| FCF VALUATION |
| This is a 2-part FCF Valuation question using data from the Norris Industries case. |
| You are killing two birds with one stone here, learning about leveraged buyouts and equity valuation at the same time. |
| Exhibit 6 is the crucial exhibit in the case - in the previous tab with minor non-material differences in the numbers. |
| Use the numbers here in that exhibit, not from the case exhibit. |
| Notice that B45 PV of FCFs is based on years 1-5 only. The year 6 column grows the year 5 FCF at the stated growth rate in G30. |
| The terminal value in G48 is as of year 5. It is discounted to year zero, as shown in B52. |
| Part 1: |
| KKR agreed to pay $43.05 per share to buy out all existing shareholders. |
| Rounding the actual number of shares to 10 million to make calculations easier, they must raise $430.5 million dollars to finance the buyout. |
| You, as a mutual fund manager owning a big block of Norris stock, must determine if $43.05 per share |
| is a fair price, even though it amounts to almost a 50% premium over the prior market price of Norris, about $29 per share. |
| Therefore, to test whether the $43.05 price is fair, and to learn how to use the FCF Equity Valuation Template, |
| with data from Ex. 6 is already entered, evaluate the results of the analysis, |
| and discuss what it tells you, answering the questions in the boxes below: |
| |
| Existing Norris Shareholder Viewpoint - Part 1 (PRE-LBO) | | | | | | | | BASE YEAR DATA FOR REFERENCE ONLY - |
| | Base Year | Forecast | Forecast | Forecast | Forecast | Forecast | | NOT INCLUDED IN CALCULATIONS |
| PERIOD | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| YEAR | 1981 | 1982 | 1983 | 1984 | 1985 | 1986 | 1987 |
| EBIT (operating profit) | | 91.6 | 100.8 | 110.8 | 121.9 | 134.1 | | from ex 6 |
| Income tax rate | | 50.0% | 50.0% | 50.0% | 50.0% | 50.0% | | from ex 6 |
| Depreciation & amortization expense | | 23.0 | 23.1 | 23.1 | 22.0 | 21.5 | | from ex 6 |
| Capital expenditures | | 15.0 | 16.0 | 17.0 | 18.0 | 19.0 | | from ex 6 |
| Increase in NWC | | 12.0 | 8.0 | 8.0 | 5.0 | 5.0 | | from ex 6 |
| Perpetual growth rate | | | | | | 3.0% | | assumed |
| K-wacc (discount rate) | 10.0% | | | | | | | assumed |
| Value of liabilities | 23.0 | pre LBO debt | | | | | | from balance sheet |
| Number of shares outstanding | 10.00 | | | | | | | given |
| PERIOD | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| YEAR | 1981 | 1982 | 1983 | 1984 | 1985 | 1986 | 1987 |
| EBIT | | 91.6 | 100.8 | 110.8 | 121.9 | 134.1 |
| Income tax | | 45.8 | 50.4 | 55.4 | 61.0 | 67.1 |
| Earnings after tax | | 45.8 | 50.4 | 55.4 | 61.0 | 67.1 |
| + Depreciation | | 23.0 | 23.1 | 23.1 | 22.0 | 21.5 |
| =Cash flow from operations (CFFO) | | 68.8 | 73.5 | 78.5 | 83.0 | 88.6 |
| - Capital expenditures | | 15.0 | 16.0 | 17.0 | 18.0 | 19.0 |
| - Increase in NWC | | 12.0 | 8.0 | 8.0 | 5.0 | 5.0 |
| =Free cash flow (FCF) | | 41.8 | 49.5 | 53.5 | 60.0 | 64.6 | 66.5 | 66.5 (H44) is 64.6 (G44) x 1.03 |
| PV of FCFs | 200.1 | |
| | | |
| Terminal value estimates: |
| Perpetual growth | | | | | | 949.9 | | terminal cash flow (H44)/(k-wacc-growth rate) |
| Warranted MV firm/EBIT(1-tax rate) | disregard | | | | | | | |
| Projected BV of debt & equity | disregard | | | | |
| Best-guess terminal value | disregard' |
| PV of terminal value | 589.8 |
| Value of firm (enterprise value) | 789.9 |
| Value of liabilities | 23.0 | | |
| Value of equity | 766.9 |
| Shares outstanding | 10.0 |
| Value per share | $ 76.69 | | |
| Q1-A: Row 25 EBIT grows at 10% yr-by-yr in this forecast. Is that reasonable for a mature, cyclical company? Explain. |
| This 10% constant growth rate is not reasonable because a company in this mature business will grow |
| at a rate closer to the GDP growth rate. Further, a constant 10% yr-to-yr growth rate does not provide for |
| inevitable cyclical downturns. More subtly, you should notice, is previous EBIT of $66.5 in 1979 and $43.9 in 1980; the |
| forecast implies a substantial incease (climbing a steep cliff) from recent achieved EBIT to the EBIT |
| forecast. Therefore, this is a forecast biased in the optimistic direction. |
