Arzac, Chapter 2

historical financial statements forecast period opportunity costs of capital market value weight

make assumptions for continuation value use formula to get value

check different scenarios

DCF valuation - incorporates estimates of FCF for set number of years with calculation of continuation value at end multiples approach comparable companies or comparable transactions

determine key performance (sales growth, profitability, and FCF generation) drivers:
internal drivers external drivers

FCF cash generated by firm after paying all cash operating expenses and associated taxes and funding capex and working capital but prior to payment of any interest expense
independent of capital structure cash available to all capital providers (debt and equity holders)

historical performance projection period length alternative cases projecting performance without management guidance
public companies you can use consensus research estimates for financial statistics to get basis to begin private companies need to use historical performance, sector trends, and consensus estimates for similar public firms

source top line projections for first 2 or 3 years from consensus estimates if public or public peers if private

derive growth rate in later years from alternative sources where???? growth rate if no guidance cyclical firms sanity check COGS and SG&A historical COGS (gross margin) and SG&A (% of sales)
usually hold constant as % of sales in later years

EBITDA and EBIT if we model DCF using EBITDA then we dont need detail for COGS and SG&A

instead focus on NWC and how it changes as a % of sales

start with NI add net interest expense after tax to get unlevered NI add back changes in deferred taxes and depreciation
(1-T)(Int. Exp. Int. Inc.) = Unlevered NI

noncash def taxes is source of cash depreciation can include all noncash charges deducted from EBIT except for goodwill

deferred taxes + unlevered NI = NOPAT depreciation to NOPAT = Gross CF

total CF given off by firm

Gross CF Gross Inv. = FCF (operations)

Gross Investment =
increase in NWC + capital expenditures (funds used to purchase, improve, expand, or replace physical assets) + investment in goodwill + increase in net other assets

Exhibit 2.1. AdvPak Technologies. Historical Data and Forecasting Assumptions ($000) Historical Forecast for Fiscal Years Ending 12/31 2006 2007 2008 2009 2010 Operations: Unit Sales Growth 5.4% 6.0% 6.0% 5.6% 5.6% Price Growth 2.0% 2.3% 2.3% 2.3% 2.3% Growth Rate of Sales 7.5% 8.4% 8.4% 8.0% 8.0% Cost of Sales (Excl. Dep. & Amort.) as % of Sales Selling, General & Administrative as % of Sales Research & Development as % of Sales EBITDA as % of Sales Growth Rate Capital Expenditures and Depreciation: Capital Expenditures (net of Disposals) Net Property, Plant & Equipment (PP&E) % of Sales Book Depreciation % of Net PP&E Tax Depreciation % of Net PP&E Working Capital: Cash balance as % of Sales Accounts Receivable as % of Sales Days Receivable Inventories as % of Cost of Sales Inventory Days on hand Other Current Assets as % of Sales Accounts Payable as % of Cost of Sales Days Payable Accrued Expenses as % of Sales Tax Payable as % of Current Income Tax Other Current Liabilities as % of Sales Debt, Interest, Dividends and Taxes: Short-term Debt & Curr. Portion of LTD as % of Total Debt Total Debt as a multiple of next year EBITDA Interest rate on debt Interest rate on cash and marketable securities Dividends paid Tax rate on income 81.8% 7.4% 0.9% 9.8% 8.5% 79.0% 7.0% 1.0% 13.0% 44.2% 77.5% 7.0% 1.0% 14.5% 21.0% 77.5% 7.5% 1.0% 14.0% 4.3% 77.5% 7.5% 1.0% 14.0% 8.0%

