ch 9

Corporate Valuation and Financial Planning

Chapter Overview

  • Title: Corporate Valuation and Financial Planning

  • Course: FIN 400

  • Main Themes:

    • Additional funds needed (AFN) equation

    • Forecasted financial statements

    • Operating input data

    • Financial policy issues

    • Changing ratios

Key Financial Concepts

Intrinsic Value Calculation

  • Formula: extValue=racFCF<em>1(1+WACC)1+racFCF</em>2(1+WACC)2+racFCFext∞(1+WACC)ext∞ext{Value} = rac{FCF<em>1}{(1 + WACC)^1} + rac{FCF</em>2}{(1 + WACC)^2} + rac{FCF_{ ext{∞}}}{(1 + WACC)^{ ext{∞}}}

    • Where:

    • FCF: Free Cash Flow

    • WACC: Weighted Average Cost of Capital

Financial Statements and Forecasting

  • Forecasted Financial Statements Include:

    • Projected income statements

    • Projected balance sheets

  • Involves forecasting the projected financing surplus or deficit

  • Requires operating and financial policy assumptions

Balance Sheet Example

  • Company: Hatfield

  • Date: 12/31/2015

Assets

  • Cash: $20

  • Accounts Receivable: $280

  • Inventories: $400

  • Net Fixed Assets: $500

  • Total Current Assets (CA): $700

  • Total Assets: $1,200

Liabilities and Equity

  • Accounts Payable & Accruals: $80

  • Line of Credit: $0

  • Long-Term Debt: $500

  • Total Liabilities: $580

  • Common Stock: $420

  • Retained Earnings: $200

  • Total Common Equity: $620

Income Statement Example

  • Company: Hatfield

  • Year: 2015

Key Figures

  • Sales: $2,000

  • Operating Costs (excl. Depreciation): $1,800

  • Depreciation: $50

  • EBIT: $150

  • Interest Expenses: $40

  • Pretax Earnings: $110

  • Taxes (40%): $44

  • Net Income: $66

  • Dividends: $20

  • Earnings per Share (EPS): $6.60

  • Dividends per Share (DPS): $2.00

  • Ending Stock Price: $52.80

Selected Financial Ratios

Hatfield vs. Industry Comparisons

  • Operating Costs/Sales: Hatfield 90.0% vs. Industry 88.0%

  • Total Liabilities/Total Assets: Hatfield 48.3% vs. Industry 36.7%

  • Depreciation/Fixed Assets: Hatfield 10.0% vs. Industry 12.0%

  • Times Interest Earned: Hatfield 3.8 vs. Industry 8.9

  • Return on Assets (ROA): Hatfield 5.5% vs. Industry 10.2%

  • Return on Equity (ROE): Hatfield 10.6% vs. Industry 16.1%

  • Price-to-Earnings (P/E) Ratio: Hatfield 8.0 vs. Industry 16.0

Additional Funds Needed (AFN) Equation

  • Purpose: Forecast the additional financing needed based on the operating plan.

  • Basic Steps:

    1. Estimate new assets required

    2. Subtract new spontaneous liabilities (accounts payable and accruals)

    3. Subtract reinvested profit (net income minus dividends)

AFN Key Assumptions

  • Operating at full capacity in 2015

  • Sales expected to increase by 10%

  • Asset-to-sales ratios remain constant

  • Spontaneous-liabilities-to-sales ratio remains constant

  • 2015 profit margin and payout ratio maintained

Definitions of Variables in AFN

  • $S_0$: Most recent sales

  • $g$: Growth rate in sales

  • $S_1$: Projected sales

  • $DS$: Increase in sales = g(S0)g(S_0)

  • $A_0^*$: Assets required to support sales

  • $L_0^*$: Spontaneous liabilities

  • $A0^*/S0$: Capital intensity ratio

  • $L0^*/S0$: Spontaneous liabilities ratio

  • $M$: Profit margin (Net income/Sales)

  • $POR$: Payout ratio (Dividends/Net income)

Data Needed for AFN Equation

  • Growth rate in sales ($g$): 10%

  • Sales ($S_0$): Calculate based on current sales

  • Profit margin ($M$)

  • Assets required ($A_0^*$)

  • Capital intensity ratio ($A0^*/S0$)

  • Payout ratio ($POR$)

  • Spontaneous liabilities ($L_0^*$)

Hatfield’s AFN Calculation

  • AFN Equation:
    extAFN=extAdditionalassets−extAdditionalspontaneousliabilities−extReinvestedprofitext{AFN} = ext{Additional assets} - ext{Additional spontaneous liabilities} - ext{Reinvested profit}

  • Expanded Form:
    extAFN=(A<em>0/S0)imesextΔS−(L0/S</em>0)imesextΔS−M(S1)(1−extPayout)ext{AFN} = (A<em>0^/S0) imes ext{Δ}S - (L0^/S</em>0) imes ext{Δ}S - M(S_1)(1 - ext{Payout})

Key Factors in AFN Equation

  1. Sales Growth Rate ($g$): Higher sales growth leads to larger AFN, holding other factors constant.

  2. Capital Intensity Ratio ($A0^*/S0$): Higher capital intensity ratio leads to larger AFN.

  3. Spontaneous Liabilities Ratio ($L0^*/S0$): Higher spontaneous liabilities lead to smaller AFN.

  4. Profit Margin ($M$): Higher profit margins lead to smaller AFN.

  5. Payout Ratio ($DPS/EPS$): Lower payout ratios lead to smaller AFN.

Self-Supporting Growth Rate

  • Definition: The maximum growth rate a firm could sustain without needing external capital.

  • Formula:
    g=racM(1−POR)S<em>0A</em>0∗−L<em>0∗−M(1−POR)S</em>0g = rac{M(1 - POR)S<em>0}{A</em>0^* - L<em>0^* - M(1 - POR)S</em>0}

  • Example from Hatfield: If sales grow less than 4.28%, no external capital will be needed.

  • Influence Factors:

    • Capital intensity ratio: More assets required reduce sustainable growth rate.

Homework Assignments

  • Chapter 9 Questions: 9-1, 9-2, 9-3, 9-6