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Investment VI
Company valuation
6 - 2
Forecast
FCF
Estimate Cost
of Capital
Estimate
Continuation
Value
Overall Valuation
Company Valuation
historical financial statements
forecast period
opportunity costs of
capital
market value weight
make assumptions
for continuation value
use formula to get
value

check different
scenarios

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Statements
Balance sheet
Income statement
Statement of cash flows
Historical Financial
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Income Statement
2010 2011
Sales 3,432,000 5,834,400
COGS 2,864,000 4,980,000
Other expenses 340,000 720,000
Deprec. 18,900 116,960
Tot. op. costs 3,222,900 5,816,960
EBIT 209,100 17,440
Int. expense 62,500 176,000
EBT 146,600 (158,560)
Taxes (40%) 58,640 (63,424)
Net income 87,960 (95,136)
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Balance Sheet: Assets
2010 2011
Cash 9,000 7,282
S-T invest. 48,600 20,000
AR 351,200 632,160
Inventories 715,200 1,287,360
Total CA 1,124,000 1,946,802
Gross FA 491,000 1,202,950
Less: Depr. 146,200 263,160
Net FA 344,800 939,790
Total assets 1,468,800 2,886,592
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Statement of Retained Earnings: 2011
Balance of ret. earnings,
12/31/2002 203,768

Add: Net income, 2003 (95,136)

Less: Dividends paid, 2003 (11,000)

Balance of ret. earnings,
12/31/2003 97,632
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Balance Sheet: Liabilities & Equity
2010 2011
Accts. payable 145,600 324,000
Notes payable 200,000 720,000
Accruals 136,000 284,960
Total CL 481,600 1,328,960
Long-term debt 323,432 1,000,000
Common stock 460,000 460,000
Ret. earnings 203,768 97,632
Total equity 663,768 557,632
Total L&E 1,468,800 2,886,592
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Statement of Cash Flows: 2011
Operating Activities
Net Income (95,136)
Adjustments:
Depreciation 116,960
Change in AR (280,960)
Change in inventories (572,160)
Change in AP 178,400
Change in accruals 148,960
Net cash provided by ops. (503,936)
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Long-Term Investing Activities
Cash used to acquire FA (711,950)

Financing Activities
Change in S-T invest. 28,600
Change in notes payable 520,000
Change in long-term debt 676,568
Payment of cash dividends (11,000)
Net cash provided by fin. act. 1,214,168
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Summary of Statement of CF
Net cash provided by ops. (503,936)
Net cash to acquire FA (711,950)
Net cash provided by fin. act. 1,214,168

Net change in cash (1,718)
Cash at beginning of year 9,000
Cash at end of year 7,282
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What are operating current assets?
Operating current assets are the CA
needed to support operations.
Op CA include: cash, inventory,
receivables.
Op CA exclude: short-term
investments, because these are
not a part of operations.
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What are operating current liabilities?
Operating current liabilities are the
CL resulting as a normal part of
operations.
Op CL include: accounts payable
and accruals.
Op CA exclude: notes payable,
because this is a source of
financing, not a part of operations.
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What effect did the expansion have on
net operating working capital (NOWC)?
NOWC
11
= ($7,282 + $632,160 + $1,287,360)
- ($324,000 + $284,960)
= $1,317,842.

NOWC
10
= $793,800.
= -
Operating
CA
Operating
CL
NOWC
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What effect did the expansion have on total
net operating capital (also just called
operating capital)?
= NOWC + Net fixed assets.


= $1,317,842 + $939,790
= $2,257,632.


= $1,138,600.
Operating
capital
11
Operating
capital
10
Operating
capital

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Did the expansion create additional net
operating profit after taxes (NOPAT)?
NOPAT = EBIT(1 - Tax rate)

NOPAT
11
= $17,440(1 - 0.4)
= $10,464.

NOPAT
10
= $125,460.
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What was the free cash flow (FCF)
for 2011?
FCF = NOPAT - Net investment in
operating capital
= $10,464 - ($2,257,632 - $1,138,600)
= $10,464 - $1,119,032
= -$1,108,568.

