The main focus of this case is to learn the principle of equity valuation using discounted free cash flow analysis to arrive at net present value. The concept of using discounted free cash flow method to arrive at NPV of an enterprise is a fundamental concept in equity valuation.
The first step is to calculate appropriate discount rate also known as weighted average cost of capital.
The second step is to calculate free cash flow of the enterprise.
Free cash flow = Net income + depreciation & amortization – capital expenditure – change in working capital. If year over year change in working capital is negative then you add it to net income, if it is positive then you subtract it from net income to arrive at free cash flow.
Depreciation and amortization is added back because it is a non-cash expense. Depreciation expense allows an enterprise to reduce its tax bite. Depreciation expense is permitted by the revenue department because it allows corporations to write off their less productive machinery and enable them to buy newer more productive machinery to enhance its competitive position.
Companies incur capital expenditure for example by buying new machinery, which involves cash outflow. Capital expenditure is seen positively as it allows corporations to generate cash flow from those assets.
In this case we need to forecast, starting from year 2008, revenue (sales). Revenues are expected to grow at a fast pace (rate given in the case) for the first five years and thereafter level off (rate given in the case) for the subsequent years (assume forever).
Forecasted EBITDA (earnings before interest taxes depreciation and amortization) can be calculated as a percentage of revenue. Keep the ratio between EBITDA/Revenue constant for your forecasted values. Do an average for years 2005, 2006 and 2007; see exhibit 4 Income Statement. EBITDA = operating income +depreciation and amortization to arrive at average EBITDA/Revenue ratio.
Depreciation and amortization values for years 2007 to 2012 are given in Exhibit 5
EBIT = EBITDA-DA
Forecasted capital expenditure: to do this look at values of capital expenditures from years 2004 to 2007 from statement of cash flow from Exhibit 4 and Revenues for the same years from income statement from Exhibit 4. Calculate average of Capex/revenue and use this ratio in your forecasted information.
Working capital values for years 2007 to 2012 are given in Exhibit 5. As noted previously you are interested in determining the change in working capital. A year over year change that is negative needed to be added; a year over year change that is positive needs to be subtracted to arrive at free cash flow.
Finally you need to calculate terminal value for years 2013 to forever, because after year 2012 the free cash flow will grow at a much lower pace. Assume 3 % growth including inflation. The terminal value can be calculated using the following formula. P0= D1/(r-g). In this case P0= P2012
Once you calculate free cash flows for years 2008 to 2012 including terminal value you can discount these cash flows back to present value using weighted average cost of capital as the discount rate. This is the net present value of the enterprise.
Once you calculate net present value you add cash value from 2007 balance sheet, subtract debt value ( short term borrowings 2007 balance sheet) subtract value of preferred shares to arrive at the equity value. Divide the equity value by the number of shares outstanding to arrive at the share price.
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