Now that the estimation procedures for the calculation of components of intrinsic value, cash flow from operations, cost of capital, terminal value, non-operating assets, and liabilities are explained, let us look at an illustration that incorporates all of the components. Consider a business 'Snap Value' with the following five-year forecast:
Assumptions for Snap value
Forecast Period |
5 Years |
Currency |
USD |
Figures in |
Millions |
Risk Free Rate |
4.1% |
Expected Inflation Rate |
4.0% |
Sales in Prior Period |
$150 Million |
CAGR of Sales |
11.0% |
OPM in Prior Period |
9.0% |
OPM - All 5 Years |
10.0% |
Incremental Fixed Asset Investment Rate |
25% |
Incremental NWC Investment Rate |
20% |
Income Tax |
21% |
Net Operating Assets & Liabilities
Cash and Securities |
30 |
Investment and Other Assets |
10 |
Minority Interest and Other Liabilities |
10 |
Debt and Obligations |
30 |
Outstanding Shares |
20 |
Market Capitalization |
70 |
Debt Ratio |
30% |
Equity Ratio |
70% |
Beta |
0.9 |
Expected Market Return |
10.9% |
Cost of Debt |
6% |
Cost of Equity |
10.22% |
WACC |
8.576% |
Terminal Period
Risk Free Rate |
2.5% |
Expected Inflation Rate |
2.0% |
Income Tax |
21.0% |
Debt Ratio |
0.0% |
Equity Ratio |
100% |
Expected Market Return |
8.90% |
Beta |
0.8 |
Cost of Equity |
7.57% |
Terminal Growth
Inflationary Growth |
2.0% |
Real Growth |
2.0% |
Terminal Growth |
4.0% |
Computation of Expected Market Returns - Forecast Period
Inflation + Expected Return Over Inflation
= 4.00% + 6.90%
= 10.90%
Computation of Cost of Equity based on CAPM - Forecast Period
ra
=
rf
+
[
βa
x
(
rm
-
rf
)
]
= 4.10% + [ 0.90 x (10.90% - 4.10%) ]
= 10.22%
Computation of WACC in Nominal Terms
Particulars |
Weight |
Cost |
Tax Rate |
Total |
Debt |
30% |
6% * |
21% |
1.422% |
Equity |
70% |
10.22% |
|
7.15% |
WACC |
|
|
|
8.57% |
Computation of Expected Market Returns - Terminal Period
Inflation + Expected Return Over Inflation
= 2.00% + 6.90%
= 8.90%
Computation of Cost of Equity based on CAPM - Terminal Period
ra
=
rf
+
[
βa
x
(
rm
-
rf
)
]
= 2.25% + [ 0.80 x (8.90% - 2.25%) ]
= 7.57%
Computation of WACC - Terminal Period
Particulars |
Weight |
Cost |
Tax Rate |
Total |
Debt |
0% |
|
|
0% |
Equity |
100% |
7.57% |
|
7.57% |
WACC |
|
|
|
7.57% |
Thus, based on the above computation, the cost of capital or WACC during Terminal Period comes to 7.57%.
Terminal Growth
The Terminal Growth for Snap value is assumed at 4% (Inflationary Growth at 2% and Real Growth at 2%).
Valuation of Snap Value
The valuation of Snap Value based on above assumptions is presented in Table 16.
Table 16 - (figures in USD / Million)
Year |
0 |
1 |
2 |
3 |
4 |
5 |
Sales |
150 |
166.5 |
184.8 |
205.1 |
227.7 |
252.8 |
Operating Profit |
|
16.65 |
18.48 |
20.51 |
22.77 |
25.28 |
Income Tax |
|
3.50 |
3.88 |
4.31 |
4.78 |
5.31 |
Incremental Fixed Assets |
|
4.13 |
4.58 |
5.08 |
5.64 |
6.26 |
Incremental Net Working Capital |
|
3.30 |
3.66 |
4.07 |
4.51 |
5.01 |
Free Cash Flow |
|
5.73 |
6.36 |
7.06 |
7.83 |
8.70 |
Discount Factor |
1 |
0.921 |
0.85 |
0.78 |
0.72 |
0.663 |
Present Value of Free Cash Flow |
|
5.28 |
5.39 |
5.51 |
5.64 |
5.76 |
Cumulative PV of Cash Flows |
|
|
|
|
|
27.58 |
PV of Terminal Value |
|
|
|
|
|
167.89 |
Cash and Securities |
|
|
|
|
|
30 |
Investment and Other Assets |
|
|
|
|
|
10 |
Minority Interest and Other Liabilities |
|
|
|
|
|
10 |
Debt & Obligations |
|
|
|
|
|
30 |
Shareholder Value |
|
|
|
|
|
195.47 |
No. of Shares |
|
|
|
|
|
20 |
Price Per Share |
|
|
|
|
|
9.77 |
Computation of Terminal Value
The formulae for computing Terminal value is,
Free Cash flow in Target Year * (1 + Terminal Growth) / (WACC - Terminal Growth)
8.70 * ( 1 + 4%) / (7.57% - 4%) = 253
Present Value of Terminal Value is Terminal Value * Discount Factor in the last year of forecast Period
253 * 0.663 = 167.89