Corporate Finance Rem - II

Recap of notations

- Beta of assets

- Beta of equity

- Beta of debt

- Beta of equity in an unlevered firm

- Beta of equity in a levered firm

And the corresponding r notations indicating the required rates of return

V Value of the firm

- Value of unlevered firm

- Value of levered firm

- Value of interest tax shelter

- Value of subsidy

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What have we learned?

Learned how to calculate WACC and what different values of mean. These have been
briefly explained below.

is the risk associated with the operations of the business. This is related to the
industry the firm is in.

When a firm is unlevered, right side has only equity and hence assets = equity and so are
the risks associated with them.

So, = as per the notations in slide 2.

For finding in a levered firm ( ), use MM propositions as shown in last presentation.

Once and are obtained, use them to find WACC.

In addition, =
rem I)

WACC is only meaningful if D/V is constant, otherwise WACC changes every year.
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when D/E is constant or there are no taxes (refer to CF

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Key equations used

= +

When D/E is constant:

When D is constant:

= DT

(1)

(1)

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Coming to valuation

Companies are valued for their assets as well as their future cash flows.

is the value of the company.

As we already know, = + = +

If the firm is unlevered, no interest tax shelter and no debt, hence = =

But, if the firm is levered, then the value increases by the amount interest provides a tax
shelter. Let us see how this translates into an equation like below in case of constant
D/E ratio

When D/E is constant:

1
2
= (1+)
+ (1+)
2 +

How?

Before we go there, a couple of notations

,0 - Value of the levered firm at t=0, ,1 - Value of the levered firm at t=1

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Equation for value of the firm

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Valuation contd

Capital cash flow to the firm = Free cash flow + Interest tax shelter

1 = 1 + 0

When the Capital cash flow is known which combines all the effects of the capital
structure (Capital structure only means how much debt you are taking), then the risk of
this cash flow is only reflective of how the business is.

It means that this CCF can be discounted at which would mean

,0 =

Let = and =

When

Then ,0 =

Rearranging, we end up with ,0 = 1+

1 +,1
(1+ )

1 + 0 +,1
(1+ )

is constant, 0 = ,0
1 + ,0 +,1
(1+ )
1 +,1

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Valuation contd
For constant , =
Substituting, we get ,0 =

1 +,1

1+ + (1)

WACC

Hence, it can be clearly seen that WACC can be used to discount the
free cash flows directly to arrive at the firm value.
Simply put, =

1
2
+
(1+)
(1+)2

+ + ,

The simple procedure for the valuation of the company levered with
constant is discussed in the next slide

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Valuation procedure for

constant D/E
Do you know the cash flows of the firm till infinity?
Then just use, =

1
2
+
(1+)
(1+)2

The growth rates and numbers are given only till first N years and
after that a constant growth rate is given for FCF?
Then we need to use =

1
2
+
(1+)
(1+)2

+ + ,

Where , is the value of the firm at time N after which firm will have
constant growth rate. This is also called the continuing value of the firm.
, =

+1
+2
+
(1+)
(1+)2

+ =

(1+)

Note: Make sure that cash flows are growing from Nth year. It means
that the cash flow in the N+1th year is (1 + ).

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Valuation for constant D

= +
In case of constant debt, = DT
Hence, = + .

How to find ?
is nothing but the value of the firm if it is run by full equity. Then
= =
So, discount the cash flows by .

1
2
+
(1+ )
(1+ )2

+ + ,

, same as how , is found in the previous slide

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Value added from other

financial distortions
To reiterate, the value of a levered firm increases from that of an
unlevered firm from the financial distortions caused by adding debt to the
firm
The distortions we see in this course are
Interest tax shelter
Subsidized loans

Lets see how this works

What if there are there are two different debts and ?
Then it also matters what are the risk levels associated with these debts
If both the debts are guarded by different security levels, like lets say 1
gets first rights to assets, then both the debts are facing different risk
levels and so are their interest tax shields.

