Forecasting and Valuation of Free Cash Flows

Arzac, Chapter 2

Firm Valuationhistorical financial statements forecast period

opportunity costs of capitalmarket value weight

make assumptions for continuation value

use formula to get value

check different scenarios

DCF valuation - incorporates estimates of FCF for set number of years with calculation of continuation value at end

multiples approach – comparable companies or comparable transactions

Firm Valuation

determine key performance (sales growth, profitability, and FCF generation) drivers:◦ internal drivers◦ external drivers

FCF – cash generated by firm after paying all cash operating expenses and associated taxes and funding capex and working capital but prior to payment of any interest expense◦ independent of capital structure – cash available

to all capital providers (debt and equity holders)

Projecting FCF

historical performance projection period length alternative cases projecting performance without

management guidance◦ public companies – you can use consensus

research estimates for financial statistics to get basis to begin

◦ private companies – need to use historical performance, sector trends, and consensus estimates for similar public firms

Projecting FCF

source top line projections for first 2 or 3 years from consensus estimates if public or public peers if private◦ derive growth rate in later years from alternative sources –

where????◦ growth rate if no guidance◦ cyclical firms◦ sanity check◦ COGS and SG&A – historical COGS (gross margin) and SG&A

(% of sales) usually hold constant as % of sales in later years

EBITDA and EBIT – if we model DCF using EBITDA then we don’t need detail for COGS and SG&A◦ instead focus on NWC and how it changes as a % of sales

Projecting Sales and EBITDA

start with NI add net interest expense after tax to get

unlevered NI◦ (1-T)(Int. Exp. – Int. Inc.) = Unlevered NI

add back changes in deferred taxes and depreciation◦ noncash◦ ↑ def taxes is source of cash◦ depreciation can include all noncash charges deducted from

EBIT except for goodwill

FCF Calculation

deferred taxes + unlevered NI = NOPAT depreciation to NOPAT = Gross CF

◦ total CF given off by firm Gross CF – Gross Inv. = FCF (operations)

◦ Gross Investment = increase in NWC + capital expenditures (funds used to purchase,

improve, expand, or replace physical assets) + investment in goodwill + increase in net other assets

FCF Valuation

Exhibit 2.1. AdvPak Technologies. Historical Data and Forecasting Assumptions($000) Historical Forecast for Fiscal Years Ending 12/31

2006 2007 2008 2009 2010 2011Operations:Unit Sales Growth 5.4% 6.0% 6.0% 5.6% 5.6% 5.1%Price Growth 2.0% 2.3% 2.3% 2.3% 2.3% 2.3% Growth Rate of Sales 7.5% 8.4% 8.4% 8.0% 8.0% 7.5%

Cost of Sales (Excl. Dep. & Amort.) as % of Sales 81.8% 79.0% 77.5% 77.5% 77.5% 77.5%Selling, General & Administrative as % of Sales 7.4% 7.0% 7.0% 7.5% 7.5% 7.5%Research & Development as % of Sales 0.9% 1.0% 1.0% 1.0% 1.0% 1.0%EBITDA as % of Sales 9.8% 13.0% 14.5% 14.0% 14.0% 14.0% Growth Rate 8.5% 44.2% 21.0% 4.3% 8.0% 7.5%

Capital Expenditures and Depreciation:Capital Expenditures (net of Disposals) 16,100 11,380 17,771 19,437 22,046 22,807Net Property, Plant & Equipment (PP&E) 80,414 81,018 86,658 91,857 98,617 105,129 % of Sales 39.50% 36.70% 36.20% 35.52% 35.30% 35.00%Book Depreciation 10,695 10,775 12,132 14,238 15,286 16,295 % of Net PP&E 13.3% 13.3% 14.0% 15.5% 15.5% 15.5%Tax Depreciation 11,740 11,829 12,999 14,973 16,075 17,136 % of Net PP&E 14.6% 14.6% 15.0% 16.3% 16.3% 16.3%

Working Capital:Cash balance as % of Sales 1.7% 1.6% 1.6% 1.6% 1.6% 1.6%Accounts Receivable as % of Sales 8.9% 8.9% 8.9% 8.9% 8.9% 8.9% Days Receivable 32 32 32 32 32 32Inventories as % of Cost of Sales 15.1% 15.1% 15.1% 15.1% 15.1% 15.1% Inventory Days on hand 55 55 55 55 55 55Other Current Assets as % of Sales 0.35% 0.35% 0.35% 0.35% 0.35% 0.35%

