Section 1:  Valuation Tools & Techniques

1)         Let’s revisit the simplest valuation model available to us:  the perpetuity formula.

Suppose you expect a company to generate FCF to the Firm of $12m next year, expect it to grow at a sustainable growth rate of 3.0%, and believe that it has a Weighted Average Cost of Capital (WACC) of 7.0%.

You also know that this firm has $100m in debt outstanding, and that there are 2m shares of its stock outstanding.

a)         What is the value of this firm using the assumptions provided above, and what is the value of equity implied by your estimate?

b)         How much should an investor be willing to pay for one share of this company’s stock? Explain your reasoning.

2)         Now let’s look at a more complex problem:  look at the tab named “toy model” on the spreadsheet provided with this assignment. You’ll find that it describes a company with an ROIC of 6.5%; a WACC of 6.5%; and a growth rate of 0%;

The “DCF Valuation” box has been left blank, however!  Please fill it in and answer the questions below.

a)         Note the significance of the assumptions given in this problem.  Is this company earning a return above its cost of capital?

b)         Estimate the value of the firm; the value of equity; and the value of one share of this company’s stock implied by this model.

c)         Now look at the valuation ratios that your estimate implies:

i)          What does your estimate suggest that the EV/Invested Capital and EV/EBITDA ratios should be for this firm (based on 2018 numbers)?

ii)         What does your estimate suggest that the Price/Book Value and Price/Earnings ratios should be for the stock (based on 2018 numbers)?

d)         Increase the growth rate assumed in this model to 2% and comment on how it affects your estimates.   How does growth affect the value of this firm?

3)         Now change this model so that it has more optimistic assumptions about profitability:

§         increase your assumption for revenues/invested capital to 85%

§         set the growth rate assumed in this model back to 0%

a)         How did changing this assumption affect your estimates for the ROIC and ROE?

Comment on why these have changed.

b)         How did changing this assumption affect your estimates for the value of the firm; the value of equity, and the value of one share of this company’s stock?

c)         How did changing this assumption affect the valuation ratios that your estimate implies?

d)         Now increase the growth rate assumed in this model to 2% and comment on how it affects your estimates.   How does growth effect the value of this firm?

4)         Now change this model so that it has more pessimistic assumptions about profitability:

§         decrease your assumption for revenues/invested capital to 45%

§         set the growth rate assumed in this model back to 0%

a)         How did changing this assumption affect your estimates for the ROIC and ROE?

Comment on why these have changed.

b)         How did changing this assumption affect your estimates for the value of the firm; the value of equity, and the value of one share of this company’s stock?

c)         How did changing this assumption affect the valuation ratios that your estimate implies?

d)         Now increase the growth rate assumed in this model to 2% and comment on how it affects your estimates.   How does growth change the value of this firm?

5)         General Conclusions:

a)         How is our estimate of this company’s value connected to our beliefs about its future profitability?

b)          How is our estimate of this company’s value connected to our beliefs about its future growth?

Section 2: Modeling Challenge

Please build out the financial statement forecasts and answer the questions below.

6)         Investigating the Model:

a)         What is happening with this company’s profitability as measured by both its ROIC & ROE in your forecasts?

b)         What is happening with its credit quality as measured by the ratio of EBIT/Interest Expense in your forecasts?

c)         If this company needs to maintain a ratio of EBIT/Interest Expense of at least 6.0 in order to maintain its current credit rating, does it meet that requirement?

d)         What does your model predict will happen to this company’s divided, and with its dividend payout ratio?  Explain what’s happening here.

e)         If we want to limit this company’s dividend to a level we are confident they can maintain throughout the forecast period, what is the highest dividend that they should pay?

7)         Valuation:

a)         Estimate the value of the firm and the value of equity implied by this model, and comment on how much this model suggests we should be willing to pay for one share of this company’s stock

b)         How would your estimates change if you thought that this company could stop its product price from falling? (ie:  if they could stabilize it at current levels)

c)         Would you be willing to buy this stock at the current market price of $30/share? Explain your reasoning.

d)         Would you be willing to buy this stock at a market price of $15 per share, if its share price fell tomorrow? Explain your reasoning.

Note:  you’re looking at one of the classic model archetypes here. This is what a company looks like when its pricing power is competed away.