Problems

Problem 9-18
Problem 9-20
Problem 9-21
Problem 9-23
Problem 9-24
Problem 9-25
Problem 9-26
Table 9-1
Problem 9-18

Heavy Metal Corporation is expected to generate the following free cash flows over the ne
five years:

Year 1 2 3 4 5
FCF ($ million) 53 68 78 75 82

After then, the free cash flows are expected to grow at the industry average of 4% per year.
discounted free cash flow model and a weighted average cost of capital of 14%:

a. Estimate the enterprise value of Heavy Metal.

b. If Heavy Metal has no excess cash, debt of $300 million, and 40 million shares outstand
its share price.

Cost of capital 14.00%

Long-run growth rate 4.00%

Year 1 2 3 4 5
FCF (millions) 53.00 68.00 78.00 75.00 82.00
Terminal Value 820.00
Total cash flow 53.00 68.00 78.00 895.00

a. Enterprise Value 681.37

b. Debt 300.00
Equity value 381.37
Number of shares
outstanding 40
Stock price 9.53
cash flows over the next

verage of 4% per year. Using the

tal of 14%:

million shares outstanding, estimate

Problem 9-20

Sora Industries has 60 million outstanding shares, $120 million in debt, $40 million in cash, and the following projected free cash flow
for the next four years:

Year 0 1 2 3 4
Earnings and FCF Forecast ($ million)
1 Sales 433.0 468.0 516.0 547.0 574.3
2 Growth versus Prior Year 8.1% 10.3% 6.0% 5.0%
3 Cost of Goods Sold (313.6) (345.7) (366.5) (384.8)
4 Gross Profit 154.4 170.3 180.5 189.5
5 Selling, General, and Administrative (93.6) (103.2) (109.4) (114.9)
6 Depreciation (7.0) (7.5) (9.0) (9.5)
7 EBIT 53.8 59.6 62.1 65.2
8 Less: Income Tax at 40% (21.5) (23.8) (24.8) (26.1)
9 Plus: Depreciation 7.0 7.5 9.0 9.5
10 Less: Capital Expenditures (7.7) (10.0) (9.9) (10.4)
11 Less: Increase in NWC (6.3) (8.6) (5.6) (4.9)
12 Free Cash Flow 25.3 24.6 30.8 33.3

a. Suppose Sora’s revenue and free cash flow are expected to grow at a 5% rate beyond year 4. If Sora’s weighted average cost of
capital is 10%, what is the value of Sora’s stock based on this information?
b. Sora’s cost of goods sold was assumed to be 67% of sales. If its cost of goods sold is actually 70% of sales, how would the
estimate of the stock’s value change?
c.
Let’s return to the assumptions of part (a) and suppose Sora can maintain its cost of goods sold at 67% of sales. However, now
suppose Sora reduces its selling, general, and administrative expenses from 20% of sales to 16% of sales. What stock price would
you estimate now? (Assume no other expenses, except taxes, are affected.)
d.
Sora’s net working capital needs were estimated to be 18% of sales (which is their current level in year 0). If Sora can reduce this
requirement to 12% of sales starting in year 1, but all other assumptions remain as in part (a), what stock price do you estimate
for Sora? (Hint: This change will have the largest impact on Sora’s free cash flow in year 1.)

Cost of Capital 10.00%

Long-run growth rate 5.00%
Cost of goods sold as a percent
of sales 67.00%

Selling, General, and Administrative as

a percent of sales 20.00%
Net working capital as a percent
of sales 18.00%

Initial Value for Net Working Capital 77.94

Shares outstanding 60
Debt 120.00
Cash 40.00
 Year 0 1 2 3 4
Earnings and FCF Forecast ($ million)
1 Sales 433.00 468.00 516.00 547.00 574.30
2 Growth vs. Prior Year 8.1% 10.3% 6.0% 5.0%
3 Cost of Goods Sold (313.6) (345.7) (366.5) (384.8)
4 Gross Profit 154.4 170.3 180.5 189.5
5 Selling, General, and Administrative (93.6) (103.2) (109.4) (114.9)
6 Depreciation (7.0) (7.5) (9.0) (9.5)
7 EBIT 53.8 59.6 62.1 65.2
8 Less: Income Tax at 40% (21.5) (23.8) (24.8) (26.1)
9 Plus: Depreciation 7.0 7.5 9.0 9.5
10 Less: Capital Expenditures (7.7) (10.0) (9.9) (10.4)
11 Less: Increase in NWC (6.3) (8.6) (5.6) (4.9)
12 Free Cash Flow 25.3 24.6 30.8 33.3
Terminal Value 665.63
Total Cash Flow 25.30 24.61 696.41

a. Enterprise value 566.57

Cash 40.00
Debt 120.00
Number of shares 60.00
Stock price 8.11
b. Cost of goods sold as a percent of sales Stock Price Excel note: Parts b, c, and d
Base case of 67% 8.11 can also be done in two
dimensional tables to see the
70.00% 5.14 effects of simultaneous changes
in two inputs. See below. To
c. Selling, general and administrative as a change more than two, you
percent of sales Stock Price should use a software add-in.
Base case of 20% 8.11
16.00% 12.07
d. Net working capital as a percent of sales Stock Price
Base case of 18% 8.11
12.00% 9.01

