12/8/2021

LECTURE 5: PROSPECTIVE ANALYSIS

Module 2: Estimations of Free Cash Flows in DCF Model
Dr. Tien Nguyen
2021

REVIEW:
VALUATION by FREE CASH FLOWS

01 02 03 04

 Historical  Determining value  Determine terminal  Perform multiple

performance and during the forecast value and total valuation
estimate Free cash period company value
flows

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REVIEW:
VALUATION MODELS

analogous to the DDM, but with FCF

Intrinsic
value

Terminal
FCF FCF value
FCF FCF FCF FCF
Time
Forecasting period Continuation period

Enterprise value = present value of forecasting period + present value of continuation period

REVIEW:
VALUATION MODELS

analogous to the DDM, but with FCF

FCF1 FCF0 1  g 
1. Constant growth (TV): V0   ,r  g
re  g re  g

2. Two stage model: Two-stage H-model

n
FCFt Vn
V0    FCF0 1  g L  FCF0 H  g S  g L 
t 1 1  r  t
1  r n V0  
r  gL r  gL
FCF0 1  g S  1  g L 
n
where: Vn 
r  gL

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REVIEW: FCF

• FCFF (Free Cash Flow to the Firm):

Cash flow the company generates after having made all the required expenditures
and is able to distribute to firm’s investors (debt- and equity-holders)
n
FCFF = CFO - CAPEX
V0  
t 1 1  WACC t
• FCFE (Free Cash Flow to Equity):
Cash flow available to firm’s equity-holders after having made all the required
expenditures and paid debt-holders
n
FCFE = FCFF + net borrowings
V0  
t 1 1  re t = (payments – receipts)

CALCULATE FCF
Lesson: FCF is not the
same as accounting
cash flow from the
statement of cash
flows (SCF) -but we
can derive FCF from
the SCF.
Statement of Cash Flows FCFF / FCFE
Net Income (NI) Net Income (NI)
+ Noncash charges + Noncash charges
- WC.Investment - WC.Investment
Cash flow operations (CFO) Cash flow operations (CFO)
+ int (1- t)
- CAPEX.Investment - CAPEX.Investment CFs avai. for
Free cash flow to firm (FCFF) D & E-holhers
payments - receipts + Net borrowings
+ Net borrowings
- int (1- t)
CFs avai. for
Free cash flow to equity (FCFE) E-holhers
- dividends
- dividends
+/- stock issues / repurchase
+/- stock issues / repurchase
Net change in Cash
Net change in Cash

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CALCULATING FREE CASH FLOWS (FCF)

• FCFF = CFO + int(1-t) – CAPEX.Inv

• FCFF = NI + NCC - WC.Inv + int(1-t) – CAPEX.Inv
• FCFF = EBIT(1-t) + NCC – WC.Inv – CAPEX.Inv

• FCFE = FCFF – int(1-t) + net borrowing

• FCFE = CFO – CAPEX.Inv + net borrowings
• FCFE = NI +NCC – WC.Inv – CAPEX.Inv + net borrowings

CALCULATING FREE CASH FLOWS (FCF)

EBIT * (1 – corporate tax rate)

+ depreciation / amortization
Free cash flows =
+/- change in working capital

- CAPEX

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FORECASTING FREE CASH FLOWS (FCF)

Profitability (EBIT)

Corporate tax Forecasted

Income Forecasted free
statement & cash flows
Depreciation/amortization
Balance sheet

Working capital

Capital expenditure (Capex)

Forecasted value drivers

FORECASTING FREE CASH FLOWS (FCF): Revenue

• Revenue = Market Size x Market Share x Price

• Understand revenue growth and the underlying drivers per revenue line (price vs. volume)
• Assess historical growth pattern / historical revenue stream cyclical
• Assess dependencies on particular markets / products / distribution channel / clients
• Differentiate organic growth and growth through acquisition
• Typical ratio: CAGR, YoY-growth in price and volume
• Note: don’t forget the stage of growth, e.g.
Year 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023
Growth 10% 10% 10% 9% 8% 7% 6% 5% 5% 5%
rate in
Sales