2011 5.1% 2.3% 7.5% 77.5% 7.5% 1.0% 14.0% 7.5%

16,100 80,414 39.50% 10,695 13.3% 11,740 14.6%

11,380 81,018 36.70% 10,775 13.3% 11,829 14.6%

17,771 86,658 36.20% 12,132 14.0% 12,999 15.0%

19,437 91,857 35.52% 14,238 15.5% 14,973 16.3%

22,046 98,617 35.30% 15,286 15.5% 16,075 16.3%

22,807 105,129 35.00% 16,295 15.5% 17,136 16.3%

1.7% 8.9% 32 15.1% 55 0.35% 10.6% 39 1.15% 0.37% 0.41%

1.6% 8.9% 32 15.1% 55 0.35% 10.8% 39 1.15% 0.37% 0.41%

1.6% 8.9% 32 15.1% 55 0.35% 10.8% 39 1.15% 0.37% 0.41%

1.6% 8.9% 32 15.1% 55 0.35% 10.8% 39 1.15% 0.37% 0.41%

1.6% 8.9% 32 15.1% 55 0.35% 10.8% 39 1.15% 0.37% 0.41%

1.6% 8.9% 32 15.1% 55 0.35% 10.8% 39 1.15% 0.37% 0.41%

16.67% 2.85

38.25%

16.67% 16.67% 16.67% 16.67% 2.49 2.56 2.52 2.56 8.35% 8.35% 8.35% 8.35% 4.61% 4.61% 4.61% 4.61% 100% of excess cash and marketable securities 38.25% 38.25% 38.25% 38.25%

16.67% 2.38 8.35% 4.61% 38.25%

Exhibit 2.2. AdvPak Technologies. Pro-Forma Income Statements ($000) Historical 2006 Sales 203,580 Cost of Sales 166,592 Gross Profit 36,988 Sales, General & Administrative Expenses 15,164 Research & Development 1,922 EBITDA 19,901 Depreciation 10,695 EBIT 9,206 Interest Expense Interest Income Pretax Income Current Income Tax Deferred Tax Net Income

2007 220,758 174,399 46,359 15,453 2,208 28,699 10,775 17,923 6,831 157 11,250 3,900 403 6,947

Forecast for Fiscal Years Ending 12/31 2008 2009 2010 239,386 258,605 279,368 185,524 200,419 216,510 53,862 58,186 62,858 16,757 19,395 20,953 2,394 2,586 2,794 34,711 36,205 39,112 12,132 14,238 15,286 22,579 21,967 23,826 7,218 7,741 8,237 163 176 191 15,524 14,403 15,780 5,606 5,228 5,734 331 281 302 9,586 8,894 9,744

2011 300,369 232,786 67,583 22,528 3,004 42,052 16,295 25,757 8,974 206 16,989 6,177 322 10,491

Exhibit 2.3. AdvPak Technologies. Pro-Forma Balance Sheets ($000) Historical 2006 Assets Current: Cash and Marketable Securities 3,417 Accounts Receivable 18,119 Inventories 25,158 Other Current Assets 717 Total Current Assets 47,411 Property, Plant & Equipment Less: Depreciation Net Property, Plant & Equipment Other Noncurrent Assets: Total Assets Liabilities Current: Short-term Debt & Current Portion of LTD Accounts Payable Accrued Expenses Taxes Payable Other Current Liabilities Total Current Liabilities Long-term Debt Deferred Income Taxes Total Liabilities Common Stock and Retained Earnings Total Liabilities and Net Worth 117,667 37,253 80,414 9,352 137,177

2007

Forecast for Fiscal Years Ending 12/31 2008 2009 2010

2011

3,532 19,647 26,337 777 50,294 129,047 48,028 81,018 9,352 140,665

3,830 21,305 28,017 843 53,996 146,818 60,160 86,658 9,352 150,006

4,138 23,016 30,267 911 58,331 166,255 74,398 91,857 9,352 159,540

4,470 24,864 32,697 984 63,015 188,301 89,684 98,617 9,352 170,984

4,806 26,733 35,155 1,058 67,752 211,108 105,979 105,129 9,352 182,233

13,632 17,659 2,341 20 835 34,487 68,162 1,209 103,859 33,319 137,177

14,405 18,835 2,539 14 905 36,699 72,027 1,612 110,338 30,327 140,665

15,449 16,439 20,037 21,645 2,753 2,974 21 19 981 1,060 39,241 42,138 77,246 82,194 1,943 2,224 118,430 126,556.48 31,576 32,983 150,006 159,540

17,910 23,383 3,213 21 1,145 45,672 89,548 2,526 137,746 33,237 170,984

17,910 25,141 3,454 23 1,232 47,759 97,626 2,848 148,233 34,000 182,233

Exhibit 2.4. AdvPak Technologies. Pro-Forma Cash Flow Statements ($000) Historical 2006 Funds from Operating Activities Net Income Depreciation Deferred Tax Decrease (Increase) in Current Assets Increase (Decrease) in Current Liabilities except debt Decrease (Increase) in Net Working Capital Funds From Operations Funds for Investment Capital Expenditures Funds to (from) Financing Decrease (Increase) in Debt Dividends Total Funds to (from) Financing Increase (Decrease) in Cash End-of-Year Cash & Marketable Securities

