Corporate Valuation and Financing Exercises Session 2 « From accounting to FCF »

Corporate Valuation and FinancingExercises Session 2« From accounting to FCF»

Laurent Frisque - [email protected] Plasman – [email protected]

Q1 various investment opportunities in various sectors

‘working capital requirement’, ‘net working capital’, ‘operating cash-flows’, ‘cash flows’ from investment’ : apply those concepts

Q1: various investment opportunities in various sectors • Insight into the cash generation capabilities of the potential targets.

• The targeted company has the following features:• Yeart-1 EPS: 1.50€• Depreciationt-1: 0.30€ (per share)• CAPEXt-1: 0.80€ (per share)• WCR: 0.20 € (per share)• Expected yearly growth for the next 5 Y: 15%After 5Y• LT earnings growth: 5%• WCR stable @5%• CAPEX = depreciation• Targeted debt ratio, : 30% (the company always issues enough new debt

to fund any required principal repayments and finances its capital needs at a target debt ratio )

• attractive tax incentive, pays no tax.


A) You are asked to present the company’s FCF to equity holders for the years t to t+6.The current targeted debt ratio is 30%Funding by equity: 1- = 70%

• FCF = NI + DEPRECIATION – AQ (CAPEX) – D WCR


1 2 3 4 5 6

EPS € 1,73 € 1,98 € 2,28 € 2,62 € 3,02 € 3,17

CAPEX € 0,92 € 1,06 € 1,22 € 1,40 € 1,61 -

DEPRECIATION € 0,35 € 0,40 € 0,46 € 0,52 € 0,60 -

D WCR € 0,03 € 0,03 € 0,04 € 0,05 € 0,05 € 0,02

FCF


• Given• OK?

1 2 3 4 5 6

CAPEX € 0,92 € 1,06 € 1,22 € 1,40 € 1,61 -

DEPRECIATION € 0,35 € 0,40 € 0,46 € 0,52 € 0,60 -

(1 - ) x (C - D) € 0,40 € 0,46 € 0,53 € 0,61 € 0,70 € 0,00


• Part of the investments funded by Equity (AQ)

1 2 3 4 5 6

D WCR € 0,03 € 0,03 € 0,04 € 0,05 € 0,05 € 0,02

(1 - ) x D WCR € 0,02 € 0,02 € 0,03 € 0,03 € 0,04 € 0,01

FCFE


• Part of the working Capital Requirement funded by Equity

1 2 3 4 5 6EPS A € 1,73 € 1,98 € 2,28 € 2,62 € 3,02 € 3,17

CAPEX € 0,92 € 1,06 € 1,22 € 1,40 € 1,61 -

DEPRECIATION € 0,35 € 0,40 € 0,46 € 0,52 € 0,60 -(1 - ) x (C - D) B € 0,40 € 0,46 € 0,53 € 0,61 € 0,70 € 0,00

D WCR € 0,03 € 0,03 € 0,04 € 0,05 € 0,05 € 0,02(1 - ) x D WCR C € 0,02 € 0,02 € 0,03 € 0,03 € 0,04 € 0,01

FCFE A – B - C € 1,30 € 1,50 € 1,72 € 1,98 € 2,28 € 3,15


• FCF = NI + DEPRECIATION – AQ (CAPEX) – D WCR

• FCF = NI + DEPRECIATION – AQ – D WCR• Alternative solution:

• FCF = DIV – D K + D Cash

• D Cash =


Cash-flow from operating activitiesCash-flow from investing activitiesCash-flow from financing activities

B) The current targeted is 30% what would be the impact on the FCFE if the company decides to enjoy a flattening yield curve ride and increase its leverage?


• The FCFE increases as the financing needs will be funded by extra debt.

C) A DDM valuation could potentially lead to the same valuation as a FCFE valuation and if so in what situations?


• YES if all the FCFE is distributed as dividend

or

• if part of the FCFE is reinvested in the company but in 0 NPV projects.

