Deadline: 5:30 pm

Intrinsic Valuation
The Constant Growth Model

Valuing a firm with depressed earnings: A German Auto Manufacturing Company -XYZ

A rationale for using the one stage FCFE Stable Model

• As one of the largest firms in a mature sector, it is unlikely that XYZ will be able to register
super normal growth over time.
• Like most German firms, the dividends paid bear no resemblance to the cash flows generated.
• The leverage is stable and unlikely to change.

Background Information

• The company had a loss of 38.63 DM per share in 2015, partly because of restructuring
charges in aerospace and partly because of troubles (hopefully temporary) at it automotive
division.
• The book value of equity was 20.25 billion DM and debt 5.2 billion DM at beginning of 2015
• While the return on equity in 2015 period is negative, the five-year average (2009-2014)
return on equity is 9.5% and ROCE is 8%
• The company reported capital expenditures of 10.15 billion DM in 2015 and depreciation of
9.7 billion DM.
• The company has traditionally financed its investment needs with 12.01% debt and 87.99%
equity.
• The working capital requirements are about 2.5% of revenues. The revenues in 2015 is 104
billion DM.
• The stock had a beta of 1.10, relative to the Frankfurt DAX. The German long bond rate is
0.5%. The risk premium for the German market is 5.5%.
• The company’s current cost of debt is 3% and Marginal tax rate is 29.7%
• In the long term, earnings are expected to grow at the same rate as the world economy 2.5%.
• There are 51.30 million shares outstanding.

THE TWO-STAGE FCFE MODEL

Exercise 1

Two-Stage FCFE Model: A US Manufacturing Company - ABC

A Rationale for using the Model

• Why two-stage? While ABC has had a history of extraordinary growth, its growth is
moderating because ñ (a) it is becoming a much larger company and (b) its products are
maturing and may face competition soon.
 • Why FCFE? ABC does not pay dividends, but has some FCFE. This FCFE is likely to
increase as the growth rate moderates, and the firm gets larger.
• Leverage is stable.

Background Information

• Current Earnings / Capital Expenditures

o Earnings per share in 2015 = $ 1.95
o Capital Expenditures in 2015 per share = $ 0.90
o Depreciation per share in 2015 = $0.32
o Depreciation Rate = 15%
o Revenues per share = $ 7.45
o RFR: 2.26%
o Cost of debt of the company = 6%
o ROCE: 40%
o Tax rate: 39.6%
o ERP: 5.6%
• Inputs for the High Growth Period
o Expected Growth Rate = 15%
o Length of high growth period = 5 years
o The beta during the high growth phase is expected to be 1.30
o Capital expenditures = 12% of Revenue
o Working capital is expected to be 20% of revenues.
o The debt ratio is approximately 9.55%; it is expected to remain unchanged.

• Inputs for the Stable Growth

o Expected Growth Rate = 4%
o Beta during stable growth phase = 1.10
o Capital expenditures = 10% of Revenue
o Working capital is expected to be 20% of revenues.
o The debt ratio is expected to remain at 9.55%.
o ROCE is expected to drop to 25%

A THREE STAGE FCFE MODEL

Exercise 1

Valuing America Online with the 3-stage FCFE model – ABC

Rationale for using Three-Stage FCFE Model

• Why three stage? The expected growth rate in earnings is in excess of 50%, partly because of
the growth in the overall market and partly because of the firm’s position in the business.
 • Why FCFE? The firm pays out no dividends, but has negative FCFE, largely as a
consequence of large capital expenditures.
• The firm uses little debt (about 10%) in meeting financing requirements, and does not plan to
change this in the near future.

Background Information

• Current Information
o Earnings per Share = $ 0.38
o Capital Spending per Share = $ 0.5
o Depreciation per Share = $ 0.7
o Depreciation Rate = 14%
o Revenues per share = $ 7.21
o Working Capital as a percent of revenues = 8.00%
o ROCE: 40%
o Cost of Debt: 5%
• Phase 1: High Growth Period
o Length of the high growth period = 5 years
o Expected growth rate in earnings during the period = 52% (from analyst projections
and market growth)
o Capital Spending = 8% of Revenue
o Working capital will remain 8% of revenues.
o Leverage: 10%
o The beta for the high growth period is 1.60.
o ROCE: 40%
• Phase 2: Transition period
o Length of the transition period = 5 years
o Growth rate will decline from 52% in year 5 to 4% in year 10 linearly.
o Capital Spending will decline to 5% by end of transition period
o Working capital will remain 8% of revenues.
o The debt ratio will remain at 10% during this period
o The beta will decline linearly from 1.60 in year 5 to 1.20 in year 10.
o ROCE will decline to 25%
• Phase 3: Stable Growth Phase
o Earnings will grow 4% a year in perpetuity.
o Capital expenditures will be offset by depreciation.
o Working capital will remain 8% of revenues.
o The debt ratio will remain at 10% during this period.
o ROCE: 25%
o The beta for the stock will be 1.20
 Calculation of WACC
Calculate missing values

Parameters Comments
Risk free rate, USD 1.51% YTM -10 Years US treasury
ERP 6%
Unlevered Beta 1.00
Re-levered Beta 1.39

YTM for Ukrainian Eurobond 9.40% YTM-2026 Ukrainian USD bonds

Sovereign risk of Ukraine 7.89%
Cost of Equity for USD denominated CFs ?

Forecasted long term inflation in US 1.90% US CPI for 2020

Forecasted long term inflation in Ukraine 3.40% Ukraine CPI for 2020

Cost of Equity for UAH denominated CFs ?

Debt to Equity ratio 50%

weight of Equity 67%
Weight of Debt 33%

Cost of debt for UAH denominated CFs 12%

Effective tax rate 23% Corporate tax rate
Marginal tax rate 18%
WACC ?

Relative Valuation
Please calculate and compare EV/EBITDAR multiple for US airlines industry. Consider operating
lease capitalisation.

Suggest the most undervalued and overvalued stock.