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Corporate Valuation for a Simple Company - MPR

This chapter discusses the three types of value (book value, market value, and intrinsic value) and their importance in corporate valuation. It also explains the concepts of valuation and provides a step-by-step process for estimating a company's intrinsic value using discounted dividend valuation and the corporate valuation model. Additionally, it covers the calculation of weighted average cost of capital (WACC) and free cash flows (FCFs), as well as the analysis of financial statements.

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Corporate Valuation for a Simple Company - MPR

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  1. Chapter 2 A Complete Corporate Valuation for a Simple Company DES Chapter 2

  2. Three types of value • Book value: company’s historical value as shown on its financial statements. • Market value: current price an asset can be bought or sold. • Intrinsic value: estimate of the value an individual buyer places on an asset. Also called its fundamental value. DES Chapter 2

  3. The process is known as fundamental valuation—Warren Buffet =success identifying a company’s fundamental value. • OBJECTIVE: Provide sound basis for estimating stock’s intrinsic value. DES Chapter 2

  4. Three basic concepts of valuation • Investors can only spend cash so "Cash is good and more cash better." • Cash today is worth more than cash tomorrow. • Risky cash flows are worth less than safe cash flows. • Imply value of a company depends on size, timing, & riskiness of its cash flows. DES Chapter 2

  5. Valuation of a Simple Company: Mayberry Personal Receivers, Inc. (MPR) • Investors are: • Debtholders • Stockholders DES Chapter 2

  6. Debtholders and the value of debt Consider a bond that pays $90 per year for 10 years, and $1,000 at the end of 10th year. • $90 is the coupon payment • $1,000 is the face value, or maturity value. • $90/$1000 = 9% is the coupon rate DES Chapter 2

  7. What do investors require? • MPR’s bonds compete in the market with other bonds. If investors can earn 9% on similar investments, then MPR has to offer at least 9% on its bonds to attract investors. The required rate of return is 9%. • rD = 9% DES Chapter 2

  8. More investors… • MPR’s shares of stock also compete in the market for investors. • Stockholders are the owners of the firm, and the value of ownership is the value of the asset, less any debt that is owed. • For example: Suppose MPR is worth $501 million. It owes $150 million to debtholders. So MPR’s equity is worth $501 – 150 = $351 million. DES Chapter 2

  9. Cash flows that equity holders receive • Dividends: • Not fixed—usually grow • No maturity date • Riskier than bond payments • The required return on equity, rS, compensates investors for this risk. MPR’s rS is 12%. DES Chapter 2

  10. Discounted dividend valuation • MPR’s last dividend, D0,was $2.34 per share, and is expected to grow at 5% per year. • The present value of these at 12% is: • Of course, this method becomes difficult to apply if the company doesn’t pay dividends! DES Chapter 2

  11. The Corporate Valuation Model • PV of cash flows available to all investors—called free cash flows (FCFs). • Discount free cash flows at the average rate of return required by all investors—called the weighted average cost of capital (WACC) DES Chapter 2

  12. Steps in the corporate value model • Determine weighted average cost of capital • Estimate expected future free cash flows • Find value of company DES Chapter 2

  13. Estimating the Weighted Average Cost of Capital (WACC) • Company has two types of investors • Debtholders • Stockholders • Each type of investor expects to receive a return for their investment • The return an investor receives is a “cost of capital” from company’s viewpoint. DES Chapter 2

  14. Cost of Debt • MPR’s cost of debt: rD = 9%. • But MPR can deduct interest, so cost to MPR is after-tax rate on debt. • If tax rate is 40%, then after-tax cost of debt is: • After-tax rD = 9%(1-0.4) = 5.4%. DES Chapter 2

  15. Cost of Equity • Cost of equity, rs, is higher than cost of debt because stock is riskier. • MPR: rs = 12% DES Chapter 2

  16. Weighted Average Cost of Capital • WACC is average of costs to all investors, weighted by the target percent of firm that is financed by each type. • For MPR, target percent financed by equity: • wS = 70% • For MPR, target percent financed by debt: • wD = 30% (More….) DES Chapter 2

  17. WACC (Continued) WACC = wD rD (1-T) + wS rS = 0.3(9%)(1 - 0.4) + 0.7(12%) = 10.02% DES Chapter 2

  18. Free Cash Flow (FCF) • FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. • A company’s value depends upon the amount of FCF it can generate. DES Chapter 2

  19. Calculating FCF • FCF = net operating profit after taxes minus investment in operating capital DES Chapter 2

  20. Financial Statements • Balance sheet • Assets (all of MPR’s assets are used in operations) • Operating assets • Operating current assets • Property, plant, and equipment (PPE) DES Chapter 2

  21. Operating Current Assets • Operating current assets are the CA needed to support operations. • Op CA include: cash, inventory, receivables. • Op CA exclude: short-term investments, because these are not a part of operations. DES Chapter 2

  22. Operating Current Liabilities • Operating current liabilities are the CL resulting as a normal part of operations. • Op CL include: accounts payable and accruals. • Op CA exclude: notes payable, because this is a source of financing, not a part of operations. DES Chapter 2

  23. Balance Sheet: Assets 200120022003 Op. CA 162,000.0168,000.0176,400.0 Total CA 162,000.0 168,000.0 176,400.0 Net PPE 199,000.0210,042.0220,500.0 Tot. Assets 361,000.0 378,042.0 396,900.0 DES Chapter 2

  24. Balance Sheet: Claims 200120022003 Op. CL 57,911.562,999.766,150.0 Total CL 57,911.5 62,999.7 66,150.0 L-T Debt 136,253.0143,061.0150,223.0 Total Liab. 194,164.5 206,060.7 216,373.0 Equity 166,835.5171,981.3180,527.0 TL & Eq. 361,000.0 378,042.0 396,900.0 DES Chapter 2

