ESTIMATING THE INTRINSIC VALUE OF AN ENTERPRISE WITH AN

INTEGRATED FINANCIAL MANAGEMENT SYSTEM

James A. Gentry
Professor Emeritus of Finance &
University Distinguished Teacher Scholar
University of Illinois, Urbana-Champaign
j-gentry@uiuc.edu


and




Frank K. Reilly
Bernard J. Hank Professor of Finance
University of Notre Dame
Reilly.1@nd.edu











November 30, 2007







2
ABSTRACT

Learning the process of estimating the intrinsic value of an enterprise can be extremely
frustrating to students because it involves a deep understanding of numerous complex
relationships. The teaching goals of this manuscript are to create a dynamic learning
experience that underlies the valuation processs. To accomplish these goals we have created
an integrated financial management system (IFMS). The IFMS provides a user friendly
approach for preparing a financial forecast and, in turn, estimating the intrinsic value of an
enterprise.
Our teaching experiences suggests students use the IFMS to simulate financial
forecasts based on carefully researched inputs that reflect a companys corporate and financial
strategies. The simulations highlight the dynamic interplay of key quantitative and
qualitative information on the value creation process. For example, students will observe why
and how changes in credit policy decisions affect the long-run firm value. Furthermore,
students can observe how changes in the target debt/ firm value ratios (D/V) can dramatically
affect enterprise value. Additionally, an important event is learning if a firms strategic
capital investment decisions result in an increase in enterprise value. Also, students will
discover that the value of interest bearing debt (V
d[FCFD]
) increases when management pursues
a long run growth strategy versus a no growth strategy in which the value of debt (V
d
)
remains constant. Finally, the IFMS helps students discover how strategic forecasting errors
related to operating, investment and/or financing decisions can affect the value of a firm.

One of the most important learning experiences created by the IFMS is the effect of a
long-run growth strategy on the free cash flow to the firm [FCFF] versus the free cash flow to
the equity [FCFE] and the free cash flow to the debt [FCFD]. That is, the value of a firm

based on a long-run growth strategy (V
f[FCFF]
) will not equal the sum of discounted free cash
flow to equity (V
s[FCFE]
) plus the discounted free cash flow to debt (V
d[FCFD]
). In reconciling
this valuation dilemma, the solver routine in Excel generates an implied terminal growth rate
of the FCFF (g
FCFF
) that causes the V
f[FCFF]
=[V
s[FCFE]
+V
d[FCFD]
]. The g
FCFF
is a valuable
financial tool for estimating a credible terminal growth rate.
Overall, the IFMS results in students having a deeper understanding of why and how
changes in financial strategies affect the intrinsic value of a firm. Our teaching experiences
suggests the IFMS provides a tool that enhances student understanding and retention of the
valuation process.

NOTE TO REVIEWERS
The authors have a minor disagreement concerning which discount rate to use in
the valuation of debt on pages 9 and 10. One approach would use (1+k
d
)(1-t) and the
other would use (1+k
d
). We would greatly appreciate participating in a discussion with
the reviewer and audience as to which approach would be theoretically correct.
Currently the paper uses the (1+k
d
)(1-t). For the June meeting in Prague, we shall
prepare an example that show the results when (1+k
d
) is the discount rate for the debt.

The authors are developing two additional approaches concerning the problem of
what to do with the excess cash. Currently, the program uses all of the excess cash to
retire debt. We are developing two other scenarios for the Prague meeting. (1) Transfer
all of the excess cash to the account called excess cash. (2) Use a percent of the excess
case (1 to 100 percent) to repurchase shares of stock and the remainder transferred to
the excess cash account. We shall use a 100 percent repurchase plan for Prague.
3









ESTIMATING THE INTRINSIC VALUE OF AN ENTERPRISE WITH AN
INTEGRATED FINANCIAL MANAGEMENT SYSTEM
1



Many professional financial specialists, investors and academics are constantly
searching for an equivalent to Harry Potters magic wand. The objectives are to gain fresh
insights into the process of analyzing a companys financial health and estimating its intrinsic
value. In recent years our students have helped us to identify gaps in their understanding of
credit risk and valuation theories. The result is the development of an integrated financial
management system (IFMS). The IFMS uses forecasting assumptions to generate financial
statements as the foundation for estimating a firms long-run value. The forecast reflects
managements assumed corporate and financial strategies. As strategies change, the financial
performance and the value of an enterprise can change. Based on the outcomes of various
simulated scenarios, the IFMS identifies various performance patterns in the long-run intrinsic
value of an enterprise. A careful analysis of financial statements highlights the variables that
were closely associated with the changes in enterprise value. The IFMS helps students
enhance their financial analysis skills in explaining possible causes in a firms financial health
and changes in its intrinsic value.

Several models have been proposed to estimate the intrinsic value of a stock. For
example, in the 1930s and 1940s Graham and Dodd [1934, 1940] advocated using
fundamental security analysis techniques to discover if the level of a stocks P/E multiple
provided signals for investment opportunities, e.g., [P/E]

x EPS
t+1
=P
t+1
. Interest in
multipliers has continued to expanded and today there are a variety of multipliers, such as
Price/Book Value (P/B), Price/Sales (P/S) and Price/EBIT, used to estimate a stocks potential
value, Damadoran [2006, Chapters 7-9]. Naturally, there are solid reasons for using
multipliers to estimate the value of a stock, but there are also shortcomings.

Near the end of the Great Depression, Williams [1938] introduced the classic
dividend discount model [DDM] for estimating the value of a stock (V
s[DDM]
). Later, Gordon
[1962] extended the Williams model by introducing a dividend constant growth model in the
late 1950s and early 1960s, that is called the constant growth model (V
s[CGM]
).

In recent years the literature for estimating the value of a firm (V
f
) and the value of a
stock (V
s
) has expanded dramatically. Copeland, Koller and Murrin [1990, 1994, 2000],
Rappaport [1988, 1998], Stewart [1991], and Hackel and Livnat [1992] were current pioneers
in modeling the free cash flow to the firm [FCFF], which is widely used to derive the V
f.


1
The authors are very grateful to Mike Sandretto, Yiyi Zeng and Yerzhan Turkushev for their valuable
programming assistance.
4
Copeland, Koller and Murrin [1994, 2000] and Damadoran [1994, 206] introduced an equity
valuation model based on discounting a stream of free cash flows to equity [FCFE] at a
required rate of return to stockholders. Also Damadoran [2001] provides several approaches
to estimate the value of a firm for which there are no comparable companies, no operating
earnings and a limited amount of cash flow data. Famas [1970] efficient market research
challenged the validity of intrinsic valuation models.

Finally, a real options approach for valuing firms that have no comparables or
operating earnings and usually only limited data for analysis was launched in 1999. The
leaders in developing a real options approach to valuation were Amram and Kulatilaka
[1999], Brennan and Trigeorgis [1999], Schwartz and Moon [2000], Copeland and Antikarov
[2000] and Damadoran [2001, Chapter 11].

A brief review of a few basic concepts used to estimate the market value of a firm
(V
f
),

its stock (V
s
) and debt (V
d
) will set the stage for this paper.
.
A basic concept in the
theory of finance is

V
f
=[V
s
+V
d
],

[1]

where: V
f
is the estimated market value of a firm,
V
s
is the estimated market value of its stock, and
V
d
is the estimated market value of its interest-bearing debt.

Separate theories are needed to estimate the intrinsic value on each side of equation 1.
One theory assumes that the V
f,
on the left hand side of equation 1, is estimated by using a
firms weighted average cost capital (WACC) to discount to infinity its estimated free cash
flows [FCFF], Brigham and Ehrhardt [2005, Chapter 15]. It is possible to create forecasted
inputs so that the V
f[FCFF]
=V
f
. On the right hand side of equation 1, a second theory assumes
the V
s
and V
d
are known or the intrinsic V
s
can be estimated by discounting to infinity the free
cash flow to equity [FCFE] at the required rate of return on the equity (k
s
), Damadoran [2006,
Chapter 5] With the appropriate forecasted inputs it is possible for the V
s[FCFE]
=V
s
.

Equation 1 makes it possible for authors to assume the V
f
V
d
=V
s ,
e.g., as shown in
Rappaport and Mauboussin [2001, pp. 74-76]. Examples that use an all equity firm, or nearly
all equity, avoid the valuation complexities that occur when the interest bearing debt is
allowed to increase as a firm pursues a long-run growth strategy
2
. On the positive side of
using an all equity firm to illustrate a valuation argument, Solomon [1963, chapter 5] used an
all equity firm to develop an insightful theoretical explanation of how growth in a firm occurs.
An explanation of Solomons growth model is presented in Appendix 1. We have concluded
that there is a gap in the explanation of how valuation models are integrated. Our challenge is
to connect these valuation theories so that the linkages are transparent.


2
However, to the best of our knowledge a methodology has not been developed that estimates the value of debt
for a firm with a long-run growth strategy. That is, discounting to infinity the free cash flow to interest-bearing
debt [V
f[FCFD]
] at a market determined rate of return on debt (1+k
d
(1-t)). Later, we shall develop the linkages
that show V
f[FCFD]
=V
s[FCFE]
+V
d[FCFD].
5
The primary objective of the paper is to present a valuation system that links the
components used in estimating the intrinsic value of equity (V
s[FCFE]
)
3
, debt (V
d[FCFD]
) and a
firm (V
f
) or an enterprise. In Section I a brief review of the valuation literature is presented,
while Section II develops a theoretical overview of an integrated valuation system. Section
III shows how to develop a forecast for integrated income statements and balance sheets.
These forecasted financial statements provide information needed to estimate the intrinsic
value of equity, debt and a firm. Likewise, Section V presents the linkages that make the
V
f[FCFF]
=[V
s[FCFE]
+V
d[FCFD]
]. Simulating various scenarios highlights the analytical power
an integrated valuation system offers to professional financial specialist, investors and
students of finance. The final section summarizes the most important contributions an
integrated valuation system can make in estimating the long-run value of a firm.

