Chapter One Basic concepts in market-based cash flow valuation 1.1 Introduction 1.1.1 Finite streams of cash flows 1.1.2 Content and organization of the chapters 1.2 Market-based procedure for valuation 1.2.1 Integrated valuation framework with complete financial statements 1.3 Steps in cash flow valuation 1.3.1 Why invest? 1.3.2 The role of information and expectations 1.4 Present value (PV) 1.4.1 Perfect capital markets and arbitrage opportunities1.4.2 Valuation in an imperfect but real world 1.4.3 Perfect capital markets 1.4.4 Replicating portfolio strategy 1.4.5 Traded firms in the U.S. stock market 1.4.6 Traded firms in an emerging market 1.5 The standard after-tax Weighted Average Cost of Capital (WACC) 1.6 Types of cash flows 1.6.1 What is FCF? 1.6.2 What is cash flow to (existing) debt? 1.6.3 What is cash flow to equity (CFE)? 1.7 The WACC in a Modigliani and Miller (M & M) world 1.7.1 WACC in an M & M world without taxes 1.7.2 An unlevered company versus a levered company1.7.3 The no-arbitrage argument 1.7.4 Slicing the cake 1.7.5 Debt and equity financing 1.7.6 Formula for the WACC without taxes 1.7.7 Equality of the unlevered and levered returns1.8 WACC in an M & M world with taxes 1.8.1 The expanding cake 1.8.2 Why firms do not have 100% debt? 1.9 The fundamental FCF relationship 1.10 The main valuation methods and formulas for cost of capital 1.10.1 The tax shield (TS) 1.10.2 After-tax WACC applied to the FCF 1.10.3 Alternative expression for the WACC applied to the FCF 1.10.4 The WACC with the CCF method 1.10.5 Losses carried forward (LCF) 1.10.6 The FCF WACC versus the CCF WACC 1.11 The CFE approach 1.12 Estimating the cost of capital 1.13 The Adjusted Present Value (APV) approach 1.14 Various formulations for the cost of capital 1.15 Summary and concluding remarks KEY CONCEPTS AND IDEAS Chapter Two Time Value of Money (TVM) and introduction to cost of capital 2.1 Introduction Section One 2.1.1 The expected inflation rate 2.1.2 Relationship between the real rate of return and the nominal rate of return 2.1.3 Expression for the cost of capital 2.2 Nominal prices, constant prices and real prices2.2.1 Expected real increase is 2% and expected inflation rate is 3% 2.2.2 Expected real increase is 2% and expected inflation rate is 0% 2.2.3 Expected real increase is 0% and expected inflation rate is 3% 2.2.4 Real increase is 0% and expected inflation rate is 0% 2.2.5 The use of nominal prices versus real prices2.2.6 Multi-period example with nominal and real prices 2.3 Risk premium with CAPM 2.4 Calculating (present) value with a finite stream of cash flows 2.4.1 Future value with the nominal risk-free rate: single period case 2.4.2 Time value of money (TVM) 2.4.3 Variable rates of return 2.4.4 The discounting process 2.4.5 Variable discount rates 2.4.6 Single and multi-period cash flows 2.4.7 Assessing an investment opportunity with the PV concept Section Two 2.5 Valuation with a finite stream of cash flows2.5.1 Unlevered values 2.5.2 Debt financing with constant leverage 2.5.3 (Present) Value of TS 2.5.4 The corrected return to levered equity and WACC 2.5.4 Alternative formulation for the WACC with circularity 2.5.5 After-tax WACC applied to the FCF 2.6 Summary and concluding remarks KEY CONCEPTS AND IDEAS APPENDIX A for Chapter Two A2.1 Calculating the present value (PV) with cash flow in perpetuity (without growth) A2.1.1 WACC in an M & M world without taxes A2.1.2 Unlevered value A2.1.3 Value of the cash flow to debt (CFD) A2.1.4 Value of the cash flow to equity (CFE) A2.1.5 Formula for the return to levered equity eA2.1.6 Deriving the Weighted Average Cost of Capital (WACC) without taxes A2.1.7 Numerical example A2.2 WACC in an M & M world with taxes A2.2.1 Annual tax shield A2.2.2 Capital cash flow A2.2.3 (Present) value of the annual tax shield A2.2.4 The levered value VL in the presence of corporate tax A2.3.1 Value of levered