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Adjusted Present Value Adjusted Present Value A study on the properties, functioning and applicability of the adjusted present value company valuation model Author: Sebastian Ootjers BSc Student number: 0041823 Master: Industrial Engineering & Management Track: Financial Engineering & Management Date: September 26, 2007 Supervisors (University of Twente) ir. H. Kroon prof. dr. J. Bilderbeek Supervisors (KPMG) dr. J. Weimer drs. F. Siblesz Educational institution: University of Twente Department: FMBE Company: KPMG Corporate Finance ABCD Foreword This research report is the result of five months of research into the adjusted present value company valuation model. This master thesis serves as a final assignment to complete the Master Industrial Engineering & Management (Financial Engineering & Management Track). The research project was performed at KPMG Corporate Finance, located in Amstelveen, from May 21, 2007 up until September 28, 2007, under supervision of Jeroen Weimer (Partner KPMG Corporate Finance), Frank Siblesz (Manager KPMG Corporate Finance), Jan Bilderbeek (University of Twente) and Henk Kroon (University of Twente). The subject of this master assignment was chosen after deliberation with the supervisors at KPMG Corporate Finance on the research needs of KPMG Corporate Finance. It is implicitly assumed in this research report that the reader has been educated or is active in the field of corporate finance. It is also assumed that the reader is aware of existence of (company) valuation as part of the corporate finance working field. Any comments, questions or remarks that come forth from reading this research report can be directed to me through the contact information given below. The only thing remaining is to wish the reader a pleasant time reading this report and to hope that this report provides the reader with a clear insight in the adjusted present value model. Sebastian Ootjers Student Industrial Engineering & Management [email protected] Master Thesis Sebastian Ootjers 3 s0041823 IEM-FEM ABCD Executive summary The research objective of this research project is to formulate a theory on the differences between the enterprise DCF model and the APV model, and the effects of these differences on the valuation outcome. There are a number of differences between the enterprise DCF model and the APV model. These differences are as shown in the table below. Enterprise DCF model APV model Cash flow FCFF FCFF Discount rate WACC Ku or Kd Cost of equity Levered Unlevered Cost of debt Credit rating based Credit rating based Constant leverage ratio Capital structure Constant leverage ratio or fixed debt Not explicitly taken into Separate term in the Probability of default account valuation Not explicitly taken into Separate term in the Costs of financial distress account valuation There are five scenarios in which the APV model can be used to determine the correct value of the company, if the capital structure and/or the probability of default assumption of the enterprise DCF model are violated. The validated differences in valuation outcomes are shown in the table below. Scenario Model Compare to Effect on valuation outcome Constant leverage ratio& DCF or APV (ME) n.a. V (APV) = V (DCF) no significant PoD Constant leverage ratio& APV (ME) DCF V (APV) < V (DCF) significant PoD V (APV) > V (DCF) or Fixedamount of debt APV (MM) DCF V (APV) = V (DCF) or V (APV) < V (DCF) V (APV) > V (DCF) or Finitelife& debt known APV (general) DCF V (APV) = V (DCF) or V (APV) < V (DCF) Combinationof scenario4 and Debt knownuptot, then APV (general) + DCF 1or acombinationof scenario4 constant leverageratio APV (ME) and2 The APV model is theoretically more correct and also gives a significantly different valuation outcome than the enterprise DCF model in cases where the company under valuation suffers from financial distress. In other cases, the APV model is theoretically more correct but the difference in valuation outcome with regard to the enterprise DCF model is negligible. The practical situations that relate to the cases in which the difference becomes insignificant are those of a management or leverage buyout and project finance. As a result of the nonsignificant difference, the APV model and the enterprise DCF model can both be used to value the company even though the APV model gives a theoretically more correct company value. In the remaining cases, either both the enterprise DCF model and the APV model can be used to determine the company value or none of the two models is fit for the determination of the company value. Master Thesis Sebastian Ootjers 5 s0041823 IEM-FEM ABCD Table of contents Chapter 1: Research design...................................................................................................... 9 1.1 Research context ............................................................................................................. 9 1.2 Research objective, research framework and research issues..................................... 10 1.3 Research strategy.......................................................................................................... 11 1.3.1 Desk research ......................................................................................................... 11 1.3.2 Justification.............................................................................................................. 11 1.4 Structure of the research report..................................................................................... 12 Chapter 2: Theoretical background ......................................................................................... 13 Introduction .......................................................................................................................... 13 2.1 Introduction to valuation theory...................................................................................... 13 2.1.1 Definitions in and rationale of valuation .................................................................. 13 2.1.2 Valuation approaches.............................................................................................. 14 2.1.3 Parameters normally used in valuation models ...................................................... 15 2.1.4 Five discounted cash flow valuation models........................................................... 18 2.1.5 Subjects of analysis regarding the general assumptions of a valuation model ...... 20 2.2 Probability of default ...................................................................................................... 20 2.2.1 Ratings .................................................................................................................... 21 2.2.1 Altman’s Z-score ..................................................................................................... 23 2.2.3 Ohlson’s O-score..................................................................................................... 25 2.2.4 Contingent-claims models....................................................................................... 26 2.2.5 Subjects of analysis regarding the probability of default......................................... 28 2.3 Capital structure............................................................................................................. 29 2.3.1 Definition of capital structure................................................................................... 29 2.3.2 Financial deficit........................................................................................................ 30 2.3.3 Effects of capital structure....................................................................................... 30 2.3.4 Capital structure development theories................................................................... 31 2.3.5 Factors that influence capital structure ................................................................... 31 2.3.6 Support for the different theories by the fourteen factors........................................ 32 2.3.7 Debt capacity........................................................................................................... 33 2.3.8 Views of other authors............................................................................................. 35 2.3.9 Subjects of analysis regarding capital structure...................................................... 35 2.4 Costs of financial distress .............................................................................................. 36 2.4.1 Definition of financial distress.................................................................................. 36 2.4.2 Cost effects of financial distress.............................................................................. 37 2.4.3 Estimation of the costs of financial distress ............................................................ 38 2.4.4 Comments on the costs of financial distress........................................................... 39 2.4.5 Subjects of analysis regarding the costs of financial distress................................. 39 Conclusion ........................................................................................................................... 40 General subjects of analysis ............................................................................................ 40 Subjects of analysis regarding the probability of default.................................................. 40 Subjects of analysis regarding the capital structure........................................................
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