I. LITERATURE REVIEW

A review of the valuation literature indicates there are several fundamental concepts
involved in estimating the intrinsic value of a stock, a bond and a firm. In the late 1930s
Professor J ohn Burr Williams [1938] developed a theory for estimating the value of a stock
based on the idea of discounting a constant stream of dividends to infinity [DDM], that is the
future cash flows that stockholders would receive. In the early 1960s, Gordon [1962]
extended Williams DDM by allowing the stream of dividends to grow at a constant forecasted
rate from time period zero to infinity. The Gordon constant growth model is widely used in
the investment management profession. Also it has been extended to incorporate dividends
growing at uneven rates.

Graham and Dodd [1934, 1940] and Graham, Dodd, and Cottle [1962] proposed an
intrinsic-value approach to equity valuation. In the 1962 edition they stated the most
important single factor determining a stocks value is now held to be the indicated average
future earning power, i.e., the estimated average earnings for a future span of years.
Furthermore, they indicated intrinsic value would then be found by first forecasting this
earning power and then multiplying that prediction by an appropriate capitalization factor,
Graham, Dodd and Cottle [1962, p. 28]. They wisely stated that any estimate of earning
power extending over future years may easily fall wide of the mark, since the major business
factors of volume, price, and cost are all largely unpredictable. Graham, Dodd and Cottle
(GDC) [1962, p. 29].

Graham, Dodd and Cottle [1962, p.741-742] reconciled their earning power theory
of value to the DDM valuation models of Williams and Gordon, by discounting low-dividend-
paying growth stocks in a manner comparable to discounting a stream of future dividends to
infinity. GDC concluded that the elements of uncertainty and risk assume a dominant position
in the discounting of a future dividend stream. Second, they reached a practical conclusion,
namely that investors in popular growth stocks do not explicitly think even vaguely in terms
of discounting future dividends.

In the mid-1960s Fama [1965] found stock price performance resembled a random
walk. Fama later developed the efficient market theory in terms of a fair game model, that is

3
We recognize the importance of the constant growth model is estimating the value of a firms equity, but we
have chosen to focus on the free cash flow to equity approach and not develop the dividend model. in this
article.
6
the price of a security fully reflects all available information at a point in time, Reilly and
Brown [1997, p. 210]. Fama divided the overall efficient market hypothesis (EMH) into three
sub-hypotheses depending on the information set involved: (1) weak-form EMH, (2) semi
strong-form EMH and (3) strong-form EMH, Reilly and Brown [1997, p. 211]. Famas EMH
raises serious questions concerning the validity of GDCs earning power theory of value and
Williams and Gordons dividend valuation models.

Late in the1980s and early 1990s several authors presented a valuation model based
on free cash flow to the firm (FCFF), e.g., Copeland, Koller and Murrin [1990,1994, 2000],
Rappaport [1988, 1998], Stewart [1991] and Hackel and Livnant [1992]. Recently, Copeland,
Koller and Murrin [1994, p. 500] presented a definition of free cash flow to the shareholder of
a bank. A few years later Damadoran [1994, 2006] presented a methodology for estimating
the free cash that flows to equity shareholder [FCFE]. This model opens the door to another
approach for estimating the value of a stock, V
s[FCFE]
, by discounting the FCFE at the
required rate of return on equity (k
s
). Thus it is possible to compare the intrinsic estimates
generated by two equity valuation models, V
s FCFE
to the V
s (CGM)
4
.

The preceding discussion briefly introduced an implied terminal growth rate of FCFF
(g
FCFF
) that causes the V
f [FCFF]
=[V
s[FCFE]
+V
d[FCFD]
]. Solving for an implied terminal
growth rate of FCFF assumes the estimated intrinsic V
s[FCFE]
and V
d[FCFD]
are +relatively
stable throughout the life of the forecast. It is also assumed there are positive operating cash
flows, comparable companies and several years of estimated cash flows. If these conditions
do not exist, can the V
s
or the V
f
be estimated? The answer is yes as shown by authors who
focus on the using of real options to estimate V
f
, e.g., Amram and Kulatilaka [1999], Brennan
and Trigeorgis [1999], Schwartz and Moon [2000], Copeland and Antikarov [2000] and
Damadoran [2001]. Also authors who developed the valuation of distressed and/or bankrupt
companies, such as Gilson [1997], Grinblatt and Titman [1998], Gilson, Hotchkiss and
Ruback [2000], Kaplan and Ruback [1995] and Ruback [2000].

An integrated financial management system (IFMS) provides a rich and stimulating
foundation for teaching and learning about valuing a firm and its equity. The integrated
valuation system highlights the forecasting and discounting of FCFF, FCFE and FCFD, that
highlight the sensitivity of the cash flow components to changes in the forecasted inputs. It
also illustrates how changes in the V
d
/ V
f
and V
s
/ V
f
weights, as well as changes in k
s
and
k
d
, can affect WACC. Finally, as shown earlier, the IFMS develops an implied terminal
growth rate of the FCFF (g
FCFF
)
,
that results in the V
f[FCFF]
=[V
s[FCFE]
+V
d[FCFD].
]


II. AN OVERVIEW OF THE VALUATION PROCESS

Value of a Firm (V
f
)

4
Regardless, whether FCFE or dividends are used to estimate the V
s
, the required
equity discount rate (k
s
) is the same. Additionally, unless there is a 100 percent dividend
payout, the V
s[FCFE]
V
s[CGM]
. Therefore, to make the value of the discounted dividends
equal to the value of the discounted FCFE, V
s (CGM)
=V
s (FCFE)
, we created an implied terminal
dividend growth rate (g
DIV
), but it is not reported in this study. A copy of this model is
available upon request to j-gentry@uiuc.edu.


7

There are two widely used methods to estimate the value of a firm. First, is a static
approach for a single point in time, where the current market value of the equity (V
s
) and the
debt (V
d
) are known. The V
s
+V
d
equals the market value of the firm (V
f
), i.e.,

V
f
=V
s
+V
d .
[2]

A second approach estimates the intrinsic value of an enterprise by discounting the
free cash flows to a firm (FCFF) at the weighted average cost of capital (WACC). V
f[FCFF]
is
based on the following equation:

V
f[FCFF]
=FCFF
1
/ (1 +WACC) +FCFF
2
/ (1 +WACC)
2
+.+[FCFF
n
+TV
n
] / [3]
(1 +WACC)
n
where:
V
f[FCFF]
=long-run intrinsic value of a firm,
FCFF
t
=forecasted annual free cash flows to a firm, periods 1 to n,
=[EBIT
t
(1-T) +depreciation
t
] +[WC
t
] +[NIF
t
],
where: -WC or NIF is an outflow of cash and +WC or +NIF is
an inflow of cash,
EBIT(1-T)
t
=Earnings before interest and taxes adjusted for tax shield,
in each of n periods.
WC
t
=Receivables
t
+Inventory
t
+OCA
t
+Payables
t
+OCL
t
,
NIF
t =
net fixed assets
t
+depreciation expense
t
+other assets
t


WACC =weighted average cost of capital,
=w
d
k
d
(1- tax rate) +w
s
k
s

w
d
=V
d
/ V
f
k
d
=market interest rate on interest-bearing debt,
w
s
=V
s
/ V
f

k
s
=required rate of return on equity derived from CAPM
V
d
=market value of permanent debt,
V
s
=market value of equity,
TV
n
= terminal value of FCFF
n
=FCFF
n
(1 +g) / [WACC g]
where: WACC >g
g
n
=estimated annual growth in FCFF from period n to

The FCFF contains the net flows (inflows outflows) related to operations (NOF),
working capital (WCF) and investments (NIF). For example, these three net cash flow
measures are based on many factors, such as a firms

corporate strategy and its implementation,
product markets served, its share of these markets and their growth potential,
competitive position within each of its product markets and its industry,
investment strategies for new and old product lines,
working capital strategies and their stability as a percent of sales,
financial strategies, e.g., dividend policy, share repurchase policy and target capital
structure, and
internal operating efficiencies.
8

Additionally, when solving for the value of a firm, the role of its discount rate, WACC,
and the expected growth in FCFF are impacted by

financial markets outlook for a firms growth rate,
performance of its operating, working capital and investment flows,
potential growth of a firms strategic investments,
expected long-run rates of return on a firms equity and debt instruments,
stability of dividend policy and target capital structure,
terminal value (TV) of the FCFF.

Theoretically, financial analysts, portfolio managers and investors estimate annual
FCFF for n periods, plus the inputs used in estimating the terminal value (TV). The estimate
of terminal value (TV) assumes the FCFF will grow at a constant growth rate from period n to
infinity. Frequently, the TV represents a significant proportion of a firms estimated value.
Finally, the stability of WACC is based on the accuracy of the estimated target weights for
debt (w
d
) and equity (w
s
), plus the outlook for the firm that is reflected in the marketplace.


Value of Equity (V
s
)
5


Several methods are used to measure the value of a firms equity. If the current market
price of a stock (P) is available, k
s
=P x N, where N is the number of shares outstanding. [4]

A second approach for estimating the intrinsic value of a stock is discounting the
FCFE. The discounted FCFE provides a dynamic method for solving the intrinsic value of an
equity:

V
s[FCFE]
= FCFE
1
/ (1 +k
s
) +FCFE
2
/ (1 +k
s
)
2
+.+[FCFE
n
+TV
n ]
]/ ( 1 +k
s
)
n
[5]
where:
V
s[FCFE]
=long-run intrinsic value of equity


FCFE
t
=forecasted free cash flow to equity in periods 1 to n,
=net income
t
+depreciation expense
t
+WC
t
+NIF
t
+principal
increment of new debt
t
principal repayment of debt
t
where: -WC
t
or NIF
t
is an outflow of cash and +WC
t
or +NIF
t
is an inflow
of cash,
k
s
=required rate of return on equity capital derived from the CAPM,
TV
n
= terminal value of FCFE
n
=FCFE
n
(1 +g
n
) / (k
s
g
n
),
where: k
s
>g
n,

g
n
=estimated annual growth rate of FCFE from period n to .