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FORECASTING FREE CASH FLOWS (FCF): Revenue

• E.g. Revenue = Market Size x Market Share x Price

1Base
Year
0
Revenue Forecasts (F2008) 1 2 3 4 5
Market Forecasts
Initial Market Size (Units, million) 1.00

Market Growth Rate 2500.00% 128.0% 9.4% 3.5%

Market Size (Units, million) 1.0 26.0 59.3 64.9 67.1
Market Share
Initial Market Share 25.00%
Market Share Annual Growth Rate 5.00% 5% 5% 5%
Market Share 25.0% 26.3% 27.6% 28.9% 30.4%
Pricing Strategy
Initial Unit Price ($/unit) 200.00

Bi-Annual Price Increases ($/unit) - 49.99 - 49.99

Unit Price ($/unit) 200.00 200.00 249.99 249.99 299.98

FORECASTING FREE CASH FLOWS (FCF): COGS

COGS
• Analyze per revenue line COGS and margin (as % of revenue),
charges/pensions (as % of wages and salaries)
• Understanding variability in COGS: fixed costs, variable costs
• Breakdown variable part in volume and price component if possible
• Typical ratio: GM as percentage of revenue, GW per unit of volume
Other operating costs
• Examples, personnel, marketing & sales, distribution, housing, IT costs
• Personnel costs analysis based on personnel cost as % of revenues and
underlying drivers (#FTE, revenues per FTE, wages and salaries per FTE)
• Typical ratio: as % of revenue, YOY-growth, or per unit of volume

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FORECASTING FREE CASH FLOWS (FCF):

Income Statement summary

1. Revenue
analysis

Profitability
2. COGS analysis
Analysis

3. Operating cost
analysis

• Understanding reporting profit before tax and tax income

4. Tax analysis • Identify non-tax deductible items and tax credits
• Analysis of (movement in) deferred tax assets and liabilities
• Assess liability statutory tax rate of taxation in different countries

FORECASTING FREE CASH FLOWS (FCF):

Working capital and CAPEX analysis

Working capital analysis

• Differentiate operating vs. non-operating working capital (debt/cash items)
• Trade working capital: account payables, account receivables, inventory
• Working capital drivers: turnover ratios, or days outstanding
• Assess trends in working capital as percentage of revenue
Capital expenditures (CAPEX) analysis
• Determine CAPEX pattern (incremental vs. lumpy CAPEX)
• Breakdown CAPEX into maintenance CAPEX and CAPEX for growth
• Analyze other movements (e.g. disposal, acquisitions, and revaluations)
• Assess CAPEX as percentage of revenue or fixed assets turnover

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FORECASTING FREE CASH FLOWS (FCF):

Capital structure analysis

• Define gross debt and excess cash position and evaluate funding structure, and
borrowing base
• Typical ratios: leverage ratios, solvency, interest coverage, debt service capacity
(free operating cash flows / debt)

STAGE OF GROWTH

Practitioners assume growth to fall into 3 stages:

GROWTH
01
PHRASE TRANSITIONAL
02
PHRASE
MATURE PHRASE 03

- Rapid earnings growth

- Earnings & dividends low growth
- High CAPEX, negative FCF - Growth at economy-wide rate
- Reduce CAPEX, positive FCF
- ROE > r, low div - ROE = r
- ROE approach r
- Key ratios to sustainable level

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FORECASTING FREE CASH FLOWS (FCF):

Example…
FINANCIAL VARIABLE FORECASTING TECHNIQUE
Cost of sales (COGS) Percentage of forecasted sales
Selling, general, & administrative costs Percentage of forecasted sales
(SG&A)
Depreciation Percentage of company’s Net PPE
Interest expense Percentage of company’s interest bearing debt
Taxes Percentage of taxable income
Dividend (Div) Constant initially
Retained earnings NI - Div
Current Assets Percentage of forecasted sales OR Historical turnover ratio

