978-1285190907 Chapter 12 Part 3

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Chapter 12

Valuation: Cash-Flow-Based Approaches

12-21

in whole or in part.

Part II—Computing Walmart’s Share Value Using Free Cash Flows to All

Debt and Equity Stakeholders

g. Walmart’s capital structure at the end of 2012 consists of the following

amounts and proportions:

Amount Weight

Debt $48,222 million 0.171

Common Equity $228,964 million = $69.09 per share ×

3,3,314925 million shares

0.810

Noncontrolling

Interests $5,395 million 0.019

Total $282,581 million 1.000

The equation presented in Chapter 12 for computing weighted-average cost of

capital is as follows:

A = [wD × RD × (1 – tax rate)] + [wP × RP] + [wE × RE] + [wNCI × RNCI]

Using this equation, Walmart’s weighted-average cost of capital at the end of

2012 is computed as follows:

RA = [0.171 × 0.042 × (1 – 0.320)] + [0.810 × 0.090] + [0.019

× 0.150] = 0.487 + 7.292 + 0.286 = 8.066%

h., i., j., k., and l.

Exhibit 12.E presents the excerpts from FSAP for the valuation of Walmart

based on projected free cash flows to all debt and equity stakeholders. The

first rows of the table present the computations for Walmart’s projected free

cash flows for all debt and equity stakeholders for Years +1 through +5. The

right-most column contains the projected free cash flows for all debt and

equity stakeholders in Year +6 based on the projected Year +6 financial

statements, assuming 3.0% long-run growth. The remaining rows of the table

include discounting the free cash flows for Years +1 through +5 to present

value discounted using the weighted-average cost of capital from Solution g,

computing continuing value, and computing share value. The share value

estimate is $89.17, which differs from the value estimate of $86.88 in Solution

f above.

In computing weighted-average cost of capital in Solution g, we

determined the weight of equity using the market price of Walmart’s stock at

the time. Our share value estimates from Solutions f and l differ from the

market price, so the weights we used to compute the weighted-average cost of

capital are not internally consistent with the share values we have estimated.

In addition, we hold the weighted-average cost of capital constant over time,

even though our forecasts project that the debt-equity weights will change.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-22

in whole or in part.

h. Projected amounts of free cash flows for all debt and equity stakeholders in

Years +1 through +5 are as follows (allow for rounding):

Year +1 Year +2 Year +3 Year +4 Year +5

Net Cash Flow from Operations $28,071.9 $29,636.4 $30,907.5 $32,354.6 $33,834.9

Add Back: Interest Expense after Tax 1,569.3 1,616.4 1,664.9 1,714.8 1,766.3

Subtract: Interest Income after Tax 0.0 0.0 0.0 0.0 0.0

+(–) Decrease (Increase) in Cash Required

for Operations 0.0 0.0 0.0 0.0 0.0

Free Cash Flow from Operations $29,641.2 $31,252.8 $32,572.4 $34,069.5 $35,601.2

Net Cash Flow from Investing –13,559.4 –13,601.7 –13,645.8 –13,691.6 –13,739.3

Add Back: Cash Flows into Financial Assets 0.0 0.0 0.0 0.0 0.0

Free Cash Flow—All Debt and Equity $16,081.8 $17,651.1 $18,926.6 $20,377.8 $21,861.9

i. Projected free cash flows for all debt and equity stakeholders in Year +6 are as

follows:

Year +6

Net Cash Flow from Operations $26,036.6

Add Back: Interest Expense after Tax 1,819.3

Subtract: Interest Income after Tax 0.0

+(–) Decr. (Incr.) in Cash Required for Operations –233.4

Free Cash Flow from Operations $27,622.5

Net Cash Flow from Investing –7,993.4

Add Back: Cash Flows into Financial Assets 0.0

Free Cash Flow—All Debt and Equity $19,629.1

j. The data in Exhibit 12.E show that the sum of the present value of free cash

flows for all debt and equity stakeholders for Walmart for Years +1 through

+5, discounted at a weighted-average cost of capital of 8.066%, is $74,768.0

million. You could query students about whether the free cash flows model

correctly measures the value being added by Walmart’s operations during this

period. The answer, of course, is no because the model places emphasis on the

cash outflows for growth in assets and does not yet include all of the cash

flows that Walmart will realize from this growth, which will occur in future

years.

k. The data in Exhibit 12.E show that the present value at the start of Year +1 of

the continuing free cash flows for all debt and equity stakeholders in Years +6

and beyond amounts to $262,893.8 million [$19,629.1 million/(0.08066 –

0.03) × 0.679].

