Chapter 5 DISCOUNTED CASH FLOWS METHODVALUATION CONCEPTS AND METHODOLOGIES DISCOUNTED CASH FLOWS METHOD in Financial Management, it has been discussed that a way to determine the value of an investment opportunity is by determining the actual cash nerated by a particular asset. Recall that discounted cash flows analysis can be done by determining the present value of the net cash flows of the avestment opportunity. In Conceptual Framework and Accounting Standards, it was discussed that the cash flows are presented and analyzed based on their sources and activities which are categorized as operating, vesting and financing. in determining the value of an asset, the cash flows are important reference or inputs. In determining the value of the asset, it is essential to include amount of cash that will be available for the claims of the equity owners. The Net Cash Flows refer to the amount of cash available for distribution to both debt and equity claims of the business or asset. This is calculated from the net cash generated from operations and for investment over time. For GCBO, the net cash flows generated will be based on the cash flows from operating and investing activities, since this represents already the amount earned or will be earned from the business and the amount that is required to be infused in the operations to generate more profit. Net Cash Flows is preferred as basis of valuation if any of the following conditions are present: * Company does not pay dividends e Company pays dividends but the amount paid out significantly differs from its capacity to pay dividends e Net Cash Flows and profits are aligned within a reasonable forecast period * Investor has a control perspective. If an investor can exert control over a company, dividends can be adjusted based on the decision of the controlling investor. Using net cash flows over other cash flow concepts is more advantageous in a valuation activity since this metric can be directly used as input to a DCF model. This is not the case for other cash flow or earnings measure such as. EBITDA, EBIT, net income and cash flow from operations since these metrics might have missed or double counted an item + EBITDA and EBIT are both metrics that are before taxes; cash flows that are available to investors should be after satisfying tax requirements of the governmente EBITDA and EBIT also do not consider differences in capital structures since it does not capture interest payments, dividends for preference shares and funds sourced from bondholders to fund additional investments. * All these measures also do not consider reinvestment of cash flows made into the firm for additional working capital and fixed assets investment that are necessary to maximize long-term stability of the business. In valuation, analysts find analyzing cash flows and its, sources helpful in understanding the following: * Source of financing for needed investments — Are investments internally funded by cash generated from operations or debt/equity financing is necessary? The best case for firms is to fund its investments wholly or partly through cash from operations. Heavy reliance on external financing from lenders or shareholders may signal that cash from operations is not enough to support the firm's long-term stability. e * Reliance on debt financing — Debt financing is an excellent financing strategy especially for expanding companies. However, it can become @ problem for a firm if its cash from operations is insufficient to repay existing debt obligations. The situation worsens if firms continuously refinance borrowings that come due by another borrowing. * Quality of earnings — Significant disparities between cash flows and income may indicate earnings does not get converted to cash easily, ‘suggesting low quality. There are two levels of Net Cash Flows: (1) Net Cash Flows to the Firm; and (2) Net Cash Flows to Equity. The Net Cash Flows to the Firm is the amount made available to both debt and equity claims against the company. The Net Cash Flows to Equity represents the amount of cash flows made available to the equity stockholders after deducting the net debt or the outstanding liabilities to the creditors less available cash balance of the company. The net cash flows can be determined by referring to the financial statements of the company. Net Cash Flow to the Firm Net cash flow to the firm refers to the cash flow available to the parties who supplied capital (je. lenders and shareholders) after paying all operating expenses, including taxes, and investing in capital expenditures and working capital as required by business needs. NCF to the firm is cash flowsONCEPTS AND METHODOLOGIES nerated from operating activities of the business which is intended to pay required return of fund providers. Valuation models based on enterprise value compass cash flows available to all investors — whether debt or equity. iterprise value of a company refers to the theoretical value of its core ousiness activities as reflected by its net cash flows. This is the basic premise of most corporate valuation methodologies. Net cash flow only capture items that are directly related to the operating and nvesting activities of the business. Consequently, net cash flow excludes tems associated with financing activities. Net cash flows to the firm can be computed or derived using the following approaches. A. Based from Net Income (or indirect approach) Net Income Available to Common shareholders __Php xxx Add: Non Cash Charges (net) XXX Add: Interest Expense (net of Taxes) YO Add/Less: Adjustment in Working Capital OX Less: Net Investment in Fixed Capital (Purchases - Sales of Fixed Capital Investment) OK Net Cash Flows to the Firm Php 200 ° Net Income Available To Common Shareholders. Basic measure of a firm’s profitability which refers to the bottom line figure in an income statement. This is the amount left for the common shareholders after deducting all costs, expenses, depreciation, amortization, interest, taxes and dividends to preferred shareholders. This is an accounting measure, meaning that non-cash items like depreciation and amortization is also included as a deduction to arrive at net income. However, this measure does not include changes in working capital nor capital investments made during the specific period which significantly affects a firm’s cash flows. « Non-Cash Charges (Net). Pertains to non-cash items thet are included in the computation of net income. Analyst usually look at the statement of cash flows to validate potential non-cash charges. lf amount in the income statement does not match amount reflect cash flows statement, it can be indicative that a portion of that expense is non-cash. The common non- cash items are the following:ate CONCEPTS AND METHODOLOGIES nd amortization ires a fixed asset like equipment or intangible it | cash outflow is made at point of acquisition and is presented in the balance sheet. In succeeding periods, @ portion of the initial cash outflow is recorded as depreciation and amortization which reduces net income, despite not having an actual cash outflow. As a result, this should be added back to arrive at the real cash flow. Restructuring charges Restructuring refers to the change in the organizational structure or business model of a company adapt to changing economic climate or business needs. Most restructuring involves involuntary separation of employees. As a result, the restructuring requires the company to pay them severance pay. Severance pay should comply with the minimum Tequirements set in the Labor Code of the Philippines. Severance pays are normally outright cash outflows. The company may also need to record write-down in value of pension assets (or reversal of previous accruals) as a result of the restructuring activity. This is usually recorded as part of the restructuring expenses (income) in the income statement. However, since there are no cash outlays involved in write- downs (reversal gains), this should be added back to (deducted from) net income to get NCF. Provisions for Doubtful Accounts These are estimated amount to be incurred for the customers inability to pay on time which is cumulatively accounted under the statement of financial position reported against the accounts receivable. Since these amounts represent the value that may have high probability of collection but not yet written off, meaning there is a positive chance that it can still be collected then it should be added back to the net income attributable to common.Reka eas AND METHODOLOGIES After-Tax Interest Expense Interest expense (net of any tax savings) This interest expense is a cash flow intended for the debt providers. In the Philippines, interest expense is a tax-deductible expense for the company. This means that when the company pays interest, it reduces tax to be paid. Hence, the cash outflow is the amount of interest expense less any tax savings. After-tax interest expense is added back to net income since the objective of NCF is to measure the cash flows associated with the operating activity of the business. The impact of financing should be neutralized to arrive at the real business value based on its operations. Working Capital Adjustment Also known as working capital, this item represents the net investment in current assets such as receivables and inventory reduced by current liabilities like payables. The amount captured is based on the movements in these accounts from prior