Solution Manual for Business Analysis and

Valuation: IFRS edition

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Solution Manual for Business Analysis and Valuation: IFRS edition

Solutions – Chapter 8

Chapter 8 Prospective Analysis: Value Implementation

Question 1.

A spreadsheet containing Hennes & Mauritz’s actual and forecasted financial statements as well as
the valuation described in this chapter is available on the companion website of this book. How will
the forecasts in Table 8.3 and the value estimates in Table 8.6 for H&M change if the company defies
the forces of competition and maintains a revenue growth rate of 10 percent from 2015 to 2022 (and
all the other assumptions are kept unchanged)?

The main purpose of this and the following three questions is to let students work with the valuation
spreadsheet that is available on the companion website of the book and learn to understand the
sensitivity of the value estimates presented in this chapter to changes in valuation assumptions.
Following are the adjusted versions of Table 8.6 and Table 8.3:

Value
Value from beyond
Beginning forecast forecast Value per
Total value
book value period horizon share (SEK)
2015–2024 (terminal
value)
Equity value (SEK billions)
Abnormal earnings 51.6 142.7 163.0 357.2 215.85
Abnormal earnings growth N.A. 291.7 65.6 357.2 215.85
Free cash flows to equity N.A. 145.6 211.7 357.2 215.85

Operating assets value (SEK billions)

Abnormal NOPAT 119.4 117.8 120.5 357.7 N.A.
Abnormal NOPAT growth N.A. 307.4 50.3 357.7 N.A.
Free cash flows to capital N.A. 126.0 231.8 357.7 N.A.

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 2
Fiscal year 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Beginning balance sheet (SEK millions)
Beginning net working capital 17,669.5 16,489.5 17,588.8 18,944.6 20,839.1 22,923.0 25,215.3 27,736.8 30,510.5 31,425.8
+ Beginning net non-current operating assets 101,744.8 97,105.0 105,716.2 115,280.1 126,808.1 139,489.0 153,437.9 168,781.6 185,659.8 191,229.6
+ Beginning investment assets 5,288.5 7,162.1 7,878.3 8,666.2 9,532.8 10,486.1 11,534.7 12,688.1 13,956.9 14,375.7
= Business assets 124,702.8 120,756.7 131,183.4 142,890.9 157,180.0 172,898.0 190,187.8 209,206.6 230,127.3 237,031.1
Debt 73,146.8 69,676.6 75,692.8 82,448.1 90,692.9 99,762.2 109,738.4 120,712.2 132,783.4 136,766.9
+ Group equity 51,556.0 51,080.1 55,490.6 60,442.9 66,487.1 73,135.9 80,449.5 88,494.4 97,343.8 100,264.2
= Capital 124,702.8 120,756.7 131,183.4 142,890.9 157,180.0 172,898.0 190,187.8 209,206.6 230,127.3 237,031.1
Solutions – Chapter 8

Income statement (SEK millions)

