FINAN204 – 21A

Tutorial 7 – Week starting 3rd May 2021

Q1: Ben Toucan, owner of the Aspen Restaurant, wants to determine the present value of
his investment. The Aspen Restaurant is currently in the development stage but hopes
to “begin” operations early next year. After-tax cash flows during the next five years
are expected to be as follows: Year 1 = 0, Year 2 = 0, Year 3 = 0, Year 4 = $2.5 million,
and Year 5 = $3 million. Cash inflows are expected to be $3.18 million in Year 6 and
are expected to grow at a 6 percent annual rate thereafter. Recall from Chapter 7 that
venture investors often use different discount rates when valuing ventures at various
stages of their life cycles. For example, target discount rates by life cycle stage are
development stage, 50 percent; startup stage, 40 percent; survival stage, 35 percent;
and early rapid-growth stage, 30 percent. As ventures move from their late rapid-
growth stages and into their maturity stages, a 20 percent discount rate is often used.

A. Determine the Aspen BrewPub’s terminal or horizon value at the end of five years.
VCF 5 ( 1+. 06 ) 3,180 ,000
Terminal Value = r−g = 20 %−6% = 22,714,285.71

B. What is the present value of the Aspen BrewPub?

VCF 1 VCF 2 VCF 3 VCF 4 VCF 5 +TermnalValue

+ 2
+ 3
+ 4
+
PV = ( 1+r ) (1+ r ) (1+r ) (1+r ) (1+r )5
2 , 500 , 000 3 , 000 , 000+22 ,714 ,285 . 71
4
+
= 0 + 0 + 0 + (1+50 %) (1+50 %)5 = 3,880,070.55.

C. What percent ownership interest should Ben Toucan be willing to give to a venture
investor, Sherri Isitar, for her $1,000,000 investment?

Under the assumption, (consistent with the textbook treatment in Section 9.2) that the
cash flow in years 4 and 5 are fixed and have already incorporated the use of the new
financing (in operating expenses), then the percent of this fixed $3,880,070.55 “pie”
is:

1 ,000,000
=25.77 %
3 ,880 ,070 .55

Some students will assume that the $1,000,000 is not already projected as being used
to generate the $3,880,070.55 “pie.” (This is the type of conjecture that is suggested
in founder’s initial “thinking” in Section 9.1, but is not consistent with the story
elsewhere.) Accordingly, they will assume that that pie is enhanced by the
$1,000,000 in present value or equivalently that the future value of the $1,000,000
will survive to be added to $22,714,285.71 terminal value currently conjectured. The
percent of this larger enhanced pie is therefore smaller at

1, 000, 000
=20. 49%
1, 000,000+3,880 ,070.55

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Q2: Assume you sell for $100,000 a 10 percent ownership stake in a future payment one year
from now of $1.5 million.

A. What are you saying about the implied return for the 10 percent owner?

Investment of $100,000 for a dollar return of $150,000 ($1.5 million x .10) one year from
now.
Implied return = ($150,000 - $100,000)/$100,000 = $50,000/$100,000 = 50%

Implied current (present) value of venture = $ Investment / Percentage Ownership =

$100,000/.10 = $1,000,000

Expected venture return = ($1,500,000 - $1,000,000)/$1,000,000 = 50%

B. What is the present value of the entire $1.5 million, using the implied return from Part A?

PV = $1,500,000/(1.50) = $1,000,000

C. What is 10 percent of the value determined in Part B?

$1,000,000 x .10 = $100,000

A. Does it matter whether you grow the $100,000 at 50 percent to $150,000

and note it is 10 percent of $1.5 million, or discount the $1.5 million at 50 percent to get
$1 million and note that $100,000 is 10 percent of this present value?

No. Both approaches provide the same result:

a) $100,000 x 1.50 = $150,000 future value
[which is 10% of the $1,500,000 total FV]
b) $1,500,000/(1.50) = $1,000,000 present value
[$100,000 is 10% of total PV]

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 MINI CASE: SOFTTEC PRODUCTS COMPANY

The SoftTec Products Company is a successful small, rapidly growing, closely held
corporation. The equity owners are considering selling the firm to an outside buyer and want
to estimate the value of the firm. Following is last year’s income statement (2019) and
projected income statements for the next four years (2020-2023). Sales are expected to grow
at an annual 7 percent rate beginning in 2024 and continuing thereafter.