PPE (Net) Percentage of forecasted sales OR Historical turnover ratio OR Inferred

from capital expenditure forecasts
Current liabilities Percentage of forecasted sales OR Historical turnover ratio

Long-term debt Constant initially

Equity Initially level in previous period plus retained earnings

FORECASTING FREE CASH FLOWS (FCF):

To summarize …

Forecasted
Forecasted Company
Income Statement
Free cash flows intrinsic value
and Balance Sheet

The key value drivers are;

• Revenue growth
• EBITDA margin
• Taxes
• Working capital
• Capex

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• E.g. Home Depot Corp.

• Dividend from 2004 to 2006 is $0.325, $0.4 and $0.675, respectively
• Current share outstanding is 1,970
• Sales in 2006 is $99,837 m.
• To be simpler, assume that:
• There is no change in capital structure; and no further issuance of
either debt or equity
• Growth rate in assets is consistent with predicted sale trend
• Dividend is constant from 2007
• Sustainable growth rate is 5%

HOME DEPOT

Pro-forma forecasting Income Statement

2007 2008 2009

Net revenues Growth assumed at 10% 99,921 109,913 120,904
Cost of sales Two-year average at 66.85% of sales 66,797 73,477 80,824
Gross margin 33,124 36,436 40,080
SG&A Two-year average at 20.21% of sales 20,195 22,214 24,436
EBITDA 12,929 14,222 15,644

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• E.g. Home Depot Corp.

• Sale growth at 10% in 3 years
• Sale (2006) = 90,837
• Sale (2007) = 99,837(1+0.1) = $99,921
• Sale (2008) = 99,921(1+0.1) = $109,913
• Cost of Sale as percentage of sales
• Two year average at 66.85%
2005 2006 2007
Sales 81,511 99,837 99,921
COS 54,191 61,054 COS2007  66.95%  99,921  66,797
COS as % of sale 66.48% 67.21% 66.85%

• Similarly forecasting on SG&A and other expense accounts

HOME DEPOT
Balance
Pro-forma forecasting Balance Sheet from CFS

2007 2008 2009

Assets
Cash & marketable securities bal. retained cash & mkt. sec. 5,390 7,266 9,548
Receivables 2-year avg turnover (37.1) 2,693 2,963 3,259
Inventories 2-year avg turnover (5.04) 13,253 14,579 16,037
Other current assets 2-year avg turnover (113.3) 882 970 1,067
PPE 2-year avg turnover (3.5) 28,754 31,630 34,793
Goodwill constant 6,316 6,316 6,316
Other assets constant 1,348 1,348 1,348
Total assets 58,636 65,071 72,367
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• E.g. Home Depot Corp.

• Receivables A/c according to turnover ratio
• 2-year T/O = 37.1
2005 2006 2007
Sales 81,511 90,837 99,921
99,921
AR 2,396 3,223 AR2007   2,693
37.1
AR T/O 42 32 37

• Similarly forecasting on Inventories, PPE and other asset accounts

HOME DEPOT
Pro-forma forecasting Balance sheet
Liabilities and Equity 2007 2008 2009 Payable TO =
Payables 2-year average turnover (9.2) 7,261 7,987 8,785 COGS/avg Payables
Accrued expenses 2-year average turnover (6.6) 3,060 3,366 3,702
Accrued exp TO =
Deferred revenue constant 1,633 1,633 1,633 SGA/avg accrued esp
Other current liabilities constant 2,643 2,643 2,643
Noncurrent LT debts constant 11,643 11,643 11,643
Other LT liabilities constant 2,965 2,965 2,965
Common stock constant 8,051 8,051 8,051
Retained earnings function of earnings & div 37,764 43,166 49,328
Treasury stock constant (16,383) (16,383) (16,383)
Total liabilities and equity 58,636 65,071 72,367

