P6-2. Assessing credit risk using cash flow forecasts

Transcription

1 P6-2. Assessing credit risk using cash flow forecasts Requirement 1: If Randall s cash flow forecasts are accurate, it will be unable to repay the loan at the end of Year 4. At the end of Year 1, Randall will have only $95,000 of cash available to make loan interest and principal payments. This amount grows to $1,815,000 by the end of Year 4, a figure that represents the sum of the net change in cash each year ($95,000 + $565,000 + $570,000 + $585,000). But Randall will owe the bank $2,000,000 plus any unpaid interest interest that totals $200,000 each year using a 10% annual interest rate. Unless Randall has other highly liquid assets that could be sold in Year 4 to generate additional cash, the company will be unable to repay the loan. Consequently, Randall s credit risk is extremely high. Requirement 2: There are several ways Randall could enhance its credit worthiness and reduce its credit risk. One approach is to focus on generating more operating cash flow each year by growing sales, reducing costs, or both. A second approach is to contractually agree to not pay dividends without bank approval. Curtailment of the company s planned dividend payments would add another $400,000 to the cash available for loan repayment in Year 4, for a total of $2,215,000. Although dividend curtailment is helpful, Randall is still an extremely high credit risk because the cumulative cash available to pay the loan is less than the combined amount owed (loan principal and interest payments). A third approach is to request repayment over a 5-year rather than 4-year period. Randall would then have the advantage of one more year of operating cash flow, projected to be in excess of $550,000, which would then be available to repay the loan. Randall might also offer to make partial principal payments of say $500,000 each year beginning 1

2 P6-3. Valuing growth opportunities Requirement 1: The cost of equity capital for ebay is higher than that of Wal-Mart because ebay has a riskier cash flow stream than does Wal-Mart. Wal-Mart has a long history of predictable earnings and operating cash flows from its geographically dispersed retail stores. By comparison, ebay is a relatively young company and its earnings and operating cash flows are more volatile. Requirement 2: To find the NPVGO for each company, you need to solve the following expression: P 0 = X 0 + NPVGO r where P is the current stock price, X is current reported earnings per share for the year, and r is the estimated cost of equity capital. Rearranging terms gives us: P 0 - X 0 r = NPVGO Using this expression and the data provided in the problem statement gives us the following estimates of NPVGO for each company. Earnings Cost of Share price per share equity NPVGO P X r X/r = P - X/r Dell Computer $26.74 $ $5.94 $20.80 ebay $67.82 $ $4.14 $63.68 Ford Motor $9.30 $ $8.68 $0.62 Home Depot $24.02 $ $12.81 $11.21 Wal-Mart $50.51 $ $20.33 $30.18 Requirement 3: The NPVGO at Home Depot is lower (in dollar terms and as a percent of share price) than that for ebay because investors believe that ebay has better growth opportunities a higher rate of growth and more profitable growth. Alternatively, 2

3 Home Depot s earnings per share may have been temporarily increased because of a one-time (transitory) gain. If so, the resulting NPVGO estimate will be too low unless the one-time gain is eliminated prior to computing NPVGO. Requirement 4: The NPVGO at Ford Motor is lower (in dollar terms and as a percent of share price) than that for Wal-Mart because investors believe that Wal-Mart has better growth opportunities a higher rate of growth and more profitable growth. At the same time, Wal-Mart s earnings per share may have been temporarily decreased because of a one-time (transitory) charge. If so, the resulting NPVGO estimate will be too high unless the one-time charge is eliminated prior to computing NPVGO. 3

4 P6-7. Determining abnormal earnings: Some simple examples Abnormal earnings (AE) = NOPAT - (r x BV t-1 ). Requirement 1: AE = $5,000 - (0.15 x $50,000) = $5,000 - $7,500 = -$2,500 Requirement 2: AE = $25,000 - (0.18 x $125,000) = $25,000 - $22,500 = $2,500 Requirement 3: AE = $30,000 - (0.18 x $125,000) = $30,000 - $22,500 = $7,500 NOTE: Higher NOPAT without additional investment (i.e., the same BV t-1 ) is good. Requirement 4: AE = $23,000 - (0.18 x $100,000) = $23,000 - $18,000 = $5,000 NOTE: Eliminating unproductive assets that do not earn as high a rate of return as other assets increases AE. In this case, the unproductive assets were earning a return of only 8% ($2,000/$25,000). Requirement 5: AE = $32,600 - (0.18 x $165,000) = $32,600 - $29,700 = $2,900 AE increases by $400 (from $2,500 to $2,900). Adding the division makes sense. The new division earns a return of 19% ($7,600/$40,000), which is more than the 4

