ERASMUS UNIVERSITY ROTTERDAM

School of Economics
Capacity group Business Economics
Section Finance
Seminar Corporate Finance March – April 2008
Group: W.L.J. Schramade

Valuing Philips Lighting

Shedding light on the optimal capital structure

Group 5:
Peter Bakker 314529
Ralf Groot Baltink 295097
Wieger Jansen 289629
Bas Lustenhouwer 293044
Index Page

Chapter 1: introduction 3
1.1 Introduction 3
1.2 Problem definition 4
1.3 Methodology 4
1.4 Recent acquisitions 5
Chapter 2: Sales Growth and margins 6
2.1 Historical Sales 6
2.2 Factors effecting future Growth 6
2.3 Forecasts Market Sectors 9
2.4 Growth conclusion 11
Chapter 3: Estimating the cost of capital 13
3.1 Discount methods 13
3.2 Methods with debt 16
Chapter 4: Multiples 17
4.1 Using multiples for valuation 17
4.2 Implications using multiples 20
Chapter 5:The capital structure of PL 21
5.1 The all equity firm 21
5.2 Finance structures with debt 22
5.3 The optimal capital structure 22
6.1 Summary 25
6.1 Background 25
6.2 Growth and Earnings 25
6.3 Multiples 25
6.4 Value and Capital structure 26
Appendix 27
A.1 Beta and WACC calculations 27
A2 Valuation and the tax advantage of debt 28
A3 Forecasted Balance sheet 29
A4 FTSE all-share 30
A5 Changes made in the final version 31
References 32

Valuing Philips Lighting: Shedding light on the optimal capital structure 2

1.1. Introduction.

1.1.1.Capital structure and finance theory

In this paper we will give a valuation of Philips Lighting B.V., which is a division of Royal
Philips Electronics and is the leading lighting company in the world(from now on Philips
Lighting will be referred to by PL). Because PL is not publicly traded we will use DCF
methods and compare PL with other companies using multiples. We will determine if their
current capital structure should be changed to maximize value. The current capital structure of
PL is an all equity-financed structure (no debt). We will present valuations using different
capital structures, the company will be valued using the current capital structure (all equity)
and different structures where PL takes on debt. In our analysis we will valuate the costs and
benefits of taking on debt to ultimately come to an optimal capital structure that maximizes
the value of PL. In this valuation we will treat the lighting division as if it were a publicly
traded entity.

1.1.2. Philips Lighting

First we will give a short description of the company and the major competitors in the lighting
market. As one of the three divisions of Netherlands based Royal Philips Electronics, PL is
the leading lighting company in the world. It makes lights for nearly every application,
including; automotive lighting, lighting for homes, professional lighting and LED lighting.
This leading position is mainly retained by innovation. Over the years PL has increased its
R&D expenses, in 2001 this percentage was 2,8% which was EUR 141 million, this is now
4,5% of sales or EUR 276 million.

The main competitors of PL are:

- OSRAM; a subsidiary of Siemens, also one of the world’s largest producers of

lighting products.
- GE Lighting; A division of the well-known General Electric.
- Matsushita; division of Panasonic.

Until now the market was an oligopolistic game, with giants like GE, OSRAM, Matsushita
and PL. This non-competitive landscape is changing as key factors such as “green energy”
and the change to solid-state lighting are changing the face of the lighting environment. The
threat of new entrants has greatly increased as a trend has developed where many companies
come in with new disruptive technologies.

Valuing Philips Lighting: Shedding light on the optimal capital structure 3

These companies can become part of the lighting game depending on the viability of their
products. In this case, change translates into opportunity, and PL anticipated this change and
has positioned itself perfectly to benefit on a large scale. Knowing that the dynamics of the
business is changing and wanting to be the big player on the market, they made 4 billion
worth of acquisitions. The major acquisitions were Genlyte and Color Kinetics, which are
both U.S. based and Partners in Lighting International which is European based.

1.2. Problem definition

The main problem this paper tries to solve is the following:

What is the current value of PL, and is the current capital structure maximizing
shareholder value?

1.3. Methodology

1.3.1 Free cash flows

To valuate PL we will first estimate the sales growth. This is an intricate process that should
be done with a lot of consideration and understanding of the markets and industries that PL
finds itself in. After estimating future sales, we will estimate the margins, the amortization,
the depreciation and the investment in working capital. These numbers can be used to
calculate the free cash flows. When estimating these numbers we will assume that PL is a
continuing operation. The calculated free cash flows will be discounted using the weighted
average cost of capital (WACC).

1.3.2. Discount methods

To calculate the WACC in different capital structures, we need an estimate of the required
rate of return on equity, the cost of debt, the corporate tax rate, the risk free rate and the
capital structure.
The required rate of return on equity is going to be calculated using the widely used CAPM
model. The cost of debt is going to be calculated using rates on bonds Philips issues on the
exchange market, the corporate tax rate is taken form the Philips annual report, as the risk free
rate we use the rate on 1-year Dutch government bonds, the market premium will be
estimated using the FTSE-all share index. We will vary the capital structure, the firm will be
valued using the current structure and three different debt ratios; ten, twenty and thirty
percent.

Valuing Philips Lighting: Shedding light on the optimal capital structure 4

1.3.3. Multiples
Because the DCF method requires a lot of estimates and therefore may not give a proper
value for PL, we will also value the firm using multiples. We will use comparable firms and
their multiples to arrive at proper multiples for PL. We will be using multiples such as:
Enterprise value to EBITDA, PE ratio and the adjusted PEG ratio.