| Adjusting the forecast was not asked for or expected, but, a less optimistic scenario is easily run by |
| reducing the 1982 EBIT estimate, cutting the 10% growth rate, and introducing a one or two year flat or |
| down EBIT to simulate a cyclical downturn. |
| You should recognize EX 6 as optimistic and |
| realize that the resulting valuation is too high. |
| Q1-B: To what extent does Terminal Value dominate the calculation of value of equity? |
| G48 TV is 949.9, interpreted as the present value of the 1987 FCF growing at the stated rate, 3% in G30, | | | | | | | | Note | Equation |
| into perpetuity. The present value as of time zero, base year 1981, is 589.8 in B52. The present value of FCFs | | | | | | COST OF DEBT: |
| in B45 is 201.1 Clearly, TV dominates the valuation. The question is: does this bias the result? Yes, it certainly | | | | | | Coupon Rate | 6.7% | Ex2 interest/Ex1 debt |
| does. Consider the key drivers, initial EBIT, EBIT growth rate, TV growth rate, and discount rate. All are optimistic, | | | | | | Marginal Tax Rate | 50% | given |
| leading to a high value. | | | | | | Cost of Debt | 3.3% | | k-d = I x (1- t) |
| | | | | | | weight of debt | 6.7% | Ex1 | d ÷ d+e |
| A meat-axe 50% haircut of the valuation estimate is routinely made in the venture capital business. Doing that here, |
| even though this is a mature business with a secure EBIT stream, the haircut compensates for the aggressive EBIT | | | | | | COST OF EQUITY: |
| forecast. A 3% growth rate is reasonable because this is not a here today-gone tomorrow type of business. Calculating | | | | | | Risk-Free Rate | 15.3% | Ex12-10 yr T-Bond |
| k-wacc using the Cost of Capital template from Wk 3 p342#4 (not asked for or expected - see it at the right) shows that | | | | | | Risk Premium | 5.0% | judgment | R-m - R-f |
| a 19.2% k-wacc is more credible than the 10% rate assumed in B31, given the extant capital market rates, | | | | | | Beta | 1.00 | judgment or based on peers |
| equity risk premium of 5%, and Norris' pre-LBO debt ratio of 6.7%. | | | | | | Cost of Equity | 20.3% | | k-e = R-f + [ß x (R-m - R-f)] |
| | | | | | | weight of equity | 93.3% | 1-b8 | e ÷ d+e |
| Grey shading in Column H indicates that it is for calculation of Terminal Value, growing the previous year FCF |
| as Higgins explained. See the annotation next to H44. This column is not included in the PV of FCF calculation. | | | | | | k-wacc | 19.2% | (b8*b7)+(b15*b14) | (k-d x wt-d)+(k-e x wt-e) |
| Q1-C:Based on the value of equity result above, is $43.05 a fair price? | | | | | | COMMENTARY: |
| Using the B59 valuation estimate of $76.69 says that the $43.05 deal price is too low by a wide margin. | | | | | | The troubles with the above are many. The 1980 |
| Deal price is 78% below the estimated value. | | | | | | Security Market Line is negatively sloped - |
| However, you should identify and question the key drivers of the valuation result, as listed above: | | | | | | not the normal long-term SML. The yield curve |
| initial EBIT | | | | | | is inverted. Further, the equity risk premium, |
| EBIT growth rate | | | | | | R-m - R-f would be negative, not positive, because |
| growth rate | | | | | | stock market return has been so low. |
| discount rate | | | | | | What now? Normalize the inputs? If you do that, |
| Both initial EBIT and its growth rate are too aggressive. An impressionistic answer, a sense that a high value is | | | | | | which k-wacc to trust? |
| too high, is an excellent finding for this question beyond merely accepting the template result without question. | | | | | | The purpose of this commentary is to clue you in |
| Still, if you accepted the template result at face value, and indicated understanding of the analysis, that is ok. | | | | | | about k-wacc. If you are a buyer, is the seller using |
| | | | | | | a too low discount rate, therefore raising the value? |
| Note: Changing the discount rate in B31 from 10% to the 19.2% in H90, reduces the value to $30.56, | | | | | | If you are a seller, is the buyer using a too high discount rate, |