5 firm s 18% required rate of return, so value is added, and the change in AE is positive. Requirement 6: AE = $8,500 - (0.15 x $75,000) = $8,500 - $11,250 = -$2,750 AE falls by $250. Adding the new division does not make sense. In essence, the new division does not earn a high enough rate of return to justify investment. The new division earns a return of 14% ($3,500/$25,000) which is less than the firm s 15% required rate of return, so value is lost, and the change in AE is negative. 5

6 P6-9. Calculating value creation by two companies Requirement 1: The abnormal earnings of the two firms for appear below. Company A NOPAT $66,920 $79,632 $83,314 $89,920 $92,690 BV t-1 478, , , , ,000 Cost of equity capital Return on capital Abnormal earnings ($5,736) ($4,536) ($2,705) ($6,744) ($6,578) Company B NOPAT $192,940 $176,341 $227,700 $198,900 $282,964 BV t-1 877, , ,999 1,020,000 1,199,000 Cost of equity capital Return on capital Abnormal earnings $28,064 $7,544 $46,530 $20,400 $59,950 Requirement 2: Company B created value each year via positive abnormal earnings, while Company A actually destroyed value each year by earning negative abnormal earnings. 6

7 Requirement 3: It s a trick question because the return investors earn from a stock depends on the difference between what must paid to buy the stock it s cost or current market price and what it will ultimately be worth at the time it is sold it s value, expressed in current dollars. In an efficient market, the current price ( cost ) of each stock is approximately equal to what the stock is worth today, and investors only get compensated for bearing risk. Exceptional investment returns are earned only if the stock is somehow mispriced currently. How do these notions apply to company A and B? Well, Company B has clearly outperformed Company A during the years shown. Let s presume that this favorable performance difference is expected to continue into the future. The performance differences between A and B are likely to be already reflected in the current market prices of each company s stock: Company A will appear cheap precisely because it underperforms, whereas Company B will have a high market price because it outperforms. Investors who purchase shares in B will, if the stock is correctly priced by the market, simply earn a return that compensates them for bearing risk. But the same holds true for investors who purchase shares in A. If the market is efficient, neither stock will be an exceptional investment because the performance differential has already been baked into the current market price of each company s shares. P6-13 Krispy Kreme Doughnuts: Valuing abnormal earnings Requirement 1: The following table implements the abnormal earnings valuation procedure illustrated in Exhibit 6.9 of the appendix. 7

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9 Notes: $1.54 x (1+0.03) = /(11%-3%) =12.5 (1.59/ 0.08)x = 11.8 Requirement 2: The value estimate from requirement 1 ($19.63 per share) is substantially below the market price of the stock ($44.00) in August There are several reasons why the abnormal earnings value estimate might differ from the company s actual market price: Investors may be more optimistic about the company s profit prospects than are analysts, and the value estimate is based on analysts less optimistic EPS forecasts. Investors and analysts may agree about EPS forecasts over the next five years, but the terminal growth assumption (3.0%) used here may be overly pessimistic. A higher terminal growth rate (say 8.5%) will produce a higher share value estimate ($47.60). It is, however, unlikely that Krispy Kreme can grow at 8.5% for ever. We may have assigned the company a cost of equity capital that is too large. Given the forecasts used in the valuation model, a 7% cost of capital (discount rate) will yield a value estimate slightly in excess of $44 per share. However, this discount rate seems unreasonably low for a company such as Krispy Kreme. The most interesting possibility is that the stock is overvalued at $44 per share. Why might this occur? One reason is that investors are overly optimistic about the company s profit prospects because they fail to properly consider the company s growth opportunities and competitive dynamics in the industry. It is interesting to note that 9 months later (May 2004) the stock was trading at about $20 per share. 9

10 Solutions to financial statement forecasts question on PowerPoint Krispy Kreme Doughnuts (source: P6-21, RCJM textbook, 4 th edition) Students may want to build their own spreadsheets to solve this problem, using the procedures outlined in Appendix B. If not, a spreadsheet template is available on the web site. The template contains historical Krispy Kreme financial statement data that corresponds to the data. Requirement 1: The following financial statement ratios and amounts summarize the forecasts used to generate projected Krispy Kreme financial statements: Historical Ratios and Forecasts Historical Projected Sales growth 31.2% 24.6% 33.7% 24.7% Historical Projected Expense margins Cost of goods sold 80.9% 78.0% 78.0% 78.0% Research & development expense 0.0% 0.0% 0.0% 0.0% Selling, general and administrative expense 6.5% 5.5% 5.5% 5.5% Non-operating income (loss) 0.5% -2.0% 0.0% 0.0% Minority interest 0.3% 0.5% 0.5% 0.5% Other comprehensive income -0.1% 0.0% 0.0% 0.0% Historical Projected Operating asset and liability utilization (% of sales) Operating cash & equivalents / sales 5.6% 6.6% 6.6% 6.6% Accounts receivable / sales 9.8% 9.4% 9.4% 9.4% Inventory / sales 4.1% 5.0% 5.0% 5.0% Other current assets / sales 6.3% 7.8% 7.8% 7.8% Property, plant and equipment (cost) / sales 39.7% 51.4% 51.4% 51.4% Other assets / sales 10.4% 13.6% 13.6% 13.6% Accounts payable / sales 3.1% 2.9% 2.9% 2.9% Other current liabilities / sales 9.1% 8.4% 8.4% 8.4% Other liabilities / sales 2.2% 3.1% 3.1% 3.1% Minority interest / sales 0.6% 1.1% 1.1% 1.1% 10