Chapter 12

Valuation: Cash-Flow-Based Approaches

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in whole or in part.

l. The data in Exhibit 12.E show the following computations:

(1) The sum of the present value of free cash flows for all debt and equity

stakeholders is $337,661.8 million ($74,768.0 million + $262,893.8

million).

(2) Subtracting the value of debt and noncontrolling interests provides the

present value of common equity, which is $284,044.8 million

($337,661.8 million – $48,222.0 million – $5,395.0 million).

(3) After adjusting the sum of the present value using the mid-year

discounting adjustment factor of 1.0706 (1 + 0.08066/2), the total

present value of free cash flows for all debt and equity stakeholders is

$295,500.5 million.

(4) The per share value estimate for Walmart, after dividing the total present

value by the 3,314 million shares outstanding, equals $89.17.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-24

in whole or in part.

Exhibit 12.E

Free-Cash-Flows-Based Valuation of Walmart Stores

(amounts in millions except per share amounts; allow for rounding)

(Problem 12.17)

Continuing

1 2 3 4 5 Value

Free Cash Flows for All Debt and Equity Year +1 Year +2 Year +3 Year +4 Year +5 Year +6

Net Cash Flow from Operations 28,071.9 29,636.4 30,907.5 32,354.6 33,834.9 26,036.6

Add back: Interest Expense after tax 1,569.3 1,616.4 1,664.9 1,714.8 1,766.3 1,819.3

Subtract: Interest Income after tax 0.0 0.0 0.0 0.0 0.0 0.0

Decrease (Increase) in Cash Required for Operations 0.0 0.0 0.0 0.0 0.0 –233.4

Free Cash Flow from Operations 29,641.2 31,252.8 32,572.4 34,069.5 35,601.2 27,622.5

Net Cash Flow from Investing –13,559.4 –13,601.7 –13,645.8 –13,691.6 –13,739.3 –7,993.4

Add back: Net CFs into Financial Assets 0.0 0.0 0.0 0.0 0.0 0.0

Free Cash Flows – All Debt and Equity 16,081.8 17,651.1 18,926.6 20,377.8 21,861.9 19,629.1

Present Value Factors 0.925 0.856 0.792 0.733 0.679

Present Value Free Cash Flows 14,881.5 15,114.5 14,997.0 14,941.7 14,833.4

Sum of Present Value Free Cash Flows 74,768.0

Present Value of Continuing Value 262,893.8

Total Present Value Free Cash Flows to Equity and Debt 337,661.8

Less: Value of Outstanding Debt -48,222.0

Less: Value of Noncontrolling Interests -5,395.0

Plus: Value of Financial Assets 0.0

Present Value of Equity 284,044.8

Adjust to midyear discounting 1.0403

Total Present Value of Equity 295,500.5

Shares Outstanding 3,314.0

Estimated Value per Share $ 89.17

Current share price $ 69.09

Percent difference 29%

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-25

in whole or in part.

Part III—Sensitivity Analysis and Recommendation

m. The data in Exhibit 12.F show the results of various sensitivity analysis

scenarios, varying discount rates and growth rates.

Scenario 1: If we assume that Walmart’s long-run growth will be 2%, not 3%

as above, and that Walmart’s required rate of return on equity is 1 percentage

point higher than the rate computed using the CAPM in Solution a (that is,

10.0%), the resulting share value estimate falls to $69.69 per share. That

amount is 20% lower than our base case estimate of $86.88, and nearly

identical to current market price of $69.09.

Scenario 2: If we assume that Walmart’s long-run growth will be 4%, not 3%

as above, and that Walmart’s required rate of return on equity is 1 percentage

point lower than the rate computed using the CAPM in Solution a (that is,

8.0%), the resulting share value estimate increases to $120.72 per share. That

amount is 39% greater than our base case estimate of $86.88 and 75% greater

than current share price of $69.09.

n. At the start of Year +1, Walmart’s share price was $69.09. Our baseline share

value estimate is $86.88, implying that Walmart shares are under-priced by

roughly 26%. Sensitivity analysis reveals that slight variations in the long-

term growth rate and discount rate can cause the share value estimate to vary

between $69 per share (equal to the current price) up to $120 per share (75%

above the current price). If our forecast and valuation assumptions are

reasonable, the current share price falls at the bottom this value estimate

range. We would have concluded that Walmart shares are under-priced at

roughly $69; therefore, we would have recommended a buy.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-26

in whole or in part.

