Business 30130

Christian Leuz

Financial Statement Analysis

Equity Valuation:
DCF, WACC and APV

ValuationReview
Valueofafirm
o Thesumofthepresentvaluesof
Netdebt(akaNetfinancialobligations)

Interestpayments

Principalrepayments
Equity

Dividends

Repurchases

Enterprisevalueif
yourdefinitionof
Netdebttreats
Cash/Equivalentsas
negativedebt

(Includestheterminaldividend/repurchase,
i.e.,capitalappreciationcomponent)

Dividenddiscountmodel(DDM)
Equityvalue=PVoffuturecashashareholdergetsbackfromtheir
investmentinthecommonstock
Let:
o AnnualfuturecashberepresentedbyD1,D2,
o Costofequityberepresentedbyre
Then,

t=0

t=1

t=2

t=3

D3
D1
D2
Equity value 0

...
1
2
3
(1 re ) (1 re ) (1 re )
Or,

Dt
t
t 1 (1 re )

Equity value 0

90
%

90
%

80
%

70
%

60
%

50
%

40
%

30
%

20
%

10
0%

<D
P<
=

<D
P<
=

<D
P<
=

<D
P<
=

<D
P<
=

<D
P<
=

<D
P<
=

<D
P<
=

<D
P<
=1
0%

<D
P<
=

80
%

70
%

60
%

50
%

40
%

30
%

20
%

10
%

0%

D
P=
0%

Number of Firm-Years

TheissuewithDDM
60,000

50,000

40,000

30,000

20,000

10,000

Dividend Payout (DP)

Overviewofcommonmethods

Dt
t
t 1 (1 re )

Valuation:

CashFlows

Earnings
Multiples

WACC
Method

Abnormal
Op.Earnings
P/E,etc.

APV
Method

Abnormal
Earnings
Cashflows
toequity
Method

M/B
Abnormal
ROE
PEG,other

Discountedcashflowvaluationmethods

OverviewofWACCandAPVmethods
Method

Flows

WACC

Free
Cash
Flows

APV

Free
Cash
Flows

DiscountFair
Rate
Value

Adjustments4

Result

WACC1

+Finassets Finoblig.=

CommonEquity

+Int.taxshield
+Finassets Finoblig.

CommonEquity

Ru2

NOA3
&Int.tax
shield
NOA3

1WACCistheWeightedAverageCostofCapital(alltypesofinvestedcapital,weightedbylongruntargeted

proportionsoftotalinvestedcapitalinmarketvalueterms)

2R
u

istheunleveredcostofequitycapital,reflectingtheriskofthenetoperatingassets

3NOAvalueisthefairvalueofthebundleofnetoperatingassetswhichgeneratestheFCF

4Theseadjustmentsaremadeintermsofthefairvalue

commonstock)atthevaluationdate

ofthefinancialassetsandfinancialobligations(otherthan

Discountedcashflowvaluationmethods
WACCMethod

WACCMethod Overview
1.ForecastFCF overforecasthorizon
2.Estimateweightedaveragecostofcapital(WACC)
3.UseWACCtoestimatePV ofFCFduringforecasthorizon
4.Estimateterminal(akacontinuing)value asofthevaluationdate
5.AddPVofFCFduringforecasthorizonandterminalvalue
i.e.,Fairvalueofnetoperatingassetsandtaxshieldoninterest

6.Addfairvalueoffinancialassets onvaluationdate
7.Subtractfairvalueoffinancialobligations (otherfinancialclaims)on
valuationdate
8.Divideby#ofsharesoutstandingonvaluationdatetoestimatepershare
value
9

WACCmethod Twokeyassumptions
1.Capitalstructureisexpectedtobestable
2.Taxsavingsoninterestexpenseswillberealizedwithoutdelay
i.e., adequatetaxableincometoabsorbinterestdeductionsandrealizethetax
benefitsofthedeductibilityofinterest

Ifcapitalstructureisnotexpectedtobestable,youneedtoestimateadifferentWACCeachtimethecapital
structureisforecastedtochange
o OnealternativeistousetheAPVmethodinsteadbecausetheAPVdiscountrateistheunleveredcostofequity
(i.e.,unaffectedbycapitalstructure)
IfthereareNOLcarryforwardsnoworinthefuture,estimatedWACCwillbetoolow(andhence,estimated
valuewillbetoohigh),becausetheWACCpresumestaxsavingsarerealizedwithoutdelay
o OnealternativeistousetheAPVmethodinstead
ExampleofanimproperuseofWACCmethod:LBOs
o ForLBOsthereisaclearchangeinexpectedcapitalstructureintheneartermandLBOsarefrequently
associatedwithNOLs
10

WACCMethod NOPLATinMcKinseyBook
Whenestimatingcashflowsfromfinancialstatementinformation,youcanstartin
multipleplaces:Netincome,EBITDA,EBITorCFO
Oneissueyoumustdealwithishowtaxesaretreated;
EasiesttoseethisinthinkingaboutNOPAT
NOPAT
o Bottomupcalculation
=NetIncomeplusaftertaxinterestexpenseminusaftertaxfinancialincome

o Topdowncalculation
=Operatingincome(EBIT)minustaxexpenseonEBIT

ThereisalsoasimilarmeasureusedintheMcKinseyvaluationbook:
o NOPLAT(NetOperatingProfitLessAdjustedTaxes)
o NOPLATisjustlikeNOPATexceptfortwothings:
1)adjustsforcashtaxesonoperatingincome
2)treatsdeferredtaxitemsasnonoperating(financial)items

o Aslongaswetreattaxexpenseanddeferredtaxitemsconsistently,wellgetthe
sameresultsusingNOPLATaswewouldusingNOPAT.Intheseslideswewilluse
NOPAT
11

WACCMethod
Step1:Illustrationoffreecashflowscalculation
IncomeStatement
2006
2007
Sales
2,663 2,830
COGS
<1,749> <1,993>
SG&A
<238>
<281>
Deprec.&amort.
<93>
<117>
Interestexpense
<37>
<75>
+Financialincome
87 184
Incometaxexpense
<230>
<199>
Netincome
403 349

CashFlowStatement
Netincome
349
PlusDeprec&amort
117

<13>
netdefdtaxliab
<184>
Minus:A/R
<3>
Inventory
<25>
Prepaidexp
74
Plus:A/P
<3>
Taxespayable
108
Otheraccexp
12
Otherncliab
CashfromOps
432
LTinvestments
<12>
Capitalexpenditures
<616>
Otherinvestments
<19>
CashfromInvesting
<647>
739
indebt
Dividends
<182 >
CashfromFinancing
557

BalanceSheet

Assets
Cash
A/R
Inventories
Prepaidexpenses
Totalcurrentassets
GrossPP&E
Accumulateddepreciation
NetPP&E
Longterminvestments
Otherassets(includingintangibles)
Totalassets

Liabilities&Stockholders'equity
CurrentportionofLTD
Notespayable
Accountspayable
Taxespayable
Otheraccruedexpenses
Totalcurrentliabilities
Longtermdebt
Deferredincometaxes
Othernoncurrentliabilities
Totalliabilities
Stockholders'Equity
TotalLiab&Stockholders'eq.