Sales 166,560.9 183,217.0 201,538.7 221,692.6 243,861.8 268,248.0 295,072.8 324,580.1 334,317.5 344,347.0
Net operating profit after tax 21,819.5 25,833.6 29,827.7 31,037.0 31,702.0 32,189.8 32,458.0 30,835.1 26,745.4 27,547.8
+ Net investment profit after tax 286.5 315.1 346.6 381.3 419.4 461.4 507.5 558.3 575.0 592.3
= Net business profit after tax 22,106.0 26,148.7 30,174.4 31,418.3 32,121.5 32,651.1 32,965.5 31,393.4 27,320.4 28,140.0
– Net interest expense after tax -1,254.2 -1,513.9 -1,813.9 -2,267.3 -2,793.3 -3,292.2 -3,621.4 -3,983.5 -4,103.0 -4,226.1
= Net profit 20,851.8 24,634.9 28,360.5 29,150.9 29,328.1 29,359.0 29,344.2 27,409.9 23,217.4 23,913.9
Return on operating assets 19.2% 21.0% 22.2% 21.0% 19.5% 18.0% 16.5% 14.3% 12.0% 12.0%
Return on business assets 18.3% 19.9% 21.1% 20.0% 18.6% 17.2% 15.8% 13.6% 11.5% 11.5%
ROE 40.8% 44.4% 46.9% 43.8% 40.1% 36.5% 33.2% 28.2% 23.2% 23.2%
BV of operating assets growth rate -4.9% 8.5% 8.9% 10.0% 10.0% 10.0% 10.0% 10.0% 3.0% 3.0%
BV of business assets growth rate -3.2% 8.6% 8.9% 10.0% 10.0% 10.0% 10.0% 10.0% 3.0% 3.0%
BV of equity growth rate -0.9% 8.6% 8.9% 10.0% 10.0% 10.0% 10.0% 10.0% 3.0% 3.0%
Net profit 20,851.8 24,634.9 28,360.5 29,150.9 29,328.1 29,359.0 29,344.2 27,409.9 23,217.4 23,913.9
– Change in net working capital 1,180.0 -1,099.3 -1,355.8 -1,894.5 -2,083.9 -2,292.3 -2,521.5 -2,773.7 -915.3 -942.8
– Change in net non-current operating assets 4,639.8 -8,611.2 -9,563.9 -11,528.0 -12,680.8 -13,948.9 -15,343.8 -16,878.2 -5,569.8 -5,736.9
– Change in investment assets -1,873.6 -716.2 -787.8 -866.6 -953.3 -1,048.6 -1,153.5 -1,268.8 -418.7 -431.3
+ Change in debt -3,470.2 6,016.2 6,755.3 8,244.8 9,069.3 9,976.2 10,973.8 12,071.2 3,983.5 4,103.0
= Free cash flow to equity 21,327.7 20,224.4 23,408.2 23,106.7 22,679.4 22,045.4 21,299.2 18,560.4 20,297.1 20,906.0
Net operating profit after tax 21,819.5 25,833.6 29,827.7 31,037.0 31,702.0 32,189.8 32,458.0 30,835.1 26,745.4 27,547.8
– Change in net working capital 1,180.0 -1,099.3 -1,355.8 -1,894.5 -2,083.9 -2,292.3 -2,521.5 -2,773.7 -915.3 -942.8
– Change in net non-current operating assets 4,639.8 -8,611.2 -9,563.9 -11,528.0 -12,680.8 -13,948.9 -15,343.8 -16,878.2 -5,569.8 -5,736.9
= Free cash flow from operations 27,639.3 16,123.1 18,908.0 17,614.5 16,937.3 15,948.6 14,592.7 11,183.3 20,260.3 20,868.1

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Solutions – Chapter 8

Question 2.

Calculate H&M’s cash payouts to its shareholders in the years 2015−2024 that are implicitly assumed
in the projections in Table 8.3.

The cash payouts to shareholders are equal to the expected free cash flows to equity:

2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Net profit 23,114.1 27,872.5 32,695.6 34,217.8 34,425.8 33,835.5 32,588.6 28,780.1 24,378.0 25,109.4
Change in shareholders' equity 5,066.1 6,161.4 6,898.4 8,361.8 7,804.4 6,867.8 5,563.0 3,931.2 3,066.3 3,158.3
Implicitly assumed cash payout 18,048.1 21,711.1 25,797.1 25,856.0 26,621.5 26,967.6 27,025.7 24,848.9 21,311.7 21,951.1
Dividend payout ratio 78.08% 77.89% 78.90% 75.56% 77.33% 79.70% 82.93% 86.34% 87.42% 87.42%

Question 3.

How will the abnormal profit calculations in Table 8.4 change if the cost of equity assumption is
changed to 10 percent?

Fiscal year 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024
Equity valuation (SEK millions)
Abnormal earnings 17,958.5 22,210.3 26,417.2 27,249.7 26,621.5 25,250.7 23,317.0 18,952.2 14,157.0 14,581.7
Abnormal ROE 30.8% 34.4% 36.9% 33.8% 30.1% 26.5% 23.2% 18.2% 13.2% 13.2%
Free cash flow to equity 18,048.1 21,711.1 25,797.1 25,856.0 26,621.5 26,967.6 27,025.7 24,848.9 21,311.7 21,951.1
Abnormal earnings growth 4,251.8 4,206.9 832.4 -628.2 -1,370.8 -1,933.6 -4,364.8 -4,795.2 424.7

Question 4.

