Reading 42: Free Cash Flow Valuation- LOS k～ Q24-26

management, recently, friendly, increase, investor

Q24. Burcar-Eckhardt, a firm specializing in value investments, has been approached by the management of Overhaul Trucking, Inc., to explore the possibility of taking the firm private via a management buyout. Overhaul’s stock has stumbled recently, in large part due to a sudden increase in oil prices. Management considers this an opportune time to take the company private. Burcar would be a minority investor in a group of friendly buyers.

Jaimie Carson, CFA, is a private equity portfolio manager with Burcar. He has been asked by Thelma Eckhardt, CFA, one of the firm’s founding partners, to take a look at Overhaul and come up with a strategy for valuing the firm. After analyzing Overhaul’s financial statements as of the most recent fiscal year-end (presented below), he determines that a valuation using Free Cash Flow to Equity (FCFE) is most appropriate.

Overhaul Trucking, Inc. Income Statement April 30, 2005 (Millions of dollars)
	2005	2006E
Sales	300.0	320.0
Gross Profit	200.0	190.0
SG&A	50.0	50.0
Depreciation	70.0	80.0
EBIT	80.0	60.0
Interest Expense	30.0	34.0
Taxes (at 35 percent)	17.5	9.1
Net Income	32.5	16.9

Overhaul Trucking, Inc. Balance Sheet April 30, 2005 (Millions of dollars)
	2005	2006E
Cash	10.0	15.0
Current Assets	50.0	55.0
Gross Property, Plant & Equip.	400.0	480.0
Accumulated Depreciation	(160.0)	(240.0)
Total Assets	300.0	310.0

Accounts Payable	50.0	70.0
Long-Term Debt	140.0	113.1
Common Stock	80.0	80.0
Retained Earnings	30.0	46.9
Total Liabilities & Equity	300.0	310.0

Eckhardt agrees with Carson’s choice of valuation method, but her concern is Overhaul’s debt ratio. Considerably higher than the industry average, Eckhardt worries that the firm’s heavy leverage poses a risk to equity investors. Overhaul Trucking uses a weighted average cost of capital of 12% for capital budgeting, and Eckhardt wonders if that’s realistic.

Eckhardt asks Carson to do a valuation of Overhaul in a high-growth scenario to see if optimistic estimates of the firm’s near-term growth rate can justify the required return to equity. For the high-growth scenario, she asks him to start with his 2006 estimate of FCFE, grow it at 30% per year for three years and then decrease the growth rate in FCFE in equal increments for another three years until it hits the long-run growth rate of 3% in 2012. Eckhardt tells Carson that the returns to equity Burcar-Eckhardt would require are 20% until the completion of the high-growth phase, 15% during the three years of declining growth, and 10 percent thereafter. Eckhardt wants to know what Burcar could afford to pay for a 15% stake in Overhaul in this high-growth scenario.

Carson assembles a few spreadsheets and tells Eckhardt, “We could make a bid of just under $16 million for the stake in Overhaul if the high-growth scenario plays out.” Eckhardt worries, though, that the value of their bid is extremely sensitive to the assumption for terminal growth, since in that scenario, the terminal value of the firm accounts for slightly more than two-thirds of the total value.

Carson agrees, and proposes doing a valuation under a “sustained growth” scenario. His estimates show Overhaul growing FCFE by the following amounts:

	2007	2008	2009	2010	2011
Growth in FCFE	40.0%	15.7%	8.6%	9.1%	8.3%

In this scenario, he would project sustained growth of 6% per year in 2012 and beyond. With the more stable growth pattern in cash flow, Eckhardt and Carson agree that the required return to equity could be cut to a more moderate 12%.

Carson also decides to try valuing the firm on Free Cash Flow to the Firm (FCFF) using this same 12% required return. Using a single-stage model on the estimated 2006 figures presented in the financial statements above, he comes up with a valuation of $1.08 billion.

Which of the following is least likely one of the differences between FCFE and FCFF? FCFF includes adjustments to revenue for:

A) working capital investment.

B) operating expenses.

C) interest payments to bondholders.

Q25. Which of the following is the least likely reason for Carson’s decision to use FCFE in valuing Overhaul rather than FCFF?

A) Overhaul’s capital structure is stable.

B) FCFE is an easier and more straightforward calculation than FCFF.

C) Overhaul’s debt ratio is significantly higher than the industry average.

Q26. Assuming that Carson is using May 1, 2005 as his date of valuation, what is the estimated value of the firm’s equity under the scenario most suited to using the two-stage FCFE method?

A) $173.3 million.

B) $125.2 million.

C) $129.5 million.