year. Required investment in current assets tend to increase when a firm's sales grow consistently year on year. Higher receivables and inventories are needed in order to support rising revenues. The company also needs higher financing through accounts payable or taxes payable to fund these receivables and inventories. Increase in current assets means cash outflow while higher current liabilities are cash inflows. Otherwise, the company may miss out on sales growth if they lack the current assets and liabilities to support it. Fast growing firms engaged in industries with high working capital needs like retailing and manufacturing tend to have substantial rise in working capital. Companies do not need to pay for taxes when they are investing in their operating capital. On the other hand, if current assets requirement decline, this means that more cash is available to debt and equity providers, thus, added back. For NCF and valuation purposes, movements in cash, marketable securities short-term notes payable and current portion of long-term debt is excluded in the computation. Cash is excluded since the purpose of the NCF exercise is to identify what is the real cash flow of the business. Marketable securities are also excluded since these are not directly linked to operations. On the other hand, notes payable and current portion of long-term debt are excluded since they areUATION CONCEPTS AND METHODOLOGIE! Investmer d Capital. Pertains to cash outflows made to purchase or pay for capital expenditures that are required to support existing and future operating needs. Capital expenditures range from property, plant and equipment necessary for production requirements to intangible assets like trademark, patent and copyrights. Firms expect that they will reap benefits for more than one year as a result of these investments. The investment in fixed capital assumes that the projects financed acceptable and has positive net present value. Increases in fixed capital investments use cash, hence, a reduction to Net Cash Flow. This is captured in the year that the cash outflow is made. Information related to these can be found in the balance sheet and statement of cash flows. Once initial cash payment is made, this is charged to succeeding year's income statement as depreciation and amortization. Treatment for depreciation and amortization applies. When gaps exist between amount of capital investment and depreciation (called as net capital expenditures), this is usual related to the growth profile of the company. Company expecting high growth tend to report high net capital expenditures compared to earnings while low-growth companies usually have negative net capital expenditures Cash paid for acquisition of a new business also falls into this category. The full purchase amount reduces the Net Cash Flow in the year of acquisition. If the acquisition involves non-cash settlement, analysts should be careful in capturing only portion denominated in cash as reduction to Net Cash Flows. On the other hand, if there are sale of capital expenditures that occurred, this should be added back to the Net Cash Flow. This sales increase the cash inflow which consequently reduces the investment in fixed capital for that period. For example, if a property is sold for Php 1,000,000, then this should reduce the amount of investment in fixed capital ((_e. ultimately, an addition to net cash flows). Hence, net investment in fixed capital is deducted to arrive at Net Cash Flow computation. A negative net investment signifies that firm received cash since it sold more assets than it purchased for the year. Analyst should use the statement of cash flows to analyze cash flows related to fixed capital investments. There are instances whenVALUATION CONCEPTS AND METHODOLOGIES companies may obtain fixed capital in exchange of shares which doesn't necessarily have impact to cash flows. Even though transactions might be non-cash for the current year, analysts should be careful in forecasting future fixed capital investments especially if it will require cash outlays B. From Statement of Cash Flows NCF can also be computed using cash flows from operating activities (in the statement of cash flows) as the starting point. Analysts usually start from this item since it already considers adjustment for noncash expenses and working capital investments As a refresher, the statement of cash flows classifies cash flow into three major sections: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. Cash Flows from Operating Activities Php xx Add: Interest Expense (net of Taxes)* XXX Less: Cash Flows from Investing Activities XxX Net Cash Flows to the Firm Php xxx *only if deducted from the operations * Cash flow from operating activities This represents how much cash the company generated from its operations. This shows how much cash is received from customers and how much cash outflows are paid to vendors. This also captures changes in current assets and current liabilities. Normally, this is computed from net income by considering non- cash items and working capital changes. This is considered in computing for NCFF. « Cash flow from investing activities This represents how much cash is disbursed (received) for investments in (sale of) long-term assets like property, plant and equipment and strategic investments in other companies. This is considered in computing for NCFF. If this section reflects transactions involving financial assets, this should be excluded. * Cash flow from financing This represents hi the company. This i ih was raised (or repaid) to finance hen computing NCFF. ThisRTO kes sare aurea) is simply because these figures will be accounted for in the calculation of the Net Cash Flows to the Equity. Analysts should be mindful how interest and dividends are classified in the statement of cash flows. IFRS allows interest and dividends received to be classified under operating or investing activities while interest and dividends paid out is placed under operating or financing activities. One-time or extraordinary items should also be eliminated from the computation C. From Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) [ EBITDA, net of Taxes Phip xox | Add: Tax Savings on Noncash Charges XXX Add / Less: Working Capital Adjustments. XXX Less: Investment in Fixed Capital Xxx | Net Cash Flows to the Firm Php xxx « EBITDA or Earnings Before Interest, Taxes, Depreciation and Amortization pertains to income before deducting interest, taxes, depreciation and amortization expenses, net of taxes Since the basis of the computation for the NCFF is already the earnings after excluding the financing costs, taxes and other non cash charges, the NCFF should only consider the amount net of the applicable taxes to be paid. This to conservatively show the EBITDA at the amount net to be realized by the investor. * Tax Savings on Non-cash Charges. Non-cash charges are not typically adjusted if NCFF starts with EBITDA. However, it is important that analyst should check whether non-cash charges were already deducted in computing for EBITDA or not. If deducted, then there is a need to add the item back. If non-cash charges are not yet deducted from EBITDA, there is no need to add it back to compute for NCFF. Instead of adjusting for the full amount, analyst should add back the corresponding tax savings related to this non-cash charges to EBITDA. Several non-cash charges such as depreciation and amortization are tax-deductible. This means that occurrence of these expenses reduces the taxes that the company should pay,thus, reducing cash outflow. This is added back to EBITDA to capture this impact. Concepts on investments in fixed and working capital is same as previous discussion. Net Cash Flow to Equity i Cash Flow to Equity or NCFE refers to cash available for common equity ticipants or shareholders only after paying operating expenses, satisfying erating and fixed capital requirements and settling cash flow transactions avolving debt providers and preferred shareholders. NCFE can be computed from NCFF by considering items related to lenders and preferred shareholders. NCFE signifies the level of available cash that a business can freely declare 2s dividends to its common shareholders. This may still differ significantly ‘rom the dividends actually declared and paid out since this decision is made upon the discretion of a company's board of directors. Companies tend to manage their dividend policy: some slowly increase dividends over time while some maintain current dividends despite actual profitability. As a result, dividend trend is seen as less volatile compared to earnings as this is managed by the board of directors. Net Cash Flows to the Firm Php xxx ‘Add: Proceeds from Borrowings x Less: Debt Service XxX | Add : Proceeds from Preferred Shares Issuance XXX | Less: Dividends on Preferred Shares XXX Net Cash Flows to the Equity Php x00 * Proceeds from Borrowing This refers to the amount of cash received by the company as a result of borrowing of long-term debt financing, it did not capture Since the cash from the b added back to NCFF an: shareholders. FF did not include items related to by the company from lenders. the company already, it is cash flow available to common.Debt Service Debt Service is the total amount used to service the loans or debt financing. This is the total amount of loan repayment and the interest expenses, net of income tax benefit. The interest expense is considered as part