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L.E.K.

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Discounted Cash Flow Valuation Primer


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Copyright 2003 by L.E.K. Consulting. No part of this document may be reproduced without the express written permission of L.E.K. Consulting, LLC

Discounted Cash Flow Valuation Primer Table of Contents

I. II. III. IV. V. VI. VII. VIII. IX.

Introduction.......................................................................... Overview of the Discounted Cash Flow Methodology ...... Calculating Cash Flow From Operations................ Forecasting Operating Cash Flows................. Calculating the Cost of Capital ......................................... Estimating Residual Value.................................................. Identifying the Present Value of Non-Operating Assets. Calculating the Market Value of Debt and Other Obligations Summary.............................................................

3 4 5 11 16 18 20 20 20

Appendix I:

Value Driver Reference Sheets.......................

22 24 25

Appendix II: Using the L.E.K. Valuation Toolkit........................ Appendix III: Glossary of Terms...................................................

Discounted Cash Flow Valuation Primer


I. Introduction Business professionals require accurate business valuations to make a broad range of decisions. Investors and corporate development professionals need precise valuations to make buy/sell decisions. CEOs, CFOs and operating managers need to assess how proposed changes in operating or financing strategies impact value. Advisors to businesses use valuation to identify opportunities to improve the economic position of their clients and demonstrate the value added by their recommendations. There are many approaches to valuing companies, each of which requires different inputs. Some of the common approaches are: Approach Comparable Multiples Transaction Multiples Asset Valuation Description Uses current market prices of peer businesses as a ratio of their Sales, EBIT, EBITDA, etc., to estimate current business prices Uses deal prices of peer businesses that recently sold as a ratio of their Sales, EBIT, EBITDA, etc., to estimate acquisition prices Uses current market values of assets and liabilities to estimate liquidation values Discounted Cash Uses long-term cash flows and risk to calculate current or Flow (DCF) acquisition values of businesses Of these approaches, discounted cash flow valuation (DCF) is by far the most useful and widely applied methodology for valuing businesses. Extensive research exists to support the notion that both public and privately owned businesses are valued based on long-term cash flows and risk: the primary components of DCF valuation. Unlike multiples analyses, DCF can be used to calculate the value of a business to a specific owner, not just the price they might have to pay to buy it. Unlike asset approaches, DCF estimates the value of a business as a going concern, not merely its liquidation value. Unlike both multiple and asset approaches, it can be used to link proposed changes in operating and financing strategies to their impacts on value. While DCF is often the preferred method of valuing businesses, it is highly dependent upon expected future cash flows. Because reasonable people may disagree about those expectations, different values may result. In the financial markets, investors different expectations drive an auction process that results in an equilibrium price for each company's stock. In addition, an accurate forecast of a business expected cash flows depends on an understanding of its competitive position and proposed strategy going forward. The more precise the required valuation, the deeper this

understanding needs to be. Once this strategic work is completed, the DCF methodology is used to translate forecasted cash flows into an estimate of value. However, applying the DCF framework requires an understanding of how to resolve several issues such as defining cash flows, choosing a forecast period, calculating a cost of capital, and estimating a residual value. The compelling benefits of DCF analysis have made resolving these issues well worth the effort. Over the last twenty years, practitioners of DCF have converged on common approaches to resolving these issues and common processes for performing DCF analysis. The goal of this primer is to provide a practical overview of todays common DCF valuation methodology. II. Overview of the Discounted Cash Flow Valuation Methodology The fundamental premise of the DCF methodology is that the value of any economic asset is equal to the present value of the expected future operating cash flows that are free to be paid to its owner(s). Since a business is owned by its debt and equity holders, its value is the combined value of its debt and equity. The value of the whole business is called corporate value, while the equity portion is called shareholder value. Equation 1. Corporate Value = Debt + Shareholder Value

To be precise, debt includes the market value of all debt instruments and all other non-operating liabilities of the firm with a prior claim to shareholders. What remains after prior claimants are paid is the value of a business to its equity owners: its shareholder value. Equation 2. Shareholder Value = Corporate Value - Debt

Therefore, to arrive at shareholder value we must first calculate corporate value. Corporate value consists of three components: a. the sum of present value of cash flows from operations throughout a forecast period. The cash flows are discounted by the firm's cost of capital, the rate of return required by investors, which takes into account the cash flows' risk and the time value of money. b. the present value of the residual value, which represents the value of the firm beyond the forecast period. c. the present value of non-operating assets. Since the cash flows in a. and b. above are cash flows from operations, any non-operating assets will be missing. Therefore, the current value of investment holdings such as marketable securities, over-funded pension plans and investments in other subsidiaries must be included.

Replacing Corporate Value in Equation 2 with these three components, we have: Equation 3. A

A PV of Shareholder = Forecast + Value Cash Flows

B PV of Residual Value

C NonOperating Assets

D Market Value of Debt

The remainder of this primer will discuss each of these components in detail. Calculating the present value of forecast cash flows (Box A) requires calculating cash flows, forecasting cash flows and calculating the cost of capital used to discount them. The next three sections cover those topics. III. Calculating Cash Flow from Operations The first step in calculating the value of a business using DCF is to forecast the expected cash flows from operations in each year of a forecast period. These represent the cash flows available to all capital providers, which will then be discounted at a cost of capital which reflects the weighted average cost of financing from both debt and equity holders. The reason for calculating cash flows from operations, which are available to all investors, is to separate operating decisions from financing decisions. In this manner, the impact of operating strategies are reflected in the cash flows and the impact of financing strategies are explicitly reflected in the cost of capital and in the value of debt (Box D above). With this approach, cash flows from operations do not include interest or principal repayments, nor do they include cash flows from other non-operating activities. Interest expense and principle repayments will be taken into consideration explicitly in the cost of debt portion of the weighted average cost of capital, and in the calculation of market value of debt (Box D above). Cash flows from non-operating activities will be valued in the present value of non-operating investments (Box C above). Cash flow from operations is defined as follows: Revenues Operating Expenses Operating Profit Cash Taxes on Operating Profit Net Operating Profit After Tax (NOPAT) Incremental Fixed Capital Expenditures Incremental Working Capital Investment Cash Flow From Operations

