT bubble burst in 2001, the volume and the value of transactions
drastically plummeted.

2.5.2. Reasons for M&A

A major motive for mergers and acquisitions is the realization of the synergy
effects in order to raise the efficiency in the company and to lower costs. These
synergies can be achieved in many ways. Firstly, production-economical syn-
ergies can be achieved by raising the economies of scale, since mass produc-
tion decreases the unit costs and therefore completes the rationalization gains
through staff reductions. Moreover, M&As give access to other markets and fa-
cilitate the creation of market entry barriers.

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 Reasons for Mergers or Acquisitions can be so fundamentally different; the
literature on the subject divides this rationale into three main groups.
1. Classical motives
A classic motive of M&A seeks its justification in the power of the mar-
ket. By merging or acquiring competitors from the same sector the com-
pany reduces competitive pressure and wins advantages in a price war. If
a company has a monopoly position, the competition completely disap-
pears and the higher prices will be forced onto the market.
2. Neoclassical motives
When a company reaches its development frontier – either in a single
market or in a product category - management must decide on the future
strategy. M&As that happen then are described as the neoclassical ap-
proach. The main specific reasons are: operational efficiencies arising
from the economies of scale, reduction in overall costs from the joint
production of complementary products, cost cuts – this motive has be-
come mostly quoted as raison d'être, market power effects,development
acceleration, and bargain search – a company may seek an acquisition
because it believes its target is undervalued, and thus it is a bargain –
a good investment capable of generating a high return for the acquiring
company's shareholders.
3. Managers motives
Mergers and acquisitions are also often triggered by managers’ motiva-
tions. There are a few types of such transactions: empire building syn-
drome (strive to grow companies as their salaries, non-wage profits, and
both business and social position depend on company size), self-realisa-
tion motive (an attempt to fully show one’s skills and knowledge), risk
diversification (the motive is linked to financial tensions and bankruptcy
possibility), and job sustention motive (a threat of evil acquisition by an-
other company).

From a financial point of view M&A are motivated mostly by:

1. Cost reduction.
2. Better exploitation of the potential of a company.
a) Typically, a company has an excess of cash but suffers from a short-
age of interesting projects to carry out.
b) A company cannot use the tax shield.
c) Companies with complementary resources.
3. Diversification. It is doubtful in the case of public companies – investors
can do that themselves. In case of small companies the reduction of risk
is likely to happen.

94
 4. Credit rating. Bigger companies may apply for bigger loans and easily
serve the existing loans.
5. Better management. Taking over another company is the simplest way to
replace an ineffective management team.
6. Increased EPS. It is doubtful whether this should be the main reason for
a merger.

2.5.3. Carrying out a merger

Mergers and acquisitions should be seen as an ordinary investment and

therefore its financing should be structured under the same rules as any other
investment. There are three basic forms of financing M&A transactions – the
acquisition by cash i.e. own resources, debt and the acquisition by stock issue.
Basically the decision about a stock swap or a cash payment influences the in-
terests of both shareholder groups – groups from the acquiring and the acquired
company. The issue of new shares to finance the purchase has usually a nega-
tive impact on the stock prices of the company which is buying. This fact is
based on the assumption that the board of the acquiring company is willing to
pay in shares if they know that these shares are overvalued.
The acquirer may repurchase its own stock or issue new stock. The key
question, however, concerns the so-called exchange rate – how many shares of
a new company (or the one that it acquires) the shareholders of a company that
is being taken over will receive per each of their own current shares. The ex-
change rate may be determined in many different ways. Let us start with an ef-
fective market example.

Example 24.

There are 3000 shares of company A in trade and they are priced 20 each. There
are 500 shares of company B, each priced at 40.

1. One can rely on the market value of companies: A has the value of
60000, B of 20000. After the acquisition, B shareholders should have
25% shares of the new company. If A company is to issue new stock,
they should issue 1000 shares and offer 2 A shares per each B share. If
the existing shares are to be offered, there should be 750 shares in circu-
lation and 1.5A/B exchange rate should apply.

95
 2. Relying on share prices leads to the same result. Comparing prices indi-
cates that 2 A shares should be offered per each B share.
3. Relying on EPS or profits level may lead to completely different conclu-
sions.
Typically, the exchange rate that is eventually negotiated is higher than the
one resulting from the comparison of the values of the two companies. It is the
shareholders of the company that is acquired who often benefit from the trans-
action. The example above does not take into account the increased post-merger
value of companies. It is also important to sieve out the reaction of the market
that precedes the planned take-over. The share prices may have discounted the
planned post-merger benefits.