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Value added from other

financial distortions
But these are the rates decided by the markets. In that case, the only
distortion will be the interest tax shelter
It is correct to use the interest rates they are borrowed at, as discounting
rates to find the respective values of .
Then 1 =

1 1
1

= 1 and 2 =

2 2
2

= 2

So, the value of the firm = + 1 +2 = + 1 + 2

But, if both the debts are facing same risk level but different interest rates,
then the cash flows or interest tax shelter should be discounted at the r
that reflects the actual risk level which is the market rate. This means that
we are getting a loan at a subsidy.
Here, lets say if the firm goes to market, it faces an interest rate 2 and it
borrows 2 at 2
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Value added from other

financial distortions
If Govt. or someone subsidizes the loan and provides loan at 1 , and the
firm borrows 1 at 1 , this interest tax shield should still be discounted
using 2 as that is the rate reflecting the actual risk level
Hence 1 =

1 1
2

and 2 =

2 2
2

= 2

But then if we assume that the firm value = + 1 +2 , we end up

with = + 1 1 2 + 2 which is less than the earlier value as
1 < 2 . But this does not make sense!! We got loan at subsidy!!

This is because here we are ignoring the value of subsidy itself that
requires us to actually pay lesser amounts than if we had got it from the
market for the same risk level
The difference comes in the actual interest and principal payments made
in the case of two loans.
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Value added from other

financial distortions
How much is this value addition?
If the repayment schedule for the subsidized loan 1 is as below,
1

Interest

Principal

These payments actually face a risk level corresponding to 2 even if the

interest payment made is 1 . So, if we use 2 to find the effective present
value of the loan by discounting these payments, we get
1

1
2
+ 2 2 + + +
+
(1+2 )
(1+2 )
(1+2 )
(1+2 )
(1+2 )2
This 1 is effectively how much we are repaying.

1 =

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+ +

(1+2 )

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Value added from other

financial distortions
So the difference between 1 and 1 is a value addition to the firm and is
called the value of subsidy.
Hence = +

Value from distortions will include value from interest tax shelter plus
subsidies if any.
These are called the adjustments and the final value obtained ( ) is
called the Adjusted Present Value (APV).

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Illustrations
To start with, let us say a firm has the following properties (perpetual CF)

Tax

PBIT

12%

50%

360

So, the value of unlevered firm, =

FCFF = PBIT (1-T) = 360 .5 = 180

Hence, =

180
12%

= 1500

Now, let us assume that instead of funding this firm fully by equity, there
is a constant debt funding of 1000 @ 10%.
The only distortion added for the firms value is the interest tax shelter.

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Illustrations
In case of constant perpetual debt, interest tax shelter = DT
Hence, = = 1000 50% = 500
= + = 1000 + 500 = 1500

But, let us say in the debt of 1000, 500 actually came at a subsidized
interest rate of 8%.
In this case there would be both interest tax shelter distortion and the
Subsidy distortion.

=
500@10% 10% +
500@8% 10%
=

50010%50%
5008%50%
+
10%
10%

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= 450

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Illustrations
= D D where D = 500 is the subsidized loan and is the effective
value paid to the subsidizer.
=
500@8% 10% =
5008%
= 400
10%

Hence = 500 400 = 100

= + + = 1000 + 450 + 100 = 2050

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Illustrations
= D D where D = 500 is the subsidized loan and is the effective

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Illustrations
We have seen this problem already once last time. So, it will be short now
If the value is calculated by completely ignoring the financial distortions,
it is nothing but which is -90 in this problem

The distortions for the two debts is for loan A and for loan B(as
it does not have interest)
For loan A:
1
ITS

20

.12 9.12

Discounting these ITS values at 10%, we get = 80.37

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Illustrations
For loan B: = D D where D = 55 is the subsidized loan and is
the effective value paid to the subsidizer.
2

10

Interest

Principal

55

=
=

+ 2 2
(1+2 )
(1+2 )

55
1.09510

+ +

(1+2 )

1
2
+
(1+2 )
(1+2 )2

+ +

(1+2 )

= 22.19328

Hence = D D = 55 22.19328 = 32.80672

APV = = + + = 90 + 80.37 + 32.81 = 23.18 > 0
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Acquisitions & Mergers

Main point Synergies and how can the synergies be split?
Revenue synergies
Cost synergies

Let the acquirer be A, target be T, synergy be S and the combined firm be

C.
Then A+T+S = C
To find S, find the independent values of A, T and find the value of C using
the valuation principles learnt till now and find S
Then the decisions has to be how much to pay to the target to acquire it
and how to pay?

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Notations
- Gains to the acquirer
- Gains to the target = Acquisition premium
- Number of shares of Target outstanding

- Number of shares of Acquirer outstanding

Number of shares of Acquirer issued to target per target share
outstanding = Exchange ratio
- Price of the target share

- Price of the acquirer share

share of Acquirer in Combined firm
share of Target in Combined firm

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Cash acquisition
An acquisition opportunity has the following properties
A

Value

40 10

20 10

100

Shares

40

20

Price

10

10

Let us say, if the acquirer decides to pay 250 to the target for the
acquisition.

