CORPORATE VALUATION AND VALUE BASED MANAGEMENT

Introduction: Value maximization is the central theme in financial management. Owners of corporate securities will hold management responsible if they fail to enhance the value. Managers in the present scenario must understand what determines value and how it should be appraised. The goal of such appraisal is to estimate fair market value of the company. Fair Market Value: ´It is the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant factsµ. - Internal Revenue Service of US

Approaches of Corporate Valuation: There are four approaches to appraise the value of a company. They are: 1. Adjusted book value approach 2. Stock and Debt approach 3. Direct comparison approach 4. Discounted cash flow approach Adjusted book value approach: It is the simplest approach to value a firm relies on the information found on its balance sheet. There are two methods to use balance sheet information to appraise the value of firm. They are: 1. Book value of investor claims summarized directly. 2. Assets of firm may be totalled and from this total non investor claims ( accounts payable and provisions) may be deducted. Following illustration gives us a clear idea about the two methods of adjusted book value approach

and advances Cash and bank Debtors Inventories Prepaid expenses Miscellaneous expenditure and losses 20 164 115 35 __ 790 360 15 334 430 . loans.Balance sheet of XYZ ltd as on 31-03-2010 Assets Share Capital Equity Preference Reserves & Surplus Secured Loans Term Loans Debentures Unsecured Loans Bank Credit Inter corporate loans Current liabilities and provisions 115 769 769 89 122 193 250 Fixed Assets (Net) Gross block Accrued depreciation Investments Current assets.

Rs in millions Total Assets 769 Less: Current liabilities and Provisions 115 654 . In the above balance sheet the investor claims are : Rs in millions Share Capital 250 Reserves & Surplus 122 Secured Loans 193 Unsecured Loans 89 654 Balance Sheet valuation based on Asset ² Liabilities Approach: In this method the value of firm is calculated as the difference between asset and liabilities.Balance Sheet Valuation based on investor claims method: In this method the book values of investor claims will be added directly.

customers. suppliers. Organizational Capital It is the value created by bringing together employees. Hence it does not consider inflation which influences the market value. Organizational Capital Inflation: The book value of asset is the difference of historical cost and depreciation. Technological changes 3. and managers in a mutually beneficial and productive relationship. . Reasons for divergence of book value from market price: 1. It will not be shown in the balance sheet and it cannot be easily separated from the firm.The accuracy of book value approach depends on how well the net book values of the assets reflect their fair market values. Technological Changes: Assets will be replaced when ever they become obsolete and worthless even before they are fully depreciated in the books. Inflation 2.

cost of raw materials plus cost of processing or based on selling price point view i. Non Operating Expenses: Assets not required for meeting the operating requirements of business are referred to as non operating assets. . Work in process and Finished goods. These are valued at their fair market value.e.. They are excess land and infrequently used buildings. Other Current Assets: These include deposits. Raw material is valued at their most recent cost of acquisition.e. buildings and civil works. 5. Debtors: They are valued at their face value. The value of plant and machinery is appraised by the market price of similar assets (used) plus cost of transportation and installation. selling and collection of receivables. Fixed Tangible Assets: They are mainly land. Land is valued as if it is vacant and available for sale. 3.Adjusting Book value to Reflect Replacement Cost: Various assets are valued as follows: 1. and accruals. Buildings and civil works may be valued at replacement cost less physical depreciation and deterioration. Finished goods are valued by determining the sale price realizable in ordinary course of business less expenses to be incurred in packaging. and plant and machinery. Work in process is valued based on cost point view i. Raw material. Inventories: It is further classified into 3 categories.. 6. prepaid expenses. handling. 2. 4. selling price of final product less expenses to be incurred in translating work in process into sales. These are valued at their book value. Cash: There is no problem in valuing it and hence it remains same. transporting.

such as appraisal of regulated industries. The adjusted book value approach or liquidation value approach makes sense for firms which derive their value mainly from owning natural resources.Adjusting book value to Reflect Liquidation Value: The most direct approach for approximating fair market value of asset on the balance sheet of a firm is to find out what they would fetch if the firm were liquidated immediately. Bottom Line : The unadjusted book value approach makes sense only in rare cases. In real life book value approach has applicability. . If there is a secondary market then liquidation values equal secondary market prices. Even such cases are not common because most firms have valuable organizational capital. If active secondary market is not available then we must try to estimate hypothetical price at which the asset may be sold. This approach makes sense for a firm that is worth more dead than alive. This method ignore organizational capital.

