FIN 430 — Finance Theory and PracticeProject AssignmentsCalculat.docx

FIN 430 — Finance Theory and PracticeProject Assignments

Calculating theWeighted Average Cost of Capital (WACC)
foryour Company

For use in Conjunction with the Firm Valuation Project

First ensure that you have read relevant pages in the text. Some
important sections would include the following, but you may
also double-check the references in the text by using the index
[see: Cost of Capital and Target (optimal) Capital Structure,
etc.]:

The important Chapter in the text is the one entitled "The Cost
of Capital," – with a particular focus on the section entitled
“The Weighted Average Cost of Capital” and the section “Four
Mistakes to Avoid” at the end of the chapter.

The WACC formula discussed below does not include Preferred
Stock. Should your company use PS, be sure to adjust the
equation for it, and see the section in the chapter on the Cost of
Preferred Stock.

The WACC formula that we use is:

WACC = wdrd(1-T) + wsrs

We need to know how to calculate:

1. rsthe cost of common equity. Use the Security Market
Line (SML) – this is why you learn how to calculate a
company’s beta and also why you learn how to find the
appropriate risk-free rate and market-risk premium. For a

review, see the section the text, The CAPM Approach.

2. The weights (wd and ws – note that: wd + ws = 1; so you
only have to calculate one of them). We need to calculate the
weight of debt and the weight of equity (for the cost of debt,
this simply means: what proportion of the firm’s financing is by
debt?). There is a lot to say here, simplified as Theory 1,
Theory 2 and Practice:

a. Theory 1: Theory says that we should use the target
weights along with the market values of both debt and equity
(see the Four Mistakes to Avoid). But the market value of debt
is typically difficult to calculate, because we need to know the
YTM (which is rd) for all of the company’s debt, but we cannot
calculate the YTM without having the current prices of the
company’s outstanding bonds, and most company’s bonds do
not trade (i.e., they will not have up-to-date or current prices –
remember how to calculate the price (value) of a bond on your
calculators?!). As a result, at least for the group project, we go
to Theory 2.

b. Theory 2: Theory also says that we should use the
TARGET weights, but this is a management decision, and as
“outsiders” we do not have access to the thoughts of the CFO or
CEO. So we should look instead to the historical pattern of the
use of debt (mix of debt and equity), and this is one reason that
you should have about 10 years of financial data.

c. Practice: Since we cannot “work” according to the strict
theory of finance, we have to estimate the relevant weights. As
a result, we will use the formula:
wd = Book Value of Debt / [Market Value of Equity + Book
Value of Debt]

The book value of debt is calculated by adding up ALL of the

debt on the balance sheet. This will typically be the sum of
Notes Payable, Current Portion of LT Debt and Long-Term
Debt.

The market value of equity is the “Market Cap,” and equals the
number of (common) shares outstanding multiplied by the
price/share. Note that the “timing” of this value should
coincide with the book value of debt. For example, if you
calculate the book value of debt as of 12/31/17, then the market
cap should also be calculated for that date. Be very careful
about using the reported Market Cap on Yahoo.finance – it may
not have the same “timing.”

3. r d; the cost of debt. There may be more than one
acceptable approach to calculate or estimate a company’s cost
of debt (be sure to read the text!). One relatively
straightforward method is to discover the company’s debt rating
(e.g., by Moodys). This can usually be found on the company’s
10K (see the link on my homepage) and doing a word search for
‘rating’ or ‘debt rating.’ For a discussion of bond ratings, see
the text (look in the index). If you can find the debt rating for
your company then you can carry out the following steps (if you
cannot find a bond rating for your company, you might try to
estimate/guess what it is by considering your company’s beta
and comparing the bond ratings for companies with similar
betas). If you are not able to find a bond rating readily, you can
register (forfree) at Standard & Poor's and at Moody's to find
company ratings. You may also find other interesting and
useful information there. For a general discussion of what the
ratings mean, see the information from these rating agencies on
my homepage at the Bond Rating link.

Once you have the actual bond rating or an estimate you can
then find or estimate your company’s cost of debt by going to
Yahoo.finance and clicking on the Bonds/Rates
link(http://bonds.yahoo.com/rates.html). Look at the yields for

the 20 year Corporate Bonds by rating. If your company’s bond
rating is listed, you’re in luck. If it is not listed then you can
estimate the cost of debt. For example, if the AAA yield is
6.50%, the AA yield is 6.75% and the A yield is 7.00%, you can
see a pattern (equation). For every increase in risk (from AAA
to AA), there is a 0.25% increase in the yield. If your company
has a BB rating, then it is two steps “below” the A rating, so
you should add approximately 0.50% more to the 7.00% for the
A rating, giving you a cost of debt for your company of about
7.50%. Note that this approach assumes a linear equation for
the cost of debt (which may not be strictly true).

Another simple way is to look at the average cost of debt for
the firm: Pre-tax cost of debt = annual interest payment / total
interest-bearing debt. Please use the average cost for last three
years.

4. The corporate tax rate ( T ). Be sure to read the section in
the text on Corporate Income Taxes (Chapter 2). The correct
tax rate for a company is the marginal tax rate for the future! If
you expect your company to be very profitable for a long time
into the future, then the tax rate ( T ) for your company should
probably be the highest marginal tax rate applicable for
corporations. But there are times when companies can obtain
long-term tax breaks so that their tax rates may be lower than
the stated (regulated) tax rate. Consequently you may want to
calculate several/manyhistorical effectivetax rates for you
company. The effective tax rate is the actual taxes paid divided
by earnings before taxes (on the income statement). You can
calculate/consider these rates for the past 5-10 years and then
compare this effective tax rate to the legally mandated highest
marginal corporate tax rate. If the past historical effective rate
is lower than the marginal tax rate, there may be a good reason
for using that lower rate in your pro formas.

5. r cs; the cost of common stock

You can use CAPM model to predict the cost of common stock.
The equation runs as followings:
ri = rRF + (RPM) bi

In order to use this model, first you should estimate the beta of
your stock. Please refer to the guidelines of beta calculationfor
more information. Please use the average 10 year Treasury bond
rates as the proxy of risk-free rates.

.

The Validity of Company Valuation

Using Discounted Cash Flow Methods

Florian Steiger
1

Seminar Paper
Fall 2008

Abstract

This paper closely examines theoretical and practical aspects of
the widely used discounted

cash flows (DCF) valuation method. It assesses its potentials as
well as several weaknesses. A

special emphasize is being put on the valuation of companies
using the DCF method. The

paper finds that the discounted cash flow method is a powerful
tool to analyze even complex

situations. However, the DCF method is subject to massive
assumption bias and even slight

changes in the underlying assumptions of an analysis can
drastically alter the valuation

results. A practical example of these implications is given using
a scenario analysis.

____________
1
Author: Florian Steiger, European Business School, e-mail:
[email protected]

Table of Contents

List of abbreviations
...............................................................................................
............ i

List of figures and tables
...............................................................................................
.... ii

1 Introduction
...............................................................................................
................... 1

1.1 Problem Definition and Objective
...................................................................... 1

1.2 Course of the Investigation
................................................................................. 2

2 Company valuation
...............................................................................................
........ 2

2.1 General Goal and Use of Company Valuation
................................................... 2

2.2 Other Valuation Methods
................................................................................... 3

3 The Discounted Cash Flow Valuation Method

............................................................ 4

3.1 Approach of the Discounted Cash Flow Valuation
............................................ 4

3.2 Calculation of the Free Cash Flow
..................................................................... 5

3.2.1 Cash Flow to Firm and Cash Flow to
Equity.................................................. 5

3.2.2 Building Future Scenarios
.............................................................................. 6

3.3 The Weighted Average Cost of Capital
............................................................. 6

3.3.1 Cost of Equity
...............................................................................................
.. 7

3.3.2 Cost of Debt
...............................................................................................
..... 8

3.3.3 Summary
...............................................................................................
.......... 9

3.4 Calculation of the Terminal Value
................................................................... 10

3.5 Determination of Company Value
................................................................... 11

4 Validity of the Discounted Cash Flow Valuation Approach

...................................... 11

4.1 Case Study: BASF
............................................................................................
11

4.2 Sensitivity Analysis
.......................................................................................... 12

5 Conclusion
...............................................................................................
................... 14

Reference List
...............................................................................................
.................. 16

Appendix
...............................................................................................
.......................... 18

Discounted Cash Flow Valuation i

List of abbreviations

APV Adjusted Present Value

bp Base Point (equal to 0.01%)

Capex Capital Expenditure

CAGR Compounded Annual Growth Rate

CAPM Capital Asset Pricing Model

COD Cost of Debt

COE Cost of Equity

D&A Depreciation and Amortization

DCF Discounted Cash Flow

EBIT Earnings Before Interests and Taxes

EBITDA Earnings Before Interests, Taxes, Depreciation and
Amortization

EURm Millions of Euro

EV Enterprise Value

Eq. V. Equity Value

FCF Free Cash Flow

FCFE Free Cash Flow to Equity

FCFF Free Cash Flow to Firm

IPO Initial Public Offering

LBO Leveraged Buyout

LIBOR London Interbank Offer Rate

M&A Mergers and Acquisitions

NI Net Income

NOPAT Net Operating Profit After Taxes

NPV Net Present Value

P / E Price Earnings Ratio

r Discount Rate

ROA Return on Assets

ROE Return on Equity

SIC Standard Industry Classification

t or T Tax Rate

T-Bill US Treasury Bill

T-Bond US Treasury Bond

TV Terminal Value

Discounted Cash Flow Valuation ii

List of figures and tables

Table 1. Long term credit rating scales: Source: adapted from

HSBC handbook, 2008

Table 2. Trading comparables analysis

Table 3. Transaction multiple analysis

Table 4. Case Study: Calculation of the enterprise value

Table 5. Case Study: Sensitivity Analysis WACC, perpetual
growth rate

Table 6. Case Study: Sensitivity analysis perpetual growth rate,
sales CAGR

Table 7. Case Study: Income statement estimates

Table 8. Case Study: Liabilities structure

Table 9. Case Study: WACC calculation

Table 10. Case Study: Terminal Value calculation

Table 11. Case Study: DCF valuation

Figure 1. LIBOR credit spread (in bp): Source: Bloomberg
Professional Database, 2008

Discounted Cash Flow Valuation 1

1 Introduction

The goal of this paper is to introduce the reader to the method
of company valuation

using discounted cash flows, often referred to as “DCF”. The
DCF method is a standard

procedure in modern finance and it is therefore very important
to thoroughly understand

how the method works and what its limitations and their
implications are. Although this

paper is on a basic level, it requires some knowledge of
accounting and corporate

finance, as well as a good understanding of general economic
coherencies, since not

every topic can be explained in detail due to size limitations.

1.1 Problem Definition and Objective

Since the beginning of the year 2008, Goldman Sachs has
advised clients on merger and

acquisition (M&A) deals with aggregated enterprise values (EV)
of more than EURm

475,000 according to recent league tables (Thomson One
Banker, 2008). There are

“probably almost as many motives for M&As as there are bidder
and targets”

(Mukherjee, Kiymaz, & Bake, 2004, p. 8), but the transaction
volumes indicate the

importance that M&A activities have for the worldwide
economy and underline the

necessity for efficient methods to adequately value companies.

The DCF method is based upon forward looking data and
therefore requires a relatively

large amount of predictions for the future business situation of
the company and the

economy in general. Minor changes in the underlying
assumptions will result in large

differences in the company’s value. It is therefore very
important to know which

assumptions are used and how they influence the outcome of the
analysis. For this

reason, this paper will introduce the key input factors that are
needed for the DCF

analysis and examine the consequences that changes in the
assumptions have on the

company value.

The DCF analysis is a very powerful tool that is not only used
to value companies but

also to price initial public offerings (IPOs) and other financial
assets. It is such a

powerful tool in finance, that it is so widely used by
professionals in investment banks,

consultancies and managers around the world for a range of
tasks that it is even referred

to as “the heart of most corporate capital-budgeting systems”
(Luehrman, 1998, p. 51).

Discounted Cash Flow Valuation 2

1.2 Course of the Investigation

This paper begins with a brief introduction to valuation
techniques in general and shows

how valuation techniques can be used to assess a company’s
value. Afterwards the basic

idea behind the DCF valuation technique will be introduced and
the key input factors

will be explained and discussed, since it is most important to
gain a deep understanding

on how the input is computed to state the company value. In the
next step a sensitivity

analysis will be conducted using BASF as an example to explain
how varying input will

lead to different results. In the end, a conclusion will be drawn
on the benefits and

shortfalls of the DCF valuation technique.

2 Company valuation

2.1 General Goal and Use of Company Valuation

The goal of company valuation is to give owners, potential
buyers and other interested

stakeholders an approximate value of what a company is worth.
There are different

approaches to determine this value but some general guidelines
apply to all of them.

In general there are two kind of possible takeover approaches.
An interested buyer could

either buy the assets of a company, known as asset deal, or the
buyer could take over a

majority of the company’s equity, known as share deal.
2
Since taking over the assets

will not transfer ownership of the legal entity known as “the
company”, share deals are

much more common in large transactions. Due to the financing
of a company by debt

and equity, valuation techniques that focus on share deals either

value the equity,

resulting in the equity value (Eq. V.) or the total liabilities,
stating the enterprise value

(EV) or firm value (FV). It is possible to derive the EV from the
Eq. V. and vice versa

(Bodie, Kane, & Marcus, 2008, pp. 630-631) by using the
following formula:

?????? − ????????? ???????????? − ??????????????????????????? ????????????????????????????????? =
??????. ???.

Net debt and the corporate adjustments are derived with the
following definitions:

????????? ???????????? = ???????????? ???????????? ???????????? + ??????????????? ????????????
???????????? + ????????????????????????????????? ??????????????????

+ ??????????????? ???????????????????????? ???????????????????????? ?????????????????????????????? −
???????????? ????????? ???????????????????????? ??????????????????

____________

2
Actually there are more possibilities to gain ownership of a
company, like a debt-to-equity swap,

where debt holders offer the equity holders to swap their debt
into equity of the company and therewith

gain equity ownership. This usually happens with companies
that are in financial distress like insolvency

or bankruptcy.

Discounted Cash Flow Valuation 3

??????????????????????????? ?????????????????????????????????

= ???????????????????????? ??????????????????????????? + ?????? ?????? ?????????????????????
?????????????????????

+ ?????????????????????????????? ??????????????? ????????????????????????????????? ±
?????????????????????????????? ???????????????????????????

2.2 Other Valuation Methods

There are many other valuation techniques besides the DCF
approach which are

commonly used. In fact, most of the time various techniques are
used and the results are

then compared to each other to increase the confidence that the
result is reasonable.

A widely used method is the so-called trading comparables
analysis. In this method a

peer group of listed companies is built, usually using firms with
similar standard

industry classification (SIC) and other similarities to the target
company like geographic

focus, financing structure, and client segments. If the company

is listed, the equity value

is simply the market capitalization
3
. The EV can be calculated based on this Eq. V. as

described above. Then some multiples are calculated to state
relationship between EV

and Eq. V. to a company’s fundamental data. Usually the
multiples are the following:

??????

???????????????

??????

???????????????

??????

????????????

??????. ???.

????????? ??????????????????
4

The median and arithmetic average of these multiples is then
calculated for the peer

group.

5
These figures are a good approximation for a target’s EV and
Eq. V., but they

tend to be lower than actual transaction values, since trading
comparables do not include

majority premiums that have to be paid when acquiring a
majority stake in a company.

A similar approach to the trading comparables method is the
transaction comparables

valuation approach. It uses the same multiples, but the peer
group consists of previous

transactions and therefore includes all premiums that arise
during transactions. This

method is very reliable but since it is very difficult to find
previous transactions that are

similar, it is difficult to build peer groups that are statistically
significant
6
. These two

methods, in combination with the DCF are the most widely used
in modern finance.

____________

3
?????????????????? ????????? = ??????????????? ??????????????? ∗ ?????????????????? ??????

?????????????????? ?????????????????????????????????

4
The

?????? .???.

????????? ??????????????????
is the same as the trailing (historical)

???

???
ratio

5
Please see table 2 in the appendix for an exemplary trading
comparables analysis of the European car

rental market

6
Please see table 3 in the appendix for an example

Discounted Cash Flow Valuation 4

3 The Discounted Cash Flow Valuation Method

3.1 Approach of the Discounted Cash Flow Valuation

The DCF method values the company on basis of the net present
value (NPV) of its

future free cash flows which are discounted by an appropriate
discount rate. The

formula for determining the NPV of numerous future cash flows
is shown below. It can

be found in various sources, e.g. in “Financial Management –
Theory and Practice”

(Brigham & Gapenski, 1997, p. 254).

????????? =
????????????

(1 + ???)???

???

???=0

The free cash flow is the amount of “cash not required for
operations or reinvestment”

(Brealey, Myers, & Allen, 2006, p. 998). Another possibility to
analyze a company’s

value using discounted cash flows is the adjusted present value
(APV). The APV is the

net present value of the company’s free cash flows assuming
pure equity financing and

adding the present value of any financing side effect, like tax
shield (Brealey, Myers, &

Allen, 2006, p. 993) In general you can say, that the APV is
based on the “principle of

value additivity” (Luehrmann, 1997, S. 135). However, APV
and NPV lead to the same

result.

Since the DCF method is a valuation technique that is based on
predictions, a scenario

analysis is usually conducted to examine the effects of changes
in the underlying

assumptions. Such a scenario analysis is usually based on three
scenarios, namely the

“base case” or “management scenario” that uses the
management’s estimations for the

relevant metrics, a “bull case” which uses very optimistic
assumptions and a “bear case”

that calculates the company’s value if it performs badly.

The process of valuing a company with the DCF method
contains different stages. In

the first stage scenarios are developed to predict future free
cash flows (FCF) for the

next five to ten years. Afterwards, an appropriate discount rate,
the weighted average

cost of capital (WACC) has to be determined to discount all
future FCFs to calculate

their NPVs. In the next step the terminal value (TV) has to be
identified. The TV is the

net present value of all future cash flows that accrue after the
time period that is covered

Discounted Cash Flow Valuation 5

by the scenario analysis. In the last step the net present values
of the cash flows are

summed up with the terminal value.
7

????????????????????? ??????????????? =
????????????

(1 + ???)???

???

???=0

+ ???????????????????????? ???????????????

3.2 Calculation of the Free Cash Flow

3.2.1 Cash Flow to Firm and Cash Flow to Equity

There are two ways of using cash flows for the DCF valuation.
You can either use the

free cash flow to the firm (FCFF) which is the cash flow that is
available to debt- and

equity holders, or you can use the free cash flow to equity
(FCFE) which is the cash

flow that is available to the company’s equity holders only.

When using the FCFF, all inputs have to be based on accounting
figures that are

calculated before any interest payments are paid out to the debt
holders. The FCFE in

contrast uses figures from which interest payments have already
been deducted. Using

the FCFF as base for the analysis will result in the enterprise
value of the company,

using the FCFE will give the equity value. Since an acquirer
usually takes over all

liabilities, debt and equity, the FCFF is more relevant than the
equity approach.

The FCFF is calculated by deducting taxes from the company’s
earnings before interest

and taxes (EBIT), resulting in the net operating profit after tax
(NOPAT). All

calculatory costs (e.g. D&A) are then added back, since they do
not express any cash

flows. The capital expenditure (Capex) is deducted. It is a cash
outflow that is not

reflected in the income statement, because Capex is activated on
the asset side of the

balance sheet. The increase in net working capital (NWC) is
also deducted, because it is

does not represent any actual cash flows. The formula for
calculating the FCFF is

shown below. (Damodaran, 1996, p. 237)

???????????? = ??????????????? + ???&??? − ??????????????? − ???????????????????????? ??????
?????????

There are more methods that can be used to calculate the FCFF,
but they will all result

in the same value.

____________

7
???????????????????????? ??????????????? =

????????????

(1+???)???
∞

???=???+1

Discounted Cash Flow Valuation 6

3.2.2 Building Future Scenarios

Deriving the NPV of the free cash flows that accrue in the
scenario period is very

complex, because all these cash flows are based on assumptions.
The method therefore

requires a detailed picture of the company’s future situation,
e.g. EBIT and Capex.

Predictions are usually made for the next five to fifteen years.
The NPV of the cash

flows accruing after this scenario period is included in the
terminal value, which is

derived using much less assumptions. These predictions are
usually based on historical

data, but may also reflect changes in the company’s business
plan, industry or in the

global economy.

To provide a detailed view on how the company’s value might
be affected by a change

in the underlying assumption, a scenario analysis is usually

conducted. In the bear case

scenario, low assumptions for rates of growth and margins are
used to build a very

pessimistic scenario. In the bull case the opposite is the case,
all assumptions are very

optimistic. These two cases mark the boundaries of where in
between the fair value of

the company should be with a high certainty. Of course,
additional scenario and risk

testing methods like value at risk using a Monte Carlo
Simulation can be used to further

evaluate any risks.

The most important scenario in the valuation of a company is
the base case. In this case

the management’s predictions and opinions regarding the future
development of the

company, its relevant markets and competitors are used to build
the scenario that is

most likely to happen. However, attention has to be paid to the
reliability of any

management provided figures, since managers often have a
personal incentive to

increase the takeover price and therefore might provide biased
estimates.

Another item that is usually included are potential synergies
between the target and the

acquirer. If the potential acquirer is a strategic acquirer who
runs a similar business,

many synergies can be realized. This will allow the strategic
bidder to offer a higher

price than a financial bidder, like a private equity funds for
example.

3.3 The Weighted Average Cost of Capital

Determining the discount rate requires extensive analysis of the
company’s financing

structure and the current market conditions. The rate that is
used to discount the FCFs is

called the weighted average cost of capital (WACC). The
WACC is one of the most

important input factors in the DCF model. Small changes in the
WACC will cause large

Discounted Cash Flow Valuation 7

changes in the firm value. The WACC is calculated by
weighting the sources of capital

according to the company’s financial structure and then

multiplying them with their

costs. Therefore the formula for the WACC calculation is:
8

???????????? =
??????????????????

???????????? + ??????????????????
∗ ???????????? ?????? ?????????????????? +

????????????

???????????? + ??????????????????
∗ ???????????? ?????? ????????????

3.3.1 Cost of Equity

The cost of equity (COE) is calculated with the help of the
capital asset pricing model

(CAPM). The CAPM reveals the return that investors require for
bearing the risk of

holding a company’s share. This required return is the return on
equity (ROE) that

investors demand to bear the risk of holding the company’s
share, and is therefore

equivalent to the company’s cost of equity. According to the
CAPM, the required ROE,

or in this case the COE is derived with the following formula
(Ross, Westerfield, &

Jordan, 2008, p. 426):

????????? = ?????? + ??? ?????? − ??????

Although the risk-free interest rate is the yield on T-Bills or T-
Bonds, professionals use

the London Interbank Offer Rates (LIBOR) as an approximation
for the short-term risk-

free interest rates, since “. . . treasury rates are too low to be
used as risk-free rates . . . “

(Hull, 2008, p. 74) It is therefore common to use the LIBOR as
the risk-free rate for

valuation purposes.

The input factor β is the risk, that holding the stock will add to
the investor’s portfolio
9

(Rhaiem, Ben, & Mabrouk, 2007, p. 80). It is derived using
linear regression analysis,

where the excess return of the stock is the dependent variable
and the excess market

return is the independent variable. The beta is the slope of the
regression line. (Brealey,

Myers, & Allen, 2006, p. 220) Beta is an empirical determined
input factor that is also

based on the company’s historical level of leverage, because
higher leverage ratios

increase the shareholder’s risk. Since the company’s level of
leverage often changes

during a transaction, the beta has to be adjusted for this change
by unlevering and

relevering to the new capital structure. If the company is not
listed there is no data

____________

8
In case of any preferred share outstanding, the formula has to be
rearranged to include this source of

financing as well. The adjusted formula will be as following:

???????????? =
??????????????????

??????????????????
∗ ????????? +

????????????

??????????????????
∗ ????????? +

???????????????????????????

??????????????????
∗ ???????????? ?????? ??????????????????????????? ?????????????????????

9
??? =

????????? (??????????????? ,?????????????????? )

????????? (?????????????????? )

Discounted Cash Flow Valuation 8

available to compute a linear regression. As a consequence, a
peer group of similar

companies is set up and the median of their unlevered betas is
then relevered to fit the

target’s financing structure. Although the CAPM approach is
very useful to estimate the

cost of equity, some scientists argue that the CAPM was
developed for liquid assets

(Michailetz, Artemenkov, & Artemenkov, 2007, p. 44), and
therefore its significance

for the valuation of illiquid assets, like non-listed companies
should be subject to further

research.

3.3.2 Cost of Debt

The cost of debt (COD) is the interest rate that a company has
to pay on its outstanding

debt. The most influencing factor on the COD is a company’s
credit rating. A company

with an investment grade credit rating
10

(e.g.: S&P AAA) is able to borrow at

considerably lower interest rates than a company that is rated as
non-investment grade

(e.g.: S&P BB-). The difference between the risk-free interest
rate and the interest rate

that a company has to pay to borrow money is called the
company’s credit spread. The

credit spread does not only depend on a company’s credit
worthiness, but is also

determined by market conditions. An indicator for these
conditions is the spread of the

USD 3m LIBOR vs. the 3m T-Bills
11

depicted in figure 1 in the appendix (Bloomberg

Professional Database, 2008). The chart reflects a massive
widening in credit spreads

that occurred in August 2007 after numerous banks and hedge

funds announced a

massive exposure to the so-called subprime mortgage market.
The dependence of

overall market conditions should be kept in mind when
calculating the COD. Especially

when the company has a high leverage ratio, special attention
has to be paid to the credit

markets.

Interest rate costs are tax deductable in most economies, so that
the true COD is lower

than the interest rate a company pays out to its debt holders
12

. Due to the fact that

taxation laws are very different around the world, a very
thorough analysis is needed to

verify how much of the interest costs are deductable. The COD
after tax can be

calculated as following, where i is the interest rate on
outstanding debt and t is the

effective tax rate paid by the company:

____________

10

Please see table 1 for an overview of long term credit rating
scales of different rating agencies

11

Another widely used benchmark to assess the credit spread is
the iTraxx Europe index, a credit index

consisting of 125 investment grade companies in Europe

12

Assuming the fact that the company is paying taxes from which
the COD can be deducted

Discounted Cash Flow Valuation 9

????????? = ??? ∗ (1 − ???)

If the company has different kinds of debt outstanding, the COD
is the weighted

average cost of debt of these different tranches, adjusted for
tax:
13

????????? = 1 − ??? ∗ ????????????

???

???=1

3.3.3 Summary

By plugging in the formulas for the COE and COD, we get the
full formula for the

WACC including all factors that influence the discount rate:

???????????? =
???

??? + ???
∗ ?????? + ??? ?????? − ?????? +

???

??? + ???
∗ ??? ∗ (1 − ???)

The WACC is therefore determined by the COE, which is
derived by applying the

CAPM with its underlying assumptions for beta. The COD is
derived from the interest

rate that the company has to pay to its debt holders and by the
tax rate that the

corporation has to pay on its profits. Changing the assumptions
for the cost of capital

will have large effects on the result of the overall valuation
process.

The WACC of a company is dependent on a variety of economic
factors. Especially the

company’s industry and the steadiness of its cash flows
influence it. Companies with

stable cash flows in mature industries with low growth rates
will typically have low

capital costs (Morningstar, 2007, pp. 1-2). For example, Bayer
will have a substantially

lower WACC than Conergy.

The WACC is used to discount the FCFs that we predicted in
our scenario analysis. The

result is the NPV of the company in the scenario period, to
which we will later add the

terminal value, which also makes uses of the WACC.

Using current figures for beta, risk-free rate, credit spread, and
interest costs will lead to

a fairly realistic approximation for the discount rate in most
cases. However, to get an

exact value, the company’s future WACC must be used.
Therefore, all input factors of

the WACC formula have to be predicted, resulting in leeway for
the outcome of the

DCF analysis.

____________

13
The weights are calculated by dividing the market value of a
tranche by the market value of total

debt outstanding: ?????? =
?????????????????? ??????????????? ?????? ??????????????? ??????

?????????????????? ??????????????? ?????? ??????????????? ????????????

Discounted Cash Flow Valuation 10

3.4 Calculation of the Terminal Value

The terminal value is the NPV of all future cash flows that
accrue after the time period

that is covered by the scenario analysis. Due to the fact that it is
very difficult to

estimate precise figures showing how a company will develop
over a long period of

time, the terminal value is based on average growth
expectations, which are easier to

predict.

The idea behind the terminal value is to assume constant growth
rates for the time

following the time period that was analyzed more extensively.
The constant perpetual

growth rate g, together with the WACC as the discount rate r
allows for the use of a

simple dividend discount model to determine the terminal value.
Therefore the TV can

be expresses as
14

(Beranek & Howe, 1990, p. 193), where the FCF is one period
before

the TV period:

?????? =
??????????????? ∗ (1 + ???)

???

(1 + ???)???

∞

???=1

=
??????????????? (1 + ???)

??? − ???

Since all these cash flows are discounted to a date in the future,

the TV has to be

discounted again to give us the NPV of all free cash flows that
occur after the scenario

predicted period.

The determination of the perpetual growth rate is one of the
most important and

complex tasks of the whole DCF analysis process, since minor
changes in this rate will

have major effects on the TV and therefore on the firm value in
total. The huge range of

values that result from a change in this growth rate will be
examined in a case study

later on in this chapter. In most cases a perpetual growth rate
should be between 0% and

5%. It has to be positive since in the long-term, the economy is
always growing.

However, according to economists, any growth rate above 5% is
not sustainable on the

long-term. The perpetual growth rate should be in line with the
nominal GDP growth.

(JP Morgan Chase, 2006).

Due to the fact, that the TV often accounts for more than half of
the total company

value, special attention has to be paid to its calculation and
input coefficients. As

discussed in the case study later in this paper, even very small
changes that might not

____________
14

?????? =
?????????∗ 1+??? 1

1+??? 1
+

?????????∗ 1+??? 2

1+??? 2
+

?????????∗ 1+??? 3

(1+???)3
…

?????????∗ 1+??? ???

(1+???)???
which can be mathematically

rearranged to equal the formula given in the text

Discounted Cash Flow Valuation 11

even be significant from an economist’s perspective will result
in substantial changes in

the company value. Therefore it is very easy to move the TV
into the desired direction

without having to drastically change any underlying business
predictions, like EBIT

margin or capital expenses.

3.5 Determination of Company Value

After having determined the NPV of the cash flows accruing
within the scenario period

and the TV, the TV is discounted to its NPV. Both NPVs are
then added together to

give the enterprise value or the equity value, depending on
whether the valuation is

based on FCFFs or FCFEs:

????????????????????? ??????????????? =
????????????

(1 + ???)???
+

??????

(1 + ???)???+1

???

???=0

Usually the company value is calculated using different levels
of leverage to find an

optimal financing structure. The determined company value can
then be used for further

analysis, e.g. the equity value could be divided by the number
of shares outstanding to

determine a fair share price for listed companies.

4 Validity of the Discounted Cash Flow Valuation Approach

4.1 Case Study: BASF

To demonstrate the wide range of possible results of the DCF
analysis, this paper will

now analyze the BASF stock and the DCF’s sensitivity to
changes in the WACC, the

perpetual growth rate, and sales growth. For this purpose, a base
scenario based on

broker estimates (Credit Suisse Equity Research, 2008) will be
built to obtain a fair

reference value for one BASF stock. Afterwards a sensitivity
analysis will be conducted

to examine the effects on this reference price that modifying
factors will have.

The base case scenario uses the estimates by Credit Suisse
analysts for the cash flow

forecasts for the years 2008 to 2013. The unlevered beta was
determined to be 0.9 using

a linear regression model leading to the cost of equity of 10.3%.
BASF’s current credit

rating results in a credit spread of 500bp according to analysts
(Credit Suisse Equity

Research, 2008). This leads to a WACC of 9.0%. Furthermore
we assume the perpetual

growth rate to be equal to 1.5%. Discounting the predicted free
cash flows to the firm

for the years 2008 to 2013 using the WACC of 9.0% and then
adding the discounted

Discounted Cash Flow Valuation 12

terminal value results in an enterprise value of EURm 67,850.
Please see tables 3 - 7 for

the exact calculations.

Period 2008E 2009E 2010E 2011E 2012E 2013E TV

FCFF 4,284 4,405 4,866 5,409 6,148 6,212 -

NPV 3,930 3,708 3,758 3,832 3,996 3,704 44,923

EV 67,850

Table 4: Case Study: Calculation of the enterprise
value

It is remarkable that the terminal value accounts for EURm
44,923 of the total EV. This

makes obvious, that the outcome of the DCF analysis is highly
sensitive to changes in

the perpetual growth rate, since it has a major effect on the TV.
Having determined the

EV, net debt and corporate adjustments are deducted from the
EV to calculate the equity

value of EURm 55,332. The equity value is then divided by the
number of shares

outstanding. The result of EUR 58.49 is the fair price for one
BASF share given the

underlying assumptions. Knowing the fact that the current share
price equals only EUR

39.41 (Thomson Reuters, 2008), this would make the BASF
share a great investment if

you believe that the underlying assumptions are valid. This
share price will serve as the

reference value for the sensitivity analysis, since it lies in
between of most research

analyst’s target price for BASF.

4.2 Sensitivity Analysis

To investigate the sensitivity of the DCF method, the BASF
case study developed above

will be used. The changes that occur in the share price will be
stated as percentage

offset from the base case share price of EUR 58.49.

The WACC and the perpetual growth rate are two main input
factors that have large

effect on the outcome of the analysis. Therefore the table below
shows the result of the

sensitivity analysis regarding those two factors. The base case
assumptions of 9.0% for

the WACC and 1.5% for the perpetual growth rate are
highlighted in dark blue.

Discounted Cash Flow Valuation 13

WACC (%)

0.00 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0%

P
e
r
p

e
tu

a
l

g
r
o

w
th

r
a

te
(

%
)

0.0% 19.2% 9.0% 0.2% -7.6% -14.5% -20.7% -26.2% -31.2% -
31.2%

0.5% 27.2% 15.8% 5.9% -2.7% -10.3% -17.0% -23.0% -28.3% -

28.3%

1.0% 36.6% 23.6% 12.5% 2.9% -5.4% -12.8% -19.3% -25.1% -
25.1%

1.5% 47.6% 32.7% 20.1% 9.3% 0.0% -8.1% -15.3% -21.6% -
21.6%

2.0% 60.9% 43.5% 29.0% 16.7% 6.2% -2.8% -10.7% -17.7% -
17.7%

2.5% 77.2% 56.4% 39.4% 25.3% 13.4% 3.2% -5.6% -13.3% -
13.3%

3.0% 97.5% 72.2% 52.0% 35.5% 21.8% 10.2% 0.3% -8.2% -
8.2%

Table 5: Case Study: Sensitivity Analysis WACC, Perpetual
growth rate

The table clearly shows that even slight changes in the WACC
or in the perpetual

growth rate, which might not even be significant from an
economist’s perspective, will

largely offset the determined fair share price from the base case
scenario. For example

increasing the WACC by 100bp and simultaneously decreasing
the perpetual growth

rate by 50bp will shrink the calculated fair stock price by more
than 19%. Since it is

very difficult to estimate the perpetual growth rate or the cost
of capital with an

exactness of just a few base points, the determined fair share
price can only be seen as

guidance, but not as an absolutely exact value.

The sensitivity to changes in the WACC can be expressed as the
first derivative of the

company value in respect to the discount rate, similar to the
concept of bond duration.

The formula below shows the approximate change in the
company value when

modifying the WACC.
15

??????

??????
=

1

1 + ???

−??? ∗ ????????????
(1 + ???)???

???

???=0

The next step in the sensitivity analysis is to assess whether
changes in the perpetual

growth rate or in the growth rate for the predicted period (Sales
CAGR) have a higher

impact on the share price. Since both growth rates affect the
nominal value free cash

flow, the result of the analysis should be helpful to understand
the importance that the

terminal value has on the DCF analysis since all other factors
are kept fixated. If

modifying the perpetual growth rate leads to larger changes than
modifying the sales

CAGR for the scenario period, the terminal value would be of
significantly higher

importance than the scenario predictions for the first years.

____________
15

Due to convexity however, this approximation should only be
used in the case of small changes

in the discount rate.

Discounted Cash Flow Valuation 14

Perpetual growth rate (%)

0.00 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.25%
2.50%

S
a

le
s

C
A

G
R

(
%

) 6.75% -14.0% -11.8% -9.4% -6.9% -4.3% -1.4% 1.6% 4.9%
8.5%

7.00% -12.8% -10.5% -8.1% -5.6% -2.9% 0.0% 3.2% 6.5%
10.1%

7.25% -11.5% -9.2% -6.8% -4.2% -1.4% 1.5% 4.7% 8.1% 11.8%

7.50% -10.3% -7.9% -5.5% -2.8% 0.0% 3.0% 6.2% 9.7% 13.4%

7.75% -9.0% -6.6% -4.1% -1.4% 1.5% 4.5% 7.8% 11.3% 15.1%

8.00% -7.7% -5.3% -2.7% 0.0% 2.9% 6.1% 9.4% 13.0% 16.9%

8.25% -6.4% -3.9% -1.3% 1.5% 4.5% 7.6% 11.0% 14.7% 18.6%

Table 6: Case Study: Sensitivity analysis perpetual growth
rate, sales CAGR

As expected, changes in the perpetual growth rate have a higher
impact than changes in

the sales CAGR have. For example an increase in the perpetual
growth rate by 25bp

result in a 3% higher share price, whereas a change by the same
amount in the sales

CAGR will only drive the fair share price up by 1.5%. Looking
at this result, the

importance of the terminal value becomes evident again. It
underlines the fact that the

TV includes all cash flows from the end of the scenario period
up to infinity compared

to just a few years in the scenario period. Therefore the TV,
together with its underlying

assumptions, is the most important and influential part of the
whole discounted cash

flow analysis. As mentioned before it is very easy to slightly
adjust the assumptions that

influence the TV, without having to justify these changes since
they are very small.

However, these small adjustments will significantly change the
TV and therefore the

value of the whole company.

5 Conclusion

The sensitivity analysis has shown that the DCF method is very
vulnerable to changes

in the underlying assumptions. Only marginally changes in the
perpetual growth rate

will lead to huge variances in the terminal value. Since the
terminal value accounts for a

large portion of the company’s value, this is of big significance
for the validity of the

DCF method.

It is very easy to manipulate the DCF analysis to result in the
value that you want it to

result in by adjusting the inputs. This is even possible without
making changes that

would be significant from an economist’s point of perspective,
e.g. a change in the

perpetual growth rate or in the WACC by just a few base points.
Analysts or business

professionals have no tools to estimate the input factors with
that kind of exactness.

Discounted Cash Flow Valuation 15

However, the DCF analysis is a great tool to analyze what
assumptions and conditions

have to be fulfilled in order to reach a certain company value.
This is especially helpful

in the case of capital budgeting and in the creation of feasibility
plans.

The company valuation using discounted cash flows is a valid
method to assess the

company’s value if special precaution is put on the validity of
the underlying

assumptions. As with all other financial models, the validity of
the DCF method almost

completely depends on the quality and validity of the data that
is used as input. If used

wisely, the discounted cash flow valuation is a powerful tool to
evaluate the values of a

variety of assets and also to analyze the effects that different
economic scenarios have

on a company’s value.

The range of reasonable rates for discount factor and perpetual

growth rate depends on

each specific firm, its business situation and many more
variables. In general you can

say that the more risky a firm is, the higher its capital costs
(WACC) are. The perpetual

growth rate should be the same for all industries, since
according to the arbitrage theory

in the long run all companies and industries will grow by the
same rate.

I conclude that using the DCF method in combination with other
methods, like the

trading comparables or precedent transaction analysis, is an
effective approach to obtain

a realistic range of appropriate company values. This
combination technique is indeed

the method that most companies and investment banks use
today. When using several

valuation techniques, their individual shortfalls are eliminated
and the ultimate goal in

the field of company valuation can be reached: determining a
fair and valid company

value.

Discounted Cash Flow Valuation 16

Reference List

Beranek, W., & Howe, K. M. (1990). The Regulated Firm and
the DCF Model: Some

Lessons From Financial Theory. Joumal of Regulatory
Economics , 193.

Bloomberg Professional Database. (2008, August 09). Credit
Derivates and Interest

Rates. New York, New York, United States of America.
Retrieved August 09,

2008

Bodie, Kane, & Marcus. (2008). Investments (7th Edition ed.).
McGraw Hill.

Brealey, R. A., Myers, S. C., & Allen, F. (2006). Principles of
Corporate Finance (8th

Edition ed.). McGraw-Hill.

Brigham, E. F., & Gapenski, L. C. (1997). Financial
Management - Theory and

Practice (8th Edition ed.). Orlando: The Dryden Press.

Credit Suisse Equity Research. (2008). BASF's balancing act.
Frankfurt: Credit Suisse.

Damodaran, A. (1996). Investment Valuation. New York: John

Wiley & Sons, Inc.

Hull, J. C. (2008). Options, Futures and Other Derivatives (7th
Edition ed.). Upper

Saddle River: Pearson Prentince Hall.

JP Morgan Chase. (2006). JP Morgan M&A EBS lecture
presentation. Frankfurt.

Luehrman, T. A. (1998, July). Investment Opportunities as Real
Options. Harvard

Business Review , 51-67.

Luehrmann, T. A. (1997). What's it worth? Harvard Business
Review , 135.

Michailetz, V. B., Artemenkov, A. I., & Artemenkov, I. L.
(2007). Income Approach

and Discount Rates for Valuing Income-Producing Illiquid
Assets. The Icfai

Journal of Applied Finance , 43-80.

Morningstar. (2007). Morningstar's Approach to Rating Stocks.

Mukherjee, T. K., Kiymaz, H., & Bake, H. K. (2004,
Fall/Winter). Merger Motives and

Targets: A Survey of Evidence from CFOs. Journal of Applied
Finance , 7-24.

Discounted Cash Flow Valuation 17

Rhaiem, N., Ben, S., & Mabrouk, A. B. (2007). Estimation of
Capital Asset Pricing

Model at Different Time Scales. The International Journal of
Applied

Economics and Finance , 80.

Ross, Westerfield, & Jordan. (2008). Corporate Finance
Fundamentals. New York:

McGraw-Hill Irwin.

Thomson One Banker. (2008, August 14). M&A League Tables.
Retrieved August 14,

2008, from Thomson One Banker:
http://banker.thomsonib.com/ta

Thomson Reuters. (2008, August 26). Worldscope Database.
New York.

Discounted Cash Flow Valuation 18

Appendix

Table 1: Long term credit rating scales

Rating Agency Moody's
Standard & Poor's

(S&P)
Fitch

Investment

grade debt

Aaa AAA AAA

Aa1 AA+ AA+

Aa2 AA AA

Aa3 AA- AA-

A1 A+ A+

A2 A A

A3 A- A-

Baa1 BBB+ BBB+

Baa2 BBB BBB

Baa3 BBB- BBB-

Non-investment

grade debt

Ba1 BB+ BB+

Ba2 BB BB

Ba3 BB- BB-

B1 B+ B+

B2 B B

B3 B- B-

Caa1 CCC+ CCC+

Caa2 CCC CCC

Caa3 CCC- CCC-

Ca CC CC

C C C

Default grade

debt C D D

Table 2: Trading comparables analysis

2008e 2009e 2010e 2008e 2009e 2010e 2008e 2009e 2010e

2008e 2009e 2010e

Sixt 1.0x 1.0x 1.0x 3.2x 3.1x 2.9x 9.2x 8.9x 8.4x 7.3x 7.1x 6.7x

Avis Europe 0.8x 0.8x 0.8x 2.4x 2.3x 2.1x 9.9x 8.9x 8.2x 6.6x
5.3x 4.6x

D'ieteren 0.5x 0.5x 0.4x 4.0x 3.7x 3.5x 8.2x 7.6x 6.8x 6.9x 5.9x
5.0x

Hertz 1.7x 1.6x 1.6x 9.5x 8.7x 8.2x 10.9x 10.3x 9.9x 8.4x 7.0x
6.0x

Dollar Thrifty 1.5x 1.4x 1.4x 29.5x 26.0x 28.3x 12.3x 8.0x 8.4x

Penske 0.3x 0.3x 0.2x 10.2x 9.3x 8.0x 14.4x 12.4x 10.7x 9.6x
9.3x

Amerco

Mean 1.0x 0.9x 0.9x 9.8x 8.8x 8.8x 10.5x 9.6x 8.3x 8.7x 7.2x
6.7x

Median 0.9x 0.9x 0.9x 6.7x 6.2x 5.8x 9.9x 8.9x 8.3x 7.8x 7.1x
6.3x

EV/Sales EV / EBITDA EV / EBIT Eq. V. / Net income

Company

Discounted Cash Flow Valuation 19

Table 3: Transaction multiple analysis

Table 4: Case Study: Calculation of the enterprise value

Period 2008E 2009E 2010E 2011E 2012E 2013E TV

FCFF 4,284 4,405 4,866 5,409 6,148 6,212 -

NPV 3,930 3,708 3,758 3,832 3,996 3,704 44,923

EV 67,850

Table 5: Case Study: Sensitivity Analysis WACC,
perpetual growth rate

WACC (%)

0.00 7.0% 7.5% 8.0% 8.5% 9.0% 9.5% 10.0% 10.5% 11.0%

P
e
r
p

e
tu

a
l

g
r
o

w

th

r
a

te
(

%
)

0.0% 19.2% 9.0% 0.2% -7.6% -14.5% -20.7% -26.2% -31.2% -
31.2%

0.5% 27.2% 15.8% 5.9% -2.7% -10.3% -17.0% -23.0% -28.3% -
28.3%

1.0% 36.6% 23.6% 12.5% 2.9% -5.4% -12.8% -19.3% -25.1% -
25.1%

1.5% 47.6% 32.7% 20.1% 9.3% 0.0% -8.1% -15.3% -21.6% -
21.6%

2.0% 60.9% 43.5% 29.0% 16.7% 6.2% -2.8% -10.7% -17.7% -
17.7%

2.5% 77.2% 56.4% 39.4% 25.3% 13.4% 3.2% -5.6% -13.3% -
13.3%

3.0% 97.5% 72.2% 52.0% 35.5% 21.8% 10.2% 0.3% -8.2% -
8.2%

Table 6: Case Study: Sensitivity analysis perpetual growth rate,
sales CAGR

Perpetual growth rate (%)

0.00 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 2.25%
2.50%

S
a

le
s

C
A

G
R

(
%

) 6.75% -14.0% -11.8% -9.4% -6.9% -4.3% -1.4% 1.6% 4.9%
8.5%

7.00% -12.8% -10.5% -8.1% -5.6% -2.9% 0.0% 3.2% 6.5%
10.1%

7.25% -11.5% -9.2% -6.8% -4.2% -1.4% 1.5% 4.7% 8.1% 11.8%

7.50% -10.3% -7.9% -5.5% -2.8% 0.0% 3.0% 6.2% 9.7% 13.4%

7.75% -9.0% -6.6% -4.1% -1.4% 1.5% 4.5% 7.8% 11.3% 15.1%

8.00% -7.7% -5.3% -2.7% 0.0% 2.9% 6.1% 9.4% 13.0% 16.9%

8.25% -6.4% -3.9% -1.3% 1.5% 4.5% 7.6% 11.0% 14.7% 18.6%

Table 7: Case Study: Income statement estimates

Target Acquirer Date EV (€m) EV / SALES EV / EBITDA EV /
EBIT EqV / Net Income

Vanguard Car Rental EMEA Europcar International 13/11/2006
670.00 1.70x 6.34x 23.92x n.m.

Keddy Car Europcar International 30/06/2006 0.00

Europcar International Eurazeo SA 03.09.2006 3083.00 2.41x

Hertz Group (Canada) FirstGroup plc 20/12/2000 18.07 1.22x

Laidlaw International FirstGroup plc 02.09.2007 2701.76 1.11x
7.43x 13.84x 22.10x

Cognisa Transportation First Transit, Inc 01.05.2007 11.87

SKE Support Services FirstGroup plc 13/09/2004 22.85 0.38x

Aircoach FirstGroup plc 11.01.2003 16.99

GB Railways Group FirstGroup plc 16/07/2003 44.51 0.34x
29.67x 55.64x 88.99x

Coach USA Kohlberg & Company LLC 06.06.2003 130.99
0.72x

Verona Bus Service FirstGroup plc 08.01.2001 6.51 1.00x 3.81x
7.15x

Avis Greece Piraeus Bank SA 05.02.2007 215.50 2.65x

Avis French Avis Europe plc 02.03.2003 8.50 0.43x

Budget International Avis Europe plc 23/01/2003 37.28

SAISC Avis Europe plc 31/01/2002 25.58

3 Arrows Avis Europe plc 12.10.1998 57.09

Fraikin SA CVC Capital 12.08.2006 1350.00 2.21x 18.10x

Average 1.29x 11.81x 23.73x 55.54x

Median 1.11x 6.89x 18.10x 55.54x

Discounted Cash Flow Valuation 20

Period 2008E 2009E 2010E 2011E 2012E 2013E 2014E

Sales 64,702.10 65,388.80 67,645.50 71,390.10 74,631.10
76,870.00 86,517.90

EBIT Margin 12.2% 11.2% 11.9% 13.2% 14.0% 13.0% 11.0%

EBIT 7,893.66 7,323.55 8,049.81 9,423.49 10,448.35 9,993.10
9,516.97

Taxes (2,368.10) (2,197.06) (2,414.94) (2,827.05) (3,134.51)
(2,997.93) (2,855.09)

NOPLAT 5,525.56 5,126.48 5,634.87 6,596.45 7,313.85

6,995.17 6,661.88

D&A 2,700.90 2,740.90 2,779.20 2,829.50 2,902.30 2,989.40
3,431.80

Increase in

NWC (1,031.20) (519.80) (503.60) (804.20) (709.70) (783.60)
(593.80)

Capex (2,911.60) (2,942.50) (3,044.00) (3,212.60) (3,358.40)
(2,989.40) (3,431.80)

FCFF 4,283.66 4,405.08 4,866.47 5,409.15 6,148.05 6,211.57
6,068.08

Table 8: Case Study: Liabilities structure

Shareholders

Equity 20,097.90

Financial Debt 10,100.70

Long Term 6,953.00

Short Term 3,147.70

Leverage 0.33

Table 9: Case Study: WACC calculation

Cost of Equity (%)

Risk free rate (%) 4.3%

Unlevered Beta 0.9

Levered Beta 1.2

Market return (%) 9.3%

CAPM required RoE 10.3%

Cost of Debt (%)
Average Credit Spread (%) 5.0%

Cost of Debt before taxes 9.3%

CoD adjusted for tax 6.5%

WACC 9.0%

Table 10: Case Study: Terminal Value calculation

Discounted Cash Flow Valuation 21

FCFF in terminal period 6,068.08

Perpetual growth rate (%) 1.5%

WACC (%) 9.0%

Terminal Value 81,731.65

NPV of TV 44,607.47

Table 11: Case Study: DCF valuation

Period 2008E 2009E 2010E 2011E 2012E 2013E TV

FCFF (EURm) 4,283.66 4,405.08 4,866.47 5,409.15 6,148.05
6,211.57 -

NPV (EURm) 3,929.96 3,707.67 3,757.81 3,831.97 3,995.81
3,703.76 44,923.18

EV (EURm) 67,850.16

Net debt (EURm) (11,547.00)

Minorities

(EURm) (971.20)

Eq.V. (EURm) 55,331.96

No. Of shares (m) 946

Fair share price 58.49

Figure 1: LIBOR credit spread (in bp)

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USD LIBOR 3m vs US Treasury 3m …

FIN 430 — Finance Theory and PracticeStock Valuation project
The purpose of the project is to estimate and justify: (1) an
intrinsic (fundamental) value for the company of your choice
and (2) the fundamental price/share of equity in the firm. You
should attempt to justify that you have calculated your best
estimate of the firm’s stock price. You may compare your
values (ratios/prices/calculations, etc.) to those you find on the
internet, but your work should be your own and your job is to
calculate these figures. All calculations/ratios/values are
assumed to have been calculated by you own. You should not
substitute those figures for yours and using such figures from
other sources is plagiarism. All of your reports (including table,
graph, figures, reference, etc) should not be longer than 25
pages.
You may use up to three different methodsto calculate firm
stock value (the FCF method is most important and you have to
include this analysis in your project). The three methods that
we study for valuing corporations include:
1. Free Cash Flow Method (or discounted cash flow
method). This method requires you to produce pro forma
financial statements as based upon the additional funds needed,
percentage of sales and constant ratio methods (see “Financial
forecasting” in the index). The pro forma statements are then
used to calculate the free cash flow as based upon the
formulas/examples in the: "Financial Statements, Cash Flow
and Taxes," "Financial Planning and Forecasting Financial
Statements," and the "Corporate Valuation," chapters in the
text. The FCF is discounted back to the present by the WACC,

which leads to the firm value as follows. Note that the present
value of the FCFs = the Value of Operations (see the CH 7 and
the formula runs as followings).

