Estimating Firm Value with Free Cash Flow: Abbott Labs Case Study, Exams of Finance

Download Estimating Firm Value with Free Cash Flow: Abbott Labs Case Study and more Exams Finance in PDF only on Docsity! FINANCE 384: Corporate Valuation, Investment Decisions and Risk Management STUDENT LECTURE NOTE 3 Sp14CR (Rev Su’14) I. Corporate Value and Value-Based Management A. Maximization of Shareholder Wealth requires forecasting financial statements under alternative investment strategies, finding the NPV of the alternatives and choosing the investment strategy that yields the maximum value. B. The Dividend Growth Model is not appropriate for valuing firms in several circumstances. • Valuing ________ ________ that cannot afford to pay dividends • Established firms not yet paying dividends • Dividend-paying firms with multiple divisions C. Value-Based Management must ensure that managers have the proper incentives to ________ stockholder welfare. II. Estimating Firm (Share) Value with Free Cash Flow A. Free Cash Flow is a measure that can be used in a (FCF) Firm Valuation Model in place of the Discounted Dividend Model for firms that do not pay dividends. B. Operating Assets are the assets necessary to operate the business and may be in the form of either assets-in-place or growth options. C. Non-operating assets are typically in the form of marketable securities and investments in other businesses. D. For most companies operating assets are ____ ____ important than non-operating assets. E. Value of Operations is found in this model as the discounted present value of the expected future FCFs. E..1The model can account for FCFs that are growing at a constant rate or at a nonconstant rate (if a constant rate can be assumed at some future point). E..2Since FCF is the return on both debt and equity, the appropriate discount rate is the firm’s (WACC) weighted average cost of capital (kC). E..3The constant growth model is given in equation (3.1) below. Note the exact parallel with the constant growth dividend model for finding stock price, where D1 = D0*(1+g). VOp(0) (Constant) = . (3.1) ⇒ P0 = . E..4The value of common equity is then equal to: Total Assets - (Total Liabs + Pref Equity), Hello? More specifically its calculation is shown in equation (3.2) below. VEquity = TAs – (TLs + PE); (3.2) = (VOpAssets + VNonOpAssets) – (S-T + L-T Debt + PE). Ex. 3.1 Assume that the following information applies to Zebco, Inc. Determine: a) The firm’s value of operations, b) Value of common equity and c) Price per share. FCF for the year just ended (FCF0) $450,000 Long-term FCF growth rate (gn) 8% a) Assume FCF for 2012 equals $3,003,006 (in thousands). Calculate Abbott's expected FCFs for years 2013 through 2017. Round amounts to the nearest dollar in the answer. A.3.2A a) Note, where the number 12 is used as the subscript, it represents 2012, and so on. FCF13 = FCF12 * (1+g13) = $3,003,006 * (1+0.7692020) = $__5312923_______. FCF14 = FCF12 * (1+g13) * (1+g14) = $3,003,006 * (1+0.7692020) * (1 +(-0.1874740)) = $____4316889___. FCF15 = FCF12 * (1+g13) * (1+g14) * (1+g15) = $3,003,006 * (1+0.7692020) * (1 +(-0.1874740)) * (1+0.135875) = $____4903446_____. (vs. $4,903,445 fr. LN03 SS) FCF16 = FCF12 * (1+g13) * (1+g14) * (1+g15) * (1+g16) = 3,003,006 * (1+0.7692020) * (1 +(-0.1874740)) * (1+0.135875) * (1+0.3329360) = $_6535980________. (vs. $6,535,977 fr. LN03 SS) FCF17 = FCF16 * (1+(Sales)g17) = $6,535,980 * (1+.04) = $_6797419________. (vs. $6,797,416 fr. LN03 SS) b) In what year will Abbott's first normal-growth FCF occur? A.3.2A b) Since there are non-normal FCF growth rates for years 2013, 2014, 2015 and 2016, the first normal-growth FCF will be in __2017___. c) Determine the Value of Operations expected at the end of year 2016 (VOp(16)) based on the first normal-growth FCF. -start at 2017-infinity A.3.2A c) VOp(16) = = ≈ $_169935485__________. (vs. $169,935,402 fr. LN03 SS) d) Find the current (year-end 