| close to market price at the time, making the deal price a healthy 41% premium over market price (recall the LBO video?) | | | | | | dropping the value? |
| This 'risk-adjustment' can be thought of as compensating for the too-high EBIT forecast, analogous to haircutting the EBITs | | | | | | BEWARE !! Cost of equity is a ghost-in-a-cloud. |
| in each cell as suggested above. | | | | | | Values that depend on it need careful interpretation. |
| Part 2: |
| Sam Mencoff needs to know the rate of return he might earn if he decides to invest $6 million (rounded) in the KKR-led buyout. |
| If he buys at time zero for $5.50 per share, he must forecast the exit price he will get if and when the KKR group sells Norris in the future. |
| Therefore, assume that such a sale will take place in 1986, and enter data from Ex. 6 into the FCF Equity Valuation Template below: |
| | | | | | | | | BASE YEAR DATA FOR REFERENCE ONLY - |
| Sam Mencoff viewpoint - Part 2 (POST-LBO) | | | | | | | | NOT INCLUDED IN CALCULATIONS |
| | Base Year | Forecast | Forecast | Forecast | Forecast | Forecast | Forecast |
| PERIOD | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| YEAR | 1986 | 1987 | 1988 | 1989 | 1990 | 1991 | 1992 |
| EBIT (operating profit) | 134.1 | 147.5 | 162.3 | 178.5 | 196.4 | 196.4 | | Case Ex 6 stops at 1990. |
| Income tax rate | 50% | 50.0% | 50.0% | 50.0% | 50.0% | 50.0% | | Repeat 1990 data for 1991, or |
| Depreciation & amortization expense | 21.5 | 21.5 | 21.5 | 21.5 | 21.5 | 21.5 | | grow them…your choice. |
| Capital expenditures | 19.0 | 25.0 | 25.0 | 25.0 | 25.0 | 25.0 |
| Increase in NWC | 5.0 | 5.0 | 5.0 | 5.0 | 5.0 | 5.0 |
| Perpetual growth rate | | | | | | 3.0% |
| K-wacc (discount rate) | 18.3% | increased 12.2% from H167 below by 50% |
| Value of liabilities | 261.3 | as of 1996 |
| Number of shares outstanding | 10.00 |
| PERIOD | 0 | 1 | 2 | 3 | 4 | 5 |
| YEAR | 1986 | 1987 | 1988 | 1989 | 1990 | 1991 |
| EBIT | 134.1 | 147.5 | 162.3 | 178.5 | 196.4 | 196.4 |
| Income tax | 67.1 | 73.8 | 81.1 | 89.3 | 98.2 | 98.2 |
| Earnings after tax | 67.1 | 73.8 | 81.1 | 89.3 | 98.2 | 98.2 |
| + Depreciation | 21.5 | 21.5 | 21.5 | 21.5 | 21.5 | 21.5 |
| =Cash flow from operations (CFFO) | 88.6 | 95.3 | 102.6 | 110.8 | 119.7 | 119.7 |
| - Capital expenditures | 19.0 | 25.0 | 25.0 | 25.0 | 25.0 | 25.0 |
| - Increase in NWC | 5.0 | 5.0 | 5.0 | 5.0 | 5.0 | 5.0 |
| =Free cash flow (FCF) | 64.6 | 65.3 | 72.6 | 80.8 | 89.7 | 89.7 | 92.4 |
| PV of FCFs | 240.6 | |
| | | |
| Terminal value estimates: |
| Perpetual growth | | | | | | 605.4 |
| Warranted MV firm/EBIT(1-tax rate) | disregard |
| Projected BV of debt & equity | disregard |
| Best-guess terminal value | disregard |
| PV of terminal value | 261.7 |
| Value of firm (enterprise value) | 502.3 |
| Value of liabilities | 261.3 |
| Value of equity | 241.0 |
| Shares outstanding | 10.0 |
| Value per share | $ 24.10 | | |
| Q2: Based on the result above, what should Mencoff do? HINT: Use IRR to calculate his rate of return. |
| Some of the work for this question was done for you, to set it up and pave the way for completion. Base year | | | | | | | | Note | Equation |
| shifts from 1981 to 1986, the target year for Sam's exit. Therefore, data is entered from Ex 6 from 1986 going forward. | | | | | | COST OF DEBT: |
| Growth rate is a judgment call - 3% is logical as discussed above, but you can make it lower (not much higher - it is | | | | | | Coupon Rate | 18.0% | Blended rate with LBO debt |
| a long-term sustainable gowth rate, forever) with a good reason. Discount rate selection is important here because | | | | | | Marginal Tax Rate | 50% | |
| the post-LBO Norris has extreme financial risk (business risk may not change unless the new owners decide to run | | | | | | Cost of Debt | 9.0% | b5*(1-b6) | k-d = I x (1- t) |
| the business differently). Venture capital has high risk on the business risk side; Norris has high risk on the financial risk side. | | | | | | weight of debt | 87.9% | Ex5 | d ÷ d+e |
| I hoped you tried to deal with k-wacc, based on prior learning in the course, and tried to increase beta, and changed the | | | | | | COST OF EQUITY: |
