All four model types introduced in this chapter – corporate models, project finance models, leveraged acquisition models and integrated merger models -- compute financial statements for the company being evaluated. However, the manner in which valuation is derived from the models and the ways risks can be measured is very different. Corporate models generally compute value from projected earnings or from forecasted free cash flow using the discounted cash flow (“DCF”) method. The foundation of this approach is the presumption that the value of real assets is not dependent on the manner in which the assets are financed. A simple definition of free cash flow – cash flow that accrues to debt investors, equity investors and anybody else who put money into the company and expects a return – is the following:
Free Cash Flow = EBITDA – Operating Taxes – Capital Expenditures – Working Capital Change +
Deferred Tax Changes
In contrast to valuation approaches in corporate models that depend to a large extent on terminal value and cost of capital assumptions, project finance analysis in essence backs into the value of the prospective equity investment through assessing whether an adequate equity return can be achieved. The equity return in these models depends in turn on the amount of debt that can be lent to the project. This means that project finance models do not have the same problem that dramatically different results come from changing variables that are very difficult to estimate. Leveraged buyout models are similar to project finance models in the sense that one can back into the value of a company accounting for the amount of debt that lenders will commit to the transaction. With acquisition models value is computed through measuring the maximum entry multiple or premium that can be paid for a company such that a given the equity internal rate of return can be achieved. As with the project finance model, the rate of return to equity investors depends to a great extent on how financing of the transaction is structured, but not on terminal growth and subjective cost of capital estimates. Finally, merger integration models also back into the value of the target company and the acquisition premium. This time however, the value is derived through comparing earnings per share and other financial ratios before and after a merger. Value can be derived by determining whether earnings per share for the combined company increase whether
financial ratios of the new combined company remain strong enough to support the desired credit rating. Use of an integrated model to back into the value of a company is illustrated below. In this artificial example, the transaction results in increased earnings (accretion) and it also maintains the bond rating
within the standards for a BBB company given the assumed business category.9 If the equity
consideration is increased or the amount of debt used in the transaction changes or the accounting treatment changes, the accretion may no longer exist.
Equity Consideration 1,700.00 Synergies 50.00 Years on Graph 7
Equity Issued 466.48 Write-up 1,000.00 Business Risk Category
Debt Issued 1,338.00 Target Bond Rating
EPS Comparison: Target Combined with Acquiror Transaction Value 2,090 Shares Issued 52
- 0.50 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 2004 2005 2006 2007 2008 2009 2010 Consolidated Standalone
Interest Coverage Comparison: Target Combined with Acquiror Transaction Value 2,090 Debt Issued 1,338
0 1 2 3 4 5 6 7 8 9 10 2004 2005 2006 2007 2008 2009 2010
Bond Rating Standard Consolidated
4 BBB
The alternative approaches to classic free cash flow valuation from project finance models, leveraged acquisition models and integrated merger models eliminate the need for debating the weighted cost of capital or the terminal growth rates. Instead, market information on the structure of the financing and direct information on the required returns for equity holders forms the foundation of the valuation process. If value is to be computed using the alternative models, the financial models must address detailed aspects of how free cash flows accrue to debt and equity investors. The cash flow process is different depending on the structure of the transaction implying that alternative starting points, different time period conventions and distinctive calculations of the manner in which cash flow is dispersed to debt and equity investors must be incorporated in the alternative types of models.
The difference in valuation techniques that are implied from using the alternative models is summarized in the table below. Subsequent chapters will further discuss the advantages and disadvantages of using alternative valuations.
Corporate Model Project Finance LBO Model M&A Integration Model Valuation from Model Present Value of Discounted Free Cash
Flow or Multiples
Investment Decision and Implied Value depends on Equity IRR versus Market
Hurdle Rate
Entry Multiple and Acquisition Premium
Depends on Equity IRR and Hurdle Rate
Acquisition Premium Depends on Earnings per Share Acretion
and Debt Ratios
Key Valuation Parameters Weighted Average Cost of Capital, Multiples, Terminal Growth
Debt Capacity, Debt Terms
Senior and Subordianted Debt Financing and Exit
Multiple
Sources of Funds Used for Tranasction
and Assessment of Credit Quality Traditional Risk Assessment from Equity Perspective Sensitivity Analysis and Scenario Analysis
of DCF and Multiple Value
Sensitivity Analysis and Scenario Analysis
of Equity IRR
Sensitivity Analysis and Scenario Analysis
of Equity IRR
Sensitivity Analysis and Scenario Analysis of EPS Accrection and
Credit Quality Traditional Risk Assessment from Debt Perspective Break-even Analysis to Determine Ability to Re-finance and Maintain Credit Rating
Break-even Analysis to Determine at what Point Cash Flow Cannot Service Debt
Break-even Analysis to Determine IRR on Senior and Subordinated Debt Break-even Analysis to Determine Prospective Credit Rating Monte Carlo Analysis with Model Probability Distribution of EPS and DCF Valuation Probability Distribution of Equity IRR and Probability of DSCR
below 1.0
Probability Distribution of Equity IRR, Senior
IRR and Junior IRR
Valuation Analysis in Alterative types of Models