How do you suppose investors reacted?
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Stock Price and Other Data
2010 2010
Stock price $8.50 $2.25
# of shares 100,000 100,000
EPS $0.88 -$0.95
DPS $0.22 $0.11
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Forecasting FCF
Method:
Sales forecasts
Percent of sales method
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Steps in Financial Forecasting
Forecast sales
Project the assets needed to support
sales
Project internally generated funds
Project outside funds needed
Decide how to raise funds
See effects of plan on ratios and stock
price
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2011 Balance Sheet
(Millions of $)
Cash. $ 20 Accts. pay. &
accruals $ 100
Accounts rec. 240 Notes payable 100
Inventories 240 Total CL $ 200
Total CA $ 500 L-T debt 100
Common stk 500
Net fixed
assets
Retained
earnings 200
Total assets $1,000 Total claims $1,000

500
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2003 Income Statement
(Millions of $)
Sales $2,000.00
Less: COGS (60%) 1,200.00
Other costs 700.00
EBIT $ 100.00
Interest 10.00
EBT $ 90.00
Taxes (40%) 36.00
Net income $ 54.00
Dividends (40%) $21.60
Addn to RE $32.40
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AFN (Additional Funds Needed):
Key Assumptions
Operating at full capacity in 2011.
Each type of asset grows proportionally
with sales.
Payables and accruals grow proportionally
with sales.
2011 profit margin ($54/$2,000 = 2.70%)
and payout (40%) will be maintained.
Sales are expected to increase by $500
million.
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Projecting Pro Forma Statements with
the Percent of Sales Method
Project sales based on forecasted
growth rate in sales
Forecast some items as a percent
of the forecasted sales
Costs
Cash
Accounts receivable
(More...)
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Items as percent of sales (Continued...)
Inventories
Net fixed assets
Accounts payable and accruals
Choose other items
Debt
Dividend policy (which determines
retained earnings)
Common stock
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Implications of AFN
If AFN is positive, then you must
secure additional financing.
If AFN is negative, then you have
more financing than is needed.
Pay off debt.
Buy back stock.
Buy short-term investments.
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Percent of Sales: Inputs
COGS/Sales 60% 60%
SGA/Sales 35% 35%
Cash/Sales 1% 1%
Acct. rec./Sales 12% 12%
Inv./Sales 12% 12%
Net FA/Sales 25% 25%
AP & accr./Sales 5% 5%
2011 2012
Actual Proj.
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Other Inputs
Percent growth in sales 25%
Growth factor in sales (g) 1.25
Interest rate on debt 10%
Tax rate 40%
Dividend payout rate 40%
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2004 Forecasted Income Statement
2011 Factor
2012
1st Pass
Sales $2,000 g=1.25 $2,500.0
Less: COGS Pct=60% 1,500.0
SGA Pct=35% 875.0
EBIT $125.0
Interest
0.1(Debt
03
)
20.0
EBT $105.0
Taxes (40%) 42.0
Net. income $63.0
Div. (40%) $25.2
Add. to RE $37.8
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2004 Balance Sheet (Assets)
Forecasted assets are a percent of forecasted sales.
Factor
2004
Cas
h
Pct= 1%
$25.0
Accts. rec.
Pct=12%
300.0
Pct=12%
300.0
Total CA $625.0
Net FA
Pct=25%
625.0
Total assets $1,250.0
2004 Sales = $2,500
Inventories
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2004 Preliminary Balance Sheet (Claims)
*From forecasted income statement.
2011 Factor Without AFN
AP/accruals Pct=5% $125.0
Notes payable 100 100.0
Total CL $225.0
L-T debt 100 100.0
Common stk. 500 500.0
Ret. earnings 200 +37.8* 237.8
Total claims $1,062.8
2012
2012 Sales = $2,500
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Required assets = $1,250.0
Specified sources of fin. = $1,062.8
Forecast AFN = $ 187.2
What are the additional funds
needed (AFN)?
The company must have the assets to
make forecasted sales, and so it needs
an equal amount of financing. So, we
must secure another $187.2 of
financing.
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Assumptions about How AFN Will
Be Raised
No new common stock will be
issued.
Any external funds needed will be
raised as debt, 50% notes payable,
and 50% L-T debt.
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How will the AFN be financed?
Additional notes payable =
0.5 ($187.2) = $93.6.

