2:48

in other words you should know how much equity and debt youâ€™ll use

Â the other thing to remember is we are thinking long run

Â and perpetuity is a convenience with the long run

Â so perpetuity is a really long run but long run is the key word

Â there right so you're thinking long run and you're thinking the future

Â so it's very important to know that this is a strategic decision

Â where keeping equity and debt ratios constant means actively managing

Â the mix of the

Â two why because value of the firm will change

Â either because you're taking new good idea strategically and

Â they turn out to be good or just life remember you make

Â valuation decision at point zero and after that life takes over

Â kind of thing so the value of equity and debt mix will

Â change and the idea is you are keeping up with it and keeping with it

Â this is very important the other key element

Â of the WACC to remember is look at the discount rate built into it

Â as far as the debt proportion is concerned you are lowering your discount

Â rate from

Â Ra to WACC simply too capture all the

Â tax break so that's the methodology

Â so let's do it what is the value of the levered firm

Â using this methodology so this is what it does

Â so you do EBIT 1 minus

Â TC these are you after-tax cash flows

Â you haven't taken financing into account what else will you

Â add and subtract from this in real life youâ€™ll add back depreciation

Â youâ€™ll subtract changes in working capital and youâ€™ll subtract

Â cap ex another item right I'm trying to capture the essence of cash flows and

Â for convenience we have assumed you will do that you know how to do that

Â and assuming this is a perpetuity youâ€™ll

Â discount it by

Â this is called enterprise value and the enterprise value we know

Â we can calculate very simply here is what was EBIT

Â 150 million what was

Â taxes 34 percent so I'm going to

Â multiply it by .66

Â okay and Iâ€™m going to divide it by how much

Â .1193

Â remember I'm not dividing by .15 also remember this number has to be

Â lower than .15 where .15 is

Â the return on your essential assets

Â and the answer to this has to be it 830

Â why because I'm cheating I already know the value of the firm

Â right but just do it and the answer will be

Â .1193 okay we'll come back to this but

Â I'm not interested in the 830 as I say always all numbers are wrong

Â because they're about the future all your assumptions make sense but your

Â numbers are wrong

Â always iterate always do sensitivity analysis

Â so we know 830 canâ€™t be the right number but it's the right way of

Â thinking the

Â key things to take away from here which I think are very important

Â are your WACC has a

Â financial asset which is the tax shield

Â built into it in other words you're not distinguishing

Â between the value of the firm coming from your real assets

Â and the value of the firm coming from the financial asset given to you by the

Â government I'm calling it that even if

Â textbooks donâ€™t so youâ€™re pushing them all together and getting

Â 830 what will be the value of debt and equity

Â in this case we know it 500 million

Â will be debt therfore 330 million

Â will be

Â equity

Â okay so this is called enterprise value there's

Â another thing you'll see where value of the firm

Â L is always equal to value of debt and

Â equity and what weâ€™ll see many times is which Iâ€™ll

Â talk again and it happens in practice the enterprise value is the value of your

Â actual assets but there's cash sitting

Â on your balance sheet as well it happens to technology firms

Â a lot because they have great ideas and then

Â they market them they sell the product and then they are waiting for the next

Â in fact Microsoft my favorite example never paid any dividends because we

Â wanted it to reinvest it

Â was just awesome and then it was sitting with

Â billions of dollars and that was called excess cash

Â that is cash that is not working for you in an idea

Â and youâ€™ll have to incorporate that so you'll see that in enterprise valuation

Â or any valuation

Â you need to worry about the value of the excess cash and

Â kind of taking that into account because the value of your whole firm

Â equity and debt is value of your levered

Â firm assets tax break included

Â plus excess cash the second method

Â is called adjusted present value and I like it

Â for many reasons and I like it because

Â it is cleaner and it's more informative

Â so what does it do we have already done it kind of

Â so letâ€™s repeat it what it does is it says let me value Vu

Â separately because those are my real assets

Â and letâ€™s value TS

Â separately and the two will be the value of

Â the firm so what am I doing here I am

Â saying the reason I like it it's called adjusted present value so what is being

