Corporate Valuation, 2e

Theory, Evidence & Practice

by Holthausen, Zmijewski

ISBN: 978-1-61853-324-1 | Copyright 2020

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Welcome to the second edition of Corporate Valuation: Theory, Evidence & Practice

We wrote this book to equip our students as well as practitioners—many of whom are our former students—with the current knowledge used to value companies, parts of companies, and the securities issued by companies. Our goal is to provide current conceptual and theoretical valuation frameworks and translate those frameworks into practical approaches for valuing companies. We present the research and descriptive data underpinning these frameworks and use detailed examples to demonstrate how to implement them, often using data from real companies.

“Corporate Valuation: Theory, Evidence & Practice has been the industry
standard on valuation for over two decades, well before it was widely
available. The corporate valuation course based on this book is one of
the few unstated requirements for graduates of The Wharton School that
hope to enter into the field of finance. Having hired dozens of Wharton
alumni who have learned valuation from this book, I cannot imagine a
more thorough guide or a better reference to learn valuation.”

                                                                                   Ben Frost
                                                                                   Partner, Managing Director
                                                                                   Goldman Sachs Consumer Retail and Mergers Departments


Corporate Valuation: Theory, Evidence & Practice is intended as a college textbook for both graduate and undergraduate courses in valuation. Given the detailed approach, it is also a useful book for practicing professionals. We have been using this material in both valuation-based finance and accounting M.B.A. classes at Chicago Booth and Wharton, as well as in undergraduate finance classes at Wharton, for many years. Although primarily serving as a text in courses that teach valuation, the book can also serve as a background book for case-based courses that include cases on valuation, leveraged buyouts, and mergers and acquisitions. The book can also be used as a “field guide” for those who engage in valuation work. We know that many of our former students refer to our writings in their work involving valuation and security analysis for years after they graduate from our respective institutions.


In teaching valuation, we found that students generally lacked the detailed knowledge required to value a company. Although other finance textbooks cover these topics, they do so at a fairly low level of detail and generally do not cover the relevant finance and accounting complexities required to perform valuations. As such, students who use these textbooks typically struggle in the workplace because they either lack the requisite knowledge or fail to understand how to integrate the accounting information with the appropriate finance theory. We integrate the relevant accounting topics with the appropriate finance theory, and demonstrate, using step-by-step examples, how to implement the valuation frameworks we discuss. The book is organized so that instructors can choose not to assign certain chapters or sections of chapters and omit some of these details. In addition, we incorporate relevant empirical evidence and theory from prior studies as well as our own work.

Overview of the Structure of the Book

The book consists of six parts. Part I (Chapters 1 through 4) presents an overview of valuation issues and topics, how valuation is used in practice, and the basic tools needed to value a company. These tools include analyzing financial statements, measuring performance, understanding and measuring cash flows, and creating a financial model. Part II (Chapters 5 through 7) discusses the discounted cash flow (DCF) valuation model, including the residual income valuation model.

This part of the book demonstrates the equivalence of the alternative forms of the DCF valuation model and when each of the forms is more appropriate to use. Part III (Chapters 8 through 11) discusses how to measure the equity, unlevered, debt, weighted average, and other costs of capital used in the valuation. Part IV (Chapter 12) discusses how to value and measure the costof capital for warrants, options, and other equity-linked securities. Part V (Chapters 13 and 14) discusses the conceptual framework and practical application of the market multiple valuation method. Finally, Part VI (Chapters 15 through 17) applies and extends these valuation frameworks to specific settings such as highly leveraged transactions, mergers and acquisitions, and cross-border valuations.

Steps in the Valuation Process

In Chapter 1, we provide a top-level overview of the steps in a valuation process used to value a company. These overview steps include analyzing the competitive landscape, analyzing the company and its potential competitive advantage, creating a financial model, measuring the costs of capital, market multiple valuation, and alternative valuation approaches. In the relevant subsequent chapters, we provide detailed steps for each of these overview steps discussed in Chapter 1. For example, in Chapter 4 we provide a detailed step-by-step process for developing a financial model. These step-by-step process guides are included in many subsequent chapters. We show an example of this step-by-step process from Exhibit 15.8 for leveraged buyout transactions.

Real Companies and Detailed Examples Incorporated Throughout

The understanding of valuation and how it plays a role in business decisions is essential to the success of any business and its decision makers. Throughout each chapter, we include real company data and examples to engage students and provide an understanding of how the theory and conceptual frameworks are used in practice. Each chapter contains excerpts and summaries from company financial statements, SEC filings, and new articles illustrating how the topics in the chapter apply to real companies using the Valuation in Practice notes as well as an opening vignette. In addition, each chapter contains one or more detailed examples demonstrating a step-by-step application of the theory and conceptual frameworks discussed in the chapter, which provide an important bridge to help students understand how to apply the concepts. Many of these detailed examples use information from real companies; for example, we use the Xerox Corporation and Affiliated Computer Services, Inc. merger to demonstrate a step-by-step application of the concepts discussed in Chapter 16 on mergers and acquisitions (Exhibit 16.26 is an example of an exhibit detailing a valuation in the context of a real-world acquisition).

Valuation Keys

Each chapter contains numerous boxed summaries of key concepts and tools called Valuation Keys. The Valuation Keys help focus the reader on the key issue or issues in each section of the chapter.

Review Exercises with Solutions Throughout Each Chapter and End-of-Chapter Problems 

Applying theory and conceptual frameworks to realistic data is challenging for most students, and it is especially challenging for students with less business experience or previous exposure to finance, management, and other valuation-related business courses. To reinforce concepts presented in each section of the chapter, we include review exercises that allow students to apply the topic discussed in each section. The solutions to the review exercises appear at the end of each chapter. In addition, each chapter contains additional end-of-chapter exercises and problems instructors can assign separately.


The curricula, instructor preferences, and course lengths vary across schools. Accordingly, to the extent possible, we designed many of the chapters in Corporate Valuation: Theory, Evidence & Practice so that they can be taught independently of one another. This design provides flexibility and allows instructors to omit certain chapters in a course. Given the nature of the topics covered in the book, however, some of the chapters are interrelated, and certain concepts in a chapter not included in the curriculum would need to be covered by the instructor separately without assigning the entire chapter. We use this approach at Chicago because we have a quarter rather than a semester course schedule. Also, instructors may wish to supplement the course with cases, which might require omitting certain chapters.

Flexibility for Courses of Varying Lengths

Given differing preferences and needs, we provide the following table of possible course designs. In the semester course, faculty members can cover all 17 chapters in the book (Wharton curriculum). In the quarter course, however, covering the entire book is not practicable. For quarter courses, we outline two alternative approaches—one that focuses more on the details underpinning valuation, omitting the transaction and cross-border valuation chapters, and another that covers the valuation topics in less detail and includes the transaction and cross-border valuation chapters (Chicago curriculum).

We also present these two versions of the curriculum for the shorter six-week and five-day courses. The book is also used in Wharton’s Executive MBA program in a half-semester format which also includes cases, so the book is flexible in how it can be used.

  • The Tax Cuts and Jobs Act of 2017 (TCJA): We include discussions of the TCJA throughout the book and how it fundamentally affects valuation. For example, we discuss and provide examples of the effect of the TCJA’s interest deductibility limitation on interest tax shields, the new rules regarding net operating loss carryforwards, the implications for the levering and unlevering formulas, multinational valuation, and more. Many of the provisions in the TCJA are common in other countries, so these discussions apply to similar provisions in other countries.
  • Changes in accounting rules: We updated the chapters for various changes in accounting rules that affect how we value firms. For example, we discuss and provide examples for the change in accounting for leases in several chapters where pertinent.
  • Edited and reorganized certain chapters: We reorganized and edited certain chapters and parts of chapters based on input from teaching assistants and students. For example, we reorganized and edited the comprehensive example in Chapter 5 (discounted cash flow valuation).
  • We expanded, reorganized, and extensively edited Chapter 12 (equity-linked securities) and included more basic examples. Chapters 13 and 14 (market multiples valuation) have been rewritten with new comprehensive examples.
  • Additional examples: We added additional examples in various chapters. For example, in Chapter 11, we have a detailed example of how to value a company with net operating loss carryforwards (NOLs) and interest carryforwards.
  • Additional companies: Throughout the book we updated and added vignettes and valuation in practice examples to provide more bridges from the concepts in the texts to applications for actual companies.
  • Additional problems: We added additional problems in certain chapters.