rather than the price on the lien date. Let us consider an example of ABC corporation whose outstanding shares on March 31.970 million. If market is considered efficient implying that security prices reflect all publicly available information there is no justification for averaging. Their argument is that the average of prices over a period of time is more reliable than current stock price to estimate the firms true value. This is called stock and debt approach. The efficient market hypothesis has two important implications for appraisal practice: . On March 31. 30 on that date. Though it is a straight forward there is some debate about what prices to use when valuing the securities.Stock and Debt Approach When the securities of a firm are publicly traded its value can be obtained by merely adding the market value of all its outstanding securities. The market value of ABC Corporation equity is Rs. 2010 is 20 million at a closing price of Rs. By adding Market value of Equity and market value of Debt the total value of firm is Rs. Lien date is the day on which the appraiser is attempting to value. 600 million. Is averaging is reasonable this depends on whether the stock market is efficient or not. particularly the equity shares. 2010 the outstanding debt of ABC Corporation with market value is Rs. Since stock prices are volatile some appraisers suggest using an average of recent stock prices.370 million.

2.1. it will produce the most reliable estimate of value. Direct Comparison Approach: This approach is based on the principle that similar assets should sell at similar prices.The securities of the firm should be valued at the market price obtaining on the lien date. Averaging of prices over a period of time is not correct. It reduces the accuracy of appraisal. This can be calculated using the formula: V T=x T V c / x c where V T is the appraised value of the target firm x T is the observed variable for the target firm that supposedly drives value V c is the observed value of the comparable firm x c is the observed variable for the comparable company. . One can value asset by looking at price at which a comparable asset has changed hands between a reasonably informed buyer and a reasonably informed seller. Where stock and debt approach can be employed.

Analyze the subject company 4. It examines the following factors and forecast their growth rates.Value the subject company Analyze the Economy: The analysis of the economy provides the basis for assessing the prospects of various industries and evaluating individual companies within an industry.Analyze subject and comparable companies 6.Select comparable companies 5. They are : a) Gross national product b) Industrial production c) Agricultural output d) Inflation e) Interest rates f) Balance of Payment g) Exchange Rates h) Government budget .Analyze multiples 7.Analyze the industry 3.Analyze the economy 2.Steps In Applying the Direct Comparison Approach This involves the following steps: 1.

leverage and access to funds 10. production costs. Managerial competence and drive. Technological and production capability. Competitive dynamics. distribution reach. Availability and cost of inputs. 5.Analyze the Industry: It focus on the following: 1. Market image. 3. Analyze the subject Company: The key aspects covered in this are: 1. margins. Quality of human resources. 6. The profit potential of the industry 4. marketing and distribution arrangements . and return on investment. The nature of regulation applicable to the industry 5. The stage in which the industry is in its life cycle 3. and customer loyalty. and technological resources. Product portfolio and market segments covered by the firm. 8. The relative competitive advantages of procurement of raw materials. 9. 7. The relationship of the industry to the economy as a whole 2. 2. Product differentiation and economic cost position. 4. Turnover. Liquidity. .

scale of operation and so on are to be selected. The purpose is to normalize the financial statements. Adjustment s are required for intangible assets for off balance sheet items and so on. It is difficult to find similar companies because companies are engaged in a variety of businesses. financial variables like earnings and cash flow are the obvious choices for x. Choose the observable financial variable: In order to provide a reliable estimate of value.Select Comparable Companies: Companies which are similar to the subject company in terms of the lines of business. In addition financial variables like sales and net worth which influence earning power are also to be considered. V/x must not vary widely for the comparable firms and the target firm. serve different segments and have varying capacities. . Where V and x are the variables which have to be chosen carefully. The value of firm is ultimately based on the cash generated for its investors. nature of markets served. In practice analyst should make effort to look carefully at 10 to 15 companies in the same industry and select at least 3 to 4 which come as close as possible to the subject company.e. Analyze the financial aspects of the subject and comparable companies: Once the comparable companies are selected the historical financial statements of the subject and comparable companies must be analyzed to identify similarities and differences and make adjustments so that they are put on a comparable basis. the ratio of value indicator to the observed financial variable i.

