978-1285190907 Chapter 12 Part 4

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Chapter 12

Valuation: Cash-Flow-Based Approaches

12-31

in whole or in part.

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

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

projected free cash flows to all debt and equity stakeholders. The first rows of the

table present the computations for Starbucks’ 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 $64.44, which differs slightly from the value estimate of $63.55 in

Solution f above.

The share value estimate from Solution f is slightly different from the share value

estimate from Solution l. In computing weighted average cost of capital in Solution g,

we determined the weight of equity using the market price of Starbucks’ stock at the

time. Our share value estimates from Solution f and l likely 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.

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 $2,603.2 $2,558.5 $3,180.9 $3,380.7 $3,900.8

Add Back: Interest Expense after Tax 23.0 23.0 23.0 23.0 11.5

Subtract: Interest Income after Tax 0.0 0.0 0.0 0.0 0.0

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

Operations

–41.2

–147.7

–159.6

–168.0

–184.2

Free Cash Flow from Operations $ 2,585.0 $2,433.8 $3,044.4 $3,235.7 $3,728.0

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

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

Free Cash Flow—All Debt and Equity $ 1,211.9 $ 906.6 $1,347.3 $1,362.6 $1,656.9

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

follows:

Year +6

Net Cash Flow from Operations $3,248.0

Add Back: Interest Expense after Tax 11.9

Subtract: Interest Income after Tax 0.0

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

Free Cash Flow from Operations $3,203.2

Net Cash Flow from Investing –529.6

Add Back: Cash Flows into Financial Assets 0.0

Free Cash Flow—All Debt and Equity $ 2,673.6

Chapter 12

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in whole or in part.

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

all debt and equity stakeholders for Starbucks for Years +1 through +5, discounted at

a weighted-average cost of capital of 7.45%, is $5,177.9 million.

k. The data in Exhibit 12.H 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 $41,921.4 million [$2,673.6 million/(0.0745 – 0.03) × 0.698].

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

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

stakeholders is $47,099.3 million ($5,177.9 million + $41,921.4 million).

(2) Subtracting the value of debt provides the present value of equity, which is

$46,549.7 million ($47,099.3 million – $549.6 million).

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

adjustment factor of 1.03725 (1 + 0.0745/2), the total present value of free cash

flows for all debt and equity stakeholders is $48,284.2 million.

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

by the 749.3 million shares outstanding, equals $64.44.

m. This value estimate is very similar to the value estimate of $63.55 in Solution f above.

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Valuation: Cash-Flow-Based Approaches

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in whole or in part.

EXHIBIT 12.H

Valuation of Starbucks’ Free Cash Flows for All Debt and Equity Stakeholders

(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 All Debt and 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

Add back: Interest Expense after tax 23.0 23.0 23.0 23.0 11.5 11.9

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

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

Free Cash Flow from Operations 2,585.0 2,433.8 3,044.4 3,235.7 3,728.0 3,203.2

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

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 1,211.9 906.6 1,347.3 1,362.6 1,656.9 2,673.6

Present Value Factors 0.931 0.866 0.806 0.750 0.698

Present Value Free Cash Flows 1,127.9 785.2 1,086.0 1,022.1 1,156.7

Sum of Present Value Free Cash Flows 5,177.9

Present Value of Continuing Value 41,921.4

Total Present Value Free Cash Flows to Equity and Debt 47,099.3

Less: Value of Outstanding Debt –549.6

Less: Value of Preferred Stock 0.0

Plus: Value of Financial Assets 0.0

Present Value of Equity 46,549.7

Adjust to midyear discounting 1.0373

Total Present Value of Equity 48,284.2

Shares Outstanding 749.3

Estimated Value per Share $ 64.44

Current share price $ 50.15

Percent difference 28%

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-34

in whole or in part.

Part III—Sensitivity Analysis and Recommendation

n. The data in Exhibit 12.I show the results of various sensitivity analysis scenarios,

varying discount rates and growth rates.

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

above, and that Starbucks’ required rate of return on equity is 1 percentage point

higher than the rate computed using the CAPM in Solution a (that is, 8.50%), the

resulting share value estimate falls to $45.25 per share, which is 29% lower than our

base case value estimate of $63.55 and 10% below current market price of $50.15.

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

above, and that Starbucks’ required rate of return on equity is 1 percentage point

lower than the rate computed using the CAPM in Solution a (that is, 6.50%), the

resulting share value estimate increases to $110.92 per share. This value is 75%

above our base case value estimate of $63.55 and 121% above the current market

price of $50.15.

o. At the start of Year +1, Starbucks’ share price was $50.15. Our baseline share value

estimate is $63.55, implying that Starbucks’ shares are under-priced by roughly 27%.

Sensitivity analyses reveal that slight variations in the long-term growth rate and

discount rate can cause the share value estimate to vary between $45 per share (10%

below the current price) up to $110 per share (more than double the current price). If

our forecast and valuation assumptions are reasonable, the current share price falls

below the middle of the value estimate range. We would have recommended that

investors buy Starbucks shares at roughly $50 per share.

p. The value estimates we have obtained in this case using the free cash flows to equity

valuation approach are identical to the value estimate we obtained in Chapter 11

using the dividends valuation approach. You can use this insight to reinforce to

students that the two approaches should be equivalent.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-35

in whole or in part.