of the financing activities and hence deducted from Net Cash Flow since this is associated with long- term debt of the company. The amount to be included must exclude the equivalent tax benefits from the interest. The tax benefit must accord with what was allowed by the tax regime where the business operates. Please note that this amount must be similar should an adjustment was made to compute for the NCFF. Proceeds from issuance of Preferred Shares Same with the debt, preferred shares as another form of financing, other than the issuance of ordinary equity, must also be factored in the calculation of the net cash flows available to equity. Dividends on Preferred Shares Since payments made to preferential shareholders in the form of dividends are outflows. This must be incorporated in the calculation as a reduction of the net cash flows to equity. Similarly, given the above formula as guiding principle, NCFE can be determined under the following approaches: A. Based from Net Income (or indirect approach) Net Income Available to Common shareholders Php x0 Add: Non Cash Charges (net) XXX Add: Interest Expense (net of Taxes) OOK Add/Less: Adjustment in Working Capital I XK Less: Net Investment in Fixed Capital (Purchases - Sales of Fixed Capital Investment) XK Net Cash Flows to the Firm XXX Add: Proceeds from Borrowing XXK Less: Debt Service Xxx Add : Proceeds from Preferred Shares Issuance XXX Less: Dividends on Preferred Shares XXX. Net Cash Flows to the Equity Php xxxB. From Statement of Cash Flows Cash Flows from Operating Activities Php xxx. Add: Interest Expense (net of Taxes)* XXX Less: Cash Flows from Investing Activities XXX Net Cash Flows to the Firm XXX, Add: Proceeds from Borrowing XXX Less: Debt Service XK Add : Proceeds from Preferred Shares Issuance: XXX Less: Dividends on Preferred Shares XxX Net Cash Flows to the Equity Php xxx C. From Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) EBITDA, net of Taxes [Php xxx Add: Tax Savings on Noncash Charges xx ‘Add / Less: Working Capital Adjustments. 3X Less: Investment in Fixed Capital XXX Net Cash Flows to the Firm Xxx | Add: Proceeds from Borrowing XXX Less: Debt Service XXX | Add : Proceeds from Preferred Shares Issuance Xxx Less: Dividends on Preferred Shares Se Wea Net Cash Flows to the Equity Php xxx Terminal Value Since GCBOs is assumed to operate in a long period of time to almost perpetuity, the risk and returns are inherent to the opportunity at the end of the projection period should also be quantified. Furthermore, the economic value that will be generated by the assets is expected to be stable after some point in time since the projections are reliant on certain assumptions made The challenge for the determination of the value of the asset is to aiso account for the economic returns that it will generate in perpetuity. This is addressed by the Terminal Value. Terminal Value represents the value of the company in perpetuity or in a going conc: In practice, there are several ways on how to determine the terAND METHODO! Basis of Terminal Value 4. Liquidation Value Some analysts find that the terminal value be based on the estimated salvage value of the assets. Methodologies on how to determine the salvage or liquidation vaiue was discussed in Chapter 3. 2. Estimated Perpetual Value Another way to determine the terminal value is by using the farthest cash flows you can estimate divided by the cost of capital less the growth rate. TW= ees P= i TV = Terminal Value CF = Farthest net cash flows T= Cost of capital g = growth rate For example, 2 Filipino company is expecting for 15% returns for a venture and assumes that their net cash flows for the next five years are as follows: Year Net Cash Flows (in million Php) 5.00 5.50 6.05 6.66 7.32 on].A]o9 [no |» In the given illustration, you may note that the net cash flows are growing annually. Assuming this is a GCBO, and it is expected that the net cash flows will behave on a normal trend. The growth rate (g) is computed using compounded annual growth rate formula: NCE, 31 js Gaz) [-ssseonATAU oly NCFo = net cash flows at the beginning NCF,, = latest net cash flows n = latest time Substituting the given figures, the growth is computed as fa" g = (110-1) x 100% g = 10% Since the growth rate is 10%, it will be applied on the farthest cash flows i.e. on the 5" year equivalent to Php7.32, thus the farthest cash flows is now Php8.05 or will substitute the CFy1. It is now assumed that the cash flows will continuously growth at the rate of 10% per annum. Thus, the formula can now be applied. Fava Cre T= Php 8.05 i IV = 5% — 10% Php 8.05 5% TW= Php 8.05 ~~ 3% TV = Phpi61 In some cases, that the historical growth pattern is undetermined, some analysts only conside: cost of capital or their required return to determine the terminal value. In the given illustration, you may note that difference on the terminal valt 118VALUATION CONCEPTS AND METHODOLOGIES Php 8.05 15% — 0% __ Php 8.05 "15% TV = Php53.66 You may observe that the terminal value in this case is more conservative by about Php107. 3. Constant Growth Challenges for some valuators is to determine the amount of required return for a specific type of asset or investment. In lieu of the required return, they use the growth rate as the proxy especially if the growth is constant and significant. 4. Scientific Estimates Other valuators especially those with vast experience already in some types of investments uses other basis for them to determine the reasonable terminal value. Using guesstimates is not prevented because in the end, equity values will stil! be based on negotiation. There is no perfect approach to determine the terminal value. Actually, some risk averse investors don’t consider the terminal value in their valuation. The differences in their appreciation on the determination or even the inclusion of the terminal value is dependent on their risk appetite. Then again, the valuation method will only serve as a reference to determine the reasonable value for the equity or the asset being purchased. This is why negotiation plays a key role in finalizing the determined value. Other inputs in the Net Cash Flows The present value of the Net Cash Flows represents the value of the assets. it may be recalled further that the assets are financed by debt and equity. Hence, these are the claims which are presented at the right side of the Statement of Financial Position, under an account form of reporting. The discounted cash flows analysis factors in all the projected stream of cash flows that the project, opportunity or investment and valuing it in present time to determine whether the investment made on this year would be less thanMETHODOLOGIES the value it will generate in the future, that means the investment yielded an amount sufficient to cover the investment and allowing the investors to earn more. Same principle applies that the best opportunity is the one that will yield the highest present value or solely if the opportunity will result into a positive amount it should be accepted. Conservatively, the total outstanding liabilities must be considered and deducted versus the asset value to determine the @mount appropriated to the equity shareholders. This is called the equity value. The opportunity that will result in the highest equity value is considered. DCF Analysis is most applicable to use when the following are available: e Validated Operational and Financial Information * Reasonable appropriated cost of capital or required rate of return * New quantifiable information Illustrative Example No.1 Bagets Corporation has projected to generate revenues, cash operating expenses, and the corresponding tax payments for the next five years: Revenue Cash Operating Taxes Working Capital Expenses Adjustments 4 92.88 65.02 45.57 18.58 2 97.52 68.26 48.23 19.50 pas3: 102.40 71.68 $1.04 20.48 4 107.52 75.26 54.04 21.50 5 112.90 79.03 S75 22.58 The investment in fixed capital that was purchased and invested in the company amounted to Php100 Million. To be financed by: * 60% from loan borrowing with an annual interest of 10% payable equally in five years. First payment will be due after 1 year; and « 10% preferred shares with 8% coupon rate. If you are going to purchase 50% of Bagets Corporation, assuming a 15% required return, how much would you be willing to pay? Based on the foregoing information Php22.80 Million. If the amount at s paid is Php11.4 Million (Php22.80 value of Bagets Corporation equity is Ke is only 50% then the amount to beVALUATION CONCEPTS AND METHODOLOGIES Bagets Corporation Discounted Cash Flows Analysis te] Year Yeard Yea? Years Yeard Years Revenue 288 9782 «102.40 ~—«10752 12.99 Less: Cash operating Expenses = GO2- 82-7168 - 75.26 - 79.03 Less: Tax Payments + 557 - A82B- S108 SOL - 57.25 Add / (Less) : Working Capital Adjust 1858-195 20.48 - 21.50 = 22.58 Net cash Flows >= 8629-3847 - 40.80 - 3.25. 45.95 Less: Investmenttin Fixed Capital 300.00 Add: Terminal Value |2 49150 Not Cash Flows to Firm Adc: Proceeds from Borrowing 7) Less: Debt Service a |Add: Proceeds from Preferred Shares B Loss: Dividends to Proferred Shares B Net Cash Flows to Equity [Som - S1an- s360- S6.25- 59.08 19.45 Discount Factor 100087 078 0.66 0570.50. Discounted Net Cash Flows (NCFE,) [2000 - aaas- 4053. 