= = =

Revenues: Only revenues from operations are used. Operating Expenses: These are cash operating expenses, which typically include items such as cost of goods sold and selling, general and administrative expenses. In addition, the amount of fixed capital expenditure that would be necessary to sustain the current level of operations (called economic depletion) is also subtracted. To estimate this amount, one frequently used assumption is that economic depletion is equal to the amount of depreciation. The primary reason this subtraction is made has to do with the calculation of residual value. If a NOPAT perpetuity approach is used for residual value (as we will suggest it often should be), it is necessary to subtract the amount of fixed capital investment necessary to sustain the current level of NOPAT. This amount is by definition economic depletion (more about this when we address residual value). For example, lets calculate operating expenses for Acme Corporation based on the following information from its 2002 income statement. Acme Corporation 2002 (millions) Revenue Cost of Goods Sold (not including Depr.) Selling General & Admin. Expense Other Operating Expenses Depreciation Interest Expense Interest Income Income Before Taxes $250.000 196.354 17.138 21.708 1.300 4.102 1.138 $10.536

In this instance, operating expenses would be calculated in the following manner, assuming that depreciation was a fair proxy for economic depletion in that year: Operating Expenses = COGS + SG&A + Other Op. Exp. + Economic Depletion = 196.354 + 17.138 + 21.708 + 1.300 = $236.500 Interest income usually arises from non-operating assets, such as marketable securities. Accordingly it is included in the market value of non-operating assets (Box C) and excluded from operating cash flows. Interest expense is not included in operating profit because is the result of debt, a financing choice. Instead, it is included in the market value of debt (Box D).

Cash Taxes on Operating Profit: In keeping with the approach of capturing only the cash flows from operations, cash taxes is the yearly amount of cash a company would pay on its operating profit only. This is the amount of cash taxes a company would pay if it had no non-operating income or expenses. The process for calculating cash taxes on operating profit is to begin with Income Before Taxes as shown on the income statement, calculate book taxes on the operating profit portion of taxable income and then adjust for changes in deferred taxes. The first step in the process is to calculate taxes on the operating profit portion of taxable income. Continuing with our Acme example: Book Tax Rate x x x 33.37% 33.37% 33.37% = = = Book Tax $3.516 $1.369 $0.380 $4.505

Item Income Before Taxes + Interest Expense - Interest Income Operating Profit

Amount $10.536 $4.102 $1.138 $13.500

The $4.505 represents the "accounting" taxes on operating profit. To calculate cash taxes, the effect of changes in deferred taxes must be removed from this amount. Remember that deferred taxes represents differences between taxes calculated for the IRS and taxes calculated for accounting purposes. In this example, if deferred tax liabilities, as read on the balance sheet, had increased by $0.455 from the previous year, it would mean that taxes calculated for accounting purposes exceeded cash taxes paid to the IRS, and that the $4.505 amount calculated above must be reduced by that amount. Therefore, for Acme: Cash Taxes on Operating Profit = $4.505 - $0.455 = $4.050 Incremental Fixed Capital Expenditures: The amount of money a firm spends in a given year for fixed capital additions, net of monies received on the sale of assets, must be subtracted in calculating the cash flows from operations in a given year. The required information can be found in a company's cash flow statements and is typically calculated as follows: Fixed Capital Expenditures + Purchases of Businesses - Proceeds From Sale of Assets = Total Fixed Capital Expenditures Total capital expenditures includes, by definition, expenditures for sustaining the current level of operations or economic depletion. Since that amount has already been included in operating expenses, it must be netted out of total fixed capital expenditures, as shown in the calculation of cash flow from operations. The resulting
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amount represents incremental fixed capital expenditures, which can be thought of as the amount of fixed capital the business invests to expand current operations from their current levels or improve efficiency. Acme Corporation, 2002 Total Fixed Capital Expenditures - Economic Depletion = Incremental Fixed Capital Expenditures $2.700 $1.300 $1.400

Incremental Working Capital Investment: For most companies with growing sales, investments must be made in working capital. This represents a use of operating cash flow. The investment amount is calculated by measuring the difference in working capital from year to year. This information is readily available on the balance sheet, but must be modified slightly to capture only operating working capital. Assume that a balance sheet shows the following working capital accounts:

Acme Corporation 2002 Current Assets Cash Marketable Securities Accounts Receivable Inventory Other Operating Current Assets Total Current Assets 2001

$1.378 $1.217 1.000 0.900 10.430 9.161 14.379 12.745 4.157 4.708 $31.896 $28.180

Current Liabilities Accounts Payable $4.796 Notes Payable 0.000 Current Portion L.T. Debt 4.102 Income Taxes Payable 0.357 Other Operating Current Liabilities 1.037 Total Current Liabilities $10.292

$4.212 0.000 3.944 0.313 0.911 $9.380

While all these amounts are considered to be working capital for accounting purposes, a number of the items are financing in nature, and must be excluded to arrive at operating working capital. Specifically, notes payable and current portion of long-term debt are financing instruments and are excluded from this calculation. Marketable securities are considered to be non-operating assets and are also excluded from the calculation of operating working capital. A distinction is made between operating cash and marketable securities. To properly capture the economics of working capital, operating cash is defined, regardless of accounting convention, as
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money that the firm must have invested in the business to meet its obligations. It can be considered as the "float" a business must maintain. This money is unavailable to invest elsewhere and, like inventory, is considered to be operating working capital. Marketable securities are monies that a business has on hand (it doesn't necessarily have to be invested in marketable securities) which could be returned to shareholders without affecting the operating strategy or cash cycle. It is a financing choice which companies can make to accumulate cash and draw it down when required. Hence, marketable securities are not included in incremental working capital investment and are included in non-operating investments (Box C in Equation 3). Of course, the accounting definitions of cash and marketable securities don't necessarily meet the economic definitions above, and consequently, some adjustments might need to be made. In practice, the accounting distinction between cash and marketable securities is often taken as the economic distinction. If better information can be obtained to arrive at the economic distinction between cash and marketable securities, those amounts should be used. Therefore, Acmes incremental working capital for 2002 is calculated as follows: Acme Corporation 2002 Current Assets Cash Marketable Securities Accounts Receivable Inventory Other Operating Current Assets Total Operating Current Assets Current Liabilities Accounts Payable Notes Payable Current Portion L.T. Debt Income Taxes Payable Other Operating Current Liabilities Total Operating Current Liabilities Total Operating Working Capital Incremental Working Capital 2001

Excluded

$1.378 $1.217 1.000 0.900 10.430 9.161 14.379 12.745 4.708 4.157 $30.896 $27.280

Excluded Excluded

$4.796 0.000 4.102 0.357 1.037 $6.190

$4.212 0.000 3.944 0.313 0.911 $5.436

$24.706 $21.844 $2.862

Acme invested $2.862 million in operating working capital in 2002.

