Chapter 8

Prospective Analysis: Valuation Implementation

Question 1. How will the forecasts in Table 8-3 for TJX change if the assumed growth rate in sales from 2002 to 2011 remains at 12 percent (and all the other
assumptions are kept unchanged)?

Table 8-3 Forecasted Financial Statements for TJX

Fiscal-Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Beginning Balance Sheet ($MM)

Beg. Net Working Capital 297.4 335.8 376.1 421.3 471.8 528.4 591.9 662.9 742.4 831.5
+ Beg. Net Long-Term Assets 1,254.2 1,410.5 1,579.8 1,769.3 1,981.7 2,219.5 2,485.8 2,784.1 3,118.2 3,492.4
= Net Operating Assets 1,551.5 1,746.3 1,955.9 2,190.6 2,453.5 2,747.9 3,077.6 3,447.0 3,860.6 4,323.9

Net Debt 210.8 237.3 265.8 297.7 333.4 373.4 418.2 468.4 524.6 587.6
+ Preferred Stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
+ Shareholders' Equity 1,340.7 1,509.0 1,690.1 1,892.9 2,120.1 2,374.5 2,659.4 2,978.5 3,336.0 3,736.3
= Net Capital 1,551.5 1,746.3 1,955.9 2,190.6 2,453.5 2,747.9 3,077.6 3,447.0 3,860.6 4,323.9

Income Statement ($MM)

Sales 11,994.1 13,433.4 15,045.4 16,850.8 18,872.9 21,137.7 23,674.2 26,515.1 29,696.9 33,260.5
Net operating profits after tax 539.7 537.3 526.6 505.5 471.8 422.8 449.8 477.3 504.8 532.2
- Net interest expense after tax 14.8 16.7 18.7 20.9 23.4 26.2 29.4 32.9 36.8 41.2
= Net income 524.9 520.7 507.9 484.6 448.4 396.5 420.4 444.4 468.0 490.9

Operating ROA 34.8% 30.8% 26.9% 23.1% 19.2% 15.4% 14.6% 13.8% 13.1% 12.3%
ROE 39.2% 34.5% 30.1% 25.6% 21.2% 16.7% 15.8% 14.9% 14.0% 13.1%
BV of Assets Growth Rate 7.4% 12.6% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%
BV of Equity Growth Rate 10.0% 12.6% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0% 12.0%
Net Operating Asset Turnover 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7

Free Cash Flow to Capital 344.9 327.8 291.9 242.7 177.4 93.0 80.5 63.6 41.6 186.3
Free Cash Flow to Equity 356.6 339.6 305.1 257.5 194.0 111.6 101.3 87.0 67.7 192.0
Question 2. Recalculate the forecasts in Table 8-3 assuming that the NOPAT profit margin declines by 0.1 percentage points per year between fiscal 2002 and 2011 (keeping all the other assumptions
unchanged).

Table 8-3 Forecasted Financial Statements for TJX

Fiscal-Year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Beginning Balance Sheet ($MM)

Beg. Net Working Capital 297.4 334.3 371.1 410.1 451.1 493.9 538.4 584.2 630.9 681.4
+ Beg. Net Long-Term Assets 1,254.2 1,404.2 1,558.7 1,722.3 1,894.6 2,074.5 2,261.3 2,453.5 2,649.7 2,861.7
= Net Operating Assets 1,551.5 1,738.5 1,929.8 2,132.4 2,345.6 2,568.5 2,799.6 3,037.6 3,280.6 3,543.1

Net Debt 210.8 236.3 262.2 289.8 318.8 349.0 380.5 412.8 445.8 481.5
+ Preferred Stock 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
+ Shareholders' Equity 1,340.7 1,502.3 1,667.5 1,842.6 2,026.9 2,219.4 2,419.2 2,624.8 2,834.8 3,061.6
= Net Capital 1,551.5 1,738.5 1,929.8 2,132.4 2,345.6 2,568.5 2,799.6 3,037.6 3,280.6 3,543.1

Income Statement ($MM)

