Problems Problem 9-18 Problem 9-20 Problem 9-21 Problem 9-23 Problem 9-24 Problem 9-25 Problem 9-26

Table 9-1

Problem 9-18

Heavy Metal Corporation is expected to generate the following free cash flows over the ne five years: Year FCF ($ million) 1 53 2 68 3 78 4 75 5 82

After then, the free cash flows are expected to grow at the industry average of 4% per year discounted free cash flow model and a weighted average cost of capital of 14%: a. Estimate the enterprise value of Heavy Metal.

b. If Heavy Metal has no excess cash, debt of $300 million, and 40 million shares outstan estimate its share price. Cost of capital Long-run growth rate Year FCF (millions) Terminal Value Total cash flow a. Enterprise Value b. Debt Equity value Number of shares outstanding Stock price 14.00% 4.00% 1 53.00 53.00 681.37 300.00 381.37 40 9.53 2 68.00 68.00 3 78.00 78.00 4 75.00 820.00 895.00 5 82.00

cash flows over the next

average of 4% per year. Using the ital of 14%:

million shares outstanding,

Problem 9-20 Sora Industries has 60 million outstanding shares, $120 million in debt, $40 million in cash, and the following projected free cash flow for the next four years: Year Earnings and FCF Forecast ($ million) 1 Sales 2 Growth versus Prior Year 3 Cost of Goods Sold 4 Gross Profit 5 Selling, General, and Administrative 6 Depreciation 7 EBIT 8 Less: Income Tax at 40% 9 Plus: Depreciation 10 Less: Capital Expenditures 11 Less: Increase in NWC 12 Free Cash Flow 0
433.0

1
468.0 8.1% (313.6) 154.4 (93.6) (7.0) 53.8 (21.5) 7.0 (7.7) (6.3) 25.3

2
516.0 10.3% (345.7) 170.3 (103.2) (7.5) 59.6 (23.8) 7.5 (10.0) (8.6) 24.6

3
547.0 6.0% (366.5) 180.5 (109.4) (9.0) 62.1 (24.8) 9.0 (9.9) (5.6) 30.8

4
574.3 5.0% (384.8) 189.5 (114.9) (9.5) 65.2 (26.1) 9.5 (10.4) (4.9) 33.3

a. Suppose Soras revenue and free cash flow are expected to grow at a 5% rate beyond year 4. If Soras weighted average cost of capital is 10%, what is the value of Soras stock based on this information? b. Soras cost of goods sold was assumed to be 67% of sales. If its cost of goods sold is actually 70% of sales, how would the estimate of the stocks value change? c. Lets return to the assumptions of part (a) and suppose Sora can maintain its cost of goods sold at 67% of sales. However, now suppose Sora reduces its selling, general, and administrative expenses from 20% of sales to 16% of sales. What stock price would you estimate now? (Assume no other expenses, except taxes, are affected.) d. Soras net working capital needs were estimated to be 18% of sales (which is their current level in year 0). If Sora can reduce this requirement to 12% of sales starting in year 1, but all other assumptions remain as in part (a), what stock price do you estimate for Sora? (Hint: This change will have the largest impact on Soras free cash flow in year 1.) Cost of Capital Long-run growth rate Cost of goods sold as a percent of sales Selling, General, and Administrative as a percent of sales Net working capital as a percent of sales Initial Value for Net Working Capital Shares outstanding Debt Cash 10.00% 5.00% 67.00%

20.00% 18.00% 77.94 60 120.00 40.00

Year Earnings and FCF Forecast ($ million) 1 Sales 2 Growth vs. Prior Year 3 Cost of Goods Sold 4 Gross Profit 5 Selling, General, and Administrative 6 Depreciation 7 EBIT 8 Less: Income Tax at 40% 9 Plus: Depreciation 10 Less: Capital Expenditures 11 Less: Increase in NWC 12 Free Cash Flow Terminal Value Total Cash Flow a. Enterprise value Cash Debt Number of shares Stock price 566.57 40.00 120.00 60.00 8.11