Finally, we combine each component to calculate Acmes 2002 cash flow from operations. Acmes 2002 Cash Flow from Operations (millions) $250.000 Operating Expenses 236.500 13.500 Operating Profit Cash Taxes on Operating Profit 4.050 17.550 Net Operating Profit After Tax (NOPAT) Incremental Fixed Capital Expenditures 1.400 Incremental Working Capital Investment 2.862 $13.288 Cash Flow From Operations

= = =

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IV. Forecasting Operating Cash Flows Having calculated last years cash flow, we now need to find a means of forecasting cash flows. As we mentioned earlier, significant strategic analysis is necessary to determine what operating cash flows a business might generate in the future. Once this work is done, five primary value drivers can be used to characterize cash flows going forward and link them to anticipated strategies. Value Driver Sales Growth Rate (G) Operating Profit Margin (P) Cash Tax Rate (T) Incremental Fixed Capital Percentage (F) Calculation = Compound Annual Growth Rate = Operating Profit Sales = Cash Taxes on Operating Profit Operating Profit = (Total Fixed Capital Inv. Economic Depletion) Change in Sales

Incremental Working Capital Change in Operating Working Capital = Change in Sales Percentage (W) The first three value drivers are both intuitive and easily calculated. Just make sure to include economic depletion as an operating cost, and make sure to calculate cash taxes as described in the last section. Incremental fixed and working capital can be a bit more challenging. They can be thought of as the amount the business must invest (above economic depletion in the case of incremental fixed capital) for each dollar of forecast sales growth. For instance, if the incremental working capital investment rate is 19%, it implies that for every new dollar in sales a business generates, it must invest $0.19 in working capital. The Value Driver Reference Sheets included in this document as Appendix I provide a quick source for value driver formulas. For example, the following information can be used to calculate Acmes value drivers for 2002.

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Acme Corporation Selected Financial Information ($ millions) Sales Operating Profit Cost of Goods Sold (COGS) +SG&A +Other Operating Expenses =Total Costs Operating Profit Operating Cash Taxes Income Tax Provision +Interest Tax Shield -Tax on Non-Operating Income -Incr. Non Deferred Tax Liability =Operating Cash Taxes Incremental Fixed Capital Total Fixed Capital Investment -Depreciation =Incremental Fixed Capital Incremental Working Capital Cash +Accounts Receivable +Inventory +Other Operating Current Assets =Total Operating Current Assets Accounts Payable +Income Taxes Payable +Other Operating Current Liabilities =Total Operating Current Liabilities Incremental Working Capital

2001 2002 $224.215 $250.000

176.519 15.305 19.386 211.211 13.004

197.655 17.138 21.708 236.500 13.500

3.061 1.192 0.330 0.397 3.526

3.516 1.369 0.380 0.456 4.050

2.500 1.300 1.200

2.700 1.300 1.400

1.217 9.161 12.745 4.157 27.280 4.212 0.313 0.911 5.436 2.683

1.378 10.430 14.379 4.708 30.896 4.796 0.357 1.037 6.190 2.862

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Value Driver Sales Growth Rate (G) Operating Profit Margin (P) Cash Tax Rate (T) Incr. Fixed Capital % (F)

Calculation ($250.000-$224.215) $224.215 = 11.5 % $13.500 $250.000 = 5.40% $4.050 $13.500 = 30.00% $1.400 ($250.000 - $224.215) = 5.43%

Incr. Working Capital % (W) $2.862 ($250.000 $224.215) = 11.10% Once appropriate value drivers are calculated, they can be used to forecast cash flow from operations, which avoids the need to model complete income statements, balance sheets and cash flow statements. For example, if we assume that Acmes 2002 value drivers will stay the same throughout the next five years (a naive assumption that we will soon improve upon), the value drivers can be used to generate the following cash flow forecast. Cash Flow Forecast for Acme Using Constant Value Drivers ($ millions, except per share data) 2002 2003 2004 2005 2006 2007

Sales (11.50% Growth Rate) $250.00 Operating Expenses ((1 5.40%) of Sales) Operating Profit (5.40% of Sales) Cash Taxes (30.00% of Operating Profit) Net Operating Profit After Tax (NOPAT) Incremental Fixed Capital Investment (5.43% of Change in Sales) - Incremental Working Capital Investment (11.10% of Change in Sales) = Cash Flow From Operations = = -

$278.8 $310.8 $346.5 $386.4 $430.8 263.7 294.0 327.8 365.8 407.6 $15.1 $16.8 $18.7 20.9 23.3 4.5 5.0 5.6 6.3 7.0 $10.5 $11.7 $13.1 $14.6 $16.3 1.6 3.2 $5.8 1.7 3.6 $6.4 1.9 4.0 $7.2 2.2 4.4 $8.0 2.4 4.9 $8.9

A more sophisticated approach would be to think through Acmes competitive position and strategy and estimate its impact on each year of the forecast. Instead of assuming that the value drivers remain constant throughout the forecast, you could calculate how the value drivers change in each period. Assuming your strategic analysis lead you to believe that the following forecast information was realistic, you could calculate the following period-by-period forecast value drivers:

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Value Driver Calculations


Company Name: Scenario: Units: First Historical Year Last Historical Year Year Sales Operating Profit Cost of Goods Sold (COGS) + SG&A + Other Operating Expenses = Total Costs Operating Profit Operating Cash Taxes Income Tax Provision + Interest Tax Shield - Tax on Non-Operating Income - Incr. in Deferred Tax Liability = Operating Cash Taxes Incremental Fixed Capital Total Fixed Capital Investment - Depreciation = Incremental Fixed Capital Incremental Working Capital Cash + Accounts Receivable + Inventories + Other Operating Current Assets = Total Operating Current Assets + + + = Accounts Payable Income Taxes Payable Other Operating Current Liabilities Total Operating Current Liabilities Incremental Working Capital Value Drivers Sales Growth (G) Operating Profit Margin (P) Operating Cash Tax Rate (T) Incr. Fixed Capital Investment (F) Incr. Working Capital Investment (W) 2000 5.00% 27.13% Acme Corporation Base Case $ millions 2000 2002 2000 201.090 2001 224.215 2002 250.000 2003 280.000 2004 313.600 2005 348.096 2006 382.906 2007 417.367

159.658 13.843 17.535 191.035 10.054

177.643 15.403 19.510 212.556 11.659

197.655 17.138 21.708 236.500 13.500

219.969 19.072 24.158 263.200 16.800

243.744 21.134 26.770 291.648 21.952

270.836 23.335 29.558 323.729 24.367

300.663 26.148 33.120 359.931 22.974

329.098 29.735 37.665 396.499 20.868

2.369 0.922 0.256 0.307 2.728

3.061 1.192 0.330 0.397 3.526

3.516 1.369 0.380 0.456 4.050

5.251 2.044 0.567 0.680 6.048

6.861 2.671 0.741 0.889 7.903

7.616 2.965 0.822 0.987 8.772

7.181 2.796 0.775 0.930 8.271

6.523 2.539 0.704 0.845 7.513

2.500 1.300 1.200

2.700 1.300 1.400

2.809 1.309 1.500

3.146 1.466 1.680

3.229 1.505 1.725

3.259 1.518 1.740

3.226 1.503 1.723

1.066 7.975 11.212 3.641 23.894 3.667 0.273 0.793 4.733

1.217 9.161 12.745 4.157 27.280 4.212 0.313 0.911 5.436 2.683 2001 11.50% 5.20% 30.24% 5.19% 11.60%

1.378 10.430 14.379 4.708 30.896 4.796 0.357 1.037 6.190 2.862 2002 11.50% 5.40% 30.00% 5.43% 11.10%

1.586 11.817 16.247 5.210 34.860 5.543 0.412 1.199 7.154 3.000 2003 12.00% 6.00% 36.00% 5.00% 10.00%

1.840 13.563 18.106 5.891 39.400 6.457 0.481 1.397 8.334 3.360 2004 12.00% 7.00% 36.00% 5.00% 10.00%

2.134 15.617 20.109 6.357 44.217 7.517 0.559 1.626 9.702 3.450 2005 11.00% 7.00% 36.00% 5.00% 10.00%

2.497 17.943 21.582 7.362 49.384 8.823 0.657 1.908 11.388 3.481 2006 10.00% 6.00% 36.00% 5.00% 10.00%

2.948 20.665 22.919 8.393 54.926 10.447 0.777 2.259 13.484 3.446 2007 9.00% 5.00% 36.00% 5.00% 10.00%

(These calculations were performed using the Value Drivers worksheet of the L.E.K. Valuation Toolkit. See Appendix II on p. 24.)

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You could then use Acmes period-by-period value drivers to calculate a more sophisticated forecast of operating cash flows:

Shareholder Value Calculator


Company Name: Scenario: Units: Shareholder Value Shareholder Value Per Share Value Growth Duration (Years) Residual Value Approach or Value Value Drivers: Historical Sales Sales Growth (G) Operating Profit Margin (P) Operating Cash Tax Rate (T) Incremental Fixed Capital Investment (F) Incremental Working Capital Investment (W) Cost of Capital (K) Non-Operating Assets Market Value of Debt Number of Shares Outstanding Operating Cash Flows & Value: Sales Operating Costs Operating Profit Cash Taxes Net Operating Profit After Taxes (NOPAT) Fixed Capital Investment Working Capital Investment Cash Flow (CF) Acme Corporation Base Case $ millions $100.0 $10.00 5 NOPAT/K 2002 $250.0 2003 12.00% 6.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2004 12.00% 7.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2005 11.00% 7.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2006 10.00% 6.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2007 9.00% 5.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000

$250.0

280.0 263.2 16.8 6.0 10.8 1.5 3.0 6.3

313.6 291.6 22.0 7.9 14.0 1.7 3.4 9.0

348.1 323.7 24.4 8.8 15.6 1.7 3.4 10.4

382.9 359.9 23.0 8.3 14.7 1.7 3.5 9.5

417.4 396.5 20.9 7.5 13.4 1.7 3.4 8.2

(These calculations were performed using the Shareholder Value worksheet of the L.E.K. Valuation Toolkit. See Appendix II on p. 24.) Having forecast operating cash flows, we now need to calculate the cost of capital that will be used to discount them.

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V. Calculating the Cost of Capital The sixth value driver is the cost of capital: the weighted average return required by a business debt and equity investors. It is also the rate of return necessary for a business or investment to create value. This makes estimating an appropriate cost of capital critically important in DCF analysis. It is calculated by weighting the cost of equity and the after-tax cost of debt by the target blend of debt and equity in a business' capital structure. Equation 5. where: Cost of Capital = KE KD T % Equity % Debt Total Capital = = = = = = (% Equity) x (KE) + (% Debt) x (KD) x (1-T) Cost of Equity Cost of Debt Marginal Tax Rate Equity Total Capital Debt Total Capital Debt + Equity

Cost of Debt: This is the after-tax cost of debt capital to a business. The market yield to maturity on debt is used since it reflects the current return demanded by debt holders and the rate at which existing debt would have to be replaced. Since longterm cash flows are being discounted, the long-term yield to maturity of both existing and new debt is used, not the short-term rate. Cost of Equity: The most common method of calculating the cost of equity is the Capital Asset Pricing Model (CAPM). The CAPM states that equity investors require, at a minimum, a return equal to the risk free rate to invest in any security. In addition, if a security is riskier than the risk free rate, investors demand a premium. The formulation is as follows: Equation 6. Cost of Equity = Risk Free Rate + (Beta x Market Risk Premium)

A. Risk Free Rate This is the rate of return investors expect from holding "safe" investments such as long-term government securities, which are considered virtually free of any risk of default. Historically, the 30-year U.S. government bond yield was used. However, since the government is no longer issuing debt of this maturity, the 10-year U.S. government bond yield is now used.

