Module 1 - Sequential Valuation

Outline of Modular Topics

  • Concept of Sequential Valuation

  • Cash Waterfall

    • Priority of Payments

  • Rules for Valuing Cash Flows

  • Valuations of Bonds and Stocks

Understanding Sequential Valuation

  • Objective:

    • To utilize the Discounted Cash Flow (DCF) process for determining the value of equity.

    • Previous calculations involve determining Present Value (PV) of Free Cash Flows for the firm.

  • Process:

    • Sequential valuation divides the total operating cash flows among capital providers:

    • Debt and Debt-like Providers

    • Equity Providers

Firm Value Equation

  • Components of Firm Value:

    • Equity Value:

    • (extEnterpriseValue−extNetDebt)( ext{Enterprise Value} - ext{Net Debt})

    • Debt Service

    • Cash Flow

    • Formula Representation:

    • extFirmValue=extDebtService+extEquityValue−extDebtValueext{Firm Value} = ext{Debt Service} + ext{Equity Value} - ext{Debt Value}

    • The relationship:

    • extEnterpriseValue=extFirmValue−extNetDebt<br>ightarrowextValueofEquityext{Enterprise Value} = ext{Firm Value} - ext{Net Debt} <br>ightarrow ext{Value of Equity}

Understanding Priority of Claims

  • Claims based on Seniority:

    • Debt is considered most senior, while equity is most junior.

  • Preferential Claims in Bankruptcy:

    • Secured Creditors: Paid first (least risky).

    • Unsecured Creditors, including:

    • Trade Creditors

    • Employees

    • Debt types with varying risk levels:

    • Senior Subordinated Debt

    • Subordinated Debt

    • Preferred Stock

    • Common Stock (paid last, most risky).

Cash Waterfall Structure

  • Chains of Payment Order:

    • Flow of payments prioritized from secured to common equity. Example:

    • Cash Flow to the Firm: Interest and principal payments must first service lenders.

    • Free Cash Flow to Equity (FCFE) follows.

Components of Debt Obligations

  • Two Types:

    • Secured Debt:

    • Backed by collateral.

    • Lien: Legal claim preventing asset sale without payment to lienholder.

    • Unsecured Debt:

  • Examples of Collateral:

    • Real Estate

    • Vehicles

    • Inventory, Accounts Receivable

    • Equipment, Cash/Securities

    • Intellectual Property, Stock

Valuing the Firm and Equity

  • Valuation Steps:

    • Step 1: Determine total cash flow (or 'bucket size'), called Enterprise Value, as the sum of PV of Unlevered Free Cash Flows (UFCFs): extEnterpriseValue=PV(extUFCF)ext{Enterprise Value} = PV( ext{UFCF})

    • Step 2: Calculate amounts due to creditors, accounting for risk level (extMVofDebtext{MV of Debt}):

    • Remaining funds indicate available cash flow or Market Value (MV) of Equity:

      • extTotalValueoftheFirm−extMVofDebt=extMVofEquityext{Total Value of the Firm} - ext{MV of Debt} = ext{MV of Equity}

Practical Example: Ginger’s Popcorn Shop

  • Cash Flow Projection Example:

    • Year 1 Free Cash flow projection of $1,000.

    • Growth at 14% for 2 years; stabilizing at 6% afterwards.

    • Nominal cost of capital: 12%.

  • Enterprise Value Calculation:

    • Using growth rates and cash flows illustrated:

    • Vextfirm=rac1,299.60(0.12−0.06)=22,959.60V_{ ext{firm}} = rac{1,299.60}{(0.12 - 0.06)} = 22,959.60

    • Enterprise Value: Vextfirm=19,068.88V_{ ext{firm}} = 19,068.88

Adjusting Valuations with Debt

  • Debt Considerations:

    • If Ginger has $7,000 in debt, equity calculation follows:

    • Total value of the firm: $19,068.88

    • V<em>extdebt−7,000ightarrowV</em>extequity=12,068.88V<em>{ ext{debt}} - 7,000 ightarrow V</em>{ ext{equity}} = 12,068.88

    • Equity per share if 500 shares outstanding:

      • rac12,068.88500=24.14rac{12,068.88}{500} = 24.14

Managing Cash and Recognition of Limits

  • Cash Availability Considerations:

    • Important to analyze cash availability when assessing debt repayment risks.

    • Distinction between:

    • Operating Cash

    • Non-Operating Cash

    • Untaxed Cash

  • Cash Treatment in Analysis:

    • Ideal Scenario: Segregate cash accordingly to understand debt servicing capabilities.

    • In practice, cash is often assumed available (simplification in analysis).

Cash Analysis in Example: Ginger’s

  • Balance Sheet Snapshot:

    • Cash: $425

    • Short-Term Investments: $152

    • Total Cash: $577

    • Re-calculating Value of Equity:

    • 19,068.88−7,000.00+577.00=12,645.8819,068.88 - 7,000.00 + 577.00 = 12,645.88

    • Per share valuation: rac12,645.88500=25.29rac{12,645.88}{500} = 25.29

Distinction Between Book Value and Market Value

  • Accountants vs. Finance:

    • Accountants prefer Book Value.

    • Financial analysts prefer Market Value for assessments.

  • Rationale for Market Value Preference:

    • Provides a current view of the cost of replacing debt; more accurately reflects market conditions than historical book value.

Asset Valuation Techniques

  • Time Value of Money (TVM) Principles Applied:

    • Valuing bonds: treated as annuities (coupon payments) plus lump-sum repayments at maturity.

    • Valuation of stocks incorporates Dividend Discount Model principles.

Analyzing Bond Characteristics

  • Bond Data:

    • Includes important variables such as issue date, maturity, coupon rate, frequency of payment, yield-to-maturity, etc.

  • Rationale Behind Coupon Rate Calculation:

    • Based on Treasury rates and credit spread depending on perceived default risk.

Determining Bond Prices and Market Reaction

  • Market Behavior:

    • Price of bonds fluctuates with interest rates, inversely related to bond values (i.e., as interest rates rise, existing bond prices fall).

  • Impact on Bonds and Investor Decisions:

    • Example scenarios illustrating the impact of changing interest rates on bond pricing and investment decisions.

Real-World Application Examples

  • Relevant Case Studies:

    • Silicon Valley Bank’s issues due to bond valuation under rising rates lead to a run on deposits.

    • Fiat-backed stable coins experiencing valuation pressures due to market fluctuations and interest rates.

Yield to Maturity Calculation

  • Understanding YTM:

    • YTM reflects the return for an investor and the bond price as a function of payment structure and remaining payment timeline.

  • Practical Application of Excel for Calculating YTM:

    • Applying required YTM calculations using financial functions available in Excel for accuracy.

Real Life Examples and Theoretical Applications

  • Bonds Pricing Mechanics:

    • Understanding bond pricing discrepancies and necessary market adjustments based on coupon versus market rates.

Preferred Stock Valuation

  • Requirements for Pricing Preferred stock, which includes evaluating dividends, required returns, and par values for assessment.

Conclusion of Study Material Coverage

  • Core Takeaway Themes:

    • Importance of cash flow discounting.

    • Understanding market versus book valuations and the implications of realized versus potential values.

  • Additional Consideration:

    • Importance of recognizing financial realities impacting operational viability and assessment strategies in real-world financial scenarios.