Valuation 방법

*Managing for Value Creation(Summer 2006)

Class #1b OutlineReviewClass #1aLectureOverview of business valuationClass discussionEskimo Pie Corp. Case

Overview of Business ValuationBasic Inc. CaseBusiness valuation in a perfect world

Business ValuationValuation MethodRelevant Cash flowAppropriate Discount Rate

Basic, Inc. (the setup)Investors have raised $600m to start Basic, Inc. ($317.44m in 9% bonds and the balance in equity).Basic is expected to produce $500m in sales annually with net income of $50m forever. All the firms net income will be paid in dividends.Annual Capex = depreciation expense and NWC does not change.No debt is issued or retired.

Finite

YearEquity Cash FlowDebt Cash FlowOperating Cash Flow

1998502070

1999543690

20005743100

20016169130

20026674140

20037080150

20047585160

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$247.94$305.91$553.84

Kwacc10.1947%

Entity Value$551.58

Exhibit 5.7

ROIC15.00%

growth (NOPLAT)6.00%

Investment Rate40.00%

Kwacc10.00%

Firm Value$1,118.61

NOPLATNet InvestmentFree Cash Flow

Year100

1106.0042.4063.60

2112.3644.9467.42

3119.1047.6471.46

4126.2550.5075.75

5133.8253.5380.29

6141.8556.7485.11

7150.3660.1590.22

8159.3863.7595.63

9168.9567.58101.37

10179.0871.63107.45

11189.8375.93113.90

12201.2280.49120.73

13213.2985.32127.98

14226.0990.44135.65

15239.6695.86143.79

16254.04101.61152.42

17269.28107.71161.57

18285.43114.17171.26

19302.56121.02181.54

20320.71128.29192.43

21339.96135.98203.97

22360.35144.14216.21

23381.97152.79229.18

24404.89161.96242.94

25429.19171.67257.51

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Infinite

Equity Cash FlowDebt Cash FlowOperating Cash Flow

Perpetuity502070

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$333.33$317.46$650.79

Kwacc10.7561%

Entity Value$650.79

Cost of Capital Calculation: Market Values

Source of CapitalProportionAfter-tax CostProduct

Debt0.48780.06300.0307

0.51220.15000.0768

0.1076

Cost of Capital Calculation: Book Values


Debt0.52910.06300.0333

Equity (book)0.47090.15000.0706

0.1040

Total Book Assets600

673.28

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FreeCashFlows

Assumptions:

Cost of Equity15.00%

Cost of debt, Kd9.00%Debt is perpetual

CAPEX$10.00All cash flows are level perpetuals

Depreciation Expense$10.00Current market rate of interest = the interest rate on debt.

Tax Rate30%Dividend payout = 100%

Dividends = Net Income$50.00

Balance Sheet

Assets$600.00

Debt$317.44

Equity282.56

Debt + Equity$600.00

Income StatementCalculation of Firm Free Cash Flow

Revenues$500.00

less: COGS(300.00)

Gross Profit200.00

less Operating Expense(100.00)EBIT100.00

EBIT100.00less: Taxes(30.00)

less: Interest(28.57)NOPAT70.00

EBT71.43plus: Depr.10.00

less: Taxes(21.43)less: CAPEX(10.00)

NI$50.00Firm FCF70.00

Calculation of Equity Free Cash Flow

NI50.00EFCF50.00

plus: Depreciation Expense10.00plus: Int(1-T)20.00

less: CAPEX(10.00)Firm FCF70.00

Equity Free Cash Flow50.00

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MVA-EVA Analysis

Tax Rate30%

EBIT100.00

Kwacc10.76%

Invested Capital600.00

NOPAT = EBIT(1-T)70.00

EVA = NOPAT - Kwacc x Invested Capital5.46

MVA = EVA / Kwacc50.79

Firm Value = MVA + Invested Capital650.79

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Business Valuation

Equity Free Cash FlowNet IncomePlus: Depreciation ExpenseLess: Debt RepaymentPlus: New debt issuedLess: Investment in Working CapitalLess: Capital Expenditures (Capex)Equals: Equity Free Cash Flow (EFCF)

EFCF CalculationRecall that there are no new debt issues nor is debt retired and NWC does not change.

Finite


1998502070

1999543690

20005743100

20016169130

20026674140

20037080150

20047585160

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$247.94$305.91$553.84

Kwacc10.1947%

Entity Value$551.58

Exhibit 5.7

ROIC15.00%



Kwacc10.00%

Firm Value$1,118.61


Year100

1106.0042.4063.60

2112.3644.9467.42

3119.1047.6471.46

4126.2550.5075.75

5133.8253.5380.29

6141.8556.7485.11

7150.3660.1590.22

8159.3863.7595.63

9168.9567.58101.37

10179.0871.63107.45

11189.8375.93113.90

12201.2280.49120.73

13213.2985.32127.98

14226.0990.44135.65

15239.6695.86143.79

16254.04101.61152.42

17269.28107.71161.57

18285.43114.17171.26

19302.56121.02181.54

20320.71128.29192.43

21339.96135.98203.97

22360.35144.14216.21

23381.97152.79229.18

24404.89161.96242.94

25429.19171.67257.51

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Infinite


Perpetuity502070

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$333.33$317.46$650.79

Kwacc10.7561%

Entity Value$650.79



Debt0.48780.06300.0307

0.51220.15000.0768

0.1076



Debt0.52910.06300.0333

Equity (book)0.47090.15000.0706

0.1040


673.28

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FreeCashFlows

Givens:


CAPEX10.00All cash flows are level perpetuals

Depreciation Expense10.00Current market rate of interest = the interest rate on debt.


