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. He also notes that there were no sales of PPE.
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 |
Accounts Receivable | 50.0 | 55.0 |
Gross Property, Plant & Equip. | 400.0 | 480.0 |
Accumulated Depreciation | (160.0) | (240.0) |
Total Assets | 300.0 | 310.0 |
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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 does not deduct: A)
| working capital investment. |
| | C)
| interest payments to bondholders. |
|
FCFF includes the cash available to all of the firm’s investors, including bondholders. Therefore, interest payments to bondholders are not removed from revenues to derive FCFF. FCFE is FCFF minus interest payments to bondholders plus net borrowings from bondholders. (Study Session 12, LOS 40.a)
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. |
|
The difference between FCFF and FCFE is related to capital structure and resulting interest expense. When the company’s capital structure is relatively stable, FCFE is easier and more straightforward to use. FCFF is generally the best choice when FCFE is negative or the firm is highly leveraged. The fact that Overhaul’s debt ratio is significantly higher than the industry average would argue against the use of FCFE. Hence, this is the least likely reason to favor FCFE. (Study Session 12, LOS 40.a)
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?
The “sustained-growth” scenario is the only scenario suitable for using the two-stage method, in part because the “high-growth” scenario uses three different required rates of return.
First, we need to calculate estimated FCFE in 2006. Since there were no sales of PPE, we can calculate FCInv as the change in Gross PPE.FCFE = NI + NCC − FCInv − WCInv + Net Borrowing
= 16.9 + 80 – (480 – 400) – [(55 – 70) – (50 – 50)] + (113.1 – 140)
= 16.9 + 80 – 80 + 15 – 26.9
= $5 million in 2006
Having calculated FCFE in 2006, we can calculate FCFE for 2007 through 2011 using the growth rates provided:
| 2007 | 2008 | 2009 | 2010 | 2011 |
Growth in FCFE | 40.0% | 15.7% | 8.6% | 9.1% | 8.3% |
Implied level of FCFE
(in millions) | $7.0 | $8.1 | $8.8 | $9.6 | $10.4 |
Now that we know FCFE, we can discount future FCFE back to the present at the cost of equity.
In the first stage of the two-stage model, we determine the terminal value at the start of the constant growth period as follows:
Terminal Value = (10.4 × 1.06)/(0.12 - 0.06) = $183.733 million.
In the second stage, we discount FCFE for the first six years and the terminal value to the present.
Equity Value = [5.0 / (1.12)1] + [7.0 / (1.12)2] + [8.1 / (1.12)3] + [8.8 / (1.12)4] + [9.6 / (1.12)5] + [(10.4 + 183.7333) / (1.12)6]
Equity Value = 4.46 + 5.58 + 5.77 + 5.59 + 5.45 + 98.35
Equity Value = $125.20 million
(Study Session 12, LOS 40.j)
What is the expected growth rate in FCFF that Carson must have used to generate his valuation of $1.08 billion?
Since Firm Value = FCFF1 / (WACC − g), we first need to determine FCFF1, which is FCFF in 2006: FCFF = NI + NCC + [Int × (1 - tax rate)] – FCInv – WCInv
= 16.9 + 80 + [34 × (1 – 0.35)] – (480 – 400) – [(55 – 70) – (50 – 50)]
= 16.9 + 80 + 22.1 – 80 – (–15) = 54 Firm Value = FCFF1 / (WACC - g) 1080 = 54 / (0.12 − x) [(1080)(0.12)] – 1080x = 54
129.6 – 1080x = 54
75.6 = 1080x
0.07 = x
The expected growth rate in FCFF that Carson must have used is 7%. (Study Session 12, LOS 40.j)
If Carson had estimated FCFE under the assumption that Overhaul Trucking maintains a target debt-to-asset ratio of 36 percent for new investments in fixed and working capital, what would be his forecast of 2006 FCFE?
FCFE = NI – [(1 - DR) × (FCInv - Dep)] – [(1 - DR) × WCInv]Where: DR = target debt to asset ratio
FCFE = 16.9 – [(1 – 0.36) × (480 – 400 – 80)] – [(1 – 0.36) × ((55 – 70) – (50 – 50))]
= 16.9 – (0.64 × 0) – (0.64 × (–15))
= 16.9 + 0 + 9.6 = 26.5
(Study Session 12, LOS 40.j)
Regarding the statements made by Carson and Eckhardt about the value of Overhaul in the high-growth scenario:
This is a complex problem. It would help to create a table:
| 2006 (year 1) | 2007
(year 2) | 2008
(year 3) | 2009
(year 4) | 2010
(year 5) | 2011
(year 6) | 2012
(year 7) | Growth in FCFE (given) | n/a | 30% | 30% | 30% | 21% | 12% | 3% | Forecast FCFE (calculated) | 5.0 | 6.50 | 8.45 | 10.99 | 13.29 | 14.89 | 15.33 | Required return to equity (given) | 20% | 20% | 20% | 20% | 15% | 15% | 15% | Total discount factor (calculated) | 1.20 | (1.20)2 | (1.20)3 | (1.20)4 | (1.20)4(1.15) | (1.20)4(1.15)2 | (1.20)4(1.15)3 | PV of FCFE | 4.17 | 4.51 | 4.89 | 5.30 | 5.57 | 5.43 | 4.86 |
We begin with the forecast growth rates in FCFE in line 1. Since we have previously calculated that FCFE is $5 million in 2006, we can use the growth rates from line 1 to forecast FCFE in each year on line 2.
Line 3, required return to equity, is given. Using that, we can calculate discount factors in line 4.
Notice that the total discount factor is simply each year’s factor multiplied together. For example, the total discount factor for year 4 is (1.20)4 so the total discount factor for year 5, when the year 5 required rate of return drops from 20% to 15%, becomes (1.20)4(1.15).
Using the total discount factors from line 4, we can calculate the present value of each year’s cash flow in line 5. For example, the present value of year 2010 FCFE of $13.29 million will be $13.29 / [(1.20)4(1.15)] or $5.57 million.
Once we have the discounted cash flows for each year, we need to calculate the terminal value. Terminal value will be:
TV = (15.33)(1.03) / (0.10 - 0.03)
TV = 15.7899 / 0.07
TV = $225.57 million
Note that the required rate of return used for the terminal value is the rate for the steady-growth period, which is lower than that used in the high-growth phase (stage) or the declining growth phase (stage two).
We now need to discount terminal value back using the total discount factor for 2012:
PV of terminal value = $225.57 million / [(1.20)4(1.15)3]
PV of terminal value = $71.53 million
Adding together the discounted cash flows for each year with the discounted terminal value, we have:
Equity value = 4.17 + 4.51 + 4.89 + 5.30 + 5.57 + 5.43 + 4.86 + 71.53 = $106.26 million
Since the equity value of the firm is $106.26 million, Burcar should be willing to pay up to $106.26 × 0.15 = $15.94 million for a 15% stake in the firm. Since this is slightly less than $16 million, Carson’s statement is correct. The terminal value represents ($71.53 / $106.26) = 67.3% of the firm’s present value, so Eckhardt’s statement is also correct. (Study Session 12, LOS 40.j |
发表于 2012-3-31 14:21
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