Learning About Intrinsic Valuation With the Help of an

Integrated Valuation Model

James A. Gentry
University of Illinois at Urbana−Champaign

Frank K. Reilly Michael J. Sandretto

University of Notre Dame University of Illinois at Urbana−Champaign

Abstract
An integrated strategic financial management system provides students of finance an
invaluable learning experience in assessing the financial health of a company or estimating
the value of this company. We found students’ questions and misunderstanding about how to
assess a company’s financial health or apply current valuation theories led to the
development an integrated valuation system (IVS). One objective of a dynamic valuation
system is to help students simulate changes in a firm’s financial strategies and discover how
these changes affect a firm’s credit health or its value. Additionally, an IVS provides a solid
conceptual foundation for a student to justify the credibility of a growth rate used to estimate
the terminal value of a project or stock. The IVS helps students learn why the intrinsic value
of a stock estimated by a dividend discount model (Vs[DIV]) may not equal the intrinsic
value of a stock estimated by discounting the free cash flow to equity (Vs[FCFE]), i.e.,
Vs[DIV] ‚ Vs[FCFE]. An IVS can also help a student to understand why the value of a firm
that is based on discounted free cash flow to the firm (Vf[FCFF]) may not equal discounted
free cash flow to equity (Vs[FCFE]) plus discounted free cash flow to debt (Vd[FCFD]), or
Vf[FCFF] ‚ [Vs[DIV] + Vd[FCFD]]. One reason for these valuation inconsistencies is that
the underlying theories were developed independently in different time periods. Also inputs
for each of the models were unique because the models were not developed as a total
integrated system. Therefore, a valuation system was created that integrates the key
components needed to estimate the intrinsic value of a company’s equity (Vs[FCFE]), debt
(Vd[FCFD]) and its firm value (Vf[FCFF]). The integrated valuation system helped reconcile
the valuation dilemmas by solving for an implied terminal growth rate of dividends [gDIV]
that causes the Vs[DIV] = Vs[FCFE]. The IVS also determines an implied terminal growth
rate of the FCFF[(gFCFF), that causes the Vf[FCFF] = [Vs[FCFE] + Vd[FCFD]]. The
challenge to the learners is to interpret accurately the information conveyed via the implied
terminal growth rate of dividends (gDIV) and the implied terminal growth rate of the FCFF
(gFCFF).
Published: 2003
URL: http://www.business.uiuc.edu/Working_Papers/papers/03−0108.pdf
LEARNING ABOUT INTRINSIC VALUATION WITH THE HELP OF AN
INTEGRATED VALUATION MODEL

James A. Gentry
IBE Distinguished Professor of Finance
University of Illinois, Urbana-Champaign
j-gentry@uiuc.edu

Frank K. Reilly
Bernard J. Hank Professor of Business Administration
University of Notre Dame
Frank.K.Reilly.1@nd.edu

and

Michael J. Sandretto
Visiting Associate Professor of Accountancy
University of Illinois, Urbana-Champaign
sandrett@uiuc.edu

FMA European Meetings

Dublin
June 5, 2003
 2

ABSTRACT

An integrated strategic financial management system provides students of finance an

invaluable learning experience in assessing the financial health of a company or estimating the
value of this company. We found students’ questions and misunderstanding about how to assess
a company’s financial health or apply current valuation theories led to the development an
integrated valuation system (IVS). One objective of a dynamic valuation system is to help
students simulate changes in a firm’s financial strategies and discover how these changes affect
a firm’s credit health or its value. Additionally, an IVS provides a solid conceptual foundation
for a student to justify the credibility of a growth rate used to estimate the terminal value of a
project or stock. The IVS helps students learn why the intrinsic value of a stock estimated by a
dividend discount model (Vs[DIV]) may not equal the intrinsic value of a stock estimated by
discounting the free cash flow to equity (Vs[FCFE]), i.e., Vs[DIV] ≠ Vs[FCFE]. An IVS can also help
a student to understand why the value of a firm that is based on discounted free cash flow to the
firm (Vf[FCFF]) may not equal discounted free cash flow to equity (Vs[FCFE]) plus discounted free
cash flow to debt (Vd[FCFD]), or Vf[FCFF] ≠ [Vs[DIV] + Vd[FCFD]]. One reason for these valuation
inconsistencies is that the underlying theories were developed independently in different time
periods. Also inputs for each of the models were unique because the models were not
developed as a total integrated system. Therefore, a valuation system was created that integrates
the key components needed to estimate the intrinsic value of a company’s equity (Vs[FCFE]), debt
(Vd[FCFD]) and its firm value (Vf[FCFF]).

The integrated valuation system helped reconcile the valuation dilemmas by solving for an
implied terminal growth rate of dividends [gDIV] that causes the Vs[DIV] = Vs[FCFE]. The IVS also
determines an implied terminal growth rate of the FCFF[(gFCFF), that causes the Vf[FCFF] =
[Vs[FCFE] + Vd[FCFD]]. The challenge to the learners is to interpret accurately the information
conveyed via the implied terminal growth rate of dividends (gDIV) and the implied terminal
growth rate of the FCFF (gFCFF).
 3

LEARNING ABOUT INTRINSIC VALUATION WITH THE HELP OF AN

INTEGRATED VALUATION MODEL
Students of financial analysis are constantly searching for the equivalent of Harry
Potter’s magic wand to provide fresh insights into the process of interpreting the financial
health of a company or estimating its intrinsic value. During the past seven decades several
models have been proposed to estimate the intrinsic value of a stock or a firm. For example, in
the 1930’s and 1940’s Graham and Dodd [1934, 1940] advocated using fundamental security
analysis techniques to discover if the level of a stock’s P/E multiple provides signals for
investment opportunities, e.g., [P/E] x EPSt+1 = Pt+1. Interest in multipliers has continued to
expanded and today there are a variety of multipliers, such as Price/Book Value (P/B),
Price/Sales (P/S) and Price/EBIT, used to estimate a stock’s potential value, Damadoran [2001,
Chapters 8-10]. Naturally, there are solid reasons for using multipliers to estimate the value of
a stock, but there are also shortcomings.

Near the end of the Great Depression, Williams [1938] introduced the classic dividend
discount model [DIV] for estimating the value of a stock (Vs[DIV]). Later, Gordon [1962]
extended the Williams model by introducing a dividend growth component in the late 1950s
and early 1960s. The DIV continues to be widely used to estimate the value of a stock, Vs[DIV].

In recent years the literature for estimating the value of a firm (Vf) and the value of a
stock (Vs) has expanded dramatically. Copeland, Koller and Murrin [1990, 1994, 2000],
Rappaport [1988, 1998], Stewart [1991], and Hackel and Livnat [1992] were current pioneers
in modeling the free cash flow to the firm [FCFF], which is widely used to derive the Vf.
Recently, Copeland, Koller and Murrin [1994] and Damadoran [1998] introduced an equity
valuation model based on discounting a stream of free cash flows to equity [FCFE] at a
required rate of return to stockholders. Also Damadoran [2001] provides several approaches to
estimate the value of a firm for which there are no comparable companies, no operating
earnings and a limited amount of cash flow data. Fama’s [1970] efficient market research
challenged the validity of intrinsic valuation models.

Finally, a real options approach for valuing firms that have no comparables or operating
earnings and usually only limited data for analysis was launched in 1999. The leaders in
developing a real options approach to valuation were Amram and Kulatilaka [1999], Brennan
and Trigeorgis [1999], Schwartz and Moon [2000], Copeland and Antikarov [2000] and
Damadoran [2001, Chapter 11].

During the past decade we have been deeply involved in learning and teaching the
theory and practice of assessing the financial health of a company or estimating its intrinsic
value. We found students’ questions and misunderstandings about how to assess a company’s
financial health or apply current valuation theories led to the development of an integrated
financial system (IVS). The purpose of creating a dynamic valuation system was to stimulate
student learning about complex issues that underlie the process of analyzing a company’s credit
rating or estimating its value. A primary goal was to integrate the strategic information
contained in a firm’s financial statements so that students could simulate various scenarios and
thereby have a rich learning experience about valuation and credit analysis. We have discovered
there are a few topics that generate big learning events, for example….
 4

• Why are net operating cash inflows so important in the wealth creation process
and/or in the assesment of a company’s credit risk?
• What can management do to improve the creation of operating cash inflows?
• How does the investment in physical, human and working capital create firm
value and/or change its credit risk?
• How does depreciation and amortization contribute to the creation firm value?
• What is the relationship between investment and financing?
• Why does a long-run stable relationship between debt and equity contribute to the
long-run value of a company?
• How does management develop the inputs used in a five-year forecast?
• How does management know the inputs used to generate the forecast are correct?
• What assumptions are most important when preparing a cash flow forecast?
• What is the relationship between the free cash flow (FCF) measures to equity
(FCFE), debt (FCFD) and the firm (FCFF)?

Another contribution of this paper can best be explained with a brief review of a few
basic concepts used to estimate the market value of a firm (Vf) , a stock (Vs) and debt (Vd). A
basic concept in the theory of finance is…

Vf = [Vs + Vd], [1]

where: Vf is the market value of a firm,

Vs is the market value of a stock, and
Vd is the market value of the long-term debt.

Separate theories are needed to estimate the intrinsic value on each side of equation 1.
One theory assumes that the Vf, on the left hand side of equation 1, is estimated by using a
firm’s weighted average cost capital (WACC) to discount to infinity its estimated free cash
flows [FCFF]. It is possible to create forecasted inputs so that the Vf[FCFF] = Vf. On the right
hand side of equation 1, a second theory assumes the Vs is estimated by discounting to infinity
either the free cash flow to equity [FCFE] or the dividend flows [DIV] at the required rate of
return on the equity (ks). With the appropriate forecasted inputs it is possible for the Vs[FCFE] =
Vs or Vs[DIV] = Vs. When the Vd is added to the Vs[FCFE] or Vs[DIV], a separate intrinsic value of
the firm (Vf*) is estimated, as shown in equation 1, e.g., Vf* = [Vs[FCFE] + Vd] and/or Vf* =
[Vs[DIV] + Vd]. Theoretically, the components of the two sides of equation 1 can be equal, i.e.,
Vf= Vf*. However, to the best of our knowledge, the linkages required to show that Vf[FCFF] =
[Vs[FCFE] + Vd ] and/or Vf[FCFF] = [Vf[DIV] + Vd] has not been previously presented. In addition,
equation 1 makes it possible for authors to assume the Vf – Vd = Vs , e.g., as shown in Rappaport
and Mauboussin [2001, pp. 74-76]. Examples that use an all equity firm, or nearly all equity,
avoid the complexities that occur when permanent debt is a significant part of a firm’s capital
structure. On the positive side of using an all equity firm to illustrate a valuation argument,
Solomon [1963, chapter 5] used an all equity firm to develop an insightful theoretical
explanation of how growth in a firm occurs. An explanation of Solomon’s growth model is
presented in Appendix 1. Finally, to the best of our knowledge, it has not been shown how to
make the Vs[FCFE] = Vs[DIV]. Our thesis is that there is a learning gap in how valuation models
are integrated. Thus one task is to connect these valuation theories so that the linkages are
transparent.
 5

The primary objective of the paper is to present a valuation system that links the
components used in estimating the intrinsic value of equity (Vs[FCFE] or Vs[DIV]), debt (Vd[FCFD])
and a firm (Vf). In Section I a brief review of the valuation literature is presented, while
Section II develops a theoretical overview of an integrated valuation system. Section III shows
how to develop a forecast for integrated income statements and balance sheets. These
forecasted financial statements provide information needed to estimate the intrinsic value of
equity, debt and a firm. The two basic models for estimating the intrinsic value of equity are
shown in Section IV, plus an implied terminal growth rate of dividends is developed. Likewise,
Section V presents the linkage that makes the Vf[FCFF] = [Vs[FCFE] + Vd[FCFD]]. Simulating
various scenarios highlights the analytical power an integrated valuation system offers to
students of financial analysis. The final section summarizes the most important contributions an
integrated valuation system can make in estimating the long-run value of a firm.

I. LITERATURE REVIEW

A review of the valuation literature indicates there are several fundamental concepts
involved in estimating the intrinsic value of a stock, a bond and a firm. In the late 1930s
Professor John Burr Williams [1938] developed a theory for estimating the value of a stock
based on the idea of discounting a constant stream of dividends to infinity [DIV], that is the
future cash flows that stockholders would receive. In the early 1960s, Gordon [1962] extended
Williams DIV by allowing the stream of dividends to grow at a constant forecasted rate from
time period zero to infinity. The Gordon constant growth model is widely used in the
investment management profession. Also it has been extended to incorporate dividends
growing at uneven rates. The estimation of bond value is similar to the dividend discount
model (DIV), in that the bond value equals to a discounted stream of interest payments and the
final maturity value at the yield to maturity, Homer and Leibowitz [1972, Chapter 11].

Graham and Dodd [1934, 1940] and Graham, Dodd, and Cottle [1962] proposed an
intrinsic-value approach to equity valuation. In the 1962 edition they stated the most important
single factor determining a stock’s value is now held to be the indicated average future
earning power, i.e., the estimated average earnings for a future span of years. Furthermore,
they indicated intrinsic value would then be found by first forecasting this earning power and
then multiplying that prediction by an appropriate capitalization factor, Graham, Dodd and
Cottle [1962, p. 28]. They wisely stated that any estimate of earning power extending over
future years may easily fall wide of the mark, since the major business factors of volume, price,
and cost are all largely unpredictable. Graham, Dodd and Cottle (GDC) [1962, p. 29].

Graham, Dodd and Cottle [1962, p.741-742] reconciled their “earning power” theory of
value to the DIVvaluation models of Williams and Gordon, by discounting low-dividend-
paying growth stocks in a manner comparable to discounting a stream of future dividends to
infinity. GDC concluded that the elements of uncertainty and risk assume a dominant position
in the discounting of a future dividend stream. Second, they reached a practical conclusion,
namely that investors in popular growth stocks do not explicitly think even vaguely in terms of
discounting future dividends.

In the mid-1960s Fama [1965] found stock price performance resembled a random
walk. Fama later developed the efficient market theory in terms of a fair game model, that is
the price of a security fully reflects all available information at a point in time, Reilly and
Brown [1997, p. 210]. Fama divided the overall efficient market hypothesis (EMH) into three
 6

sub-hypotheses depending on the information set involved: (1) weak-form EMH, (2)
semistrong-form EMH and (3) strong-form EMH, Reilly and Brown [1997, p. 211]. Fama’s
EMH raises serious questions concerning the validity of GDC’s earning power theory of value
and Williams and Gordon’s DIV.

In the late 1980s and early 1990s several authors presented a valuation model based on
free cash flow to the firm (FCFF), e.g., Copeland, Koller and Murrin [1990,1994, 2000],
Rappaport [1988, 1998], Stewart [1991] and Hackel and Livnant [1992]. Recently, Copeland,
Koller and Murrin [1994, p. 500] presented a definition of free cash flow to the shareholder of a
bank. A few years later Damadoran [1998, 2001] and Reilly and Brown [2000, p. 797]
presented a methodology for estimating the free cash that flows to equity shareholder [FCFE].
This model opens the door to another approach for estimating the value of a stock, Vs[FCFE], by
discounting the FCFE at the required rate of return on equity (ks). Thus it is possible to
compare the intrinsic estimates generated by two equity valuation models, Vs (FCFE to the Vs
(DIV). Regardless, whether FCFE or dividends are used to estimate the Vs, the required equity
discount rate (ks) is the same. Additionally, unless there is a 100 percent dividend payout, the
Vs[FCFE] ≠ Vs{DIV]. Therefore, this study creates an implied terminal dividend growth rate (gDIV)
that makes the value of the discounted dividends equal to the value of the discounted FCFE, Vs
(DIV) = Vs (FCFE).

The preceding discussion briefly introduced the importance of the gDIV why it causes
the Vs[DIV] = Vs[FCFE]. Equally important, is an implied terminal growth rate of FCFF (gFCFF)
that causes the Vf [FCFF] = [Vs[FCFE] + Vd[FCFD]]. Solving for an implied terminal growth rate of
FCFF assumes the estimated intrinsic Vs[FCFE] and Vd[FCFC] are correct. It is also assumed the
gFCFF is positive and relatively constant throughout the life of the forecast. It is also assumed
there are positive operating cash flows, comparable companies and several years of estimated
cash flows. If these conditions do not exist, can the Vs or the Vf be estimated? The answer is
yes as shown by authors who focus on the using of real options to estimate Vf, e.g., Amram and
Kulatilaka [1999], Brennan and Trigeorgis [1999], Schwartz and Moon [2000], Copeland and
Antikarov [2000] and Damadoran [2001].

