1. Identify and describe the major components that are used to calculate the equity valuation cash flow.

5. [Venture Present Value Concepts] Refer to the FrothySlope microbrewery example at the beginning of this chapter. How does the $500,000 piece of the terminal value relate to the future value of the $100,000? That is, the brewpub investor was looking for a 40% return. The five-year-out future value of $100,000 growing at 40% is 100,000*(1.4)5 =$537,824, slightly more than $500,000. Does this mean the investor is not really expected to make 40% on the $100,000, even though we used that discount rate to arrive at the initial $5,856,935 valuation? (Hint: What about explicit forecast period flows?) The investor actually does make a 40% return. The $500,000 future value only takes into account the terminal value of venture. It does not take into account the present value of the cash flows in years 4 and 5. Returning to the brewpub spreadsheet with all flows included, how much more of the ventures ownership of surplus cash flows would have to be sold for the $100,000 if the investor expected to make 70% (given Jims utopian vision of his future)? PV of Venture @ 70% discount = 0 0 0 2,500,000     2 2 1.7 1.7 1.7 1.7 4 = $2,271,355.50 3,000,000  3,500,000 (20%  6%) 1.7 5

Percent ownership with investment = $100,000/$2,271,355.50 = 4.40% What percentage of the brewpubs present value is contained in the present value of the terminal value (the ventures reversion value)? $3,500,000 = $4,648,360.80 (1  40%) 5 (20%  6%) PV of the Brewpub = $5,86,935 $4,648,360.8 Percent of PV in the Terminal Value = = 79.37% 5,856,935 PV of Terminal Value = How much ownership of the brewpub cash flows would need to be sold to an investor demanding 40% but agreeing that the mature brewpub venture would terminally grow at a rate of 8% with a risk profile requiring a discount rate of 16%? What if the terminal growth rate were 10% and the discount rate 18%? (The spread between the discount rate and the growth rate is sometimes referred to as the capitalization rate for the terminal flows or just the cap rate.)

With a 40% discount rate, and 8% terminal growth with 16% discount: 3,000,000  3,500,000 (16%  8%) 1.4 5

Firm Value =

0 0 0 2,500,000     2 2 1.4 1.4 1.4 1.4 4

= $9,343,205 % of the Ownership with $100,000 investment = $100,000/$9,343,205 = 1.07% With 10% terminal growth rate and 18% discount rate: Firm Value = 0 0 0 2,500,000     2 2 1.4 1.4 1.4 1.4 4 3,000,000  3,500,000 (18%  10%) 1.4 5

= $9,343,205 As indicated above, the firm has the same value as with 16% discount and 8% terminal growth rate, therefore the 1.07% of the ownership should be sold in exchange for $100,000 investment. (Note that this would not normally be the case because the cash flow in period (T+1) would normally be determined by CF at time T multiplied by (1+g). In this example the cash flow in time (T+1) was given.)

6. [Equity Valuation Cash Flows] Following are financial statements (historical and forecasted) for the Global Products Corporation. GLOBAL PRODUCTS CORPORATION Forecast 2011 $60,000 290,000 570,000 920,000 380,000 $1,300,000 $180,000 70,000 90,000 340,000 550,000 50,000 200,000

2010 Cash Accounts Receivables Inventories Total Current Assets Fixed Assets, Net Total Assets Accounts Payable Accruals Bank Loan Total Current Liabilities Long-Term Debt Common Stock ($1 par) Capital Surplus $50,000 200,000 450,000 700,000 300,000 $1,000,000 $40,000 50,000 80,000 270,000 400,000 50,000 200,000

Retained Earnings Total Liab. & Equity

80,000 $1,000,000

160,000 $1,300,000 Forecast 2011 $1,600,000 960,000 640,000 160,000 150,000 55,000 275,000 55,000 220,000 88,000 $132,000

