Annuity Cost of Equity (r E) -> return to shareholders
PV of
( 1+r )
X = amount of Dividend Discount Constant long-term growth:
annuity
Payment 1 ¿ 1+ P 1
beginning PV ( X ,n ,r ) =X × ¿] Model (DDM) Price=P 0= ¿1 ¿2
next
r = Interest rate/yield r E + P 0= +…
period:
n = time 1+r E (1+ r E )2
PV of a
g = growth rate 1 ¿1
growing PV ( X , g , n , r )= X × ¿ ¿ 1+ P 1 ¿1 P 1−Pℜ=
0 +g
annuity at g
r>g r −g r E= −1= + P0
P0 P0 P0
Perpetuity Div Yield
Capital Gain
X
PV of perpetuity beginning next period: PV = Total Payout
Model
P 0=Total Payout / ( ℜ−g ) / Number of Shares
r
Capital Asset Establishes relationship between price of a security and its risk
X Pricing Model CAPM used to determine the cost of capital (r): minimum
PV of a growing perpetuity at g PV = (CAPM) return required by investors for a certain level of risk
r−g Assumes investors are well diversified, thus risk premium
potential is proportional to a measure of market risk (Beta)
Cash-Flow
EBIT(1-τ c) EBIT ( 1−τ c )=(Sales−COGS−SGA −Depreciation)∗(1−τ c)
τ c =Net income / EBT Expected return on stock = Risk-free rate + Beta of stock * Market
risk premium
Operating CF EBIT(1-τ c) + Depreciation
r E=r f + β i∗[ E ( r M ) −r f ]
FCFF FCFF=EBIT ( 1−τ c ) + Depreciation−CapEx−Changes∈WC
FCFF (incl.
liquidation value) FCFF (+liq )=FCFF +liquidation value−Tc∗(liquidation value−BV ¿assets)
Cost of Debt (r D) -> return to creditors
FCFF Yield to Maturity Single discount rate that equates the PV of the bond’s remaining
FCFF discounted FCFF (disc .)= t r =cost of capital (YTM) CF to its current price
(1+r )
FCFF disc.
cumulative
FCFF ( disc . cumul . t 0 ) =FCFF disc . at t 0
FCFF ( disc . cumul . )=disc . cumul . at t−1+cumul . FCFF at current t
Price=
( Couponrate∗par value )∗1
Find y
y
1−
1
[
( 1+ y ) n
+
(1+ y)]
par value
n
CF based Criteria r D= y− p∗L=YTM −Prob ( default )∗expected loss rate
Payback Period FCFF d . c .(Year
yearof of change)
change = last
(PP) PP=t at year of change− neg. Binomial Model
FCFF d ( year o . c .+ 1) Call: right to buy at strike price
Put: right to sell
FCFF FCFF (t 0) FCFF (t 1) FCFF (t 2)
NPV NPV =Σ = + + +…
(1+r )t (1+ r )0 (1+r )1 (1+r )2 1. Given, dt, volatility and Rf
Profitability Index
(PI) PI =NPV /CapEx u=e σ √ dt
IRR
Cash Flow: -/+/- do not compute; if NPV positive IRR higher than cost d=1/u
of capital (r) ( Rf∗dt )
NPV comparing projects with different lives e −d (contin.)