2012) Value of Operations (VOp(12)) at which Abbott's stock should be trading based on the variable-growth model values developed above. A.3.2A d) Will use LN03 Abbott_Valuation worksheet results here. VOp(12) = + = = $4,988,711 + $3,770,538 + $3,947,080 + $129,711,732 = $___142418061________. (vs. $142,418,010 fr. LN03 SS) e) Use the value of operations (VOp(12)) and the approach in equation (3.2) above to find the market price per share. Note: From Abbott’s SEC 10-K filing there were 1,575,378 shares (in thousands) outstanding at year-end 2012. VEquity = VOp(12) + Marketable Securities =TA – (Notes Pay + L-T Bonds + Other L-T Liabs). = $142,418,010 + $4,371,821 – ($3,267,426 + $18,085,302 + $9,056,234) = $146,789,831 - $30,408,962 = $____116_______. Projected MPS = $116,380,869 ÷ 1,575,378 = $ _73.87____. f) What might Rasmus conclude about his estimate compared to the market price of $65.50 (as of that date)? A.3.2A f) Obviously Rasmus’ estimate of $73.87 is somewhat higher ($8.37) than the current share price of $65.50 (or, about 12.8% = (Diff ÷Actual)). F.Y.I. To make the 2012 Value of Operations even this low, I have decreased the Yahoo forecast for Industry and Firm growth rates and also increased the WACC. Obviously, there are a lot of estimates involved here, and I believe there are no mistakes in my calculations. But, this last point does not guarantee that my analysis matches that of other analysts, eg. Bloomberg. Homework Extension: Extra Critical Thinking g) Determine the value of Abbott’s operations at year-end 2014 (VOp(14)) given the previous information, including the estimated FCFs and WACCs. A.3.2A g) If you were the CFO performing this valuation you would need to identify the FCFs received and then find the present value at the appropriate discount rates. If the firm were purchased at year-end 2014, the 2014 FCF is not relevant, as it is an historical cash Earnings before taxes $6,262,614 Taxes $299,694 EAT (Net income before pref. div.) $5,962,920 Preferred div. - EAC (Net income avail. for com. div.) $5,962,920 Common dividends $3,182,811 Addition to retained earnings $2,780,109 Number of shares (in millions) 1,575,378 Dividends per share $2.02 Projected Inputs Actual Projected Projected Projected Projected 2012 2013 2014 2015 2016 Sales Growth Rate 2.63% 11.90% 10.90% 10.20% 4.00% COS / Sales 37.92% 43.08% 43.08% 43.08% 43.08% Other Costs (exc Depr)/Sales 38.39% 35.49% 35.49% 35.49% 35.49% Depreciation / Net PPE 16.91% 14.94% 14.94% 14.94% 14.94% Cash / Sales 27.09% 13.43% 13.43% 13.43% 13.43% Acct. Rec. / Sales 19.09% 19.10% 19.10% 19.10% 19.10% Inventories / Sales 9.51% 11.15% 11.15% 11.15% 11.15% Net PPE / Sales 20.22% 26.60% 26.60% 26.60% 26.60% Acct. Pay. / Sales 4.51% 4.82% 4.82% 4.82% 4.82% Accruals / Sales 20.60% 18.64% 18.64% 18.64% 18.64% Tax rate 4.79% 23.66% 23.66% 23.66% 23.66% WACC 6.50% 7.00% 7.50% 8.00% 8.00% A3.2B.a) Use the “Projected Input” ratios to forecast Sales, Costs, Depreciation, and then calculate EBIT. Note: FAs must be forecast before Depr. Partial Income Statement for the Year Ending December 31 ($ thousands) Actual Projected Projected Projected Projected 2012 2013 2014 2015 2016 Net Sales $39,873,910 $44,618,905 $49,482,366 $54,529,567 $56,710,750 Cost of Sales $15,119,718 $19,221,824 $21,317,003 $23,491,338 $24,430,991 Other Costs (exc Depr) $15,306,004 $15,835,249 $17,561,292 $19,352,543 $20,126,645 Depreciation $ 1,363,673 $ 1,773,173 $ 1,966,449 $ 2,167,027 $ 2,253,708 Total Oper Costs $31,789,395 $36,830,246 $40,844,744 $45,010,907 $46,811,344 EBIT $8,084,515 $ 7,788,659 $ 8,637,622 $ 9,518,660 $ 9,899,406 Next, use the relevant ratios to forecast Cash, Accounts Receivable, Inventory, Net Physical Plant and Equipment (PPE), Accounts Payable and Accruals. Recall that Other Current Assets and Other L-T Assets are assumed to be unchanged. Partial Balance Sheet for December 31 ($ thousands) Actual Projected Projected Projected