Â adjusted

Â this is the value of your real assets

Â to me that's life I mean that's what

Â that is the iPods the iPads name it service University of Michigan's courses

Â are hopefully creating a lot of value but then the government

Â in the case of debt gives you a tax break obviously to

Â for-profit companies right so this

Â part I like to think of it separately because they have very

Â directly very little to do with the value of your assets

Â so what does this do adjusted present value takes the present value of

Â your fundamentals and

Â adjusts them upwards for the tax break

Â but it's also important to remember if you do it well

Â youâ€™ll also adjust it downwards

Â for the value of bankruptcy costs so think about this

Â you take the value the firm VU and then you adjust it upwards for any kind of

Â non real asset related

Â breaks you're getting and adjust it downwards for any costs you're imposing on

Â yourself

Â so bankruptcy costs can be very important when you have high levels of

Â leverage and youâ€™re close to bankruptcy

Â okay so you have to build them in tricky

Â very tricky to do simply because it's easy to think of a tax break because

Â it's based on cash flows that are simple and the tax rate

Â bankruptcy is tough to predict and then what are the costs involved are

Â tough to predict but let's get started on this

Â how would you do this so what is Vu

Â Vu is the value of the firm without any

Â tax break of debt included we know the answer already

Â but let's go slowly how did I get 660 million

Â I took 150 million

Â which was what EBIT 1

Â minus TC and discounted it at what

Â Ra and this was

Â EBIT which is

Â 99 million discounted at 15 percent

Â remember I'm not discounting at WACC this is clean

Â I'm just taking the after-tax cash flows and discounting it at the

Â true cost of capital for my business and it is 660 million

Â but then I'm saying TS how do you do TS let's go slowly

Â we did it once you take debt

Â and you multiply it by the interest rate on debt

Â and then multiply it by tax

Â this is the cash flow every year on your tax shield

Â why let's put it in numbers this is 500 million

Â this is multiplied by .1 and this is multiplied by .34

Â and remember this was what 17 million

Â and then you discount it at a rate that makes sense for the tax shield

Â let's make the assumption for the time being before getting practical

Â is that that's the same as Rd which is what

Â 10 percent answer turns out to be

Â 170 million okay

Â so the total value of the firm is what

Â 830 million clean value of the firm

Â unlevered and then you add the tax shield turns out the

Â tax shield formula becomes very simple instead of multiplying it right

Â through three terms do you see something in common between the

Â numerator and the denominator

Â answer is yes in this case all you are looking at is the same Rd so Rd Rd cancels

Â and this number

Â turns out to be TcD

Â what is TC .34

Â what is this 500

Â million so about a third of the 500 million

Â is 170 so valued of the levered firm

Â is equal to 660 plus 170 million

Â to 830 so that is called the

Â adjusted present value there's a third

Â method and remember theyâ€™re multiples but they're based on

Â basically this kind of thinking so let's do that

Â the before we do that just very quickly what are the

Â assumptions underlying adjusted present value the assumptions underlying

Â adjusted present value is

Â when we used enterprise value we said we need to know

Â D over E quick question

Â what do you need to know for doing the APV method

Â here you need to know a ratio

Â here you need to know the level

Â level of

Â because think about it what did we do we took the tax break, tax shield

Â Vu very easy to calculate but then we calculated the tax shield and

Â to do the tax shield you need to know three things

Â debt actually four level of debt

Â multiplied by Rd multiplied by TC

Â I said three because TC everybody knows right

Â but you also needed to know what the discount rate was

Â turns out you could be used two discount rates based on logic

Â but here weâ€™re using Rd

Â right so remember if you don't know this

Â we cannot do it it's the level of debt not the ratio

Â remember E is not showing up the important point about here is that

Â D is the same here throughout in perpetuity for convenience

Â but usually what happens to the level of debt it'll

Â change over time so the important thing to remember is

Â AP needs a level of debt this need a ratio

Â okay letâ€™s go to the last method now

Â the last method is called equity valuation method

Â and what the equity valuation method does is it looks at the balance sheet

Â identity and says look

Â instead of valuing the assets letâ€™s value the equity

Â and add back the value of debt

Â because the value of the levered firm can be written as

Â value of equity value of debt and add them together

Â here we already know this is $500 million

Â so the only thing left to do is value equity

Â this method is used particularly in certain instances but I put it third

Â because it's very similar to one of the earlier methods itâ€™s just going

Â it's going directly to the value of the firm

Â from the value of the liabilities whereas the earlier two methods are much more