This article is not about a real options approach to valuation, but rather the development
of an integrated valuation system (IVS). An IVS provides a rich and stimulating foundation
for teaching and learning about valuing a firm and an equity. The integrated valuation system
highlights the forecasting and discounting of FCFF and FCFE. Also it shows the sensitivity of
the cash flow components to changes in the forecasted inputs. The IVS simulates the effect of
using different growth rates of FCFF and FCFE in estimating the Vs[FCFE] and Vf[FCFF]. It also
shows how changes in the [D / Vf] and [E / Vf] weights, and changes in ks and kd can affect
WACC. The most challenging and important contribution of this paper is the sensitivity of the
value of a firm (Vf[FCFF]) to the implied terminal growth rate of the FCFF.
 7

II. AN OVERVIEW OF THE VALUATION PROCESS

Value of a Firm (Vf)

There are two widely methods employed to estimate the value of a firm. First, is a
static approach for a single point in time, where the current market value of the equity (Vs) and
the debt (Vd) are known. The market value of the firm is…

Vf = Vs + Vd . [2]

A second approach estimates the intrinsic value of a firm by discounting the free cash
flows to a firm (FCFF) at the weighted average cost of capital (WACC). Vf[FCFF] is based on
the following equation:

Vf[FCFF] = FCFF1 / (1 + WACC) + FCFF2 / (1 + WACC)2 +….+ [FCFFn + TVn] / [3]

(1 +WACC)n
where:
Vf = intrinsic value of a firm,
FCFFt = forecasted annual free cash flows to a firm, periods 1 to n,
= [EBITt (1-T) + depreciationt] + [∆WCt] + [NIFt] + [∆OAt],
where: -∆WC or –NIF is an outflow of cash and +∆WC or +NIF is
an inflow of cash,
EBIT(1-T)t = Earnings before interest and taxes adjusted for tax shield,
in each of n periods.
∆WCt = ∆Receivablest + ∆Inventoryt + ∆OCAt + ∆Payablest + ∆OCLt,
NIFt = ∆net fixed assetst + depreciaton expenset + ∆other assetst

WACC = weighted average cost of capital,

= wd kd (1- tax rate) + ws ks
wd = Vd / Vf
kd = market interest rate on long-term debt,
ws = Vs / Vf
ks = required rate of return on equity derived from CAPM
Vd = market value of permanent debt,
Vs = market value of equity,
TVn = terminal value of FCFFn = FCFFn (1 + g) / [WACC – g]
where: WACC > g
gn = estimated annual growth in FCFF from period n to ∞

Although the FCFF looks like an innocent acronym, it is a very complex variable. It
contains the net flows (inflows – outflows) related to operations (NOF), working capital (WCF)
and investments (NIF). For example, these three net cash flow measures are based on many
factors, such as a firm’s…

• corporate strategy and its implementation,

• product markets served, its share of these markets and their growth potential,
• competitive position within each of its product markets and its industry,
 8

• investment strategies for new and old product lines,

• working capital strategies and their stability as a percent of sales,
• financial strategies, e.g., dividend policy and target capital structure, and
• internal operating efficiencies.

Additionally, when solving for the value of a firm, the role of its discount rate, WACC,
and the expected growth in FCFF are impacted by…

• financial markets’ outlook for a firm’s growth rate,

• performance of its operating, working capital and investment flows,
• potential growth of a firm’s strategic investments,
• expected long-run rates of return on a firm’s equity and debt instruments,
• stability of dividend policy and target capital structure,
• terminal value (TV) of the FCFF.

Theoretically, financial analysts, portfolio managers and investors estimate annual

FCFF for n periods, plus the inputs used in estimating the terminal value (TV). The estimate of
terminal value (TV) assumes the FCFF will grow at a constant growth rate from period n to
infinity. Frequently, the TV represents a major proportion of a firm’s estimated value. Finally
the stability of the WACC is based on the stability of management’s target weights for debt (wd)
and equity (ws), plus thestability of the economic outlook for the firm as reflected in the
marketplace.

Value of Equity (Vs)

Several methods are used to measure the value of a firm’s equity. If the current market
Vf and Vd are known, the current market equity value equals:

Vs = Vf - Vd. [4]

A second approach for estimating the intrinsic value of a stock is discounting the FCFE.
The discounted FCFE provides a dynamic method for solving the intrinsic value of an equity:

Vs[FCFE] = FCFE1 / (1 + ks) + FCFE2 / (1 + ks)2 +….+ [FCFEn + TVn ]]/ ( 1 + ks)n [4]
where:
Vs[FCFE] = intrinsic value of equity
FCFEt = forecasted free cash flow to equity in periods 1 to n,
= net incomet + depreciation expenset + ∆WCt + NIFt + principal
increment of new debtt – principal repayment of debtt
where: -∆WCt or –NIFt is an outflow of cash and +∆WCt or +NIFt is an inflow
of cash,
ks = required rate of return on equity capital derived from the CAPM,
TVn = terminal value of FCFEn = FCFEn (1 + gn) / (ks – gn),
where: ks > gn,
gn = estimated annual growth rate of FCFE from period n to ∞ .
 9

The discounted FCFE approach incorporates the cash flows directly associated with
equity shareholders for an infinite time period. Theoretically, the FCFE reflects the net cash
flows that equity shareholders expect to receive throughout the life of the company. It includes
net income plus depreciation, and plus the outflows associated with capital investments (NIFt)
and working capital (∆WCt). Additionally, an increase in permanent debt becomes a cash
inflow to equity holders, while a decrease in permanent debt reflects an outflow of cash. It is
assumed the permanent debt is used to finance capital investment projects, that, in turn,
generate operating cash inflows. Likewise, the cost of equity (ks) reflects the returns required
by equity shareholders and does not explicitly include the costs associated with debt, wd, kd, (1-
T), that are included in the WACC.

A dividend discount model (DIV) is a third approach used to estimate the intrinsic value
of equity (Vs). In equation form it is:

Vs[DIV] = DIV0 (1 + g) / (1 + ks) + DIV0 (1 + g)2 / (1 + ks)2 + …. + DIV∞(1 + g)∞ /

(l+ks)∞ [5]
where:
Vs = intrinsic value of equity,
DIV0 = annual dividend flows to shareholders in period zero,
1+ gn = estimated annual compound growth in DIV in period n,
ks = required rate of return on equity derived from CAPM.

The DIV discounts the dividend flows to equity shareholders that estimates the Vs[DIV].
The dividends are assumed to compound annually at a constant growth rate. Theoretically,
with 100 percent dividend payout and DIV forecasted inputs identical with FCFE forecasted
inputs, Vs[DIV] = Vs [FCFE].

Value of Debt (Vd)

When estimating the value of the permanent debt, the conventional valuation practice is
to assume the Vd equals the book value of the long-term debt. However, if the short-term debt
is rolled over each year or it increases annually, it is reasonable to assume that the total short-
term debt takes on the characteristics of permanent long-term debt, which would not include
accounts payable and deferred taxes. Therefore, when a DCF infinite horizon model is used to
estimate the Vf[FCFF] or Vs[FCFE], it seems reasonable to assume that the permanent debt
(Vd[FCFD]) includes the sum of the long and the short-term debt, i.e., the interest bearing
instruments. Practically speaking, it seems that a financial management staff would be best
prepared to indicate the percentage of the short-term debt (including bank loans, notes payable
and capitalized leases), that is considered to be permanent.

In a zero growth to infinity scenario, the value of the debt (Vd) can be estimated with
the following formula.

Vd = [INT1] / (1 + kd) + [INT2] / (1 + kd)2 + ….+ [INT + Maturity]∞ / (1 + kd)∞ [6]

where:
 10

Vd = value of debt in a zero growth to infinity scenario,

INT = annual interest payments,
kd = yield to maturity,

In estimating the value of a firm’s debt, where an infinite horizon is assumed, the value
of the debt would be equal the discounted stream of estimated interest payments (INT). For
example, assuming a dynamic scenario, the level of permanent debt increases when a firm is
forecasting real growth in its sales. The inference is that assets and debt will grow at the real
rate needed to support the sales growth. The debt is assumed to be discounted at the current
market rate of return required by fixed income investors, that is the yield to maturity, i.e.,
infinity. Thus, the Vd[FCFD] is an estimate of discounted interest flows to infinity, as reflected in
equation 8, and the Vd[FCFD] is not equal to the market Vd in [7].

Vd[FCFD] = [INT1]/(1 + kd) + [INT2]/(1 + kd)2 +…+ [INTn] /[kd – g] / (1 + kd)n [7]

where:
Vd = intrinsic value of permanent debt,
INTn = annual interest payment for n time periods
kd = current market rate of return on permanent debt,
gn = estimated annual growth in sales from period n to infinity.