Q2 investing in other sectors.

• A consumer electronics company, Nokin. The company’s statements show that in 2010 (in ‘000 €) : Revenues: 10.000 Net earnings: 1.750 CAPEX: 3.000 DEPR: 2.000 Interest charge: 500 WCR: 15% of sales Revenues growth next 3Y: 10% Long term growth 5% Targeted debt ratio : 15% Tax rate, Tc: 50% EBIT, Capex and depreciation follow the revenues growth.

Q2

• A) How much Free Cash Flows will be generated by this company the next 4Years (2011-2014) ?

2010Sales € 10.000EBIT € 4.000EBIT x (1-Tax) € 2.000Capex € 3.000Depreciation € 2.000WCR € 1.500

D WCR

FCFE = EBIT x (1-Tax) - CAPEX + DEPRECIATION - D WCR

Q2

2010 2011 2012 2013 2014

Sales € 10.000 € 11.000 € 12.100 € 13.310 € 13.976

EBIT € 4.000 € 4.400 € 4.840 € 5.324 € 5.590

EBIT x (1-Tax) € 2.000 € 2.200 € 2.420 € 2.662 € 2.795

Capex € 3.000 € 3.300 € 3.630 € 3.993 € 4.193

Depreciation € 2.000 € 2.200 € 2.420 € 2.662 € 2.795

WCR € 1.500 € 1.650 € 1.815 € 1.997 € 2.096

D WCR € 150 € 165 € 182 € 100

FCFE € 950 € 1.045 € 1.150 € 1.298

Q2

• B) 2 intriguing elements in the Nokin’s annual reports :• Do you believe you should let Mitchell know as these elements could

impact your previous analysis?

1. The 2010 figures include a charge to face a potential lawsuit by Nonac who claims Nokin stole some IP. This charge is (hopefully) a onetime 100,000€ for the lawsuit which is expected to start in 2013. This amount has been paid to Mac & Mac their law firm.

Cash disbursement (sunk cost) does not impact the cash flow no adjustment needed.

Q2

• B) 2 intriguing elements in the Nokin’s annual reports :

2. Years ago Nokin acquired a Korean start-up. The price paid at the time represented a significant premium to the book value which created a goodwill on Nokin’s B/S. After a careful review it appears the technology was not that great and the board has decided to write-off the goodwill in order to reflect the value loss. This creates a 1,000,000 amortisation charge in 2010.

Non cash item ! Should be added back in 2010 Depreciation (& amortisation) should be 3.000 (instead of 2.000) in 2011 3000 x 1,1 = 3,300 (i.e. 'the depreciation line' will increase

every year)

Q3 ‘THE PROJECT’

• The seller, wants to get rid of its retail activities. • It is a very thin margin business where the cash cycle is very important:

the working capital needs to be optimised. • Following the well-known rule ‘if you can’t convince them confuse them’

the bankers have provided Eddy and Mitchell with plenty of data:

Q3

DATA'THE PROJECT' B/S 2010 2011Total Assets € 2.425 € 3.476Total LT Assets € 900 € 900Gross Fixed Assets € 1.200 € 1.300Accumulated Depr. € 350 € 450Net Fixed Assets € 850 € 850LT Investments € 50 € 50Total Current Assets € 1.525 € 2.576Trade Receivables € 100 € 125Inventories € 1.000 € 2.116Short-Term Investments € 25 € 15Cash & Near Cash Items € 400 € 320

Total Liabilities & Equity € 2.425 € 3.476Total Shareholders' Equity € 1.300 € 2.031Share Capital € 1.200 € 1.200Retained earnings € 100 € 831Total liabilities € 1.125 € 1.445Long term debt € 650 € 625Short term debt € 225 € 670Account payables € 250 € 150

'THE PROJECT' INCOME STATEMENT2010 2011

Sales € 22.330 € 22.800COGS € 16.300 € 17.200SG&A € 3.950 € 4.020Depr. € 55 € 100Op.Inc € 2.025 € 1.480Other inc. € 1 € 2Int.exp. € 37 € 76Pre-tax € 1.989 € 1.406Tax (35%) € 696 € 492NI € 1.293 € 914

PAY-OUT ratio 2011 20%

Q3

• A) Turn the accounting balance sheet into a summarized managerial balance sheet. reveal the capital you employ and the net assets.