Firm value to book value of assets 3. Firm value to sales 2.The value indicator must be consistent with the financial variable chosen. Bottom Line: The direct comparison approach is very popular because it relies on multiples that are easy to relate to and can be obtained easily and quickly. Firm value to PBIT 5. . If equity earnings is chosen it should be matched with equity value not the total firm value.e. overvaluation or undervaluation of the market. Equity value to net worth (Market ² Book value) Value the subject Company: In this step we will decide where the subject company fits in relation to the comparable companies. If several bases are employed the several value estimates may be averaged. Firm value to PBIDT 4. They are particularly useful when several comparable companies are traded and the market prices them accurately. Once this is done. The multiples used reflect the valuation errors i. But there is a possibility of misuse and manipulation as no two firms are likely to be identical in terms of risk and growth. The ratios or multiples that are commonly used on direct comparison method are: 1. If PBDIT( Profit Before Depreciation Interest and Tax) is chosen then is should be matched with total firm value. appropriate multiples may be applied to the financial numbers of the subject company to estimate its value. Equity value to equity earnings (Price ² Earnings multiple) 6.

Valuing a firm using DCF approach is conceptually identical to valuing the capital project using PV method. There are two important differences: 1. For a firm we don·t define economic life and impute a salvage value to its assets at the end of such a period. i.. 2. . A capital project is valued as one off investment.e. emphasis. and acceptance mainly because of its conceptual superiority and its strong endorsement by leading consultancy organizations. A firm is viewed as a growing entity and for valuing a firm we take into account all the investments in fixed assets and net working capital that are expected to be made over time to sustain the growth of the firm.Discounted Cash Flow Approach: Traditionally adjusted book value approach and direct comparison approach were used more commonly but from 1990s. DCF approach has received greater attention. A capital project will have finite life and a firm has an indefinite life. a project is valued based on its economic life and impute salvage value to the assets of the project at the end of its economic life.

Estimating the cost of capital 3. Calculating the firm value and interpreting the results Analyzing Historical Performance: The historical performance focus on: a) extracting valuation related metrics from accounting statements b) Calculating the free cash flow and the cash flow available to investors c) Getting a perspective on the drivers of free cash flow d) Developing the ROIC tree To understand the concept of historical performance analysis let us consider an example of ALWIL LTD whose balance sheet and profit and loss account for 3 years are as follows: . Forecasting performance 4. Determining the continuing value 5.Value of firm= Present value of cash flow during an explicit forecast period + Present value of cash flow after the explicit forecast period. Analyzing historical performance 2. The DCF method of valuing a firm involves the following steps: 1. Explicit forecast period is normally for 5 to 15 years.

Rs in million Profit and Loss Account Particulars Net Sales Income from marketable securities Non operating Income Total Income Cost of goods sold Selling and general administration expenses Depreciation Interest expenses Total costs and expenses PBT Tax provision PAT Dividend Retained earnings 1 180 ----180 100 30 12 12 154 26 8 18 11 7 2 200 ----200 120 35 15 15 170 30 9 21 12 9 3 229 ----240 125 45 18 16 204 36 12 24 12 12 .

Balance Sheet Years 1 Equity capital Reserves & Surplus Debt Total Fixed assets Investments Net Current Assets Total 60 40 100 200 150 --50 200 2 90 49 119 258 175 20 63 258 3 90 61 134 285 190 25 70 285 .

NOPLAT 3. Let us assume that investment represent excess cash and marketable securities.Net operating profit less adjusted taxes(NOPLAT) = EBIT ² Taxes on EBIT EBIT= PBT + Interest expense ² Interest income ² non operating income Taxes on EBIT = Tax provision from income statement + Tax shield on interest expense ² tax on interest income ² tax on non operating income. Net Investment 1. Operating invested capital = total assets in the balance sheet ² Non operating fixed assets like surplus land ² excess cash and marketable securities. . ROIC 4. Operating invested capital 2. Operating invested capital for year 1=200-0=200 Operating invested capital for year 2=258-20=238 Operating invested capital for year 3=285-25=260 2.Extracting valuation related metrics from accounting statements: The following are evaluated using accounting statements: 1.