[$ Thousands] Actual Projected -----------------------

2019 2020 2021 2022 2023
Net Sales 150.0 200.0 250.0 300.0 350.0
Cost of Goods -75.0 -100.0 -125.0 -150.0 -175.0
Sold Gross Profit . 75.0 100.0 125.0 150.0 175.0
SG&A Expenses -30.0 -40.0 -50.0 -60.0 -70.0
Depreciation -7.5 -10.0 -12.5 -15.0 -17.5
37.5 50.0 62.5 75.0 87.5
EBIT -3.5 -3.5 -3.5 -3.5 -3.5
Interest EBT 34.0 46.5 59.0 71.5 84.0
Taxes (40% -13.6 -18.6 -23.6 -28.6 -33.6
rate) Net Income 20.4 27.9 35.4 42.9 50.4

Selected balance sheet accounts at the end of 2019 were as follows. Net fixed assets
were $50,000. The sum of the required cash, accounts receivable, and inventories accounts
was $50,000. Accounts payable and accruals totaled $25,000. Each of these balance sheet
accounts was expected to grow with sales over time. No changes in interest-bearing debt
were projected and there were no plans to issue additional shares of common stock. There
are currently 10,000 shares of common stock outstanding.
Data have been gathered for a “comparable” publicly-traded firm in the same industry
that SoftTec operates in. The cost of common equity for this other firm, Wakefield Products,
was estimated to be 25 percent. SoftTec has survived for a period of years. Management is
not currently contemplating a major financial structure change and believes a single discount
rate is appropriate for discounting all cash flows.

A. Project SoftTec’s income statement for 2024.

See the spreadsheet base case results below. Net sales grow to $374.5 thousands in 2024.
This amount is 7% greater than the 2023 level. Net income increases to $54.1 thousands
in 2024.

B. Determine the annual increases in required net working capital and capital expenditures
(CAPEX) for SoftTec for the years 2020 to 2024.

Annual increases in required NWC and in CAPEX are shown below in the spreadsheet
base case output.

C. Project annual operating free cash flows for the years 2020 to 2024.

The annual operating free cash flow to equity is calculated as: net income + depreciation
– CAPEX – increases in required NWC + increases in interest-bearing debt. Note: No

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 changes in interest-bearing debt were projected and there were no plans to issue
additional shares of common stock. Annual operating free cash flows are shown below in
the spreadsheet base case output.

D. Estimate SoftTec’s terminal value cash flow at the end of 2023.

The terminal cash flow is estimated to be $232.4 thousands (rounded). This is estimated
by dividing $41.8 thousands (rounded) by .18 (.25 - .07). See the spreadsheet base case
output below.

E. Estimate SoftTec’s equity value in dollars and per share at the end of 2019.

The equity value at the end of 2019 is $123.7 thousands and since there are 10 thousand
shares outstanding, the value per share is $12.37. See the spreadsheet base case output
below.

F. SoftTec’s management was wondering what the firm’s equity value (dollar amount and
on a per share basis) would be if the cost of equity capital was only 20 percent.
Recalculate the firm’s value using this lower discount rate.

By changing the discount rate from 25% to 20%, to calculate the terminal value cash
flows and the present value of the total free cash flows, results in a 2019 present value of
$187.4 thousands and a value per share of $18.74. See the last section (Part F) of
spreadsheet base case output shown below for these calculations.

G. Now assume that the $35,000 in long-term debt (and therefore interest expense at
10%) is expected to grow with sales. Recalculate the equity using the original 25%
discount rate.

See the spreadsheet revised case results (Part G) shown below. One difference between
this solution and the base case results solution is the increasing interest expense on the
income statement causes the net income to decline. However, this decline in net income
is more than offset by the free cash flows contributed by the issuing of more long-term
debt. The result is a higher terminal value cash flow as well as higher operating free cash
flows. Discounting these cash flows at 25% produces an equity value of $153.4
thousands and a value per share of $15.34.

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SOFTTEC PRODUCTS COMPANY
Base Case Results [Parts A, B, C, D, & E]:
Chapter 10 Mini Case Percent Change in Net Sales
% of 33.3% 25.0% 20.0% 16.7% 7.0%
[Thousands of Dollars] 2019 Actual Pro forma --------------------------------------------
Income Statements Sales 2019 2020 2021 2022 2023 2024
Net Sales 100.0% 150.0 200.0 250.0 300.0 350.0 374.5
Cost of Goods Sold -50.0% -75.0 -100.0 -125.0 -150.0 -175.0 -187.3
Gross Profit 50.0% 75.0 100.0 125.0 150.0 175.0 187.3
SG&A Expenses -20.0% -30.0 -40.0 -50.0 -60.0 -70.0 -74.9
Depreciation -5.0% -7.5 -10.0 -12.5 -15.0 -17.5 -18.7
EBIT 25.0% 37.5 50.0 62.5 75.0 87.5 93.6
Interest -2.3% -3.5 -3.5 -3.5 -3.5 -3.5 -3.5
EBT 22.7% 34.0 46.5 59.0 71.5 84.0 90.1
Taxes (40% rate) -9.1% -13.6 -18.6 -23.6 -28.6 -33.6 -36.1
Net Income 13.6% 20.4 27.9 35.4 42.9 50.4 54.1

Required Net Working Capital:

Req Cash+Receivables+Inventories 33.3% 50.0 66.7 83.3 100.0 116.7 124.8
Minus: Payables+Accruals -16.7% -25.0 -33.3 -41.7 -50.0 -58.3 -62.4
Req Net Working Capital (RNWC) 25.0 33.3 41.7 50.0 58.3 62.4
Increase in RNWC 8.3 8.3 8.3 8.3 4.1
Fixed Assets Schedule:
Net Fixed Assets (NFA) 33.3% 50.0 66.6 83.3 100.0 116.7 124.8
Increase in NFA 16.7 16.7 16.7 16.7 8.2
Plus: Depreciation 10.0 12.5 15.0 17.5 18.7
CAPEX 26.7 29.2 31.7 34.2 26.9

Free Cash Flows to Equity:

Net Income 27.9 35.4 42.9 50.4 54.1
Plus: Depreciation 10.0 12.5 15.0 17.5 18.7
Minus: CAPEX -26.7 -29.2 -31.7 -34.2 -26.9
Minus: Increase in NWC -8.3 -8.3 -8.3 -8.3 -4.1
Operating Free Cash Flows 2.9 10.3 17.9 25.4 41.8

Terminal Value CF (r=.25, g =.07) 232.4

Total Free Cash Flows 2.9 10.3 17.9 257.8
PV of TFCF (25% Discount Rate) $123.7
Value Per Share (10,000 shares) $12.37

Part F:
Operating Free Cash Flows 2.9 10.3 17.9 25.4 41.8
Terminal Value CF (r=.20, g =.07) 321.7
Total Free Cash Flows 2.9 10.3 17.9 347.2
PV of TFCF (20% Discount Rate) $187.4
Value Per Share (10,000 shares) $18.74

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SOFTTEC PRODUCTS COMPANY
Revised Case Results [Part G]:
Chapter 10 Mini Case Percent Change in Net Sales
% of 33.3% 25.0% 20.0% 16.7% 7.0%
[Thousands of Dollars] 2019 Actual Pro forma --------------------------------------------
Income Statements Sales 2019 2020 2021 2022 2023 2024
Net Sales 100.0% 150.0 200.0 250.0 300.0 350.0 374.5
Cost of Goods Sold -50.0% -75.0 -100.0 -125.0 -150.0 -175.0 -187.3
Gross Profit 50.0% 75.0 100.0 125.0 150.0 175.0 187.3
SG&A Expenses -20.0% -30.0 -40.0 -50.0 -60.0 -70.0 -74.9
Depreciation -5.0% -7.5 -10.0 -12.5 -15.0 -17.5 -18.7
EBIT 25.0% 37.5 50.0 62.5 75.0 87.5 93.6
Interest -2.3% -3.5 -4.7 -5.8 -7.0 -8.2 -8.7
EBT 22.7% 34.0 45.3 56.7 68.0 79.3 84.9
Taxes (40% rate) -9.1% -13.6 -18.1 -22.7 -27.2 -31.7 -34.0
Net Income 13.6% 20.4 27.2 34.0 40.8 47.6 50.9

Required Net Working Capital:

Req Cash+Receivables+Inventories 33.3% 50.0 66.7 83.3 100.0 116.7 124.8
Minus: Payables+Accruals -16.7% -25.0 -33.3 -41.7 -50.0 -58.3 -62.4
Req Net Working Capital (RNWC) 25.0 33.3 41.7 50.0 58.3 62.4
Increase in RNWC 8.3 8.3 8.3 8.3 4.1
Fixed Assets Schedule:
Net Fixed Assets (NFA) 33.3% 50.0 66.6 83.3 100.0 116.7 124.8
Increase in NFA 16.7 16.7 16.7 16.7 8.2
Plus: Depreciation 10.0 12.5 15.0 17.5 18.7
CAPEX 26.7 29.2 31.7 34.2 26.9

Long-Term Debt Financing:

Amount of Long-Term Debt 23.3% 35.0 46.7 58.3 70.0 81.7 87.4
Increase in Long-term Debt 11.7 11.7 11.7 11.7 5.7

Free Cash Flows to Equity:

Net Income 27.2 34.0 40.8 47.6 50.9
Plus: Depreciation 10.0 12.5 15.0 17.5 18.7
Minus: CAPEX -26.7 -29.2 -31.7 -34.2 -26.9
Minus: Increase in NWC -8.3 -8.3 -8.3 -8.3 -4.1
Plus: Increase in L-T Debt 11.7 11.7 11.7 11.7 5.7
Operating Free Cash Flows 13.9 20.6 27.5 34.3 44.4

Terminal Value CF (r=.25, g =.07) 246.7

Total Free Cash Flows 13.9 20.6 27.5 281.0
PV of TFCF (25% Discount Rate) $153.4
Value Per Share (10,000 shares) $15.34