11 Historical Projected Financial Structure Debt / Assets 3.3% 15.0% 15.0% 15.0% Current portion long-term debt / debt 54.1% 6.8% 10.0% 10.0% Interest rate on beginning debt 3.5% 2.9% 6.0% 6.0% Dividends ($ in thousands) - - $0 $0 Historical Projected Depreciation expense / PP&E cost 5.1% 4.9% 4.9% 4.9% Tax expense / pre-tax earnings 37.1% 37.3% 35.0% 35.0% The historical and projected financial statements are as follows: ($ in thousands) Historical Projected INCOME STATEMENT Sales $394.4 $491.5 $657.0 $819.0 Cost of goods sold Research & development expense Selling, general and administrative expense Depreciation expense Pre-tax operating income Interest expense Non-operating income (loss) 2.1 (10.0) - - Pre-tax earnings Tax expense Minority interest Net income $26.4 $33.5 $54.0 $ = x 4.9% = 6%x z( ) = 35% x

12 Historical Projected BALANCE SHEET Operating cash and equivalents $21.9 $32.2 $43.4 $54.1 Accounts receivable Inventories Other current assets Current assets Property, plant and equipment (gross) Accumulated depreciation (43.9) (50.2) (66.7) 1 (87.4) Other assets Total assets $255.4 $410.5 $549.5 $680.8 Current portion of long-term debt $4.6 $4.2 $8.2 $10.2 Accounts payable Other payables Current liabilities Long-term debt Other liabiltiies Minority interest Shareholders equity: Contributed capital Retained earnings Total shareholders equity Total liabilities and equity $255.4 $410.5 $549.5 $680.8 Historical Projected RETAINED EARNINGS Beginning retained earnings $40.6 $66.6 $100.2 $ Net income Other comprehensive income items (0.4) Dividends = Ending retained earnings $66.6 $100.2 $154.2 $ = A plug in number 12

13 ($ in thousands) Historical Projected CASH FLOW STATEMENT Net income $26.4 $33.5 $54.0 $67.1 Non-cash expenses: Depreciation Changes in non-cash working capital accounts Accounts receivable decrease (14.0) (7.5) (15.6) (15.2) Inventory decrease (4.2) (8.2) (8.4) (8.1) Other current asset decrease (1.9) (13.3) (12.9) (12.6) Accounts payable increase Other current liabilities increase Cash from operations $27.5 $24.4 $52.4 $70.1 Increase in property, plant and equipment ($55.8) ($102.2) ($84.9) ($83.3) Increase in other assets 12.3 (25.8) (22.6) (22.0) Cash used in investing activities ($43.5) ($128.0) ($107.4) ($105.3) Increase in long-term debt $5.0 $52.9 $21.0 $19.7 Increase in other liabilities Increase in contributed capital Dividends paid Cash from financing activities $30.9 $113.9 $66.2 $45.9 Net increase (decrease) in cash $14.9 $10.3 $11.2 $10.7 Requirement 2: In October 2003, Analysts were forecasting Krispy Kreme s net income to be $50.7 million in 2003 and $65.9 million in These amounts compare to $54.0 million and $67.1 million, respectively, from Requirement 1 above. Analysts appear to be forecasting high operating expenses in 2003 and 2004 than the solution above would suggest since both sets of forecasts rely on the same projected sales levels. Requirement 3: This assumption may seem odd at first, but it is necessary to balance the books. Recall that Appendix B (and the Krispy Kreme template) relies on an explicit forecast of Cash (as a percent of sales). To achieve this desired cash balance and to make certain that the net income statement, balance sheet, and cash flow statement agree with one another any cash shortfall or 13

14 excess must be resolved as part of the forecasting process. A common approach for doing so is to raise needed cash by assuming the company sells stock, and to distribute excess cash by assuming the company buys back stock. This assumption ensures that the resulting financial statement forecasts are internally consistent with one another. Requirement 4: The following amounts (in millions) are from the company s 2003 and 2004 financial statements: Revenues $491.5 $665.6 Net income Total assets $410.5 $660.7 Receivables Current liabilities Long-term debt Cash from operations $ 51.0 $