CORPORATE VALUATION Separation of Financing from Investment The Separation Theorem allows for the evaluation of an investment without regard to how it is financed as long as the required rate of return reflects the financing via the use of the Average Cost of Capital. Assume the following: Cost of Debt = 10% Tax Rate = 40% After-tax Cost of Debt = 6% Cost of Equity = 14% Percent Debt Financing = 50% Percent Equity Financing = 50% Average Cost of Capital = Cost of Debt * (Percent Debt Financing) + Cost of Equity * (Percent Equity Financing) = 10% * (1-.4) * (.5) + 14% * (.5) = 6% * (.5) + 14% * (.5) = 10% A) Project Cash Flows Year 0 Investment Cost Revenues Costs Year 2 Year 3 3,000 (800) 3,000 (800) 4,792 (1,000) 2,200 (880) 2,200 (880) 3,792 (1,517) 1,320 1,320 2,275 (4,000) Taxable Inc. Taxes (40%) Net Cash Flows Year 1 (4,000) NPV @ 10% = 0 A NPV of zero indicates that both lenders and stockholders are earning their respective required rates of return as well as getting their investment back (with no surplus). Consider the financing explicitly with the payment of interest and a repayment of principal as follows: B) Equity Cash Flows Year 0 Year 1 Year 2 3,000 (800) 3,000 (800) 4,792 (1,000) Operating Inc. Interest Expense 2,200 (200) 2,200 (154) 3,792 (103) Taxable Income Taxes (40%) 2,000 (800) 2,046 (818) 3,689 (1,475) 2,000 1,200 (460) 1,228 (506) 2,213 (1,034) (2,000) 740 722 1,179 Investment Cost Revenues Costs Net Income Debt Payment Equity Cash Flow IRR = Year 3 (4,000) 14% Return of Principal Calculations: Year 1 Cash Flow Interest on Debt Shareholder Rate of Return Taxes 2,200 (200) (10% * 2,000) (280) (14% * 2,000) (800) Return of Principal 920 Return of Principal to Lenders = Return of Principal to Stockholders = Beg. Debt Balance - Yr. 1: Debt Repayment Ending Debt Balance - Yr. 1: 460 (50%) 460 (50%) 2,000 (460) Beg. Equity Balance - Yr. 1 Equity Repayment 1,540 End. Equity Balance - Yr. 1 Year 2 Cash Flow Interest on Debt Shareholder Rate of Return Taxes 2,200 (154) (10% * 1,540) (216) (14% * 1,540) (818) Return of Principal 1,012 Return of Principal to Lenders = Return of Principal to Stockholders = 506 (50%) 506 (50%) 2,000 (460) 1,540 Beg. Debt Balance - Yr. 2: Debt Repayment 1,540 (506) Beg. Equity Balance - Yr. 2 Equity Repayment 1,540 (506) Ending Debt Balance - Yr. 2 1,034 End. Equity Balance - Yr. 2 1,034 Year 3 Cash Flow Interest on Debt Shareholder Rate of Return Taxes 3,792 (103) (10% * 1,034) (145) (14% * 1,034) (1,475) Return of Principal 2,068 Return of Principal to Lenders = Return of Principal to Stockholders = Beg. Debt Balance - Yr. 3: Debt Repayment 1,034 (50%) 1,034 (50%) 1,034 (1,034) Ending Debt Balance - Yr. 3: Cash Flows To Lenders Beg. Equity Balance - Yr. 3 Equity Repayment 0 End. Equity Balance - Yr. 3 Year 0 1,034 (1,034) 0 Year 1 Year 2 Year 3 200 460 154 506 103 1,034 Loan Interest Principal (2,000) Net Cash Flows (2,000) 660 660 1,138 Year 0 Year 1 Year 2 Year 3 280 460 216 506 145 1,034 740 722 1,179 IRR = 10% Cash Flows To Stockholders Investment Dividends Principal (2,000) Net Cash Flow (2,000) IRR = 14% Since the result is the same whether utilizing Project Cash Flows and the average cost of capital, or Equity Cash Flows and the cost of equity, the investment decision can be made at the divisional level and the financing decision can be made at the corporate level. Project Valuation Capital budgeting, as in the previous example, usually assumes that a project “ends” after a number of years. In general, however, investments are made with the expectation that, if successful, the activities will continue indefinitely. The best way to evaluate any sort of investment is to create two scenarios: a base-case which projects the cash flows if a company just continues business as usual, and an expansion (or NewCo, etc.) scenario which reflects the