Accounts Payable as % of Cost of Sales 10.6% 10.8% 10.8% 10.8% 10.8% 10.8% Days Payable 39 39 39 39 39 39Accrued Expenses as % of Sales 1.15% 1.15% 1.15% 1.15% 1.15% 1.15%Tax Payable as % of Current Income Tax 0.37% 0.37% 0.37% 0.37% 0.37% 0.37%Other Current Liabilities as % of Sales 0.41% 0.41% 0.41% 0.41% 0.41% 0.41%

Debt, Interest, Dividends and Taxes:Short-term Debt & Curr. Portion of LTD as % of Total Debt 16.67% 16.67% 16.67% 16.67% 16.67% 16.67%Total Debt as a multiple of next year EBITDA 2.85 2.49 2.56 2.52 2.56 2.38Interest rate on debt 8.35% 8.35% 8.35% 8.35% 8.35%Interest rate on cash and marketable securities 4.61% 4.61% 4.61% 4.61% 4.61%Dividends paid 100% of excess cash and marketable securitiesTax rate on income 38.25% 38.25% 38.25% 38.25% 38.25% 38.25%

Exhibit 2.2. AdvPak Technologies. Pro-Forma Income Statements($000) Historical Forecast for Fiscal Years Ending 12/31

2006 2007 2008 2009 2010 2011Sales 203,580 220,758 239,386 258,605 279,368 300,369 Cost of Sales 166,592 174,399 185,524 200,419 216,510 232,786Gross Profit 36,988 46,359 53,862 58,186 62,858 67,583Sales, General & Administrative Expenses 15,164 15,453 16,757 19,395 20,953 22,528Research & Development 1,922 2,208 2,394 2,586 2,794 3,004EBITDA 19,901 28,699 34,711 36,205 39,112 42,052Depreciation 10,695 10,775 12,132 14,238 15,286 16,295EBIT 9,206 17,923 22,579 21,967 23,826 25,757Interest Expense 6,831 7,218 7,741 8,237 8,974Interest Income 157 163 176 191 206 Pretax Income 11,250 15,524 14,403 15,780 16,989 Current Income Tax 3,900 5,606 5,228 5,734 6,177 Deferred Tax 403 331 281 302 322Net Income 6,947 9,586 8,894 9,744 10,491

Exhibit 2.3. AdvPak Technologies. Pro-Forma Balance Sheets($000) Historical Forecast for Fiscal Years Ending 12/31

2006 2007 2008 2009 2010 2011AssetsCurrent: Cash and Marketable Securities 3,417 3,532 3,830 4,138 4,470 4,806 Accounts Receivable 18,119 19,647 21,305 23,016 24,864 26,733 Inventories 25,158 26,337 28,017 30,267 32,697 35,155 Other Current Assets 717 777 843 911 984 1,058 Total Current Assets 47,411 50,294 53,996 58,331 63,015 67,752

Property, Plant & Equipment 117,667 129,047 146,818 166,255 188,301 211,108Less: Depreciation 37,253 48,028 60,160 74,398 89,684 105,979 Net Property, Plant & Equipment 80,414 81,018 86,658 91,857 98,617 105,129

Other Noncurrent Assets: 9,352 9,352 9,352 9,352 9,352 9,352 Total Assets 137,177 140,665 150,006 159,540 170,984 182,233

LiabilitiesCurrent: Short-term Debt & Current Portion of LTD 13,632 14,405 15,449 16,439 17,910 17,910 Accounts Payable 17,659 18,835 20,037 21,645 23,383 25,141 Accrued Expenses 2,341 2,539 2,753 2,974 3,213 3,454 Taxes Payable 20 14 21 19 21 23 Other Current Liabilities 835 905 981 1,060 1,145 1,232 Total Current Liabilities 34,487 36,699 39,241 42,138 45,672 47,759Long-term Debt 68,162 72,027 77,246 82,194 89,548 97,626Deferred Income Taxes 1,209 1,612 1,943 2,224 2,526 2,848 Total Liabilities 103,859 110,338 118,430 126,556.48 137,746 148,233Common Stock and Retained Earnings 33,319 30,327 31,576 32,983 33,237 34,000 Total Liabilities and Net Worth 137,177 140,665 150,006 159,540 170,984 182,233

Exhibit 2.4. AdvPak Technologies. Pro-Forma Cash Flow Statements($000) Historical Forecast for Fiscal Years Ending 12/31

2006 2007 2008 2009 2010 2011Funds from Operating Activities Net Income 6,947 9,586 8,894 9,744 10,491 Depreciation 10,775 12,132 14,238 15,286 16,295 Deferred Tax 403 331 281 302 322 Decrease (Increase) in Current Assets (2,768) (3,404) (4,028) (4,351) (4,401) Increase (Decrease) in Current Liabilities except debt 1,439 1,498 1,907 2,064 2,087 Decrease (Increase) in Net Working Capital (1,330) (1,905) (2,121) (2,287) (2,314) Funds From Operations 16,796 20,144 21,292 23,044 24,793

