DES Chapter 4 1

Estimating the Value of ACME

DES Chapter 4 2

Steps in a valuation

Estimate cost of capital (WACC)DebtEquity

Project financial statements and FCF

Calculate horizon value

Discount at WACC to Calculate VOPS

Calculate value of equity

DES Chapter 4 3

Estimating the required return on the components of WACC

ACME has debt and equityThe 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.

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?

.wrwr)T1(WACC SSDD

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.

DES Chapter 4 6

Bond prices

nD

n

1tt

D

cB )r1(

M

)r1(

2/MrV

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 7

ACME’s bond price

nD

n

1tt

D )r1(

000,1$

)r1(

4015.900$

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 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%

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.

DES Chapter 4 10

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%

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.

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.

DES Chapter 4 13

Income statement projectionsIncome Statements Actual Projected Projected Projected Projected 2009 2010 2011 2012 2013 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 80.00 80.00 80.00 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

DES Chapter 4 14

Balance Sheet Projections

Balance Sheets Actual Projected Projected Projected Projected

2009 2010 2011 2012 2013 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

DES Chapter 4 15

Balance Sheet ProjectionsLiabilities Actual Projected Projected Projected Projected 2009 2010 2011 2012 2013 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 Common 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 16

FCF Projections Actual Projected Projected Projected Projected 2009 2010 2011 2012 2013 Operating profit 586.62 633.55 671.56 711.85 754.56 Tax on operating profit 234.65 253.42 268.62 284.74 301.83 NOPATa 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 NOWCb 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 capitald 279.45 270.74 219.31 232.46 246.41 FCFe 72.52 109.39 183.63 194.65 206.33

DES Chapter 4 17

ROIC Projections

Long term projected growth is 6%

Actual

2009 Projected

2010 Projected

2011 Projected

2012 Projected

2013 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%

DES Chapter 4 18

Horizon Value

.gWACC

)g1(FCF

gWACC

FCFHV N1N

N

.75.467,5$

06.0100.0

)06.01(33.206$)1(20132013

million

gWACC

gFCFHV

DES Chapter 4 19

Value of operations

.million92.272,4$

)10.01(

75.467,5$

)10.01(

33.206$

)10.01(

65.194$

)10.01(

63.183$

)10.01(

38.109$V

44

32Op

DES Chapter 4 20

Value of equity

Vequity = VOPS + non-operating assets – debt = $4,272.92 + 0 – debtDebt: $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 21

10 million shares outstanding

Value per share = $29.91

Per share equity