2010 Net Sales $1,300,000 Cost of Goods Sold 780,000 Gross Profit 520,000 Marketing 130,000 General & Administrative 150,000 Depreciation 40,000 EBIT 200,000 Interest 45,000 Earnings Before Taxes 155,000 Income Taxes (40% rate) 62,000 Net Income $93,000

A. Assume that the cash account includes only required cash. Determine the dollar amount of equity valuation cash flow for 2011. Equity Valuation Cash Flow = Net Income: $132,000 + Depreciation: $55,000 - Change in NOWC: [($60,000 + $290,000 + $570,000 - $180,000 - $70,000) ($50,000 + $200,000 + $450,000 - $140,000 - $50,000)] = $670,000 - $510,000 = $160,000 - Change in Gross Fixed Assets: ($380,000 - $300,000 + depreciation of $55,000) = $135,000 + Net Debt Issues: ($90,000 + $550,000) ($80,000 + $400,000) = $640,000 - $480,000 = $160,000 Equity Valuation Cash Flow = $132,000 + $55,000 - $160,000 - $135,000 + $160,000 = $52,000

B. Now assume that Global Products required cash is set at 3 percent of sales. Any additional cash would be surplus cash. Re-estimate the dollar amount of equity valuation cash flow for 2011. Required Cash: 2004 = $1,300,000 x .03 = $39,000 Surplus Cash: $50,000 - $39,000 = $11,000 Required Cash: 2005 = $1,600,000 x .03 = $48,000 Surplus Cash: $60,000 - $48,000 = $12,000

Change in NOWC (without surplus cash): [($48,000 + 290,000 + $570,000 - $180,000 $70,000) ($39,000 + $200,000 + $450,000 - $140,000 - $50,000)] = $658,000 - $499,000 = $159,000 Equity Valuation Cash Flow = $132,000 + $55,000 - $159,000 - $135,000 + $160,000 = $53,000. The 2005 stripping of the additional $1000 of surplus cash leads directly to a $1000 increase in the valuation cash flow. C. Lets assume that investors in Global Products want to estimate the ventures present value at the end of 2010. Forecasted financial statements reflect the stepping stone year. Cash flows are expected to grow at a perpetual 8 percent annual rate beginning in 2012. Assume that all cash is required cash as was done in Part A. What is the Global Products ventures present value if investors want an annual rate of return of 25 percent? Present Value @ 25% = $52,000/(.25 - .08) = $305,882.35

1. [Discount Rates] Calculate the discount rate consistent with a cap rate of 12% and a growth rate of 6%. Show how your answer would change if the cap rate dropped to 10 percent while the growth rate declined to 5 percent. Cap Rate = (r g), so r = Cap Rate + g r = 12% + 6% = 18% r = 10% + 5% = 15% 2. [Venture Present Values] A venture investor wants to estimate the value of a venture. The venture is not expected to produce any free cash flows until the end of year 6 when the cash flow is estimated at $2,000,000 and is expected to grow at a 7 percent annual rate per year into the future. A. Estimate the terminal value of the venture at the end of year 5 if the discount rate at that time is 20 percent. $2,000,000/(.20 - .07) = $15,384,615.38 B. Determine the present value of the venture at the end of year 0 if the venture investor wants a 40 percent annual rate of return on the investment. $15,384,615.38/1.405 = $2,860,529.72 3. [Venture Capital Valuation Method] A venture capitalist wants to estimate the value of a new venture. The venture is not expected to produce net income or earnings until the end of year 5 when the net income is estimated at $1,600,000. A publicly-traded competitor or