The discounted FCFE approach incorporates the cash flows directly associated with
equity shareholders for an infinite time period. Theoretically, the FCFE reflects the net cash
flows that equity shareholders expect to receive throughout the life of the company. It
includes net income plus depreciation, plus the outflows associated with capital investments
(NIF
t
) and working capital (WC
t
). Additionally, an increase in permanent debt becomes a

5
This segment of the paper is based on Damadoran [2006 Chapter 5] and [1994 Chapter 7].
9
cash inflow to equity holders, while a decrease in permanent debt reflects an outflow of cash.
It is assumed the permanent debt is used to finance capital investment projects, that, in turn,
generate operating cash inflows. The cost of equity (k
s
) reflects the returns required by equity
shareholders. Finally, the FCFE does not include the costs associated with debt, w
d
, kd, (1-T),
that are explicitly included in the WACC.
6


Value of Debt (V
d
)

When estimating the value of the permanent interest bearing debt, one approach is to
assume the V
d
equals the current book value of the long-term and short-term interest-bearing
instruments.
7
This approach to estimating V
d
implicitly assumes management of the firm is
pursuing a zero growth strategy. That is, there is no future growth in sales, assets, liablities or
equity. Permanent sources of financing are long-term debt, short-term debt, current portion
long-term debt, notes payable, bank loans, and capitalized leases. Therefore, when a DCF
infinite horizon no growth model is used to estimate the V
f[FCFF]
or V
s[FCFE]
, the permanent
debt (V
d[FCFD]
) includes the sum of all long and short-term interest-bearing debt.

When a firm is pursuing a zero economic growth policy, its sales, assets and
permanent debt are considered to be constant throughout time. Under these stable conditions,
the value of its debt equals the stream of estimated interest payments (INT) discounted to
infinity at 1 plus

the current cost of debt (1 + k
d
) times (1- tax rate), as shown in [7].

In a zero growth to infinity scenario, the value of the debt (V
d
) can be estimated
with the following formula.

V
d
=[INT
1
] / (1 +k
d
(1-t)) +[INT
2
] / (1 +k
d
(1-t))
2
+.+ [INT +Maturity] / (1 +
k
d
(1-t)) [7]

where:
V
d
=value of debt in a zero growth to infinity scenario,
INT =annual interest payments based on a constant interest rate,
(1 + k
d
(1-t)) =1 + current market rate of return on debt times (1- tax rate),

The following explanation of the free cash flow to debt (FCFD) is presented as a
conceptual companion to Damadorans [2006, Chapter 5] explanation of the FCFE. When an
enterprise pursues a long-run growth strategy, it is assumed the growth rate of assets and the

6
A constant growth of dividends model (CGM) is a third approach used to estimate the intrinsic value of equity
(V
s
). In equation form it is:
V
s[CGM]
=DIV
0
(1 +g)/ (1+k
s
) +DIV
0
(1+g)
2
/(1+k
s
) +.+DIV

(1+g)

/(1+k
s
)

[6]
Where:
V
s
=intrinsic value of equity,
DIV
0
=annual dividend flows to shareholders in period zero,
1+g
n
=estimated annual compound grow in DIV in period n,
k
s
=required rate of return on equity derived from CAPM.

The CGM discounts the dividend flows to equity shareholders that estimates theV
s[CGM]
. The dividends are
assumed to compound annually at a constant growth rate. Theoretically, with 100 percent dividend payout, the
CGM forecasted inputs are identical with FCFE forecasted inputs, V
s[CGM]
=V
s [FCFE]
.

7
For example, textbooks that present this approach are: Brigham and Ehrhardt [2005, 514-515], Smart,
Meggison and Gitman [2004, 143-144], and Stowe, Robinson and Pinto [2002, 170]
10
growth rate of interest bearing debt will match the growth rate of its sales. Implicitly, it is
assumed, the growth rate of the interest payments, hereafter called the free cash flow to debt
(FCFD), are directly tied to the growth rate of sales. Thus the value of a firms debt (V
d[FCFD]
)
equals a stream of increasing FCFD being discounted to infinity at the current market rate of
return (k
d
) times (1- tax rate). Therefore, when comparing the value of a no growth firms
debt (V
d
) to the value of a firm pursuing a long-run growth strategy (V
d[FCFD]
), it becomes
apparent that the V
d
is less than the V
d[FCFD]
because the INT is constant for the no growth
firm and the FCFD is increasing for the growth firm.

In the financial literature an accepted convention is to assume that the market V
f
=V
s

+V
d,
shown in equation (1), and

an algebraic restructuring of (1) becomes V
s
=[V
f
- V
d
].
However, it was shown above, if a firm pursues a long-run growth strategy that the value of
the forecasted debt (V
d[FCFD]
) will be proportionally greater than its current market debt (V
d
).
Likewise, it is assumed if a firm pursues a long-run growth strategy that the value of its
equity, V
s[FCFE]
, would also be proportionally increased. Thus, theoretically, in a long-run
growth strategy, the intrinsic enterprise value [V
f[FCFF]
] would be proportionally greater than
no growth value [V
f
]. The difference between V
f
and V
f[FCFF]
occurs because the firm
pursuing a no growth strategy is theoretically less the value of a growth firm, i.e., [V
s +
V
d
] <
[V
s[FCFE]
+V
d[FCFD]
].

Equation 8 introduces the equation used in the IFMS to estimate the V
d[FCFD].
To the
best of our knowledge this is the first time the V
d[FCFD]
concept has been presented.

V
d[FCFD]
=[FCFD
1
]/(1+k
d
(1-t)) +[FCFD
2
]/(1+k
d
(1-t))
2
++ [FCFD
n
+TV
n
] /


((1+k
d
) (1-t))
n
[8]
where:
V
d[FCFD]
=intrinsic value of a growth firms permanent debt,
FCFD
n
=annual interest payments based on a long-run growth strategy,
TV
n
=terminal value of FCFD
n
=FCFD
n
(1+g)/((k
d
(1-t) g), where k
d
(1-t)

>g
(1 +k
d
(1-t))

=1 +current market rate of return on the debt times (1- tax rate),
g
n
=estimated annual terminal growth rate of INT from period n to .

Summary
The above analyses indicates there are several approaches to estimating the value of
equity, debt and the enterprise. As shown below, valuation equations (9-14) are listed in
column 1 and the titles in column 2. The titles reflect two different valuation approaches--
market-determined (MD) and discounted cash flow (DCF), that are based on either a no
growth (NG) or a long-run growth (LG) strategy. The three valuation strategies are entitled
(1) market-determined no-growth (MD-NG,), (2) DCF-no-growth (DCF-NG) or (3) DCF-
long-run-growth (DCF-LG), as shown in column 2. For example, the left hand side of
equation 10 is V
f[FCFF]
, and it represents a DCF valuation that is based on a no growth
strategy. The right hand side of the equation 10, V
s
+V
d
, represents a market-determined
valuation with a no growth strategy (MD-NG) for the equity (V
s
) and the debt (V
d
).


Equations [13 and 14] reflect a DCF valuation that is based on long-run growth strategies on
both sides of the equation. In summary,

Market-Determined No-Growth (MD-NG);
11
Valuation equations DCF-No-Growth Strategy(DCF-NG);
DCF-Long-run-Growth Strategy (DCF-LG).
(1) (2)
V
f
=V
s
+V
d
,

MD-NG = MD-NG

[9]
V
f [FCFF]
=V
s
+V
d
, DCF-NG = MD-NG [10]

V
s =
V
f
- V
d


MD-NG = MD-NG [11]

V
s
=V
f [FCFF]
V
d
.

MD-NG = DCF-NG MD-NG

[12]


V
s [FCFE]
=V
f[FCFF]
V
d[FCFD]
DCF- LG = DCF-LG [13]


V
f[FCFF]
=V
s[FCFE]
+V
d[FCFD]
DCF-LG

= DCF-LG

[14]

The above set of relationships provide the foundation for the remainder of the paper.
The analysis will focus on the linkages between the two sides of equation 14, that is the
conditions necessary for V
f[FCFF]
=[V
s[FCFE]
+V
d[FCFD]
]. However, before explaining these
linkages, we present an overview of the structure of the IFMS. Following the overview is a
brief introduction to the process of preparing a financial forecast and critical assumptions that
may create forecasting issues or problems of interpreting the results.


III. CREATING A FINANCIAL FORECAST

An Overview of IFMS
The structure of the Integrated Financial Management System (IFMS) is best viewed
via a flowchart that is shown in Figure 1. First, the historical information sources needed in
preparing the financial forecast are introduced in Boxes 1 4. Next, Box 5 represents the
assumptions needed for creating a financial forecast, i.e., the drives of the IFMS. The
assumptions underlying a firms proforma income statement and balance sheet should reflect
managements realistic expectations about the future. Box 6 reflects the income statement
and the balance sheet used in calculating the companys free cash flow to debt (FCFD), free
cash flow to equity (FCFE) and free cash flow to the firm (FCFF) that are reflected in Box 7.

Figure 1 utilizes Box 8 to highlight the estimation of cost of equity and debt; Box 9
to present an estimation of a companys equity and its debt; and Box 10 to show the
components of a firms weighted average cost of capital. The costs of capital are presented in
Exhibit 3 and used to discount the FCFE and the FCFD. In turn, the sum of the V
s[FCFE]

+

V
d[FCFD]
result in V
f[FCFF],
that becomes the foundation against which the estimated value of the
enterprise in Exhibits 4 and 5 are compared. The value of an enterprise (V
f[FCFF
) in Exhibit 4
is based on FCFF discounted with a WACC based on the firms target capital structure, that
is its target debt ratio (V
d
/V
f
) as shown in Box 11 of Figure 1. The next step, Box12, involves
solving the implied terminal growth rate used in valuing the firm, that is shown in Exhibit 4.
Boxes 14 repeats the valuation of the firm based on market-determined WACC and the
calculation of the implied terminal value growth rate (g
FCFF
) is reflected in Box 15. Box 16
highlights the presentation of a comparative overview of the previous valuation results. This
overview is presented in Exhibit 6.

12
Financial Forecast

Recommendations for preparing the financial forecast are found in Appendix 2. That
is, the recommendations provide the technical steps to follow when preparing the financial
forecast for the income statement and the balance sheet.