2.5.4. Hostile takeovers

Hostile takeover transactions are usually finalized through cash payments.

LBO (leveraged buyout) is a case when a group of investors acquires a company
in a transaction financed largely by debt. Immanent risk of LBOs lies in the fact
that such transactions are heavily financially leveraged. What is more, the cash
often comes from junk bonds issued to finance the acquisition. This addition-
ally increases risk. Hence, the bonds need to offer an exceptionally high rate
of return. Ultimately, the acquired company is usually withdrawn from a stock
exchange, and radical cost reduction schemes are implemented. The economiz-
ing is enforced by high interest payments on the bonds. All in all, LBOs can
be beneficial for the acquirer (they benefit from the cost reduction scheme) and
shareholders of the acquired company (the bids are usually higher than the cur-
rent market price).
Companies (management in particular) that want to avoid being taken over
use a range of defensive strategies: restructuring leading to a high tax lever-
age, or changes in their statute (high majority of votes needed to approve of a
merger, “golden votes” – a privileged vote, “poison pills”- provision that allows
the stockholders of a firm that is taken over by another firm to buy shares in the
second company at a reduced price, or issuing preemptive rights – giving stock-
holders the right to purchase any new shares sold by the firm).

2.5.5. Formal issues

Anti-monopoly regulations that exist in many countries may be an obsta-

cle in the M&A process. Political interventions or social protest may also take
place, if companies that are considered “national assets” are at stake.

96
 In terms of accounting rules, depending on the type of acquisition, the trans-
action can be executed through so-called “pooling-of-interests-method” or
“purchase method”. In the former case, the balance sheets are simply added.
In the latter case, there usually appears a difference between the book value of
assets and the price. The good will (as it is called) is included in the books and
subject to depreciation. The approach thus has tax effects (on net profits only),
but does not affect the cash flows.

Example 25.

The SH company is composed of two operational units: the software unit (SU) and
the hardware unit (HU).The company is to operate for three years with sales of 200,
240, 270 for the SU and 150, 120, 100 for the HU. Variable costs are 50% of sales.
The units require the upfront investment of 120 and 60 respectively. Straight line de-
preciation is assumed. The cost of capital (unleveraged) for the units is 12% (SU)
and 10% (HU). The company pays 30% corporate tax.

The example is to illustrate a problem that is both a benefit and handicap

of companies that have just merged: how to exploit the synergy effect, how to
share costs, and how to use debt to finance the branches. Here we will limit
ourselves to an attempt to allocate fixed costs. The same approach can be used
to allocate any costs (debt, retained earnings) that are hard to classify as belong-
ing to one branch only.

Hardware Software Total

Year 1 2 3 1 2 3 1 2 3
Sales 200 240 270 150 120 100 350 360 370
Variable cost 100 120 135 75 60 50 175 180 185
Fixed cost 50 50 50
Depreciation 40 40 40 20 20 20 60 60 60
EBIT 60 80 95 55 40 30 65 70 75
Tax 18 24 29 17 12 9 20 21 23
EAT 42 56 67 39 28 21 46 49 53

Having the initial book values, one can calculate cash flows and the value
of equity (which in this case is tantamount to the value of the branch/company,
since the company is financed by equity only).

97
 Hardware Software Total
Year 1 2 3 1 2 3 1 2 3
Sales 200 240 270 150 120 100 350 360 370
Variable cost 100 120 135 75 60 50 175 180 185
Fixed cost 50 50 50
Depreciation 40 40 40 20 20 20 60 60 60
EBIT 60 80 95 55 40 30 65 70 75
Tax 18 24 29 17 12 9 20 21 23
EAT 42 56 67 39 28 21 14 15 16
CF 82 96 107 59 48 41 74 75 76
kE 0.12 0.12 0.12 0.10 0.10 0.10 0.11 0.11 0.11
Year 0 1 2 0 1 2 0 1 2
E 226 171 95 124 78 37 349 248 132
wF 0.65 0.69 0.72 0.35 0.31 0.28
wF (the ratio of each branch’s (F) value to the value of the whole company) be-
comes a key component: it is used to find the cost of capital for the company
and allocate fixed costs.
The loop is closed when the cells for fixed costs (in bold) are filled (it is
wF’s proportion of the total fixed costs for a given year). This in turn affects E,
and then wF. As a result, one can appropriately and fairly allocate fixed costs to
the branches. This relatively easy exercise may be followed when trying to allo-
cate to the branches any other resources they share: debt, extra revenues.