2 Year 2 30 15 ----45 9 6 ----15 30 Year 3 36 16 3 8 41 12 6.8 ----12.8 25.2 14 27 .Year 1 Profit before tax Add: Interest expense Less: Interest income Less: Non operating income EBIT Tax provision from income statement Add: Tax shield on interest expense Less: Tax shield on interest income Less: Tax shield on non operating income Taxes on EBIT NOPLAT 26 12 ----38 8 4.4 1.2 3.

Net investment during the year can be calculated as follows: Net fixed assets at the end of the year + net current assets at the end of the year ² ( Net fixed assets at the beginning of the year + net current assets at the beginning of the year) . Net Investment: Net investment is the difference between gross investment and depreciation.3% ROIC focuses on the true operating performance of the firm. Net Investment = Gross investment ² Depreciation Gross investment is sum of incremental outlays on capital expenditures and net working capital.Return on Invested Capital: ROIC = NOPLAT / Invested capital Invested capital is usually measured at the beginning of the year or as the average at the beginning and end of the year. The ROIC of ALWIL LTD is calculated as follows: Year 2 Year 3 NOPLAT 30 27 Invested capital at the Beginning of the year 200 238 ROIC 30/200 =15% 27/238=11. Depreciation refers to all non cash charges.

2 45 45 Increase / decrease in working capital 13 7 33 Capital expenditure 40 Gross Investment 53 40 Free Cash Flow (8) 5 Year 2 175 63 150 50 38 Year 3 27 70 175 63 22 .5 30.0 27. FCF = NOPLAT ²Net Investment FCF = ( NOPLAT + Depreciation ) ² ( Net Investment + Depreciation) FCF = Gross cash flow ² Gross Investment FCF of ALWIL LTD is calculated as follows: Year 1 Year 2 Year 3 NOPLAT 25.0 15 18 Depreciation 12 Gross cash flow 37.Net investment of ALWIL LTD is as follows: Net fixed assets at the end of the year Add: Net current assets at the end of the year Less: Net fixed assets at the beginning of the year Less: Net current assets at the beginning of the year Net Investment Calculating The Free Cash Flow: The free cash flow is the post tax cash flow generated from the operations of the firm after providing for investments in fixed investment and net working capital required for the operations of the firm.

Cash flow available to investors = Free cash flow + Non operating cash flow Non operating cash flow arises from non operating items like sale of assets. The cash flow available to investors can be viewed as the financing flow which is derived as follows: Financing flow = After tax interest expense + Cash dividend on equity and preference capital + Redemption of debt ² New borrowings + Redemption of preference shares + Share buybacks ² Share issues + change in excess marketable securities ² after tax income on excess market securities Calculation of cash flow available to the investors is as follows: . restructuring and settlement of disputes.

8 9.8 .8 9.6 12 --15 ----5 1.8 9.Year 2 Free cash flow Add: Non operating cash flow Cash flow available to investors After tax interest expense Add: Cash dividend on equity and preference capital Add: Redemption of debt Less : New borrowings Add: Share buybacks Less: Share issues Add: Difference of excess marketable securities Less: After tax income on excess securities Financing flow (8) --(8) 9 12 --19 --30 20 --(8) Year 3 5 4.

Estimating The Cost of Capital: Cost of capital is the discount rate used for converting the expected free cash flow into its present value. r D = Pre Tax Cost of Debt. S = Market Value of Equity. . represent the economic claims of various providers of capital. P = Market Value of Preference Capital. T = Marginal Rate of Tax Applicable . ‡ It is based on market value weights for each component of financing. as market values. ‡ It is defined in nominal terms since the free cash flow is stated in nominal terms. r E = Cost of Equity Capital . R P = Cost of Preference Capital. B = Market Value of Interest Bearing Debt. Features of cost of capital: ‡ It represents a weighted average of the costs of all sources of capital as the free cash flow reflects the cash available to all providers of capital. ‡ It reflects the risks borne by various providers of capital. V = Market Value of Firm.T) (B / V) Where WACC = Weighted Average Cost of Capital. ‡ It is calculated in post tax terms because the free cash flow is expressed in post tax terms. The formula for calculating weighted average cost of capital is: WACC = r E (S / V) + R P (P / V) + r D ( 1 . not book values.