The outlook for economic conditions and the competitive environment are factored
into the forecast along with the annual growth rate in sales. The IFMS assumes a
relationship between sales and the related cost of sales, administrative expenses and
other expenses. Also in the IFMS, depreciation is assumed to be closely related to the
performance of a firms net fixed asset. Best practices in forecasting assume all assets,
accounts payable and other current liabilities are a function of sales. The IFMS assumes
..

each asset is a function of sales, i.e., there is a relatively stable relationship between
the ith asset in the jth period and sales in the jth period;
selected liabilities are a function of sales, i.e., there exists a stable relationship between
salesand accounts payable
j
,

other current liabilities
j
and all interest bearing debt.
the percentage of earnings retained is stated explicitly and is assumed to maintain a
stable relationship with net income.
the main data file shows the existing debt that will retire in the next five years;
based on these data, the remaining long-term debt for each year is calculated and
is presented as continuous debt in each of the next five years.

When forecasted assets are greater than forecasted liabilities in the IFMS, there a
shortfall in financing is discovered. This strategic financing gap is referred to as the
additional funds needed (AFN). The AFN are offset first by retained earnings from the
income statement. If the AFN are not satisfied with retained earnings, the next step is to
use long-term debt. If the long-term debt limit is reached and the shortfall continues,
the IFMS assumes the remaining shortfall is financed with short-term borrowing.
Alternatively, if the forecasted assets (A) are less than the forecasted liabilities
(L), A<L, the first step is to reduce the short-term debt. If the assets continue to be less
than the total liabilities, the second step is to reduce the long-term debt. When the firm
has no short or long-term debt, the remaining cash is programmed to an account called
excess cash. However, repurchasing common stock could be achieved to reduce extra
cash.

Additional Insights

Preparing different scenarios based on separate sets of conditions is a widely used
technique to accommodate uncertainties in the financial forecast. The use of different
scenarios provides valuable insights to the user. Initially, an example has been prepared that
assumes a relatively stable long-run outlook for the example company, Archer Daniels
Midlands Company (ADM). The ADM financial data were provided by the WRDS data sets,
where the base data are provided by COMPUSTAT.

13
Appendix 3 provides examples of critical assumptions associated with the financial
forecast that can create problems in interpreting the financial health of a company or in
deciding what may be the financial outcome.


IV. DIFFERENCES BETWEEN ENTERPRISE VALUATION THEORIES

Estimating Base Value of ADMDiscounted FCFE + Discounted FCFD


We are now ready to interpret the valuation results presented in Exhibits 3-5. Previously it
has been shown that the value of an enterprise can be estimated in a variety of ways. The first
step is to refer to Exhibit 3 and to find that the value of ADM was $25.404 billion, which was
the sum of the present value of its free cash flow to equity, $14.207 billion, and the present
value of the free cash flow to debt, $11.197 billion. The cost of equity was 6.9 percent and
the cost of debt was 6.5 percent, with a terminal growth rate of 3.2 percent. The $25.404
billion valuation becomes the base value to be matched in Exhibits 4 and 5. It is important to
note that the cash flow difference between the FCFE is primarily either the addition of debt
financing--an inflow to the FCFE, or the repayment of debtan outflow to the FCFE.

Estimating Value ADMDiscounted FCFF
The next step involves estimating the value of ADM (V
f[FCFF]
) by referring to Exhibit
4. The task is to discount the free cash flows to the firm (FCFF) at the weighted average cost
of capital (WAAC). The components of the FCFF for years 1-5 are presented in Exhibit 4
and originally presented at the bottom of Exhibit 2 The equation for estimating the WACC
are shown at the bottom of Exhibit 3. The target debt weight (V
d
/V
f
) and the equity weight
(V
s
/V
f
) are 20 and 80 percent, respectively. The cost of debt and equity, k
d
and k
s,
are 6.5
percent and 6.9 percent. Using these data results with a WACC of 6.439 percent, the annual
FCFF for years 1-5 are presented in Exhibit 4, and the present value of this discounted stream
of FCFF
[1 to 5]
is $3.650 billion.
In order for theV
f[FCFF]
in Exhibit 4 to equal the V
f[FCFE +FCFD]
in Exhibit 3, the Solver
routine in Excel was used to calculate an implied terminal value growth rate (g
FCFF]
).
Instructions for using the Solver routine are presented in Appendix 4. After inserting the
inputs, the Solver calculates the terminal growth rate that matches the present value of the
discounted FCFF in Exhibit 4 to the present value of the firm in Exhibit 3, specifically, sum of
the PVFCFE +PVFCFD. The Solver calculated implied terminal growth rate ( g
FCFF
) was
0.00329. Please see Appendix 5 and 6 for further interpretation of g
FCFF
. The present value
of the terminal value of the FCFF is $21.753 billion, as reflected in Exhibit 4. That is, at the
beginning of year 6, ADMs estimated future FCFF must grow at 0.329 percent annually to
infinity in order to achieve an intrinsic value of $21.753 billion. Finally, V
f
=PV
FCFF(2006-2010)
+PVTV
FCFF,
or $25.404 billion =$3.650 billion +$21.753 billion.


Interpretation of implied terminal growth rate effect
There are several possible interpretations of the g
FCFF
<g
FCFE & FCFD
, 0.329 percent <
3.2 percent. Discounting the FCFF at WACC is considered a better predictor of V
f
than the
sum of the discounted FCFE at k
s
plus discounted FCFD at k
d
. As explained above, ADMs
valuation of $25.4 billion was achieved with a 3.2 percent terminal growth rate of the
14
FCFE
2010
and FCFD
2010
, as shown in Exhibit 3. However, Exhibit 4 shows that only a 0.329
percent implied terminal growth rate (g
FCFF
) was required in order to achieve a value of $25.4
billion. Also, Exhibit 5 provides a similar FCFF analysis with a lower WACC of 5.885
percent, that was based on market-determined D/E weights of 0.441for w
d
and 0.559 for w
s.

The resulting implied terminal growth rate was 0.367 percent. This lower g
FCFF
provides
further confirmation that the growth rate required to achieve the value of $25.4 billion was
substantially lower than 3.2 percent.
The current market value of ADMs stock was $35.37 per share ($23.13
billion/0.64289 billion shares) compared to an estimated intrinsic value $22.10 per share
($14.207 billion/ 0.64289 billion shares). Likewise, ADMs current debt was valued at $7.32
billion compared to an intrinsic debt valuation of $11.197 billion. Thus the implication being
that the current value of ADMs stock is currently overvalued by approximately 60 percent
and the current debt is undervalued debt by approximately 53 percent. A summary of the
preceding valuation data are found in Exhibit 6 and an interpretation of these data will provide
a deeper interpretation of implied terminal value growth rate.
Exhibit 6 provides a comparison of the valuation results that were presented in
Exhibits 3, 4 and 5. Column 3 in Exhibit 3 shows the present value of the FCFF
1-5
being
$3.557b compared to a FCFF
1-5
of $3.650 in Exhibit 4 and 5, where the difference of
approximately $0.2 billion is a relatively small difference. However, the difference between
the FCFF
5
in Exhibit 3 and Exhibit 4/5 is slightly greater than $1.0 billion ($1.810 b - $0.755
b), and has a dramatic affect on the respective terminal values. That is assuming a 3.2 percent
terminal growth rate, the terminal value of FCFF
5
in Exhibit 3 is $29.0 billion vis--vis the
terminal FCFF
5
in Exhibit 4 is $57.6 billion. However, when applying the implied terminal
growth rate of 0.33 percent to the FCFF
5
in Exhibit 4 the present value of the terminal value
is $21.75 billion or nearly identical to the PVFCF
5
of $21.85billion. The final result in
Column 8 shows the present value of ADM is $25.4 billion in both Exhibit 3 and 4.

Finally, if the terminal growth rate of FCFF
5
in Exhibit 4 had been 3.2 percent, as
shown in column 5 of Exhibit 6, a required terminal growth rate of 4.57 percent, in column 5
of Exhibit 6, would be required in order for the two terminal values be equal, as shown in
column 6 for Exhibits 3 and 4, or $57,658 billion. If this were the case the intrinsic value of
ADM's stock would be $55.50 per share, ($46.877 billion - $11.197 billion /0.64289).


CONCLUSIONS

The objective of this manuscript is to create an exciting teaching and learning tool for
professors and students. The paper presents a valuation system that integrates strategic and
financial information. It is designed to allow users to simulate various financial management
policies and discover how they affect the financial health and valuation of a company. It is
requirement for students to learn how to create financial forecast and learn how to interpret
the results of their forecast. Thus an integrated financial management system (IFMS) is
presented that generates a five year forecast of a companys financial statements, plus the
terminal value forecast. The financial forecast provides a solid foundation for calculating
cash flow measures and, in turn, estimate the value of an enterprise, its equity and debt. Also
the system allows the user to observe the differences in the valuation of the enterprise that
15
uses a target capital structure weighted average cost of capital (WACC) versus a market
determined WACC.

It is important to use an existing company and involve its corporate officers in the
discussion related to the inputs to be used in the IFMS. The inputs in forecasting the value of
ADM generated conflicting information that created lively discussions within study groups
and the classroom. For example, the financial forecast for ADM was relatively optimistic for
years 1-5, but the intrinsic value of the stock was $22 per share compared to the market value
of $36. What were the causes of the significant differences between intrinsic and market
value of ADM? Or what were the causes of the overvaluation of ADM in the market place?
Why did a low cost of capital not create a higher valuation of ADM? Why was the value of
the forecasted debt substantially greater than the current debt value? Also there were many
questions concerning ADMs capital structure. For example why was the target value D/E
.20/.80, but market-determined D/E was .44/.56 and the book D/E in 2006 was .34/.66 ?
What is the correct capital structure? Other questions that always occur are: What is the
correct growth rate of sales? What is the correct cost of goods/sales relationship? Is the
company planning a large acquisition in the future? Does the company plan a major
investment plan in the next few years?

The IFMS creates a new approach in estimating the value of the debt that is used in
calculating the value of an enterprise. The introduction of the concept of free cash flow to
debt (FCFD) as a companion to the free cash flow to equity (FCFE) provides unique
discussions and challenges to the concept of V
s
+V
d
=V
f
. Historically, it is an accepted
convention when estimating the value of a the firm to subtract the current value of the existing
debt as an approach to determining the value of the equity. This paper suggests the practice of
adding the current interest bearing debt to the discounted FCFE can results in understating
the value of the firm. The discussion related to the valuation of debt are always lively.