For Instructors

Solutions Manual Created by the authors and contains solutions to each of the problems at the end of the chapters.

PowerPoint Presentations Created and classroom tested by the authors, the PowerPoint slides outline key elements of each chapter and provide additional examples not used in the textbook. Because most of the examples in the PowerPoint presentations are different from those used in the book, instructors are not just repeating what is in the book. Spreadsheets We provide author-created Excel spreadsheets for the underlying examples in the PowerPoint presentations. This allows instructors to see exactly how the spreadsheets are created and would also allow instructors to create other examples if they so desired.

For Students

Example, Review Exercise, and Problem Data We provide Excel spreadsheets of “hard-coded” data for chapter examples, review exercises, and end-of-chapter problems. We also provide hard-coded solutions to the chapter examples and review exercises. These hard-coded solutions provide students with the template used as well as the data for the problems, and make it easier to solve the problems, as students do not have to input the raw data into an Excel file.

In some cases, the exhibits in the book have small rounding errors because we do not show enough significant digits in order to avoid the clutter of multiple significant digits. When that occurs, the following phrase appears at the bottom of the exhibit: “Exhibit may contain small rounding errors.” The Excel spreadsheets provide more significant digits for students who want to refer to them.

Option Pricing Spreadsheet Chapter 12 includes applications of option pricing theory to plain vanilla options, warrants, employee stock options, convertible debt, and financial distress prediction. We provide an Excel file that aids with these applications.