comparable firm has current earnings of $1,000,000 and a market capitalization value of $10,000,000. A. Estimate the value of the new venture at the end of year 5. Show your answer using both the direct comparison method and the direct capitalization method. What assumption are you making when using the current price-to-earning relationship for the comparable firm? P/E of comparable firm = $10,000,000/$1,000,000 = 10 times New Venture Value: $1,600,000 net income times 10 = $16,000,000 Assumptions: 1. The comparable firm is really comparable to the new venture. 2. The current price-to-earning relationship of 10 will still be the appropriate multiple to use 5 years from now. B. Estimate the present value of the venture at the end of year 0 if the venture capitalist wants a 40 percent annual rate of return on the investment. $16,000,000/1.405 = $2,974,950.91 4. [Multiple Financing Rounds] Ratchets.com anticipates that it will need $15,000,000 in venture capital to achieve a terminal value of $300,000,000 in five years. Assuming it is a seed stage firm with no existing investors, what annualized return is embedded in their anticipation? r = (300,000,000/15,000,000)^(1/5)-1 = 82.0564% Suppose the founder wants to have a venture investor inject $15,000,000 in three rounds of $5,000,000 at time 0, 1 and 2 with time 5 exit value of $300,000,000. If the founder anticipates returns of 70%, 50% and 30% for round 1, 2 and 3, respectively, what percent of ownership is sold during the first round? During the second round? During the third round? What is the founders year-five ownership percentage? First Round FV: 5,000,000 x (1.7)^5 = 70,992,850 Second Round FV: 5,000,000 x (1.5)^4 = 25,312,500 Third Round FV: = 5,000,000 x (1.3)^3 = 10,985,000 Total FV = 107,290,350 First Round % of Total FV = 23.66% = 70,992,850/300,000,000 Second Round % of Total FV = 8.44% = 25,312,500/300,000,000 Third Round % of Total FV = 3.66% = 10,985,000/300,000,000)

Founder final ownership = 1 23.66% - 8.44% - 3.66% = 64.24% = 192,709,650/300,000,000 Assuming the founder will have 10,000 shares, how many shares will be issued in rounds 1, 2 and 3 (at times 0, 1 and 2)? Founder shares = 10,000 Total shares at year 5: =10,000 / .6424 = 15,567 Round one shares = .2366 x 15,567 = 3684 Round two shares = .0844 x 15,567 = 1313 Round three shares = .0366 x 15,567 = 570 What is the second round share price derived from the answers in Parts B and C? Second Round Price = 5,000,000 / 1313 =3808/share How does the answer to part D change if 10% of the year-five firm is set aside for incentive compensation? How many total shares are outstanding (including incentive shares) by year 5? Founder final ownership = 1 -23.66% - 8.44% - 3.66% -10% = 54.24% Total shares at year 5 = 10,000 / .54.24 = 18,438 Round two shares = .0844 x 18,438 = 1556 Round two price = 5,000,000 / 1556 = 3213/share

[Pre-money and Post-money Valuations] Suppose you are considering a venture conducting a current financing round involving an issue of 100,000 new shares at $3. The existing number of shares outstanding is 200,000. What are the related pre-money and post-money valuations? Share price = $3. Pre-money = Share Price * Pre-money shares = 3 * 200,000 = 600,000 Post-money = Share Price * Post-money shares = 3 * 300,000 = 900,000 Proceeds = Post-money Pre-money = 900,000 600,000 = 300,000 = 3 * 100,000 [Venture Capital Valuation Method] A venture capitalist firm wants to invest $1.5 million in your NYDeli dot.com venture that you started six months ago. You do not expect to make a profit until year four when your net income is expected to be $3 million. The common stock of BioSystems, a comparable firm, currently trades in the over-the-counter market at $30 per share. BioSystems net income for the most recent year was $300,000 and the firm has 150,000 shares of common stock outstanding. A. Apply the VC method to determine the value of the NYDeli at the end of four years.