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HOME DEPOT

Pro-forma forecasting Income Statement

EBITDA 12,929 14,222 15,644

Depreciation & amort. 2-year avg depr./PPE (6.5%) 1,869 2,056 2,262
Interest & investment constant 27 27 27
Interest expense prior year debt rate (5.55%) 640 640 640
EBT 10,393 11,499 12,715
Income taxes 2-year avgtax rate (37.6%) 3,908 4,323 4,781
• Current tax rate
Net income 6,485 7,175 7,934
• Effective tax rate
Diluted weight-average common (i.e. tax exp/NI)
share 2,062 2,062 2,062
Diluted EPS 3.14 3.48 3.85

• E.g. Home Depot Corp.

• Calculating Retained Earnings
(RE is a function of Dividend Paid and NI)
• Dividend assumption:
• 2-year average growth at 45%
2004 2005 2006 2007
cash dividend 0.330 0.400 0.675
dividend growth 21% 69% 45% div2007  0.675  1.45  0.9

Total dividend paid (1970 outstanding shares)= $1,773

• RE in 2007: end bal. = beg bal. + NI - div

RE 2007  33,052  6,485  1,773  37,764

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HOME DEPOT
Pro-forma forecasting Cash flows Statement
2007 2008 2009
Cash flow provided by operating activities
Net income/loss 6,485 7,175 7,934
Depreciation/amortization 1,869 2,056 2,262
Increase/Decrease in operating account 2,227 (651) (716)
Net cash provided/used by operations 10,581 8,580 9,480
Cash flow provided by investing activities
Capital expenditure (4,018) (4,931) (5,424)
Acquisition/disposal of subs., business _ _ _
Purchase/sale of investments _ _ _
Other investing activities _ _ _
Net cash provided/used by investing (4,018) (4,931) (5,424)
Cash flow provided by financing activities
Proceeds from common stock sale _ _ _
Repurchases on common stock _ _ _
Proceeds from borrowing _ _ _
Repayment of debt _ _ _
Dividend, other distribution (1,773) (1,773) (1,773)
Other financing activities _ _ _
Net cash provided/used by financing (1,773) (1,773) (1,773) 27
Change in cash 4,790 1,876 2,282

• Calculate change in WC accounts:

Change in
2006 2007 2007
Receivables 3,223 2,693 (530) ADD decrease
Inventories 12,822 13,253 431 DEDUCT increase
Other Current Assets 1,340 882 (458) ADD decrease

Payables 7,356 7,261 (95) DEDUCT decrease

Accrued Expenses 1,295 3,060 1,765 ADD increase
Deferred Revenues 1,633 1,633 0
Other Current Liabilities 2,646 2,646 0
Change in WC a/cs 2,227

WC  530  431  458  95  1,765  2,227

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• Calculate change in CAPEX:

2006 2007 Change in 2007

PPE, net
= PPE, total – accum.depr 26,605 28,754 2,149
• Then, add back depreciation:
CAPEX  PPE , net  depr  2,149  1,869  4,018

 This is the cash outflows

HOME DEPOT
Balance
Pro-forma forecasting Balance Sheet from CFS

2007 2008 2009

Assets = 5,390 + 1,876
Cash & marketable securities bal. retained cash & mkt. sec. 5,390 7,266 9,548
Receivables 2-year avg turnover (37.1) 2,693 2,963 3,259
Inventories 2-year avg turnover (5.04) 13,253 14,579 16,037
Other current assets 2-year avg turnover (113.3) 882 970 1,067
PPE 2-year avg turnover (3.5) 28,754 31,630 34,793
Goodwill constant 6,316 6,316 6,316
Other assets constant 1,348 1,348 1,348
Total assets 58,636 65,071 72,367

