Arzac, Chapter 2
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


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

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)




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

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


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


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
Exhibit 2.1. AdvPak Technologies. Historical Data and Forecasting Assumptions
($000)
Historical
Forecast for Fiscal Years Ending 12/31
2006
2007
2008
2009
2010
Operations:
Unit Sales Growth
5.4%
6.0%
6.0%
5.6%
5.6%
Price Growth
2.0%
2.3%
2.3%
2.3%
2.3%
Growth Rate of Sales
7.5%
8.4%
8.4%
8.0%
8.0%
Cost of Sales (Excl. Dep. & Amort.) as % of Sales
Selling, General & Administrative as % of Sales
Research & Development as % of Sales
EBITDA as % of Sales
Growth Rate
2011
5.1%
2.3%
7.5%
81.8%
7.4%
0.9%
9.8%
8.5%
79.0%
7.0%
1.0%
13.0%
44.2%
77.5%
7.0%
1.0%
14.5%
21.0%
77.5%
7.5%
1.0%
14.0%
4.3%
77.5%
7.5%
1.0%
14.0%
8.0%
77.5%
7.5%
1.0%
14.0%
7.5%
16,100
80,414
39.50%
10,695
13.3%
11,740
14.6%
11,380
81,018
36.70%
10,775
13.3%
11,829
14.6%
17,771
86,658
36.20%
12,132
14.0%
12,999
15.0%
19,437
91,857
35.52%
14,238
15.5%
14,973
16.3%
22,046
98,617
35.30%
15,286
15.5%
16,075
16.3%
22,807
105,129
35.00%
16,295
15.5%
17,136
16.3%
Working Capital:
Cash balance as % of Sales
Accounts Receivable as % of Sales
Days Receivable
Inventories as % of Cost of Sales
Inventory Days on hand
Other Current Assets as % of Sales
1.7%
8.9%
32
15.1%
55
0.35%
1.6%
8.9%
32
15.1%
55
0.35%
1.6%
8.9%
32
15.1%
55
0.35%
1.6%
8.9%
32
15.1%
55
0.35%
1.6%
8.9%
32
15.1%
55
0.35%
1.6%
8.9%
32
15.1%
55
0.35%
Accounts Payable as % of Cost of Sales
Days Payable
Accrued Expenses as % of Sales
Tax Payable as % of Current Income Tax
Other Current Liabilities as % of Sales
10.6%
39
1.15%
0.37%
0.41%
10.8%
39
1.15%
0.37%
0.41%
10.8%
39
1.15%
0.37%
0.41%
10.8%
39
1.15%
0.37%
0.41%
10.8%
39
1.15%
0.37%
0.41%
10.8%
39
1.15%
0.37%
0.41%
16.67%
16.67%
16.67%
16.67%
2.49
2.56
2.52
2.56
8.35%
8.35%
8.35%
8.35%
4.61%
4.61%
4.61%
4.61%
100% of excess cash and marketable securities
38.25%
38.25%
38.25%
38.25%
16.67%
2.38
8.35%
4.61%
Capital Expenditures and Depreciation:
Capital Expenditures (net of Disposals)
Net Property, Plant & Equipment (PP&E)
% of Sales
Book Depreciation
% of Net PP&E
Tax Depreciation
% of Net PP&E
Debt, Interest, Dividends and Taxes:
Short-term Debt & Curr. Portion of LTD as % of Total Debt
Total Debt as a multiple of next year EBITDA
Interest rate on debt
Interest rate on cash and marketable securities
Dividends paid
Tax rate on income
16.67%
2.85
38.25%
38.25%
Exhibit 2.2. AdvPak Technologies. Pro-Forma Income Statements
($000)
Historical
2006
Sales
203,580
Cost of Sales
166,592
Gross Profit
36,988
Sales, General & Administrative Expenses
15,164
Research & Development
1,922
EBITDA
19,901
Depreciation
10,695
EBIT
9,206
Interest Expense
Interest Income
Pretax Income
Current Income Tax
Deferred Tax
Net Income
2007
220,758
174,399
46,359
15,453
2,208
28,699
10,775
17,923
6,831
157
11,250
3,900
403
6,947
Forecast for Fiscal Years Ending 12/31
2008
2009