Value of Operations (Enterprise Value )
+ Value of non-operating assets (one example would be
marketable securities)
= Total Firm value
- Value of Debt [we use the book value of ST and LT debt;
though theory suggests that the market value
- Value of Preferred Shares [if any]
= Value of Equity
÷ Number of Shares of Common Stock outstanding
Price per share

This price per share is your estimate of the fundamental value
of the firm stock, which you would then use to argue that the
firm is either currently over/under/fairly valued according to the
market, i.e., by comparing your price/share to
the current market price/share. Warren Buffet calls this
estimate the "intrinsic value" of the firm. Remember that you
may consider the efficient market hypothesis in relation to your
price estimate.
2. Dividend Growth Model (Multi-stage growth model)

3. Comparables (Stock Price Multiples Model): This method is
relatively easy and provides some useful valuations that often
set the ranges for the stock price. The course packet lecture
entitled “Using Stock Price Multiples to Estimate Stock Price”
describes this method. You may use either a direct competitor
or industry averages. For example, if you are analyzing Ford
Motor Corp. it would be appropriate to use GM as a comparable
firm (and/or the auto industry). Note that sector/industry ratios
can be obtained on Yahoo.finance [look under profiles, then on
the left hand side under Financial Links you should
see competitors]. Many different financial ratios can be used,

although the P/E and Price/CF ratios are common. Another
alternative is to create your own "industry" averages from a
diverse group of firms within the industry. You are limited
only by your creativity; and a great deal of information is
available on the Internet. The goal should be to calculate
fundamental values by yourself.

General Guidelines(Mandatory)
The major focus of the project is to calculate and justify your
estimate of the price/share of equity using the FCF
Method. Many other elements of the project are necessary in
order to complete a satisfactory project. Minimally, these
include:

An example is given on CH12 (page 489- 495).
Completing 5-year pro-formas for your firm. The pro formas
serve as the central element of your project. Many steps lead up
to the pro formas, and many important steps follow from the pro
forma. All of your estimates should include
appropriate justification/ support/ explanation. Many of the
estimates of growth rates and ratios needed below should be
calculated using regression analysis.

Growth. You will need to calculate the historical growth
in dividends or in revenue for your firm (in order to obtain an
estimate of future growth). The method for estimating growth
is illustrated by an example of dividend growth for Firm XXX.
– the related file is provided on Blackboard (BB) by the name
of “Growth estimate sheet”.

Data Needed to Construct the Pro Formas
* Dividend data: You can attain the historical data from
https://www.dividata.com/

*An Excel spreadsheet that you use to construct your pro

formas. An excel file is provided on BB and here under the
name: CH12 (Figure 1-3) . This file “automatically” completes
the 5 years of pro formas for you; given that you have input the
data and assumptions correctly.
* 2 years of the firm’s historical financial statements,
including annual balance sheets, income and cash flow
statements (these form the basis of your pro formas). You may
also want to download 5-10 year historical data to do a better
estimate. This data may be downloaded at Mergent-
Online (available through the university library) or through the
SEC official site:
http://www.sec.gov/edgar/searchedgar/companysearch.html

NOTE: While you may want to read or skim the 10Ks for your
company, you need not construct the 10 years of financial data
from the 10Ks. Rather, using either SEC site or MergentOnline,
you are able to download the 5-10 years of financial statements
directly as a file which can be read by Excel. Should you have
difficulty, please contact me.

* Estimates of the company’s current and future (long-term
normal – gn ) sales growth (this should be completed in the
same manner that you calculate dividend growth for a company)
– you may use the Growth estimate sheet available on
Blackboard as a guide. Use the 10 years of financial
statements for the historical sales figures.
* A justification of your choice of constant or non-constant
ratios when completing the pro-formas (the base case should
usually be the constant ratio approach as discussed in the text).
* An estimate of the firm’s target capital structure (see the
guideline below about Calculating a Firm’s WACC) – note that
you need these weights both for the WACC.
* An estimate of the firm’s dividend payout policy.
* The firm’s tax rate.

Steps to Take after Completing the Pro Formas

* As mentioned above, the goal is to calculate the firm’s
value (in the end, your estimate of the stock price/share). This
requires that you calculate the firm’s FCFs (free cash flows) as
discussed in the relevant chapters in your text (CH2 and
CH12). This should be a relatively easy procedure, and should
be done on the same Excel spreadsheet as your pro-formas (see
CH12 (Figure 1-3)).
* You also need to calculate the Continuing Value (or
terminal or horizon values) as discussed in CH6 - see the related
equation (it is analogous to the constant growth part of the
supernormal growth model)! This is a crucial part of the
project, because the continuing value of the firm will typically
be the largest proportion of any firm’s current value.
* To discount the FCFs back to the “present” (to the date
of your last historical financial statements) you need to have
an estimate of the firm’s WACC(note that this includes the
weights of debt and equity, the costs of debt and equity, the
latter of which is calculated by using the CAPM, with your
estimate of the firm’s beta). Again, see the guidelines of
WACC Calculationabout Calculating a Firm’s WACC, and also
review the “Four Mistakes to Avoid” (see the index to your
text).
* Once you have completed these steps, you are then ready
to follow the general steps described above to calculate your
estimate of the stock price/share.

Improving the Quality of your Project(Optional)
Other elements are left up to you, in terms of how complete
and/or creative you want your project to be. Some of these
elements must be completed in order to earn a higher than
average or satisfactory evaluation for the project. You
may/should include these other elements if you believe that they
will improve your “case” for your estimate of the price/share
for your firm. For example, a SWOT analysis is often used in
business. For this project, it may be useful, but only if you can

connect the main conclusions of the SWOT analysis to your
evaluation of the firm.

The most important extensions include:

* Using ratios that are not a constant percentage of sales
when constructing the pro formas (the basic percent of sales
method is described in the Financial Planning and Forecasting
Financial Statements chapter of the text). The relevant
procedures are either discussed in the text or are available on
spreadsheets that come with the text and/or are on the text's
homepage (listed in the syllabus). The firm’s profit margin has
a very important impact on firm value. If you use the most
recent profit margin in the pro formas, you may not be
providing an accurate longer-term picture of the firm’s
operations. As a result, it may be useful or even crucial to
analyze this ratio and/or others when constructing the pro
formas.

* Sensitivity analysis. How does your estimate of the
price/share change with changes in the firm’s WACC, the firm’s
short or long-term growth rates, changes in the firm’s profit
margin(s) and so on. The amount of work that could be done
here is almost limitless, so good projects would demonstrate
good judgment in which sensitivity analyses they conduct.

* Scenario analysis. This is similar to sensitivity analysis,
but discrete scenarios (e.g., a recession or a boom) are analyzed
instead.
* Ratio analysis. Ratios can be used as diagnostic tools in
evaluating the “health” of a firm. Note that such analysis would
typically include comparisons of your firm’s financial ratios to
the industry standards (or averages). These averages are
available on the Yahoo.finance site
under: Profile/Competitors (Sector or Industry). Ratio analysis
by itself is not very useful in terms of valuation. It provides a

diagnostic view of the company which may be helpful in terms
of analyzing the better and poorer practices of a company. In
order to make ratio analysis relevant for this project, it must be
tied directly to the firm's valuation. For example, if a
company's current Inventory Turnover is very poor, the group
can suggest that it should get better into the future, and then
make the necessary adjustments (which may require changes in
the formulas) in the pro forma sheets, to see how improving the
inventory turnover would increase the firm's value.

Advanced Elements of the Firm Valuation Project If you
attempt any of the following, you should connect the additional
analysis directly to the base case for your firm valuation
project.

* Managerial/Strategy Analysis. You may view your job of
this project as the managers of the firm. In completing the
project, you may recognize that the company is either
performing some function very well or very poorly. It is
perfectly appropriate to make suggestions for improving or
maintaining the operation of the firm.

* Marketing Analysis. Future sales typically depend upon
marketing. Projects which focus on companies for which this
may be particularly important may consider analyzing the
marketing policies of the company in order to determine how
those policies affect firm value.

Updated 08/01/2007

Discounted Cash Flow
Analysis

By Ben McClure

http://www.investopedia.com/university/dcf/
Thanks very much for downloading the printable version of this
tutorial.

As always, we welcome any feedback or suggestions.
http://www.investopedia.com/contact.aspx

Table of Contents

1) DCF Analysis: Introduction
2) DCF Analysis: The Forecast Period & Forecasting Revenue
Growth
3) DCF Analysis: Forecasting Free Cash Flows
4) DCF Analysis: Calculating The Discount Rate
5) DCF Analysis: Coming Up With A Fair Value
6) DCF Analysis: Pros & Cons Of DCF
7) DCF Analysis: Conclusion

Introduction

It can be hard to understand how stock analysts come up with
"fair value" for
companies, or why their target price estimates vary so wildly.
The answer often
lies in how they use the valuation method known as discounted
cash flow (DCF).
However, you don't have to rely on the word of analysts. With
some preparation

and the right tools, you can value a company's stock yourself
using this method.
This tutorial will show you how, taking you step-by-step
through a discounted
cash flow analysis of a fictional company.

In simple terms, discounted cash flow tries to work out the
value of a company
today, based on projections of how much money it's going to
make in the future.
DCF analysis says that a company is worth all of the cash that it
could make
available to investors in the future. It is described as
"discounted" cash flow
because cash in the future is worth less than cash today. (To
learn more,
see The Essentials Of Cash Flow and Taking Stock Of
Discounted Cash Flow.)

For example, let's say someone asked you to choose between
receiving $100
today and receiving $100 in a year. Chances are you would take
the money
today, knowing that you could invest that $100 now and have
more than $100 in

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a year's time. If you turn that thinking on its head, you are
saying that the amount
that you'd have in one year is worth $100 dollars today - or the
discounted value
is $100. Make the same calculation for all the cash you expect a
company to
produce in the future and you have a good measure of the
company's value.

There are several tried and true approaches to discounted cash
flow analysis,
including the dividend discount model (DDM) approach and the
cash flow to firm
approach. In this tutorial, we will use the free cash flow to
equity approach
commonly used by Wall Street analysts to determine the "fair
value" of
companies.

As an investor, you have a lot to gain from mastering DCF
analysis. For starters,
it can serve as a reality check to the fair value prices found in
brokers' reports.
DCF analysis requires you to think through the factors that

affect a company,
such as future sales growth and profit margins. It also makes
you consider the
discount rate, which depends on a risk-free interest rate, the
company's costs of
capital and the risk its stock faces. All of this will give you an
appreciation for
what drives share value, and that means you can put a more
realistic price tag on
the company's stock.

To demonstrate how this valuation method works, this tutorial
will take you step-
by-step through a DCF analysis of a fictional company called
The Widget
Company. Let's begin by looking at how to determine the
forecast period for your
analysis and how to forecast revenue growth.

The Forecast Period & Forecasting Revenue Growth

The Forecast Period
The first order of business when doing discounted cash flow
(DCF) analysis is to
determine how far out into the future we should project cash
flows.

For the purposes of our example, we'll assume that The Widget
Company is
growing faster than the gross domestic product (GDP)
expansion of the
economy. During this "excessive return" period, The Widget
Company will be
able to earn returns on new investments that are greater than its
cost of capital.

So, our discounted cash flow needs to forecast the amount of
free cash flow that
the company will produce for this period.

The excess return period tells us how far into the future we
should forecast the
company's cash flows. Alas, it's impossible to say exactly how
long this period of
excess returns will last. The best we can do is make an educated
guess based
on the company's competitive and market position. Sooner or
later, all companies
settle into maturity and slower growth. (The common practice
with DCF analysis
is to make the excess return period the forecast period. But it is
important to note

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that this valuation method does not restrict your analysis to only
excess return
periods - you could estimate the value of a company growing
slower than the
economy using DCF analysis too.)

The table below shows good guidelines to use when determining
a company's
excess return period/forecast period:

Company Competitive
Position

Excess
Return/Forecast

Period
Slow-growing company;
operates in highly
competitive, low margin
industry

1 year

Solid company; operates with
advantage such as strong
marketing channels,
recognizable brand name, or
regulatory advantage

5 years

Outstanding growth
company; operates with very

high barriers to entry,
dominant market position or
prospects

10 years

Figure 1

How far in the future should we forecast The Widget Company's
cash flows?
Let's assume that the company is keeping itself busy meeting
the demand for its
widgets. Thanks to strong marketing channels and upgraded,
efficient factories,
the company has a reasonable competitive position. There is
enough demand for
widgets to maintain five years of strong growth, but after that
the market will be
saturated as new competitors enter the market. So, we will
project cash flows for
the next five years of business.

Revenue Growth Rate
We have decided that we want to estimate the free cash flow
that The Widget
Company will produce over the next five years. To arrive at this
figure, the
standard procedure is to forecast revenue growth over that time
period. Then (as
we will see in later chapters), by breaking down after-tax
operating profits,
estimated capital expenditure and working capital needs, we can
estimate the
cash flow the company will produce.

Let's start with top line growth. Forecasting a company's

revenues is arguably the
most important assumption one can make about its future cash
flows. It can also

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be the most difficult assumption to make. (For more on
forecasting sales, see
Great Expectations: Forecasting Sales Growth.)

We need to think carefully about what the industry and the
company could look
like as they evolve in the future. When forecasting revenue
growth, we need to
consider a wide variety of factors. These include whether the
company's market
is expanding or contracting, and how its market share is
performing. We also
need to consider whether there are any new products driving

sales or whether
pricing changes are imminent. But because that future can never
be certain, it is
valuable to consider more than one possible outcome for the
company.

First, the upbeat revenue growth scenario: The Widget Company
has grown
revenues at 20% for the past two years, and your careful market
research
suggests that demand for widgets will not let up any time soon.
Management -
always optimistic - argues that the company will keep growing
at 20%.

That being said, there may be reasons to downplay revenue
growth
expectations. While the company's revenue growth will stay
strong in the first few
years, it could slow to a lower rate by Year 5 as a result of
increasing
international competition and industry commoditization. We
should err on the
side of caution and conservatism and assume that The Widget
Company's top
line growth rate profile will commence at 20% for the first two
years, then drop to
15% for the next two years and finally drop to 10% in Year 5.
Posting $100
million of revenue in its latest annual report, the company is
projected to grow its
revenues to $209.5 million at the end of five years (based on
realistic, rather than
optimistic, growth expectations).

