Valuation - Reviewer

1. What are the 3 major valuation methodologies?

- Comparable Companies, Precedent Transactions and Discounted Cash Flow Analysis.

2. Rank the 3 valuation methodologies from highest to lowest expected value.

- There is no ranking that always holds. In general, Precedent Transactions will be higher than
Comparable Companies due to the Control Premium built into acquisitions.
Beyond that, a DCF could go either way and it's best to say that it's more variable than other
methodologies. Often it produces the highest value, but it can produce the lowest value as well depending
on your assumptions.

3. When would you not use a DCF in a Valuation?

- You do not use a DCF if the company has unstable or unpredictable cash flows (tech or bio-tech startup)
or when debt and working capital serve a fundamentally different role. For example, banks and financial
institutions do not re-invest debt and working capital is a huge part of their Balance Sheets - so you
wouldn't use a DCF for such companies.

4. What other Valuation methodologies are there?

Other methodologies include:
• Liquidation Valuation - Valuing a company's assets, assuming they are sold off and then subtracting
liabilities to determine how much capital, if any, equity investors receive
• Replacement Value - Valuing a company based on the cost of replacing its assets
• LBO Analysis - Determining how much a PE firm could pay for a company to hit a "target" IRR,
usually in the 20-25% range
• Sum of the Parts - Valuing each division of a company separately and adding them together at the end
• M&A Premiums Analysis - Analyzing M&A deals and figuring out the premium that each buyer paid,
and using this to establish what your company is worth
• Future Share Price Analysis - Projecting a company's share price based on the P / E multiples of the
public company comparables, then discounting it back to its present value

5. When would you use a Liquidation Valuation?

- This is most common in bankruptcy scenarios and is used to see whether equity shareholders will
receive any capital after the company's debts have been paid off. It is often used to advise struggling
businesses on whether it's better to sell off assets separately or to try and sell the entire company.
6. What are the most common multiples used in Valuation?
- The most common multiples are EV/Revenue, EV/EBITDA, EV/EBIT, P/E (Share Price / Earnings per
Share), and P/BV (Share Price / Book Value).
7. What are some examples of industry-specific multiples?
Technology (Internet): EV / Unique Visitors, EV / Pageviews
Retail / Airlines: EV / EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization & Rent)
Energy: P / MCFE, P / MCFE / D (MCFE = 1 Million Cubic Foot Equivalent, MCFE/D = MCFE per
Day), P / NAV (Share Price / Net Asset Value)
Real Estate Investment Trusts (REITs): Price / FFO, Price / AFFO (Funds From Operations, Adjusted
Funds From Operations)
For Retail / Airlines, you often remove Rent because it is a major expense and one that varies
significantly between different types of companies. For REITs, Funds From Operations is a common
metric that adds back Depreciation and subtracts gains on the sale of property. Depreciation is a non-cash
yet extremely large expense in real estate, and gains on sales of properties are assumed to be non-
recurring, so FFO is viewed as a "normalized" picture of the cash flow the REIT is generating.

8.  When you're looking at an industry-specific multiple like EV / Scientists or EV / Subscribers,

why do you use Enterprise Value rather than Equity Value?
- You use Enterprise Value because those scientists or subscribers are "available" to all the investors (both
debt and equity) in a company. The same logic doesn't apply to everything, though - you need to think
through the multiple and see which investors the particular metric is "available" to.

9.  How would you value an apple tree?

- The same way you would value a company: by looking at what comparable apple trees are worth
(relative valuation) and the value of the apple tree's cash flows (intrinsic valuation).
Yes, you could do a DCF for anything - even an apple tree.

10. Why can't you use Equity Value / EBITDA as a multiple rather than Enterprise Value /
EBITDA?
- EBITDA is available to all investors in the company - rather than just equity holders. Similarly,
Enterprise Value is also available to all shareholders so it makes sense to pair them together.
Equity Value / EBITDA, however, is comparing apples to oranges because Equity Value does not reflect
the company's entire capital structure - only the part available to equity investors.
11. When would a Liquidation Valuation produce the highest value?

- This is highly unusual, but it could happen if a company had substantial hard assets but the market was
severely undervaluing it for a specific reason (such as an earnings miss or cyclically). As a result, the
company's Comparable Companies and Precedent Transactions would likely produce lower values as well
- and if its assets were valued highly enough, Liquidation Valuation might give a higher value than other
methodologies.
12 . Let's go back to 2004 and look at Facebook back when it had no profit and no revenue. How
would you value it?
- You would use Comparable Companies and Precedent Transactions and look at more "creative"
multiples such as EV/Unique Visitors and EV/Pageviews rather than EV/Revenue or EV/EBITDA. You
would not use a "far in the future DCF" because you can't reasonably predict cash flows for a company
that is not even making money yet.
This is a very common wrong answer given by interviewees. When you can't predict cash flow, use other
metrics - don't try to predict cash flow anyway!

13. What would you use in conjunction with Free Cash Flow multiples - Equity Value or Enterprise
Value?
- For Unlevered Free Cash Flow, you would use Enterprise Value, but for Levered Free Cash Flow you
would use Equity Value. Remember, Unlevered Free Cash Flow excludes Interest and thus represents
money available to all investors, whereas Levered already includes Interest and the money is therefore
only available to equity investors. Debt investors have already "been paid" with the interest payments
they received.

14. How do you select Comparable Companies / Precedent Transactions?

- The 3 main ways to select companies and transactions:
1. Industry classification
2. Financial criteria (Revenue, EBITDA, etc.)
3. Geography
For Precedent Transactions, you often limit the set based on date and only look at transactions within the
past 1-2 years. The most important factor is industry - that is always used to screen for
companies/transactions, and the rest may or may not be used depending on how specific you want to be.

15. How do you apply the 3 valuation methodologies to actually get a value for the company you're
looking at?
- Sometimes this simple fact gets lost in discussion of Valuation methodologies. You take the median
multiple of a set of companies or transactions, and then multiply it by the relevant metric from the
company you're valuing.
Example: If the median EBITDA multiple from your set of Precedent Transactions is 8x and your
company's EBITDA is $500 million, the implied Enterprise Value would be $4 billion.
To get the "football field" valuation graph you often see, you look at the minimum, maximum,
25th percentile and 75thpercentile in each set as well and create a range of values based on each
methodology.
16. What do you actually use a valuation for?
- Usually you use it in pitch books and in client presentations when you're providing updates and telling
them what they should expect for their own valuation.
It's also used right before a deal closes in a Fairness Opinion, a document a bank creates that "proves" the
value their client is paying or receiving is "fair" from a financial point of view.
Valuations can also be used in defense analyses, merger models, LBO models, DCFs (because terminal
multiples are based off of comps), and pretty much anything else in finance.

17. Why would a company with similar growth and profitability to its Comparable Companies be
valued at a premium?
- This could happen for a number of reasons:
• The company has just reported earnings well-above expectations and its stock price has risen recently.

• It has some type of competitive advantage not reflected in its financials, such as a key patent or other
intellectual property.
• It has just won a favorable ruling in a major lawsuit.
• It is the market leader in an industry and has greater market share than its competitors.

18. What are the flaws with public company comparables?

• No company is 100% comparable to another company.
• The stock market is "emotional" - your multiples might be dramatically higher or lower on certain dates
depending on the market's movements.
• Share prices for small companies with thinly-traded stocks may not reflect their full value.

19. Do you ALWAYS use the median multiple of a set of public company comparables or precedent
transactions?
- There's no "rule" that you have to do this, but in most cases you do because you want to use values from
the middle range of the set. But if the company you're valuing is distressed, is not performing well, or is at
a competitive disadvantage, you might use the 25th percentile or something in the lower range instead -
and vice versa if it's doing well.

20. You mentioned that Precedent Transactions usually produce a higher value than Comparable
Companies - can you think of a situation where this is not the case?
- Sometimes this happens when there is a substantial mismatch between the M&A market and the public
market. For example, no public companies have been acquired recently but there have been a lot of small
private companies acquired at extremely low valuations.
For the most part this generalization is true but keep in mind that there are exceptions to almost every
"rule" in finance.

21. What are some flaws with precedent transactions?

• Past transactions are rarely 100% comparable - the transaction structure, size of the company, and
market sentiment all have huge effects.
• Data on precedent transactions is generally more difficult to find than it is for public company
comparables, especially for acquisitions of small private companies.

22. Two companies have the exact same financial profile and are bought by the same acquirer, but
the EBITDA multiple for one transaction is twice the multiple of the other transaction - how could
this happen?
Possible reasons:

1. One process was more competitive and had a lot more companies bidding on the target.
2. One company had recent bad news or a depressed stock price so it was acquired at a discount.
3. They were in industries with different median multiples.

23. Why does Warren Buffett prefer EBIT multiples to EBITDA multiples?

- Warren Buffett once famously said, "Does management think the tooth fairy pays for capital
expenditures?"
He dislikes EBITDA because it excludes the often sizable Capital Expenditures companies make and
hides how much cash they are actually using to finance their operations. In some industries there is also a
large gap between EBIT and EBITDA - anything that is very capital-intensive, for example, will show a
big disparity.

24. The EV / EBIT, EV / EBITDA, and P / E multiples all measure a company's profitability.

What's the difference between them, and when do you use each one?
- P / E depends on the company's capital structure whereas EV / EBIT and EV / EBITDA are capital
structure-neutral. Therefore, you use P / E for banks, financial institutions, and other companies where
interest payments / expenses are critical.
EV / EBIT includes Depreciation & Amortization whereas EV / EBITDA excludes it -you're more likely
to use EV / EBIT in industries where D&A is large and where capital expenditures and fixed assets are
important (e.g. manufacturing), and EV / EBITDA in industries where fixed assets are less important and
where D&A is comparatively smaller (e.g. Internet companies).