2007 6,947 10,775 403 (2,768) 1,439 (1,330) 16,796

Forecast for Fiscal Years Ending 12/31 2008 2009 2010 9,586 12,132 331 (3,404) 1,498 (1,905) 20,144 8,894 14,238 281 (4,028) 1,907 (2,121) 21,292 9,744 15,286 302 (4,351) 2,064 (2,287) 23,044

2011 10,491 16,295 322 (4,401) 2,087 (2,314) 24,793

11,380

17,771

19,437

22,046

22,807

3,417

(4,638) 9,939 5,301 115 3,532

(6,262) 8,337 2,075 298 3,830

(5,939) 7,486 1,547 308 4,138

(8,824) 9,490 666 332 4,470

(8,078) 9,728 1,650 336 4,806

Required cash balance ... Excess cash .. Increase in Net Debt Net debt

Actual 3,417 0.000

78,378

3,532 0.000 4,523 4,523 82,901

3,830 0.000 5,964 5,964 88,865

4,138 0.000 5,631 5,631 94,496

4,470 0.000 8,492 8,492 102,988

4,806 0.000 7,742 7,742 110,730

includes all interest-earning or interestpaying financial securities and equity

independent estimate from FCF must be equal to FCF (good check!)
excess marketable securities - AT interest income + debt + AT interest expense + dividends + share repurchases Total Financial Flow = Total FCF

forecast financial statements

consistency compare with analysts ?

common forecasting error plugs for building balance sheet calculate FCF for set number of years
how long?

Continuation Value idea is that over time most firms regress to industry norm estimate FCFs over period of competitive advantage relative to industry and then make growth assumptions with firm converging to industry norm i.e., constant growth

NOPAT T (1 g )[1 ( g / r )] VCV 0 WACC g

NOPATN 1 VN WACC

assumption that competition drives return on invested capital in LR to equal WACC perpetuity model
discount VN back to time 0 (discount using?)
growth rate in CF not relevant because no value creation

value driver model

dominant firm in industry Microsoft, Coca-Cola potential to earn high returns on invested capital for very long time discount to get value at T=0

NOPAT N 1(1 g / r ) VN WACC g

M&M Proposition I The market value of any firm is independent of its capital structure and is given by capitalizing its expected return at a rate appropriate to its risk class. tax shield on debt and changes resulting now consider bankruptcy costs

VL = VU + tCB where B is the market value of the bonds (B=kDD/kb) so the value of a levered firm is equal to the value of an unlevered firm plus the PV of the tax shield from debt in an M&M world with no taxes (tc=0), VL = VU which is prop. I (the method of financing is irrelevant)

return on assets to firm is equal to return on a portfolio of its net debt and equity claims beta coefficient of firms levered assets: A = (D/D+E)D + (E/D+E)E so E = (1+D/E)A (D/E)D* E = (1+D/E)U (D/E)D*** E = (1+D/E)U***

Exhibit 3.8. Cost of Equity of AdvPak Technologies (as of December 2006)

10-year U.S. Treasury bond yield = Market risk premium = Market Equity2 Buckeye Technologies Caraustar Inc. Glatfelter Co. Rock-Tenn Company Wausau Paper. Mean Median AdvPak Technologies, Inc. 451.0 233.0 694.0 992.0 761.0 4.62% 4.36%
Adjusted

Beta 0.90 1.42 1.24 1.14 1.25

Beta 0.934 1.277 1.158 1.092 1.165

Net Debt1 511.0 268.0 401.0 789.0 152.0

Debt-toEquity 1.13 1.15 0.58 0.80 0.20

Unlevered

Beta

CAPM Cost of Equity 8.7% 10.2% 9.7% 9.4% 9.7%

Size
Premium
4

Cost of Equity 12.6% 14.1% 11.5% 11.2% 11.5%

145.6

0.936

0.54

0.438 0.594 0.734 0.608 0.971 0.669 0.608 0.608

3.90% 3.90% 1.80% 1.80% 1.80%

8.70%

3.90%

12.6%

AdvPak's cost of equity = riskless rate + market risk premium x beta + size premium = 4.62% +4.36% x 0.936 + 3.90% = 12.6%
Notes: 1. Book interest bearing debt minus cash in $ million. 2. Shares outstanding times share price in $ million. 3. Beta unlevered according to (3.15). 4. From Exhibit 3.6.