Exhibit 12.F

Free-Cash-Flows-Based Valuation of Walmart Stores—Sensitivity Analyses

(Problem 12.17)

Free Cash Flow Valuation Sensitivity Analysis:

Long-Run Growth Assumptions

86.88 0% 2% 3% 4% 5% 6% 8% 10%

Discount 5% 125.13 182.65 254.55 470.24

Rates: 6% 104.21 137.48 170.75 237.29 436.92

7% 89.27 110.37 128.83 159.60 221.13 405.74

8% 78.08 92.29 103.66 120.72 149.15 206.00

9% 69.39 79.38 86.88 97.37 113.11 139.34 349.21

10% 62.44 69.69 74.88 81.78 91.46 105.97 178.52

11% 56.76 62.16 65.87 70.64 77.00 85.90 121.52 299.62

12% 52.03 56.13 58.86 62.27 66.65 72.50 92.96 154.36

13% 48.04 51.19 53.24 55.74 58.87 62.90 75.78 105.83

14% 44.62 47.08 48.64 50.52 52.81 55.68 64.28 81.48

15% 41.66 43.60 44.81 46.24 47.95 50.05 56.04 66.82

16% 39.08 40.61 41.56 42.66 43.97 45.53 49.83 57.00

18% 34.78 35.76 36.35 37.03 37.81 38.72 41.08 44.63

20% 31.35 31.99 32.37 32.79 33.27 33.82 35.19 37.12

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-27

in whole or in part.

Integrative Case 12.1: Starbucks

Free-Cash-Flows-Based Valuation of Starbucks’ Common Equity. This is an

extensive, integrated case that connects all of the topics of the text. In this portion of the

case, we connect the valuation techniques described in Chapter 12 to the financial

statement forecasts we developed in Chapter 10 for Starbucks and the dividends valuation

approach presented in Chapter 11. This case will carry forward and be used in Chapters

13 and 14 to demonstrate the valuation approaches in those chapters. Note that these

analyses have been prepared using FSAP. The FSAP file containing these analyses is

available for download by instructors (not students) from the book’s website for

instructors. Go to instructor’s resources page at www.cengagebrain.com.

In Integrative Case 10.1, we projected financial statements for Starbucks for Years +1

through +5. In this portion of the Starbucks Integrative Case, we apply the techniques in

Chapter 12 to compute Starbucks’ required rate of return on equity and weighted-average

cost of capital and estimate Starbucks’ share value based on both free cash flows

approaches presented in Chapter 12. At the end of the case, we conduct sensitivity

analysis, varying key valuation parameters and assessing the effects on share value. We

also compare our value estimate to Starbucks’ share price at the time of the case to

develop an investment recommendation.

The case data indicate that the market equity beta for Starbucks at the end of 2012 is

0.75, the risk-free interest rate is 3.0%, and the market risk premium is 6.0%. Starbucks

has 749.3 million share million shares outstanding at the end of 2012. At the start of Year

+1, Starbucks’ share price was $50.15.

Part I—Computing Starbucks’ Share Value Using Free Cash Flows to Common

Equity Shareholders

a. Following the CAPM, Starbucks faces a required rate of return on equity capital of

7.50% at the end of 2012. This rate is computed as follows:

E[RSBUX] = E[RF] +

SBUX × E[RM – RF]

= 3.0% + [0.75 × 6.0%]

= 7.50%

b., c., d., e., and f.

Exhibit 12.G presents the excerpts from FSAP for the valuation of Starbucks based on

projected free cash flows to common equity. The first rows of the table present the

computations for Starbucks’ projected free cash flows for common equity

shareholders for Years +1 through +5. The right-most column contains the projected

free cash flows for common equity shareholders in Year +6 based on the projected

Year +6 financial statements, assuming 3.0% long-run growth. The remaining rows of

the table include discounting the free cash flows for Years +1 through +5 to present

value, computing continuing value, and computing share value. The share value

estimate is $63.55, which is identical to the estimate using the dividends model in

Chapter 11.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-28

in whole or in part.

b. Projected free cash flows for common equity shareholders in Years +1 to +5 are as

follows (allow for rounding):

Year +1 Year +2 Year +3 Year +4 Year +5

Net Cash Flow from Operations $2,603.2 $2,558.5 $3,180.9 $3,380.7 $3,900.8

+(–) Decr. (Incr.) in Cash Required for

Operations

–41.2

–147.7

–159.6

–168.0

–184.2

Net Cash Flow for Investing –1,373.1 –1,527.2 –1,697.0 –1,873.1 –2,071.1

Net Cash Flows from Debt Financing –0.0 –0.0 –0.0 –0.0 –549.6

Net Cash Flows – Noncontrolling Interests -5.5 –0.0 –0.0 –0.0 –0.0

Free Cash Flow for Common Equity $ 1,183.4 $ 883.6 $ 1,324.3 $ 1,339.6 $ 1,095.8

c. Projected free cash flows for common equity shareholders in Year +6 are as follows:

Year +6

Net Cash Flow from Operations $3,248.0

+(–) Decrease (Increase) in Cash Required for Operations –56.7

Net Cash Flow from Investing –529.6

Net Cash Flows from Debt Financing 0.0

Net Cash Flows – Noncontrolling Interests 0.0

Free Cash Flows for Common Equity $2,661.7

d. The data in Exhibit 12.G show that the sum of the present value of free cash flows for

common equity for Starbucks for Years +1 through +5, discounted at 7.5%, is

$4,697.8 million.

e. The data in Exhibit 12.G show that the present value at the start of Year +1 of the

continuing free cash flows for common equity in Years +6 and beyond amounts to

$41,201.0 million [$2,661.7 million/(0.0750 – 0.0300) × 0.697].

f. The data in Exhibit 12.G show the following computations:

(1) The sum of the present value of free cash flows for common equity is $45,898.9

million ($4,697.8 million + $41,201.0 million).

(2) After adjusting the sum of the present value using the mid-year discounting

adjustment factor of 1.0375 (1 + 0.0750/2), the total present value of free cash

flows for common equity is $47,620.1 million.

(3) The per share value estimate for Starbucks, after dividing the total present value

by the 749.3 million shares outstanding, equals $63.55.

This value agrees with the value we computed in Chapter 11 using the dividends

valuation approach.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-29

in whole or in part.

Part II—Computing Starbucks’ Share Value Using Free Cash Flows to All Debt and

Equity Stakeholders

g. You can use the Starbucks case to demonstrate computing weighted-average cost of

capital. We assume that Starbucks will retire the minor amount of noncontrolling

interests at the beginning of Year +1. Therefore, Starbucks’ capital structure at the

beginning of Year +1 consists of the following amounts and proportions:

Amount Weight

Debt $549.6 million 0.014

Common Equity $37,577 million = $50.15 per share ×

749.3 million shares

0.986

Total $38,126.6 million 1.000

The equation presented in Chapter 12 for computing weighted-average cost of capital

is as follows:

RA = [wD × RD × (1 – tax rate)] + [wP × RP] + [wNCI × RNCI] + [wE × RE]

Starbucks faces a 6.25% interest rate on this debt and a 33.0% tax rate. Using this

equation, Starbucks’ weighted-average cost of capital at the end of 2012 is computed

as follows:

RA = [0.014 × 6.25 × (1 – 0.33)] + [0.986 × 7.50]

= 0.06 + 7.39 = 7.45%

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-30

in whole or in part.

Exhibit 12.G

Free Cash Flows for Common Equity Valuation for Starbucks

(amounts in millions except per share amounts; allow for rounding)

(Integrative Case 12.1)

Continuing

1 2 3 4 5 Value

Free Cash Flows for Common Equity Year +1 Year +2 Year +3 Year +4 Year +5 Year +6

Net Cash Flow from Operations 2,603.2 2,558.5 3,180.9 3,380.7 3,900.8 3,248.0

Decrease (Increase) in Cash Required for Operations –41.2 –147.7 –159.6 –168.0 –184.2 –56.7

Net Cash Flow from Investing –1,373.1 –1,527.2 –1,697.0 –1,873.1 –2,071.1 –529.6

Net CFs from Debt Financing 0.0 0.0 0.0 0.0 –549.6 0.0

Net CFs into Financial Assets 0.0 0.0 0.0 0.0 0.0 0.0

Net CFs – Pref. Stock and Noncontrolling Interests –5.5 0.0 0.0 0.0 0.0 0.0

Free Cash Flow for Common Equity 1,183.4 883.6 1,324.3 1,339.6 1,095.8 2,661.7

Present Value Factors 0.930 0.865 0.805 0.749 0.697

Present Value Free Cash Flows 1,100.8 764.6 1,066.0 1,003.1 763.3

Sum of Present Value Free Cash Flows 4,697.8

Present Value of Continuing Value 41,201.0

Total 45,898.9

Adjust to midyear discounting 1.0375

Total Present Value Free Cash Flows to Equity 47,620.1

Shares Outstanding 749.3

Estimated Value per Share $ 63.55

Current share price $ 50.15

Percent difference 27%