Asset Valuation in Finance

There are nine theories and ten methods for valuation. The valuation of any asset is a highly subjective one and depends on hosts of factors, some beyond the control of buyer or seller. This picture captures some of the essence of valuation.

The nine theories are

1. Fernandez (2007) assumes that the company will have a constant debt-to-equity ratio in book value terms. In this scenario, the risk of the increases of debt is equal to the risk of the free cash flow.
2. Miles and Ezzell (1980) assume that the company will have a constant D/E ratio in market value terms: the correct discount rate for the tax shield (D Kd T) is Kd for the first year, and Ku for the following years.
3. Modigliani and Miller (1963) assume that the amount of debt of every future year is known today and discount the tax savings due to interest payments at the risk-free rate (RF).
4. Myers (1974) makes assumptions similar to those of Modigliani and Miller (1963) and discounts the tax savings due to interest payments at the required return to debt (Kd).
5. Miller (1977) concludes that the leverage-driven value creation or value of the tax shields is zero.
6. Harris and Pringle (1985) and Ruback (1995) discount the tax shields at the required return to the unlevered equity (Ku). According to them, the value of tax shields (VTS) is VTS = PV[D Kd T ; Ku].
7. Damodaran (1994). To introduce leverage costs, Damodaran assumes that the relationship between the levered and unlevered beta is:  βL = βu + D (1-T) βu / E (Instead of the relationship obtained in Fernandez (2007), βL = βu + D (1-T) (βu - βd) / E).
8. Practitioners method. To introduce higher leverage costs, this method assumes that the relationship between the levered and unlevered beta is: βL = βu + D βu / E.
9. With-cost-of leverage. This theory assumes that the cost of leverage is the present value of the interest differential that the company pays over the risk-free rate.

The ten methods are

1. equity cash flows discounted at the required return to equity;
2. free cash flow discounted at the WACC;
3. capital cash flows discounted at the WACC before tax;
4. APV (Adjusted Present Value);
5. the business’s risk-adjusted free cash flows discounted at the required return to assets;
6. the business’s risk-adjusted equity cash flows discounted at the required return to assets;
7. economic profit discounted at the required return to equity;
8. EVA discounted at the WACC;
9. the risk-free rate-adjusted free cash flows discounted at the risk-free rate; and
10. the risk-free rate-adjusted equity cash flows discounted at the required return to assets.

But valuation of asset is a highly subjective. There can never be generalizations. Value depends on the

1. Demand and supply
2. Urgency to buy or sell
3. Behavior of seller and buyer
4. One’s forecast of future events
5. One’s future planning
6. Cash flows and discount rates

Impact of Debt Financing on EBIT of Firm–Introduction Part 1

In finance, capital structure refers to the way a corporation finances its assets. A firm can be financed by 100% equity or with some mix of equity and debt. It is an important decision, how the assets of a firm are financed i-e what should be the financing mix? Should the firm be financed with 100 equity or with some mix of equity and debt? The finance literature on the subject of capital structure is extensive but yet to come up to any definite answer.

Equity in finance is defined as the residual claim or interest of the most junior class of investors in assets, after all liabilities are paid. Debt imply intent to pay a fixed periodic payment and pay back an amount owed by a specific date, which is set forth in the repayment terms. It has a claim ahead of equity on the earnings of the firm.

Does capital structure choice of a firm matter? In financial literature related to the question of financing mix of a firm, we find five major strands of research viz.