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B. Market Risk Premium The market risk premium is the additional rate of return equity investors require over the risk free rate for bearing the higher level of systematic risk inherent in the market equity portfolio. It is calculated by subtracting the expected long-term risk free rate from the expected market return. While it changes over time, the market risk premium hovers around 5.0% - 7.0%. C. Beta Individual stocks can be more or less risky than the overall market. Hence the market risk premium must be adjusted by a measure that represents an individual stock's riskiness relative to the market portfolio. The riskiness of a stock, measured by the covariance of its returns relative to the market's, is indicated by an index called Beta. If a company's Beta is equal to 1, it indicates that on average, the stock's returns fluctuate step for step with the market's return. If a company's Beta is greater than 1, it indicates that the stock's returns vary more than the market's return and that its risk exceeds that of the market as a whole. The opposite is true if a company's Beta is less than 1. Combining these factors for Acme results in a cost of equity of 11.00%. Cost of Equity = Risk Free Rate + (Beta x Market Risk Premium) = 4.50% + (1.00 x 6.50%) = 11.00% Capital Structure: The proportion of debt and equity employed in the cost of capital calculation should be the market-weighted amounts of debt and equity that a business expects to utilize in the future. Once calculated, these components can be combined to estimate the cost of capital. For example, the Acmes cost of capital is calculated as follows: Cost of Capital = (% Equity) x (KE) + (% Debt) x (KD) x (1-T) = (90.25% x 11.00%) + 9.75% x [8.5% x (1 36.00%)] = 10.46% The resulting cost of capital can be used to discount forcasted cash flows. However, since it is also used to discount the residual value, we now turn to that topic.

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VI. Estimating Residual Value Residual value is the value of a business at the end of the forecast period. The size of the residual value and the approach used to calculate it depend upon the optimal strategy for the business at the end of the forecast period. For example, if a business has harvested its operations during the forecast period by failing to invest in fixed capital and other assets necessary to support the business long-term, the optimal strategy at the end of the forecast period might be to liquidate the assets. In that case, residual value would be calculated as the market value of the business assets minus the market value of its liabilities. More commonly, if a business has made investments to support a long-term strategy, the optimal strategy is to continue operations. In this situation a liquidation value would understate the going concern value of the business and another approach must be used. For businesses that are expected to be ongoing entities, the perpetuity method is the most compelling. As the name suggests, this approach assumes that cash flows continue in perpetuity after the forecast period. However, instead of forecasting each successive years cash flows independently, a formula is applied to calculate the present value of all cash flows beyond the forecast period. The present value of any perpetuity of cash flows is: Present Value of a Perpetuity = Annual Cash Flow Cost of Capital But what level of cash flows should be anticipated in perpetuity? To answer this question we will need to make some assumption about the level of investment and the value created from those investments going forward. The most common and economically justifiable assumption for most businesses is that Net Operating Profit After Taxes in the last forecast period (NOPATL) is the appropriate level of cash flows for the residual value calculation. If for any reason the last forecast year's NOPAT is not representative of what a business would generate into perpetuity, it should be normalized. Residual Value = NOPATL Cost of Capital The implicit assumption of this approach is that all new investments (i.e., investments in fixed and working capital over economic depletion) will neither create nor destroy value after the forecast period. This approach is based on the economic reality that (non-monopolistic) businesses that generate returns greater than the cost of capital will attract competitors. This eventually drives returns down to the cost of capital: the minimum required rate of return for investors.

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This is not to say that a business will not be able to earn returns above the cost of capital after the forecast period. It means that as investors value a business today, they are not willing to pay a price that assumes it will create value beyond the forecast period. Also, despite the NOPAT/K formula, this method does not imply that NOPAT after the forecast period will be constant. It merely reflects the economic implication that although a business will continue to make investments and generate cash flows beyond the forecast period, the value of the firm will not be affected by those investments because their rate of return will be equal to the cost of capital (i.e., their net present value will be zero). Since the perpetuity residual value is the value at the end of the last forecast period, it must be discounted by the cost of capital to calculate the present value of the residual value. Equation 4. Where:
PV of Residual Value = (NOPATL Cost of Capital) (1 + Cost of Capital)N

NOPATL N

= =

NOPAT in last forecast period Length of forecast period

The forecast period should also be chosen to be consistent with this approach. It should be number of periods investors would be willing to bet that a business will be able to earn above its cost of capital (i.e., create value) under the anticipated strategy. This, in turn, is a function of the strength of the business competitive position and strategy going forward. Note that this period of time is often different than a standard 5 years or the number of periods of information available. When determined in this manner, the forecast period is called the Competitive Advantage Period or Value Growth Duration. For example, if 5-year value growth duration is appropriate for Acme, NOPAT in the fifth year is $13.350 million, and its cost of capital is 10.46%, Acmes present value of residual value would be calculated as follows: PV of Residual Value = ($13.350 .1046) (1.1046)5 = $77.6 million

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VII: Identifying the Present Value of Non-Operating Assets To arrive at corporate value, non-operating assets (Box C in Equation 3) must be added to the present value of all future cash flows from operations. These include the current market values of marketable securities, investments in stocks and bonds, investment in subsidiaries whose cash flows have not been included in cash flows from operations, over-funded pension plans and other non-operating assets.

VIII. Calculating the Market Value of Debt and Other Obligations Finally, to arrive at shareholder value, any liabilities that have a prior claim on the assets of a business (Box D) must be subtracted from corporate value. These obligations typically include the current market value of long- and short-term debt, preferred stock and under-funded pension plans. The expected value of contingent liabilities, such as legal cases pending or potential site remediation efforts must also be subtracted.

IX. Summary We have now discussed each of the primary components of DCF analysis. Equation 3. A

A PV of Shareholder = Forecast + Value Cash Flows

B PV of Residual Value

C NonOperating Assets

D Market Value of Debt

On the next page each of these components is used to calculate Acme Corporations shareholder value. Our goal has been to provide a practical overview of DCF methodology. Greater detail and answers to remaining questions you might have will be provided in our upcoming program. We look forward to meeting you.