Summary

The above analyses indicates there are several approaches used to estimate the value of
equity, debt and the firm. As shown below the market value of equity (Vs), debt (Vd), or firm
(Vf) can be on either or both sides of the valuation equation. Likewise, it is also shown that the
intrinsic or discounted cash flow (DCF) value can be on either or both sides of the equation.
Under certain conditions, market and intrinsic values can be on opposite sides of the valuation
equation. In summary,

Valuation equations Market or Intrinsic (DCF)

Conditions
Vf = Vs + Vd , or market = market [8]

Vf [FCFF] = Vs + Vd, also DCF = market [9]

Vs = Vf [FCFF] – Vd . market = DCF & market [10]

Vs [FCFE] = Vf[FCFF] – Vd[FCFD], or DCF = DCF [11]

Vs [DIV] = Vf[FCFF] – Vd[FCFD]. DCF = DCF [12]

Vs[FCFE] = Vs[DIV] DCF = DCF [13]

Vf[FCFF] = Vs[DIV] + Vd[FCFD], or DCF = DCF [14]

Vf[FCFF] = Vs[FCFE] + Vd[FCFD] DCF = DCF [15]

 11

These set of relationships provide the framework for the remainder of the paper. First,
the analysis focuses on explaining linkages between the two equity models in equation 13.
After 13 has been demonstrated, the linkages between the two sides of equation 15 are
developed. That is, the task is to highlight why Vf[FCFF] = [Vs[FCFE] + Vd[FCFD]]. Before
explaining the linkages in equations 13 and 15, we focus on creating a financial forecast and
the resulting cash flow metrics.

III. CREATING A FINANCIAL FORECAST

Explaining the assumptions underlying a financial forecast highlights the important

steps involved in the valuation process. A financial forecast reflects the dynamics in a firm’s
product markets and its financial markets. Also good forecasting practices incorporate realistic
assumptions concerning internal management efficiencies. The technical steps involved in
preparing a financial forecast are presented in Appendix 2. The outlook for economic
conditions and the competitive environment are factored into the forecast along with the annual
growth rate in sales. Initially, it is important to assume that a stable relationship exists between
sales and the related cost of sales, administrative expenses and other expenses. Also
depreciation is assumed to be closely tied to the performance of a firm’s net fixed asset. Best
practices in forecasting assume all assets and selected liabilities are a function of sales. That is,
it is assumed …

• each asset is a function of sales, i.e., there is a relatively stable relationship between the
ith asset in the jth period and sales in the jth period;
• selected liabilities are a function of sales, i.e., there exists a stable relationship between
salesj and accounts payablej, other current liabilitiesj and long and short term debt.

Also the percentage of earnings retained is stated explicitly and is assumed to maintain
a stable relationship with net income.

When the forecasted assets are greater than forecasted liabilities, the shortfall in
financing, frequently called the additional funds needed (AFN), is offset first by increasing long
term debt in order to maintain a stable relationship with sales and also a target capital structure.
If further debt is needed to offset the shortfall, it is financed with short-term borrowing.
Alternatively, if the forecasted assets (A) are less than the forecasted liabilities (L), A<L, the
first step is to reduce the short-term debt. If the asset continue to be less than the total
liabilities, the second step is to reduce the long-term debt. If there is no short or long-term
debt, the remainder flows to excess cash.

Additional Insights

The financial forecast program is an extremely valuable tool when you wish to simulate
various scenarios of possible outcomes. Initially we have developed an example that assumes a
relatively stable long-run outlook for the example company. Now, we wish to identify a few
assumptions that can cause the forecast to be unstable and thereby create problems in
interpreting the financial health of a company.
 12

Growth rate of sales. The financial forecast program is driven by the growth rate of
sales. The growth of the several asset classes and accounts payable and other current liabilities
are directly related to the growth of sales. The example assumes a stable 3 percent growth of
sales. However, if the growth rate of sales is assumed to be markedly higher or if it is assumed
to be erratic and unstable, the outcomes of the forecast will look dramatically different and
create uncertainty in the validity of the outcomes. It is extremely important to carefully track
the cash flow results and discover why the forecasted results look vastly different from the base
forecast. The results of your forecast are correct, but it is the task of the user to understand
what happened and why it happened.

Sales growing too fast. If the firm’s strategic plan is for sales to grow more rapidly than the
operating income or the net income during the next several years, the financial forecast will
show the total assets are more-than-likely growing more rapidly than the total liabilities. To
finance this rapid growth strategy, where forecasted assets > liabilities, the firm will need to
increase it temporary and/or permanent financing. The financial forecasting model is
programmed to first utilize the retained earning from the income statement, discretionary cash
flow, before increasing its long-term debt to accomplish management’s target debt/total market
value ratio. Short-term debt can be used to provide additional funds needed (AFN) until the
target capital structure is reached and forecasted total liabilities equal total assets. At this point
if additional funds are still needed to make liabilities = assets, the target debt ratio is overridden
and the debt ratio will expand causing the financial risk and the cost of capital to increase.
From a planning perspective, a red flag appears because the capital structure is out of control.
The financial forecast stops, because the firm either needs to reduce it growth of sales or
determine a new set of inputs to accommodate the increase in market risk. The new inputs
would be an increase in the cost of equity and debt because of market expectations have
changed, plus a revised target capital structure (Debt/Equity).

Growth in profit margins > growth in sales. When profit margins are increasing more
rapidly than sales, operating profits will be increasing at a rate greater than sales. According to
Solomon [1963, chapter 5] this set of conditions reflects true growth. That is, when rate of
return on new capital investments (r) is greater than the weighted average cost of capital
(WACC), r > WACC, a firm is experiencing true growth. If this condition is not permanent, it
will create some instability in forecasting future performance.

Sales in decline. If the forecast is for sales to decline over several years, the strategy of the
firm will change dramatically. The relationship between sales and assets will decline, and it is
crucial to track the return on operating income and/or net income vis-à-vis sales. Management
needs a new strategic plan that where forecasted total assets to equal total liabilities. Keeping
within the capital structure boundaries established and reducing debt if possible, would be the
conservative strategy for the financial forecast to follow.

Increasing operating profit margins. If new product markets result in and increase in
operating profit margins (EBIT/Sales) and/or profit margins (NI/Sales), the FCFF and
discretionary cash flow will likely rise, assuming other forecasted components remain
unchanged. Under these conditions, equity in the balance sheet will rise and it is possible that
forecasted liabilities > assets. An increase in equity can result in the debt ratio (debt/Vf)
declining, and/or debt can be retired. Either of these acts can result in the debt ratio falling
below the target established by management or to zero. If the cost of equity and debt is not
 13

readjusted downward the WACC will likely increase as the percentage of equity approaches
100 percent.

No growth, expansion and true growth. Solomon [1963] developed four scenarios that
were related to the forecasted growth rate of net earnings or dividends. The scenarios
highlighted the effect that investment and how it was financed had on growth of earnings
and/or dividends. If 100 percent of the net income was paid out in dividends, for an all equity
firm, there would be no growth in value over time. However, investing a portion of the
earnings retained at exactly the WACC will result in an expansion of assets, but earning,
debt/equity ratio and asset value of will experience a constant increase, as would the growth in
firm value. The third condition occurred when a portion of earnings retained was invested at a
rate of return greater than WACC. Solomon referred to this condition as true growth and over
time equity would increase and the debt/equity ratio would decrease. True growth creates
complex issues in estimating the optimal capital structure, cost of equity (ks) and value of the
stock. Likewise, the stability of the investment pattern can have a profound affect on the value
of the equity. Each of these conditions creates issues in estimating the value of a stock.

IV. DIFFERENCES BETWEEN EQUITY VALUATION THEORIES

In this illustration the basic inputs for estimating the equity value of Abbott
Laboratories --free cash flow to equity [FCFE] and dividends [DIV]—are presented in the
preformed income statement and balance sheet that is located in Exhibit 1. The sales of Abbott
Laboratories are assumed to grow at 7.5 percent annually for five years. The forecasted
relationships between sales and income statement expenses, assets and selected liabilities are
found in first column of Exhibit 1. Other key assumptions relating sales to income statement
and balance sheet items are also located in column 1 of Exhibit 1. Exhibit 1A shows
relationships between FCFE, FCFD and FCFF in the financial forecast. Also Exhibit 1A
provides an overview of the book and market value estimates of the debt/equity measures.
These summary cash flow and debt/equity measures provide a valuable perspective of the long-
run stability of the example company, Abbot Laboratories.

The FCFE is composed of cash flows associated with operations (CFFO), net
investment (NIF), working capital (WCCF) and permanent debt (FCFD). The cash flows for
each of the three components of FCFE are presented in Exhibit 2. The FCFE is also shown in
Exhibit 3. Likewise, the annual dividend flows are shown at the top of Exhibit 4.