equity
size premium three factor model
SMB HML liquidity

investment grade debt high yield debt convertible debt

WACC =
(rd x (1t)) x (D/(D+E)) + re x (E/(D+E))

Exhibit 2.5. AdvPak Technologies. Enterprise Valuation as of 12/31/2006

($000)

Year-end Net Income Net Interest after Tax Unlevered net income Change in deferred taxes NOPAT Depreciation Change in Net Working Capital Capital Expenditures Free cash flow Valuation WACC PV{FCF} @ Continuation growth rate Continuation value PV{Continuation value} @ Enterprise value

2006

2007 6,947 4,121 11,068 403 11,470 10,775 (1,330) (11,380) 9,537

2008 9,586 4,357 13,942 331 14,274 12,132 (1,905) (17,771) 6,729

2009 8,894 4,671 13,565 281 13,846 14,238 (2,121) (19,437) 6,526

2010 9,744 4,969 14,713 302 15,014 15,286 (2,287) (22,046) 5,966

2011 10,491 5,414 15,905 322 16,226 16,295 (2,314) (22,807) 7,400.3

10.03% WACC 7.52% WACC

27,783 316,370 196,153 223,936

($000) EBIT Tax on EBIT @ 38.25% Unlevered Net Income Change in deferred taxes NOPAT Depreciation Change in Net Working Capital Capital Expenditures Free cash flow

2007 17,923 6,856 11,068 403 11,470 10,775 (1,330) (11,380) 9,537

2008 22,579 8,636 13,942 331 14,274 12,132 (1,905) (17,771) 6,729

2009 21,967 8,402 13,565 281 13,846 14,238 (2,121) (19,437) 6,526

2010 23,826 9,113 14,713 302 15,014 15,286 (2,287) (22,046) 5,966

2011 25,757 9,852 15,905 322 16,226 16,295 (2,314) (22,807) 7,400

AdvPak Technologies, Inc. Cost of Capital Calculation

Levered Unlevered

Long-term government bond yield Market equity premium Beta coefficient Cost of equity before small cap premium Small capitalization premium AdvPak Technologies cost of equity Cost of debt Corporate tax rate Debt ratio WACC

4.62% 4.36% 0.9361 8.70% 3.90% 12.60% 8.52% 38.25% 35.00% 10.03%

4.62% 4.36% 0.6085 7.27% 3.90% 11.17%

WACC

Exhibit 2.6. AdvPak Technologies Value Table ($000) Growth Rate 7.0% 7.5% 8.0% 9.50% 229,340 283,060 366,605 10.03% 189,690 223,936 271,616 10.50% 164,798 189,394 221,525 10.00% 191,692 226,797 275,933 12.00% 116,376 127,231 139,891

8.0% 366,605 271,616 221,525 275,933 139,891

WACC

Exhibit 2.7. AdvPak Technologies Implied EBITDA Multiples from Continuation Value Estimates Growth Rate 7.0% 7.5% 8.0% 9.50% 7.0 8.9 11.7 10.03% 5.8 7.0 8.7 10.50% 5.0 5.9 7.0 10.0% 5.87 7.09 8.80 12.0% 3.52 3.93 4.40

8.0% 11.73 8.66 7.04 8.80 4.40

Exhibit 2.8. AdvPak Technologies. Free Cash Flow Decomposition

($000)

Net Income Depreciation Deferred Tax Decrease in Net Working Capital Capital Expenditures Increase in Net debt Cash flow to equity holders Net Interest after Tax Increase in Net Debt Cash flow paid to debtholders, after tax Free cash flow to all security holders

2007 6,947 10,775 403 (1,330) (11,380) 4,523 9,939 4,121 (4,523) (402) 9,537

2008 9,586 12,132 331 (1,905) (17,771) 5,964 8,337 4,357 (5,964) (1,607) 6,729

2009 8,894 14,238 281 (2,121) (19,437) 5,631 7,486 4,671 (5,631) (960) 6,526

2010 9,744 15,286 302 (2,287) (22,046) 8,492 9,490 4,969 (8,492) (3,524) 5,966

2011 10,491 16,295 322 (2,314) (22,807) 7,742 9,728 5,414 (7,742) (2,328) 7,400

Exhibit 2.9. AdvPak Technologies. Equity Valuation as of 12/31/2006 ($000) 2002 2003 2004 Free cash flow to equity Cost of equity Continuation value growth rate Continuation value PV of equity cash flows PV of continuation value Equity value 9,939 12.60% 7.5% 8,337

