Seminar 3 N1591

Valuation of Companies and Cash Flow Generating Assets (N1591)

Autumn Term 2019/20

Seminar 3: Frameworks for Valuation (McK Chap 8)

Short Answer Questions

1. List the four basic steps in valuing a company’s common equity using the DCF approach.

Calculation Questions

2. (McK Q.1) Exhibit 8.18 displays the income statement and reorganised balance sheet for
BrandCo, a consumer products company.

EXHIBIT 8.18 BrandCo: Income Statement and Reorganized Balance Sheet

$ million

Income statement Today Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Revenues 3,777.1 4,041.5 4,304.2 4,583.9 4,859.0 5,126.2 5,382.5
Operating costs (3,245.1) (3,435.2) (3,658.5) (3,896.3) (4,130.1) (4,357.3) (4,575.1)
Depreciation (82.9) (97.0) (103.3) (110.0) (116.6) (123.0) (129.2)
Operating profits 449.1 509.2 542.3 577.6 612.2 645.9 678.2

Interest (14.0) (14.0) (14.0) (14.0) (14.0) (14.0) (14.0)

Earnings before taxes 435.1 495.2 528.3 563.5 598.2 631.9 664.2

Taxes (130.5) (148.6) (158.5) (169.1) (179.5) (189.6) (199.2)

Net income 304.6 346.6 369.8 394.5 418.7 442.3 464.9

Reorganized balance sheet Today Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Operating working capital1 188.9 202.1 215.2 229.2 242.9 256.3 269.1
Property and equipment 1,510.8 1,616.6 1,721.7 1,833.6 1,943.6 2,050.5 2,153.0
Invested capital 1,699.7 1,818.7 1,936.9 2,062.8 2,186.5 2,306.8 2,422.1

Debt 280.5 280.5 280.5 280.5 280.5 280.5 280.5

Shareholders' equity 1,419.2 1,538.2 1,656.4 1,782.3 1,906.0 2,026.3 2,141.6
Invested capital 1,699.7 1,818.7 1,936.9 2,062.8 2,186.5 2,306.8 2,422.1

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Seminar 3 N1591

 Using the methodology outlined in Exhibit 8.5, determine NOPLAT for years 1 to 6.
Assume an operating tax rate of 30%.

 Using the methodology outlined in Exhibit 8.6, determine FCF for years 1 to 6.

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3. (McK Q.2) BrandCo has currently 65.6m shares outstanding.

 If BrandCo shares are trading at $ 57/share, what is the company’s market

capitalisation?
 Assuming the market value of debt equals today’s book value of debt, what percentage
is attributable to debt and what percentage is attributable to equity?
 When would the market value of debt not equal the book value?
 Using these weights, compute WACC. Assume the pre-tax cost of debt of 8%, the cost
of equity of 12%, and the marginal tax rate of 30%.

4. (McK Q.3) Using the next five years of CF computed in Question 2, an estimate of continuing
value at the end of year 5, and the WACC computed in Question 3, estimate BrandCo’s
enterprise value.

Assume a long-term growth in cash flows of 5% and a RONIC of 15%. BrandCo currently has
no non-operating assets.

5. (McK Q.4) Assuming the market value of debt equals today’s book value of debt, what is the
intrinsic book value for BrandCo? What is the value per share? Does it differ from the share
price used to determine the cost of capital weighting in Question 3?

6. (McK Q.8) Exhibit 8.19 displays key financial information for VidCo, an entertainment firm.

Fill in the shaded areas of the exhibit to arrive at a value of the operations using the APV
model. Assume that the interest tax shields are as risky as the overall firm.

EXHIBIT 8.19 VidCo: Key Financial Figures

$ million
Discounted Prior-year Interest Interest Marginal Interest
Forecast year FCF FCF debt rate, % payment tax rate, % tax shield (ITS) Discounted ITS
1 100.0 1,000.0 8.0% 35.0%
2 105.0 1,040.0 8.0% 35.0%
3 110.3 1,081.6 8.0% 35.0%
4 115.8 1,124.9 8.0% 35.0%
5 121.6 1,169.9 8.0% 35.0%
6 127.6 1,216.7 8.0% 35.0%
7 134.0 1,265.3 8.0% 35.0%
8 140.7 1,315.9 8.0% 35.0%
9 147.7 1,368.6 8.0% 35.0%
10 155.1 1,423.3 8.0% 35.0%
Continuing value 1,480.2 8.0% Continuing value

Sum of discounted FCFs Sum of discounted ITSs

Marginal tax rate, % 35.00%

Unlevered cost of equity, % 10.00% PV of FCF and ITS
Midyear adjustment factor
Value of operations

Growth rate in FCFs 5.00%

Growth rate in Debt 4.00%
Interest Rate on Debt 8.00%

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Multiple Choice Questions

7. Which of the following valuation methods use(s) the weighted average cost of capital
(WACC) as the discount rate?

I. The economic profit model.

II. The adjusted present value model.
III. The discounted cash flow model.
IV. None of the above.

A. I and II only.
B. I and III only.
C. II and III only.
D. IV.

8. Given the following information, compute the estimated value per share.

Present value of cash flow $ 25m

Value of investments $ 1m
Value of debt $ 8.6m
Value of post-retirement obligations $ 2.2m
Number of shares outstanding 8m

A. $ 0.9
B. $ 1.9
C. $ 2.7
D. $ 3.6

9. Use the following information to find the NOPLAT in year t + 1 that yields the continuing
value expressed below.

NOPLAT growth rate = 1.5%

Return on new invested capital = 9%
Weighted average cost of capital = 6.8%
Continuing value = $1,750

A. $ 111m
B. $ 95m
C. $ 105m
D. $ 184m

10. In the APV approach, why is the unlevered cost of equity used instead of the WACC?

A. To account for retained earnings risk.

B. To avoid measuring the impact of debt.
C. To value the company as if it were all equity financed.
D. To incorporate the risk of newly issued shares.