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Valuation The Art and Science of Corporate Investment Decisions Edition 5

by Sheridan Titman EBOOK PDF Instant Download

Table of Contents

Valuation

Valuation The Art and Science of Corporate Investment Decisions

About the Authors

Brief Contents

Detailed Contents

Preface

Project and Enterprise Valuation

What’s New in the Third Edition?

A Holistic Approach to Valuation

Pedagogical Features

Supplements

Structure of the Book

Chapter 1 Introduction to Valuation

Chapter Overview

1.1 Introduction

1.2 The Nature of Major Investment Decisions

1.3 Valuing Projects and Businesses

Project Valuation—Investing in the Caspian Sea Oil Fields

Issues to Consider When Valuing an Investment

Issue #1: Does the “Story” Make Sense?

Issue #2: What Are the Risks Entailed in the Investment, and How Can They Be Assessed and Dealt with in the Analysis?

Issue #3: How Can the Investment Be Financed?

Issue #4: How Does the Investment Affect Near-Term Earnings?

Issue #5: Does the Investment Have Inherent Flexibilities That Allow the Firm to Respond to Changing Circumstances?

Can the investment be staged?

Does the investment offer the opportunity for follow-on investments?

Does the investment provide production or marketing synergies with existing products?

Enterprise Valuation—Mergers and Acquisitions

1.4 Dealing with Complexity—Process and Discipline

The Investment Evaluation Process

Phase I: Investment (Idea) Origination and Analysis

Phase II: Managerial Review and Recommendation

Phase III: Managerial Decision and Approval

1.5 Case Study—CP3 Pharmaceuticals Laboratories Inc.

Example: Investing in a New Materials-Handling System

Addressing the Possibility of Decision Bias

The Role of the Strategic Planning Committee As the Skeptical Boss

1.6 Summing Up and Looking Forward

Final Comments—The Investment Decision-Making Process

Looking Forward—The Structure of the Rest of the Text

Part I Project Analysis Using Discounted Cash Flow

Chapter 2 Forecasting and Valuing Cash Flows

Chapter Overview

2.1 Discounted Cash Flows and Valuation

Example—Car Wash

The Three-Step DCF Process

2.2 Defining Investment Cash Flows

Only Incremental Cash Flows Are Relevant

Expected Versus Conservative and Optimistic Cash Flow Estimates

Equity Versus Project Free Cash Flow

Calculating Project Free Cash Flow (FCF)

2.3 Comprehensive Example—Forecasting Project Free Cash Flows

Lecion’s Strategic Assessment of the LCD Investment Opportunity

Estimating the Investment’s Project Free Cash Flow

Forecasting Incremental Revenues

Estimating Total Annual Expenses

2.4 Valuing Investment Cash Flows

Example—Valuing Lecion’s Project Cash Flows

Using NPV and IRR to Evaluate the Investment

Mutually Exclusive Projects

2.5 Calculating Project Free Cash Flows Using Pro Forma Accounting Statements

Example—Extracting FCF from Pro Forma Financial Statements

Constructing Pro Forma Financial Statements

Computing FCFs Using Pro Forma Financial Statements

Computing Project NPV

Key Learning Points—Pro Forma Financial Statements and FCF

2.6 Summary

Exercises

Problems

Chapter 3 Project Risk Analysis

Chapter Overview

3.1 Introduction

3.2 Uncertainty and Investment Analysis

The Investment Process with Risky Cash Flows

Example—The Earthilizer Proposal

Estimating Earthilizer’s Project Free Cash Flows (FCFs)

Valuing Earthilizer’s Project FCFs

The Decision to Invest (or Not)—NPV and IRR

3.3 Sensitivity Analysis—Learning More About the Project

Scenario Analysis

Breakeven Sensitivity Analysis

Simulation Analysis

Using Scenario Analysis as a Prelude to Building a Simulation Model

Preparing and Running a Simulation

Simulating Project Revenues

Forecasting Project Cash Flows

Liquidating the Investment and the Terminal Value

Simulation Software

Interpreting Simulation Results

Analyzing the Distributions of NPV and IRR

Using the Tornado Diagram to Perform Sensitivity Analysis

Summarizing the Simulation Results

Reflections on the Use of Simulation

Extensions of the Earthilizer Model

Using Simulations to Estimate an Investment’s Contribution to Firm and Market Risk

3.4 Decision Trees—Valuing Project Flexibility

Example—Decision Tree Analysis of the Abandonment Option

Evaluating the Revised Earthilizer Project Without the Abandonment Option

The Value of the Abandonment Option

Using Option Pricing Theory to Evaluate the Abandonment Option

3.5 Summary

Exercises

Problems

What Is Simulation?