= = Price paid Target value = 250-200 = 50

= Synergy Acquisition premium
This means acquirer will have the remaining part of the synergy which he
is not paying as a premium
Hence = 100 50 = 50
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Cash acquisition
What will happen to the share prices of the acquirer and target shares
once the announcement of acquisition is made?
Acquirer pays + for the acquisition. This value goes to the
outstanding shares of the target. So, the price becomes
=

200+50
20

= 12.5

Acquirers final value will be + . This will be owned by shares. So,

the price becomes

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400+50
40

= 11.25

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All stock acquisition

If the firm decides to go with all-stock acquisition and decides to pay 250
by issuing 25 more shares of A to T.
Then, the total number of share of combined firm = 40+25 = 65

In this 65, A has 40 and T has 25.

Total value of combined firm, C = 700
Hence As ratio =
Bs ratio =

25
65

40

65

700 = 430.76

700 = 269.23

Hence, = 430.76 400( ) = 30.76

= 269.23 200( ) = 69.23

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All stock acquisition

This can also be looked at in this way.
Acquirer gets of targets firm T and loses of his own firm A, but in
addition he gets of the synergy as well.

Hence the total gain to the acquirer, = +

Here, =
=

40
65

40
65

25
65
25
400
65

, =

200

40

65

100

Similarly, = +

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Stock Acquisition
So, to generalize if r acquirer shares are issued for every target share
outstanding, then total number of shares in the combined firm =
+ , where acquirer has shares and target has shares
Hence, =

and =

What will happen to the prices of the stocks soon after the announcement
is made. Everyone knows combined value of the firm is A+T+S and the
total number of shares would be + . So, the combined share
++
price should be
+

As the acquirers shares are the same as combined firm shares, price of
++
share of acquirer would become this value. =
+

For the target, every one of its current shares represent shares in the
combined firm.
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Stock Acquisition
Hence, its share price should reflect the same thing. So, its price moves to
=

++
+

So, we know that the prices depend on the value of . How to decide the
value of ?
In addition to the sharing of synergy, another important criterion
generally used would be not to dilute the EPS as this is considered
important from shareholders point of view.
Let us say is the EPS of acquirer and is the EPS of target.
Let = 1 and = 2. Then the total earnings of A = 1 and
total earnings of T = 2 . Earnings of combined firm = + 2
Total number of shares of combined firm = + .
Hence the total EPS of the combined firm =
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+2
+

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Stock Acquisition
If the acquirer does not want the EPS to get diluted, then

+2
+

If = , this would give 2 which means the acquirer would not be

willing to give more than 2 of his shares per target share
If the share in synergy demands more pay, the rest he might choose to
pay in cash
In such cases, both cash and stock components should be used to measure
the gains as well as new prices.

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LBOs and CCF method

Leveraged Buy-Out is nothing but taking huge debt and buying out all the
equity holders to take the firm private
It is mandatory to value the equity(not the firm) here as it involves
specifically buying out equity holders
Methods
FCFF
FCFE
CCF (refer to slide 6)

FCFF and CCF methods of valuation is discussed already

When WACC is changing continuously, CCF method is preferred as is
used for discounting in this case which depends on the business does not
change with the capital structure

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LBOs and CCF method

FCFF and CCF methods both give the value of the firm. Value of debt and
other liabilities should be subtracted from the value of the firm to give the
value of the equity
FCFE This is the direct measure of the cash flows to the equity. This can
be broadly written as = (1 )
This FCFE can be discounted at to directly give the value of equity

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Illustrations

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Illustrations

12%

10%

PBIT

40%

150

500

= 12% 0.5 + 10% 1 0.4 0.5 = 9%

= 12% 0.5 + 10% 0.5 = 11%

FCFF:

1 = 90

Firm value = 90/WACC = 1000

Equity value = Firm value Debt = 1000-500 = 500

CCF:

PAT + Interest = (150-50) 0.6 + 50 = 110

Firm value = 110/ = 1000

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Illustrations

Value of equity = Firm value Debt = 1000-500 = 500

FCFE:

PAT = (150-50) .6 = 60

Equity value = 60/ = 60

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12%

= 500

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Thank You