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HOME DEPOT

FORECASTED CASH FLOWS

2007 2008 2009

CFO 10,581 8,580 9,480

Add: interest (1-t) 400 400 400
Less: ∆CAPEX (4,018) (4,931) (5,424)
FCFF 6,962 4,048 4,456
Terminal value 79,436

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ROAD MAP

• Valuation fundamentals:
• DCF valuation model
• Forecasting FCF
• Where now:
• Properly calculating cost of capital
• The WACC (weighted average cost of capital) is the weighted average of
the (after tax) returns required by capital providers

D E
WACC  rd (1  TC )  re
V V

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COST OF EQUITY

• Systematic risk determines required expected return …

• The CAPM:

E r  r f   r m  r f 
stock’s sensitivity
to market risk
factors

Calculate BETA for stock return

• Beta of a publicly traded company can be calculated using Market Model

Regression (Slope)

ri     r m
market return
stock’s return
=(VNindex1-VNindex0)/VNindex0
= (P1-P0)/P0 intercept slope

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• Setting the regression in excel

1 K L M N O
2 Index Price Return (%)
3 Date VN-index PVD VN-index PVD
4 Jan-11 510.60 55.50
5 Feb-11 461.40 48.50 -9.6357 -12.6126
6 Mar-11 461.10 49.90 -0.0650 2.8866
7 Apr-11 480.10 51.00 4.1206 2.2044
8 May-11 421.40 47.00 -12.2266 -7.8431
9 Jun-11 432.50 39.50 2.6341 -15.9574
10 Jul-11 405.70 39.30 -6.1965 -0.5063
11 Aug-11 424.70 40.00 4.6833 1.7812
12 Sep-11 427.60 37.50 0.6828 -6.2500
13 Oct-11 420.80 38.20 -1.5903 1.8667
14 Nov-11 380.70 36.20 -9.5295 -5.2356
15 Dec-11 351.60 33.20 -7.6438 -8.2873
16 Jan-12 388.00 38.00 10.3527 14.4578
17 Feb-12 423.60 39.00 9.1753 2.6316
18 Mar-12 441.00 39.90 4.1076 2.3077
19 Apr-12 473.80 40.70 7.4376 2.0050
20 May-12 429.20 35.90 -9.4133 -11.7936
21 Jun-12 422.40 36.20 -1.5843 0.8357
22 Jul-12 414.50 33.50 -1.8703 -7.4586
23 Aug-12 396.00 35.20 -4.4632 5.0746
24 Sep-12 392.60 33.60 -0.8586 -4.5455
25 Oct-12 388.40 35.00 -1.0698 4.1667
26 Nov-12 377.80 34.00 -2.7291 -2.8571
27 Dec-12 388.40 35.00 2.8057 2.9412

• Output:
SUMMARY OUTPUT

Regression Statistics
Multiple R 0.60641113
R Square 0.367734459
Adjusted R Square 0.337626576
Standard Error 5.653476337
Observations 23

ANOVA
df SS MS F Significance F
Regression 1 390.377939 390.3779 12.21389 0.002158461
Residual 21 671.1976885 31.96179
Total 22 1061.575627

Upper Lower Upper

Coefficients Standard Error t Stat P-value Lower 95% 95% 95.0% 95.0%
Intercept -1.073799401 1.194480029 -0.89897 0.378862 -3.557856598 1.410258 -3.55786 1.410258
X Variable 1 0.677150304 0.193757277 3.494838 0.002158 0.274209989 1.080091 0.27421 1.080091

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Index Price Return (%) (Ri - E(Ri)) (%)