• FA + WCR + Cash = SE + D

• Working Capital Requirement- WCR: Trade Rec + Inventories - Account payables

2010 2011

Assets € 2.175 € 3.326Fixed Assets € 900 € 900

WCR € 850 € 2.091Cash € 425 € 335

Liabilities € 2.175 € 3.326SE € 1.300 € 2.031Debt € 875 € 1.295

Q3

• B) Compute the Net Working Capital and check its evolution over 2010 and 2011. Has the company done a good job? What went potentially wrong?• NWC = Current Assets – Curent Liabilities

• NWC = SE + Lt Debt – FA

• NWC = WCR + Net liquid balance (ST Inv + Cash – ST Debt)

NWC € 1.050 € 1.756Current assets € 1.525 € 2.576<Current liabilities> € 475 € 820

NWC € 1.050 € 1.756+SE € 1.300 € 2.031+LT D € 650 € 625<FA> € 900 € 900

Q3

• B) Compute the Net Working Capital and check its evolution over 2010 and 2011. Has the company done a good job? What went potentially wrong?

• The working capital requirement has increased by 146% over 2011 !• Looking at the details, inventories have massively increased while

accounts payable have decreased • --> it seems suppliers want their cash faster.

Q3

• C) Provide a cash-flow statement for 2011. direct and indirect methodologies• (NI+Dep - D WCR) – (AQ) + (D K + D D – DIV) = D Cash

Indirect method 2011Net income € 914

Depreciation € 100

< D WCR > - € 1.241

Cash Flow from Operating activities -€ 227AQ € 100

Cash Flow from investing activities -€ 100 D K € 0

D D € 420

< DIV > - € 183

Cash Flow from financing activities € 237= D CASH -€ 90

Q3

• C) Provide a cash-flow statement for 2011. direct and indirect methodologiesDirect method 2011Cash collection from customers € 22.775

<Cash payment to suppliers & empl.> € 22.436

<Cash paid for interest> € 76

<Cash paid for taxes> € 492

Cash collection from other income 2

CFO -€ 227AQ € 100

CFI -€ 100 D K € 0

D D € 420

< DIV > € 183

CFF € 237D CASH -€ 90

Q3

• D) Assess the FCF. Goal is to steadily acquire a majority stake in the open market before offering a squeeze out. what is the relevant FCF to compute in 2011?

• At this stage BHHC wants to acquire en equity piece • -> the focus is on the Free cash flows of all Equity firm (FCFE)

FCFE = DIV - DK + D CASH = € 93

Q3

• E) Relevant to present a single year FCF?

It is useless but thank you for the computation anyway

Q3

• F) Industry wide profitability analysis: Industry wide average EBIT margin of 5.84% and an EBITDA margin of 7.91%. How does ‘THE PROJECT’ company compare to those benchmarks in 2011? How do you interpret the comparison?

EBIT € 1.482

EBIT margin 6,50%

EBITDA € 1.582

EBITDA margin 6,94%

At very first sight it seems that the company is doing a good job in terms of profitability compared to its peers.However looking at the EBITDA metric it does not look so good. It seems that the D&A level is much lower compared to the industry.Does the company correctly depreciate its assets ? Could it jeopardise its future growth ? Questions to further investigate.

Q3

• G) Merits of the EBTIDA measure to assess the cash generation capabilities of a company. Any comment you could share with them taking into account your recent work on ‘THE PROJECT’ ?

The EBITDA measure does not take into account the WCR nor the need to invest and maintain productive capacity so it should not be used blindly.

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Corporate Valuation and Financing Exercises Session 2 « From accounting to FCF »