1. 1 Managing for Value Creation (Summer 2006)

2. Class #1b Outline Review—Class #1a Lecture—Overview of business valuation Class discussion—Eskimo Pie Corp. Case

3. Overview of Business Valuation Basic Inc. Case—Business valuation in a perfect world

4. Business Valuation Valuation Method Relevant Cash flow Appropriate Discount Rate

5. Basic, Inc. (the setup) Investors have raised $600m to start Basic, Inc. ($317.44m in 9% bonds and the balance in equity). Basic is expected to produce $500m in sales annually with net income of $50m forever. All the firm’s net income will be paid in dividends. Annual Capex = depreciation expense and NWC does not change. No debt is issued or retired.

6. Business Valuation

7. Equity Free Cash Flow Net Income Plus: Depreciation Expense Less: Debt Repayment Plus: New debt issued Less: Investment in Working Capital Less: Capital Expenditures (Capex) Equals: Equity Free Cash Flow (EFCF)

8. EFCF Calculation Recall that there are no new debt issues nor is debt retired and NWC does not change.

9. Security Valuation Debt value Equity value

10. Firm Value Firm Value = Debt Value + Equity Value $650.77 = $317.44 + $333.33

11. Business Valuation

12. Firm Free Cash Flow (FFCF) Net Operating Income (NOI) Less: Taxes on Incremental NOI Equals: Net Operating Profit after Tax Plus: Depreciation Expense Less: Investment in Working Capital Less: Capital Expenditures (Capex) Equals: (Firm) Free Cash Flow

13. How does FFCF compare to payments made to financial claimants? Financial Claimant:Payment: CreditorsAfter-tax interest plus principal payments less new debt issued. StockholdersCommon dividends plus share repurchases less new shares issued.

14. Free Cash Flow Calculations Firm Free Cash Flow (FFCF) Equity Free Cash Flow (EFCF) Used to value a levered firm or “entity” value and the equity of an unlevered firm. Used to value the “common equity” of a levered firm.

15. Basic, Inc.’s WACC Financing proportions are based on market values calculated earlier!

16. Entity Valuation

17. EVA, MVA and Firm Value Economic Value Added (EVA) EVA = NOPAT - K wacc x Invested Capital = $70 -.1076 x $600 = $70.00 - 64.54 = $5.46 Market Value Added (MVA) = PV(EVAs) MVA = $5.46/.1076 = $50.78 Firm Value = MVA + Invested Capital = $50.78 + 600.00 = $650.78 NPV firm =Firm Value - Invested Capital = MVA

18. Business Valuation

19. Adjusted Present Value Model

20. Calculating Unlevered EFCF Firm Free Cash Flow (FFCF) Net Operating Income (NOI) Less: Taxes on Incremental NOI Equals: Net Operating Profit after Tax Plus: Depreciation Expense Less: Investment in Working Capital Less: (Capex) Equals: (Firm) Free Cash Flow Unlevered Firm’s EFCF Net Operating Income (NOI) Less: Taxes on Incremental NOI Equals: Net Operating Profit after Tax and firm Net Income Plus: Depreciation Expense Less: Investment in Working Capital Less: (Capex) Equals: (Unlevered) Free Cash Flow Note that for the unlevered firm there is no new debt issued or retired.

21. APV Valuation for Basic Inc. K d =r f +  d (Market Risk Premium).09 =.08 +  d (.07)  d =.14 V u = $70/.126 = $555.56 V ITS = ($28.57 x.3)/.09 = $95.24

22. Compressed APV Approximation of firm value—Interest tax savings discounted using the unlevered cost of equity.

23. Eskimo Pie Corporation Business valuation in practice

24. Revised FCF—1991

25. Cost of Capital Estimate K unlevered = risk-free rate + Beta unlevered (Market Risk Premium) K unlevered =.0742 + 1.136 (.075) =.1594 or 15.94%

26. Firm and Equity Value (Compressed APV Model)

27. Firm Value (DCF) Ignoring debt financing (all equity firm)

28. Firm Value (Comparables)

29. Preparation for BumbleBee The Compressed APV model. Cash flow estimation Estimating the unlevered cost of equity. Estimating the value of subsidized debt

30. Compressed APV Model and Equity Value

31. Cash flows

32. Estimating “Unlevered Betas”

33. Valuing debt subsidies Example—5 year (interest only) loan with interest rate of 10% for a borrower that would otherwise have to pay 13%. In year 5 the borrower repays the $1,000 principal amount.

34. What have we learned? There are multiple “DCF” models of firm value. The APV model offers significant advantages over alternative methods in some applications but is “not the standard” DCF model (yet). Subsidized financing is valuable and the value can be quantified. Unlevering beta coefficients can be very confusing.