Prof Dr Catherine Ho

12
.1



Review How did we get here?

Simplistic Techniques for Company Valuation
Valuing Hersheys Hypothetical Strategic Plan
(from Chapter 9)
Generalized Valuation Models
Options on Assets or Real Options

12
.2



Company Valuation
Further discussion about Capital Investment
Analysis

12
.3

Historical Financial Analysis

Chapters 2, 7, and 8

Review of General Economic Conditions

Chapters 4, 5, and 6

Forecasts of Future Performance

Chapter 9

Valuation of Projected Cash Flow

Chapters 3, 10, and 11

12
.4

12
.5

PVAr , =

CF( 0) (1 + g )
(r g )

Note: If g=0 then this

model is the same as
the zero growth
perpetuity model.

After Tax Operating Income Net Operating Investment

V0 =
(k g)
V0 =

R 0 [m(1 T ) + d I fg I w ](1 + g )
(k g)

12
.6

Variables

V0
R0
m
T
d
Ifg
Iw
g
k

= Value of firm as of today (Year 0)

= Revenue (or sales) of firm (Can be last year of actual sales)
= Operating income (EBIT) margin (% of sales)
= Tax Rate
= Depreciation (% of sales)
= Capital expend., gross or fixed capital invested (% of sales)
= Working capital incremental investment (% of sales)
= Growth
= Cost of capital (previously called r)

Results

R0 (1+g) = Revenue (or sales) for the next (first) year = R1

R1 (m)
= Operating income (EBIT) in year 1
R1 (m)(1-T) = After-tax operating income in year 1
R1(Ifg d) = Net capital investment

R1(Ifg d)+ Iw = Investment in operating assets less operating liabilities (or

Net
Operating Investment)

12
.7

After Tax Operating Income Net Operating Investment

V0 =
(k g)
V0 =

R 1[m(1 T)]

R 1[(I fg + d) + I w ]

(k g)

$4,957[0.213(1 0.37)] $4,957[(0.041 0.039) + (0.0074)]

V0 =
(0.082 0.025)
= ($665 - $10 + $37) / 0.057 = $692 / 0.057 = $12,140

12
.8

Valuation Equations:
Multiple Stage

V0 = PV (Growth Period CF) +

Vo = Ro [ms (1 Ts ) Is ]

(1 + gs )t

(1 + k)t
t =1

PV (Perpetual Period CF)

[
R (1 + g ) [m (1 T ) I ]] (1 + g )
+

c
n

(k g )

1
(1 + k)n

12
.9

12
.1
0

Simplistic Equations are appropriate for first

estimates, but
Spreadsheet models allow:

Appropriate levels of annual detail

Performance standards and measures
Communication to all levels of management
Expansion to lines of business
Detailed cost and investment analysis
Additional sensitivity analysis

12
.1
1

The following models are presented:

Table 12.1: Valuation of the Strategic Financial
Plan from Chapter 9
Table 12.2: Cash flow conversion to percent of
sales from Table 12.1
Table 12.3: Partial valuation model
Table 12.4: Comprehensive valuation model

12
.1
2

The following page (Table 12.1) uses the

techniques discussed in chapter 11 to value
the operating cash flows detailed in the
Strategic Financial Plan (chapter 9)
The operating assumptions come directly
from chapter 9
Table 12.1 only contains operating cash flows
NO interest income or expense, no debt
repayment, no dividends, etc.
Taxes are recalculated due to the removal of
interest
12
.1
3

Strategic Financial Management: Applications of Corporate Finance

The Hershey Company Hypothetical Strategic Plan
Table 12.1

Valuation
($ Millions)

2006
Net Sales

2007

2008

Projected
2009
2010

2011

2012

2013

Additional Assumptions

$ 5,077.8 $ 5,331.7 $ 5,571.6 $ 5,794.5 $ 6,026.3 $ 6,207.1 $ 6,362.3 $ 6,521.4

Cost of Sales
Selling, General, & Administrative
Total Costs

2,894.3
204.4
949.5
4,048.2

3,017.7
218.1
986.4
4,222.2

3,136.8
232.6
1,019.6
4,389.0

3,244.9
247.6
1,048.8
4,541.3

3,356.6
263.1
1,078.7
4,698.4

3,444.9
279.1
1,098.7
4,822.7

3,512.0
295.6
1,113.4
4,921.0

3,599.8
312.6
1,141.2
5,053.6

Operating Income (or Earnings Before Interest and Taxes)