Valuation inconsistencies may occur because the underlying theories were developed
independently in different time periods and they were not constructed as an integrated system.
Also the inputs for each of the theoretical valuation models are unique. Additionally, the
IFMS uses the Solver routine in Excel to generate an implied terminal growth rate of FCFF.
What does the implied terminal growth rate tell the user? If the implied terminal growth rate
of FCFF is less than the terminal growth rate of the FCFE and FCFD, it signals a scenario that
the intrinsic value of the equity plus the debt is overvalued, or vice versa. The only time the
V
f[FCFF]
=V
f[FCFE+FCFD]
would be when there was an all equity firm with a 100 percent payout
ratio and the return on investment equals the cost of equity.

In closing, students have indicated the IFMS
helps identify the key pieces of the valuation puzzle and highlights the delicate
tradeoffs decisions of management associated with operations, investments,
working capital, financing and optimal capital structure;
clarifies credit analysis linkages with cash flow, profitability, liquidity, efficiency,
leverage and growth;
highlights the interrelationships between academic disciplines such as marketing,
production, accounting and finance;
shows preparing the inputs requires informed inputs and analyzing the outcomes
requires analytical skills and is not a mechanical process;
16
forces careful unbiased reasoning when comparing the derived intrinsic value of
the firm to the market determined valuation;
shows each company requires different inputs when searching for the intrinsic
valuation;
can be used in as a valuable learning tool in advanced courses in corporate finance,
investments, accounting and strategic management.
17
APPENDIX 1

ALL EQUITY FINANCED FIRM WITH THREE SEPARATE STRATEGIESNO
GROWTH, EXPANSION AND TRUE GROWTH

Solomon [1963, Chapter 5] recognized the importance of growth in firm value and
how it was created. In the modern context, he identified an all equity strategy that would
generate true growth. Solomon used an all equity financed firm to develop three separate
strategiesno growth, expansion and true growthto illustrate how wealth or growth was
created. The definitions of the three all equity strategies were:
Zero Growth is represented by 100 percent payout of earnings and the rate of
return on capital investments equals the cost of equity capital (k
s
), r =k
s.

Expansion reflects a firm that increases its size, by investing in
capital investment projects that earn the cost of equity, r =k
s
, and these projects
were financed with the retention of earnings, thus payout ratio is <100 percent.
True Growth occurs when the firm invests in projects that earn more than the cost
of equity, r>k
s
, and they projects were financed with retained earnings.

The first of two exhibits presents the three strategies and shows the inputs used to
create a firms pro forma income statement and a balance sheet. Note the inputs for the three
all equity strategies are nearly the same with the exception of the cost of goods sold and the
percent of earnings paid out in dividends for the true growth firm and the payout ratio for the
expansion strategy. The inputs are used in the same financial forecasting model used in
generating Exhibits 1-6 in the text.

The second exhibit highlights the simulated financial results for each of the
strategies. The Dupont System results are identical with the exception of the profit margin in
the true growth strategy. The weighted average cost of capital inputs are identical. The
market values for thezero growth and expansion strategy are identical, while the value of the
stock, firm and value per share are greater for the true growth strategy. The value of the
dividends and free cash flow are the same for zero growth and expansion, but they are larger
for the true growth scenario. Finally, the implied terminal value for the free cash flow to
equity are identical for the zero growth and expansion, but greater for the true growth
strategy.
18
APPENDIX 1 (continued)



ALL EQUITY FINANCED FIRMS WITH THREE STRATEGIESNO GROWTH,
EXPANSION AND TRUE GROWTH
Percentage of Sales Forecast Method


Financial Input Zero Growth Expansion
1
True Growth
2

I. Income Statement
1. Growth of Sales 0% 0% 0%
2. Cost of Goods Sold
3
50% 50% 46%
3. Administrative Expenses
3
15% 15% 15%
4. Other Expenses
3
5% 5% 5%
5. Depreciation Expense
4
10% 10% 10%
6. Percent of Earnings Paid Out 100% 88.095% 89.583%

Assets
7. Cash
5
3% 3% 3%
8. Accounts Receivable 20% 20% 20%
9. Inventories 20% 20% 20%
10. Other Current Assets 2% 2% 2%
11. Net Fixed Assets 20% 20% 20%
12. Other Assets 0% 0% 0%


Liabilities and Equity
13. Accounts Payable 0% 0% 0%
14. Notes Payable $0 $0 $0
15. Other Current Liabilities 0% 0% 0%
16. Other Liabilities $0 $0 $0
17. Long Term Debt $0 $0 $0
18. Common Stock
6
$12.50 $12.50 $12.50
19. Retained Earnings
6
$20.00 $20.00 $20.00

1
Expansion occurs when the retention of earnings is sufficient to finance a firms capital
investments and the return on the investments equals cost of equity (k
s
), r =k
s
.
2
True growth occurs when the retention of earnings is sufficient to finance the firms capital
investments and the investments earn more than the cost of equity (k
s
), r>k
s
.

8 Percentage of sales
4
Percentage of net assets
5
All assets, accounts payable and other current liabilities are a percentage of sales.
8 Common Stock and Retained earnings are in millions of dollars

19
APPENDIX 1 (continued)

SIMULATED FINANCIAL RESULTS FOR EACH OF THE GROWTH
STRATEGIES



Financial Results Zero Growth Expansion True Growth

Dupont System
1. Profit Margin (%) 0.1680 0.1680 0.1970
2. Asset Turnover (X) 1.5385 1.5873 1.5873
3. Rate of Return on Assets 0.2585 0.2667 0.3048
4. Leverage Multiplier 1.0 1.0 1.0
5. Rate of Return on Equity 0.2585 0.2667 0.3048

WACC Components
6. Weight in debt (w
d
) 0.0 0.0 0.0
7. Cost of debt (k
d
) 0.07 0.07 0.07
8. (1 Tax Rate) 0.60 0.60 0.60
9. Weight in equity (w
e
) 100.0% 100.0% 100.0%
10. WACC 0.10 0.10 0.10


Market Values l
11. Value of Stock (V
s
) $84 M $ 84M $96M
12. Value of Debt (V
d
) 0.0 0.0 0.0
13. Value of Firm (V
f
) $84M $84M $96M
14. Value per share $1.0 $1.0 $1.1429
15 Number of Shares 84M 84M 84M

Dividend and FCFE
16. Dividends $8.40M $7.4M $8.6M
17. Rate of Return on Div. 0.10 0.10
7
0.1429
8

18. Free Cash Flow to Equity $8.40M $8.40M 9.60M
19. Rate of Return on FCFE 0.10 0.10 0.1429

Implied Terminal Growth (TV) Rate
20. Implied TV Div. Growth 0.0 0.02416 0.02159
21. Implied TV FCFE Growth 0.0 0.0 0.02159
___
7
Dividend return =0.08810 and capital gain=0.0119, total return =0.10
8
0.1429 =$96M / 84M.
20
APPENDIX 2

INPUTS REQUIRED FOR PREPARING A FINANCIAL FORECAST

The objective of Appendix 2 is to explain the key steps involved in preparing a
percentage of sales forecast for an income statement and balance sheet. The information is to
be inserted in Exhibit 1.

Inputs required for Income Statement forecast, where percentage of sales method for
inputs are used, except where explanation is shown.

Annual growth rate of sales ( F5 to J 5) [e.g., 7.5%]
Cost of Sales/Sales (F6 to J 6)
Administrative expenses/ Sales (F7 to J 7)
Depreciation/Net Fixed Assets (D11)
Interest Expense C126 [determined by program and inserted in G13 to J 13
Other expenses/Sales (D14) [may be a used as a balancing entry]
Tax rate (D16)
Net Income (F17 to J 17) [calculated by program]
Payout Ratio Dividends/Net Income (D18)
Change in retained earnings [net income dividends is calculated by program].

Inputs required for Balance Sheet forecast

Excess Cash [If: (Total Liabilities +Equity) >Total Assets] (see row 22)
Cash/Sales (D23)
Accounts Receivable/Sales (D24)
Inventories/Sales (D25)
Other Current Assets/Sales (D26) sometimes may be a plug value for years 1 to 5
Net Fixed Assets/Sales (D28)
Other Assets/Sales (D29) sometimes may be a plug value for 1 to5 years.
Accounts Payable/Sales (D32)
Notes Payable (row 33) determined internally [increases if: Total Assets >Total
Liabilities +Equity, decreases if opposite occurs]
Other Current Liabilities/Sales (D34) sometimes may be a plug value for years 1 to 5
Other liabilities/Sales (D36) sometimes may be a plug value for years 1 to 5
Book value Long Term Debt/Sales (D37).
Common Stock (Row 38) [Constant all years]
Retained earnings +change in retained earnings in income statement (Row 39)

Inputs required for valuation assumptions. These inputs are referred to in Exhibits 3 of
the financial forecast worksheet.
Cost of equity (k
s
) [Exhibit 3 (C115)]
Terminal growth rate of FCFE & FCFD [Exhibit 3 (C116)]
Cost of debt (k
d
) [Exhibits 3 (C126)]


21
APPENDIX 3

Financial Forecasting Assumptions That Can Create Problems In
The Forecasted Results


Growth rate of sales. The financial forecast program is driven by the growth rate of
sales. The growth of receivables, inventories and accounts payable are directly related to the
growth of sales. The financial forecast in Exhibit 1 assumes a 7.5 percent growth of sales for
years 1 through 4.. However, if the growth rate of sales is assumed to be markedly lower or
if it is assumed to be erratic and unstable, the cash flow components will look dramatically
different from the standard forecast.. It is extremely important to track the cash flow results
and discover why they changed. The results of the forecast are based on the inputs. It is the
users responsibility to interpret the data and explain what happened and why it happened.

Sensitivity of CGS / Sales and SG&A /Sales. The operating income of a company is
highly sensitive to increases or decreases in Cost of Goods Sold or Selling, General and
Administrative Expenses as a percent of Sales. What appears to be minor percentage
changes in CGS/Sales or SG&A/Sales ratios can have a profound effect on operating income.
At a minimum a forecast should simulate most likely and worst case scenarios for CGS/Sales
and SG&A/Sales.