67 (1 ² 0. The firm earns a fixed profit margin achieves a constant asset turnover and hence earns a constant rate of return on the invested capital. Developing a strategic perspective on the future performance of the company 3. Converting the strategic perspective into financial forecasts 4. A story is to be developed on the basis of thoughtful strategic analysis of the company and the industry to which it belongs. The reinvestment rate and growth rate remain constant.27%.27 + 2/5 * 12. Selecting the explicit forecast period 2. Checking for consistency and alignment Selecting the explicit forecast period: It is such that the business reaches a steady state at the end of this period. 2.4) =14% FORECASTING PERFORMANCE: This involves the following steps: 1. and competitive business system analysis. Developing a Strategic perspective: It reflects a credible story about the company·s future performance. It is based on the following assumptions: 1. The prominent among them are classical industry structure analysis.ALWIL LTD has a target capital structure in which debt and equity have weights of 2 and 3. The weighted average of capital is : WACC = 3/5 *18. customer segmentation analysis. . Marginal rate of tax is 40%. The component costs of debt and equity are 12.67% and 18.

3. Net worth at the end of the ear n is equal to net worth at the end of year n ² 1. Use the cash and debt account as the balancing account. minus share repurchases during year n. Checking for consistency and alignment: The forecast for consistency and alignment is done by asking the following questions: . working capital. Forecast non operating items such as investments. interest expense and interest income. 4. Sometimes free cash flow is developed directly without going through the profit and loss account and balance sheet. Develop the revenue forecast on the basis of volume growth and price changes 2. non operating income.Converting the strategic perspective into financial forecasts: Once story is crafted you have to develop a forecast of free cash flow. It is advisable to base free cash flow on the basis of profit and loss account and balance sheet. plus new share issues during year n. plus the amount ploughed back from the earnings of year n. and fixed assets. For non financial companies the most common method for forecasting the profit and loss account and balance sheet is as follows: 1. Use the revenue forecast to estimate operating costs. 5. Project net worth.

1. Is the company capable of managing the proposed investments? 5. There are two steps in estimating the continuing value: ‡ Choosing an appropriate method ‡ Calculating the continuing value Choosing an appropriate method: A variety of methods are available for estimating the continuing value. Is the ROIC justified by the industry·s competitive structure? 3. What will be the impact of technological changes on risk and returns? 4. Will the company be in a position to raise capital for its expansion needs? Empirical evidence suggests that: ‡ Industry average ROICs and growth rates are related to economic fundamentals. The second one represents the terminal value of continuing value. They are as follows: . Is the projected revenue growth consistent with industry growth? 2. ‡ It is difficult for a company to out perform its peers for an extended period of time because competition often catches up sooner or later. DETERMINING THE CONTUNING VALUE: A company value is sum of two terms: Present value of cash flow during the explicit forecast period + Present value of cash flow after the explicit forecast period.

. The continuing value of such a stream can be established by applying the constant growth valuation model: CV T = FCF T+1 / WACC ² g Where CV T = Continuing value at the end of year T FCF T+1 = Expected free cash flow for the first year after the explicit forecast period WACC = Weighted average cost of capital g = Expected growth rate of free cash flow forever.Cash flow Methods: ‡ Growing free cash flow perpetuity method ‡ Value driver method Non Cash flow Methods: ‡ Replacement cost method ‡ Price PBIT ratio method ‡ Market to book ratio method Growing free cash flow perpetuity method: This method assumes that free cash flow would grow at a constant rate for ever after the explicit forecast period T.

. ‡ It may simply be uneconomical for a firm to replace some of its assets. Limitations: ‡ It assumes that PBIT drives prices which is not a reliable bottom line for purposes of economic evaluation. Price to PBIT ratio method: In this method PBIT in the first year after the explicit forecast period is multiplied by a suitable price to PBIT ratio. Limitations: ‡ Only tangible assets can be replaced.Value Driver Method: It uses the growing free cash flow perpetuity formula but expresses it in terms of value drivers as follows: CV T = NOPLAT T+1 ( 1 ² g / r ) / WACC ² g Where CV T = Continuing value at the end of year T NOPLAT T+1 = Net operating profit less adjusted tax for the first year after the explicit forecast period WACC = Weighted average cost of capital g = Constant growth rate of NOPLAT after the explicit forecast period r = Expected rate of return on net new investment. Replacement Cost Method: The continuing value is equated with expected replacement cost of fixed assets of the company.

