1. DES Chapter 4 1 DES Chapter 4 Estimating the Value of ACME

2. DES Chapter 4 2 Steps in a valuation Estimate cost of capital (WACC) Debt Equity Project financial statements and FCF Calculate horizon value Discount at WACC to Calculate V OPS Calculate value of equity

3. DES Chapter 4 3 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.

4. DES Chapter 4 4 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?

5. DES Chapter 4 5 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.

6. DES Chapter 4 6 Bond prices M is the maturity value, or $1,000 for ACME r C is the coupon rate, or 0.08, which is 8% for ACME n is the maturity, or 26 x 2 = 52 6-month periods. r D is the discount rate.

7. DES Chapter 4 7 ACME’s bond price A financial calculator or a spreadsheet can be used to solve for r D, which is 4.5% for a 6-month period, or 9% per year.

8. DES Chapter 4 8 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%

9. DES Chapter 4 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.

10. DES Chapter 4 10 ACME’s cost of equity CAPM: r S = r RF + Beta (RPM) Beta = 1.1 r RF = 5.4% = long term rate on Treasuries RP M = market risk premium = 6% r S = 5.4% + 1.1(6%) = 12%

11. DES Chapter 4 11 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.

12. DES Chapter 4 12 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.

13. DES Chapter 4 13 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 Sales, 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 new 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

14. DES Chapter 4 14 Balance Sheet Projections Balance Sheets Actual Projected 2003 2004 2005 2006 2007 Cash 45.12 48.73 51.66 54.76 58.04 Inventory 631.74 682.28 723.22 766.61 812.61 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

15. DES Chapter 4 15 Balance Sheet Projections Liabilities Actual 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 Total liabilities 2,058.57 2,207.05 2,332.42 2,465.27 2,606.05 Common stock 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

16. DES Chapter 4 16 FCF Projections

17. DES Chapter 4 17 ROIC Projections Long term projected growth is 6% Actual 2003 Projected 2004 Projected 2005 Projected 2006 Projected 2007 ROIC = (NOPAT/Beginning capital) 11.3% 11.2% 11.0% Growth in Sales 9.0% 8.0% 6.0% Growth in NOPAT 9.0% 8.0% 6.0% Growth in total net op. cap. 9.0% 8.0% 6.0% Growth in FCF 376.6% 50.8% 67.9% 6.0% Growth in dividends -34.5% 28.8% 41.7% 6.0%

18. DES Chapter 4 18 Horizon Value

19. DES Chapter 4 19 Value of operations

20. DES Chapter 4 20 Value of equity V equity = V OPS + 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 V equity = $4,272.92 - 1,281.86 = $2,991.06 million

21. DES Chapter 4 21 10 million shares outstanding Value per share = $29.91 Per share equity

22. DES Chapter 4 22 Alternate valuation method Method of multiples Not as reliable as the free cash flow model we’ve developed But it is frequently used by less- sophisticated analysts

23. DES Chapter 4 23 Method of Multiples The idea is to find some representative measure that should capture what makes the firm valuable, like sales, or net income, or earnings before interest, taxes, depreciation and amortization (EBITDA).

24. DES Chapter 4 24 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. To find the estimated value of the firm being analyzed, multiply its EBITDA by this representative ratio.

25. DES Chapter 4 25 Method of Multiples: EBITDA To find the stock price, subtract the firm’s debt from the estimate value, then divide by the number of shares. This method is simple, but it doesn’t provide much discrimination among firms.

26. DES Chapter 4 26 Method of Multiples… 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). To find the estimated value of the firm being analyzed, multiply its EBITDA by this representative ratio. To find the stock price, subtract the firm’s debt from the estimate value, then divide by the number of shares. This method is simple, but it doesn’t provide much discrimination among firms.