FIN 630 University of Maryland MOD4 Enterprise Valuation TV Homework Worksheet Virgin Hawaiian is a start-up low cost airline which started its service th

FIN 630 University of Maryland MOD4 Enterprise Valuation TV Homework Worksheet Virgin Hawaiian

is a start-up low cost airline which started its service three years ago. Its historical revenues, net income

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and free cash flows are shown below. Expected growth for the airline industry in the next 5 years is

16%

with subsequent

slow down to

3%

. The industry P/E is

12

and WACC is

9.8%

Estimate the range for the company’s market capitalisation. Module 4. Enterprise Valuation
DCF
While we have a fairly good idea what the cash flows for the target firm will be the next few
years, we cannot predict with accuracy what they will be in the more distant future.
Solution is to split the valuation of the enterprise into two parts: the present value of the cash
flows for the next few years; plus the present value of all subsequent cash flows (also called the
terminal value). One can think of Terminal Value as the price at which the enterprise can be sold
a the end of the forecast period. We can estimate the Terminal Value by using a simplifying
assumption about future cash flows, for example, by assuming steady but slow growth until
infinity and using the growing perpetuity formula. Alternatively the terminal value may also be
estimated using multiples (as studied in Module 3).
In the later part of the session we will also look into WACC assumptions and problems, and the
Adjusted Present Value (APV) approach.
Enterprise Value – Overview
• Enterprise value represents the present value of future cash flows in two segments
– Planning period (finite number of years)
– Terminal period (all years thereafter)
Estimating growth and terminal value
Enterprise Valuation using DCF Analysis and Gordon Growth Model
• The present value of cash flows in the planning period is calculated using a simple DCF
approach.
• Using the Gordon growth model we can calculate the estimated present value of cash flows
beyond the planning period.
Hybrid Approach to Enterprise Valuation
• Hybrid valuation combines DCF analysis with relative valuation
– The present value of planning period cash flows are discounted using the traditional DCF
approach
– Terminal value is calculated using an EBITDA multiple and end-of-planning period EBITDA
– The present value of the terminal value is added to the present value of planning period cash
flows to estimate enterprise value
• Using EBITDA to calculate terminal value is beneficial because it ties the analysis of distant
cash flows back to recent market transactions involving similar firms
• Used in establishing the enterprise value for IPO’s, LBO’s, spin-offs, carve-outs, and equity
valuation for investment purposes
• EBITDA multiple and Gordon growth model should generate very similar terminal value
estimates when there are no extraordinary capital expenditures or investments in net working
capital
Adjusting for leverage
Two approaches are used to adjust for leverage: WACC approach and APV approach
WACC Approach
• Traditional WACC approaches to enterprise valuation are widely used but also require a
number of assumptions which may be difficult to justify in most applications, specifically:
– Risks of cash flows do not change over time
– Company maintains a steady capital structure
Often a constant discount rate is inconsistent with projected changes to capital structure. For
example, in cases of LBO’s, acquisitions and equity buybacks the capital structure of the
company and thus its WACC changes dramatically.
Adjusted Present Value (APV) Approach to Enterprise Valuation
Alternative to WACC, the APV approach estimates enterprise value as the sum of the present
value of future unlevered equity free cash flows and the present value of interest tax savings. It
makes estimation of unlevered cash flows relatively easy, but estimation of the present value of
interest tax savings can represent a challenge, unless simplifying assumptions are made, for
example, the constant absolute level of debt.
Value from Cash Flow
Unlevered equity free cash flows represents value of firm’s cash flows under the assumption that
the firm is 100% equity financed (no debt)
Value from Financing
Debt financing provides a tax benefit because of the interest tax deduction realized by the firm.
The value from financing is thus equal to the present value of these benefits
APV Implementation
• The APV approach is implemented using a procedure similar to the traditional WACC
approach. Planning period cash flows are discounted and added to a discounted terminal value.
But unlike a traditional WACC approach, we have two cash flow streams to value: the unlevered
equity cash flows and the interest tax savings.
• The Hybrid APV approach combines the APV method of valuing equity free cash flows and
interest tax savings but implements the EBITDA multiple approach to calculate terminal value.
Comparables method (relative valuation)
We have till now done valuation by finding the present value of future cash flows through
discounting. In this session we study another approach, valuation using comparables.
The idea is that, while we may not be able to predict future cash flows, we can find other similar
assets and use their known market prices
For example, if you are trying to find the price of a 2 acre land, and a 1 acre land in the vicinity
recently sold for $100,000 then $200,000 seems like a reasonable value. Of course there are
many specific considerations that may make the land less than or greater than $200,000 in value,
for example ease of access, distance from highway etc. but $200,000 is a reasonable starting
point for valuation. It is good to remember that valuation by discounting isn’t an exact science
either, as we need to forecast uncertain future cash flows, and also decide upon an appropriate
discount rate.
When valuing enterprises by using comparables, measures of cash flows like EBITDA may be
used. We will study equity valuations using price-earnings multiples, the impact of growth,
normalizations and adjustments, and compare to valuation using DCF.
Relative Valuation/Market Comparables
• Technique used to value businesses, business units, and other major investments.
– Assumes similar assets should sell at similar prices.
– The critical assumption underlying the approach is that the “comparable” assets/transactions
are truly comparable to the investment being evaluated.
• Relative valuation should be used to complement DCF analysis
• For income-producing investments, analysts consider additional ratios such as market values
relative to the various earnings and cash flow numbers, sales, or the book value of recent
transactions.
Steps in Relative Valuation
• Step 1: Identify similar or comparable investments and recent market prices for each.
• Step 2: Calculate a “valuation metric” for use in valuing the asset (Price/Earnings, EBITDA
Multiple, market-to-book are commonly used ratios).
• Step 3: Calculate an initial estimate of value.
• Step 4: Refine or tailor your initial valuation estimate to the specific characteristics of the
investment.
Virgin Hawaiian is a start-up low cost airline which started its service three years ago. Its historical revenues, net inco
free cash flows are shown below. Expected growth for the airline industry in the next 5 years is 16%
down to 3%. The industry P/E is 12 and WACC is 9.8%
Estimate the range for company’s market capitalization
Given
In $, Mil
Year
Revenues
Net Income (Loss)
FCF
Industry growth,
short-term
Industry growth,