Extension: Both COGS and Selling, general and administrative change

8.11 16.00%
70.00% 9.10

Extension: Both COGS and Net working capital change

8.11 12.00%
70.00% 6.04

Extension: Both Selling, general and administrative and net working capital change
8.11 16.00%
12.00% 12.97
Problem 9-21

Consider the valuation of Kenneth Cole Productions in Example 9.7.

a. Suppose you believe KCP’s initial revenue growth rate will be between 7% and 11% (with growth slowing in equal steps
to 4% by year 2011.) What range of share prices for KCP is consistent with these forecasts?
b. Suppose you believe KCP’s EBIT margin will be between 7% and 10% of sales. What range of share prices for KCP is
consistent with these forecasts (keeping KCP's initial revenue growth at 9%)?
c. Suppose you believe KCP’s weighted average cost of capital is between 10% and 12%. What range of share prices for
KCP is consistent with these forecasts (keeping KCP's initial revenue growth and EBIT margin at 9%)?
d. What range of share prices is consistent if you vary the estimates as in parts (a), (b), and (c) simultaneously?

Kenneth Cole Productions

Cost of Capital 11.00%
Notice that the cell
Year 2005 2006 2007 2008 2009 2010 2011 that calculate the f
FCF Forecast ($millions) growth rates must
function of the init
1 Sales 518.00 564.62 609.79 652.47 691.62 726.20 755.25 growth rate.
2 growth vs. prior year 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% Otherwise, only th
3 EBIT 9.00% of sales 50.8 54.9 58.7 62.2 65.4 68.0 initial growth rate
be varied in the Da
4 Less: Income Tax 37.00% of EBIT (18.8) (20.3) (21.7) (23.0) (24.2) (25.1) Table.
5 Less: Net Investment 8.00% of Δ sales (3.7) (3.6) (3.4) (3.1) (2.8) (2.3)
6 Less: Increase in NWC 10.00% of Δ sales (4.7) (4.5) (4.3) (3.9) (3.5) (2.9)
7 Free Cash Flow 23.62 26.44 29.31 32.17 34.95 37.59
8 Terminal Value 558.54
9 PV of Free Cash Flows 424.83
10 Value of Cash 100.00
11 Value of Debt 3.00
12 Number of Shares 21
13 Share price 24.85

a. If Initial Revenue Growth Rate can vary between 4% and 11%,

the stock price can vary between 22.86 and 25.70

b. If EBIT Margin can vary between 7% and 10%, the stock price
can vary between 19.59 and 27.48