25. If you were buying a vending machine business, would you pay a higher multiple for a business
where you owned the machines and they depreciated normally, or one in which you leased the
machines? The cost of depreciation and lease are the same dollar amounts and everything else is
held constant.
- You would pay more for the one where you lease the machines. Enterprise Value would be the same for
both companies, but with the depreciated situation the charge is not reflected in EBITDA - so EBITDA is
higher, and the EV / EBITDA multiple is lower as a result. For the leased situation, the lease would show
up in SG&A so it would be reflected in EBITDA, making EBITDA lower and the EV / EBITDA multiple
higher.

26. How do you value a private company?

- You use the same methodologies as with public companies: public company comparables, precedent
transactions, and DCF. But there are some differences:
• You might apply a 10-15% (or more) discount to the public company comparable multiples because the
private company you're valuing is not as "liquid" as the public comps.

• You can't use a premiums analysis or future share price analysis because a private company doesn't have
a share price.
• Your valuation shows the Enterprise Value for the company as opposed to the implied per-share price as
with public companies.
• A DCF gets tricky because a private company doesn't have a market capitalization or Beta - you would
probably just estimate WACC based on the public comps' WACC rather than trying to calculate it.

27. Let's say we're valuing a private company. Why might we discount the public company
comparable multiples but not the precedent transaction multiples?
- There's no discount because with precedent transactions, you're acquiring the entire company - and once
it's acquired, the shares immediately become illiquid.
But shares - the ability to buy individual "pieces" of a company rather than the whole thing - can be either
liquid (if it's public) or illiquid (if it's private).
Since shares of public companies are always more liquid, you would discount public company
comparable multiples to account for this.

28. Can you use private companies as part of your valuation?

- Only in the context of precedent transactions - it would make no sense to include them for public
company comparables or as part of the Cost of Equity / WACC calculation in a DCF because they are not
public and therefore have no values for market cap or Beta.

.
TOPIC: APPROACHES TO VALUATION

Question 1 - DCF Valuation Fundamentals

Discounted cash flow valuation is based upon the notion that the value of an asset is the present value of
the expected cash flows on that asset, discounted at a rate that reflects the riskiness of those cash flows.
Specify whether the following statements about discounted cash flow valuation are true or false, assuming
that all variables are constant except for the variable discussed below:

A. As the discount rate increases, the value of an asset increases.

- False. The reverse is generally true.

B. As the expected growth rate in cash flows increases, the value of an asset increases.

- True. The value of an asset is an increasing function of its cash flows.

C. As the life of an asset is lengthened, the value of that asset increases.

- True. The value of an asset is an increasing function of its life.

D. As the uncertainty about the expected cash flows increases, the value of an asset increases.

- False. Generally, the greater the uncertainty, the lower is the value of an asset.

E. An asset with an infinite life (i.e., it is expected to last forever) will have an infinite value.

- False. The present value effect will translate the value of an asset from infinite to finite terms.

Question 2 - Approaches to DCF Valuation

There are two approaches to valuation. The first approach is to value the equity in the firm. The
second approach is to value the entire firm. What is the distinction? Why does it matter?

When equity is valued, the cash flows to equity investors are discounted at their cost (the cost of equity)
to arrive at a present value, which is the value of the equity stake in the business. When the firm is valued,
the cash flows to all investors in the firm (including equity investors, lenders and preferred stockholders)
are discounted at the weighted average cost of capital to arrive at a present value, which equals the value
of the entire firm (generally much higher than the value of just the equity stake.)

The distinction matters for two reasons:

(1) Mismatching cash flows and discount rates can cause significant errors in valuation.
(2) Not recognizing what the present value of the cash flows measures can also lead to misinterpretations.
For instance, if the present value of cash flows to the firm is treated as the value of equity, there is an
obvious problem.

Question 3 - Mismatching Cash flows and Discount Rates

The following are the projected cash flows to equity and to the firm over the next five years:

CF to
Year Int (1-t) CF to Firm
Equity
1 $250.00 $90.00 $340.00
2 $262.50 $94.50 $357.00
3 $275.63 $99.23 $374.85
4 $289.41 $104.19 $393.59
5 $303.88 $109.40 $413.27
Terminal
$3,946.50 $6,000.00
Value

(The terminal value is the value of the equity or firm at the end of year 5.)

The firm has a cost of equity of 12% and a cost of capital of 9.94%. Answer the following questions:

A. What is the value of the equity in this firm?

PV of CF to Equity = 250/1.12 + 262.50/1.12^2 + 275.63/1.12^3 + 289.41/1.12^4 +

(303.88+3946.50)/1.12^5 = $3224

B. What is the value of the firm?

PV of CF to Firm = 340/1.0994 + 357/1.0994^2 + 374.85/1.0994^3 + 393.59/1.0994^4 +

(413.27+6000)/1.0994^5 = $5149

Question 4 - Problems in DCF Valuation

Why might discounted cash flow valuation be difficult to do for the following types of firms?

A. A private firm, where the owner is planning to sell the firm.

- It might be difficult to estimate how much of the success of the private firm is due to the owner's special
skills and contacts.

B. A biotechnology firm, with no current products or sales, but with several promising product
patents in the pipeline.
- Since the firm has no history of earnings and cash flow growth and, in fact, no potential for either in the
near future, estimating near term cash flows may be impossible.

C. A cyclical firm, during a recession.

- The firm's current earnings and cash flows may be depressed due to the recession. Other measures, such
as debt-equity ratios and return on assets may also be affected.

D. A troubled firm, which has made significant losses and is not expected to get out of trouble for a
few years.

- Since discounted cash flow valuation requires positive cash flows some time in the near term, valuing
troubled firms, which are likely to have negative cash flows in the foreseeable future, is likely to be
difficult.

E. A firm, which is in the process of restructuring, where it is selling some of its assets and changing
its financial mix.

- Restructuring alters the asset and liability mix of the firm, making it difficult to use historical data on
earnings growth and cash flows on the firm.

F. A firm, which owns a lot of valuable land that is currently unutilized.

- Unutilized assets do not produce cash flows and hence do not show up in discounted cash flow
valuation, unless they are considered separately.

Question 5 - Relative Valuation: Fundamentals

An analyst tells you that he uses price/earnings multiples, rather than discounted cash flow
valuation, to value stocks, because he does not like making assumptions about fundamentals -
growth, risk, and payout ratios. Is his reasoning correct?

-No. Any time a multiple is used, there is implicit, in that multiple, assumptions about growth, risk and
payout. In fact, any multiple can be stated as an explicit function of these variables.
Question 6 - Industry Average P/E Ratios

You are estimating the price/earnings multiple to use to value Paramount Corporation, by looking at the
average price/earnings multiple of comparable firms. The following are the price/earnings ratios of firms
in the entertainment business.

P/E
Firm
Ratio
Disney (Walt) 22.09
Time Warner 36.00
King World Productions 14.10
New Line Cinema 26.70
CCL 19.12
PLG 23.33
CIR 22.91
GET 97.60
GTK 26.00

A. What is the average P/E ratio? 31.98

B. Would you use all the comparable firms in calculating the average? Why or why not?

No. Eliminate the outliers, because they are likely to skew the average. The average P/E ratio without
GET and King World is 25.16.

C. What assumptions are you making when you use the industry-average P/E ratio to value
Paramount Communications?

You are assuming that

(1) Paramount is similar to the average firm in the industry in terms of growth and risk.

(2) The marker is valuing communications firms correctly, on average.

Question 7 - CAPM: Divisional and Corporate Betas

You have been asked to estimate the beta of a high-technology firm which has three divisions with the
following characteristics

Division Beta Market Value

Personal Computers 1.60 $100 million
Software 2.00 $150 million
Computer Mainframes 1.20 $250 million

A. What is the beta of the equity of the firm?

Beta = 1.60 * 100/500 + 2.00 * 150/500 + 1.20 * 250/500 = 1.52

B. What would happen to the beta of equity if the firm divested itself of its software business?

If they pay the cash out as a dividend: Beta = 1.60 * 100/350 + 1.20 * 250/350 = 1.31

C. If you were asked to value the software business for the divestiture, which beta would you use in
your valuation? Use 2.00, the beta for the software division.

Question 8 - CAPM: Betas and Financial Leverage

The following are the betas of the equity of four forestry/paper product companies, and their debt/equity
ratios.

Company Beta Debt/Equity Ratio

Weyerhauser 1.15 33.91%
Champion
1.18 54.14%
International
Intenational Paper 1.05 45.50%
Kimberly-Clark 0.91 11.29%

(All the firms face a corporate tax rate of 40%)

A. Estimate the unlevered beta of each firm. What do the unlevered betas tell you about these
firms?

Unlevered
Beta D/E
Beta
Weyerhauser 1.15 33.91% 0.95557808
Champion
1.18 54.14% 0.89067359
International
Intenational Paper 1.05 45.50% 0.82482325
Kimberly-Clark 0.91 11.29% 0.85226741

The unlevered betas measure the business and operating leverage risk associated with each of these firms.

B. Assume now that Kimberly Clark is planning to increase its debt/equity ratio to 30%. What will
its new beta be?

New beta for Kimberly Clark = 0.85 * (1 + (1-0.4) (0.30)) = 1.00

C. If you were valuing an initial public offering in the paper products area, what beta would you
use in the valuation? (Assume that the firm going public plans to have a debt/equity ratio of 40%.)

The average unlevered beta of these comparable firms should be relevered using the debt equity ratio of
the initial public offering.