2010
239,386
258,605
279,368
185,524
200,419
216,510
53,862
58,186
62,858
16,757
19,395
20,953
2,394
2,586
2,794
34,711
36,205
39,112
12,132
14,238
15,286
22,579
21,967
23,826
7,218
7,741
8,237
163
176
191
15,524
14,403
15,780
5,606
5,228
5,734
331
281
302
9,586
8,894
9,744
2011
300,369
232,786
67,583
22,528
3,004
42,052
16,295
25,757
8,974
206
16,989
6,177
322
10,491
Exhibit 2.3. AdvPak Technologies. Pro-Forma Balance Sheets
($000)
Historical
2006
Assets
Current:
Cash and Marketable Securities
3,417
Accounts Receivable
18,119
Inventories
25,158
Other Current Assets
717
Total Current Assets
47,411
2007
Forecast for Fiscal Years Ending 12/31
2008
2009
2010
2011
3,532
19,647
26,337
777
50,294
3,830
21,305
28,017
843
53,996
4,138
23,016
30,267
911
58,331
4,470
24,864
32,697
984
63,015
4,806
26,733
35,155
1,058
67,752
Property, Plant & Equipment
Less: Depreciation
Net Property, Plant & Equipment
117,667
37,253
80,414
129,047
48,028
81,018
146,818
60,160
86,658
166,255
74,398
91,857
188,301
89,684
98,617
211,108
105,979
105,129
Other Noncurrent Assets:
Total Assets
9,352
137,177
9,352
140,665
9,352
150,006
9,352
159,540
9,352
170,984
9,352
182,233
Liabilities
Current:
Short-term Debt & Current Portion of LTD
Accounts Payable
Accrued Expenses
Taxes Payable
Other Current Liabilities
Total Current Liabilities
Long-term Debt
Deferred Income Taxes
Total Liabilities
Common Stock and Retained Earnings
Total Liabilities and Net Worth
13,632
17,659
2,341
20
835
34,487
68,162
1,209
103,859
33,319
137,177
14,405
18,835
2,539
14
905
36,699
72,027
1,612
110,338
30,327
140,665
15,449
16,439
20,037
21,645
2,753
2,974
21
19
981
1,060
39,241
42,138
77,246
82,194
1,943
2,224
118,430 126,556.48
31,576
32,983
150,006
159,540
17,910
23,383
3,213
21
1,145
45,672
89,548
2,526
137,746
33,237
170,984
17,910
25,141
3,454
23
1,232
47,759
97,626
2,848
148,233
34,000
182,233
Exhibit 2.4. AdvPak Technologies. Pro-Forma Cash Flow Statements
($000)
Historical
2006
Funds from Operating Activities
Net Income
Depreciation
Deferred Tax
Decrease (Increase) in Current Assets
Increase (Decrease) in Current Liabilities except debt
Decrease (Increase) in Net Working Capital
Funds From Operations
6,947
10,775
403
(2,768)
1,439
(1,330)
16,796
9,586
12,132
331
(3,404)
1,498
(1,905)
20,144
8,894
14,238
281
(4,028)
1,907
(2,121)
21,292
9,744
15,286
302
(4,351)
2,064
(2,287)
23,044
10,491
16,295
322
(4,401)
2,087
(2,314)
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
Dividends
Total Funds to (from) Financing
Increase (Decrease) in Cash
End-of-Year Cash & Marketable Securities
(4,638)
9,939
5,301
115
3,532
(6,262)
8,337
2,075
298
3,830
(5,939)
7,486
1,547
308
4,138
(8,824)
9,490
666
332
4,470
(8,078)
9,728
1,650
336
4,806
Required cash balance ………………...……
Excess cash …………………………………..
Increase in Net Debt
Net debt
3,417
Actual
3,417
0.000
78,378
2007
3,532
0.000
4,523
4,523
82,901
Forecast for Fiscal Years Ending 12/31
2008
2009
2010
3,830
0.000
5,964
5,964
88,865
4,138
0.000
5,631
5,631
94,496
4,470
0.000
8,492
8,492
102,988
2011
4,806
0.000
7,742
7,742
110,730

includes all interest-earning or interestpaying 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?