c. If Weighted Average Cost of Capital can vary between 10% and

12%, stock price can vary between 22.24 and 28.34

d.
If all three of the above can vary, the stock price can vary between 16.54 and 32.62
 Weighted Average
Initial Revenue Growth Rate EBIT Margin Cost of Capital
Base Case Stock Price 24.85 Base Case 24.85 Base Case 24.85
4.00% 22.86 7.00% 19.59 10.00% 28.34
4.18% 22.93 7.15% 19.98 10.10% 27.94
4.35% 22.99 7.30% 20.38 10.20% 27.55
4.53% 23.06 7.45% 20.77 10.30% 27.17
4.70% 23.13 7.60% 21.17 10.40% 26.81
4.88% 23.19 7.75% 21.56 10.50% 26.46
5.05% 23.26 7.90% 21.95 10.60% 26.12
5.23% 23.33 8.05% 22.35 10.70% 25.79
5.40% 23.40 8.20% 22.74 10.80% 25.46
5.58% 23.47 8.35% 23.14 10.90% 25.15
5.75% 23.53 8.50% 23.53 11.00% 24.85
5.93% 23.60 8.65% 23.93 11.10% 24.55
6.10% 23.67 8.80% 24.32 11.20% 24.27
6.28% 23.74 8.95% 24.72 11.30% 23.99
6.45% 23.81 9.10% 25.11 11.40% 23.72
6.63% 23.88 9.25% 25.51 11.50% 23.46
6.80% 23.95 9.40% 25.90 11.60% 23.20
6.98% 24.02 9.55% 26.30 11.70% 22.95
7.15% 24.09 9.70% 26.69 11.80% 22.70
7.33% 24.16 9.85% 27.09 11.90% 22.47
7.50% 24.23 10.00% 27.48 12.00% 22.24
7.68% 24.30
7.85% 24.37
8.03% 24.45
8.20% 24.52
8.38% 24.59
8.55% 24.66
8.73% 24.73
8.90% 24.81
9.08% 24.88
9.25% 24.95
9.43% 25.03
9.60% 25.10
9.78% 25.18
9.95% 25.25
10.13% 25.32
10.30% 25.40
10.48% 25.47
10.65% 25.55
10.83% 25.63
11.00% 25.70
 Worst case scenario: Initial Revenue Growth is 4%, initial EBIT margin is 7%, and initial WACC is 12%:
Cost of Capital 12.00%
Kenneth Cole Productions
Year 2005 2006 2007 2008 2009 2010 2011
FCF Forecast ($millions)
1 Sales 518.00 538.72 560.27 582.68 605.99 630.23 655.44
2 growth vs. prior year 4.00% 4.00% 4.00% 4.00% 4.00% 4.00%
3 EBIT 7.00% of sales 37.7 39.2 40.8 42.4 44.1 45.9
4 Less: Income Tax 37.00% of EBIT (14.0) (14.5) (15.1) (15.7) (16.3) (17.0)
5 Less: Net Investment 8.00% of Δ sales (1.7) (1.7) (1.8) (1.9) (1.9) (2.0)
6 Less: Increase in NWC 10.00% of Δ sales (2.1) (2.2) (2.2) (2.3) (2.4) (2.5)
7 Free Cash Flow 20.03 20.83 21.66 22.53 23.43 24.37
8 Terminal Value 316.77
9 PV of Free Cash Flows 250.35
10 Value of Cash 100.00
11 Value of Debt 3.00
12 Number of Shares 21
13 Share price 16.54

Best Case Scenario: Initial Revenue Growth is 11%, initial EBIT margin is 10%, and iniitial WACC is 10%:
Cost of Capital 10.00%
Kenneth Cole Productions
Year 2005 2006 2007 2008 2009 2010 2011
FCF Forecast ($millions)
1 Sales 518.00 574.98 630.18 681.85 728.22 767.54 798.24
2 growth vs. prior year 11.00% 9.60% 8.20% 6.80% 5.40% 4.00%
3 EBIT 10.00% of sales 57.5 63.0 68.2 72.8 76.8 79.8
4 Less: Income Tax 37.00% of EBIT (21.3) (23.3) (25.2) (26.9) (28.4) (29.5)
5 Less: Net Investment 8.00% of Δ sales (4.6) (4.4) (4.1) (3.7) (3.1) (2.5)
6 Less: Increase in NWC 10.00% of Δ sales (5.7) (5.5) (5.2) (4.6) (3.9) (3.1)
8 Free Cash Flow 25.97 29.77 33.66 37.53 41.28 44.76
9 Terminal Value 775.89
10 PV of Free Cash Flows 588.00
11 Value of Cash 100.00
12 Value of Debt 3.00
13 Number of Shares 21
14 Share price 32.62
Notice that the cells
that calculate the future
growth rates must be a
function of the initial
growth rate.
Otherwise, only the
initial growth rate will
be varied in the Data
Table.
Problem 9-23

Suppose that in January 2006, Kenneth Cole Productions had EPS of

$1.65 and a book value of equity of $12.05 per share.

EPS 1.65
Book value of equity 12.05

a. Using the average P/E multiple in Table 9.1, estimate KCP’s

share price.
Price per share 24.77

b. What range of share prices do you estimate based on the highest and
lowest P/E multiples in Table 9.1?
Range based on highest to lowest
High 37.32
Low 14.29

c. Using the average price to book value multiple in Table 9.1, estimate
KCP’s share price.
Price per share 34.22

d. What range of share prices do you estimate based on the highest and
lowest price to book value multiples in Table 9.1?
Range based on highest to lowest
High 97.73
Low 13.50
Problem 9-24

Suppose that in January 2006, Kenneth Cole Productions had sales of

$518 million, EBITDA of $55.6 million, excess cash of $100 million,
$3 million of debt, and 21 million shares outstanding.

Sales 518.00
EBITDA 55.60
Cash 100.00
Debt 3.00
Shares outstanding 21

a. Using the average enterprise value to sales multiple in Table 9.1,

estimate KCP’s share price.
Price per share 30.77

b.
What range of share prices do you estimate based on the highest
and lowest enterprise value to sales multiples in Table 9.1?
Range based on highest to lowest
High 58.64
Low 16.21

c. Using the average enterprise value to EBITDA multiple in Table

9.1, estimate KCP’s share price.
Price per share 27.10

d.

