DES Chapter 4
Estimating the Value of ACME
DES Chapter 4
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Steps in a valuation
Estimate cost of capital (WACC)
Debt
 Equity

Project financial statements and FCF
Calculate horizon value
Discount at WACC to Calculate VOPS
Calculate value of equity
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Estimating the required return on
the components of WACC
ACME has debt and equity
The cost of capital for each type of
financing depends on it risk, as perceived
by the investor, and taxes.
 Higher risk securities have higher required
rates of return.
 If payments (like interest) are deductible,
then the cost to the firm is lowered.

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Acme's WACC
WACC  (1  T) rD w D  rS w S .
Debt: Acme has 2 types of debt—shortterm and long-term. The short-term rate
is 9%.
Long-term debt: 8% coupon debt with 26
years left to maturity are selling for
$900.15 each. What is the cost (to
ACME) of this source of capital?
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Bond prices
In general the price of a bond depends
on its coupon payments, its maturity,
and its risk.
ACME’s bonds pay $40 every 6 months,
and $1,000 when they mature in 26
years.
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Bond prices
n
rc M / 2
M
VB  

t
n
(1  rD )
t 1 (1  rD )
M is the maturity value, or $1,000 for ACME
rC is the coupon rate, or 0.08, which is 8% for
ACME
n is the maturity, or 26 x 2 = 52 6-month periods.
rD is the discount rate.
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ACME’s bond price
n
40
$1,000
$900.15  

t
n
(1  rD )
t 1 (1  rD )
A financial calculator or a spreadsheet can be used to
solve for rD, which is 4.5% for a 6-month period, or 9%
per year.
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Cost of long-term debt
The cost of debt when it was issued 4
years ago was 8%, but the cost now is
different because the bond price has
declined from $1,000 to $900.15
Now the cost is 9%
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Cost of equity
The cost of equity (its required return)
depends on how risky the stock is to
investors.
This risk is measured by “Beta” and the
Capital Asset Pricing Model (CAPM)
relates Beta to the required return.
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ACME’s cost of equity
CAPM: rS = rRF + Beta (RPM)
Beta = 1.1
rRF = 5.4% = long term rate on
Treasuries
RPM = market risk premium = 6%
rS = 5.4% + 1.1(6%) = 12%
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Target weights and WACC
Target is 30% debt, 70% equity
Tax rate = 40%
WACC = 0.70(12%) + 0.30(9%)(1-0.40)
= 10.0%
This is the discount rate to be used for
the free cash flows.
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Projections
Next chapter will have the nuts and bolts
of projections. For now, assume that
your financial analyst has already made
the projections on the following page.
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Income statement projections
Income Statements
Actual Projected Projected Projected Projected
2003
2004
2005
2006
2007
Sales
4,512.44 4,873.44 5,165.84 5,475.80 5,804.34
Costs of Goods Sold
2,797.71 3,021.53 3,202.82 3,394.99 3,598.69
Sales, General and Administrative 902.49
974.69 1,033.17 1,095.16 1,160.87
Depreciation
225.62
243.67
258.29
273.80
290.22
Operating Profit 586.62
633.55
671.56
711.85
754.56
Interest on original debt
80.00
80.00
80.00
80.00
80.00
Interest Expense on new debt
25.73
34.35
42.84
50.18
57.95
Interest expense
105.73
114.35
122.84
130.18
137.95
Earnings Before Taxes 480.89
519.19
548.72
581.67
616.61
Taxes
192.35
207.68
219.49
232.67
246.65
Net Income 288.53
311.52
329.23
349.00
369.97
Dividends
104.89
135.10
191.43
202.90
215.05
Additions to retained earnings 183.64
176.41
137.80
146.11
154.91
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Balance Sheet Projections
Balance Sheets
Cash
Inventory
Accounts receivable
Total current assets
Gross PPE
Accumulated depreciation
Net PPE
Total assets
Actual Projected Projected Projected
2003
2004
2005
2006
45.12
48.73
51.66
54.76
631.74 682.28 723.22 766.61
1,128.11 1,218.36 1,291.46 1,368.95
1,804.98 1,949.38 2,066.34 2,190.32
3,443.32 3,867.49 4,271.98 4,700.75
1,187.09 1,430.77 1,689.06 1,962.85
2,256.22 2,436.72 2,582.92 2,737.90
4,061.20 4,386.09 4,649.26 4,928.22
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Projected
2007
58.04
812.61
1,451.09
2,321.74
5,155.24
2,253.07
2,902.17
5,223.91
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Balance Sheet Projections
Liabilities
Actual
2003
Accounts payable
451.24
Accrued expenses
225.62
Short-term debt
381.71
Total current liabilities 1,058.57
Long-term debt
1,000.00
Total liabilities 2,058.57
Common stock
600.00
Retained earnings
1,402.63
Total common equity 2,002.63
Total liabilities and equity 4,061.20
Projected
2004
487.34
243.67
476.04
1,207.05
1,000.00
2,207.05
600.00
1,579.04
2,179.04
4,386.09
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Projected
2005
516.58
258.29
557.55
1,332.42
1,000.00
2,332.42
600.00
1,716.84
2,316.84
4,649.26
Projected
2006
547.58
273.79
643.90
1,465.27
1,000.00
2,465.27
600.00
1,862.95
2,462.95
4,928.22
Projected
2007
580.43
290.22
735.40
1,606.05
1,000.00
2,606.05
600.00
2,017.86
2,617.86
5,223.91
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FCF Projections
Operating profit
Tax on operating profit
NOPATa
Operating current assets
Operating current liabilities
NOWCb
Total operating capital c
Investment in total net
operating capitald
FCFe
Actual Projected Projected Projected Projected
2003
2004
2005
2006
2007
586.62
633.55
671.56
711.85
754.56
234.65
253.42
268.62
284.74
301.83
351.97
380.13
402.94
427.11
452.74
1,804.97 1,949.37 2,066.34 2,190.32 2,321.74
676.86
731.01
774.87
821.37
870.65
1,128.11 1,218.36 1,291.47 1,368.95 1,451.09
3,384.34 3,655.08 3,874.39 4,106.85 4,353.26
279.45
72.52
270.74
109.39
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219.31
183.63
232.46
194.65
246.41
206.33
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ROIC Projections
Actual Projected Projected Projected Projected
2003
2004
2005
2006
2007
ROIC =
(NOPAT/Beginning capital) 11.3%
Growth in Sales
9.0%
Growth in NOPAT
9.0%
Growth in total net op. cap.
9.0%
Growth in FCF
376.6%
Growth in dividends
-34.5%
11.2%
8.0%
8.0%
8.0%
50.8%
28.8%
11.0%
6.0%
6.0%
6.0%
67.9%
41.7%
11.0%
6.0%
6.0%
6.0%
6.0%
6.0%
11.0%
6.0%
6.0%
6.0%
6.0%
6.0%
Long term projected growth is 6%
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Horizon Value
FCFN 1
FCFN (1  g)
HVN 

