Chapter 2
A Complete Corporate
Valuation for a Simple
Company
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Three types of value
Book value: company’s historical value
as shown on its financial statements.
Market value: current price an asset can
be bought or sold.
Intrinsic value: estimate of the value an
individual buyer places on an asset.
Also called its fundamental value.
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The process is known as fundamental
valuation—Warren Buffet =success
identifying a company’s fundamental
value.
OBJECTIVE: Provide sound basis for
estimating stock’s intrinsic value.
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Three basic concepts of
valuation
Investors can only spend cash so "Cash is
good and more cash better."
Cash today is worth more than cash
tomorrow.
Risky cash flows are worth less than safe
cash flows.
Imply value of a company depends on size,
timing, & riskiness of its cash flows.
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Valuation of a Simple
Company: Mayberry Personal
Receivers, Inc. (MPR)
Investors are:
Debtholders
 Stockholders

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Debtholders and the value of
debt
Bond with 10 yrs to maturity pays 9% coupon.
$1,000 is the face or maturity value (FV)
$90 is coupon pmt (9%x$1000 FV)
N= 10 yrs
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What do investors require?
MPR’s bonds compete in market with
other bonds. If investors can earn 9%
on similar investments, then MPR has
to offer at least 9% on its bonds to
attract investors. The required rate of
return is 9%.
rD = 9%
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More investors…
MPR’s shares of stock also compete in
market for investors.
Stockholders = owners of firm, and value of
ownership is value of asset, less any debt
owed.
Ex: Suppose MPR’s worth $501 million. It
owes $150 million to debtholders. So MPR’s
equity worth = $501 – 150 = $351 million.
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Cash flows received by equity holders
Dividends:
Not fixed—usually grow
 No maturity date
 Riskier than bond payments
 The required return on equity, rS,
compensates investors for this risk. MPR’s
rS is 12%.

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Discounted dividend valuation
MPR’s last dividend, D0,was $2.34 per share, and
expected to grow at 5% per year.
The price today of the stock based on this at 12%
required return:
Do (1  g ) $2.34(1.05)
Po 

 $35.10
Rg
.12  .07
If co. doesn’t pay dividends, doesn’t work!
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The Corporate Valuation Model
PV of cash flows available to all
investors—called free cash flows
(FCFs).
Discount free cash flows at average rate
of return reqr’d by all investors—WACC
(weighted average cost of capital)
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Steps in the corporate value
model
Determine WACC
Estimate expected future FCF’s
Find value of company
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Estimating the Weighted Average
Cost of Capital (WACC)
Company has two types of investors


Debtholders
Stockholders
Each type of investor expects to receive a
return for their investment
The return an investor receives is a “cost of
capital” from company’s viewpoint.
One person’s return is another’s cost.
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Cost of Debt
MPR’s cost of debt: rD = 9%.
Interest deductable, so cost is after-tax
rate on debt.
If tax rate is 40%, then after-tax cost of
debt:

After-tax rD = 9%(1-0.4) = 5.4%.
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Cost of Equity
Cost of equity, rs, is higher than cost of
debt because stock is riskier.

MPR: rs = 12%
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Weighted Average Cost of
Capital
WACC is average of costs to all investors,
weighted by target % of firm financed by each
For MPR, target % equity financing equity:

wS = 70%
Target % debt financing:

wD = 30%
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WACC (Continued)
WACC = wD rD (1-T) + wS rS
= 0.3(9%)(1 - 0.4) + 0.7(12%)
= 10.02%
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Free Cash Flow (FCF)
FCF=amount of cash available from
operations for distribution to all
investors (stockholders and
debtholders) after making necessary
investments to support operations.
Firm’s value depends upon amount of
FCF generated.
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Calculating FCF
FCF = net operating profit after taxes (NOPAT)
minus investment in operating capital
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Financial Statements
Balance sheet

Assets (all of MPR’s assets are used in
operations)

Operating assets


Operating current assets
Property, plant, and equipment (PPE)
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Operating Current Assets
Operating current assets: CA needed to
support operations.
Op CA include: cash, inventory,
receivables.
 Op CA exclude: s/t investments, because
not part of ops.

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Operating Current Liabilities
Operating current liabilities: are normal
part of operations.
Op CL include: accounts payable and
accruals.
 Op CL exclude: notes payable, because is
financing source, not operating.