How will the terminal values in Table 8.6 change if the revenue growth rate in years 2025 and beyond
is 4 percent, and the company keeps forever its abnormal returns at the same level as in fiscal 2024
(keeping all the other assumptions in the table unchanged)? If revenue growth is 3 percent in 2024
and 4 percent in 2025, why are the equity value estimates of the free cash flow model and the
abnormal profit model no longer the same?

This question illustrates that if the terminal growth rate deviates from the growth rate in the last year
of the forecast horizon, the firm is assumed not to be in a steady state at the end of the forecast
horizon. As a consequence, the cash flow based model produces a different value estimate than the
profit-based models:

Value
Value from beyond
Beginning forecast forecast Value per
Total value
book value period horizon share (SEK)
2015–2024 (terminal
value)

Equity value (SEK billions)

Abnormal earnings 51.6 161.0 218.2 430.8 260.30
Abnormal earnings growth N.A. 314.8 116.0 430.8 260.30
Free cash flows to equity N.A. 161.4 283.5 444.9 268.82

Operating assets value (SEK billions)

Abnormal NOPAT 119.4 133.5 164.2 417.1 N.A.
Abnormal NOPAT growth N.A. 326.6 90.5 417.1 N.A.
Free cash flows to capital N.A. 136.0 315.9 451.9 N.A.

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Solutions – Chapter 8

Question 5.

Calculate the proportion of terminal values to total estimated values of equity under the abnormal
earnings method, the abnormal earnings growth method and the discounted cash flow method. Why
are these proportions different?

Value
Value from beyond
TV as a %
Beginning forecast forecast Value per
Total value of total
book value period horizon share (SEK)
value
2015–2024 (terminal
value)
Equity value (SEK billions)
Abnormal earnings 51.6 161.0 171.1 383.7 231.83 44.6%
Abnormal earnings growth N.A. 314.8 68.9 383.7 231.83 17.9%
Free cash flows to equity N.A. 161.4 222.3 383.7 231.83 57.9%

Operating assets value (SEK billions)

Abnormal NOPAT 119.4 133.5 126.5 379.4 N.A. 33.3%
Abnormal NOPAT growth N.A. 326.6 52.8 379.4 N.A. 13.9%
Free cash flows to capital N.A. 136.0 243.3 379.4 N.A. 64.1%

Why are these proportions different? The abnormal earnings method begins with the book value
(which represents in some sense "normal earnings") and adds to it abnormal earnings over time. The
terminal value in this method, therefore, represents the present value of only that portion of earnings
that are above the cost of capital. The discounted cash flow method, in contrast, ignores book value
completely. Instead, it captures the present value of total cash flows - both normal and abnormal.
Therefore, the terminal value in this method is significantly larger than the terminal value in
accounting based valuation approaches. In essence, part of the terminal value in DCF is substituted
by the book value in accounting-based valuation.

Question 6.

Under the competitive equilibrium assumption the terminal value in the discounted cash flow model
is the present value of the end-of-year book value of equity in the terminal year. Explain.

Under the competitive equilibrium assumption, a firm is not able to earn abnormal returns on its
equity in the years beyond the terminal year. The firm’s value in the terminal year is, consequently,
equal to its book value. Shareholders would, therefore, be indifferent between receiving a terminal
cash flow equal to the book value of equity or continuance of firm operations.

Question 7.

Under the competitive equilibrium assumption the terminal value in the discounted abnormal earnings
growth model is the present value of abnormal earnings in the terminal year times minus one,
capitalized at the cost of equity. Explain.