Comparables EPS = $300,000 / 150,000 = 2 Comparables P/E = 30/2 = 15 Ventures projected value at year 4 = 15 * 3,000,000 = 45,000,000 B. If VCs want a 40% compound annual rate of return on similar investments, what is the present value of your NYDeli venture? 45,000,000 / 1.4^4 = 11,713,869 C. What percentage of ownership of the NYDeli dot.com venture will you have to give up to the VC firm for its $1.5 million investment? 1,500,000 / 11,713,869 = 12.81% [Present Values and Investor Ownership] Vail Venture Investors, LLC is trying to decide how much percent equity ownership in Black Hawk Products, Inc. it will need in exchange for a $5 million investment. Vail Venture Investors has a target compound rate of return of 25 percent on venture investments like Black Hawk Products. Depending on the success of products currently under development, Vail Ventures investment in Black Hawk could turn out to be a complete failure (black hole), barely surviving (living dead), or wildly successful (venture utopia). Vail Venture assigns probabilities of .20, .50, and .30, respectively, to the three possible outcomes. Following are the 3 cash flow scenarios or outcomes for the Black Hawk Products investment that Vail Venture expects to exit at the end of five years. Outcome Black Hole Living Dead Venture Utopia Yr1 0 0 0 Yr2 0 0 0 Yr3 0 0 0 Yr4 0 0 0 Yr5 $0 $10 million $50 million

Part A A. Calculate the present value of each scenario or outcome for Black Hawk Products. PV of Black Hole PV of Living Dead PV of Venture Uptopia 0 $3,276,800 $16,384,000

B. Calculate the weighted average of the present values for the three scenarios. What is the total equity value for the Black Hawk Products venture?

Weighted Average Present Value

$6,553,600

C. Determine the acquired percentage of final ownership of Black Hawk Products that Vail Venture Investors would need for its $5 million proposed investment.

Amount Invested Firm Value Equity percentage

$5,000,000 $6,553,600 76.29%

Part B Now assume under the venture utopia scenario that, in addition to the $50 million cash inflow in year 5, there will be an annual $1million preferred dividend (to be paid to Vail Venture Investors but not other equity investors). Vail Venture expects to receive this $1 million dividend under the venture utopia scenario in each of the five years that the Black Hawk investment will be maintained. No preferred annual cash flows are expected under either the black hole or the living dead scenarios. D. Calculate the acquired percentage of final ownership of Black Hawk Products that Vail Venture Investors would need to earn a 25 percent compound rate of return on its investment. Use the mean flow method described in the chapter. [Hint: use goal seek in a spreadsheet software program to find the necessary percentage ownership.]
Outcome Black Hole Living Dead Venture Utopia Mean Flow Interest Rate PV Yr2 $1,000,000 $1,000,000 300,000 300,000 25% $5,000,000 63.98% Yr1 Yr3 $1,000,000 300,000 Yr4 $1,000,000 300,000 Yr5 $6,398,340 $32,991,699 13,096,680 Probability 0.2 0.5 0.3

E. Use the expected present value (PV) method described in the chapter when solving for the acquired percentage of final ownership in the Black Hawk to Vail Venture needs to earn its 25 percent target rate of return.
Outcome Black Hole Living Dead Venture Utopia Interest Rate Expected PV Yr1 $0.00 0 $2,096,608 0 $13,172,320 $1,000,000 25% $5,000,000.00 63.98% PV Yr2 0 0 $1,000,000 Yr3 0 0 $1,000,000 Yr4 0 0 $1,000,000 Yr5 $0 $6,398,340 $32,991,699 Probability 0.2 0.5 0.3

1. [convertible Preferred Stock Concepts] The CCC (triple C) Venture has issued convertible preferred stock to its venture investors. Each share of preferred stock is convertible into .80 shares of common stock and pays an annual cash dividend of $.25. A. If each share of preferred stock has a market value of $4.00, what is the minimum price that a share of the CCC Ventures common stock should be selling for (ignore the dividend yield on the preferred stock)? $4.00/.80 = $5.00 B. If a share of the CCC Ventures common stock is actually trading at $3.00 per share, what are the implied conversion terms? Given the above actual conversion terms, explain how the common stock could be

