FCFFt [FCFFniWACC gn 1 WACCt1 WACCn

The final problem is that the use of a debt ratio in the cost of capital to incorporate the effect of leverage requires us to make implicit assumptions that might not be feasible or reasonable. For instance, assuming that the market value debt ratio is 30% will require a growing firm to issue large amounts of debt in future years to reach that ratio. In the process, the book debt ratio might reach stratospheric proportions and trigger covenants or other negative consequences. In fact, we count the expected tax benefits from future debt issues implicitly into the value of equity today.

Illustration 15.2: Valuing The Gap: Dealing with Operating Leases

The Gap is one of the largest specialty retailers in the world and sells its products at Gap, GapKids, babyGap, Banana Republic and Old Navy stores. While it has operations around the world, it gets the bulk of its revenues from the United States. Rationale for using Model

• Why two-stage? While the Gap is one of the largest and most successful specialty retailers in the world, its dependence on the mature U.S. market for growth restricts its capacity to maintain high growth in the future. We will assume a high growth period of 5 years and then put the firm into stable growth.

• Why FCFF? The Gap has a significant operating lease commitments and the firm has increased its leverage aggressively over the last few years.

Background Information

In 2000, the Gap reported operating income $1,445 million on revenues of $13,673 million. The firm also reported capital expenditures of $1,859 million and depreciation of $590 million for the year, and its non-cash working capital increased by $323 million during the year. The operating lease expenses for the year were $705.8 million and Table 15.2 reports the lease commitments for future years.

Table 15.2: Lease Commitments for future years: The Gap

Year

Commitment

1

$774.60

2

$749.30

3

$696.50

4

$635.10

5

$529.70

6 and beyond

$5,457.90

To convert these operating lease expenses into debt, we first compute a pre-tax cost of debt for the firm based upon its rating of A. The default spread for A rated firms is 1.80%, which when added to the riskfree rate of 5.4%, yields a pre-tax cost of debt of 7.2%. Treating the commitment in year 6 and beyond as an annuity of $682.24 million for 8 years, we estimate a debt value for the operating leases in Table 15.3.

Table 15.3: Present value of lease commitments

Year

Commitment

Present Value

1

$ 774.60

$722.57

2

$ 749.30

$652.03

3

$ 696.50

$565.38

4

$ 635.10

$480.91

5

$ 529.70

$374.16

6 and beyond

$ 682.24

$2,855.43

Debt Value of leases =

$5,650.48

This amount is added on to the debt outstanding on the balance sheet of $1,809.90 million to arrive at a total value for debt of $7,460.38 million. The Gap's market value of equity at the time of this valuation was $28,795 million, yielding a market debt to capital ratio of:

Debt

Market Debt to Capital

Debt + Market value of equity

7,460

The operating income is also adjusted to reflect this shift by adding the imputed interest expense on the debt value of operating leases: Adjusted Operating Income

= Operating Income + Debt value of operating leases * Pre-tax cost of debt = 1445 + 5650*0.072 = $1,851 million

Multiplying by (1- tax rate), using a marginal tax rate of 35%, we get an after-tax operating income of $1,203 million.

Adjusted after-tax operating income = Adjusted Operating Income (1- tax rate) = 1851 (1-0.35) = $1,203 million

Dividing this value by the book value of debt (including capitalized operating leases) and the book value of equity at the end of the previous year yields an adjusted return on capital of 13.61% in 2000 for the firm.

1203

6604+2233

We will assume that the firm will be able to maintain this return on capital in perpetuity. Valuation

We will begin with a cost of equity estimate for the Gap, using a bottom-up beta of 1.20 (based upon the betas of specialty retailers) for the high growth period, a riskfree rate of 5.4% and a mature market premium of 4%. In stable growth, we will lower the beta to 1.00, keeping the riskfree rate and risk premium unchanged. Cost of equityHigh Growth = 5.4% + 1.2 (4%) = 10.2% Cost of equitystable Growth = 5.4% + 1.0 (4%) = 9.4%

To estimate the cost of capital during the high growth and stable growth phases, we will assume that the pre-tax cost of debt will remain at 7.2% in perpetuity and that the current market debt ratio of 20.58% will remain the debt ratio.

