Ch 7

Report
DES Chapter 7
Multiyear Projections and
Valuation
DES Chapter 7
1
Current Information
Current market price is $40.12 per
share
Given you knowledge about Van Leer, is
this a fair price?
 You must create multi-year financial
projections for Van Leer, perform a
valuation, and compare the value to the
market price of the stock.

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Short-term, Long–term
There are three types of time periods in
these projections:



The short-term, in which there is plenty of
specific information on which to base
projections
The steady state, in which the firm is assumed
to be at constant growth and some form of
competitive equilibrium. It starts with the last
year of projections.
The long-term is between the short term and
the steady state--general firm and industry
information is used to base projections.
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How long?
The point at which short-term specific
information gives way to reliance on
more general industry and market
movements varies from firm to firm and
industry to industry.

Frequently 3 to 5 years is the length of the
short-term specific projections.
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The Short Run
Just about anything can happen.
Reasonableness of your projections
depends on firm-specific knowledge and
history of the firm.
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Over the Long-term
It is difficult to maintain high growth for a
long time
Constrained by industry size
 Constrained by size of economy
 Competitors will enter profitable industries

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Projecting Operating Profit
Long-run sales growth
Real growth about 2% to 3% for U.S.
economy most years
 Inflation? 2% to 3%?
 Adds to 4% to 6%, and higher when
inflation is higher.
 What about Van Leer?

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Projections for Van Leer:
Sales Growth
Year
2004 2005 2006 2007 2008 2009 after
Growth 11% 8% 7% 7% 6% 6%
6%
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Cost of Goods Sold
To maintain profit margins a firm must:

Establish and defend a competitive
advantage.

Like brand identity, patents, reputation for
quality, corporate culture, supply chain,
technology that allows cost control.
To improve profit margins a firm must:

Improve its competitive position.
Otherwise, profit margin declines.
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COGS for Van Leer
Assume Van Leer can raise prices in
2004, and hold for 2 years. After that,
competition will drive down prices:
2004 2005 2006 2007 2008 after
COGS% 62.5% 62.5% 62.5% 63% 64% 64%
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SGA
How does SGA interact with CGS?

With sales growth?
Ask yourself: If sales growth is
projected to be larger in the future than
in the past, how (specifically) is this
going to be accomplished? Are there
costs associated with this plan?
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Van Leer’s SGA and depreciation
SGA will increase slightly in 2004 to
22.5% of sales and then remain there.
Depreciation will remain at 15% of net
PPE.
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Ratios--historical
Projected parameters
Ratiosto calculate
operating profit
Sales Growth
CGS % of sales
SGA % of sales
Depreciation % net PPE
Actual Actual Actual Actual
2001
2002
2003 Average
na
61.9%
23.8%
14.9%
12.4% 5.9%
66.2% 64.0%
21.7% 21.5%
15.0% 15.0%
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9.2%
64.0%
22.3%
15.0%
13
Ratios--projected
Projected
2004 2005
2006
2007
2008
2009 after
Ratios to calculate
operating profit
Sales growth rate 11.0% 8.0%
7.0%
7.0%
6.0%
6.0% 6.0%
COGS / Sales
62.5% 62.5% 62.5% 63.0% 64.0% 64.0% 64.0%
SGA / Sales
22.5% 22.5% 22.5% 22.5% 22.5% 22.5% 22.5%
Depreciation / Net
PPE
15.0% 15.0% 15.0% 15.0% 15.0% 15.0% 15.0%
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Projecting operating capital
Cash

Reduce to 3% of sales from 2004 to 2006,
then 2% in 2007 and thereafter.
Inventory

11% of sales in 2004 and thereafter.
Accounts receivable

7.6% of sales in 2004 and thereafter.
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Operating capital…
Net PPE as % of sales
Depends on whether the firm is at full
capacity or not.
 Currently at 95% capacity, and must build a
new plant to meet growth.
 PPE will increase from 30% to 34% of
sales in 2004. Will drop to 31.5% and then
to the average of 30.8% by 2006.