VN- VN- VN-
Date PVD PVD PVD
index index index
• Beta can also be calculated using Jan-11 510.60 55.50
excel Feb-11 461.40 48.50 -9.6357 -12.6126 -12.1215 -15.7242
• Covariance / Variance Mar-11 461.10 49.90 -0.0650 2.8866 -2.5508 -0.2250

matrix Apr-11 480.10 51.00 4.1206 2.2044 6.1551 -0.9072

May-11 421.40 47.00 -12.2266 -7.8431 -14.7124 -10.9548
Jun-11 432.50 39.50 2.6341 -15.9574 0.1483 -19.0691
… ... … ... … ... …
COV(ri , rm )
i 
Apr-12 473.80 40.70 7.4376 2.0050 7.4376 0.0181
May-12 -9.4133 -11.7936 -9.4133 -12.7015
 m2
429.20 35.90
Jun-12 422.40 36.20 -1.5843 0.8357 -1.5843 0.8357
Jul-12 414.50 33.50 -1.8703 -7.4586 -1.8703 -7.4586
Aug-12 396.00 35.20 -4.4632 5.0746 -4.4632 5.0746
Sep-12 392.60 33.60 -0.8586 -4.5455 -0.8586 -4.5455
Oct-12 388.40 35.00 -1.0698 4.1667 -1.0698 4.1667
Nov-12 377.80 34.00 -2.7291 -2.8571 -2.7291 -2.8571
Dec-12 388.40 35.00 2.8057 2.9412 2.8057 2.9412
AVG -2.0345 -2.7913
STDEV 6.2208 6.9465
VAR (Rm) 38.6983
COVAR(Rm,Rpvd) 27.7995
BETA (PVD) 0.7184

Where do we get the information?

• Estimation period?
• KEY ISSUE! This is an estimation from historical data
• Estimation is typically 60 months (5 years, monthly)
• Where do we get risk – free rate?
• The T-bond rate
• Where do we get market premium?
• Homepage of Professor A. Damodaran:
• http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/ct
ryprem.html

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COST OF DEBT

• Calculate cost of all interest-bearing debt:

• Calculate interest using net debt
• Cost of debt = interest exp./avg. net Debt
• PV(FCFE) = PV(FCFF) - net Debt = PV(FCFF) – Debt + cash
• Calculate interest using total debt
• Cost of debt = cash paid for interest/avg. total Debt
• PV(FCFE) = PV(FCFF) – D
• Calculate interest using credit spread
• Cost of debt = risk free rate + credit spread on debt

THE WACC

• Company cost of capital = weight average of debt and equity returns

• note that total value of the assets owned by the firm (V) will be equal to
the sum of
• Market value of debt (D), and
• Market value of equity (E)

D E
WACC  rd (1  TC )  re
V V

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• E.g. Home Depot

Ke Kd
Beta (Jan 2017) 1.40 Interest rate 5.5%
T-bill rate (Jan 2017) 5% Tax rate 37.6%
Risk premium 5% Cost of debt after tax (Rd) 3.43%
Cost of equity (Re) 12%

Stock price (Dec 2006) 39.60

Share outstanding 1970
Equity value 78,012
Debt value 11,463
Total market value 89,655

11,643 78 , 012
WACC  3 . 43 %  12 %  10 . 89 %
89 , 655 89 , 655

THE TERMINAL VALUE

• E.g. Home Depot

• Calculate terminal value (with SGR 5%):

4,4561.05
T  79,436
.1089  .05
• Calculate value of firm:
6 ,962 4 , 048 4 , 455 79 , 436
PV   2
 3
  71 , 096
1 . 1089 1 . 1089 1 . 1089 1 . 1089 3

Recall : SGR - the only rate at which a firm can grow without changing key financial
ratios and without issuing new equity (SGR = ROE x Retention)

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SUSTAINABLE GROWTH RATE

EPS = 10.49¢

Payout 76.3% Plow-back 23.7%

DPS = 8¢ Retained Profit = 2.49¢

Reinvest at ROE of 9.32%

Growth = 0.23¢
(g = 2.21%=23.7%  9.32%)
growth rate = return on equity x plowback ratio

