Saito Solar - Discounted Cash Flow Valuation

by Lena Booth and Frank Tuzzolino

Source: Thunderbird School of Global Management

Product #: TB0357-PDF-ENG

Questions

Summary:

The case makes note of Saito Solar, a homegrown Japanese solar Photovoltaic Cell

manufacturing company which is run by Mr. Saito, and his two sleeping partners – Mr. Yoshida

and Mr. Suzuki. The company was founded with the mission to introduce a cost effective

alternative energy solution for the commercial and residential market in Japan. They had been

successful in introducing and marketing their products to a niche, small market, and had

successfully navigated the financial crisis to be presented with future growth opportunities on the

back of rising fossil fuel costs and better solar tariffs. The company has now been approached by

a boutique investment firm which is looking to acquire the Saito Solar, for which they have

opened up the conversation for the potential valuation of the company. For this the partners were

forced to band together and come up with a logical figure for the valuation of Saito Solar in view

of its growth potential and future market prospects.

1. Using the discounted cash flow approach, why are projected free cash flows,
rather than profits, used in estimating the value of the firm?
 Ans. On a holistic level, some might believe that free cash flows can be used
interchangeably with accounting profits, and hence be utilized to value a firm; however,
that is not the case. Profits refer to accounting profits that are shaped by practices of
following internationally approved standards of financial reporting. Profits are therefore a
function of the accounting rules applied by a firm to ascertain and quantify its operational
matters in financial terms. They are derived from subtracting Cost of Goods Sold,
expenses including overheads such as labour and variance in materials, and other items
such as non-cash charges (depreciation/amortization), interest and taxes. Cash flows on
the other hand are a direct subset of the actual cash generating ability of the business.
This implies that though a firm might adjust its profits in any way, to showcase a profit of
its choice (recognize revenues differently, change practice for adjusting depreciation
etc.), there is truly only one way for it to calculate the cash flows that it generates for a
particular year. This involves concepts of matching of costs and revenues, causing a
smoothening of profits over the years. Moreover, earnings also include noncash
transactions such as depreciation. Therefore, cash flows are a more reliable way to
ascertain the financial prowess and potential of a firm and this is realized by the fact that
cash flows allow for the concept of time value of money to be applied much more
coherently. Since cash flows are not liable to be changed by calculations, they can be
projected much more easily – that is they are not subject to changes in accounting
practices, and can be discounted more readily at known rates, allowing companies to
arrive at quantifiable answers for the value of a firm by focusing on incremental
cashflows for subsequent years.
2. What is the role of WACC in valuation?
Ans. WACC refers to the Weighted Average Cost of Capital for the firm which is
essentially the cost incurred at raising the firm’s capital. The need for a weighted average
arises as a firms capital is composed of two segments, which includes debt and equity.
Both creditors and equity investors, ask for return on their investment, which is basically
the cost for the firm at which it has obtained this financial capital, which it must repay to
capital providers. Cost of equity is associated with the required rate of return associated
with equity holders, whilst the cost of debt is associated with the interest rates liable to be
paid to the creditors of the firm. In that sense, WACC serves multiple purposes when
 used in investment analysis, mainly as the discount rate at which future cash flows are
discounted to ascertain the possible undertaking of a financial investment. In order to
satisfy the requirements of the stakeholders in terms of financial capital providers, all
proceeding cashflows must be discounted at the WACC as it is the true opportunity cost
that the firm would incur and hence, is the basis of DCF valuation. As WACC is the
minimum return that must be derived to satisfy investors, any rate achieved WACC is
thought to be a sufficient enough rate as it meets the minimum required rate of return.
Therefore, WACC serves as the opportunity cost against which a possible new
investment is judged against, particularly in terms of discounting as well as in capital
budgeting decisions that look at Internal Rates of Return, which are gauged against
hurdle rates which is essentially WACC. WACC is the underlying return expected by all
shareholders of the firm and is therefore the adequate measure for the opportunity cost
against which any other project or its valuation is measured.
3. Based on Mr. Suzuki’s estimate of 1-3% growth rate of Saito Solar’s free
cash flows over the next 20 years, how much would Saito Solar be valued
at? The owners’ required rate of return was 10%.
Ans. The answer greatly differs based on Mr. Suzuki’s estimate in terms of the growth
rate applied. Interestingly enough, it is a commendable fact that Mr. Suzuki is aware of
key financial concepts such as time value of money, for which he rightly suggests
discounting of future cash flows, however his assumption for applying a growth rate
directly to cash flows is somewhat questionable. Cash flows are dependent on factors
including net income, depreciation, changes in working capital as well as capital
expenditures, all of which are further influenced by fundamental assumptions such as
changes in a firms revenue and the costs attributed to those revenues. Nonetheless, by
applying Mr. Suzuki’s simplified approach, we utilize the cash flow figure available to us