| debt ratio. You can't change the equity risk premium because it is R-m - R-f, determined by the market, not you. | | | | | | Risk-Free Rate | 15.3% | Ex12-10 yr T-bond |
| | | | | | | Risk Premium | 5.0% | judgment | R-m - R-f |
| Therefore, if Sam buys at $5.50 per share in 1980 and sells at $24.10 per share in 1986, what is his rate of return (IRR)? | | | | | | Beta | 4.00 | judgment-more fin'l risk,high beta |
| If the IRR compensates for his exposure to risk, he joins the deal, if not, he politely refuses. | | | | | | Cost of Equity | 35.3% | | k-e = R-f + [ß x (R-m - R-f)] |
| | | 28% | IRR | | | weight of equity | 12.1% | | e ÷ d+e |
| | 1980 | -5.5 |
| Any reasonable IRR is acceptable if your analysis | 1981 | 0 | | | | k-wacc | 12.2% | (b8*b7)+(b15*b14) | (k-d x wt-d)+(k-e x wt-e) |
| is logical and internally consistent. | 1982 | 0 | | | | COMMENTARY: |
| | 1983 | 0 | | | | This k-wacc of 12.2% is an enigma. How can |
| | 1984 | 0 | | | | a much riskier capital structure (financial risk - |
| | 1985 | 0 | | | | post LBO) produce a lower k-wacc than a less |
| | 1986 | $ 24.10 | | | | risky capital structure (pre LBO) of 19.2% from H90 above? |
| A 28% IRR would be marginally acceptable. Sam's high risk deals sometimes fail, so the IRR on the good ones | | | | | | One reason: low cost debt has a very high weight; high cost |
| must be high enough to cover for the bad ones, much like venture capital required rates of return. | | | | | | equity has a very low weight. |
| A valuation shortcut if you already have an income statement forecast: multiply EPS times P/E… |
| say F17 from Ex. 6 tab (choice of year is up to you) and K13 from the Multiples tab: | | | $ 44.73 | per share… |
| much higher than the $24.10 in C172 above - IT'S ALL IN THE ASSUMPTIONS | | | | | | Business risk is about the same per and post LBO, |
| See what actually happened, as suggested in the lbo overview.xls file, in the commentary at the right. | | | | | | because Norris' operations will remain the same. |
| | | | | | | Is the value of Norris truly higher (driven by lower |
| | | | | | | discount rate) post LBO? |
| | | | | | | To the owners, yes, because of the power of financial |
| | | | | | | leverage…as long as the EBIT forecast comes true, so |
| | | | | | | they can service the debt. If they can't service the debt, |
| | | | | | | they lose their investment, $48 million. |
| | | | | | | Does the k-wacc properly reflect the defaut scenario? |
| | | | | | | No! |
| | | | | | | Now you see how the LBO deal structure planted the |
| | | | | | | seeds of our global financial crisis. |
| | | | | | | Now you see why I use such an old case. |
| | | | | | | Love of excessive debt has not been good for us. |
| | | | | | | Are you jealous of investment bankers who earned such high |
| | | | | | | rates of return for so long? I am! |
| | | | | | | The actual deal took only two years for the exit to occur, at $40 per share. |
| | | | | | | | 170% | IRR |
| | | | | | | 1980 | -5.5 |
| | | | | | | 1981 | 0 |
| | | | | | | 1982 | 40 |
| | | | | | | 170% per year return is outstanding, don't you think? Far off the scale |
| | | | | | | of the Security Market Line. The KKR group bought a company for about $400 |
| | | | | | | putting about $50 million down (their equity investment). Then they sold |
| | | | | | | it in a IPO 2 years later for about $400 (plus the debt on the balance sheet). |
| | | | | | | I don't know the story, but presume that KKR anticipated a stock market |
| | | | | | | recovery from the flat performance in the prior 15 years or so, which would |
| | | | | | | pull up all stock prices and create demand for stocks. |
| | | | | | | To what extent did the forecast and valuation drive the deal? |
| | | | | | | To what extent did the expectation of a bull stock market drive the deal? |
| | | | | | | Even if KKR did not exit at a price as high as $40 per share, the IRR |
| | | | | | | would still have been very high. You can test this by changing |
| | | | | | | the number in H196. |
| | | | | | | Remember what you watched in the LBO Video. |
bdnaoa
norris_industries_guideline_solutions1.xlsx
