0:09

welcome

back we

did the comparable analysis

we got

Ra of

6.3 percent matched by a beta asset of .86

6 percent matched by .8 depending on which valuation method is more appropriate

for the tax shield we are now going to apply it to valuation I'm going to use

both approaches

throughout but at the end of the day based on information you have you’ll use

one approach

because there's no point actually there is some point in using all approaches

and trying to figure out what's going on

always you know if you set it up but at the end of the day you don't have to use

all three

in fact you may need information you may be able to do only one of them based on

what information you have

I always prefer adjusted present value though

okay so where did you get all this

Ra beta A information you got it from your comparable

so let's assume that the most important part is over

getting the comparable right getting beta asset and return on asset

right ok so now you want to do the valuation of the Sears idea

so let's give you some numbers for Sears what belongs to

Sears is the new online business

by what belongs I mean the cash flows are something that should have really

worried about and done

so let's assume for simplicity the cash flows are $250 million per year

for the foreseeable future what does that mean hint hint

you can do perpetuities simplicity

but by the way not too far from real life

because why not do a quick analysis to figure out how you're doing

and then more detail in life there are only four or five things in

every valuation there are discount rates cash flow estimates

growth rate in cash flows pretty much you're done to make calculations

simple sears is expected not to make capital investments

they've already made them working capital changes and depreciation are also

likely to be

close to zero this is not true in real life

just again to make things a little bit easier

now the first thing that Sears has to do

is to figure out whether it wants debt or not

and in order to do that it has to figure out

what is it focusing on so let's assume that Sears has thought through

this

and it wants its target debt to equity ratio to be 1

please write this but will leave this slide

up for a little while even while I'm talking

you are writing these notes so that this is basic information

but about whom not about bears anymore

not about the comparable but about your cash flows

and your financial policy so cash flows are 250 million per year

your financial policies are targeting a debt to equity ratio of 1

but when you go there you realize the debtto equity ratio means what 50 50

how much debt did the comparable have

30 out of 150 million only 20 percent

here it’s fifty percent so to make things a little bit realistic

the return on debt is 4 percent what was it before

2 percent for bears because they have lower debt

so making a little bit real because chances are the more debt you have the

riskier it is

for the debt holders as well there’s some chance of bankruptcy

and actually 50/50 is pretty high ratio so let's keep the

return on debt at 4 percent and remember that this is an example

now suppose the tax shield is

as the risky as Sears’ debt why am I saying

this because I want you to think about this because you can’t blindly run with

valuation

making some such assumption okay what does that mean

I'm signaling to you that if you want to use the tax shield

value of the tax shields of debt

for Sears not for bears that is done

you have to know use Rd as the discount rate simply because you've made that

assumption ok not Ra Rd so we are using approach one

using approach one let's do

all three methods so the first method we're going to talk about

and making sure my pen is working the first method we’ll talk about is

enterprise value method should be EBIT

I'm going to write this very slowly 1 minus TC

divided by

weighted average cost of capital

it's very important to have a symbol on weighted average cost of capital

because the weighted average cost of capital will be different

for bears and sears what will be same

Ra will be the same but the weighted average cost of capital will be

different why because weighted average cost of capital incorporates

the financial policy in the break you get

so this is so enterprise

valuation method is used a lot simply because it's simple

it looks simple but I think it's quite complicated because you're mixing

real and financial things

together quick question do I know the numerator

the answer is yes I know 250 million

times .66 so this is I'm going to use this number

over and over again so you might as well just calculate it

and see what it is okay but then

we don't know what WACC is

you have to figure out WACC so let's write the formula for WACC

and make sure we have

clear about what we know and what we don’t know

okay now I want Rd

and when I'm writing WACC I always pause and leave a gap so that

you know you're thinking instead of plugging and chugging
0:06:27.370,0:06:31.260
right so here have one minus

6:31

TC so let's just pause for a second do I know

my debt to equity ratio D over E

if D over E is 1 and by the way in a hurry many people make this mistake

they think D over E is the proportion it can’t be

the proportion has to be less than 1 so when I use 1 very often

you don't make this mistake but if D over E was .8 many people

substitute it here .8 and make this .2 now

D over E is not the proportion of debt in your entire capital structure

it’s the ratio of debt to equity right something we talk a lot about but

when you're using WACC you need weights which are not the same

so can you tell me what the weights are

think about it what would be the weights on equity and debt and do we know that

if we know the ratio of debt to equity we should know the weights as well

and they turn out to be half

and one way to think about it is if there are half and you take a ratio what

do you get

half divided by half is 1

so this is a nice way for me to also remember this

quick do you know this

the corporate tax rate is not different for bears and sears

so that's one same thing what was the Rd for bears

this was low because they are low debt but here I've given you that number how much

is it

4 percent everybody fine till now

so we know all the numbers and as I said earlier in the theoretical

or conceptual manifestation of this this is the number I need

and to get this number we go through a process called

re-levering okay so let's do that

we re-lever

there should be an E there re-lever what

Ra coming from whom

comp

and re-lever to get to whom

we re-lever to get to Re for

sears

using which approach approach number one

do we know the comp Ra using approach number one

answer is yes 6.3

percent now we need to go to Re of Sears

and we have all the formulas with you I'm going to now walk through and do

the

calculation Re will be equal to Ra

plus D what should I always think of

1 minus TC over E

Ra minus Rd

okay fair enough what do you get here

6.3 percent I’m going to just write out

the numbers

okay D over E okay

.66

because one minus TC is .34 D over E is one

you get .66 everybody okay yep

I’m saying yes myself what was Rd

4 percent so instead of cracking

through this together wasting our time a little bit we know that it has to be

greater than 6.3 percent

and we know by about 2 percent maybe or so

so the answer turns out to be actually

7.82 percent

I can't keep everything round right because it would be a

challenge creating a problem but I will carry two decimals because it's a discount

rate

so Re turns out to be 7.82 percent

now let's go back and figure out WACC

so WACC was what

half times 7.82

7.82 percent

plus half times .66

.66 why .66 1 minus TC

before you multiply

4 percent so your answer turns out to be

how much I think 5.23

5.23 percent

let's see if this makes sense 7.8 half is about

less than 4 a little bit plus a number

about 1 plus so it makes sense it's about 5.23 percent

okay almost done with enterprise value method

there’s one step left and let's write it out here

enterprise value is equal to 250

times .66 divided by

how much .0523

.0523 and the answer

turns out to be 3.11

11 sorry 15

5 billion dollars 3.155

3.155 billion dollars

this is the total value of the firm

can you tell me during the break

what is the split between debt and equity

you should be able to come back and tell me how much debt

how much equity let's take a break

enterprise value method using approach one has been done

we’ll do APV we’ll do equity valuation

but the toughest piece has been done one thing to remember from this

is Re the other thing to remember from this is Ra

and why am I saying that because Ra will be used in the APV method

and Re will be used in the equity valuation method

wheras enterprise kinda squishes both of them together

and uses some kind of average which is 5.23

see you in a bit