1. Tax Based Theories
2. Agency Costs Theories
3. Signaling Theories
4. Pecking Order Theories
5. Information Asymmetry Theories

 Modigliani Miller (1958) argued that under certain assumptions value of the firm is independent of how its assets are financed i-e its capital structure. Later in (1963) they revised their famous MM proposition by saying that the existence of tax subsidies on interest payments would cause the value of the firm to rise with the amount of debt financing by the amount of the capitalized value of the tax subsidy. For value of the firm to increase in case of debt financing because of larger cash inflows due to tax subsidy is only possible when EBIT of the firm remains the same no matter how the assets are financed. So, essentially they argued that EBIT of the firm would be independent no matter how the capital is divided among equity and debt. Jensen and Meckling (1976) argued that the firm is not an individual. It is a legal fiction which serves as a focus for a complex process in which the conflicting objectives of individuals (some of whom may “represent” other organizations) are brought into equilibrium within a framework of contractual relations. In this sense the “behavior” of the firm is like the behavior of a market, that is, the outcome of a complex equilibrium process. If the behavior of the firm is “the outcome of complex equilibrium process” – balancing act of value maximization of different stakeholders given the positive monitoring and bonding costs then it cannot be said that its operations are independent of its choice of capital structure. They further argued that Modigliani-Miller theorem is based on the assumption that the probability distribution of the cash flows to the firm is independent of the capital structure. It is now recognized that the existence of positive costs associated with bankruptcy and the presence of tax subsidies on corporate interest payments will invalidate this irrelevance theorem precisely because the probability distribution of future cash flows changes as the probability of the incurrence of the bankruptcy costs changes, i.e., as the ratio of debt to equity rises. The existence of agency costs provide stronger reasons for arguing that the probability distribution of future cash flows is not independent of the capital or ownership structure. They went on to assert that debt carries covenants that limit management’s ability to take optimal actions on certain issues and that would reduce the profitability of the firm. In general the revenues or the operating costs of the firm are not independent of the probability of bankruptcy and thus the capital structure of the firm. As the probability of bankruptcy increases, both the operating costs and the revenues of the firm are adversely affected, therefore, its EBIT of the firm cannot be independent of how it is financed. Stephen A. Ross (1977) advocated that implicit in the irrelevancy proposition is the assumption that the market knows the (random) return stream of the firm and values this stream to set the value of the firm. What is valued in the marketplace, however, is the perceived stream of returns for the firm. Putting the issue this way raises the possibility that changes in the financial structure can alter the market's perception. Value of a firm will rise in case of debt financing because it will signal to the market that EBIT of the firm would be sufficient enough to meet its obligations. The reason was that any change in financial structure of the firm changes its perception in the market about its earnings stream and when leverage is increased, it is perceived in the market that the firm has expectations of strong earnings stream. So, in his opinion, if the firm decides to finance future expansion or change its financial structure with debt, it is because that firm expects a strong earnings stream and so the value of the firm would increase. Stewart C. Myers (1984) argued that optimal debt ratio in capital structure is determined by tradeoff of benefits and costs of debt financing by holding constant the firm’s assets and investment plans. Benefits of debt are interest tax shields whereas costs include various costs of bankruptcy and financial distress. If there were no adjustment costs then each firm’s debt-to-value ratio should be its optimal ratio. But there are adjustment costs and time lag as the firms move toward their target debt ratio that is why there is observable dispersion in debt ratios in cross section of data. He cited a study by Donaldson (1961) that states “Management strongly favored internal generation as a source of new funds even to the exclusion of external funds except for occasional unavoidable ‘bulges’ in the need for fund.” He further cited Donaldson “Given that external finance was needed, managers rarely thought of issuing stock.” This behavior of managers is due to asymmetric information and costs of financial distress. Because of asymmetry of information, managers are unwilling to issue equity if market undervalue new issue of equity. If the firm does seek external funds, it is better off issuing debt than equity securities. The general rule is, "Issue safe securities before risky ones." What if the managers' inside information is unfavorable, so that any risky security issue would be overpriced? In this case, wouldn't the firm want to make /\N as large as possible, to take maximum advantage of new investors? If so, stock would seem better than debt (and warrants better still). The decision rule seems to be, "Issue debt when investors undervalue the firm, and equity, or some other risky security, when they overvalue it.” If the manager with superior information acts to maximize the intrinsic value of existing shares, then the announcement of a stock issue should be bad news, other things equal, because stock issues will be more likely when the manager receives bad news. On the other hand, stock retirements should be good news. The news in both cases has no evident necessary connection with shifts in target debt ratios.It is assumed that EBIT of the firm is independent from source of financing. It does not matter as far as EBIT is concerned how the new investment opportunity is financed. It is a matter of perception in the market due to asymmetry of information that changes the value of the firm. Stewart C. Myers and Nicholas S. Majluf (1984) argued that because of asymmetry of information new stockholders assume that  management acts in the interests of 'old' (existing) stockholders. If managers have inside information there must be some cases in which that information is so favorable that management, if it acts in the interest of the old stockholders, will refuse to issue shares even if it means passing up a good investment opportunity. That is, the cost to old shareholders of issuing shares at a bargain price may outweigh the project's NPV. Investors, aware of their relative ignorance, will reason that a decision not to issue shares signals 'good news'. The news conveyed by an issue is bad or at least less good. This affects the price investors are willing to pay for the issue, which in turn affects the issue-invest decision. Under these circumstances, a firm with ample financial slack - e.g., large holdings of cash or marketable securities, or the ability to issue default-risk-free debt - would take all positive-NPV opportunities. The same firm without slack would pass some up and if external financing is required will prefer debt to equity. This model also assumes that EBIT of a firm is independent of its choice of financing mix, it is the discount rate that varies with the perception of investors about a particular choice of financing mix.