Balance Sheet

Assets600.00

Debt317.46

Equity282.54

Debt + Equity600.00

Income Statement

Revenues500.00

less: COGS(300.00)Calculation of Firm Free Cash Flow

Gross Profit200.00

less Operating Expense(100.00)EBIT$100.00





NI50.00Firm FCF$70.00


NI$50.00

plus: Depreciation Expense10.00

less: CAPEX(10.00)

Equity Free Cash Flow$50.00

or

EFCF$50.00

plus: Int(1-T)20.00

Firm FCF$70.00

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MVA-EVA Analysis

Tax Rate30%

EBIT100.00

Kwacc10.76%






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Security ValuationDebt value

Equity value

Firm Value Firm Value = Debt Value + Equity Value

$650.77 = $317.44 + $333.33

Business Valuation

Firm Free Cash Flow (FFCF)Net Operating Income (NOI)Less: Taxes on Incremental NOIEquals: Net Operating Profit after TaxPlus: Depreciation ExpenseLess: Investment in Working CapitalLess: Capital Expenditures (Capex)Equals: (Firm) Free Cash Flow

How does FFCF compare to payments made to financial claimants?Financial Claimant:Payment:CreditorsAfter-tax interest plus principal payments less new debt issued.StockholdersCommon dividends plus share repurchases less new shares issued.

Free Cash Flow CalculationsFirm Free Cash Flow (FFCF)

Equity Free Cash Flow (EFCF)Used to value a levered firm or entity value and the equity of an unlevered firm.Used to value the common equity of a levered firm.

Finite


1998502070

1999543690

20005743100

20016169130

20026674140

20037080150

20047585160

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$247.94$305.91$553.84

Kwacc10.1947%

Entity Value$551.58

Exhibit 5.7

ROIC15.00%



Kwacc10.00%

Firm Value$1,118.61


Year100

1106.0042.4063.60

2112.3644.9467.42

3119.1047.6471.46

4126.2550.5075.75

5133.8253.5380.29

6141.8556.7485.11

7150.3660.1590.22

8159.3863.7595.63

9168.9567.58101.37

10179.0871.63107.45

11189.8375.93113.90

12201.2280.49120.73

13213.2985.32127.98

14226.0990.44135.65

15239.6695.86143.79

16254.04101.61152.42

17269.28107.71161.57

18285.43114.17171.26

19302.56121.02181.54

20320.71128.29192.43

21339.96135.98203.97

22360.35144.14216.21

23381.97152.79229.18

24404.89161.96242.94

25429.19171.67257.51

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Infinite


Perpetuity502070

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$333.33$317.46$650.79

Kwacc10.7561%

Entity Value$650.79



Debt0.48780.06300.0307

0.51220.15000.0768

0.1076



Debt0.52910.06300.0333

Equity (book)0.47090.15000.0706

0.1040


673.28

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FreeCashFlows

Givens:





Balance Sheet

Assets600.00

Debt317.46

Equity282.54

Debt + Equity600.00

Income Statement

Revenues500.00


Gross Profit200.00

less Operating Expense(100.00)Net Operating Income (NOI)$100.00





NI50.00Firm Free Cash Flow (FFCF)$70.00


Net Income (NI)$50.00


less: CAPEX(10.00)

Equity Free Cash Flow (EFCF)$50.00

or

EFCF$50.00

plus: Int(1-T)20.00

FFCF$70.00

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MVA-EVA Analysis

Tax Rate30%

EBIT100.00

Kwacc10.76%






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Basic, Inc.s WACCFinancing proportions are based on market values calculated earlier!

Finite


1998502070

1999543690

20005743100

20016169130

20026674140

20037080150

20047585160

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$247.94$305.91$553.84

Kwacc10.1947%

Entity Value$551.58

Exhibit 5.7

ROIC15.00%



Kwacc10.00%

Firm Value$1,118.61


Year100

1106.0042.4063.60

2112.3644.9467.42

3119.1047.6471.46

4126.2550.5075.75

5133.8253.5380.29

6141.8556.7485.11

7150.3660.1590.22

8159.3863.7595.63

9168.9567.58101.37

10179.0871.63107.45

11189.8375.93113.90

12201.2280.49120.73

13213.2985.32127.98

14226.0990.44135.65

15239.6695.86143.79

16254.04101.61152.42

17269.28107.71161.57

18285.43114.17171.26

19302.56121.02181.54

20320.71128.29192.43

21339.96135.98203.97

22360.35144.14216.21

23381.97152.79229.18

24404.89161.96242.94

25429.19171.67257.51

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Infinite


Perpetuity5019.99969.999

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$333.33$317.44$650.78

Kwacc10.7562%

Entity Value$650.78



Debt0.48780.06300.0307

Equity0.51220.15000.0768

WACC10.76%



Debt0.52910.06300.0333

Equity (book)0.47090.15000.0706

0.1040


673.27

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FreeCashFlows

Givens:





Balance Sheet

Assets600.00

Debt317.46

Equity282.54

Debt + Equity600.00

Income Statement

Revenues500.00


Gross Profit200.00






NI50.00Firm FCF70.00


NI50.00


less: CAPEX(10.00)


or

EFCF50.00

plus: Int(1-T)20.00

Firm FCF70.00

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MVA-EVA Analysis

Tax Rate30%

EBIT100.00

Kwacc10.76%






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Entity Valuation

EVA, MVA and Firm ValueEconomic Value Added (EVA)EVA = NOPAT - Kwacc x Invested Capital= $70 - .1076 x $600 = $70.00 - 64.54 = $5.46Market Value Added (MVA) = PV(EVAs) MVA = $5.46/.1076 = $50.78Firm Value = MVA + Invested Capital = $50.78 + 600.00 = $650.78NPVfirm=Firm Value - Invested Capital = MVA

Business Valuation

Adjusted Present Value Model

Calculating Unlevered EFCFFirm Free Cash Flow (FFCF)Net Operating Income (NOI)Less: Taxes on Incremental NOIEquals: Net Operating Profit after TaxPlus: Depreciation ExpenseLess: Investment in Working CapitalLess: (Capex)Equals: (Firm) Free Cash FlowUnlevered Firms EFCFNet Operating Income (NOI)Less: Taxes on Incremental NOIEquals: Net Operating Profit after Tax and firm Net IncomePlus: Depreciation ExpenseLess: Investment in Working CapitalLess: (Capex)Equals: (Unlevered) Free Cash FlowNote that for the unlevered firm there is no new debt issued or retired.

APV Valuation for Basic Inc.Kd=rf+bd(Market Risk Premium).09 = .08 + bd(.07)bd = .14Vu = $70/.126 = $555.56VITS = ($28.57 x .3)/.09 = $95.24

Inputs and FreeCashFlows

Givens:





Beta coefficient1.00Levered Beta

Market risk premium7%

Risk free rate`8%

Balance Sheet

Assets600.00Cost of equity, Ke15%

Debt317.46

Equity282.54

Debt + Equity600.00

Income Statement

Revenues500.00


Gross Profit200.00








NI50.00


less: CAPEX(10.00)


or

EFCF50.00

plus: Int(1-T)20.00

Firm FCF70.00

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Finite


1998502070

1999543690

20005743100

20016169130

20026674140

20037080150

20047585160

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$247.94$305.91$553.84

Kwacc10.1947%

Entity Value$551.58

Exhibit 5.7

ROIC15.00%



Kwacc10.00%

Firm Value$1,118.61


Year100

1106.0042.4063.60

2112.3644.9467.42

3119.1047.6471.46

4126.2550.5075.75

5133.8253.5380.29

6141.8556.7485.11

7150.3660.1590.22

8159.3863.7595.63

9168.9567.58101.37

10179.0871.63107.45

11189.8375.93113.90

12201.2280.49120.73

13213.2985.32127.98

14226.0990.44135.65

15239.6695.86143.79

16254.04101.61152.42

17269.28107.71161.57

18285.43114.17171.26

19302.56121.02181.54

20320.71128.29192.43

21339.96135.98203.97

22360.35144.14216.21

23381.97152.79229.18

24404.89161.96242.94

25429.19171.67257.51

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WACC and Valuation



Ke0.15

Kd9.00%

Tax Rate30%

DCF Values$333.333$317.460$650.79

Kwacc10.7561%

Entity Value$650.79



Debt0.48780.06300.0307

Equity0.51220.15000.0768

WACC10.76%



Debt0.52910.06300.0333

Equity (book)0.47090.15000.0706

WACC10.40%

Total Book Assets600.00

Firm Value673.28

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MVA-EVA Analysis

Tax Rate30%

EBIT100.00

Kwacc10.76%






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APV Analysis

Analysis of the Unlevered Cost of Equity:

Levered Equity Beta1.00

Debt Beta0.14

Levered Equity Value333.33

Debt Value317.46

Corporate tax rate30%

Cost of debt financing9%

Risk free rate8%


Unlevered Beta0.66

Unlevered Cost of Equity12.60%

APV Estimate of Firm Value

Value of Unlevered Cash Flows555.56

Value of Interest Tax Savings95.24

Firm Value650.79

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In this analysis we evaluate the firm's unlevered beta using the following relationship:

(BeSe + BdD(1-T))/(Se + D(1-T)) = Bu

This relationship reflects the presence of corporate taxes and risky debt in the context of the CAPM.

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Compressed APVApproximation of firm valueInterest tax savings discounted using the unlevered cost of equity.

Inputs and FreeCashFlows

Givens:





Beta coefficient1.00Levered Beta


Risk free rate`8%

Balance Sheet

Assets600.00Cost of equity, Ke15%

Debt317.46

Equity282.54

Debt + Equity600.00

Income Statement

Revenues500.00


Gross Profit200.00








NI50.00


less: CAPEX(10.00)


or

EFCF50.00

plus: Int(1-T)20.00

Firm FCF70.00

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Finite


1998502070

1999543690

20005743100

20016169130

20026674140

20037080150

20047585160

Ke0.15

Kd0.09

Tax Rate0.3

DCF Values$247.94$305.91$553.84

Kwacc10.1947%

Entity Value$551.58

Exhibit 5.7

ROIC15.00%



Kwacc10.00%

Firm Value$1,118.61


Year100

1106.0042.4063.60

2112.3644.9467.42

3119.1047.6471.46

4126.2550.5075.75

5133.8253.5380.29

6141.8556.7485.11

7150.3660.1590.22

8159.3863.7595.63

9168.9567.58101.37

10179.0871.63107.45

11189.8375.93113.90

12201.2280.49120.73

13213.2985.32127.98

14226.0990.44135.65

15239.6695.86143.79

16254.04101.61152.42

17269.28107.71161.57

18285.43114.17171.26

19302.56121.02181.54

20320.71128.29192.43

21339.96135.98203.97

22360.35144.14216.21

23381.97152.79229.18

24404.89161.96242.94

25429.19171.67257.51

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WACC and Valuation



Ke0.15

Kd9.00%

Tax Rate30%

DCF Values$333.333$317.460$650.79

Kwacc10.7561%

Entity Value$650.79



Debt0.48780.06300.0307

Equity0.51220.15000.0768

WACC10.76%



Debt0.52910.06300.0333

Equity (book)0.47090.15000.0706

WACC10.40%

Total Book Assets600.00

Firm Value673.28

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Tax Rate30%

EBIT100.00

Kwacc10.76%






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APV Analysis



Debt Beta0.14


Debt Value317.46



Risk free rate8%


Unlevered Beta0.6571


APV Estimate of Firm Value



Firm Value650.79

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In this analysis we evaluate the firm's unlevered beta using the following relationship:

(BeSe + BdD(1-T))/(Se + D(1-T)) = Bu

This relationship reflects the presence of corporate taxes and risky debt in the context of the CAPM.

Compressed APV



Debt Beta0.14


Debt Value317.46



Risk free rate8%


Unlevered Beta0.6571


Compressed APV Estimate of Firm Value

Unlevered FCF$70.00

Interest tax savings8.57

Capitalized Cash Flow$78.57

Firm Value623.58



Firm Value623.58

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Eskimo Pie CorporationBusiness valuation in practice

Revised FCF1991

($ thousands)

1991

Explanation

Projected Net Income

$ 4,000

Revised estimate by Wheat First Securities of 1991 revenues found on page 5.

plus: After-tax interest expense

32

$52.5 (1 - .40) -- from Exhibit 6 for 1991.

NOPAT = NOI(1 - T)

4,032

NI + I(1 T)

Plus: Depreciation expense

1,400

Exhibit 2Depreciation expense for 1990 = $1,352

Less: Capital expenditures

(1,000)

Page 5estimate by Wheat First Securities

Less: Change in working capital

-

Netting out cash NWC appears to decline with increasing sales.

Free cash flow (unadjusted)

$ 4,432

less: After-tax interest income

(396)

$13.191m x 5% x (1 - .40)one-time cash dividend.

Free cash flow (adjusted)

$ 4,036

Cost of Capital EstimateKunlevered = risk-free rate + Betaunlevered(Market Risk Premium)Kunlevered = .0742 + 1.136 (.075) = .1594 or 15.94%

Book Value

Market

Total

Equity

Equity Value/

Asset

Company

of Equity

Value of Equity

Debt

Beta

Firm Value

Beta

Ben & Jerry's

26.3

110.1

2.8

1.2

0.98

1.170

Dreyer's Grand Ice Cream

113.1

534.0

44.3

1.4

0.92

1.293

Empire of Carolina, Inc.

45.1

51.4

89.8

0.3

0.36

0.109

Steve's Homemade Ice Cream

11.1

37.4

3.1

2.5

0.92

2.309

Hershey Foods Corp

1,335.3

4,002.5

282.9

1.0

0.93

0.934

Tootsie Roll Inds.

152.8

728.8

-

1.0

1.00

1.000

Average

1.2

0.85

1.136

Firm and Equity Value (Compressed APV Model)

Firm Value (DCF)Ignoring debt financing (all equity firm)

Value of Free Cash Flows (excluding excess cash)

Growth Rates in FCF

Discount Rates

0%

2%

4%

6%

8%

10%

12%

15%

26,905

31,665

38,156

47,532

62,266

88,787

150,669

16%

25,224

29,403

34,977

42,779

54,483

73,989

113,002

17%

23,740

27,443

32,286

38,890

48,429

63,419

90,401

FCF (1991)

$ 4,035.77

Excess Cash

$ 13,000.00

Total Value including excess cash

Growth Rates in FCF

Discount Rates

0%

2%

4%

6%

8%

10%

12%

15%

39,905

44,665

51,156

60,532

75,266

101,787

163,669

16%

38,224

42,403

47,977

55,779

67,483

86,989

126,002

17%

36,740

40,443

45,286

51,890

61,429

76,419

103,401

Firm Value (Comparables)

Firm Value to

Equity Value

Firm Value

Company

Cash Flow

to Net Income

to Sales

Ben & Jerry's

16.85

29.76

1.16

Dreyer's Grand Ice Cream

24.00

33.58

1.63

Empire of Carolina, Inc.