equity A2.3.2 Cash flow to equity A2.3.3 Return to levered equity with taxes A2.3.4 Formula for the return to levered equity A2.4.1 Traditional after-tax WACC with the FCF A2.4.2 Alternative expression for the WACC with the FCF A2.4.3 WACC with the Capital Cash Flow (CCF) A2.4.4 Another WACC formulation with the Capital Cash Flow (CCF) A2.5 FCF in perpetuity with growth A2.5.1 Unlevered value A2.5.2 Value of the debt A2.5.3 The annual tax shield A2.5.4 (Present) Value of the tax shield A2.6 Cash flow to equity A2.6.1 Value of levered equity A2.6.2 Return to levered equity APPENDIX B B2 Using CAPM to find the cost of capital B2.1 Discount rate for the tax shield is the cost of debt d B2.2 Discount rate for the tax shield is the return to unlevered equity r Basic Review of Financial Statements and Accounting Concepts 3.1 Financial statements and accounting concepts SECTION ONE 3.1.1 Pro-forma financial statements 3.1.2 Integrated framework 3.2 Balance sheet 3.2.1 Assets 3.2.2 Current assets 3.2.3 Liabilities 3.2.4 Current liabilities 3.3 Working capital 3.4 (Book) Value of equity 3.5 Income statement 3.5.1 Line items in the income statement 3.5.2 Gross profit 3.5.3 Earnings before Interest and Taxes (EBIT) 3.5.4 EBT 3.5.5 Taxes 3.5.6 Net income 3.5.7 Dividends 3.5.8 Retained and accumulated retained earnings3.6 Cash flow statement 3.6.1 Cash flow from operating activities 3.6.2 Cash flow from investing activities 3.6.3 Cash flow from financing activities 3.7 Cash budget statement 3.7.1 Annual cash budget statement 3.7.2 NCB before financing and reinvestment 3.7.3 NCB after debt financing 3.7.4 NCB after equity financing 3.7.5 Reinvestment of surplus funds 3.7.6 Final NCB after reinvestment 3.7.7 Cumulative Cash balance 3.8 Differences between the CFS according to GAAP and the CB statement 3.9 Integration of the financial statements SECTION TWO 3.10 Preliminary tables 3.10.1 Depreciation schedule 3.10.2 Loan schedule 3.10.3 Quantity sold, inventories and purchases 3.10.4 Cost of Goods Sold (COGS) 3.10.5 Adjustments for credit sales and purchases3.10.6 Accounts Receivable (A.R.) 3.10.7 Accounts Payable (A.P.) 3.11 Summary and concluding remarks Appendix A APPENDIX B Sample Balance Sheet Sample Income Statement Chapter Four Constructing Integrated Pro-forma Financial Statements, Part One 4.1 Basic financial statements 4.2 Simple numerical example 4.2.1 Basic data for the simple example 4.2.2 Cash Required for Operations (CRO) 4.2.3 Reinvestment of surplus funds 4.2.4 Terminal value calculation 4.3 Goals and policies for selected variables 4.4 Depreciation schedule 4.5 Estimated target variables 4.5.1 Annual sales volume 4.5.2 Annual sales revenues 4.5.3 Selling and administrative expenses 4.6 Preliminary tables for the simple example 4.6.1 Initial cash budget statement for year 0 4.6.2 Loan schedule 4.6.3 Inventory and purchases 4.6.4 Final inventory in year 1 4.6.5 Purchases (units) 4.6.6 Cost of goods sold (COGS) 4.6.7 Receivables and payables 4.6.8 Accounts receivable 4.6.9 Accounts payable 4.6.10 Cash receipts and cash expenditures 4.7 Constructing the financial statements for the simple example 4.7.1 Cash budget statement in year 0 revisited 4.7.2 Cash budget statement for year 1 4.7.3 Income statement for year 2 4.7.4 Iterations between the income statement and cash budget statement 4.7.5 Cash budget statement for year 2 4.7.6 Completed income statement for all years 4.7.7 Complete budget statement for all years 4.7.8 Calculation of the new loan in year 4 4.8 Detailed cash budget statement in year 5 4.8.1 NCB before financing and reinvestment in year 5 4.8.2 NCB after debt financing in year 5 4.8.3 NCB after debt and equity financing in year 54.8.4 Reinvestment of surplus funds in year 5 4.8.5 Final NCB after reinvestment in year 5 4.8.6 Cumulative cash balance in year 5 4.8.7 Adjustments in the cash budget statement 4.9 Balance sheet 