Chapter 12
Valuation: Cash-Flow-Based Approaches
12-41
in whole or in part.
Exhibit 12.J
Partial Projected Income Statements for Holmes Corporation
(amounts in thousands)
Income Statement
Y
ear 15 Year 16 Year 17 Year 18 Year 19 Year 20
Sales Revenue: 102,699 107,834 113,226 118,887 124,831 131,073
Assumptions:
Growth Rate of Sales 5% 5% 5% 5% 5%
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-42
in whole or in part.
E. The next step is to project the balance sheet. Make the following assumptions:
Cash: Plug to equate projected assets and liabilities plus shareholders’ equity.
Accounts Receivable: Grow at the growth rate in sales.
Exhibit 12.K shows a projected balance sheet based on these assumptions.
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-43
in whole or in part.
Exhibit 12.K
Partial Projected Balance Sheets for Holmes Corporation
(amounts in thousands)
Balance Sheet Year 15 Year 16 Year 17 Year 18 Year 19 Year 20
Assets
Cash 3,857 12,494 18,424 24,650 31,187 38,051
Marketable Securities 2,990 0 0 0 0 0
Accounts Receivable 14,303 15,018 15,769 16,558 17,385 18,255
Liabilities & S.E.
Accounts Payable 4,400 4,620 4,851 5,094 5,348 5,616
Assumptions
Cash Plug
Accounts Receivable Sales Growth Rate
Inventory Sales Growth Rate
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-44
in whole or in part.
F. Next, project the operating and investing sections of the statement of cash flows
and calculate free cash flow to all debt and equity stakeholders. Assume that
depreciation grows at the growth rate in fixed assets and that changes in Other
Noncurrent Liabilities are operating activities. Exhibit 12.L presents the
amounts.
V. Establishing the Purchase Price
1. Continuing Value—Revenues are projected to grow at a compound annual
growth rate of 5% between Year 15 and Year 20. (See Exhibit 12.J.) An
revenue growth decays over time toward the long-run growth rate of the
bid.
2. Cost of Capital—Question c. indicates the mix of financing and the interest
rates on the debt. The combined federal and state income tax rate is 37.5%.
We use this rate in calculating the after-tax cost of debt capital.
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-45
in whole or in part.
Exhibit 12.L
Partial Projected Statements of Cash Flows for Holmes Corporation
(amounts in thousands)
Cash Flow Statement Year 15 Year 16 Year 17 Year 18 Year 19 Year 20
Operations:
Net Income 6,602 6,740 7,077 7,430 7,802 8,192
Depreciation 643 675 709 744 782 821
Amortization 0 0 0 0 0 0
Cash Flow from Operations 8,854 6,631 6,963 7,311 7,676 8,060
Investing
Acquisition of Property, Plant, and
Equip.
Financing:
Inc/(Dec) in Short-Term Bor. 0 0 0 0 0 0
Assumptions:
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-46
in whole or in part.
3. The cost of equity capital is more problematic. The capital asset pricing
model requires an estimate of market equity beta. The case gives market
equity betas for four companies in similar industries. The market equity
betas range between 0.85 and 1.12, with a simple average of 0.96. However,
two companies. The calculation of unlevered equity betas and the resulting
equity beta for Holmes appear below:
Levered Unlevered
RateofValueMarket
RateTax Income11 ⎥
⎦
⎤
⎢
⎣
⎡⎟
⎟
⎠
⎞
⎜
⎜
⎝
⎛
−+
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-47
The valuation of Holmes assuming no growth in free cash flows to all debt
and equity capital stakeholders after Year 20 is as follows (keeping in mind
that this is quite a conservative forecast):
Free Cash Present Value Factor Present
Year Flowsa at 8.44% Values
16 $ — 0.92217 $ —
aFree cash flows from operations minus free cash flows from investing minus
increase in cash nets to zero for Year 16 to Year 20.
For an upper bound on valuation, we might assume that free cash flows to all
debt and equity capital stakeholders continue to increase at 5% per year
forever. The estimated market value of Holmes is as follows:
Free Cash Present Value Factor Present
Year Flow at 8.44% Values
16 $ — 0.92217 $ —
17 — 0.85040 —
5% to forecast the Year 21 amounts and then deriving the cash flow amount.
Chapter 12
Valuation: Cash-Flow-Based Approaches
12-48
A middle-of-the-road alternative growth assumption is that free cash flows to all
debt and equity capital stakeholders grow at 2.5% per year (about the long-run
rate of growth in the economy) forever. The estimated valuation of Holmes
following this set of assumptions is as follows:
Free Cash Present Value Factor Present
Year Flow at 8.44% Values
cash flow.
B. Residual Income Model
The projected financial statements indicate the forecasted net income for Year
16 to Year 20 and the amounts for common shareholders’ equity at the
income.
1. Valuation with no growth in earnings after Year 20
Present Value
Net Required Residual Factor at Present
Year Income Incomea Income 8.44% Value
16 $6,740 $2,481 $4,259 0.92217 $ 3,928