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Solutions – Chapter 8

Under the competitive equilibrium assumption, a firm is not able to earn abnormal returns on its
equity in the years beyond the terminal year. In the first year after the terminal year, the firm’s
abnormal earnings will thus revert to zero. Hence, the “last” change in abnormal earnings (i.e.,
abnormal earnings growth) is equal to minus one times abnormal earnings in the terminal year.

Question 8.

What will be H&M’s cost of equity if the equity market risk premium is 6 percent?

The company’s estimated equity beta was 0.45 at the end of 2014. The risk-free rate in the EU at that
time was 4.2 percent. Using the risk premium of 6 percent, we can calculate its cost of equity to be
6.9 percent: 4.2 + 0.45 * 6 = 6.9

Question 9.

Assume that H&M changes its capital structure so that its market value weight of debt to capital
increases to 45 percent, and its after-tax interest rate on debt at this new leverage level is 4 percent.
Assume that the equity market risk premium is 7 percent. What will be the cost of equity at the new
debt level? What will be the weighted average cost of capital?

H&M’s asset beta was estimated at 0.41 at the end of 2014. At a debt-to-capital ratio of 45 percent,
H&M’s equity beta will be:

[1 + 0.45 / (1 – 0.45)] x 0.41 = 0.75

Consequently, H&M’s cost of equity will be 9.45 percent: 4.2 + 0.75 * 7 = 9.45. The weighted average
cost of capital will then be 7 percent: 0.45 * 4 + 0.55 * 9.45 = 7.00.

Question 10.

Nancy Smith says she is uncomfortable making the assumption that H&M’s dividend payout will vary
from year to year. If she makes a constant dividend payout assumption, what changes does she have
to make in her other valuation assumptions to make them internally consistent with each other?

If Nancy Smith doesn't want to allow dividend payout to vary across the years, then she can hold the
dividend payout constant. However, then she will have to allow for the capital structure to vary from
year to year, since a constant dividend payout may not result in a stream of equity values that will
result in a constant debt to equity ratio. If the capital structure is allowed to vary, then the cost of
capital will vary each period as well.

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Solutions – Chapter 8

Problem 1. Hugo Boss’ and Adidas’ terminal values

1. The analyst following Hugo Boss estimates a target price of €105 per share. Under the
assumption that the company’s profit margins, asset turnover, and capital structure remain
constant after 2016, what is the terminal growth rate that is implicit in the analysts’ forecasts
and target price?
2. Using the analyst’s forecasts, estimate Hugo Boss’ equity value under the following three
scenarios: (a) Hugo Boss enters into a competitive equilibrium in 2017; (b) after 2016, Hugo
Boss’ competitive advantage can only be maintained on the nominal sales level achieved in
2016, and (c) after 2016, Hugo Boss’ competitive advantage can be maintained on a sales
base that remains constant in real terms.
3. Using the analyst’s forecasts, estimate Hugo Boss’ equity value under the assumption that the
company’s profitability gradually reverts to its required level (i.e., AEt = 0.75 × AEt-1) after the
terminal year.
4. Using the analyst’s forecasts, estimate Adidas’ terminal values in the discounted cash flow
and the abnormal earnings growth models under the assumption that the company enters
into a competitive equilibrium in 2015.

1. A target price of €105 per share implies a market value (on April 1, 2014) of €7,245 million. A
market value of €7,245 million on April 1, 2014, corresponds with a market value of €7,076.7
million on January 1, 2014. The discounted value of Hugo Boss’ expected abnormal profits equals:

Value = BVE +
AP2014
+
AP2015
+
AP2016
+
(1 + g)  AP2016
(1 + re ) (1 + re ) (1 + re ) (re − g)  (1 + re )3
2 3

294.6 340.8 379.1 (1 + g)  379.1

= 714 + + + + = 7,076.7
(1.10) (1.10) (1.10) (0.10 − g)  (1.10)3
2 3

Because the sum of the beginning book value of equity and the present value of 2014-2016
abnormal earnings equals 1,548.3, the present value of the expected equity value at the end of
2016 must be equal to: 7,076.7 – 1,548.3 = 5,528.4. Consequently, the average expected growth
rate in abnormal earnings after the terminal year equals:

(1 + g)  379.1
= 5,528.4
(0.10 − g)  (1.10)3
(1 + g) 5,528.4  (1.10)
3
= = 19.41
(0.10 − g) 379.1
g = 4.61%

Note that, because Hugo Boss is not in a steady state at the end of the forecast horizon (i.e.,
growth in FCF in 2016 ≠ terminal growth), the terminal growth rate obtained from the FCF model
will not be equal to the terminal growth rate from the abnormal profits model (as estimated
above).