4.10 Cash Flow Statement according to GAAP 4.11 Summary and concluding remarks Key Concepts and Ideas Appendix A: A4.12 Detailed income statement for year 1 A4.12.1 Gross profits in year 1 A4.12.2 EBIT in year 1 A4.12.3 EBT in year 1 A4.12.4 Net income in year 1 A4.12.5 Dividends declared in year 1 A4.12.6 Retained earnings in year 1 A4.13 Detailed cash budget statement for year 1 A4.13.1 NCB before financing and reinvestment A4.13.2 NCB after debt financing A4.13.3 NCB after equity financing A4.13.4 Reinvestment of surplus funds in year 1 A4.13.5 Final NCB after reinvestment A4.13.6 Cash balance after reinvestment in year 1A4.14 Detailed cash budget statement for year 2 A4.14.1 NCB before financing and reinvestment A4.14.2 NCB after debt financing A4.14.3 NCB after equity financing A4.14.4 Reinvestment of surplus funds A4.14.5 Final NCB after reinvestment A4.14.6 Cumulative cash balance in year 1 Chapter Five 5.1 Constructing Financial Statements (continued), Part Two 5.1.1 The construction of the financial statements5.1.2 A complex example 5.1.3 Model assumptions 5.1.4 Goals and policies for selected variables 5.1.5 Relationship between the quantity purchased and the purchase price 5.1.6 Simulation of market demand 5.2 Impact on demand of changes in price and of expenditures on advertising and promotion 5.2.1 Annual Sales 5.2.2 Impact on demand of change in price 5.2.3 Impact on demand of expenditures on advertising and promotion 5.2.4 Preliminary tables for the complex example5.2.5 Annual increase in the volume of sales 5.2.6 Annual expenditures on advertising and promotion 5.2.7 Cash Requirements for Operations (CRO) 5.2.8 Expected domestic inflation rate 5.2.9 Annual sales volume 5.2.10 Annual sales revenue 5.3 Real rate of interest, the risk-premium for debt and the reinvestment return: Interest rates estimation 5.4 Depreciation Schedule 5.4 Initial cash budget for year 0 5.5 Loan schedule 5.6 Inventory and quantity purchased 5.7 Relationship between the quantity purchased and the purchase price 5.8 Cost of goods sold (COGS) 5.9 Selling and administrative expenses 5.10 Receivables and payables 5.11 The logic of the model 5.12 Constructing the financial statements for the complex example 5.12.1 Income Statement 5.12.2 Cash budget statement 5.12.3 Balance Sheet 5.12.4 The Cash flow statement 5.13 Summary and concluding remarks Key concepts and ideas Appendix A A Brief Introduction to Price-Demand Elasticity A1.1 Own Price. A1.2 Consumption. A1.3 Income. A1.4 Substitutability. A1.5 Kind of goods. A1.6 Habits and time. A1.7 Taste. A1.8 Determinants of quantity sold A1.9 An expression for the Quantity demanded APPENDIX B A Detailed Spreadsheet Example 6.1 Derivation of the free cash flows 6.2 The fundamental free cash flow (FCF) relationship 6.2.1 CB statement versus free cash flow 6.2.2 Operational cash flow 6.2.3 Inflation adjustments for financial statements6.2.4 Treatment of tax savings 6.3 Deriving the FCF from the CB statement 6.3.1 Cash flow to equity (CFE) 6.3.2 Cash Flow to Debt 6.3.3 Tax shields 6.3.4 Deferred taxes 6.3.5 Total Free Cash Flow 6.3.6 Capital cash flow 6.4 Total CCF versus operational CCF 6.4.1 Total capital cash flow 6.4.2 Operational CCF 6.4.3 Non-operational CCF 6.4.4 Other relationships for operational cash flows6.5 Deriving the FCF from the CF statement according to GAAP 6.6 Deriving the FCF from the EBIT in the income statement 6.6.1 Adjustments to the income statement 6.6.2 Depreciation charges and amortization 6.6.3 Working capital adjustment 6.6.4 Deriving the FCF from the EBIT 6.7 Deriving the CFE from the Net Income, NI 6.8 Advantages of using the CB Approach 6.9 Summary and concluding remarks APPENDIX A A1: Calculating the excess cash from the Income Statement and the Balance Sheet APPENDIX B B1: Deriving the FCF from NI B2: Deriving the CCF from NI Chapter Seven Using the WACC in theory and in practice