Sensitivity of working capital cash flows to changes in sales. For example, when current
asset components are increasing more rapidly than the growth of sales, the free cash flow and
managements discretionary cash flow can decline significantly. Likewise, when the growth
rate of accounts payables are less than the growth of sales, the free cash flow and
managements discretionary cash flow [MDCF] can decline rapidly. In summary, working
capital components have a significant effect on the financial performance of a company.

Sales growing too fast. If the firms strategic plan calls for sales to grow more rapidly
than the operating income or the net income during the next few years, the financial forecast
will show the total assets are more-than-likely growing more rapidly than the total liabilities.
To finance this rapid growth strategy, where forecasted assets >liabilities, the firm will need
to increase its temporary and/or permanent financing. The IFMS is programmed to first
utilize the retained earning from the income statement, discretionary cash flow, before
increasing its long-term debt to accomplish managements target debt/total market value ratio.
Short-term debt can be used to provide additional funds needed (AFN) until the target capital
structure is reached and forecasted total liabilities equal total assets. At this point if additional
funds are still needed to make liabilities =assets, the target debt ratio is overridden and the
debt ratio will expand causing the financial risk and the cost of capital to increase. From a
planning perspective, the capital structure is out of control. The financial forecast stops,
because the user either needs to reduce the growth of sales or determine a new set of inputs to
offset the increase in market risk. Under these conditions, the cost of equity and debt are
increased because market expectations and credit risk have increased. Naturally, there is an
increase in the debt/ equity mix.

Growth in operating profit margins > growth in sales. When operating profit margins
increase more rapidly than sales, operating profits are growing at a rate greater than the
growth of sales. According to Solomon [1963, chapter 5] this set of conditions reflects true
22
growth. That is, when rate of return on new capital investments (r) is greater than the
weighted average cost of capital (WACC), r >WACC, a firm is experiencing true growth. If
this condition is not permanent, it will create some instability in forecasting future
performance in the IFMS.

Sales in decline. If the forecast is for sales to decline over several years, the strategy of a
distressed or bankrupt firm is markedly different than a non-distressed company The
relationship between sales and assets will decline, as will the return on operating income
and/or net income. The target capital structure will be mostly debt. Management needs a new
strategic plan.

Increasing operating profit margins. If new product markets result in an increase in
operating profit margins (EBIT/Sales) and/or profit margins (NI/Sales), the FCFF and
discretionary cash flow will likely rise, assuming other forecasted components remain
unchanged. Under these conditions, equity in the balance sheet will rise and it is possible
that forecasted liabilities >assets. An increase in equity can result in the debt ratio (D0/V
f
)
declining, and/or debt can be retired. Either of these events can result in the debt ratio falling
below the target established by management or to zero. If the cost of equity and debt is not
readjusted downward the WACC will likely increase as the percentage of equity approaches
100 percent.

No growth, expansion and true growth. Solomon [1963] developed four scenarios that
were related to the forecasted growth rate of net earnings or dividends. The scenarios showed
how investment and its financing affected the growth of earnings and/or dividends. If 100
percent of the net income was paid out in dividends, for an all equity firm, there would be no
growth in value over time. However, investing a portion of the earnings retained at exactly
the WACC will result in an expansion of assets, but earnings, debt/equity ratios and asset
value will experience a constant increase, as would the growth in firm value. The third
condition occurred when a portion of earnings retained was invested at a rate of return greater
than WACC. Solomon referred to this condition as true growth and over time equity would
increase and the debt/equity ratio would decrease. True growth creates complex issues in
estimating the optimal capital structure, cost of equity (k
s
) and value of the stock. Finally, the
stability of the investment pattern can have a profound affect on the value of the equity. Each
of these conditions creates issues in estimating the value of a stock.

Capital Structure inputs and growth rates. The valuation of a firm is highly sensitive to
the assumed capital structure,V
d
/V
f
and the V
s
/V
f,
and the terminal growth rate. It is
recommended that the first task in creating a financial forecast is to create a most likely
income statement and balance sheet, the financial forecast in Exhibit 1. When you are
comfortable with the forecasted financial statements, you can make adjustments to the target
capital structure in Exhibit 4.






23
APPENDIX 4

USING THE SOLVER ROUTINE IN EXCEL


Inputs required to solve for growth rate of terminal value (TV) using Solver

To find the implied growth rate of TV of free cash flow to firm in Exhibit 4

Go to Tools and select Solver and follow instructions by inserting
1. Set Target Cell $E$162 (present value of FCFF in Exhibit 4)
2. Equal to Value of. Dollar Value in cell E136 (PV of FCFF in Exhibit 3)
3. By changing cell $C$155 (implied growth of TV of FCFF in Exhibit 4)

To discover the implied growth rate of TV of FCFF, in Exhibit 5

Go to Tools and select Solver and follow instructions by inserting
1. Set Target Cell.. $E$176 (present value of FCFF in Exhibit 5)
2. Equal to Value of.. Dollar value in cell E136 (PV of FCFF in Exhibit 3)
3. By changing cell. $C$168 (implied growth of TV of FCFF in Exhibit 5)


APPENDIX 5

Equation 14 hypothesizes that V
f[FCFF]
=V
s[FCFE]
+V
d[FCFD]
. An objective of this section
is to discover why the two sides of [14] may differ. The first task is to examine the right hand
side of [14]. In this illustration the basic inputs for estimating the free cash flow to equity
[FCFE] and free cash flow to debt [FCFD] are presented in the proforma income statement
and balance sheet located in Exhibit 1. The sales of Archer Daniels Midland Company
(ADM) are assumed to grow at 4.5 percent annually for the period 2006-2010. The forecasted
relationships between income statement expenses, assets and selected liabilities as a
percentage-of-sales are found in third column of Exhibit 1. Appendix 2 provides the inputs
used in the Excel spread sheet in preparing the financial forecast.

Exhibit 1A shows relationships between FCFE, FCFD and FCFF in the financial
forecast. Also Exhibit 1A provides an overview of the book and market value estimates of
the debt/equity measures. These summary cash flow and debt/equity measures provide a
valuable perspective of the long-run stability of the example company, ADM.

The annual FCFE and FCFD for years 1-5 FCFE are presented in Exhibit 2.
The annual FCFE are discounted at the cost of equity capital (k
s
) and they are shown at the
top of Exhibit 3. The capital asset pricing model (CAPM) is used to estimate k
s
. The CAPM
is
k
s
=r
f
+ [MRP] [16]
where:
r
f
= risk free rate =0.05
= beta = 0.80
MRP = market risk premium =0.0238
24

With the assumed CAPM inputs above, the k
s
is 0.069 and the discounted FCFE for
years 1 5, PV
FCFE, 1- 5,
shown in Exhibit 3, are $2.571 billion. The terminal growth rate is
assumed to be 3.2 percent. The present value of the terminal value (PVTV
FCFE
) is $11.636
billion and the intrinsic value of ADM is $14.2 billion or $22.10 per share

Thus the V
s[FCFE]
=PV
FCFE, 1 5
+PVTV
FCFE ,
[18]

= $2.571 billion + $11.636 billion
= $14.207 billion

The current value of ADM stock was approximately $36 per share at the time this
example was created. Also there were approximately 642.89 million shares of ADM stock
outstanding at this time, which makes the current market value of the stock (V
s
) equals to
$23.14 billion.

The annual FCFD(1-T) for years 1-5 are shown in Exhibit 2 and they are discounted at
the current cost of debt (k
d
)(1-t), and the PVFCFD equal $0.986 billion, as shown in Exhibit
3. The PVTV
FCFD
is $10.211 billion, and the V
d[FCFD]
equals $11.197 billion, as presented in
the middle of Exhibit 3. Thus the intrinsic estimated enterprise (present) value of the ADM
(V
f[FCFE +FCFD]
) based on the sum of PV
FCFE
and PV
FCFD
equals $25.4 billion, as shown in
Exhibit 3. The current market value of the permanent debt at this time was approximately
$7.32billion or approximately $3.9 billion less than the $11.2 billion intrinsic value of the
debt.


APPENDIX 6


To find g
FCFF
, assuming the numerals are in billions (B) $. The following is presented
in Exhibit 4.


TV
FCFF, year 5
=$1.810 B (1 +g
FCFF
) / [0.06439 g
FCFF
] =$25.404 B [20]

where: $1.810 =FCFF
year 5
0.06439 =WACC
$25.404 B = TV
0.06722, year 5


therefore, applying algebra to [20]
8
, we find g
FCFF
is

$25.404 B (0.06439 g
FCFF
) =$1.810 B +$1.810 B g
FCFF
$1.6358 B- $25.404B g
FCFF
=$1.810 B +$1.810 B g
FCFF
g
FCFF
* =[$1.6358 B - $1.810 B] / [$25.404 B +$1.810 B]
g
FCFF
* =0.0032948


8
This calculation is accomplished by Solver in Excel, as shown below. Differences are
related to rounding estimates.

25





IMPLIED TERMINAL GROWTH RATES: INSIGHTS

The implied growth of the terminal value of free cash flow to firm (g
FCFF
) in C155
or C168 should be compared to the growth rate of free cash flow to equity and debt
(g
FCFE & FCFD
), that is found in C116. For example, if the implied growth rate of the
terminal value of FCFF (g
FCFF
) in C155 is less than the annual terminal growth rate of
FCFE and FCFD (g
FCFE

& FCFD
) in C116, it shows that the terminal FCFF in year 5 of
Exhibit 4 is greater than the sum of the terminal values of FCFE and FCFD in Exhibit
3. Thus the slope of the TV g
FCFF
<slope of g
FCFE & FCFD,
0.0033<0.032. Because the g
FCFF
is
consider a better proxy for the terminal growth rate, it means that the V
s
and V
d
in
Exhibit 3 are more-than-likely undervalued. The opposite occurs if C155 is greater-than
C116.

Exhibits 4 and 5 provide a comparison of the value of ADM based on different
capital structures. The percentage of the capital structure in Exhibit 4 is based on
managements perception of a target D/V equal to 20 percent, while Exhibit 5 uses a
market determined D/V of 44.1 percent. The target debt ratio created a WACC of
6.439 percent compared to an 5.885 percent for the market determined debt ratio. This
difference between the two WACCs resulted in the terminal growth in FCFF being
0.00329 percent for the target debt ratio and 0.00367 percent for the market
determined debt proportion.

