2. Hugo Boss’ equity value under scenario (a) is:

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Solutions – Chapter 8

Value = BVE +
AP2014
+
AP2015
+
AP2016
+
(1 + g)  AP2016
(1 + re ) (1 + re ) (1 + re ) (re − g)  (1 + re )3
2 3

294.6 340.8 379.1

= 714 + + + + 0 = 1,548.3
(1.10) (1.10) (1.10)3
2

The company’s value under scenario (b) is:

Value = BVE +
AP2014
+
AP2015
+
AP2016
+
(1 + g)  AP2016
(1 + re ) (1 + re ) (1 + re ) (re − g)  (1 + re )3
2 3

294.6 340.8 379.1 379.1

= 714 + + + + = 4,396.5
(1.10) (1.10) (1.10) 0.10  (1.10)3
2 3

The company’s value under scenario (c) is (assuming that the long-term inflation rate is 2
percent):

Value = BVE +
AP2014
+
AP2015
+
AP2016
+
(1 + g)  AP2016
(1 + re ) (1 + re ) (1 + re ) (re − g)  (1 + re )3
2 3

294.6 340.8 379.1 (1.02)  379.1

= 714 + + + + = 5,179.8
(1.10) (1.10) (1.10)3 (0.08)  (1.10)3
2

To summarize:

Scenario Value on 1/1 Value on 1/4 Value per share on

1/4
a €1,548.3m €1,585.1m €22.97
b €4,396.5m €4,501.1m €65.23
c €5,179.8m €5,303.0m €76.85

3. Hugo Boss’ equity value under this scenario is:

Value = BVE +
AP2014
+
AP2015
+
AP2016
+
(1 + g)  AP2016
(1 + re ) (1 + re ) (1 + re ) (re − g)  (1 + re )3
2 3

294.6 340.8 379.1 (0.75)  379.1

= 714 + + + + = 2,158.6
(1.10) (1.10) (1.10) (0.10 - (- 0.25))  (1.10)3
2 3

4. In a competitive equilibrium, the terminal value in the discounted free cash flow valuation model
is equal to the present value of the book value of equity at the end of the forecasting period, i.e.,
7272.2 / 1.103 = 5,463.7. The terminal value in the abnormal earnings growth valuation model is
equal to:

1 − 1 AE 2014 1 − 478.0
TV = = = −3591.3
re (1+ re )3
0.10 (1.10 )3

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Solutions – Chapter 8

Problem 2. Anheuser-Busch InBev S.A.

1. The analyst estimates that AB InBev’s weighted average cost of capital is 9 percent and
assumes that the free cash flow to debt and equity grows indefinitely at a rate of 1 percent
after 2018. Show that under these assumptions, the equity value per share estimate exceeds
AB InBev’s share price.
2. Calculate AB InBev’s expected abnormal NOPATs between 2009 and 2018 based on the above
information. How does the implied trend in abnormal NOPAT compare with the general trends
in the economy?
3. Estimate AB InBev’s equity value using the abnormal NOPAT model (under the assumption
that the WACC is 9 percent and the terminal growth rate is 1 percent). Why do the discounted
cash flow model and the abnormal NOPAT model yield different outcomes?
4. What adjustments to the forecasts are needed to make the two valuation models consistent?
1. The calculations are:

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Free cash flow to debt
and equity (FCFDE) 7425 7590 8077 8014 8301 8556 8777 8958 8915 9011
Discount factor 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224
Present value of FCFDE 6811.9 6388.4 6236.9 5677.3 5395.1 5101.7 4801.3 4495.7 4104.7 3806.3
Sum of PV FCFDE 52,819.4
+ Terminal value 48,055.1
= Asset value 100,874.5
- Book value of debt -45,231.0
= Equity value 55,643.5
Equity value per share 34.93

where the terminal value is calculated as:

TV =
(1 + g )  FCFDE 2018 =
1.01  9,011
= 48,055.1
(WACC − g )  (1 + WACC )10 (0.09 − 0.01)  (1.09)10
2. Assume that in every year during the forecasting period, net non-current assets equal prior year’s
net non-current assets minus depreciation and amortization plus investments in non-current
assets. Likewise, in every year, working capital equals prior year’s working capital plus current
year’s investment in working capital. Consequently, net assets between 2009 and 2018 are as
follows:

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Net non-current assets 63,412 62,695 62,016 61,441 60,844 60,229 59,599 58,955 58,315 57,667
Working capital -3,311 -3,891 -4,560 -4,995 -5,446 -5,911 -6,388 -6,875 -7,360 -7,850

Net assets 60,101 58,804 57,456 56,446 55,398 54,318 53,211 52,080 50,955 49,817

Abnormal NOPAT between 2009 and 2018 is calculated as follows:

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
Net assets 60,101 58,804 57,456 56,446 55,398 54,318 53,211 52,080 50,955 49,817
NOPAT 6,169 6,294 6,729 7,003 7,254 7,476 7,669 7,828 7,790 7,874
Net assets x 9% 5,522.1 5,409.1 5,292.4 5,171.0 5,080.1 4,986.8 4,889.6 4,789.0 4,687.2 4,586.0

Abnormal NOPAT 646.9 884.9 1,436.6 1,832.0 2,173.9 2,490.2 2,780.4 3,039.0 3,102.8 3,288.1
Abnormal ROA 1.05% 1.47% 2.44% 3.19% 3.85% 4.50% 5.12% 5.71% 5.96% 6.45%

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Solution Manual for Business Analysis and Valuation: IFRS edition

Solutions – Chapter 8

These numbers show that the analysts assumes that AB InBev’s abnormal profitability steadily
increase over time. This contrasts with the general trends in the economy. This exercise nicely
illustrates why a focus on abnormal profitability, rather than on free cash flows, helps in assessing
how reasonable predictions are.

3. AB InBev’s asset value, calculated using the abnormal NOPAT valuation method, is:

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Abnormal NOPAT 646.9 884.9 1,436.6 1,832.0 2,173.9 2,490.2 2,780.4 3,039.0 3,102.8 3,288.1
Discount factor 0.9174 0.8417 0.7722 0.7084 0.6499 0.5963 0.5470 0.5019 0.4604 0.4224
PV Abnormal NOPAT 593.5 744.8 1109.3 1297.8 1412.9 1484.8 1521.0 1525.2 1428.6 1388.9

Beginning book value

of net assets 61,357
+ Sum op PV abn
NOPAT 12,506.8
+ Terminal value 17,535.0
= Asset value 91,398.7
- Book value of debt -45,231.0
= Equity value 46,167.7
Equity value per
share 28.98

This equity value estimate is considerably lower than the estimate obtained under 1. Both models
yield different outcomes because the analysts’ predictions imply that AB InBev is not yet in a
steady state at the end of the forecasting period. In particular, in the abnormal NOPAT model we
assumed that assets (like abnormal NOPAT) would grow at a constant rate of 1 percent after the
terminal year. The assumption that the free cash flow to debt and equity grows at a constant rate
of 1 percent after the terminal year implies, however, that net assets continue to decrease after
the terminal year. This is an unrealistic assumption, which, as shown under (2), results in an ever-
increasing abnormal ROA.

4. To make the two models consistent, one needs to:

a. Extend the forecasting period with two years: 2019 and 2020;
b. Let net assets and NOPAT increase at a rate of 1 percent during 2019 and 2020;
c. Calculate free cash flows to debt and equity and abnormal NOPAT in 2019 and 2020;
d. Make 2020 the terminal year and assume constant growth (of 1 percent) during 2020
and beyond.

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