in Appendix 3 for the current year of 2012, 250.1 Million Yen, and apply a steady growth
rate for the next 20 years, up till 2032. In the excel sheet we have created a sensitivity
analysis which showcases how drastically the value of the firm would be altered in case
we applying a growth rate between 1% to 3% for the firms revenues. As we have applied
the growth rate directly to the firms free cash flows it is easy to see the changes in effect
of the firms value as the effect on the increase in cash flow is self-evident where it rises
 from 250.1 Million Yen to 305.17 Million Yen by the 20th Year, in case of scenario 1
where the growth rate is taken as 1% growth per anum. Discounted at the required rate of
return of 10%, we see that the firm’s value turns out to be almost 2.5 Billion Yen, in
consideration of the twenty year cashflows. In the case of the greatest possible growth
rate assumed of 3%, we see that the same value rises to 451.71 Million Yen of cash flow
in 2032, followed by a valuation of 2.94 Billion Yen. Hence, we can see that the value of
the firm is altered greatly by the assumptions that are utilized when it comes to
forecasting the future financial position and operational capacity of the firm. This figure
has great underlying assumptions that might be questionable in certain scenarios as it
would require sales to grow at a fixed rate, compared to its attributable costs, on a year on
year basis, to sustain a consistent growth in cashflows, which is rarely the case. At the
same time, underlying assumptions of sales being achieved with respect to current capital
employed in terms of capacities, inventories, cash cycles are also missing from the
analysis. Nonetheless, approaching the issue of valuation from Mr. Suzuki’s perspective,
the value of the firm could lie anywhere between 2.5 to 2.9 Billion Yen, depending on the
growth rate and discount rate applied to the analysis. Workings of the same have also
been shared via the attached excel sheet as Scenario 1-3.
4. How do you estimate firm value when free cash flows of the firm are uneven
for the first few years but stay constant after?
Ans. As per the appendix attached to the case, there are various ways to ascertain the
value of a firm that would take into consideration the nature of cashflows that a firm
generates in the future periods. In the case that the cashflows would have been consistent
in all future periods, the simplest proposition would have been to employ a simple
annuity formula that would make the case for obtaining the present value of future
cashflows. In cases where there are uneven cashflows in the initial years, and consistent
ones in the following years, there could be multiple approaches to solve for the firms
value. The simplest and traditional possibility would be to solve for discounted cash
flows of each year individually at the required WACC, as have been down for question 3
in the excel sheet. Such a way to calculate present value is seemingly tedious but employs
the most simplistic and intuitive way to obtain the present value of future cashflows in
the case of uncertain cashflows. However, to simplify the working of the calculations
 further, one could also possibly break the question in two parts and solve for the uneven
cashflows on an individual basis and solve for the consistent cashflows on the basis of an
annuity. Either way the solution will work out to be the same.
5. Based on the free cash flow forecast provided in Appendix 3 of the case, and
assume a range of 9-11% WACC and 1-3% terminal value growth rate, what
is the range of values for Saito Solar?
Ans. In view of the assigned assumptions, it is easy to deduce the possible value of the
firm by ensuring that the final year cashflow is treated as a perpetuity to find its terminal
value by ensuring that is grow at the stated perpetual growth rate in the final year, and is
discounted by the difference in WACC and perpetual growth rate. This gives us the
terminal value of the firm at the start of the final year of the projected year of cashflow.
We can then discount this figure by the number of years it is ahead of the current (year 0)
which will help us get the terminal value in terms of today. This figure can then be added
to the discounted cashflows for all figure preceding the final year of cashflow, thus
giving us the value of the firm today. By applying a data table and ascertaining different
values for both the terminal growth rate and WACC, we come up with a range of the
value of the firm which lies somewhere between 5.5 Billion Yen to 6.4 Billion Yen. The
workings have been shared in the attached excel sheet as well as summarized in the table
below.
Sensitivity Anlaysis
6,691.96 1% 2% 3%

9% 6,956.83 7,686.25 8,658.81

10% 6,149.95 6,691.96 7,388.83

11% 5,508.05 5,922.48 6,440.52

6. Strategically, do you think Mr. Saito and his partners should sell the firm at
this time? Why? Conclude.
Ans. In my opinion, it would not be an opportune time for Mr. Saito and his partners to
sell the firm, the reason being that the most lucrative time for the organization lay ahead
of it in the not so distant future. An important figure to consider in this is the possibility
of achieving the valuation figures as showcased in the sensitivity analysis. Probabilities
need to be ascertained with the expected growth rates to end up at a more justifiable
valuation figure. Moreover, the subsequent offer from the boutique investment is also to
be considered as the required rate of return for the partners as been 10%, hence an offer
about the 7.4 Billion Yen figure satisfies that mark. At the same time, if the offer is not
lucrative enough then it would be better to retain the organization and focus on achieving
higher growths, as the requirement for alternative fuels is set to rise in the long term, as
fossil fuels become vastly depleted, and more costly, both in terms of their financial
impact, as well as their effect on the environment.