Determinants of Intrinsic Value

Sales revenues

− Operating costs and taxes

− Required investments in operating capital

Free cash flow

=
(FCF)

FCF1 FCF2 ... + FCF∞

Value = + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

1
Strategic Plan → Operating Plan of Action → Sales forecast→ Project
financial statements → Determine Additional Funds Needed required
to achieve targeted growth
 Tire City Inc.

• A rapidly growing retail distributor of automotive tires in north-east

USA
– A chain of 10 shops and a central warehouse
• Stores kept sufficient inventory on hand to service immediate customer demand
• Bulk of the inventory is managed at central warehouse. Orders from Individual
stores are filled within 24 hours.
– NI of $1.19M from sales of $23.505M in 1995
• Reputation for excellent service and competitive pricing ➔high levels of customer
satisfaction
 Relationship with MidBank
• In 1991, TCI felt that hub-and-spoke approach to sales and
distribution. Through 5-year financial planning, they learnt
that it requires
– $2 mil (say) capital exp on WH
– 3.5% of sales as incremental OC in 1992-1995
• Borrowed $1.375M in 1991 to fund it
– Principal repayable in 11 annual installments
– Interest at 10% p.a.
• Established a line of credit but not borrowed any
 Income Statement, Tire City, 1993-1995
common-size
For years ending 12/31 1993 1994 1995 1993 1994 1995

Net sales $ 16,230 $ 20,355 $ 23,505 100% 100% 100%

Cost of sales 9,430 11,898 13,612 58.1% 58.5% 57.9%
Gross profit 6,800 8,457 9,893 41.9% 41.5% 42.1%
GAS expenses (excl. depreciation) 5,195 6,352 7,471 32.0% 31.2% 31.8%
EBITDA 1,605 2,105 2,422 9.9% 10.3% 10.3%
Depreciation 160 180 213 1.0% 0.9% 0.9%
Operating Profit (PBIT) 1,445 1,925 2,209 8.9% 9.5% 9.4%
Net interest expense 119 106 94 0.7% 0.5% 0.4%
Pre-tax income (PBT) 1,326 1,819 2,115 8.2% 8.9% 9.0%
Income taxes 546 822 925 3.4% 4.0% 3.9%
Net income (PAT) 780 997 1,190 4.8% 4.9% 5.1%
Effective tax rate 41.2% 45.2% 43.7%
NOPAT 850 1,055 1,243 5.2% 5.2% 5.3%
Less: Increase in OC 672 825 0.0% 3.3% 3.5%
Free cash flow (financial) 383 418 1.9% 1.8%
Financial Statements – Tire City
Balance Sheet – Tire City
 TireCity-Financial Health@ 1995
• Is it profitable ?
– Its RoE is declining, why?
• Is it liquid?
• How about its leverage position?
• How about its asset turnover ratios?
• How about A/c Paybles and A/c Receivable
ratios?
• How about its Cash Flows?
Financial Ratio Analysis of Tire City
ROE = Profit Margin  Total Asset Turnover  Equity Multiplier
Net Income Sales Total Assets
=  
Sales Total Assets Common Equity
Mgmt can improve RoE by improving its return on sales and / or its asset turnover and / or by
increasing its financial leverage as measured by total assets divided by owners’equity

For Tire City, Total Capital is decreasing as debt is being repaid and hence RoE slightly
declined.
Operating Capital
Return on Invested Capital (ROIC)

ROIC = NOPAT / operating capital

1993 1994 1995

NOWC 2,496 2,785 3,455
Net Fixed Assets 1,897 2,280 2,435
Operating capital 4,393 5,065 5,890
Increase in OC 672 825

NOPAT 850 1,055 1,243

FCF 383 418
ROIC 19.3% 20.8% 21.1%
How much is the company’s EVA?....assume 9% as Cost of Capital

EVA = NOPAT- (COC) (operating Capital)

EVA93 = 850,000 – 0.09 * 4,393,000

= $454,630.
EVA94 = 1,055,000 – 0.09 * 5,065,000
= $599,250

EVA95 = $1,243,000 – 0.09 * 5,890,000

= $712,790
Assessment of current financial health
• TCI is growing rapidly but managed growth well.
– It is profitable, liquid and reducing its leverage.
– Profitability and asset turnover are improving.
– The slight decline in ROE is immaterial and entirely due to
decreasing leverage.
– Appears to be extending generous credit to its customers
– Appears to be taking more than a month to repay its own bills

• TCI appears to have strong CF

– Did not depend on any bank for funding the growth
– It has been able to reduce debt and build cash balances over the
past three years
 Task of Martin??
• Need to approach the bank for a possible loan to fund WH
construction
– Need to project balance sheet for 1996 and 1997
– Convince Bank Manager – Tire City’s financial health is sound
even after taking bank loan
– Propose several adjustments while forecasting statements, with
optimistic view
• Bank Manager will have conservative / pessimistic view and
may not agree with proposed adjustments
– Might need projected statements with ‘status-quo’ assumptions
(no adjustments allowed) = Formula approach
• Prepare two sets of projected statements
– One with adjustments (optimistic view)
– Another with no adjustments,formula based (conservative view)
 Pro Forma Financial Statements

• Three important uses:

– Forecast the amount of external financing (EFN) that
will be required
– Managers can assess whether the anticipated
performance is in line with general targets and with
investors expectations ---> Set appropriate targets for
compensation plans
– To estimate the effect of propose operating changes,
enabling managers to conduct ‘what-if’ analyses.
– Evaluate the impact that changes in the operating plan
have on the firm value.
 Steps in Financial Forecasting

• Forecast sales
• Project the assets needed to support sales
• Project internally generated funds
• Project outside funds needed
• Decide how to raise funds
• See effects of plan on ratios and stock price
 Projecting Pro Forma Statements
with the Percent of Sales Method
• Project sales based on forecasted growth rate in sales
• Forecast some items as a percent of the forecasted sales
– Costs
– Cash
– AR
– Inventory
– Net FA
– AP and AE
• Choose other items
– Debt (which determines interest)
– Dividends (which determines retained earnings)
– Common stock
 Assumptions about How AFN Will Be Raised

• Assets are operating at full capacity

• No new common stock will be issued.
• Any external funds needed will be raised as debt
• AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - D)

– M=profit margin
– D = Dividend Payout ratio
– S0= Current Sales; S1 = Projected sales
– L = Liabilities (in support of sales growth)
– A = Assets (in support of sales growth)
 AFN (Additional Funds Needed):
Key Assumptions under FORMULA

• Operating at full capacity in 1995.

• Each type of asset grows proportionally with
sales.(Asset / sales ratios remain same)
• Spontaneous Liabilities (Payables and accruals)
grow proportionally with sales.
• 1995 profit margin (5.06%) and payout (20.2%)
will be maintained.
• Sales are expected to increase by $4,701
thousands. (%S = 20%)
Assets must increase by $1,796,600. What
is the AFN for 1996, based on the AFN
equation?

AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)

= ($8,983/$23,505)($4,701) 1796.6
- ($3,093/$ 23,505)($4,701)
618.6
- 0.0506($28,206)(1 - 0.20)
= $35,600. 1142.4
Assets must increase by $2,082,000.
What is the AFN for 1997, based on
the AFN equation?

AFN = (A*/S0)S - (L*/S0)S - M(S1)(1 - d)

= ($10,780 / $28,206) ($5,641)
- ($3,712 / $28,206) ($5,641)
- 0.0506 ($33,847) (1 - 0.20)
= $42,720.
 Summary of
Formula approach for AFN
1996 1997
Expected growth rate in sales 20% 20%
Current sales S 0 = 23,505 28,206
Projected Sales S1 = 28,206 33,847
Increase in sales = 4,701 5,641
Spontaneous Assets = 8,983 10,780
Spontaneous Liab. = 3,093 3,712
a/s = 38.2% 38.2%
L / s = 13.2% 13.2%
DPO = 20.0% 20%
m = 5.06% 5.06%

AFN = (A*/S) dS - (L*/S) dS - m(S+dS)(1-d)

= 35.60 42.72

SGR = 23.43% 23.50%

IGR = 11.85% 11.85%
 Forecasted Income Statements
(Formula Approach)
1995 1996 1997
Net sales 100% 28,206.0 33,847.2
Cost of sales 57.9% 16,334.4 19,601.3
Gross Profit 11,871.6 14,245.9

GAS expenses 31.8% 8,965.2 10,758.2

Depreciation 0.9% 255.6 306.7
Net interest expense 0.4% 112.8 135.4
Pre-tax income 9.00% 2,538.0 3,045.6
Income taxes 43.7% 1,110.0 1,332.0
Net Income 5.06% 1,428.0 1,713.6

Dividends 20.0% 285.6 342.7

Addition to RE 1,142.4 1,370.9
 Forecasted Balance Sheets
Assets 1996 1997
Cash balances 3.0% 847 1017
Accounts receivable 15.5% 4382 5259
Inventories 9.3% 2628 3154
Total CA 27.9% 7858 9429
Gross plant and equipment 4906 5797
Accumulated depreciation 1984 2290
Net plant and equipment 10.4% 2922 3506
Total assets 38.2% 10780 12936
Liabilities
Accounts payable 6.1% 1728 2074
Accrued expenses 7.0% 1984 2380
Operating CL 13.2% 3712 4454
CMLTD 125 125
Bank debt 36 78
Long-term debt 750 750
Total liabilities 4622 5407
Common stock 1135 1135
Retained earnings 5022 6393
Total shareholders' equity 6157 7528
Total liabilities and equity 10780 12936
How could the following affect AFN:
• Sales increase
• DPO increases
• NPM increases
• Capital intensity ratio increases
• Making supplier payments sooner
• Excess Capacity
 Self-Supporting Growth Rate
• What is the maximum growth rate the firm
could achieve if it had no access to external
capital?
– It can be found as the value of g that, when used
in the AFN equation, results in an AFN of zero.
– Replace Change_in_Sales with gSo and S1 with
(1+g)So and then solve for unknown g
• The AB Corporation has the following ratios:
Ao /So =1.6; Lo /So =0.4; profit margin = 0.10 and dividend payout ratio = 0.45.
So = Rs.100million.
Assuming that these ratios will remain constant, determine the maximum
growth rate ABC can achieve without having to employ non-spontaneous
external funds.

0=1.6(100g) – 0.4(100g) – 0.1(100(1+g))(1-0.45)

0=160g-40g-5.5g-5.5
g= 5.5/114.5 = 4.8%
Maximum growth rate without external financing
• A.