Average Unlevered Beta = 0.88

Beta of the Initial Public Offering = 0.88 (1 + (1-0.4) (0.40)) = 1.09

Question 9 - Betas and Operating Leverage

The following is a description of the cost structure and betas of five firms in the food production industry:

Fixed Variable
Company Beta D/(D+E)
Costs Costs
CPC International 62% 38% 1.23 18.83%
Ralston Purina 47% 53% 0.81 38.32%
Quaker Oats 45% 55% 0.75 13.28%
Chiquita 50% 50% 0.88 75.35%
Kellogg's 40% 60% 0.76 5.57%

(Assume that all firms have a tax rate of 40%.)

A. Based upon just the operating leverage, which firms would you expect to have the highest and
lowest betas (assuming that they are in the same business)?

CPC should have the highest beta (because of its high fixed costs) and Kellogg's should have the lowest
beta (because of its low fixed costs).

B. Chiquita's beta is believed to be misleading because its financial leverage has increased
dramatically since the period when the beta was estimated. If the average D/(D+E) ratio during the
period of the regression (to estimate the betas) was only 30%, what would your new estimate of
Chiquita's beta be?

Old Debt/Equity Ratio = D/(D+E)/( 1 - D/(D+E)) = 0.3/ (1-0.3) = 0.4286

Unlevered Beta (using D/E ratio of 30%) = 0.88/(1 + (1 - 0.4) * 0.4286) = 0.70

New Debt/Equity Ratio = 0.7535/(1 - 0.7535) = 3.06

New Levered Beta = 0.70 (1 + (1 - 0.4) * (3.06)) = 1.985

Question 10 - CAPM: Betas and Mergers

The following are the betas of three companies involved in a merger battle. The target firm is Paramount
Communications, and the competing bidders are QVC and Viacom:

Company Beta Market Debt

Value of
 Equity
$6,500
Paramount 1.05 $817 million
million
$2,000
QVC 1.70 $100 million
million
$7,500
Viacom 1.15 $2,500 million
million

(Assume that all firms have a tax rate of 35%.)

A. If QVC acquires Paramount, using a mix of debt and equity comparable to its current
debt/equity ratio, what would the beta of the combined firm be?

QVC/Paramount Beta = 1.05 * 6500/8500 + 1.70 * 2000/8500 = 1.20

When leverage will not change after the acquisition, the equity betas can be weighted by equity market
values to get a approximate estimate of the beta after the acquisition.

B. If QVC acquires Paramount, using only debt, what would the beta of the comparable firm be?

values to get a approximate estimate of the beta after the acquisition.

B. QVC Unlevered Beta = 1.70/(1 + (1 - 0.35)(100/2000)) = 1.65

Paramount Unlevered Beta = 1.05/(1 + (1 - 0.35)(817/6500)) = 0.97

QVC/Paramount Unlevered Beta = 1.65 * 2100/(2100 + 7317) + 0.97* 7317/(2100 + 7317) =1.12

[Use values of the firm (debt + equity) as the weights for unlevered betas]

QVC/Paramount Levered Beta = 1.12 * (1+ (1 - 0.35) (7417/2000)) = 3.82

(New Debt = 817 + 100 + 6500 = 7417; New Equity = 2000)

C. If Viacom acquires Paramount, using a mix of debt and equity comparable to its current
debt/equity ratio, what would the beta of the combined firm be?

Viacom/Paramount Beta = 1.05 * 6500/14000 + 1.15 * 7500/14000 = 1.10

D. If Viacom acquires Paramount, using only equity, what would the beta of the comparable firm
be?

Viacom Unlevered Beta = 1.15/(1 + (1 - 0.35)(2500/7500)) = 0.95

Paramount Unlevered Beta = 1.05/(1 + (1 - 0.35)(817/6500)) = 0.97

Viacom/Paramount Unlevered Beta = 0.95 * 10000/(10000 + 7317) + 0.97 * 7317/(10000 + 7317) =
0.958

Use values of the firm (debt + equity) as the weights for unlevered betas.

Viacom/Paramount Levered Beta = 0.958 * (1 + (1 - 0.35)(3317/14000)) = 1.11

(New Debt = 817 + 2500 = 3317)

Question 11 - WACC Calculation

Merck & Company has 1.13 billion shares traded at a market value of $32 per share, and $1.918 billion in
book value of outstanding debt (with an estimated market value of $2 billion). The equity has a book
value of $5.5 billion, and the stock has a beta of 1.10. The firm paid interest expenses of $160 million in
the most recent financial year, is rated AAA and paid 35% of its income as taxes. The thirty-year
government bond rate is 6.25%, and AAA bonds trade at a spread of twenty basis points (0.2%) over the
treasury bond rate.

A. What are the market value and book value weights on debt and equity?

Market Book
Weights Weights
Value Value
$2,000.00
Debt 5.24% $1918 25.86%
m
$36,160.00
Equity 94.76% $5500 74.14%
m

B. What is the cost of equity?

Cost of Equity = 6.25% + 1.10 * 5.50% = 12.30%

C. What is the after-tax cost of debt?

After-tax Cost of Debt = 6.45% (1 - 0.35) = 4.19%

D. What is the cost of capital?

Cost of Capital = 12.30% * (36160/38160) + 4.19% * (2000/38160) = 11.87%

Question 12 - WACC: Another exercise

General Motors has 710 million shares trading at $55 per share and $69 billion in debt outstanding (with a
market value of $65 billion), on which it incurred an interest expense of $5 billion in the most recent year.
It also has $4 billion in preferred stock outstanding, trading at par, on which it paid a dividend of $365
million. The stock has a beta of 1.10 and is rated A (which commands a spread of 1.25% over the treasury
bond rate of 6.25%). The company faced a corporate tax rate of 40%.
A. What is the cost of equity for GM?

Cost of Equity = 6.25% + 1.10 * 5.50% = 12.30%

B. What is the after-tax cost of debt for GM?

After-tax Cost of Debt = 7.50% * (1 - 0.4) = 4.50%

C. What is the cost of preferred stock?

Cost of Preferred Stock = 365/4000 = 9.125%

D. What is the cost of capital?

Cost of Capital = 12.30% * (710 * 55)/[(710 * 55)+ 65000 + 4000] + 4.50% * 65000/[(710 * 55) + 65000
+ 4000] + 9.125% * 4000/[(710 * 55)+ 65000 + 4000] = 7.49%

TOPIC: ESTIMATION OF CASH FLOWS

Much of the tedium in valuation is associated with estimating cash flows, a necessary element of
discounted cash flow valuation. This chapter examines the process of estimating cash flows and
establishes some general principles which should be adhered to in all valuation models. The one
overriding principle governing cash flow estimation is the need to match cash flows to discount rates:
equity cash flows to cost of equity; firm cash flows to cost of capital; pre-tax cash flows to pre-tax rates;
post-tax cash flows to post-tax rates; nominal cash flows to nominal rates; and real cash flows to real
rates. The process of estimating these cash flows is explained in detail in the pages that follow.

Question 13 - Cash Flows to Equity: Concepts

Which of the following is the best description of the free cash flow to equity?

A. It is the cash that equity investors can take out of the firm.

B. It is the dividend that is paid to stockholders.

C. It is the cash that equity investors can take out of the firm after financing investment needed to sustain
future growth.

D. It is the cash left over after meeting debt payments and paying taxes.

E. None of the above.

Answer: C. It is the cash that equity investors can take out of the firm after financing investment needed
to sustain future growth.

Question 14 - Cash Flows: Concepts

Answer true or false to the following statements.

A. The free cash flow to equity will always be higher than the net income of the firm, because
depreciation is added back.

False. Capital expenditures may be greater than depreciation.

B. The free cash flow to equity will always be higher than the dividend.

False. The dividends can exceed the free cash flow to equity.

C. The free cash flow to equity will always be higher than cash flow to the firm, because the latter is
a pre-debt cash flow.

False. The FCFF is a pre-debt cash flow. In the long term, it can be equal to, but it cannot be lower than
the FCFE. In any one year, however, the FCFE can exceed the FCFF is there are substantial new debt
issues.

D. The entire free cash flow to equity cannot be paid out as a dividend because some of it has to be
invested in new projects.

False. The free cash flow to equity is after capital expenditures.

Question 15 - The Effects of Inflation

Answer true or false to the following statements relating to the effect of inflation on cash flows and value.

A. Discounting nominal cash flows at the real discount rate will result in too low an estimate of
value.

False. It will result in too high a value.

B. Dicounting real cash flows at the nominal discount rate will result in too low an estimate of
value.

True

C. If done right, the value estimated should be the same if either real cash flows are discounted at
the real discount rate or nominal cash flows are discounted at the nominal discount rate.
True

D. If companies can raise prices at the same rate as inflation, their value should not be affected by
changes in the inflation rate.

False. There might be loss of value due to loss of depreciation tax benefits.

E. Inflation should increase the value of stocks because it increases expected future cash flows.

False. The discount rate also goes up.

Question 16 - Estimating Cash Flows: Diebold Incorporated

Diebold Incorporated manufactures, markets, and services automated teller machines in the United States.
The following are selected numbers from the financial statements for 1992 and 1993 (in millions):

1992 1993
Revenues $544.0 $620.0
(Less) Operating Expenses ($465.1) ($528.5)
(Less) Depreciation ($12.5) ($14.0)
= Earnings before Interest and
$66.4 $77.5
Taxes
(Less) Interest Expenses ($0.0) ($0.0)
(Less) Taxes ($25.3) ($29.5)
= Net Income $41.1 $48.0
Working Capital $175.0 $240.0

The firm had capital expenditures of $15 million in 1992 and $18 million in 1993. The working capital in
1991 was $180 million.

A. Estimate the cash flows to equity in 1992 and 1993.

FCFE in 1992 = $41.10 + $12.50 - $15 - (175 - 180) = $43.60 million

FCFE in 1993 = $48 + $14 - $18 - (240 - 175) = - $21 million

B. What would the cash flows to equity in 1993 have been if working capital had remained at the
same percentage of revenue it was in 1992.