2006
144
409
286
13
852
1,851
<588>
1,263
390
150
2,655

2007
486
593
289
38
1,406
2,467
<699>
1,768
402
163
3,739

29
102
151
48
84
414
390
221
39
1,064
1,591
2,655

39
40
225
45
192
541
1,181
208
51
1,981
1,758
3,739

12

WACCMethod
Step1:Threewaystocomputefreecashflows(FCF)

Way#1:StartwithEBIT
Way#2:StartwithCashflowfromoperations
Way#3:StartwithNOPAT

13

WACCMethod
Way#1:BeginwithEBIT
EBIT(i.e.includesallpretaxearningsclassifiedasoperating)
TaxesonEBIT
=NOPAT
+Depreciation&amortization
=GrossCashFlows
Increaseinoperatingworkingcapital(includingoperatingcash)
Capitalexpenditures(netofdisposals)
Netexpendituresforotheroperatingassets(netofchangesinoperatingliabilities)
=FreeCashFlows(FCF)
EBIT

=
=

TaxexpenseonEBIT =

Increase inoperating =
workingcapital

Operatingearningsbeforeinterestandtax
Sales COGS SG&A Otheroperatingexpenses depreciation&amortization
(ifdepreciation&amortizationarereportedseparatelyontheincomestatement)
Totalincometaxexpense
+Interestexpensexmarginaltaxrate(t)
Financialrevenuesxappropriatetaxrate(t*)

[ort*EBIT]

Increaseinoperatingcash
+increaseinA/R
+increaseinInventory
+increaseinPrepaidexpenses
increaseinA/P
increaseinTaxespayable
increaseinAccruedexpenses
increaseinOtheroperating(noninterestbearing)noncurrentliabilities

14

Way#1illustration
CalculatingfreecashflowsfromEBIT
ASSUMPTIONS:1.Financialincomeistaxedatthemarginaltaxrate(t)of.36(i.e.t*=t)
2.Noproperty,plant,orequipmentissoldorretiredduring2007

2007
Sales
2,830
COGS
(1,993)
SG&A
(281)
Depreciation&amortization (117)
=EBIT
439
Less:
(160)
EBITtaxes
=NOPAT
279
+Depreciation&amortization 117
=Grosscashflows
396
Operatingworkingcapital (376)
(616)
Netcapex

Investmentsinothoperasset (19)
=FREECASHFLOW
<615>

2006
Current Assets:
Cash
144
A/R
409
Inventory
286
Prepaidexpens 13
Totalcur.asset 852
Op.liab:

A/P
151
Taxespayable 48
Otheraccr.exp 84
Otherliabilities 39
Deferredtaxes 221
Totalopliab 543
Changeop.w.c

2007

Change

486
593
289
38
1,406

225
45
192
51
208
721

342
184
3
25
554

74
(3)
108
12
(13)
178
376

EBITtaxes=[totaltaxexp +(Interestexpense)xt (financialincome)xt*]

=[199+
(75x.36)

(184x.36)]
=160
15

Way#1illustration
CalculatingfreecashflowsfromEBIT(cont.)
Net capex

=Capitalexpenditures cashproceedsfromsaleofPP&E
=NetPP&E+depreciationexpense+loss(gain)ondisposalPP&E
=17681263+111+0
=616

NetPPE
061263
Capexp616

111Depexp
0sold/ret

071768

AccumDep
Onassetssold
sold/retired 0

06588
111Deprecexp

{Plug}

07699

YoucanuseGross PP&Etogetnetcapex:
o Netcapex =GrossPPE+Accum deprec onassetssold/retired+Loss(Gain)ondisposal
o IfnoPP&Esoldorretired Netcapex =ChangeingrossPP&E
Investmentsinotherop.assets

=Changeinotherop.assets+amortizationexpense
=163 150+6
=19
(Note:Amort exp=Deprec &Amort exp Deprec exp=117 111=6)
16

Way#2illustration
Calculatingfreecashflowsfromthecashflowstatement
Freecashflows

=Cashfromoperations"(fromcashflowstatement)
Increaseinoperatingcashbalance
+Interestexpensex(1 t)
Cashflowfromfinancialincomex(1 t*)
Capex(netofdisposals)
Netexpendituresforotheroperatingassets

432
342
+75(1.36)
184(1.36)
616
19
= <615>

Theaddbackofinterestexpensenetoftaxisintendedtoremovealleffectsofinterestthatwereincludedin
operatingcashflowsfromthefreecashflowcalculation.Thisisoftenwellapproximatedby:interestexpx(1t).
However,ifbondswereissuedatadiscountorpremiumsothataportionoftheprojectedinterestexpenseisa
noncashitem,onlytheeffectsofinterestwithincashfromoperations (netoftax)shouldbeaddedback.For
example,supposeafirmhasapurediscountbondoutstanding,withanaftertaxinterestexpenserecognizedon
theincomestatementof100x(1.36)=64.Cashflowsfromoperatingactivitiesonthecashflowstatement
wouldincludethefollowing:
EffectsofaftertaxinterestonNetincome
Addback:Amortizationofbonddiscount
Effectofinterestoncashflowsfromoperations

<64>includedonincomestatement
100 oncashflowstatement
36

(i.e.,thetaxbenefitof$36istheonlyeffectofinterestexpensewithincashflowsfromoperations)
HencetheinterestexpenseonthepurediscountbondincreasesCFOby36duetotaxsavings.Wewouldsubtract
the36fromCFOinourFCFcalculation.
NotethatcapitalizedinteresthasnoeffectonCFO,sonoaddbackisneededforthisinterest.
However,technicallytheamountofinterestcapitalizedduringtheperiodshouldbeeliminatedfromprojected
capitalexpendituressinceinterestpaymentsarenonoperating.
17

Way#3illustration
CalculatingfreecashflowsusingNOPATandNOA
ThesimplestmethodtocalculateFCFistotakeNOPATandsubtractthechangeinnet
operatingassets(NOA):
NOA2006

NOA2007

=OA2006 OL2006
=2,265 543
=1,722
=OA2007 OL2007
=3,337 721
=2,616

Theitemsintheredboxes
onthefinancialstatements
(severalslidesback)

Thus,
Freecashflows

=NOPAT ChangeinNOA
=NOPAT (NOA2007 NOA2006)
=279 (2,616 1,722)
=279 894
=<615>

Theintuitionhereisfreecashflowequalsincomeminusinvestment.AlthoughNOPATisan
accrualnumber,anynoncashitemsinNOPAT(suchasdepreciation)canceloutwhenthe
changeinnetoperatingassetsissubtractedfromNOPAT.Forexample,ifdepreciationis
$100,then,allelseequal,netoperatingassetsdecreaseby$100andNOPATdecreasesby
$100.
18

WACCMethod
Step2:EstimatingWACC Idealvs.practical
TobetruetothetheoreticalfoundationofDCF,
WACC=weightedaveragecostofeverycomponentofinvestedcapital
(i.e.allfinancialclaimsnetoffinancialassets),whereweightsarebasedon
expected(targeted) capitalstructureinfutureintermsofmarketvalue
proportions
o Capitalstructurescanbecomplex,complicatingcomputationofWACC
Notethecircularity:ForecastingWACCpresumesyouknowmarketvaluesofbothdebt
andequityforperiods>timet(whichiswhatyouaretryingtovalueattimet)

