Teton Valley Case Solution Process

Free Cash Flow For each future year you want to calculate: FCF = EBIT(1 – Tc) (no debt tax shields) + Depr & Amort. (adjust for non-cash expenses) - Capital Expenditures (a cash flow not part of EBIT) - Changes in NWC (almost, to adjust for incr. or decr. in ST assets and liab.) Non cash interest is taken out of EBIT and is not cash.

Free Cash Flow We start with earnings before interest and taxes. Why? Before interest because financing costs should not be taken out. Before taxes to make it easier to ignore the debt tax shields that are likely to be included if you use actual taxes.

Ignore Financing Costs? Consider a very simple example: You are considering a risk free investment in a world with no taxes. It costs $1,000 now to undertake and will provide a payout in one year of $1,100 (FCF). The risk free rate is 8%. What is it’s NPV? Ans: -$1,000 + $1,100/1.08 = $18.52 Now consider that you will borrow the $1,000 start up cash.

Ignore Financing Costs? Suppose we consider financing costs and subtract the interest payments on the loan from FCF. 8% interest on $1,000 for a year is $80. After interest FCF is $1,100 - $80 = $1,020 The NPV of this is: -$1,000 + $1,020/1.08 = -$55.56 Clearly wrong! Why would the value of the investment itself have changed due to the financing?

Ignore Financing Costs? Is something that “looks like this” correct? Flow to equity approach. This separates the cash flows that go to the debt holders and the equity holders, then values the equity piece at the cost of equity capital. This assumes that the debt is priced fairly, i.e. that the money raised up front by selling the debt just equals the PV of the cash flows that go to the debt holders (NPV = 0). $1,000 from debt (now), $1,080 to debt (later). $0 from equity (now), $20 to equity (later) The cash flow is risk free so NPV = -$0 + $20/1.08 = $18.52 – same value as before.

Why is it almost -NWC? Two reasons: 1st – one of the NWC accounts is the current portion of long term debt. We leave out changes in long term debt from cash flow since this is a financing cash flow. Why put it in 19 years later? 2nd – a level of the cash account is necessary only up to a balance required for liquidity. Increases in the cash account above this minimum could be paid out as dividends or used to pay down principal without reducing the effectiveness of the firm going forward. Thus increases in cash above the minimum are not to be subtracted to find FCF so should not be counted in the change to NWC. In applications most everyone ignores the “almost” part and just uses changes in NWC.

Teton Valley Corporation Sales growth at 10% for 5 years then 4% in perpetuity. CGS at 65% of sales. SGA at $500,000 + 4.5% of sales. Net Fixed assets grow at 5% per year for next 5 years. Depreciation is 20% of beginning of year net fixed assets. NWC is $80,000, grows with sales. FCFs grow at 4% in perpetuity after 2005.

Forecasting Earnings

From Earnings To Free Cash Flow FCF = EBIT(1-Tc) + Depr. - ∆NWC – Cap Ex. So: 2001 2002 2003 2004 2005 FCF: 791,175 912,418 1,046,141 1,193,610 1,356,219

WACC Method First find the value of the 5 years of FCFs that we forecasted by discounting at the WACC. Find the present value of the terminal value of the FCFs, again using the WACC. The sum of the two is the total firm value before any discount. Subtract the current value of the existing debt from total firm value to find your estimate of the current value of the equity. As suggested in the case apply the 20% liquidity discount to the equity value.

APV Method Use the cost of capital of the assets (cost of equity capital of an unlevered firm) to value the forecasted FCFs and the terminal value of the FCFs, this is unlevered firm value. Add the total value of the tax shields (using the cost of debt capital as the appropriate discount rate) to find firm value. Subtract debt value from firm value to find equity value before the discount. In this example, apply the 20% discount to equity value to find estimated equity value.

The Unlevered Cost of Capital Equity beta at current leverage is 1.4. We can estimate the debt beta as 0.134. The asset beta can be estimated with: The cost of capital of the assets follows from: Putting in the estimate of the debt beta rather than assuming it is zero in this example changes share price by 0.01 from 6.87.

Debt Tax Shields To estimate their value I made the heroic assumption that the firm will have $350,000 in debt from now till the end of time. Then the value of the annual tax shield is just the interest payment times the tax rate: Assuming this is perpetual, the total value of the debt tax shields is:

Terminal Value: Teton Valley FCF in 2005 is estimated at $1,356,219. The case suggests a constant growth of 4% in perpetuity is expected from this point onward. Thus we can calculate the terminal value as of 2005 as (in the WACC version): Don’t forget to use the present value of this figure.