Why Build Simulation Models?

What Is Crystal Ball Software?

How Do I Build a Simulation Model Using Crystal Ball?

Part II Cost of Capital

Chapter 4 Estimating a Firm’s Cost of Capital

Chapter Overview

4.1 Introduction

4.2 Value, Cash Flows, and Discount Rates

Defining a Firm’s WACC

Use Market Value Weights

Use Market-Based Opportunity Costs

Use Forward-Looking Weights and Opportunity Costs

Discounted Cash Flow, Firm Value, and WACC

Illustration—Using Discounted Cash Flow Analysis to Value an Acquisition

Equity Valuation

Equity Free Cash Flow

Equity Valuation Example—OfficeMart Inc.

4.3 Estimating WACC

Evaluate the Firm’s Capital Structure Weights—Step 1

Calculate the Cost of Debt—Step 2

Promised or Contractual Yields to Maturity on Corporate Bonds

Promised Versus Expected Rates of Return

Estimating the Cost of Convertible Corporate Bonds

Calculate the Cost of Preferred Equity—Step 2 (continued)

Calculate the Cost of Common Equity—Step 2 (continued)

Method 1—Asset Pricing Models

The Traditional CAPM

Selecting the Risk-Free Rate of Interest

Identifying the Risk-Free Rate

Choosing a Maturity

Estimating the Beta

Case 1: Constant Level of Debt

Case 2: Constant Debt to Value Ratio

Summary of Equity Betas and Financial Leverage

Estimating the Market Risk Premium

Common Valuation Mistakes: Failure to Risk-Adjust Comparison Firms

Historical Estimates

CAPM with a Size Premium

Factor Models

Limitations of Cost of Equity Estimates Based on Historical Returns

Historical Security Returns Are Highly Variable

Market Conditions Are Changing

Historical Returns Exhibit Survivor Bias

Method 2—Discounted Cash Flow or Imputed Rate of Return Approaches

Single-Stage DCF Growth Model

Aggregating the Forward-Looking Equity Risk Premia

Three-Stage Growth Model

Calculating the WACC (Putting It All Together)—Step 3

Evaluating Champion’s Capital Structure

Estimating Champion’s Costs of Debt and Equity Capital

Calculating Champion’s WACC

Taking a Stand on the Issues—Estimating the Firm’s Cost of Capital

4.4 Summary

Exercises

Problems

Estimating the Expected Cost of Below-Investment-Grade Debt Financing

Default Rates, Recovery Rates, and Yields on Corporate Debt

Estimating the Expected Yield to Maturity for a Long-Term Bond

Estimating the Cost of Hybrid Sources of Financing—Convertible Bonds

Off-Balance-Sheet Financing and WACC

Special-Purpose Entities

Chapter 5 Estimating Required Rates of Return for Projects

Chapter Overview

5.1 Introduction

5.2 Pros and Cons of Multiple Risk-Adjusted Costs of Capital

The Rationale for Using Multiple Discount Rates

Convincing Your Skeptical Boss—Low-Risk Projects Can Be Good Investments

The Benefits of Using a Single Discount Rate

Influence Costs

Weighing the Costs and Benefits of Multiple Versus Single Discount Rates

5.3 Choosing a Project Discount Rate

Method 1: Divisional WACC (Industry-Based Divisional Costs of Capital)

Divisional WACC—Estimation Issues and Limitations

Method 2: Project-Specific WACCs

Example: Determining Project-Specific WACC for Project-Financed Projects

Estimating Project Equity Value Directly—the Flow-Through-to-Equity Model

Estimating the Cost of Equity and Project Free Cash Flows (FCFs)

Estimating the Value of the Equity and the Cost of Equity Capital Using Iteration

Calculating Project Value and Project Finance WACC

Project-Specific WACC with Corporate Financing

Project Debt Capacity—How Much Debt Will the Project Support?