Hardware Software Total

Year 1 2 3 1 2 3 1 2 3
Sales 200 240 270 150 120 100 350 360 370
Variable cost 100 120 135 75 60 50 175 180 185
Fixed cost 32 34 36 18 16 14 50 50 50
Depreciation 40 40 40 20 20 20 60 60 60
EBIT 28 46 59 37 24 16 65 70 75
Tax 8 14 18 11 7 5 20 21 23
EAT 20 32 41 26 17 11 46 49 53
CF 60 72 81 46 37 31 106 109 113
kE 0.12 0.12 0.12 0.10 0.10 0.10 0.11 0.11 0.11
Year 0 1 2 0 1 2 0 1 2

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 Hardware Software Total
E 169 129 73 96 59 28 264 189 101
wF 0.64 0.69 0.72 0.36 0.31 0.28

2.6. Case study – valuing a company

L-ectron Ltd. is a start-up that is beginning to produce electronic devices.

Sales of 1800 EUR for five years and then 500 EUR for another three, with
costs reaching 60% of sales are predicted. The equipment needed for the start
costs 1000 EUR, and it is 50% financed by a 5-year loan taken at 12% APR.
The costs of equity (which finances the rest) is 34%. Some more equipment will
have to be bought during the first three years – each year 100 EUR is planned
to be spent. The equipment is subject to straight line depreciation schedule. The
company pays 25% corporate tax. What is the value of the company?
As the above question suggests, the purpose of the case is to valuate the
company. We will use techniques described in the two previous chapters. Cal-
culating cash flows is relatively easy.

Year 1 2 3 4 5 6 7 8
Operational profit 720 720 720 720 720 200 200 200
Depreciation 200 220 240 260 260 60 40 20
EBIT 520 500 480 460 460 140 160 180
Interest 60 48 36 24 12
EBT 460 452 444 436 448 140 160 180
Tax 115 113 111 109 112 35 40 45
EAT 345 339 333 327 336 105 120 135
Investment 100 100 100
Loan installments 100 100 100 100 100
CF 345 359 373 487 496 165 160 155
Tax on EBIT 130 125 120 115 115 35 40 45
NOPAT 390 375 360 345 345 105 120 135
FCF 490 495 500 605 605 165 160 155
Debt installment
160 148 136 124 112 0 0 0
plus interest

99
 For the time being, the cost of capital of an unleveraged company ku is as-
sumed to be 25%. As a matter of fact the cost of equity kE is known, but the val-
uation is recursive and is going to start from the year 8 – the cost of equity then
is still a mystery.

Year 0 1 2 3 4 5 6 7 8
Operational profit 720 720 720 720 720 200 200 200
Depreciation 200 220 240 260 260 60 40 20
EBIT 520 500 480 460 460 140 160 180
Interest 60 48 36 24 12
EBT 460 452 444 436 448 140 160 180
Tax 115 113 111 109 112 35 40 45
EAT 345 339 333 327 336 105 120 135
Investment 100 100 100
Loan installments 100 100 100 100 100
CF 345 359 373 487 496 165 160 155
Tax on EBIT 130 125 120 115 115 35 40 45
NOPAT 390 375 360 345 345 105 120 135
FCF 490 495 500 605 605 165 160 155
Debt installment
160 148 136 124 112 0 0 0
plus interest
D 500 400 300 200 100 0 0 0
E 1071 1043 984 886 640 314 227 124
G 304 278 245 203 149 77 61 36
Gu 355 314 268 215 153 77 61 36
Vu 1514 1402 1258 1072 735 314 227 124
Vtotal 1869 1716 1525 1287 888 390 288 160
kD 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12
kE 0.30 0.29 0.28 0.27 0.27 0.25 0.25 0.25
ku 0.25 0.25 0.25 0.25 0.25 0.25 0.25 0.25
WACC 0.23 0.23 0.24 0.24 0.24 0.25 0.25 0.25
V 1571 1443 1284 1086 740 314 227 124
Tax 0.25

100
 The formulae in the cells for E, G, V, WACC, kE is in accordance with the
theory shown in the two previous chapters. The key formulae are presented be-
low again.

