Historical Financial Statements - Return on Invested Capital (ROIC) - Accounting and Finance Assessment Answer

Internal Code: 1AHFFC

Accounting and Finance Assessment Answer

TASK: Part 1: This section asks you to value a company from the perspective of a potential investor: they’ve asked you to build a set of financial forecasts, estimate its cost of capital, and produce an estimate of value. They’ve also asked you to consider how the value of the firm might change if we value it using different assumptions; you’ll find specific guidance on this in the questions below. Information Provided: ? Historical financial statements (see spreadsheet). ? Assumptions for cash flow forecasts (given in questions). ? Assumptions for cost of capital estimates (see spreadsheet). 1) Examine the historical financial statements provided with this assignment and answer the following questions: a) What has this company’s Return on Invested Capital (ROIC) been for the last 3 years, and why has it been changing? b) What has this company’s EBIT/Interest Expense ratio been for the last few years, and is its credit risk higher or lower than it was in 2016? c) Calculate Free Cash Flow to the Firm & Free Cash Flow to Equity for the years shown, and explain what would have to change in order for it to increase. d) Calculate the dividend payout ratio of this firm for the years shown, and explain what would have to change in order for this company to increase its dividend. e) Now look at this company’s valuation ratios: Calculate the Price/Earnings Ratio and Price/Book Ratio for 2018, and compare them against the industry averages below. * Industry Average Price/Earnings Ratio: 25.0 * Industry Average Price/Book Ratio: 2.0 Do this company’s Price/Earnings and Price/Book Ratios look high or low relative to its industry? 2) You have been asked to produce a conservative set of forecasts based on the assumptions below. ? Revenue growth will be 2.0% per year during both the forecast period and the terminal year; ? The operating profit margin will remain at 2018 levels; ? The average tax rate will be 21%; ? The average interest rate on the company’s debt will be 4%; ? Both net working capital and net property plant & equipment will grow at the same rate as revenues (so that asset efficiency remains constant); ? The company will maintain its current capital structure (ie, debt/invested capital ratio should remain constant throughout the forecast period) ? Depreciation is 5% of Net Property, Plant, & Equipment. ? The company will pay all of its Free Cash Flow to Equity to Shareholders in the form of a dividend every year. Build out the unfinished sections of the model, and use your forecasts to answer the questions below. a) What have you predicted about this company’s Return on Invested Capital (ROIC)? Note your estimate for 2019, and explain whether you’ve predicted that the ROIC will increase, decrease, or remain the same in your forecast. b) What have you predicted about this company’s EBIT/Interest Expense ratio? Note your estimate for 2019, and explain whether you’ve predicted that this company’s credit risk will increase, decrease, or remain the same in your forecast. c) What have you predicted about this company’s Free Cash Flow? Note your estimates for Free Cash Flow to the Firm & Free Cash Flow to Equity for 2019, and discuss how they compare with the company’s free cash flow in 2018. d) What have you predicted about this company’s dividend? Note your estimates for both the Dividend Per Share and the Dividend Payout Ratio in 2019, and discuss how they compare with what we saw in 2018. e) What have you predicted about this company’s valuation ratios? Note your estimates for the Price/Earnings Ratio, Price/Book Ratio, and Dividend Yield in 2019, and discuss how they compare with your estimates from 2018. 3) Estimate this firm’s Cost of Equity, Cost of Debt, and Weighted Average Cost of Capital (WACC) using the assumptions provided in the spreadsheet. ? Unlevered Beta = 0.6 ? Market Risk Premium = 5% ? Credit Rating BBB ? Average Maturity of Debt = 5 years ? Assumptions for both interest rates on government bonds & risk premiums associated with different credit ratings are provided in “assumption” box of spreadsheet. a) Show your Cost of Equity calculation. b) Show your calculation for the After-tax Cost of Debt. c) Explain how you calculated the financing mix of this firm. d) Show your Weighted Average Cost of Capital (WACC) calculation. 4) Estimate the value of this firm using the forecasts you constructed above, and use your estimate to answer the questions below: a) What is your estimate for the value of this firm? b) How much should an investor be willing to pay for one share of its stock? c) Use your estimate to construct “target” valuation ratios for this company’s stock. What should the Price/Earnings ratio and Price/Book ratio for 2019 be based on your estimated value? d) Should our client invest in this company at the current market price of $62 per share based on these estimates? Section 2: Considering an alternate forecast 5) Our client would also like us to estimate the value of this company using a more optimistic forecast. Specifically, they have pointed out that this company’s competitors have an average operating profit margin of 14%, and they would like to see what this company’s value would be if it could raise its operating profit margin to 14% over the next 4 years. Change your forecast to reflect this assumption, and note how your estimated value changes as a result. Note: use the original assumption of 30% debt/invested capital a) What is the value of the firm using these assumptions? b) How much should an investor be willing to pay for one share of its stock? c) How have your “target” valuation ratios for this company’s stock changed using these new assumptions? Calculate the target Price/Earnings ratio and target Price/Book ratio for 2019 based on your new estimates, and discuss how they have changed. d) Should our client invest in this company at the current price of $62 per share based on these estimates? Section 3: Considering a different capital structure Our client is considering two possibilities: paying off this company’s debt entirely, or increasing its debt to 50% debt/invested capital. Use the original modeling assumptions (ie: 2% growth, operating profit margin of 12%) to answer the questions below. 6) Scenario #1: 100% equity financing Estimate how the value of this firm would change if it pays back all its debt immediately and chooses not to use any debt financing for the foreseeable future. You may assume that they obtain the cash needed to do this from shareholders. a) What would the value of this firm be if it had no debt? b) Explain how you arrived at this estimate: which parts of your calculation changed, and in what way? c) How has the use of debt affected this company’s value, and would this company be better off with its current capital structure, or with 100% equity? Explain your reasoning. 7) Scenario #2: 50% debt/invested capital Estimate how the value of this firm would change if it begins using 50% debt/invested capital in 2019, and maintains that capital structure for the foreseeable future. You may assume that the cash raised is given to shareholders; and that this company’s their credit rating will fall to B as a result. a) What would the value of this firm be if it increased its use of debt as described in this question? b) Explain how you arrived at this estimate: which parts of your calculation changed, and in what way? c) Would making this choice increase or decrease the value of this company’s equity? Explain your reasoning. d) Would you recommend that this firm change its capital structure, and if so in what way? Explain your reasoning, Section 4: Considering the Role of Growth 8) Our client also suspects that this company may be able to grow by significantly more than 2.5%, and would like our assessment of how higher growth is likely to affect our estimate of value. a) Explain, in principle, whether higher growth likely to increase or decrease the value of this firm. b) What would the value of this firm be if revenues grew by 15% per year during the forecast period, then slowed to a sustainable growth rate of 2% in the terminal year? 9) The connection between growth & financing requirements: a) What is the limit on how fast this company can grow if it does NOT want to use any external financing (ie: would like to finance all of its investment spending using internally generated cash flows)? b) If this company does have external financing needs: would it be better off using debt or equity to finance its investment spending? Explain your reasoning. Section 4: Conclusions 10) Based on the analysis that you’ve conducted in this assignment, would you recommend that our client invest in this firm at the correct price of $62 per share? Explain your reasoning.

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