anticipated cash flows should a project be undertaken. The relevant cash flows are just the difference between the two scenarios. Rather than shutting the project down at the end of the planning horizon, however, the free cash flow can be capitalized using the WACC. As an example, consider the following company which is considering opening an office in another city to expand its territory. For simplicity, we’ll use the percentage-of-sales method for forecasting the balance sheet. Base-case: Income Statements Year 0 Revs COGS Year 1 Year 2 Year 3 1,000,000 1,040,000 1,081,600 1,124,864 600,000 624,000 648,960 674,918 4% Growth 60% of Sales Gross Profit 400,000 416,000 432,640 449,946 Salaries Utilities Depreciation 150,000 16,000 12,500 153,000 16,320 13,000 156,060 16,646 13,520 159,181 16,979 14,061 2% Inflation 2% Inflation 5% of Net FA EBIT Interest 221,500 15,600 233,680 15,600 246,414 15,600 259,724 15,600 8% of Debt Tax. Inc. Taxes (40%) 205,900 82,360 218,080 87,232 230,814 92,325 244,124 97,650 Net Income 123,540 130,848 138,488 146,475 Balance Sheets Year 0 Year 1 Year 2 Year 3 25,000 150,000 26,000 156,000 27,040 162,240 28,122 168,730 175,000 182,000 189,280 196,851 Net Fixed Assets 250,000 260,000 270,400 281,216 Total Assets 425,000 442,000 459,680 478,067 A/P Bank Note 60,000 15,000 62,400 15,000 64,896 15,000 67,492 15,000 Total CL 75,000 77,400 79,896 82,492 L-T Debt C/S Retained Earnings 180,000 10,000 160,000 180,000 10,000 174,600 180,000 10,000 189,784 180,000 10,000 205,575 Total Liabs. & Eq. 425,000 442,000 459,680 478,067 0 0 0 0 Cash A/R Total CA Assets - Liab. & Eq. Pct of Sales Pct of Sales Pct of Sales Pct of COS Constant Constant Constant Plug Figure Statement of Cash Flows From Operations: Year 1 Year 2 Year 3 Net Income Depreciation 130,848 13,000 138,488 13,520 146,475 14,061 Oper. CF 143,848 152,008 160,535 Working Capital A/R A/P (6,000) 2,400 (6,240) 2,496 (6,490) 2,596 Total W/C (3,600) (3,744) (3,894) Total From Operations 140,248 148,264 156,642 From Investing Activities Net Fixed Assets (23,000) (23,920) (24,877) (23,000) (23,920) (24,877) 0 0 0 (116,248) 0 0 0 (123,304) 0 0 0 (130,683) (116,248) (123,304) (130,683) Total Cash Flows Plus: Beg. Cash Ending Cash 1,000 25,000 26,000 1,040 26,000 27,040 1,082 27,040 28,122 Cash from B/S 26,000 27,040 28,122 Total from Investing From Financing Activities Bank Note L-T Debt Common Stock Dividends Total from Financing Of course, the actual financing may vary either by borrowing more money to finance the asset expansion or by paying down the debt due to a debt schedule for the loans. It really doesn’t matter with respect to the valuation since we are assuming that either (1) the actual long-term financing target is reflected in the WACC or (2) the average cost of capital is independent of capital structure. In any event, the cash flows we will be analyzing will not include any financing cash flows since the financing is reflected in the WACC. Now consider the expansion case where we anticipate the following: Sales will increase by $200,000 in Year 1 over current projections and then grow at 4% annually. Salaries will increase by $40,000 in Year 1 over current projections and then grow at 2% per year. Utilities will increase by $5,000 over current projections and grow by 2% per year. $150,000 of additional Fixed Assets will be required Additional L-T debt of $75,000 will be required to cover much of the asset expansion Expansion: Income Statements Revs COGS Gross Profit Salaries Utilities Depreciation EBIT Interest Tax. Inc. Taxes (40%) Net Income Year 0 Year 1 Year 2 Year 3 1,000,000 1,240,000 1,289,600 1,341,184 600,000 744,000 773,760 804,710 400,000 496,000 515,840 536,474 150,000 16,000 12,500 221,500 15,600 205,900 82,360 123,540 193,000 21,320 20,500 261,180 21,600 239,580 95,832 143,748 196,860 21,746 21,320 