Course Project 2

Final Project Handout

To complete the final project, you will need to estimate future cash flows for a firm and then apply discounted cash flow analysis to estimate the value of a firm. This will all be done in Excel and should be done in a way that utilizes formulas and cell references. This project is worth a total of 25 points. Estimating Free Cash Flows Finding WACC

Estimating Free Cash Flow Start with the operating profit or EBIT for a firm and make the following adjustments: 1. Add back the owner’s salary and benefits. 2. Subtract out a more reasonable compensation for the work performed by the owner 3. Add back any of the owner’s personal expenses that have been run through the company. 4. Add back any depreciation and amortization expenses that were claimed this year.

Remember, these are noncash expenses. They are not actual payments made to someone, but merely a number from a table or formula that the IRS allows the owner to subtract out before the calculation of the firm’s taxable income.

5. If a major piece of equipment or asset is intended to be purchased in this particular year, then subtract this amount.

6. Subtract the amount of money it would take to bring the inventory of the company up to a reasonable level. For instance, sometimes when a business owner knows that the company will be sold, he may “sell out of inventory” rather than reorder new inventory. Therefore, by the time the new owner takes possession, there may be nothing on the shelves to sell. As a result, the new owner may need to invest in inventory or other types of working capital before the business is able to operate and generate income. An analogy might be the way that people sell their cars. They typically do not pay for new tires, a brake job, a battery, a tune-up, and a tankful of gas the day before a car is sold.

Finding Terminal Value Terminal value = year 6 cash flow / WACC Discounted Cash Flow Analysis Steps 1. Calculate a firm’s free cash flows for the next five years. 2. Calculate the terminal value of the firm after year five. 3. Estimate a weighted average cost of capital for a firm. 4. Calculate the NPV of the firm. 5. Calculate any taxes that will be owed as a result of the sale of the firm. 6. Calculate the net proceeds from selling the firm.

Final Project Handout

Practice Problem 1. A potential buyer is interested in purchasing a company called MacroTech from an owner

whose financial statements report that this year’s EBIT was $200,000. 2. Other information gathered reveal that the owner paid himself salary and benefits of

$100,000 when a more reasonable compensation, given the local job market, was $50,000. 3. There was $20,000 in depreciation expense this year. 4. The owner had $10,000 in personal expenses such as lease payments on a Lexus that he

called a “company” car. 5. The firm will need a net investment of $200,000 to replace worn-out equipment during

year 2. 6. It is believed that EBIT will increase by 7% per year for the next five years given the

productive capacity of the firm and the nature of the product market. Beyond five years, a reasonable estimate of growth is neither possible nor relevant because the buyer should not have to pay for growth that would come from his own efforts and future investment.

7. The firm has an outstanding loan of $500,000. 8. The cost basis of the firm is $100,000. In other words, the original owner has

$100,000 of his money invested in the company. If the firm sells for more than $100,000, the difference between the selling price and the $100,000 invested would be considered income to the seller. Further suppose that the original owner would fall in a combined state and federal tax bracket of 40%. 9. MacroTech has a history of maintaining an average inventory balance of

$80,000. Since MacroTech first appeared on the market for sale, the owner has not purchased any new inventory and has allowed the level to drop to $65,000, thus suggesting that the buyer will probably need to invest $15,000 in inventory just to bring the firm’s inventory back up to a safe level. This would occur in the first year of operations. 10. Assume this firm finances itself using 25% debt. The cost of debt has been estimated to be

15% while the cost of equity has been estimated to be 27%.