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Balance Sheet: Assets
2001
Op. CA
162,000.0
Total CA 162,000.0
Net PPE
199,000.0
Tot. Assets 361,000.0
2002
168,000.0
168,000.0
210,042.0
378,042.0
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2003
176,400.0
176,400.0
220,500.0
396,900.0
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Balance Sheet: Claims
2001
Op. CL
57,911.5
Total CL 57,911.5
L-T Debt
136,253.0
Total Liab.194,164.5
Equity
166,835.5
TL & Eq. 361,000.0
2002
62,999.7
62,999.7
143,061.0
206,060.7
171,981.3
378,042.0
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2003
66,150.0
66,150.0
150,223.0
216,373.0
180,527.0
396,900.0
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Income Statement
2001
Sales
400,000.0
Costs
344,000.0
Op. prof. 56,000.0
Interest
11,678.7
EBT 44,321.3
Taxes (40%) 17,728.4
NI
26,592.7
Dividends
21,200.0
Add. RE
5,392.7
2002
420,000.0
361,994.2
58,005.8
12,262.8
45,743.0
18,297.2
27,445.8
22,300.0
5,145.8
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2003
441,000.0
374,881.6
66,118.4
12,875.5
53,242.9
21,297.2
31,945.7
23,400.0
8,545.7
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NOPAT (Net Operating Profit
After Taxes)
NOPAT: amount of after-tax profit from
operations.
NOPAT: amt of net income, or earnings,
a company with no debt or interestincome/expense would have.
NOPAT
= (Operating profit) (1-T)
= EBIT (1-T)
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Calculating NOPAT
NOPAT = (Operating profit) (1-T)
= EBIT (1-T)
NOPAT03=
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Calculating Operating Capital
Operating capital (total operating
capital, or just capital): amount of assets
required to support the company’s
operations, less liabilities arising from
those ops.
S/T piece: net operating working capital
(NOWC).
 L/T piece:factories, land, equipment.

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Net Operating Working Capital
NOWC = Operating current assets
– Operating current liabilities
Net amount tied up in “things” needed to
run company on a day-to-day basis.
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Net Operating Working Capital
NOWC = Operating CA – Operating CL
NOWC03 =
=
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Operating Capital
Operating capital =
 Net
operating working capital
(NOWC) plus
 Long-term capital, such as factories,
land, equipment.
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Operating Capital = NOWC + LT Op.
Capital
Capital03 =
=
::In 2003 MPR had $330.75 million tied up in
capital needed to support its operations.
Investors supplied this money. Not
available for distribution.
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Investment in operating capital
Operating capital in 2002: $
Operating capital in 2003: $
MPR makes net investment of $
million in operating capital
in 2003.
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Calculating FCF
FCF = NOPAT – Investment in operating
capital
FCF03 = `
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There are five ways for a
company to use FCF
1. Pay interest on debt.
2. Pay back principal on debt.
3. Pay dividends.
4. Buy back stock.
5. Buy nonoperating assets (e.g.,
marketable securities, investments in
other companies, etc.)
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Reinvestment
Bucket
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Free Cash Flow
Bucket 36
How Did MPR use its FCF?
Paid:
Paid:
Totals $31.1253 million. Is
more than
FCF available.
Comes from?
MPR increased
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Corporate Valuation
Forecast financial statements and use
them to project FCF.
Discount the FCFs at the WACC
This gives the value of operations
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Value of Operations:

FCFt
VOp  
t
t 1 1  WACC 
Requires projecting free cash flows out forever.
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Constant growth
If free cash flows expected to grow at
5% constant rate:
FCF
2003
23.963
2004
25.161
2005
26.419
2006
27.740
2007
29.127
2008
30.584
Use constant growth approach as would with
constant growth dividends to get stock price
today Po
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Constant Growth Formula
The summation can be replaced by a
single formula:
FCF1
VOp 
WACC  g 
FCF0 (1  g )

WACC  g 
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The value of operations
FCF0 (1  g )
VOp 
WACC  g 
$23.96334 (1  0.05)
VOp 
0.1002  0.05
 $501.225 million
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Value of Equity
Sources of Corporate Value
Value of operations =
 Value of non-operating assets =
 Claims on Corporate Value=
 Value of Debt =

Value of Equity = ?
Value of Equity =
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Value of Equity
Price per share
= Equity / # of shares
= $351 million / 10 million shares
= $35.10 per share
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A picture of the breakdown of
MPR’s value
Debt
Equity
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Return on Invested Capital
(ROIC)
ROIC: used to evaluate Firm’s
performance:
ROIC = NOPAT / Total operating capital
at beginning of year
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ROIC calculation
ROIC03 = NOPAT03 / Capital02
ROIC03 =
ROIC good because greater than return
investors require (WACC), of 10.02%.
So MPR added value during year.
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Economic Value Added (EVATM)
(also called Economic Profit)
EVA: another key measure of operating
performance.
EVA:trademarked by Stern Stewart, Inc.
Measures amount of profit firm earned,
over and above amount of profit
investors required.
EP = NOPATt – WACC(Capitalt-1)
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Calculating EVA
EVA = NOPAT- (WACC)(Begng. Capital)
EVA03 = NOPAT03 – (0.1002)(Capital02)
EVA03 = $
(More…)
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Economic profit…
In 2003 MPR earned about $8 million
more than its investors required.
Another way to calculate EP:
EPt = (ROIC – WACC)Capitalt-1
=(
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Intuition behind EP
If ROIC – WACC spread positive, then
firm generates more than enough
“profit,” & increases value. But, if ROIC
– WACC spread negative, then firm
destroys value, in the sense that
investors would be better off taking their
money and investing it elsewhere.
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Applications of the corporate
valuation model
Mergers and acquisitions

Evaluate how much a target is worth under
various operating scenarios
Value-based management

Make decisions with the goal of increasing the
company’s value
Fundamental investing

Identify firms that are worth more than current
stock price
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