Estimating the Value of ACME 1

Steps in a valuation Estimate cost of capital (WACC) – Debt – Equity Project financial statements and FCF Calculate horizon value Discount at WACC to Calculate V OPS Calculate value of equity 2

Estimating the required return on the components of WACC ACME has debt and equity – The cost of capital for each type of financing depends on it risk, as perceived by the investor, and taxes. – Higher risk securities have higher required rates of return. – If payments (like interest) are deductible, then the cost to the firm is lowered. 3

Acme's WACC Debt: Acme has 2 types of debt—short-term and long-term. The short-term rate is 9%. Long-term debt: 8% coupon debt with 26 years left to maturity are selling for $ each. What is the cost (to ACME) of this source of capital? 4

Bond prices In general the price of a bond depends on its coupon payments, its maturity, and its risk. ACME’s bonds pay $40 every 6 months, and $1,000 when they mature in 26 years. 5

Bond prices 6 M is the maturity value, or $1,000 for ACME r C is the coupon rate, or 0.08, which is 8% for ACME n is the maturity, or 26 x 2 = 52 6-month periods. r D is the discount rate.

ACME’s bond price 7 A financial calculator or a spreadsheet can be used to solve for r D, which is 4.5% for a 6-month period, or 9% per year.

Cost of long-term debt The cost of debt when it was issued 4 years ago was 8%, but the cost now is different because the bond price has declined from $1,000 to $ Now the cost is 9% 8

Cost of equity The cost of equity (its required return) depends on how risky the stock is to investors. This risk is measured by “Beta” and the Capital Asset Pricing Model (CAPM) relates Beta to the required return. 9

ACME’s cost of equity CAPM: r S = r RF + Beta (RPM) Beta = 1.1 r RF = 5.4% = long term rate on Treasuries RP M = market risk premium = 6% r S = 5.4% + 1.1(6%) = 12% 10

Target weights and WACC Target is 30% debt, 70% equity Tax rate = 40% WACC = 0.70(12%) (9%)(1-0.40) = 10.0% This is the discount rate to be used for the free cash flows. 11

Projections Next chapter will have the nuts and bolts of projections. For now, assume that your financial analyst has already made the projections on the following page. 12

Income statement projections 13 Income Statements Actual Projected Sales 4, , , , , Costs of Goods Sold 2, , , , , Sales, General and Administrative , , , Depreciation Operating Profit Interest on original debt Interest Expense on new debt Interest expense Earnings Before Taxes Taxes Net Income Dividends Additions to retained earnings

Balance Sheet Projections 14 Balance Sheets Actual Projected Cash Inventory Accounts receivable 1, , , , , Total current assets 1, , , , , Gross PPE 3, , , , , Accumulated depreciation 1, , , , , Net PPE 2, , , , , Total assets 4, , , , ,223.91

Balance Sheet Projections 15 Liabilities Actual Projected Accounts payable Accrued expenses Short-term debt Total current liabilities 1, , , , , Long-term debt 1, Total liabilities 2, , , , , Common stock Retained earnings 1, , , , , Total common equity 2, , , , , Total liabilities and equity 4, , , , ,223.91

FCF Projections 16

ROIC Projections 17 Long term projected growth is 6% Actual 2014 Projected 2015 Projected 2016 Projected 2017 Projected 2018 ROIC = (NOPAT/Beginning capital) 11.3% 11.2% 11.0% Growth in Sales 9.0% 8.0% 6.0% Growth in NOPAT 9.0% 8.0% 6.0% Growth in total net op. cap. 9.0% 8.0% 6.0% Growth in FCF 376.6% 50.8% 67.9% 6.0% Growth in dividends -34.5% 28.8% 41.7% 6.0%

Horizon Value 18

Value of operations 19

Value of equity V equity = V OPS + non-operating assets – debt = $4, – debt Debt: $ million short term + 1 million long-term bonds at $ each = = $1, million V equity = $4, , = $2, million 20

Per share equity 10 million shares outstanding Value per share = $