HOME DEPOT’S VALUATION

Discounted cash flow valuation

2007 2008 2009
Cash from operations 10,581 8,580 9,480
add: interest expense(1-t) 400 400 400
less: capital expenditures (4,018) (4,931) (5,424)
Free cash flows 6,962 4,048 4,456
Terminal value 79,436
Cost of debt (after tax) 3.43%
Cost of equity (CAPM) 12.00%
Beta (as of Jan 2007) 1.40
T-bill rate (2007) 5.00%
Market premium 5.50%
WACC 10.89%
Sustainable growth rate 5.00%
Present value 6,278 3,292 61,524
Enterprise value 71,094
Less: market value of debt (11,643)
Market value of equity 59,451
Share outstanding 1970
Estimated share price 30.18

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SENSITIVITY ANALYSIS

 Comparative Static
 Scenario Analysis

SENSITIVITY ANALYSIS

• How sensitive is value to changes in:

• The discount rate (& all underlying determinants?
• The growth rate of sales?
• The asset turnover ratio?
• The profitability ratio?

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COMPARATIVE STATICS

• Comparative statics quantifies the sensitivity of the valuation to variation in a

parameter, holding fixed all other parameters

Worst Base Best

How does Cost of Capital
70.42
15.01%
59.19
12.01%
70.42
9.61%
81.29
Investment ($mil) 284 227.7 185
valuation change 70.42 64.47 70.42 75.13
PP&E 30% 50% 75%
parameter 70.42 70.27 70.42 71.11
PP&E Life for Depreciation 3 5 7
variation from 70.42 67.2 70.42 72.23
Initial Market Size (Units Mil) 0.5 1 2
worst to best case? 70.42 31.05 70.42 218.36
Market Growth Rate 1000% 2500% 5000%
70.42 33.83 70.42 369.24
Initial Market Share 15.00% 25.00% 35.00%
70.42 11.84 70.42 130
Market Share Growth Rate 1.00% 5.00% 8.00%
70.42 55.3 70.42 83.22
Initial Unit Price ($/unit) 175 200 250
70.42 56 708.42 99.25
Bi-Annual Price Increases ($/unit) 24.99 49.99 99.99
70.42 54.58 70.42 103.1
COGS / Sales (% Sales) 84.30% 80.66% 74.25%
70.42 42.9 70.42 120.93
SG&A Expense Growth Rate 30% 25% 15%
70.4 68.34 70.42 75.99
Inventory Days 15 7.58 6
70.4 65.42 70.42 72.13
Days Receivable 45 38.49 30
70.4 69.99 70.42 72.93
Days Payable 50 61.54 75
70.4 68.22 70.42 73.81

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COMPARATIVE STATICS: Elasticity

• What is the elasticity of the valuation with respect to each parameter?

• Elasticity = % change in value / % change in parameter
elasticity 
elasticity

∆ Value / Value
Elasticity =
∆ Parameter / Parameter

Worst Base Best

Cost of Capital 15.01% 12.01% 9.61%
70.42 59.19 70.42 81.29
Investment ($mil) 284 227.7 185
70.42 64.47 70.42 75.13
PP&E 30% 50% 75%
70.42 70.27 70.42 71.11
Elasticity (Kc) = -0.49 = PP&E Life for Depreciation 3 5 7
70.42 67.2 70.42 72.23
Initial Market Size (Units Mil) 0.5 1 2
(59.19-81.29) / 81.29 70.42 31.05 70.42 218.36
Market Growth Rate 1000% 2500% 5000%
(0.1501-0.0961)/ 0.0961 Initial Market Share
70.42 33.83
15.00%
70.42
25.00%
369.24
35.00%
70.42 11.84 70.42 130
Market Share Growth Rate 1.00% 5.00% 8.00%
70.42 55.3 70.42 83.22
Initial Unit Price ($/unit) 175 200 250
70.42 56 708.42 99.25
Bi-Annual Price Increases ($/unit) 24.99 49.99 99.99
70.42 54.58 70.42 103.1
COGS / Sales (% Sales) 84.30% 80.66% 74.25%
70.42 42.9 70.42 120.93
SG&A Expense Growth Rate 30% 25% 15%
70.4 68.34 70.42 75.99
Inventory Days 15 7.58 6
70.4 65.42 70.42 72.13
Days Receivable 45 38.49 30
70.4 69.99 70.42 72.93
Days Payable 50 61.54 75
70.4 68.22 70.42 73.81

