Chapter 14: Security Structures and Determining Enterprise Values
196
2019) before settling down to a long-run growth rate of 7 percent annually. The cost
of goods sold is expected to vary with sales. Operating expenses are expected to
grow at 75 percent of the sales growth rate (i.e., be semi-fixed) for the next three
years before again growing at the same rate as sales beginning in 2020. Interest
expense is expected to grow with sales. Depreciation can be forecasted either as a
percentage of sales or as a percentage of net fixed assets (since net fixed assets are
expected to grow at the same rate as sales growth). Individual asset accounts are
expected to grow at the same rate as sales. Accounts payable and accrued liabilities
are also expected to grow with sales.
Because Datametrix is in its start-up life cycle stage, management and venture
investors believe that 35 percent is an appropriate weighted average cost of capital
(WACC) discount rate until the firm reaches its long run or perpetuity growth rate.
At that time it will have survived, recapitalized its capital structure, and will become
a more typical firm in the industry with an estimated WACC of 18 percent. Calculate
Datametrix’s enterprise value as of the end of 2016. Also indicate what the equity
would be worth.
_________________________________
Datametrix Corporation
Income Statement for December 31, 2016
(Thousands of Dollars)
__________________________________
Sales $20,000
Cost of goods sold -10,000
Gross profit 10,000
Operating expenses -7,500
Depreciation -400
EBIT 2,100
Interest -100
EBT 2,000
Taxes (40%) -800
Net income $1,200
______________________________________________________________________________
Datametrix Corporation
Balance Sheet as of December 31, 2016
(Thousands of Dollars)
______________________________________________________________________________
Cash $ 1,000 Accounts payable $ 1,500
Accounts receivable 2,000 Accrued liabilities 1,000
Inventories 2,000 Total current liabilities 2,500
Total current assets 5,000 Long-term debt 1,000
Gross fixed assets 5,400 Common stock 5,300
Accumulated depreciation 400 Retained earnings 1,200
Net fixed assets 5,000 Total equity 6,500
Total assets $10,000 Total liabilities & equity $10,000
Chapter 14: Security Structures and Determining Enterprise Values
198
DATAMETRIX, INC. [Enterprise Valuation Method]
Ch 14, Prob 16 Actual Projected ——–––––—–––––––––––––––—––––––––––––––>I
Percent Sales Increase-——-> 30.0% 30.0% 30.0% 7.0%
% of 2016 [Thousands of Dollars]
Income Statements Sales 2016 2017 2018 2019 2020
Sales 100.0% 20000 26000 33800 43940 47016
Cost of goods sold –50.0% –10000 –13000 -16900 –21970 –23508
Gross profit 50.0% 10000 13000 16900 21970 23508
Operating expenses –7500 –9188 –11255 –13787 –14752
Depreciation –2.0% -400 –520 –676 -879 –940
EBIT 2100 3293 4969 7304 7816
Interest -0.5% –100 –130 -169 -220 –235
EBT 2000 3163 4800 7085 7580
Taxes (40%) –800 -1265 -1920 -2834 -3032
Net income 1200 1898 2880 4251 4548
Balance Sheets
Cash 5.0% 1000 1300 1690 2197 2351
Surplus cash 0 –53 293 1248 4797
Accounts receivable 10.0% 2000 2600 3380 4394 4702
Inventories 10.0% 2000 2600 3380 4394 4702
Total current assets 5000 6448 8743 12233 16550
Gross fixed assets 5400 7420 10046 13460 15169
Accumulated depreciation –400 -920 –1596 –2475 –3415
Net fixed assets 25.0% 5000 6500 8450 10985 11754
Total assets 50.0% 10000 12948 17193 23218 28304
Accounts payable 7.5% 1500 1950 2535 3296 3526
Accrued liabilities 5.0% 1000 1300 1690 2197 2351
Total current liabilities 2500 3250 4225 5493 5877
Long-term debt 1000 1300 1690 2197 2351
Common stock 5300 5300 5300 5300 5300
Chapter 14: Security Structures and Determining Enterprise Values
199
DATAMETRIX, INC. [Enterprise Valuation Method]
Work Sheet for Estimating Free Cash Flows to the Enterprise:
2016 2017 2018 2019 2020
Income Statement Flows:
NOPAT 1976 2982 4383 4689
Depreciation 520 676 879 940
Required Net Working Capital:
Required Cash 1000 1300 1690 2197 2351
Accounts Receivable 2000 2600 3380 4394 4702
Inventories 2000 2600 3380 4394 4702
Accounts payable -1500 -1950 -2535 –3296 –3526
Accrued liabilities –1000 –1300 –1690 –2197 –2351
Required NWC 2500 3250 4225 5493 5877
Increase in Required NWC 750 975 1268 384
Capital Expenditures (CAPEX):
Net fixed assets 5000 6500 8450 10985 11754
Increase in net fixed assets 1500 1950 2535 769
Depreciation 520 676 879 940
Increase in gross fixed assets 2020 2626 3414 1709
Free Cash Flows to Enterprise:
2016 2017 2018 2019 2020
NOPAT 1976 2982 4383 4689
Total Free Cash Flows to Enterprise –275 57 32724
PV of Operations (35% disc rate) $13,128
Plus: Existing Surplus Cash $0
Per Share Value (1 million shares) $12.13
Chapter 14: Security Structures and Determining Enterprise Values
200
MINI CASE: WOK YOW IMPORTS, INC.