Sales 11,994.1 13,373.4 14,844.5 16,403.1 18,043.5 19,757.6 21,535.8 23,366.3 25,235.6 27,254.5
Net operating profits after tax 539.7 588.4 638.3 688.9 739.8 790.3 839.9 887.9 933.7 981.2
- Net interest expense after tax 14.8 16.6 18.4 20.3 22.4 24.5 26.7 29.0 31.3 33.8
= Net income 524.9 571.8 619.9 668.6 717.4 765.8 813.2 858.9 902.4 947.4

Operating ROA 34.8% 33.8% 33.1% 32.3% 31.5% 30.8% 30.0% 29.2% 28.5% 27.7%
ROE 39.2% 38.1% 37.2% 36.3% 35.4% 34.5% 33.6% 32.7% 31.8% 30.9%
BV of Assets Growth Rate 7.4% 12.1% 11.0% 10.5% 10.0% 9.5% 9.0% 8.5% 8.0% 8.0%
BV of Equity Growth Rate 10.0% 12.1% 11.0% 10.5% 10.0% 9.5% 9.0% 8.5% 8.0% 8.0%
Net Operating Asset Turnover 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7 7.7

Free Cash Flow to Capital 352.7 397.2 435.7 475.7 516.9 559.1 601.9 644.9 671.3 697.7
Free Cash Flow to Equity 363.3 406.6 444.8 484.3 524.9 566.1 607.6 649.0 675.6 702.4
Question 3. Recalculate the forecasts in Table 8-4 assuming that the ratio of net operating working capital to sales is 3 percent, and the ratio of net long-term assets to
sales is 15 percent for all the years from fiscal 2003 to fiscal 2011. Keep all the other assumptions unchanged.

Table 8-4 Performance Forecasts for TJX for the fiscal years 2002 to 2011

Fiscal year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Equity Valuation ($000's)

Abnormal Earnings 372,897 276,090 232,238 174,607 101,850 12,738 -7,651 -31,668 -59,437 -91,446

Abnormal ROE 27.8% 13.3% 10.1% 6.8% 3.6% 0.4% -0.2% -0.9% -1.5% -2.2%

Free Cash Flow to Equity -214,454 283,162 251,632 208,795 153,489 84,648 87,479 89,720 71,662 1,321,879

Asset Valuation ($000's)

Abnormal NOPAT 365,129 264,038 218,860 159,824 85,589 -5,067 -27,059 -52,726 -82,179 -116,008

Abnormal Operating ROA 23.5% 11.0% 8.2% 5.4% 2.6% -0.1% -0.7% -1.3% -1.8% -2.4%

Free Cash Flow to Capital -315,933 270,143 238,996 196,838 142,543 75,079 79,682 84,119 65,613 1,515,348

Discount rates:

Equity 0.898 0.807 0.725 0.651 0.584 0.525 0.471 0.423 0.380 0.342

Assets 0.899 0.808 0.726 0.653 0.587 0.527 0.474 0.426 0.383 0.344

Growth factors*:

Equity 1.000 1.551 1.722 1.903 2.093 2.292 2.498 2.711 2.928 3.162

Assets 1.000 1.551 1.722 1.903 2.093 2.292 2.498 2.711 2.928 3.162

*The growth factor is relevant only for calculating the present value for abnormal ROA and ROE.
Question 4. Calculate TJX’s cash payouts to its shareholders in the years 2002-2011 implicitly assumed in the projections in Table 8-3.

Cash Payouts:
Beg.Equity1 1,340.7 1,502.3 1,667.5 1,842.6 2,026.9 2,219.4 2,419.2 2,624.8 2,834.8
+ Net Income1 524.9 518.4 501.1 471.8 428.7 370.6 382.5 391.6 397.7
- Beg.Equity2 1,502.3 1,667.5 1,842.6 2,026.9 2,219.4 2,419.2 2,624.8 2,834.8 3,061.6
= Cash Payouts 363.3 353.1 326.1 287.5 236.2 170.9 176.8 181.6 170.9
Question 5. How will the abnormal earnings calculations in Table 8-4 change if the cost of equity assumption is changed to 15%?