trading at $3.00 per share while the preferred stock is trading at $4.00 per share. $4.00/$3.00 = 1.3333 implied conversion terms That is, one share of preferred stock should be convertible into 1.3333 shares of common stock Actual conversion value: $3.00(.80) = $2.40 implied value of preferred stock Even considering the expected $.25 dividend on the preferred stock results in a value of $2.65 ($2.40 + $.25). Thus, there is an unexplainable current price anomaly between the preferred stocks value in terms of its worth in common stock and its current trading price. Possibly very little trading of one or both of these securities occurs. Arbitrageurs will soon cause these price differentials to converge by purchasing the common stock and selling the preferred stock short. 2. [Conversion Price and Market Price Formulas] Calculate the conversion price formula (CPF) and market price formula (MPF) prices for an offering involving an existing conversion price of $1, a hypothesized market price of $2, and a new offering price of $.95 for 1,000 shares with 2,000 shares outstanding prior to the new issue. Relate the new conversion price to the implied new conversion ratio.

CPF = [(Shares before issue)(Old Conversion Price) + (New Issue Price)(New Shares)]/(Total shares after issue) = [(2000)($1.00) + ($0.95)(1000)]/3000 = $2,950/3,000 = $0.9833 MPF = (Old Conversion Price) x [(Shares before issue) + ((New issue price)(New shares)/(Share value w/o new))/(Total shares after issue)] = ($1.00)[(2000) + (($0.95)(1000)/($2.00))/3000] = $1.00[$2,475/3,000] = $0.825
3. [Conversion Price and Market Price Formulas] Show how your answers for Problem 3 would change if the new offering price was $.80 for 1,500 shares. Assume other things remain the same.

CPF = [(2000)($1.00) + ($0.80)(1500)]/(3500) = $3,200/3,500 = $0.9143

MPF = ($1.00) x [(2000) + (($0.80)(1500)/($2.00))/(3500)] = $1.00[$2,600/3,500] = $0.7429

MINI CASE: WOK YOW IMPORTS, INC. Wok Yow Imports, Inc., is a rapidly growing, closely held corporation that imports and sells oriental style furniture and accessories at several retail outlets. The equity owners are considering selling the venture and want to estimate the enterprise or entity value and then determine the value of the ventures equity. Following is last years income statement (2010) and projected income statements for the next four years (2011-2014). Sales are expected to grow at an annual 6 percent rate beginning in 2015 and thereafter. [Note: In the first printing of the Fourth Edition, the actual and projected headings were not properly aligned. Only income statement data for 2010 are actual. Projected income statement data are provided for 2011 through 2014 as shown below.]

[$ Thousands] Net Sales Cost of Goods Sold Gross Profit SG&A Expenses Depreciation EBIT Interest EBT Taxes (40% rate) Net Income

Actual 2010 $150.0 -75.0 75.0 -30.0 -7.5 37.5 -3.5 34.0 -13.6 20.4

Projected -----------------------------------------------2011 2012 2013 2014 $200.0 $250.0 $300.0 $350.0 -100.0 -125.0 -150.0 -175.0 100.0 125.0 150.0 175.0 -40.0 -50.0 -60.0 -70.0 -10.0 -12.5 -15.0 -17.5 50.0 62.5 75.0 87.5 -3.5 -3.5 -3.5 -3.5 46.5 59.0 71.5 84.0 -18.6 -23.6 -28.6 -33.6 27.9 35.4 42.9 50.4