Inpractice,
EstimatesofWACCareimprecise,sowecankeepthecomputationsimple,anduse
sensitivityanalysisasasanitycheck
o Estimatingtargetedcapitalstructure:
1.Pastcapitalstructureforthefirmexpectedtocontinue?
2.Capitalstructureofsimilarfirmsintheindustry?
3.Specificknowledgeoffuturedebtpolicy?
19

WACCMethod
Step2:EstimatingWACC Calculation
Forillustrationpurposes,assumesimplecapitalstructurewithstraightdebt(D)andcommon
stock(E)only(i.e.,nootherfinancialclaimsandimmaterialfinancialassets)

WACC=[Wd xRd x(1t)]+[We xRe]

Wd

=targetedproportionofinterestbearingdebtincapitalstructure(marketvalues)
=D/(D+E)

We

=targetedproportionofcommonstockincapitalstructureinfuture(marketvalues)
=E/(D+E)=1 Wd

=marginalcorporatetaxrate

Rd
Re

=expectedcostofdebtcapital(pretax)
=costofequitycapital

Comments:
o IncludecapitalleaseswithinD
o DonotincludeoperatingleaseswithinDunlessyouadjustNOPATbyaddingbackimplied
interestexpense(netoftax)associatedwithPVofoperatinglease(consistency!)
o DonotincludepensionorpostretirementliabilitiesunlessyoualsoadjustNOPATtoexclude
thesecostsforimpliedinterestexpense(netoftax)andpensionassetreturns
Iffirmhascomplexcapitalstructure,APVmethodmaybepreferable,whereyouunlever betasofcompetitorstoestimatediscountrate,Ru

20

WACCMethod
Step2:EstimatingWACC Interesttaxshield
WACC=[Wd xRd x(1t)]+[We xRe]
WACCMethodreducesthediscountratetoreflecttaxsavingsoninterest
ByusingthisreduceddiscountratetoestimatethePVoffuturefreecashflows,
o TheWACCmethodcomminglesthevalueoftheNOAwiththevalueofthetaxsavingsfrom
interestondebtfinancing:
PVoffuturefreecashflows=FairvalueofNOA+Valueofinteresttaxshield

Incontrast,theAPVMethodseparatelyestimatesthevalueofNOAandtheinteresttaxshieldby
usingunleveredcostofequity(Ru)todiscountfreecashflows
o Ru reflectsriskoffreecashflowsstreamfromNOA
o PVoffreecashflows=pureestimateoffairvalueofNOA
21

WACCMethod
Step2:EstimatingWACC Rd(costofdebtcapital)
Usingobservableyields:
o 1.Ifpubliclytraded:Rd =Yieldtomaturityonlongtermdebt
(IRRsuchthatbondprice=PVofpromisedfutureinterestandprincipal
payments)
o 2.Ifnotpubliclytraded,butrated:
Yieldoncorporatedebtwithsimilarrating
o 3.Ifnotpublicandnotrated:Estimatewhatratingwouldbe(e.g .,basedon
financialriskratios)andthenuse2.
Alternatives:
o UsedebtbetaandCAPMtodeterminecostofdebt
Rd =Rf +[d*(E(Rm) Rf)](usingCAPM)
d 0.4ifhighyielddebt(d 0.3ifinvestmentgradedebt)

o UseyieldonBBBdebt(loweryieldthanjunkbonds)asanchor,andthenuse
CAPMmerelytoadjustyield,i.e.,add(0.4 0.3)*[E(Rm) Rf]
o Iftheprobabilityoffinancialdistressishigh,thenWACCisproblematic
Valueofinteresttaxshieldislikelyoverstated considerAPV

22

WACCMethod
Step2:EstimatingWACC Re (costofequitycapital)
Re =Expectedreturndemandedbyshareholders,givenriskoffirmscommonequity
NouniversallyacceptedassetpricingmodelorapproachforestimatingRe
Widelyusedinpractice:CAPM
o Re =Rf +[*(E(Rm) Rf)](ifusingCAPM)
Rf
E(Rm)Rf

=Riskless"(zerobeta)return
=Expectedequityriskpremiumonthemarketportfolio

NoagreementonbestmethodsforestimatingRf andE(Rm)Rf
Rangesofequityriskpremiumestimatesfrom1%to8%arecommon

Recommendationforthisclass:
o Rf =Currentyieldonlongterm(e.g.10year)USTreasurybondsandE(Rm)Rf =5%
(canuse4.0% 6.0%forsensitivityanalysis,consistentwithmanypractitioners)
o =Betaofcommonstock(levered)
Recommendationforelsewhere:
o Dowhatyourbossorfinancialbackersdo

Note:Ideally,geographiclocationofRf shouldmatchlocationoffreecashflows
becauseexpectedinflationaffectsRf andfuturecashflows(bothareinnominalterms).

23

WACCMethod
Step2:EstimatingWACC Changesincapitalstructure
Note:Ifanewtargetcapitalstructurewillbeadopted...WACCshouldreflect
thenewcapitalstructure
o i.e.,newRd,Re,Wd andWe
Forexample,Rd shouldreflectdefaultriskassociatedwithnewcapitalstructureand
coverageratios

o Cancomparefinancialriskratiosbasedonproformafinancialstatements
reflectingfuturecapitalstructurewithpublishedmedianratiovaluesfordebt
ratingcategoriestoapproximatewhatdebtratingwouldbe
o Re canbeestimatedbyunlevering basedonoldcapitalstructureandre
leveringtoreflectfuture(new)capitalstructure
o AlternativelyuseAPVMethodinsteadofWACCMethod
==============================================================
Note:ManyacademicsandpractitionersnowuseFamaFrench3factormodel
insteadofCAPM
o Wewillcoverthisintheregularclasssession
o FFfactorsareavailableat:
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html
24

WACCMethod
Step3:UseWACCtodiscountfreecashflows(forecasthorizon)
PV(FH)

=FCF1/(1+WACC)1 +FCF2/(1+WACC)2 +...+FCFT/(1+WACC)T

where
PV(FH)

=Presentvalueoffreecashflowsduring ForecastHorizon

=#ofyearsinforecasthorizon

Note:ThisformulaassumesFCFoccuratendofeachyear
WellillustratemidyearadjustmentinStep5

25

WACCMethod
Step4:Estimateterminalvalue Constantgrowthmethod
Terminalvalue(presentvalue)=FCFT+1/(WACC g)
(1+WACC)T
where
o FCFT+1 =Normalized"FCFinthefirstyearaftertheforecasthorizon
og

=ExpectedconstantgrowthrateinFCFandNOPATbeyondyearT+1

Distortions/misunderstandings
=
FCFT x(1+g)
o FCFT+1
Likelytounderstate normalizedFREECFT+1 andfirmvalueiftherewerelargeinvestments
duringyearTtosupporthigherrevenuegrowthrateduringyearT(nolongerneedsuchlarge
investmentsbeyondforecasthorizonifgrowthratebeginninginT+1<yearTgrowthrate)

o FCFT+1

NOPATT

Likelytooverstate FCFT+1 andfirmvaluebecauseitassumesnonewinvestmentsarerequired

tosupportgrowthafteryearT
26

RationaleforFCFT+1inconstantgrowthmodel
EBIT
taxesonEBIT
=NOPAT
+Depreciation&amortization
=GROSSCASHFLOW
Increaseinoperatingworkingcapital
Capitalexpenditures(netofdisposals)

GROSSINVESTMENTSINNETOPERATINGASSETS

Expendituresforotheroperatingassets(i.e.toreplaceassetsplusincreaseassets)
=FREECASHFLOW

RecallFCFT+1

=GrossCashFlowT+1

GrossInvestmentsT+1

=[NOPAT+deprec &amort]T+1

[Netinvestment+deprec &amort]T+1

=NOPATT+1

NetinvestmentT+1

where:
1)NetInvestmentistoexpand scopeorscaleofops.=NOA
2)Investmentstoreplaceexistingassetsareapproximatedbydeprec &amortizationexpenses
27

RationaleforFCFT+1inconstantgrowthmodel(cont.)