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
NOPATT (1  g )[1  ( g / r )]
VCV 0 
WACC  g
NOPAT N  1
VN 
WACC


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?)

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
NOPATN  1(1  g / r )
VN 
WACC  g



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



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)





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 =
Market risk premium
=
Market
Equity2
Buckeye Technologies
Caraustar Inc.
Glatfelter Co.
Rock-Tenn Company
Wausau Paper.
Mean
Median
AdvPak Technologies, Inc.
451.0
233.0
694.0
992.0
761.0
145.6
4.62%
4.36%
Adjusted
Beta
0.90
1.42
1.24
1.14
1.25
Beta
0.934
1.277
1.158
1.092
1.165
0.936
Net
Debt1
511.0
268.0
401.0
789.0
152.0
Debt-toEquity
1.13
1.15
0.58
0.80
0.20
0.54
Unlevered
Beta
3
0.438
0.594
0.734
0.608
0.971
0.669
0.608
0.608
CAPM
Cost of
Equity
Premium
8.7%
10.2%
9.7%
9.4%
9.7%
3.90%
3.90%
1.80%
1.80%
1.80%
12.6%
14.1%
11.5%
11.2%
11.5%
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.
Size
4
Cost of
Equity

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))
Exhibit 2.5. AdvPak Technologies. Enterprise Valuation as of 12/31/2006
($000)
Year-end
2006
Net Income
Net Interest after Tax
Unlevered net income
Change in deferred taxes
NOPAT
Depreciation
Change in Net Working Capital
Capital Expenditures
Free cash flow
Valuation
WACC
PV{FCF} @
Continuation growth rate
Continuation value
PV{Continuation value} @
Enterprise value
10.03%
WACC
7.52%
2007
2008
2009
2010
2011
6,947
4,121
11,068
403
11,470
10,775
(1,330)
(11,380)
9,537
9,586
4,357
13,942
331
14,274
12,132
(1,905)
(17,771)
6,729
8,894
4,671
13,565
281
13,846
14,238
(2,121)
(19,437)
6,526
9,744
4,969
14,713
302
15,014
15,286
(2,287)
(22,046)
5,966
10,491
5,414
15,905
322
16,226
16,295
(2,314)
(22,807)
7,400.3
27,783
316,370
WACC
196,153
223,936
($000)
EBIT
Tax on EBIT @
38.25%
Unlevered Net Income
Change in deferred taxes
NOPAT
Depreciation
Change in Net Working Capital
Capital Expenditures
Free cash flow
2007
17,923
6,856
11,068
403
11,470
10,775
(1,330)
(11,380)
9,537
2008
22,579
8,636
13,942
331
14,274
12,132
(1,905)
(17,771)
6,729
2009
21,967
8,402
13,565
281
13,846
14,238
(2,121)
(19,437)
6,526
2010
23,826
9,113
14,713
302
15,014
15,286
(2,287)
(22,046)
5,966
2011
25,757
9,852
15,905
322
16,226
16,295
(2,314)
(22,807)
7,400
AdvPak Technologies, Inc.
Cost of Capital Calculation
Levered
Long-term government bond yield
Market equity premium
Beta coefficient
Cost of equity before small cap premium
Small capitalization premium
AdvPak Technologies cost of equity
Cost of debt
Corporate tax rate
Debt ratio
WACC
4.62%
4.36%
0.9361
8.70%
3.90%
12.60%
8.52%
38.25%
35.00%
10.03%
Unlevered
4.62%
4.36%
0.6085
7.27%
3.90%
11.17%
WACC
WACC
Exhibit 2.6. AdvPak Technologies