For example, the unshaded cells for E and kE include:

Year 0 1
Operational profit 720
Depreciation 200
EBIT =C2-C3
Interest =12%*500
EBT =C4-C5
Tax =25%*C6
EAT =C6-C7
Investment 100
Loan installments 100
CF =C8+C3-C9-C10

101
 Year 0 1
Tax on EBIT =25%*C4
NOPAT =C4-C12
FCF =C13+C3-C9
Debt service =C10+C5
D 500 400
E =(C11+C17)/(1+B23) =(D11+D17)/(1+C23)
G =(C7+C18)/(1+B23) =(D7+D18)/(1+C23)
Gu =(C12+C19)/(1+B24) =(D12+D19)/(1+C24)
Vu =(C14+C20)/(1+B24) =(D14+D20)/(1+C24)
Vtotal =(C2-C9+C21)/(1+B24) =(D2-D9+D21)/(1+C24)
kD 0,12 0,12
=B24+(B16/B17)* =C24+(C16/C17)*
kE
(1-$B$27)*(B24-B22) (1-$B$27)*(C24-C22)
Ku 0,278988 =B24
=B22*(1-$B$27)*B16/ =C22*(1-$B$27)*C16/
WACC (B16+B17)+B23*B17/ (C16+C17)+C23*C17/
(B16+B17) (C16+C17)
V =(C26+C14)/(1+B25) =(D26+D14)/(1+C25)
Tax 0,25

The table above shows formulae for the cells in columns for year 0 and 1.
The table starts in the top left corner of the spreadsheet. This is cell A1. The
unshaded cell in the spreadsheet is represented by B17.
The final maneuver that must be undertaken is to use the GoalSeek tool
and change kE. The one resulting from our calculation appears to be 30%. We
know, however, that it should be 34% – the number from our initial calcula-
tions based on year 0 data. As a matter of fact, it is kU that must be changed
in such a way that kE is 34%. After the change, the value of the company is fi-
nally known: E = 977, V = 1477.

102
 Year 0 1 2 3 4 5 6 7 8
Operational profit 720 720 720 720 720 200 200 200
Depreciation 200 220 240 260 260 60 40 20
EBIT 520 500 480 460 460 140 160 180
Interest 60 48 36 24 12
EBT 460 452 444 436 448 140 160 180
Tax 115 113 111 109 112 35 40 45
EAT 345 339 333 327 336 105 120 135
Investment 100 100 100
Loan installments 100 100 100 100 100
CF 345 359 373 487 496 165 160 155
Tax on EBIT 130 125 120 115 115 35 40 45
NOPAT 390 375 360 345 345 105 120 135
FCF 490 495 500 605 605 165 160 155
Debt installment
160 148 136 124 112 0 0 0
plus interest
D 500 400 300 200 100 0 0 0
E 977 964 922 842 614 301 220 121
G 279 258 230 193 143 73 59 35
Gu 333 296 254 205 147 73 59 35
Vu 1415 1320 1194 1027 708 301 220 121
Vtotal 1749 1617 1448 1232 856 374 279 156
kD 0.12 0.12 0.12 0.12 0.12 0.12 0.12 0.12
kE 0.340 0.33 0.32 0.31 0.30 0.28 0.28 0.28
ku 0.279 0.28 0.28 0.28 0.28 0.28 0.28 0.28
WACC 0.26 0.26 0.26 0.27 0.27 0.28 0.28 0.28
V 1477 1364 1222 1042 714 301 220 121
Tax 0.25

103
 III. Risk

The risk notion involves uncertainty with regard to future events. We are
aware of the fact that future cash flows cannot be precisely predicted. Suppose,
we consider cash flows in one year’s time – there is a range of numbers that de-
pend on various factors. Thus, we typically use expected values, and risk is seen
as the probability distribution of these values. The distribution can be measured
and modeled (taking into account the fact that we will be able to take decisions
after certain scenarios materialize with the use of decision trees technique).

3.1 Measures of risk

3.1.1. Variance and the like

Variance is the most commonly used measure of risk (or its square root –
standard deviation). It measures deviations from the expected value. For an un-
known future value denoted by X, its expected value is defined as:

where X1, X2, ... are the consecutive values of random variable X (in consecutive
scenarios), and p1, p2, ... are the corresponding probabilities. Variance (square
root of standard deviation) is given by the formula:

Example 26.