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Shareholder Value Calculator


Company Name: Scenario: Units: Shareholder Value Shareholder Value Per Share Value Growth Duration (Years) Residual Value Approach or Value Value Drivers: Historical Sales Sales Growth (G) Operating Profit Margin (P) Operating Cash Tax Rate (T) Incremental Fixed Capital Investment (F) Incremental Working Capital Investment (W) Cost of Capital (K) Non-Operating Assets Market Value of Debt Number of Shares Outstanding Operating Cash Flows & Value: Sales Operating Costs Operating Profit Cash Taxes Net Operating Profit After Taxes (NOPAT) Fixed Capital Investment Working Capital Investment Cash Flow (CF) Discount Factor Present Value (PV) of CF Cumulative PV of CF Residual Value (NOPAT Perpetuity Method) PV of Residual Value Non-Operating Assets Corporate Value Market Value of Debt Shareholder Value (SHV) Share Price Acme Corporation Base Case $ millions $100.0 $10.00 5 NOPAT/K 2002 $250.0 2003 12.00% 6.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2004 12.00% 7.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2005 11.00% 7.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2006 10.00% 6.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000 2007 9.00% 5.00% 36.00% 5.00% 10.00% 10.46% $1.00 $10.80 10.000

$250.0

280.0 263.2 16.8 6.0 10.8 1.5 3.0 6.3 0.9053 5.7 5.7

313.6 291.6 22.0 7.9 14.0 1.7 3.4 9.0 0.8196 7.4 13.0

348.1 323.7 24.4 8.8 15.6 1.7 3.4 10.4 0.7420 7.7 20.8

382.9 359.9 23.0 8.3 14.7 1.7 3.5 9.5 0.6717 6.4 27.1

417.4 396.5 20.9 7.5 13.4 1.7 3.4 8.2 0.6081 5.0 32.1 127.7 77.6 1.0 110.8 10.8 $100.0 $10.00

(These calculations were performed using the Shareholder Value worksheet of the L.E.K. Valuation Toolkit. See Appendix II on p. 24.)

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Appendix I: Value Driver Reference Sheets


Value Driver Sales Growth (G) Description Sales growth rate anticipated during the forecast period Pre-Tax Operating profits as a percent of Sales Cash Taxes that would have been paid if the firm had no debt as a percent of Operating Profits Formula Hints

Future Sales G = Last Historical Sales Where: N = # years

1 N

-1

Calculate this rate using % Growth, exponent, or PV, FV keys on a calculator Subtract economic depletion of assets in OP. Exp. (or use Depreciation as a proxy). Interest Tax Shield is the tax savings resulting from Debt (Interest Expense x Tax Rate) The tax advantage of debt will be included in valuations by using the after-tax cost of debt in the weighted average cost of capital. Not in cash flows. Depreciation can be used as a proxy for Economic Depletion of Assets.

Operating Profit Margin (P) Cash Tax Rate (T)

P=

Sales Op. Expenses Sales

T = Cash Taxes / Op. Profit Where Cash Taxes = + Book Taxes - Non. Operating Taxes + Interest Tax Shield - Incr. In Deferred Tax Liability

Incremental Fixed The addition to fixed Capital Investment capital, over and above (F) economic depletion, as a percent of change in sales Incremental Working Capital Investment (W) The addition to operating working capital as a percentage of change in sales

( Total Cap. Expenditure - ) Economic Depletion F=


Change in Sales W=
Ch. in Working Capital Change in Sales

Exclude cash not necessary for operations (add it to non-operating assets). Exclude Short Term Debt Exclude Deferred Taxes

Where Working Capital = Operating Current Assets (-) Operating Current Liabilities

Value Driver Cost of Capital (K)

Description The weighted average return that a company's debt and equity holders require given the levels of risk of their investments

Formula K = [K x %Eq] + [K x (1-T) x %Debt] d e Where: K = Cost of Equity = Risk-free Rate + (Beta x MRP) K = Cost of Debt d T = Cash Tax Rate %Eq = Equity/(Debt + Equity) %Debt = Debt/(Debt + Equity)

Hints For public companies get Beta from published sources. Use peer group analysis for private firms/divisions. Betas may need to be relevered if the target capital structure of peers differs from that of the firm being valued. Cost of debt is the weighted average yield to maturity for public firms. Use comparables or bond rating analysis for private firms. %Eq and %Debt should be the firm's target capital structure for the future. Use Market values for debt and equity.

Number of Forecast Periods (N) (Value Growth Duration)

The number of periods investors today are willing to bet the firm being valued will be able to create value with its current strategy

Estimate qualitatively by asking how long it would take for a company to enter the industry, emulate the strategy and "compete away" the firm's advantage. OR Estimate quantitatively by using market signals analysis

Consider: Proprietary Technologies Distribution Channels Patented Products Product Life Cycles Established Brands Other Competitive Advantages

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Appendix I (contd): Value Driver Reference Sheets

Value Driver Residual Value (RV)

Description The value of a firm after the forecast period (N)

Formula If returns = K after the fcst period: RV = NOPAT / K If value is created in perpetuity:

Hints Returns equal K is almost always the best assumption for going concerns. Value creation in perpetuity should only be used for monopolies and other instances where an advantage can never be competed away. Don't forget to take the present value of residual value. Use market values or recently appraised values to estimate non-operating assets.

RV =

CFT + 1 (K - G)

If firm will be sold after fcst period: RV = After-tax Sale Price Anything that has NOA = Marketable Securities value that has + Real Estate not been + Investments in Affiliates included in Working Capital or cash flows Anything that could detract from the value of the firm to shareholders not reflected in cash flows MVD = Mkt. Value of Debt Instruments + Underfunded Pensions + Environmental Liabilities + Litigation Liabilities

Non-Operating Assets (NOA)

Market Value of Debt (MVD) and other obligations

Use market values, recently appraised values or expected values to estimate market value of debt. Any time the yield to maturity is different than the coupon rate, book value will misstate market value for debt.