Expand/Collapse All
About the Authors (pg. iii)
Preface (pg. iv)
Brief Contents (pg. xvi)
Contents (pg. xvii)
Chapter 1: Introduction to Valuation (pg. 2)
Introduction (pg. 4)
1.1 What Do We Mean By “The Value of a Company”? (pg. 4)
1.2 The Economic Balance Sheet: Resources Equal Claims on Resources (pg. 6)
Example Economic Balance Sheet (pg. 6)
The Economic Balance Sheet Does Not Equal the Accounting Balance Sheet (pg. 9)
Review Exercise 1.1 (pg. 10)
1.3 Valuation Principles (pg. 10)
Introduction to Measuring Free Cash Flows (pg. 10)
Review Exercise 1.2 (pg. 12)
The Discounted Cash Flow Valuation Model (pg. 12)
Illustration of the Discounted Cash Flow Valuation Using Snap Inc. (pg. 13)
Review Exercise 1.3 (pg. 15)
1.4 Measuring the Value of the Firm (pg. 15)
Two Forms of the Discounted Cash Flow (DCF) Valuation Model (pg. 15)
The Discounted Excess Flow Valuation Models (pg. 16)
Market Multiple Valuation Models (pg. 17)
Leveraged Buyout Valuation Models (pg. 18)
1.5 Measuring the Value of the Firm’s Equity (pg. 18)
1.6 Real Options in Valuation (pg. 19)
1.7 How Managers and Investors use Valuation Models (pg. 20)
Control Transactions (pg. 21)
Asset and Financial Restructuring Activities (pg. 23)
Raising Capital (pg. 27)
Strategic Analysis and Value-Based Management (pg. 28)
Contracts Between a Company and Its Investors and Employees (pg. 28)
Regulatory and Legal Uses of Valuation (pg. 29)
Identifying Over- and Undervalued Securities (pg. 29)
1.8 An Overview of the Valuation Process (pg. 30)
Summary and Key Concepts (pg. 31)
Additional Reading and References (pg. 31)
Exercises and Problems (pg. 31)
Solutions for Review exercises (pg. 34)
Chapter 2: Financial Statement Analysis (pg. 38)
Introduction (pg. 40)
2.1 Sources of Information (pg. 41)
Information About a Company (pg. 41)
Information About an Industry (pg. 42)
Privately Held (Owned) Companies (pg. 43)
2.2 How We Use Financial Ratios in Valuation (pg. 43)
Competitive Analysis (pg. 43)
Measuring the Debt and Preferred Stock Costs of Capital (pg. 43)
Creating, Driving, and Assessing the Reasonableness of Financial Forecasts (pg. 44)
Assessing the Degree of Comparability in Market Multiple Valuation (pg. 44)
Constraints and Benchmarks in Contracts (pg. 44)
2.3 Identifying a Company’s Industry and Its Comparable Companies (pg. 45)
2.4 The Gap, Inc.-An Illustration of the Calculation and Analysis of Financial Ratios (pg. 46)
2.5 Measuring a Company’s Performance Using Accounting Rates of Return (pg. 48)
Return on Assets (pg. 48)
Return on Investment (pg. 49)
Return on (Common) Equity (pg. 50)
Adjusting Financial Ratios for Excess Assets (pg. 51)
Alternative Ways to Measure Financial Ratio Inputs (pg. 52)
Limitations of Accounting Rates of Return as Measures of Performance (pg. 52)
2.6 Disaggregating the Return on Assets (pg. 53)
Disaggregating the Return on Assets (pg. 53)
Relation Between the Return on Asset Components (pg. 54)
How Does GAP Perform Relative to Other Companies in Its Industry? (pg. 54)
Review Exercise 2.1 (pg. 55)
2.7 Measuring a Company’s Cost Structure Using Expense Ratios (pg. 55)
The Gap, Inc.’s Expense Ratios (pg. 56)
Review Exercise 2.2 (pg. 58)
2.8 Analyzing a Company’s Asset Utilization Using Turnover Ratios (pg. 58)
Review Exercise 2.3 (pg. 59)
2.9 Summary Of Disaggregating The Gap, Inc.’S Rates Of Return (pg. 59)
2.10 Analyzing A Company’s Working Capital Management (pg. 60)
Ability to Pay Current Liabilities (pg. 60)
Inventories, Accounts Receivable, Accounts Payable, and Trade Cash Cycle Ratios (pg. 61)
Review Exercise 2.4 (pg. 63)
2.11 Analyzing A Company’s Fixed Asset Structure And Capital Expenditures (pg. 63)
Depreciable Life (Age) (pg. 63)
Capital Expenditures (pg. 64)
2.12 Other Types Of Financial Statement Relations-Growth, Trends, Per Share, Per Employee, And Per (pg. 64)
Employee, Unit of Capacity, and Unit of Output Measures (pg. 65)
Growth Rates and Trend Analyses (pg. 65)
Per Share Measures (pg. 66)
2.13 Analyzing A Company’s Financial Leverage And Financial Risk (pg. 66)
Measurement Issues-What Is Debt? (pg. 67)
Coverage Ratios (pg. 69)
Debt to Earnings Ratio (pg. 70)
2.14 Disaggregating The Return On (Common) Equity (pg. 70)
Review Exercise 2.5 (pg. 71)
2.15 Assessing Competitive Advantage (pg. 71)
Cost Leadership as a Competitive Advantage (pg. 72)
Differentiation as a Competitive Advantage (pg. 72)
Strategic Positioning (pg. 72)
Achieving and Sustaining Competitive Advantage (pg. 73)
Identifying the Source of Competitive Advantage (pg. 74)
Assessing the Sustainability of Competitive Advantage (pg. 74)
Fort Howard Corporation (pg. 75)
Nike, Inc. (pg. 77)
2.16 Implementation And Measurement Issues (pg. 78)
Some Basic Measurement Rules (pg. 78)
Seasonality (pg. 79)
Quarterly Data (pg. 79)
Different Fiscal Year-ends (pg. 79)
Adjusting the Data for Influential Observations (Outliers) (pg. 79)
Negative Denominators (pg. 80)
Inflation Adjustments (pg. 80)
The Role of Accounting (pg. 80)
“Quality” of the Financial Disclosures (pg. 81)
Accounting Rates of Return Do Not Equal Economic Rates of Return (pg. 81)
Summary and Key Concepts (pg. 82)
Additional Reading and References (pg. 82)
Exercises and Problems (pg. 82)
Solutions for Review exercises (pg. 88)
Chapter 3: Measuring Free Cash Flows (pg. 90)
Introduction (pg. 92)
3.1 Introduction To Measuring Free Cash Flows (pg. 92)
Measuring (Unlevered) Free Cash Flows (FCF) (pg. 93)
Measuring Equity Free Cash Flows (EFCF) (pg. 94)
How Issuing and Repaying Debt Affects Equity Free Cash Flows (pg. 95)
3.2 The Bob Adams Company Example (pg. 96)
The Bob Adams’s Unlevered Free Cash Flows (pg. 97)
Bob Adams’s Equity Free Cash Flows (pg. 99)
Reconciling Free Cash Flows to Change in Cash Balance (pg. 100)
Bob Adams Free Cash Flow Forecasts (Year 1 through Year 3) (pg. 100)
Review Exercise 3.1 (pg. 101)
3.3 Cash Flow Statement Basics (pg. 101)
The Algebra Underpinning the Cash Flow Statement (pg. 102)
Using the Cash Flow Statement to Measure Free Cash Flows (pg. 103)
The Bob Adams Company Revisited (pg. 104)
Review Exercise 3.2 (pg. 106)
3.4 The Relationships Between The Free Cash Flow Schedule And The Cash Flow Statement (pg. 106)
The Relationships (pg. 106)
Preparing Starbucks Free Cash Flow Schedule Using the Components on Its Statement of Cash Flows (pg. 108)
Measuring Starbucks’ Unlevered Free Cash Flow (pg. 110)
Measuring Starbucks’ Equity Free Cash Flow (pg. 112)
Reconciling Starbucks’ Equity Free Cash Flow to Its Change in Cash Balance (pg. 113)
Calculating Starbucks’ Free Cash Flow Using the Cash Flow Statement (pg. 113)
Using Cash Flows in Financial Analysis and Valuation (pg. 114)
3.5 Differences Between Book And Tax Accounting And The Effect On Income Tax Rates (pg. 115)
Permanent Differences Between Book and Tax Accounting (pg. 115)
Review Exercise 3.3 (pg. 117)
Temporary Differences Between Book and Tax Accounting (pg. 117)
Example of a Deferred Tax Liability Resulting from Depreciation (pg. 118)
Overview of the Modified Accelerated Cost Recovery System (MACRS) (pg. 120)
Review Exercise 3.4 (pg. 121)
Example of a Deferred Tax Asset Arising from a Warranty Liability (pg. 121)
Disclosures of Uncertain Tax Positions (pg. 122)
3.6 Understanding And Analyzing Income Tax Disclosures (pg. 122)
The Deferred Income Tax Schedule (pg. 123)
Measuring the Income Tax Rate Used on the Tax Forms (pg. 125)
3.7 Effects Of Interest Deduction Limitations And Net Operating Loss Carryforwards (pg. 126)
Interest Deduction Limitations (pg. 127)
Review Exercise 3.5 (pg. 133)
Net Operating Loss Carryforwards (pg. 133)
Review Exercise 3.6 (pg. 140)
Summary and Key Concepts (pg. 141)
Additional Reading and References (pg. 141)
Exercises and Problems (pg. 141)
Solutions for Review exercises (pg. 146)
Chapter 4: Creating a Financial Model (pg. 154)
Introduction (pg. 156)
4.1 An overview of the process of creating a financial model (pg. 157)
Steps in the Process of Creating a Financial Model (pg. 157)
Level of Aggregation (pg. 158)
Real or Nominal Cash Flow Forecasts (pg. 158)
Choice of Horizon for Explicit Year-by-Year Cash Flows (pg. 159)
Timing of Cash Flows Within a Year (pg. 159)
4.2 Forecasting Starbucks Corporation (Starbucks) (pg. 160)
4.3 Selecting and Forecasting the Forecast Drivers for the Company’s Operations (Steps 2 and 3) (pg. 162)
Forecast Drivers for the Starbucks Corporation Financial Model (pg. 164)
4.4 Creating a Financial Model for the Company’s Operations (Step 4) (pg. 166)
Starbucks’ Income Statement Forecasts-Part 1 (pg. 166)
Using Expense Ratios to Forecast Expenses (pg. 167)
Review Exercise 4.1 (pg. 168)
Starbucks’ Property, Plant, and Equipment Forecasts (pg. 169)
Starbucks’ Income Statement Forecasts-Part 2 (pg. 170)