Section One: Introduction 7.1 Approaches to the cost of capital 7.2 Review of basic ideas 7.2.1 Impact of taxes 7.2.2 Cash flow relationships 7.2.3 Relationships between values and cash flows7.2.4 Two period example 7.2.5 Discount rate for the tax shield 7.2.6 Return to levered equity ei 7.3 Three simple expressions for the cost of capital 7.3.1 Standard after-tax WACC applied to the FCF7.3.2 Adjusted WACC applied to the FCF 7.3.3 WACC applied to the CCF 7.4 General framework 7.4.1 First dimension 7.4.2 Second dimension 7.4.3 Third dimension 7.4.4 Matrix for the WACC applied to the FCF 7.4.5 Matrix for the WACC applied to the CCF 7.4.6 How do we estimate the cost of capital? Practical issues. 7.5 Numerical examples with the complex example7.5.1 Standard WACC applied to the FCF 7.5.2 Adjusted WACC applied to the FCF 7.5.3 WACC applied to the CCF 7.5.4 Cash flow to equity (CFE) approach 7.6 Summary and concluding remarks APPENDIX A A.1 Algebraic approach A.1.1 General expression for the return to levered equity ei A.1.2 Standard WACC applied to the FCF A.1.3 Adjusted WACC applied to the FCF A.1.4 Standard WACC applied to the CCF A.1.5 Adjusted WACC applied to the CCF APPENDIX B: Using the Capital Asset Pricing Model (CAPM) to find the cost of capital Appendix C The Calculation of Levered Values with Operational Cash Flows Operating CFD, CFE, TS, FCF and CCF 7.5.1 Standard WACC applied to the FCF 7.5.2 Adjusted WACC applied to the FCF 7.5.3 WACC applied to the CCF 7.5.4 Cash flow to equity (CFE) approach Chapter Eight Estimating the WACC for Non Traded firms Introduction 8.1 Practical Approaches to the Cost of Capital for Traded and Non Traded Firms 8.2 Finding the Relationship between Levered and Unlevered b’s 8.3 Valuation for Traded Firms 8.3.1 Estimating the Return to Levered Equity e for a Traded Firm 8.3.2 Using CAPM to find the Cost of Capital 8.3.3 Adjusted WACC applied to the FCF 8.3.4 WACC applied to the CCF 8.4 Valuation for Non-Traded Firms 8.4.1 Valuing Firms, both Traded and Non-traded, in Emerging Markets 8.4.2 Systematic Risk and Total Risk 8.4.3 The Estimation of the Cost of Levered Equity with Systematic Risk 8.4.3.1 Using a Proxy Traded Firm 8.4.3.2 Accounting Betas 8.4.4 The Estimation of the Unlevered Return to Equity, r with Systematic Risk 8.5 Summary and Concluding Remarks APPENDIX A A.1 The Estimation with Total Risk A.1.1 The Estimation of the Levered Cost of Equity, e with Total Risk A.1.2 The Estimation of the Unlevered Return to Equity, r with Total Risk APPENDIX B Appendix C Chapter Nine Beyond the planning period: calculating the terminal value 9.1 Introduction 9.2 Operation versus liquidation 9.3 Calculating the salvage (or liquidation) value9.4 Terminal value versus salvage value 9.5 The standard approach for estimating the terminal value 9.5.1 Assumptions in the model 9.5.2 Simple numerical example 9.5.3 Estimating the key parameters 9.5.4 Growth in the steady state 9.5.5 Estimating the growth rate of the NOPLAT, g9.6 Terminal Value is Calculated for Discounted Cash Flow (DCF) Method Using NOPLAT and Using Constant Leverage 9.7 Amount of reinvestment for the growth in the Free Cash Flow 9.8 Calculating the Return on the Market Value of the Invested Capital (ROMVIC) 9.9 A Comment on constant leverage 9.9.1 The Tax Savings with Terminal Value 9.9.2 CFE with terminal value 9.9.3 CFD with terminal value 9.9.4 CCF with terminal value 9.10 Calculating the terminal value with the CCF and APV approaches 9.11 Summary and concluding remarks Appendix A: Terminal value and amount of reinvestment A.1 Return on the Market Value of the Invested Capital A.2 Additional reinvestment for higher growth of NOPLAT Appendix B: Independent Calculation of the TV Levered Value B.1 Value of debt in the terminal period N B.2 Value of tax shield in the terminal year N B.3 Levered value in terminal year N B.4 The Terminal Value with CCF and