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Appendix II: Using the L.E.K. Valuation Toolkit Because value driver, cash flow and shareholder value calculations can become tedious to do by hand, you have been provided with the L.E.K. Valuation Toolkit which performs these, and other useful calculations for you. The Toolkit contains the following worksheets and employs certain conventions as follows:

L.E.K. Valuation Toolkit


Version: January 1, 2003 Welcome to the L.E.K. Valuation Toolkit. This model is designed to help you quickly assess a business' value, identify its primary value drivers, and choose an appropriate capital structure. It contains several worksheets: Sheet Value Drivers ValueLine Peer Group Beta Shareholder Value Sensitivities Analysis Economic Profit Current Multiples Transaction Multiples Capital Structure Peer Group Cap. Struct. Description Calculates value drivers from historical and forecast financial information Calculates value drivers from information on a ValueLine Report Relevers Betas for use in peer group cost of equity analysis Calculates shareholder value based on value drivers input from either the Value Drivers or ValueLine worksheets or drivers that are entered directly Identifies which drivers have the largest impact on shareholder value Calculates value created in any year for which information is provided Calculates current prices based on multiples Calculates acquisition prices based on past transactions Assesses an appropriate capital structure based on "downside" cash flows Calculates debt to total capital ratios for peers using book and market numbers Buttons with These must be pressed to calculate an answer Blue Text

It also employs the following conventions: Conventions: Blue Text Black Text These cells are inputs. You may enter values. These cells are formulas. They are protected and cannot be modified.

Buttons with These either select inputs or reset inputs Black Text

The value driver, cash flow and valuation calculations for Acme shown in this document were performed using the Value Drivers and Shareholder Value worksheets of the Toolkit. To switch from one worksheet to another, click on the appropriate worksheet name listed in the tabs located on the bottom of your Excel screen. The value drivers from the Value Driver worksheet were imported into the Shareholder Value worksheet by clicking the button at the top of the Shareholder Value worksheet that says Use Input from Value Driver Sheet. The Toolkit is a Microsoft Excel template, which operates exactly as a standard *.xls file except that it creates a new file name each time it is opened so that the original file will not be overwritten. Once you call it up, it can be saved as a standard .xls file under another name. If you get lost or forget how an input is defined or how a calculation is performed, the L.E.K. Valuation Toolkit contains hundreds of comment boxes that provide helpful hints and reminders. Cells that contain comment boxes are marked with small red triangles in the upper right corner. When the cursor is placed on a triangle a comment appears. To make a comment disappear, simply move the cursor to another cell.

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Appendix III: Glossary of Terms

Abnormal Returns: The difference between the expected return on a stock (usually determined by its CAPM Beta) and the actual return on the stock. After-tax Cost of Debt: The cost of debt adjusted for the tax-deductibility of interest on debt. If a $100 loan is priced at 9%, annual interest paid is $9.00. Since the interest is deductible for tax purposes (at, say a tax rate of 40%), interest expense reduces taxes that would otherwise have to be paid, resulting in an after-tax cost of $9.00 x (1 - .40) = $5.40. Hence, the after-tax cost of debt in this example is 9% x (1.40) = 5.4% Annuity: A series of equal, periodic cash flows. Arbitrage Pricing Theory (APT): Invented by Stephen Ross in 1976, APT uses several explanatory variables to estimate the cost of equity (instead of only one variable, Beta, as in CAPM). Bankruptcy Costs: Costs that a firm incurs by going bankrupt. These costs include forced sale of assets and legal fees (also see pre-bankruptcy costs). Black-Scholes Option Pricing Model: A model used to price options such as stock puts and calls. Book Value: The value of an asset as it appears on the balance sheet. Business Risk: A firm's risk if it has no debt in its capital structure. A firm's business risk is measured by its unlevered cost of equity. Capital Asset Pricing Model (CAPM): Developed by William F. Sharpe and John Lintner in 1965, CAPM is used to calculate the cost of equity as the sum of the risk free rate and the product of the CAPM Beta and the market risk premium. CAPM Beta: A measure of a firm's stock price covariance with a diversified portfolio of financial assets. In the U.S., the Standard and Poors (S&P) 500 is commonly used as a proxy for this portfolio. Beta = 1 implies that on average, when the market goes up (down) 10%, the stock also goes up (down) 10%. Beta > 1 implies the stock is more volatile than the market, while Beta < 1 implies a stock is less volatile, and therefore less risky than the average of the market. Cash Flow Discount: The reduction in market value that many mature, slow growth firms experience as a result of investors' perceptions that the firm is investing in negative NPV projects.

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Control Premium: The amount that a buyer pays over the stand alone value of a target firm to acquire the firm. Corporate Value: The total value of a firm calculated as the market value of its equity plus the market value of its debt. Cost of Capital (K): (See "Weighted Average Cost of Capital") Cost of Debt (Kd): Typically, it is the rate of interest required by debt holders. It should include the cost of any upfront costs. Cost of Equity (Ke): The rate of return that owners on a firm require on their investment. Cumulative Abnormal Returns (CAR): CAR is the summation of abnormal stock price returns over a period of time. Currency Exposure: The amount of foreign currency that must be bought or sold to offset the change in value as a result of changes in the exchange rate. Discount Rate (R): The weighted average rate of return that investors in a business require as compensation for the level of risk or their investment. Discounted Cash Flow (DCF) Method: A method of determining value by summing the present value of a business' expected cash flows. Duration: Duration is the weighted average time to cash receipt. The greater a debt instrument's duration, the greater the interest rate and inflation risk that its investors must bear. Equity: Money that has been obtained from owners (shareholders). Equity Carve-out: A partial initial public offering of a division or subsidiary of a company. The subsidiary becomes publicly traded, but the parent maintains a controlling interest. Carve-outs provide funding for subsidiaries and often restructure the incentives for subsidiary management. Expectations Gap: The portion of a value gap that is due to differing expectations between management and investors. A firm's expectations gap can be calculated as the difference between management's expected value of the firm if its strategy is implemented and the current market value of the firm. Credible communication of a firm's strategy to the marketplace can sometimes reduce expectation gaps.

