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«Dealing with Cash, Cross Holdings and Other Non-Operating Assets: Approaches and Implications Aswath Damodaran Stern School of Business September ...»

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financial investments (interest on bonds, dividends on stock) and use the non-cash net income to estimate free cash flows to equity. These free cash flows to equity would be discounted back using a cost of equity that would be estimated using a beta that reflected only the operating assets. Once the equity in the operating assets has been valued, you could add the value of cash and marketable securities to it to estimate the total value of equity.

If cash is kept separate from other assets, there is one final adjustment that has to be factored into the valuation. To estimate sustainable or fundamental growth, we link growth in net income to returns on equity and growth in operating income to return on capital.18 These returns should be computed using only the non-cash earnings and capital

invested in operating assets:

Net Income - Interest Income from Cash Non-cash Return on Equity = Book Value of Equity - Cash EBIT (1- tax rate) Return on invested Capital = Book Value of Equity + Book Value of Debt - Cash !

These are the also the returns we should be comparing to the costs of equity and capital to make judgments on ! whether firms are generating excess returns on their investments.

Including cash in the picture (which we almost always do with return on equity and sometimes with return on capital) just muddies the waters.

Illustration 1: Consolidated versus Separate Valuation: All Equity Firm To examine the effects of a cash balance on firm value, consider a firm with investments of $1,000 million in non-cash operating assets and $200 million in cash. For simplicity, let us assume the following.

The non-cash operating assets have a beta of 1.00 and are expected to earn $120 • million in net income each year in perpetuity and there are no reinvestment needs (to match the assumption of no growth).

The cash is invested at the riskless rate, which we assume to be 4.5%.

• The market risk premium is assumed to be 5.5% • The firm is all equity funded •

–  –  –

Gross Debt, Net Debt and the Treatment of Cash In much of Latin America and Europe, analysts net cash balances out against debt outstanding to come up with a net debt value, which they use in computing debt ratios and costs of capital. In firm value calculation, therefore, the differences between using

the gross debt approach and the net debt approach will show up in the following places:

Assuming that the bottom-up beta of the company is computed, we will begin • with an unlevered beta and lever the beta up using the net debt to equity ratio rather than the gross debt to equity ratio, which should result in a lower beta and a lowest cost of equity when using the net debt ratio approach.

When computing the cost of capital, the debt ratio used will be the net debt to • capital ratio rather than the gross debt ratio. If the cost of debt is the same under the two approaches, the greater weight attached to the cost of equity in the net debt ratio approach will compensate (at least partially) for the lower cost of equity obtained under the approach. In general, the cost of capital obtained using the gross debt ratio will not be the same as the cost of capital obtained under the net debt approach.

The cashflows to the firm are the same under the two approaches, and once the • value is obtained by discounting the cashflows back at the cost of capital, the adjustments under the two approaches for debt and cash are the same. In the gross debt approach, we add the cash balance back to the operating assets and then subtract out the gross debt. In the net debt approach, we accomplish the same by subtracting out the net debt.

The reason that the two approaches will yield different values lies therefore in the difference in the costs of capital obtained with the two approaches. To understand why there is the difference, consider a firm, with a value for the non-cash assets of $1.25 billion and a cash balance of $ 250 million. Assume further that this firm has $ 500 million in debt outstanding, with a pre-tax cost of debt of 5.90% and $ 1 billion in market value of equity. In the gross debt approach, we assume that the gross debt to capital ratio that we compute for the firm by dividing the gross debt ($500) by the market value of the firm (1500) is used to fund both its operating and cash assets. Thus, we compute the cost of capital using the gross debt ratio and use it to discount operating cashflows.

In the net debt ratio approach, we make a different assumption. We assume that cash is funded with riskless debt (and no equity). Consequently, the operating assets of the firm are funded using the remaining debt ($250 million) and all of the equity. The resulting lower debt ratio (250/1250) will usually result in a slightly higher cost of capital and a lower value for the operating assets and equity. Figure 4 summarizes the different assumptions we make about how assets are financed under the two approaches.