Wok Yow Imports, Inc., is a rapidly growing, closely held corporation that imports and
sells oriental style furniture and accessories at several retail outlets. The equity owners
are considering selling the venture and want to estimate the enterprise or entity value and
then determine the value of the venture’s equity. Following is last year’s income
statement (2016) and projected income statements for the next four years (2017-2020).
Sales are expected to grow at an annual 6 percent rate beginning in 2021 and thereafter.
Actual Projected ———————————————-—
[$ Thousands] 2016 2017 2018 2019 2020
Net Sales $150.0 $200.0 $250.0 $300.0 $350.0
Cost of Goods Sold -75.0 -100.0 -125.0 -150.0 -175.0
Gross Profit 75.0 100.0 125.0 150.0 175.0
SG&A Expenses -30.0 -40.0 -50.0 -60.0 -70.0
Depreciation -7.5 -10.0 -12.5 –15.0 -17.5
EBIT 37.5 50.0 62.5 75.0 87.5
Interest -3.5 -3.5 -3.5 -3.5 -3.5
EBT 34.0 46.5 59.0 71.5 84.0
Taxes (40% rate) -13.6 -18.6 -23.6 -28.6 -33.6
Net Income 20.4 27.9 35.4 42.9 50.4
Selected balance sheet accounts at the end of 2016 are as follows: Required cash,
accounts receivable, and inventories accounts totaled $50,000, net fixed assets were
$50,000, and accounts payable and accruals totaled $25,000. Each of these balance sheet
accounts was expected to grow with sales over time. Long-term debt was $30,000 and
there were 10,000 shares of common stock outstanding at the end of 2016.
Data have been gathered for a “comparable” publicly traded firm, Fine Furniture
Products, in Wok Yow’s industry. Fine Furniture’s risk index is judged to be 2.00
compared to a risk index of 1.00 for firms of average riskiness. Management believes
that a 2.00 adjustment factor should be multiplied times the expected market risk
premium for average firms to reflect Wok Yow’s (and Fine Furniture’s) relatively greater
riskiness. Wok Yow’s long-term debt to long-term capital (long-term debt plus equity)
ratio was 40 percent at the end of 2016. The interest rate on long-term U.S. government
bonds is 7 percent, Wok Yow could issue new long-term debt at a 12 percent rate, and the
average expected market risk premium (common stocks over government bonds) is 7.5
percent for average firms.
A. Project Wok Yow’s net operating profit after-tax (NOPAT) statements for 2017-
2021.
Chapter 14: Security Structures and Determining Enterprise Values
201
B. Determine the annual increases in required net working capital and capital
expenditures (CAPEX) for Wok Yow for the years 2017 through 2021.
and 25.5 (2021).
C. Project annual operating free cash flows to the entity for the years 2017 through
2021.
D. Management initially thought that an 18 percent discount rate was reasonable.
Estimating an appropriate required rate of return on an equity investment is
critical to the valuation effort. For very early stage ventures, various VC “rules-of
E. Use the information from Part D above to estimate Wok Yow’s terminal value
cash flow at the end of 2020.
The terminal value cash flow is estimated to be 376.3 and is calculated by
F. Estimate the firm’s enterprise or entity value at the end of 2016.
G. Adjust the enterprise value to determine Wok Yow’s equity value in dollars and on
a per share basis at the end of 2016.