‡There is a practical problem as no reliable method is available for forecasting the price to PBIT ratio. Market to book ratio method: The continuing value of the company at the end of the explicit forecast period is assumed to be some multiple of its book value. Calculating the continuing value: Continuing value = FCF9 / WACC ² g = FCF8 (1+g) / WACC ² g Calculating the firm value and interpreting the results: Calculating the firm value: The value of firm is equal to sum of the following three components: ‡ Present value of the free cash flow during the explicit forecast period ‡ Present value of the continuing value at the end of the explicit forecast period ‡Value of non operating assets which were ignored in free cash flow analysis . The distortion from inflation and arbitrary accounting policies may be high.‡ There is an inherent inconsistency in combining cash flows during the explicit forecast period with PBIT for the post forecast period. It suffers from same problems as that of previous method.

We should evaluate the following questions: ‡ If the decision is positive. what upside potential is being given up? What is the probability of the same? The process of examining initial results may well uncover unanticipated questions tat are best resolved through evaluating additional scenarios. divesting a division or adopting a strategic initiative. While decision based on any one scenario is fairly obvious given its expected impact on shareholder value. Two Stage growth model: This model allows for two stages of growth an initial period of higher growth followed by a stable growth forever. DCF Approach : 2 STAGE and 3 STAGE Growth Model: This method is useful when detailed forecasts are not available.Interpreting the results: Valuation is done to guide some management decision like acquiring a company. what can possibly go wrong to invalidate it? How likely is that to happen? ‡ If the decision is negative. interpreting multiple scenarios is far more complex. . FCF = cash flow available to investors. In Value of firm = present value of the FCF (free cash flow) during the high growth phase + Present value of terminal value.

10 par) Rs. 200 million Working capital as a percentage of revenues 30 percent Corporate tax rate (for all time) 40 percent Paid up equity capital (Rs.333 . EBIT and capital expenditure 10 percent Working capital as a percentage of revenues 30 percent Cost of debt 15 percent (pre tax) Debt Equity ratio 1:1 Risk free rate 13 percent Market risk premium 6 percent Equity beta 1. depreciation. ABC Ltd is expected to grow at a higher rate for five years thereafter the growth rate will fall and stabilize at a lower level. 1250 million Inputs for the High Growth Rate: Length of the high growth phase 5 years Growth rate in revenues. 4000 million EBIT (8% of Revenues) Rs. 500 million Capital expenditure Rs. 300 million Market value of debt Rs. 300 million Depreciation Rs. The following information is available: Base Year Information: Revenues Rs.Let us consider an example to understand this model.

6 399.t) (tax=40%) Capital expenditure ² depreciation Change in working capital FCF (3-4-5) 4400 4840 5324 550 330 110 120 100 605 363 121 132 110 665.6 -----------512.2 146.1 483.7 133.3 131.0 396.Inputs for the Stable Growth Period: Expected growth rate in revenues and EBIT Capital expenditures are offset by depreciation Working capital as a percentage of revenues Cost of debt Debt Equity ratio Risk free rate Market risk premium Equity beta Forecasted FCF during high growth rate are calculated as below: Particulars Years Revenues EBIT EBIT (1.1 .4 6442.1 493.4 6828.1 145.2 161.1 805.1 175.7 146.0 Terminal year 5856.2 123 1 2 3 4 5 6 percent 30 percent 15 percent 2:3 12 percent 7 percent 1.1 ---------116.0 732.4 159.

‡ The transition period will be followed by a stable growth rate forever.15 ² 0. .5 (21%) + 0.4/(1.333 (6%) = 21% Stable growth period = 12% + 1(7%)= 19% Weighted average cost of capital = proportion of equity * cost of equity + proportion of debt * cost of debt (1.23 million Value of firm = 397.44 + 2188.44 million Present value of terminal value is 396.6(19%)+ 0.15)4 +146.1/(1.15)5 = 397.15)3 + 131.6) = 15% Stable growth firm = 0.5 (15)(0.15)5 = Rs.15 +110/(1.23 = 2585 million Three Stage Growth Model: It has the following assumptions: ‡ The firm will enjoy a high growth rate for a certain period ( usually 3 to 7 years) ‡ The high growth period will be followed by a transition period during which the growth rate will decline in linear increments. 2188.06)*(1.1/(0.6) = 15% Present value of FCF during explicit forecast is 100/1.15)2 +121/(1.t) High growth firm = 0.Cost of equity and weighted average cost of capital during the high growth period and stable growth period is calculated as follows: Cost of equity = risk free rate + equity beta (market risk premium) High growth period = 13% +1.4(15%)(0.