Working Capital as Proportion of Revenues: 1992 = 175/544 = 32.17%

Change in Revenues in 1993 = 620 - 544 = 76

FCFE in 1993 = $48 + $14 - $18 - (175/544) * (620 - 544)

= $19.55 million

Question 17 - Estimating Cash Flows: Ryder System

Ryder System is a full-service truck leasing, maintenance, and rental firm with operations in North
America and Europe. The following are selected numbers from the financial statements for 1992 and
1993 (in millions).

1992 1993
Revenues $5,192.0 $5,400.0
(Less) Operating Expenses ($3,678.5) ($3848.0)
(Less) Depreciation ($573.5) ($580.0)
= EBIT $940.0 $972.0
(Less) Interest Expenses ($170.0) ($172.0)
(Less) Taxes ($652.1) ($670.0)
= Net Income $117.9 $130.0
Working Capital $92.0 <$370.0>
Total Debt $2,000 mil $2,200 mil

The firm had capital expenditures of $800 million in 1992 and $850 million in 1993. The working capital
in 1991 was $34.8 million, and the total debt outstanding in 1991 was $1.75 billion. There were 77
million shares outstanding, trading at $29 per share.

A. Estimate the cash flows to equity in 1992 and 1993.

. FCFE1992 = $117.9 + $573.5 - $800 - ($92 - $34.8) + (2000-1750)

= $84.20 million

FCFE1993 = $130 + $580 - $850 - (-370 - 92) + (2200 - 2000)

= $522 million

B. Estimate the cash flows to the firm in 1992 and 1993.

. FCFF1992 = $117.9 million + $170 (1 - (652/770)) + $573.5 - $800 - ($92 - $34.8)

= - $139.75 million

(The tax rate is extraordinarily high = 652/770; the taxable income is 770 million (940 - 170))

FCFF in 1993 = $130 million + $172 (1 - (670/800)) + $580 - $850 -

(-370 - 92) = $349.95 million

C. Assuming that revenues and all expenses (including depreciation and capital expenditures)
increase 6%, and that working capital remains unchanged in 1994, estimate the projected cash
flows to equity and the firm in 1994. (The firm is assumed to be at its optimal financial leverage.)

Debt Ratio = $2200 million/($2200 million + 77 * $29) = 49.63%

1994 projection
Net Income = $137.80
- (1 - 0.4963) * (850 - 580) * 1.06
$144.16
=
FCFE = -$6.36

D. How would your answer in (c) change if the firm planned to increase its debt ratio in 1994 by
financing 75% of its capital expenditures (net of depreciation) with new debt issues?

(Also in millions)

Net Income = $137.80

- (1 - 0.75) * (850 - 580) * 1.06 = $71.55
FCFE = $66.25

Question 18 - Inflation and Value

Watts Industries, a manufacturer of valves for industrial and residential use, had the following projected
free cash flows to equity per share for the next five years , in nominal terms.

Terminal
Year FCFE/sh
Value
1 $1.12
2 $1.25
3 $1.40
4 $1.57
5 $1.76 $23.32

The terminal price is based upon a stable nominal growth rate of 6% a year after year 5. The discount
rate, based upon financial market rates, is 14%, and the expected inflation rate is 3%.

A. Estimate the value per share, using nominal cash flows and the nominal discount rate.

Terminal
Year FCFE/share Real CF
Value
1 $1.12 $1.09
2 $1.25 $1.18
3 $1.40 $1.29
4 $1.57 $1.40
5 $1.76 $23.32 $21.63

Real Cash Flow = Nominal Cash Flowt/(1.03)t

Present Value = 1.12/1.14 + 1.25/1.142 + 1.40/1.143 + 1.57/1.144 + (1.76 + 23.32)/1.145 = $16.84

B. Estimate the value per share, using real cash flows and the real discount rate.

. Real Discount Rate = 1.14/1.03 - 1 = 10.68%

Present Value =1.09/1.1068 + 1.18/1.10682 + 1.29/1.10683 + 1.40/1.10684 + (21.63)/1.10685 = $16.84

(Use real discount rates on real cash flows.)

Question 19 - After-tax and Pre-tax Valuation

Consider the example of Polaroid Corporation. The stock is trading at $37.00 per share currently. The
expected dividends, prior to personal taxes, as well as the expected terminal price, are given below:

Expected Terminal
Year
DPS Price
1 $0.67
2 $0.75
3 $0.84
4 $0.94
5 $1.06 $62.79

The expected return, prior to personal taxes, on Polaroid is 13%, of which 1.81% is expected to come
from dividends. An investor facing a tax rate of 36% on dividends and 25% on capital gains is
considering investing in the stock.

A. What is the expected return, after personal taxes, to this investor?

 Expected Return = Expected Dividend Yield * (1 - 0.36) + Expected Price Appreciation * (1 - 0.25) =
0.0181 * 0.64 + 0.1119 * 0.75 = 9.55%

B. What are the expected dividends and terminal price, after personal taxes, to this investor?

Before Taxes After Taxes

Expected Terminal Expected Terminal
Year
DPS Price DPS Price
1 $0.67 $0.43
2 $0.75 $0.48
3 $0.84 $0.54
4 $0.94 $0.60
5 $1.06 $62.79 $0.68 $56.34

Terminal price after taxes = $62.79 - (62.79 - 37.00) * 0.25 = $56.34.

C. What is the value of the stock, using these after-personal-tax cash flows and discount rates?

Value = $0.43/1.0955 + $0.48/1.0955^2 + $0.54/1.0955^3 + $0.60/1.0955^4 + ($0.68 + $56.34)/1.0955^5

= $37.76

D. What is the value of the stock, using the pre-personal-tax cash flows and discount rates?

Present Value = $0.67/1.13 + $0.75/1.13^2 + $0.84/1.13^3 + $0.94/1.13^4

+ ($1.06 + $62.79)/1.13^5 = $36.99

Question 20 - Terminal Values for Cash Flow Calculation

The terminal value in a capital budgeting project is generally much lower than the initial
investment. The terminal price in a stock valuation is generally much higher than the initial
investment. How would you explain the difference?

A capital budgeting project generally has a finite life. Consequently it loses value over time. A stock has
an infinite life. It generally increases in value over time, both as a consequence of inflation and real
growth.
TOPIC: FREE CASH FLOW TO EQUITY DISCOUNT MODELS

The dividend discount model is based upon the premise that the only cash flows received by stockholders
are dividends. This chapter uses a more expansive definition of cash flows to equity as the cash flows left
over after meeting all financial obligations, including debt payments, and after covering capital
expenditure and working capital needs. It discusses the reasons for differences between dividends and
free cash flows to equity, and presents the discounted free cash flow to equity model for valuation.

Question 21 - FCFE Calculation: Concepts

Respond true or false to the following statements relating to the calculation and use of FCFE.

A. The free cash flow to equity will generally be more volatile than dividends.

True. Dividends are generally smoothed out. Free cash flows to equity reflect the variability of the
underlying earnings as well as the variability in capital expenditures.

B. The free cash flow to equity will always be higher than the dividends.

False. Firms can have negative free cash flows to equity. Dividends cannot be less than zero.

C. The free cash flow to equity will always be higher than net income.

False. Firms with high capital expenditures, relative to depreciation, may have lower FCFE than net
income.

D. The free cash flow to equity can never be negative.

False. The free cash flow to equity can be negative for companies, which either have negative net income
and/or high capital expenditures, relative to depreciation. This implies that new stock has to be issued.

Question 22 - Two-Stage FCFE Model: Basics

Ecolab Inc. sells chemicals and systems for cleaning, sanitizing, and maintenance. It reported earnings per
share of $2.35 in 1993, and expected earnings growth of 15.5% a year from 1994 to 1998, and 6% a year
after that. The capital expenditure per share was $2.25, and depreciation was $1.125 per share in 1993.
Both are expected to grow at the same rate as earnings from 1994 to 1998. Working capital is expected to
remain at 5% of revenues, and revenues which were $1,000 million in 1993 are expected to increase 6% a
year from 1994 to 1998, and 4% a year after that. The firm currently has a debt ratio (D/(D+E)) of 5%,
but plans to finance future investment needs (including working capital investments) using a debt ratio of
20%. The stock is expected to have a beta of 1.00 for the period of the analysis, and the treasury bond rate
is 6.50%. (There are 63 million shares outstanding.)

A. Assuming that capital expenditures and depreciation offset each other after 1998, estimate the
value per share.
 Cap Term
Year EPS Depr DWC FCFE
Exp Price
1 $2.71 $2.60 $1.30 $0.05 $1.64
2 $3.13 $3.00 $1.50 $0.05 $1.89
3 $3.62 $3.47 $1.73 $0.05 $2.19
4 $4.18 $4.00 $2.00 $0.06 $2.54
5 $4.83 $4.62 $2.31 $0.06 $2.93 $84.74
6 $5.12 $4.90 $4.90 $0.04 $5.08

The net capital expenditures (Cap Ex - Depreciation) and working capital change is offset partially by
debt (20%). The balance comes from equity. For instance, in year 1:

FCFE = $2.71 - ($2.60 - $1.30) * (1 - 0.20) - $0.05 * (1 - 0.20) = $1.64)

Cost of Equity = 6.5% + 1 * 5.5% = 12%

Terminal Value Per Share = $5.08/(.12 - .06) = $84.74

Present Value Per Share = 1.64/1.12 + 1.89/1.12^2 + 2.19/1.12^3 + 2.54/1.12^4 + (2.93 + 84.74)/1.12^5
= $55.89

B. Assuming that capital expenditures continue to be 200% of depreciation even after 1998,
estimate the value per share.

Cap Term
Year EPS Depr DWC FCFE
Exp Price
1 $2.71 $2.60 $1.30 $0.05 $1.64
2 $3.13 $3.00 $1.50 $0.05 $1.89
3 $3.62 $3.47 $1.73 $0.05 $2.19
4 $4.18 $4.00 $2.00 $0.06 $2.54
5 $4.83 $4.62 $2.31 $0.06 $2.93 $52.09
6 $5.12 $4.90 $2.45 $0.04 $3.13

Terminal Value Per Share = $3.13/(.12 - .06) = $52.09

Present Value Per Share = 1.64/1.12 + 1.89/1.12^2 + 2.19/1.12^3 + 2.54/1.12^4 + (2.93+52.09)/1.12^5 =

$37.36
C. What would the value per share have been, if the firm had continued to finance new investments
with its old financing mix (5%)? Is it fair to use the same beta for this analysis?