Chapter 14: Security Structures and Determining Enterprise Values
202
H. Now, estimate Wok Yow’s after-tax cost of long-term debt. Use the risk free rate,
the expected market risk premium, and the risk index for the Fine Furniture
Company to estimate Wok Yow’s cost of equity capital. Determine Wok Yow’s
weighted average cost of capital (WACC).
I. Re–estimate Wok Yow’s enterprise value using the WACC calculated in Part H.
Then, adjust the enterprise value to determine Wok Yow’s equity value in dollars
and on a per share basis at the end of 2016.
Chapter 14: Security Structures and Determining Enterprise Values
204
WOK YOW IMPORTS, INC.
Enterprise (Entity) Valuation Solution [Parts H and I]:
Percent Change in Net Sales
% of 33.3% 25.0% 20.0% 16.7% 6.0%
[Thousands of Dollars] 2016 Actual Pro forma ——–————————————————
NOPAT Statements Sales 2016 2017 2018 2019 2020 2021
Net Sales 100.0% 150.0 200.0 250.0 300.0 350.0 371.0
Cost of Goods Sold -50.0% -75.0 –100.0 –125.0 -150.0 -175.0 -185.5
Gross Profit 50.0% 75.0 100.0 125.0 150.0 175.0 185.5
SG&A Expenses -20.0% -30.0 –40.0 -50.0 -60.0 -70.0 -74.2
Depreciation –5.0% -7.5 –10.0 -12.5 –15.0 -17.5 –18.6
EBIT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8
Interest 0.0% 0.0 0.0 0.0 0.0 0.0 0.0
EBT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8
Taxes (40% rate) -10.0% -15.0 –20.0 -25.0 –30.0 -35.0 –37.1
NOPAT 15.0% 22.5 30.0 37.5 45.0 52.5 55.7
Increase in NFA 16.7 16.7 16.7 16.7 7.0
Plus: Depreciation 10.0 12.5 15.0 17.5 18.6
CAPEX 26.7 29.2 31.7 34.2 25.5
Terminal Value CF (r = .161, g = .06) 447.1
Total Free Cash Flows (TFCF) 5.0 12.4 20.0 474.6
PV of TFCF (16.1% Discount Rate) $270.1
Value Per Share (10,000 shares) $24.01
Cost of Capital Worksheet:
Chapter 14: Security Structures and Determining Enterprise Values
205
MINI CASE 2: RxDELIVERY SYSTEMS, INC. (Revisited)
RxDelivery Systems is an R&D venture specializing in the development and testing of
new drug delivery technologies. The market for alternative drug delivery systems grew
rapidly during the past several years. Driving factors behind this growth include efforts
to reduce drug side effects through site-specific delivery, the need to maintain the activity
of new biopharmaceutical compounds, and the extension of drug patent life. Improved
drug delivery methods are expected to reduce the number of surgical interventions and
the length of hospital stays, and improve patient compliance in taking prescribed drugs.
The world market for biopharmaceuticals (including peptide, protein, RNA, and
DNA drugs) was more than $50 billion in 2013. Sales of polymer-based drug delivery
systems are forecasted to exceed $2.0 billion in 2020. Pulmonary delivery systems
currently account for one-third of the drug delivery market and sales are projected to
exceed $25 billion by 2020.
RxDelivery Systems believes it can compete effectively in both the polymer-
based and pulmonary drug delivery areas. The venture’s delivery technology is expected
to utilize hydrophobic ion pairing and supercritical carbon dioxide precipitation to
incorporate water soluble drug molecules into biodegradable controlled-release
microspheres. The resulting microspheres will take the form of dry powders and will
contain drug molecules small enough to allow for intravenous, intranasal, or pulmonary
delivery. It is anticipated that this technology will be incorporated into products for
controlled release applications including treatment of cancer, infectious diseases, and
gene therapy.