1.4. Recent acquisitions;

As mentioned before, the market PL is operating in is changing. To sustain their leading
position in the market and to anticipate on the changing dynamics of the business, the shift
from incandescent lighting to new forms of lighting (solid-state lighting in particular), PL has
mode some major acquisitions with a total worth of €4 billion. The major acquisitions are:
Genlyte, Lumileds and Color Kinetics, which are U.S. based and Partners in Lighting
International which is European based. A description of these acquired companies will be
given in the next chapter.

Valuing Philips Lighting: Shedding light on the optimal capital structure 5

Chapter 2: Sales Growth and margins

2.1. Historical Sales

2.1.1. Sales in recent years

Before 2005 PL’s organic sales figures (adjusted for the currency effect) were relatively
stable. From 2000 till 2005 organic growth averaged between 3% and 5% per year. Sales in
Euro figures were very negatively affected in 2002/03 by the depreciation of the dollar versus
major currencies.

2.2. Factors effecting future Growth

2.2.1. Acquisitions
The four major acquisitions made in the last years will become a substantial growth
opportunity for the future.
- Lumileds (2005): With the takeover of Lumileds in the end of 2005 PL will become one of
the leading companies in the development for LED’s. The acquisition places PL in a very
good position to take advantage of the changing dynamics of the lighting market. LED’s
durability and efficiency are features which establish it as the future of lighting.
- Color Kinetics (2007): In 2007, PL paid €515 million for a firm with sales of only €50
million a year. This might seem odd, yet Color kinetics has major growth potential. Color
Kenetics had a growth rate of 31% in 2007, Color Kinetics also owns a lot of patents in the
LED business. These patents should prove to be very valuable in the future when the market
for LED’s becomes more mature. The acquisitions of color Kinetics and Lumileds made PL
the leader in LED technologies.
- Partners in Lighting (2007): Early 2007 PL acquired PLI for an amount of €561 million.
This has also been a strategic move to cover sales channels, and to capture a leading position
in solid-state lighting for the home. With revenues of about €400 million and a margin of
12%, PL paid roughly 11.6 times the profit of 2006.

Valuing Philips Lighting: Shedding light on the optimal capital structure 6

- Genlyte: Genlyte is the most expensive acquisitions in the history of PL amounting to 1.85
billion (52% above the market price). Genlyte produces professional Luminaires. Genlyte’s
sales figures for 2007 amounted to more then €1 billion and a growth rate of 12%. By
acquiring Genlyte PL eliminated a shackle from the value chain, strengthening its position in
North America in the process. This is why PL paid a major premium over the market price of
Genlyte.
All in all these acquisitions provide PL with major growth opportunities for the future. With
the acquisition PL acquired a lot of patents on new technologies, strengthening the market
position of the company is the process.

2.2.2. LED market prognosis

With the acquisitions PL will become a major player in the LED and Luminaires market. As
the LED technology takes off and starts to enter the averages consumer’s homes, PL will
benefit from all sections of the LED value chain therefore experiencing exceptional growth.
PL is now in the position to supply LED technology directly to the market. In the past, PL had
to supply LED lighting to the manufacturers of luminaires. Since the acquisition of Genlyte,
PL now supplies LED Lighting and components directly to the consumer. On the downside,
LED technology still is relatively expensive. This hampers the fast take-up of LED lighting
by the average consumer.

The US LED market is the frontrunner for LED sales and a driving force behind the LED
technology development. The US economy has been hit by the sub-prime crisis that has
crippled the financial system. These factors coupled with other macro-economic variables
have caused an economic slowdown. Exact figures and predictions of the depth of the
slowdown are yet to be fully understood. We therefore feel that LED growth in the USA will
be somewhat limited for the next couple of years We estimate that the slowdown will
negatively impact market growth for the next 2-3 years. We expect the growth rate achieved
by Genlyte and other LED related divisions to be a bit disappointing in the coming years, so
the 31% growth of Color Kinetics and 12% growth rate of Genlyte must be adjusted for the
next three years.
We do however believe that LED technologies provide PL with huge growth opportunities in
the coming decade.

2.2.3. Energy savings

“Approximately 19 % of the world’s electricity bill comes from lighting” Rudy Provoost,
CEO of PL. New innovative lighting could save up to 40% energy used in lighting per
household.

Valuing Philips Lighting: Shedding light on the optimal capital structure 7

Global warming has highlighted the need for efficient and clean energy. “An Inconvenient
Truth”, by Al Gore and other forms of media attention, initiated a trend towards massive
consumer expenditures on energy saving technologies. This brought about the emergence and
popularity of the Energy saving light bulbs and other energy saving lighting technologies.

Since LED’s are the most energy efficient lighting solution to date, they are seen as the future
of lighting and could experience massive growth as the world’s average consumer adapts to
more responsible patterns of energy consumption. The shift to new technologies, provide PL
with a lot of growth opportunities. We have seen the GLS market being replaced by the
energy savings light bulb. We expect this trend to continue into the near future given current
conditions. Although energy saving light bulbs are twice as expensive as the average GLS
bulb, we believe that due to global shifts towards efficient electricity consumption combined
with government regulation, the current growth in the lighting business will continue into the
future. Prior to 2004, the compound annual growth rate (CAGR) in the lamps market was 3%
annually, since 2004 PL has seen an increase of 7%. The growth of the total market provides
opportunities, but the shift to energy savers could also provide PL with a competitive
advantage. PL spends a lot on R&D and owns a lot of patents; therefore PL is a frontrunner in
energy saving technologies.

The point of government regulation requires further elaboration. In 2010, it will be illegal for
any person to purchase conventional GLS light bulbs in Australia. This is a trend that could
be passed on to many other countries as the world tries to save energy. This could act as a
very powerful growth catalyst. Furthermore, a national power shortage in South Africa is now
prevalent. The South African government is considering various forms of regulation to save
energy to deal with the crisis. We believe that regulation enforcing all households to switch to
energy saving light bulbs could be announced very soon. Philips released a press statement on
Thursday the 28’th of March 2008 stating that they are building an factory in Lesotho in
partnership with CEF and Karebo Systems to manufacture energy saving light bulbs.
If such regulation is passed, a market opens up to PL that will increase sales as well as
margins due to lower wages and input costs. It is upmost important for PL to stay on top of
these developments, when the market shifts and competitors fight for there place in this new
market, PL must stay one step ahead to maintain there leading position.

Valuing Philips Lighting: Shedding light on the optimal capital structure 8

2.3. Forecasts Market Sectors

2.3.1 Current distribution across continents

In total, the sales distribution in 2007 was:
- 39% in Western Europe
- 19% in North America
- 37% in Emerging
- 5% in the Asian Pacific

2.3.2. Western Europe

In Western-Europe the market has shown enormous growth in the last two years. 10.5% in
2006 and 20.5% in 2007. This growth was mainly due to acquisitions. Organic growth for
Western Europe in 2007 comes to 3.2% which can mostly be attributed to energy savings
sales. Although Western Europe could be affected by a possible US recession, analysts
project a 1.5% growth of the European economy. We therefore believe that PL should be able
to maintain a stable growth of around 2% in Western Europe.

2.3.3. North America

In North-America the sales declined in 2007 with 5%, this was caused by the sharp decline in
the dollar value. Before 2006 the sales growth rates were zero. This could be explained by the
leading position that GE has in this market. By removing a shackle in the value chain, PL
improved it’s positions on the American market. With the acquisition of Color Kinetics and
Genlyte, PL can provide the American consumers with entire lighting solutions. PL will be
the second player in the professional luminaire business and has a lot of LED patents. But
with the expected economic recession and the “not yet cost efficient” production of LED’s the
sales growth in North-America will probably be disappointing in the following years. It is
hard to predict what the value of the dollar will be in the upcoming years since the current
value of the dollar could lead to many outcomes. The low value of the dollar could stimulate
exports and cause the dollar to rise, on the other hand the major US current account deficit
could cause the dollar to decline even more. We have, since the inception of this analyses,
been informed that PL plans to hedge itself against shifts in the dollar value versus the euro.
We therefore do not recognize the currency effect. We see the opportunity that the high-
margin LED market brings, but we believe that the US recession will dampen the
developments of LED sales. We also foresee more intense competition in the US market and
we therefore forecast very slow growth in the coming years.

Valuing Philips Lighting: Shedding light on the optimal capital structure 9

2.3.4. Emerging Markets
‘Five years ago there where 9 million bicycles in Beijing and 100.000 cars, today there are 6
million cars’
Emerging markets are the fastest growing markets in the world. In China, PL opened 8000
establishments last year. This is also the prognosis for 2008. The average growth percentage
in sales was 16% last year for emerging countries. The emerging market share of overall sales
of PL has risen from 31% in 2006 till 37% in 2007. The strategic targets of PL are to
continuously expand market share and sales in emerging markets. Emerging markets have
been the main factor in the growth of PL sales.

The possible American recession could however negatively impact emerging markets. This is
mostly due to the export market that America represents. The Chinese, Indian and also the
Latin American economy are very dependent on the American economy. Furthermore, high
inflation has been taking its toll in China. To combat this we foresee higher interest rates.
Although higher interest rates could bolster the currency, it could also further slow economic
growth as the cost of borrowing increases. These factors have lead to China downgrading its
GDP growth forecasts twice in that last while. We therefore find the current growth forecasts
slightly too optimistic. We see the opportunity that the situation in South Africa brings, but
we still remain reluctant due conditions expressed above. The average growth of 16% must be
adjusted to 12 %. Upcoming markets will stay very important in the next decades, the growth
opportunity’s in these markets are by far the highest. We therefore believe that 12 % growth
is achievable for the foreseeable future with a potential upside.

New technologies can also be applied more easily in emerging markets because western
economies sometimes tend to be imbedded in old standards. When lighting solutions are
introduced for the first time, it is easier to move directly to the latest standards.

2.3.5. Asia Pacific

Although the Asia Pacific region has not experienced high growth till present, we expect this
figure to increase somewhat in the next few years and then maintain a somewhat slower
growth rate. Due to Government regulation, all households will be forced to switch to energy
savers by 2010. Traditional light bulbs will no longer be available for sale in any shops by
law. We therefore predict a growth rate of 6 %.

Valuing Philips Lighting: Shedding light on the optimal capital structure 10

2.4. Growth conclusion

2.4.1. Forecasting variables

We have downgraded the overall growth predictions for PL to 4.5% for the next 2.5 years,
thereafter predicting a steady increase to reach 6% till 2017.
We believe that there is enough evidence that PL will be able to keep up the growth rate of
6% for the most part of the coming decade. The previously mentioned strong position in
emerging markets and the fact that PL is investing in new technologies will continue to create
growth. After ten years the growth becomes hardly predictable, we therefore use the world
economies growth rate of 2% for the infinite growth. Due to increased competition in major
markets that PL operates in, we believe that PL will experience pressure on its margins
brought on by price wars with competitors.

The above figures translate into:

We have maintained a very conservative stance with regard to earnings. We believe that PL is
well positioned to benefit vastly from that energy savings drive, but we foresee global
economic slowdown coupled with increased competition as factors that will keep the earnings
of PL in check for the next couple of years.

Valuing Philips Lighting: Shedding light on the optimal capital structure 11

We therefore predict that EBIT will decline slightly over the next couple of years. We believe
that although PL has just acquired companies with higher margins, we also believe that in
order for these companies to become large market players, the margins of these companies
will have to be reduced.
With the forecasted growth figures a forecasted balance sheet can be constructed, this balance
sheet can be found in appendix 3.