36.99 - 33.77 20858 Equity Value “4 | 2a Notes to Analysis “1 Terminal Value Calculation CEnix _ 18.862 45%) _ 48.15 v= ee r-@ 15% —5% 10% = Php 481.50 2 Proceeds from Borrowings and Debt Service Financial Models in Discounted Cash Flows Analysis Financial Modelling is a sophisticated and confidential activity in a company or for an analyst. Information is can also be considered as competitive advantage of a company or a person. Most of the companies hire financial modelers to assist them in determining the value of GCBOs or other Opportunities. They also ask them to validate ballpark estimates and may also be used to determine impairments. Most financial modelers have extensive financial acumen and vast knowledge and experience. Financial modelers normally are economists, financial managers, and accountants. Management accountants are good candidate for this role given their ability to understand operational models and design long term financial strategies.| VALUATION CONCEPTS AND METHODOLOGIES | fn order to develop financial models, the following steps needs to be observed: Gather historical information and references Historical information must be made available before the financial model is to be constructed. Historical information may be generated from, but not limited to the following: audited financial statements, corporate disclosures, contracts, and peer information Audited Financial Statements are the most ideal reference for the historical performance of the company. The components of the Audited Financial Statements enable the analyst or the financial modeler to assess the future of the company based on its past performance. Statement of Income are used to determine the historical financial performance, Statement of Financial Position is used to determine the book value of the assets and the disclosed stakes of the debt and equity financiers, Statement of Cash Flows illustrate how the company historically financing its operations and investments. Statement of Changes in Stockholder's Equity provides the information on how much is the claim and dividend background of the company. One of the most important components of the financial statements are the Notes to the Financial Statements. It provides the summary of important disclosure that should be considered in the valuation. The financial modeler must be able to quantify these disclosures and more importantly the risks involved. Corporate disclosures are also key in developing the financial model. Corporate disclosures provide more context for the future plans and strategies of the company. This will enable the analysis or the financial modelers to identify the risks about the GCBO and quantify them accordingly. Since these are available to the public, it is the same information that is known to others. The difference among modelers are their personal appreciation to risk and their client's appetite for risks. Contracts are formal agreements is important for the modeler to covenants contained in it. Large a services to assist their clients who necessary to verify any continge: that opportunity and quantify it ac: The modeler must be able to Gathering this information is im, and incorporate it in the finan parties. In valuing the GCBOs, it the existing contracts and the firms offer transaction advisory into new ventures. Due diligence is and other legal risks surrounding have a more conservative value. ability of these from occurring @ reasonable basis to quantify(RANTS Peer information and other public information are also essential inputs to the financial model. Peer information provides more context and even supports the risks identified or will be assumed in the valuation process. Peers may be other analysts, industry experts and other consultants. Internal members of the organization may also be considered as peers. However, the information sharing is restricted by law since these are insider information and is not fair for the public. Researches and studies can also be used as peer information. In the Philippines, reliable sources could be the National Library and Philippine Institute on Development Studies. Researches and studies shared through conventions and forums will also be relevant inputs in the development of the financial! model and in valuation. Collectively, the financial mode] must be able to filter the information that would be necessary for the valuation. Relevance and reliability of information are important. Not all information should be given consideration. Materiality is another consideration. Even if there are additional information gathered, there should be a sense of materiality assessment involved. Note that projections remain to be estimates. Therefore, only relevant items should be considered in the valuation. 2. Establish drivers for growth and assumptions Once all relevant information was gathered and validated, drivers and assumptions can be established by conducting financial analysis. Drivers are suggested to be those validated and is represented by authorities like government or experts. Growth drivers are normally based on population. since most of the businesses are consumer goods. If services, indusiry growth may be used as a driver. In the Philippines, information is available from the Philippine Statistics Authority. Because the government needs to be transparent to its citizens, it fortunate that the information can be found in the government website or is disclosed to public through media with wider reach and scale. 123Population National leas ag sop 365% h jase GNI 70% nllaton tate 2.% a suitdg ion auger oe eal i] Mire © 1% Sidaby aut) pul E161 Pip 313,000.00 2.7 bits pes sea ane ® 2 am Philippine Statistics Authority Dashboard For other economic factors, drivers, and estimates, Bangko Sentral ng Pilipinas and National Economic and Development Authority are also other agencies that can be relied with. Certain statistical information can also be found from the websites or research centers of the Local Government Units and National Government Agencies. Research organizations may also be used, however, strong validation and evaluation needs to be done to isolate any form of biases that may affect value. The usual growth indicators used re: inflation, population growth, GNP or GDP growth. in economics, the inflation is the result of the movement of prices from a year to another. This is calculated by comparing the movement of the price of the basket of commodities from a year to another or a period to another. Inflation is computed using this formula: (CP CPI, \ Inflation = )— 1% 100% CPi, = consumer price index — current year CP le = consumer price index — base year The consumer price index represents the price of the basket of commodities for a particular period. In financial modelling, you need the inflation to be used as driver for certain operating at expenditures. There are two ways to calculate the value: (1) nom Nominal financial models are a’ stated in the model already as: case of inflation or deflation determine the current price. Ree! include the effect of changes in prices, meaning, the prices ices grew or decline, in the es the headline inflation to on the other hand, does not ner preserve the price ofVALUATION CONCEPTS AND METHODOLOGIES operating expenses and capital expenditures, as if no changes in prices occur. If the financial | is in real prices, the cost of capital should also excludes the effect 07 n. With the given equation, to illustrate, that in year 2019 the CPI is 151 meaning the cost of the basket is Php151. In year 2020, the CPI published is Php155. Obviously, the price of the basket grew, hence, inflation is expected to be 2.64% [(155/151)-1 x 100%]. On the other hand, if the CPI published for 2020 is Php149, then it will be a deflation or decrease in prices at 1.32% [(149/151) —1x 100%]. To illustrate its application, supposed you are projecting for how much is the communication costs for 2021 when the cost in 2020 is Php5 Million. Given the calculated inflation of 2.64%, the communication costs to be incorporated in the financial model is Php9.132 Million. Other indicator is‘population growth rate. Population growth rate is factored in to serve as a growth driver for the demand of the product, particularly for the merchandising or manufacturing business. The services sector may use the growth rate in the businesses or the industry or sector that they are going to serve. The formula to calculate for the population growth rate is similar with the inflation, except that the input is the population count of a particular segment in a particular year. To illustrate, suppose that in Barangay A in 2019 the population is 25,200. The survey is conducted in 2020 and the population is 26,460. Using the formula of inflation to calculate for population growth rate: 1x 100% (ezoa) g=5% To illustrate the application, assuming that the estimated consumption of pan de sal in Barangay A is 5 pes average per head. If you are going to project the number of pan de sal to be sold in 2027, it will be 138,915 units computed as follows: Current pan de sal sold (26,460 x 5) 132,300 Increase in pan de sal (26,460 x 5% x 5) 6.615 Total estimated pan de sal 138,915 Financial ratios may be used as tools to determine the growth drivers anc assumptions. Trend analysis will also help you establish the trajectory of growth pattern. The financial modeler must assess whether the company cansustain the pattern otherwise it is conservative to assume a less aggressive growth. Normally the weighted growth pattern will be considered in the long- term financial perspective. It must be assessed whether the average year on year growth will be sustained or may be surpassed. To illustrate, PUP Company's historical production grows 10% per year. Itis expected that in the next five years the probability are as follows: Scenario Rate Probability A 5% 10% B 10% 40% Cc 15% 50% J With the given information, the weighted average growth rate to be used is 12% computed as follows: Scenario Rate Probability Weighted (4) (2) (1) x (2) A 5% 10% 0.5% B 10% 40% 4.0% Cc 15% 50% 75% Total 12.0% In this situation, the financial modeler can safely use the 12.0% for projecting sales moving forward. Hence, if the sales for this year was reported to 8,500 units then under the average sales computed will result to 9,520 units sold. 3. Determine the reasonable cost of capital In determining the reasonable cost of capital, the financial modeler must be able to use the appropriate parameters for the company. Generally, cost of debt and cost of equity are weighted to determine the cost of capital reasonable for the valuation. 