Capital Valuation Models - Research Paper Example

Financial Paper: Capital Valuation The present paper seeks to apply some capital valuation models in order to justify current market values of equityand debt of Home Depot. There exist different types of capital valuation models that are used in order to determine the value of a firm or the value of equity or debt of a firm at any particular time. Valuation is generally regarded as a method which forecast the present value of the expected pay offs to the shareholders of a firm. Valuation process also helps in converting forecasted value in to one particular number which corresponds to the basic intrinsic value of the firm.

According to Lee (1999), capital valuation models are nothing but a set of accounting systems which helps in constituting the tools that are essential for communicating the assessment regarding any future event. Capital valuation models are of different types. Some of them are based on asset based valuations, while some others take in to account discounted cash flow measures. For the purpose of the present study, focus will be placed on those models that use the technique of discounted cash flows.

Before moving into analyzing how far findings regarding current market value of equity or debt, it would be better to have a look at different discounted cash flow models of capital valuation. Discounted capital valuations model are mainly of three types: Free Cash Flow based accounting system, dividend based accounting system and earning based accounting system. All of these three types of capital valuation techniques can be used for the valuation of entire firm as well as for the equity of the firm.

Once, value of firm and value of equity is determined, it becomes quite easy to calculate value of debt. Present value of debt can be calculated by subtracting the present value of equity from the present value of firm as a whole. Free cash flow based valuation system: Under this system, for the valuation of entire firm’s capital free cash flow to the firm is taken into account, while for the valuation of equity only, free cash flow to the equity holders is taken into account. Free cash flow to firm (FCFF) is defined as the cash flow that is made before any repayment of debt, but after incurring all sorts of operating expenses and taxes.

On the other hand, free cash flows to equity (FCFE) can be defined as the cash flows which are generated after incurring all expenses and taxed along with the repayment of debt due to that period. (Vishwanath, n.d) In terms of equation, FCFF can be represented as follows: FCFF= cash flows from operation + interest (1-t)-capital expenditure And FCFE can be written as follows: FCFE= cash flows from operation + interest (1-t)-capital expenditure- net debt paid. In both of the cases interest benefit of taxation has not been included as the discount rate includes such benefit.

Now, under free cash flow based valuation technique, to calculated present value of the firm with infinite life a terminal period is required to be set after which the firm is expected to grow at a rate which is different from the ongoing rate. For the terminal period, a terminal price is calculated and then it is discounted by a specific discount rate. The formulae for the present value of a firm and the present value of the firm’s equity can be represented as follows: (Vishwanath, n.d.; Levin and Olsson, 2000) T (Value of firm)t=0 = FCFF0 + ∑PV (FCFFi) + PV (Terminal Price); i=1 Where Terminal Price = (FCFFT)/(r-g), where r is the discount rate and g is the growth rate after terminal period.

And, T (Value of firm’s equity)t=0 = FCFE0 + ∑PV (FCFEi) + PV (Terminal Price); i=1 Where Terminal Price = (FCFET)/(r-g), where r is the discount rate and g is the growth rate after terminal period. Now to calculate value of firm working cost of capital is used as the discount rate. Cost of capital to a firm is generally defined as the opportunity costs of investors for making their investment in the firm.

WACC can be represented by the following formula: (Miles and Ezzell, 1980) WACC = were + wdrd Where we is defined as the weight of equity, re is defined as the cost of equity, wd is defined as the weight of debt, rd is defined as the cost of debt. The weight of equity can be defined as the ratio of market capitalization to the market value of the firm and the weight of debt can be defined as the ratio of market value of debt to the market value of the firm. Total market value of firm is generally measured by summing total market value of equity and total market value of debt.

(Miles and Ezzell, 1980; Fama, 1970; Fama, 1991) Cost of equity is generally treated as the return that the investors expect to be paid by the firm for compensating them for the variability in returns which is generally caused by fluctuating earnings and fluctuating prices of shares. Cost of equity can be presented by the following formula: (Miles and Ezzell, 1980) Cost of Equity = risk free return to yield on long run government bonds + market risk premium * Beta variant for the company. Cost of debt, on the other hand, is generally taken at the effective rate of interest applicable to an AAA rated company in the market with an appropriate mix of short, medium and long term debt, net of taxes.