The annual FCFE are discounted at the cost of equity capital (ks) and they are shown at
the top of Exhibit 3. The capital asset pricing model (CAPM) is used to estimate ks. The
CAPM is…
ks = rf + β [MRP] [16]
where:
rf = risk free rate = 0.044
β = beta = 0.85
MRP = market risk premium = 0.02
 14

With the assumed CAPM inputs, the ks is 0.061 and the discounted FCFE for years 1 -5,
PVFCFE, 1- 5, shown in Exhibit 3, are $7.931 billion. The terminal growth rate is assumed to be 3
percent. The present value of the terminal value (PVTVFCFE) is $55.544 billion. That is,

PVTVFCFE = FCFE5 [ (1 + growth rate) / (ks – g)] / (1 + ks)5 [17]

= [ $2.248 billion (1.03) / (0.061 – 0.03)] / (1 + 0.061)5
= $55,544 billion

Thus the Vs[FCFE] = PVFCFE, 1 –5 + PVTVFCFE , [18]

= $7.931 billion + $57.544 billion
= $63.475 billion

The annual flows to dividends (DIV) for years 1 –5 are growing at a rate of 7.5 percent
annually, the same as the growth rate of sales. Exhibit 4 shows discounting the dividends at ks,
6.1 percent, for years 1 to 5 results in the PVDIV, 1-5 equaling $7.950 billion. Thus the PVDIV, 1-5
are $0.019 billion greater the PVFCFE,1-5, $7.950 billion - $7.931 billion. In order to make the
total PVDIV = PVFCFE the program calculates an implied terminal growth rate of dividends(gDIV).
First, assuming equation 13, we find…

Vs[FCFE] = Vs[DIV] [19]

Vs[FCFE] = PVDIV, years 1- 5 + PVTVDIV, year 5
$63.475 billion = $7.950 billion + PVTVDIV, year 5
PVTVDIV, year 5 = $55.524 billion

To solve for gDIV the next step is to find the future value of $55.524 billion, where ks is
0.061 and terminal year in year 5 (FV0.061, year 5). That is, FV0.0610, year 5 = $55.524 / PVIF0.061, year
5 , thus FV0.061, year 5 = $55.524 billion / 0.74374 = $74.655 billion, as shown in Exhibit 4.

The third step is to find gDIV, assuming the numerals are in billions (B) $. The
following is presented in Exhibit 4.

TVDIV, year 5 = $2.221 (1 + gDIV) / [0.061 – gDIV] = $74.655 [20]

where: $2.221 = DIVyear 5
0.061 = ks
$55,524 = FV0.061, year 5

therefore, applying algebra to [20]1, we find gDIV is…

$74.655 (0.061 – gDIV) = $2.221 + $2.221gDIV

$4.55396 - $74.655 gDIV = $2.221 + $2.221 gDIV
gDIV* = [$4.55396 - $2.221] / [$74.655 + $2.221]
gDIV* = 0.030348775

Thus, the implied terminal value growth rate of dividends is 3.03 percent, which is
shown as 3.0 percent in Exhibit 4. That is, at the beginning of year 6, the estimated future
dividends must grow at 3.03 percent annually to infinity in order to achieve an intrinsic value
of $63.475 billion, thereby making the estimated Vs[DIV] = Vs[FCFE]. There are two possible
_____
1
This calculation can be accomplished in Excel by using Solver under Tools.
 15

interpretation of the gDIV > gFCFE. First, if the estimated flows from DIV are considered a
better predictor of Vs than FCFE flows, the $63.475 billion intrinsic value of the equity
(Vs[FCFE]) may be understated. This interpretation occurs because the $63.475 billion in equity
value is achieved with only a 3.0 percent terminal growth rate of a FCFE to a company’s
shareholders, while a 3.03 percent terminal value of DIV flows is necessary to achieve the same
equity value of $63.475 billion. Why did this happen? One possible explanation for the gDIV >
gFCFE , .0303 > .03, is that the undiscounted annual FCFE in years 1 to 5 are larger than the
undiscounted annual DIV for the same period, as shown in Exhibits 3 and 4, respectively, e.g.,
the FCFE is $2.248 billion, while the DIV5 is $2.221 billion. This relationship can occur
because the payout ratio < 100 percent, and the higher retained earnings allows the FCFE in
years 1- 5 to increase more rapidly than the DIV in years 1-5. The dividends are based on the
percentage of net income disbursed to shareholders, and it is only indirectly related to balance
sheet flows associated with FCFE. In closing, it is relatively common to find the present value
of the dividend stream being less-than the stream of free cash flows to equity (FCFE).

A second interpretation occurs because many investors consider the estimated flows
from DIV a better predictor of the value of equity than the FCFE flows. That is, investors
physically receive dividends, while the flows associated with FCFE do not flow directly to
investors. Namely, it is assumed that cash outflows associated with capital investments and
working capital earn at least the weighted average cost of capital (WACC), that in the future
become operating cash inflows. Likewise, it is assumed that the increase in debt will be used to
invest in investments that will earn at least theWACC.

V. DIFFERENCES BETWEEN FIRM AND EQUITY VALUATION

It was hypothesized in equation 15 that Vf[FCFF] = Vs[FCFE] + Vd[FCFD]. The objective of

this section is to discover why the two sides of equation 15 differ. The first task is to examine
the Vf[FCFF], the left hand side of 15. The components of undiscounted free cash flows to a firm
[FCFF] are presented at the bottom of Exhibit 2-- net operating flows (NOF), net investment
flows (NIF) and working capital flows (WCCF). The FCFF is shown in Exhibit 2 and 5. The
WACC is used to discount the FCFF and its components-- the equation for estimating the
market weights for debt (wd) and equity (ws), plus market costs of capital for debt (kd)(1-tax
rate) and equity (ks)—are shown at the bottom of Exhibit 3. The debt weight (Vd/Vf) and the
equity weight (Vs/Vf) are .152 and .848, respectively, and the kd and ks are 5.5 percent and 6.1
percent, respectively. Inserting these components into the WACC equation creates a WACC of
5.807 percent.

In estimating the Vs[FCFF], the annual FCFF are discounted at the WACC, as presented in
Exhibit 5. It is assumed the FCFF grows at a rate of 7.5 percent annually from years 1 to 5.
When the annual FCFF for years 1 to 5 are discounted at 5.807 percent, the present value is
$9.382 billion, as shown in Exhibit 5.

By comparison, the Vs[FCFE] is $63,475 billion and the Vf[FCFD] is $11.345 billion.2
_____
2
Note the book value of debt in year 1 was $6.307 billion. It is common practice to solve for
the Vf by adding the book value of debt in year 1 to the present value of the FCFE (Vs[FCFE]).
The estimated value of Abbott Laboratories would be understated by approximately $5 billion
and the wd in the WACC would be 9.04 percent vis-à-vis the 15.16 percent in Exhibit 3.
 16

Thus, summing the equity and debt components shows the Vf is $74.82 billion, as shown in
Exhibit 3. Equation 21 shows how to solve for the PVTVFCFF, year 5. Assume the numerals are
in billion $.

Vs[FCFE] + Vd[FCFD] = Vf [FCFF] [21]

Vs[FCFE] + Vd[FCFD] = PVFCFF, years 1-10 + PVTVFCFF, year 10
$63,475 + $11,345 = $ 9.382 + PVTVFCFF, year 10
PVTVFCFF, year 5 = $65.438.

To solve for the gFCFF, it is necessary to determine the future value (FV) of $65,437
billion, shown in equation 21. The FV0.061, year 5 = [$65.438 billion / PVIF0.061, year 5] = [$65.437
billion / .74374] = $87.983 billion. The next step is to find gFCFF, assuming numerals are in
millions $:

TVFCFF,year 10 = $2.732billion (1 + gFCFF) / [0.061 – gFCFF] = $74.820billion [22]

Applying algebra similar to that used in equation 20 makes the two sides of equation 15
equal. The result is the implied terminal growth rate of FCFF (gFCFF), 0.02578, that equals 2.6
percent when rounded, as shown in Exhibit 5. Thus, at the beginning of year 6 the estimated
FCFF must grow at 2.6 percent annually to infinity in order for the intrinsic Vf[FCFF] to equal
$74.820 billion, where the estimated Vf[FCFF] = [Vs[FCFE] + Vd[FCFD]]. One possible
interpretations of equation 15 is that the sum of the estimated discounted flows from FCFE and
FCFD may be overstated. Exhibit 3 indicates the $74.820 billion intrinsic value of the firm is
achieved with a 3 percent terminal growth of FCFE5 and FCFD5, while only a 2.6 percent
growth in terminal FCFF10 was necessary to achieve a Vf[FCFF] equal to $74.820 billion. One
explanation for this occurrence is that the FCFF in years 1-5 is slighty greater than the sum of
FCFE + FCFD for years 1-5. In summary, the two sides of equation 15 are equal, but in order
for this to occur, the growth rate of the FCFF had to be adjusted downward to make the Vf[FCFF]
= [Vs[FCFE] + Vd[FCFD]].

