The Foundation – Some very basic knowledge you should already have in place

Key Takeaways: we are going to provide some very basic theoretical concepts before introducing the questions. They are not in any way a substitute of your own personal study, which you need to get to a higher level. We just want to provide some basic guidelines to help you orientate your personal studies.

Enterprise Value

The value of the Assets of a company is given by the fact that owning 100% of the company will give you 100% of all the future income generated from the company. Therefore, the value on the financing side (owners of the future income) is equal to value on the assets side (you are as rich as much it’s valued what you own). Usually companies are financed through a mix of debt and equity; therefore the enterprise value is equal to the sum of the value of debt and the equity

Why debt is part of the EV?

Think about the case you buy a house worth $100m using $70m of Debt. After one year you decide to sell the house, which is worth now $120m, how much is the value of the equity?

You receive $120m, from the sale, but you have to repay your debts for $70m, so equity is what remains after you repay debt: $120 - $70 = $50m. Here we go.

Value of Assets: present value of the future income generated by the assets of the company.

Value of Debt: present value of the payments to debt holders less the excess cash (Net Financial Position). Payments to interest holders include passive interests and capital repayments (think to your HSBC loan).

Value of Equity: present value of payments to equity holders (if listed, share price x shares outstanding). Payments to equity holders include all the income left after having paid the debt holders. For this reason equity represents a “residual” claim on the value of the company assets.

Therefore, in every valuation we will use the following equation: Enterprise Value = Equity Value + (Debt – Cash “net debt”)

However, given that you are interviewing from LBS and have studied Corporate Finance, you need to come up with a more sophisticated answer to this question: Enterprise value =

common equity at market value + preferred equity at market value + minority interest at market value, if any + net debt (debt at market value - cash and cash- equivalents) + unfunded pension liabilities and other debt-deemed provisions - Long term and Equity Investments – Net Operating Losses + Capital Leases

• Preferred and Minority Interest are just other types of equity and thus treated just as common equity is treated

• Net Operating Losses – Should be valued and arguably added in, similar to cash.

• Long-Term Investments – These should be counted, similar to cash. • Equity Investments – Any investments in other companies should also be

added in, similar to cash (though they might be discounted).

• Capital Leases – Like debt, these have interest payments – so they should be added in like debt.

• (Some) Operating Leases – Sometimes you need to convert operating leases to capital leases and add them as well.

• Unfunded Pension Obligations – Sometimes these are counted as debt as well.

How do I find the value of an Asset?

Good question, the value of an asset depends on the cash you will receive from it. But because future cash flows are risky, we have to discount them in order to account for risk and time value of money.

Discount Rates - how do you value something that is uncertain and in the future?

By using discount rates, which reflect the cost for the time value of money and the cost for remunerating the risk of volatility of the future cash flows.

How do you find the right discount rate for cash flows to equity investors?

Using the CAPM:

Return of market portfolio = Rf + Beta (Rm – Rf)

Let’s start from a basic question, what does return to equity investors compensate? It compensates for the time value of money and for the risk of the investment.

• Time Value of Money: imagine a US govt T-bill which matures in 1 year. It is assumed to carry no risk (US Govt will not default), but is still offering a positive return on your investment. Why? The return offered from a T-bill (Rf) is compensating the investors for the fact that if you lend money today you will not get it back for a year.

• Risk: risk arises from the standard deviation of the cash flow profile. As we have seen, a T-Bill carries no risk (standard deviation = 0), because the US government is asumed to be able to pay back the exact amount promised. However, if you are buying a market portfolio ( eg ETF on SP500), you will require a higher expected return than T-Bills since it does not offer the same certainties of return. Since there is a higher risk that you might lose money, you want to be compensated for that by receiving a greater return.

But how do we find out about risk and how we measure it?

It all boils down to the variability (standard deviation) of cash flows, which are influenced by two kinds of risks:

• Unique project risk: These are the risks associated with the fact that there are some perils which threaten the success of an individual company but not necessarily the economy in general (management, plant failure, etc.)

• Market risk: These are the risks arising from the fact that there are economy wide perils which threaten all businesses (nuclear meltdown, recession, FED interest rates…)

Good, but should investors be worried about both types of risk?

If you own only one stock in your portfolio, of course the unique project risk is going to be important, but if you own more than 20 stocks, you are going to worry more about the covariance of the stocks of your portfolio (market risk).

Think in the following way: if the specific risk of each stock is idiosyncratic, it means that it moves randomly. If each specific risk in your portfolio moves randomly it means that their net effect will be zero (one stock goes up and some other goes down, net effect averages zero).

