Assumptions of an ideal Objective Function Other Approaches

Objective is to maximise shareholder wealth.

1) Shrholdrs & Managers : Principal - agency conflict / Moral
Hazard | Right incentives, shareholder activism
2) Shrholdrs & Lenders : Risk shifting, Expropriation of wealth |
Covenants, More info
3) Managers & Financial Mkt : Information Availability/Self Interest |
Regulation on financial disclosure, liquid markets
4) Firms & Society : Detrimental actions (fake tests, claims) | Govt
policy such as carbon credits, judicial intervention , contracts/regulation

 Key Decisions – Investment, Financial , Dividend

 Evidence that mkt undervalues innovation(R&D) , human
capital( employee satisfaction) etc.
WACC
 Total Risk = Market Risk + Unique Risk
What - Minimum required rate of return for any project such that
 CAPM:
the free cash flows are enough to meet payment expectations to
debt and equity holders, given the riskiness of the investment.
Also the rate at which you can discount free cash flows to get
SML (Securities Mkt Line)
the current market value of firm/investment.
In equilibrium, all assets must
lie on this line.
• If stock’s return is above
SML -> Undervalued  Right benchmark for any project is the project cost of capital.
• If stock’s return is below  Beta of project should be used for reference
SML -> Overvalued
Free Cash flow
Determinants of Beta
1) Cyclicity (Higher cyclicity means higher Beta) • Noncash operating expenses is typically depreciation
- Firms that do well in the expansion phase (Auto, High Tech) NOPAT :
2) Leverage -> Magnifies the effects of sensitivity to mkt movts. • Net Op Profit after Taxes generated from core ops
- Financial Leverage (When firm has a high debt in capital strt) • Excludes any income from non-op assets (interest earned on
- Operating Leverage ( High fixed costs) investments or excess cash)
- Growth Options • NOPAT is the profit available to both equity and debt capital
Relation b/w A, Beta, Debt providers. It’s independent of the capital structure.
• D and E are market values of debt and • NOPAT = EBIT ( 1 – Tax Rate)
equity. Also, D is net debt i.e., debt net Invested Capital :
of extra cash. • Must only reflect current and long-term assets for Ops.
• Equity B is the Beta with leverage • Fixed Assets + Working Capital
(Contains business + financial risk) • Investment in invested capital=Capex + change in NWC
• Asset Beta only contains business risk • FCF=EBIT (1 - Tax )+ Depreciation - Capex - ΔNWC
Also known as Unlevered Beta
How to find Unlevered B
• For firms with low risk of default ie Bd = 0 ;

• βe = Levered Beta = Operational + Financial Risk

• βu = Measures risk from operations
How to Measure
1 ) Get Equity Beta of comparable firms
2) Calculate the Unlevered Beta and calculate average across all comparables.
3) Relever using target D/E : How to Forecast future Cash Flows
βE, private =Average( βU;comp)*[1+ target D/E ] Revenue
4) Use it in CAPM - Existing Prods: Estimate future size likely the mkt. share
Inputs for a Credit Ratings - New Industries: Size of the target demographic & likely
1) Business risk : industry risk, market position, and operating effciency penetration. Also, account for competition, threat of entrants/subs.
2) Mgmt. risk - Competence, integrity and risk appetite of the firm’s mgmt. Cost : Change in Technology, Inflation, Cost of Inputs
3) Financial risk - Accounting quality, Present & future financial position, cash NWC : % of Sales Revenue ; As sales grow -> additional
flows, and financial exibility of the firm. Project based risks are also factored in at
investment is needed
this stage.”
How to Estimate the Cost of Debt Enterprise Value =PV (Free cash flows) + PV (Terminal Value)
1) Crude approach: Use Rd = Interest Payments / Debt Outstanding (Total Value generated by firm’s operations)
Debt Outstanding Enterprise value is the present value of all firm free cash from next
2) Referring to YTM on a straight bond outstanding. Limitation of this approach is year to infinity and beyond coming from existing and new projects
that very few firms have long term straight bonds that are liquid & widely traded.
3) Looking up the rating for the firm and estimate a default spread based upon the Equity value = Enterprise value+Net non-operating assets – Debt
rating : Rd = Rf + Default spread, rf is the risk- free rate
DCF Valuation Steps
How to get a synthetic rating of a firm 1) Forecast Unlevered CF’s during the forecast horizon (high-
1) Using financial characteristic for a firm: growth period
2) Estimate Residual/Terminal Value
Major advantage of using synthetic ratings is that it reflects significant current changes in
3) Discount everything using WACC
business environment, industry or economic outlook
This gives you Enterprise Value or Value from Ops
Value of Firm = Enterprise Value + Cash/Marketable Securities
Methods to calculate Terminal Value:
1) Salvage Value
• TV = Current book value +/- Adj to reflect true economic
depreciation
2) Going Concern
• PV of a growing perpetuity beginning at T and stable growth rate g
• Stable Growth Cap: For an average company, the stable growth rate
g <= Nominal growth rate of the economy

Firm Value and NPV

• Firm value is the total of the NPVs of every project in the firm, current
and future
• To maximize the firm's shareholder value, we must accept projects that
have a positive NPV
• Positive NPV projects generally reduce as firms age.

Internal Rate of Return (IRR):

What :
• The rate of return generated by any project.
• The discount rate that makes the NPV of any investment equal to 0
• Aka hurdle rate , break even discount rate for Inv.

• Decision Criteria : Accept if IRR> Discount Rate(WACC)

Choosing among several projects & when IRR/NPV r contradictory
• Depends on the project and firm type
• If availability of capital isn’t an issue -> Invest in a high NPV project.
• Select the project with highest NPV
• Cannot say the same for IRR as the scale of cash flows may differ
• Doubling all cash Flows will double NPV but will not affect IRR.
• If a business has limited access to capital (startups or high growth
companies) -> go for IRR (PE firms use that!)
• If a business has substantial funds on hand, go for NPV (Stock
markets)
• When in doubt, pick a project with higher NPV

NPV Profile :
- Graph of NPV vs Cost of Capital.
- Always downward sloped
- Cross Over Rate : Rate at which 2 NPV profiles intersect
Another Decision-Making Framework
- Independent Projects (No Capital constraints)
- Mutually exclusive project (capital constraints)
Time Value of Money
• Constant Perpetuity

• Growing Perpetuity

• Present Value of an Ordinary Annuity