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COMPARATIVE STATICS

• Lesson: Comparative statics implicitly assumes parameters are independent

of one another

SCENARIO ANALYSIS

• Scenario Analysis quantifies the sensitivity of the valuation to variation in

multiple parameters

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Worst Base Best

Cost of Capital 15.01% 12.01% 9.61%
70.42 59.19 70.42 81.29
Investment ($mil) 284 227.7 185
70.42 64.47 70.42 75.13
PP&E 30% 50% 75%
70.42 70.27 70.42 71.11
PP&E Life for Depreciation 3 5 7
70.42 67.2 70.42 72.23
Initial Market Size (Units Mil) 0.5 1 2
70.42 31.05 70.42 218.36
Market Growth Rate 1000% 2500% 5000%
70.42 33.83 70.42 369.24
Initial Market Share 15.00% 25.00% 35.00%
70.42 11.84 70.42 130
Market Share Growth Rate 1.00% 5.00% 8.00%
70.42 55.3 70.42 83.22
Initial Unit Price ($/unit) 175 200 250
70.42 56 708.42 99.25
Bi-Annual Price Increases ($/unit) 24.99 49.99 99.99
70.42 54.58 70.42 103.1
COGS / Sales (% Sales) 84.30% 80.66% 74.25%
70.42 42.9 70.42 120.93
SG&A Expense Growth Rate 30% 25% 15%
70.4 68.34 70.42 75.99
Inventory Days 15 7.58 6
70.4 65.42 70.42 72.13
Days Receivable 45 38.49 30
70.4 69.99 70.42 72.93
Days Payable 50 61.54 75
70.4 68.22 70.42 73.81
Scenario Analysis Worst Base Best

(813.97) 708.42 33,293.68

Strategy wants to reduce the price $3 in order to increase the initial market
penetration from 25% to 28%? How does this affect the company’s value?

Quantity (Initial Market

Share)
20.92% 21.62% 22.38% 23.19% 24.06% 25.00% 26.02% 27.12% 28.32% 29.63% 31.07%
Price 25 70.42 75.38 81.83 86.16 93.80 99.25 100.10 114.05 123.89 132.58 142.27
24 66.09 70.42 76.13 81.58 87.20 93.48 100.99 108.39 116.45 125.12 135.49
23 61.76 65.46 70.42 76.00 81.61 88.72 94.88 102.72 110.02 118.66 128.70
22 56.43 60.50 65.71 70.42 76.01 82.95 88.76 95.06 103.59 111.19 121.92
21 51.11 55.54 60.00 65.84 7.42 76.18 82.65 89.40 97.15 105.73 113.13
20 46.78 50.58 55.30 60.26 65.82 70.42 76.53 83.74 90.72 98.27 106.35
19 41.45 45.62 50.59 54.68 59.23 65.65 70.42 77.08 83.29 91.81 99.56
18 37.12 40.66 44.88 49.10 54.63 59.89 64.30 70.42 77.85 84.34 92.78
17 32.79 35.69 39.17 44.52 48.04 50.12 58.19 64.76 70.42 77.88 85.99
16 27.47 30.73 34.47 38.94 43.44 47.35 52.08 58.10 64.98 70.42 78.20
15 22.14 25.77 29.76 33.35 37.85 41.59 46.96 52.43 57.55 63.96 70.42

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Some other question to consider …

• Given the current valuation level, what levels of the key variables must exist to
warrant the valuation, given the discount rate?
• Do these implied values make sense, given the likely evolution of the
company and industry?
• Do the growth rate make sense, given the growth rate of the economy, and
industry and the company’s market share?

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