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Source of Proportion Opportunity Tax After-tax Contribution
capital of total cost rate cost to weighted
Debt 121 5.5 39.0 3.4 0.4
Equity 87.9 8.1 8.1 7.1
solved by separating the value of the business into two periods, during and after an explicit forecast period. In this case,
y . Present value of cash flow + Present value of cash flow during explicit forecast period aftt’r explicit forecast period
The value after the explicit forecast period is referred to as the continuing value. Formulas derived from discounted cash flows using several simplifying assumptions can be used to estimate continuing value. One such formula that we recommend is as follows (Chapter 12 contains a more detailed look at continuing value approaches):
NOPLAT (1 -g/ROIC,) WACC-g
Where NOPLAT Net operating profits less adjusted taxes (in the year after the = explicit forecast period)
Incremental return on new invested capital Expected perpetual growth in the company's NOPLAT Weighted average cost of capital
Exhibit 8.6 shows the continuing value calculation for Hershey.
Value of Debt
The value of the company's debt equals the present value of the cash flow to debt holders discounted at a rate that reflects the riskiness of that flow. The discount rate should equal the current market rate on similar-risk debt with comparable terms. In most cases, only the company's debt outstanding on the valuation date must be valued. Future borrowing can be assumed to have zero net present value because the cash inflows from these borrowings will exactly equal the present value of the future repayments discounted at the opportunity cost of the debt.
Exhibit 8.6 Hershey Foods—Continuing Value
NOPLAT 2009 634
Return on incremental invested capital (ROICi) 21.3% Continuing value = NOPLAT,,., (1 - g/ROIC|)
NOPLAT growth rate in perpetuity (g) 4.0% WACC-g
Weighted average cost of capital (WACC) 7.5% = 14,710
Value of Equity
The value of the company's equity is the value of its operations plus nonoperating assets, such as investments in unrelated, unconsolidated businesses, less the value of its debt and any nonoperating liabilities. The valuation of Hershey's equity (as illustrated in Exhibit 8.3) is $9.4 billion, including $450 million representing the value of its pasta business, which was sold in early 1999.
What Drives Cash Flow and Value
You could stop right here and say that once you have projected free cash flow and discounted it at the WACC, the valuation is complete. This would not be satisfying, however, because you have not evaluated the free cash flow projection upon which the valuation was based. How does the projection compare to past performance? How does the projection compare with other companies? What are the economics of the business? Are they expressed in a way that managers and others can understand? What are the important factors that could increase or decrease the value of the company? You need to step back and understand the underlying economic value drivers of the business.
Since value is based on discounted free cash flow, the underlying value drivers of the business must also be the drivers of free cash flow. As we explained in Chapters 3 and 4, there are two key drivers of free cash flow and ultimately value: the rate at which the company is growing its revenues, profits, and capital base, and the return on invested capital (relative to the cost of capital). These value drivers make common sense. A company that earns higher profit for every dollar invested in the business will be worth more than a similar company that earns less profit for every dollar of invested capital. Similarly, a faster growing company will be worth more than a slower growing company if they are both earning the same return on invested capital (and this return is high enough to satisfy the investors).
A simple model will demonstrate how growth and return on invested capital actually drive free cash flow. First, some definitions are needed. Return on invested capital (ROIC) equals the operating profits of the company divided by the amount of capital invested in the company.
ROIC =; NOPLAT
Where, = Net operating profits less adjusted taxes
Invested capital = Operating working capital + Net property, plant, and equipment + Other assets
Earlier in this chapter (see Exhibit 8.4), we defined free cash flow as equal to gross cash flow (NOPLAT plus depreciation) minus gross investment (increases in working capital plus capital expenditures). To simplify the following examples, we will show free cash flow as NOPLAT less net investment, having subtracted depreciation from both gross cash flow and gross investment. In year 1, Company A's NOPLAT equals $100 and net investment equals $25, so free cash flow must equal $75.
Company A NOPLAT Net investment Free cash flow
Year 1 $100.0 25.0 $ 75.0
Company A invested $25 over and above depreciation to earn additional profits in future years. Assume Company A earns a 20 percent return on its new investment in year 2 and every subsequent year. Year 2's NOPLAT would equal year 1's NOPLAT ($100) plus 20 percent of year 1's investment or $5 ($25 x 20%) for a total of $105. (We have also assumed that the operating profit on the base level of capital in place at the beginning of year 1 does not change.) Suppose the company reinvests the same percentage of its operating profits each year and earns the same return on new capital. Company A's free cash flow would look as follows: