Valuing Financial Services Firms Include Banks

Question: Discuss about the Valuing Financial Services Firms for Include Banks. Answer: Financial institutions include banks, insurance companies and investment banks. Valuing the financial institutions has always been a matter of concern as it is very difficult to estimate cash flows of a financial institution specially banks. There are various characteristics of the financial institutions which make it different from other firms in the market and because of these characteristics, the discounted cash flow valuations models are difficult to use. The four characteristics are: The treatment of debt and capital expenditure of a financial firm is very different from a other firms. Debt is not reinvested by the financial firm; rather it is used as a raw material to create products. Since debt is not reinvested, the enterprise value of the firm has no value and hence, free cash flow to firm is definitely not a good choice of valuation. The financial firms operate under strict government regulations which determine how the firms should run their business and the regulations also require the firms to set aside some part of their capital as reserves. A change in the regulatory requirement may change the value of the firm as the change increases the risk of a firm, hence again the FCFF method will render no consequences. The accounting treatment of the assets and liabilities of the financial institution is different from other firms. For a financial institution the assets are mostly in the form of bonds and secured obligations which are actively traded in the open market. Hence the assets are market at market price. Also banks look at long term profits for which short term losses are interspersed with long term gains. It is very difficult to define the capital expenditure and working capital of a financial firm which means the future cash flows cannot be calculated. The fixed assets of a financial firm is not plant and equipment like in a manufacturing set up, rather it is human capital and the brand name. The investment in the above which is required for growth is treated as operating expenses and not capital expenditure. Hence the statement of cash flows for a financial firm shows no or little capital expenditure. Since the calculation of FCFF is solely based on the future cash flows, hence it is impossible to use FCFF to value the financial institutions. Because of the above characteristics of a financial firm, FCFF is not a feasible valuation method, however, a dividend discount model is more appropriate as the dividends can be estimated and used to value the firms equity. 1b) Cost of equity and weighted average cost of capital are used as discount rates for calculating FCFE and FCFF respectively. WACC is the sum of cost of equity and cost of debt (after tax) of a company. The capital asset pricing model is used to calculate the cost of equity. The above costs are then multiplied by their respective weights in the capital structure to arrive at the WACC. WACC is the most appropriate discounting factor for FCFF as FCFF refers to the free cash flow that belongs to the debt holders and shareholders and since WACC takes both the debt and equity into consideration, it is appropriate. (Bearly, Myers, 2001) Cost of equity is the most appropriate discounting factor for FCFE since FCFE is the cash flow available to equity shareholders. A good discounting factor should account for all the risks associated with the project. Since FCFE belongs to the equity shareholders, so the risk of equity is covered in the cost of equity and hence it proves to be most appropriate discounting factor. 2a) under capital expenditure projects, net present value (NPV) is used as a tool to determine the feasibility of the project. In the given scenario, where a theme park is to be built in two years and the project will go on for a period of 10 years, the NPV of the project before tax and after tax has been calculated and on this basis, decision has been taken. The NPV and IRR values are presented below( as per the annexure): Before tax After tax NPV $75,98,702.58 ($12,05,488.89) IRR 6% -1% From the above table we see that the NPV of the project before tax is positive and NPV after tax is negative. For a project to be feasible, it is important for the NPV to be positive. NPV is the difference between the project outflows and cash inflows. There are other methods also available to assess a projects feasibility which includes IRR, payback period, discounted payback period, profitability index. However, NPV is the most effective because it uses a discount factor to discount the future cash flows to the present in order to compensate for the uncertainty of the future cash flows. According to the above results, the project should be rejected because the NPV after tax is negative. Considering NPV after tax is more appropriate as compared to NPV before tax as every company is required to pay taxes on its profits and the hence the cash flows are reduced by the applicable taxes. The NPV is affected by tax in two ways i.e. the operating cash flows are reduced by the taxes and the salvage value of the project is also affected as tax is applied on any gain or loss on sale of the project equipment. Other tax implications include tax on non cash expenses like depreciation and amortization which are not included in cash flow but are tax deductible, hence after taking tax into consideration, the net operating cash flow is calculated. 2b.) Assuming that the friendly investor induces another $10 million into the project after year 10 which increases the project life by another 10 years, the new NPV of the project after tax is ($11,25563.97). Even after further cash inflow, the NPV of the project is still negative which means the project is not feasible and should be rejected. Hence, it is not worthwhile to extend the project from 10 years to 20 years. References Damodaran, A., (2009), Valuing Financial Services Firms, accessed online on 25th July, 2016, available at https://people.stern.nyu.edu/adamodar/pdfiles/papers/finfirm09.pdf Deev, O., (2011), Methods of Bank Valuation: A Critical Overview, Financial Assets and Investing, Masaryk University Bearley, Myers, (2001), Principles of Corporate Finance, 7th Edition, McGraw Hill. Jennergren, P., (2011), A Tutorial on the Discounted Cash Flow Model for Valuation of Companies, SSE/EFI Working Paper Series in Business Administration No. 1998:1