8.40

5.84

0.58

Steve's Homemade Ice Cream

15.00

20.78

1.15

Hershey Foods Corp

14.66

18.23

1.48

Tootsie Roll Inds.

22.42

28.58

3.51

Average multiple (less max and min)

17.23

24.34

1.36

Estimate for Eskimo Pie--1991

4,432

4,000

61,000

Implied Firm Value

$ 76,373

$ 97,350

$ 82,737

Excess cash in 1991

$ 13,000

$ 13,000

$ 13,000

Total Value including excess cash

$ 89,373

$ 110,350

$ 95,737

Preparation for BumbleBeeThe Compressed APV model.Cash flow estimation Estimating the unlevered cost of equity.Estimating the value of subsidized debt

Compressed APV Model and Equity Value

Cash flows

Estimating Unlevered Betas

Unlevered Cost of Equity

Comparable Company Information:

LeveredDebt toUnlevered

BetaEquityTax RateBeta

Campbell Soup0.700.130.380.65

Ralston Purina0.850.290.380.72

H.J. Heinz0.750.080.380.72

Average0.70

Risk - free rate10.37%

Market risk premium6.00%


Notes:1. Beta(levered) = Beta(unlevered(1 + (D/E)(1-Tax Rate)). Note that E is market value = Bk Value Equity x Mkt/Book

2. Tax rate for competitors is assumed to be 38% but for Bumble Bee it is expected to be only 15% according to the proforma income statement found in Exhibit 8.

3. Note that I use the market value debt to equity ratio where market value equity = book value equity times the market to book ratio given in Exhibit 10.

Debt to market value equity ratio. Market value of equity = Book Equity x Mkt/Book Ratio.

Cash Flows

19861987198819891990199119921993

NOI (1-T) (Exhibit 8 & 15% tax rate)$12.4$13.2$13.5$14.3$16.2$16.2$16.2

Plus: depreciation (Exhibit 7)0.30.50.60.60.70.80.8

Less: CAPEX (Exhibit 7)(1.0)(1.0)(1.0)(1.0)(1.0)(1.0)(1.0)

Less: Additions to WC (Exhibit 7)(4.0)(0.3)0.82.3(9.4)0.0(2.4)

Firm Free Cash Flow$7.7$12.4$13.9$16.2$6.5$16.0$13.6

Tax Rate (Implied Exhibit 8 taxes)15%

Interest Expense (Exhibit 8)$8.4$5.2$7.6$6.6$5.4$4.5$2.5

Interest Tax Savings1.260.781.140.990.810.6750.375

Analysis of Growth Rate in Sales and Earnings

Projected Sales208.9211.9208.7209.5225.7225.7225.7

% Changes in Sales1.44%-1.51%0.38%7.73%0.00%0.00%

% Changes in NOI(1-T)6.16%2.58%5.66%13.10%0.00%0.00%

Analysis of Equity Free Cash Flows

($ millions)1986198719881989199019911992

Net Income (Exhibit 8)5.36.27.08.711.612.314.0

plus: Depreciation0.30.50.60.60.70.80.8

less: CAPEX(1.0)(1.0)(1.0)(1.0)(1.0)(1.0)(1.0)

less: Change in NWC(4.0)(0.3)0.82.3(9.4)0.0(2.4)

less: Debt principal repayments0.0(6.0)(6.0)(9.5)(5.5)(17.0)(10.0)

Equity Free Cash Flow0.6(0.6)1.41.1(3.6)(4.9)1.4

The tax shield for years 1993 and beyond is calculated as the difference in the value of the levered firm and unlevered firm in 1992. To calculate the value of the levered firm in 1992 we assume a constant debt/value ratio and use the Miles and Ezzel formula for the weighted average cost of capital. An alternative method is to assume a constant level of interest expense equal to 1992 interest expense ($.38), a tax rate of 15% and a cost of debt equal to the cost in 1992. This latter calculation results in a present value interest tax savings of only $.1241

The point of this analysis is to demonstrate that the presence of fixed costs (i.e., operating leverage) makes the growth rate in firm operating earnings different than the rate of growth in sales. In this instance, the year to year % changes in sales range from -1.51% to 7.73%. The corresponding range of growth in operating earnings is 2.58% to 13.1%.

Valuation

Growth in FCF beyond 19920.02

Borrowing Rate0.16

Estimation of Firm Value

PV of Unlevered FCFs

Planning period FCFs$50.39

Terminal Value FCFs$42.58

Value of Unlevered Firm$92.97

PV of Interest Tax Savings

Planning period$3.74

Terminal value$0.83

Value of Interest Tax Savings$4.57

Firm Value$97.54

Estimation of the Value of Subsidized Puerto Rican Debt Financing

Puerto Rican 936 Debt

Annuity payments based on 12%, $10 m principal, 5 year maturity$2.77

Present value of payments using 16% current market rate$9.08

Value of subsidy = $10 m - pv of payments at 16%$0.92

Castle Cooke Sub Debt at 12%$1.05

Total value of subsidized debt financing$1.96

Present value savings from subsidized financing

Firm Value + Debt Subsidy$98.45

Estimation of Equity Value

less: Debt value(59.20)

Equals: Equity value$39.25

Valuation Summary:

PV of Unlevered FCFs

Planning period FCFs50.39

Terminal Value FCFs42.58

Value of Unlevered Firm92.97

PV of Interest Tax Savings

Planning period3.74

Terminal value0.83Castle & Cooke Sub Debt

Value of Interest Tax Savings4.57YearPayments

0.51.50

PV of Subsidized Debt11.50

Section 936 Debt$0.921.52.00

Castle & Cooke Jr Sub Debt$1.0520.0

Total Value of subsidized debt$1.962.50.0

32.50

Firm Value99.503.50.0

less: Debt ($62.5m - $3.3m)(59.20)42.50

4.50.0

Equity Value40.3055.00

PV 12%$10.55

PV 16%$9.50

Difference$1.05

Debt value = total assets of $62.5 less equity of $3.3 which is the initial financing of the company.

Terminal value as of year end 1992 [FFCF(1992)(1+.02)/(.1455 - .02)]We discount this back 7 years using the unlevered cost of equity of 14.55%. Note the very conservative growth rate assumption for FFCF which is equal to the rate of growth in revenues for the tuna market.

Debt Amortization

Debt Amortization Schedule (millions)

198719881989199019911992

Senior Secured Bank Debt3.004.007.003.0012.0010.00

Senior Subordinated Notes

Junior Suborninated Notes3.002.002.502.505.00

Amortization of Debt6.006.009.505.5017.0010.00

For purposes of the valuation analysis we will assume that new debt will be issued in exactly the amounts of the

required principal payments of this debt, that is, the firm's debt financing remains constant after 1992.

Valuing debt subsidiesExample5 year (interest only) loan with interest rate of 10% for a borrower that would otherwise have to pay 13%. In year 5 the borrower repays the $1,000 principal amount.

Dhahran

Edit the "blue" cells with appropriate Crystal Ball Pro formulas:

Stochastic Variables:

Pb of final receipt of retention pymtCustom distribution with payoffs of 0 and 1 and associated probabilities 0.10 and 0.90.

Total equipment costTriangular distribution with parameter values ($32 m, 38 m, 48 m).

Operating cost overrun %Normal with mean 0 and standard deviation .01. The correlation between year to year

cost overrun% is .70.

Retention payment factor1.00

Total equipment cost38,000,000

Beg. 1993End 1993End 1994End 1995End 1996End 1997End 1998Total

Billing$11,000,000$36,000,000$45,000,000$43,000,000$33,000,000$168,000,000

Advance$25,200,000$25,200,000

Advance Recovery (15%)$1,650,000$5,400,000$6,750,000$6,450,000$4,950,000$25,200,000

Retention (5%)$550,000$1,800,000$2,250,000$2,150,000$1,650,000$8,400,000

Retention repayment$4,200,000$4,200,000$8,400,000

Receipts$25,200,000$8,800,000$28,800,000$36,000,000$34,400,000$30,600,000$4,200,000$168,000,000

Equipment expenditures$28,500,000$9,500,000$38,000,000

Operating expense cost overrun factor0.00.00.00.00.0

Operating expenditures$7,000,000$25,000,000$29,000,000$27,000,000$20,000,000$108,000,000

Total Disbursements$28,500,000$16,500,000$25,000,000$29,000,000$27,000,000$20,000,000$146,000,000

Net Cash Flow$(3,300,000)$(7,700,000)$3,800,000$7,000,000$7,400,000$10,600,000$4,200,000$17,800,000

Hurdle Rate18%

NPV$7,170,101

IRR40.76%

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MWPetr(Alternative)

123456789101112131415

Production

(1) Net crude and condensates (MB)10.009.808.908.107.106.506.506.606.405.805.204.604.303.803.40

(2) Net gas (MMCF)50.2049.5043.7037.8031.8028.1026.2024.4021.6018.3015.9013.1011.8010.209.30

Price Forecast

Growth rate in crude prices6.00%

Crude20.3921.6122.9124.2825.7427.2928.9230.6632.5034.4536.5238.7141.0343.4946.10

Growth rate in gas prices8.00%

Gas2.002.162.332.522.722.943.173.433.704.004.324.665.045.445.87

Cash Flows (in millions)

(3) Revenues - oil203.90211.81203.90196.71182.77177.36188.00202.35207.99199.80189.88178.05176.42165.26156.74

(4) Revenues - gas100.40106.92101.9495.2386.5382.5883.1583.6379.9673.1668.6561.0959.4355.4854.63

(5) Total revenues304.30318.73305.84291.94269.29259.94271.16285.98287.95272.96258.53239.14235.85220.74211.37

(6) Direct production taxes27.5228.8227.6626.4024.3523.5124.5225.8626.0424.6823.3821.6321.3319.9619.11

(7) Direct operating expense88.6389.2788.7088.0887.0886.6687.1687.8287.9187.2486.6085.7485.5984.9284.50

(8) Overhead36.6038.7036.3033.6031.0028.8029.2029.3027.9026.3023.2021.4020.1019.1017.80

(9) Fin. Book DD&A71.4060.0049.6045.7037.0030.2031.6028.9023.0019.2018.0015.7013.8012.3011.00

(10) Net income before taxes80.15101.94103.5998.1689.8790.7798.68114.10123.11115.54107.3694.6795.0384.4678.95