Cost of capitalHigh Growth = 10.2%(0.7942)+ 7.2% (1-0.35)(0.2058) = 9.06%

Cost of capital stable Growth = 9.4%(0.7942)+ 7.2% (1-0.35)(0.2058) = 8.43%

To estimate the expected growth in operating earnings during the high growth period, we will assume that the firm will continue to earn 13.61% as its return on capital and that its reinvestment rate will equal its average reinvestment rate over the last 4 years.5 Average reinvestment rate over last 4 years = 93.53%

Expected Growth rate = Reinvestment rate * Return on Capital = 0.9353*0.1361 = 12.73%

5 The Gap has had volatile capital expenditures and working capital changes. This is our attempt to average out this volatility.

Table 15.4 summarizes the expected cash flows for the high growth period.

Table 15.4: Estimated FCFF: The Gap

Year

EBIT(l-t)

Reinvestment rate

Reinvestment

FCFF

Present Value

Current

$1,203

1

$1,356

93.53%

$1,269

$88

$80

2

$1,529

93.53%

$1,430

$99

$83

3

$1,732

93.53%

$1,620

$112

$86

4

$1,952

93.53%

$1,826

$126

$89

5

$2,190

93.53%

$2,049

$142

$92

Sum of present values of cash flows =

$430

Note that the cash flows during the high growth period are discounted back at 9.06%. To estimate the terminal value at the end of year 5, we assume that this cash flow will grow forever at 5%. The reinvestment rate can then be estimated and used to measure the free cash flow to the firm in year 6: Expected growth rate =5%

Reinvestment rate in stable growth =-g-= ——— = 36.73%

Stable period ROC 13.61%

FCFF = EBIT5 (1- t X1 + gStable Period X1 - Reinvestment Rate)

The terminal value is:

FCFFjj

Cost of capital in stable growth - Growth rate

Terminal value

1455

Discounting the terminal value to the present and adding it to the present value of the cash flows over the high growth period yields a value for the operating assets of the firm. Value of Operating assets = PV of cash flows during high growth + PV of terminal value

$42 441

Adding back the firm's cash and marketable securities (estimated to be $409 million at the end of 2000) and subtracting out the value of the debt yields a value for the equity in the firm:

Value of the equity

= Value of the operating assets + Cash and Marketable securities - net debt = 27,933 + 409 - 7460 = $20,882 million

Note that the debt subtracted out includes the present value of operating leases. At its prevailing market value of equity of $27,615 million, the Gap is overvalued.

Illustration 15.3: Valuing Amgen: Effects of R&D

As a leading biotechnology firm, Amgen has substantial research and development expenses and we capitalized these expenses earlier in this book. In this valuation, we will consider the implications of this capitalization for firm and equity values. Rationale for using Model

• Why three-stage? Amgen, in spite of being one of the largest biotechnology firms has significant potential for future growth, both because of drugs that it has in commercial production and other drugs in the pipeline. We will assume that the firm will continue to grow for 10 years, five at a high growth rate followed by five year in transition to stable growth.

• Why FCFF? The firm has little debt on its books currently but will come under increasing pressure to increase its leverage as its cash flows become larger and more stable.

Background Information

In 2000, Amgen reported operating income $1,549 million on revenues of $3,629 million. The firm also reported capital expenditures of $437 million and depreciation of $212 million for the year, and its non-cash working capital increased by $146 million during the year. Recapping the analysis of Amgen's R&D from Chapter 9, we will use a 10-year amortizable life to estimate the value of the research asset in Table 15.5.

Table 15.5: Capitalizing the Research Asset

Amortization

Year

R&D Expense

Unamortized portion

this year

Current

845.00

1.00

845.00

-1

822.80

0.90

740.52

$82.28

-2

663.30

0.80

530.64

$66.33

-3

630.80

0.70

441.56

$63.08

-4

528.30

0.60

316.98

$52.83

-5

451.70

0.50

225.85

$45.17

-6

323.63

0.40

129.45

$32.36

-7

255.32

0.30

76.60

$25.53

-8

182.30

0.20

36.46

$18.23

-9

120.94

0.10

12.09

$12.09

-10

0.00

0.00

0.00

$0.00

Value of Research Asset =

$3,355.15

$397.91

The operating income is adjusted by adding back the current year's R& D expense and subtracting out the amortization of the research asset. Adjusted operating income