Thenuseestimatesofgandreturnonnewinvestedcapitalbasedoncompetitiveenvironmentto
computeFCFT+1
FCFT+1

=NOPATT+1

NOAT+1

=NOPATT+1 (1 NOAT+1)
NOPATT+1
=NOPATT+1 (1

g )
RONIC

where
RONIC

=Returnonnew invested capitaltoexpandscaleand/orscopeofoperations

=NOPATs+1 NOPATs foranyfutureyears
NOAs

=ExpectedlongrungrowthrateinNOPATandFCF

NOAT+1
NOPATT+1

=g/RONIC=Constantinvestmentrate

(Seenextslidetoseewhytheconstantinvestmentrate=g/RONIC)

28

RationaleforFCFT+1inconstantgrowthmodel(cont.)
Illustrationofwhy NOAT+1
NOPATT+1
FCF

=NOPAT

=NETINVESTMENTT+1
NOPATT+1

=g/RONIC

NETINVESTMENT

=NOPATx(1 NETINVESTMENT
NOPAT
investmentrate

IfinvestmentrateisconstantbeyondforecasthorizonANDRONICisconstant
FCFwillgrowatthesameconstantrateasNOPAT
Letg=growthrateinNOPAT(andFCF)
g=NOPAT
NOPAT
Foranyfutureyears(multiplyanddividebyNETINVESTMENT):
g=NETINVESTMENTS XNOPATS+1 NOPATS
NETINVESTMENTS

NOPATS

RONIC
g=NETINVESTMENTS XRONIC

NOPATS

g/RONIC=NETINVESTMENTS
NOPATS
29

WACCMethod
Step4:Estimateterminalvalue Perpetuitymethod
Terminalvalue(presentvalue)=[NOPATT+1 /WACC]
(1+WACC)T
where
o NOPATT+1 =Normalized"NOPATinthefirstyearaftertheforecasthorizon
Distortions/misunderstandings
o Perpetuitymethodimpliesnogrowthbeyondforecasthorizon
FALSE!!! Theperpetuitymethoddoesnot assumethatthereisnogrowthbeyondtheforecasthorizon.It
assumesthatthegrowthbeyondtheforecasthorizonistheresultofincrementalinvestmentsthatearnthe
costofcapital,therebyhavingnoeffectonfirmvalue(0NPV).Itdoesimplythatrealcashflowsonassetsin
placewilldeclineovertimebecauseWACChasbuiltininflationaryexpectations,butNOPATisassumedtobe
constantinnominal$.

o UsingNOPATabandonsFCF,andusesaccountingbasedprofitsinstead
FALSE!!!NOPATT+1 is theestimateofFCFT+1 givenunderlyingassumptions:

Incrementalinvestmentsare0NPVprojectsandcanbeignored.

TheonlyinvestmentsinnetoperatingassetsthatneedtobesubtractedfromgrossCFT+1 toget
FCFT+1 areinvestmentstoreplaceassetswearingout.

Depreciationandamortizationexpensesapproximateexpendituresrequiredtoreplaceassets
wearingout
30

WACCMethod
Step4:Estimateterminalvalue Perpetuitymethod(cont.)
Toshowthelastpointonthelastslide
(re:NOPATbeingequivalenttoFCFintheterminalvalueyear
undertheperpetuitymethodtoestimatingtheterminalvalue):
FCFT+1
=NOPATT+1 +deprec &amortT+1 InvestmentstoreplaceassetsT+1 InvestmentstoNOAT+1
=NOPATT+1 +deprec &amortT+1

deprec &amortT+1

0(nogrowth)

=NOPATT+1

31

WACCMethod
Step5:EstimatetotalPVofFCF
TotalPVofFCF

PV(FH)+PV(TV)
(step3)
(step4)

BecausethesecalculationsassumeFCFoccuratendofeachyear,some
valuationexpertsapplyamidyearadjustmentfactor:
o TotalPVofFCF(above)x(1+WACC)0.5

=Valueofoperations
(includestaxshield)

32

WACCMethod
Step6:Addfairvalueoffinancialassets
Examples:
o Excessmarketablesecurities(Note:interestonoperatingcashisincludedinFCF)
o Longterminvestmentsindebtorequitysecurities
MakesurethecashflowsoftheseassetsareNOTinyourFCFestimates

WACCMethod
Step7:Subtractfairvalueoffinancialobligations
Examples:
o Shortterminterestbearingdebt(notespayable)
o LTinterestbearingdebt(includingcurrentportionandcapitalleases)
o Minorityinterest
o Preferredstock
o Employeestockoptions
o Note:DonotsubtractPVofoperatingleases,orpensionandpostretirementliabilitieson
thebalancesheetunless youconsistentlytreattheseitemsasinterestbearingdebt
throughout(whichmeansyouexcludetheircashflowsfromFCF,i.e.,youaddthemback)
33

WACCMethod
Step8:Divideby#sharesoutstanding
Valueofequity=PVFCF(FH)+PVFCF(TV)+FVFA FVFO
Valuepershare
=Valueofequity/#sharesofcommonstockoutstanding

#Issued #inTreasury
(fromrecentbalancesheet)
Becarefulaboutdilutivesecuritiesandtheireffectsonsharesoutstanding.If
theyaresubtractedinStep7,youdonotneedtoaccountfortheireffectsonthe
totalsharesoutstanding(thiswouldbedoublecounting)

34

Discountedcashflowvaluationmethods
APVMethod

35

AdjustedPresentValue(APV)Method
AdvantagesoverWACCmethod:
o SeparatesvaluationofFCFfromfinancingsideeffects(i.e.,interesttax
shield)
o Providespureestimateofvalueofnetoperatingassets,
w/ocomminglingvalueofinteresttaxshield
TheAPVMethodcanmoreeasilyaccommodate:
o Changingcapitalstructure
o Complexcapitalstructure
o Interestdeductionscarriedforward(NOLs)
o Financialdistress
o Appealingforvaluingdivisions,asyoudonotneedtoallocatecorporatedebt
tospecificdivisions,whichislikelywiththeWACCmethod

36

APVMethod Overview
[DifferencesfromWACCMethodhighlightedinred anditalicized]

1.

ForecastFCFoverforecasthorizon

2.

Estimateunleveredcostofequitycapital(Ru)

3.

UseRu todiscountFCFduringforecasthorizon

4.