Â interesting

Â value comes from your assets so you go to the asset side and value them

Â the beauty of this method is you can see equity trading and itâ€™s

Â pretty straightforward to figure out but let's go through the logic of it

Â in our example so

Â debt is $500 million

Â not a problem so what is value of equity

Â what are the two things I need I need cash flow to equity

Â and I need return on equity

Â do I know the return on equity already answer is yes we did it

Â it was equal to 20 percent and it'll always be

Â greater than or equal to what return on assets

Â simply because itâ€™ll be equal to return on assets if

Â there's no debt as soon as you take debt you make equity riskier

Â what is the cash flow to equity so let's do it

Â systematically you have EBIT

Â of 150 million

Â do you get this cash flow you just get it directly or do you first

Â pay somebody else you just first have to pay somebody else and that is called

Â interest which is 50 million a year

Â how do I know that my debt is $500 million and my Rd is

Â 10 percent so you have $50 million how much is left over

Â 100 million but somebody else is waiting to

Â get its money and it's called taxes negative

Â 34 million youâ€™re left with $66 million

Â so every year in the levered firm

Â with the tax deductibility of interest please with the taxes you are left with

Â 66 million so what's cash flow 66

Â million so that's what it does the formula is this

Â EBIT minus I

Â 1 minus TC remember this is different all of these look similar this is

Â different from cash flow to the firm

Â and the difference is coming only because of the fact

Â that you're paying this guy before paying taxes

Â you have to do that because you have tax deduction but you also have to do that

Â because youâ€™ll have to pay

Â interest first so you pay this and discount it by

Â Re and the answer turns out to be 66 million

Â divided by .20 which is

Â 330 million value of the levered firm

Â is 330 million plus 500 million is equal

Â to 830 million

Â okay couple more minutes and weâ€™ll be done

Â so what are the underlying assumptions of the equity valuation method

Â pretty much the same as WACC

Â and equity valuation you need to know

Â the ratio of D over E

Â because if you don't know your capital structure and how it looks like

Â it's tough to figure it out return on equity okay we'll go through

Â applications of this so many times

Â that youâ€™ll get tired of it but it's good to know

Â how to do all three methods

Â alternative methods of valuation so the wrap-up

Â to this is are all valuation method substitutes

Â the real world answer is no

Â they are different ways of looking at the value of the firm

Â and based on your assumptions you'll use

Â methods that apply so the two most used methods are

Â WACC based enterprise value and

Â the method of adjusted present value they are substitutes because one requires knowing

Â the capital structure

Â ratio the other requires the level of debt should they provide the same valuation

Â answer is actually a little bit tricky and we'll get the answer in the future

Â and as you know answers are tougher always to figure out of tougher questions

Â here we got the same valuation I will leave it at that

Â and let you think about it just to give you a hint

Â that's not true always and the question is why what about this situation made you

Â get the same answers

Â I can't help myself another hint value

Â of everything was a perpetuity and it was

Â without growth so thatâ€™s one hint what is excess cash

Â Iâ€™ll come back to that this has been all about valuing

Â what is called the existing assets of the firm

Â but the firm many times also sits on cash

Â because it has ideas for the future

Â now you may ask why does it do it well maybe it's the case that

Â cash sitting on your balance sheet or in your company

Â is easier to access than raising more capital

Â so that could be one reason there are several reasons why

Â you would prefer internal cash

Â as opposed to going out the market over and over again

Â the point here is not about your financial policy the point here is if your excess cash

Â sitting

Â the trick is to figure our that amount and then add it back to the

Â value of the firm your existing assets

Â think about it the following way if somebody came to buy your firm

Â and your firmâ€™s assets were worth 100 million and 20 million you had set aside for

Â taking future projects or whatever you wonâ€™t sell your firm for 100 million

Â you will sell it for 120 right

Â that's the logic I hope this has been useful

Â I'm going to do in my next modular form

Â most closely related to this method I mean to this topic

Â itâ€™s called practical aspects of valuation

Â and it will build on what we just learned and

Â use a lot of numbers always but more importantly

Â show you little issues about real life and the primary issue there will be

Â how do you value a tax shield in the real world

Â is using the discount rate Rd for your tax shield

Â the only way to do it and the answer is no

Â so a lot of detail a lot of real-world

Â stuff in the next module closely related to

Â this see you

Â