= Operating income + Current year's R&D - Amortization of Research asset = $1,549+ $845 - $398 = $1996 million

To get to the after-tax operating income, we also consider the tax benefits from expensing R&D (as opposed to just the amortization of the research asset). Adjusted after-tax operating income

= Adjusted Operating Income (1- tax rate) + (Current year R&D - Amortization) Tax rate = 1996 (1-0.35) + (845-398) (0.35) = $1,454 million

The current year's R&D expense is added to the capital expenditures for the year, and the amortization to the depreciation. In conjunction with an increase in working capital of $146 million, we estimate an adjusted reinvestment rate for the firm of 56.27%. Adjusted Capital expenditures = 437+ 845 = $1,282 million Adjusted Depreciation = 212 + 398 = $610 million Adjusted Reinvestment rate

Capital Expenditures - Depreciation + DWC Adjusted EBIT(l-t )

1454

To estimate the return on capital, we estimated the value of the research asset at the end of the previous year and added it to the book value of equity. The resultant return on capital for the firm is shown. Return on capital

Adjusted book value of equity (includes research asset) + Book value of debt 1454

5932+323 Valuation

To value Amgen, we will begin with the estimates for the 5-year high growth period. We use a bottom-up beta estimate of 1.35, a riskfree rate of 5.4% and a risk premium of 4% to estimate the cost of equity: Cost of equity = 5.4% + 1.35 (4%) = 10.80%

We estimate a synthetic rating of AAA for the firm, and use it to come up with a pre-tax cost of borrowing of 6.15% by adding a default spread of 0.75% to the treasury bond rate of 5.4%. With a marginal tax rate of 35% and a debt ratio of 0.55%, the firm's cost of capital closely tracks its cost of equity.

Cost of capital = 13.08% (0.9945) + 6.15%(1-0.35)(0.0055) = 10.76% To estimate the expected growth rate during the high growth period, we will assume that the firm can maintain its current return on capital and reinvestment rate estimated in the section above.

Expected Growth rate = Reinvestment rate * Return on capital = 0.5627*0.2324 = 13.08%

Before we consider the transition period, we estimate the inputs for the stable growth period. First, we assume that the beta for Amgen will drop to 1, and that the firm will raise its debt ratio to 10%. Keeping the cost of debt unchanged, we estimate a cost of capital of

Cost of capital = 9.4% (0.9) + 6.15% (1-0.35) (0.1) = 8.86%

We assume that the stable growth rate will be 5% and that the firm will have a return on capital of 20% in stable growth. This allows us to estimate the reinvestment rate in stable growth.

Reinvestment rate in stable growth = —— = 5% = 25%

ROC 20%

During the transition period, we adjust growth, reinvestment rate and the cost of capital from high growth levels to stable growth levels in linear increments. Table 15.6 summarizes the inputs and cash flows for both the high growth and transition period.

Table 15.6: Free Cashflows to Firm: Amgen

Year

Expected Growth

EBIT(l-t)

Reinvestment Rate

FCFF

Cost of Capital

Present Value

Current

$1,454

1

13.08%

$1,644

56.27%

$719

10.76%

$649

2

13.08%

$1,859

56.27%

$813

10.76%

$663

3

13.08%

$2,102

56.27%

$919

10.76%

$677

4

13.08%

$2,377

56.27%

$1,040

10.76%

$691

5

13.08%

$2,688

56.27%

$1,176

10.76%

$705

6

11.46%

$2,996

50.01%

$1,498

10.38%

$814

7

9.85%

$3,291

43.76%

$1,851

10.00%

$914

8

8.23%

$3,562

37.51%

$2,226

9.62%

$1,003

9

6.62%

$3,798

31.25%

$2,611

9.24%

$1,077

10

5.00%

$3,988

25.00%

$2,991

8.86%

$1,133

Sum of the present value o:

the FCFF during high growth =

$8,327 m

Finally, we estimate the terminal value, based upon the growth rate, cost of capital and reinvestment rate estimated above.