Funds for Investment Capital Expenditures 11,380 17,771 19,437 22,046 22,807

Funds to (from) Financing Decrease (Increase) in Debt (4,638) (6,262) (5,939) (8,824) (8,078) Dividends 9,939 8,337 7,486 9,490 9,728 Total Funds to (from) Financing 5,301 2,075 1,547 666 1,650 Increase (Decrease) in Cash 115 298 308 332 336End-of-Year Cash & Marketable Securities 3,417 3,532 3,830 4,138 4,470 4,806

Actual Required cash balance ………………...…… 3,417 3,532 3,830 4,138 4,470 4,806 Excess cash ………………………………….. 0.000 0.000 0.000 0.000 0.000 0.000 Increase in Net Debt 4,523 5,964 5,631 8,492 7,742Net debt 4,523 5,964 5,631 8,492 7,742

78,378 82,901 88,865 94,496 102,988 110,730

Financial Flows

includes all interest-earning or interest-paying financial securities and equity◦ independent estimate from FCF◦ must be equal to FCF (good check!)

∆ excess marketable securities - AT interest income + ↓ debt + AT interest expense + dividends + share repurchases −−−−−−−−−−−−−−−−−−−−−−−−−−−−− Total Financial Flow = Total FCF

forecast financial statements◦ consistency◦ compare with analysts ?

common forecasting error “plugs” for building balance sheet calculate FCF for set number of years

◦ how long?

Estimating FCF

Estimating FCF

Continuation Value◦ idea is that over time most firms regress to industry norm◦ estimate FCFs over period of “competitive advantage”

relative to industry and then make growth assumptions with firm converging to industry norm – i.e., constant growth

gWACC

rggNOPATV

TCV

)]/(1)[1(

0

Estimating FCF

WACC

NOPATV

NN

1

assumption that competition drives return on invested capital in LR to equal WACC

perpetuity model◦ growth rate in CF not relevant because no value

creation discount VN back to time 0 (discount

using?)

Estimating FCF

value driver model◦ dominant firm in industry – Microsoft, Coca-Cola◦ potential to earn high returns on invested capital for

very long time◦ discount to get value at T=0

gWACC

rgNOPATV

N

N

)/1(1

Miller and Modigliani M&M Proposition I – The market value of any

firm is independent of its capital structure and is given by capitalizing its expected return at a rate appropriate to its risk class.

tax shield on debt and changes resulting now consider bankruptcy costs

Miller and Modigliani VL = VU + tCB where B is the market value of

the bonds (B=kDD/kb) so the value of a levered firm is equal to the

value of an unlevered firm plus the PV of the tax shield from debt

in an M&M world with no taxes (tc=0), VL = VU which is prop. I (the method of financing is irrelevant)

Cost of Equity and Leverage

return on assets to firm is equal to return on a portfolio of its net debt and equity claims

beta coefficient of firm’s levered assets:βA = (D/D+E)βD + (E/D+E)βE

so βE = (1+D/E)βA – (D/E)βD* βE = (1+D/E)βU – (D/E)βD*** βE = (1+D/E)βU***

Exhibit 3.8. Cost of Equity of AdvPak Technologies (as of December 2006)

10-year U.S. Treasury bond yield = 4.62% Market risk premium = 4.36%

CAPMMarket Adjusted Net Debt-to- Unlevered Cost of Size Cost of

Equity2Beta Beta Debt1 Equity Beta3

Equity Premium4 Equity

Buckeye Technologies 451.0 0.90 0.934 511.0 1.13 0.438 8.7% 3.90% 12.6% Caraustar Inc. 233.0 1.42 1.277 268.0 1.15 0.594 10.2% 3.90% 14.1% Glatfelter Co. 694.0 1.24 1.158 401.0 0.58 0.734 9.7% 1.80% 11.5% Rock-Tenn Company 992.0 1.14 1.092 789.0 0.80 0.608 9.4% 1.80% 11.2% Wausau Paper. 761.0 1.25 1.165 152.0 0.20 0.971 9.7% 1.80% 11.5% Mean 0.669 Median 0.608 AdvPak Technologies, Inc. 145.6 0.936 0.54 0.608 8.70% 3.90% 12.6%

AdvPak's cost of equity = riskless rate + market risk premium x beta + size premium = 4.62% +4.36% x 0.936 + 3.90% = 12.6%