2005 7,486

2006 9,490

2007 9,728

205,729 31,923 113,652 145,575

Exhibit 2.10. AdvPak Technologies. Net Debt Valuation as of 12/31/2006 ($000) 2002 2003 2004 Free cash flow to net debt Cost of net debt after taxes Net debt balance in 2007 PV of net debt cash flows PV of net debt balance Net debt value (402) 5.26% (1,607)

2005 (960)

2006 (3,524)

2007 (2,328) 110,730

(7,327) 85,689 78,361

GCL Industries is an industrial conglomerate undergoing restructuring. As part of its restructuring program GCL is considering the sale of its low-growth Fleet Meat Packing unit. Fleet is in the high volume-low margin meatpacking business. Fleets volume sales are not expected to increase in the future and the long-term growth of dollar sales is projected at 3% per year. Operating projections and other pertinent data are presented below. Estimate the price GCL may get for Fleet as of January 1, 2008.

Fleet Meat Packing Co., 2008-2012 Projection Actual 2007 2223.2 2.55% 29.0 0.5 38.7 Forecast 2010 2308.0 2.71% 32.9 2.9 33.4

Sales EBITDA margin Depreciation Increase in deferred taxes CAPEX + Net WC increase

2008 2245.6 2.57% 32.6 1.6 41.8

2009 2284.2 2.65% 34.2 2.2 42.2

2011 2550.0 2.71% 32.0 2.5 32.5

2012 2616.7 2.71% 31.5 2.5 32.5

Corporate tax rate: 38% GCL estimates that the buyer can finance the acquisition with 50% debt that can be raised at 7%. The beta of companies in Fleets industry with similar capital structures is 1.32. The yield on 10-year Treasury notes is 4.5%, the equity risk premium is about 4.4% and the micro-cap size premium is about 3.9%. Valuation multiple: An examination of comparable companies yielded an average EBITDA multiple equal to 6 times current (2007) EBITDA.

Debt Equity WACC

WACC (%) Weight Before-tax After-tax Weighted cost cost cost 50% 7.00% 4.34% 2.17% 50% 14.21% 14.21% 7.10% 9.27%
14.21%

Cost of equity = 4.5% + (1.32)(4.4%) + 3.9% =

TPI Inc., a manufacturer of computer storage devices, is planning to go public at the end of 2007. The purpose of the initial public offering is to retire debt and liquefy the position of some of its original investors. Future growth will be financed by TPIs internally generated CF and the additional borrowing made possible by the expected increase in the company debt capacity. The company has put together the following projections:

TPI Projections ($ millions) EBIT Depreciation Increase in deferred taxes CAPEX NWC change

2008 24.8 5.8 0.8 18.2 -0.8

2009 28.0 7.6 0.6 12.2 -0.8

2010 32.0 9.2 0.7 14.3 1.0

2011 34.0 10.2 0.7 14.3 1.8

2012 37.0 11.0 1.0 12.0 0.0

After 2012, EBIT is expected to grow at 7% per year, capital expenditures will equal depreciation and working capital will be self-financed. Currently TPI has net debt of $112m, but its CFO has already negotiated retiring $53m with the proceeds of the equity issue and refinancing the rest at 7.86%. As a consequence, TPI is expected to begin 2008 with its net debt reduced to about $59m and its interest coverage ratio increased to about 5.99. The CFO plans to maintain the coverage ratio at that level afterwards and expects to raise future debt at an interest rate of about 8%. As far as the debt ratio is concerned, the goal is to keep it at 26% of enterprise value. The CFO believes that debt ratio would be consistent with the target coverage ratio. TPIs corporate tax rate is 38%. Its cost of equity is estimated accounting for risk and its relatively small size (its beta for the planned capital structure equals 2.0, Treasury yield is 4.5%, equity premium is 4.4%, and micro-cap size premium is 3.9%.) TPI has issued 10 million shares to its present owners and plans to issue 5 million new shares in the IPO, bringing the total number of shares outstanding to 15 million. On the basis of the share prices of recent IPOs and other companies in the industry and the growth prospects of TPI, the investment bankers have suggested a preliminary IPO price based upon a P/E multiple of 13-14 times 2008 earnings. Underwriter fees are expected to be 5% of gross proceeds and additional issue expenses to amount to $600,000. Estimate the value of TPIs share of common equity.