¿
pu =
not sufficient for comparison when different u−d
[ ]
Equivalent
1 1 EA 1+ R f −d
Annuity ∗ 1− discount rates (r) – Perpetuity
r (1+ r )n r pu = (discrete)
u−d
pd =1− pu
2. Build tree for underlying asset E E E
3. Compute payoffs at maturity T (S at T-K is S0) rU = r E+ r D− r τ reduction due to interest tax shield
Call=Max ¿ ) E+ D E+ D E+ D D c
(ITS)
Put =Max ¿ ) -> negative = 0 (will not be executed)
4. Discount back payoffs at maturity + repeat until you get value at t=0 PV of the Interest Tax Shield
u d
p u∗C + ( 1− pu )∗C Regular Case
Annual ITS = τ c (Corporate tax rate) * (Interest
(continuous) Payment)
(¿ Rf ∗dt )
e ¿ τ c (R D D)
Special Case #1: Firm borrows
u
p u∗C + ( 1− pu )∗C
d
debt D and keeps level of D
PV ( ITS )= =τ c D -> debt
(discrete) permanently
RD
(1+ R f )t is perpetuity
5. Calculate expected payoff 1
Special Case #2: Interest PV ( ITS )=annualinterest × tax rate × ¿
current value of call option=( C 1∗pu ) +(C2∗p d )/(R f +1) payments are known r
)
current value of put option= ( P1∗pu ) +(P2∗pd )/( Rf +1)
E D
( 1 ) Pre−Tax wacc= r E+ r ;
Black-Scholes Model E +D E+ D D
Assumes that rate of return of underlying asset follows random walk
( )
Call0=N d1 ∗S0−N d 2 ∗PVN(d) ( )
( K )= cumulative
normal distribution
S = current share
price U FCF
S0 K = exercise price = volatility (st.d. V =
ln ( ) t = time to maturity in of r) Special Case #3: Target D/E Pre tax wacc−growth rate of FCF / perpetuity
PV ( K ) σ √ t years *d2: use positive Ratio E D
d 1= + value, then 1-value (2) r wacc = r + r (1−τ c ) ;
σ√t 2 from table E + D E E+ D D
d 2=d 1−σ √ t * L FCF
V =
PV ( K )=K∗e
(−R ∗dt) f r wacc −growt h rate of FCF
(3) PV ( ITS ) =V L −V U
Put-Call Parity
Put =Call−S0 + PV (K ) // Call +PV(K)=Put +S Valuation with Corporate Taxes (Tc) I Constant D/E Ratio
WACC (1) Determine FCFs and rwacc :
Modigliani-Miller Model Method E D
MM I r wacc = r E+ r ( 1−τ c )
Value of levered Firm = Value E +D E+ D D
of unlevered Firm (zero debt) MM II
rE = Cost of levered
L FCF 1 FCF 2 FCF 3
L U Equity (2) Compute V0L : V 0= + + +…
V =V D rU = Cost of unlevered 1+r wacc (1+r wacc)2 (1+r wacc )3
With r E=r U + (r U −r D ) Equity
L U E ! FCF0+V0L = NPV of project
τ c :V =V + PV (ITS ) E = Market value of
Equity APV Method (1) Determine unlevered value of firm:
FCF D = Market Value of Debt (adjusted PV) E D
V U= r U = pretax WACC= r + r
rU E+ D E E+ D D
E E U FCF 1 FCF 2 FCF 3
rU = pre-tax WACC = rA ; rU = r E+ r (2) Compute V :V =
U
+ + +…
E+ D E+ D D 1+ r U (1+ r U ) (1+r U )3
2
WACC with Corporate Taxes
(3) Estimate annual interest payments: t=r D × D t −1
(4) Compute PV (ITS):
ITS1 ITS 2 ITS 3
PV ( ITS )= + + +…
1+r U (1+r U ) (1+r U )3
2
L U
(5) Determine VL: V =V + PV ( ITS )
FTE Method (1) Calculate FCFE = FCF - (1-τ c) x Interest Payments
t t t + Net
(Flow-to-
Equity) Borrowingt // FCFEt= Net Incomet + Depreciationt - CapExt –
Increase in NWCt+ Net Borrowingt [with Net Borrowing at t =
*rE = Equity Dt – Dt-1]
cost of D
capital (2) Compute FCFE and rE (r E=r U + (r −r ))
E U D
(3) Determine NPV(FCFE) at rE*:
FCFE1 FCFE 2
NPV ( FCFE )=FCFE0 + + +…
1+ r E (1+r E)2
EXAMPLES
What is the value (BS) of a call option? [=40%, S=5.75, YTM=30months/2.5 years,
Rf=2% (cont.), K=6.55]
Calculate PV(K) −0.02× 2.5
PV (6.55 )=6.55 × e =6.23
Calculate d1 and d2 5.75
ln ( )
6.23 0.4 √ 2.5 ;
d 1= + =0.189
0.4 √ 2.5 2
d 2=0.189−0.4 √ 2.5=−0.443
Compute N(d1) and N(d2) Table Normal: N(d1) = .5793; N(d2) = .3300
Calculate Call-Option- 0.5793 ×5.75−0.3300 ×6.23=1.275
Price