26


REFERENCES

Amram, Martha and Nalin Lulatilaka [1999], Real Options: Managing Strategic Investment
Options in an Uncertain World, Boston, Harvard Business School Press.

Block, Stanley B. and Geoffrey A. Hirt [2001], Foundations of Financial Management, Tenth
Edition, New York, The McGraw-Hill Companies, Inc.

Brealey, Richard A. and Stewart C. Myers [1996], Principles of Corporate Finance, Fifth
Edition, New York, The McGraw-Hill Companies, Inc.

Brennan, Michael J . and L. Trigeorgis [1999], Project Flexibility, Agency and Competition;
New Developments in the Theory and Applications of Real Options, New York, Oxford
Press.

Brigham, Eugene F. and Michael C. Ehrhardt [2005], Financial Management: Theory and
Practice, 11th Edition, Fort Worth, The Dryden Press.

Copeland, Tom, Tim Koller and J ack Murin [2000], Valuation: Measuring and Managing the
Value of Companies, Third edition, New York, J ohn Wiley & Sons, Inc.

__________[1995], Valuation: Measuring and Managing the Value of Companies, Second
Edition, New York, J ohn Wiley & Sons, Inc.

__________[1990], Valuation: Measuring and Managing the Value of Companies, First
Edition, New York, J ohn Wiley & Sons, Inc.

Damadoran, Aswath [1994], Damadoran on Valuation, New York, J ohn Wiley & Sons, Inc.

________, [2001], The Dark Side of Valuation, Upper Saddle River, NJ , Financial Times
Prentice Hall.

Damadoran, Aswath [2006], Damadoran on Valuation, Second Edition, New York, J ohn
Wiley & Sons, Inc.

Fama, Eugene F. [J anuary 1965], The Behavior of Stock Market Prices, J ournal of
Business, Vol. 38, No. 1, 34-105.

Fama, Eugene F. [May 1970], Efficient Capital Markets: A Review of Theory and
Empirical Work, J ournal of Finance, Vol. 25, No. 2, 383-417.

Gordon, Myron J . [1962], The Investment, Financing, and Valuation of the Corporation,
Homewood, IL, Irwin.

Graham, Benjamin and David L. Dodds [1934, 1940], Security Analysis: Principles and
Technique, First and Second Editions, New York, McGraw-Hill Book Company, Inc.

27
Graham, Benjamin, David L. Dodds, Sidney Cottle with the collaboration of Charles Tatham
[1962], Security Analysis: Principles and Technique, Fourth Edition, New York,
McGraw-Hill Book Company, Inc.

Hawawini, Gabriel and Claude Viallet [1999], Finance for Executives: Managing for Value
Creation, Cincinnati, South-Western College Publishing.

Hackel, Kenneth S. and J oshua Livnat [1992], Cash Flow and Security Analysis, Homewood,
Business One Irwin.

Homer, Sidney and Martin L. Leibowitz [1972], Inside the Yield Book, Englewood Cliffs, N.
J ., Prentice-Hall Inc.

Palepu, Krishna G., Paul M. Healy and Victor L. Bernard [2000], Business Analysis &
Valuation, Second Edition, Cincinnati, South-Western College Publishing.

Rappaport, Alfred [1988, 1998], Creating Shareholder Value, New York, The Free Press.

Rappaport, Alfred and Michael J . Mauboussin [2001], Expectations Investing, Boston,
Harvard Business School Press.

Reilly, Frank K. and Keith C. Brown [1997], Investment Analysis and Portfolio, Fort Worth,
The Dryden Press.

Smart, Scott B., William L. Megginson and Lawrence J . Gitman [2004], Corporate Finance,
Mason, OH, South-Western.

Solomon, Ezra [1963], The Theory of Financial Management, New York, Columbia
University Press.

Stewart, G. Bennett III [1991], The Quest for Value, New York, HarperBusiness.

Stickney, Clyde P. and Paul R. Brown [1999], Financial Reporting and Statement Analysis,
Fort Worth, The Dryden Press.

Williams, J . B. [1938], The Theory of Investment Value, Cambridge, Mass., Harvard
University Press.