.
WACC  g WACC  g
HV2007
FCF2007 (1  g) $206.33 (1  0.06)


WACC  g
0.100  0.06
 $5,467.75 million .
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Value of operations
$109.38
$183.63
$194.65
VOp 


2
3
(1  0.10) (1  0.10) (1  0.10)
$206.33
$5,467.75


4
4
(1  0.10) (1  0.10)
 $4,272.92 million .
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Value of equity
Vequity = VOPS + non-operating assets
– debt
= $4,272.92 + 0 – debt
Debt: $381.71 million short term + 1 million
long-term bonds at $900.15 each
= 381.71 + 900.15 = $1,281.86 million
Vequity = $4,272.92 - 1,281.86
= $2,991.06 million
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Per share equity
10 million shares outstanding
Value per share = $29.91
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Alternate valuation method
Method of multiples
Not as reliable as the free cash flow
model we’ve developed
But it is frequently used by lesssophisticated analysts
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Method of Multiples
The idea is to find some representative
measure that should capture what
makes the firm valuable, like sales, or
net income, or earnings before interest,
taxes, depreciation and amortization
(EBITDA).
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Method of Multiples: EBITDA
Calculate the ratio of Value/EBITDA for a
representative sample of firms. Value is
defined as the total value of the firm (the
value of debt plus the value of equity),
because EBITDA is available for all of the
firm’s investors.
To find the estimated value of the firm being
analyzed, multiply its EBITDA by this
representative ratio.
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Method of Multiples: EBITDA
To find the stock price, subtract the firm’s
debt from the estimate value, then
divide by the number of shares.
This method is simple, but it doesn’t
provide much discrimination among
firms.
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Method of Multiples…
Calculate the ratio of Value/EBITDA for a
representative sample of firms. Value is
defined as the total value of the firm (the
value of debt plus the value of equity).
To find the estimated value of the firm being
analyzed, multiply its EBITDA by this
representative ratio.
To find the stock price, subtract the firm’s debt
from the estimate value, then divide by the
number of shares.
This method is simple,
but it doesn’t provide
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much discrimination among firms.
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