Cap Term
Year EPS Depr DWC FCFE
Exp Price
1 $2.71 $2.60 $1.30 $0.05 $1.43
2 $3.13 $3.00 $1.50 $0.05 $1.66
3 $3.62 $3.47 $1.73 $0.05 $1.92
4 $4.18 $4.00 $2.00 $0.06 $2.23
5 $4.83 $4.62 $2.31 $0.06 $2.58 $45.85
6 $5.12 $4.90 $2.45 $0.04 $2.75

Terminal Value Per Share = $2.75/(.12 - .06) = $45.85

Present Value Per Share = 1.43/1.12 + 1.66/1.12^2 + 1.92/1.12^3 + 2.23/1.12^4 + (2.58 + 45.85)/1.12^5
= $32.87

The beta will probably be lower because of lower leverage.

Question 23 - Two-Stage FCFE Model: An Extended Application

Dionex Corporation, a leader in the development and manufacture of ion chromography systems (used to
identify contaminants in electronic devices), reported earnings per share of $2.02 in 1993, and paid no
dividends. These earnings are expected to grow 14% a year for five years (1994 to 1998) and 7% a year
after that. The firm reported depreciation of $2 million in 1993 and capital spending of $4.20 million, and
had 7 million shares outstanding. The working capital is expected to remain at 50% of revenues, which
were $106 million in 1993, and are expected to grow 6% a year from 1994 to 1998 and 4% a year after
that. The firm is expected to finance 10% of its capital expenditures and working capital needs with debt.
Dionex had a beta of 1.20 in 1993, and this beta is expected to drop to 1.10 after 1998. (The treasury bond
rate is 7%.)

A. Estimate the expected free cash flow to equity from 1994 to 1998, assuming that capital
expenditures and depreciation grow at the same rate as earnings.

Year EPS Cap Ex Deprec DWC FCFE

Term.
Price
1 $2.30 $0.68 $0.33 $0.45 $1.57
2 $2.63 $0.78 $0.37 $0.48 $1.82
3 $2.99 $0.89 $0.42 $0.51 $2.11
4 $3.41 $1.01 $0.48 $0.54 $2.45
5 $3.89 $1.16 $0.55 $0.57 $2.83 $52.69
6 $4.16 $0.88 $0.59 $0.20 $3.71
The net capital expenditures (Cap Ex - Depreciation) and working capital change is offset partially by
debt (10%). The balance comes from equity. For instance, in year 1 -

FCFE = $2.30 - ($0.68 - $0.33) * (1 - 0.10) - $0.45 * (1 - 0.10) = $1.57)

B. Estimate the terminal price per share (at the end of 1998). Stable firms in this industry have
capital expenditures which are 150% of depreciation, and maintain working capital at 25% of
revenues.

Terminal Price = $3.71/ (.1305 - .07) = $52.69

C. Estimate the value per share today, based upon the FCFE model.

Present Value Per Share = 1.57/1.136 + 1.82/1.136^2 + 2.11/1.136^3 + 2.45/1.136^4 + (2.83 +

52.69)/1.136^5 = $35.05

Question 24 - Three-Stage FCFE Model: Manufacturing Firm

Biomet Inc., designs, manufactures and markets reconstructive and trauma devices, and reported earnings
per share of $0.56 in 1993, on which it paid no dividends. (It had revenues per share in 1993 of $2.91). It
had capital expenditures of $0.13 per share in 1993 and depreciation in the same year of $0.08 per share.
The working capital was 60% of revenues in 1993 and will remain at that level from 1994 to 1998, while
earnings and revenues are expected to grow 17% a year. The earnings growth rate is expected to decline
linearly over the following five years to a rate of 5% in 2003. During the high growth and transition
periods, capital spending and depreciation are expected to grow at the same rate as earnings, but are
expected to offset each other when the firm reaches steady state. Working capital is expected to drop from
60% of revenues during the 1994-1998 period to 30% of revenues after 2003. The firm has no debt
currently, but plans to finance 10% of its net capital investment and working capital requirements with
debt.

The stock is expected to have a beta of 1.45 for the high growth period (1994-1998), and it is expected to
decline to 1.10 by the time the firm goes into steady state (in 2003). The treasury bond rate is 7%.

A. Estimate the value per share, using the FCFE model.

A.

Year 1 2 3 4 5
Earnings $0.66 $0.77 $0.90 $1.05 $1.23
(CapEx-Deprec'n) *
$0.05 $0.06 $0.07 $0.08 $0.10
(1-_)
DWorking Capital *
$0.27 $0.31 $0.37 $0.43 $0.50
(1-_)
FCFE $0.34 $0.39 $0.46 $0.54 $0.63
Present Value $0.29 $0.30 $0.30 $0.31 $0.31

Transition Period (up to ten years)

Year 6 7 8 9 10
Growth Rate 14.60% 12.20% 9.80% 7.40% 5.00%
Cumulated Growth 14.60% 28.58% 41.18% 51.63% 59.21%
Earnings $1.41 $1.58 $1.73 $1.86 $1.95
(CapEx-Deprec'n) * (1-_) $0.11 $0.13 $0.14 $0.15 $0.16
DWorking Capital * (1-_) $0.45 $0.39 $0.30 $0.22 $0.13
FCFE $0.84 $1.07 $1.29 $1.50 $1.67
Beta 1.38 1.31 1.24 1.17 1.10
Cost of Equity 14.59% 14.21% 13.82% 13.44% 13.05%
Present Value $0.37 $0.41 $0.43 $0.44 $0.43
End-of-Life Index 1
Stable Growth Phase
Growth Rate: Stable Phase = 5.00%
FCFE in Terminal Year = $1.92
Cost of Equity in Stable Phase = 13.05%
Price at the End of Growth Phase = $23.79
PV of FCFE in High Growth Phase = $1.51
Present Value of FCFE in Transition Phase = $2.08
Present Value of Terminal Price = $6.20
Value of the Stock = $9.79

B. Estimate the value per share, assuming that working capital stays at 60% of revenues forever.

Year 1 2 3 4 5
Earnings $0.66 $0.77 $0.90 $1.05 $1.23
(CapEx-Deprec'n)*
$0.05 $0.06 $0.07 $0.08 $0.10
(1-_)
DWorking Capital *
$0.27 $0.31 $0.37 $0.43 $0.50
(1-_)
FCFE $0.34 $0.39 $0.46 $0.54 $0.63
Present Value $0.29 $0.30 $0.30 $0.31 $0.31

Transition Period (up to ten years)

Year 6 7 8 9 10
Growth Rate 14.60% 12.20% 9.80% 7.40% 5.00%
Cumulated Growth 14.60% 28.58% 41.18% 51.63% 59.21%
Earnings $1.41 $1.58 $1.73 $1.86 $1.95
(CapEx-
$0.11 $0.13 $0.14 $0.15 $0.16
Deprec'n)*(1-_)
DWorking Capital
$0.50 $0.48 $0.43 $0.36 $0.26
*(1-_)
FCFE $0.79 $0.97 $1.16 $1.35 $1.54
Beta 1.38 1.31 1.24 1.17 1.10
Cost of Equity 14.59% 14.21% 13.82% 13.44% 13.05%
Present Value $0.34 $0.37 $0.39 $0.40 $0.40
End-of-Life Index 1

Stable Growth Phase

Growth Rate in Stable Phase = 5.00%

FCFE in Terminal Year = $1.78
Cost of Equity in Stable Phase = 13.05%
Price at the End of Growth Phase = $22.09
PV of FCFE in High Growth Phase = $1.51
Present Value of FCFE in Transition Phase = $1.90
Present Value of Terminal Price = $5.76
Value of the Stock = $9.17

C. Estimate the value per share, assuming that the beta remains unchanged at 1.45 forever.

Year 1 2 3 4 5
Earnings $0.66 $0.77 $0.90 $1.05 $1.23
(CapEx-Deprec'n) *
$0.05 $0.06 $0.07 $0.08 $0.10
(1-_)
DWorking Capital *
$0.27 $0.31 $0.37 $0.43 $0.50
(1-_)
FCFE $0.34 $0.39 $0.46 $0.54 $0.63
Present Value $0.29 $0.30 $0.30 $0.31 $0.31

Transition Period (up to ten years)

Year 6 7 8 9 10
Growth Rate 14.60% 12.20% 9.80% 7.40% 5.00%
Cumulated Growth 14.60% 28.58% 41.18% 51.63% 59.21%
Earnings $1.41 $1.58 $1.73 $1.86 $1.95
(CapEx-Deprec'n) *
$0.11 $0.13 $0.14 $0.15 $0.16
(1-_)
DWorking Capital *
$0.45 $0.39 $0.30 $0.22 $0.13
(1-_)
FCFE $0.84 $1.07 $1.29 $1.50 $1.67
Beta 1.45 1.45 1.45 1.45 1.45
Cost of Equity 14.98% 14.98% 14.98% 14.98% 14.98%
Present Value $0.36 $0.40 $0.42 $0.43 $0.41
End-of-Life Index 1

Stable Growth Phase

Growth Rate in Stable Phase = 5.00%

FCFE in Terminal Year = $1.92
Cost Of Equity in Stable Phase = 14.98%
Price at End of Growth Phase = $19.19
PV of FCFE In High Growth Phase = $1.51
Present Value of FCFE in Transition Phase = $2.03
Present Value of Terminal Price = $4.75
Value of the Stock = $8.29

Question 25 - Three-Stage FCFE Model: Service Firm

Omnicare Inc., which provides pharmacy management and drug therapy to nursing homes, reported
earnings per share of $0.85 in 1993 on revenues per share of $12.50. It had negligible capital
expenditures, which were covered by depreciation, but had to maintain working capital at 40% of
revenues. Revenues and earnings are expected to grow 20% a year from 1994 to 1998, after which the
growth rate is expected to decline linearly over three years to 5% in 2001. The firm has a debt ratio of
15%, which it intends to maintain in the future. The stock has a beta of 1.10, which is expected to remain
unchanged for the period of the analysis. The treasury bond rate is 7%.

