Estimating the Value of ACME

Steps in a valuation Estimate cost of capital (WACC) Debt Equity Project financial statements and FCF Calculate horizon value Discount at WACC to Calculate VOPS Calculate value of equity

Estimating the required return on the components of WACC ACME has debt and equity The cost of capital for each type of financing depends on it risk, as perceived by the investor, and taxes. Higher risk securities have higher required rates of return. If payments (like interest) are deductible, then the cost to the firm is lowered.

Acme's WACC Debt: Acme has 2 types of debt—short-term and long-term. The short-term rate is 9%. Long-term debt: 8% coupon debt with 26 years left to maturity are selling for $900.15 each. What is the cost (to ACME) of this source of capital?

Bond prices In general the price of a bond depends on its coupon payments, its maturity, and its risk. ACME’s bonds pay $40 every 6 months, and $1,000 when they mature in 26 years.

Bond prices M is the maturity value, or $1,000 for ACME rC is the coupon rate, or 0.08, which is 8% for ACME n is the maturity, or 26 x 2 = 52 6-month periods. rD is the discount rate.

ACME’s bond price A financial calculator or a spreadsheet can be used to solve for rD, which is 4.5% for a 6-month period, or 9% per year.

Cost of long-term debt The cost of debt when it was issued 4 years ago was 8%, but the cost now is different because the bond price has declined from $1,000 to $900.15 Now the cost is 9%

Cost of equity The cost of equity (its required return) depends on how risky the stock is to investors. This risk is measured by “Beta” and the Capital Asset Pricing Model (CAPM) relates Beta to the required return.

ACME’s cost of equity CAPM: rS = rRF + Beta (RPM) Beta = 1.1 rRF = 5.4% = long term rate on Treasuries RPM = market risk premium = 6% rS = 5.4% + 1.1(6%) = 12%

Target weights and WACC Target is 30% debt, 70% equity Tax rate = 40% WACC = 0.70(12%) + 0.30(9%)(1-0.40) = 10.0% This is the discount rate to be used for the free cash flows.

Projections Next chapter will have the nuts and bolts of projections. For now, assume that your financial analyst has already made the projections on the following page.

Income statement projections Income Statements Actual Projected 2016 2017 2018 2019 2020 Sales 4,512.44 4,873.44 5,165.84 5,475.80 5,804.34 Costs of Goods Sold 2,797.71 3,021.53 3,202.82 3,394.99 3,598.69 S ales, General and Administrative 902.49 974.69 1,033.17 1,095.16 1,160.87 Depreciation 225.62 243.67 258.29 273.80 290.22 Operating Profit 586.62 633.55 671.56 711.85 754.56 Interest on original debt 80.00 Interest Expense on ne w debt 25.73 34.35 42.84 50.18 57.95 Interest expense 105.73 114.35 122.84 130.18 137.95 Earnings Before Taxes 480.89 519.19 548.72 581.67 616.61 Taxes 192.35 207.68 219.49 232.67 246.65 Net Income 288.53 311.52 329.23 349.00 369.97 Dividends 104.89 135.10 191.43 202.90 215.05 Additions to retained earnings 183.64 176.41 137.80 146.11 154.91

Balance Sheet Projections Balance Sheets Actual Projected Projected Projected Projected 2016 2017 2018 2019 2020 Cash 45.12 48.73 51.66 54.76 58.04 Inventory 631.74 6 82.28 723.22 766.61 812.61 Accounts receivable 1,128.11 1,218.36 1,291.46 1,368.95 1,451.09 Total current assets 1,804.98 1,949.38 2,066.34 2,190.32 2,321.74 Gross PPE 3,443.32 3,867.49 4,271.98 4,700.75 5,155.24 Accumulated depreciation 1,187.09 1,430 .77 1,689.06 1,962.85 2,253.07 Net PPE 2,256.22 2,436.72 2,582.92 2,737.90 2,902.17 Total assets 4,061.20 4,386.09 4,649.26 4,928.22 5,223.91

Balance Sheet Projections Liabilities Actual Projected Projected Projected Projected 2016 2017 2018 2019 2020 Accounts payable 451.24 487.34 516.58 547.58 580.43 Accrued expenses 225.62 243.67 258.29 273.79 290.22 Short - term debt 381.71 476.04 557.55 643.90 735.40 Total current liabilities 1,058.57 1,207.05 1,332.42 1,465.27 1,606.05 Long - term debt 1,000.00 1,000.00 1,000.00 1,000.00 1,000.00 Total liabilities 2,058.57 2,207.05 2,332.42 2,465.27 2,606.05 Commo n stock 600.00 600.00 600.00 600.00 600.00 Retained earnings 1,402.63 1,579.04 1,716.84 1,862.95 2,017.86 Total common equity 2,002.63 2,179.04 2,316.84 2,462.95 2,617.86 Total liabilities and equity 4,061.20 4,386.09 4,649.26 4,928.22 5,223.91

FCF Projections Actual Projected 2016 2017 2018 2019 2020 Operating profit 586.62 633.55 671.56 711.85 754.56 Tax on operati ng profit 234.65 253.42 268.62 284.74 301.83 NOPAT a 351.97 380.13 402.94 427.11 452.74 Operating current assets 1,804.97 1,949.37 2,066.34 2,190.32 2,321.74 Operating current liabilities 676.86 731.01 774.87 821.37 870.65 NOWC b 1,128.11 1,218.36 1,291. 47 1,368.95 1,451.09 Total operating capital c 3,384.34 3,655.08 3,874.39 4,106.85 4,353.26 Investment in total net operating capital d 279.45 270.74 219.31 232.46 246.41 FCF e 72.52 109.39 183.63 194.65 206.33

ROIC Projections Long term projected growth is 6% Actual Projected 2016 2017 2018 2019 2020 ROIC = (NOPAT/Beginning capital) 11.3% 11.2% 11.0% 11.0% 11.0% Growth in Sales 9.0% 8.0% 6.0% 6.0% 6.0% Growth in NOPAT 9.0% 8.0% 6.0% 6.0% 6.0% Growth in total net op. cap. 9.0% 8.0% 6.0% 6.0% 6.0% Growth in FCF 376.6% 50.8% 67.9% 6.0% 6.0% Growth in dividends -34.5% 28.8% 41.7% 6.0% 6.0% Long term projected growth is 6%

Horizon Value

Value of operations

Value of equity Vequity = VOPS + non-operating assets – debt = $4,272.92 + 0 – debt Debt: $381.71 million short term + 1 million long-term bonds at $900.15 each = 381.71 + 900.15 = $1,281.86 million Vequity = $4,272.92 - 1,281.86 = $2,991.06 million

Per share equity 10 million shares outstanding Value per share = $29.91