Lowe's Home Improvement comany 1. Free Cash Flow to the Firm (FCF). We demonstrated in class how we introduce some adjus

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Lowe's Home Improvement comany
1. Free Cash Flow to the Firm (FCF). We demonstrated in class how
we introduce some adjustments to identify the FCFs generated by the
project under valuation. To apply this concept at the firm level,
we adjust net income for depreciation then subtract capital
expenditures (CapEx) and any increase in Net Working Capital (NWC).
Note that in the project valuation we considered the after-tax
salvage value but in firm valuation this is not applicable.
2. Terminal Value (TV) or Continuation Value of the firm. We will
assume that the firm will operate indefinitely, or the cash flow
generated by the firm will continue to grow in perpetuity. This
perpetual property of FCF allows us to compute the value of the
firm in a way like growing perpetuity. Therefore, we will define
the terminal value of the firm that is growing at a constant growth
rate g by:
𝑇𝑉𝑛=𝐹𝐶𝐹𝑛+1𝑤𝑎𝑐𝑐−𝑔 (1)
3. The weighted average Cost of Capital (WACC): In equation (1), if
the firm is completely financed by equity, then we use the required
rate of return by equity holders (ROE) as our discount rate (cost
of equity capital). Because equity holders expect a return on their
investments that is commensurable to risk, we need to be able to
determine the riskiness of the firm. Consequently, we need a
measure for risk. We use the Capital Asset Pricing Model (CAPM),
the most widely celebrated model, to measure the risk-adjusted
return on investments. Certainly, it is much more common that a
firm is financed by both equity and
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debt. Therefore, the best measure for the cost of capital is the
weighted average cost of capital (WACC) which is given by:
𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥 𝑊𝐴𝐶𝐶=𝑅𝑒(𝐸𝐸+𝐷)+𝑅𝑑(1−𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)(𝐷𝐸+𝐷) (2)
Where Re is cost of equity (or required rate of return by
shareholders), Rd is cost of debt, E is market value of equity, and
D is market value of debt.
4. The Required Rate of Return or Cost of equity is captured by the
CAPM model which states that the return on equity “i” is given
by:
𝑅𝑖=𝑅𝑓+(𝑅𝑚−𝑅𝑓)𝛽𝑖 (3)
Where Ri is return on stock i, Rf is risk-free return, that is
return on long-term government bonds, usually measured as the
average of 20-year Treasury Bond. Rm is return on market portfolio
which can be proxied by the return on S&P500, and βi is the
beta of the stock which measures the riskiness of the stock with
respect to market portfolio. For example, if β for IBM is 1.18 this
means that if the return on the market portfolio rises by 1%, the
return on IBM stock will go up by 1.18% and vice versa. Beta is
given by:
𝛽𝑖=𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑖,𝑅𝑚)𝑉𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑚) (4)
The cost of debt can be measured by the yield to maturity on a
corporate bond that has same risk attribute as the firm in
question. More on this will be covered in class (chapter 12).
5. Computing growth. We also need to develop a simple model to
measure growth. In a crude definition, we might trace the growth of
earnings by the firm and apply this growth rate to its FCF. We may
also consider growth of sales revenue or net income. However, most
commonly, practitioners tend to measure growth as proxied by the
percentage change in Earnings before Interest, Taxes, Depreciation
and Amortization (EBITDA). The reason is that firms differ in their
methods how they compute depreciation and amortization, so using
the percentage change in EBITDA as a measure for growth eliminates
these biases. Additionally, you can cross examine this estimation
of growth rate with the growth rate that is derived by multiplying
the return on invested capital by the investment rate:
𝐺𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒=𝑅𝑒𝑡𝑒𝑛𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 ×𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
Retention rate is the ratio of retained earnings. The return on
Invested Capital (ROIC) is given by: 𝑅𝑂𝐼𝐶=𝐸𝐵𝐼𝑇(1−𝑇)𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓
𝐸𝑞𝑢𝑖𝑡𝑦 +𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐷𝑒𝑏𝑡−𝐶𝑎𝑠ℎ (5)
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Another important dimension that should be considered when we
analyze growth is whether the firm is currently experiencing a
supernormal growth. This is common in technology, pharmaceutical,
or oil and gas industries where firms enjoy high growth periods due
to technological innovations. Over this period, the firm enjoys
some sort of a patented monopoly power that allows the firm to reap
higher return than normal. In such a case, the valuation of the
firm is subject to two distinct streams of FCF. In the first stage,
FCF will be expected to grow at a higher-than-average rate, before
it levels off to its long run average. In the second stage, the
terminal or continuation value should be computed based on the
long-run stable growth rate which converges to the growth rate of
the economy or gross domestic product (GDP).
6. FCFE and APV. Students are expected to compute the Free Cash
Flow to Equity and the value of the firm based on the Adjusted
Present Value (APV) model. This part will be covered in week
8.
7. Individual Project. The purpose of the project is to broaden the
students’ view of how corporate valuation is applied in practice
and to acquire a hands-on training in financial decision making.
There will be some challenges throughout this process but keep in
mind that the purpose is to learn about the nature of these
challenges and devise means to overcome them. You might not be able
to find every single piece of information needed to complete the
valuation, but we can always find solutions by making reasonable
assumptions. We should also be tolerant of the fact that our
valuation result might not accurately match reality, and this is
where learning begins.
8. Finding Data. Information on financial statements for each
corporation can be found at finance.yahoo.com. Below you will find
tips on how to locate the data needed for the valuation. These URL
links keep changing all the time. Make sure you notify me in case
you are not able to collect the required data for your target
company. The website of each company is very resourceful in
providing financial data.
9. Excel File. This exercise can be best done in an Excel
spreadsheet appended with some background explanations on how
variables such as growth rate and WACC are calculated. Each student
is expected to build an Excel spreadsheet with multiple workbooks.
Each workbook will be used to calculate each of the main variables
of the model. Students will give a 15-minute presentation each
during the last week of classes. I will announce the exact date and
time later.
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