0 433.00

1 468.00
8.1% (313.6) 154.4 (93.6) (7.0) 53.8 (21.5) 7.0 (7.7) (6.3) 25.3

2 516.00
10.3% (345.7) 170.3 (103.2) (7.5) 59.6 (23.8) 7.5 (10.0) (8.6) 24.6

3 547.00
6.0% (366.5) 180.5 (109.4) (9.0) 62.1 (24.8) 9.0 (9.9) (5.6) 30.8

4 574.30
5.0% (384.8) 189.5 (114.9) (9.5) 65.2 (26.1) 9.5 (10.4) (4.9) 33.3

25.30

24.61

665.63 696.41

b. Cost of goods sold as a percent of sales Stock Price 8.11 Base case of 67% 5.14 70.00% c. Selling, general and administrative as a percent of sales Stock Price 8.11 Base case of 20% 12.07 16.00% d. Net working capital as a percent of sales Stock Price 8.11 Base case of 18% 9.01 12.00% Extension: Both COGS and Selling, general and administrative change 8.11 16.00% 9.10 70.00% Extension: Both COGS and Net working capital change 8.11 12.00% 6.04 70.00% Extension: Both Selling, general and administrative and net working capital change 8.11 16.00% 12.97 12.00%

Problem 9-21 Consider the valuation of Kenneth Cole Productions in Example 9.7. a. Suppose you believe KCPs initial revenue growth rate will be between 7% and 11% (with growth slowing in equal steps to 4% by year 2011.) What range of share prices for KCP is consistent with these forecasts? b. Suppose you believe KCPs EBIT margin will be between 7% and 10% of sales. What range of share prices for KCP is consistent with these forecasts (keeping KCP's initial revenue growth at 9%)? c. Suppose you believe KCPs weighted average cost of capital is between 10% and 12%. What range of share prices for KCP is consistent with these forecasts (keeping KCP's initial revenue growth and EBIT margin at 9%)? d. What range of share prices is consistent if you vary the estimates as in parts (a), (b), and (c) simultaneously? Kenneth Cole Productions Cost of Capital FCF Forecast ($millions) 1 Sales 2 growth vs. prior year 3 EBIT 4 Less: Income Tax 5 Less: Net Investment 6 Less: Increase in NWC 7 Free Cash Flow 8 Terminal Value 9 PV of Free Cash Flows 10 Value of Cash 11 Value of Debt 12 Number of Shares 13 Share price

11.00% Year 2005 518.00 9.00% 37.00% 8.00% 10.00% of sales of EBIT of sales of sales 2006 2007 2008 652.47 7.00%
58.7 (21.7) (3.4) (4.3)

2009

2010

2011 755.25 4.00%

68.0 (25.1) (2.3) (2.9)

564.62 609.79 9.00% 8.00%

50.8 (18.8) (3.7) (4.7) 54.9 (20.3) (3.6) (4.5)

691.62 726.20 6.00% 5.00%

62.2 (23.0) (3.1) (3.9) 65.4 (24.2) (2.8) (3.5)

23.62 424.83 100.00 3.00 21 24.85

26.44

29.31

32.17

34.95

37.59 558.54

a. If Initial Revenue Growth Rate can vary between 4% and 11%, the stock price can vary between b. If EBIT Margin can vary between 7% and 10%, the stock price can vary between c. If Weighted Average Cost of Capital can vary between 10% and 12%, stock price can vary between d. If all three of the above can vary, the stock price can vary between

22.86 19.59 22.24

and and and

25.70 27.48 28.34

16.54

and

32.62

Initial Revenue Growth Rate Base Case Stock Price 24.85 22.86 4.00% 22.93 4.18% 22.99 4.35% 23.06 4.53% 23.13 4.70% 23.19 4.88% 23.26 5.05% 23.33 5.23% 23.40 5.40% 23.47 5.58% 23.53 5.75% 23.60 5.93% 23.67 6.10% 23.74 6.28% 23.81 6.45% 23.88 6.63% 23.95 6.80% 24.02 6.98% 24.09 7.15% 24.16 7.33% 24.23 7.50% 24.30 7.68% 24.37 7.85% 24.45 8.03% 24.52 8.20% 24.59 8.38% 24.66 8.55% 24.73 8.73% 24.81 8.90% 24.88 9.08% 24.95 9.25% 25.03 9.43% 25.10 9.60% 25.18 9.78% 25.25 9.95% 25.32 10.13% 25.40 10.30% 25.47 10.48% 25.55 10.65% 25.63 10.83% 25.70 11.00%

EBIT Margin Base Case 7.00% 7.15% 7.30% 7.45% 7.60% 7.75% 7.90% 8.05% 8.20% 8.35% 8.50% 8.65% 8.80% 8.95% 9.10% 9.25% 9.40% 9.55% 9.70% 9.85% 10.00%

