Daves Chapter 4 Estimating the Value of ACME DES Chapter 4

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 DES Chapter 4

Estimating the required return on the components of WACC ACME has debt and equity Cost of capital for each type of financing depends on its risk, as perceived by investors, and taxes. Higher risk securities = higher required return. If payments (like interest) are deductible, then cost to firm is lowered. DES Chapter 4

Acme's WACC Debt: Acme has 2 types: short-term and long-term. S/T i = 9%. L/T: 8%, semi-annual coupon, 26 years left to maturity, selling @ 90.015% of par each. What is its cost of debt? DES Chapter 4

Bond prices In general, bond price depends on its coupon payments, its maturity, and its risk (YTM). Bonds pay $40 every 6 months, and $1,000 @ maturity in 26 years. DES Chapter 4

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. DES Chapter 4

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. DES Chapter 4

Bond prices & i VB = bond’s price today = $900.15 M=Maturity Value = FV = <$1,000> rc = Coupon %= 8% = Pmt = .08($1,000)/2 = $80/2=<$40> n = periods to maturity = 26 years x 2 periods/yr = 52 Rd = discount % = i = YTM = ? = 4.5% x 2 periods = 9% DES Chapter 4

Calcuating the Yield to Maturity for a Bond Year Month Day 2003 8 20 Input the bond's settlement date in these cells. Technically, bonds "settle" a couple of days after the "purchase" date, but that will have virtually no impact on the calculated yield. So entering today's date is fine for the purpose of calculating yield. 2029 15 Input the bond's maturity date in these cells. 8.000% Input the coupon rate here. For a 5% coupon bond, enter 5%. 90.015 Input the bond's price. Most sources quote prices as a percent of par, so enter the percent here. For example, if the quoted price 98.192 percent, enter 98.192. If the price is quoted in dollars, enter it as a percent of par. For example, if the quoted price is $9,81.92 for a $1,000 bond, enter $9,81.92/$1,000 = .98192 = 98.192 percent. 100.000 Input the bond's maturity value (also called face value or par value) here, based on 100 percent. For example, if a bond has a maturity value of $1,000, enter $1,000/$1,000 = 1.00 = 100 percent. Some callable bonds will have a higher "price" if called, usually expressed as a percent. For example, a callable bond might have a call price of $1,070. In this case, enter $1,070/$1,000 = 1.07 = 107 percent. 2 Input the number of times a year coupons are paid. This is usually 2. Input the basis here. For US bonds, leave this blank or put 0. See the comment in the cell if the bond is not a US bond. 8.9999% This is the bond's yield. DES Chapter 4

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

Cost of equity Its required return: depends on how risky stock is to investors. This risk is measured by “Beta” and the Capital Asset Pricing Model (CAPM) relates Beta to required return. DES Chapter 4

ACME’s cost of equity CAPM: rS = rRF + Beta (RPM) Beta = 1.1 rRF = 5.4% = L/T rate on Treasuries RPM = market risk premium = 6% rS = 5.4% + 1.1(6%) = 12% DES Chapter 4

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% WACC used as discount rate on FCFs. DES Chapter 4

Projections Next chapter focuses on nuts and bolts of projections. For now, assume your financial analyst already made following projections. DES Chapter 4

Income statement projections Income Statements Actual Projected 2003 2004 2005 2006 2007 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 DES Chapter 4

Balance Sheet Projections Balance Sheets Actual Projected Projected Projected Projected 2003 2004 2005 2006 2007 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 DES Chapter 4

Balance Sheet Projections Liabilities Actual Projected Projected Projected Projected 2003 2004 2005 2006 2007 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 DES Chapter 4

FCF Projections Actual Projected 2003 2004 2005 2006 2007 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 DES Chapter 4

ROIC Projections Long term projected growth is 6% Actual Projected 2003 2004 2005 2006 2007 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% DES Chapter 4

Horizon Value DES Chapter 4

Value of operations DES Chapter 4

Value of operations Excel Fin Calculator: Use NPV Function Cf0 = 0 NPV = Vop = $4272.92 Excel Use NPV Function =NPV(Rate,Value1,Value2, Value3,. . .) DES Chapter 4

Value of equity Vequity = VOPS + non-operating assets – 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 DES Chapter 4

Per share equity 100 million shares outstanding Value per share = $29.91 DES Chapter 4

Per share equity To find stock price, subtract co’s debt from estimate of firm value, then divide by number of c.s. shares o/s. Simple method, but doesn’t provide much discrimination among firms. DES Chapter 4

Alternate valuation method Method of multiples Not as reliable as Discounted FCF model But is frequently used by less-sophisticated analysts DES Chapter 4

Method of Multiples P/E Price / EBITDA Price / Sales Price / Book Price / CF Price / FCF Use current value, ave historic, ave projected DES Chapter 4

Method of Multiples Idea is to find some representative measure that should capture what makes firm valuable, like sales, or net income, or earnings before interest, taxes, depreciation and amortization (EBITDA). Need to determine comparable multiples for firms of same size and same line of business. DES Chapter 4

Method of Multiples: EBITDA Calculate the ratio of Value/EBITDA for a representative sample of firms. Value is defined as the total value of the firm (the value of debt plus the value of equity), because EBITDA is available for all of the firm’s investors- - both debt and stock holders. Suppose, it’s determined the value of similar firms to ACME equals 5.261 times EBITDA To find estimated value of firm being analyzed, multiply its EBITDA by this representative ratio. DES Chapter 4

Method of Multiples: EBITDA To find estimated value of firm being analyzed, multiply its EBITDA by this representative ratio of 5.261x. So, need EBITDA (using actual ’03) Sales $4,512.44 -CGS 2,797.71 -SGA 902.49 =EBITDA 812.24 x 5.261 comparable EBITDA multiple =Firm Value 4,273.19 Acme DES Chapter 4

Method of Multiples: EBITDA From Multiples, $4,273.19 ACME Firm Value - 1,281.86 ACME Debt =2,991.33 Vequity for ACME Price per share = $2,991.33 / 100 mm shs Value per share = $29.91 DES Chapter 4

Variations is multiples ratios Average for industry may be 5.26x, but range from 2x to 18x. Why? i.e. Co.’s in same industry with identical EBITDA’s have variety of different prices due to: Diff FCFs Higher sales and FCF growth rate than others Ignores potential differences in risk. BOTTOM LINE: Multiples easy to use, but not nearly best gauge. DES Chapter 4