A. Estimate the value per share, using the free cash flow to equity model.

A.

Year 1 2 3 4 5
Earnings $1.02 $1.22 $1.47 $1.76 $2.12
(CapEx-Deprec'n)*
$0.00 $0.00 $0.00 $0.00 $0.00
(1-_)
DWorking Capital *
$0.85 $1.02 $1.22 $1.47 $1.76
(1-_)
FCFE $0.17 $0.20 $0.24 $0.29 $0.35
Present Value $0.15 $0.16 $0.17 $0.18 $0.19

Transition Period (up to ten years)

Year 6 7 8
Growth Rate 15.00% 10.00% 5.00%
Cumulated Growth 15.00% 26.50% 32.83%
Earnings $2.43 $2.68 $2.81
(CapEx-Deprec'n)*(1-_) $0.00 $0.00 $0.00
D Working Capital *(1-_) $1.59 $1.22 $0.67
FCFE $0.85 $1.46 $2.14
Beta 1.1 1.1 1.1
Cost of Equity 13.05% 13.05% 13.05%
Present Value $0.41 $0.62 $0.80
End-of-Life Index 1
Stable Growth Phase
Growth Rate in Stable Phase = 5.00%
FCFE in Terminal Year = $2.25
Cost of Equity in Stable Phase = 13.05%
Price at the End of Growth Phase = $27.92
PV of FCFE in High Growth Phase = $0.85
Present Value of FCFE in Transition Phase = $1.83
Present Value of Terminal Price = $10.46
Value of the Stock = $13.14

B. Assume now that you find out that the way that Omnicare is going to create growth is by giving
easier credit terms to their clients. How would that affect your estimate of value? (Will it increase
or decrease?)

It is impossible to say. Easier credit terms will increase working capital as a percentage of revenues, and
thus act as a drain on cash flows. On the other hand, the higher growth in revenues and earnings will
create a positive effect. The net effect can be either positive or negative.

C. How sensitive is your estimate of value to changes in the working capital assumption?

Working Capital as % of
Value Per Share
Revenues
60% $8.62
50% $10.88
40 $13.14
30% $15.40
20% $17.66

* This assumes that there is no change in expected growth, as a consequence.

TOPIC: VALUING A FIRM - THE FREE CASH FLOW TO FIRM (FCFF) APPROACH

There are two approaches to valuing the equity in the firm: the dividend discount model and the FCFE
valuation model. This chapter develops another approach to valuation where the entire firm is valued, by
discounting the cumulated cash flows to all claim holders in the firm by the weighted average cost of
capital, and examines its limitations and applications.

Question 26 - Free Cash Flow to the Firm: Concepts

Respond true or false to the following statements about the free cash flow to the firm.

A. The free cash flow to the firm is always higher than the free cash flow to equity.

False. It can be equal to the FCFE if the firm has no debt.

B. The free cash flow to the firm is the cumulated cash flow to all investors in the firm, though the
form of their claims may be different. True

C. The free cash flow to the firm is a pre-debt, pre-tax cash flow.

False. It is pre-debt, but after-tax.

D. The free cash flow to the firm is an after-debt, after-tax cash flow.

False. It is after-tax, but pre-debt.

E. The free cash flow to the firm cannot be estimated without knowing interest and principal
payments, for a firm with debt.

False. The free cash flow to firm can be estimated directly from the earnings before interest and taxes.

Question 27 - Free Cash Flow to Firm and Other Definitions of FCFF

Lay out how you would get to the free cash flow to the firm (what would you add and/or subtract to the
base number?) from the following measures of cash flow.

A. Net Income

FCFF = Net Income + Interest (1-t) + Depreciation - Capital Spending - DWorking Capital

B. Earnings before taxes

FCFF = (Earnings before taxes + Interest Expenses) (1 - tax rate) + Depreciation - Capital Spending
- DWorking Capital

C. EBIT (Earnings before interest and taxes)

FCFF = EBIT (1- tax rate) + Depreciation - Capital Spending - DWorking Capital

D. EBITDA (Earnings before interest, taxes, and depreciation)

FCFF = (EBITDA - Depreciation) (1- tax rate) + Depreciation - Capital Spending - DWorking Capital

E. Net Operating Income

FCFF = (NOI - Non-operating Expenses) (1- tax rate) + Depreciation - Capital Spending - DWorking
Capital

F. Free Cash Flow to Equity

. FCFF = FCFE + Interest Expenses (1 - tax rate) - New Debt Issues + Principal Repayments

* Assumed no preferred stock is outstanding.

Question 28 - FCFF Steady State Model

Union Pacific Railroad reported net income of $770 million in 1993, after interest expenses of $320
million. (The corporate tax rate was 36%.) It reported depreciation of $960 million in that year, and
capital spending was $1.2 billion. The firm also had $4 billion in debt outstanding on the books, rated AA
(carrying a yield to maturity of 8%), trading at par (up from $3.8 billion at the end of 1992). The beta of
the stock is 1.05, and there were 200 million shares outstanding (trading at $60 per share), with a book
value of $5 billion. Union Pacific paid 40% of its earnings as dividends and working capital requirements
are negligible. (The treasury bond rate is 7%.)

A. Estimate the free cash flow to the firm in 1993.

FCFF in 1993 = Net Income + Depreciation - Capital Expenditures - DWorking Capital + Interest
Expenses (1 - tax rate)

= $770 + $960 - $1200 - 0 + $320 (1 - 0.36) = $734.80 million

B. Estimate the value of the firm at the end of 1993.

EBIT = Net Income/(1 - tax rate) + Interest Expenses = 770/0.64 + 320 = $1523.125 million

Return on Assets = EBIT (1-t)/ (BV of Debt + BV of Equity) = 974.80/9000 = 10.83%

Expected Growth Rate in FCFF = Retention Ratio * ROC = 0.6 * 10.83% = 6.50%

Cost of Equity = 7% + 1.05 * 5.5% = 12.775%

Cost of Capital = 8% (1 - 0.36) (4000/(4000 + 12000)) + 12.775% = (12000/(4000 + 12000)) = 10.86%

Value of the Firm = 734.80/(.1086 - .065) = $16,853 millions

C. Estimate the value of equity at the end of 1993, and the value per share, using the FCFF
approach.

Value of Equity = Value of Firm - Market Value of Debt

= $16,853 - $4,000 = $12,853 millions

Value Per Share = $12,853/200 = $64.27

Question 29 - Two-Stage FCFF Model: Lockheed Corporation

Lockheed Corporation, one of the largest defense contractors in the U.S., reported EBITDA of $1290
million in 1993, prior to interest expenses of $215 million and depreciation charges of $400 million.
Capital Expenditures in 1993 amounted to $450 million, and working capital was 7% of revenues (which
were $13,500 million). The firm had debt outstanding of $3.068 billion (in book value terms), trading at a
market value of $3.2 billion, and yielding a pre-tax interest rate of 8%. There were 62 million shares
outstanding, trading at $64 per share, and the most recent beta is 1.10. The tax rate for the firm is 40%.
(The treasury bond rate is 7%.)

The firm expects revenues, earnings, capital expenditures and depreciation to grow at 9.5% a year from
1994 to 1998, after which the growth rate is expected to drop to 4%. (Capital spending will offset
depreciation in the steady state period.) The company also plans to lower its debt/equity ratio to 50% for
the steady state (which will result in the pre-tax interest rate dropping to 7.5%.)

A. Estimate the value of the firm.

_
Yr EBITDA Deprec'n EBIT EBIT Cap FCFF Term
WC
(1-t) Exp. Value
0 $1,290 $400 $890 $534 $450 $82 $402
1 $1,413 $438 $975 $585 $493 $90 $440
2 $1,547 $480 $1,067 $640 $540 $98 $482
3 $1,694 $525 $1,169 $701 $591 $108 $528
4 $1,855 $575 $1,280 $768 $647 $118 $578
5 $2,031 $630 $1,401 $841 $708 $129 $633 $14,326
'93-97 After 1998
Cost of Equity = 13.05% 12.30%
AT Cost of Debt = 4.80% 4.50%
Cost of Capital = 9.37% 9.69%
Terminal Value

= {EBIT (1-t)(1+g) - (Rev1998 - Rev1997) * WC as % of Rev}/(WACC-g)

= (841 * 1.04) - (13500 * 1.0955 * 1.04 - 13500 * 1.0955)

* 0.07 /(.0969-.04) = $14,326

Value of the Firm

= 440/1.0937 + 482/1.09372 + 528/1.09373 + 578/1.09374 + (633 + 14941)/1.09375 = $11,172

B. Estimate the value of the equity in the firm and the value per share.

Value of Equity in the Firm = ($11566 - Market Value of Debt) = 11172 - 3200 = $7,972

Value Per Share = $7,972/62 = $128.57

Question 30 - Choosing the Optimal Leverage and Moving There

Bally's Manufacturing, a large leisure-time company, that owns three casinos in Las Vegas and over 300
fitness centers had debt outstanding of $1.180 billion in 1993, and 45.99 million shares outstanding,
trading at $9 per share. The debt is rated B-, and commands a pre-tax interest rate of 10.31%. The
company had $236 million in earnings before interest, taxes and depreciation in 1993, and depreciation of
$109 million. (Capital expenditures amounted to $125 million in 1993.) The stock had a beta of 2.20.

