Chapter 9 PowerPoint - IfM 12th Ed

CHAPTER 9
Corporate Valuation and Financial

Planning
1
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Topics in Chapter
 Financial planning
 Additional funds needed (AFN) equation
2
Pro Forma Financial
Statements
1. Assess if firm’s performance is in line with
anticipated performance
2. “What if” analysis
3. Anticipate future financing needs
4. Forecast free cash flows and capital
requirements to choose plan that
maximizes shareholder wealth
3
Operating plans
 Provide managers with a detailed
implementation guidance that will help
the firm realize its strategic vision
 Coca-Cola vs. General Electric
 Divisional breakdown of operating plans
4
Financial Planning Process
 Forecast financial statements under
alternative operating plans.
 Determine amount of capital needed to
support the plan.
 Forecast the funds that will be
generated internally and identify
sources from which required external
capital can be raised.
5
Financial Planning Process
(Continued)
 Establish a performance-based
management compensation system that
rewards employees for creating
shareholder wealth.
 Management must monitor operations
after implementing the plan to spot any
deviations and then take corrective
actions.
6
Balance Sheet, Hatfield, 12/31/15
($ in millions)
7
Income Statement, Hatfield, 2015
($ in millions)
8
Comparison of Hatfield to
Industry Using DuPont Equation
ROE= NI/S × S/TA × TA/E
NI/S = $24/$2,000 = 1.2%
S/TA = $2,000/$1,200 = 1.67
TA/E = $1,200/$500 = 2.4
ROEHatfield = 1.2% × 1.67 × 2.4 = 4.8%.
ROEIndustry = 2.74% × 2.0 × 2.13 = 11.6%.
9
Comparison (Continued)
 Profitability ratios lower because of

higher interest expense.
 Lower asset management ratios due to
high levels of receivables and inventory.
 Higher leverage than industry.
10
Key Factors in AFN Equation
 Sales growth (g): The higher g is, the
larger AFN will be—other things held
constant.
 Capital intensity ratio (A0*/S0): The
higher the capital intensity ratio, the
larger AFN will be—other things held
constant.
 Spontaneous-liabilities-to-sales ratio
(L0*/S0): The higher the firm’s
spontaneous liabilities, the smaller AFN
will be—other things held constant. 11
AFN Key Factors (Continued)
 Profit margin (Net income/Sales): The
higher the profit margin, the smaller
AFN will be—other things held constant.
 Payout ratio (DPS/EPS): The lower the
payout ratio, the smaller AFN will be—
other things held constant.
AFN = (A0*/S0)∆S −(L0*/S0)∆S −M(S1)(1−POR)
12
Definitions of Variables in AFN
 A0*/S0: Assets required to support
sales: called capital intensity ratio.
 S: Increase in sales.
 L0*/S0: Spontaneous liabilities ratio.
 M: Profit margin (Net income/Sales)
 POR: Payout ratio (Dividends/Net
income)
13
AFN (Additional Funds Needed)
Equation: Key Assumptions
 Operating at full capacity in 2015.
 Sales are expected to increase by 15%
 Asset-to-sales ratios remain the same.
 Spontaneous-liabilities-to-sales ratio
remains the same.
 2015 profit margin ($24/$2,000 =
1.2%) and payout ratio ($9/$24 =
37.5%) will be maintained.
14
Hatfield’s AFN Using AFN
Equation
AFN = (A0*/S0)∆S −(L0*/S0)∆S −M(S1)
(1−POR)
AFN = ($1,200/$2,000)($300)
− ($100/$2,000)($300)
− 0.012($2,300)(1 - 0.375)
AFN = $180 − $15 − $17.25
AFN = $147.75 million.
Self-Supporting Growth Rate
Self-Supporting growth rate is the maximum
growth rate the firm could achieve if it had no
access to external capital.
M(1 − POR)S
Self-supporting g = 0
______________________________
A0* − L0* − M(1 − POR)S0

