Equity Valuation - NYUigiddy/val-short.pdfIan H. Giddy Valuation -11 Equity Valuation: Application to M&A Prof. Ian Giddy New York University Equity Valuation: Application to M&A Prof.
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Choice Cost1. Equity Cost of equity- Retained earnings - depends upon riskiness of the stock- New stock issues - will be affected by level of interest rates- Warrants
l A publicly traded firm potentially has an infinite life. The value is therefore the present value of cash flows forever.
l Since we cannot estimate cash flows forever, we estimate cash flows for a “growth period” and then estimate a terminal value, to capture the value at the end of the period:
l When a firm’s cash flows grow at a “constant” rate forever, the present value of those cash flows can be written as:Value = Expected Cash Flow Next Period / (r - g)where,
r = Discount rate (Cost of Equity or Cost of Capital)g = Expected growth rate
l This “constant” growth rate is called a stable growth rate and cannot be higher than the growth rate of the economy in which the firm operates.
l While companies can maintain high growth rates for extended periods, they will all approach “stable growth” at some point intime.
l When they do approach stable growth, the valuation formula above can be used to estimate the “terminal value” of all cash flows beyond.
l A key assumption in all discounted cash flow models is the period of high growth, and the pattern of growth during that period. Ingeneral, we can make one of three assumptions:u there is no high growth, in which case the firm is already in
stable growthu there will be high growth for a period, at the end of which the
growth rate will drop to the stable growth rate (2-stage)u there will be high growth for a period, at the end of which the
growth rate will decline gradually to a stable growth rate(3-stage)
l The assumption of how long high growth will continue will dependupon several factors including:u the size of the firm (larger firm -> shorter high growth periods)u current growth rate (if high -> longer high growth period)u barriers to entry and differential advantages (if high -> longer
l Assume that you are analyzing two firms, both of which are enjoying high growth. The first firm is EarthlinkNetwork, an internet service provider, which operates in an environment with few barriers to entry and extraordinary competition. The second firm is Biogen, a bio-technology firm which is enjoying growth from two drugs to which it owns patents for the next decade. Assuming that both firms are well managed, which of the two firms would you expect to have a longer high growth period?
o Earthlink Networko Biogeno Both are well managed and should have the same high
l Fakawi Navigation plans to acquire Feng-ShuiCompass Co. This would result in $25 million of incremental operating revenues in each of the first 5 years, and in $15 million of additional debt servicing costs per annum, as well as $5 million in tax shields.Fakawi expects to divest the target in year 6 for $100 million. The Treasury note rate is 6%, and the S&P return is 16%. Fakawi's advisors estimate that Feng-Shui has a beta of 1.3. For this advice they are charging 2% of the acquisition price.
l What is the maximum price that Fakawi should offer for Feng-Shui?