Figure 4: Gross Debt versus Net Debt Approaches- Implicit Assumptions Entire Firm

–  –  –

Note that the cost of the debt used to fund debt in both approaches is assumed to be the riskfree rate. In the gross debt approach, we assume that equity used to fund debt is also riskfree (and has a beta of zero).

Illustration 2: Valuing a Levered Firm with Cash: Gross Debt and Net Debt Approaches Consider a firm with $ 1 billion invested in operating assets, earning an after-tax return on capital of 12.5% on its operating investments and $250 million invested in cash, earning 4% risklessly; there is no expected growth in earnings from either component and the earnings are expected to be perpetual. Assume that the unlevered beta of the operating assets is 1.42 and that the firm has $500 million in outstanding debt (with a pre-tax cost of debt of 5.90%). Finally, assume that the market value of equity is $ 1 billion, that the firm faces a tax rate of 40% and that the equity risk premium is 5%.

Gross Debt Valuation Gross Debt to Capital Ratio = Gross Debt/ (Gross Debt + Equity) = 500/(500 + 1000) = 33.33% Levered Beta = Unlevered Beta (1 + (1- tax rate) (Gross Debt/ Market Equity)) = 1.42 (1 + (1-.40) (500/1000)) = 1.846 Cost of Equity = Riskfree Rate + Beta * Risk Premium = 4% + 1.846 (5%) = 13.23% Cost of Capital = 13.23% (1000/1500) + 5.90% (1-.4) (500/1500) = 10.00% Expected After-tax Operating Income = Capital Invested * Return on capital = 1000 *.125 = $125 million Value of Operating Assets = Expected after-tax operating income/ Cost of capital = 125/.10 = $1250 million Expected Cash Earnings = $250 million *.04 = $ 10 million Value of Cash = Expected Cash Earnings/ Riskfree Rate = $10 million/.04 = $250 million Value of Firm = Value of operating assets + Cash = $1,250 + $250 = $1500 million Value of Equity = Value of Firm – Gross Debt = $1,500 - $500 = $1,000 million Net Debt Valuation Net Debt = Gross Debt – Cash = $ 500 - $250 = $250 million Net Debt to Capital Ratio = Net Debt/ (Net Debt + Equity) = 250/(250 + 1000) = 20% Levered Beta = Unlevered Beta (1 + (1- tax rate) (Net Debt/ Market Equity)) = 1.42 (1 + (1-.40) (250/1000)) = 1.644 Cost of Equity = Riskfree Rate + Beta * Risk Premium = 4% + 1.644 (5%) = 12.22% Cost of Capital = 12.22% (1000/1200) + 5.90% (1-.4) (250/1250) = 10.41% Expected After-tax Operating Income = Capital Invested * Return on capital = 1000 *.125 = $125 million Value of Operating Assets = Expected after-tax operating income/ Cost of capital = 125/.1041 = $1200.45 million Value of Equity = Value of Operating Assets – Net Debt = $1,200.45 - $250 = $950.45 million Reconciling the two approaches In the specific case that we examined, the value of equity is lower using the net debt ratio approach than with the gross debt ratio approach but that is not always the case.

Figure 5 reports the value of the firm described above for tax rates varying from 0 to 50%.

For tax rates less than 15%, the net debt value approach delivers a higher value for equity than the gross debt ratio approach. In fact, the equity value is identical if we assume a zero tax rate and that the cost of debt is the riskfree rate.

There are two factors causing the equity value difference. The first is that we used the same cost of debt used under the two approaches for computing the cost of capital for operating assets. If there is default risk, the cost of debt used for computing the cost of capital should be higher under the net debt approach than under the gross debt approach.

To see why, consider the cost of debt of 5.90% used in the last example and assume that this is the cost of debt for the entire company on its total debt of $ 500 million. In the net debt approach, $ 250 million of this debt is used to fund cash and is at the riskfree rate.

The pre-tax cost of borrowing on the remaining debt (used to fund operating assets)

therefore has to be much higher:

Pre-tax cost of borrowing under net debt = (.059*500 -.04*250)/250 = 7.80% In the gross debt approach, only a third of the cash is funded with debt- this works out to $83.33 million at the riskless rate.