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Financial Risk: The additional risk that a firm's equity holders face because of the amount of debt in the firm's capital structure. Financial risk is calculated as the difference between the levered cost of equity and the unlevered cost of equity. Future Value (FV): The value of an investment at the end of a specified time period after interest has been earned and added to the initial investment. Hurdle Rate: (see "Weighted Average Cost of Capital"). Incremental Cash Flows: The increase or decrease in the cash flows if a firm undertakes an investment. Inflation Risk: The risk that inflation will increase reducing the present value of a debt instrument's promised cash flows. Interest: Payment for the use of money. Interest Rate: Payment for the use of money expressed as a percentage per unit of time. Interest Rate Risk: The risk that interest rates will increase, reducing the present value of a debt instrument's promised cash flows and raising interest expense on floating rate debt. Internal Rate of Return (IRR): The rate of return at which the net present value of an investment's cash flows equals zero. (see "Trial and Error Method of Calculating IRR") Leverage: Also known as financial gearing, leverage is the amount of debt in a firm's capital structure as measured by its Debt/Equity ratio or Debt/Total Capital ratio. Liquidity Risk: The risk that the holder of an asset will not be able to dispose of it when they desire. Market Risk Premium (MRP): The excess return over the risk-free rate that is just sufficient to induce investors to invest in assets with the "market level" of systematic risk. Net Present Value (NPV): A method of valuation where initial investment is subtracted from the present value of future expected cash flows. If NPV is greater than 0, then the investment creates value. NOPAT: Net Operating Profit After Tax

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Operating Leverage: The percentage of total costs that is comprised of fixed costs (Fixed Costs/Total Costs). Optimal Capital Structure: The capital structure at which a firm's value is maximized. It maximally accomplishes the following: Avoids corporate and personal taxes Minimizes pre-bankruptcy and bankruptcy costs Minimizes the cost of capital Avoids sending unnecessary negative signals to the marketplace about the prospects of the firm Meets the lender's requirements for repayment. Payback Period: The number of years that it takes before the sum of the present value of positive cash flows equals the initial investment. Perpetuity: An infinite series of cash flows. Pre-Bankruptcy Costs: These are costs that are incurred as the financial health of the firm deteriorates but before actual bankruptcy. Pre-bankruptcy costs include loss of new sales and valuable employees, increased financing costs, and inability to invest in value-creating strategies. Present Value (PV): The value today of one or more future cash flows. Residual Value (RV): The value of a firm at the end of a specific forecast period. Return on Equity (ROE): A performance measure calculated by dividing Net Income by Equity. Return on Investment (ROI): A performance measure calculated by dividing Net Income by Investment. Risk-free Rate (rf): The rate of return on the safest financial instrument (commonly securities issued by government) with the same duration as the life of the investment being evaluated. R-Squared: A result of regression analysis describing the percentage of changes in the dependent variable captured by the independent variable. For example, an RSquared of 22% for a CAPM regression indicates that 22% of a stock's return movement is explained by the CAPM Beta. Sell-off: A divestment of part of a firm in exchange for cash or some other remuneration.

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Shareholder Value: Shareholder Value is the estimated value of a business to its equity holders. It is calculated by subtracting the market value of debt from corporate value. Specific Risk: Also known as unsystematic risk and unique risk, specific risk is part of an investment's total risk that investors can eliminate by holding the investment in a diversified portfolio of other investments. Specific risks are incorporated in valuation analysis through the expected cash flows using scenario analysis. Spin-off: Spin-offs result in a subsidiary or division becoming an independent, publicly traded firm. Shares of the subsidiary are typically distributed to the parent firm's shareholders on a pro-rata basis. Stand-alone Value: The value of a firm as a stand-alone or single separate entity (as opposed to its value as part of another entity that might include additional value from synergies). Strategic Business Unit (SBU): A distinct business unit that is a full-fledged competitor in one or more clearly defined external markets, and whose management has full control over most areas critical to the success of the business. Strategic Risk Unit (SRU): Part of a strategic business unit that has distinct business risk characteristics and therefore should be valued using a separate cost of capital. Strategy Gap: The part of a value gap that exists because the current strategy is not perceived by investors to be optimal. A firm's strategy gap is calculated as the difference between its value under the optimal strategy and its value under the current strategy. Synergies: The difference between the value of two firms combined and the sum of their stand alone values. Synergies can result from improvements in both the buyer and target's operating and financial strategies. Systematic Risk: Investor's risk that cannot be diversified by holding an investment as part of a portfolio of other investments. Systematic risks are incorporated in valuation analysis through the cost of capital. Tax Shield: A reduction in a firm's taxes resulting from allowable expenses such as interest and depreciation. Time Value of Money: Money you will receive in the future has less value than the same amount of money today. Why? Because you can invest the money you receive today to earn interest.

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Trial and Error Procedure for Calculating IRR: A procedure for computing the IRR of a series of unequal cash flows. The procedure is as follows: choose an interest rate, compute the present value of the cash flows at that rate, and then compare the resulting present value with the cost of the investment. If the present value exceeds the cost, then repeat the procedure using a higher interest rate. If the present value is less than the cost, repeat the procedure using a lower interest rate. Repeat this process until the present value equals cost. Unquoted Firm: A firm that does not have a quoted share price such as a private company or operating division of a public firm. CAPM or APT Beta estimates are not directly available for these enterprises. Value Drivers: Key factors that drive performance of a business and that are used to calculate its value. They are: G: Sales Growth P: Operating Profit Margin T: Cash Tax Rate F: Incremental Fixed Capital Investment W: Incremental Working Capital Investment K: Cost of Capital N: Number of Forecast Periods Value Gap: The difference between the value of a firm under the value maximizing strategy and the value of the firm under the current strategy. It is comprised of two components: a strategy gap and an expectations gap. Value Growth Duration: In pricing shares the market implicitly assigns a finite time period to the companys expected ability to create value or, equivalently, to find opportunities to invest at above the cost of capital. At the end of the value growth duration, it is assumed that the company will earn at its cost of capital. Walk-away Price: The maximum price a bidder can pay (or seller can accept) without destroying value. Weighted Average Cost of Capital (K): Also called the hurdle rate, discount rate and rate of return, the weighted average cost of capital is the return demanded by a firm's debt and equity holders weighted in proportion to the percentages of debt and equity, respectively, in the firm's capital structure. Working Capital: A firm's investment in current assets net of current liabilities

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