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Operating capital
Accounts payable as % of sales

Days payable is about 45 days, which is
the industry average, so Van Leer will keep
AP at the historical average of 8.1% of
sales.
Accrued expenses have been 1% of
sales and will remain there.
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Historical Ratios
Ratios to calculate
operating capital
Actual Actual Actual Actual
2001 2002
2003Average
Cash/sales
5.0% 5.0% 5.0% 5.0%
Inventory/sales
8.9% 9.0% 10.0% 9.3%
A R/sales
7.7% 7.4% 7.5% 7.6%
Net PPE/ sales
32.7% 29.7% 30.0% 30.8%
A/P / sales
9.5% 7.4% 7.5% 8.1%
Accrued exp./sales 1.0% 1.1% 1.0% 1.0%
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Ratios to calculate operating
capital
Projected
2004
2005
Cash / Sales
3.0%
3.0%
Inventory/ Sales
11.0% 11.0%
Accts. Rec. / Sales
7.6%
7.6%
Net PPE / Sales
34.0% 31.5%
Accts. Pay./ Sales
8.1%
8.1%
Accruals / Sales
1.0%
1.0%
2006
3.0%
11.0%
7.6%
30.8%
8.1%
1.0%
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2007
2008
2.0%
2.0%
11.0% 11.0%
7.6%
7.6%
30.8% 30.8%
8.1%
8.1%
1.0%
1.0%
2009 after
2.0%
2.0%
11.0% 11.0%
7.6%
7.6%
30.8% 30.8%
8.1%
8.1%
1.0%
1.0%
19
Projecting operating taxes
Taxes have averaged 39.7% of pre-tax
income, and are projected to remain
there.
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Dividend growth rate
Van Leer is stabilizing its historically
erratic dividend policy. Growth for 2004
through 2007 is set at 10%. 2008
growth is projected to be 8%, and
dividend growth is projected to be 6%
thereafter.
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Target debt ratio and interest
Historically, 16% of operating capital
has been financed with long-term debt.
This is expected to be reduced to 15%.
Short-term and long-term debt is
expected to cost 9%, and the yield on
short-term investments is expected to
be 3%.
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Balancing
Projected assets too big? Short-term
debt is the plug—after driving short-term
investments to zero.
Projected liabilities too big? Short-term
investments are the plug—after driving
short-term debt to zero.
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Historical Income Statement
Net Sales
Cost Of Goods Sold
Selling, general &
administrative
Depreciation
Operating profit
Interest income
Interest expense
Earnings before taxes
Taxes
Net income
Dividends
Additions to RE
Actual Actual Actual
2001
2002
2003
840.0
944.0 1,000.0
520.0
625.0
640.0
200.0
41.0
79.0
0.0
9.0
70.0
28.0
42.0
12.0
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205.0
42.0
72.0
1.0
9.0
64.0
25.0
39.0
11.0
28.0
215.0
45.0
100.0
0.0
10.0
90.0
36.0
54.0
16.0
38.0
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Projected Income Statement
Projected
2004
Income Statement
1,110.0
Net Sales
693.8
Cost Of Goods Sold
249.8
SG&A
56.6
Depreciation
109.9
Operating profit
0.8
Interest income
11.2
Interest expense
99.5
Earnings before taxes
39.5
Taxes
60.0
Net income
17.6
Dividends
42.4
Additions to RE
2006
2005
1,198.8 1,282.7
801.7
749.3
288.6
269.7
59.3
56.6
133.1
123.2
8.7
11.9
124.5
111.2
49.4
44.2
75.1
67.1
21.3
19.4
53.8
47.7
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2009
2008
2007
1,372.5 1,454.9 1,542.1
987.0
931.1
864.7
347.0
327.3
308.8
71.2
67.2
63.4
136.9
129.2
135.6
2.5
1.9
0.9
10.1
9.5
9.1
129.3
121.6
127.4
51.3
48.3
50.6
78.0
73.3
76.8
26.8
25.3
23.4
51.2
48.0
53.4
25
Historical Assets
Cash
Short- term investments
Inventory
Accounts receivable
Total current assets
Net PP&E
Total assets
Actual Actual Actual
2001
2002
2003
42.0
47.0
50.0
10.0
15.0
25.0
75.0
85.0
100.0
65.0
70.0
75.0
192.0 217.0 250.0
275.0 280.0 300.0
467.0 497.0 550.0
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Projected Assets
2004
33.3
Cash
Short term investments
122.1
Inventory
84.4
Accounts receivable
Total current assets 239.8
377.4
Net PP&E
Total assets 617.2
2005
36.0
131.9
91.1
258.9
377.6
636.6
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2006
38.5
30.3
141.1
97.5
307.3
395.1
702.4
2007
27.5
63.5
151.0
104.3
346.3
422.7
769.0
2008
29.1
83.1
160.0
110.6
382.8
448.1
830.8
2009
30.8
104.0
169.6
117.2
421.7
475.0
896.7
27
Historical liabilities
Accounts payable
Accrued expenses
Short-term debt
Total current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total commonequity
Total liabilities and equity
Actual Actual Actual
2001
2002
2003
80.0
70.0
75.0
8.0
10.0
10.0
50.0
30.0
25.0
138.0 110.0
110.0
54.0
84.0
99.0
192.0 194.0
209.0
125.0 125.0
125.0
150.0 178.0
216.0
275.0 303.0
341.0
467.0 497.0
550.0
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Projected Liabilities
Accounts payable
Accrued expenses
Short-term debt
Total current liabilities
Long-term debt
Total liabilities
Common stock
Retained earnings
Total common equity
Total liabilities and
equity
89.9
11.1
40.2
141.2
92.6
233.8
125.0
258.4
383.4
97.1
12.0
0.9
110.0
95.5
205.5
125.0
306.1
431.1
103.9
12.8
116.7
100.8
217.5
125.0
359.9
484.9
111.2
13.7
124.9
105.8
230.7
125.0
413.3
538.3
117.8
14.5
132.4
112.2
244.6
125.0
461.3
586.3
124.9
15.4
140.3
118.9
259.2
125.0
512.5
637.5
617.2
636.6
702.4
769.0
830.8
896.7
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Debugging—what is
reasonable?
Is it reasonable for sales to be so large?
how big is company relative to industry?
 relative to economy?