long-term
Industry P/E
Industry WACC
2017
$57
($130)
($74)
2018
$234
($75)
($15)
2019
$467
($17)
$54
Expected Forecast
2020
2021
$750
$1.200
$50
$125
$90
$165
16%
3%
12
9,80%
Solution
Let us have a look at company’s growth trends
Growth
Revenues
Net Income
FCF
2018
311%
Expected Forecast
2019
2020
2021
100%
61%
60%
150%
67%
83%
We could not establish company’s Net Income and FCF growth over years when these numbers were nega
Numerous approaches can be used to estimate company’s market capitalization
Using current industry’s P/E
Estimated Market
Value
$600
Forecasting FCF for the next five years and estimating future Terminal Value
Although current revenues of the company are growing faster than the industry, we may assume that this g
For the purposes of this exercise we make a simplifying assumption that FCF will growth at the same rate
projected growth
Revenues
FCF
2020
61%
$750
$90
2021
60%
$1.200
$165
2022
50%
$1.800
$248
2023
40%
$2.520
$347
2024
20%
$3.024
$416
Using steady growth assumption, the Terminal Value is expected to be
TV
$6.298
Please notice that the steady growth assumption implies the following P/E:
Implied P/E
15,14706
Combined FCF is
FCF
Estimated Market
Value
2020
$90
2021
$165
2022
$248
2023
$347
2024
$6.714
$4.851
Using industry’s P/E to estimate the Terminal Value we get
TV
$4.990
Combined FCF is
FCF
Estimated Market
Value
2020
$90
$4.031
2021
$165
2022
$248
2023
$347
2024
$5.405
Its historical revenues, net income and
16% with subsequent slow
Solution Legend
Value given in problem
Formula/Calculation/Analysis required
try, we may assume that this growth will eventually slow down to the industry level
F will growth at the same rate as revenues. In reality we would have to create proforma financial statements and derive FCF from
atements and derive FCF from them.
Enterprise Valuation & Terminal Value
Given
Gross Margin
$
Fixed Costs
Revenue Growth Rate for Years 1 – 5
FCF Steady Growth
Discount Rate
$
Year 1 Revenue
Tax Rate
Terminal Year
40%
2.000
10%
3%
12%
5.000
21%
5
1
Revenues
Gross profits
Fixed Costs
Net Operating Income
Taxes
Free Cash Flow
NPV for Years 1-5 Cash Flows
Terminal Value (as of Year 5)
PV of Terminal Value
Enterprise Value
PV of Terminal Value / Enterprise Value
2
3
4
Solution Legend
Value given in problem
Formula/Calculation/Analysis required
Crystal Ball Input
Crystal Ball Output
5
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
A
B
C
D
Using historical financial statements you have established the following ratios:
E
Sales growth
15%
Current assets/Sales
15%
Current liabilities/Sales
10%
Net fixed assets/Sales
8%
Costs of goods sold/Sales
60%
Depreciation rate
10%
Interest rate on debt
4,00%
Interest paid on cash & marketable securities
0,25%
Tax rate
21%
Dividend payout ratio
5%
$ 25,00
Constant Debt
Now your task is to find the company’s value using DCF valuation method
The first step is to create proforma financial statements based on established ratios
Year
Income statement
0
$ 200,00
Sales
Costs of goods sold
Interest payments on debt
Interest earned on cash & marketable securities
Depreciation
Profit before tax
Taxes
Profit after tax
Dividends
Retained earnings
Balance sheet
Cash and marketable securities
Current assets
Fixed assets
Fixed assets at cost
Accumulated depreciation
Net fixed assets
Total assets
1
2
$ 230,00
$ (138,00)
$ (1,00)
$
0,15
$ (2,00)
$ 89,15
$ (18,72)
$ 70,43
$ (3,52)
$ 66,90
$ 264,50
$ (158,70)
$ (1,00)
$
0,31
$ (2,04)
$ 103,07
$ (21,64)
$ 81,42
$ (4,07)
$ 77,35
0
1
3
$
$
$
$
$
$
$
$
$
$
304,18
(182,51)
(1,00)
0,50
(2,52)
118,65
(24,92)
93,74
(4,69)
89,05
2
3
$ 30,00
$
$
87,00
34,50
$ 159,87
$ 39,68
$ 243,76
$ 45,63
$ 20,00
$ 20,40
$
2,00
$ 18,40
$ 139,90
$ 25,20
$
4,04
$ 21,16
$ 220,71
$ 30,89
$
6,56
$ 24,33
$ 313,72
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
A
Current liabilities
Debt
