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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is a start-up low cost airline which started its service th

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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 IPOs, LBOs, 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 LBOs, 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 firms 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 isnt 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 dont use Depreciation Tax Shield at all.

When 0

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