Selected balance sheet accounts at the end of 2010 are as follows: Required cash, accounts receivable, and inventories accounts totaled $50,000, net fixed assets were $50,000, and accounts payable and accruals totaled $25,000. Each of these balance sheet accounts was expected to grow with sales over time. Long-term debt was $30,000 and there were 10,000 shares of common stock outstanding at the end of 2010. Data have been gathered for a comparable publicly traded firm, Fine Furniture Products, in Wok Yows industry. Fine Furnitures risk index is judged to be 2.00 compared to a risk index of 1.00 for firms of average riskiness. Management believes that a 2.00 adjustment factor should be multiplied times the expected market risk premium for average firms to reflect Wok Yows (and Fine Furnitures) relatively greater riskiness. Wok Yows long-term debt to long-term capital (long-term debt plus equity) ratio was 40 percent at the end of 2010. The interest rate on long-term U.S. government bonds is 7 percent, Wok Yow could issue new longterm debt at a 12 percent rate, and the average expected market risk premium (common stocks over government bonds) is 7.5 percent for average firms. A. Project Wok Yows net operating profit after-tax (NOPAT) statements for 2011-2015. The NOPAT results are shown below in the spreadsheet solution. NOPAT amounts were: 30.0 (2011), 37.5 (2012), 45.0 (2013), 52.5 (2014), and 55.7 (2015). B. Determine the annual increases in required net working capital and capital expenditures (CAPEX) for Wok Yow for the years 2011 through 2015. Results are shown below in the spreadsheet solution. The increases in RNWC were: 8.3 (2011), 8.3 (2012), 8.3 (2013), 8.3 (2014), and 3.5 (2015). The increases in CAPEX were: 26.7 (2011), 29.2 (2012), 31.7 (2013), 34.2 (2014), and 25.5 (2015). C. Project annual operating free cash flows to the entity for the years 2011 through 2015. Results are shown below in the spreadsheet solution. Operating free cash flows were: 5.0 (2011), 12.4 (2012), 20.0 (2013) and 27.5 (2014). An operating free cash flow of 45.2 was estimated for 2015.

D.

Management initially thought that an 18 percent discount rate was reasonable. Estimating an appropriate required rate of return on an equity investment is critical to the valuation effort. For very early stage ventures, various VC rules-of thumb might be used ranging from development stage discount rates of 50% down to 20% discount rates for relatively mature, but small ventures. The alternative is to estimate an appropriate discount rate using the security market line approach described in Chapter 7. A venture that employs some interest-bearing debt will have a weighted average cost of capital WACC that is less than the cost of equity capital. Management has made a rough estimate of the firms WACC or enterprise (entity) discount rate to be 18%.

E.

Use the information from Part D above to estimate Wok Yows terminal value cash flow at the end of 2014. The terminal value cash flow is estimated to be 376.3 and is calculated by dividing the estimated operating free cash flow for 2012 of 45.2 by .12 which is the difference between the discount rate (r = .18) and the perpetuity growth rate (g = .06). See the spreadsheet solution presented below. In greater detail, the calculation is: 45.152/(.18 .06) = 376.267.

F.

Estimate the firms enterprise or entity value at the end of 2010. The enterprise or entity value at the end of 2010 is estimated to be 233.6 (thousands of dollars). See the spreadsheet solution presented below.

G.

Adjust the enterprise value to determine Wok Yows equity value in dollars and on a per share basis at the end of 2010. The enterprise value of $233.6, minus the long-term debt value of $20, results in an equity value of $203.6. On a per share basis, the value is $20.36. See the spreadsheet solution presented below.

H.

Now, estimate Wok Yows after-tax cost of long-term debt. Use the risk free rate, the expected market risk premium, and the risk index for the Fine Furniture Company to estimate Wok Yows cost of equity capital. Determine Wok Yows weighted average cost of capital (WACC). Cost of common equity capital = 7% + (7.5%)2.00 = 7% + 15% = 22% After-tax cost of debt = 12%(1 - .40) = 7.2% WACC = 7.2%(.40) + 22%(.60) = 2.88% + 13.20% = 16.08% or 16.1% rounded See the second spreadsheet solution presented below for answers to Parts H and I.

I.

Re-estimate Wok Yows enterprise value using the WACC calculated in Part H. Then, adjust the enterprise value to determine Wok Yows equity value in dollars and on a per share basis at the end of 2010.

Revised terminal value = $447.1 [i.e., actually $45.152/(.161 - .06)] Revised enterprise value = $270.1 Revised equity value = $240.1 (i.e., $270.1 - $30.0) Revised per share value = $24.01 See the second spreadsheet solution presented below for answers to Parts H and I.