Additional L-T debt =
0.5 ($187.2) = $93.6.
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2012 Balance Sheet (Claims)
w/o AFN AFN With AFN
AP/accruals $ 125.0 $ 125.0
Notes payable 100.0 +93.6 193.6
Total CL $ 225.0 $ 318.6
L-T debt 100.0 +93.6 193.6
Common stk. 500.0 500.0
Ret. earnings 237.8 237.8
Total claims $1,071.0 $1,250.0
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What are the forecasted
free cash flow and ROIC?
2003 2004(E)
Net operating WC $400 $500
(CA - AP & accruals)
Total operating capital $900 $1,125
(Net op. WC + net FA)
NOPAT (EBITx(1-T)) $60 $75
Less Inv. in op. capital $225

Free cash flow -$150
ROIC (NOPAT/Capital) 6.7%

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Value of Operations

=
+
=
1 t
t
t
Op
) WACC 1 (
FCF
V
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Nonoperating Assets
Marketable securities
Ownership of non-controlling
interest in another company
Value of nonoperating assets usually
is very close to figure that is reported
on balance sheets.
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Total Corporate Value
Total corporate value is sum of:
Value of operations
Value of nonoperating assets
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Claims on Corporate Value
Debtholders have first claim.
Preferred stockholders have the next
claim.
Any remaining value belongs to
stockholders.
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Applying the Corporate Valuation Model
Forecast the financial statements, as
shown.
Calculate the projected free cash flows.
Model can be applied to a company that
does not pay dividends, a privately held
company, or a division of a company,
since FCF can be calculated for each of
these situations.
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Data for Valuation
FCF
0
= $20 million
WACC = 10%
g = 5%
Marketable securities = $100 million
Debt = $200 million
Preferred stock = $50 million
Book value of equity = $210 million
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Value of Operations:
Constant Growth
Suppose FCF grows at constant rate g.
( )
( )

=
+
+
=
+
=
1 t
t
t
0
1 t
t
t
Op
WACC 1
) g 1 ( FCF
WACC 1
FCF
V
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Constant Growth Formula
Notice that the term in parentheses is
less than one and gets smaller as t
gets larger. As t gets very large,
term approaches zero.

=
|
.
|

\
|
+
+
=
1 t
t
0 Op
WACC 1
g 1
FCF V
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Constant Growth Formula (Cont.)
The summation can be replaced by a
single formula:
( )
( ) g WACC
) g 1 ( FCF
g WACC
FCF
V
0
1
Op

+
=

=
6 - 45
Find Value of Operations
( )
( )
420
05 . 0 10 . 0
) 05 . 0 1 ( 20
V
g WACC
) g 1 ( FCF
V
Op
0
Op
=

+
=

+
=
6 - 46
Value of Equity
Sources of Corporate Value
Value of operations = $420
Value of non-operating assets = $100
Claims on Corporate Value
Value of Debt = $200
Value of Preferred Stock = $50
Value of Equity = ?
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Value of Equity
Total corporate value = V
Op
+ Mkt. Sec.
= $420 + $100
= $520 million

Value of equity = Total - Debt - Pref.
= $520 - $200 - $50
= $270 million
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Expansion Plan: Nonconstant Growth
Finance expansion by borrowing $40
million and halting dividends.
Projected free cash flows (FCF):
Year 1 FCF = -$5 million.
Year 2 FCF = $10 million.
Year 3 FCF = $20 million
FCF grows at constant rate of 6%
after year 3.
(More)
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The weighted average cost of capital,
r
c
, is 10%.
The company has 10 million shares
of stock.
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Horizon Value Formula




Horizon value is also called terminal
value, or continuing value.
( ) g WACC
) g 1 ( FCF
V HV
t
t time at Op

+
= =
6 - 51
V
op
at 3
Find the value of operations by discounting
the free cash flows at the cost of capital.
0
-4.545
8.264
15.026
398.197
1 2 3 4
r
c
=10%
416.942 = V
op
g = 6%
FCF= -5.00 10.00 20.00 21.2
$21.2
. .
$530.
10 0 06
=

=
0
6 - 52
Find the price per share of common
stock.
Value of equity = Value of operations
- Value of debt
= $416.94 - $40
= $376.94 million.

Price per share = $376.94 /10 = $37.69.