2.4.2. SWOT Analyses

We can summarize the growth chapter with the following SWOT analyses

Strengths
- Philips Lighting is market leader in the lighting industry.
- PL controls the whole value chain after recent acquisitions.
- PL offers all possible lighting products.
- PL has been in the lighting game for more then a hundred years
- PL is a frontrunner with innovation in the lighting industry
- Philips is a well know brand that stands for quality
Weaknesses
- Possible integration problems with the recent acquisitions
- Although a diversified product line can be a strength it can also we a weakness
because it makes PL less specialized
Opportunities
- The LED industry where PL has created an important position with the acquisitions
of CK and Lumileds.
- The upcoming emerging markets where PL is achieving huge growth
- The global change to energy saving technologies.
Threats
- Competition of GE and Osram for market leadership especially in the future LED and
energy saving markets.
- Stagnation of the LED sales in the far future ie. Changing traditional structure of PL
from sales based to one of service delivery
- Most of the sales growth comes from emerging markets, economic growth rates in
these countries are very volatile.

Valuing Philips Lighting: Shedding light on the optimal capital structure 12

Chapter 3: Estimating the cost of capital

3.1. Discount methods

3.1.1. The CAPM and WACC

To calculate the cost of capital we use the weighted average cost op capital (WACC). The
WACC calculates the cost of capital by multiplying the required rate on equity and debt by
their ratio in the firm. Because PL is currently financed using equity only, the WACC simply
is the required return on equity. In our further analysis we will introduce debt in our WACC,
in order to calculate the value of PL as if it were partly financed with debt.

To calculate the required return on equity the following formula is used.

 Re  Rf    Rm  Rf 

3.1.2. Calculating the Beta

To estimate the risk profile of PL, the CAPM method is used. In the CAPM model the Beta is
used to estimate a company’s systematic risk. This Beta can be calculated by using a
regression analysis. The company’s earning is regressed against the earnings of the market
portfolio1. The regression takes on the following form:

2.) Ri  i  i  Rm  i

With Ri being the return of company i, I the intercept and i company i’s Beta.

PL is a division of Philips N.V., so PL does not have publicly traded shares. Therefore we can
not use the return on shares in our regression and we must resort to after tax earnings. This
implicates the calculation of the Risk profile of PL and its accompanying Beta.

Bloomberg estimates the Beta of Philips to be 1.08. When we compare the income stream of
PL to the other division of Philips, we find that the income of the Lighting the division is less
volatile2. A Beta lower then 1.08 is expected. To estimate the Beta using a regression we
could use S&P Europe 350 index. The S&P Europe 350 is reliable because it contains
approximately 70% of the total market capitalization of 17 pan-European markets.

1
Because a true market portfolio does not exists, a proxy is used, for instance the S&P 500
2
This was also stated by the CFO of Philips Lighting, Mr. R. de Vree

Valuing Philips Lighting: Shedding light on the optimal capital structure 13

It is always important to use a T-test to see if the Beta is statistically significant. There has to
be a significant relation between the return of a company and the return on the market
portfolio for the Beta to be a good predictor of the volatility of the company’s returns. For the
return on Philips the Accounting profit can be used. Although we realized that accounting
earnings can give a distorted image of the volatility of returns because managers tend to
smooth out earnings.

Because the traditional method for calculating the Beta creates some serious limitations, we
use a different method. We try to dissect the Beta for Philips as a whole, into three Beta’s for
the separate divisions. We use Bloomberg to look for average Beta’s in the consumer
electronics and medical systems industries and then solve the following equation for the
Lighting Beta.

3a.)  Ph   l * Xl   c * Xc   h * Xh

which can be rewritten as

3b.)  l  (  Ph   c * Xc   h * Xh) / Xl

With  Ph as the Beta for Philips as a whole,  l is the lighting Beta,  c stands for

consumer electronics and  h the healthcare industry Beta. X stands for the weight the
division has in the company. By filling in the numbers we find the following value for the
lighting Beta: 1.0765

One might wonder why we don’t estimate an industry beta for the Lighting division. This is
because the major players on the market are all sub divisions of companies3 and therefore an
industry Beta is not available.

This method gives a rough estimation of the PL Beta, but of course this method also has it’s
limitations. The industry Beta’s of consumer electronics and medical systems do not have to
be the same as the Beta’s for the two Philips divisions. We still believe that this Beta does
give a good estimation.

3
Osram subdivision of Siemens and GE Lighting, Division of GE

Valuing Philips Lighting: Shedding light on the optimal capital structure 14

3.1.3. The risk free rate and the market return
Apart from the Beta we need a risk free rate and the return on the market portfolio. For the
risk free rate we use the rate on Dutch government bonds, which is four percent. For the
market return we use the FTSE-all share index4, we calculated the returns of this index from
1950 till 2007

When we fill in the numbers in equation two, we arrive at the following cost of equity.