Bally's is planning to pay down debt and reduce its debt ratio (D/(D+E)) to 50%, which should raise its
debt rating to A (and lower the pre-tax rate to 7.51%). The tax rate for the firm is 40%. The treasury bond
rate is 7%.

A. What is Ballys' current cost of capital?

Cost of Equity = 7% + 2.2 * 5.5% = 19.10%

After-tax Cost of Debt = 10.31%(1 - 0.4) = 6.19%

Market Value of Equity = 45.99 * 9 = $413.91 million

Cost of Capital = 19.10% (413.91/(413.91 + 1180)) + 6.19% (1180/(413.91 + 1180)) = 9.54%

B. What will the effect of the debt reduction be on the cost of capital?

Unlevered Beta = 2.2/(1 + 0.6 * (1180/413.91)) = 0.81

New Beta = 0.81 (1 + 0.6 * 1) = 1.30

New Cost of Equity = 14.14%

After-tax Cost of Debt = 7.51%(1 - 0.6) = 4.51%

Cost of Capital = 14.14% (0.5) + 4.51% (0.5) = 9.32%

C. The firm value is expected to increase by $100 million as a consequence of the debt reduction.
Assuming that the firm is in steady state, what is the expected growth rate in cash flows to the firm
that will yield this value increase?

Old New
Growth Rate Change
Value Value
3% $1,978 $2,046 $67
4% $2,358 $2,453 $95
5% $2,905 $3,050 $145

The value of the firm is calculated as follows:

FCFF in Current Year = 236 * (1 - 0.4) + 109 - 125 = $125.6 million

Value of the Firm Before the Change = 125.6 (1+g)/(.0954-g)

Value of the Firm After the Change = 125.6 (1+g)/(.0932-g)

TOPIC: SPECIAL CASES IN VALUATION

The standard discounted cash flow valuation models have to be modified in special cases - for cyclical
firms, for troubled firms, for firms with special product options and for private firms. This chapter
examines the problems associated with valuing these firms and suggests possible solutions.

Question 31 - Cyclical Firm: Normalized Earnings Per Share

Intermet Corporation, the largest independent iron foundry organization in the country, reported a deficit
per share of $0.15 in 1993. The earnings per share from 1984 to 1992, were as follows:
Year EPS
1984 $0.69
1985 $0.71
1986 $0.90
1987 $1.00
1988 $0.76
1989 $0.68
1990 $0.09
1991 $0.16
1992 <$0.07>

The firm had capital expenditures of $1.60 per share, and depreciation per share of $1.20 in 1993.
Working capital was expected to increase $0.10 per share in 1994. The stock has a beta of 1.2, which is
expected to remain unchanged, and finances its capital expenditure and working capital requirements with
40% debt. (D/(D+E)). The firm is expected, in the long term, to grow at the same rate as the economy
(6%).

A. Estimate the normalized earnings per share in 1994, using the average earnings approach.

Year EPS
1984 $0.69
1985 $0.71
1986 $0.90
1987 $1.00
1988 $0.76
1989 $0.68
1990 $0.09
1991 $0.16
1992 ($0.07)
1993 ($0.15)

Average Earnings Per Share = $0.48

Normalized Earnings Per Share in 1994 = $0.48 * 1.06 = $0.51

B. Estimate the normalized free cash flow to equity per share in 1994, using the average earnings
approach.

Normalized Earnings Per Share = $0.51

- (Cap Ex - Deprec'n) * (1 - Debt
$0.25
ratio) =
- D Working Capital * (1- Debt
$0.06
ratio) =
Normalized FCFE Next Year = $0.19
(Assume that capital expenditures and depreciation will grow 6%
in 1994.)

Question 32 - Valuing a Cyclical Firm: Normalized Earnings (ROC)

General Motors Corporation reported a deficit per share in 1993 of $4.85, following losses in the two
earlier years (the average earnings per share is negative). The company had assets with a book value of
$25 billion, and spent almost $7 billion on capital expenditures in 1993, which was partially offset by a
depreciation charge of $6 billion. The firm had $19 billion in debt outstanding, on which it paid interest
expenses of $1.4 billion. It intends to maintain a debt ratio (D/(D+E)) of 50%. The working capital
requirements of the firm are negligible, and the stock has a beta of 1.10. In the last normal period of
operations for the firm between 1986 and 1989, the firm earned an average return on assets of 12%. (The
tax rate was 40%.) The treasury bond rate is 7%.

Once earnings are normalized, GM expects them to grow 5% a year forever, and capital expenditures and
depreciation to keep track.

A. Estimate the value per share for GM, assuming earnings are normalized instantaneously.

Total Assets in 1993 = $25,000 (in millions)

Normalized Return on Assets = 12%
Normalized Return on Assets (pre-tax) = 20%
Normalized Income statement (based upon 12% ROC)
Earnings Before Interest and Taxes = 5000
Interest Expenses = 1400
Earnings Before Taxes = 3600
Taxes (at 40%) = 1440
Net Income = 2160
- (Cap Ex - Deprec'n) * (1-Debt ratio) = 500
FCFE = 1660
Cost of Equity = 7% + 1.1 * 5.5% = 13.05%
Expected Growth Rate = 5%

Earnings before interest and taxes is calculated using the ROC:

ROC = EBIT (1- tax rate) / Total Assets = 12% (given in the problem)

Value of Equity = (1660 * 1.05)/(.1305 - .05) = $21,652

B. How would your valuation be affected if GM is not going to reach its normalized earnings until
1995 (in two years)?

Value of Equity = $21,652/1.1305^2 = $16,942

Question 33 - Valuing a Troubled Firm: Using Bond Rating

Toro Corporation, which manufactures lawn mowers and tractors, had revenues of $635 million in 1992,
on which it reported a loss of $7 million (largely as a consequence of the recession). It had interest
expenses of $17 million in 1992, and its bonds were rated BBB. [A typical BBB rated company had an
interest coverage ratio (EBIT/Interest Expenses) of 3.10.] The company faced a 40% tax rate. The stock
had a beta of 1.10. The treasury bond rate is 7%.

Toro spent $25 million on capital expenditures in 1992, and had depreciation of $20 million. Working
capital amounted to 25% of sales. The company expects to maintain a debt ratio of 25%. In the long term,
growth in revenues and profits is expected to be 4%, once earnings return to normal levels.

A. Assuming that the bond rating reflects normalized earnings, estimate the normalized earnings
for Toro Corporation.

Earnings Before Interest and Taxes = $52.70

- Interest Expense = $17.00
Earnings Before Taxes = $35.70
- Taxes (40%) = $14.28
Earnings After Taxes = $21.42
- (Cap Ex - Deprec'n) * (1-Debt
$3.75
Ratio) =
- DWorking Capital * (1- Debt Ratio)
$4.76
=
FCFE = $12.91

EBIT = Interest Expense * Interest Coverage Rate = $17 * 3.10 = $ 52.70

The change in working capital is based upon revenues growing at 4%.

B. Allowing for the long-term growth rate on normalized earnings, estimate the value of equity for
Toro Corporation.

Cost of Equity = 7% + 1.1 * 5.5% = 13.05%

Expected Growth Rate = 4%

Value of Equity = 12.91 * 1.04/(.1305 - .04) = $148.36 million

Question 34 - Valuing a Troubled Firm: Normalized Earnings

Kollmorgen Corporation, a diversified technology company, reported sales of $194.9 million in 1992, and
had a net loss of $1.9 million in that year. Its net income had traced a fairly volatile course over the
previous five years:

Year Net Income

1987 $0.3 million
1988 $11.5 million
1989 -$2.4 million
1990 $7.2 million
1991 -$4.6 million

The stock had a beta of 1.20, and the normalized net income is expected to increase 6% a year until 1996,
after which the growth rate is expected to stabilize at 5% a year (the beta will drop to 1.00). The
depreciation amounted to $8 million in 1992, and capital spending amounted to $10 million in that year.
Both items are expected to grow 5% a year in the long term. The firm expects to maintain a debt ratio of
35%. (The treasury bond rate is 7%.)

A. Assuming that the average earnings from 1987 to 1992 represents the normalized earnings,
estimate the normalized earnings and free cash flow to equity.

Year Net Income (in millions)

1987 $0.30
1988 $11.50
1989 ($2.40)
1990 $7.20
1991 ($4.60)
1992 ($1.90)
Average = $1.68
Net Income = $1.68
- (Cap Ex - Deprec'n) * (1 - Debt ratio) = 1.30
= FCFE = $0.38

B. Estimate the value per share.

Cost of Equity (until 1996) = 7% +1.2 * 5.5% = 13.6%

Cost of Equity (after 1996) = 7% + 5.5% = 12.5%

Net (Cap. Ex - Terminal

Year FCFE
Income Deprec'n) * Value
(1 - Debt Ratio)
1993 $1.78 $1.37 $0.42
1994 $1.89 $1.43 $0.45
1995 $2.00 $1.50 $0.50
1996 $2.12 $1.58 $0.54 $29.73
Term
$2.23 $0.00 $2.23
Year

Capital expenditures are offset by depreciation in the terminal year.