For simplicity, let us consider just two scenarios of future returns. Here are the
data:
Scenarios Returns Probabilities
1 30% 0.4
2 -15% 0.6

104
 Both the expected value (3%) and standard deviation (22.05%) can be easily
calculated. Suppose that a more precise analysis of the project makes us verify
the return in the optimistic scenario, which turns out to be 40% instead of 30%.
The expected value grows to 7%, and standard deviation to 26.94%.
The result contradicts our intuition, since the modified project is not any
riskier. The deviations are in fact bigger, but the returns more favorable. We ac-
cept that risk is defined as the measure of deviations but the intuitive definition
of risk says that it is exposure to loss. To capture the contradiction, a modifica-
tion of variance notion is introduced and called semi-variance. The formula is
similar, but only results represented by the scenarios in which returns are lower
than the expected one are calculated:

Example 27.

In this example, semi-standard deviation is 13.94% for returns of 30% and -15%,
and 17.04% for the modified returns (40%, -15%).

The attempt to enhance variance as measure of risk was evidently a failure.

In spite of rejecting the positive scenario, the variance grows which still does
not agree with our intuition. The reason is simple: after the modification the ex-
pected value grows, and then so does the semi-variance.
Another attempt to improve the risk measure is to reject the expected value
as a reference point. Let us use another fixed target rate (risk free rate, for ex-
ample) and calculate semi-variance (below target) again:

Example 28.

Take the target rate k = 10%, then b = 19.36%, whose value does not change if 30%
return is replaced with 40%. If, however, the unfavorable return changes into even
less favorable (for example, it changes from –15% to –20%), the semi-variance (be-
low target) falls (to 23.34%). Now, the model works as designed.

Another philosophy often adopted to measure risk is based on setting cer-

tain limits beyond which returns (or value of investment portfolio, or the level
of net profit) become unacceptable. Setting the limit is up to an individual in-

105
vestor. Even then, however, there is a hard floor determined by the economic
and financial circumstance the investor cannot ignore.

Example 29.

Suppose a company exports goods worth 100 000 EUR. Their costs are 320 000
PLN at most, but shareholders demand 16% return on the equity whose value is
200 000 PLN. The company has bought a put option with a 3.8 PLN/EUR strike. If
the exchange rate falls below the strike, the company will exercise the option, sell
euros at the rate, and receive 380 000 PLN, which will cover both the costs and the
dividend (there will be 20 000 PLN left)

Let us suppose, however, that the options the company has bought have
a strike of 3.4. Then the final number becomes negative (-20 000 PLN). The
number that distinguishes the unfavorable results (in this case it is simply loss)
from the good ones could be a measure of risk. The notion of risk presented
here is quite flexible. Value at Risk (VaR) exemplifies the use of the concept in
practice.

3.1.2. Value at Risk

VaR is a measure of risk that is becoming more and more popular. Its focus
is on risk as a loss, but it also takes into account probabilities with which the
event (loss) will occur.
When VaR is defined, first it is usually assumed that future returns are nor-
mally distributed. The distribution is determined by a function denoted by N(x)
(cumulated normal distribution). In spreadsheets the function is available as:

NORMDIST(x).

The function yields the probability that a random return is lower than x. The
underlying assumption is that the expected value is zero and standard deviation
is 1.

106
 Example 30.

Let us suppose that some analysis proves that the expected return is 25%, and
standard deviation is 20%.

We pose the following question: what is the probability that the return we
are facing in the nearest period of time will be lower than 30%? Let us calculate
x from the formula below:

And then we find:

If the return we mean is based on the share price (today the price is 57), then
it can be said that with 60% probability at the end of the period the price will
fall below:

or with 40% probability will go above 74.10.

The method applied above can also help answer the important question:
what is the limit such that the future return (or asset value) will fall below the
limit with a given probability (e.g. 5% or 1%)?
The number (limit) sets the loss which is the value at risk.

VaR at the 95% confidence level is such a number that probability of loss
lower than VaR is 95%.

VaR can be easily found with the use of the GoalSeek tool. The demanded
probability of 5% corresponds to the return of – 8%. In this case,the limit price
is 52.51. Buying at 57 and selling at 52.51, we incur a loss of 4.49.

Should the confidence level be 99%, VaR is:

107
 It means that with the probability of 1% the price of the asset will fall below
44.73, and the loss will be lower than 12.27 (with 99% chance).
Experiments with the use of spreadsheets are easier if the inversed normal
distribution function is used:

NORMSINV(p)

It calculates the value of x at a given probability:

.
and then the border value of the asset, and finally VaR:

where V(0) is the initial value of the asset.

The numbers in the formulae below correspond to 95% and 99% confidence
levels.