24.85 19.59 19.98 20.38 20.77 21.17 21.56 21.95 22.35 22.74 23.14 23.53 23.93 24.32 24.72 25.11 25.51 25.90 26.30 26.69 27.09 27.48

Weighted Average Cost of Capital Base Case 24.85 28.34 10.00% 27.94 10.10% 27.55 10.20% 27.17 10.30% 26.81 10.40% 26.46 10.50% 26.12 10.60% 25.79 10.70% 25.46 10.80% 25.15 10.90% 24.85 11.00% 24.55 11.10% 24.27 11.20% 23.99 11.30% 23.72 11.40% 23.46 11.50% 23.20 11.60% 22.95 11.70% 22.70 11.80% 22.47 11.90% 22.24 12.00%

Worst case scenario: Initial Revenue Growth is 4%, initial EBIT margin is 7%, and initial WACC is 12%: Cost of Capital 12.00% Kenneth Cole Productions Year 2005 2006 2007 2008 2009 2010 FCF Forecast ($millions) 538.72 560.27 582.68 605.99 630.23 1 Sales 518.00 2 growth vs. prior year 4.00% 4.00% 4.00% 4.00% 4.00% 3 EBIT 7.00% of sales 37.7 39.2 40.8 42.4 44.1 4 Less: Income Tax 37.00% of EBIT (14.0) (14.5) (15.1) (15.7) (16.3) 5 Less: Net Investment 8.00% of sales (1.7) (1.7) (1.8) (1.9) (1.9) 6 Less: Increase in NWC 10.00% of sales (2.1) (2.2) (2.2) (2.3) (2.4) 20.03 20.83 21.66 22.53 23.43 7 Free Cash Flow 8 Terminal Value 250.35 9 PV of Free Cash Flows 100.00 10 Value of Cash 3.00 11 Value of Debt 21 12 Number of Shares 16.54 13 Share price Best Case Scenario: Initial Revenue Growth is 11%, initial EBIT margin is 10%, and iniitial WACC is 10%: Cost of Capital 10.00% Kenneth Cole Productions Year 2005 2006 2007 2008 2009 2010 FCF Forecast ($millions) 574.98 630.18 681.85 728.22 767.54 1 Sales 518.00 2 growth vs. prior year 11.00% 9.60% 8.20% 6.80% 5.40% 3 EBIT 10.00% of sales 57.5 63.0 68.2 72.8 76.8 4 Less: Income Tax 37.00% of EBIT (21.3) (23.3) (25.2) (26.9) (28.4) 5 Less: Net Investment 8.00% of sales (4.6) (4.4) (4.1) (3.7) (3.1) 6 Less: Increase in NWC 10.00% of sales (5.7) (5.5) (5.2) (4.6) (3.9) 25.97 29.77 33.66 37.53 41.28 8 Free Cash Flow 9 Terminal Value 588.00 10 PV of Free Cash Flows 100.00 11 Value of Cash 3.00 12 Value of Debt 21 13 Number of Shares 32.62 14 Share price

2011 655.44 4.00%

45.9 (17.0) (2.0) (2.5)

24.37 316.77

2011 798.24 4.00%

79.8 (29.5) (2.5) (3.1)

44.76 775.89

Problem 9-23 Suppose that in January 2006, Kenneth Cole Productions had EPS of $1.65 and a book value of equity of $12.05 per share. EPS Book value of equity 1.65 12.05

a. Using the average P/E multiple in Table 9.1, estimate KCPs share price. Price per share 24.77 b. What range of share prices do you estimate based on the highest and lowest P/E multiples in Table 9.1? Range based on highest to lowest High 37.32 Low 14.29 c. Using the average price to book value multiple in Table 9.1, estimate KCPs share price. Price per share 34.22 d. What range of share prices do you estimate based on the highest and lowest price to book value multiples in Table 9.1? Range based on highest to lowest High 97.73 Low 13.50

Problem 9-24 Suppose that in January 2006, Kenneth Cole Productions had sales of $518 million, EBITDA of $55.6 million, excess cash of $100 million, $3 million of debt, and 21 million shares outstanding. Sales EBITDA Cash Debt Shares outstanding 518.00 55.60 100.00 3.00 21

a. Using the average enterprise value to sales multiple in Table 9.1, estimate KCPs share price. Price per share 30.77 b. What range of share prices do you estimate based on the highest and lowest enterprise value to sales multiples in Table 9.1? Range based on highest to lowest High 58.64 Low 16.21 c. Using the average enterprise value to EBITDA multiple in Table 9.1, estimate KCPs share price. Price per share 27.10 d. What range of share prices do you estimate based on the highest and lowest enterprise value to EBITDA multiples in Table 9.1? Range based on highest to lowest High 33.08 Low 22.25