4%+1.0765*(9.244%-4%)=9.645%

The cost of equity for Philips Lighting without debt is 9.645%

4
In appendix 4 we explain why we chose this index

Valuing Philips Lighting: Shedding light on the optimal capital structure 15

3.2. Methods with debt

3.2.1. Calculating the WACC with debt

To see if PL can increase its value by taking on debt we use the following method:
Because of the tax shield the WACC changes5 when the D/E ratio changes. To calculate the
higher Beta that comes with the risk of debt we use the following formula6:

a  unlevered   levered / 1  1  taxrate   Debt / Equity   


which can be rewritten as:

4b.) levered   unlevered * 1  1  taxrate   Debt / Equity  

The WACC with debt, no longer is the cost of equity only, the WACC is calculated using the
following equation:

5.) WACC  Rd (1  T )( D / V )  Re( E / V )

With Rd the return on debt, T the Tax rate, Re the return on equity, D for Debt and E for
equity.
Philips currently issues bonds at 6 percent. We will use this percentage in our further
calculations as the return on Debt.
Using these formula’s we arrive at the following WACC’s.7

WACC Equity only 9.645%

WACC Including 10% debt 9.438%
WACC Including 20% debt 9.230%
WACC Including 30% debt 9.022%

5
Schauten, M.B. J. 2005,’’Three discount methods for valuing projects and the required return’’, Erasmus
university Rotterdam
6
New York University Stern School of Business Valuing private companies and divisions
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/pvt.html
7
See Appendix 1

Valuing Philips Lighting: Shedding light on the optimal capital structure 16

Chapter 4: Multiples

4.1.1. Using multiples for valuation

Although DCF analysis is the most accurate and flexible method for valuing a company, it is
only as accurate as the forecasts it relies on. There could be errors in our estimations of
growth, WACC and other fundamental figures.
With a multiple analysis we can calculate the value of PL using multiples of a comparable
firm, which in turn can be useful in making our valuation more accurate.

4.1.2. Price Earnings ratio

For our P/E ratio analyses we will use the P/E Ratio of two comparable firms. We found a
P/E ratio of 13.1 for Genlyte just before the take-over (Genlyte was acquired by PL in 2008)
and we found a P/E ratio of 12.65 for Acuity Brands Inc.8. To calculate the value of PL we
will use their EBIT (EUR 675 million) of 2007 found in PL’s financials and the average of
the two P/E ratio’s of Genlyte and Acuity Brands.

Value = 12.86 * EUR 675 million = EUR 8.7 billion

The value we found using the P/E ratios of Genlyte and Acuity Brands is slightly higher then
the €8 billion we calculated using the DCF method. This is not a surprising outcome, because
the growth opportunities for companies like Acuity Brands and Genlyte where a bit higher.
Furthermore, we have been very conservative in our growth projections for PL in our DCF
valuation. The P/E ratio does not account for this difference in growth rates, the P/E ratio also
ignores the differences in capital structure. The P/E ratio is therefore not the optimal ratio in
this scenario.

8
Acuity Brands Inc. is a lighting company located in the U.S.

Valuing Philips Lighting: Shedding light on the optimal capital structure 17

4.1.3. Enterprise Value / EBITDA
Because the P/E ratio is systematically affected by the capital structure of a firm or industry
and it does not account for growth opportunities, we will also use a forward-looking
enterprise-value multiple which consists of the value of debt plus equity minus excess cash
divided by EBITDA.

We use Genlyte as a comparable firm for the EV/EBITDA multiple. The data we’ve used for
the calculation of this multiple was acquired from Bloomberg.
EV Genlyte = USD 2.29 Billion
EBITDA Genlyte = USD 240 million

Enterprise Value = USD 2.29 billion = 9.5

EBITDA USD 240 million

When we look at the financials of PL for the year 2007 we see an EBITDA of EUR 943
million.Value of PL using the EV/EBITDA multiple 

EUR 943 million * 9.5 = EUR 8.95 billion EV

This value for PL of EUR 8.95 billion is roughly 1 billion above the value we've calculated
using the DCF model. Plausible reason for this deviation is the difference in margins between
the two companies (PL and Genlyte) and again the difference in growth opportunities. We
therefore expect the EV/EBITDA multiple somewhat lower for PL.
A second company we're going to use for our multiple EV/EBITDA is Acuity Brands. Data
for this calculation was acquired from Bloomberg.

EV Acuity Brands = USD 2.140 million

EBITDA Acuity Brands = USD 295.34 million

Enterprise Value = USD 2.140 million = 7.25

EBITDA USD 295.34 million
We again use the EBITDA of EUR 943 million which was stated on the financials of PL.

Value of PL using the EV/EBITDA multiple

EUR 943 million * 7.25 = EUR 6.836 billion

Valuing Philips Lighting: Shedding light on the optimal capital structure 18

The result we get from this second company differs a lot from our DCF calculated value of
EUR 8 billion. This is due to some differences between these companies. Once again this
could be attributed to different growth expectations and margins.

4.1.4. PEG ratio

As mentioned before, we achieved variations in values due to, in part, differences in the
growth opportunities of the various companies. To eliminate the effects of these growth rates
we will use the following ratio:

Adjusted PEG ratio = 100 x (EVmultiple/Expected EBITA Growth)

To calculate this ratio, we first need to calculate the EV multiples using EBITA.

From Bloomberg: EV/EBITA of Genlyte = USD 2.29 billion/ USD 212.73 million = 10.8

For Genlyte, we calculate the PEG ratio assuming an expected growth of 18% based on past
growth figures.

Adjusted PEG ratio = 10.8 / 18 = 0.6

We follow the same procedure for Acuity Brands; first we obtain an EV multiple using
EBITA.

From Bloomberg: EV/EBITA of Acuity Brands = USD 2.140 billion / USD 260.18 = 8.2
For Acuity Brands, we calculate the PEG ratio assuming an expected growth of 20% based on
past growth figures.

Adjusted PEG ratio = 8.2 / 20 = 0.41

To compare these companies with PL we follow the same procedure.

From our DCF calculations we use the NPV as the EV and use the EBITA from the financials
of PL.

EV/EBITA = EUR 8 billion / EUR 722 million = 11.08

For PL, we calculate the PEG ratio assuming an expected growth of 6% for the median term.

Valuing Philips Lighting: Shedding light on the optimal capital structure 19

Adjusted PEG ratio = 11.08 / 6 = 1.8

According to these figures PL would be trading at a premium if listed at these EV values. We

believe the growth forecasts made by Acuity Brands and Genlyte are to optimistic given the
economic outlook and increased competition. Furthermore PL is established in many different
markets which makes it slightly less ideal when comparing to firms based wholly in the U.S.