Value Table ($000)
Growth Rate
7.0%
7.5%
8.0%
9.50% 229,340
283,060
366,605
10.03% 189,690
223,936
271,616
10.50% 164,798
189,394
221,525
10.00% 191,692
226,797
275,933
12.00% 116,376
127,231
139,891
8.0%
366,605
271,616
221,525
275,933
139,891
Exhibit 2.7. AdvPak Technologies
Implied EBITDA Multiples from
Continuation Value Estimates
Growth Rate
7.0%
7.5%
8.0%
9.50%
7.0
8.9
11.7
10.03%
5.8
7.0
8.7
10.50%
5.0
5.9
7.0
10.0%
5.87
7.09
8.80
12.0%
3.52
3.93
4.40
8.0%
11.73
8.66
7.04
8.80
4.40
Exhibit 2.8. AdvPak Technologies. Free Cash Flow Decomposition
($000)
Net Income
Depreciation
Deferred Tax
Decrease in Net Working Capital
Capital Expenditures
Increase in Net debt
Cash flow to equity holders
Net Interest after Tax
Increase in Net Debt
Cash flow paid to debtholders, after tax
Free cash flow to all security holders
2007
6,947
10,775
403
(1,330)
(11,380)
4,523
9,939
2008
9,586
12,132
331
(1,905)
(17,771)
5,964
8,337
2009
8,894
14,238
281
(2,121)
(19,437)
5,631
7,486
2010
9,744
15,286
302
(2,287)
(22,046)
8,492
9,490
2011
10,491
16,295
322
(2,314)
(22,807)
7,742
9,728
4,121
(4,523)
(402)
9,537
4,357
(5,964)
(1,607)
6,729
4,671
(5,631)
(960)
6,526
4,969
(8,492)
(3,524)
5,966
5,414
(7,742)
(2,328)
7,400
Exhibit 2.9. AdvPak Technologies. Equity Valuation as of 12/31/2006
($000)
2002
2003
2004
Free cash flow to equity
Cost of equity
Continuation value growth rate
Continuation value
PV of equity cash flows
PV of continuation value
Equity value
9,939
8,337
2006
2007
7,486
9,490
9,728
12.60%
7.5%
205,729
31,923
113,652
145,575
Exhibit 2.10. AdvPak Technologies. Net Debt Valuation as of 12/31/2006
($000)
2002
2003
2004
Free cash flow to net debt
Cost of net debt after taxes
Net debt balance in 2007
PV of net debt cash flows
PV of net debt balance
Net debt value
2005
(402)
(1,607)
2005
2006
2007
(960)
(3,524)
(2,328)
5.26%
110,730
(7,327)
85,689
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.
Fleet Meat Packing Co., 2008-2012 Projection
Sales
EBITDA margin
Depreciation
Increase in deferred taxes
CAPEX + Net WC increase




Actual
2007
2223.2
2.55%
29.0
0.5
38.7
2008
2245.6
2.57%
32.6
1.6
41.8
2009
2284.2
2.65%
34.2
2.2
42.2
Forecast
2010
2308.0
2.71%
32.9
2.9
33.4
2011
2550.0
2.71%
32.0
2.5
32.5
2012
2616.7
2.71%
31.5
2.5
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.
Debt
Equity
WACC
WACC (%)
Weight Before-tax After-tax Weighted
cost
cost
cost
50%
7.00%
4.34%
2.17%
50%
14.21%
14.21%
7.10%
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:
TPI Projections
($ millions)
EBIT
Depreciation
Increase in deferred taxes
CAPEX
NWC change





2008
24.8
5.8
0.8
18.2
-0.8
2009
28.0
7.6
0.6
12.2
-0.8
2010
32.0
9.2
0.7
14.3
1.0
2011
34.0
10.2
0.7
14.3
1.8
2012
37.0
11.0
1.0
12.0
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.