CONCLUSIONS

An integrated valuation system (IVS) is presented that reflects a company’s strategic

financial forecast. The IVS and makes is possible to simulate changes in a company’s financial
strategies and discover how they affect the firm’s financial health and/or valuation. This
integrated valuation system (IVS) generates a five year forecast of a company’s financial
statements and creates a solid foundation for calculating cash flow measures used to estimate
the value of a firm, its equity and it permanent debt. The cash flow components can also be
used to assess the financial health of a company.

The IVS allows a student to discover why the intrinsic value of stock based on a free cash
flow to equity valuation model (Vs{FCFE] ) does not equal the value generated by a dividend
discount model (Vs[DIV]). Additionally, the IVS generates an implied terminal growth rate of
dividends where a discounted stream of dividends is to equal a discounted stream of free cash
flows to equity. When the implied terminal growth rate of dividends is greater than the growth
rate of the FCFE, it signals a scenario where the intrinsic value of the equity is underestimated
by the dividend discount model or vice versa. The only time the Vs[DIV] = Vs[FCFE] would be
 17

when there was an all equity firm with a 100 percent payout ratio and the return on investment
equals the cost of equity. Many investors believe dividends provide a more accurate measure
of equity value than FCFE because dividends are physically distributed to its stockholders,
while FCFE are an indirect measure equity value.

Another contribution of this research is the development of an implied terminal growth rate
of free cash flows to the firm. This implied growth rate causes the value of a firm based on its
free cash flows (Vf[FCFF]) to equal the value of a firm based on the sum of its free cash flow to
equity and debt [Vs]FCFE] + Vd[FCFD]]. If the implied terminal growth rate of FCFF is less than
the growth rate of the FCFE and FCFD, it suggests the equity is likely to be overvalued. The
inputs for these two models are also substantially different. The challenge to the learner is to
develop an understanding of a company’s financial health based on the inputs used in the
financial forecast and information conveyed in the implied terminal growth rate of FCFF.
 18

APPENDIX 1

ALL EQUITY FINANCED FIRM WITH THREE SEPARATE STRATEGIES—NO

GROWTH, EXPANSION AND TRUE GROWTH

Solomon [1963, Chapter 5] recognized the importance of growth in firm value and how
it was created. In the modern context, he identified an all equity strategy that would generate
true growth. Solomon used an all equity financed firm to develop three separate strategies—
no growth, expansion and true growth-- to illustrate how wealth or growth was created. The
definitions of the three all equity strategies were:
Zero Growth is represented by 100 percent payout of earnings and the rate of
return on capital investments (r) equals the cost of equity capital (ks), r = ks.
Expansion reflects a firm that increases its size, by investing in
capital investment projects that earn the cost of equity, r = ks, and these projects
were financed with the retention of earnings, thus payout ratio is <100 percent.
True Growth occurs when the firm invests in projects that earn more than the cost
of equity, r>ks, and they projects were financed with retained earnings.

The first of two exhibits presents the three strategies and shows the inputs used to create
a firm’s pro forma income statement and a balance sheet. Note the inputs for the three all
equity strategies are nearly the same with the exception of the cost of goods sold and the
percent of earnings paid out in dividends for the true growth firm and the payout ratio for the
expansion strategy. The inputs are used in the same financial forecasting model used in
generating Exhibits 1-6 in the text.

The second exhibit highlights the simulated financial results for each of the strategies.
The Dupont System results are identical with the exception of the profit margin in the true
growth strategy. The weighted average cost of capital inputs are identical. The market values
for the zero growth and expansion strategy are identical, while the value of the stock, firm and
value per share are greater for the true growth strategy. The value of the dividends and free
cash flow are the same for zero growth and expansion, but they are larger for the true growth
scenario. Finally, the implied terminal value for the free cash flow to equity are identical for
the zero growth and expansion, but greater for the true growth strategy.
 19

APPENDIX 1 (continued)

ALL EQUITY FINANCED FIRMS WITH THREE STRATEGIES—NO GROWTH,

EXPANSION AND TRUE GROWTH
Percentage of Sales Forecast Method

Financial Input Zero Growth Expansion1 True Growth2

I. Income Statement
1. Growth of Sales 0% 0% 0%
2. Cost of Goods Sold3 50% 50% 46%
3. Administrative Expenses3 15% 15% 15%
4. Other Expenses3 5% 5% 5%
5. Depreciation Expense4 10% 10% 10%
6. Percent of Earnings Paid Out 100% 88.095% 89.583%

Assets
7. Cash5 3% 3% 3%
8. Accounts Receivable 20% 20% 20%
9. Inventories 20% 20% 20%
10. Other Current Assets 2% 2% 2%
11. Net Fixed Assets 20% 20% 20%
12. Other Assets 0% 0% 0%

Liabilities and Equity

13. Accounts Payable 0% 0% 0%
14. Notes Payable $0 $0 $0
15. Other Current Liabilities 0% 0% 0%
16. Other Liabilities $0 $0 $0
17. Long Term Debt $0 $0 $0
18. Common Stock6 $12.50 $12.50 $12.50
19. Retained Earnings6 $20.00 $20.00 $20.00
1
Expansion occurs when the retention of earnings is sufficient to finance a firm’s capital
investments and the return on the investments (r) equals cost of equity (ks), r = ks.
2
True growth occurs when the retention of earnings is sufficient to finance the firm’s capital
investments and the investments earn more than the cost of equity (ks), r>ks.
3
Percentage of sales
4
Percentage of net assets
5
All assets, accounts payable and other current liabilities are a percentage of sales.
6
Common Stock and Retained earnings are in millions of dollars
 20

APPENDIX 1 (continued)

SIMULATED FINANCIAL RESULTS FOR EACH OF THE GROWTH STRATEGIES

Financial Results Zero Growth Expansion True Growth

Dupont System
1. Profit Margin (%) 0.1680 0.1680 0.1970
2. Asset Turnover (X) 1.5385 1.5873 1.5873
3. Rate of Return on Assets 0.2585 0.2667 0.3048
4. Leverage Multiplier 1.0 1.0 1.0
5. Rate of Return on Equity 0.2585 0.2667 0.3048

WACC Components
6. Weight in debt (wd) 0.0 0.0 0.0
7. Cost of debt (kd) 0.07 0.07 0.07
8. (1 – Tax Rate) 0.60 0.60 0.60
9. Weight in equity (we) 100.0% 100.0% 100.0%
10. WACC 0.10 0.10 0.10

Market Values l
11. Value of Stock (Vs) $84 M $ 84M $96M
12. Value of Debt (Vd) 0.0 0.0 0.0
13. Value of Firm (Vf) $84M $84M $96M
14. Value per share $1.0 $1.0 $1.1429
15 Number of Shares 84M 84M 84M

Dividend and FCFE

16. Dividends $8.40M $7.4M $8.6M
17. Rate of Return on Div. 0.10 0.107 0.14298
18. Free Cash Flow to Equity $8.40M $8.40M 9.60M
19. Rate of Return on FCFE 0.10 0.10 0.1429

Implied Terminal Growth (TV) Rate

20. Implied TV Div. Growth 0.0 0.02416 0.02159
21. Implied TV FCFE Growth 0.0 0.0 0.02159
___
7
Dividend return = 0.08810 and capital gain=0.0119, total return = 0.10
8
0.1429 = $96M / 84M.
 21

APPENDIX 2

The objective of Appendix 2 is to explain the key assumptions and steps involved in
preparing a percentage of sales forecast for an income statement and balance sheet. The
explanation is based on the information provided in Exhibit 1 for years 0 and 1 . The growth of
sales is assumed to be 7.5 percent annually.