APV Appendix C Pure Free Cash Flow and non pure Free Cash Flow Matching the RIM (Residual Income Model), EVA® and DCF (Discounted Cash Flow) D9.1 What is value added? D9.2 Assumptions and financial statements for the complex example D9.2.1 RIM for the complex example D9.2.2 EVA for the complex example D9.3 Conclusion Chapter Ten Theory for cost of capital revisited 10.1 Cost of capital with a finite stream of cash flows 10.1.1 WACC in an M & M world without taxes 10.1.2 Value relationships 10.1.3 Cash flow relationships 10.1.4 Unlevered value in year 1 10.1.5 Unlevered value in year 0 10.2 Numerical example 10.2.1 Unlevered equity schedule 10.2.2 Loan Schedule for the debt financing 10.2.3 Value of debt in year 1 10.2.4 Value of debt in year 0 10.2.5 Annual cash flow to (levered) equity 10.2.6 Debt-Equity Ratios 10.2.7 Returns to levered equity in year 1 and year 2 10.2.8 Value of (levered) equity in year 1 10.2.9 Value of (levered) equity in year 0 10.2.10 Levered equity schedule 10.2.11 Calculation of the multi-period WACC 10.3 Loan schedule with constant leverage 10.3.1 Calculation of the multi-period WACC 10.4 Policy on debt financing and the WACC in the presence of taxes 10.4.1 Risk-free tax shields 10.4.2 Fixed loan schedule 10.4.3 Constant leverage 10.5 The M & E WACC 10.5.1 The M & E argument in the limit 10.5.2 Relaxation of the M & E assumptions (Optional) 10.6 WACC for a finite stream of cash flows in an M & M world with taxes 10.6.1 Fixed loan schedule 10.6.2 Option 1: WACC applied to finite FCF (fixed amount of debt) with y = r 10.6.3 Option 2: WACC applied to the finite CCF (fixed amount of debt) with y = r 10.7 Fixed percentage of debt 10.7.1 M & E specification for the WACC applied to the FCF 10.7.2 Harris & Pringle (H & P) specification 10.7.2.1 Option 1: WACC applied to FCF (fixed percentage of debt and y = r) 10.7.2.2 Option 2: WACC applied to the CCF (fixed percentage of debt and y = r) 10.7.3. Standard (inaccurate) specification 10.7.3.1 Option 1: WACC applied to FCF (fixed percentage of debt and y = d) 10.8 Theory on the cost of capital applied to finite cash flows 10.8.1 Value relationships 10.8.2 Cash flow relationships 10.8.3 Tax shield in year 1 and year 2 10.8.5 (Present) value of the tax shield in year 010.9 Standard WACC applied to the CCF 10.10 Standard after-tax WACC applied to the FCF10.11 Return to (levered) equity 10.11.1 Case 1 10.11.2 Case 2 10.11.3 Case 3 10.12 Alternative adjusted WACC applied to the FCF (Optional) 10.12.1 Alternative adjusted WACC in year 1 applied to the FCF 10.12.2 Assuming the discount rate for the tax shield is r 10.13 Alternative WACC applied to the CCF (Optional) 10.14 Numerical example 10.14.1 Amount of the Tax Shields 10.14.2 Summary of the cash flows 10.14.3 (Present) Value of the tax shields 10.15 Adjusted Present Value (APV) approach 10.15.1 Percent debt and percent equity in year 110.15.2 Percent debt and percent equity in year 210.15.3 Returns to levered equity in year 1 and year 2 10.15.4 WACC applied to the CCF 10.15.5 Standard after-tax WACC applied to the FCF 10.15.6 Alternative WACC applied to the FCF 10.16 Summary and concluding remarks KEY CONCEPTS AND IDEAS Appendix A A10.1 Derivation of the M & E WACC A10.1.1 Levered value in Year 2 A10.1.2 Levered value in Year 1 A10.1.3 Levered value in Year 0 APPENDIX B B10.1 Numerical example with constant leverage B10.1.1 Leverages in year 1 and year 2 B10.1.2 Relationship between the levered and unlevered value in year 1 B10.1.3 Relationship between the levered and unlevered value in year 0 B10.2 Basic information B10.2.1 Levered values in year 0 and year 1 B10.2.2 Values of debt in year 0 and year 1 B10.2.3 Tax shields in year 1 and year 2 B10.2.4 CCF in year 1 and year 2 B10.2.5 Return to levered equity B10.3 WACC applied to the CCF B10.4 Standard after-tax WACC applied to the FCFB10.5 Alternative adjusted WACC for the FCF