Terminal Value = $2.23/(.125 - .05) = $29.73

Value of Equity

= 0.42/1.136 + 0.45/1.136^2 + 0.50/1.136^3 + (0.54 + 29.73)/1.136^4

= $19.24 million

Question 35 - Valuing a Troubled Firm: Operating Margin

Delta Airlines, the third ranking domestic airline, had revenues of $12 billion in 1993 and reported a loss
of $415 million in that year. Between 1988 and 1990, which was the last period of significant profitability
for the firm, the firm had a pre-tax operating margin of 12% (Pre-tax Operating Margin = EBIT/Sales).
Delta Airlines had interest expenses of $340 million in 1993, and its capital expenditures were offset by
depreciation. The company faces a tax rate of 40%. The stock had a beta of 1.15, and the treasury bond
rate is 7%. Working capital requirements are negligible.

The expected growth rate in revenues/net incomes is 6% in the long term.

A. Assuming that the firm returns to 1988-90 levels of profitability by 1994, estimate the value of
equity.

EBIT (based upon operating margin of

$1,440
12%) =
Interest Expenses = $340
Earnings Before Taxes = $1,100
Taxes (at 40%) = $440
Net Income (also FCFE)= $660
Cost of Equity = 7% + 1.15 * 5.5% = 13.33%
Expected Growth Rate in FCFE = 6.00%
Value of Equity= (660 * 1.06)/ (.1333 - .
$9,010
06) =

B. Estimate the value of equity, if the firm does not return to 1988-90 levels of profitability until
1995. (The firm continues to lose money in 1994.)

Value of Equity (assuming two year delay in return to profitability)

= 9010/1.133252 = $7,016 million

Question 36 - Valuing a Troubled Firm: FCFF Approach

OHM Corporation, an environmental service provider, had revenues of $209 million in 1992 and reported
losses of $3.1 million. It had earnings before interest and taxes of $12.5 million in 1992, and had debt
outstanding of $109 million (in market value terms). There are 15.9 million shares outstanding, trading at
$11 per share. The pre-tax interest rate on debt owed by the firm is 8.5%, and the stock has a beta of 1.15.
The firm's EBIT is expected to increase 10% a year from 1993 to 1996, after which the growth rate is
expected to drop to 4% in the long term. Capital expenditures will be offset by depreciation, and working
capital needs are negligible. (The corporate tax rate is 40%, and the treasury bond rate is 7%.)

A. Estimate the cost of capital for OHM.

Equity Debt
Market Value Weight 61.61% 38.39%
Cost of Component 13.33% 5.10%

Cost of Capital = 13.33% (0.6161) + 5.1% (0.3839) = 10.17%

B. Estimate the value of the firm.

Terminal
Year 1993 1994 1995 1996
Year
EBIT (1-t) $8.25 $9.08 $9.98 $10.98 $11.42
- (Cap Ex -
$0.00 $0.00 $0.00 $0.00 $0.00
Deprec'n)
- DWorking Capital $0.00 $0.00 $0.00 $0.00 $0.00
= FCFF $8.25 $9.08 $9.98 $10.98 $11.42
Terminal Value $185.18

Terminal Value = $11.42/(.1017 - .04) = $185.18

Present Value = $8.25/1.1017 + $9.08/1.1017^2 + $9.98/1.1017^3 + ($10.98 + $185.18)/1.1017^4 =

$155.60 million

C. Estimate the value of equity (both total and on a per share basis).

Value of Equity = Value of Firm - Market Value of Debt = $155.60 - $109 = $46.60 million

Value of Equity Per Share = $46.60/15.9 = $2.93

Question 37 - Valuing a Private Firm

You have been asked by the owner of a small firm that produces and sells computer software to estimate
the value of his firm. The firm had revenues of $20 million in the most recent year, on which it made
earnings before interest and taxes of $2 million. The firm had debt outstanding of $10 million, on which
pre-tax interest expenses amounted to $1 million. The book value of equity is $10 million. The average
beta of publicly traded firms that are in the same business is 1.30, and the average debt-equity ratio is 0.2
(based upon the market value of equity). The market value of equity of these firms is, on average, three
times the book value of equity. All firms face a 40% tax rate. Capital expenditures amounted to $1
million in the most recent year, and were twice the depreciation charge in that year. Both items are
expected to grow at the same rate as revenues for the next five years, and to offset each other in steady
state.

The revenues of this firm are expected to grow 20% a year for the next five years, and 5% after that. Net
income is expected to increase 25% a year for the next five years, and 8% after that. The treasury bond
rate is 7%.

A. Estimate the cost of equity for this private firm.

Unlevered Beta for Publicly Traded Firms in Same Business

= 1.30/(1 + 0.6 * 0.2) = 1.16

Debt/Equity Ratio for Private Firm

= Debt/Estimated Market Value of Equity = 10/30 = 33.33%

New Levered Beta For Private Firm = 1.16 * (1 + 0.6 * .3333) = 1.39

New Cost Of Equity = 7% + 1.39 * 5.5% = 14.66%

B. Estimate the cost of capital for this private firm.

Pre-Tax Cost of Debt = $1/$10 = 10%

After-Tax Cost of Debt = 10% (1 - 0.4) = 6%

Cost of Capital = 6% (0.25) + 14.66% (0.75) = 12.49%

C. Estimate the value of the owner's stake in this private firm, using both the firm approach and
the equity approach.

Using the Firm Approach:

1 2 3 4 5 Terminal
year
EBIT $2.40 $2.88 $3.46 $4.15 $4.98 $5.23
EBIT (1 - tax rate) $1.44 $1.73 $2.07 $2.49 $2.99 $3.14
- (Cap Ex -
$0.60 $0.72 $0.86 $1.04 $1.24 $0.00
Deprec'n)
= FCFF $0.84 $1.01 $1.21 $1.45 $1.74 $3.14
Terminal Value $41.85

Terminal Value = $3.14/(.1249 - .05) = $41.85

Present Value (Value of Firm) (@ 12.49%) = $0.84/1.1249 + $1.01/1.1249 2 + $1.21/1.12493 +

$1.45/1.12494 + ($1.74 + $41.85)/1.12495 = $27.50 million

Value of Equity = $27.50 million - $10 million = $17.50 million

Using the Equity approach:

1 2 3 4 5 Terminal
year
Net Income $0.75 $0.94 $1.17 $1.46 $1.83 $1.98
- (Cap Ex -
Deprec'n) * (1-
$0.45 $0.54 $0.65 $0.78 $0.93 $0.00
Debt ratio) =
= FCFE $0.30 $0.40 $0.52 $0.69 $0.90 $1.98
Terminal Value of Equity $29.71

Terminal Value of Equity = $1.98/(.1466 - .05) = $29.71

Present Value (using Cost of Equity of 14.66%) = $0.30/1.1466 + $0.40/1.1466 2 + $0.52/1.14663 +
$0.69/1.14664 + ($0.90 + $29.71)/1.14665 = $16.76 million

Question 38 - Estimating Value: Initial Public Offering

Boston Chicken, a company selling roasted chickens and accompaniments in outlets through the country,
went public in 1993. In the year prior to going public, it had revenues of $40 million, on which it reported
earnings before interest and taxes of $12 million. The firm had no debt outstanding, and expected
revenues to grow 35% a year from 1993 to 1997, 15% a year from 1998 to 2000, and 5% a year after that,
while pre-tax operating margins (EBIT/Revenues) were expected to remain stable. Capital expenditures ñ
which exceeded depreciation by $5 million in the year prior to going public ñ were expected to grow 20%
a year from 1993 to 1997, as is depreciation. After 1998, capital expenditures are expected to offset
depreciation. Working capital requirements are negligible.

The average beta of publicly traded fast-food chains with which Boston Chicken will be competing is
1.15, and their average debt-equity ratio is 25%. Boston Chicken plans to maintain its policy of no debt
until 1997, and to move to the industry average debt ratio after that (the pre-tax cost of debt is expected to
be 8%). The treasury bond rate is 7%. All firms face a tax rate of 40%.

A. Estimate the cost of equity for Boston Chicken.

Unlevered Beta for Comparable Firms = 1.15/(1 + 0.6 * .25) = 1.00

Cost of Equity (until 1997) = 7% + 5.5% = 12.50%

Cost of Capital (until 1997) = 12.50%

Beta after 1997 for Boston Chicken = 1.15

Cost of Equity (after 1997) = 7% + 1.15 * 5.5% = 13.325%

Cost of Capital (after 1997)

= 13.325% (0.8) + 8% (1 - 0.4) (0.2) = 11.62%

B. Estimate the value of equity for Boston Chicken

1993 1994 1995 1996 1997

EBIT (1-t) $9.72 $13.12 $17.71 $23.91 $32.29
Cap Ex -
$6.00 $7.20 $8.64 $10.37 $12.44
Deprec'n
FCFF $3.72 $5.92 $9.07 $13.55 $19.84
Terminal
1998 1999 2000
year
EBIT (1-t) $37.13 $42.70 $49.10 $51.56
Cap Ex -
$0.00 $0.00 $0.00 $0.00
Deprec'n
FCFF $37.13 $42.70 $49.10 $51.56
Terminal Value $778.80

Terminal Value = $51.56 /(.1162 - .05) = $778.80 million

Present Value (using 12.50% for the first five years, and 11.62% after that) =$3.72/1.125 +
$5.92/1.1252 + $9.07/1.1253 + $13.55/1.1254 + $19.84/1.1255 + $37.13/(1.1255 * 1.1162) +
$42.70/(1.1255 * 1.11622) + ($49.10 + 778.80)/(1.1255 * 1.11623) = $401.67 million

This is both the value of the firm and the value of equity.