4. Apply the formulae to compute for the value Normally in Financial Modelling, DCF is used to calculate for the value. Since most information are already available in Financial model, it can be easier to use other capital budgeting techn’ like Internal Rate of Return, Profitability Index etc.ION CONCEPTS AND METHODOLOGIES required return of 10 net income margin of 2 pan de sal is sold at Php15 per unit with a cash Delight's equipment is capable of producing the volume required for 10 years. It was noted that the company has outstanding debt of Php500,000. Using the inputs, the financial model may be presented through: ala 5 4 [Delight Bakery tne 2 |Finencial modet 3 4] 5| volume 5) Price 7 | Revenue | Cash Net Income margin 9 | Cash Net income 30 piscount Factor Vi Discounted Net cash Flows Enterprise Vatue (sum) Less: Debt 14 Equity Value 2a @ # Yeort___Year2___Year3___Yeara__ Yeas s 18Si5__uasaek_asea54 asoam 6a, 5 5 5 13 3 7 2083,725 2187915 2,297,210 2,412,180 2532,795_ 20% 20% KOK Moms yee Gam ana SOB 58 aoe? os” oss? ozs? 068” 2 378,809.09 J61,86.88 345,500.60 39551028 Had S32 26 4,729,7%2.30 =SUna{DIiH3) 5,000 3,229,74 Observe that the enterprise value is calculated by getting the sum of all discounted net cash flows. Alternatively, NPV function can be used in electronic spreadsheets. Below is an illustration where both should arrive the same results. AA e 1 [Delight Bakery ine 2 [Financial Mode! 3| Volume Price Revenue Cash Net Income Margin Cash Net income 10) Discount Factor i Discounted Net Cash Flows 12| _ Enterprise Value (sum) 12, Enterprise Value (NPV) 14 Less: Debe 15) Equity value ei pevennpiner ‘veurt | Year| Years Veara | Years sk! aagais a4s,e01 253,587 6082 368; 5 as| a8) 15 1s 20085 paBiais 270 Daizbo | ASE: a a ae Wigs Wisaa —aSsacz —aabaas 10%" os” os3 0.75” 0.68” 37as59.00 | 964,888.04 | $45 20080 295i HAS 1,723,742.10 =SUM(DI2:H11) 1.729,74010 =NY(30%,0:9) _se0,000 za7na0| VALUATION CONCEPTS AND METHO! 5. Make scenarios and sensitivity analysis based on the results. The advantage of having a financial model is that you can easily tweak the given information and get the results immediately. For instance, in the previous illustration the cost of capital used is 10%. How about if you find that cost of capital will be 12% or 15%, what will be the Enterprise Value? f this is the case, we need to design the financial model to accommodate this through the use of Data Table feature in Microsoft Excel. First, design a table where the values will be inputted. Next, select the table we prepared by highlighting cells C17 to D19 and you go to DATA Tab and go to ‘What if Analysis then select ‘Data Table’ Hone med Paging tomas ta Reror wae QOD Py Tecmenteenasn ag woHl eli ge (a ee ii Seae seegey | EL Py fens Ohne ae peace Sher oon Samad age — A a ieee ea ae Data Table Dialogue box will appear and will ask you to enter the inputs. Since the table we are doing provides for a columnar input. Then we'll input C17 in the COLUMN INPUT and click OK. Data Table Row input cel ‘Column input cel: C31] Then the results will now be shown to you in the table. ae 8 € Dace Bal cate ae fa fae en 16 | r Equity Value 47 Base 10% 1,229,742.10 48} Scenarioi 42% _1,142,000.20 49) Scenario it 15% 1,023,049.99 7 20}VALUATION CONCEPTS AND METHODOLOGIES ‘etermine which value to use. Since, in our example 7500,000 then you have to play in the range of lion. The scenarios will be developed based on the set of possible occurrences like level of operating expense, mode of operations, capital expenditure development period ete. Emerging trend is having a Risk Based Valuation, wherein major systematic risk is incorporate such as climate change, war, economic sabotage, pandemic etc. Sensitivity Analysis is almost similar with Scenario Modelling. The difference is that sensitivity analysis will have to select a driver or few drivers, ceteris paribus, and check the degree of change it will cause to the results. Sensitivity analysis is a useful exercise in developing ballpark estimates. Components of Financial Mode! As described in the earlier part of this chapter, a financial model should be understandable, printable and auditable. The financial model should be designed in a way that the investor or the client of the analysts or the Proponent themselves can understand the dynamics and follow the drivers to enable them to have a better appreciation and sound judgment of the results. Please bear in mind that the results of the financial models are just guide for the investors or even sellers of investment to determine the reasonable value. As a quick guide in developing a financial model the following components are recommended, particularly when using Microsoft Excel: ° Title Page This provides an overview and the project being valued or assessed This includes also necessary information to secure the proprietary rights of the modeler or the firm he or she is working with. It may also include data cut-off to serve as a guide to the readers * Data Key Results This sheet summarizes the results of the study. This will serve as the dashboard to enable the modelers to analyze the results and to facilitate the readers’ appreciation on the results of the project. This also facilitate preparation of pertinent reports. This also contains the valuation results, scenarios, and sensitivity analysis. Graphs can also be found in this sheetICEPTS AND METHODOLOGIES Assumption Sheet This sheet summarizes the assumptions used in the model. This is normally an input sheet where all inputs should be made. The information that can be found in this sheet must be linked to all the output sheets like Pro-forma Financial Statements, Supporting Schedules and Data Key Results. Pro-forma Financial Statements This presents the 3 components of the financial statements namely: Statement of Income, Statement of Financial Position and Statement of Cash Flows. In this sheet, you can also find some key financial ratios particularly those that has to do with financial performance and efficiency ratios. Some modelers also find it convenient to have their valuation computation be done in this sheet since the inputs of cash flows are already available here Supporting Schedules This is like a subsidiary ledger which provides supporting computation to the components of the pro forma financial statements. There is no limit for the supporting schedules the only challenge is that the electronic financial models consume large amount of data because of the supporting schedules.VALUATION CONCEPTS AND METHODOLOGIES Ea In determining the value of equity, it is necessary to value the asset first. Asset based valuation Methodologies on asset-based valuation are discounted cash flows or DCF analysis, comparable company analysis and economic value added. Discounted cash flows analysis is meticulous but more conservative method or approach that can be used to determine the asset value for it clearly demonstrate the movement of the'transactions. 131APN RUT ie) Re) RNP le) EXERCISES True or False. Write TRUE if the Statement is true and the word FALSE if you find the statement inconsistent with the truth, EVE Sea eS 1. Discounted cash flows analysis is meticulous but more conservative method or approach that can be used to determine the asset value for it clearly demonstrate the movement of the transactions. 2. In discounted cash flows method, the value of investment opportunities is highly dependent on the value that the asset will generate from now until the future. 8. Discounted cash flows analysis can be done by determining the present value of the Net Cash Flows of the investment opportunity. 4. The amount that should be included in determining the value of the asset is the amount of cash that will be available for the claims of the equity owners and creditors. 5. The Net Cash Flows are the amounts of cash available for distribution to equity claim from the business or asset. 6. For GCBO, the net cash flows generated will be based on Cash from Operations which are composed of the cash flows from operating and investing activities, since this represents already the amount earned or will be earned from the business and the amount that is required for you to infuse in the operations to generate more profit. 7. There are three levels of Net Cash Flows: (1) Net Cash Flows to the Firm; (2) Net Cash Flows to Creditors and (3) Net Gash Flows to Equity. 