Forecast Revenue Growth Profiles

Current Year Year 1 Year 2 Year 3 Year 4 Year 5

Optimistic:
Growth Rate

Revenue

-

$100 M

20%

$120 M

20%

$144 M

20%

$172.8 M

20%

$207.4 M

20%

$248.9 M

Realistic:

Growth Rate
Revenue

-

$100 M

20%

$120 M

20%

$144 M

15%

$165.6 M

15%

$190.4 M

10%

$209.5 M
Figure 2

Now that we've determined our forecast period and our revenue
growth for that
period, we can move on to the next step in our analysis, where
we will estimate
the free cash flow produced over the forecast period.

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Forecasting Free Cash Flows

Now that we have determined revenue growth for our forecast
period of five
years, we want to estimate the free cash flow produced over the
forecast period.

Free cash flow is the cash that flows through a company in the
course of a
quarter or a year once all cash expenses have been taken out.

Free cash flow
represents the actual amount of cash that a company has left
from its operations
that could be used to pursue opportunities that enhance
shareholder value - for
example, developing new products, paying dividends to
investors or doing share
buybacks. (To learn more, see Free Cash Flow: Free, But Not
Always Easy.)

Calculating Free Cash Flow
We work out free cash flow by looking at what's left over from
revenues after
deducting operating costs, taxes, net investment and the
working capital
requirements (see Figure 1). Depreciation and amortization are
not included
since they are non-cash charges. (For more information, see
Understanding The
Income Statement.)

Figure 1 - How free cash flow is calculated

In the previous chapter, we forecasted The Widget Company's
revenues over the
next five years. Here we show you how to project the other
items in our
calculation over that period.

Future Operating Costs
When doing business, a company incurs expenses - such as
salaries, cost of

goods sold (CoGS), selling and general administrative expenses
(SGA), and
research and development (R&D). These are the company's
operating costs. If
current operating costs are not explicitly stated on a company's
income
statement, you can calculate them by subtracting net operating
profits -
or earnings before interest and taxation (EBIT) - from total
revenues.

A good place to start when forecasting operating costs is to look
at the
company's historic operating cost margins. The operating
margin is operating
costs expressed as a proportion of revenues.

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For three years running, The Widget Company has generated an
average
operating cost margin of 70%. In other words, for every $1 of
revenue, the
company incurs $0.70 in operating costs. Management says that
its cost cutting
program will push those margins down to 60% of revenues over
the next five
years.

However, as analysts and investors, we should be concerned
that competing
widget factories might be built, thus squeezing The Widget
Company's
profitability. Therefore, as we did when forecasting revenues,
we will err on the
side of conservatism and assume that operating costs will show
an increase as a
percentage of revenues as the company is forced to lower its
prices to stay
competitive over time. Let's say operating costs will hold at
65% of revenues over
the first three projected years, but will increase to 70% in Year
4 and Year 5 (see
Figure 2).

Taxation
Many companies do not actually pay the official corporate tax
rate on their
operating profits. For instance, companies with high capital
expenditures receive
tax breaks. So, it makes sense to calculate the tax rate by taking
the average
annual income tax paid over the past few years divided by
profits before income
tax. This information is available on the company's historic
income statements.

Let's assume that for each of the past three years, The Widget
Company paid
30% income tax. We will project that the company will continue
to pay that 30%
tax rate over the next five years (see Figure 2).

Net Investment
To underpin growth, companies need to keep investing in
capital items such as
property, plants and equipment. You can calculate net
investment by taking
capital expenditure, disclosed in a company's statement of cash
flows, and
subtracting non-cash depreciation charges, found on the income
statement.

Let's say The Widget Company spent $10 million last year on
capital
expenditures, with depreciation of $3 million, giving net
investment of $7 million,
or 7% of total revenues (see Figure 2). But in the two prior
years, the company's
net investment was much higher: 10% of revenues.

If competition does intensify in the widget industry, The Widget
Company will
almost certainly have to boost capital investment to stay ahead.
So, we will
assume that net investment will steadily return to its normal
level of 10% of sales
over the next five years, as seen in Figure 2: 7.6% of sales in
Year 1, 8.2% in
Year 2, 8.8% in Year 3, 9.4% in Year 4 and 10% in Year 5.

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Figure 2 - Forecasting The Widget Company's operating costs,
taxes,
net investment and change in working capital over the five-year
forecast
period

Change in Working Capital
Working capital refers to the cash a business requires for day-
to-day operations,
or, more specifically, short-term financing to maintain current
assets such as
inventory. The faster a business expands, the more cash it will
need for working
capital and investment.

Working capital is calculated as current assets minus current
liabilities. These
items are found on the company's balance sheet, published in its
quarterly and
annual financial statements. At year end, The Widget
Company's balance sheet
showed current assets of $25 million and current liabilities of
$16 million, giving
net working capital of $9 million.

Net change in working capital is the difference in working
capital levels from one
year to the next. When more cash is tied up in working capital
than the previous
year, the increase in working capital is treated as a cost against
free cash flow.

Working capital typically increases as sales revenues grow, so a
bigger
investment of inventory and receivables will be needed to match
The Widget
Company's revenue growth. In our forecast, we will assume that
changes in
working capital are proportional to revenue growth. In other
words, if revenues
grow by 20% in the first year, working capital requirements will
grow by 20% in

the first year, from $9 million to $10.8 million (see Figure 2).
Meanwhile, we will
keep a close watch for any signs of a changing trend.

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Figure 3 - Free cash flow forecast calculation for The Widget
Company

As you can see in Figure 3, we've determined our estimated free
cash flow for
our forecast period. Now we are one step closer to finding a
value for the
company. In the next section of the tutorial, we will estimate
the value at which
we will discount the free cash flows.

Calculating The Discount Rate

Having projected the company's free cash flow for the next five
years, we want to
figure out what these cash flows are worth today. That means
coming up with an
appropriate discount rate which we can use to calculate the net
present value
(NPV) of the cash flows.

So, how do we figure out the company's discount rate? That's a
crucial question,
because a difference of just one or two percentage points in the
cost of capital
can make a big difference in a company's fair value.

A wide variety of methods can be used to determine discount
rates, but in most
cases, these calculations resemble art more than science. Still, it
is better to be
generally correct than precisely incorrect, so it is worth your
while to use a
rigorous method to estimate the discount rate.

A good strategy is to apply the concepts of the weighted
average cost of capital
(WACC). The WACC is essentially a blend of the cost of equity
and the after-tax
cost of debt. (For more information, see Investors Need A Good
WACC.)
Therefore, we need to look at how cost of equity and cost of
debt are calculated.

Cost of Equity
Unlike debt, which the company must pay at a set rate of
interest, equity does
not have a concrete price that the company must pay. But that

doesn't mean that
there is no cost of equity. Equity shareholders expect to obtain a
certain return on
their equity investment in a company. From the company's
perspective, the
equity holders' required rate of return is a cost, because if the
company does not
deliver this expected return, shareholders will simply sell their
shares, causing
the price to drop.

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Therefore, the cost of equity is basically what it costs the
company to maintain a
share price that is satisfactory (at least in theory) to investors.
The most
commonly accepted method for calculating cost of equity comes
from the Nobel
Prize-winning capital asset pricing model (CAPM), where: Cost
of Equity (Re) =
Rf + Beta (Rm-Rf).

Let's explain what the elements of this formula are:

Rf - Risk-Free Rate - This is the amount obtained from
investing in securities
considered free from credit risk, such as government bonds from
developed
countries. The interest rate of U.S. Treasury bills or the long-
term bond rate is
frequently used as a proxy for the risk-free rate.

ß - Beta - This measures how much a company's share price
moves against the
market as a whole. A beta of one, for instance, indicates that the
company
moves in line with the market. If the beta is in excess of one,
the share is
exaggerating the market's movements; less than one means the
share is more
stable. Occasionally, a company may have a negative beta (e.g.
a gold mining
company), which means the share price moves in the opposite
direction to the
broader market. (To learn more, see Beta: Know The Risk.)

(Rm – Rf) = Equity Market Risk Premium - The equity market
risk premium

(EMRP) represents the returns investors expect, over and above
the risk-free
rate, to compensate them for taking extra risk by investing in
the stock market. In
other words, it is the difference between the risk-free rate and
the market rate. It
is a highly contentious figure. Many commentators argue that it
has gone up due
to the notion that holding shares has become riskier.

Barra and Ibbotson are valuable subscription services that offer
up-to-date equity
market risk premium rates and betas for public companies.

Once the cost of equity is calculated, adjustments can be made
to take account
of risk factors specific to the company, which may increase or
decrease the risk
profile of the company. Such factors include the size of the
company, pending
lawsuits, concentration of customer base and dependence on key
employees.
Adjustments are entirely a matter of investor judgment and they
vary from
company to company.

Cost of Debt
Compared to cost of equity, cost of debt is fairly
straightforward to calculate. The
rate applied to determine the cost of debt (Rd) should be the
current market rate
the company is paying on its debt. If the company is not paying
market rates, an
appropriate market rate payable by the company should be
estimated.

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As companies benefit from the tax deductions available on
interest paid, the net
cost of the debt is actually the interest paid less the tax savings
resulting from the
tax-deductible interest payment. Therefore, the after-tax cost of
debt is Rd (1 -
corporate tax rate).

Finally, Capital Structure
The WACC is the weighted average of the cost of equity and the

cost of debt
based on the proportion of debt and equity in the company's
capital structure.
The proportion of debt is represented by D/V, a ratio comparing
the company's
debt to the company's total value (equity + debt). The
proportion of equity is
represented by E/V, a ratio comparing the company's equity to
the company's
total value (equity + debt). The WACC is represented by the
following formula:
WACC = Re x E/V + Rd x (1 - corporate tax rate) x D/V.

A company's WACC is a function of the mix between debt and
equity and the
cost of that debt and equity. On the one hand, in the past few
years, falling
interest rates have reduced the WACC of companies. On the
other hand,
corporate disasters like those at Enron and WorldCom have
increased the
perceived risk of equity investments.

Be warned: the WACC formula seems easier to calculate than it
really is. Rarely
will two people derive the same WACC, and even if two people
do reach the
same WACC, all the other applied judgments and valuation
methods will likely
ensure that each has a different opinion regarding the
components that comprise
the company's value.

Widget Company WACC
Returning to our example, let's suppose The Widget Company
has a capital

structure of 40% debt and 60% equity, with a tax rate of 30%.
The risk-free rate
(RF) is 5%, the beta is 1.3 and the risk premium (RP) is 8%.
The WACC comes
to 10.64%. So, rounded up to the nearest percentage, the
discount rate for The
Widget Company would be 11% (see Figure 1).

WACC for The Widget Company

Cost of Debt Cost of Equity

0.40 [Rd x (1-.30)] +

0.40 [5.0 x 0.7)] +

0.40 [3.5] +

1.40 +

0.60 [RF + b(RP)]

0.60 [5.0 + 1.3(8)]

0.60 [15.4]

9.24

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WACC

Rounded WACC

10.64%

11%

Figure 1

In the next section of the tutorial, we'll do the final calculations
to generate a fair
value for The Widget Company.

Coming Up With A Fair Value

Now that we have calculated the discount rate for the Widget
Company, it's time
to do the final calculations to generate a fair value for the
company's equity.

Calculate the Terminal Value
Having estimated the free cash flow produced over the forecast
period, we need
to come up with a reasonable idea of the value of the company's
cash flows after
that period - when the company has settled into middle-age and
maturity.
Remember, if we didn't include the value of long-term future
cash flows, we
would have to assume that the company stopped operating at the
end of the five-
year projection period.

The trouble is that it gets more difficult to forecast cash flows
over time. It's hard
enough to forecast cash flows over just five years, never mind
over the entire
future life of a company. To make the task a little easier, we use
a "terminal
value" approach that involves making some assumptions about
long-term cash
flow growth.

Gordon Growth Model
There are several ways to estimate a terminal value of cash
flows, but one well-
worn method is to value the company as a perpetuity using the
Gordon Growth
Model. The model uses this formula:

Terminal Value = Final Projected Year Cash Flow X (1+Long-
Term Cash Flow Growth Rate)
(Discount Rate – Long-Term Cash
Flow Growth Rate)

The formula simplifies the practical problem of projecting cash
flows far into the
future. But keep in mind that the formula rests on the big
assumption that the
cash flow of the last projected year will stabilize and continue
at the same rate
forever. This is an average of the growth rates, not one expected
to occur every
year into perpetuity. Some growth will be higher or lower, but
the expectation is
that future growth will average the long-term growth
assumption.

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Returning to the Widget Company, let's assume that the
company's cash flows
will grow in perpetuity by 4% per year. At first glance, 4%
growth rate may seem
low. But seen another way, 4% growth represents roughly
double the 2% long-
term rate of the U.S. economy into eternity.

In the section on "Forecasting Free Cash Flows", we forecast
free cash flow of
$21.3 million for Year 5, the final or "terminal" year in our
Widget Company
projections. You will also recall that we calculated The Widget
Company's
discount rate as 11% (see "Calculating The Discount Rate"). We
can now
calculate the terminal value of the company using the Gordon
Growth Model:

Widget Company Terminal Value = $21.3M X 1.04/ (11% - 4%)
=
$316.9M

Exit Multiple Model
Another way to determine a terminal value of cash flows is to
use a multiplier of
some income or cash flow measure, such as net income, net
operating profit,
EBITDA (earnings before interest, taxes, depreciation, and
amortization),
operating cash flow or free cash flow. The multiple is generally
determined by
looking at how comparable companies are valued by the market.

Was there a
recent sale of stock of a similar company? What is the standard
industry
valuation for a company at the same stage of maturity?

In Year 5, the Widget Company is expected to produce free cash
flow of $21.3M.
Multiplying this by a projected price-to-free cash flow of 15
gives us a terminal
value of $319.9M.

Widget Company Terminal Value = $21.3M X 15 =
$319.9M

You will see that the terminal value can contribute a great deal
to total value, so it
is important to use an exit multiple that can be justified. One
way to make the
multiple more believable is to give estimates on the
conservative side. Justifying
a multiple of 15 with your figures would certainly be easier to
justify than one at
20 or 25. Because it can be tricky to justify the multiple, this
method isn't used as
much as the Gordon Growth Model.

Calculating Total Enterprise Value
Now you have the following free cash flow projection for the
Widget Company.

Forecast
Period Year 1 Year 2 Year 3 Year 4 Year 5

Terminal Value (Gordon
Growth Model)

Free Cash $18.5M $21.3M $24.1M $19.9M $21.3M $316.9M

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Flow
Figure 1

To arrive at a total company value, or enterprise value (EV), we
simply have to
take the present value of the cash flows, divide them by the
Widget Company's
11% discount rate and, finally, add up the results.

EV = ($18.5M/1.11) + ($21.3M/(1.11)2) + ($24.1M/(1.11)3) +
($19.9M/(1.11)4) + ($21.3M/(1.11)5) +

($316.9M/(1.11)5)
EV = $265.3M

Therefore, the total enterprise value for The Widget Company is
$265.3 million.

Calculating the Fair Value of Equity
But we are not finished yet - we cannot forget about debt. The
Widget Company's
$265.3M enterprise value includes the company's debt. As
equity investors, we
are interested in the value of the company's shares alone. To
come up with a fair
value of the company's equity, we must deduct its net debt from
the value.

Let's say The Widget Company has $50M in net debt on its
balance sheet. We
subtract that $50M from the company's $265.3M enterprise
value to get the
equity value.

Fair Value of Widget Company Equity = Enterprise Value –
Debt

Fair Value of Widget Company = $265.3M - $50M =$215.3M

So, by our calculations, the Widget Company's equity has a fair
value of $215.3
million. That's it - the DCF valuation is complete.

Having finished the DCF valuation, we can judge the merits of
buying Widget
Company shares. If we divide the fair value by the number of
Widget Company

shares outstanding, we get a fair value for the company's shares.
If the shares
are trading at a lower value than this, they could represent a
buying opportunity
for investors. If they are trading higher than the per share fair
value, shareholders
may want to consider selling Widget Company stock.

You are familiar with the mechanics of DCF analysis and you
have seen it
applied to a practical example; now it's time to consider the
strengths and
weaknesses of this valuation tool. What makes DCF better than
other valuation
methods? What are its shortcomings? We answer those
questions in the following section of this tutorial.

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Pros & Cons Of DCF

Having worked our way through the mechanics of discounted
cash flow analysis,
it is worth our while to examine the method's strengths and
weaknesses. There is
a lot to like about the valuation tool, but there are also reasons
to be cautious
about it.

Advantages
Arguably the best reason to like DCF is that it produces the
closest thing to an
intrinsic stock value. The alternatives to DCF are relative
valuation measures,
which use multiples to compare stocks within a sector. While
relative valuation
metrics such as price-earnings (P/E), EV/EBITDA and price-to-
sales ratios are
fairly simple to calculate, they aren't very useful if an entire
sector or market is
over or undervalued. A carefully designed DCF, by contrast,
should help
investors steer clear of companies that look inexpensive against
expensive
peers. (To learn more, see Relative Valuation: Don't Get
Trapped.)

Unlike standard valuation tools such as the P/E ratio, DCF
relies on free cash
flows. For the most part, free cash flow is a trustworthy
measure that cuts
through much of the arbitrariness and "guesstimates" involved

in reported
earnings. Regardless of whether a cash outlay is counted as an
expense or
turned into an asset on the balance sheet, free cash flow tracks
the money left
over for investors.