Estimateterminalvalue(usingRu)asofthevaluationdate

5.

AddPVofFCFduringforecasthorizonandterminalvalue

6.

AddPVofinteresttaxshield

7.

Addvalueoffinancialassets

8.

Subtractvalueoffinancialobligations

9.

Subtractcostsoffinancialdistress

10.

Divideby#sharesoutstandingtoestimatevaluepershare
37

APVMethod
Step1:ForecastFCF
SameasWACCMethod

APVMethod
Step2:EstimatingRu Calculation
Ru =Rf +u *[E(Rm) Rf]
where
o u =Unleveredbeta(i.e.foranallequityfinancedfirm)(assetbeta)
ReflectsriskofFCFgeneratedbyNetOperatingAssets
Formulaforu Dependsonassumptionaboutriskofthetaxshieldoninterest

38

APVMethod
Step2:EstimatingRu usingu
Approach1:Assumetheriskofthetaxshieldoninterest=riskofthenetoperatingassets(u)
UNLEVER:
o u = D *d
+ E *e
D+ED+E
RELEVER:
o e =u +[(u d)*(D/E)]
where

Note:ifd =0, u=
e
(debtisriskfree)
[1+(D/E)]

e =u *[1+(D/E)]

e =Leveredbetaoncommonequity
d =Betaondebt
D/E=capitalstructure(debtrelativetoequityinmarketvalueterms)
(Iffirmhaslotsofexcesscash,cansetD=netdebt=debt excesscash)

Reasonableifuncertaintyabouttaxshieldsismainlyassociatedwithgeneratingoperatingincome
AND/OR
Ifcapitalstructureexpectedtoremainstable AmountofdebtdependsonfuturevalueofNOA
Themainuncertaintyaboutthefuturetaxshieldistheamountofdebtthatwillbeoutstanding
(whichisafunctionoftheNOAandcapturedbytheriskofthenetoperatingassets)

39

APVMethod
Step2:EstimatingRu usingu

(cont.)

Approach2:Assumetheriskofthetaxshield=riskonthedebt(d)ANDdebtisconstantindollars
UNLEVER:
o u =D(1t) *d + E *e
D(1t)+E
D(1t)+E

Note:ifd =0 u =
e
(debt&taxshield
[1+(1t)(D/E)]
areriskfree)

RELEVER:
o e =u +[(u d)*(1t)(D/E)]
where

e =u *[1+(1t)(D/E)]

e =Leveredbetaoncommonequity
d =Betaondebt
D/E=Capitalstructure(inmarketvalueterms)
(aswithMethod1,canuseD=netdebtiflotsofexcesscash)
t=Marginaltaxrate

Reasonableifthemainsourceofuncertaintyiswhethertheinterestispaid,asreflectedintheriskofthedebt.

40

APVMethod
Step2:EstimatingRu Comments onunlevering
Canbeadvantageoustounlever betasoffirmswithsimilarassetrisk,andtake
meanormedianasanestimateofunleveredbetaforthecompanyofinterest:
o Individualbetasareestimatedwitherror.Thehopeisthatbytakingaverage
(ormedian),errorsinestimatesofindividualbetasarediversifiedaway,
producingamoreaccurateestimateofunleveredbetaforthecompany.
o Forprivatecompanies,noequitybetaisavailabletounlever.
Unlevering betasofpublicfirmswithsimilarassetriskisagoodwayto
estimateunleveredbetaofaprivatecompany.
o Ifunlevering betasofcomparable companiesinanindustrywithheavy
relianceonoperatingleases,itcanbeusefultotreatoperatingleasesasdebt.
Ifso,needtotreatoperatingleasesofthecompanyasdebtalso
o Ifafirmhasacomplexcapitalstructure (sosimplecapitalstructureassumed
inunlevering formulasisntaccurate),youcanunlever betasoffirmswith
similarassetriskbutwithsimplercapitalstructures,andusetheaverageor
medianoftheseunleveredbetas(henceAPVmethodmakesiteasierto
handleacomplexcapitalstructurethanWACCmethod).
41

APVMethod
Step2:EstimatingRu Examplesofunlevering betas

Equity
Beta

Debt/EquityRatio

Debt
Beta

Southwest

1.13

0.15

0.00

AlaskaAir

1.80

1.06

0.15

SkyWest

1.69

1.05

0.15

Mesa

3.27

3.52

0.30

Continental

3.76

5.59

0.40

Firm

Source:Berk andDeMarzo
42

APVMethod
Step2:EstimatingRu Examplesofunlevering betas(cont.)

Firm

Equity
Beta X

E/(E+D) +

Debt
Beta X

D/(E+D)

UnLevered
=
Beta

Southwest

1.13

87%

0.00

13%

0.98

AlaskaAir

1.80

49%

0.15

51%

0.96

SkyWest

1.69

49%

0.15

51%

0.90

Mesa

3.27

22%

0.30

78%

0.95

Continental

3.76

15%

0.40

85%

0.90

43

APVMethod
Step2:EstimatingRu Estimatingdebtbetas
Wheredowegetdebtbetas?
Inprinciple,debtbetascouldbeestimatedusingthesameregression
methodsthatwedevelopedforequitybetasInpractice,however,datafor
thehistoricalreturnsofdebtsecuritiesaremuchmoredifficulttoobtain,
makingadirectcalculationofthebetafordebtproblematic.Asa
consequence,debtbetasareoftenapproximatedusingothermeans.For
example,givenanexpectedreturnforthedebtrd (basedonitsyield,but
adjusteddownwardtoreflectthepossibilityofdefault),wecanestimatethe
betaofdebtusingthesecuritymarketlineoftheCAPM.
(Berk andDeMarzo,page443)

44

APVMethod
Step3:UseRu todiscountFCF(forecasthorizon)
PV(FH)=FCF1/(1+Ru)1 +FCF2/(1+Ru)2 +...+FCFT/(1+Ru)T
(sameasstep3forWACCMethod,exceptuseRu insteadofWACC)

APVMethod
Step4:Estimateterminalvalue
(Sameasstep4forWACCMethod,exceptuseRu insteadofWACC)

45

APVMethod
Step4:Estimateterminalvalue Constantgrowth
=

FCFT+1/(Ru g) =[NOPATT+1 (1 (g/RONIC))]/(Ru g)

(1+Ru)T
(1+Ru)T

where
o
o
o
o
o

FCFT+1
=Normalized"FCFinthefirstyearaftertheforecasthorizon
NOPATT+1 =Normalized"netop.profitaftertaxin1st yrafterforecasthorizon
g
=ExpectedconstantgrowthrateinFCFandNOPAT
RONIC=Returnonnew investedcapitaltoexpand scaleofoperations
=Unlevered costofequitycapital
Ru

APVMethod
Step4(Alternative):Estimateterminalvalue Perpetuity
=

[NOPATT+1 /Ru]
(1+Ru)T
46

APVMethod
Step5:EstimatetotalPVofFCF
TotalvalueofFCF=[PV(FH)+PV(TV)]x(1+Ru)0.5
(sameasstep5ofWACCMethod,includingmidyearadjustmentfactorbasedonRu)

APVMethod
Step6:AddPV ofinteresttaxshield
PVofinteresttaxshield=PVofinteresttaxshieldduring forecasthorizon
+PVofinteresttaxshieldbeyond forecasthorizon

