Corporate Valuation and Risk Management - Essay Example

In business, the purpose of valuation is to determine what is very much worthy. Valuation procedure is accomplished with the help of different techniques and tools so to get the approximation of the economic value of a business interest. The main pillar of a firm can be obviously its finance which has three elements: Cash flow Risk that is distinct as volatility–standard deviation and Time Well! For the valuation and risk management, you have to know already about the following subjects: Business ideas and their components such as: market efficiency, equilibrium pricing, arbitrage and portfolio concepts Applications and their parts like: financial mathematics, risk & return and valuation Risk & return and their components such as: forecast returns, portfolio theory, systematic vs. non systematic risk and CAPM Finance and their braches as: business Finance, investment, derivative &securities markets, banking markets, fund management and studies of economics, law and statistics etc Major types of financial risks involved in a business Following are the basic risks engaged in the business: Market risk that is consisted on: interest rate risk, commodity price risk, foreign exchange risk and equity price risk Liquidity risk Credit risk that is included: country or supreme ruler risk, systematic and firm-specific credit risk Operational risks is covering: fraud risk, technology risk, model risk, business reputation risk, institutional risk and foreign investment But business risk in involved: competition risk, cost risk and efficiency risk In the world of business, value-at-risk (VaR) is mainly focused on the value (V) of firm. By and large, this type of risk is concentrated on the business worst case scenarios such as what will be the utmost lost that one can face if the certain condition will remain over a specified time. Likewise, portfolio VaR for N equities has in each n unit holdings as = (n1, n2, …, nN), in each p equity price as = (p1, p2, …, pN) and in each Weight w as = (w1,w2, …, wN) for a specified time period T. Diverse natures of approaches are applied to estimate an existing business. But to value a firm, you have to follow the certain steps. Suppose, if you are going to estimate first the WACC (cost of capital) so to look at the capital arrangement plus capital cost profoundly. The key idea behind these two capital structure and cost is to compute the different elements such as debt-to-value, debt-to-equity, sizes of capital structure’s different components, and to perform the estimation of average capital cost and to get the required return on different capital components etc. WACC approach To estimate correctly the costs as well as the each finance source weight (used for a project) is really significant so to gain the consistent estimation of on the whole required return rate for a particular project. Individual capital cost should return the project relative risk to each fund’s supplier in addition to the existing cost for raising funds. But you need to employ the subsequent relative amounts so to evaluate businesses 1. free cash flow to the firm (FCFF) 2. V = PV of CFs 3. Adjustment for the interest tax-shield by reducing WACC 4. PVH (horizon value) 5. Deduction of debt value (D) in order to acquire the value of equity (E) Capital structure of the firm can be both the mix up of long-term investment sources and the product of the firm’s financing course of action. Below is the list of the key features of each amount to estimate the cost of each financing choice. Debt (stands for the contractual claim on the firm’s cash flows in the outward appearance of loans and bonds) Leasing (if relative tax benefits to the firm can be achieved from leasing, other incentives and considerable debt ratio etc) First choice Shares (with considerable leverage effect, default risk effect and dividend effect) Equity (an outstanding claim on the real asset’s cash flows of the firm). Exchangeable Notes In any case, cost of equity can be estimated with the help of two key methods such as DMM and CAMP (risk based model). More light should be putted on those approaches that are well suited to conclude the capital cost for a business or a project, resting on the WACC. Empirical approach CAPM as a risk based model is not based as much of on theory but more rely on the historical regularities. Moreover, the Fama and French (1993) model is using three variables: Ri = RF + Im(Rm - RF)t + Nstyle(Style - RF )t + Nsize(Size - RF ). But whenever these are tested with the company data, equations with additional variables such as P/E and P/BV are seemed to perform a better job than the reserve bet. Furthermore, policy relating to finance matters a lot according to this approach, if changeable debt-equity (D/E) ratio is resulted in the raise of firm’s value (M&M propositions). CAPM formula can be applied to calculate the r (market asking price of equity of a company) r = risk free rate + beta (market risk premium). The same formula can be used to get the discount price on equity too. Relative valuation procedure This procedure for the enterprise valuation is also required certain steps which are as following: 1. identification of comparable investments and the most up to date market prices for such assets 2. for assets valuation, calculation of valuation metric is required 3. Development of initial valuation 4. Refining the valuation Anyhow, the process of valuation is done with the help of different techniques such as using cash flow and other relative valuation as P/E (price earnings ratio) and P/BV (price book value ratio) techniques. But one can estimate and evaluate the capital structure features for instance a company WACC, P/E and P/BV by following the some important steps and formulas in a step-wise manners. For example, WACC can be estimated with the assistance of functions available in the Excel program. In the same way, a company