Best of all, you can also apply the DCF model as a sanity check.
Instead of trying
to come up with a fair value stock price, you can plug the
company's current
stock price into the DCF model and, working backwards,
calculate how quickly
the company would have to grow its cash flows to achieve the
stock price. DCF
analysis can help investors identify where the company's value
is coming from
and whether or not its current share price is justified.

Disadvantages
Although DCF analysis certainly has its merits, it also has its
share of
shortcomings. For starters, the DCF model is only as good as its
input
assumptions. Depending on what you believe about how a
company will operate
and how the market will unfold, DCF valuations can fluctuate
wildly. If your inputs
- free cash flow forecasts, discount rates and perpetuity growth
rates - are wide
of the mark, the fair value generated for the company won't be
accurate, and it
won't be useful when assessing stock prices. Following the
"garbage in, garbage
out" principle, if the inputs into the model are "garbage", then
the output will be

similar.

DCF works best when there is a high degree of confidence about
future cash
flows. But things can get tricky when a company's operations
lack what analysts
call "visibility" - that is, when it's difficult to predict sales and
cost trends with

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much certainty. While forecasting cash flows a few years into
the future is hard
enough, pushing results into eternity (which is a necessary
input) is nearly
impossible. The investor's ability to make good forward-looking
projections is

critical - and that's why DCF is susceptible to error.

Valuations are particularly sensitive to assumptions about the
perpetuity growth
rates and discount rates. Our Widget Company model assumed a
cash flow
perpetuity growth rate of 4%. Cut that growth to 3%, and the
Widget Company's
fair value falls from $215.3 million to $190.2 million; lift the
growth to 5% and the
value climbs to $248.7 million. Likewise, raising the 11%
discount rate by 1%
pushes the valuation down to $182.7 million, while a 1% drop
boosts the Widget
Company's value to $258.9 million.

DCF analysis is a moving target that demands constant
vigilance and
modification. A DCF model is never built in stone. If the
Widget Company
delivers disappointing quarterly results, if its major customer
files for bankruptcy,
or if interest rates take a dramatic turn, you will need to adjust
your inputs and
assumptions. If any time expectations change, the fair value will
change.

That's not the only problem. The model is not suited to short-
term investing. DCF
focuses on long-term value. Just because your DCF model
produces a fair value
of $215.3 million that does not mean that the company will
trade for that any time
soon. A well-crafted DCF may help you avoid buying into a
bubble, but it may
also make you miss short-term share price run-ups that can be

profitable.
Moreover, focusing too much on the DCF may cause you to
overlook unusual
opportunities. For example, Microsoft seemed very expensive
back in 1995, but
its ability to dominate the software market made it an industry
powerhouse and
an investor's dream soon after.

DCF is a rigorous valuation approach that can focus your mind
on the right
issues, help you see the risk and help you separate winning
stocks from losers.
But bear in mind that while the DCF technique we've sketched
out can help
reduce uncertainty, it won't make it disappear.

What's clear is that investors should be conservative about their
inputs and
should not resist changing them when needed. Aggressive
assumptions can lead
to inflated values and cause you to pay too much for a stock.
The best way
forward is to examine valuation from a variety of perspectives.
If the company
looks inexpensive from all of them, chances are better that you
have found a
bargain.

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Conclusion

As you have seen, DCF analysis tries to work out the value of a
company today,
based on projections of how much money it will generate in the
future. The basic
idea is that the value of any company is the sum of the cash
flows that it
produces in the future, discounted to the present at an
appropriate rate.

In this tutorial, we have shown you the basic technique used to
generate fair
values for the stocks that you follow. But keep in mind that this
is just one
approach to doing DCF analysis; every analyst has his or her
own theories on
how it should be done.

Although manually working your way through all the numbers
in DCF analysis

can be a time-consuming and tricky process at times, it's not
impossible. Yes,
using a DCF model probably entails a lot more work than
relying on traditional
valuation measures such as the P/E ratio, but we hope this step-
by-step guide
has shown you that it is worth the effort.

DCF analysis treats a company as a business rather than just a
ticker symbol
and a stock price, and it requires you to think through all the
factors that will
affect the company's performance. What DCF analysis really
gives you is an
appreciation for what drives stock values.

Here are some external resources that you may want to check
out:

Damodaran Online - Aswarth Damodaran, professor of finance
at New York
University's Stern School of Business, has created an excellent
website devoted
to valuation techniques. He offers numerous DCF models set up
in Excel
spreadsheets, and he gives details on the intricacies of the
models.

Valuing Intel: A Strange Tale Of Analysts And Announcements
- Bradford
Cornell, professor at UCLA's Anderson Graduate School of
Management, has
produced an excellent DCF analysis that assesses market and
stock analysts'
reactions to an Intel Corp. earnings announcement.

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http://pages.stern.nyu.edu/~adamodar
http://www.anderson.ucla.edu/documents/areas/fac/finance/33-
00.pdfDiscounted Cash Flow AnalysisTable of Contents
FIN 430 — Finance Theory and PracticeProject Assignments
Estimating Beta for your stock
For use in Conjunction with the Firm Valuation Project
a) Collect historical price data.
You will begin by collecting historical stock price data for the
company. Historical stock prices are available on the internet
through at the http://finance.yahoo.com website. At this
website you will put the ticker symbol for your company in the
symbol box and press “go”. At this point you will see a page
that has financial information about your company. On the left-
hand side of the screen there will be a series of option which
you can choose to get more information about your company.
At this point you want to look under “quotes” and choose
“historical prices”.
At this point, you will be given some options about the time
period and frequency of the data you are collecting. You want
monthly data beginning January 1, 2013 and ending December
31, 2017. Once you have specified this time period, push the
“get prices” button. After the historical price information
appears, you will see an option “download to spreadsheet” at
the bottom of the historical price table. Select this option to
bring the information into an excel file.
b) Collect historical S&P500 data.
We would like to compare the activity of an individual
company’s stock price to how stock prices are doing in the

market overall. We will use the S&P500 as our benchmark for
overall stock market performance. Just as we gathered
historical stock prices, we can gather historical S&P500 data
using the http://finance.yahoo.com website. To do this, use the
same procedure as above, but instead of using your company’s
ticker symbol, type “^GSPC” in the symbol box. Collect
monthly S&P500 data for the January 1, 2013 and ending
December 31, 2017time period and save the information in an
excel file.
Now that you have the information in an excel file, you can use
your excel skills to manipulate it as you need. We will be using
the “adjusted close” column for both of your company stock and
S&P500.
c) Calculate monthly returns.
Monthly returns report gains or losses in percentage terms. For
example, we will look at our sample company Valero Energy,
VLO. Assume that I bought VLO stock at the beginning of
January for $23.09 per share. If I wanted to sell the same share
one month later, at the beginning of February, I would have
been able to sell it for $22.76. Thus, I would have lost $0.33.
Looking at percentage returns gives us an ability to compare
how poorly (or well) this VLO investment did relative to other
investments. For example, let’s take a hypothetical company,
Roadrunner Enterprises. Assume that Roadrunner’s stock was
selling for $200 a share at the beginning of January. By the
beginning of February, the stock was selling for only $199. If
you had bought one share of Roadrunner stock over this time
period, you would have lost $1.00. In absolute (dollar) terms,
you would have lost more on the Roadrunner investment.
However, looking at percentage returns, we get a different (and
more accurate) picture.
VLO Returns:

(P2-P1)/P1 = (22.76-23.09)/23.09 = - 0.01429 or -1.429%

Or P2/P1 -1 =22.76/23.09 – 1 = -1.429%

Roadrunner Returns:

(P2-P1)/P1 = (199-200)/200 = -0.005 or -0.5%
This allows us to compare different investments relative to the
amount of money we have invested in the stock. For example,
if we had had $10,000 at the beginning of January and invested
it all in VLO, we would have lost ($10,000)*0.01429 or
$142.90. If, instead, we had invested the money in Roadrunner,
we would have lost only ($10,000)*.005 or $50.
Using excel, calculate monthly returns for both your stock and
the S&P500 for each month beginning January 1, 2013 and
ending December 31, 2017. Calculating these returns will
require the “Adjusted Close” for each month-end from
beginning January 1, 2013 and ending December 31, 2017.

d) Manipulate Data and Regression Analysis.
There are several methods for calculating a regression in excel.
Please use three different methods we introduced in the class
for this project. (1) using the formula to solve beta. (2) using
the regression function on Data Analysis (You may need to
google and see how to have this function installed) in case you
can’t find Data Analysis under the Data Panel. (3) draw the
characteristic line and show the equation (please see the
instruction below for the third method).
For this assignment, we will use the charting capability to
calculate beta for our stock. You will begin by choosing the
“insert” option above the excel spreadsheet. You will choose
“chart” and then “XY (scatter)” for the type of chart. The chart
wizard will guide you through the process.
You will want to choose the “series” option to tell excel what
data you want to use. Be sure to use your S&P500 return
column for your “X value” and your stock return column for
your “Y value”.
This process will give you a scatter graph that plots your
stock’s return and the S&P500 return. However, it does not

give you a regression line or slope. To get a regression line,
you will need to click your left mouse key to make several of
the data points turn yellow. With your mouse pointing to one of
these yellow data points, right click your mouse. Choose “add
trendline”. We will use the default (linear) trend line.
However, you will want to choose “options” so that you can
place “display equation on chart”.
You may find that your regression equation is difficult to read
if it is placed over the data points. You can move this equation
to the side of the graph (it is in a text box) so that it will be
easier to read.
Make sure that you have properly labeled your graph and that
your graph has a title.

University of Wollongong
Research Online

Faculty of Commerce - Papers (Archive) Faculty of Business

2004

An example of the use of financial ratio analysis: the
case of Motorola
H. W. Collier

University of Wollongong, [email protected]
T. Grai
Oakland University, USA

S. Haslitt
Oakland University, USA

C. B. McGowan
Universiti Kebangsaan Malaysia, [email protected]
Research Online is the open access institutional repository for
the
University of Wollongong. For further information contact the
UOW
Library: [email protected]
Publication Details
This article was originally published as Collier, H, Grai, T,
Haslitt, S and McGowan, CB, An example of the use of
financial ratio
analysis: the case of Motorola, Decision Sciences Institute
Conference, Florida, 2-6 March 2004.

http://ro.uow.edu.au/
http://ro.uow.edu.au/
http://ro.uow.edu.au/
http://ro.uow.edu.au
http://ro.uow.edu.au/commpapers
http://ro.uow.edu.au/business
http://ro.uow.edu.au/
http://ro.uow.edu.au/

An example of the use of financial ratio analysis: the case of
Motorola

Abstract
In this paper, we demonstrate the use of actual financial data for

financial ratio analysis. We construct a
financial and industry analysis for Motorola Corporation. The
objective is to show students exactly how to
compute ratios for an actual company. This paper demonstrates
the difficulties in applying the principles of
financial ratio analysis when the data are not homogeneous as is
the case in textbook examples. We use
Motorola as an example because the firm has several segments,
two of which account for the majority of sales
and represent two industries (semi-conductor and
communications) that have different characteristics. The
case illustrates the complexity of financial analysis.

Disciplines
Business | Social and Behavioral Sciences

Publication Details
This article was originally published as Collier, H, Grai, T,
Haslitt, S and McGowan, CB, An example of the
use of financial ratio analysis: the case of Motorola, Decision
Sciences Institute Conference, Florida, 2-6
March 2004.

This conference paper is available at Research Online:
http://ro.uow.edu.au/commpapers/24

http://ro.uow.edu.au/commpapers/24

7

An Example of the Use of Financial Ratio Analysis: The Case
of Motorola

Henry W. Collier, University of Wollongong, [email protected]
Timothy Grai, Oakland University
Steve Haslitt, Oakland University

Carl B. McGowan, Jr., Universiti Kegangsaan Malaysia,
[email protected]
Abstract: In this paper, we demonstrate the use of actual
financial data for financial ratio analysis. We construct a
financial and
industry analysis for Motorola Corporation. The objective is to
show students exactly how to compute ratios for an actual
company. This paper demonstrates the difficulties in applying
the principles of financial ratio analysis when the data are not
homogeneous as is the case in textbook examples. We use
Motorola as an example because the firm has several segments,
two of
which account for the majority of sales and represent two
industries (semi-conductor and communications) that have
different
characteristics. The case illustrates the complexity of financial
analysis.

MOTOROLA SEGMENT ANALYSIS

Motorola is a global manufacturer of communication products,
semiconductors, and embedded electronic solutions. The
company is
divided into six operating segments that publicly report
financial results. The Personal Communication Segment (PCS)
designs,
manufactures, and markets wireless communication products for
service subscribers. Products include wireless handsets,
personal 2-
way radios, and messaging devices, along with the associated

accessories. The Personal Communication Segment accounted
for
37.8% of 2002 sales, making it the largest of Motorola’s
operating segments. The Global Telecommunications Segment
(GTS)
designs, manufactures, and markets the infrastructure
communication systems purchased by telecommunication
service providers.
Products include electronic exchanges, telephone switches, and
base station controllers for various wireless communication
standards.
This segment accounted for 15.8% of Motorola’s sales in 2002.
The Broadband Communication Segment (BCS) designs,
manufactures, and markets a variety of products to support the
cable and broadcast television and telephony industries in
delivering
high speed data, including cable modems, Internet-based
telephones, set-top terminals, and digital satellite television
systems. This
segment accounted for 7.3% of Motorola’s sales in 2002. The
Commercial, Government, & Industrial Segment (CGIS)
designs,
manufactures, and markets integrated communication systems
for commercial, government, and industrial applications,
typically
private 2-way wireless networks for voice and data
transmissions, such as would be used by public safety
authorities in a community.
This segment accounted for 13% of Motorola’s sales in 2002.
The Semiconductor Product Segment (SPS) designs,
manufactures, and
markets microprocessors and related semiconductors for use in
various end products, such as computers, wireless and
broadband
devices, automobiles, and other consumer electronic devices.
Some of the semiconductors produced are used in products

marketed by
other Motorola segments. This segment accounted for 16.8% of
Motorola’s sales in 2002. The Integrated Electronic Systems
Segment (IESS) designs, manufactures, and markets automotive
and industrial electronic systems, single board computer
systems, and
energy storage products to support portable electronic devices
(such as wireless handsets). This segment accounted for 7.6%
of
Motorola’s sales in 2002.

Condensed Statement of Financial Performance 1998 to 2002
2002 2001 2000 1999 1998
Sales 26,679 30,004 37,580 33,075 31,340
Net Earnings (2,485) (3,937) 1,318 891 (907)
Note: All figures in millions except per share data, as is typical
in this report, unless noted.

Total Motorola sales and profitability has varied widely over
the last five years. Sales peaked at over $37B in 2000 and

dropped to less than $27B in 2002. Motorola had a net loss in
2001 and 2002. Motorola’s stock price has varied from a high
of over
$55 in February of 2000 to a low price of less than $8 in
January of 2003. Despite the losses incurred recently and the
variability of
reported income, Motorola has continued to pay a steady
dividend of $0.16 per share since 1997. This is a clear
indication of the
importance that Motorola attaches to the informational content
associated with dividends: despite significant losses, dividends
have
not been reduced. The most recent data indicates that Motorola

has returned to profitability, posting a $0.01 per share profit for
the
first quarter of 2003.

8

INDUSTRY ANALYSIS

Value Line classifies Motorola as being part of the
semiconductor industry sector, while Yahoo! Finance classifies
Motorola as being
part of the telecommunications equipment industry segment.
Given that four of Motorola’s six operating segments (PCS,
GTS, BCS,
CGIS) design, manufacture, and market telecommunications
equipment and account for over 73% of Motorola’s sales,
telecommunications equipment industry classification seems
more appropriate. This paper will uses both industries in the
presentation. Operating results for both industries are likely to
be highly correlated since the semiconductor industry is a major
supplier to the telecommunications industry.

The Telecommunications Equipment Industry

The telecommunications equipment industry provides the
products required to support land-based and wireless
communications: both
the end-consumer equipment, and the infrastructure of the
networks that enable the end-consumer products. Nokia is
market leader in
the handset portion of this industry, followed by Motorola,

Siemens and Sony-Ericsson. Ericsson leads the infrastructure
portion of
the equipment industry. The five largest companies are: Cisco
Systems, Nokia, Qualcomm, Motorola, and Ericsson,
yahoo.marketguide.com.

The telecommunications equipment industry, in particular, has
seen difficult operating conditions among the technology
industries over the last several years. The difficult operating
conditions are the result of two underlying issues. First, after a
rapid
build up of wireless network infrastructure by the service
providers (firms such as Verizon Wireless that provide
telecommunication
services to the end-consumer) in 2000, the demand for
equipment by the service providers dropped some 15% in 2001
and likely
dropped by even a higher percentage in 2002, yahoo.finance.
Second, the demand for third generation (3G) wireless
technologies
(which includes mobile data services that can combine voice,
data, email, PDA, & other features) has not evolved as quickly
as
expected. Wireless subscribers have chosen to not replace their
handsets with the new 3G technologies in anticipation of the
price of
the equipment dropping, yahoo.finance.