Income Statement
0 1 Explanation for Period 1
1. Sales $17.68 $19,01 Sales1 increased 7.5 percent, $17.68(1.075
2. Cost of Sales 7.33 7.79 C0S1 = 0.414 (Sales1): 0.414($19.01)
3. Administrative Expenses 3.98 4.28 AE1 = 0.225 (Sales1): 0.225 ($19.01)
4. Other Expenses 1.67 1.81 OE1 = 0.095 (Sales1): 0.095 ($19.01)
5. Depreciation 1.18 0.59 Depr. = 0.102 (NFA1): 0.102($6.274)
6. EBIT $3.53 $4.54 EBIT1 = Sales – COS –AE – OE – Depr.
7. Interest Income 0.00 0.00 II1 = 0.00
8. Interest Expense -0.143 0.33 IE1 = i [NP0 + LTD0] = 0.055 [1.71 + $4.60]
9. Net Income before taxes 3.67 4.21 NIBT1= EBIT1 + II1 – IE1: $4.54 + 0.0 - 0.33
10.Taxes 0.88 1.02 T1 = (TR)NIBT1: 0.242 ($4.21)
11.Net Income $2.79 $3.19 NI1 = NIBT1 – T1: $4.21 – $1.02
12.Dividends 1.43 1.63 DIV = [DIV/NI] (NI): 0.51 ($3.19)
13.Change to retained. earn. 1.36 1.56 ∆RE = NI – DIV: $3.19 - $1.63

Balance Sheet
Assets
14.Excess Cash 0.00 0.00
15.Cash $0.97 $1.05 CASH = i [Sales1]: 0.055 ($19.01)
16.Accounts Receivable 2.93 3.16 AR = %Sales1 [Sales1]: 0.167 ($19.01)
17.Inventory 2.44 2.62 INV = %Sales1 [Sales1]: 0.138 ($19.01)
18.Other Current Assets 2.79 3.00 OCA = % Sales1 [Sales1]: 0.158 ($19.01)
19.Net Fixed Assets 5.83 6.27 NFA = % Sales1 [Sales1]: 0.33 ($19.01)
20.Other Assets 9.31 10.0 OA = %Sales1[Sales1]: 0.526 ($19.01)
21.Total Assets $24.26 $26.10 TA = MS1 + AR1 + INV1 + OCA1 + NFA1 +
OA1

Liabilities
22.Accounts Payable 1.93 2.07 AP = %Sales1 [Sales1]: 0.109 ($19.01))
23.Notes Payable 1.66 1.71 NP= TA- [AP + OCL +LTD + CS+ RE]
24.Other Current Liabilities 3.41 3.00 OCL = % Sales1 [Sales1]: 0.158 [$19.01]
25.Other Liabilities 7.00 6.78 OL = % Sales1 [Sales1]: 0.131 [$19.01]
26.Long Term Debt 4.27 4.66 LTD = See paragraph 3 on page 11.
27.Common Stock 2.89 2.89 CS = no change
28.Retained Earnings 7.77 9.34 RE = RE0 + ∆RE: 7.77 + 1.57
29.Total Liabilities+Equity $24.26 $26.10 TL+E=AP+NP+OCL+LTD+CS+RE
 22

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 23

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 Exhibit 1: Financial Statements (in millions)
Example Analyst
Income Statement % of Sales % of Sales Forecast
Year ended Dec 31, year: Historical Base % of Sales 2001 +1 +2 +3 +4 +5
Growth of Sales (Last 5 yrs) Year & Others Base YR 7.5% 7.5% 7.5% 7.5% 7.5%
Cost of Sales /Sales 41.0% 41.0% 41.0% 41.0% 41.0%
Admin. Exp. /Sales 22.5% 22.5% 22.5% 22.5% 22.5%
Sales $17,684.66 $19,011.01 $20,436.84 $21,969.60 $23,617.32 $25,388.62
Cost of sales 6.83% 41.4% $7,328.91 $7,794.51 $8,379.10 $9,007.54 $9,683.10 $10,409.33
Administrative expenses 0.00% 22.5% $3,978.91 $4,277.48 $4,598.29 $4,943.16 $5,313.90 $5,712.44
Other expenses 9.11% 9.4% 9.5% $1,669.49 $1,806.05 $1,941.50 $2,087.11 $2,243.65 $2,411.92
Depreciation (% of net fixe 70.0% 10.2% 10.2% $1,177.35 $594.47 $639.91 $687.90 $739.50 $794.96
Earnings before interest and taxes $3,530.00 $4,538.50 $4,878.03 $5,243.89 $5,637.18 $6,059.97
Net Interest expense 13.66% -0.8% -$143.27 $326.46 $346.87 $337.29 $326.92 $315.04
Net income before tax $3,673.27 $4,212.05 $4,531.16 $4,906.60 $5,310.26 $5,744.92
Taxes 23.54% 5.0% 24.2% $879.57 $1,019.31 $1,096.54 $1,187.40 $1,285.08 $1,390.27
Net Income $2,793.70 $3,192.73 $3,434.62 $3,719.20 $4,025.18 $4,354.65
Dividends 57.09% 8.1% 51.0% $1,427.85 $1,628.29 $1,751.66 $1,896.79 $2,052.84 $2,220.87
Change to retained earnings $1,365.85 $1,564.44 $1,682.97 $1,822.41 $1,972.34 $2,133.78

Balance Sheet
Excess Cash $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
Cash #VALUE! 5.5% 5.5% $966.12 $1,045.61 $1,124.03 $1,208.33 $1,298.95 $1,396.37
Accounts Receivable 0.01% 16.6% 16.6% $2,927.37 $3,155.83 $3,392.51 $3,646.95 $3,920.47 $4,214.51
Inventory 0.00% 13.8% 13.8% $2,441.30 $2,623.52 $2,820.28 $3,031.80 $3,259.19 $3,503.63
Other current assets 123.69% 15.8% 15.8% $2,787.98 $3,003.74 $3,229.02 $3,471.20 $3,731.54 $4,011.40
Total current assets $9,122.77 $9,828.69 $10,565.84 $11,358.28 $12,210.15 $13,125.91
Net fixed assets 27.18% 33.0% 33.0% $5,828.12 $6,273.63 $6,744.16 $7,249.97 $7,793.71 $8,378.24
Other assets 123.69% 52.6% 52.6% $9,308.21 $9,999.79 $10,749.78 $11,556.01 $12,422.71 $13,354.41
Total Assets $24,259.10 $26,102.12 $28,059.77 $30,164.26 $32,426.58 $34,858.57

Accounts payable 46.86% 10.9% 10.9% $1,927.54 $2,072.20 $2,227.62 $2,394.69 $2,574.29 $2,767.36
Notes payable $1,661.65 $1,706.07 $1,186.76 $627.31 $12.68 $0.00
Other current liabilities 0.00% 19.3% 15.8% $3,413.01 $3,003.74 $3,229.02 $3,471.20 $3,731.54 $4,011.40
Total current liabilities $7,002.20 $6,782.01 $6,643.40 $6,493.20 $6,318.51 $6,778.76
Other Liabilities 88.80% 13.1% 13.1% $2,318.37 $2,490.44 $2,677.23 $2,878.02 $3,093.87 $3,325.91
Long term debt 290.52% 24.2% 24.2% $4,273.97 $4,600.66 $4,945.71 $5,316.64 $5,715.39 $5,482.75
Common Stock $2,891.27 $2,891.27 $2,891.27 $2,891.27 $2,891.27 $2,891.27
Retained Earnings $7,773.29 $9,337.73 $10,902.17 $12,585.13 $14,407.54 $16,379.88
Total Liabilities + Equity $24,259.10 $26,102.12 $28,059.77 $30,164.26 $32,426.58 $34,858.57
 Exhibit 1A: Financial Statement reasonableness tests (in millions)

Year ended Dec 31, year: 0 1 2 3 4 5

Free cash flow to firm, FCFF $1,412.05 $2,199.01 $2,363.93 $2,541.23 $2,731.82

Free cash flow to equity, FCFE $1,535.71 $1,761.82 $1,919.75 $2,077.54 $2,247.70
Free cash flow to debt, FCFD $326.46 $346.87 $337.29 $326.92 $315.04
FCFE + FCFD $1,862.16 $2,108.69 $2,257.04 $2,404.46 $2,562.74

FCFF - (FCFE + FCFD) -$450.12 $90.32 $106.90 $136.77 $169.08

Total debt $6,306.74 $6,132.48 $5,943.96 $5,728.07 $5,482.75

Total equity $12,229.00 $13,793.44 $15,476.40 $17,298.81 $19,271.15

BV Debt/BV Equity 51.57% 44.46% 38.41% 33.11% 28.45%

BV Debt/BV Firm 34.02% 30.78% 27.75% 24.88% 22.15%
BV Equity/BV Firm 65.98% 69.22% 72.25% 75.12% 77.85%

PCFCFD/PVFCFE 17.87%
PVFCFD/PV Firm 15.16%
PVFCFE/PV Firm 84.84%

% increase in dividends 7.576% 8.286% 8.227% 8.185%

% increase in debt -2.763% -3.074% -3.632% -4.283%
% increase in equity 12.793% 12.201% 11.775% 11.402%
% increase in FCFE 8.964% 8.219% 8.190%
% increase in FCFD -2.763% -3.074% -3.632%
% increase in FCFF 7.500% 7.500% 7.500%
xhibit 2: Calculation of free cash flow to equity (FCFE), free cash flow to debt (FCFD), and free cash flow to the firm (FCFF) (in millions)