The cost of the remaining debt is as follows:

Pre-tax cost of borrowing under gross debt = (.059*500 –.04*83.33)/ 416.67 = 6.28% If we use these different pre-tax costs of debt in computing the operating cost of capital, the values of equity are identical using both the gross debt and net debt approaches under a zero tax rate assumption.

The second factor is that the net debt approach nullifies the tax advantage that you receive on the debt used to fund cash, whereas the gross debt approach preserves the tax advantage on all debt, even if it is used to fund cash.19 As the tax rate increases, this difference between the two valuations will increase. The bottom line is that the difference in values between the two approaches will increase as tax rates and the default risk increase. As to which one yields the better estimate of value, we remain undecided. The net debt approach makes the more realistic assumption about the tax advantage of debt being canceled out by the tax liability on the income from cash. However, the net debt ratio can become negative (if cash exceeds debt)20 and shifting cash balances over time can add to its volatility. On balance, we are inclined to use the gross debt approach to value operating assets and keep cash as a separate asset.

Should you ever discount cash?

In general, we would argue that a dollar in cash should be valued at a dollar and that no discounts and premiums should be attached to cash, at least in the context of an 19 In the net dent ratio approach, we are assuming that any tax benefits from debt (used to fund cash) are exactly offset by the tax costs associated with receiving interest income on the cash;

20 When net debt ratios become negative, analysts should continue to use the negative values, even though it may give rise to some discomfort. In effect, this will mean that the levered beta will be lower than the unlevered beta and that the debt ratio in the cost of capital calculation will be a negative number.

intrinsic valuation. There are two plausible scenarios where cash may be discounted in value; in other words, a dollar in cash may be valued at less than a dollar by the market.21

1. The cash held by a firm is invested at a rate that is lower than the market rate, given the riskiness of the investment.

2. The management is not trusted with the large cash balance because of its past track record on investments..

1. Cash Invested at below-market Rates The first and most obvious condition occurs when much or all the cash balance does not earn a market interest rate. If this is the case, holding too much cash will clearly reduce the firm’s value. While most firms in the United States can invest in government bills and bonds with ease today, the options are much more limited for small businesses and in some markets outside the United States. When this is the case, a large cash balance earning less than a fair rate of return can destroy value over time.

Illustration 3: Cash Invested at below market rates In Illustration 1, we assumed that cash was invested at the riskless rate. Assume, instead, that the firm was able to earn only 3% on its cash balance of $200 million, while the riskless rate is 4.5%. The estimated value of the cash kept in the firm would then be (0.03)(200) = 133.33 Estimated value of cash invested at 3% = 0.045 The value of cash that is invested at a lower rate is $133.33 million. In this scenario, if the cash is returned to stockholders, it would yield them a surplus value of $66.67 million. In fact, liquidating any asset that has a return less than the required return would yield the same result, as long as the entire investment can be recovered on liquidation.22

2. Distrust of Management:

While making a large investment in low-risk or riskless marketable securities by itself is value neutral, a burgeoning cash balance can tempt managers to accept large investments or make acquisitions even if these investments earn sub-standard returns. In 21 There is a third scenario. When interest income from cash (which is riskless) is discounted back at a risk adjusted discount rate (see illustration 1), cash will be discounted in value, but for the wrong reasons.

22 While this assumption is straight forward with cash, it is less so with real assets, where the liquidation value may reflect the poor earning power of the asset. Thus, the potential surplus from liquidation may not be as easily claimed.

some cases, these actions may be taken to prevent the firm from becoming a takeover target.23 To the extent that stockholders anticipate such sub-standard investments, the current market value of the firm will reflect the cash at a discounted level. The discount is likely to be largest at firms with few investment opportunities and poor management and there may be no discount at all in firms with significant investment opportunities and good management.

Illustration 4: Discount for Poor Investments in the Future Return now to the firm described in Illustration 1, where the cash is invested at the riskless rate of 4.5%. Normally, we would expect the equity in this firm to trade at a total value of $1,400 million. Assume, however, that the managers of this firm have a history of poor acquisitions and that the presence of a large cash balance increases the probability from 0% to 30% that the management will try to acquire another firm.

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