In many cases (such as share prices or exchange rates, where Black-Scholes

model can be used) VaR calculations are fairly simple. Suppose the underlying
asset is a currency, and a company is worried that the exchange rate may fall
below certain level. At the current exchange rate of S(0), the VaR relevant ex-
change rate at time tis:

where a is the difference between interest rate for the two involved currencies
(PLN and EUR).
VaR, simple as it is, has also its disadvantages. One needs to know and
assume a certain distribution function. Another disadvantage is related to
portfolios and risk diversification. It turns out that it is possible to find two
instruments such that the risk of the portfolio (composed of the two) is high-
er than the risk of individual instruments. It contradicts the common sense
and the idea of diversification. Luckily, such examples are quite rare.

108
 3.2. Risk management in a company

3.2.1. Risk in a company

Companies are exposed to a range of risk factors. Let us focus on those

whose adverse influence on the value of companies can be prevented with the
use of financial instruments.
The factors are as follows:
• interest rate
• exchange rates
• prices of materials
• prices of our products
In certain circumstances, companies may be protected against unfavorable
changes in their product prices with the use of futures contracts. It is rare, how-
ever – the lack of availability of such futures being the main obstacle. Protection
against changes in materials prices (even in the case of crude oil prices) is also
difficult due to differences between the size of futures contracts and quantities de-
manded by most of companies.
Exchange rate risk is faced by both exporters and importers. The importer is
worried that the foreign currency may appreciate – the foreign goods get more
expensive in the local currency, the exporter, on the contrary, finds depreciation
unattractive. As it will be shown, the relationship between net profit and the ex-
change rate is given by a linear function (assuming flat tax rates).

Example 31.

A company has sales of 100 000 PLN.A part of costs is incurred in dollars (10 000
USD), the rest in PLN (30 000). The company pays 30% tax. At 4 PLN/USD ex-
change rate the net profit of the company is 21 000 PLN.

Sales 100000
Exchange rate 4
Costs-USD 10000
Costs-PLN 30000
Total costs 70000
EBIT 30000
EAT 21000

109
 By changing the exchange rate we can easily model the relationship between
net profit and the exchange rate.

Example 32.

An exporter’s sales are 25 000 USD, and costs 70 000 PLN. The tax rate is 30%.
The net profit at 4 PLN/USD exchange rate is again 21 000 PLN.

Sales USD 25000

Exchange rate 4
Sales 100000
Costs 70000
EBIT 30000
EAT 21000

The linear relationship between net profits and exchange rate still can be
observed. The line, however, is much steeper, since this time the whole sales
amount is exposed to exchange rate risk.

110
 When it comes to the interest rates risk, companies are typically worried
about increasing rates which mean higher interest payments. There are cases
when companies have an excess of cash that needs to be deposited in banks or
invested in bonds. The situation is rare or temporary – in the long run a compa-
ny should be able to reinvest their profits and finance its own operations, other-
wise it contradicts the purpose of setting up the company in the first place.
An increase in interest rates triggered by inflation can affect profits only to
some extent as the change concerns both sales and costs.

A special kind of risk (gap risk) concerns mostly banks.

Example 33.

Imagine a very simple situation of a bank which accepts a deposit (100 deposited
for one year) and loans the amount for five years. For simplicity, both deposit and
loan are zero-coupon bonds.

111
 Assets Liabilities
100 100
r 10% 8%
Time 5 1
FV 161 108

Now suppose the interest rate goes up by 200 basis points. The future values
will not change as they are the nominal values of the bonds, but the present val-
ues do change.

Assets Liabilities
FV 161 108
r 12% 10%
PV 91.38 98.18

The value of the assets falls much lower than the value of the liabilities (mar-
ket values, not the book ones), which affects the market value of the bank. As
it can be noticed, the gap analysis focuses on the value of rate sensitive assets
and rate sensitive liabilities with different maturities being the main problem. In
practice, the banks positions are much more complicated as they are composed
of millions of such transactions. Still, the problem remains the same though it is
harder to cope with.

3.2.2. Risk management versus value

Does risk management add value?

The simplest answer is: lower risk translates into a lower cost of capital,
hence a higher present value of cash flows.

