The Value of Control Aswath Damodaran Home Page : www.damodaran.com E-Mail : adamodar@stern.nyu.edu Stern School of Business Aswath 1 Damodaran
Why control matters… When valuing a firm, the value of control is often a key factor is determining value. For instance, • In acquisitions, acquirers often pay a premium for control that can be substantial • When buying shares in a publicly traded company, investors often pay a premium for voting shares because it gives them a stake in control. • In private companies, there is often a discount atteched to buying minority stakes in companies because of the absence of control. Aswath 2 Damodaran
What is the value of control? The value of controlling a firm derives from the fact that you believe that you or someone else would operate the firm differently (and better) from the way it is operated currently. The expected value of control is the product of two variables: • the change in value from changing the way a firm is operated • the probability that this change will occur Aswath 3 Damodaran
Discounted Cashflow Valuation: Basis for Approach where CF t is the expected cash flow in period t, r is the discount rate appropriate given the riskiness of the cash flow and n is the life of the asset. Proposition 1: For an asset to have value, the expected cash flows have to be positive some time over the life of the asset. Proposition 2: Assets that generate cash flows early in their life will be worth more than assets that generate cash flows later; the latter may however have greater growth and higher cash flows to compensate. Aswath 4 Damodaran
Equity Valuation Figure 5.5: Equity Valuation Assets Liabilities Assets in Place Debt Cash flows considered are cashflows from assets, after debt payments and after making reinvestments Discount rate reflects only the needed for future growth cost of raising equity financing Growth Assets Equity Present value is value of just the equity claims on the firm Aswath 5 Damodaran
Firm Valuation Figure 5.6: Firm Valuation Assets Liabilities Assets in Place Debt Cash flows considered are cashflows from assets, Discount rate reflects the cost prior to any debt payments of raising both debt and equity but after firm has financing, in proportion to their reinvested to create growth use assets Growth Assets Equity Present value is value of the entire firm, and reflects the value of all claims on the firm. Aswath 6 Damodaran
Valuation with Infinite Life DISCOUNTED CASHFLOW VALUATION Expected Growth Firm: Growth in Cash flows Operating Earnings Firm: Pre-debt cash Equity: Growth in flow Firm is in stable growth: Net Income/EPS Equity: After debt Grows at constant rate cash flows forever Terminal Value CF1 CF2 CF3 CF4 CF5 CFn Value ......... Firm: Value of Firm Forever Equity: Value of Equity Length of Period of High Growth Discount Rate Firm:Cost of Capital Equity: Cost of Equity Aswath 7 Damodaran
DISCOUNTED CASHFLOW VALUATION Cashflow to Firm Expected Growth EBIT (1-t) Reinvestment Rate - (Cap Ex - Depr) * Return on Capital Firm is in stable growth: - Change in WC Grows at constant rate = FCFF forever Terminal Value= FCFF n+1/(r-gn) FCFF1 FCFF2 FCFF3 FCFF4 FCFF5 FCFFn Value of Operating Assets ......... + Cash & Non-op Assets Forever = Value of Firm Discount at WACC= Cost of Equity (Equity/(Debt + Equity)) + Cost of Debt (Debt/(Debt+ Equity)) - Value of Debt = Value of Equity Cost of Equity Cost of Debt Weights (Riskfree Rate Based on Market Value + Default Spread) (1-t) Riskfree Rate : - No default risk Risk Premium Beta - No reinvestment risk - Premium for average + X - Measures market risk - In same currency and risk investment in same terms (real or nominal as cash flows Type of Operating Financial Base Equity Country Risk Business Leverage Leverage Premium Premium Aswath 8 Damodaran