Dividend based capital valuation: Dividend based valuation formula can be represented as follows: Value of the firm = Dividend / (WACC – g); where g is the growth rate of dividend. Value of the firm’s equity = Dividend / (cost of equity – g); where g is the growth rate of dividend. (Feltham and Ohlson, 1995) Earning based capital valuation = Earnings per share / (cost of equity – g) (Feltham. and Ohlson,. 1995) Calculation for Home Depot: In case of Home Depot, cash flow from operating activities has started to diminish from the year of 2007 owing to the global recession.

From 2007 to 2008 cash flow from operation had declined by around 25 percent, while from 2008 to 2006 it declined by 3.4 percent. Hence, it is assumed that the market will grow by a rate of -2 percent for the coming two years and from third year it will attain a growth rate of -3 percent which is assumed to continue for the rest of its life time. Now, it is required to calculate WACC for discounting cash flows. Before calculating WACC, it is necessary to calculate cost of equity. On the basis of available information, beta for the firm is 0.

56, which is quite high. Now risk free rate is around 4.3 percent, while market risk premium on U.S. securities is 6.8 percent (for 2008). Given these values, cost of equity is – Cost if equity = 4.3 % + 0.56(6.8 %) = 8.19 % Now cost of debt of the firm is around 5 percent (approximately). From the balance sheet for the period ended on 1st January, 2009, market value of equity and market value of debt can be obtained. Market value of equity is $17,777 million, while market value of debt is $11434 million.

Therefore, WACC = 8.19 *(17,777/ 29211) + 5 * (11434/29211) = 4.98 + 1.95 = 6.94 (approximately) Now from available information FCFF and FCFE can be calculated for Home Depot. FCFF and FCFE for the current period are $3681 million and $1636 million. Now, FCFE for the current period is $1636. Given that the firm will grow at a negative rate of -2 percent and since the third year it will grow at a rate of -3, the present value of the firm’s value can be given as = 1636 + (1636(1-0.02))/(1+0694) + (1636 (1-0.02)2)/(1+0694)2 + 1373(1-0.03)/(0.498-0.03) = 17777.

It implies that on the basis free cash flow based technique of calculation of firm equity value it is possible to justify current market value of equity with the assumptions of appropriate rate of growth. Now it would be interesting to find out whether with the assumption of same rate of growth in dividend and earning per share it would be possible to justify current market valuation of equity of the firm Home depot. Now from available information, total dividend earnings for the period ended on 1st January, 2009 was (.90*1.68) billion = 1512 million.

Now applying the formula of dividend based the following can be obtained: Total value of firm’s equity will be = 1512/(0.0498+0.03)= 18984. Here results can not properly justify the current market value as current market value is lower than the estimated. But it can be taken as a good approximation as difference between the estimated value and current value is not quite large. Now the formula based on earning per share can be applied. From available information, total earnings of the share holders for the period ended on 1st January, 2009 was (1.37*1.68) billion = 2301.6 million. Now applying the formula of earning based valuation method the following can be obtained: Total value of firm’s equity will be = 2301.6/(0.0498+0.03)= 28842 Here results can not justify at all the current market value as current market value is lower than the estimated.

Hence, with similar kind of growth rates, free cash flow based technique seems to be best applied for the purpose of valuation. References: Feltham G.A. and Ohlson, J.A. (1995), “Valuation and clean surplus accounting for operating and financial activities”, Contemporary Accounting Research 11, 689-731 Lee, C.M, Myers, J. and Swaminathan, B. (1999). “What is the Intrinsic Value of the Dow?”, Journal of Finance 54, 1693-1741 Levin, J. and Olsson, P. (2000), Terminal Value Techniques in Equity Valuation: Implications of the Steady State Assumption.

SSE/EFI Working Paper Series in Business Administration No 2000:7 Miles, J. and Ezzell, R. (1980). The Weighted Average Cost of Capital, Perfect Capital Markets and Project Life: A Clarification. Journal of Financial and Quantitative Analysis, 15: 719-730. Vishwanath, P.V. (n.d.) Fundamentals of Valuations. Available at www.swlearning.com/finance/daves/valuation/ [accessed on 12th June, 2009]