(11) Federal and state income taxes:

(12) Current

(13) Deferred

(14) Total income taxes28.0735.7036.2834.3831.4731.7934.5639.9643.1240.4737.6033.1633.2829.5827.65

(15) Profit contribution52.0866.2467.3163.7858.3958.9864.1274.1479.9975.0769.7661.5261.7554.8851.30

(16) Non-cash charges47.6040.6033.8032.4027.7023.3023.6021.8018.1015.1014.3012.5011.3010.409.30

(17) Cash from operations99.68106.84101.1196.1886.0982.2887.7295.9498.0990.1784.0674.0273.0565.2860.60

(18) Capital expenditures42.6033.8041.8057.5034.109.401.902.602.003.9011.000.00.601.100.20

(19) Cash flow57.0873.0459.3138.6851.9972.8885.8293.3496.0986.2773.0674.0272.4564.1860.40

(20) Terminal Value464.619471534

Project ValuationPercent of Revenue Calculations

Unlevered cost of Equity13.00%(6) Direct production taxes9.04%of Revenues

Base case valuation(7) Direct operating expense26.87%of Revenues

Planning period cash flows$436.92(14) Total income taxes35.02%of taxable income

Terminal value$74.29

Base Case Value Estimate$511.21

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All % are based on year 1 projections from Exhibit 7.

RealOptions

Project revenues and investment cost

012345678910

Revenues$1.16$1.21$1.27$1.34$1.40$1.47$1.55$1.63$1.71$1.79

Initial Cost$(3.00)

Fuel Cost Analysis

Oil CostsProbabilities

High30%1.181.241.301.371.431.511.581.661.741.83

Normal40%0.790.830.870.910.961.011.061.111.171.23

Low30%0.390.410.430.450.470.500.520.550.580.61

Cost of Oil0.780.830.850.930.981.031.081.101.171.22

Cost of Gas1.001.001.001.001.001.001.001.001.001.00

Cost of Fuel0.780.830.850.930.981.001.001.001.001.00

Project Cash Flows

Cash Flows$(3.00)$0.38$0.38$0.42$0.41$0.42$0.47$0.55$0.63$0.71$0.79

Project Analysis

Cost of Capital10.00%

NPV($0.05)

IRR9.69%

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Project analysis of the Kulatilaka and Marcus (1992) flexible fuel power plant

Is this a good project? Why or why not?Is the analysis consistent with the "flexibility" in the project?Construct a simulation model that appropriately captures the value of the flexible plant.

HMGSimulation

Givens:

Investment4,000,000

Plant life5

Salvage value400,000

Variable Cost %45%

Fixed operating cost1,000,000

Tax rate38%

Working capital10%Change in revenues

Required Rate of Return15%

012345

Sales volume1,000,0001,500,0003,000,0003,500,0002,000,000

Unit Price2.002.002.502.502.50

Revenues2,000,0003,000,0007,500,0008,750,0005,000,000

Variable Operating Costs(900,000)(1,350,000)(3,375,000)(3,937,500)(2,250,000)

Fixed Operating Costs(1,000,000)(1,000,000)(1,000,000)(1,000,000)(1,000,000)

Depreciation Expense(800,000)(800,000)(800,000)(800,000)(800,000)

Net Operating Income(700,000)(150,000)2,325,0003,012,500950,000

less: Taxes266,00057,000(883,500)(1,144,750)(361,000)

NOPAT(434,000)(93,000)1,441,5001,867,750589,000

plus: Depreciation800,000800,000800,000800,000800,000

less: CAPEX(4,000,000)0.00.00.00.0248,000

less: Working Capital(200,000)(100,000)(450,000)(125,000)375,000500,000

Free Cash Flow(4,200,000)266,000257,0002,116,5003,042,7502,137,000

NPV419,435

IRR18.01%

Random Variables

Sales Volume (error)00000

Sales Price (error)11111

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Sales(t+1) Error = normal(0,200000) where correlation[Sales(t+1),Sales(t)] = .50

Price(t+1) Error Factor = lognormal(1,.1) where correlation [Error Factor (t+1),Error Factor (t)] = .80

DebtSubsidy

Subsidized interest rate10%

Market rate13%

Principal amount$1,000.00

Maturity (years)5

Principal and InterestYear

$100.001

$100.002

$100.003

$100.004

$1,100.005

Value of Note (10%)$1,000.00

Value of Note (13%)$894.48

Value of Subsidy$105.52

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What have we learned?There are multiple DCF models of firm value.The APV model offers significant advantages over alternative methods in some applications but is not the standard DCF model (yet).Subsidized financing is valuable and the value can be quantified.Unlevering beta coefficients can be very confusing.