4.2. Implications using multiples

In concluding, we strongly believe that in the case of valuing PL using multiples gives a less
accurate presentation of the value of PL. We therefore believe the DCF model is a lot more
accurate and therefore essential in establishing a realistic EV.

This is due to the fact that there are no comparable companies to which multiples can
accurately compared. There are no self-standing lighting companies in the lighting industry.
All lighting companies of substantial size are all subsidiaries of larger corporations. And in
the case of smaller lighting companies that do exist, these only operate in one or two of the
markets where PL is active in.

Valuing Philips Lighting: Shedding light on the optimal capital structure 20

Chapter 5: The capital structure of Philips Lighting

5.1. The all equity firm

PL is currently financed using equity only. This gives PL some advantages

5.1.1. Flexibility
In chapter one and two we showed that the lighting business will probably change drastically
in the coming decades. The shift from traditional lighting to energy saving techniques and the
focus on lifestyle products will require that companies are flexible and on top of there game.
The vision of PL states that PL is the clear market leader and that the company should set the
pace in de industry. This means that PL wants’ to be the first to introduce new techniques and
always stay one step ahead of its opponents. In order to act fast on developments in the
market PL should always have access to a sufficient amount of capital. By staying debt free
PL stays flexible. Banks and investors are probably eager to lend PL money and therefore PL
can always access funds when developments in the market require to invest heavily. Apart
from the possibility to borrow money PL generates a sufficient amount of profit to use
internal funds for financing projects. If PL decides to take on debt, it could find itself in a
situation where its last resort to financing investments is the equity market. If this happens
when the share price is undervalued, the firm could sustain substantial losses.

5.1.2. Absence of financial distress costs

According to Moody’s PL has debt a rating of triple A9 which means that the chance of
default is 0.00 percent. The absence of debt causes the firm to have no chance of default and
the firm has no payment obligations. Therefore there are no financial distress costs.

9
Blaha.net explanation of debt ratings http://www.blaha.net/Finance%20Corporate%20Debt%20Ratings.htm
(30th of March 2008)

Valuing Philips Lighting: Shedding light on the optimal capital structure 21

5.2. Finance structures with debt

5.2.1. Advantages of debt

By changing the capital structure into a form which includes debt PL can utilize the following
advantages

5.2.2. Tax advantage of debt

Because interest payments are deducted from the accounting profit and tax is levered over a
smaller amount of accounting profit, debt has a tax advantage. The tax advantage of debt is
incorporated in the WACC formula10 .

5.2.3. Higher return on equity

By taking on debt PL can increase its return on equity and increase the risk in the process.
This creates an advantage to investors who prefer a higher return/risk profile.

5.2.4. Disciplining effect

A company that is levered, needs to have a constant income cash flow stream to be able to
make debt payments. Even though a healthy cash flows is also important for unlevered firms,
the pressure of debt gives managers an incentive to work harder11 .

5.3. The optimal capital structure

5.3.1. Tax advantages for PL

To see if PL can increase its value by taking on debt, we will calculate the value of PL in the
case of a 10%, 20% and 30% debt ratio.
When PL increases its debt level, the costs of financial distress and the costs of decreased
flexibility increase. The further the firm increases its debt level, the more the costs of debt
increase. The increase in costs of debt is exponential, when moving from a situation with no
debt to a situation with 10% debt, the chance of default still is negligible, when a firm moves
from 30% to 40% debt, the increase in costs in substantial.
Using the methods provided in chapter three we calculate the value of PL without the costs of
debt.

10
Equation 5 on page 14
11
Opler, T.C., M. Saron and S. Titman, 1997 (spring), “Designing capital structure to create shareholder value”,
Journal of Applied Corporate Finance 10, pp.21-32.

Valuing Philips Lighting: Shedding light on the optimal capital structure 22

Tax advantage of debt
Debt ratio Firm value Value increase
0% € 8,000,000,000 € -
10% € 8,279,000,000 € 279,000,000
20% € 8,578,000,000 € 299,000,000
30% € 8,896,000,000 € 318,000,000

The WACC formula accounts for the fact that the ratio of debt is certain, but the amount of
debt is uncertain because of the uncertain returns of the firm.
We believe that PL will stay profitable throughout the upcoming years, furthermore Dutch
legislation gives firms the option to compensate losses in years that the company is profitable.
So far the calculations that we have made are pretty simple and straightforward. The
implications occur when estimating the negative value effects of taking on debt.
PL will have to outweigh the costs of taking on debt against the value increase because of the
tax advantage.

5.3.2. Financial distress at relatively low debt ratio’s

If we look at the predicted profitability forecast in chapter two, we believe that PL will not
have any problems to meet the payment requirements that amount from taking on debt. We
therefore believe that financial distress is improbable and its accompanying costs will be
relatively low.

5.3.3. Loss of flexibility

We believe that the true costs of taking on debt lay in the fact that the firm becomes less
flexible. Future borrowing will be compromised and the firm has less influence over its cash
flows. Interest payments must be made every year, but dividend payments can be postponed.
This means that it becomes harder for the firm to acquire funds to make future investments.
Of course PL will still be able to raise internal funds, more debt and new equity, but the
flexibility will decrease. The decrease in flexibility may cause PL to be unable to invest when
value adding opportunities occur. Although it is relatively easy to move from a situation were
the capital structure contains debt, it is much harder to return to an equity only situation.
Buying back shares with debt should not cause many problems, issuing shares to pay back
debt however is not easy, furthermore issuing equity could cause the share price to decline
because of the signaling effect.12.