The telecommunication equipment industry has a beta
coefficient of 2.09, explaining in part the difficult operating
conditions
in the industry as a magnification of the poor conditions in the
economy as a whole, yahoo.marketguide.com. A key segment
within
the telecommunications industry is the wireless handset
(cellular phone) segment, both because of its size and because

of its visibility
to end-consumers. In this wireless handset segment, Nokia is
the clear market leader, with a substantial 35.8% market share
in 2002
and a strong presence in the critical European market. This is
important because Europe is where much of the technological
innovation in the industry occurs. Motorola is in second place
in this industry segment with a market share of 15.3%, less than
half of
Nokia’s share. Third place belongs to Samsung, with a 9.8%
market share, but Samsung’s strong technology and significant
resources
pose significant challenges to Motorola and Nokia’s leadership
positions. Siemens held an 8.4% market share in 2002, while
the joint
venture between Sony and Ericsson held a 5.5% market share in
the industry segment, Reiter (2003).

The Semiconductor Industry

The semiconductor industry provides the semiconductor “chips”
which are integral to consumer electronics such as PC’s; PDA’s;
audio, visual and entertainment equipment, and cellular phones.
These chips are also used in commercial electronics such as
network
servers, communication switch equipment, industrial controls.
Intel is the largest firm in the industry. Intel is known in
particular for
supplying the microprocessors used in PC’s. The top 5
companies in this industry in order of descending market
capitalization are:
Intel, Texas Instrument, Taiwan Semiconductor, Advanced
Materials, and ST-Microelectronics, yahoo.marketguide.com.

The semiconductor industry experienced a record year in 2000

with worldwide sales of $200B. Sales experienced a
significant declined in 2001, down some 30% to $140B. The
decline in 2001 was attributed to weak sales in nearly every
consumer
electronics segment and to weak sales in commercial electronic
segments resulting in low demand for semiconductors,
yahoo.finance.
The year 2002 brought only a slight recovery in the
semiconductor industry, with expected worldwide sales increase
likely to be only
several percentage points higher than 2001 levels. November
2002 sales, only increased by 1.3%, less than the 1.8% increase
in
October 2002. This low increase is significant because
November sales have historically averaged larger increases as
electronic
manufacturers prepare for the holiday season, Value Line,
January 17, 2003, p 1051. The semiconductor industry has a
Beta
coefficient of 2.17, and, like the telecommunication equipment
industry, this explains in part the severe downturn in the
industry as the
entire economy took a downturn over the last several years,
yahoo.marketguide.com.

9

FINANCIAL RATIO ANALYSIS

Financial ratios for Motorola, for the semiconductor industry,
and for the telecommunications industry are provided below.
The firms
in the semiconductor industry subset represent 87% of the

estimated total semiconductor industry sales of $100 billon in
2002, Value
Line, January 3, 2003, pp 744, 770. The firms
telecommunications equipment industry represent in 91% of
telecommunication
equipment industry sales of $277 billion in 2002, Value Line,
January 17, 2003, p 1051.

Evaluating Motorola relative to the semiconductor industry, we
first note that Motorola is slightly less liquid than the average
firm in the industry, with both a current ratio and a quick ratio
that is lower than the industry average. Motorola’s average
collection
period, at 61 days, is lower than the industry average of 50
days, indicating Motorola should evaluate its credit policies.
Both fixed
asset turnover and total asset turnover are above the
semiconductor industry averages, indicating that Motorola is
using its assets more
efficiently than the industry average in generating sales.
Motorola’s debt ratio and debt to equity ratio indicate that
Motorola is more
leveraged than the average firm in the industry. This higher
leverage in part explains Motorola’s poor financial performance
relative
to the semiconductor industry because the leverage commits
Motorola to interest payments that must be paid regardless of
economic
and market conditions. The ratios indicate that Motorola has a
higher cost of sales than the average firm in the semiconductor
industry, resulting in a lower gross profit margin, and higher
indirect costs, resulting in lower net profit margin performance
relative to
the semiconductor industry.

2002 Ratio Analysis

Motorola Semiconductor Industry

Telecommunication
Equipment
Industry

Current Ratio 1.77 2.44 1.52
Quick Ratio 1.47 2.08 1.23
Average Collection Period 61 days 50 days 73 days
Inventory Turnover 6.25 6.01 5.66
Fixed Asset Turnover 4.37 1.58 6.24
Total Asset Turnover 0.86 0.61 0.90
Debt Ratio 0.64 0.34 0.65
Debt to Equity Ratio 1.77 0.52 1.82
Times Interest Earned NA NA NA
Gross Profit Margin 32.76% 37.49% 29.52%
Net Profit Margin -9.31% -3.00% -1.24%
Return on Investment -7.98% -1.82% -1.11%
Return on Equity -22.11% -2.78% -3.14%
Assets / Equity 2.77 1.52 2.82

The situation is different when evaluating Motorola relative to
the telecommunications equipment industry, and, considering

that the majority of Motorola’s business is in this industry
rather than the semiconductor industry, this is the more
interesting and
relevant story. Relative to the telecommunications equipment
industry, Motorola has a better liquidity position, with both the
current
ratio and the quick ratio being higher than the industry average.
Motorola collects receivables quicker than the average firm in
this

industry. Relative to this industry, Motorola may want to
evaluate credit policies to determine if perhaps strict credit
policies are
negatively impacting sales. Motorola uses its total assets
slightly less efficiently than the average firm in the
telecommunications
equipment industry and its fixed asset turnover is significantly
less than the industry average, at 4.37 compared to the industry
average
of 6.24. Motorola is more highly leveraged than the average
firm in the telecommunications industry. Motorola may want to
examine
its capital structure policy to ensure it has the right balance of
benefit from the tax shield of increased debt relative to the
bankruptcy
and related financial distress costs associated with increased
debt.

Several explanations are possible for the deviation from
industry norms. Perhaps this is the result of a conscious choice
to
invest heavily in technology and automation in its
manufacturing processes (as opposed to a more labor-intensive
manufacturing
strategy); while such fixed investments will yield significant
gains in good market conditions, the investments commit the
firm to
fixed costs (depreciation) in bad economic conditions.
Alternatively, the poor fixed asset turnover may indicate
overcapacity caused
by extremely poor forecasts of future sales. Or, the poor ratio
may indicate a fundamental inability or inefficiency in using the
deployed assets. Motorola is slightly less leveraged, with a
lower debt and debt-to-equity ratio. Keep in mind, though, that
the debt
ratios used in the ratio analysis above used total liabilities as a

measure of debt. In contrast, capital structure analysis focuses
specifically on long-term debt in calculating leverage.

Motorola has a higher gross profit margin than the average firm
in the telecommunications equipment industry (32.8% versus
29.5%), but has a lower net margin. Motorola a higher fixed
and indirect cost structure. As an illustration of the potential
fixed and
indirect cost issues, consider the productivity, for this purpose
defined as sales per employee, of Motorola relative to its chief

10

competitor in the telecommunications equipment industry,
Nokia. In 2001, Motorola generated sales of $31,191M with
111,000
employees, for a productivity of $0.27M per employee. In
contrast, Nokia generated sales of $27,645M with just 53,800
employees,
for a productivity of $0.53M per employee, nearly double the
productivity of Motorola. Clearly, Motorola has significant
costs
associated with its level of employment that are not being
returned in sales. This is interesting because Motorola, as
observed earlier,
also has poor fixed asset use in addition to this effective and /
or efficient use of human assets. Perhaps contributing to the
poor fixed
and indirect cost structure is that Motorola has elements of
being a conglomerate that most of the other firms in the
industry do not
have. Motorola is involved in diverse business segments –
telecommunications, semiconductors, automotive components,
and

batteries, to name a few – and must evaluate whether the
administrative and infrastructure costs of managing these
diverse segments
are less than the benefits of having the segments under one
corporate umbrella. It is not obvious that the diverse business
segments
within Motorola are being used synergistically to increase
overall value. If there are not synergies between the business
segments,
Motorola shareholders should prefer that Motorola divest the
segments as investors can diversify there portfolios more
efficiently than
Motorola can. Most of the other firms in the industry do not
have to absorb the costs associated with managing such diverse
business
activities.

Dupont System of Financial Analysis

A Dupont analysis of Motorola, the semiconductor industry, and
the telecommunications equipment industry is shown in the
table
below. The story told by the Dupont analysis is similar to the
story told by analyzing ratios: Motorola must focus on
controlling
operating costs. Relative to the semiconductor industry as a
whole, Motorola has an advantage in its leverage ratio (Assets
to Equity
of 2.77 compared to 1.52 for the industry) and in its use of
assets (Total Asset Turnover of 0.86 compared to 0.61), yet has
a poorer
return on equity due to its low net profit margin. While one
would expect a somewhat lower net profit margin for a firm
with a higher
leverage ratio (the firm has to pay interest to service the debt

that gives the higher leverage ratio), in the Motorola case there
are
apparently other operational inefficiencies impacting the net
profit margin because the overall return on equity is less than
the industry
average. A similar story, though not quite as obvious, is told by
comparing Motorola to the telecommunications equipment
industry
averages for the Dupont analysis, where Motorola again stands
out as being deficient in its ability to generate profits from its
sales.

Motorola Semiconductor Industry

Telecommunication
Equipment
Industry

ROE (Return on Equity) -22.11% -2.78% -3.14%
= = = =
NPM (Net Profit Margin) -9.31% -3.00% -1.24%
X X X X
TAT (Total Asset Turnover) 0.86 0.61 0.90
X X X X
A/E (Assets/Equity) 2.77 1.52 2.82

Figure 1 (available upon request) shows the Return on Asset
(ROA) portion of the Dupont analysis

ROE = NPM * TAT * A/E = ROA * A/E (1)

and helps to illustrate Motorola’s situation. Large variable and

fixed expenses (relative to the level of sales) are negatively
impacting
ROA, and these expenses, especially variable expenses (selling,
general, and administrative expenses) since they are perceived
to be
more easily controllable, need to be closely evaluated.
Increases in sales revenues may also help the ROA situation.
Although poor
overall market conditions can be blamed for a portion of
Motorola’s low sales figure, Motorola also needs to critically
evaluate why it
has lost market share in some of its key business areas over the
last several years (for example, Nokia’s and Samsungs market
share in
wireless handsets has improved while Motorola’s has declined)
making the operating results from poor market conditions even
worse.
The impact of Motorola’s decision early in the lifecycle of the
cellular industry not to participate in developing digital cellular
technology likely opened the door for firms such as Nokia to
gain significant market positions, and Motorola’s sales – and its
financial
position - still suffer from this decision. New product
development investments must be closely evaluated to assure
that Motorola is
developing products that will be valued in the marketplace.
However, competitors will not simply let Motorola gain sales
and market
share at their expense. Nokia capitalized on Motorola’s
incorrect earlier strategic decision to forego entry in the digital
wireless
handset arena. Nokia gained a dominant position in Europe and
is now clearly aiming to challenge Motorola’s leadership in
CDMA
wireless handset technology in the United States through the
introduction of multiple new handset models based on the

CDMA
technology prevalent in America, Nokia Unveils New Phones to
Crack CDMA. Motorola – and – are also losing share in
foreign
markets, such as China, because domestic firms in those
markets use price advantages to drive sales, Nokia, Motorola
Lose China

11

Market Share to Domestic Companies Motorola must develop a
product and business strategy to increase sales in the midst of
these
threats while at the same time controlling variable and fixed
expenses.

Short Term Liquidity Management

The telecommunication equipment industry averages a current
ratio of 1.52 and a quick ratio of 1.23, so Motorola’s current
ratio and
quick ratio of 1.77 and 1.47, respectively, compares favorably
to the industry. This, combined with the observation that both
ratios are
above one, leads to the conclusion that Motorola is in a solid
short-term liquidity position.
While this favorable absolute liquidity position is important,
perhaps just as important to debt investors in Motorola is the
trend over
time in the ratios. In Motorola’s case, there have been very
solid improvements in its liquidity position since 1999 and
2000. Some of
this improvement in liquidity comes from reductions in notes

payable and the current portion of long-term debt. But a
significant
portion of the improvement is attributable to large increases in
cash and cash equivalents. The cash and cash equivalent
balance
increased 97% percent during period. In addition to the cash
increases seen above, Motorola has very recently taken
additional steps
to “further boost” its cash position by selling $325M of Nextel
stock, Motorola Sells $325M of Nextel Stock. This sale of 25
million
of Motorola’s 108 million Nextel shares was completed “to
realize the price appreciation of some of its investment in the
wireless
communications services provider and to enhance its already
strong cash position,” Motorola Completes Sale of 25 Million of
Its 108
Million Shares of Nextel. After the sale, Motorola will remain
one of Nextel’s largest shareholders, retaining over a 9% stake
in
Nextel, Motorola Sells $325M of Nextel Stock.

Since a good deal of a firm’s cash balance is to cover expenses
related to manufacturing and selling products, and since
Motorola’s sales have been falling over the last several years,
Motorola’s cash buildup leads to an interesting question that is
difficult
to answer using publicly available information: is the build-up
of the cash balance appropriate? Or, asked another way, is
Motorola
currently keeping too high of a cash balance since, after all,
cash balances do not generate a return for investors? If
Motorola was in
an extremely poor cash position in 1999 and 2000, perhaps the
build-up is appropriate. On the other hand, having too large of
a cash

balance reduces firm value; for example, keeping 25 million
shares of Nextel stock may well enhance firm value more than
having the
proceeds of the sale sit idle as cash. Perhaps the increase in
cash balances is in fact contributing to the decline in firm value
observed
over the last several years as investors see the cash sitting idle
rather than providing at least a risk free market rate of return.

2002 2001 2000 1999
Cash and cash equivalents 6,507 6,082 3,301 3,537
Short-term investments 59 80 354 699
Accounts receivable, net 4,437 4,583 7,092 5,627
Inventories, net 2,869 2,756 5,242 3,707
Other current assets 3,262 3,648 3,896 4,015
Total current assets 17,134 17,149 19,885 17,585

Notes payable & current portion of long-term

debt
1,524 870 6,391 2,504

Accounts payable 2,268 2,434 3,492 3,285
Accrued liabilities 5,913 6,394 6,374 7,117
Total current liabilities 9,705 9,698 16,257 12,906

Current Ratio 1.77 1.77 1.22 1.36
Quick Ratio 1.47 1.48 0.90 1.08
Net Working Capital 7,429 7,451 3,628 4,679

Capital Structure & Debt Management

From this data, it is evident that there has been a significant
change in Motorola’s capital structure over the last several

years,. When
viewed from either a book value or market value basis there is a
significant increase in leverage. Motorola’s long term debt
increased
by more than 85% from 2000 to 2001, while equity dropped on
both a book value and market value basis. From the data, it
does not
appear that Motorola has a strict or a tight target debt-equity
ratio that they maintain to balance the benefits of debt
(primarily, the tax
savings due to interest) with the cost of debt (primarily,
financial distress costs), unlike many large firms, Graham, and
Harvey (2001).
It is unclear whether Motorola has a strategy to minimize their
weighted average cost of capital.

12

2002 2001 2000 1999
Long Term Debt, Book Value ($M) 7,779 8,857 4,778 3,573
Long Term Debt, Market Value ($M) 7,722 8,857 4,778 3,573
Stockholders Equity, Book Value

($M)
11,239 13,691 18,612 18,693

# Shares (M) 2,301 2,213 2,257 2,202
Share Price ($) 8.01 16.05 19.59 44.72
Stockholders Equity, Market Value

($M)
18,431 35,523 44,207 98,473

Debt/Equity (Book Value) 0.69 0.65 0.26 0.19
Debt/Equity (Market Value) 0.42 0.25 0.11 0.04
Note: 2001, 2000, 1999 market value of debt assumed same as
book value of debt

Some of the increase in long-term debt from 2000 to 2001 was
used to replace short-term debt, Motorola 2001 Proxy

Statement. However, we observed earlier that cash balances
increased significantly in the same time period, indicating that
some of
the long-term financing was used to improve the short-term
liquidity position. But these improvements in the short-term
liquidity
position came at the expense of an increase in operating risk.
The increased leverage committed the company to increased
interest
payments to service the long-term debt. Interest payments
increased from $529M to $844M from 2000 to 2001, increasing
Motorola’s
losses in 2001 as economic and market conditions worsened,
Motorola 2001 Proxy Statement. The significant amount of debt
added
in 2001 could also impact Motorola’s ability to acquire long-
term debt at favorable rates in the future. If funds are needed
beyond
which are available internally, Motorola may have no choice but
to turn to the equity market, which is generally considered to be
unfavorable at this point in time. The increase in long-term
debt may, in part, support the free cash flow hypothesis, which
asserts that
bad investment decisions are often made in the presence of a
large amount of free cash flow.

