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Lecture Notes

Session 6

Introduction

Up to this point in the class we have progressed through several important steps in

corporate financial analysis. We began with an understanding of financial statements and

methods of evaluating standing and performance with the use of financial ratios. We then

learned how to forecast financial performance using financial statements and ratios to

develop an understanding of how companies might perform in the future. Next, we

turned our attention to present value and methods of pricing stocks and bonds. Stocks

and bonds are the means by which companies raise money, as well as the markets way of

assigning value to a company once it begins its operations. In our last unit, we examined

how those stock and bond pricing models can be used to determine the cost of capital for

a company. The cost of capital is an important measure because it represents the return

required by investors prior to their allowing a company to use their money. It becomes

the cost of using that money to the corporation.

In this unit, we begin to put these concepts together to determine the market value

of a corporation. The process will begin with financial statements and end with a net

present valuation using the weighted average cost of capital (WACC) as a discount factor.

Theory of Valuation

The main source of value of a corporation is the income it can provide its

investors. One way in which we have measured income is using the net income on the

income statement. While this is a great measure of the economic performance of a

company, it is not necessarily a good measure for determining value to investors. The

reason is that net income does not necessarily translate into available cash flow for

investors.

Investors in a corporation include bondholders and other creditors (such as

banks), and both preferred and common equity owners. Creditors are not paid out of the

net income of the company, but rather, out of the free operating cash flows generated by

the company in the pursuit of its business. A free cash flow is an amount of dollars that

are available for distribution to investors. This distribution can take the form of interest

and/or principle payments to creditors, dividends paid to shareholders, or funds used to

repurchase shares from stockholders. A firm may not have a positive net income, but

may have positive free cash flow. Likewise, it may have positive net income, but a

negative free cash flow. You will see why as you read on.

In finance, value is generally determined by discounting net cash flows. In the

case of determining corporate value, we first identify the free cash flows and then we

discount them using an appropriate cost of capital. If we are trying to value the firm as a

whole (as opposed to valuing the debt or equity separately), we will use the WACC as the

discount factor. More will be said about the implicit assumptions and limitations of this

use later on.

Free Cash Flows

Free cash flows represent cash available for investors after all of the needs of

operating the business including its ability to operate in the future are met. The starting

point for calculating free cash flow is the net operating income after tax (the book uses

the term NOPAT, or net operating profit after taxgenerally speaking, income and profit

are the same). The net operating income typically includes all revenues and expenses that

relate to the day-to-day operation of the business. It does not include interest expenses or

any other financial cash flow. It is important to note that the differentiation here is

between operating and financial cash flows.

Operating revenues are earned and operating expenses incurred as a direct result

of applying corporate resources to do business. Financial cash flows, on the other hand,

relate to decisions the company has made regarding how it raises its capital. For

example, interest and principle payments are financial cash flows. These need to be paid

out of the operating cash flows. The companys ability to make these payments is an

important factor in determining its value. Since the payments are made out of the free

cash flows, the amounts are not deducted from the free cash flows in determining value.

In addition to the NOIAT, there are two other elements to the calculation of the

free cash flow. First is the new investment in net working capital required to sustain

business operations. As you know, net working capital is the difference between current

assets and current liabilities. When measuring current liabilities, however, it is important

to include only those that result from day-to-day operations. This would not include any

interest bearing liabilities such as notes payable. Notes payable relate to financial and not

operating cash flows. The impact of these will be picked up in the WACC.

The new investment in net working capital is measured by the change in the level

of net working capital required to sustain operations from year-to-year. For example, if

the current years net working capital level is $469MM, and next years required level is

$522MM, the new investment in net working capital is the difference between the two, or

$53MM.

The second element included in the determination of free cash flow is the net

investment in plant, property and equipment (fixed assets) needed to sustain the business

operation. This amount includes the increase (or decrease) in gross fixed assets (that is,

before accumulated depreciation) less the depreciation expense for that year. Subtracting

the depreciation expense is the same as adding it back to the free cash flow. This is

important because depreciation is a non-cash flow expense that is deducted from the net

operating income before taxes are calculated. Since it is available cash, however, it

should be included in the free cash flow calculation.

In order to determine the free cash flow for a year, it is necessary to have the

income statement for the year and the balance sheets from both the beginning and end of

the year. The first step is to identify the net operating income after tax (NOIAT or

NOPAT) and then adjust for operating net working capital and net new fixed investments.

An example is included in a spreadsheet named freecashflow.xls.