Avg Reinvestment SAP: Status Quo rate = 36.94% Return on Capital Reinvestment Rate 19.93% Current Cashflow to Firm 57.42% Expected Growth EBIT(1-t) : 1414 Stable Growth in EBIT (1-t) - Nt CpX 831 g = 3.41%; Beta = 1.00; .5742*.1993=.1144 - Chg WC - 19 Debt Ratio= 20% 11.44% = FCFF 602 Cost of capital = 6.62% Reinvestment Rate = 812/1414 ROC= 6.62%; Tax rate=35% =57.42% Reinvestment Rate=51.54% Terminal Value10= 1717/(.0662-.0341) = 53546 Growth decreases First 5 years gradually to 3.41% Op. Assets 31,615 Term Yr Year 1 2 3 4 5 6 7 8 9 10 + Cash: 3,018 EBIT 2,483 2,767 3,083 3,436 3,829 4,206 4,552 4,854 5,097 5,271 5451 - Debt 558 3543 EBIT(1-t) 1,576 1,756 1,957 2,181 2,430 2,669 2,889 3,080 3,235 3,345 - Pension Lian 305 - Reinvestm 905 1,008 1,124 1,252 1,395 1,501 1,591 1,660 1,705 1,724 1826 - Minor. Int. 55 1717 = FCFF 671 748 833 929 1,035 1,168 1,298 1,420 1,530 1,621 =Equity 34,656 -Options 180 Cost of Capital (WACC) = 8.77% (0.986) + 2.39% (0.014) = 8.68% Value/Share106.12 Debt ratio increases to 20% Beta decreases to 1.00 On May 5, 2005, SAP was trading at Cost of Equity Cost of Debt 122 Euros/share Weights 8.77% (3.41%+..35%)(1-.3654) E = 98.6% D = 1.4% = 2.39% Riskfree Rate : Risk Premium Beta Euro riskfree rate = 3.41% 4.25% + X 1.26 Unlevered Beta for Mature risk Country Sectors: 1.25 premium Equity Prem 4% 0.25% Aswath 9 Damodaran
A. Value of Gaining Control Using the DCF framework, there are four basic ways in which the value of a firm can be enhanced: • The cash flows from existing assets to the firm can be increased, by either – increasing after-tax earnings from assets in place or – reducing reinvestment needs (net capital expenditures or working capital) • The expected growth rate in these cash flows can be increased by either – Increasing the rate of reinvestment in the firm – Improving the return on capital on those reinvestments • The length of the high growth period can be extended to allow for more years of high growth. • The cost of capital can be reduced by – Reducing the operating risk in investments/assets – Changing the financial mix – Changing the financing composition Aswath 10 Damodaran
I. Ways of Increasing Cash Flows from Assets in Place More efficient Revenues operations and cost cuttting: * Operating Margin Higher Margins = EBIT Divest assets that - Tax Rate * EBIT have negative EBIT Live off past over- = EBIT (1-t) investment Reduce tax rate - moving income to lower tax locales + Depreciation - transfer pricing - Capital Expenditures - risk management - Chg in Working Capital Better inventory = FCFF management and tighter credit policies Aswath 11 Damodaran
II. Value Enhancement through Growth Reinvest more in Do acquisitions projects Reinvestment Rate Increase operating Increase capital turnover ratio * Return on Capital margins = Expected Growth Rate Aswath 12 Damodaran
III. Building Competitive Advantages: Increase length of the growth period Aswath 13 Damodaran
IV. Reducing Cost of Capital Outsourcing Flexible wage contracts & cost structure Reduce operating Change financing mix leverage Cost of Equity (E/(D+E) + Pre-tax Cost of Debt (D./(D+E)) = Cost of Capital Make product or service Match debt to less discretionary to assets, reducing customers default risk Changing More Swaps Derivatives Hybrids product effective characteristics advertising Aswath 14 Damodaran
SAP : Optimal Capital Structure Debt Ratio Beta Cost of Equity Bond Rating Interest rate on debt Tax Rate Cost of Debt (after-tax) WACC Firm Value (G) 0% 1.25 8.72% AAA 3.76% 36.54% 2.39% 8.72% $39,088 10% 1.34 9.09% AAA 3.76% 36.54% 2.39% 8.42% $41,480 20% 1.45 9.56% A 4.26% 36.54% 2.70% 8.19% $43,567 30% 1.59 10.16% A- 4.41% 36.54% 2.80% 7.95% $45,900 40% 1.78 10.96% CCC 11.41% 36.54% 7.24% 9.47% $34,043 50% 2.22 12.85% C 15.41% 22.08% 12.01% 12.43% $22,444 60% 2.78 15.21% C 15.41% 18.40% 12.58% 13.63% $19,650 70% 3.70 19.15% C 15.41% 15.77% 12.98% 14.83% $17,444 80% 5.55 27.01% C 15.41% 13.80% 13.28% 16.03% $15,658 90% 11.11 50.62% C 15.41% 12.26% 13.52% 17.23% $14,181 Aswath 15 Damodaran
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