What Are the Appropriate Costs of Debt and Equity for an Individual Project?

Summary for Adjusting Project WACC Using Project Debt Capacity

5.4 Hurdle Rates and the Cost of Capital

Mutually Exclusive Projects

High Hurdle Rates May Provide Better Incentives for Project Sponsors

Accounting for Optimistic Projections and Selection Bias

5.5 Summary

Exercises

Problems

Part III Financial Statements and Valuation

Chapter 6 Forecasting Financial Performance

Chapter Overview

6.1 Introduction

6.2 Understanding Financial Statements and Cash Flow

The Income Statement

Cash Versus Accrual Accounting—Net Income Is Not the Same As Cash Flow

Operating Versus Nonoperating Income

Common Size Income Statement

The Balance Sheet

Measurement—Where Do the Numbers Come From?

Nonoperating Assets and Investments

The Common Size Balance Sheet

Statement of Cash Flow

Free Cash Flow Computations

Firm (Project) Free Cash Flow

Direct Method for Calculating Firm Free Cash Flow

Indirect Method for Calculating Firm Free Cash Flow

Other Income and Firm Free Cash Flow

Equity Free Cash Flow

Reconciling the Cash Flow Statement with Firm FCF

Free Cash Flow and Nonoperating Income

6.3 Forecasting Future Financial Performance

Step 1: Perform an Analysis of Historical Financial Statements

Performing a Financial Statement Analysis

Step 2: Construct Pro Forma Financial Statements for the Planning Period

The Forecast Horizon

Developing a Revenue Forecast

Forecast Methods Used to Construct Pro Forma Statements

Pro Forma Income Statements

Pro Forma Balance Sheets

When the Percentage of Sales Method Should Not Be Used

Step 3: Convert Pro Forma Financial Statements to Cash Flow Forecasts

Step 4: Estimate the Terminal Value of Firm Free Cash Flows

6.4 Looking Ahead—The Mechanics of Calculating Enterprise Value

Planning Period and Terminal Value

6.5 Summary

Exercises

Problems

Chapter 7 Earnings Dilution, Incentive Compensation, and Project Selection

Chapter Overview

7.1 Introduction

7.2 Are Reported Earnings Important?

Why Managers Care About Earnings

7.3 Project Analysis—Earnings per Share and Project Selection

Example 1—Bad Project with Good Earnings Prospects: The Equity-Cost Problem

How Can Projects with Negative NPVs Increase EPS?

Issuing New Equity: EPS Accretion/Dilution and the Price-to-Earnings Ratio

Generalizing the Earnings Accretion/Dilution Analysis

Debt Financing and Earnings Dilution

Example 2—Good Project with Back-Loaded Earnings Prospects

Earnings Effects—Accretion Versus Dilution

7.4 Economic Profit and the Disconnect Between EPS and NPV

Economic Profit (EVA®)

Using Economic Profit to Evaluate the Equity-Cost Problem

Using Economic Profit to Evaluate the Back- and Front-Loaded Earnings Problems

Back-Loaded Earnings

Front-Loaded Earnings

Summing Up

7.5 Practical Solutions—Using Economic Profit Effectively

Modifying the Calculation of Economic Profit

Modifying the Method Used to Pay Bonuses Based on Economic Profit

7.6 Summary

Exercises

Problems

Part IV Enterprise Valuation

Chapter 8 Relative Valuation Using Market Comparables

Chapter Overview

8.1 Introduction

8.2 Valuation Using Comparables

Valuing Residential Real Estate Using Comparables

Valuing Commercial Real Estate

Valuation Ratios (Multiples) and DCF Valuation

Office-Building Example

Valuation When the Buildings Are Not Identical

Operating Leverage and Investment Risk

Investigating the Determinants of Cash Flows

Key Learning Points

8.3 Enterprise Valuation Using EBITDA Multiples

Enterprise Value Versus Firm Value

The Airgas EBITDA Multiple

Example: Valuing a Privately Held Firm

EBITDA and Firm Free Cash Flow

Why Use EBITDA Multiples Rather than Cash Flow Multiples?