Finally, we estimate the terminal value, based upon the growth rate, cost of capital and reinvestment rate estimated above.

FCFFn = EBITjj (1 -1 )(1-Reinvestment rate)= 3988(1.05)1 - 0.25)= $3,140 million

_ FCFFjj

. , , Cost of capital in stable growth - Growth rate Terminal value10

3140

Adding the present value of the terminal value to the present value of the free cash flows to the firm in the first 10 years, we get:

Value of the operating assets of the firm

= $39,161 million

Adding the value of cash and marketable securities ($2,029 million) and subtracting out debt ($323 million) yields a value for the equity of $40,867 million. At the time of this valuation in May 2001, the equity was trading at a market value of $58,000 million.

Illustration 15.4: Valuing Embraer: Dealing with Country Risk

Embraer is a Brazilian aerospace firms that manufactures and sells both commercial and military aircraft. In this valuation, we will consider the implications of valuing the firm in the context of country risk and uncertainty about expected inflation. Rationale for using Model

• Why two-stage? Embraer has done exceptionally well in the last few years though it operates in a mature business with strong competition from giants such as Boeing and Airbus. We believe that it can sustain growth for a long period (10 years) and that there will be a transition to stable growth in the second half of this growth period.

• WhyFCFF? The firm's debt ratio has been volatile. While it does not use much debt to fund its operations currently, it does have the capacity to raise more debt now, especially in the United States.

• Why real cash flows? We had two choices when it came to valuation - to work with U.S. dollars or work in real cash flows. We avoided working with nominal real, largely because of the difficulties associated with getting a riskfree rate in that currency.

Background Information

In 2000, Embraer reported operating income of 810.32 million BR on revenues of 4560 million BR, and faced a marginal tax rate of 33% on its income. At the end of 2000, the firm had net debt (debt minus cash) of 215.5 million BR on which their net interest expenses for 2000 were 28.20 million BR. The firm's non-cash working capital at the end of 2000 amounted to 915 million BR, an increase of 609.7 million BR over the previous year's amount.

The firm's capital expenditures were 233.5 million BR and depreciation was 127.5

million for the year, yielding a reinvestment rate of 131.83% for the year.

Normalizing the non-cash working capital component6 yields a change in non-cash working capital of 239.59 million BR and a normalized reinvestment rate.

Normalized Reinvestment Rate2000 =-7-r— = 63.65%

Based upon the capital invested of 1,470 million BR in the firm at the beginning of

2000, the return on capital at Embraer in 2000 was 36.94%.

1470

Valuation

We first have to estimate a country risk premium for Brazil. Drawing on the approach developed in Chapter 7, we estimate a country risk premium for Brazil of 10.24%.

Country rating for Brazil = B1

Default spread on Brazilian Government C-bond (U.S. dollar denominated) = 5.37% To estimate the country equity risk premium, we estimated the standard deviation in weekly returns over the last 2 years in both the Bovespa (the Brazilian equity index) and the C-Bond.

Standard deviation in the Bovespa = 32.6% Standard deviation in the C-Bond = 17.1%

= (Default Spread/ Standard >

\ Standard DeviationC-Bond 0

Country risk premium

6 The normalized change in non-cash working capital was computed as follows: Normalized change = (Non-cash WC2000/Revenues2000)*(Revenues2000-Revenues1999)

To make an estimate of Embraer's beta, we used a bottom-up unlevered beta of 0.87 and Embraer's market net debt to equity ratio (to stay consistent with our use of net debt in the valuation) of 2.45%.

Finally, to estimate the cost of equity, we used a real riskless rate of 4.5% and a mature market risk premium of 4% (in addition to the country risk premium of 10.24%): Cost of equity = 4.5% + 0.88 (4%+10.24%) = 17.03%

We estimate a synthetic rating of AAA for Embraer and use it to come up with a pre-tax cost of borrowing of 10.62% by adding a default spread of 0.75% to the real riskless rate of 4.5%, and then adding the country default spread of 5.37%.7

Pre-tax cost of debt = Real riskfree rate + Country default spread + Company default spread = 4.5% + 5.37% + 0.75% = 10.62%

With a marginal tax rate of 33% and a net debt to capital ratio of 2.40%, the firm's cost of capital is shown below:

Cost of capital = 17.03% (0.976) + 0.1062(1-0.33)(0.024) = 16.79%

To estimate the expected growth rate during the high growth period, we will assume that the firm can maintain its current return on capital and use the normalized reinvestment rate.