8. The Net Cash Flows to Equity represents the amount of cash flows made available to the equity stockholders after | deducting the net debt or the outstanding liabilities to the creditors less available cash balance of the company. | 9. Terminal Value represents the value of the company in perpetuity of a going concern business. | 10. The net present value of the Net Cash Flows represents the value of the equity 11. Valuation is a si analyst and inves’ 12. Financial Modell: activity ina com 13. Information cai advantage of 2 f@ and meticulous task for every @ sophisticated and confidential for an analyst. considered as competitive y of @ person.kanes aera Eas SUS SS 30. If the financial model is in real prices, the cost of capital should also exclude the effect of inflation. 31. Population growth rate is factored in to serve as a growth driver for the demand of the product, particularly for the merchandising or manufacturing business. 32. Trend analysis will also help you establish the trajectory of growth pattern. Generally, cost of debt and cost of equity are weighted to determine the cost of capital reasonable for the valuation. 34. The financial model should be designed in a way that the investor or the client of the analysts or the proponent themselves can understand the dynamics and follow the drivers to enable them to have a better appreciation and sound judgment of the results. 35. Data Key Results serve as the dashboard to enable the modelers to analyze the results and to facilitate the readers’ appreciation on the results of the project. 3. aMULTIPLE CHOICE THEORY. the number of the ques Write the letter of the best answer before or statement being answered. 1. These are business opportunities that has long-term to infinite operational period. a. Going Concer Business Opportunities b, Perpetual Business Opportunities c. Stable Business Opportunities d. Strategic Business Opportunities 2. This refers to the amount of cash available for distribution to both debt and equity claim from the business or asset a. Operating cash flows b. Investing cash flows c. Financing cash flows d. Net cash flows 3. In determining the value of the equity value using discounted cash flows, are comprised by activities based on operating and investing activities, then adjusted by the financing activities to determine the , which is the basis for equity value a. Net Cash Flows to the Firm; and Net Cash Flows to Equity b. Net Cash Flows to the Firm; and Net Cash Flows to Creditors c. Net Cash Flows to the Creditors; and (2) Net Cash Flows to Equity d. None of the above since there are three levels of net cash flows. 4. This represents the cash flows made available to both debt and equity claims against the company. a. Net Cash Flows to the Firm | b. Net Cash Flows to Creditors c. Net Cash Flows to Equity d. Operating Cash Flows 5. This represents the amount of cash flows made available to the equity stockholders after deducting the net debt or the outstanding liabilities to the creditors less available cash balance of the company. a. Net Cash Flows to the Firm b. Net Cash Flows to Creditors c. Net Cash Flows to Equity d. Operating Cash Flows Le6. This represents the value of the company in perpetuity or in a going concern environment. a. Terminal Vaiue b. Salvage Value c. Perpetuity Value d. Infinity Value 7. DCF Analysis is most applicable to use when the following are available, except 2 a. Validated operational and financial information b. Reasonable appropriated cost of capital or required rate of return c. Cash flow pricing multiples d. New quantifiable information 8. The following statements are fallacy on financial modelling concept except a. Financial Modelling is a sophisticated and nonconfidential activity in a company or for an analyst. b. Most of the companies hire financial modelers to assist them in determining the value of GCBOs or any opportunities ¢, Most financial modelers do not have extensive financial acumen and vast knowledge and experience. d. Operations Manager are good candidate for this role given their ability to understand operational models and design long term financial strategies. 9. The following are truths about the gathering information except for a. Historical information must be made available before the financial model is constructed. b. Historical information may be generated from, but not limited to the following: audited financial statements, corporate disclosures, contracts, industry and market prospects and peer information. c. Audited Financial Statements are the most ideal reference for the historical performance of the company. d. Statement of Income are used to determine the historical financial performance. 40. These are the most ideal reference for the historical performance of the company. a. Audited Financial Statements b. Statement of Income c. Statement of Financial Po: d. Notes to Financia’inancial Position d. Notes to Financial Statements 12. This component of Audited Financial Statement is used to determine the book value of the assets and the disclosed stakes of debt and equity financiers. a. Statement of Stockholder's Equity b. Statement of Income ¢. Statement of Financial Position d. Notes to Financial Statements 13. This component of Audited Financial Statement is used to illustrate the company historically financed its operations and investments. a. Statement of Stockholder's Equity b. Statement of income ¢. Statement of Financial Position d. Statement of Cash Flows 14. This is one of the most important components of the financial statements which provides the summary of important disclosures that should be considered in the valuation. a, Statement of Stockholder's Equity b. Statement of Income ¢. Statement of Financial Position d. Notes to Financial Statements / 18. Collectively, the financial model must be able to filter the information that would be necessary for the valuation. What are the two characteristics of information that are considered very important in financial modelling? a. Availability and Relevance b. Reliability and Relevance c. Timeliness and Reliability d. Timeliness and Availability 4 a . Drivers for growth used in financial modelling are suggested to be those validated and is represented by authorities like government or experts. The following govemment agencies provide this information except a. Philippine Statistics Authority b. Bangko Sentral ng Pilipinas ¢. Research Centers funded by Local Government Units d. All of the above are sources of information for financial modelling. 13719. 20. 2 22. . The usual growth indicators used in financial modelling are as follows, except . Gross National Product Inflation Population Consumer price index ago growth rate is factored in to serve as a growth driver for the demand of the product, particularly for the merchandising or manufacturing business. a. Gross National Product b. Inflation c. Population d. Consumer price index The can be used determine the appropriate cost of capital by weighing the portion of the asset was funded through equity and debt. a. Weighted Average Cost of Capital b. Capital Asset Pricing Model c. Cost of Equity and Debt Model d. All of the above This will serve as the dashboard to enable the modelers to analyze the results and to facilitate the readers’ appreciation on the results of the project. a. Data Key Results b. Title Page c. Cover Page d. Assumption Sheet . This refers to the theoretical value of the core activities of a business entity as reflected its net cash flows. a. Enterprise Value b. Equity Value c. » Shareholder Value d. Core Value Which of the following is not 2 included in the computation a. Depreciation b. Amortization c. Impairment of d. After-tax interest cash charges that are ncome?Ue) hee) esa 2! 23. This item represents the net investment in current assets like receivables and inventory reduced by current liabilities. a. Investment in fixed capital b. Investment in operating capital c. Investment in marketable securities d. Investment in shareholder capital 24. When computing net cash flows from EBITDA, which of the following items should be added back to EBITDA? a. Investment in working capital b. Investment in fixed capital c. After-tax non-cash charges d. Tax impact on EBITDA 25. This signifies the level of available cash that a business can freely declare as dividends to its common shareholders. a. Net Cash Flow to Equity b. Net Cash Flow to the Firm ¢. Discounted Net Cash Flows d. Net Cash Flow to CreditorsMULTIPLE CHOICE PROBLEM. Write the letter of the best answer before the number of the question or statement being answered. 