Exhibit 12.I

Free Cash Flows for Common Equity Valuation for Starbucks

(Integrative Case 12.1)

Free Cash Flows Valuation Sensitivity Analysis:

Long-Run Growth Assumptions

63.55 0% 2% 3% 4% 5% 6% 8% 10%

Discount 5% 68.44 104.48 149.53 284.68

Rates: 6% 55.89 76.88 97.87 139.84 265.78

6.5% 51.08 67.70 83.14 110.92 175.75 499.87

7.50% 43.43 54.41 63.55 77.93 103.80 164.17

8.5% 37.62 45.25 51.14 59.66 73.03 97.11 434.25

9% 35.21 41.67 46.50 53.28 63.44 80.38 215.88

10% 31.15 35.87 39.25 43.75 50.05 59.50 106.75

11% 27.84 31.39 33.83 36.97 41.15 47.01 70.43 187.55

12% 25.12 27.84 29.65 31.91 34.83 38.71 52.31 93.10

13% 22.83 24.95 26.32 28.01 30.11 32.81 41.46 61.65

14% 20.89 22.56 23.62 24.90 26.46 28.41 34.26 45.95

15% 19.22 20.55 21.39 22.37 23.55 25.00 29.13 36.56

18% 15.40 16.11 16.54 17.03 17.59 18.25 19.96 22.52

20% 13.54 14.02 14.31 14.63 14.99 15.40 16.44 17.89

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-36

in whole or in part.

Case 12.2

Holmes Corporation: LBO Valuation

I. Case Objectives and Questions

A. Identify attractive and unattractive characteristics of an LBO candidate.

B. Identify appropriate assumptions for projecting financial statements.

C. Illustrate the computation of the purchase price using a present-value-of-cash-

flows-based approach.

D. Illustrate the computation of the purchase price using the residual income

approach.

E. Illustrate the computation of the purchase price using price-earnings ratios and

market-to-book ratios.

F. Demonstrate how the purchase price and financing package for an LBO

interrelate. Assess a justifiable purchase price for the acquisition.

II. Teaching Strategy

We have followed two approaches to teaching this case and both have worked well.

One approach is to assign the preparation of projected financial statements with

Chapter 10, the valuation using the present value of projected cash flows with

Chapter 12, the valuation using residual income with Chapter 13, and the valuation

using market multiples of earnings and book values with Chapter 14. A second

approach is to use the case in its entirety as a synthesis after covering Chapters 10–

14. We tend to prefer the first approach because the case is sufficiently rich to use

over several class periods. We spend approximately one hour on the first question,

identifying the characteristics that make Holmes an attractive and unattractive LBO

candidate. Students are generally surprised at the number of insights that the

financial statements and notes can provide about a firm. This discussion is an

excellent setup for the projection of financial statements. We devote approximately

90 minutes of class time to the preparation of projected financials and valuation

using the present value of future cash flows. We devote approximately 60 minutes

of class time on the residual income approach and valuation using market multiples.

We synthesize the various valuation approaches in approximately 30 minutes of

class.

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in whole or in part.

III. Holmes as an LBO Candidate

A. Factors that make Holmes an attractive LBO candidate

1. No short- or long-term debt. The lack of debt provides Holmes with unused

debt capacity that could be used to help finance the LBO. Ask students why

Holmes would have no debt on its balance sheet. Students should see that

Holmes is not in need of additional financing. The statement of cash flows

shows that Holmes recently completed the repayment of debt. Its cash flow

from operations exceeds its capital expenditures. It is paying out significant

dividends. Customers provide advance payments on contracts, so Holmes

does not need substantial financing for accounts receivable.

2. Positive taxable income to take advantage of interest tax shields. The buyers

would like to get immediate tax savings from interest deductions on the

LBO financing. Note E indicates that Holmes paid approximately $3.6

million in income taxes during the last two years. At a 37.5% tax rate, this

suggests approximately $9.6 million ($3.6/0.375) of available taxable

income to shield interest expense deductions.

3. Despite management’s statements about the importance of having a

technological edge, investment in R&D does not appear to be critical. R&D

to sales was approximately 0.4% ($467,733/$109,373,718) in Year 14 and

0.5% ($479,410/$102,698,836 in Year 15). Rapid technology changes

require continuing investments in R&D, which use cash that could otherwise

be used to service debt financing. Rapid technological change also can make

current products obsolete and cause operating cash flows to diminish.

4. Highly liquid assets. Holmes could probably sell its accounts receivable and

at least part of its inventories quickly (inventories of large cranes are

probably unique to particular customers’ needs) if it needed cash to service

debt payments coming due.

5. Dividends that the company could cut. Holmes will be privately held after

the LBO. The purchasers would prefer not to take out dividends, which are

taxed immediately at ordinary income rates. Rather, they would prefer to

allow Holmes to retain the earnings to fund future growth. The purchasers

could later sell their common shares and be taxed at capital gain rates.