47

APVMethod
Step6:Estimatingthevalueoftheinteresttaxshield

STEP6A:
o EstimatePVofinteresttaxshieldduring forecasthorizonperiod1:
[txinterestexp1]/(1+R)1 +...+[txinterestexpT]/(1+R)T
whereRisthediscountratewhichreflectstheriskofthetaxshield

WhatisR?
o UseR=Ru ifriskofthetaxshield=riskofassets
o UseR=Rd ifriskofthetaxshield=riskofthedebt
Beconsistentwithmethodofestimatingunleveredbeta

Whatist?
o Wewillusemarginalcorporatetaxrate(seeslidesinWeek3)

Thisexpressionassumesthattheinteresttaxdeductioncanbeusedintheyearinterestispaid.Ifnot(e.g.tax
losscarryforwards),reflecttheexpectedtimingoftherealizationofthetaxsavingsintheexpressiongivenforthe
PVoftaxshieldoninterest.Thisexpressionalsoassumesinterestrevenueonexcesscashisimmaterial.If
material,canusenetinterestexpenseintheformula=interestexp interestrevenueonexcesscash.

48

APVMethod
Step6:Estimatingthevalueoftheinteresttaxshield(cont.)
STEP6B:
o EstimatePVofinteresttaxshieldbeyond forecasthorizon
Severalapproaches:
o Method1:
o Assumingcapitalstructureisfixedbeyondforecasthorizon:
o PVtaxshieldbeyondforecasthorizon
=[terminalvalueusingWACC terminalvalueusingRu]/(1+R)T
o EXAMPLE:
CONSTANTGROWTHINPERPETUITYmethodofestimatingterminalvalue:
continuingvalueusingWACC
=FCFT+1/(WACC g)
=FCFT+1/(Ru g)
continuingvalueusingRu
PVoftaxshieldbeyondforecasthorizon
={[FCFT+1 /(WACCg)] [FCFT+1/(Rug)]}/(1+R)T
NOTE:R=Ru orRd dependingonassumedriskoftaxshield.

Beconsistentwithformulaforestimatingu

MostcompellingtouseR=Ru ifdebtgrowingforeveratsamerateasFCF
(i.e.,stablecapitalstructurebeyondforecasthorizon)
49

APVMethod
Step6:Estimatingthevalueoftheinteresttaxshield(cont.)
Method2:
o AssumeDT+1 (debtoutstandingatT+1)willgrowforeveratgrowthrateg.
o PVoftaxshieldbeyondforecasthorizon=[txRd xDT+1]/(Rg)/(1+R)T
o NOTE:R=Ru orRd dependingonassumedriskoftaxshield
Beconsistentwithformulaforestimatingu
MostcompellingtouseR=Ru ifdebtgrowingforeveratsamerateasFCF(stablecapital
structurebeyondforecasthorizon)
Method3:
o AssumeDT+1 (debtoutstandingatT+1)willremainconstantin$beyondforecast
horizon
o PVoftaxshieldbeyondforecasthorizon=[txRd xDT+1]/R/(1+R)T
o NOTE:IfR=Rd PVoftaxshieldbeyondforecasthorizon=[txDT+1 ]/(1+Rd)T
================================================================
PVoftaxshield=6A+6B,assumingtaxsavingsoccuronlastdayofyear
Toadjusttaxsavingstomidyear:[6A+6B]x(1+R)0.5
50

APVMethod
Step7:Addfairvalueoffinancialassets
SameasWACCMethod

APVMethod
Step8:Subtract fairvalueoffinancialobligations
SameasWACCMethod

APVMethod
Step9:Subtractcostsoffinancialdistress
Oftenignoredinpractice
o Duetoimprecisionofeverything,especiallyquantifyingcostsoffinancialdistress
o Willhavemoreonthistopicnextclass

51

APVMethod:SUMMARY
Valueofequity=
Totalvalueoffreecashflowstoallequityfinancedfirm
+PVofinteresttaxshield
+Fairvalueoffinancialassets
Fairvalueoffinancialobligations
Costsoffinancialdistress

APVMethod
Step10:Divideby#sharesoutstanding
Valuepershare
=Valueofequity/#sharesofcommonstockoutstanding
#Issued #inTreasury
52

APPENDIX1
DCFVALUATION(WACCMETHOD)
AnIllustration:PepsiCo
From:
FinancialReportingandStatementAnalysis
Stickney,Brown,Wahlen[2004]

Assume:Allassetsareoperatingassets
AllsourcesofincomewillbeincludedwithinFreeCashFlows

53

EXHIBIT10.3

ProFormaStatementsofIncomeandRetainedEarningsforPepsiCo
(amountsinmillions;allowforroundingerrors)
Year+1
Projected

Year+2
Projected

Year+3
Projected

Year+4
Projected

Year+5
Projected

Sales a
CostofGoodsSoldb
GrossMargin
SellingandAdministrativeExpensec

$ 28,841
(11,450)
$17,391
(12,429)

$ 30,890
(12,202)
$18,688
(13,312)

$ 33,094
(13,006)
$20,088
(14,262)

$ 35,464
(13,866)
$21,598
(15,284)

$ 38,013
(14,825)
$23,188
(16,382)

OtherRevenues d
OtherExpenses e
OperatingIncome

169
(58)
$5,073

187
(62)
$5,501

201
(66)
$5,960

215
(71)
$6,458

231
(76)
$6,961

InterestIncomef

73

80

86

92

99

InterestExpenseg
IncomebeforeIncomeTaxes
IncomeTaxExpenseh
NetIncome
PreferredDividends i

(189)
$4,957
(1,586)
$3,371
(4)

(199)
$5,382
(1,722)
$3,660
(4)

(194)
$5,852
(1,873)
$3,980
(4)

(203)
$6,347
(2,031)
$4,316
(4)

(216)
$6,844
(2,190)
$4,654
(4)

CommonDividends j
ChangeinRetainedEarnings

(1,600)
$1,767

(1,692)
$1,964

(1,572)
$2,404

(2,395)
$1,917

(1,920)
$2,730
54

Exhibit10.3notes:
a

Salesprojectedusingexpectedgrowthratesforthethreeprimaryproductmarket

segments.
7.1%yrs+1to+3,7.2%inyrs+4and+5
b COGSprojectedassumingasteadydeclinefrom39.7percentto39.0percentofsales
(39.7%,39.5%,39.3%,39.1%,39.0%)
c

SG&Aprojectedassuming43.1percentofsales.

Otherrevenuesprojectedassuming5.5percentreturnoninvestments.

Otherexpensesprojectedassuming0.2percentofsales.

Interestincomeprojectedassuminganinterestrateof4.2percentearnedonaveragecash
&shortterminvestments.

Interestexpenseprojectedassuminganinterestrateof6percentonaverageshortterm
borrowing,currentmaturitiesoflongtermdebt,&longtermdebt.

Incometaxexpenseprojectedassuminganeffective&marginaltaxrateof32.0%.
(federalstatutory+state&local+foreigninrecentyears effectiveratealso)

Preferreddividendsprojectedassumingaconstantpreferredstockdividend.

