Equity Valuations

Chapter 8 – Cash, Cross Holdings, and Other Assets

Cash, Cross Holdings, and Other Assets

  • Assets can be classified as operating and non-operating. Assets like cash and equivalents, investments in equities and bonds of other firms (reason may be investment purpose or strategic one) and holding in other firms.​​ 

  • Reason as per Maynard Keynes for accumulating cash – transactions purpose, as a precaution against unanticipated expenses, and for speculative purposes

  • Cash accumulation for transaction (operation) purposes is function of the following variables

    • Cash-oriented versus credit-oriented businesses. Firms that are in cash-oriented businesses (fast-food restaurants, grocery stores) will require more cash for operations than firms that operate in credit-oriented businesses.

    • Firms that do​​ large number of​​ small transactions​​ would need more cash compared to firms doing small number of big transactions

    • More developed banking system in the country would result in less amount of cash accumulation with the firms

  • The second reason for holding cash is to cover unanticipated expenses or to meet unspecified contingencies. For example, cyclical firms will accumulate cash during economic booms and draw on that cash in the event of a recession to cover operating deficits. In general, therefore, we would expect this component of the cash balance to be a function of the following variables

    • Volatility in the economy

    • Volatility in the operations

    • Competitive environment

    • Financial leverage

  • Future Capital – Speculative purpose

    • If raising fresh capital is easy in the market then there is no need to accumulate cash, whenever there would be new investment opportunity firm can raise fresh capital from the market. So it depends on how efficient the market is.

  • Cash is categorized as operating cash and excess cash. More useful categorization from valuation point of view is wasting cash and non-wasting cash. Operating cash is a part of working capital and it affects the cash flows.​​ As far as wasting and non-wasting cash is concerned, cash which gives return is non-wasting cash e.g. cash accumulated for operation purposes can be invested in short term assets like treasury bills and commercial paper so this cash would be non-wasting cash but cash put in current account would be classified as wasting asset. Wasting asset would be taken in working capital and non-wasting cash would be added to the value of operating assets.

  • When we do FCFF we take operating income which does not take income from finance like interest on corporate or treasury bonds, interest from other short term investments so​​ we calculate the value of operating assets and then to get the firm value we add the cash, but when we do FCFE we include finance income and then we discount the FCFE with cost of equity which is incorrect since income from financial assets should not be discounted with cost of equity.​​ 

    • Consolidated Valuation -​​ In this case we should take the weighted average of unlevered beta of equity and unlevered beta of cash (beta of cash is 0) and then calculate the cost of equity using this beta for discounting the FCFE.​​ Weights used should be ratio of non-cash assets to total assets and cash assets to total assets. As the firm grows this ratio will also change thus the cost of capital or cost of equity will also have to​​ be​​ adjusted.​​ This method considers reinvestment in both operating assets and cash

    • Separate Valuations -​​ The other approach is we can do separate valuation of operating assets and cash, we can calculate FCFE without income from financial assets. This FCFE would be discounted with the cost of equity and cash would be added to this to get the equity value.

  • Shall we use Gross debt or net debt (Gross Debt – Cash) for weight of debt for computing cost of capital?​​ 

    • When we use gross debt we assume that cash is funded from debt and equity both and this cash will earn some return so we value the firm by adding the value of operating assets and value of cash assets. Value of operating assets will be computed by discount the FCFF by cost of capital and value of cash assets will be computed by discounting the cash return by risk free rate. Value of equity would be value of operating assets + value of cash assets – gross debt.

    • When we use net debt, we assume that the cash is solely funded by the debt and we value the firm by discounting the FCFF by cost of capital. Value of equity would be Value of firm – Net debt. Net debt is Gross debt – Cash.

  • When the firm invests in corporate bonds or equity of other firms, we compute the value of firm by computing the value of the operating assets and adding the market value of the securities in which the firm has invested.

  • Holding in other firms can be categorized as a minority passive investment, a minority active investments, and a majority active investments.

    • If the securities or assets owned in another firm represent less than 20 percent of the overall ownership of that firm, an investment is treated as a minority passive investment.​​ These investments have an acquisition value, which represents what the firm originally paid for the securities, and often a market value. Accounting principles require that these assets be subcategorized into one of three groups—investments that will be held to maturity, investments that are available for sale, and trading investments. The valuation principles vary for each.

      • For investments that will be held to maturity, the valuation is at historical cost or book value, and interest or dividends from this investment are shown in the income statement.

      • For investments that are available for sale, the valuation is at market value, but the unrealized gains or losses are shown as part of the equity in the balance sheet and not in the income statement. Thus, unrealized losses reduce the book value of the equity in the firm and unrealized gains increase the book value of equity.

      • For trading investments, the valuation is at market value and the unrealized gains and losses are shown in the income statement.

    • If the securities or assets owned in another firm represent between 20 percent and 50 percent of the overall ownership of that firm, an investment is treated as a minority active investment. While these investments have an initial acquisition value, a proportional share (based on ownership proportion) of the net income and losses made by the firm in which the investment was made is used to adjust the acquisition cost. In addition, the dividends received from the investment reduce the acquisition cost. This approach to valuing investments is called the equity approach. The market value of these investments is not​​ considered until the investment is liquidated, at which point the gain or loss from the sale, relative to the adjusted acquisition cost, is shown as part of the earnings in that period.

    • If the securities or assets owned in another firm represent more than 50 percent of the overall ownership of that firm, an investment is treated as a majority active investment.​​ In this case, the investment is no longer shown as a financial investment but is instead replaced by the assets and liabilities of the firm in which the investment was made. This approach leads to a consolidation of the balance sheets of the two firms, where the assets and liabilities of the two firms are merged and presented as one balance sheet. The share of the firm that is owned by other investors is shown as a minority interest on the liability side of the balance sheet. A similar consolidation occurs in the other financial statements of the firm as well, with the statement of cash flows reflecting the cumulated cash inflows and outflows of the combined firm. This is in contrast to the equity approach, used for minority investments, in which only the dividends received on the investment are shown as a cash inflow in the cash flow statement.​​ Here again, the market value of this investment is not considered until the ownership stake is liquidated. At that point, the difference between the market price and the net value of the equity stake in the firm is treated as a gain or loss for the period

Chapter 7 – Enterprise Multiples (Prev Lesson)
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