Margin

1,029.6
20.3%

1,109.5
20.8%

1,182.6
21.2%

1,253.2
21.6%

1,327.9
22.0%

1,384.4
22.3%

1,441.3
22.7%

1,467.8
22.5%

Tax Expense

381.0

410.5

437.6

463.7

491.3

512.2

533.3

543.1 Recalculated Based on EBIT * Tax Rate

After Tax Operating Income

Margin

648.6
12.8%

699.0
13.1%

745.0
13.4%

789.5
13.6%

836.6
13.9%

872.2
14.1%

908.0
14.3%

924.7
14.2%

Depreciation
Deferred Income Taxes - Long-Term Liabilities

204.4
27.3

218.1
30.5

232.6
33.6

247.6
36.3

263.1
39.2

279.1
41.5

295.6
44.0

312.6
45.5

51.5
(15.7)
6.3
(10.0)
(30.0)
55.6
5.0

(14.9)
(21.2)
10.8
(10.0)
(30.0)
52.9
5.0

(13.0)
(13.5)
9.9
(10.0)
(30.0)
57.6
5.0

(16.2)
(10.9)
10.6
(10.0)
(30.0)
24.6
5.0

(16.6)
(11.4)
10.1
(12.0)
(40.0)
25.4
10.0

(11.6)
(6.6)
10.2
(12.0)
(40.0)
20.9
10.0

(9.0)
(2.7)
7.9
(12.0)
(40.0)
16.7
10.0

(9.2)
(19.0)
10.9
(12.0)
(40.0)
21.0
10.0

Depreciation

Change in:
Accounts Receivable - Trade
Inventory
Accounts Payable
Prepaid Expenses
Other Assets
Accrued Liabilities
Accrued Income Taxes
Other Long-Term Liabilities
Cash from Operating Activities

18.7

21.6

20.4

18.9

19.7

15.4

13.2

13.5

(A)

961.7

961.8

1,037.6

1,065.4

1,124.1

1,179.1

1,231.7

1,258.0

Investment Activities
Capital Expenditures
Business Acquisitions
Other, Net
Cash (used for) Investing

(B)

(185.0)
(185.0)

(190.0)
(190.0)

Free Cash Flow

(A) + (B)

$ 776.7 $ 771.8 $ 837.6 $ 865.4 $ 914.1 $ 969.1 $ 1,011.7 $ 1,038.0

Present Value
8.2%
Total Present Value $ 5,025.4

Cost of Capital
Million

$ 717.8 $ 659.3 $ 661.2 $ 631.4 $ 616.4 $ 604.0 $ 582.7 $ 552.6

(200.0)
(200.0)

(200.0)
(200.0)

(210.0)
(210.0)

(210.0)
(210.0)

(220.0)
(220.0)

(220.0)
(220.0)

12
.1
4

The following page (Table 12.2) illustrates

the conversion of the Strategic Plan Cash
Flows to a percent of sales basis.
This will develop the assumptions to
facilitate a stand alone valuation model.
The notation also aligns with the valuation
equations presented earlier.

12
.1
5

Strategic Financial Management: Applications of Corporate Finance

The Hershey Company Hypothetical Strategic Plan
Table 12.2

Valuation as a % of Sales
($ Millions)

2006
Net Sales

2007

2008

Projected
2009
2010

2011

2012

2013

Additional Assumptions

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

100.00%

Selling, General, & Administrative

Total Costs

57.00%
4.03%
18.70%
79.72%

56.60%
4.09%
18.50%
79.19%

56.30%
4.17%
18.30%
78.77%

56.00%
4.27%
18.10%
78.37%

55.70%
4.37%
17.90%
77.96%

55.50%
4.50%
17.70%
77.70%

55.20%
4.65%
17.50%
77.35%

55.20%
4.79%
17.50%
77.49%

Operating Income (or Earnings Before Interest and Taxes)

20.28%

20.81%

21.23%

21.63%

22.04%

22.30%

22.65%

22.51% Operating Margin (M)

7.50%

7.70%

7.85%

8.00%

8.15%

8.25%

8.38%

8.33%

12.77%

13.11%

13.37%

13.62%

13.88%

14.05%

14.27%

14.18%

4.03%
0.54%

4.09%
0.57%

4.17%
0.60%

4.27%
0.63%

4.37%
0.65%

4.50%
0.67%

4.65%
0.69%

4.79% Depreciation (D)