Starbucks’ Balance Sheet Forecasts-Part 1 (pg. 170)
Review Exercise 4.2 (pg. 171)
The Balance of Shareholders’ Equity Is Not a Plug (pg. 171)
Starbucks’ Free Cash Flow Forecasts (pg. 172)
Starbucks’ Balance Sheet Forecasts-Part 2 (pg. 173)
Starbucks’ Cash Flow Statement Forecasts (pg. 174)
Review Exercise 4.3 (pg. 175)
4.5 Stress Testing the Model and Assessing the Reasonableness of the Forecasts (Steps 5 and 6) (pg. 175)
Checking and Stress Testing the Model-Step 5 (pg. 175)
Step Back and Ask, “Do the Forecasts Make Sense?”-Step 6, Part 1 (pg. 175)
Comparing Historical Financial Ratios to the Financial Ratios Based on the Forecasts-Step 6, Part 2 (pg. 176)
Starbucks’ Historical Financial Ratios and Financial Ratio Forecasts (pg. 176)
4.6 Incorporating the Company’s Capital Structure Strategy (pg. 177)
Incorporating an Alternative Capital Strategy in the Financial Model (pg. 178)
Review Exercise 4.4 (pg. 179)
4.7 Sensitivity and scenario analyses and simulations (pg. 179)
4.8 Forecasting Required Cash and Valuing Excess Cash (pg. 180)
Forecasting the Cash Required to Operate the Business (Required Cash) (pg. 181)
Valuing Excess Cash (pg. 181)
4.9 Forecasting Income Tax Rates and Payments (pg. 183)
Forecasting the Average Tax Rate and Adjustments to Forecast Income Taxes Paid (pg. 183)
Forecasting the Marginal Tax Rate for Interest, TINT (pg. 184)
4.10 More Detailed Forecasts of Revenues and Capital Expenditures (pg. 185)
The Price and Quantity Components of the Revenue Growth Rate (pg. 185)
Adjusting Growth Rates for Inflation (pg. 186)
Potential Forecast Drivers for Revenues and Capital Expenditures (pg. 186)
Potential Forecast Drivers for Capital Expenditures (and Property, Plant, and Equipment) (pg. 187)
Illustration of a More Detailed Revenue Forecast (pg. 188)
Illustration of More Detailed Capital Expenditure and Depreciation Forecasts (pg. 189)
Summary and Key Concepts (pg. 192)
Additional Reading and References (pg. 192)
Exercises and Problems (pg. 192)
Solutions for Review exercises (pg. 195)
Chapter 5: The Adjusted Present Value and Weighted Average Cost of Capital Discounted Cash Flow Valu (pg. 200)
Introduction (pg. 202)
5.1 creating Value from Financing (pg. 202)
Insights from Miller and Modigliani and Others (pg. 203)
The Single Investor Company (pg. 204)
Countervailing Forces (pg. 207)
5.2 The Adjusted Present Value and Weighted Average Cost of Capital Valuation Models (pg. 209)
Adjusted Present Value (APV) Method (pg. 209)
Weighted Average Cost of Capital (WACC) Method (pg. 210)
The Weighted Average Cost of Capital (pg. 211)
The Link between the Unlevered Cost of Capital and the Equity Cost of Capital (pg. 212)
How the Cost of Capital Links Are Used in Practice (pg. 213)
The Adjusted Present Value and Weighted Average Cost of Capital Valuation Methods Are Typically Not (pg. 214)
5.3 The Andy Alper Company (pg. 215)
Which Valuation Method Do We Use to Value Andy Alper Company? (pg. 215)
Alper’s Valuation Based on Capital Structure Ratios Used to Initially Finance the Company-The Weight (pg. 216)
Review Exercise 5.1 (pg. 218)
Alper’s Valuation Based on Growing Its Debt and Preferred Stock Financing at the Free Cash Flow Grow (pg. 220)
Costs of Capital Implicit in the Adjusted Present Value Valuation (pg. 221)
Review Exercise 5.2 (pg. 221)
5.4 The Discounted Equity Free Cash Flow Valuation Method (pg. 222)
Valuing Common Equity by First Measuring the Value of the Firm (pg. 222)
Valuing the Equity Directly Using the Equity Discounted Cash Flow Method (pg. 222)
Equity Discounted Cash Flow Model for the Alper Company (pg. 223)
Complexities and Limitations of the Equity Discounted Cash Flow Method (pg. 224)
Assumption About Distributing Equity Free Cash Flows to Equityholders (pg. 225)
Review Exercise 5.3 (pg. 225)
5.5 The Discounted Dividend Valuation Model (pg. 225)
5.6 Useful Valuation Concepts to Keep in Mind (pg. 226)
The Value of the Firm Is Net of Its Non-Interest-Bearing Operating Liabilities (pg. 226)
Using Nominal or Real (Inflation-Adjusted) Cash Flows and Discount Rates (pg. 227)
The Concept of Expected Free Cash Flows (pg. 229)
The Risk-Adjusted Discount Rate (Cost of Capital) (pg. 231)
Don’t Use “Fudge Factors” (pg. 232)
5.7 Comprehensive Example-Dennis Keller, INC. (pg. 234)
Value of Keller Based on the 20% Debt Capital Structure Valuation-The Seller’s Perspective (pg. 235)
Value of Keller Based on the $20 Million Debt Capital Structure-The Buyer’s Perspective (pg. 238)
Summary and Key Concepts (pg. 243)
Additional Reading and References (pg. 244)
Exercises and Problems (pg. 244)
Solutions for Review Exercises (pg. 248)
Chapter 6: Measuring Continuing Value Using the Constant-Growth Perpetuity Model (pg. 250)
Introduction (pg. 252)
6.1 The Constant-Growth Perpetuity Model (pg. 253)
Using the Free Cash Flow in Year Zero (FCF0) (pg. 254)
Basic Assumptions Underlying the Constant-Growth Perpetuity Model (pg. 254)
The Steady State Company (pg. 255)
When Will a Company Meet the Constant-Growth Perpetuity Model Assumptions? (pg. 255)
Value Derived from Continuing Value Is Often More Than 50% (pg. 256)
Does an Infinite Horizon Really Assume the Company Exists Forever? (pg. 258)
6.2 Estimating The Long-Term Growth Rate For The Constant-Growth Perpetuity Model (pg. 259)
Factors to Consider When Estimating the Long-Term Growth Rate (pg. 259)
The Present Value Weighted Average Growth Rate (pg. 260)
Review Exercise 6.1 (pg. 262)
A Two-Stage Continuing ValueGrowth Rate Illustration (pg. 262)
Review Exercise 6.2 (pg. 263)
Using Comparable Companies to Measure Present Value Weighted Average Growth Rates (pg. 263)
Review Exercise 6.3 (pg. 265)
6.3 Estimating The Base-Year Year Free Cash Flow (pg. 265)
Preparing the Base-Year Free Cash Flow Forecast for the Financial Model (pg. 265)
“Lumpy” Capital Expenditures Result in “Lumpy” Free Cash Flows (pg. 268)
Review Exercise 6.4 (pg. 271)
Relationship Between Capital Expenditures and Depreciation (pg. 272)
6.4 Real Growth And Value Creation In The Constant-Growth Perpetuity Model (pg. 273)
A Constant Growth Rate Equal to Inflation (No Real Growth) (pg. 274)
Real Growth from New Investment Can Decrease the Value of the Firm (pg. 275)
Yahoo! with New Investments as of the Continuing Value Date (pg. 278)
6.5 Assessing The Reasonableness Of The Continuing Value Estimate (pg. 279)
Analyzing Yahoo!’s Forecasts (pg. 279)
Review Exercise 6.5 (pg. 280)
Using Market Multiples to Assess the Reasonableness of the Continuing Value (pg. 281)
Yahoo!’s Implied Market Multiples (pg. 281)
Summary and Key Concepts (pg. 282)
Additional Reading and References (pg. 284)
Exercises and Problems (pg. 284)
Solutions for Review Exercises (pg. 287)
Chapter 7: The Excess Earnings (Residual Income) Valuation Method (pg. 290)
Introduction (pg. 292)
7.1 The Excess Cash Flow Valuation Framework (pg. 292)
Excess Free Cash Flow Form (pg. 293)
An Excess Returns Presentation of the Excess Flow Model (pg. 294)
Review Exercise 7.1 (pg. 294)
7.2 The Excess Earnings Valuation Framework (pg. 294)
The Excess Free Cash Flow Form (pg. 296)
The Excess (or Residual) Earnings Form (pg. 296)
Extending the J. Stern Company Example to the Excess Earnings Valuation Method (pg. 298)
Review Exercise 7.2 (pg. 299)
The Articulation of the Income Statement and the Balance Sheet and Comprehensive Income (pg. 299)
7.3 The Weighted Average Cost of Capital Form of the Model (pg. 300)
Dennis Keller, Inc. Revisited-Weighted Average Cost of Capital Form of the Model (pg. 301)
Review Exercise 7.3 (pg. 304)
7.4 The Adjusted Present Value Form of the Model (pg. 305)
Dennis Keller, Inc. Revisited-Adjusted Present Value Form of the Model (pg. 305)
7.5 The Equity Discounted Excess Earnings Model (pg. 307)
Dennis Keller, Inc. Revisited-Equity Discounted Excess Earnings Form of the Model (pg. 309)
Review Exercise 7.5 (pg. 312)
7.6 Possible Information Advantages of the Excess Earnings Valuation Method (pg. 312)
Adjustments to Earnings and Book Value to Estimate “Economic Earnings” (pg. 313)
Potential Adjustments for Implementing the Excess Earnings Model (pg. 314)
Summary and Key Concepts (pg. 315)
Additional Reading and References (pg. 315)
Exercises and Problems (pg. 316)
Solutions for Review Exercises (pg. 320)
Chapter 8: Estimating the Equity Cost of Capital (pg. 326)
Introduction (pg. 328)
8.1 The Capital Asset Pricing Model (pg. 328)
The Effects of Diversification (pg. 329)
Beta as a Measure of Security Risk (pg. 330)
Review Exercise 8.1 (pg. 331)
A Quick Look at Some Betas (pg. 332)
A Portfolio Beta Is a Weighted Average of the Betas of the Securities in the Portfolio (pg. 333)
Review Exercise 8.2 (pg. 333)
Further Observations and Empirical Evidence (pg. 334)