Commondividendsprojectedassumingadividendpayoutrateof38.0percentofnet
income,plusanynecessaryadjustmenttobalancethebalancesheet.
55

EXHIBIT10.4

ProFormaBalanceSheetsforPepsiCo
(amountsinmillions;allowforroundingerrors)
Year+1
Projected

Year+2
Projected

Year+3
Projected

Year+4
Projected

Year+5
Projected

Assets
Cash
ShorttermInvestments
AccountsReceivable
Inventories
OtherCurrentAssets
TotalCurrentAssets
Investments
Property,Plant,andEquipment(cost)
AccumulatedDepreciation
OtherAssets
TotalAssets

$790
1,057
2,291
1,316
822
$6,276
3,287
13,598
(6,207)
6,526
$23,481

$846
1,133
2,454
1,402
881
$6,716
3,524
15,117
(7,174)
6,990
$25,173

$907
1,215
2,629
1,495
945
$7,191
3,779
16,744
(8,210)
7,489
$26,993

$972
1,302
2,818
1,594
1,013
$7,699
4,052
18,488
(9,320)
8,025
$28,944

$1,041
1,397
3,020
1,704
1,086
$8,248
4,346
20,357
(10,510)
8,602
$31,043

LiabilitiesandShareholder'sEquity
AccountsPayable
ShorttermBorrowings
CurrentMaturitiesofLongtermDebt
OtherCurrentLiabilities
TotalCurrentLiabilities
LongtermDebt
DeferredIncomeTaxes
OtherNoncurrentLiabilities
TotalLiabilities
PreferredStock
CommonStock
RetainedEarnings
OtherEquityAdjustments
TreasuryStock
TotalShareholders'Equity
TotalLiabilitiesandShareholders'Equit

$1,287
117
485
3,647
$5,536
2,700
1,602
4,150
$13,989
$26
43
13,286
(1,646)
(2,217)
$9,492
$23,481

$1,380
126
441
3,906
$5,853
2,769
1,716
4,445
$14,782
$26
43
15,251
(1,646)
(3,283)
$10,391
$25,173

$1,471
135
167
4,185
$5,958
2,834
1,838
4,762
$15,394
$26
43
17,655
(1,646)
(4,479)
$11,599
$26,993

$1,569
145
602
4,484
$6,800
2,894
1,970
5,103
$16,768
$26
43
19,572
(1,646)
(5,819)
$12,176
$28,944

$1,678
155
310
4,807
$6,950
3,104
2,111
5,470
$17,636
$26
43
22,302
(1,646)
(7,318)
$13,407
$31,043

56

Exhibit10.4notes:
Cashprojectedassuming10daysofsalesincash=endingcash/(sales/365)

Marketablesecurities(STinvestments)projectedtobe4.5%oftotalassets

A/Rprojectedassuming29daysofsalesinA/R=endingA/R/(sales/365)
Inventoryprojectedassuminginventoryturnoverof8.7
(usingyrendbalancesonlyinturnoverratio)
Othercurrentassetsprojectedtobe3.5%oftotalassets

Investmentsinsecuritiesprojectedtobe14.0%oftotalassets
NetPP&EcomputedasbeginningNetPP&E+CAPEX depreciation,assumingCAPEX
growsanddepreciationexpgrowatsamerateassales,noassetssoldorretired.

Otherassetsgrowatsamerateassales

Toprojectamountsthatarespecified%oftotalassets,notewehave:
Assetsas%ofTotalAssets:AssetsPredictedDirectly(year+1)
Marketablesecurities4.5%
Cash
790
Othercurrentassets3.5% A/R
2291
Investments14.0%
Inventory
1316
Total22.0%
NetPP&E
7391
Otherassets
6526
Subtotal18,314
Hence18,314=78%oftotalassets Totalassets+1 =18,314/.78=23,481

57

Exhibit10.4notes:(cont.)
A/Pprojectedassumingaccountspayableperiod=41days(usingyrendbalanceofA/PonlyinA/P
turnoverratio)
Shorttermborrowingsprojectedtobe0.5%oftotalassets
CurrentmaturitiesofLTDprojectedusinginfoindebtnoteaboutfuturematurities
(Beyondyear+5assumedtobe10%ofLTD)
Othercurrentliabilitiesassumedtogrowatsamerateassales
LTDdeclinesto10%oftotalassets(11.5%inyear+1,11%inyear+2,10.5%inyear+3, 10.0%in
year+4andbeyond)
Deferredtaxesgrowassamerateassales
Othernoncurrentliabilitiesgrowatsamerateassales
Preferredstockremainsthesame
Commonstockremainsthesame(usesthetreasurystockaccounttoreflectstockbuybacksand
reissuances)
Retainedearnings=Beginningbalance+netincome implieddividends
(Implieddiv=constantpref.dividends($4M)+38%netincomeplusplugtobalancebalsheet)
Otherequityadjustments=0(followrandomwalk,sopredictedchangeiszero)
Treasurystock:neteffectofassumedstockrepurchasesof1,$1,700Minyear+1,increasingby
10%ayeartoyear+5,andstockreissuanceforexerciseofstockoptionsof$751Minyear+1,and
growingatsamerateassalethru+5. Beyondyear+5treasurystockwillgrowat10%.
58

EXHIBIT10.6

ProFormaStatementsofCashFlowsforPepsiCo
(amountsinmillions;allowforroundingerrors)
Year+1
Projected

Year+2
Projected

Year+3
Projected

Year+4
Projected

Year+5
Projected

Operations
(1)NetIncome
(2)Depreciation
(3)(Increase)DecreaseinAccountsReceivable
(4)(Increase)DecreaseinInventories
(5)(Increase)DecreaseinOtherCurrentAssets
(6)Increase(Decrease)inAccountsPayable
(7)Increase(Decrease)inOtherCurrentLiabilities
(8)Increase(Decrease)inDeferredTax
(9)Increase(Decrease)inOtherNoncurrentLiabilities
CashFlowfromOperations

$3,371
903
(149)
(6)
(70)
49
241
106
274
$4,719

$3,660
967
(163)
(86)
(59)
93
259
114
295
$5,080

$3,980
1,036
(175)
(92)
(64)
91
279
122
317
$5,494

$4,316
1,110
(188)
(99)
(68)
97
300
132
341
$5,941

$4,654
1,190
(203)
(110)
(74)
109
322
142
367
$6,397

Investing
(10)AcquisitionofProperty,PlantandEquipment(atcos
(11)AcquisitionofMarketableSecurities(net)
(12)AcquisitionofInvestmentSecurities(net)
(13)OtherAssets
CashFlowfromInvesting

$(1,418)
(91)
(416)
(431)
$(2,356)

$(1,519)
(76)
(237)
(464)
$(2,295)

$(1,627)
(82)
(254)
(499)
$(2,461)

$(1,744)
(88)
(273)
(536)
$(2,641)

$(1,869)
(95)
(294)
(577)
$(2,834)

Financing
(14)Increase(Decrease)inShorttermBorrowing
(15)Increase(Decrease)inLongtermDebt
(16)Increase(Decrease)inPreferredStock
(17)Increase(Decrease)inCommonStock
(18)Increase(Decrease)inOtherEquityAdjustments
(19)AcquisitionofTreasuryStock
(20)Dividends
CashFlowfromFinancing
(21)NetChangeinCash
CashBeginningofYear
CashEndofYear