Expected Growth rate = Normalized Reinvestment rate * Return on capital

= 0.6365*0.3694 = 23.51% In stable growth, we assume that the beta for Embrarer will rise slightly to 0.90, that its net debt ratio will remain unchanged at 2.40% and that the country risk premium will drop to 5.37%. We also assume that the pre-tax cost of debt will decline to 7.50% Cost of equity = 4.5% + 0.9(4%+ 5.37%) = 12.93% Cost of capital = 12.93% (0.976) + 7.5% (1-0.33) (0.024) = 12.74% We assume that the stable real growth rate will be 3% and that the firm will have a return on capital of 15% in stable growth. This is a significant drop from its current return on

7 This is a conservative estimate. It is entirely possible that the market will not assess Embraer with all of the country risk and may view Embraer as safer than the Brazilian government.

capital but reflect the returns of more mature firms in the business. This allows us to estimate the reinvestment rate in stable growth

Reinvestment rate in stable growth = —— = —— = 20%

ROC 15%

During the transition period, we adjust growth, reinvestment rate and the cost of capital from high growth levels to stable growth levels in linear increments. Table 15.6 summarizes the inputs and cash flows for both the high growth and transition period. Table 15.7: Free Cashflows to Firm: Embraer

Year

Expected Growth

EBIT(l-t)

Reinvestment Rate

FCFF

Cost of Capital

Present Value

Current

BR 543

1

23.51%

BR 671

63.65%

244

16.79%

BR 209

2

23.51%

828

63.65%

301

16.79%

221

3

23.51%

1,023

63.65%

372

16.79%

233

4

23.51%

1,264

63.65%

459

16.79%

247

5

23.51%

1,561

63.65%

567

16.79%

261

6

19.41%

1,864

54.92%

840

15.98%

333

7

15.31%

2,149

46.19%

1,156

15.17%

398

8

11.21%

2,390

37.46%

1,495

14.36%

450

9

7.10%

2,559

28.73%

1,824

13.55%

484

10

3.00%

2,636

20.00%

2,109

12.74%

496

Sum of the present value o:

the FCFF during high growth =

BR 3,333 m

Finally, we estimate the terminal value, based upon the growth rate, cost of capital and reinvestment rate estimated.

Finally, we estimate the terminal value, based upon the growth rate, cost of capital and reinvestment rate estimated.

FCFF11 = EBITjj (1 -1)1 - Reinvestment rate)= 2636(1.03)1 - 0.2)= 2172 million BR

= FCFFjj

Cost of capital in stable growth - Growth rate

Terminal value10

2172

Adding the present value of the terminal value to the present value of the free cash flows to the firm in the first 10 years, we get: Value of the operating assets of the firm

22,295

= 8,578 million BR

We do not add back cash and marketable securities, because we are using net debt (and the cash has therefore already been netted out against debt). Adding the value of non-operating assets ($510 million) and subtracting out net debt ($223 million) yields a value for the equity of 8,865 million BR and a per-share value of 14.88 BR. At the time of this valuation in March 2001, the equity was trading at a market price of 15.2 BR per share.

Doing a valuation is only the first part of the process. Presenting it to others is the second and perhaps just as important. Valuations can be complicated and it is easy to lose your audience (and yourself) in the details. Presenting a big picture of the valuation often helps. In Figure 15.1, for instance, the valuation of Embraer is presented in a picture. The valuation contains all of the details presented in the Amgen and Gap valuations but they are presented both in a more concise format and the connections between the various inputs are much more visible.

fcffginzu.xls: This spreadsheet allows you to estimate the value of a firm using the FCFF approach.

Bank Loan Busters

Bank Loan Busters

There are many physical and mental implications when one is in debt, especially if the said debt is of a considerable amount. Many people don’t realize the extent these implications can have both in the long term and short term. Therefore careful consideration should be given to the following to understand just how debt impacts one’s life.

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