The Effects of Risk and Growth Potential on EBITDA Multiples

Normalizing EBITDA

Adjusting the Valuation Ratio for Liquidity Discounts and Control Premiums

8.4 Equity Valuation Using the Price-to-Earnings Multiple

Example—Valuing ExxonMobil’s Chemical Division Using the P/E Method

P/E Multiples for Stable-Growth Firms

P/E Multiple for a High-Growth Firm

8.5 Pricing an Initial Public Offering

8.6 Other Practical Considerations

Selecting Comparable Firms

Choosing the Valuation Ratio

Maintaining Consistency When Selecting a Valuation Ratio

Dealing with Unreliable Financial Information

Valuation Ratios Versus DCF Analysis

8.7 Summary

Exercises

Problems

Valuation Assignment

Chapter 9 Enterprise Valuation

Chapter Overview

9.1 Introduction

9.2 Using a Two-Step Approach to Estimate Enterprise Value

Example: Immersion Chemical Corporation Acquires Genetic Research Corporation

Valuing GRC Using DCF Analysis

Valuing GRC Under the Growth Strategy

Sensitivity Analysis

Sensitivity Analysis: Cost of Capital

Sensitivity Analysis: Revenue Growth Rate

Sensitivity Analysis: Terminal-Value EBITDA Multiple

Scenario Analysis

9.3 Using the APV Model to Estimate Enterprise Value

Introducing the APV Approach

Using the APV Approach to Value GRC Under the Growth Strategy

Step 1: Estimate the Value of the Planning Period Cash Flows

Step 2: Estimate GRC’s Terminal Value

Step 3: Summing the Values of the Planning Period and Terminal Period

Using an EBITDA Multiple to Calculate the Terminal Value

Comparing the WACC and APV Estimates of GRC’s Enterprise Value

A Brief Summary of the WACC and APV Valuation Approaches

Estimating the Value of Subsidized Debt Financing

9.4 Summary

Exercises

Problems

Chapter 10 Valuation in a Private Equity Setting1

Chapter Overview

10.1 Introduction

10.2 Overview of the Market for Private Equity

Market for Private Equity—Financial Intermediaries

Investors—The Suppliers of Private Equity Finance

Investments—The Demand for Private Equity Finance

10.3 Valuing Investments in Startups and Deal Structuring

The Cost of Capital for Venture Capital Financing

How do you think about rates of return you target for private equity investing?

How much of your endowment portfolio do you allocate to private equity?

Valuing a VC Investment and Structuring the Deal

Investor Expectations

Valuing Bear-Builders.com’s Equity

Estimating Enterprise Value at the End of the Planned Investment Period

Computing Ownership Interests—Defining the Deal Structure

Summing Up the Venture Capital Method

Pre- and Post-Money Value of the Firm’s Equity

Refining the Deal Structure

Using Staged-Financing Commitments

Using Debt or Preferred Stock

10.4 Valuing Leveraged Buyout Investments

Alternative LBO Acquisition Strategies—Bust-Ups and Build-Ups

Example—Build-Up LBOs

Estimating Equity Returns for the Platform Company

Analyzing the Returns from the Add-On Investment

A Limitation of the Private Equity (LBO) Valuation Approach

Valuing PMG Inc. Using the Hybrid Adjusted Present Value Approach

Private Equity Value Drivers

10.5 Summary

Exercises

Problems

Terminology

Part V Futures, Options, and the Valuation of Real Investments

Chapter 11 Using Futures and Options to Value Real Investments

Chapter Overview

11.1 Introduction

11.2 The Certainty-Equivalence Method

Forward Prices as Certainty-Equivalent Cash Flows

11.3 Using Forward Prices to Value Investment Projects

Example: Pricing Against the Forward Price Curve

Convincing Your Skeptical Boss

11.4 Using Option Prices to Value Investment Opportunities

Option Value and Nonrecourse Financing

Valuing the Investment Using Forward Prices

Analyzing Equity Value with the Default Option—Managing the Project

Convincing Your Skeptical Boss

11.5 Caveats and Limitations—Tracking Errors

How Liquid Are Futures, Forward, and Option Markets?

