1. Drake DRAKE UNIVERSITY Fin 200 Firm Valuation A Discounted Cash Flow Approach

2. Drake Drake University Fin 200 A General Valuation Model The basic components of the valuation are: An estimate of the future cash flow stream from owning the asset The required rate of return for each period based upon the riskiness of the asset The value is then found by discounting each cash flow by its respective discount rate and then summing the PV’s (Basically the PV of an Uneven Cash Flow Stream)

3. Drake Drake University Fin 200 The Formal Model The value of any asset should then be equal to:

4. Drake Drake University Fin 200 Applying the general valuation formula to a firm The only question is what to use as the future cash flows when valuing the firm. Free Cash Flow The cash flow from operations that is actually available for distribution to investors (stockholders, bondholders and preferred stockholders)

5. Drake Drake University Fin 200 Free Cash Flow Net Operating Profit After Taxes + depreciation -Gross Capital Expenditure -Change in net operating working capital Free Cash Flow

6. Drake Drake University Fin 200 NOPAT NOPAT = EBIT(1-Tax Rate) NOPAT is the amount of profit a firm would earn if it had no debt and held no financial assets.

7. Drake Drake University Fin 200 FCF Five good uses of FCF 1. Pay interest to debtholders (cost to firm is after tax interest expense) 2. Repay debt 3. Pay dividend to shareholders 4. Repurchase stock from shareholders 5. Buy marketable securities or other nonoperating assets.

8. Drake Drake University Fin 200 Developing estimates of free cash flow To develop the estimates of future cash flows you need to forecast the future income of the firm. This will be a result of your financial plan and proforma financial statement.

9. Drake Drake University Fin 200 Financial Planning Establish an outline of the process by which the firms goals are to be realized

10. Drake Drake University Fin 200 Goals of the Plan Examining interactions Exploring Options Avoiding Surprises Evaluating Feasibility

11. Drake Drake University Fin 200 Elements of a Financial Plan 1. Forecasting: What future assets will be needed and how will they be obtained 2. Capital Structure Policy: How will the assets be financed 3. Dividend Policy: What portion of earnings will be returned to shareholders 4. Working Capital: The amount of liquidity needed for the firm to conduct daily operations

12. Drake Drake University Fin 200 Main issues addressed Corporate Purpose: Overview of long run mission of firm Corporate Scope: Geographic location and main business line Corporate Objectives: Specific Goals for the firm ( targets)

13. Drake Drake University Fin 200 Main Issues Corporate Strategy: A plan to obtain the firms objectives Operating Plans: Five year horizon each year less specific

14. Drake Drake University Fin 200 Steps in the process 1. Pro Forma Financial Statements 2. Determine the funds needed to support the plan 3. Forecast the funds available 4. Establish controls 5. Plan for other contingencies 6. Establish a performance based compensation plan

15. Drake Drake University Fin 200 A simple model Assume that all variables are directly tied to sales – If sales increases so do the other entries on the balance sheet and income statement (by the same %) As sales increase so do assets – why? (Assume total capacity utilization)

16. Drake Drake University Fin 200 Simple Income Statement Sale1,000 Costs800 Net income200 Sale1,250 Costs1,000 Net income250

17. Drake Drake University Fin 200 Simple Balance Sheet Assets500Debt250 Equity250500 Assets625Debt325 Equity325625

18. Drake Drake University Fin 200 Percentage of Sales Approach Two categories those that vary directly with sales and those that do not. Income Statement: Costs – remain a set % of sales Dividend Payout – Assume it remains constant Balance Sheet Find % of sales for LHS, on the RHS not for L-T Debt or retained earnings or equity (only CL) Retained Earnings – use dividend payout

19. Drake Drake University Fin 200 Income Statement Sales1,000 Costs800 Taxable income200 Taxes68 Net Income132 Dividends44 Addition to Ret E88 RetRate=88/132=66.67% Sales1,250 Costs1,000 Taxable income250 Taxes85 Net Income165 Addition to Ret Earn.6667(165) = 110

20. Drake Drake University Fin 200 Balance Sheet Assets Current Assets16016% Accts Rec44044% Inventory60060% Total1200120% Fixed Assets1800180% Total Assets3000300% Liabilities Current Liab30030% Notes Pay500na Total400na L-T debt800na Ret Earn1000na Total Liab3000300%

21. Drake Drake University Fin 200 Proforma Balance Sheet Sales increase by 25% Assets Current Assets20016% Accts Rec55044% Inventory75060% Total1500120% Fixed Assets2250180% Total Assets3750300% Laibilitess Current Liab37530% Accts Pay500na Total875na LT Debt800na Ret Earn1110na Total Liab2785300% They do not balance! The difference is the EFN EFN = 3750 –2785 = 965

22. Drake Drake University Fin 200 External Financing Needed Should be equal to Change in Assets – Change in Liabilities Represents the amount of cash that needs to be raised to finance the assets.

23. Drake Drake University Fin 200 Internal Growth Rate The rate of growth where the amount of external financing needed is equal to zero. This would mean that the additional assets required are equal to the increase in retained earnings Internal Growth Rate = (ROA)b/[1-(ROA)b] b = retention rate

24. Drake Drake University Fin 200 Sustainable Growth Rate The firm wants to maintain a constant debt equity ratio (not increase its financial leverage). This implies that the firm will raise funds only in the form of debt, not external equity. sustainable growth rate = (ROE)b/[1-(ROE)b]

25. Drake Drake University Fin 200 Problems Financial Planning models that depend upon the financial statements leave out important financial relationships such as cash flows, risk,and timing

26. Drake Drake University Fin 200 The Formal Model Again The value of any asset should be equal to:

27. Drake Drake University Fin 200 Value of Operations After forecasting the free cash flows it is then possible to find the value of operations for the firm. Notice, this depends upon a forecast of future free cash flow which much like dividends are not certain.

28. Drake Drake University Fin 200 Cost of Capital What required return should be used in the formula? Weighted average measure of the returns required by the providers of capital (debt, preferred stock, common stock) to the firm. The weight corresponds to the amount of financing that comes from each source. We will calculate it in more detail soon.

29. Drake Drake University Fin 200 Weighted Average Cost of Capital (WACC) Pacific corporation is considering a new project. It wants to issue debt for 75% of the funding, investors will require an 8% return on the debt. The other 25% would come from new equity, investors require a 12% return on the equity. The WACC would then be: = (.75)(.08) + (.25)(.12) =.09

30. Drake Drake University Fin 200 Constant Growth in FCF Just like the constant growth in dividend model if constant growth in free cash flow is assumed you can shorten the equation.

31. Drake Drake University Fin 200 This is the PV of the FCF from time N to time Infinity (think about the last part of a nonconstant dividend valuation) We will call it the terminal value or horizon value or continuing value. If the firm had constant growth forever N would be today.

32. Drake Drake University Fin 200 Value of operations Generally we will not assume that the firm has constant growth in Free Cash Flow. Instead you want to forecast the future free cash flows for the firm over a reasonable period (5 to 10 years). Then calculate the terminal value for the firm from the end of the forecast period to infinity. (the process is very similar to finding the PV of a nonconstant growth dividend stream.

33. Drake Drake University Fin 200 Estimating price per share of stock The PV of all the future free cash flows provides an estimate of the total value of the firm We need to subtract the total amount of debt and claims by the owners of preferred stock. Divide the remaining amount by the number of shares outstanding to get the value of one share of outstanding stock.