How much is being invested in assets
from year to year? Are these increases
similar to other years?
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Debugging
How much are dividend payments?

Are they sustainable?
What happens to short-term debt?

Is it increasing over the period?
What happens to short-term
investments?

Is it increasing over the period?
May need to reconsider financing mix.
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Debugging
What are the projected ROICs?
Are they comparable with previous years?
 Comparable with those of other companies
in the industry?

What is the projected growth in FCF
from year to year?
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Using the Projections for
Valuation
Calculate projected free cash flows
Calculate WACC
Calculate projected horizon value
Discount FCFs and horizon value at WACC
Add in short-term investments
Subtract debt
Divide by shares outstanding
DES Chapter 7
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Free Cash Flow
Operating Income
Tax on Operating Income
NOPAT
Net Operating WC
Net Operating Long Term
Assets
Total Net Operating Capital
Investment in net operating
capital
Free Cash Flow
growth in FCF
ROIC
Actual Actual Actual
2001 2002
2003
79.0
72.0
100.0
31.6
28.1
40.0
47.4
43.9
60.0
94.0 122.0
140.0
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275.0
369.0
280.0
402.0
300.0
440.0
33.0
10.88
38.0
22.00
102.3%
11.9% 14.9%
34
Free Cash Flow
Projected
2004
109.9
43.6
Operating Income
Tax on Operating
Income
NOPAT
66.3
138.8
Net Operating WC
Net Operating Long
Term Assets
377.4
Total Net Operating
Capital
516.2
Investment in net
operating capital
76.2
Free Cash Flow
-9.9
growth in FCF
-144.9%
ROIC
15.1%
2005
123.2
48.9
2006
133.1
52.9
2007
135.6
53.8
2008
129.2
51.3
2009
136.9
54.4
74.3
149.9
80.3
81.8
160.3 157.8
77.9
167.3
82.6
177.3
377.6
395.1
422.7
448.1
475.0
527.5
555.4
580.6
615.4
652.3
11.3
27.9
25.2
34.8
36.9
63.0
52.3
56.6
43.1
45.7
na
-16.9% 8.2% -23.9% 6.0%
14.4% 15.2% 14.7% 13.4% 13.4%
35
DES Chapter 7
Cost of Equity
Using the capital asset pricing model
(CAPM):
Van Leer’s beta is 1.4.
 The risk-free rate is 6%.
 The market risk premium is 5%.

rS = rRF + beta (RPM)
= 6% + 1.4 (5.0%) = 13%
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Cost of Capital…
Target debt is 19.8%, target equity is
80.2%
WACC = (1-T)rDwD + rSwS
= (1 - 0.397)(9.0%)(0.198) + (13%)(0.802)
= 11.5%
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Valuation
HV2009
FCF2009 (1  g) 45.65(1.06)


 $879.80
WACC g
0.115 0.06
2004 2005 2006 2007 2008
2009
Horizon Value
879.80
Free Cash Flow
(9.89) 62.95 52.34 56.61 43.07 45.65
FCF + Horizon Value (9.89) 62.95 52.34 56.61 43.07 925.45
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Valuation
Present value at the WACC of 11.5% is
$622.79 million.
This is as of the end of 2003
Debt at end of 2003 is $124 million,
short-term investments are $25 million
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Valuation
Equity = $622.79 + $25 – $124 =
$523.79 million.
There are 10 million shares, so per
share is $52.38 per share.
Compared to the existing market price
of $40.12, this Van Leer appears to be a
good investment at this time.
DES Chapter 7
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