  25. Income Statement 200120022003 Sales 400,000.0 420,000.0 441,000.0 Costs 344,000.0361,994.2374,881.6 Op. prof. 56,000.0 58,005.8 66,118.4 Interest 11,678.712,262.812,875.5 EBT 44,321.3 45,743.0 53,242.9 Taxes (40%) 17,728.418,297.221,297.2 NI 26,592.7 27,445.8 31,945.7 Dividends 21,200.022,300.023,400.0 Add. RE 5,392.7 5,145.8 8,545.7 DES Chapter 2

  26. NOPAT (Net Operating Profit After Taxes) • NOPAT is the amount of after-tax profit generated by operations. • NOPAT is the amount of net income, or earnings, that a company with no debt or interest-income would have. NOPAT = (Operating profit) (1-T) = EBIT (1-T) DES Chapter 2

  27. Calculating NOPAT NOPAT = (Operating profit) (1-T) = EBIT (1-T) NOPAT03 = 66.1184 (1-0.4) = 39.67104 million. DES Chapter 2

  28. Calculating Operating Capital • Operating capital (also called total operating capital, or just capital) is the amount of assets required to support the company’s operations, less the liabilities that arise from those operations. • The short-term component is net operating working capital (NOWC). • The long-term component is factories, land, equipment. DES Chapter 2

  29. Net Operating Working Capital NOWC = Operating current assets – Operating current liabilities This is the net amount tied up in the “things” needed to run the company on a day-to-day basis. DES Chapter 2

  30. Net Operating Working Capital NOWC = Operating CA – Operating CL NOWC03 = $176.4 – $66.15 = $110.25 million DES Chapter 2

  31. Operating Capital • Operating capital = • Net operating working capital (NOWC) plus • Long-term capital, such as factories, land, equipment. DES Chapter 2

  32. Operating Capital = NOWC + LT Op. Capital Capital03 = $110.25 + $220.50 = $330.75 million This means in 2003 MPR had $330.75 million tied up in capital needed to support its operations. Investors supplied this money. It isn’t available for distribution. DES Chapter 2

  33. Investment in operating capital • Operating capital in 2002 was $315.0423 million • Operating capital in 2003 was $330.75 million • MPR had to make a net investment of $330.75 – $315.0423 = $15.7077 million in operating capital in 2003. DES Chapter 2

  34. Calculating FCF FCF = NOPAT – Investment in operating capital FCF03 = $39.67104 – (330.75 – 315.0423) = $39.67104 – $15.7077 = $23.96334 million DES Chapter 2

  35. There are five ways for a company to use FCF 1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.) DES Chapter 2

  36. Non-operating income NOPAT Dividends Buy back stock Working Capital Pay interest Fixed Assets Buy non-op assets Pay principal Free Cash FlowBucket ReinvestmentBucket DES Chapter 2

  37. How Did MPR use its FCF? • Paid dividends: $23.4 million • Paid after-tax interest of: $12,875.5 (1-0.4) = $7.7253 million • For a total of $31.1253 million! This is $7.162 million more than the $23.9 million FCF available! Where did it come from? • MPR increased its borrowing by $150.223 – $143.061) = $7.162 million to make up the difference. DES Chapter 2

  38. Corporate Valuation • Forecast financial statements and use them to project FCF. • Discount the FCFs at the WACC This gives the value of operations DES Chapter 2

  39. Value of Operations: Of course, this requires projecting free cash flows out forever. DES Chapter 2

  40. Constant growth • If free cash flows are expected to grow at a constant rate of 5%, then this is easy: 200320042005200620072008 FCF 23.963 25.161 26.419 27.740 29.127 30.584 There is an easy formula for the present value of free cash flows that grow forever at a constant rate… DES Chapter 2

  41. Constant Growth Formula • The summation can be replaced by a single formula: DES Chapter 2

  42. The value of operations DES Chapter 2

  43. Value of Equity • Sources of Corporate Value • Value of operations = $501.225 million • Value of non-operating assets = $0 (in this case) • Claims on Corporate Value • Value of Debt = $150.223 million • Value of Equity = ? • Value of Equity = $501.225 - $150.223 = $351.002 million, or just $351 million. DES Chapter 2

  44. Value of Equity Price per share = Equity / # of shares = $351 million / 10 million shares = $35.10 per share DES Chapter 2

  45. A picture of the breakdown of MPR’s value DES Chapter 2

  46. Return on Invested Capital (ROIC) ROIC can be used to evaluate MPR’s performance: ROIC = NOPAT / Total operating capital in place at the beginning of the year DES Chapter 2

  47. ROIC calculation ROIC03 = NOPAT03 / Capital02 ROIC03 = 39.67104 / 315.0423 = 12.6%. This is a good ROIC because it is greater than the return that investors require, the WACC, which is 10.02%. So MPR added value during 2003. DES Chapter 2

  48. Economic Value Added (EVATM) (also called Economic Profit) • EVA is another key measure of operating performance. • EVA is trademarked by Stern Stewart, Inc. • It measures the amount of profit the company earned, over and above the amount of profit that investors required. • EP = NOPATt – WACC(Capitalt-1) DES Chapter 2

  49. Calculating EVA EVA = NOPAT- (WACC)(Begng. Capital) EVA03 = NOPAT03 – (0.1002)(Capital02) EVA03 = $39.67104 – (0.1002)(315.0423) = $39.67104 – $31.56742 = $8.1038 million (More…) DES Chapter 2

  50. Economic profit… This shows that in 2003 MPR earned about $8 million more than its investors required. Another way to calculate EP is EPt = (ROIC – WACC)Capitalt-1 = (0.125923 – 0.1002)$315.0423 = $8.1038 million DES Chapter 2

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