Table 8-4 Performance Forecasts for TJX for the fiscal years 2002 to 2011

Fiscal year 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

Equity Valuation ($000's)

Abnormal Earnings 324,095 293,309 251,350 195,726 125,082 38,176 20,077 -1,583 -26,946 -56,356

Abnormal ROE 24.2% 19.5% 15.1% 10.6% 6.2% 1.7% 0.8% -0.1% -1.0% -1.8%

Free Cash Flow to Equity 363,347 353,099 326,056 287,489 236,155 170,899 176,840 181,629 170,924 157,344

Asset Valuation ($000's)

Abnormal NOPAT 309,782 277,270 233,547 176,054 103,442 14,482 -5,751 -29,606 -57,210 -89,041

Abnormal Operating ROA 20.0% 15.9% 12.1% 8.3% 4.4% 0.6% -0.2% -1.0% -1.7% -2.5%

Free Cash Flow to Capital 352,737 343,696 316,929 278,853 228,250 163,988 171,209 177,584 166,555 152,625

Discount rates:

Equity 0.870 0.756 0.658 0.572 0.498 0.433 0.376 0.327 0.285 0.248

Assets 0.871 0.759 0.661 0.575 0.501 0.436 0.380 0.331 0.288 0.251

Growth factors*:

Equity 1.000 1.121 1.244 1.374 1.512 1.655 1.804 1.958 2.114 2.284

Assets 1.000 1.121 1.244 1.374 1.512 1.655 1.804 1.958 2.114 2.284

*The growth factor is relevant only for calculating the present value for abnormal ROA and ROE.
Question 6. How will the terminal values in Table 8-5 change if the sales growth in years 2012 and beyond is 5 percent (keeping all the other assumptions in the table
unchanged)?

Table 8-5 Valuation Summary for TJX Under Varying Scenarios*

Value from
forecasts
Scenario 1 Value from beyond 2011
Beginning forecasts for (Terminal
Book Value 2002-2011 Value) Total Value Value per Share ($)

Equity Value ($000s)

Abnormal Earnings 1,340,698 1,329,973 311,625 2,982,295 10.83

Abnormal ROE 1,340,698 1,329,973 311,625 2,982,295 10.83

Free Cash Flows to Equity N/A 1,572,614 1,409,681 2,982,295 10.83

Asset Value ($000s)

Abnormal NOPAT 1,551,545 1,266,154 215,863 3,033,562 N/A

Abnormal ROA 1,551,545 1,266,154 215,863 3,033,562 N/A

Free Cash Flows to Capital N/A 1,537,052 1,496,510 3,033,562 N/A

 Value from
Scenario 2 Value from forecasts
Beginning forecasts for beyond 2011
Book Value 2002-2011 (Terminal Value) Total Value Value per Share ($)

Equity Value ($000s)

Abnormal Earnings 1,340,698 1,320,663 157,445 2,818,807 10.24

Abnormal ROE 1,340,698 1,320,663 157,445 2,818,807 10.24

Free Cash Flows to Equity N/A 1,563,305 1,255,502 2,818,807 10.24

Asset Value ($000s)

Abnormal NOPAT 1,551,545 1,256,772 58,336 2,866,652 N/A

Abnormal ROA 1,551,545 1,256,772 58,336 2,866,652 N/A

Free Cash Flows to Capital N/A 1,527,670 1,338,983 2,866,652 N/A

* Scenario 1: Sales growth and NOPAT/Sales of 5% and 1.6%, respectively.

Scenario 2: Sales growth and NOPAT/Sales of 5% and 1.5%, respectively.
Question 7. Calculate the proportion of terminal values to total estimated values of equity under the abnormal earnings method and the discounted cash flow method.

Table 8-5 Valuation Summary for TJX Under Varying Scenarios*

Scenario 1 Value from Value from forecasts Proportion of terminal

Beginning Book forecasts for 2002- beyond 2011 values to total estimated
Value 2011 (Terminal Value) Total Value Value per Share ($) values of equity

Equity Value ($000s)

Abnormal Earnings 1,340,698 1,329,973 608,428 3,279,098 11.91 18.55%

Abnormal ROE 1,340,698 1,329,973 608,428 3,279,098 11.91 18.55%

Free Cash Flows to Equity N/A 1,541,241 1,737,857 3,279,098 11.91 53.00%

Asset Value ($000s)

Abnormal NOPAT 1,551,545 1,266,154 426,755 3,244,454 N/A 13.15%

Abnormal ROA 1,551,545 1,266,154 426,755 3,244,454 N/A 13.15%

Free Cash Flows to Capital N/A 1,500,462 1,743,992 3,244,454 N/A 53.75%
Scenario 2 Value from Value from forecasts Proportion of terminal
Beginning Book forecasts for 2002- beyond 2011 values to total estimated
Value 2011 (Terminal Value) Total Value Value per Share ($) values of equity