RxDelivery Systems, through an agreement with its pharmaceutical parent, a
major drug company, will initially operate as an independent corporation but will be
merged into the parent at the end of its second year. At that time, RxDelivery Systems’
entrepreneurial team will be paid a lump sum of $2,500,000 as the terminal value for the
venture. Following are limited financial statement projections for the next two years for
the RxDelivery Systems Corporation:
First year revenues $12,500
Second year revenues $16,000
Expenses (including depreciation) $125,000 per year
Initial time-zero (net) fixed assets $50,000
Depreciation 10% of beginning-of-year net fixed assets
Accounts Payable (Yr. 1 and 2) $750
Inventories (Yr. 1 and 2) $0
Corporate marginal tax rate 30%
Accounts Receivable (Yr. 1 and 2) $0
Accrued Expenses (Yr. 1 and 2) $300
Required Cash $3000
Debt (all years) $0
Chapter 14: Security Structures and Determining Enterprise Values
206
A. Construct the venture’s balance sheet at startup. Then construct financial statements
for Years 1 and 2. [Put initial fixed asset investments in Year 0 and initial working
capital investments in Year 1. Assume the initial $50,000 is equity financed.]
See spreadsheet below.
B. Construct the enterprise valuation cash flows including the $2,500,000 terminal
payment. Treat existing liabilities at the terminal time as though the pharmaceutical
firm assumes them. (The $2,500,000 is “free and clear.”) Strip all non-required cash
out of net working capital (effectively declaring a pseudo dividend).
See spreadsheet below.
C. What is the value of the enterprise at time 0 assuming a discount rate of 30%??
The venture has no debt and therefore WACC is the same as the discount rate for
equity.
See spreadsheet below.
D. What is the value of the equity at time 0?
See spreadsheet below.
E. Why does this value differ from the value for the equity method in the RxDelivery
Systems mini case at the end of Chapter 10?
The venture has no debt and therefore WACC is the same as the discount rate for
Chapter 14: Security Structures and Determining Enterprise Values
207
Income Statements Year 1 Year 2
Valuation (PDM) (Surplus Cash is Zero for Valuation Purposes)
Revenue 12,500 16,000 Year 0 Year 1 Year 2
Expenses Including Depreciation -125,000 -125,000 NI 0 -112,500 –109,000
EBIT -112,500 -109,000 +Dep 0 5,000 4,500
-Interest 0 0 -Capex -50,000 0 0
EBT -112,500 -109,000 -dNWC 0 -1,950 0
– Cash Taxes 0 0 +Principal Proc. 0 0 0
Net Income -112,500 –109,000 Equity VCF -50,000 –109,450 -104,500
Terminal Flow 2,500,000
Depreciation 5,000 4,500 Total Flow -50,000 –109,450 2,395,500
NPV 1,283,263
Balance Sheets Startup Year 1 Year 2
Assets Valuation (DDA) (Surplus Cash Situation Affects Terminal Flow)
Required Cash 0 3,000 3,000 Year 0 Year 1 Year 2
Surplus Cash 0 –109,450 -213,950 NI 0 -112,500 -109,000
Gross Fixed Assets 50,000 50,000 50,000 +Dep 0 5,000 4,500
Accumulated Depreciation 0 -5,000 -9,500 -Capex -50,000 0 0
Net Fixed Assets 50,000 45,000 40,500 -dNWC 0 107,500 104,500
Total Assets 50,000 -61,450 –170,450 +Principal Proc. 0 0 0
Liabilities and Equity Equity VCF -50,000 0 0
Accounts Payable 750 750 Terminal Flow 2,286,050
Accrued Expenses 300 300 Total Flow -50,000 0 2,286,050
Debt 0 0 0
Equity 50,000 -62,500 –171,500 NPV 1,302,692
Total L+E 50,000 -61,450 –170,450
Sum
Accounting Cash Flows Year 0 Year 1 Year 2 Difference in EqCF 0 109,450 -109,450 0
NI 0 –112,500 -109,000 NPV of Difference 19,429
+Depr 0 5,000 4,500 DDA Value Increase 19,429 (=1,302,263-1,283,263)
-dAR 0 0 0 due to timing differences on surplus cash
-dInv 0 0 0
+dAP 0 750 0
+dAccrd 0 300 0
-Capex -50,000 0 0
+Principal 0 0 0
-Dividend 50,000 0 0
Acct CF 0 –106,450 -104,500
Beg Cash 0 0 -106,450
End Cash 0 –106,450 -210,950
The enterprise valuation approach is:
Terminal Flow 250,000
Total Enterprise Flow -5,000 -10,945 239,550
NPV @ 30% 128,326
-Market Value ‘ Debt’ 0