0.70% Working Capital Investment (Iw)

1.01%
-0.31%

-0.28%
-0.40%

-0.23%
-0.24%

-0.28%
-0.19%

-0.28%
-0.19%

-0.19%
-0.11%

-0.14%
-0.04%

-0.14% Working Capital Investment (Iw)

-0.29% Working Capital Investment (Iw)

0.12%
-0.20%

0.20%
-0.19%

0.18%
-0.18%

0.18%
-0.17%

0.17%
-0.20%

0.16%
-0.19%

0.12%
-0.19%

0.17% Working Capital Investment (Iw)

-0.18% Working Capital Investment (Iw)

-0.59%
1.09%

-0.56%
0.99%

-0.54%
1.03%

-0.52%
0.42%

-0.66%
0.42%

-0.64%
0.34%

-0.63%
0.26%

-0.61% Working Capital Investment (Iw)

0.32% Working Capital Investment (Iw)

0.10%

0.09%

0.09%

0.09%

0.17%

0.16%

0.16%

0.15% Working Capital Investment (Iw)

Cost of Sales
Depreciation

Tax Expense
After Tax Operating Income
Depreciation
Deferred Income Taxes - LT Liab
Change in:
Accounts Receivable - Trade
Inventory
Accounts Payable
Prepaid Expenses
Other Assets
Accrued Liabilities
Accrued Income Taxes
Other Long-Term Liabilities
Cash from Operating Activities

Working Capital Investment (Iw) - Total

Investment Activities
Capital Expenditures
Business Acquisitions
Other, Net
Cash (used for) Investing
Free Cash Flow - % of Sales

0.37%

0.41%

0.37%

0.33%

0.33%

0.25%

0.21%

18.94%

18.04%

18.62%

18.39%

18.65%

19.00%

19.36%

19.29%

0.21% Working Capital Investment (Iw)

2.14%

0.84%

1.08%

0.49%

0.40%

0.45%

0.44%

0.32%

-3.64%

-3.56%

-3.59%

-3.45%

-3.48%

-3.38%

-3.46%

-3.37% Fixed Capital Investment (Ifg)

0.00%
0.00%
-3.64%

0.00%
0.00%
-3.56%

0.00%
0.00%
-3.59%

0.00%
0.00%
-3.45%

0.00%
0.00%
-3.48%

0.00%
0.00%
-3.38%

0.00%
0.00%
-3.46%

0.00%
0.00%
-3.37%

15.30%

14.48%

15.03%

14.93%

15.17%

15.61%

15.90%

15.92%

Investment (Iw)

12
.1
6

The following table (table 12.3)

presents a valuation of the explicit
eight year period.
In practice valuation, models often are
5, 8, 10, 12, 15, 20 years or longer.
This model assumes no value after the
terminal year.

12
.1
7

Table 12.3

Valuation Model
($ Millions)

Year 1
2006

Year 2
2007

Year 3
2008

Year 4
2009

Year 5
2010

Year 6
2011

Year 7
2012

Year 8
2013

$ 5,077.8

$ 5,331.7

$5,571.6

$5,794.5

$6,026.3

$6,207.1

$6,362.3

$6,521.4

Panel A - Projected Free Cash Flow

Net Reveneue
Cost of sales (excluding depreciation)
Selling, marketing, and administrative
Depreciation
Operating Income
% of Sales

2,894.3
949.5
204.4
1,029.6
20.3%

3,017.7
986.4
218.1
1,109.5
20.8%

3,136.8
1,019.6
232.6
1,182.6
21.2%

3,244.9
1,048.8
247.6
1,253.2
21.6%

3,356.6
1,078.7
263.1
1,327.9
22.0%

3,444.9
1,098.7
279.1
1,384.4
22.3%

3,512.0
1,113.4
295.6
1,441.3
22.7%

3,599.8
1,141.2
312.6
1,467.8
22.5%

Taxes
After Tax Operating Income
% of Sales

381.0
648.6
12.8%

410.5
699.0
13.1%

437.6
745.0
13.4%

463.7
789.5
13.6%

491.3
836.6
13.9%

512.2
872.2
14.1%

533.3
908.0
14.3%

543.1
924.7
14.2%

Depreciation
Working Capital Investment
Capital Expenditures

204.4
108.7
(185.0)

218.1
44.7
(190.0)

232.6
60.0
(200.0)