Imagine a company that has been exposed to a given exchange rate risk for
years. Its profits naturally fluctuate reflecting the ups and downs of the core op-
erations. The fluctuations may be fortified or weakened by the changes caused
by jumps in and cycles of the exchange rate. Imagine the company starts hedg-
ing the risk. An effective market should notice that and the stock of the com-
pany should be priced higher (due to the lower required rate of return implied

112
by lower risk due to hedging). Or at least, it should be easier to issue new stock,
since new shareholders may appreciate risk management strategies and accept
higher prices. The same applies to an attempt to take new loans – the terms
(size, interest rate) should now be more beneficial.
On the other hand, a lack of strategies that provide stability may have disas-
trous effects for a company. Companies facing bankruptcy quickly lose buyers
who are afraid of facing servicing problems. Conflicts between shareholders
and debt holders are likely to happen too. Such a conflict may result in reject-
ing reorganization plans – shareholders may conduct aggressive policies in or-
der to use their position, and increase the value of equity by carrying out risky
projects. Due to restrictions imposed by banks, the company may be forced to
reject good projects that are recognized as too risky by the bank.
The last argument in favor of risk management concerns tax payments.

Example 34.

There are two tax brackets: 20% tax is paid on income up to 30 000, and 30% tax is
paid on income above 30 000. Let us suppose a company expects profits of 25000.
If the profits are exposed to fluctuations, they might be 10 000 or 40 000 (both with
50% probability) and then the company pays 12 000 or 2 000 in taxes (on average 7
000). If however the risk is eliminated, the company pays 5 000 in taxes. The lesson
is that a stable company pays less tax and generates more cash.

3.2.3. Risk managements tools

Let us review the instruments that can be used to manage risk – it is mostly
derivatives.
Forward contracts are agreements where one party agrees to buy a com-
modity (also exchange rate, interest rate) at a specific price on a specific future
date, and the other party agrees to sell. There are some limitations to the use of
forward contracts: first, as a matter of fact it is a credit instrument, second, there
is always a need to find the counterparty that would be willing to take a posi-
tion opposite to ours.
Futures contracts solve the counterparty and credit rating problems, but cre-
ate others: standardizing. Marking to market is a new feature of such contracts
– deposit and then money to be put up to cover losses.

113
 Options are sophisticated derivatives, whose feature is that call or put
premium has to be paid when purchasing options. If the option is unex-
ercised, it is money down the drain, as some managers may say. They
ignore the fact that buying an option (especially put) can be compared
to buying a car insurance policy – nobody complains if the car is stolen.
Still, options are highly leveraged and a small miscalculation may lead
to huge losses.

3.3. Case study – hedging exchange rate risk exposure

Look at the example below. It deals with the exposure to exchange rate risk.
The three questions that will be asked and answered are:
1. What are the sources of risk?
2. How to measure risk?
3. How to hedge the exposure to risk?

HL company exports its products (from England) to the USA. It needs to invest 5
million pounds in order to launch a new line of products. The sales are predicted
to generate 8 million USD at the end of the year, the costs being 3 million GBP per
year. The interest rates are 8% and 11% in the USA and UK respectively (continu-
ous compounding is assumed). The USD/GBP spot is 1.6. Logarithmic returns are
normally distributed with 15% standard deviation. The company pays 20% effective
income tax.
It must be added that the company should be able to achieve a profit of 1.25 million
pounds a year to satisfy the expectations of the investors with regard to the required
rate of return (25%) and pay the dividends. Any lower profit will be regarded as a
loss.

We assume that USD/GBP exchange rate is the only source of risk. The risk
is going to be measured by VaR. The risk exposure will try to be lowered with
the use of OTC (over the counter) forward contracts and options.
Let us consider a few cases.
1. The currency position remains unhedged.
Depending on the exchange rate S(1), the result (after the dividend)
changes drastically (from 350 000 to -450 000). Obviously, the exchange
rates of 1.8 or 2.0 are hardly acceptable for the company. What is the val-
ue of the exchange rate S(1) at which the company breaks even?

114
 S (1) 1.6 1.8 2
Sales 5000000 4444444 4000000
Cost 3000000 3000000 3000000
EBIT 2000000 1444444 1000000
Tax 400000 288889 200000
EAT 1600000 1155555 800000
Dividend 1250000 1250000 1250000
Result 350000 -94445 -450000

Let us explore the issue a bit further. Here is the model of how future values
of USD/GBP can be forecasted. The model is based on the uncovered interest
rate parity, and it also fulfills the assumptions of Black-Scholes model:

where N has the standard normal distribution. With probability of 95%, N will
not exceed 1.6449, which corresponds to an exchange rate S(1)= 1.9649.

NORMSINV(95%) = 1.64485.