Evidence on the Capital Asset Pricing Model (pg. 334)
8.2 An Overview on Estimating the Equity Cost of Capital Using the Capital Asset Pricing Model (pg. 336)
8.3 Estimating Beta (pg. 337)
The Equity Cost of Capital Used in Valuation is Forward Looking but Estimated Using Historical Data (pg. 337)
The Market Model (pg. 338)
Return Dichotomization in the Market Model (pg. 338)
Market Model Estimates for Four Example Companies (pg. 339)
Equity Betas Capture Systematic Financial Risk and Business Risk (pg. 340)
The Market Model Applied to Portfolios (pg. 342)
Review Exercise 8.3 (pg. 342)
Beta Estimation: Choosing the Proxy for the Market Portfolio (Market Index) (pg. 343)
Beta Estimation: Choosing the Time Period for the Estimation and Time Interval (Periodicity) for Mea (pg. 344)
Mean Reversion in Estimated Betas and Adjusted Betas (pg. 346)
Using Commercially Available Betas (pg. 347)
Potential Spurious Effects of Company Specific Information on Beta (pg. 348)
8.4 Adjusting Estimated Betas for Changes in Risk (Non-Stationary Betas) (pg. 349)
Adjustments to Beta for Changes in Operations (pg. 349)
Direct Adjustments to Unlevered Betas for Excess Assets and Divestitures (pg. 350)
Shifting Betas in the Future (pg. 350)
Review Exercise 8.4 (pg. 351)
Review Exercise 8.5 (pg. 351)
8.5 Estimating the Market Risk Premium (pg. 351)
The 1926 to 2016 U.S. Return Experience (pg. 352)
Choice of the Proxy for the Market Portfolio (Market Index) (pg. 353)
Choice of Proxy for the Risk-Free Return to Measure the Market Risk Premium (pg. 353)
The Historical Approach to Estimating the Market Risk Premium (pg. 355)
Time Variation in Estimating the Market Risk Premium (pg. 358)
Estimates of the Market Risk Premium from Market Participants (pg. 358)
Estimates of the Market Risk Premium from Implied Cost of Capital Estimates (pg. 359)
Uncertainty in Estimates of the Market Risk Premium (pg. 359)
Where Does All of the Evidence Leave Us? (pg. 359)
8.6 Estimating the Risk-Free Rate of Return to Use in the Capm (pg. 360)
8.7 Putting the Pieces Together (pg. 361)
Informed Judgment and Guiding Principles (Links) (pg. 361)
CAPM Example Using Our Four Companies (pg. 361)
Review Exercise 8.6 (pg. 363)
How Finance Professionals Put the Pieces Together (pg. 363)
8.8 Adjusting the Capital Asset Pricing Model for Market Capitalization (pg. 364)
8.9 The Build-Up Method (pg. 366)
Typical Formulation of the Build-Up Method (pg. 366)
8.10 Multi-Factor Models (pg. 367)
The Fama and French Three-Factor Model and Its Estimation (pg. 368)
Review Exercise 8.7 (pg. 371)
8.11 Implied Cost of Capital Estimates (pg. 371)
The Constant Dividend Growth Model (pg. 371)
Implied Cost of Capital Estimates from Forecasts of Excess Earnings or Cash Flows (pg. 372)
Summary and Key Concepts (pg. 373)
Additional Reading and References (pg. 373)
Exercises and Problems (pg. 373)
Solutions for Review Exercises (pg. 376)
Chapter 9: Measuring the Cost of Capital for Debt and Preferred Securities (pg. 380)
Introduction (pg. 382)
9.1 Types of Non-Common-Equity Securities (pg. 383)
How Do Companies Finance Their Balance Sheets? (pg. 383)
Current and Non-Current Operating Liabilities Not Included in Non-Common-Equity Financing (pg. 385)
The Cost of Capital for Warrants, Employee Stock Options, and Other Equity-Linked Securities (pg. 386)
9.2 Credit Ratings, Recovery Rates, Default Rates, and Yield to Maturity Versus the Cost of Debt (pg. 386)
Credit Rating Agencies and Credit Ratings (pg. 386)
Recovery and Default Rates (pg. 387)
The Promised Yield to Maturity versus the Cost of Debt (pg. 393)
Review Exercise 9.1 (pg. 396)
9.3 Measuring The Debt and Preferred Stock Costs of Capital (pg. 396)
An Overview of the Process for Measuring the Debt and Preferred Stock Costs of Capital (pg. 397)
Measuring the Yield to Maturity (pg. 397)
Measuring the Cost of Debt Using the Internal Rate of Return Approach (pg. 399)
Review Exercise 9.2 (pg. 402)
Measuring the Preferred Stock Cost of Capital Using the Adjusted Promised Yield Approach (pg. 402)
Measuring the Cost of Debt Using the Expected Default Loss Approach (pg. 402)
Using the Capital Asset Pricing Model to Measure the Cost of Debt (pg. 405)
Review Exercise 9.3 (pg. 407)
Using Credit Default Swaps to Measure Default Risk and Recovery Rates (pg. 407)
Measuring the Cost of Debt-Summary (pg. 409)
9.4 Credit Rating Models (pg. 409)
Estimating Credit Ratings Using Financial Ratios (pg. 410)
Review Exercise 9.4 (pg. 411)
The HZ Credit Rating Model (pg. 412)
Review Exercise 9.5 (pg. 416)
Preferred Stock Rating Models (pg. 416)
Yield Prediction Models (pg. 417)
9.5 Bankruptcy Prediction and Financial Distress Models (pg. 417)
The HZ Financial-Ratio-Based Bankruptcy Prediction Model (pg. 417)
Review Exercise 9.6 (pg. 420)
Option Pricing-Based Financial Distress Models (pg. 420)
Which Approach Works Better (Ratio-Based or Option Pricing-Based Financial Distress Models)? (pg. 423)
Summary and Key Concepts (pg. 423)
Additional Reading and References (pg. 424)
Appendix: An Overview of the Black-Scholes and Merton Option Pricing Models (pg. 424)
The Black-Scholes and Merton Option Pricing Models (pg. 425)
Review Exercise A9.1 (pg. 427)
Exercises and Problems (pg. 427)
Solutions for Review Exercises (pg. 428)
Chapter 10: Levering and Unlevering the Cost of Capital and Beta (pg. 434)
Introduction (pg. 436)
10.1 An Overview of the Unlevering and Levering Process (pg. 436)
Identifying and Selecting Comparable Companies (pg. 437)
The Steps in the Unlevering Process (pg. 438)
The Steps in the Levering Process (pg. 438)
Measuring the Inputs (pg. 439)
10.2 Selecting the Discount Rate and Measuring the Value of Interest Tax Shields (pg. 440)
The Conditions When the Cost of Debt Is a Reasonable Discount Rate for Interest Tax Shields (pg. 440)
The Conditions When the Unlevered Cost of Capital Is a Reasonable Discount Rate for the Interest Tax (pg. 441)
Discount Rate for Interest Tax Shields with Annual Refinancing (pg. 442)
Interest Deduction Limitations or Caps (pg. 442)
Guidelines for Choosing Discount Rates for Interest Tax Shields (pg. 443)
10.3 Levering the Unlevered Cost of Capital (pg. 444)
The Economic Balance Sheet (pg. 444)
The General Levering Formula (pg. 445)
Levering Formulas for Specific Simplifying Assumptions for the Value of Interest Tax Shields (pg. 446)
The Booth Company-Levering the Unlevered Cost of Capital (pg. 448)
Review Exercise 10.1 (pg. 451)
Choosing a Levering Method (pg. 452)
10.4 Levering the Unlevered (Asset) Beta from the Capital Asset Pricing Model (pg. 453)
Using the Capital Asset Pricing Model to Measure Beta from an Observed Cost of Capital (pg. 453)
Integrating the Capital Asset Pricing Model into the Levering Formula (pg. 454)
The Booth Company Revisited-Levering the Unlevered Beta (pg. 454)
Review Exercise 10.2 (pg. 456)
10.5 Unlevering the Equity Cost of Capital and Equity Beta (pg. 456)
Unlevering the Equity Cost of Capital (pg. 456)
The Bakwin Company-Unlevering the Equity Cost of Capital (pg. 456)
Review Exercise 10.3 (pg. 458)
Unlevering the CAPM Equity Beta (pg. 459)
The Bakwin Company Revisited-Unlevering the CAPM Equity Beta (pg. 459)
When the Cost of Debt Is the Discount Rate for Some but Not All Interest Tax Shields (pg. 461)
Review Exercise 10.4 (pg. 462)
Choosing an Unlevering Method (pg. 462)
10.6 Using Comparable Companies to Estimate Betas (pg. 462)
Using Individual Betas (Instead of Portfolio Betas) to Improve Precision (pg. 463)
Measuring a Company’s Unlevered Beta from Its Comparable Companies’ Unlevered Betas (pg. 463)
Review Exercise 10.5 (pg. 465)
10.7 Limitations of the Levering and Unlevering Formulas (pg. 465)
Considering Financial Distress Costs When Choosing Comparable Companies (pg. 466)
Does the Cost of Debt Multiplied by the Value of the Debt Measure Expected Interest Tax Shields? (pg. 466)
Limitations of Modigliani and Miller’s Levering and Unlevering Formulas (pg. 467)
Assuming Zero Debt and Preferred Stock Betas (pg. 470)
Summary and Key Concepts (pg. 474)
Additional Reading and References (pg. 474)
Exercises and Problems (pg. 474)
Solutions for Review Exercises (pg. 477)
Chapter 11: Measuring the Weighted Average Cost of Capital and Related Valuation Issues (pg. 482)
Introduction (pg. 484)
11.1 The Weighted Average Cost of Capital-Overview (pg. 485)
How the Weighted Average Cost of Capital Embeds the Value of Interest Tax Shields (pg. 486)
Target Long-Term Capital Structure and the Free Cash Flow Perpetuity Method (pg. 487)
Review Exercise 11.1 (pg. 488)
Limitations of the Weighted Average Cost of Capital Valuation Method (pg. 488)
11.2 Measuring Target Capital Structures and the Income Tax Rate for Interest Tax Shields (pg. 490)