247.6
28.3
(200.0)

263.1
24.4
(210.0)

279.1
27.8
(210.0)

295.6
28.1
(220.0)

312.6
20.7
(220.0)

Free Cash Flow

% of Sales
Present Value

$5,025.4

8-Year Total

776.7 $
15.3%

771.8 $ 837.6 $ 865.4 $ 914.1 $ 969.1 $1,011.7 $1,038.0

14.5%
15.0%
14.9%
15.2%
15.6%
15.9%
15.9%

717.8

659.3

$ 661.2

$ 631.4

$ 616.4

$ 604.0

$ 582.7

$ 552.6

Panel B - Valuation Model Assumptions

Year 0 Revenue
$4,836.0
Revenue growth
Tax rate
% of Sales
Cost of sales (excluding depreciation)
Selling, marketing, and administrative
Expenses excluding depreciation
Operating margin before depreciation
Fixed capital investment
Depreciation (% of Sales)
Net, fixed investment
Working capital (dis) investment
Cost of Capital

5.00%

5.00%

4.50%

4.00%

4.00%

3.00%

2.50%

2.50%

37.00%

37.00%

37.00%

37.00%

37.00%

37.00%

37.00%

37.00%

57.00%
18.70%
75.70%

56.60%
18.50%
75.10%

56.30%
18.30%
74.60%

56.00%
18.10%
74.10%

55.70%
17.90%
73.60%

55.50%
17.70%
73.20%

55.20%
17.50%
72.70%

55.20%
17.50%
72.70%

24.30%

24.90%

25.40%

25.90%

26.40%

26.80%

27.30%

27.30%

3.64%
4.03%
0.38%
-2.14%

3.56%
4.09%
0.53%
-0.84%

3.59%
4.17%
0.59%
-1.08%

3.45%
4.27%
0.82%
-0.49%

3.48%
4.37%
0.88%
-0.40%

3.38%
4.50%
1.11%
-0.45%

3.46%
4.65%
1.19%
-0.44%

3.37%
4.79%
1.42%
-0.32%

8.20%

12
.1
8

Table 12.4 presents a comprehensive

valuation model that values the explicit eight
year period as well as provides a terminal or
residual value.
Residual value is estimated as a perpetuity of
the final years cash flow grown at some
residual period growth rate:

PVAr , =

CF(8) (1 + g )
(k g )

= Re sidualValue (8)

12
.1
9

Table 12.4

Comprehensive Valuation Model

Including Terminal Year

Year 1
2006

Year 2
2007

($ Millions)

Year 3
2008

Year 4
2009

Year 5
2010

Year 6
2011

Year 7
2012

Year 8
2013

Panel A - Projected Free Cash Flow

Net Reveneue

$ 5,077.8 $ 5,331.7 $ 5,571.6 $ 5,794.5 $ 6,026.3 $ 6,207.1 $ 6,362.3 $ 6,521.4

Cost of sales (excluding depreciation)

Selling, marketing, and administrative
Depreciation
Operating Income

2,894.3
949.5
204.4
1,029.6

3,017.7
986.4
218.1
1,109.5

3,136.8
1,019.6
232.6
1,182.6

3,244.9
1,048.8
247.6
1,253.2

3,356.6
1,078.7
263.1
1,327.9

3,444.9
1,098.7
279.1
1,384.4

3,512.0
1,113.4
295.6
1,441.3

3,599.8
1,141.2
312.6
1,467.8

Taxes
After Tax Operating Income
% of Sales

381.0
648.6
12.8%

410.5
699.0
13.1%

437.6
745.0
13.4%

463.7
789.5
13.6%

491.3
836.6
13.9%

512.2
872.2
14.1%

533.3
908.0
14.3%

543.1
924.7
14.2%

Depreciation
Working Capital Investment
Capital Expenditures

204.4
108.7
(185.0)

218.1
44.7
(190.0)

232.6
60.0
(200.0)

247.6
28.3
(200.0)

263.1
24.4
(210.0)

279.1
27.8
(210.0)

295.6
28.1
(220.0)

312.6
20.7
(220.0)

Free Cash Flow

% of Sales

$ 776.7 $ 771.8 $ 837.6 $ 865.4 $ 914.1 $ 969.1 $ 1,011.7 $ 1,038.0

15.3%
14.5%
15.0%
14.9%
15.2%
15.6%
15.9%
15.9%

Terminal Value
Present Value

$ 18,665.8
$ 5,025.4 8-Year Total
9,936.5 Terminal Value
$ 14,961.9 Value of the Operations