Stock
Accumulated retained earnings
Total liabilities and equity
B
$ 25,00
$ 25,00
C
$ 23,00
$ 25,00
$ 25,00
$ 66,90
$ 139,90
D
$ 26,45
$ 25,00
$ 25,00
$ 144,26
$ 220,71
E
$ 30,42
$ 25,00
$ 25,00
$ 233,31
$ 313,72
0
1
2
3
Year
Free Cash Flow
$ 70,43
$
2,00
PAT
Add back depreciation
Minus NWC
Minus increase in CA
Add back increase in CL
Subtract CAPEX
Add back net interest after taxes
Free Cash Flow
$
$
$ (34,50) $
$ 23,00 $
$ (0,40) $
$
0,67 $
$ 61,20 $
81,42
2,04
$
$
93,74
2,52
(5,18)
3,45
(4,80)
0,55
77,49
$
$
$
$
$
(5,95)
3,97
(5,69)
0,39
88,97
The next step is to find FCF and Terminal value using approaches that we studied before
16%
4%
WACC
Long-term FCF growth
0
Year
FCF
Terminal value
Total
Enterprise value:
PV of FCFs and terminal value
Add back initial cash
Asset value
Subtract year 0 debt
Imputed equity value
1
2
3
$ 30,00
$
61,20
$
77,49
$
88,97
$ 30,00
$
61,20
$
77,49
$
88,97
$
$
$
$
$
793,74
30,00
823,74
(25,00)
798,74
F
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
G
H
Solution Legend
Value given in problem
Formula/Calculation/Analysis required
4
$
$
$
$
$
$
$
$
$
$
349,80
(209,88)
(1,00)
0,73
(3,09)
136,56
(28,68)
107,88
(5,39)
102,49
4
5
$
$
$
$
$
$
$
$
$
$
402,27
(241,36)
(1,00)
0,99
(3,76)
157,13
(33,00)
124,14
(6,21)
117,93
5
$ 340,32 $ 451,43
$ 52,47 $ 60,34
$ 37,63
$
9,65
$ 27,98
$ 420,78
$ 45,59
$ 13,41
$ 32,18
$ 543,95
I
42
43
44
45
46
47
48
49
50
51
52
53
54
55
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
F
G
$ 34,98 $ 40,23
$ 25,00 $ 25,00
$ 25,00 $ 25,00
$ 335,80 $ 453,73
$ 420,78 $ 543,95
4
5
$ 107,88 $ 124,14
$
3,09 $
3,76
$ (6,84)
$
4,56
$ (6,74)
$
0,21
$ 102,17
$ (7,87)
$
5,25
$ (7,96)
$
0,01
$ 117,32
4
5
$ 102,17 $ 117,32
$ 1.016,80
$ 102,17 $ 1.134,13
H
I
Find the value of a start-up company Ksenia. Gross margin is GM %. Revenues are as shown in the table below. Initial investment is I, which
will be depreciated over N years. Revenues and costs are assumed to be growing at constant rate g from year 6 onwards. To finance its
operations the company has already borrowed D with kd interest, which it will keep in perpetuity. The remaining capital will be raised as equity.
The risk-free rate kRF; market premium is Dkm and the industry beta is b. The tax rate is Tc without any carryforward of tax credit for losses. Net
working capital requires immediate outlay of K and additional increase equals to f% of sales.
What is your estimate of company’s post-money equity valuation? (Post-money means “after all external capital is raised”)
In Thousand of $
Revenues
I
N
GM
g
K
f
Tc
2020
$
$1.000
5
40%
2%
$300
10%
21%
2021
200,00 $
D
kD
2022
200,00 $
2023
300,00 $
$500
8%
kRF
4%
Dkm
b
6%
1,2
2024
500,00 $
2025
700,00
Solution Legend
Value given in problem
Formula/Calculation/Analysis required
Solution
1. Determine a forecast horizon T (3-7 years)
We have detailed forecast of company’s revenues for 5 years. This gives us a clear indication that the forecast horizon is 5 years.
By coincidence, depreciation is 5 years as well. If it were longer, we would have to take into account the depreciation effect after the end of the forecast horizon
2. Forecast free operating cash flows for every year during the forecast horizon
To calculate the FCF we make a proforma statement for all equity financed company
We include interest payments for the reason that will become clear later
Data for one year after the end of forecast horizon will be used to calculate the terminal value
In Thousand of $
Revenues
-Costs
EBITDA
-Depreciation (over 5 years)
EBIT
-Interest
EBT
-Taxes
Net Income
2020
2021
2022
2023
2024
2025
2026
Then we take into account investment and NWC and calculate FCF
CapEx
Net Working Capital
Changes in NWC
FCF
Notice that when EBITDA is negative, we don’t use Depreciation Tax Shield at all.
When 0
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