Measuring Target Capital Structure Ratios (pg. 491)
Measuring the Income Tax Rate for Interest Tax Shields (pg. 496)
11.3 The Effects of Treating Liabilities as Debt Versus Operating Liabilities (pg. 499)
The Debt versus Operating Liability Issue (pg. 499)
The Perpetual Leasing Company (pg. 500)
Other Examples of the Debt versus Operating Liability Issue (pg. 502)
Conclusions (pg. 503)
Review Exercise 11.2 (pg. 504)
11.4 Converting Operating Leases to Finance (or Capital) Leases (pg. 504)
Review Exercise 11.3 (pg. 506)
Review Exercise 11.4 (pg. 509)
11.5 Valuing a Company with Interest and Net Operating Loss Carryforwards (pg. 510)
Effect on Unlevered Cash Flows, Interest Tax Shields, and Income Tax Forecasts (pg. 511)
Review Exercise 11.5 (pg. 515)
Adjusting the APV Valuation Model for Interest and NOL Carryforwards (pg. 516)
Review Exercise 11.6 (pg. 518)
Adjusting the Weighted Average Cost of Capital Valuation Model for Interest and NOL Carryforwards (pg. 518)
Review Exercise 11.7 (pg. 521)
A Common “Short-Cut” Adjustment to the WACC Valuation Method (pg. 522)
Review Exercise 11.8 (pg. 523)
11.6 Other Factors that Affect the Value Created from Debt Financing (pg. 523)
The Potential Effects of Personal Income Taxes on the Costs of Capital and the Value from Debt Finan (pg. 524)
The Effects of Financial Distress Costs on the Value Created from Debt Financing (pg. 528)
Summary and Key Concepts (pg. 531)
Additional Reading and References (pg. 531)
Appendix: Financial Statement and Free Cash Flow Effects of Leases (pg. 531)
Review Exercise A11.1 (pg. 535)
Exercises and Problems (pg. 536)
Solutions for Review Exercises (pg. 540)
Chapter 12: The Effects of Stock-Based Compensation and Other Equity-Linked Securities on Discounted (pg. 554)
Introduction (pg. 556)
12.1 Adjusting Discounted Cash Flow Valuations for the Expected Issuance of Future Stock-Based Comp (pg. 557)
Overview of Stock-Based Compensation (pg. 558)
Analysis of Financial Statement Disclosures of Stock-Based Compensation (pg. 560)
Forecasting the Issuance and Free Cash Flow Effects of Future Stock-Based Compensation (pg. 563)
Review Exercise 12.1 (pg. 568)
12.2 Adjusting a Discounted Cash Flow Valuation for Previously Issued and Outstanding Equity-Linked (pg. 568)
The Effect of Option-Based Equity-Linked Securities Is Already Included in the Weighted Average Cost (pg. 569)
Adjusting the Shares Outstanding for Outstanding Share Equivalent Equity-Linked Securities (pg. 570)
Allocating the Value of the Combined or Total Equity to Common Stock and Outstanding Warrants When t (pg. 572)
Review Exercise 12.2 (pg. 574)
Allocating the Value of the Combined or Total Equity to Common Stock and Outstanding Employee Stock (pg. 574)
Review Exercise 12.3 (pg. 576)
12.3 Valuing Warrants, Employee Stock Options, and Other Option-Based Equity-Linked Securities (pg. 577)
The Black-Scholes and Merton Option Pricing Models (pg. 577)
Measuring the Price (Value) of Warrants and Employee Stock Options (pg. 578)
Allocating the Value of the Combined or Total Equity to Option-Based Equity-Linked Securities When t (pg. 581)
Review Exercise 12.4 (pg. 583)
Review Exercise 12.5 (pg. 584)
12.4 Measuring the Cost of Capital for Option-Based Equity-Linked Securities (pg. 584)
Determinants (Inputs) of the Valuation and Cost of Capital of Option-Based Equity-Linked Securities (pg. 586)
The Effect of Option-Based Equity-Linked Securities When Measuring the Unlevered Cost of Capital of (pg. 588)
Review Exercise 12.6 (pg. 591)
12.5 Convertible Debt (pg. 591)
Convertible Debt Contract Provisions (pg. 592)
The Valuation and Cost of Capital of Convertible Debt (pg. 593)
Alcoa Inc.’s Convertible Notes (pg. 594)
Review Exercise 12.7 (pg. 598)
Summary and Key Concepts (pg. 598)
Additional Reading and References (pg. 599)
Exercises and Problems (pg. 599)
Solutions for Review Exercises (pg. 605)
Chapter 13: Introduction to Market Multiple Valuation Methods (pg. 610)
Introduction (pg. 612)
13.1 The Market Multiple Valuation Process (pg. 613)
13.2 Commonly Used Market Multiples (pg. 614)
Firm Value versus Enterprise Value (pg. 614)
Market Multiples Used to Value the Firm and Equity (pg. 614)
Review Exercise 13.1 (pg. 616)
Market Multiples Vary Over Time (pg. 617)
13.3 Risk and Growth Value Determinants of Market Multiples (pg. 618)
The Relation Between the Discounted Cash Flow Model and Free Cash Flow Multiples (pg. 618)
Review Exercise 13.2 (pg. 619)
Why Free Cash Flow Multiples Are Not Very Popular (pg. 619)
Review Exercise 13.3 (pg. 620)
13.4 Additional Factors to Consider When Assessing Comparability (pg. 620)
When Is a Factor Relevant for Assessing Comparability? (pg. 620)
PepsiCo, Inc. (Pepsi) Simulation (pg. 621)
Review Exercise 13.4 (pg. 632)
Does Firm Size Matter When Assessing Comparability? (pg. 634)
Review Exercise 13.5 (pg. 635)
Assumptions Underlying Non-Accounting-Based Market Multiples (pg. 635)
13.5 The Process for Identifying Comparable Companies (pg. 636)
Understand the Businesses in Which the Company Operates (pg. 636)
Identifying Competitors and Companies in the Same Industry Is Only the Starting Point (pg. 637)
13.6 Transitory Shocks and Market Multiples (pg. 640)
13.7 Analyzing and Measuring Continuing Value Multiples (pg. 642)
Changing Growth Rates (pg. 642)
Cyclical Industries (pg. 644)
Effect of Market Multiples Varying Over Time (pg. 644)
Review Exercise 13.6 (pg. 645)
Summary and Key Concepts (pg. 645)
Additional Reading and References (pg. 645)
Exercises and Problems (pg. 646)
Solutions for Review Exercises (pg. 652)
Chapter 14: Market Multiple Measurement and Implementation (pg. 656)
Introduction (pg. 658)
14.1 First Principles for Measuring Market Multiples (pg. 658)
Principle 1: Consistency of Claims Represented in the Numerator and Denominator (pg. 659)
Principles 2 and 3: Use a Numerator and Denominator that Represent the Value of the Company’s Long-R (pg. 659)
Timing Issues (pg. 660)
14.2 Initial Financial Statement Review (pg. 662)
Categories of Potential Adjustments to Market Multiple Denominators (pg. 662)
Initial Review of Merck & Co., Inc.’s Financial Statements (pg. 664)
14.3 Measuring Market Multiple “Numerators” (pg. 669)
Value of the Firm’s Operations and Enterprise Value as Alternative Numerators (pg. 669)
Relation Between the Valuation Date and the Measurement Date for Value (Numerator) (pg. 670)
Measuring the Value of the Common Equity Shares (pg. 670)
Measuring the Value of Debt and Preferred Stock (pg. 670)
Measuring the Value of Stock Options and Other Equity-Linked Securities (pg. 671)
Measuring the Value of Other Securities and Off-Balance-Sheet Financing (pg. 671)
Adjustments to the Numerator as a Result of Adjustments to the Denominator (pg. 671)
Measuring Merck’s Enterprise Value and Equity Value as of December 31, 2014 (pg. 672)
Review Exercise 14.1 (pg. 677)
14.4 Basics of Measuring Market Multiple “Denominators” (pg. 677)
Measuring the Denominators-Basic Calculations (pg. 677)
Changes in Accounting, Correction of Errors, and Restated Financial Statements (pg. 679)
Adjusting Market Multiple Inputs for Excess Assets (pg. 680)
14.5 Adjusting Market Multiple Inputs for Non-Recurring Items (pg. 685)
Restructuring Charges (pg. 686)
Review Exercise 14.2 (pg. 688)
Impairment Charges (pg. 688)
Gains and Losses from Debt Redemptions and Repurchases (pg. 690)
14.6 Adjusting Market Multiple Inputs for Partially Owned Companies (pg. 690)
Noncontrolling Interest (Minority Interest) (pg. 691)
Unconsolidated Affiliates (pg. 692)
14.7 Adjusting Market Multiple Inputs for Corporate Transactions (pg. 694)
Mergers and Acquisitions (pg. 695)
Divestitures (pg. 697)
14.8 Comparison of Merck’s Market Multiples Based on Reported and Adjusted Inputs (pg. 699)
Merck’s Adjusted Enterprise Value and Equity Value (pg. 700)
Merck’s Adjusted Income Statement and Balance Sheet (pg. 700)
Comparison of Merck’s Market Multiples Based on Reported and Adjusted Inputs (pg. 703)
Review Exercise 14.3 (pg. 704)
14.9 Adjusting Market Multiple Inputs for Leases and Discontinued Operations (pg. 705)
Adjusting for United Airlines Leases (pg. 705)
Discontinued Operations (pg. 707)
Review Exercise 14.4 (pg. 708)
14.10 Selecting Among Alternative Market Multiples and Establishing a Range (pg. 709)
Negative Denominators Can Eliminate a Multiple from Consideration (pg. 709)
Revenue Multiples Can Be Appropriate When We Conclude the Cost Structure Will Change (pg. 710)
Using Multiple Comparable Companies to Offset Differences (pg. 710)
Does the Variation in Multiples Across Companies Line Up According to Expectations? (pg. 710)
Establishing a Reasonable Range of Values and Measuring Central Tendency (pg. 711)
Selecting the Range of Values (or Value) to Use in Our Valuation (pg. 711)