717.8 $ 659.3 $ 661.2 $ 631.4 $ 616.4 $ 604.0 $ 582.7 $

552.6
$ 9,936.5

Panel B - Valuation Model Relationships

Year 0 Revenue
Revenue growth
Tax rate
% of Sales
Cost of sales (excluding depreciation)
Selling, marketing, and administrative
Expenses excluding depreciation
Operating margin before depreciation
Fixed capital investment
Depreciation (% of Sales)
Net, fixed investment
Working capital (dis) investment
Cost of Capital

$ 4,836.0
5.00%
37.00%

5.00%
37.00%

4.50%
37.00%

4.00%
37.00%

4.00%
37.00%

3.00%
37.00%

2.50%
37.00%

2.50%
37.00%

57.00%
18.70%
75.70%

56.60%
18.50%
75.10%

56.30%
18.30%
74.60%

56.00%
18.10%
74.10%

55.70%
17.90%
73.60%

55.50%
17.70%
73.20%

55.20%
17.50%
72.70%

55.20%
17.50%
72.70%

24.30%

24.90%

25.40%

25.90%

26.40%

26.80%

27.30%

27.30%

3.64%
4.03%
0.38%
-2.14%

3.56%
4.09%
0.53%
-0.84%

3.59%
4.17%
0.59%
-1.08%

3.45%
4.27%
0.82%
-0.49%

3.48%
4.37%
0.88%
-0.40%

3.38%
4.50%
1.11%
-0.45%

3.46%
4.65%
1.19%
-0.44%

3.37%
4.79%
1.42%
-0.32%

8.20%

12
.2
0

The Comprehensive Valuation Model provides:

Value of the operations
Intrinsic value of the business
Business valuation

To focus on the equity value:

Need to adjust the value of the operations
Add excess cash
Subtract interest bearing debt

Divide the value of the equity by shares

outstanding to determine the value per share.

12
.2
1

Present
Value
($mms)

Explicit Period
Terminal Value
Enterprise Value
Add:
Less:

Value of the Operations

Cash and equivalents
Interest bearing debt
Value of the Equity
Shares outstanding
Value per share

$5,025.4
9,936.5
$14,961.9
$14,961.9
67.2
(1,762.0)
$13,267.1
240.5
$55.16
12
.2
2



Review your base case results.

Test the impact of your assumptions:

Sensitivity analysis
Scenario analysis
Probabilistic analysis
Monte Carlo Sensitivity

12
.2
3

Table 12.5

Sensitivity Analysis
1% Change in the Assumption

Year 1 Assumption
Sensitivity
Original 1.01 * Orig.

Value Per
Share Impact
$
%

Revenue growth (Explicit period only)

Expenses (excluding depreciation)
Tax rate

5.000%
75.700%
37.000%

5.050% $ 0.35
76.457%
(1.83)
37.370%
(0.32)

0.641%
-3.316%
-0.587%

Fixed capital investment

Depreciation (% of Sales)
Working capital (dis) investment

3.640%
4.030%
-2.140%

3.676%
4.070%
-2.161%

(0.14)
0.07
0.02

-0.246%
0.126%
0.034%

2.500%
8.200%

2.525%
8.282%

0.19
(0.65)

0.348%
-1.186%

Residual period growth rate

Cost of capital

12
.2
4

A company can use the Strategic Financial

Plan developed in Chapter 9 along with the
valuation concepts developed here to
monitor and manage shareholder value.
The plan can be revisited each year to assure
an increase in shareholder value.

12
.2
5

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Recent development in capital evaluation

Applies concepts of financial options to real
assets
Acknowledges the flexibility in projects that
may never be taken into account with a
standard discounted cash flow analysis.

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Abandonment Option
Ability to walk away from an investment.

Option to Expand or Grow

Phased in approach to development. New shopping
mall example.

Option to Shrink
Build larger to take advantage of lower per unit cost,
but be prepared to downsize. Distribution center
example.

Option to Defer Development

Only take the steps necessary today to be able to
develop fully later. Retailer who buys the land and
defers development.

Switching Option
Ability to switch between products or for different uses.
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Chapter 13 discusses a firms cost of capital

which is critical to the valuation analysis.
Chapter 17 applies these topics and applies
these concepts to Mergers and Acquisitions.

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