Capital Structure and Its Determinants

Harris, M. and A. Raviv (1991) in their paper "The Theory of Capital Structure" identified four categories of factors that are responsible for determination of capital structure of a firm. These factors or as they put it "desires" are

• ameliorate conflicts of interest among various groups with claims to  the firm's resources,  including managers (the agency approach), 
• convey private  information  to capital markets or mitigate adverse selection effects  (the asymmetric  information approach), 
• influence  the  nature  of  products  or  competition  in  the  product/input market, or 
• affect the outcome of corporate control contests. 

The theories that it is to "ameliorate conflict of interest" and "affect the outcome of corporate control contests" have nothing to do with the basic purpose of the firm - to create value for stakeholders - and in all probability, these are satanic designs that ruin the firm in the end. If all the stakeholders are working according to the well defined norms of justice and fair play than why there is conflict of interest? The theory of Capital Structure to avoid agency costs that Jensen and Meckling identified lead the managers on the path of destruction since the managers are given incentives such as based on EVA etc. and managers when faced with -ve results try to manipulate the earnings in order to achieve the target and earn incentives, the examples are "Enron", "Worldcom", etc. Debt provides incentive to engage in suboptimal investment because  in debt  contract  there is an implicit provision  that  if  an  investment  yields  large returns, well  above  the face value of the debt, equityholders capture most of the  gain.  If,  however,  the  investment  fails,  because  of  limited  liability, debtholders  bear  the  consequences in case liquidation is insufficient to cover the entire amount of debt. So clever managers who would like to hold on to power would go for the higher debt equity ratio and this is the strategy that comes to mind immediately there is any threat of take over. But that is a dangerous path to move on because debt has to be paid at some fixed time in future and that future is highly uncertain. Uncertainty coupled with fixed nature of debt commitment puts the managers under pressure for results and that is where the best laid out plans fall apart and lead the managers to play games.

