Principles of Finance with Excel, 2 nd edition Instructor materials Chapter 7 Financial Planning Models and Valuation

Basic corporate valuation model The Enterprise Value is the value of the firm’s operating activities (as distinguished from its financial activities, or its operations + financing). 2

Definitions (1)  Free cash flow (FCF): Cash produced by firm’s operating activities (different from accounting consolidated cash flow)  Weighted average cost of capital (WACC): Risk-adjusted discount rate for firm’s FCFs 3

Definitions (2): Enterprise value Net working capital: Bring Current Liabilities from right-hand side of balance sheet to left. Firm value: Enterprise Value + Cash and marketable securities 4

Definitions (2a): Enterprise value 5

Definitions (3): Free cash flow (FCF)  Profit after taxes  + Depreciation  - Increase in current assets  + Increase in current liabilities  - Capital expenditures (CAPEX=increase in fixed assets at cost)  + After-tax net interest  = FCF 6

Definitions (4): Weighted average cost of capital (WACC) 7

Reprise: What’s enterprise value? Implementation issues (next slides) Terminal value Mid-year discounting 8

Implementation issue (1): Terminal value Big issue: Difficult to project FCFs for long horizons Model used for Terminal Value is often different than that used for initial FCFs: FCFs, years 1,..., N: Use financial planning model (PFE, Chap. 7) Terminal value: Use other model (next slides) 9

Terminal value model 10

Other terminal value models  Terminal value = (year-N EBITDA) *(EBITDA multiple)  Terminal value = (year-N BV) * (market/book multiple)  Terminal value = (year-N PAT) *multiple + year N projected debt 11

Implementation issue (2): Mid- year discounting Standard discounting model assumes FCFs occur at year end But FCFs occur throughout year Discount each FCF as if it occurs in mid-year 12

Implementing mid-year discounting 13

Building a financial planning model—Whimsical Toenails  Owns chain of toenail-painting parlors  Build financial model to project FCFs for years 1-5  Project terminal value 14

Whimsical Toenails— Current income statement 15

Whimsical Toenails— Current balance sheet 16

WT: Model value drivers (1) years 1-5  Sales growth: 10% per year  COGS: 50% of sales  Current assets: 15% of sales  Current liabilities: 8% of sales  Net fixed assets: 77% of sales  Depreciation: 10% of average FA 17

WT value drivers (2)  Interest on debt: 10%  Interest on cash: 8%  Tax rate: 40% 18

WT balance sheet model 19

WT financial model The PLUG  Plug: Item which guarantees that Assets = Liabilities  Plug is usually a financing item:  Cash (this model)  Debt  Common stock 20

The PLUG (2)  The Plug is not a number  It’s an equation. Examples:  Cash = Total liabilities – Current Assets – Net Fixed Assets  Debt = Total assets – Current liabilities – Equity  Equity = Total assets – Current liabilities – Debt 21

PLUG (3): Plug = Cash  Plug = cash means: Debt & Stock are predetermined. In WT, for example:  No new common stock issued  Debt paid $800k/year  Plug = cash asks: Can operations be supported with these Debt/Stock financing assumptions?  Answer: “Yes,” if cash > 0 22

PLUG (4): Plug = Debt  Plug = Debt means: Cash and Stock are predetermined.  Example:  Cash balances = $250k each year  No new Stock issued  Then Plug = Debt means: All available extra cash used to pay down debt. 23

Plug = Debt  Useful in project finance  If Debt increases, then tracks financing needs of firm 24

WT financial model  Build spreadsheet for initial year (2004) and subsequent year (2005)  Excel tip: Be careful about absolute versus relative references ($B$2 is very different from B2)  Example: Initial model (on disk with book) 25

Excel model  Interest: based on average debt/cash over year (Excel function =Average )  Depreciation  Value driver is net fixed assets (NFA)  Depreciation based on fixed assets at cost  Circularity?  Other models? 26

Depreciation: A circular argument? FA at cost = NFA + Depreciation Accumulated Depreciation Based on FA at cost Net fixed assets (Sales-driven) = FA at cost - depreciation 27

The most mysterious Excel dialog box? Proper answer: CANCEL 28

Then: Excel Options|Formulas 29

Other circularities? Profit after tax Interest: Depends on Debt/Cash Retained earnings Accumulated retained CashDebt Income statement Balance sheet 30

Copy initial model to years 2-5  Look at spreadsheet for this chapter  Play with the model!  Change parameter values (growth, COGS/Sales, etc.)  Does it make sense?  Can you explain its behavior? 31

Use model to project FCFs 32

Use model to value firm (Below: end-year discounting) Per share valuation: 1,000,000 shares 33

Valuation: Mid-year discounting Mid-year: Multiply by (1+WACC)

Sensitivity analysis Learn to use Data table! PFE, Chapter 27 35

Sensitivity analysis: Firm value as function of LT FCF growth and WACC Two dimensional Data Table (PFE Chapter 27, again... ) Why do you need an If statement? 36

Summing up: Technical  Excel functions:  NPV (PFE Chapter 2)  Sum (PFE Chapter 26)  If (PFE Chapter 26)  Relative vs absolute copying  Circular references  Data tables (PFE Chapter 27) 37

Summing up: Theoretical  Valuing firm: Build financial planning model  Excel model of firm  Value drivers  Project FCFs  Terminal value  GREAT DISCIPLINE: TIE EVERYTHING TOGETHER 38

Model variations  Change the plug  Cash? (This model)  Debt?  Hard wired? (Good for debt capacity)  Plug—project finance?  Common stock?  Year-by-year value drivers? 39