hi what we have been talking about

is practical

aspects of valuation and

the world gets

complicated going from a simple scenario which is

I think a natural scenario of having a company without any

frictions then we added taxes and

as long as the financing doesn't have tax benefits

in this case debt things are pretty simple things are complicated as soon as

you allow for the tax deductibility of interest and debt

so let's get started so you know

the first step is you've figured out your cash flows

and I'm going to assume that we have done that

and this is your responsibility

i.e. you are valuing the company that you are starting

your responsibility and for the time being we’ll assume

to focus on EBIT right

because we won’t worry about change in working capital depreciation

cap ex it's always there but we'll have taxes of course so this is taken care of

this is your business second I

want the discount rate and to go to a discount rate

that's where we started saying I want to go to a comparable

right and the comparable

is actually multiple why do you want multiple comparables you want multiple comparables

because

each one is one data point and you want

accuracy in your discount rate because remember because

compounding answer to all questions in finance

it's very important to get it right

right so as much data as possible the

trouble is that they should be pure plays which means what

that they should be very similar to your business but

comparables are not you they are the next best alternative for the investor

so

when you're valuing the company even if it’s your idea

always think of your responsibility as cash flows and comparables for the

discount rate

but more pure plays are tough to find

because companies don't do just one thing they are a complex mix of things

okay so yes you want more pure plays but you don't want a mix of

businesses coming into companies which form your comparables

very important step think about this when you buy a house you want to know

what the value of the house is

but even in the same neighborhood houses are very different from each other

so what does your real estate agent do they find comparables

but they look at them to make sure at least some basic things at the same

like number of bedrooms general view

number of windows kind of living room total space number of bathrooms

so in that sense your comparable is extremely important because if you

miss this step

there's no point doing the analysis right

so again if you're investing in the stock market but your’re

comparing it to a bank there's no point apples and oranges

so what is the discount rate you get from incomparable

its always Ra remember that Ra would have been your WACC

would have been your discount rate would have been return on equity if there was no

debt

right but now with taxes and with debt

things get a little bit complicated but you go to comparables

to get the basic discount rate of business

and this is for business and then the third step will be

how do you convert that to your discount rate

and that's a tricky one because there are three ways of valuation

and we’ll talk about them in a second but the first one is

enterprise value which doesn't use Ra which uses WACC

which has the tax subsidy of interest

built in but depends on your financial policy not the financial policy of the

comparable

right then equity valuation uses Re

not Ra the only valuation method that uses Ra to value the pure

business is adjusted present value

and then it tags on the interest

deductibility as a second piece that's why i like APV

much better it's very clean anyway how do you get Ra

there are two approaches right one assumes that

Rd is the discount rate for

and I can afford to use symbols tax shield

the other one is that Ra is the discount rate

for the tax shield

so I hope this makes sense what I'm going to do now is I’m going to go over

one more time the equations that

relate to these if you take approach one

this is the set of equations you get you get Ra

is equal to what E

over every time you see D

you write 1 minus TC plus

E and what is the

return Re plus

D 1 minus TC

over D 1 minus TC

plus E if you're notice I sometimes kinda

have trouble writing with this pen well I have trouble writing with anything for that

matter

because we don't write anymore but just be patient and

as I'm talking write these equations even if you write them

ten times over that's fine so notice that everytime D enters 1 minus TC

enters and we covered this last time

now which side of the equation do you observe

you observe the Res and Rds then you get to Ra

right but it's also important to recognize what's going on

and I can rewrite Re

and this is just algebra and you’ll see we'll use it

in terms of Ra plus

D 1 minus TC

over E Ra

minus Rd please note

this equation number two

one two follows from one

so if I rearranged one I get two

and here the nice thing about two is return on equity is more observable and it

gives you a sense of

what it is composed of if there's no debt

this second part of the question disappears and Re and Ra are the same

which would be an ideal case easiest case to do if your comparable has no

debt you directly go to Ra to Re

so it's nice to have but also it tells you that Re will be greater than Ra

because this ratio is positive and it turns out

this will always be positive return on your assets will always be greater than Rd

right so the right hand side has two components one is business

return and the other is a financial return for taking on

debt I now give you a little homework

and do this when we take a break not right now

what will be the corresponding beta equations

and the hint is that the beta

always goes one in one in a linear way

with returns so whenever you see R you can replace it by beta

that's a big hint by the way what is approach two approach two kind of

comes out cleaner and in approach two what are you assuming for the tax shield and let

me write this

this is Rd applies to the tax shield

here Ra applies to the tax shield

the equation becomes very much simpler

Ra is equal to E over D plus

E Re plus

D over D plus E Rd

Rd and that I'll call 1 prime remember these are alternative

approaches a little bit confusing but once you get the hang of why this is

going on it's simply going on because we don't know

what is the appropriate discount rate for the tax shield

you can rewrite this as Re Ra

plus now you can stare above D over E

1 minus TC's are just disappearing do it right okay

so just make these notes remembering that these are two different ways of

figuring out the Ra and

which land are we in our own analysis

or comparables we are thinking of comparables but we'll use similar

equations

to then figure out our own discount rate

okay so let's talk a little bit about the three methods of valuation before

jumping into a

mega problem okay just a little bit then we'll take a break

so first method is called enterprise value what information do I need to

figure it out

well the information I need for enterprise value is

cash flows and I'm going to talk to this you can make notes

cash flow and I need to know

the weighted average cost of capital but in order to know the weighted average

cost of capital

I need to know the Ra from the alternative business

but go from Ra to WACC

the two are not the same so please remember we have done this

RA is always greater than weighted average cost of capital

simply because

you are now subsidizing you as in sorry

the government is now subsidizing you for taking on debt

okay what is the information I need to figure out

APV APV is the second method of valuation

well in this case I need to figure out cash flows again

but now the cash flows have to be thought of

in slightly different ways so

one is the cash flow to the business and it'll be discounted at

Ra and we call that Vu and the second piece is

we tag along the present value of the tax shield

okay so the information we need is when we are valuing the tax shield now

what is the appropriate discount rate and we’ll go through those steps

okay we'll take an example and go to those steps

finally is the equity valuation method

what information do I need to figure out the value of the firm using equity

valuation well

the equity valuation method if you remember goes from the

liability side okay so just

just remember that you know the value of the debt

you just add on the value of equity but to know the value of equity

you again start off with the cash flows of the firm but you have to think

about

which part of those cash flows goes to the shareholders

and the part that goes to shareholders has to first

pay interest then pay taxes

because interest is tax deductible

you can do it this way save some money right

and that's the part that goes to shareholders and the interest goes to

the debt holders

I have on purpose kept these in words

and the reason is every time I have this tendency to write things out for you

because we are more advanced and we have done this till now

I'm going to let you think about it what is the information you need

to do enterprise value to do

APV and to do equity valuation

we are going to take a break right now and I'm going to come back with a

problem

but promise me that you'll be ready with this

thought process in place I’ll repeat one more time

cash flows are your discount rates come from

comparable the discount rate from the comparable we have in place is Ra

but we’ll then need to modify it to get to WACC

to get to a APV we retain Ra but worry about the tax shield’s

discount rate because your tax shield depends on your debt

right and the third method is equity valuation which

you’ll see you need the return on equity for yourself

again source Ra see you in a little bit

we will start doing a problem and through the problem we’ll walk through all these steps

see ya