Year ended Dec 31, year: 0 1 2 3 4 5

Working Capital
Current assets - (excess cash + cash) $8,156.65 $8,783.09 $9,441.82 $10,149.95 $10,911.20 $11,729.54
Current liabilities - Debt in CL $5,340.55 $5,075.94 $5,456.64 $5,865.88 $6,305.82 $6,778.76
Net working capital (ΔNWC) $2,816.10 $3,707.15 $3,985.18 $4,284.07 $4,605.38 $4,950.78
Change in working capital (WCCF) $891.05 $278.04 $298.89 $321.31 $345.40

Change in net fixed assets (NFA) $445.51 $470.52 $505.81 $543.75 $584.53
(+) Depreciation $594.47 $639.91 $687.90 $739.50 $794.96
Change in Other Assets $691.58 $749.98 $806.23 $866.70 $931.70
Net investment flow (NIF) $1,731.56 $1,860.42 $1,999.95 $2,149.94 $2,311.19

Net income $3,192.73 $3,434.62 $3,719.20 $4,025.18 $4,354.65

(+) Depreciation $594.47 $639.91 $687.90 $739.50 $794.96
CFFO $3,787.20 $4,074.53 $4,407.11 $4,764.67 $5,149.61
(-)NIF $1,731.56 $1,860.42 $1,999.95 $2,149.94 $2,311.19
(-) WCCF $891.05 $278.04 $298.89 $321.31 $345.40
Principal increase (repayment) in debt $371.12 -$174.26 -$188.52 -$215.88 -$245.32
Change in excess cash $0.00 $0.00 $0.00 $0.00 $0.00
Free cash flow to equity (FCFE) $1,535.71 $1,761.82 $1,919.75 $2,077.54 $2,247.70

(+) Interest on total interest bearing debt $326.46 $346.87 $337.29 $326.92 $315.04
Free cash to debt FCFD $326.46 $346.87 $337.29 $326.92 $315.04

Earnings before interest and taxes (EBIT) $4,538.50 $4,878.03 $5,243.89 $5,637.18 $6,059.97
EBIT(1 - tax rate) $3,440.19 $3,697.55 $3,974.87 $4,272.98 $4,593.46
(+) Depreciation expense $594.47 $639.91 $687.90 $739.50 $794.96
Net operating flow (NOF) $4,034.65 $4,337.46 $4,662.77 $5,012.48 $5,388.41
(-) NIF $1,731.56 $1,860.42 $1,999.95 $2,149.94 $2,311.19
(+) WCCF $891.05 $278.04 $298.89 $321.31 $345.40
Free cash flow to firm (FCFF) $1,412.05 $2,199.01 $2,363.93 $2,541.23 $2,731.82
 Exhibit 3: Calculation of the value of free cash flow to equity (FCFE) and free cash flow to debt (in millions)

Year ended Dec 31, year: 0 1 2 3 4 5

Cost of Equity (Ks) 6.1%
Growth rate in FCFE, years 1 to 5 3.0%

Free cash flows to equity (FCFE) $1,535.71 $1,761.82 $1,919.75 $2,077.54 $2,247.70
Terminal value: (1+ g)/(Ks - g) x $2,247.70 $0.00 $0.00 $0.00 $0.00 $74,681.51
Total: FCFE + terminal value of FCFE $1,535.71 $1,761.82 $1,919.75 $2,077.54 $76,929.21
Present value of free cash flows to equity $7,930.90
Present value of terminal value $55,543.88
Present value of free cash flows to equity $63,474.78

Cost of Debt (Kd) 5.5%

Growth in free cash flow to debt (FCFD) 3.0%

Free cash flows to debt (FCFD) $326.46 $346.87 $337.29 $326.92 $315.04
Terminal value: (1+g)/(Kd - g) x $315.04 $0.00 $0.00 $0.00 $0.00 $12,979.82
Total: FCFD + terminal value of FCFD $326.46 $346.87 $337.29 $326.92 $13,294.86
Present value of cash flows to debt $1,413.27
Present value of terminal value $9,931.30
Present value of free cash flows to debt $11,344.57

Present value of the firm (Value of equity + debt) $74,819.35

Weighted average cost of capital (WACC)(value of debt / value of firm) x Kd x (1 - Tax rate) + (value of equity / value of firm) x Ke

Wd 15.2%
Kd 5.5%
(1 - T) 75.8%

Ws 84.8%
Ks 6.1%

Debt portion 0.63%

Equity portion 5.18%
WACC 5.807%
 Exhibit 4: Calculation of the value of dividends and free cash flow to debt (in millions)

Year ended Dec 31, year: 0 1 2 3 4 5

Cost of Equity (Ks) 6.1%
Growth rate in DIV, years 1 to 5 3.0%
Implied growth rate in TVof DIV 3.0%

Dividends $1,628.29 $1,751.66 $1,896.79 $2,052.84 $2,220.87

Terminal value: (1+ g)/(Ks - g) x $2,220.87 $0.00 $0.00 $0.00 $0.00 $74,655.20
Total: dividends + terminal value of dividends $1,628.29 $1,751.66 $1,896.79 $2,052.84 $76,876.07
Present value of dividends $7,950.47
Present value of terminal value $55,524.31
Present value of dividends $63,474.78

Cost of Debt (Kd) 5.5%

Growth rate in FCFD, years 1 to 5 3.0%

Free cash flows to debt (FCFD) $326.46 $346.87 $337.29 $326.92 $315.04
Terminal value: (1+g)/(Kd - g) x $315.04 $0.00 $0.00 $0.00 $0.00 $12,979.82
Total: FCFD + terminal value of FCFD $326.46 $346.87 $337.29 $326.92 $13,294.86
Present value of free cash flows to debt $1,413.27
Present value of terminal value $9,931.30
Present value of free cash flows to debt $11,344.57

Present value of the firm (Value of equity + debt) $74,819.35

Weighted average cost of capital (WACC)(value of debt / value of firm) x Kd x (1 - Tax rate) + (value of equity / value of firm) x Ke
Debt portion 0.63%
Equity portion 5.18%
WACC 5.807%
 Exhibit 5: Calculation of the value of free cash flow to firm using WACC from Exhibit 3 (in millioins)

Year ended Dec 31, year: 0 1 2 3 4 5

WACC, Exhibit 3 (Kf) 5.807%
Growth in Free cash flows (FCFF) 3.0%
Implied growth in terminal value of Free c 2.6% $0.00

Free cash flows to the firm (FCFF) $1,412.05 $2,199.01 $2,363.93 $2,541.23 $2,731.82
Terminal value: (1+ g)/(Kf - g) x $2,731.82 $0.00 $0.00 $0.00 $0.00 $86,776.33
Total: FCFF + terminal value of FCFF $1,412.05 $2,199.01 $2,363.93 $2,541.23 $89,508.15
Present value of free cash flows to firm $9,382.11
Present value of terminal value $65,437.24
Present value of free cash flows to firm (FCFF) $74,819.35
 Exhibit 6: Calculation of the value of free cash flow to firm using WACC from Exhibit 4 (in millions)

Year ended Dec 31, year: 0 1 2 3 4 5

WACC, Exhibit 4 (Kf) 5.807%
Growth in Free cash flows (FCFF) 3.0%
Implied growth in terminal value of Free c 2.6%

Free cash flows to the firm (FCFF) $1,412.05 $2,199.01 $2,363.93 $2,541.23 $2,731.82
Terminal value: (1+ g)/(Kf - g) x $2,731.82 $0.00 $0.00 $0.00 $0.00 $86,776.33
Total: FCFF + terminal value of FCFF $1,412.05 $2,199.01 $2,363.93 $2,541.23 $89,508.15
Present value of free cash flows to firm $9,382.11
Present value of terminal value $65,437.24
Present value of free cash flows to firm $74,819.35
 Exhibit 7: Comparisons, Exhibits 3, 4, 5, and 6 (in millions)

Exhibit 3 Exhibit 4 Exhibit 5 Exhibit 6

FCFE Dividends FCF, Exh 3 FCF, Exh 4
+ FCD + FCD WACC WACC

Present value of cash flows $9,344.17 $9,363.74 $9,382.11 $9,382.11

Present value of terminal values $65,475.18 $65,455.61 $65,437.24 $65,437.24
Present value of the firm $74,819.35 $74,819.35 $74,819.35 $74,819.35

Difference, Exhibit 5 - Exhibit 3

Cash flows $37.94
Terminal values -$37.94
Firm value $0.00

Difference, Exhibit 6 - Exhibit 4

Cash flows $18.37
Terminal values -$18.37
Firm value $0.00