This is the VaR exchange rate (at 95% confidence level). In other words,
there is 5% chance that the USD/GBP exchange rate in one year will be equal
to or higher than 1.964979. If this is the spot rate that will materialize in one
year, then the income statement for the company looks as follows:

115
 Sales 4071290
Cost 3000000
EBIT 1071290
Tax 214258
EAT 857032
Dividend 1250000
Result -392968

VaR = 392 968 dollars and hedging seems a necessity. The question is how
to manage the risk exposure.

2. Forward contract.
We can also try to hedge with forward contracts. The forward exchange
rate is 1.5527 (formula below). The assumption is that all the 5 million
from sales will be exchanged at the rate:

Seemingly, the income statement now looks good (the gain is 471 818). The
problem is however that we are locked into the 1.5527 exchange rate. If the spot
rate is more favorable, we are still forced to use the one from the forward con-
tract. Hedging with options leaves much more flexibility.

Sales 5152273
Cost 3000000
EBIT 2152273
Tax 430455
EAT 1721818
Dividend 1250000
Result 471818

3. Full hedge with Options.

Let us begin with call options so the exchange rate is capped at a certain
level. Suppose European call options with the following characteristics
are available: strike =1.6, call premium = 0.066902, and a maturity of 1
year. Then the cost of buying options is 334 510 dollars (209 069 pounds),
plus the interest (16%) paid on the money that is borrowed, which is 53

116
 522 dollars (33 451 pounds). The options will be exercised if the spot at
the end of the year is higher than 1.6. Let us see what happens if the most
pessimistic scenario occurs, and the 1.964979 spot rate materializes. The
income statement looks much better (compared to the unhedged version)
as VaR was negative (it means the gain of 114 170).

Sales 5000000
Cost 3000000
Interest 33451
EBT 1966549
Tax 393310
EAT 1573239
Loan repaid 209069
Dividend 1250000
Result 114170

If the exchange rate drops to 1.5, the option will not be exercised. The strat-
egy then leads to a positive result of 380 837 pounds.
4. Partial hedge with options
When hedging with options, one incurs a cost of paying the option pre-
mium. Let us try to reduce the cost by hedging only a fraction (50%) of
the exposure. Assuming the same characteristics of the option, only 4
million dollars will be exchanged into pounds at the strike price of 1.6,
the rest at 1.965.

Sales 4535646
Costs 3000000
EBIT 1535646
Interest 16726
EBT 1518921
Tax 303784
EAT 1215136
Loan repaid 104534
Dividend 1250000
Result -139398

117
 5. There are more combinations possible, one of them being for example
combining options and forward contracts. The outcome is shown below,
where we summarize the resulting VaR for all strategies considered (the
results below are equal to minus VaR):

Strategy 1 2 3 4 5
Result -392 968 471 818 114 170 -139 399 292 994

The values are computed at a 95% confidence level, corresponding to the ex-
change rate of USD/GBP 1.9887.
We hedged with options (line 3), used delta hedging and covered only 50%
of the exposure (line 4), used forward contracts (line 2), combined options and
forward (line 5), and last but not least did nothing (line 1). The figure below
shows the outcomes as a function of the exchange rate S(1) for each of the strat-
egies.

The strategy using a forward contract appears to be the safest one, but leaves
no flexibility. Those believing that the pound will weaken may remain un-
hedged. A variety of middle-of-the road strategies are also available. The final
choice should depend on the VaR amount itself. If, say, losing 392 968 (strategy
1) puts the whole company in jeopardy, then we definitely should hedge. Basi-
cally, derivatives in commercial use should be used with the aim of protecting
companies, not for speculation.

118
 Conclusions

This book, for a few different reasons, was focused on the DCF method, the
main of the reasons being that the DCF method captures best the value of prof-
itable, economically sound companies – it works for all firms which have real
expertise. The main purpose of this book was to explain the inner workings of
the DCF method, especially the variant in which capital structure constantly af-
fects cost of equity, as it does in reality.
The focus then was on the valuation model which integrates the three com-
ponents that elsewhere are often treated separately: cash flows, the cost of capi-
tal and the discounting process itself. The book revolved around these three is-
sues. For example, it is commonly known that if the value of equity changes,
the capital structure changes too. At the same time the change may affect the
cost of capital, which in turn will influence the value of equity itself. The re-
cursive approach to company valuation that was presented in the book relied
on solving such logical loops that appeared both at each time period and along
time periods. Performing the company valuation is such a way is much more
complicated than assuming no links between for example the value of equity
and the cost of capital, but leads to a much more reliable and methodically flaw-
less valuation.

119
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120