What range of share prices do you estimate based on the highest

and lowest enterprise value to EBITDA multiples in Table 9.1?
Range based on highest to lowest
High 33.08
Low 22.25
Problem 9-25

In addition to footwear, Kenneth Cole Productions designs and sells

handbags, apparel, and other accessories. You decide, therefore, to
consider comparables for KCP outside the footwear industry.

Kenneth Cole information

EPS 1.65
EBITDA 55.60
Cash 100.00
Debt 3.00
Shares outstanding 21

a.
Suppose that Fossil, Inc., has an enterprise value to EBITDA
multiple of 9.73 and a P/E multiple of 18.4. What share price would
you estimate for KCP using each of these multiples, based on the
data for KCP in Problems 23 and 24?
Fossil multiple price
EBITDA 9.73 30.38
P/E 18.40 30.36

Thus, KCP is trading at a discount relative to Fossil.

b.

Suppose that Tommy Hilfiger Corporation has an enterprise value to

EBITDA multiple of 7.19 and a P/E multiple of 17.2. What share
price would you estimate for KCP using each of these multiples,
based on the data for KCP in Problems 23 and 24?
Tommy Hilfiger multiple price
EBITDA 7.19 23.66
P/E 17.20 28.38
Thus, KCP is trading at a premium relative to Tommy Hilfiger using
EV/EBITDA, but a slight discount using P/E.
Problem 9-26

Consider the following data for the airline industry in early 2009 (EV = enterprise value, BV = book value,NM = not meaningful
because divisor is negative). Discuss the usefulness of using multiples to value an airline.

Company Name Market Cap EV EV/Sales EV/EBITDA EV/EBIT P/E P/Book

Delta Air Lines 4,799.60 16,887.60 0.7 15.0 NM NM NM
AMR Corp. 1,296.50 8,743.50 0.4 17.5 NM NM NM
JetBlue Airways 1,246.90 3,834.90 1.1 10.4 25.7 NM 1.0x
Continental Airlines 1,216.80 4,506.80 0.3 14.7 NM NM NM
UAL Corp. 701 6,192.00 0.3 NM NM NM NM
Air Tran Holdings 651.3 1,354.70 0.5 21.7 NM NM 2.3
SkyWest 588.7 1,699.70 0.5 3.8 7.5 6.5 0.5
Hawaiian 257.1 262.1 0.2 1.7 2.7 3.6 NM
Pinnacle Airlines 44 699.7 0.8 6.6 10.1 3.4 1.0
Average 0.53 11.43 11.50 4.50 1.27
Median 0.50 12.55 8.80 3.60 1.00
Max Value 1.10 21.70 25.70 6.50 2.30
Min Value 0.20 1.70 2.70 3.40 0.50
Standard Deviation 0.29 7.00 9.95 1.73 0.93

Many of the cases are not meaningful, because the earnings are negative or even (in several cases) the book value of equity is negative.
There is a wide variation between low and high values.
There must be more to valuation than what is revealed by the multiples.
Table 9-1
Stock Prices and Multiples for the Footwear Industry, January 2006
Ticker Name Stock Market Enterprise P/E Price/Book Enterprise Enterprise
Price ($) Capitalizatio Value ($ Value/Sales value/EBITDA
n ($ millions)
millions)
NKE Nike 84.2 21,830 20,518 16.64 3.59 1.43 8.75
PMMAY Puma AG 312.05 5,088 4,593 14.99 5.02 2.19 9.02
RBK Reebok 58.72 3,514 3,451 14.91 2.41 0.9 8.58
WWW Wolverine 22.1 1,257 1,253 17.42 2.71 1.2 9.53
World Wide
BWS Brown Shoe 43.36 800 1,019 22.62 1.91 0.47 9.09
SKX Sketchers 17.09 683 614 17.63 2.02 0.62 6.88
SRR Stride Rite 13.7 497 524 20.72 1.87 0.89 9.28
DECK Deckers 30.05 373 367 13.32 2.29 1.48 7.44
Outdoor
WEYS Weco Group 19.9 230 226 11.97 1.75 1.06 6.66
RCKY Tocky Shoes & 19.96 106 232 8.66 1.12 0.92 7.55
Boots
DFZ R.G. Barry 6.83 68 92 9.2 8.11 0.87 10.75
Corp.
BOOT LaCross 10.4 62 75 12.09 1.28 0.76 8.3
Footwear
Average 15.01 2.84 1.06 8.49
Maximum 51% 186% 106% 27%
Minimum -42% -61% -56% -22%