Financial Management - Kendle Quesuestions

8/2/2019 Financial Management - Kendle Quesuestions

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Market size linked to profitability

Growth rate in revenues (or sales) gris:gr= (%average mkt share) x (growth rate in mkt segment)

Hence a firm can only increase sales growth if:(1) % mkt share increase or(2) Growth rate in mkt segment increasesExample: 50% x 10% = 5%

Alternatively this means that the firm growth rate, gr, is limited by these variables.If a firm has new technology and even if its mkt share is 100%, if growth rate of mktsegment is only 10%, the firms gr= 10%.

Generally growth in mkt segment is fixed, so a firm can only increase grby increasing its

mkt share by taking competitors market share.

Finally the growth rate in net profits (net profit margin) grimpacts ge.ge = (net profit margin) x (gr)

Note that there may be a trade-off between the net profit margin and % mkt share. Forexample, if a firm decreases labor expense to cut costs to increase net profit margin, itcould reduce %mkt share.

However, if a firm is expected to compete, they must increase mkt share at the same timethat the firm increases net profit margin in order to increase ge.


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Valuation Methods

There are at least 3 different methods to value common equity of a firm.

1. Discounted Cash Flow (DCF) Valuation: PV of future free cash flow of the firm PLUS a PV ofa terminal value based on assumptions about future sustainable constant growth rate.

2. Comparable Firms Valuation: Taking ratios of comparable firms and applying it to the IPOfirm. Ratios often used are P/E, market-to-book, price-to-sales, and Price/EBIT.

3. Real Options: Using a modified version of Black Scholes Option Pricing Model to value thecommon equity as a call option to the future investment opportunities of the firm.

We will use the first 2 methods to value IPOs.

DCF Approach to Valuation: Value of a firm equals the PV of future Free Cash Flows PLUS the PV of theterminal value growth at a constant sustainable growth rate, gs.

Twsw

sTT

1t

w

t

)k)(1g-(k

)g(1FCF

)k1(

FCF

+

++

+=

=tFIRMV

Where: FCF = Free Cash Flow defined as:FCF = (1-tax rate)(EBIT) + Depreciation-Capital Expenditures+/-changes in NWCAnd kw is the weighted average cost of capital (WACC).

DCF Approach has 2 parts to evaluate its firm value. Part I estimates the cash flows and Part II requires anestimation of WACC or kw.

PART I. See the tables on the next page to determine the cash flows for F&C International. It requiresmany forecasts by the analysts and the numbers are usually difficult to assess for new firms. See TABLE 1and TABLE 2.

PART II. The WACC must be estimated for F&C International. The usual method for estimating thediscount rate is to use the Capital Asset Pricing Model (CAPM). Before using the CAPM, the following

procedure is taken to estimate beta.(1) Unlevered beta is estimated using Hamadas equation using publicly traded firms similar to F&C.

Using Exhibit 5, there are 4 comparable firms with levered beta. This indicates that the betaincludes the financial risk associated with the amount of debt held by these firms. Hence, theunlevered beta, A, is estimated by plugging in each firms E or levered beta. The average for the4 firms is an unlevered beta, A equaled to 1.00. (This is a coincidence to equal the market beta).

(2) Next F&Cs levered beta, E can be calculated using F&Cs capital structure after the IPO andHamadas general equation assuming D=0:

+=

=

+=

)1(Equity

Debt1

then0thenriskfreeisdebtAssume

)1)((

AE

D

DAA

taxrate

taxrate

Equity

DebtE


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TABLE 1. Forecasts of variables used in DCF valuation.Year 1992 1993 1994 1995 1996 1997 &

beyond

Growth rate of revenues (%)

Pre-tax operating margin (%) orEBIT/revenues

Working capital/revenues (%) 15% 15 15 15 15 15Net capital expenditures/revenues(%)

2% 2 2 2 2 2

Corporate tax rate (%) 35% 35 35 35 35 35

TABLE 2. Cash flow forecasts for F&C InternationalNet FCF (in millions) = (1-tax rate)EBIT Net capital expenditure Change in NWC

YEAR (1-taxrate)EBIT

NetCapitalExpenditure(with added

depreciation)

+/-change inNetWorkingCapital

(NWC)

=Free CashFlow (FCF)

PV factor@kw rate

1992

1993

1994

1995

1996

Terminalvalue*

*Terminal value =)g-(

)1(

sw

sT

k

gFCF +

VFIRM = VEQUITY + VDEBT therefore VEQUITY = VFIRM VDEBTFor F&C we have: V

EQUITY= $ M - $6 M = $ M

F&C wants to raise net proceed in the amount of $21M and their issuance ocst is expected to be 12 to 13%(rounded to 12.5%). This means that the TOTAL PROCEED (TP) that must be raised including issuancecost is: (1 - .125)TP = $21M which means TP = $24M.

What is IPO PRICE?


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Comparable Firms Valuation Approach.By examining several firms of comparable line of businesses and capital structure, determine various ratios.

Price/earnings = P/EPrice/salesMV of Equity/EBIT

MV of equity/BV of equityUsing ratios from Comparable Firms in Exhibits 3, 4, 5, and 6 we can calculate:F&C Total Equity Value = AVE of 4 comparable firms MV of equity/BV of equity x F&C BV of equityF&C Total Equity value = AVERAGE of 4 comparable firms P/E x F&C 1992 earningsF&C Total Equity Value = AVE of 4 comparable firms Price/sales x F&C 1992 SalesF&C Total Equity Value = AVE of 4 comparable firms MV of equity/EBIT x F&C 1992 EBIT

RATIOS Mkt Value/Book Price/Earnings Price/Sales Price/EBIT

Range

Average

Total Equity Value

Price/sharerange**

IPO price/share

**IPO price/share = (Total Equity Value - $24M)/(4.98M - .457M shares)

NOTES: 1992 EBIT = .11(1992 revenues) = .11 x ($70.385) = $7.7MEarnings = (EBIT Int Expense)(1-tax rate) = ($7.7M-(.08)($6M))(1-.35) = $4.7MAssuming interest rate on debt is 8%.

NOW CHOOSE ONE comparable firm in Exhibits 3, 4, 5, & 6 that is MOST similar to F&C. STATEreasons for the chosen firm. Define the criteria used to determine the Most similar firm to F&C.

RATIOS Mkt Value/Book Price/Earnings Price/Sales Price/EBIT

Ratio estimates

Average

Total Equity ValuePrice/sharerange**

IPO price/share

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Financial Management - Kendle Quesuestions