$(237)
534

(949)
(1,604)
$(2,256)
$107
683
$790

$8
25

(1,066)
(1,696)
$(2,729)
$56
790
$846

$9
(209)

(1,196)
(1,576)
$(2,972)
$61
846
$907

$10
495

(1,340)
(2,400)
$(3,235)
$65
907
$972

$10
(82)

(1,499)
(1,923)
$(3,494)
$69
972
$1,041

59

EXHIBIT11.4
ValuationofPepsiCo:
PresentValueofFreeCashFlowstoAllDebtandEquityCapitalStakeholders
Year+1throughYear+10
Year+1
Projected
NETCASHFLOWFROMOPERATIONS
Addback:InterestExpenseaftertax(intexpx(1.32))
Subtract:InterestIncomeaftertax
+/Investmentinoperatingcash
FREECASHFLOWSFROMOPERATIONS
NETCASHFLOWFROMINVESTING
FREECASHFLOWS
PresentValueFactors(WACC=7.90%)
PVsofFreeCashFlows
SumofPVFreeCashFlowsYear+1throughYear+10

$4,718.6
128.7
0.0
107.2
4,740.1
2,356.0
$2,384.1
0.927
$2,209.6
$24,317.6
Year+6
Projected

NETCASHFLOWFROMOPERATIONS
Addback:InterestExpenseaftertax
Subtract:InterestIncomeaftertax
+/Investmentinoperatingcash
FREECASHFLOWSFROMOPERATIONS
NETCASHFLOWFROMINVESTING
FREECASHFLOWS
PresentValueFactors(WACC=7.90%)
PVsofFreeCashFlows

$6,863.2
151.0
0.0
74.9
6,939.2
3,038.7
$3,900.6
0.634
$2,472.1

Year+2
Projected

Year+3
Projected

Year+4
Projected

Year+5
Projected

$5,079.9
135.4
0.0
56.1
5,159.2
2,295.3
$2,864.0
0.859
$2,460.1

$5,493.7
132.0
0.0
60.4
5,565.3
2,461.7
$3,103.6
0.796
$2,470.8

$5,940.4
138.3
0.0
64.9
6,013.7
2,640.3
$3,373.4
0.738
$2,489.0

$6,396.8
147.1
0.0
69.8
6,474.0
2,833.9
$3,640.1
0.684
$2,489.2

Year+7
Projected

Year+8
Projected

Year+9
Projected

Year+10
Projected

$7,356.0
161.9
0.0
80.2
7,437.7
3,257.1
$4,180.6
0.587
$2,455.7

$7,884.8
173.7
0.0
86.0
7,972.5
3,491.2
$4,481.3
0.544
$2,439.6

$8,451.6
186.3
0.0
92.2
8,545.7
3,742.1
$4,803.6
0.505
$2,423.7

$9,061.5
199.8
0.0
99.0
9,162.3
4,013.3
$5,149.0
0.468
$2,407.8
60

Beyondyear5,similarassumptionsto5(7.2%growthinsales,op.income,CFO,CFInvesting,FCF)

Capital
Debt
Preferred
Common
Total

WeightedAverageCostofCapitalforPepsiCo
Aftertax
Value
Costof
Basis
Amount
Weight
Capital
Fair
Fair
Market

$3,266
50
86,132
$89,448

0.0365
0.0006
0.9629
1.0000

0.041
0.080
0.080

Weighted
Average
Component
0.00150
0.00005
0.07703
0.07858

Debt:
3,266fairvalueofdebtoutstandingdisclosedinnotestomostrecentfinancialstatements.
Aftertaxcosts=.06x(1.32)=.041.
Statedratesondebtexceedprevailingmarketratessince3,266exceedsbookvalueof3,005
However,prevailinglowratesnotexpectedtocontinue,souserecenteffectiverates
fromproformas
Preferredstock:
Assumeriskofpfdstock commonstocksosimilarcostofcapital.
Impliesamarketvalueofpfdstockof4M/.08=50M
CommonStock:
Re =Rf + (ERm Rf)=.042+.76(.05)=.08(Noteuses.05aspremiumonmarket)
86,132=$49.05stockpricex1,756Msharesoutstanding
61

WACC (cont.)
InitiallyusesactualmarketvalueofequityonvaluationdatetogetinitialWACC=.07858
Finalestimateofequityvalue(121,249.8million)suggestsinitialWACCcalculationabove
usestoolowaweightoncommonequity
Iterates,resultingin.079asthefinalestimateofWACC
Alternativeapproachthatavoidsiterationistoassumealongruntargetedcapitalstructure

62

EstimateofTerminalValue
Usesconstantgrowthmethod:
TerminalValue=FCFT+1 /(1+WACC)T
(WACC g)
FCF11 =$5,925.5million

Assumeg,longtermconstantgrowthrate=5%beginninginyear11.
Basedonexpectedlongtermgrowthofeconomyof 2%andlongterm
inflationof 3%(1+.02)(1+.03)=1.0506

Assumeallitemsofincomestatementgrowfromyear10to11by5%

Assumeassetsandliabilities(netoperatingassets)growby5%fromyear10to11

ComputeFCFinyear11fromprojectedincomestatementandbalancesheet

NoteifusedFCFinyear10x(1.05)=5406,wouldunderstateterminalvalue.

Reasonisthatsinceassumedterminalgrowthrateof5% 7.2%growthrateinyear
+10,appropriatetoreduceCFusedforinvestinginyr+11belowyr10levels.(i.e.CF
frominvestingisnotgrowingat.05fromyr+10toyr+11)
FCFgrowfromyear10(5149)toyear11(5925.5)by15%

Withg=.05andWACC=.079
TerminalValue=FCFT+1 /(1+WACC)T =5,925.5 /(1.079)10 95,642.4M
(WACC g)(.079.05)

63

EXHIBIT11.5
ValuationofPepsiCousingFreeCashFlowstoAllDebtandEquityCapital
ValuationSteps

Computations

PVFCFYear+1throughYear+10
PVFCFYears+11andBeyond

SeeExhibit11.4
Longrungrowthrateassumedtobe
5%;discountedat7.90%.

PVofAllDebtandEquityCapital
SubtractDebtCapital
SubtractPreferredStock
AddFinancialAssets
PVofCommonEquity
AdjustforMidyearDiscounting
TotalPVofCommonEquity
DividebyNumberofSharesOutstanding
ValueperShareofCommonEquity
CurrentPriceperShare
PercentDifference

FairValueofDebt
FairValueofPreferredStock
AssumedtobeZero
Multiplyby1+(WACC/2)
Inmillionsofshares

Amounts
+ $24,317.6
+ $95,642.4

+
=

(Positivenumberindicatesunderpricing)

$119,960.0
$3,266.0
$50.0
$
$116,644.0
1.0395
$121,249.8
$1,756
$69.05
$49.05
41%

Comments:
1. Canuse(1.079)0.5 =1.0387insteadof1.079/2=1.0395
2. Ifmarketvaluesofdebtandpfdstockonvaluationdatearereadilyavailableinsteadof
estimatingfromfutureCF,donotneedtodomidyearadjustmentfortheseitems
64