Solution 9/27/2016 Chapter: 7 Valuation of Stocks and Corporations Problem: 23 V

Question

Solution 9/27/2016 Chapter: 7 Valuation of Stocks and Corporations Problem: 23 Value Drivers in the Free Cash Flow Valuation Model Traver-Dunlap Corporation's has a 15% weighted average cost of capital (WACC). Its most recent sales were $980 million and its total net operating capital is $870 million. The following shows estimates of the forecasted growth rates, operating profitability ratios, and capital requirement ratios for the next three years. All of these ratios are expected to remain constant after the third year. Use this information to answer the following questions. Estimated Data for Traver-Dunlap Corporation Forecast 1 2 3 Annual sales growth rate 20% 6% 6% Operating profitability (NOPAT/Sales) 12% 10% 10% Capital requirement (OpCap/Sales) 80% 80% 80% Tax rate 35% 35% 35% a. Use the data to forecast sales, net operating profit after taxes (NOPAT), total net operating capital (OpCap), free cash flow (FCF), growth rate in FCF, and return on invested capital (ROIC) for the next three years. What is the FCF growth rate for Year 3 and how does it compare with the growth rate in sales? What is the ROIC for Year 3 and how does it compare with the 15% WACC? Current Forecast Year 0 1 2 3 Sales $980 Net operating profit after taxes Total net operating capital $970 FCF = NOPAT – Investment in OpCap Growth in FCF ROIC = NOPAT/OpCap b. What is the value of operations at Year 3, Vop,3? What is the current value of operations, Vop,0? How does the value of operations at Year 0 compare with the total net operating capital at Year 3, and what might explain this relationship? Free cash flow at beginning of the constant growth phase (FCF3) = Weighted average cost of capital (WACC) = 15.00% Constant growth rate (gL) = HV3 = Vop, 3 = Present value of HV = Present value of free cash flows = Total value of operations at Year 0, Vop, 0 = c. Suppose the growth rates for Years 2, 3, and thereafter can be increased to 7%. What is the new value of operations? Did it go up or down? Why did it change in this manner? Sales growth rates after Year 1 = 7% Total value of operations at Year 0, Vop, 0 = Hint: Create a scenario and copy the new scenario's output as a value. d. Return the growth rates to the original values. Now suppose that the capital requirement ratio can be decreased to 60% for all three years and thereafter. What is the new value of operations? Did it go up or down relative to the original base case? Why did it change in this manner? Capital requirement ratios = 60% Total value of operations at Year 0, Vop, 0 = Hint: Create a scenario and copy the new scenario's output as a value. e. Leave the capital requirement ratios at 60% for all three years and thereafter, but increase the sales growth rates for Years 2, 3, and thereafter to 7%. What is the new value of operations? Did it go up or down relative to the other scenarios? Why did it change in this manner? Sales growth rates after Year 1 = 7% Capital requirement ratios = 60% Total value of operations at Year 0, Vop, 0 = Hint: Create a scenario and copy the new scenario's output as a value. Solution 9/27/2016 Chapter: 7 Valuation of Stocks and Corporations Problem: 23 Value Drivers in the Free Cash Flow Valuation Model Traver-Dunlap Corporation's has a 15% weighted average cost of capital (WACC). Its most recent sales were $980 million and its total net operating capital is $870 million. The following shows estimates of the forecasted growth rates, operating profitability ratios, and capital requirement ratios for the next three years. All of these ratios are expected to remain constant after the third year. Use this information to answer the following questions. Estimated Data for Traver-Dunlap Corporation Forecast 1 2 3 Annual sales growth rate 20% 6% 6% Operating profitability (NOPAT/Sales) 12% 10% 10% Capital requirement (OpCap/Sales) 80% 80% 80% Tax rate 35% 35% 35% a. Use the data to forecast sales, net operating profit after taxes (NOPAT), total net operating capital (OpCap), free cash flow (FCF), growth rate in FCF, and return on invested capital (ROIC) for the next three years. What is the FCF growth rate for Year 3 and how does it compare with the growth rate in sales? What is the ROIC for Year 3 and how does it compare with the 15% WACC? Current Forecast Year 0 1 2 3 Sales $980 Net operating profit after taxes Total net operating capital $970 FCF = NOPAT – Investment in OpCap Growth in FCF ROIC = NOPAT/OpCap b. What is the value of operations at Year 3, Vop,3? What is the current value of operations, Vop,0? How does the value of operations at Year 0 compare with the total net operating capital at Year 3, and what might explain this relationship? Free cash flow at beginning of the constant growth phase (FCF3) = Weighted average cost of capital (WACC) = 15.00% Constant growth rate (gL) = HV3 = Vop, 3 = Present value of HV = Present value of free cash flows = Total value of operations at Year 0, Vop, 0 = c. Suppose the growth rates for Years 2, 3, and thereafter can be increased to 7%. What is the new value of operations? Did it go up or down? Why did it change in this manner? Sales growth rates after Year 1 = 7% Total value of operations at Year 0, Vop, 0 = Hint: Create a scenario and copy the new scenario's output as a value. d. Return the growth rates to the original values. Now suppose that the capital requirement ratio can be decreased to 60% for all three years and thereafter. What is the new value of operations? Did it go up or down relative to the original base case? Why did it change in this manner? Capital requirement ratios = 60% Total value of operations at Year 0, Vop, 0 = Hint: Create a scenario and copy the new scenario's output as a value. e. Leave the capital requirement ratios at 60% for all three years and thereafter, but increase the sales growth rates for Years 2, 3, and thereafter to 7%. What is the new value of operations? Did it go up or down relative to the other scenarios? Why did it change in this manner? Sales growth rates after Year 1 = 7% Capital requirement ratios = 60% Total value of operations at Year 0, Vop, 0 = Hint: Create a scenario and copy the new scenario's output as a value.

Explanation / Answer

There were a lot of calculations involved. I was able to complete first two parts of the question within the available time.

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Part a)

The completed table is given as below:

The FCF growth rate of 6% for year 3 is same as growth rate in sales for year 3 (which is 6% only). The ROIC of 12.50% for year 3 is less than the WACC of 15%.

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Part b)

The value of various figures is determined as below:

The relationship between value of operations at Year 0 ($807.119) and net operating capital at Year 3 ($1,057.08) is on account of increase in ROIC. An increase in ROIC will result in an increase in the value of business operations.

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Part c)

Forecast Year Current 1 2 3 Sales 980.00 1,176.00 [980*(1+20%)] 1,246.56 [1,176*(1+6%)] 1,321.35 [1,246.56*(1+6%)] Net operating profit after taxes 141.12 (1,176*12%) 124.66 (1,246.56*10) 132.14 (1,321.35*10%) Total net operating capital 970.00 940.80 (1,176*80%) 997.25 (1,246.56*80%) 1,057.08 (1,321.35 *80%) FCF = NOPAT – Investment in OpCap 170.32 (141.12 + 970 - 940.80) 68.21 (124.66 + 940.80 - 997.25) 72.30 (132.14 + 997.25 - 1,057.08] Growth in FCF -60% [(68.21 - 170.32)/170.32*100] 6% [(72.30 - 68.21)/68.21*100] ROIC = NOPAT/OpCap 15.00% (141.12/940.80*100) 12.50% (124.66/997.25*100) 12.50% (132.14/1,057.08*100)

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