Notes:

1. Book interest bearing debt minus cash in $ million.

2. Shares outstanding times share price in $ million.

3. Beta unlevered according to (3.15).

4. From Exhibit 3.6.

Other Components of Capital Structure equity

◦ size premium◦ three factor model

SMB HML liquidity

investment grade debt high yield debt convertible debt

WACC =

(rd x (1–t)) x (D/(D+E)) + re x (E/(D+E))

Weighted Average Cost of Capital

Exhibit 2.5. AdvPak Technologies. Enterprise Valuation as of 12/31/2006($000)

Year-end 2006 2007 2008 2009 2010 2011

Net Income 6,947 9,586 8,894 9,744 10,491Net Interest after Tax 4,121 4,357 4,671 4,969 5,414Unlevered net income 11,068 13,942 13,565 14,713 15,905Change in deferred taxes 403 331 281 302 322NOPAT 11,470 14,274 13,846 15,014 16,226Depreciation 10,775 12,132 14,238 15,286 16,295Change in Net Working Capital (1,330) (1,905) (2,121) (2,287) (2,314)Capital Expenditures (11,380) (17,771) (19,437) (22,046) (22,807)Free cash flow 9,537 6,729 6,526 5,966 7,400.3

ValuationWACC 10.03%PV{FCF} @ WACC 27,783 Continuation growth rate 7.52%Continuation value 316,370PV{Continuation value} @ WACC 196,153 Enterprise value 223,936

Free Cash Flows 2007-2011EBIT Path

($000) 2007 2008 2009 2010 2011EBIT 17,923 22,579 21,967 23,826 25,757 Tax on EBIT @ 38.25% 6,856 8,636 8,402 9,113 9,852 Unlevered Net Income 11,068 13,942 13,565 14,713 15,905 Change in deferred taxes 403 331 281 302 322NOPAT 11,470 14,274 13,846 15,014 16,226Depreciation 10,775 12,132 14,238 15,286 16,295Change in Net Working Capital (1,330) (1,905) (2,121) (2,287) (2,314)Capital Expenditures (11,380) (17,771) (19,437) (22,046) (22,807)Free cash flow 9,537 6,729 6,526 5,966 7,400

AdvPak Technologies, Inc. Cost of Capital Calculation

Levered Unlevered

Long-term government bond yield 4.62% 4.62%Market equity premium 4.36% 4.36%Beta coefficient 0.9361 0.6085Cost of equity before small cap premium 8.70% 7.27%Small capitalization premium 3.90% 3.90%AdvPak Technologies cost of equity 12.60% 11.17%Cost of debt 8.52%Corporate tax rate 38.25%Debt ratio 35.00%WACC 10.03%

Exhibit 2.6. AdvPak Technologies Value Table ($000)

Growth Rate7.0% 7.5% 8.0% 8.0%

9.50% 229,340 283,060 366,605 366,605 WACC 10.03% 189,690 223,936 271,616 271,616

10.50% 164,798 189,394 221,525 221,525 10.00% 191,692 226,797 275,933 275,933 12.00% 116,376 127,231 139,891 139,891

Exhibit 2.7. AdvPak Technologies Implied EBITDA Multiples from Continuation Value Estimates

Growth Rate7.0% 7.5% 8.0% 8.0%

9.50% 7.0 8.9 11.7 11.73 WACC 10.03% 5.8 7.0 8.7 8.66

10.50% 5.0 5.9 7.0 7.04 10.0% 5.87 7.09 8.80 8.80 12.0% 3.52 3.93 4.40 4.40

Exhibit 2.8. AdvPak Technologies. Free Cash Flow Decomposition($000)

2007 2008 2009 2010 2011Net Income 6,947 9,586 8,894 9,744 10,491 Depreciation 10,775 12,132 14,238 15,286 16,295 Deferred Tax 403 331 281 302 322 Decrease in Net Working Capital (1,330) (1,905) (2,121) (2,287) (2,314) Capital Expenditures (11,380) (17,771) (19,437) (22,046) (22,807) Increase in Net debt 4,523 5,964 5,631 8,492 7,742 Cash flow to equity holders 9,939 8,337 7,486 9,490 9,728

Net Interest after Tax 4,121 4,357 4,671 4,969 5,414 Increase in Net Debt (4,523) (5,964) (5,631) (8,492) (7,742) Cash flow paid to debtholders, after tax (402) (1,607) (960) (3,524) (2,328) Free cash flow to all security holders 9,537 6,729 6,526 5,966 7,400

Exhibit 2.9. AdvPak Technologies. Equity Valuation as of 12/31/2006($000)