Equity Value ($000s)

Abnormal Earnings 1,340,698 1,329,973 266,605 2,937,276 10.67 9.08%

Abnormal ROE 1,340,698 1,329,973 266,605 2,937,276 10.67 9.08%

Free Cash Flows to Equity N/A 1,583,072 1,354,204 2,937,276 10.67 46.10%

Asset Value ($000s)

Abnormal NOPAT 1,551,545 1,266,154 184,331 3,002,030 N/A 6.14%

Abnormal ROA 1,551,545 1,266,154 184,331 3,002,030 N/A 6.14%

Free Cash Flows to Capital N/A 1,549,248 1,452,781 3,002,030 N/A 48.39%
 Scenario 3 Value from Value from forecasts Proportion of terminal
Beginning Book forecasts for 2002- beyond 2011 values to total estimated
Value 2011 (Terminal Value) Total Value Value per Share ($) values of equity

Equity Value ($000s)

Abnormal Earnings 1,340,698 1,329,973 134,700 2,805,370 10.19 4.80%

Abnormal ROE 1,340,698 1,329,973 134,700 2,805,370 10.19 4.80%

Free Cash Flows to Equity N/A 1,583,072 1,222,299 2,805,370 10.19 43.57%

Asset Value ($000s)

Abnormal NOPAT 1,551,545 1,266,154 49,814 2,867,513 N/A 1.74%

Abnormal ROA 1,551,545 1,266,154 49,814 2,867,513 N/A 1.74%

Free Cash Flows to Capital N/A 1,549,248 1,318,265 2,867,513 N/A 45.97%

* Scenario 1: Sales growth and NOPAT/Sales of 8% and 1.6%, respectively.

Scenario 2: Sales growth and NOPAT/Sales of 4% and 1.6%, respectively.
Scenario 3: Sales growth and NOPAT/Sales of 4% and 1.5%, respectively.

Why are these proportions different?

The abnormal earnings method begins with the book value (which represents in some sense "normal earnings") and adds to it abnormal earnings over time. The terminal value in this method, therefore, represents
the present value of only that portion of earnings that are above the cost of capital. The discounted cash flow method, in contrast, ignores book value completely. Instead, it captures the present value of total cash
flows - both normal and abnormal. Therefore, the terminal value in this method is significantly larger than the terminal value in accounting based valuation approaches. In essence, part of the terminal value in
DCF is substituted by the book value in accounting-based valuation.
Question 8. What will be TJX’s cost of equity if the equity market risk premium is 5%?

Market risk premium 5%

x Common equity beta 0.9
4.5%
+ Risk free rate 5%
= Cost of common equity 9.50%

Question 9. Assume that TJX changes its capital structure so that its market value weight of debt to capital
increases to 30%, and its after-tax interest rate on debt at this new leverage level is 8%. Assume
that the equity market risk premium is 7%. What will be the cost of equity at the new debt level?
What will be the weighted average cost of capital?

Cost of Equity

Market risk premium 7%

x Common equity beta 0.9
6.3%
+ Risk free rate 5%
= Cost of common equity 11.30%

Weighted Average Cost of Capital

After tax cost of debt 8.0%

x Net debt/ market value of net capital 30.0%
+
Cost of preferred equity (if applicable) N/A
x Preferred equity/ market value of net capital 0.0%
+
Cost of common equity 11.3%
x Shareholders' equity/ market value of net capital 70.0%

= Weighted Average Cost of Capital 10.3%

Question 10. Nancy Smith says she is uncomfortable making the assumption that TJX’s dividend payout
 will vary from year to year. If she makes a constant dividend payout assumption, what changes does she have to make in her other valuation assumptions to
make them internally consistent with each other?

If Nancy Smith doesn't want to allow dividend payout to vary across the years, then she can hold the dividend payout constant. However, then she will have to allow for the
capital structure to vary from year to year, since a constant dividend payout may not result in a stream of equity values that will result in a constant debt to equity ratio. If the
capital structure is allowed to vary, then the cost of capital will vary each period as well.