275,914 21,600 254,314 101,725 152,588 200,797 22,181 22,173 291,322 21,600 269,722 107,889 161,833 4% Growth 60% of Sales 2% Inflation 2% Inflation 5% of Net FA 8% of Debt Balance Sheets Cash A/R Total CA Year 0 25,000 150,000 175,000 Year 1 31,000 186,000 217,000 Year 2 32,240 193,440 225,680 Year 3 33,530 201,178 234,707 Pct of Sales Pct of Sales Net Fixed Assets 250,000 410,000 426,400 443,456 Pct of Sales Total Assets 425,000 627,000 652,080 678,163 60,000 15,000 75,000 74,400 15,000 89,400 77,376 15,000 92,376 80,471 15,000 95,471 Pct of COS Constant L-T Debt C/S Retained Earnings 180,000 10,000 160,000 255,000 10,000 272,600 255,000 10,000 294,704 255,000 10,000 317,692 Constant Constant Plug Figure Total Liabs. & Eq. 425,000 627,000 652,080 678,163 0 0 0 0 A/P Bank Note Total CL Assets - Liab. & Eq. Statements of CF Year 2 152,588 21,320 173,908 Year 3 161,833 22,173 184,006 From Operations: Net Income Depreciation Oper. CF Year 1 143,748 20,500 164,248 Working Capital A/R A/P Total W/C (36,000) 14,400 (21,600) Total From Operations 142,648 169,444 179,364 From Investing Activities Net Fixed Assets Total from Investing (180,500) (180,500) (37,720) (37,720) (39,229) (39,229) From Financing Activities Bank Note L-T Debt Common Stock Dividends Total from Financing 0 75,000 0 (31,148) 43,852 0 0 0 (130,484) (130,484) 0 0 0 (138,845) (138,845) Total Cash Flows Plus: Beg. Cash Ending Cash 6,000 25,000 31,000 1,240 31,000 32,240 1,290 32,240 33,530 Cash from B/S 31,000 32,240 33,530 (7,440) 2,976 (4,464) (7,738) 3,095 (4,643) The incremental cash flows can be calculated by simply subtracting the cash flows in the BaseCase from the cash flows in the Expansion Case. Note that the financing cash flows have been ignored with the exception that a line has been included to add back the after-tax additional interest expense that occurred in the Expansion case due to the additional loan of $75,000. Incremental Cash Flows From Operations: Net Income Depreciation Oper. CF Year 1 12,900 7,500 20,400 Working Capital A/R A/P Total W/C (30,000) 12,000 (18,000) (1,200) 480 (720) (1,248) 499 (749) 2,400 21,180 22,722 (13,800) (13,800) (14,352) (14,352) 3,600 3,600 3,600 3,600 10,980 31,000 41,980 11,970 32,240 44,210 Total From Operations From Investing Activities Net Fixed Assets Total from Investing From Financing Activities Bank Note L-T Debt Common Stock Add-back After-tax Interest Total from Financing Total Cash Flows Plus: Beg. Cash Ending Cash (157,500) (157,500) 3,600 3,600 (151,500) 25,000 (126,500) Year 2 14,100 7,800 21,900 Year 3 15,359 8,112 23,471 The Free Cash Flows (FCF) are readily available from these figures. It is customary to accelerate the outflows, in this case the investment in Fixed Assets and Working Capital, to the beginning of each year. Thus, we’ll have to add in an adjustment for the now-missing 3rd year. We also need to calculate a Terminal (or Residual) Value to capture the cash flows beyond our three-year planning horizon. Free Cash Flows and Valuation Year 0 Net Income Plus: After-tax Interest Plus: Depreciation Working Capital Capital Investment Free Cash Flows Terminal Value Total Cash Flows (18,000) (157,500) (175,500) (175,500) Terminal Value Calculation: Increase Year 3 FCF by 4% WACC = 10% Growth = 4% Terminal Value = 147,659/(0.10 - 0.04) = Year 1 12,900 3,600 7,500 (720) (13,800) 9,480 9,480 Year 2 14,100 3,600 7,800 (749) (14,352) 10,399 10,399 Year 3 15,359 3,600 8,112 (779) Increase by 4% (14,926) Increase by 4% 11,366 197,010 208,376 11,821 197,010 NPV @ 10% = $(1,574) Since the NPV is negative, the expansion is not desirable. Of course, it is very close to be acceptable. One could argue that there are strategic reasons for going ahead with the expansion. That, however, assumes that there are benefits that have not been captured in the cash flow projections.