2002 2003 2004 2005 2006 2007

Free cash flow to equity 9,939 8,337 7,486 9,490 9,728Cost of equity 12.60%Continuation value growth rate 7.5%Continuation value 205,729PV of equity cash flows 31,923PV of continuation value 113,652Equity value 145,575

Exhibit 2.10. AdvPak Technologies. Net Debt Valuation as of 12/31/2006($000) 2002 2003 2004 2005 2006 2007

Free cash flow to net debt (402) (1,607) (960) (3,524) (2,328)Cost of net debt after taxes 5.26%Net debt balance in 2007 110,730PV of net debt cash flows (7,327) PV of net debt balance 85,689 Net debt value 78,361

GCL Industries is an industrial conglomerate undergoing restructuring. As part of its restructuring program GCL is considering the sale of its low-growth Fleet Meat Packing unit. Fleet is in the high volume-low margin meatpacking business. Fleet’s volume sales are not expected to increase in the future and the long-term growth of dollar sales is projected at 3% per year. Operating projections and other pertinent data are presented below. Estimate the price GCL may get for Fleet as of January 1, 2008.

Problem 2.4

Projections for 2.4

Fleet Meat Packing Co., 2008-2012 Projection

Actual Forecast2007 2008 2009 2010 2011 2012

Sales 2223.2 2245.6 2284.2 2308.0 2550.0 2616.7EBITDA margin 2.55% 2.57% 2.65% 2.71% 2.71% 2.71%Depreciation 29.0 32.6 34.2 32.9 32.0 31.5Increase in deferred taxes 0.5 1.6 2.2 2.9 2.5 2.5CAPEX + Net WC increase 38.7 41.8 42.2 33.4 32.5 32.5

Corporate tax rate: 38% GCL estimates that the buyer can finance the acquisition with 50%

debt that can be raised at 7%. The beta of companies in Fleet’s industry with similar capital

structures is 1.32. The yield on 10-year Treasury notes is 4.5%, the equity risk premium is about 4.4% and the micro-cap size premium is about 3.9%.

Valuation multiple: An examination of comparable companies yielded an average EBITDA multiple equal to 6 times current (2007) EBITDA.

WACC (%)Weight Before-tax After-tax Weighted

cost cost costDebt 50% 7.00% 4.34% 2.17%Equity 50% 14.21% 14.21% 7.10%WACC 9.27%Cost of equity = 4.5% + (1.32)(4.4%) + 3.9% = 14.21%

TPI Inc., a manufacturer of computer storage devices, is planning to go public at the end of 2007. The purpose of the initial public offering is to retire debt and liquefy the position of some of its original investors. Future growth will be financed by TPI’s internally generated CF and the additional borrowing made possible by the expected increase in the company debt capacity. The company has put together the following projections:

Problem 2.7

Projections for TPITPI Projections($ millions) 2008 2009 2010 2011 2012

EBIT 24.8 28.0 32.0 34.0 37.0Depreciation 5.8 7.6 9.2 10.2 11.0Increase in deferred taxes 0.8 0.6 0.7 0.7 1.0CAPEX 18.2 12.2 14.3 14.3 12.0NWC change -0.8 -0.8 1.0 1.8 0.0

After 2012, EBIT is expected to grow at 7% per year, capital expenditures will equal depreciation and working capital will be self-financed.

Currently TPI has net debt of $112m, but its CFO has already negotiated retiring $53m with the proceeds of the equity issue and refinancing the rest at 7.86%. As a consequence, TPI is expected to begin 2008 with its net debt reduced to about $59m and its interest coverage ratio increased to about 5.99. The CFO plans to maintain the coverage ratio at that level afterwards and expects to raise future debt at an interest rate of about 8%. As far as the debt ratio is concerned, the goal is to keep it at 26% of enterprise value. The CFO believes that debt ratio would be consistent with the target coverage ratio.

TPI’s corporate tax rate is 38%. Its cost of equity is estimated accounting for risk and its relatively small size (its beta for the planned capital structure equals 2.0, Treasury yield is 4.5%, equity premium is 4.4%, and micro-cap size premium is 3.9%.) TPI has issued 10 million shares to its present owners and plans to issue 5 million new shares in the IPO, bringing the total number of shares outstanding to 15 million.

On the basis of the share prices of recent IPOs and other companies in the industry and the growth prospects of TPI, the investment bankers have suggested a preliminary IPO price based upon a P/E multiple of 13-14 times 2008 earnings. Underwriter fees are expected to be 5% of gross proceeds and additional issue expenses to amount to $600,000.

Estimate the value of TPI’s share of common equity.