0:05

Welcome back.

Promise, last set of valuation exercises.

And we try to go through this a little bit quicker.

I'm assuming you've seen these last three valuation methods

being used in the context of this example, but let me throw up the data again.

So are valuing Sears online attempt to compete with business,

online business as opposed to bricks and mortar.

0:40

So Sears is considering this.

Its EBIT is $250 million per year for the foreseeable future.

It has done those cash flows.

To make calculations simple,

we are assuming below the line items are not there.

Sears' target debt to equity ratio is 1.00, which is important to know.

And the level of debt is such that the return on debt is 4%.

Remember the is 2%.

Now instead of assuming that the tax shield of

the Sears debt is as risky as the debt itself, and therefore we're

going to make assumption that it's actually as risky as the value of Sears.

And you'll see that within the context of this problem,

it makes a lot of sense to assume number two.

But I don't want to presume that up front.

I want you to come to these realizations yourself.

So, we'll have a five to ten minute

1:36

kind of takeaways about valuation at the end, but first let's do this.

So what does this do?

It makes me approach the whole exercise we just did a little bit differently,

and that is, I'm going to value the tax shield using RA.

Okay, so let's get started with the enterprise value method.

And very quickly, what does enterprise value method need?

2:01

I know you're getting tired of this, but

it needs EBIT(1- Tc), and it needs WACC.

But in the calculation of WACC, you need to know what?

D to E, which we know is 1.00.

And the WACC is for Sears.

You are the valuing.

But we already know what Ra is.

Ra is 6%, not 6.3, 6 in this case because

we are capturing the Ra assuming the valuation

method of the tax shield of the company bears and

using that number moving forward, okay, 6%.

Now in order to calculate WACC,

I need WACC = Re E over D + E +

Rd(1- Tc) D over D + E.

3:07

Everybody okay with this?

Yeah?

So this is pretty straightforward.

I have half here. I have half here, the ratios.

Rd is 4%, and this is 0.34.

So these are numbers again which are pretty easy to figure out.

All I need to figure out now is what Re is.

4:37

So I've got my Re of 8%, and I am now going to plug and chug and

my WACC will turn out to be very similar to before.

And that's one thing you please must realize that the numbers are not going to

be that different.

So it's going to be half Re

+ Rd (1- Tc) times half.

Re is 0.08.

Rd is 4.04, and this is 0.34.

When you plug and chug, you get a WACC of 5.32%.

Okay, so the WACC has changed a little bit.

What I'm going to do is now I'm going to

use this WACC to figure out enterprise value.

And enterprise value, using second approach,

is EBIT (1- Tc) over 0.0532, very minor differences.

So, sometimes these small numbers,

you get it is $3.102 billion, right?

Now the question becomes how much is debt, how much is equity?

And it could be half and half.

So I think in this case it's 1.551 debt,

1.551 equity.

So we know the value of the firm using WACC.

And WACC requires debt to equity ratios being given and figuring out Re.

The Ra we have used in all of this is which Ra?

The 6%.

Okay, now the question is, how do we APV method, what do we do about it?

So the APV method, if you remember, what we do is we take the EBIT

(1- Tc), and we're going to go quickly through this.

But we now discount by Ra and add Ts.

6:42

And here what are we assuming?

We are assuming the approach two.

And I'll talk about this a little bit later where it's actually making our life

a little simpler.

We could actually create more ways of doing stuff within this one problem,

but let's just stick with this for time being.

What is Ra here?

We know Ra is 6%, and we know the debt

to equity ratio is 1, right?

And we know Rd is 4%.

7:17

So which of this information is pertinent to just Sears?

Rd and D over E is pertinent to Sears.

Ra comes from the comparable, and we are just taking 6% from the comparable.

Okay, so 250.66

over 0.06 + tax shield

now is a little bit tricky.

It's D times Rd times Tc,

discounted at what?

Ra, okay?

So just so that we have some space to do this, let's just move on.

9:10

I don't want to keep repeating it.

But I want you to understand that actually, in life, it's good to know where

value is coming from, real assets or financial transactions, and so on.

When we do global finance, what I like this approach even better,

because many times tax rates are different in different counties.

Exchange rate issues may cause some frictions,

not because of the exchange rate actually working.

It's because some frictions arise because of that.

You want to take all non-real valuations and kind of add them to the real value.

So where's the beef?

I say the beef is 2.775 billion.

Let me ask you this question.

If I instead had the tax shield of 2.75 billion and

the 0.352 as the value of the real assets,

what would you think about this business?

This business is surviving based on government policy.

And many times, people think that actually that dominates this in

the following sense, not just in magnitude.

But the real value is actually negative and

being supported by some tax law or whatever.

So that's APV.

Let's keep going because we now know the third method.

And the third method says this, value of equity E + value of debt.

Do we know value of debt?

Yes, it's 1.551 billion.

What is value of equity?

Let's do it a little bit quickly.

EBIT- I (1- Tc)

divided by Re.

Do we know Re here?

Yes, it's 0.08.

What is I?

11:06

I is 62.04.

How did I get this?

Well, I've calculated it here.

And it should be this, 1.551 multiplied by 0.04.

So approximately, 1.55 divided by 25 because 0.04 is 1 over 25.

I'm assuming my numbers are right, and I know this 0.34 too.

So this value turns out to be 1.551 billion equity, and what was debt?

1.551 billion, and

the total is of course the same as before,

$3.102 billion.

Now, I don't think this method is used very often in most analysis.

But I feel that this may be among the three methods, the least revealing because

this is not telling you, it's not focused on the assets.

It's focused on the liabilities.

But if you're interested in getting the value of the firm and the information

is available to you readily on Re, and you can do this quickly, do it.

I personally think, focused on the assets is a good thing.

And because that focus on assets in WACC is a little bit corrupted by

the discount rate incorporating the tax shield, I prefer the APV.

I hope this makes sense.

Let us take a break. And what we'll do when we come back is

try to put this all together by emphasizing what we have done now and

what are the takeaways.