Review Exercise 14.5 (pg. 711)
Summary and Key Concepts (pg. 712)
Additional Reading and References (pg. 712)
Exercises and Problems (pg. 713)
Solutions for Review Exercises (pg. 729)
Chapter 15: Leveraged Buyout Transactions (pg. 736)
Introduction (pg. 738)
15.1 Leveraged Buyout Activity, Deal Characteristics, and the Role of the Financial Sponsor (pg. 739)
Time-Series of Leveraged Buyout Transactions (pg. 739)
Home Country Preference (pg. 741)
Private versus Public Targets and Acquirers (pg. 741)
Premiums Paid and Transaction Market Multiples (pg. 742)
Leveraged Buyout Deal Characteristics (pg. 743)
Characteristics of Potential Leveraged Buyout Candidates (pg. 746)
Financial Sponsors-Who They Are and What They Do (pg. 747)
15.2 Potential Motivations, Economic Forces, and Economic Research (pg. 751)
Potential Tax Benefits from Increased Interest Tax Shields (pg. 751)
Potential Agency Cost Reductions from Increased Debt-Jensen’s Free Cash Flow Theory (pg. 752)
Potential Agency Cost Reductions from Management Ownership (pg. 752)
More Effective Monitoring by the Board of Directors (pg. 752)
Information Asymmetry Advantage of Insiders (pg. 753)
Wealth Transfer from Employees and Pre-Buyout Bondholders (pg. 753)
Who Can Pay More for a Company-A Financial Buyer (LBO) or Strategic Buyer? (pg. 754)
The Effects of LBOs on Operating Performance and Firm Values (pg. 754)
15.3 Steps in Assessing the Investment Value of Leveraged Buyout Transactions (pg. 756)
15.4 The John Edwardson & Company Leveraged Buyout Transaction (pg. 758)
Initial Price and Capital Structure (Steps 1-2) (pg. 758)
Review Exercise 15.1 (pg. 761)
Financial Model, Capital Structure, and Debt Rating (Steps 3-5) (pg. 761)
Investor Internal Rate of Return (Steps 7-8) (pg. 767)
15.5 Using Discounted Cash Flow Valuation Models to Evaluate LBO Transactions (Steps 9 and 10) (pg. 771)
Using the Weighted Average Cost of Capital Valuation Method to Measure Exit Values-Step 9 (Another V (pg. 771)
Review Exercise 15.2 (pg. 771)
Review Exercise 15.3 (pg. 773)
Adjusted Present Value Method Valuation, Net Present Value of the Investment, Implied Equity Costs o (pg. 774)
The Adjusted Present Value Valuation of an LBO Investment (pg. 774)
Review Exercise 15.4 (pg. 777)
Implied Equity Costs of Capital, Equity Betas, and Weighted Average Costs of Capital (pg. 778)
Review Exercise 15.5 (pg. 779)
Summary and Key Concepts (pg. 779)
Additional Reading and References (pg. 779)
Exercises and Problems (pg. 780)
Solutions for Review Exercises (pg. 786)
Chapter 16: Mergers and Acquisitions (pg. 792)
Introduction (pg. 794)
16.1 What Do We Know About Merger and Acquisition Transactions? (pg. 794)
Time-Series of Merger and Acquisition Transactions (pg. 795)
Cross-Border versus Home Country Preference (pg. 796)
Private versus Public Targets and Acquirers (pg. 797)
Merger Premiums and Market Multiples (pg. 798)
16.2 What Motivates Mergers and Acquisitions, and Do They Create Value? (pg. 799)
What Motivates Merger and Acquisition Transactions? (pg. 799)
Do Merger and Acquisition Transactions Create Value, and If They Do, for Whom? (pg. 801)
Factors Affecting the Ability of Mergers to Create Value (pg. 803)
Cross-Border Acquisitions (pg. 805)
Mitigating Risks (pg. 806)
16.3 Deal Structure, Income Taxes, and Other Contract Provisions (pg. 806)
Types of Transactions (pg. 807)
Other Common Contract Provisions (pg. 808)
16.4 Synergies (pg. 810)
Cost Efficiency Synergies (pg. 811)
Revenue Synergies (pg. 811)
Financial Synergies (pg. 812)
Synergy Uncertainty (pg. 813)
Valuing Expected Synergies from Amberjack Inc.’s Example Acquisition of Tarpon Inc. (pg. 813)
Review Exercise 16.1 (pg. 817)
16.5 Overview Of How To Value Merger and Acquisition Transactions (pg. 817)
The Acquirer’s Perspective on Valuation (pg. 818)
The Target’s Perspective on Valuation (pg. 818)
Control Premiums (Minority Discounts) (pg. 819)
Liquidity Premiums (Illiquidity Discount) (pg. 820)
16.6 Is the Merger and Acquisition Transaction Accretive or Dilutive? (pg. 822)
Accretive and Dilutive Effects on Earnings and Other Performance Measures (pg. 822)
Review Exercise 16.2 (pg. 825)
Accretive and Dilutive Effects on Market Multiples (pg. 825)
Review Exercise 16.3 (pg. 827)
16.7 Cash-Based Transactions-Negotiation Ranges and Allocation of Gains (pg. 827)
Cash Deal (pg. 828)
Review Exercise 16.4 (pg. 830)
16.8 Stock-Based Transactions-Negotiation Ranges and Allocation of Gains (pg. 830)
Minimum and Maximum Exchange Ratios (pg. 830)
The Exchange Ratio for Proportional Allocation of the Post-Merger Value (pg. 834)
Allocating Synergies Based on the Proportion of Pre-Merger Standalone Values (pg. 835)
Allocation of Merger Gains and Losses in a Stock-for-Stock Merger (pg. 835)
Review Exercise 16.5 (pg. 836)
16.9 The Xerox Corporation and Affiliated Computer Services, Inc. Merger (pg. 836)
The Deal (pg. 837)
Post-Merger Value of Xerox (pg. 838)
Review Exercise 16.6 (pg. 840)
Allocation of the Gain to ACS and Xerox Shareholders (pg. 842)
Negotiation Range for the Xerox Corporation and Affiliated Computer Services Inc. (pg. 843)
Summary and Key Concepts (pg. 845)
Additional Reading and References (pg. 846)
Exercises and Problems (pg. 846)
Solutions for Review Exercises (pg. 849)
Chapter 17: Valuing Businesses Across Borders (pg. 854)
Introduction (pg. 856)
17.1 How Cross-Border Valuations Are Different (pg. 857)
Potential Adjustments to Free Cash Flow Forecasts (pg. 857)
Potential Adjustments to the Risk-Adjusted Discount Rate (pg. 857)
Investor Currency (Centralized) and Foreign Currency (Decentralized) Discounted Cash Flow Valuation (pg. 858)
Example Illustrating the Centralized and Decentralized Approaches (pg. 859)
Review Exercise 17.1 (pg. 861)
Other Potential Economic Forces Affecting Cross-Border Valuations (pg. 861)
17.2 Exchange Rate Basics (pg. 861)
Spot and Forward Exchange Rates (pg. 861)
Currency Appreciation and Depreciation, Premiums and Discounts, and Real Exchange Rates (pg. 863)
17.3 Exchange Rate Theories and Forecasting Methods (pg. 864)
Purchasing Power Parity and Relative Purchasing Power Parity (pg. 865)
Covered and Uncovered Interest Rate Parity (and the International Fisher Effect) (pg. 865)
Are Forward Rates Unbiased and Efficient Forecasts of Future Spot Rates? (The Forward Premium Puzzle (pg. 867)
Understanding the Discount Rates Used in the Investor Currency (Centralized) and Foreign Currency (D (pg. 868)
Review Exercise 17.2 (pg. 868)
Practical Applications of Exchange Rate Theories and Other Potential Methods of Forecasting Exchange (pg. 869)
Review Exercise 17.3 (pg. 871)
17.4 Overview Of Potential Income and Other Tax Issues in a Cross-Border Setting (pg. 871)
Foreign Tax Credits and Deferral of Foreign Income for Worldwide (Resident) Tax Regimes (pg. 874)
Worldwide (Resident) and Territorial (Source) Tax Regime Example-The Holdem Company (with Two Foreig (pg. 875)
Review Exercise 17.4 (pg. 878)
An Overview of Strategies to Minimize Tax Liabilities and Manage Cash (pg. 878)
The Bottom Line on Taxes in a Cross-Border Valuation (pg. 880)
17.5 Measuring the Equity Cost of Capital (pg. 881)
Integrated Capital Markets (pg. 881)
Segmented Markets (pg. 883)
Implications for Domestic Investments (pg. 885)
What if Markets Are Neither Fully Integrated nor Completely Segmented? (pg. 885)
Arwana Citramulia TBK PT Beta and Equity Cost of Capital Estimates (pg. 886)
Lack of a Publicly Traded Comparable Company in the Relevant Market (pg. 888)
17.6 Cross-Border Valuation in Less Developed or Troubled Economies or Emerging Markets (pg. 889)
Adjusting Expected Free Cash Flows for Country-Specific Risks (pg. 889)
RiskTel’s Valuation (pg. 890)
Review Exercise 17.5 (pg. 892)
Review Exercise 17.6 (pg. 895)
Using Insurance and Insurance Premiums as an Alternative to Adjusting for Political Risks (pg. 895)
Estimating the Equity Cost of Capital in Emerging Markets (pg. 896)
17.7 Challenges Using Market and Transactions Multiples Across Borders (pg. 898)
Cross-Border Market Multiples (pg. 898)
Using Within-Country Market Multiples in a Cross-Border Valuation (pg. 899)
Using Transaction Multiples in a Cross-Border Valuation (pg. 900)
17.8 Exchange Rate Exposure and Hedging Basics (pg. 900)
Operating Exchange Rate Exposure (pg. 900)
Review Exercise 17.7 (pg. 903)
Transaction and Financial Exchange Rate Exposure (pg. 903)
Translation Exposure (pg. 904)
Should Managers Hedge? (pg. 904)
What Methods Can a Company Use to Hedge Its Exchange Rate Exposure? (pg. 905)
Summary and Key Concepts (pg. 906)
Additional Reading and References (pg. 906)
Exercises and Problems (pg. 906)
Solutions for Review Exercises (pg. 910)
Index (pg. 914)
Robert W. Holthausen