Projected Operating Assets 2012 2013 2014 2015 2016 Cash $10,802,163 $5,992,319 $6,645,482 $7,323,321 $7,616,254 Accts Recs $7,612,860 $8,522,211 $9,451,132 $10,415,147 $10,831,753 Inventories $3,792,313 $4,975,008 $5,517,284 $6,080,047 $6,323,249 Other Cur Assets $4,743,426 $4,743,426 $4,743,426 $4,743,426 $4,743,426 Net PPE $8,063,047 $11,868,629 $13,162,309 $14,504,865 $15,085,059 Other L-T Assets $27,849,314 $27,849,314 $27,849,314 $27,849,314 $27,849,314 Total Fixed Assets $35,912,361 $39,717,943 $41,011,623 $42,354,179 $42,934,373 Operating Liabs Accts Payable $1,796,990 $2,150,631 $2,385,050 $2,628,325 $2,733,458 Accruals $8,215,760 $8,316,964 $9,223,513 $10,164,311 $10,570,884 A3.2B.b) Calculate Free Cash Flow using the approach developed in F384 Lecture Note #2. Equations given previously: • Operating Current Assets = (Cash+AR+Inv+Other CAs). • Operating Current Liabilities = (AP+Accruals). • Net Operating Working Capital = Oper CA - Oper CL. • Operating Capital = NOWC + Net FA. • NOPAT = EBIT * (1-t). • Free Cash Flow = NOPAT - Net Cap Invest. Actual Projected Projected Projected Projected Calculation of FCF 2012 2013 2014 2015 2016 Operating Cur Assets $26,950,762 $24,232,964 $26,357,324 $28,561,941 $29,514,682 Operating Cur Liabs $10,012,750 $10,467,595 $11,608,563 $12,792,636 $13,304,342 Net Oper Work Cap $16,938,012 $13,765,369 $14,748,761 $15,769,305 $16,210,340 Total Fixed Assets $35,912,361 $39,717,943 $41,011,623 $42,354,179 $42,934,374 Net Operating Capital $52,850,373 $53,483,311 $55,760,384 $58,123,484 $59,144,714 NOPAT $ 7,697,267 $ 5,945,862 $ 6,593,961 $ 7,266,545 $ 7,557,207 Investmnt in Oper Cap $ 4,694,261 $ 632,939 $ 2,277,072 $ 2,363,100 $ 1,021,230 Free cash flow $ 3,003,006 $ 5,312,923 $ 4,316,889 $ 4,903,445 $ 6,535,977 % Growth in FCF na 76.92020% -18.74740% 13.58750% 33.29360% % Growth in Sales 2.63% 11.90% 10.90% 10.20% 4.00% A3.2B.c) Sample Calculations shown below: Oper Profit2012 = $7,697,267/$39,873,910 = ______%. =B102/B66 Cap Reqs2012 = $52,850,373/$39,873,910 =_______%. =B101/B66 ROIC2013 = = _______%. =C102/B101 Spread2013 = 11.25% - 7.00% = ______%. =C117-C118 Actual Projected Projected Projected Projected 2012 2013 2014 2015 2016 Oper Profitability = NOPAT/Sales 19.30% 13.33% 13.33% 13.33% 13.33% Cap Req = Oper Cap/Sales 132.54% 119.87% 112.69% 106.59% 104.29% ROIC = NOPAT/OperCap na 11.25% 12.33% 13.03% 13.00% WACC 6.50% 7.00% 7.50% 8.00% 8.00% ROIC-WACC Spread na 4.25% 4.83% 5.03% 5.00% Conclusion: As the spread between ROIC and WACC is projected to be positive, MVA should also be ________. A3.2B.d) The FCF shown below was already found in part b) above. Further, Value of Operations was previously calculated as the answer to part a) of Ex. 3.2A. Note: MVA = MV of company – BV of company = Value of operations - Operating capital. (3.8) Actual Projected Projected Projected Projected Projected 2012 2013 2014 2015 2016 2017 FCF na $5,312,923 $4,316,889 $4,903,445 $ 6,535,977 $ 6,797,416 L-T FCF growth rate 4.00% WACC 6.50% 7.00% 7.50% 8.00% 8.00% a – Calculated using the Black-Scholes model with the following material assumptions and adjustments: (1) an interest rate equal to the rate on U.S. Treasury securities with a maturity date corresponding to the assumed option term of five years; (2) volatility determined using daily stock prices during the five-year period immediately preceding date of grant; (3) a dividend rate of $0; and (4) in each case (other than the options described in note c), a reduction of 25% to reflect the probability of forfeiture due to termination of employment prior to vesting and the probability of a shortened option term due to termination of employment prior to the option expiration date. The actual value realized will depend on the difference between the market value of the common stock on the date the option is exercised and the exercise price. b – These options vest and become exercisable ratably over five years (20% per year) beginning on the first anniversary of the date of grant. c – These options were granted as a part of the Executive Stock Ownership Incentive Program, under which the executives can elect to receive options in lieu of their annual bonus. The exercise price of the options was 80% of the fair market value of the common stock on the date of grant, and the number of shares awarded was calculated by dividing the designated bonus amount by 20% of the fair market value of the common stock on the date of grant. The awards shown were granted in lieu of the 2002 annual bonus amounts shown in the “Summary Compensation Table” above. These options vest and become exercisable with respect to 50% of the underlying shares on each of the first two anniversaries of the date of grant. www.dell.com/investor A3.3.a) If the stock price on 3/22/04 equals $33.09 should the options be exercised? The issue is whether a logical investor would be willing to pay $27.64 to purchase shares that are worth $33.09. Of course! In General: Exercise Value = Current Stock Price – Strike Price, = S – K. (3.9) Here: Exercise Value = $33.09 - $27.64 = $__5.45___. A3.3.b) Total Exercised Value = ($33.09-$21.39) * 64,940 = $____759798.00_____. A3.3.c) HPY = = _11.24_____%. A3.3.d) (CAPM) kDell = .034 + [1.68 * (.06)] = _13.48____%. Conclusion: Since the realized return (from part c)) is less than the CAPM required return, at least over this period, Dell’s stock underperformed______________ investor expectations. .b Employee Stock Ownership Plans (ESOPs): Authorized by Congress to help improve employee retirement incomes and corporate productivity. .c Five principal reasons the firm benefits: • Employees with an ______ stake are expected to work harder and smarter. • ESOP represents a potential wealth transfer from ________ shareholders to employees. • ESOP may improve ________ of employees. • Tax incentives as the firm can borrow at lower rates through the ESOP and cash dividends paid on ESOP stock may be deductible. • Potentially undesirable benefit is that if the ESOP owns a significant portion of company stock, this may be used to help avoid a takeover. H. The Possibility of Takeover is the primary factor that acts as a stick in threatening management with ________ consequences. I. Entrenched Management may result from strong anti-takeover provisions in the corporate charter and/or a weak Board of Directors. There are several undesirable consequences that may result. • Executives may consume unnecessary perquisites (nonpecuniary benefits). • Management may not properly reduce _____ through layoffs or plant closures. • Managers may not undertake projects that will generate primarily long-term profits, or prema- turely abandon such projects. • Acquisitions may be undertaken at excessive prices, when the focus is on increasing firm ____, instead of firm value. J. Anti-takeover Provisions serve as barriers to hostile takeovers. In such cases, typically, poorly- performing firms are acquired and incumbent management is replaced. The acquired firm’s shareholders _______ as long as the acquiring firm does a better job of managing the assets. K. Shareholder-friendly Charters should ban the following provisions. e) Greenmail is a share repurchase where a potential bidder’s stock is targeted for purchase at a ______ price than other shareholders could receive. f) Poison Pills are a shareholder rights provision that allow the target firm’s s-holders to buy a certain number of shares at a very ____price if a bidder acquires a specified percentage of the target’s stock. g) Restricted Voting Rights automatically deprive a shareholder of ______ ______ if they acquire more than a specific amount of the target firm’s stock. L. Effective Monitoring by the Board of Directors C..bBoard seats are ________ in terms of compensation and prestige and the board member might feel allegiance to the person who helped them get the seat.