Uncertain Quantities and Operating Costs

Basis Risk

Differences in Product Quality

Differences in Geographic Locations

Differences in Contract Terms

The Relation Between Tracking Error and Imperfect Comps

11.6 Using an Option Pricing Model to Value Investments

Example—Valuing the Cotton Valley Investment Using the Binomial Option Pricing Model

How Does Volatility Affect Option Values?

Calibrating Option Pricing Models

11.7 Summary

Exercises

Problems

What Is an Option?

How Can We Characterize the Payoffs to Option Contracts?

Defining Call Option Payoffs

Defining Put Option Payoffs

Risk and the Valuation of Options

Valuing Call Options Using the Black-Scholes Model

Summing Up

Chapter 12 Managerial Flexibility and Project Valuation: Real Options

Chapter Overview

12.1 Introduction

12.2 Types of Real Options

Real Options to Consider Before an Investment Launch

Real Options to Consider After an Investment Launch

12.3 Why Real Option Valuation Is Difficult

12.4 Valuing Investments That Contain Embedded Real Options

The Option to Invest: Staged Investments

Valuing an Oil Lease

Traditional (Static) DCF Analysis of the Lease

Certainty-Equivalent Analysis—Using the Forward Price to Value the Lease

Dynamic Analysis—Valuing the Lease As an Option to Produce Oil

Valuing the Option to Delay or Wait

Hedging the Price Risk of Delaying the Decision to Invest

More Complicated Options and the Incentive to Wait

Do Firms Delay Optimally?

Option to Abandon

Stripper Well Example

12.5 Analyzing Real Options As American-Style Options

Evaluating National Petroleum’s Option to Drill

Hedging Oil Price Risk

Considering the Option to Delay

Valuing American Options Using a Binomial Lattice

Solving for the Value of the Undeveloped Oil Field

Constructing the Binomial Lattice for the Developed Oil Field

Real Option Valuation Formula

Real Estate Development Option

How Do Changes in Model Parameters Affect Real Option Values?

Extensions of the Model

Applying the Model to a Chemical Plant

Limitations of the Model

12.6 Using Simulation to Value Switching Options

Option to Switch Inputs

Static NPV Analysis of the Plant Choices

Dynamic Analysis—Valuing the Option to Switch Fuel Sources

Modeling Future Oil and Gas Prices

Using Simulation to Value the Flexibility Option

Trying to Fit the Problem into the Black-Scholes Model

Using the Wrong Volatility

Assuming That the Exercise Price of the Real Option Is Fixed

Overestimating the Value of Flexibility

Double-Counting Risk

12.7 Summary

Exercises

Problems

Multiple Time Steps per Year

Building the Binomial Lattice for the National Petroleum Oil Field Investment

Chapter 13 Strategic Options: Evaluating Strategic Opportunities

Chapter Overview

13.1 Introduction

13.2 Where Do Positive NPV Investments Come From?

13.3 Valuing a Strategy with Staged Investments

Description of Vespar’s New Coal Technology

Stand-Alone Project Analysis of the Initial Plant

Analyzing Projects As Part of a Strategy

Details of the Plan

A Naïve, Static Analysis of the Value of Vespar’s Strategy

An Option Pricing Approach for Evaluating Vespar’s Strategy

Recapping the Analysis of the Vespar Strategy

Using DCF Analysis to Estimate the Value of Vespar’s Strategy

The Anatomy of Vespar’s Power Plant Strategy

Sensitivity Analysis of Vespar’s Power Plant Strategy

Sensitivity Analysis of the Strategy One Variable at a Time

Simulation Analysis of the Strategy

13.4 Strategic Value When the Future Is Not Well Defined

Which Investments Generate Strategic Options?

How Does Corporate Structure Affect Strategic Option Value?

Management Incentives, Psychology, and the Exercise of Strategic Options

13.5 Summary

Exercises

Problems

Epilogue

Index