Therefore, for a reasonably well-diversified portfolio, only market risk matters since it influences all your stocks in the same direction. This is the risk you can’t diversify. That is why stocks have a tendency to move together, and that’s why investors are exposed to market uncertainties, no matter how many stocks they hold.

Which risk should then be remunerated?

As we have just seen, the risk of a well-diversified portfolio depends only on the market risk of the securities included in the portfolio, in others words from the covariance of the stocks with the market portfolio. Why the market portfolio? Because market risk is by definition measured by the movement of the market portfolio (SP500 for example).

Great, and how do I measure the market risk of a stock?

You simply measure how sensitive it is to market movements. The sensitivity of an asset to the market is called beta. Stock with betas greater than 1.0 tend to amplify the overall movements of the market. Stocks with betas between 0 and 1.0 tend to move in the same direction of the market, but not as far. Of course the market is the portfolio of all stocks, so it has a beta of 1.0.

Example: a stock with a beta equal to 1.20 will amplify market movement by a factor of 1.2 (market movement +10%, the stock will perform +12%).

CAPM states that the return required by equity investors in order to invest in a stock, is a function of the market return and its sensitivity with it (remunerates only non diversifiable risk).

Required return for stock A = Rf + BetaA (Rm – Rf) Rf = Risk free

Rm = Return on the market portfolio Beta A = Beta of company A

CAPM can be expressed graphically:

0.0% 2.0% 4.0% 6.0% 8.0% 10.0% 12.0% 14.0% 0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1 1.1 1.2 1.3 1.4 1.5 Return Beta CAPM relation CAPM return Data: Rf = 3% Rm = 9% For Beta = 1 Return is equal to the mkt return

Rf: Risk free return, ie the yield on a US bond, no risk of default and no risk of variability of cash flows. It’s the return offered when there is no risk at all.

Rm: return of the all stock market, if you owned the “market portfolio” you will get exactly the market return.

(Rm – Rf): is the market risk premium (MRP), how much more is the market offering in order to attract investors to invest in the market instead that in risk free assets? Rm should always be higher.

Ok great; we have just seen how the value of a company is equal to the present value of the future cash flows it will pay. But how does a company generate value for its shareholders?

As easy as that, it should generate a return higher than the required return by investors. In doing so it will become a positive NPV investment and its stock price will appreciate.

What if a company can’t deliver the required rate of return?

Investors will discount expected cash flows with the required return, thus achieving a lower valuation. Stock price will go down in order to align it with the required rate of return.

We talked about discounting the cash flows, but what exactly are we discounting?

That depends on what you want to value. A company produces Revenues through its business activities on an ongoing basis. Then it pays all the operating costs, taxes and makes important investments decisions for the future. What remains is called “unlevered” cash flow, which is not influenced by how the company is financed.

However, the financing mix dictates how this cash flow is then divided among holders of rights on the company. If there is debt, debtholders have a fixed claim and get paid first. What is left goes to equity holders.

So, if you discount the cash flows to debtholders using the debt discount rate, you will find the value of the debt.

In the same vein, if you discount the cash flow to equity holders using the CAPM discount rate, you will find the equity value. Adding the value of debt and equity will give you the enterprise value.

However, what do you derive if you discount the unlevered cash flows? You will get directly to the Enterprise Value, but of course the discounting rate will be the weighted average of the cost of debt and the cost of equity (CAPM), which is called WACC (Weighted Average Cost of capital)

The formula of the WACC is:

WACC = Rd (1-tc) * D/EV + Re * E/EV

Unlevered

Cash Flows

(Enterprise

Value)

Cash Flows to

Debt Holders

Cash Flows

to Equity

Holders

Return on

Assets

(WACC)

Return on Debt

(Rd)

Return on

Equity

(CAPM)

6.2.2

How would WACC change if debt were to go up? How would WACC change if tax rates were to go up?

These are the category of questions, which are derived from the formula given above, so if debt were to go up, given that it is a cheaper source of capital, WACC would go down.

Now answering the second question, if tax rates were to go up, WACC would go down as the after tax cost of capital has come down. Thus, remember the formula and also reason what the effect of each component of WACC’s formula is on WACC and why.

How would you find the WACC of a private company with no debt?

Firstly, here WACC is simply the cost of equity or in other words how much should the equity sponsors be compensated for taking on the business risk of the company. The answer lies in looking at similar companies on the basis of the following criteria:

• Industry • Size