While we have examined Motorola’s capital structure from an
absolute perspective, it is worthwhile to look at the capital
structure relative to the industry segment that Motorola
primarily participates in, the telecommunications equipment
industry.
Company wide financial structure data is as follows:

Industry
Long Term Debt, Book Value ($M) 56,346.6
Stockholders Equity, Book Value ($M) 119,349.3
Stockholders Equity, Market Value ($M) 270,388.9

Debt/Equity (Book Value) 0.47
Debt/Equity (Market Value) 0.21

Motorola’s Debt/Equity ratio on a book value basis is 0.69,
which is higher than the industry average of 0.47, and
Motorola’s
Debt/Equity ratio on a market value basis is 0.42, double the
industry average of 0.21. So, Motorola has not only increased
its
leverage, it has increased its leverage well above the industry
average leverage ratio. Is this bad, in the sense that the higher
leverage
level is detracting from firm value? We believe that this
question is difficult to answer with information from publicly
available
sources. The appropriate amount of leverage is unique to each
firm based on the firm balancing the tax benefits of increased
debt
against the financial distress costs associated with increased
debt. However, the deviation from the industry average
leverage ratio

should be closely examined as, on average, other firms in
similar business situations see the appropriate balance between
the tax
shelter benefit and distress costs at much lower levels of
leverage.

SUMMARY AND CONCLUSIONS

In this paper, we have shown that financial ratio analysis is
complicated for companies that do not readily fall into a single
industry.
Motorola has six operating units that fall into several industries
with two industries accounting for most of the sales –
telecommunications and semi-conductor. The differences in the
industry characteristics of these two industries complicate the
financial ratio analysis of Motorola. However, a more relevant
picture of the operating characteristics of Motorola is achieved
by
increasing the complexity of the analysis, that is, by comparing
Motorola to both industries.

13

REFERENCES

Brigham, Eugene F. and Joel F. Houston. Fundamentals of
Financial Management, Ninth Edition, Harcourt College
Publishers, Fort
Worth, 2001.

Graham, John R. and Campbell R. Harvey. “The Theory and
Practice of Corporate Finance: Evidence from the Field,”

Journal of
Financial Economics, 60, 2001, pp. 187-243.

Motorola Completes Sale of 25 Million of Its 108 Million
Shares of Nextel, retrieved from
http://biz.yahoo.com/prnews/030304/cgtu025_1.html

Motorola Sells $325M of Nextel Stock, retrieve from
http//biz.yahoo.com/ap/030305/Motorola_Nextel_1.html

Nokia Unveils New Phones to Crack CDMA Market, retrieved
from
http://biz.yahoo.com/rc/030317_tech_nokia_handsets_2.html

Nokia, Motorola Lose China Market Share to Domestic
Companies, retrieved from
http://biz.yahoo.com/djus/030314/0020000011_1.html

Reiter, Chris. Mobile Phone Sales Rose 6% to 423 Million
Units Last Year, Dow Jones Business New, retrieved from
http://biz.yahoo.com/djus/030309/2037000327_3.html

Yahoo.finance.com

Yahoo.marketguide.com

The data tables and sources of data used in this paper are
available upon request from Carl B. McGowan, Jr.,
[email protected] .

University of WollongongResearch Online2004An example of
the use of financial ratio analysis: the case of MotorolaH. W.
CollierT. GraiS. HaslittC. B. McGowanPublication DetailsAn
example of the use of financial ratio analysis: the case of
MotorolaAbstractDisciplinesPublication Details

FIN 430 — Finance Theory and PracticeProject
AssignmentsYou have been assigned a company to research
(please check the excel list for the firm you are assigned to).
During this quarter you are expected to analyze a firm’s
financial statements, stock price, WACC, and valuation.
Project 1 focuses on the financial statement analysis.
Goals for this assignment:
· Gather financial statements
· Calculate financial ratios
· Financial performance analysisProject 1: Financial Statement
Analysis

a) Collect financial statements.
Financial statements are available on the internet through at the
http://finance.yahoo.com website. At this website you will put
the ticker symbol for your company in the symbol box and press
“go”. At this point you will see a page that has financial
information about your company. On the left-hand side of the
screen there will be a series of options that you can choose to
get more information about your company. Under the heading
“financial statements” you will see an option for “income
statement” and “balance sheet.” You want annual statements.
The financial statements for the past 3 years should be
available. (Depending on the fiscal year for your company,
these might be 2014, 2015, and 2016 or 2015, 2016 and 2017.)

b) Calculate the financial ratio.

Calculate the ratios listed at the end of this document from the
financial statements of your company for the most recent 3
years. To do this, you will need to make a spreadsheet, (on
Excel or other), that essentially copies certain lines of your
various financial statements onto the spreadsheet. Then, make
spreadsheet formulas to calculate each financial ratio that is
required.

c) The DuPont decomposition Analysis.
Using the ratios you calculate above to conduct the DuPont
Decomposition analysis for each of the three years for your
company. The DuPont Decomposition is composed of
ROE = NI/Equity = NI/Sales *Sales/Assets * Assets/Equity
Therefore, you should include a total of twelve calculations
(four ratios for each of the three years). You can present the
ratios in the following format.
Year
ROE
Operation Management
Asset Management
Leverage Management

NI/Equity
NI/Sales
Sales/Assets
Assets/Equity
2012

2013

2014

d) Check information of M&A located in the company’s 10k

Once you have made these calculations, read the MA&D located
in the annual report, as well as the footnotes to the various
financial statements. These are the pieces of information that
management wants you to know, (or is required to tell you!), in
addition to “the numbers.”
e) Make observations.
Write a 2 page summary in which you describe what you
observe about the financial ratios for your company (double
spaced). And you can also discuss the most interesting and
relevant changes from one year to the next from your
calculations. After reading the MD&A and footnotes, you
should have a good idea of why certain ratios and figures
changed from one year to the next. If certain changes are not
explained, try to think of reasons why the figures might have
changed. For example, did one part of an equation change in
greater proportion than another part? (i.e. did a numerator grow
much faster than a denominator?) Why might that have
occurred?
These observations will vary greatly depending upon the
company you are analyzing. Some things you may want to
consider are:
Has the company drastically increased or decreased its use
of debt?
1. Has the company’s liquidity position changed over the three
years?
1. Has ROE been rising or falling? If so, what has contributed
to this change?
1. What trends do you see developing in the data?
1. Do you see any major changes in the financial status of the
company over the time period?

The goal with this project is to not only give you a chance to
calculate the ratios that accountants and analysts frequently use
when evaluating a company, but to also make you look for
reasons, (i.e. “drivers”), for those changes and to think of your
own reasons if none are given. If you only do the calculations

but do not discuss why certain changes took place, then you
haven’t achieved the goal of the assignment. Therefore, do
your best to go past the numbers!
f) Report Submit
In the end, you will hand in: (1) your page with cogs, assets,
sales etc.,. that you copied from your financial statements, (2) a
sheet of your calculations, labeled so that I know which
calculation is which, (3) a print out of your formulas, and (4)
your 2-3 page report on those calculations. (You can print out
your Excel formulas by choosing “Tools” then “Options” then
the “View” tab, then under “Windows options” check the
“formulas” box. This might mess up the layout of your page, so
don’t try to make it look pretty. Just print out the formulas,
then uncheck the box to make your spreadsheet go back to
normal).Keep it in mind that you are expected to be a business
person in the future and your report should look professional.

Required ratio calculations, (in their simplest form), are listed
below:
A. Profitability Ratios:
1. Return on Assets (net income/total assets)
2. Return on Sales, (aka profit margin percent) (net
income/sales)
3. Assets-to-Equity (total assets/stockholder’s equity)
4. Return on Equity (net income/stockholder’s equity)
B. Efficiency Ratios:
1. Asset Turnover (sales/total assets)
2. A/R Turnover Rate (sales/accounts receivable)
3. Inventory Turnover Rate (COGS/average inventory)
4. Fixed Asset Turnover (sales/average fixed assets)
C. Leverage Ratios:
1. Debt Ratio (total liabilities/total assets)
2. Debt-to-Equity Ratio (total liabilities/stockholder’s equity)
3. Times Interest Earned (earnings before interest and
taxes/interest expense)
D. Liquidity Ratios:

1. Current Ratio (current assets/current liabilities)
2. Working Capital (current assets – current liabilities)

These ratios are explained in your textbook, so if you don’t
understand why a particular calculation is important or relevant,
you can look up more information there.
3

ChapterTool KitChapter 1212/9/12Corporate Valuation and
Financial Planning12-2 Financial Planning at MicroDrive,
Inc.The process used by MicroDrive to forecast the free cash
flows from its operating plan is described in the sections
below.Setting Up the Model to Forecast OperationsWe begin
with MicroDrive's most recent financial statements and selected
additional data.Figure 12-1 MicroDrive’s Most Recent Financial
Statements (Millions, Except for Per Share Data)INCOME
STATEMENTSBALANCE
SHEETS20122013Assets20122013Net sales$ 4,760$
5,000Cash$ 60$ 50COGS (excl. depr.)3,5603,800ST
Investments40-Depreciation170200Accounts
receivable380500Other operating
expenses480500Inventories8201,000EBIT$ 550$ 500Total
CA$ 1,300$ 1,550Interest expense100120Net
PP&E1,7002,000Pre-tax earnings$ 450$ 380Total assets$
3,000$ 3,550Taxes (40%)180152NI before pref. div.$ 270$
228Liabilities and equityPreferred div.88Accounts payable$
190$ 200Net income$ 262$ 220Accruals280300Notes
payable130280Other DataTotal CL$ 600$ 780Common
dividends$48$50Long-term bonds1,0001,200Addition to
RE$214$170Total liabilities$ 1,600$ 1,980Tax
rate40%40%Preferred stock100100Shares of common
stock5050Common stock500500Earnings per
share$5.24$4.40Retained earnings800970Dividends per
share$0.96$1.00Total common equity$ 1,300$ 1,470Price per
share$40.00$27.00Total liabs. & equity$ 3,000$ 3,550The

figure below shows all the inputs required to project the
financial statements for the scenario that has been selected with
the Scenario Manager: Data, What-If Analysis, Scenario
Manager. There are two scenarios. The first is named Status
Quo because all operating ratios except the sales growth rate are
assumed to remain unchanged. The initial sales growth rate was
chosen by MicroDrive's managers based on the existing product
lines. The growth rate declines over time until it eventually
levels off at a sustainable rate. The other scenario is named
Final because it is the set of inputs chosen by MicroDrive's
management team.Section 1 shows the inputs required to
estimate the items in an operating plan. For each of these
inputs, Section 1 shows the industry averages, the actual values
for the past two years for MicroDrive, and the forecasted values
for the next five years. The managers assumed the inputs for
future years (except the sales growth rate) would be equal to the
inputs in the first projected year.MicroDrive's managers assume
that sales will eventually level off at a sustaniable constant
rate.Sections 2 and 3 show the data required to estimate the
weighted average cost of capital. Section 4 shows the forecasted
growth rate in dividends.Note: These inputs are linked
throughout the model. If you want to change an input, do it here
and not other places in the model.Figure 12-2MicroDrive's
Forecast: Inputs for the Selected ScenarioStatus
QuoIndustryMicroDriveMicroDriveInputsActualActualForecast1
. Operating Ratios20132012201320142015201620172018Sales
growth rate5%15%5%10%8%7%5%5%COGS (excl. depr.) /
Sales76%75%76%76%76%76%76%76%Depreciation / Net
PP&E9%10%10%10%10%10%10%10%Other op. exp. /
Sales10%10%10%10%10%10%10%10%Cash /
Sales1%1%1%1%1%1%1%1%Actual Historical FinancingAcc.
rec. / Sales8%8%10%10%10%10%10%10%20122013Inventory /
Sales15%17%20%20%20%20%20%20%Long -term
debt$1,000$1,200Net PP&E /
Sales33%36%40%40%40%40%40%40%Short -term
debt$130$280Acc. pay. /

Sales4%4%4%4%4%4%4%4%Preferred stock$100$100Accruals
/ Sales7%6%6%6%6%6%6%6%Market value of equi ty = (Price
x # shares)$2,000$1,350Tax
rate40%40%40%40%40%40%40%40%Total$3,230$2,9302.
Capital StructureActual Market WeightsTarget Market
Weights% Long-term
debt22%31%41%28%28%28%28%28%See the box to the right
for calculations of the actual capital structures, based on market
values, for the past two years.Percent long-term debt31%41%%
Short-term debt3%4%10%2%2%2%2%2%Percent short -term
debt4%10%% Preferred stock0%3%3%3%3%3%3%3%Percent
preferred stock3%3%% Common
stock75%62%46%67%67%67%67%67%Percent market value of
equity62%46%3. Costs of CapitalForecastTotal100%100%Rate
on LT debt9.0%9%9%9%9%Rate on ST
debt10.0%10%10%10%10%Rate on preferred stock (ignoring
flotation costs)8.0%8%8%8%8%Cost of
equity13.58%14%14%14%14%4. Target Dividend
PolicyActualGrowth rate of
dividends11%4.2%5%5%5%5%5%12 -3 Forecasting
OperationsThe figure below shows the forecasted items for the
operating plan. For convenience, we repeat the inputs of
operating ratios.Section B1 shows the sales forecast. Each
year's sales is equal to the previous year's sales multiplied by
the forecasted sales growth rate.Section B2 shows the
projections of operating assets and operating liabilities. The
operating asset for a particular year is equal to the product of
that asset's ratio in Section A1 and that particular year's
projected sales. The operating liabilities are projected in a
similar manner.Section B3 shows the projections of operating
income. The COGS and other operating expenses are equal to
the product of the ratio in Section A1 and that particular year's
projected sales. Depreciation is equal to the product of the ratio
in Section A1 and that particular year's projected net PP&E.
EBIT is net sales minus COGS, depreciation, and other
operating expenses. NOPAT is EBIT(1-T), where T is the tax

rate. Section B4 shows the projections of free cash flows.
NOWC is equal to operating CA (i.e., cash, accounts receivable,
and inventories from Section B2) minus operating CL (i.e.,
accounts payable and accruals from Section 4). Total capital is
equal to the sum of NOWC and net PP&E (from Section B2).
Section B5 shows the results of the operating plan. The first
rows in Section B5 report the target WACC (calculated as
shown in Chapter 9), the return on invested capital, and the
growth rate in FCF. The horizon value, value of operations, and
estimated intrinsic stock price are calculated using the FCF
valuation model as present in Chapter 7.Note: Do not change
inputs here because these inputs are linked to the ones in Figure
12-2. If you want to change inputs, do so in Figure 12-2.Figure
12-3MicroDrive's Forecast of Operations for the Selected
Scenario (Millions of Dollars, Except for Per Share Data)Status
QuoIndustryMicroDriveMicroDrivePanel A:
InputsActualActualForecastA1. Operating
Ratios20132012201320142015201620172018Sales growth
rate5%15%5%10%8%7%5%5%COGS (excl. depr.) /
Sales76%75%76%76%76%76%76%76%Depreciation / Net
PP&E9%10%10%10%10%10%10%10%Other op. exp. /
Sales10%10%10%10%10%10%10%10%Cash /
Sales1%1%1%1%1%1%1%1%Acc. rec. /
Sales8%8%10%10%10%10%10%10%I nventory /
Sales15%17%20%20%20%20%20%20%Net PP&E /
Sales33%36%40%40%40%40%40%40%Acc. pay. /
Sales4%4%4%4%4%4%4%4%Accruals /
Sales7%6%6%6%6%6%6%6%Tax
rate40%40%40%40%40%40%40%40%Panel B:
ResultsActualForecastB1. Sales
Revenues201320142015201620172018Net
sales$5,000$5,500$5,940$6,356$6,674$7,007B2. Operating
Assets and Operating
LiabilitiesCash$50$55$59$64$67$70Accounts
receivable$500$550$594$636$667$701Inventories$1,000$1,100
$1,188$1,271$1,335$1,401Net

PP&E$2,000$2,200$2,376$2,542$2,669$2,803Accounts
payable$200$220$238$254$267$280Accruals$300$330$356$38
1$400$420B3. Operating IncomeCOGS (excl.
depr.)$3,800$4,180$4,514$4,830$5,072$5,326Depreciation$200
$220$238$254$267$280Other operating
expenses$500$550$594$636$667$701EBIT$500$550$594$636$
667$701Net operating profit after
taxes$300$330$356$381$400$420B4. Free Cash FlowsNet
operating working
capital$1,050$1,155$1,247$1,335$1,401$1,472Total operating
capital$3,050$3,355$3,623$3,877$4,071$4,274FCF = NOPAT –
Δ op capital−$260$25$88$128$207$217B5. Estimated Intrinsic
ValueTarget WACC11.0%11.0%11.0%11.0%11.0%Return on
invested capital9.8%9.8%9.8%9.8%9.8%9.8%Growth in
FCF252%45.1%61.7%5.0%Horizon Value:Value of
operations$2,719+ ST investments$0=$3,814Estimated total
intrinsic value$2,719− All debt$1,480Value of Operations:−
Preferred stock$100Present value of HV$2,267Estimated
intrinsic value of equity$1,139+ Present value of FCF$453÷
Number of shares$50Value of operations =$2,719Estimated
intrinsic stock price =$22.78
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