1 Green Tea Corp. reported the fallowing information: Revenue of Php 32,500, Operating Expenses of Php16,250. Included in the operating expense are salaries and wages of Php 1,450, depreciation of Php500, and rentals of Php275. The interest expense incurred is Php200. How much is the EBITDA for the period? Php16,750 b. Php16,250 c. Php16,550 d. Php14,025 » Cornerstone Inc. reported revenue for the period amounting to Php75,200 and EBITDA Margin of 60%. How much is the operating expenses excluding depreciation? a. Php75,200 b. Php45,120 c. Php30,080 d. Zero Singapore Ltd. has reported Php125,000 revenue where their EBITDA Margin is 45%. If the taxes are 30% of the EBITDA, how much is the Net Cash Flows if the capital expenditure was purchased at Php1,500? Php37,875 b. Php39,375 c. Php56,250 d. Php46,625 » Malaysia Inc. purchased a capital expenditure amounting to Php 1,500 and reported revenue of Php125,000 and operating expenses is Php50,000. The company incurred Php500 for interest. If the depreciation:is Php5,000, how much is the Net Cash Flows? Tax Rate is 30% a. Php75,000 b. Php57,650 c. Php52,150 d. PhpS6,150INCEPTS AND METHODOLOGIES Pawikan Corp. reported the following information: Year __| Net Cash Flows 1 Php250 z Php300, 3 Php3s0. How much is the net present value of the Net Cash Flows, using discount rate of 10%? @. Php300.12 b. Php900.85 c. Php738.17 d. Php1,000 Dracaris Inc. purchased an investment and expected to earn: Year Net Cash Flows 4 Php250 2 Php300 3 Php450 Tv Php900 Assuming a 10% discount factor, how much is the net present value based on the foregoing question, considering an additional investment is Php1,000? a. Php489 b. Php580 c. Php1,000 d. Php1,489 Lumus Corp. incurred business meetings expenses for the year amounting to Php65,200.00. The company assumes 5% inflation all its expenses for the following year. The business meeti expenses for the following yearis Php65,200 Php68,460 Php70,000 Php72,400 aeop Skywalker Inc. incurred office supplies expenses amounting to Phe 22,680 and Php21,000 for the years 20x2 and 20x1, respectively There is no change in the volume or quantity of the office supplies except prices. The inflation of office supplies is 141VALUATION CONCEPTS AND METHODOLOGIES TA% 8% 9% 10% pore 9. Certified Inc. is developing its financial plan for the following year. In the current year, they are very certain that the volume to be sold is 750 units at Php125.00 per unit. Their operating profit margin is 40%, where depreciation is Php1,250. For purposes of valuation, they would like to get quickly determine their EBITDA. Certified inc is expecting a growth rate of 12%. They will not increase their prices to maintain their captured market. The units they are projecting to be sold the following year is a. 750 b. 800 c. 840 d. 880 10. Refer to Certified Inc. The company is expecting a growth rate of 12%. They will not increase their prices to maintain their captured market. The projected sales to be eared the following year is a. Php110,000 b. Php105,000 ¢. Php100,000 d. Php93,750 4 . Refer to Certified Inc. projected EBITDA for t a Based on the information provided, the succeeding year is 0 b. ce d. 4 value of its future cash flows pany’s investment is Php500 for it to f the company is Ss . Basketball Corp. amounting to Phpt.4 operates. The net ¢] VALUATION CONCEPTS AND METHODOLOGIES 413. Republika Inc. reported the following prospective information: | Year 1 Year2__| Year 3 Revenues |_ 750,000 1,200,000 1,600,000 Cost of Goods Sold_| 400,000 650,000 900,000 Operating Expenses | 150,000 200,000 300,000 Income tax rate is at 30%. Capital investment of Php150,000 is expected to be spent every year while working capital investment is at Php40,000. Depreciation of property is at Php200,000 yearly. How much is the projected net cash flows for Year 2? e. Php245,000 a. Php255,000 b. Php350,000 c. Php445,000 14. Refer to Republika Inc. How much is the projected net income for Year 3? Php280,000 Php290,000 Php400,000 Php700,000 eee 15. Refer to Republika Inc. How much is the EBITDA in Year 17 a. Php140,000 b. Php150,000 c. Php340,000 d. Php400,000 16. Gising Company is preparing the following financial information for presentation to prospective investors. Year 1 Year 2 Year 3 Revenues |_ 1,000,000 1,500,000 2,000,000 Cost of Goods Sold 500,000 700,000. 1,100,000 Operating Expenses 300,000 500,000 700,000 Corporate income tax rate is 30%. Gising Company is looking at a constant growth on net cash flows after the three-year histori forecast they prepared. Weighted average cost of capital of Gisi Company is 8%. The operating expenses include annual depreciati of Php250,000. Gising Company has long-term debt amounting to Php1,000,000. Gising Company projected that it will need additia PhP50,000 every year to support increasing working capi 14317. 18. 1 9 20. VALUATION CONCEPTS AND METHODOLOGIES requirements and PhP120,000 for capital investments. How much is the net cash flow of Gising Company in Y1? a. Php390,000 b. Php290,000 c. Php220,000 d. Php140,000 Refer to Gising Co. How much is the terminal value recognized after the three-year forecast period? a. Php10,880,000 b. Php12,466,667 c. Php13,090,000 d. Php10,880,000 Refer to Gising Company. What is the net cash flow to the firm? a. Php11,140,489 b. Php12,103,272 c. Php12,808,412 d. Php13,974,000 ). Refer to Gising Company. What is the net cash flow to equity? a. Php10,140,489 b, Php11,103,272 c. Php11,140,489 d, Php12,103,272 Magsaysay Company reported the following revenues in the last 5 years. Year 1 Year 2 Year3 | Year4 Year 5 2,000,000 | 2,500,000 | 2,320,000 | 2,700,000 | 3,100,000 What is the compounded annual growth rate of the revenues reported by Magsaysay Company? a. 55.0% b. 14.8% c. 11.6% d. 9.2%Re Kee esa areata 21. The income statement of Orange Company showed the following figures: Revenues Php750,000 Cost of Goods Sold 290,000 Gross Margin 500,000 Operating Expenses 200,000 Operating Income 300,000 Orange Company owns an equipment with original acquisition cost of P1,000,000 with useful life of 10 years. Operating expenses also include interest expense of P15,000. Prevailing income tax rate is at 25%. How much is the EBITDA of Orange Company? a. Php415,000 b. Php400,000 c. Php340,000 d. Php325,000 22. BTZ Company is projecting its income statement for the next 3 years using the prior year information as baseline: * Revenue in prior year is at P1,500,000 ¢ Revenues are projected to grow by 5% year-on-year in line with inflation. * Variable cost of goods sold is projected to be at 30% of revenues. * Fixed cost of goods sold is 400,000 — including equipment depreciation of 200,000. * Operating expense % to revenue is 20% « Corporate tax rate is 30%. * Annual investment of P25,000 for working capital is anticipated to support growth. What is the net income of BTZ Company in Year 1? a. Php245,000 b. Php271,250 c. Php295,250 d, Php387,500 23. Refer to BTZ Company. What is the net cash flow in Year 2? a. Php298,813 b. Php473,813 c. Php498,813 d. Php626.875 145VALUATION 24, Unicap Company is opening its doors to investors and shared the following prospective financial information 2021 2022 2023 2024 Revenues 10,000,000 12,000,000 14,000,000 15,000,000 Cost of Goods Sold 5,000,000 6,000,000 7,000,000 7,500,000 Gross Profit 5,000,000 6,000,000 7,000,000 7,500,000 Selling and Distribution 1,600,000 1,200,000 1,400,000 1,500,000 Administrative 400,000 400,000 400,000 400,000 Depreciation Expense 2,000,000 2,000,000 2,000,000 2,000,000 Operating Income 1,600,000 2,400,000 3,200,000 3,600,000 Income Tax Expense 480,000 720,000 += 960,000 1,080,000 Net Profit 1,120,000 1,680,000 2,240,000 -—-2,520,000 Required Annual Capital Investment 1,000,000 1,000,000 1,000,000 1,000,000 XYZ, an equity capital venture company, is considering infusing money to Unicap Company. Based on its assessment, cost of capital associated with this type of investment is at 10%. Unicap Company has going concern assumption with net cash flows expected to grow by 5%. In addition to potential capital investment, Unicap Company has outstanding debt of P10,000,000. What is the net cash flow to the firm of Unicap Company? a. Php70,958,800 b. Php59,468,971 ¢. Php54,879,120 a. Php50,488,355 25. Refer to Unicap Company. if XYZ Company is buying 20% of Unicap Company, what is the reasonable price that they should pay? a. Php49,468,971 b. Php17,096,000 c. Php11.893,794 d. Php9,893,794VALUATION CONCEPTS AND METHODOLOGIES Problem Solving P5-1. Frequently Corp has projected that their performance for the next five years will result to the following: Year Revenue Cash Operating in_millions) Expenses (in mi 4 | 50.00 30.00 2 55.00 33.00, 3 60.50 36.30 4 66.55 39.93. 5 73.21 43.92 The company owns a property originally acquired at Php50 million with useful life of 10 years. The terminal value was assumed based on the growth rate of the cash flows. Annual capital investment requirement is at Php2 million. The outstanding loans is Php16.62 Million. Income tax rate is at 30%. The required rate of return for this business is 14%. Requirements: 1. 2. 3. 4. Assuming there are no outstanding loans, how much is the 5. How much is the Terminal Value? How much is the Discounted Net Cash Flows to the Firm? How much is the Discounted Net Cash Flows to the Equity? Discounted Net Cash Flows to the Equity? Assuming that the required rate of return is 12%, how much is the Discounted Net Cash Flows to the Equity? P5-2. An investor was offered by an existing stockholder to purchase his shares from Sansrival Corp at Php46.00 per share. The outstanding shares of the company is 1 Million. The Year 1 revenue is Php5 Million and expectec to constantly grow by 5%. The EBITDA margin remains to be stable at 50% The required rate of return is 10%. Their outstanding loans is Php 17 Million. 1 2. How much is the value of the stocks? Are you going to accept the offer? How much is the value of the stocks if the there is no loans outstanding? . Are you going to accept the offer if the required return is 12%? Why? 147P5-3. Hats and Shoes Corp. is projecting for the next five years. The volume of units to be sold on the first year is 60 and is expected to grow by 15% every year. They are selling their merchandise at Php5SO on the average. Operating income margin is 25%. 1. Compute for Hats and Shoes Corp’s Revenue for Year 1, 2, 3, 4, and 5. 2. Compute for Hats and Shoes Corp’s Operating Income for Year 1, 2, 3, 4, and 5. 