The theory that capital structure decison is to convey inside / private information to market means it is used / can be used as a deception. Why can't we convey inside information in a straight forward manner without taking any steps that can lead the firm on the road to destruction? If the answer is no, then something is wrong that is being dragged under the rug. Information asymmetry between insiders and outsiders cause different value for the firms' assets and that may result in financing a new project / investment opportunity by existing owners / managers with debt if internal fund are insufficient - pecking order theory of capital structure. This pecking order begins when outsiders have some serious doubts about the information not available to them and that makes them suspicious. The question is why such asymmetry of information in the first place? Market, it seems always thinks of the information asymmetry that is why  "Noe shows that the average quality of  firms  issuing  debt  is  higher  in  equilibrium  than  that  of  firms  issuing equity.  Therefore,  like Myers-Majluf,  Noe's model  predicts  a  negative  stock market response to an announcement of an equity issue. Noe  also predicts a positive  market  response  to  an  announcement  of  a  debt  issue." There is always mistrust of managers by the market about firm's inside information. Why can't insiders speak the truth? Or why can't market take the words of insiders to be true on its face value unless otherwise proved? Is there lack of trust or lack of reputation? Because of lack of trust and distortion of communication between management and market, the market tends to heavily tilted towards the debt, which promises a fixed return irrespective of any reference to profit / (loss) - a figure that is highly questionable from the point of view of the outsiders for numbers of reasons but mainly on account of asymmetry of information. 

Leverage changes the behavior of the firm and its strategy because a levered firm assumes a sure commitment of periodic fixed payment to debtholders to remain in business. In the face of debt, it is very difficult to sustain high quality. Because quality can only be achieved through truth - speaking truth about its systems, products, people and speaking truth to its suppliers, customers, but when a firm has a debt to pay its ability to speak truth is highly undermined. This is even more true in case of an adverse forecast or less than expected results then the deviations from the straight path take start. All information asymmetries, conflicts of interests, contests for control of firm and competitive strategies move in different directions than the relevant theoretical models predict. 

Capital Structure Decision and Firm Value

According to famous MM proposition I, value of the firm is independent of its capital structure - firm value is invariant to its financial structure. They proved this proposition mathematically. Intuitively this proposition hold value. Valuation of a firm is a function of its expected earnings over time capitalized at an appropriate rate for its given risk class. Critics, however, are ready to point out that value of the firm can be increased by taking tax advantage of debt, which has been rejected by the MM by going over the investors' side and taking help from personal Income Tax. The value maximization criticism can't be overruled as a firm's net after tax cash inflow to firm increase with the addition of debt in the capital structure. 

Inherent in the discussion on capital structure decision is that EBIT of a firm is independent of its financing structure. Expected earnings are a function of assets' earning capacity and its productivity and this has nothing to do with how the assets are financed. But "DEBT is as powerful a drug as alcohol and nicotine. In boom times Western consumers used it to enhance their lifestyles,companies borrowed to expand their businesses and investors employed debt to enhance their returns." Can we say that inclusion of debt in capital structure is synonymous to introduction to a healthy person "drug and alcohol"? In the words of Hyman Minsky, an American economist "these debt crises were both inherent in the capitalist system and cyclical. Prosperous times encourage individuals and companies to take on more risk, meaning more debt. Initially such speculation is successful and encourages others to follow suit; eventually credit is extended to those who will be able to repay the debt only if asset prices keep rising (a succinct description of the subprime-lending boom). In the end the pyramid collapses." 

The problem with debt is that it needs to repay it. That is where the problem starts. The need to repay something in future and future is a t the very best is a mere guess - uncertain. This compulsory payment in future coupled with uncertainty about future is the root cause of the problem that needs to be probed into and analysed thoroughly. A firm which has future obligations for payment must meet the minimum necessary to honor its commitments. In the words of Merton H. Miller "The firm pays  its debts not just  because the  law says it must, but because the value of  the stock to  its shareholders is  greater  to  them  if  the  firm  pays  the  debts  than  if  it  doesn't." So  to remain on the same level of value before inclusion of debt in the capital structure, a firm has to honor its commitment to pay the debt obligation and has to earn a minimum to honor that commitment. This compulsory or mandatory nature of target puts some kind of an extra pressure on the levered firm as compared to unlevered firm. Because of that extra pressure, the EBIT of a levered firm may be different than an unlevered firm keeping everything else same.