(0.012)(1−0.375)($2,000)
g= ______________________________________________
$1,200 − $100 − (.012)(1−0.375)($2,000)
$15
g= ____________
= 1.38%
$1,085
16
Self-Supporting Growth Rate
 If Hatfield’s sales grow less than 1.38%,
the firm will not need any external
capital.
 The firm’s self-supporting growth rate is
influenced by the firm’s capital intensity
ratio. The more assets the firm requires
to achieve a certain sales level, the lower
its sustainable growth rate will be.
17
Corporate Valuation: A company
owns two types of assets.
 Operating
 Assets-in-place
 Growth options
 Nonoperating
 Financial assets
18
Assets-in-Place
 Assets-in-place are tangible, such as
buildings, machines, inventory.
 Usually they are expected to grow.
 They generate free cash flows.
 The PV of their expected future free
cash flows, discounted at the WACC, is
the value of operations.
19
Nonoperating Assets
 Marketable securities
 Ownership of non-controlling interest in
another company
 Value of nonoperating assets usually is
very close to figure that is reported on
balance sheets.
20
Total Corporate Value
 Total corporate value is sum of:
 Value of operations
 Value of nonoperating assets
21
Applying the Corporate
Valuation Model
 Forecast the financial statements
 Calculate the projected free cash flows.
 Model can be applied to a company that
does not pay dividends, a privately held
company, or a division of a company,
since FCF can be calculated for each of
these situations.
22
Data for Valuation
Price per Share?
 FCF0 = $24 million
 WACC = 11%
 g = 5%
 Marketable securities = $100 million
 Debt = $200 million
 Preferred stock = $50 million
 Book value of equity = $210 million
 Number of shares =n = 10 million
23
Value of Operations: Constant
FCF Growth at Rate of g
∞
Vop = Σ
t=1
FCFt
(1 + WACC)t
∞ FCF0(1+g)t
= Σ
t=1 (1 + WACC)t
24
Constant Growth Formula
(Cont.)
 The summation can be replaced by a

single formula:
FCF1
Vop =
(WACC - g)
FCF0(1+g)
= (WACC - g)
25
Find Value of Operations
FCF0 (1 + g)
Vop =
(WACC - g)
24(1+0.05)
Vop = = 420
(0.11 – 0.05)
26
Total Value of Company (VTotal)
Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00
27
Intrinsic Value of Equity (VEquity)
Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00
− Preferred Stk. 50.00
− Debt 200.00
VEquity $270.00
28
Intrinsic Stock Price per Share, P
Voperations $420.00
+ ST Inv. 100.00
VTotal $520.00
− Preferred Stk. 50.00
− Debt 200.00
VEquity $270.00
÷n 10
P $27.00 29
Expansion Plan: Nonconstant
Growth
 Finance expansion by borrowing $40
million and halting dividends.
 Projected free cash flows (FCF):
 Year 1 FCF = -$5 million.
 Year 2 FCF = $10 million.
 Year 3 FCF = $20 million
 FCF grows at constant rate of 6% after
year 3.
(More…)
30
 The weighted average cost of capital,
WACC, is 10%.
 The company has 10 million shares of
stock.
31
Horizon Value
 Free cash flows are forecast for three
years in this example, so the forecast
horizon is three years.
 Growth in free cash flows is not
constant during the forecast, so we
can’t use the constant growth formula
to find the value of operations at time
0.
32
Horizon Value (Cont.)
 Growth is constant after the horizon (3
years), so we can modify the constant
growth formula to find the value of all
free cash flows beyond the horizon,
discounted back to the horizon.
33
Horizon Value Formula
FCFt(1+g)
HV = Vop at time t =
(WACC - g)
 Horizon value is also called terminal

value, or continuing value.
34
Value of operations is PV of
FCF discounted by WACC.
0 WACC =10% 1 2 3 g = 6%
−5.00 10.00 20.00

FCF3(1+g)
−4.545 (WACC−g)
8.264 $20(1.06)
15.026 0.10−0.06
398.197 $530 = V op at 3
416.942 = Vop $530/(1+WACC)3

35
Intrinsic Stock Price per Share, P
Voperations $416.942
+ ST Inv. 0
VTotal $416.942
− Preferred Stk. 0
− Debt 40.000
VEquity $376.942
÷n 10
P $37.69 36

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CHAPTER 9

Corporate Valuation and Financial

 Profitability ratios lower because of

AFN = (A0/S0)∆S −(L0/S0)∆S −M(S1)(1−POR)

A0* − L0* − M(1 − POR)S0

$1,200 − $100 − (.012)(1−0.375)($2,000)

 The summation can be replaced by a

 Horizon value is also called terminal

−5.00 10.00 20.00

416.942 = Vop $530/(1+WACC)3

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