3. Hats and Shoes Corp’s Compounded Annualized Growth Rate for the 5 years is P5-4. Electricute Inc. has projected net cash flows from operations at Php45 Million on the first year. In order to realize the 10% growth for the next 4 years, Electricute purchased CAPEX amounting to Php250 Million within the first year. Half of the CAPEX was funded by liability and no other long term liability was existing before the purchase on the first year. 1. For its five-year projection, Electricute’s discounted net cash flow to the firm assuming a discount rate of 7.5% is 2. For its five-year projection, Electricute’s net cash flow to equity assuming a discount rate of 7.5% is P5-5. An analyst is evaluating Wicked Inc. and shared the following projected net cash flows for the next 10 years. v1 1,000,000 y2 4,000,000 XS 1,150,000 ¥4 1,200,000 Y5 1,200,000 Yé 1,300,000 Y7 1,500,000 Ys 4,700,000 ye 2,000,000 Y10 2,200,000 Wicked expects to continue to a forecast period. Required return y using the CAGR of the 10-year ked Inc. is at 12.1%. Requirements: 1. What is the compoun: projection of Wicked ‘ate of 10-yr net cash flowWZ ired i Kee) ot ae eile) ener Sy 2. What is the terminal value to be incorporated in the net cash flow to the firm computation? 3. What is the net cash flow to the firm of Wicked Inc.? 4. What is the net cash flow to equity of Wicked Inc.? P5-6. You are the management accountant of Cheesecake and Pearl Company. You were tasked to make an internal projection for the valuation exercise of the company. 2017 2018 » 2019 2020 Volume 4,000,000 1,100,000 1,210,000 605,000 Revenues 5,000,000 5,500,000 6,050,000 3,025,000 Cost of Goods Sold 3,000,000 3,150,000 3,315,000 2,407,500 Variable 1,500,000 1,650,000 1,815,000 907,500 Fixed 4 1,500,000 1,500,000 1,500,000 1,500,000 Gross Profit 2,000,000 2,350,000 2,735,000 617,500 Operating Expenses 900,000 950,000 1,005,000 702,500 Variable 500,000 550,000 605,000 302,500 Fixed 400,000 400,000 400,000 400,000 Operating Income 1,100,000 1,400,000 1,730,000 (85,000) Management directed that the future trajectory of the business will be basec ‘on its historical revenue performance with the exclusion of 2020 as it is an unusual year because of pandemic. Management assumes that it can achieve the same level of sales growth pre-pandemic from 2021 onwards with 2020 as its base year. Variable and fixed COGS and operating expenses will exhibit the same behavior as historical results. 60% of fixed COGS are related to depreciation while 30% of fixed operating expenses are related to depreciation. Capita investment is estimated to be infused yearly at P500,000. Net cash flow estimated to grow by 5% after the initial 5-yr forecast period. Cost of capita for Cheesecake and Pearl Company is at 8%. Corporate income tax rate imposed at 25%. Outstanding loans at end of 2020 is at P5,000,000 Requirements: 4. What is the compounded annual growth rate for revenues for 201 2020? 2. What is the compounded annual growth rate for revenues for 2017 to 2019? 3. Whatis the growth rate that will be used in the forecast preparation? 149aye) . Whatis the projected net income from 2021 to 2025? . What is the net cash flows from 2021 to 2025? . What is the enterprise value of Cheesecake and Pearl Company? What is the equity value of Cheesecake and Pearl Company? Noon P§-7. Elsa Company shared the following prospective financial information to @ group of private equity investors. You were tasked to compute for the approximate price that should be set if the investor buys out 15% share in Elsa Company. 2024 2022 2023 2024 2025 |_Revenues 2,250,000 | 2,750,000 | 3,250,000 | 3,500,000 | 4,000,000 Variable COGS 562,500. 687,500 812,500 875,000 | 1,000,000 | Fixed COGS 750,000 | _750,000| _750,000| 750,000] 750,000 Gross profit 937,500 | 1,312,500 | 1,687,500 | 1,875,000 | 2,250,000 Variable operating expenses 450,000 | 550,000} 650,000 | 700,000 | _ 800,000 Fixed operating expenses 200,000 200,000 200,000 200,000 200,000 Operating income | 287,500| 562,500 | 837,500 975,000] 1,250,000 Other pertinent assumptions can be found below: « Depreciation of P500,000 is included in fixed cost of goods sold while 100,000 of depreciation is charged to fixed operating expenses. » Income tax rate is at 20% * Elsa Company estimates it needed P200,000 cash on an annual basis to sustain its capital investments. « From 2026 until perpetuity, the company estimates net cash flows to grow at constant rate of 4%. « Elsa Company has debt-to-equity ratio of 1.5. Pre-tax cost of debt is at 4% while cost of equity is at 9%. * Elsa Company has outstanding loans of PhP2,000,000. Compute for the following: . Weighted average of cost of capital of Elsa Company . Net income from 2021 to 2025 Terminal value of Elsa Comr Net cash flow to the firm . Net cash flow to equity . Price to pay to buy 15% sha eohons n Elsa Company.Chapter 6 MARKET APPROACH VALUATIONVALUATION CONCEPTS AND METHODOLOGIES MARKET VALUE APPROACH Market Value Approach follows the concept that the value of the business can be determined by reference to reasonably comparable guideline companies for which transaction values are known. The values may be known because these companies are publicly traded or because they were recently sold, and the terms of the transaction were disclosed. The business valuation methods under the market approach that are typically used in professional business appraisals include comparative transaction method/comparative private company sale data method, guideline publicly traded company method and use of expert opinions of professional practitioners. Market-based business valuation methods are routinely used by business owners, buyers and their professional advisors to determine the business worth. This is especially so when a business sale transaction is planned. After all, if you plan to buy or sell your business, it is a good idea to check what the market thinks about the selling price of similar businesses. The market approach offers the view of business market value that is both easy to grasp and straightforward to apply. The idea is to compare your business to similar businesses that have actually sold. If the comparison is relevant, analysts can gain valuable insights about the kind of price the business would fetch in the marketplace. Analysts can use the market-based business valuation methods to get a quick sanity check of the pricing estimate or use this as a compelling market evidence of the likely business selling price. All business valuation methods under the market approach fall within one or more of the following categories. It is either based on statistics/empirical or heuristics or combination of these methods. Empirical / Statistical Approach Empirical or Statistical approach generally uses research and database processing in order to come up with conclusion and recommendation. The approach requires references and evidences to support the determination and evaluation. Information may take the form of Sales Data, Financial Performance and other historical benchmarking maybe used to process available to facilitate processing large i information. Trend analysis and information. Tools are also made formation.VAL \TION CEPTS AND METHODOLOGIES approach is that there is insufficient market evidence in some industries, and it will require careful data selection, analysis and consistent data reporting standards. Guideline Public Company Data The guideline public company method involves identifying a comparable company and obtaining the stock price for the company’s listed securities. Publicly listed companies (PLCs) are required to file their financial statement electronically with the Securities and Exchange Commission (SEC). These filing are public information and are available on the SEC website at https:/Awww.sec.gov.ph Information are also available in Philippine Stock Exchange website at https://pse.com.ph In most cases, the stock prices as obtained from a public market represent a minority stake. The advantage of this method lies in the availability of a large set of recent data. However, it might not be very appropriate in valuing early-stage and/or small businesses. In using public company data to value private companies, proper adjustments must be made to the benchmarks being used on account of size, growth potential, capital structure, business life cycle (ie. early stage ‘or maturity), etc. The advantage of this approach is that there are plenty of transaction data available from the public capital markets. Business sale data reporting is generally consistent and reliable and business financial reporting data are readily available. Although it can be noted that the limitation of this approach is that comparison to small businesses may not be as relevant, the data generally involves sales of non-controlling business ownership interest (not the entire company) and data requires adjustment for lack of marketability of private company ownership interest. Prior Transactions Method The prior transaction method involves looking up_ historical transactions in securities of the business undervaluation. The valuation might be for minority stake such a historical stock quote from a listed stock exchange or it might be for a majority stake such a merger and acquisition transact ing the business. Additional considerations in selecting orior transactions as a benchmark include the timeline of the transa: the economic situation at the time of the transaction, etc.