12
Billet, O.W., 2007, “Share repurchases and the need for external finance”, Journal of Applied Corporate
Finance 19, 42-55

Valuing Philips Lighting: Shedding light on the optimal capital structure 23

Therefore Paying back debt will have to be done by using retained profits. Because it is hard
to lower the debt ratio, PL will always have to be cautious when issuing debt.

5.3.4. Recommendations
In the first chapter we showed that the lighting business is changing, with its shift to new
energy saving technologies and the increased appliances of lighting products. In order to stay
flexible and therefore maintain the ability to act fast on market developments, PL should not
increase its debt level drastically. We do however believe that the optimal debt ratio is a
positive one. By increasing the debt ratio to 10% PL can has a tax advantage of €279 million.
We believe that the financial distress costs and losses from decreased flexibility, do not
amount to this level, therefore a 10% debt ratio will increase the Value of PL. By increasing
the debt level to 20% another €299 million tax advantage can be added to the company Value,
we do however stress that at twenty percent flexibility is damaged. When we move to a 30%
percent debt ratio the tax advantage ads another €318 million to the value. At this rate
however flexibility is to low in our opinion, this could cause PL to give up on positive NPV
projects. The debt rating will also be affected and this will increase the cost of debt.
Therefore we arrive at an optimal debt level of 20%. We believe that at this rate the financial
distress costs are negligible and the costs from decreased flexibility to do not amount to the
tax advantage of debt. This amounts to the following trade off13 .

Advantages of a 20% debt ratio:

 Tax advantage amounting to €578 million
 Disciplining effect
Disadvantages of a 20% debt ratio:
 Financial distress cost
 Loss in flexibility
 Decrease in debt rating

Apart from the tax advantage it is hard to give the advantages and disadvantages a monetary
value. We do however believe that if we were able to do so, the advantages would definitely
outweigh the disadvantages at this 20% ratio. At higher debt levels we are not so confident
about this, therefore we recommend to increase the debt level to 20%.

13
Miller, M.H., 1977, “Debt and taxes”, Journal of Finance 32, pp.261-275

Valuing Philips Lighting: Shedding light on the optimal capital structure 24

Chapter 6: Summary

6.1. Background
Philips Lighting (PL) is a division of Royal Philips Electronics. PL has a leading position in
the market for lighting solutions. To increase its market share in the United States and to
prepare itself for rapidly changing business dynamics, PL has made some major acquisitions.
Over the last three years, Color Kinetics (LED Manufacturer), Partners in Lighting
International (Solid state lighting producer) and Genlyte (luminaires manufacturer). By
staying ahead of its competitors PL protects its leading position. Investments in the latest
energy saving technologies and substantial R&D expenditures will ensure the leading position
of PL.

6.2. Growth and Earnings

The organic sales growth of PL lightning has been around 6% in recent years. PL predicts a
continuous growth at the same rate. We believe that the economic slowdown led by a possible
US recession will cause the growth rate to be somewhat disappointing in the upcoming years.
We also believe that that the growth will return to a steady ratio of six percent in 2012. The
major growth opportunities lay in emerging markets which consist of one third of the PL
sales. The weight of emerging markets will increase in the future. The second largest growth
opportunity is the growing need for energy saving technologies. We believe that there is
enough evidence that PL can continue to grow at the mentioned levels till 2017 after this year
uncertainty becomes too high and we used a rate of 2% for the infinite growth.

6.3. Multiples
Because DCF methods are only as accurate as the forecasts it relies on, we also use multiples
to valuate PL. In our analyses we used three multiples: The price earnings ratio, the enterprise
value to EBITDA multiple and the adjusted PEG ratio. We use Genlyte and Acuity Brands as
our comparable firms. The P/E ratios gives a value of 8,7 billion which is about 10 percent
higher then the 8 billion we calculated using DCF. This can be explained by the fact that the
comparable firms have higher growth rates. Our findings using the EV/EBITDA give similar
outcomes. To eliminate growth and capital structure differences we use the adjusted PEG
ratio.

Multiple analyses in the case of Philips Lighting is not a very accurate method. Most of the
major players in the lighting business are sub divisions of companies. It is therefore hard to
find good comparable firms. We believe that the DCF method gives a much better picture of
the value of Philips Lighting

Valuing Philips Lighting: Shedding light on the optimal capital structure 25

6.4. Value and Capital structure
PL is currently financed using equity only. We calculate the value of the firm at €8,000
Million. In chapter five we state the increase in company value due to tax advantages of debt.
The increase in firm value has to be compared to the costs of debt, the financial distress costs
and the costs occurred trough loss of flexibility. We believe that flexibility is very important
for PL in order to be able to act fast on market changes. PL could sustain huge losses if the
company is not able to invest in new technologies when the market requires it. We therefore
believe that the debt ratio should be around 20%. At the 20% debt ratio the firm is worth
€8,578 million minus the costs of decreased flexibility and distress costs. We believe that the
tax advantage value increase, outweighs the costs of debt at the 20% ratio.