Robert W. Holthausen

Robert W. Holthausen is the Ernst and Young and the Nomura Securities Company Professor of Accounting and Finance and is the Chairman of the Department of Accounting.

Prior in going to Wharton, he was a Professor of Accounting and Finance at the Graduate School of Business of the University of Chicago. He earned his doctorate at the University of Rochester where he also earned his M.B.A. Prior to his academic career, he was a C.P.A. working at Price Waterhouse and he was also in the finance group at Mobil.

Professor Holthausen is widely published in both finance and accounting journals. His research has studied the effects of management compensation and governance structures on firm performance, the effects of information on volume and prices, corporate restructuring and valuation, the effects of large block sales on common stock prices, and numerous other topics. His research has appeared in such journals as the Journal of Accounting and Economics, The Accounting Review, the Journal of Accounting Research, the Journal of Finance and the Journal of Financial Economics. He has served in various editorial capacities for all five journals listed above; either as consulting editor, associate editor, editorial board member or reviewer. He is currently an editor of the Journal of Accounting and Economics.

His teaching has been concentrated in the areas of investment management and valuation. Currently, his primary teaching responsibility is for the valuation class he developed. He has teaching experience at the undergraduate, M.B.A., and Ph.D. levels and has won teaching awards from both the undergraduate and M.B.A. students at Wharton, including the David J. Hauck award. He is currently the academic director of Wharton’s Mergers and Acquisitions program.

Professor Holthausen has consulted with a variety of companies. His specific consulting engagements are varied and include such diverse activities as serving as a compensation consultant to a Fortune 500 Company, consulting with an investment company in the development of fundamental trading rules used to manage equity portfolios and performing valuation analysis in a variety of situations.

Mark E. Zmijewski

Mark E. Zmijewski

Mark E. Zmijewski is the Leon Carroll Marshall Professor of Accounting at The University of Chicago Booth School of Business. He has been a member of Chicago Booth since 1984. Professor Zmijewski earned his doctorate at the State University of New York at Buffalo, where he also earned his B.S. and M.B.A. degrees.

Professor Zmijewski's research focuses on the valuation of the firm and its parts, as well as the ways in which various capital market participants use information to value securities. He has published various articles in academic journals such as the Journal of Accounting Research and the Journal of Accounting and Economics, and won the American Accounting Association's Competitive Manuscript Award (1984). He has been an Associate editor of The Accounting Review and on the editorial Boards of both the Journal of Accounting Research and The Accounting Review. In addition to his faculty duties at the University of Chicago, Professor Zmijewski also held the positions of Deputy Dean, Ph.D. Program faculty director, and the Center for Research in Security Prices faculty director. He teaches courses in valuation, mergers and acquisitions, financial analysis, accounting, and entrepreneurship and has won teaching awards for his teaching in both the M.B.A. and executive M.B.A. programs at Booth.

Last Updated: Feb 22 2024

Errors identified after publication, corrected. 

Data Spreadsheets - Exhibits
Last Updated: Oct 1 2019

These are the excel spreadsheets for the 2e exhibits and review exercises.

Data Spreadsheets - Problems
Last Updated: Oct 13 2021

These are the excel spreadsheets for the 2e problems. These spreadsheets will save time in data entry and allow students to dedicate additional time to learning the material. 

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