6. No apparent “golden parachutes.” No large payments need to be paid to

current management or shareholders if the buyout group successfully

completes the LBO. Such payments require cash that could otherwise be

used to service LBO debt.

7. Excellent growth and profitability record, despite cyclicality of Holmes’

industry.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-38

in whole or in part.

8. Relatively low level of fixed costs (approximately $1.7 million of $90

million operating costs), so not much operating leverage. High operating

leverage coupled with cyclical demand could result in sharp decreases in

operating profitability and cash flows and prevent the firm from servicing its

debt during the downturn.

9. Selling for only seven to eight times earnings despite rapid growth

experience.

10. Could shift to LIFO to save taxes. LIFO charges the most recent costs to

cost of goods sold, whereas FIFO charges the oldest costs to cost of goods

sold. With inflation, LIFO’s cost of goods sold exceeds FIFO’s cost of

goods sold and provides lower taxable income, thereby saving taxes.

11. Has approximately a nine-month backlog of orders.

12. Managerial expertise probably not critical to running this business. The

business is essentially an assembly operation for relatively standard

products. Thus, if management does not stay, it would not be a big loss.

13. Has two identifiable segments, making breakup of Holmes easier if

necessary. If purchasers are unable to make the required debt service

payments, they might sell one or the other product divisions to generate

cash.

14. Has an overfunded pension plan when pension liabilities are measured using

the accumulated benefit obligation. The purchasers might revert the excess

cash back to Holmes to help service debt. However, the tax on such

reversions is sufficiently high that most firms would not revert the excess

funds.

B. Factors that make Holmes an unattractive LBO candidate

1. Fixed assets 61% depreciated ($9,703/$15,876), so may need to replace

fixed assets soon. Such replacements require cash that otherwise could be

used to service debt.

2. Fixed assets have increased 5% compounded annually, while sales have

increased 25.5% annually over last five years. Perhaps Holmes is

approaching capacity and will need to replace its fixed assets soon to

maintain growth.

3. Sales subject to cyclical swings in the economy. Holmes may have difficulty

servicing its debt during the down times in the business cycle.

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-39

in whole or in part.

4. Not clear how long cutback in capital expenditures in the economy will last.

5. Much of sales growth has recently come from abroad (21.4% of Year 14

sales from abroad; 29.7% of Year 15 sales from abroad). An increasing

value to the U.S. dollar could dampen these sales increases.

6. Most of cash represents customer advances that company should not use to

finance an LBO.

7. Several union contracts due for renegotiation in the next 15 months. Ask

students whether it is preferable to have a unionized or a nonunionized work

force in an LBO firm. The advantage of a nonunionized work force is that

employees are not organized and are less likely to strike. A strike could

jeopardize the firm’s ability to service its LBO debt. On the other hand, a

unionized work force with a contract in place enhances the predictability of

future cash flows for compensation and makes cash planning to service LBO

debt easier.

8. Nature of company’s technological edge in foreign markets unclear. Given

the low level of R&D, any technological edge could quickly dissipate if

other firms are able to duplicate the technology in foreign markets. Note that

Holmes does not suggest that it has any technology advantage in domestic

markets.

IV. Projecting Future Financial Statements

A. The first step in projecting future financial statements is to project sales. Sales

have grown at a compound annual growth rate of 25.5% over the last five years.

However, sales decreased between Year 14 and Year 15. The backlog is also

down at the end of Year 15 relative to the previous two years. It appears that

Holmes used some of its backlog during Year 15 just to keep sales from

declining still further. One generally takes a conservative view on growth when

analyzing an LBO because of the substantial leverage involved. Assume a 5%

growth rate in sales in this case.

B. The next step is to determine the cost structure of Holmes.

Cost of Goods Sold (CGS) Year 13/Year 14 Year 14/Year 15

Variable Cost:

Change in CGS

Change in Sales

0.76756

045,33$

364,25$ =0.76476

$6,674

$5,104 =

−

Chapter 12

Valuation: Cash-Flow-Based Approaches

12-40

in whole or in part.

Fixed Costs:

Total Costs – Variable Cost $1,414 $1,720

Selling and Administrative

(S&A) Year 13/Year 14 Year 14/Year 15

Variable Costs:

Change in S&A

Change in Sales

Fixed Costs:

Total Costs – Variable Cost –$124 –$8,314

Cost of goods sold and selling and administrative expenses are virtually

completely variable costs in their behavior. The cost function for selling and

administrative expenses obviously shifted between Year 14 and Year 15

because the fixed cost amount is negative. Use the following cost structure to

make projections:

Variable Cost Fixed Cost

Cost of Goods Sold ……………. 78% of Sales $0

Selling and Administrative …. 12% of Sales $0

C. Assume an income tax rate of 37.5%, approximately equal to the effective tax

rate during Year 15. This tax rate includes both federal and state taxes.

D. Exhibit 12.J presents a partial projected income statement.

0.1238

$33,045

4,091 $ =0.19868

$6,674

$1,326 =

−