Valuing Philips Lighting: Shedding light on the optimal capital structure 26

Appendix

A.1. Beta and WACC calculations

A.1.1. Beta calculations

Estimating The Beta of PL

Beta Philips 1.08
Consumer electronics industry Beta 1.17
Medical systems industry Beta 0.9

Beta PL 1.0765

Sales 2007 (Millions) Weight

Philips NV (without innovation and emerging sector) 25,022 € 1
Consumer electronics including DAP 13,108 € 52.39%
Medical Systems 6,448 € 25.77%
Lighting 5,466 € 21.84%

A.1.2. WACC calculations

Calculating the WACC

Risk free rate (dutch state bonds) 4.000%
Required return on debt 6.000%
Market Rate FTSE-All Shares 9.244%
Market Premium 5.244%
PL Beta 1.0765
PL Beta 10% debt 1.1543
PL Beta 20% debt 1.2514
PL Beta 30% debt 1.3764
Required return on equity with 10% debt 10.053%
Required return on equity with 20% debt 10.562%
Required return on equity with 30% debt 11.218%
Tax rate 35.000%
Required return on equity without debt 9.645%
WACC Equity only 9.645%
WACC Including 10% debt 9.438%
WACC Including 20% debt 9.230%
WACC Including 30% debt 9.022%

Valuing Philips Lighting: Shedding light on the optimal capital structure 27

A.2. Valuation

A.2.1. Forecasting variables

A.2.2. DCF

Valuing Philips Lighting: Shedding light on the optimal capital structure 28

A.3. Forecasted Balance sheet

Valuing Philips Lighting: Shedding light on the optimal capital structure 29

A.4. FTSE all-share

A.4.1. Why did we choose the FTSE all-share?

One of the restrictions of the assignment was to valuate Philips Lightings as if it was traded in
a universe with only European companies. We therefore limited ourselves to European
market proxies. Our first choice was the S&P Europe 350. The S&P 350 is a well diversified
portfolio of European stocks. Because of its relatively short existence, the available data was
limited. In this Final version we chose to use the FTSE all-share. The FTSE all-share is a
portfolio that contains all the shares that are traded on the FTSE Europe indexes. We
therefore believe it’s a good market proxy for the European stock market.

A.4.2. Return on the FTSE index

Valuing Philips Lighting: Shedding light on the optimal capital structure 30

A.5. Changes made in the final version

After the presentation by Rolf Metz, the remarks by Dr. Schramade and the remarks
by our fellow students, we revised our paper substantially. This appendix gives an
overview of the changes that where made.

Major Changes
 The layout was slightly changed and the whole document was checked for
spelling and grammar mistakes
 We added a SWOT analyses
 We chose a different market proxy and calculated a new market return, this
changed the WACC and therefore the value of the company.
 We have rewritten our multiples chapter
 We have adjusted our debt ratio recommendation

Minor Adjustments
 We changed the infinite growth rate to 2%
 We changed the growth in capital expenditure for the harvesting period
 We have subtracted the Genlyte acquisition from the 2008 free cash flow
 We have made some small changes in our introduction, we removed the part
of the acquisitions because this was already mentioned in chapter two.
 We have added a balance sheet
 We have added references to some of the articles we have studied in the
seminar

Valuing Philips Lighting: Shedding light on the optimal capital structure 31

References

R.1. Books
Koller, Goedhart & Wessels (2005) Valuation: university edition Hoboken,New Jersey: John
Wiley and sons.

Berk & DeMarzo (2007) Corporate Financ: International edition Boston: Pearson Education

R.2. Papers
Myers, S. C., 1984, ‘’The capital structure puzzle’’, Journal of finance39, no3, pp 575-592.

Schauten, M.B. J. 2005,’’Three discount methods for valuing projects and the required
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Inselbag, and H. Kaufold, 1997, “Two DCF approaches for valuing companies under
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Modigliani,F and M.H. Miller, 1958,’’The cost of capital, corporation finance and the theory
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Grinblatt, M. and S. Titman, 1998, Ch17: “How managerial incentives affect financial
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Miller, M.H., 1977, “Debt and taxes”, Journal of Finance 32, pp.261-275

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Billet, O.W., 2007, “Share repurchases and the need for external finance”, Journal of Applied
Corporate Finance 19, 42-55

Valuing Philips Lighting: Shedding light on the optimal capital structure 32

R.3. Internet
Bloomberg Database for financial information http://www.bloomberg.com (28th,29th and 30th
of March)

New York University Stern School of Business Beta’s for different industries
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html (29th of March
2008)

Texas university library beta reference

http://libraryasp.tamu.edu/blogs/westcampusinformer/2007/02/looking-for-industry-beta.html
(29th of March 2008)

Blaha.net explanation of debt ratings

http://www.blaha.net/Finance%20Corporate%20Debt%20Ratings.htm (30th of March 2008)

Royal Philips company 2007 annual report

http://www.annualreport2007.philips.com/pages/notes_to_the_group_financial_statements/lo
ng-term_debt.asp (28th of March 2008)

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of March 2008)

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europe-adru-fez-iev (28th of march 2008)

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http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/pvt.html
(30th of March 2008)

PL Press release Acquisition Color Kinetics

http://www.lighting.philips.com/gl_en/news/press/lighting_company_news/archive_2007/pre
ss_philips_color_kinetics.php?main=global&parent=4390&id=gl_en_news&lang=en (28th of
March 2008)

Color Kinetics Annual report 2006

http://www.colorkinetics.com/corp/news/pr/releases/2007-02-08_earnings.html
(28th of March 2008)

PL Press release Acquisition Partners In lighting

http://www.lighting.philips.com/gl_en/news/press/lighting_company_news/archive_2006/pre
ss_philips_acquire_pli.php?main=global&parent=4390&id=gl_en_news&lang=en (27th of
March 2008)

Osram Lighting Company Annual review 2007

http://www.osram.com/_global/pdf/Misc/About_Us/902R017GB_AnnualReview_2007.pdf
(27th of March 2008)

Wikipedia, the price earnings ratio, http://en.wikipedia.org/wiki/PE_ratio (31st of march)

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http://www.philips.com/global/index.page (28th,29th and 30th of march 2008)

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http://www.finfacts.com/Private/curency/ftseperformance.htm (20th of april 2008)

Valuing Philips Lighting: Shedding light on the optimal capital structure 33

Valuing Philips Lighting: Shedding light on the optimal capital structure 34