Problem 9-25

In addition to footwear, Kenneth Cole Productions designs and sells handbags, apparel, and other accessories. You decide, therefore, to consider comparables for KCP outside the footwear industry. Kenneth Cole information EPS 1.65 EBITDA 55.60 Cash 100.00 Debt 3.00 Shares outstanding 21 a. Suppose that Fossil, Inc., has an enterprise value to EBITDA multiple of 9.73 and a P/E multiple of 18.4. What share price would you estimate for KCP using each of these multiples, based on the data for KCP in Problems 23 and 24? Fossil EBITDA P/E multiple price 9.73 30.38 18.40 30.36

Thus, KCP is trading at a discount relative to Fossil. b. Suppose that Tommy Hilfiger Corporation has an enterprise value to EBITDA multiple of 7.19 and a P/E multiple of 17.2. What share price would you estimate for KCP using each of these multiples, based on the data for KCP in Problems 23 and 24? Tommy Hilfiger EBITDA P/E multiple price 7.19 23.66 17.20 28.38

Thus, KCP is trading at a premium relative to Tommy Hilfiger using EV/EBITDA, but a slight discount using P/E.

Problem 9-26 Consider the following data for the airline industry in early 2009 (EV = enterprise value, BV = book value,NM = not meaningful because divisor is negative). Discuss the usefulness of using multiples to value an airline. Company Name Delta Air Lines AMR Corp. JetBlue Airways Continental Airlines UAL Corp. Air Tran Holdings SkyWest Hawaiian Pinnacle Airlines Market Cap 4,799.60 1,296.50 1,246.90 1,216.80 701 651.3 588.7 257.1 44 EV EV/Sales EV/EBITDA 16,887.60 0.7 15.0 8,743.50 0.4 17.5 3,834.90 1.1 10.4 4,506.80 0.3 14.7 6,192.00 0.3 NM 1,354.70 0.5 21.7 1,699.70 0.5 3.8 262.1 0.2 1.7 699.7 0.8 6.6 Average 0.53 11.43 Median 0.50 12.55 Max Value 1.10 21.70 Min Value 0.20 1.70 Standard Deviation 0.29 7.00 EV/EBIT NM NM 25.7 NM NM NM 7.5 2.7 10.1 11.50 8.80 25.70 2.70 9.95 P/E NM NM NM NM NM NM 6.5 3.6 3.4 4.50 3.60 6.50 3.40 1.73 P/Book NM NM 1.0x NM NM 2.3 0.5 NM 1.0 1.27 1.00 2.30 0.50 0.93

Many of the cases are not meaningful, because the earnings are negative or even (in several cases) the book value of equity is negative. There is a wide variation between low and high values. There must be more to valuation than what is revealed by the multiples.

Table 9-1
Stock Prices and Multiples for the Footwear Industry, January 2006 Ticker Name Stock Market Enterprise P/E Price/Book Enterprise Enterprise Price ($) Capitalizatio Value ($ Value/Sales value/EBITDA n ($ millions) Nike 84.2 millions) 21,830 20,518 16.64 3.59 1.43 8.75 NKE 312.05 5,088 4,593 14.99 5.02 2.19 9.02 PMMAY Puma AG Reebok 58.72 3,514 3,451 14.91 2.41 0.9 8.58 RBK 22.1 1,257 1,253 17.42 2.71 1.2 9.53 WWW Wolverine World Wide Brown Shoe 43.36 800 1,019 22.62 1.91 0.47 9.09 BWS Sketchers 17.09 683 614 17.63 2.02 0.62 6.88 SKX Stride Rite 13.7 497 524 20.72 1.87 0.89 9.28 SRR 30.05 373 367 13.32 2.29 1.48 7.44 DECK Deckers Outdoor 19.9 230 226 11.97 1.75 1.06 6.66 WEYS Weco Group 19.96 106 232 8.66 1.12 0.92 7.55 RCKY Tocky Shoes & Boots R.G. Barry 6.83 68 92 9.2 8.11 0.87 10.75 DFZ Corp. 10.4 62 75 12.09 1.28 0.76 8.3 BOOT LaCross Footwear Average 15.01 2.84 1.06 8.49 Maximum 51% 186% 106% 27% Minimum -42% -61% -56% -22%