240 million Working capital as a percentage of revenues 20 % Tax rates 40 % (for all time to come) Inputs for the High Growth Period: Length of the high growth period 5 years Growth rate in revenues.Value of firm = PV of FCF during high growth period + PV of FCF during the transition period + PV of terminal value The above will be explained with an example: Let XYZ Ltd is being appraised by an banker the following is the information of XYZ Ltd: Base Year Information: Revenues Rs. and capital expenditures 25 % Working capital as a percentage of revenues 20 % Cost of Debt 15 % (pre tax) Debt Equity Ratio 1. 250 million Capital Expenditure Rs. 295 million Depreciation and Amortization Rs.583 WACC = 0. 1000 million EBIT Rs.4))=14 % .583(6))+0.6(15(1 ² 0.5 Risk free rate 12 % Market risk premium 6% Equity Beta 1.4(12+1. depreciation. EBIT.

.1(6)]+0.Inputs for the Transition Period: Length of transition period 5 years Growth rate in EBIT will decline from 25 % in year 5 to 10 % in year 10 in linear movements of 3 % each year Working capital as a percentage of revenues 20% The debt equity ratio during his period will drop to 1:1 and the pre tax cost of debt will be 14 % Risk free rate 11 % Market risk premium 6% Equity beta 1.5[14(1-0.10 WACC 0. EBIT.5[11+1. cost of capital and present values during high growth and transition period. capital Expenditure and depreciation 10% Working capital as a percentage of revenues 20 % Debt equity ratio 0:1 Pre tax cost of debt 12 % Risk free rate 10 % Market risk premium 6% Equity beta 1 WACC 1[10+1(6)] = 16 % From the above inputs we will estimate free cash flows to firm.4)]=13% Growth rate in revenues.

0 1.5 1.2 1884.7 85.1 134.3 134.26 66.100 1.6 886.8 1533.5 390.5 141.6 D /E 1.4 346.09 100.5 418.44 124.Period 1 2 3 4 5 6 7 8 9 10 Growth rate 25 25 25 25 25 22 19 16 13 10 EBIT (1±t) 187.100 1.1 1027.100 WACC 14 14 14 14 14 13 13 13 13 13 Present Value 60.1 97.3 610.5 1.9 1161.2 FCF 68.6 488.583 1.35 .1 958.1 1713.6 770.583 1.74 139.7 122.2 457.0 1516.4 744.8 219.8 133.3 1233.5 1277.2 Cap Exp 368.6 279.0 1.100 1.5 1.9 576.1 490.2 WC 250 312.0 Beta 1.5 234.96 138.4 893.5 1393.583 1.0 1.0 1.45 87.8 558.2 141.3 1307.2 720.4 293.0 366.6 1063.5 664.80 113.2 900.10 72.6 Dep 300 375 468.6 116.3 1098.5 78.9 732.2 167.5 1.9 107.9 871.7 ¨ WC 50 62.583 1.8 585.43 79.583 1.5 1.8 460.100 1.

7 / 0.29 million Present value of the terminal value is Rs.7 Terminal value 10 = FCF 11 / WACC ² g = 539.2535.62 million The value of firm is as follows: Present value of FCF during the high growth period is Rs. 617.13)5 = Rs. 2535.10 =Rs. and the WACC of the stable growth period. 3518.06) = 490.6 (1.The terminal value at the end of the year 10 can be calculated based on FCF in 11 year.16 ² 0.24 million . 8995 million Present value of terminal value = 8995 / (1.33 million Present value of FCF during the transition period is Rs.62 million Value of firm is Rs. 365. 16% FCF 11 = FCF 10 (1. the stable growth rate of 10 %.10) = 539.14)5(1.

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