From the example you can see several important points. First, dividend payments

are not included in the calculation. Dividend payments are residual financial cash flows

and are not part of the operating free cash flow. Next, note that the notes payable are not

included in the calculation for the same reason. The example shows an operating free

cash flow made up of the following:

Free Cash Flow Calculation for 2003E

2002

EBIT

Taxes at 40%

NOIAT (NOPAT)

Change in Operating Net Working Capital

Operating Current Assets (Total Current)

Change in Operating Current Assets (2003E-2002)

Operating Current Liabilities (A/P and accruals)

Change in Operating Current Liabilities (2003E-2002)

$9,471

($3,788)

$5,683

$5,610

$2,652

Change in Fixed Assets

Gross Fixed Assets

Change in Gross Fixed Assets (2003E-2002)

Less depreciation expense (2003E)

Net new investment

2003E

$6,292

$682

$3,105

$453

$229

$13,200

$15,700

$2,500

($1,320)

$1,180

NOIAT (NOPAT)

(Increase) decrease in Operating Net Working Capital

(Increase) decrease in Net new investment

Operating Free Cash Flow

$5,683

($229)

($1,180)

$4,273

As mentioned earlier, determining value involves discounting a string of net cash

flows. In this application, the net cash flows are the operating free cash flows as

measured above. To complete the process of cash flow estimation, we would generate a

set of pro forma financial statement forecasts forward for about five to ten years. The

calculation of operating free cash flows would be replicated for each of those five to ten

years as above. Once this step has been completed, it is necessary to estimate the value

of any cash flow earned by the company beyond the end of the five to ten year forecast

period. The present value of these cash flows constitutes what is referred to as the

horizon or continuation value of the company. Calculating this value is important

because we assume that a company is a going concern with a theoretically unlimited life

as an entity. To determine this horizon value, we can take advantage of the constant

growth stock valuation model we learned in Session 4.

Suppose we have a five-year financial forecast, and that the operating cash flow

for the fifth year is $5,398MM. To calculate the horizon value we first need to make an

assumption about the rate of growth in the cash flows beyond year five. Here, it is

always safe to be conservative, so we will use four percent (4%). Assuming that we

know the discount factor (as will be seen, it is the WACC) is 12.83%, the horizon value

would be calculated as follows:

HV5 = OFCF5(1+g)/(WACC g) = $5,398(1.04)/(.1283-.04) = $5,614/(.0883) = $63,546MM.

The $63,546 will become a net cash flow measured at the end of period five. Imagine it

as the price at which the firm will sell at that time. If you were investing in the firm

today, the $63,546MM would be the value youd expect to receive when you sell the

company in five years. Regardless of whether the company is sold, however, it is still

worth that much at the time.

The Discount Factor

The discount factor used to discount the operating free cash flows is the weightedaverage cost of capital. As you learned in Session 5, the WACC accounts for the different

types of debt and equity in the capital structure of the company. The weights are

determined by the amount of capital raised by each unit. These amounts are usually

obtained from the balance sheet, and therefore represent historical book values. The

freecashflow.xls spreadsheet has a sample calculation of the WACC, assuming that you

already know the values of the individual component costs of capital (e.g. such as the

cost of equity that results from the CAPM). The component costs here are assumed (made

up), so dont worry about where they came from. The amounts come from the 2002

balance sheet.

Weighted Average Cost of Capital

Calculation

Type of Capital

Note Payable

Long Term Debt

Common Equity

Total Capital

Amount

$950

$1,200

$12,688

$14,838

Weight

Component

Tax

(2)*(3)*(4)

Cost

Adjustment

6.40%

9.20%

0.60

0.35%

8.09%

10.50%

0.60

0.51%

85.51%

14.00%

1.00

11.97%

100.00%

WACC=

12.83%

There are two critical assumptions we implicitly make by using the WACC as a

discount factor. First, we assume that the component costs of capital are going to be the

same over the entire forecast horizon (which is infinite in this case!). Second, We assume

that the relative weights of each source of capital (note payable, long-term debt and

common equity) will remain the same over the forecast horizon. While these are

somewhat restrictive, we will make do for now and show what happens when things are

allowed to change at a later time.

Discounting to Determine Value

Once we have completed the calculation of the operating free cash flows for the

forecast period (in this case, five years), the horizon value, and the WACC, we are ready

to measure market value. To do this we simply discount the net cash flows as follows:

Corporate Valuation Using Free Cash

Flows and WACC

Year

Operating Free Cash Flow

Horizon Value

Total Free Cash Flow

WACC

Present (Market) Value @ WACC

2002

2003E

$4,273

2004E

$4,658

2005E

$4,987

2006E

$5,123

$4,273

$4,658

$4,987

$5,123

12.83%

$51,774

Book Value of Long Term Debt

Book Value of Common Stock

Total Book Value of Capital

$950

$1,200

$12,688

$14,838

$36,936

Note that the horizon value is included as a cash flow to be discounted in year five

(2007E). The present value of the total free cash flows discounted at 12.83% is

$51,774MM as of 2002. This is the market value of the company (this can also be

referred to as the market value of the assets, as this company has no non-operating

assets).

The market value added by managing the assets is $36,936. It is obtained by

subtracting the book value of the capital from the market value of the assets, as can be

seen above.

What you should do now is go through the textbook reading for this session

(Chapter 12) and reconcile what you find there to the material in this presentation. A

discussion problem will be posted to give you practice in making this calculation.

2007E

$5,398

$63,546

$68,944

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