Stowe, J ohn D., Thomas R. Robinson, J erald E. Pinto, Dennis W. McLeavey [2002], Analysis
of Equity Investments; Valuation, Charlottesville, VA, Association of Investment
Management.
Figure 1: A Flowchart Showing the Structure of the Integrated Financial Management System
1) Six years of
company data and
ratio analysis
(Main Data)
Figure 1: A Flowchart Showing the Structure of the Integrated Financial Management System
2) Balance Sheet and
Income Statement
(B.S.+I.S.)
3)
Statements of
cashflows (CFL)
4) Cashflow
analysis (Cash
Flow)
5)
Assumptions for
Financial Forecast Financial Forecast
(Exhibit 1)
6)
Pro forma BS and
IS (Exhibit 1)
7)
Calculation of
FCFE, FCFD,
FCFF (Exhibit 2)
8)
Estimation of Ks
and Kd (Exhibit 3)
9)
PV of the Firm
(FCFE + FCFD)
(Exhibit 3)
10) Estimation of
WACC using
target capital
structure (Exhibit FCFF (Exhibit 2) (Exhibit 3) structure (Exhibit
3)
11)
PV of the Firm
with target
12) Solve for implied
terminal growth
rate for FCFF
13)
Estimation on
WACC using
14)
PV of the Firm
with market
values of D/E
15) Solve for implied
terminal growth
rate for FCFF using
capital structure
(FCFF) (Exhibit 4)
using value of the
firm from Exhibit
3 (Exhibit 4)
market values of
D/E (Exhibit 5)
values of D/E
(FCFF) (Exhibit
5)
g
value of the firm
from Exhibit 3
(Exhibit 5)
16)
Compare results
(Exhibit 6) (Exhibit 6)
Exhibit 1: Financial Statements (in millions)
HER-DANIELS-MIDLAND CO Analyst
Income Statement Mean % of Sales Forecast
Year ended Dec 31, year: % of Sales Base % of Sales 2005 2006 2007 2008 2009 2010
Growth of Sales (Last 5 yrs) Year & Others Base YR 1.8% 8.0% 8.0% 7.0% 7.0%
Cost of Sales /Sales 90.1% 88.0% 87.0% 86.0% 86.0%
Admin. Exp. /Sales 3.0% 1.2% 1.2% 1.2% 1.2%
Sales $35,943.81 $36,594.39 $39,521.94 $42,683.70 $45,671.56 $48,868.57
Cost of sales - Depreciation 91.53% 91.4% $32,847.82 $32,971.55 $34,779.31 $37,134.82 $39,277.54 $42,026.97
Administrative expenses 3.14% 3.0% $1,080.81 $1,108.81 $1,197.51 $1,293.32 $1,383.85 $1,480.72
Depreciation (% of net fixed assets 12.2% 12.8% 12.4% $664.65 $772.03 $833.79 $900.50 $963.53 $1,030.98
Earnings before interest and taxes $1,350.53 $1,742.00 $2,711.32 $3,355.07 $4,046.64 $4,329.90
Net Interest expense 1.25% 0.9% $337.58 $271.63 $386.00 $363.90 $321.38 $244.66
Other expenses -0.86% -1.40% -0.8% -$503.43 -$283.61 -$306.30 -$330.80 -$353.95 -$378.73
Net income before tax $1,516.38 $1,753.98 $2,631.62 $3,321.97 $4,079.22 $4,463.98
Taxes 0.83% 31.1% 29.3% $471.99 $513.57 $770.54 $972.67 $1,194.39 $1,307.05
Net Income $1,044.39 $1,240.42 $1,861.08 $2,349.29 $2,884.82 $3,156.92
Dividends 0.00% 20.1% 15.4% $209.43 $191.52 $287.35 $362.73 $445.42 $487.43
Changetoretainedearnings $83496 $104890 $157373 $198656 $243940 $266950 Change to retained earnings $834.96 $1,048.90 $1,573.73 $1,986.56 $2,439.40 $2,669.50
Balance Sheet
Excess Cash $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
Cash 4.07% 4.0% 6.4% $1,430.42 $2,334.72 $2,521.50 $2,723.22 $2,913.85 $3,117.81
Accounts Receivable 11.43% 11.4% 12.2% $4,102.26 $4,475.49 $4,833.53 $5,220.22 $5,585.63 $5,976.63
Inventory 12.26% 10.9% 12.8% $3,906.70 $4,680.42 $5,054.86 $5,459.25 $5,841.39 $6,250.29
Other current assets 0.94% 0.8% 0.9% $271.32 $343.99 $371.51 $401.23 $429.31 $459.36
Total current assets $9,710.70 $11,834.63 $12,781.40 $13,803.91 $14,770.18 $15,804.09
Net fixed assets 17.58% 14.4% 17.0% $5,184.38 $6,221.05 $6,718.73 $7,256.23 $7,764.17 $8,307.66
Other assets 11.76% 10.3% 11.4% $3,703.02 $4,153.46 $4,485.74 $4,844.60 $5,183.72 $5,546.58
Total Assets $18,598.11 $22,209.14 $23,985.87 $25,904.74 $27,718.07 $29,658.33
Accounts payable 9.30% 9.5% 11.0% $3,399.35 $4,018.06 $4,339.51 $4,686.67 $5,014.74 $5,365.77
Notes payable $648.75 $449.35 $0.00 $0.00 $0.00 $0.00
Other current liabilities 3.98% 3.7% 4.2% $1,318.77 $1,522.33 $1,644.11 $1,775.64 $1,899.94 $2,032.93
Total current liabilities $5,366.86 $5,989.74 $5,983.62 $6,462.31 $6,914.67 $7,398.70
Other Liabilities 1.31% 3.5% 3.4% $1,267.63 $1,247.87 $1,347.70 $1,455.51 $1,557.40 $1,666.42
Long term debt 12.03% 9.8% 15.0% $3,530.14 $5,489.16 $5,598.45 $4,944.25 $3,763.93 $2,441.65
Common Stock $5,385.84 $5,385.84 $5,385.84 $5,385.84 $5,385.84 $5,385.84
Retained Earnings $3,047.63 $4,096.53 $5,670.26 $7,656.82 $10,096.22 $12,765.72
Other equity $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
Total Liabilities +Equity $18,598.11 $22,209.14 $23,985.87 $25,904.74 $27,718.07 $29,658.33
Exhibit 1A: Financial Statement reasonableness tests (in millions)
Year ended Dec 31, year: 2005 2006 2007 2008 2009 2010
Free cash flow to firm, FCFF -$652.51 $770.73 $1,134.24 $1,691.44 $1,809.84
Free cash flow to equity, FCFE $1,115.58 $374.30 $456.64 $534.16 $582.38
Free cash flow to debt, FCFD $192.10 $272.98 $257.35 $227.28 $173.02
FCFE +FCFD $1,307.68 $647.28 $713.98 $761.43 $755.40
FCFF - (FCFE +FCFD) -$1,960.19 $123.45 $420.26 $930.00 $1,054.44
Continuous debt $2,881.39 $3,458.14 $3,460.14 $3,494.14 $3,487.14
Cumulative new debt (repayment) $2,607.76 $2,140.31 $1,484.11 $269.79 -$1,045.49
Total debt $5,938.51 $5,598.45 $4,944.25 $3,763.93 $2,441.65
Total equity $9,482.37 $11,056.10 $13,042.66 $15,482.06 $18,151.56
BV Debt/BV Equity 62.63% 50.64% 37.91% 24.31% 13.45%
BV Debt/BV Firm 38.51% 33.62% 27.49% 19.56% 11.86%
BV Equity/BV Firm 61.49% 66.38% 72.51% 80.44% 88.14%
PCFCFD/PVFCFE 78.81%
PVFCFD/PV Firm 44.08%
PVFCFE/PV Firm 55.92%
% increase in dividends 50.04% 26.23% 22.80% 9.43%
% increase in debt -5.73% -11.69% -23.87% -35.13%
% increase in equity 16.60% 17.97% 18.70% 17.24%
% increase in FCFE -66.45% 22.00% 16.98% 9.03%
% increase in FCFD 42.11% -5.73% -11.69% -23.87%
% increase in FCFF -218.12% 47.17% 49.12% 7.00%
Exhibit 2: Calculation of free cash flow to equity (FCFE), free cash flow to debt (FCFD), and free cash flow to the firm (FCFF) (in millions)
Year ended Dec 31, year: 2005 2006 2007 2008 2009 2010
Working Capital
Current assets - (excess cash +cash) $8,280.28 $9,499.90 $10,259.90 $11,080.69 $11,856.34 $12,686.28
Current liabilities - Debt in CL $4,718.12 $5,540.39 $5,983.62 $6,462.31 $6,914.67 $7,398.70
Net working capital (NWC)
$3,562.16 $3,959.51 $4,276.27 $4,618.38 $4,941.66 $5,287.58
Change in working capital (WCCF) $397.35 $316.76 $342.10 $323.29 $345.92
Net Investment Flow (NIF)
Change in net fixed assets (NFA) $1,036.67 $497.68 $537.50 $507.94 $543.49
(+) Depreciation $772.03 $833.79 $900.50 $963.53 $1,030.98
Change in Other Assets $450.44 $332.28 $358.86 $339.12 $362.86
Net investment flow (NIF) $2,259.14 $1,663.76 $1,796.86 $1,810.59 $1,937.33
Free Cash Flow To Equity (FCFE)
Net income $1,240.42 $1,861.08 $2,349.29 $2,884.82 $3,156.92
(+) Depreciation $772.03 $833.79 $900.50 $963.53 $1,030.98
CFFO $201245 $269487 $324979 $384835 $418791 CFFO $2,012.45 $2,694.87 $3,249.79 $3,848.35 $4,187.91
(-)NIF $2,259.14 $1,663.76 $1,796.86 $1,810.59 $1,937.33
(-) WCCF $397.35 $316.76 $342.10 $323.29 $345.92
Principal increase (repayment) in debt $1,759.62 -$340.06 -$654.20 -$1,180.32 -$1,322.28
Change in excess cash $0.00 $0.00 $0.00 $0.00 $0.00
Free cash flow to equity (FCFE) $1,115.58 $374.30 $456.64 $534.16 $582.38
Free Cash To Debt (FCFD)
(+) Interest on total interest bearing debt $192.10 $272.98 $257.35 $227.28 $173.02
Free cash to debt (FCFD) $192.10 $272.98 $257.35 $227.28 $173.02
Free Cash Flow To Firm (FCFF)
Earnings before interest and taxes (EBIT) $1,742.00 $2,711.32 $3,355.07 $4,046.64 $4,329.90
EBIT(1 - tax rate) $1,231.94 $1,917.45 $2,372.70 $2,861.78 $3,062.11
(+) Depreciation expense $772.03 $833.79 $900.50 $963.53 $1,030.98
Net operating flow (NOF) $2,003.98 $2,751.24 $3,273.20 $3,825.31 $4,093.09
(-) NIF $2,259.14 $1,663.76 $1,796.86 $1,810.59 $1,937.33
(+) WCCF $397.35 $316.76 $342.10 $323.29 $345.92
Free cash flow to firm (FCFF) -$652.51 $770.73 $1,134.24 $1,691.44 $1,809.84
Exhibit 3: Valuation of FCFE and FCFD ($ in millions), target Wd and Ws
Year ended Dec 31, year: 2005 2006 2007 2008 2009 2010
Cost of Equity (Ks) 6.9%
Growth rate in FCFE, end year 5 to inf. 3.2%
Implied Growth Rate FCFE
Free cash flows to equity (FCFE) $1,115.58 $374.30 $456.64 $534.16 $582.38
Terminal value: (1+g)/(Ks - g) x $582.38 $0.00 $0.00 $0.00 $0.00 $16,243.69
Total: FCFE +terminal value of FCFE $1,115.58 $374.30 $456.64 $534.16 $16,826.07
Present value of free cash flows to equity $2,571.12
Present value of terminal value $11,635.80
Present value of free cash flows to equity $14,206.92
Cost of Debt (Kd) 6.5%
Growth in free cash flow to debt (FCFD) 3.2%
Free cash flows to debt (FCFD) $192.10 $272.98 $257.35 $227.28 $173.02
Terminal value: (1+g)/(Kd - g) x $173.02 $0.00 $0.00 $0.00 $0.00 $12,783.29
$ $ $ $ $ Total: FCFD +terminal value of FCFD $192.10 $272.98 $257.35 $227.28 $12,956.31
Present value of cash flows to debt $986.14
Present value of terminal value $10,210.59
Present value of free cash flows to debt $11,196.72
Present value of the firm (Value of equity + debt) $25,403.64
Weighted average cost of capital (WACC) = (target Wd) x Kd x (1 - Tax rate) +(target Ws) x Ks
Wd [target] 20.0%
Kd 6.5%
(1 - T) 70.7%
Ws [target] 80.0%
Ks 6.9%
Debt portion 14.28%
Equity portion 85.72%
WACC 6.439%
Exhibit 4: Valuation of FCFF using WACC from Exhibit 3 ($ in millions), target Wd and Ws
Year ended Dec 31, year: 2005 2006 2007 2008 2009 2010
WACC, Exhibit 3 (Kf) 6.439%
Implied terminal growth rate of FCFF 0.3% 20.0%
Free cash flows to the firm (FCFF) -$652.51 $770.73 $1,134.24 $1,691.44 $1,809.84
Terminal value: (1+g)/(Kf - g) x $1,809.84 $0.00 $0.00 $0.00 $0.00 $29,719.11
Total: FCFF +terminal value of FCFF -$652.51 $770.73 $1,134.24 $1,691.44 $31,528.95
Present value of free cash flows to firm $3,650.37
Present value of terminal value $21,753.27
Present value of free cash flows to firm (FCFF) $0.00 $25,403.64
Exhibit 5: Valuation of FCFF using WACC from Exhibit 3 ($ in millions), market Wd and Ws
Year ended Dec 31, year: 2005 2006 2007 2008 2009 2010
WACC, Exhibit 5 (Kf) 5.885% $0.15
Implied terminal growth rate 0f FCFF -0.4%
Free cash flows to the firm (FCFF) -$652.51 $770.73 $1,134.24 $1,691.44 $1,809.84
Terminal value: (1+g)/(Kf - g) x $1,809.84 $0.00 $0.00 $0.00 $0.00 $28,844.33
Total: FCFF +terminal value of FCFF -$652.51 $770.73 $1,134.24 $1,691.44 $30,654.17
Present value of free cash flows to firm $3,732.03
Present value of terminal value $21,671.61
Present value of free cash flows to firm $25,403.64
Weighted average cost of capital (WACC) = (market Wd) x Kd x (1 - Tax rate) +(market Ws) x Ks
Wd [market = D/V] 44.1%
Kd 6.5%
(1 - T) 70.7%
Ws [market = E/V] 55.9%
Ks 6.9%
Debt portion (D/V) 34.43%
Equity portion (E/V) 65.57%
WACC 5.885%
Exhibit 6: Comparisons, Exhibits 3 and 4 ($ in millions)
Exhibit #
Target of
valuation
PV of
Cashflows
FCF in 5th year
of forecast
TV growth (%)
Terminal
Value
PV of
Terminal
Value
Sum of PV of
CF and PV of
TV
(1) (2) (3) (4) (5) (6) (7=6/(1+r)^5) (8=7+3)
Exhibit 3 EQUITY $2,571.12 $582.38 3.20% $16,243.69 $11,635.80 $14,206.92
Exhibit 3 DEBT $986.14 $173.02 3.20% $12,783.29 $10,210.59 $11,196.72
Exhibit 3 FIRM $3,557.26 $755.40 $21,846.39 $25,403.64
Exhibit 3 FIRM $3,557.26 $755.40 4.57% $57,658.08 $43,320.24 $46,877.50
Exhibit 4 FIRM $3,650.37 $1,809.84 0.33% $29,719.11 $21,753.27 $25,403.64
Exhibit 4 FIRM $3,650.37 $1,809.84 3.20% $57,658.08 $42,203.54 $45,853.91
Exhibit 5 FIRM $3,732.03 $1,809.84 -0.37% $28,844.33 $21,671.61 $25,403.64
Exhibit 5 FIRM $3,732.03 $1,809.84 3.20% $69,566.16 $52,267.14 $55,999.17