stock beta can be computed using the SLOPE and VARP functions. How to manage risk and uncertainty level Different types of analysis can be performed in order manage risk as well as uncertainty in the businesses. The range of analysis is included: sensitivity analysis, break-even analysis, scenario analysis, and simulation analysis. The main purpose of these studies is to identifying the principal factors, determination of sales level, probabilities estimation for different outcomes and exposing inappropriate forecast etc. Sensitivity analysis to put into practice Suppose, a project is designed for 5 years that will cost you around $500,000 but this business is having no salvage value. Well, expected depreciation will be the straight line to zero but price cut will be 12%. In view of these circumstances, the tax rate will be 30%. Now come to base case. Rummage sales are predictable as at 500 units for each year. Similarly, price and variable cost per unit can be predicted as $3,000 and $1,800, respectively in this example. But $250,000 is fixed cost per year. Now question is that what will be the NPV sensitivity level of that project for each of its key variables in a case when evaluation of errors will be10%. For such assessment, you must have the relevant information first. Such information is included: estimates, sales of unit, price per unit, variable cost per unit, and fixed cost of a business. Suppose expected unit sale is 500, price unit is 3,000, variable cost per unit is 1,800 and fixed cost is 250,000. Similarly, optimistic estimates can be supposed as 550 (unit sale), 3,300 (price unit) 1,620 (variable cost per unit) 225,000 (fixed cost) but pessimistic estimates can be as 450 (unit sale) 2,700 (price unit) 1,980 (variable cost per unit) and 275,000 (fixed cost). In this case, depreciation charge can be calculated as a result as: $500,000/5 = $100,000 Now calculate the net present value (VPN) including base case for each case in the following given way: (EBIT) (‘000s) [E(EBIT)]= (500)($3) – (500)($1.8) – ($250) - $100 = $250 Expected (CF) [E(CF)]= $250,000 + $100,000 – ($250,000)(0.3) = $275,000 Expected (NPV) [E(NPV)]= - $500,000 + [(A5,12)(E(CF))]= - $500,000 + (3.6048)($275,000) = $491,320 The fundamental process of valuing business involves both assets characteristics (cash-flow riskiness) and investor’s attributes (willingness with bearing risk). But you can process the analysis further anytime too. For that purpose, you can make use of currency correlations along with treat exposures in the current value terms the same as the portfolio of exposures. Besides this, make use of netting and correlations. Now objective can be proficient enough to reduce the cost or value of contract (hedge) that is undertaken. Actually, hedge can be either operation or asset. Cash Flow Statement That is the report, containing cash inflows as well as outflows of a company. The procedure of transporting accrual accounting based information such as income statement and balance sheet into the statement of cash flows should be done very carefully for your own right judgment of a business. There are three major parts that are considered the actual sources of cash flows are mentioned as below: 1. Operating behaviors 2. Investing activities 3. Financing activities But in order to get the change in a firm’s cash balance for the specific period, one must have to achieve the total of all the above mentioned three activities. Though, hold opposing views to FCFF but can be prepared to accept. Free Cash Flow for Firm (FCFF) Very important part of firm’s valuation is FCFF. That is a measure of a firm’s financial routine which can communicate you in sequence the net-amount of cash and that ready money is generated by the firm. Amount is included: operating cost, taxes and even the adjustments in the net working investment. Anyhow, FCFF is required to view at a glance the cash flow of a firm. But free cash flow for a firm for a specific tenure is known as FCFFt that will represent the after-tax flow of cash to equity. That will be the free cash flow to equity’s total. Similarly, CFDt that is cash flow to debt which can be in latter stages condensed. Moreover, tt is tax rate paid. In other words, CFDt – It x tt will be the after-tax flow of cash to debt, which be familiar with the tax-shield benefits and these are produced by the interest cash flow to debt. In order to update the firm’s cash flown, use the following formulas: FCFFt = FCFEt + CFDt – It x tt Note that FCFFt is the full amount cash flows on hand and will be paid to the shareholders (equity and debt) of the firm. Both firms free cash flows and the firm’s financing cash flows are equal also. Earnings benchmarks is important to keep up or boost up stock price, to have an effect on the external name of management, to trim down the stock price instability, to achieve required credit ranking and to keep away from violating debt convention etc. In the same way, EPS (earning per share) calculation is very important because that is the part of a company profit. This will also indicate the business real profitability. You can calculate earning per share with the following formula: Generally, earning per share (EPS) is measured to be the most imperative variable in getting a shares current price. In addition to this, it can be used as a part to estimate the price-to-earnings evaluation ratio.  But you can make use of EBITDA instead of FCFF because free cash flow for firm is more unstable than EBITDA by reason of new nest egg in CAPEX plus NWC. Certain advantages are associated with it as offering us good way to measure pre tax related cash flow etc. But attached disadvantages can’t be ignored also like value of latest investments can be ignored in EBITDA. This way is much better for evaluating a stable and mature business. References: Veronesi, P. (2010) Fixed Income securities: Valuation, Risk and Risk Management. New Jersey: Wiley. Read More