****Comments:This diagram characterizes three separate but equivalent ways of performing a discounted cash flow analysis of the value of a business firm. Our objective in todays lecture is to move rather quickly through the first two methods to the third (APV) that will be used in your analysis of the MW Petroleum case for next class.Note that there are two fundamental elements involved in DCF valuationa cash flow definition and an appropriate discount rate.**Comments:The first method we consider (Method A in your lecture note on Basic, Inc. that is attached to the assignment sheet on the class web page).This method is commonly referred to as either the component method or flow through to equity method. It is the component method as we value the firm by valuing each of the component securities it has issued and summing those values. Flow through to equity is used for the method entails valuing the firms equity directly based on the cash flows that flow through to the common shareholders.*Comments:Note that EFCF represents the cash that could be distributed to the firms stockholders without impairing the firms ability to take advantage of new investment opportunities. Note, too, that the firm can borrow money that can, in turn, be used to distribute cash to shareholders (assuming there are no restrictions or covenants that forbid such payments). When a firm does this it sometimes repurchases its own common shares in which case this transaction is referred to as a leveraged recapitalization.****Comment: this is the approach taken in your Entrepreneurial Finance class.*Comments:Note that with the Entity Method we are valuing the enterprise of firm as a whole so our cash flow must include all the cash available to pay to all classes of security holders (debt and equity). Thus, interest expense (which is part of the payment made to the firms creditors) is not deducted.Transition:The next slide details the exact nature of the FFCF calculation. *Fundamental Point:The Free Cash Flow calculation we made in the previous slide is equivalent to summing up the payments made to each of the firms claimants (net of new financing raised during the period). That is, the firms free cash flow is simply the total amount of funds paid to its sources of financing for the period (after tax).Thus when we discount FFCF we are simply discounting the sum of the after tax payments being made to the firms financial claimants for each period. See T. Copeland, T. Koller, and J. Murrin, 1994, Valuation: Measuring and managing the value of companies, John Wiley), p. 136.Transition:Lets now calculate free cash flow for the Basic Inc. example.**Comments:The key point to make here is that the financing proportions are based on market values of equity, debt and the firm. For example, the proportion of equity financing equals $333.33/650.77 = .5122. Contrast this with the proportion of equity where book values are used, i.e.,Equity proportion (book) = ($600 - 317.44)/600 = .470933Had we used book values to calculate the WACC the result would have been as follows:

Cost of Capital Calculation: Book ValuesSource of CapitalProportion After-tax CostProductDebt 0.5291 0.0630 0.0333 Equity (book) 0.4709 0.1500 0.0706 10.40%Total Book Assets 600.00 Firm Value 673.27

Transition:As we see on the next slide, the cost of capital is higher than 10.40% and consequently the value of the firm is lower than $673.27.**Comments:EVA is a measure of a firms contribution to value for a single period. Although the concept has been around for years it has recently been popularized by Stern Stewart & Co.Although the measure does have some serious shortcomings, it has been used very effectively by a number of firms to improve firm performance.*Comments:The last approach to firm valuation is the APV method.We will use this model in valuing Bumble Bee Tuna and MW Petroleum in subsequent classes. *Comments:How does the use of debt financing impact your estimate of firm value using the APV model?Whats missing here?*CommentsYup!, thats right. They are the same thing.*****Comments:Note that we unlever the comparable company betas and use the unlevered beta to estimate Eskimos cost of capital. This is appropriate only where Eskimo has no financial leverage (and this is approximately true).We use a very simple delevering formula that ignores the presence of taxes and the possibility that debt is risky.Specifically, the delevering formula is based on the following relationship:Beta(unlevered equity) = Beta(debt)(D/V) + Beta(Levered Equity)(E/V)Which reduces to the following expression where debt has a beta of zero and there are no taxes:Beta(unlevered equity) = Beta(Levered Equity)(E/V)*Comments:Note that interest tax savings are assumed to equal the full corporate tax rate times interest expense.Interest tax savings are assumed to grow at the same rate as the firms FCF.Capitalized Cash Flow = FCF + Interest tax savings**Comments:These results suggest that the Nestle offer may be too low.Note that the first and third columns provide estimates of the value of the entire firm while column two offers a value estimate for the firms equity. However, Eskimo uses only $744 in debt as of the end of 1990. The average multiples are based on an average of the set of comparables after throwing out the lowest and highest multiple. *Comments:This case involves the valuation of a management buyout of the Bumble Bee Tuna division of Castle Cook. The analysis entails use of the APV methodology as the capital structure for the buyout varies greatly over the first several years as the firm pays down the buyout debt. The buyout also includes some subsidized debt financing (I.e., below market rate loans) whose value must be estimated.Finally, we must estimate the unlevered cost of equity.Cash flow estimates are provided in the documentation of the case.*Comments:The CAPV differs from the standard version of the APV model only in that it uses the unlevered cost of equity for the firm to evaluate the present value of the interest tax savings.Technically, the liabilities total should only include interest bearing debt since only interest bearing debt is considered in the valuation of the firm as a whole.Note that you will be discounting cash flows for a planning period and adding a terminal value to get the value of the firms capitalized cash flows.You will encounter subsidized financing in the case and will need to estimate the value of the subsidy.*Comments:This slide illustrates the calculation of firm free cash flows (recall that this is the same as the cash flow to the unlevered firms equity), and the calculation of interest tax savings.*Comments:This particular relationship for the levered and unlevered beta corresponds to the situation where debt has a beta of zero and the firm pays corporate taxes on its income. The final equation captures the full relationship between the unlevered or firm beta and the betas of the firms equity and debt.

*Questions:What is the value of the subsidy on this loan where the market rate of interest is 15%?Where have you observed subsidized loans in your business or personal life?*

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Valuation 방법