valuation

Portfolio Organizer • June 200549

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Equity VEquity VEquity VEquity VEquity Valuationaluationaluationaluationaluation

FFFFFree Cash Flowsree Cash Flowsree Cash Flowsree Cash Flowsree Cash Flows

The application of

free cash flow

models is thought of

as the most

challenging and

enriching exercise

for analysts involved

in equity valuation.

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In our previous article, “Equity Valuation: DividendDiscount Model”, published in Portfolio Organizer,May 2005, we learnt the practical application of

Dividend Discount Model (DDM) of valuation. There aremany shortcomings in DDM. It cannot be used to valuecompanies which do not pay dividends. Also, theearnings of the companies must exhibit a significantrelationship with the dividends. Due to these reasons,analysts began focusing on alternate measures of value.The free cash flow valuation came in vogue in the 1980’sbut till very recently, analysts used to have a fascinationfor earnings. Companies were also doing their bit byfocusing on short-term earnings to make up goodnumbers for quarterly analysts’ meets. Severalaccounting scandals followed by the collapse of some ofthe major firms like Enron and WorldCom changed thisscenario. Analysts and academicians began tounderstand the importance of cash flows. Cash flows,rather than earnings, as indicators of the future marketprice may look absurd to staunch supporters of earnings;but earnings are affected by diverse accounting policiesadopted by various firms while cash flows reduce thisvariability. Market experiences have established thatcurrent stock prices are more influenced by long-termcash flows than by short-term earnings numbers. Notlong ago, Indian banks were making huge provisionsNPAs and writing them off. Going by the earnings logic,share prices should have tumbled, but in most cases, thereverse happened as the market viewed this as anindicator of healthy cash flows in future. According toRappaport and Mouboussim, 2001, the discounted cashflow model is the only theoretically correct valuationmodel that can explain the pricing of equity stock.

Free Cash Flows

Free cash flows are the cash flows available to thesuppliers of capital to the firm after meeting all the cashexpenses and necessary investment needs. These arealso called discretionary cash flows or operating cashflows. These are the true operating cash flows of the firm(Tim Copelland, et al). Free cash flows can further besegregated into Free Cash Flows to Firm (FCFF) and

© 2005 The ICFAI University Press. All Rights Reserved.

G Kumaraswamy NaiduConsulting Editor,

Portfolio Organizer.

Manoj GautamResearch Associate,

Examinations Department,The ICFAI University.

Sanchita PatnaikResearch Associate,

Examinations Department,The ICFAI University.

Portfolio Organizer • June 2005 50

Equity Valuation: Free Cash Flows

Free Cash Flows to Equity (FCFE). FCFF are computed before taking financial chargesinto consideration, as these are the cash flows available to all the suppliers of capital.Suppliers of capital include debt holders, equity shareholders and preferredshareholders. The choice between FCFF and FCFE depends upon the leverage factor.Generally, when firms have a stable capital structure and are expected to continue withthis in foreseeable future, FCFE is used as the leverage needs of the firms can be easilypredicted and can be factored in. However, in real life, the capital structure of firms isvolatile depending upon business conditions and their reinvestment needs. In suchcases, FCFF can give a good measure of value, as it is a pre-debt cash flow. Valuesobtained under both the approaches will be equal if the leverage ratio is insignificant.Contrary to common perception, FCF are different from operating cash flows reportedin the financial statements, as we will see later.

Since the growth of firms assumes different stages depending on their life cycle,analysts use N-stage models to find out the value of the firm. It is similar to DDM inmany respects. We have discussed single stage, 2-stage and 3-stage DDMs. Let usdiscuss the application of these stages to the FCF model.

Free cash flows Model

There are different stages models which analysts use. First is Single stage model.

Mathematically, Single stage model can be represented as follows:

Present value of free cash flows = gk1

FCF

−

Where

FCF = Free cash flows of the firm

k = Discount rate

g = Likely growth rate in free cash flows of the firm in next period

This model is suited to value firms, which are expected to grow at stable growth ratein perpetuity. The problem with this model lies in the denominator. If k in the aboveequation is less than the growth rate, then this model becomes worthless.

Generally n stage model is used to value firms. As in dividends discount model, wecan use H-model, 2 and 3 stage model in FCF valuation. Dividends are substituted byFCF here.

The n-stage model can be represented as follows:

Value of the firm = ( )∑∞

= +1 1t tk

tFCF

We have used the term FCF i.e. free cash flows, which can be either FCFF or FCFE.As FCFF indicates the total value of the operating assets of the firm including the valueof debt, if we use FCFF to find the value of the firm then we need to deduct the market


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value of debt from the cumulated present value. After arriving at the value of operatingassets, we add the value of non-operating assets like investments to find the value ofequity

Deriving Free Cash Flows

Free cash flow to firm can be derived from net income as follows:Net income (as reported)Plus Net non-cash chargesPlus Interest expense (1-t)Less Gross investment in fixed assetsLess Investment in working capital

Forecasting FCFF is quite a challenging and enriching exercise for analysts andrequires a complete understanding of the financial statements of the company.

As we see in the equation, the starting point for the calculation of FCFF is the netincome as reported in the financial statements of the company. Net income as reportedis after deducting depreciation, financial charges, income tax and amortizations. If firmshave preferred share capital, then preferred dividends are also deducted. In order togive our readers a comprehensive view of FCFF, we will discuss the segments of FCFFone by one.

Net Non-cash Charges

A company incurs some non-cash expenses in the course ofbusiness such as depreciation and amortizations. No cashoutflow occurs in the case of such expenses. Since we try tofind out the cash flows of the firm, these expenses are to beadded back to the net income. To ensure consistency in ourcalculations, non-cash income is also not considered. This iswhy we prefer to call this segment net non-cash charges.Depreciation is one major non-cash item. It results out ofthe use of assets to generate income. It is recorded in thebooks of the company but it is merely a book entry and nocash outflow occurs. Similarly, in case of patents andintangibles, the company incurs cash expenses in one periodand then it allocates these expenses over a period of time.These also have to be amortized over a period of time. These amortizations are also tobe added back. There are some more items like gains or losses on sale of investmentsand restructuring charges which are to be adjusted accordingly. Apart from this,deferred taxes warrant special attention. Sometimes there is a vast difference betweencash taxes paid by the firm and taxes considered while arriving at the net income.Sometimes companies deduct expenses like penalties paid for late payment of taxes,etc. which are not tax-allowed u/s 37 of the Income Tax Act, 1961. This lead to theunderstatement of tax reported in the financial statements in comparison to actual taxpayments. Sometimes the company may have the ability to defer taxes till a long period.In such a case, the reported tax has to be added back to the net income. While valuingnew economy companies, stock options are also found in the balance sheets of fewcompanies. Although these represent expenses from an accounting point of view andare recorded under the expenditure head, no cash outflow is involved. But at the time ofexercise by employees, companies receive cash. These factors are to be consideredwhile calculating cash flows.

While valuing neweconomy

companies, stock

options are alsofound in the

balance sheets of

few companies



Interest Expense

While arriving at the net income, interest expenses are deducted from total income.Since our aim is to find out the cash flows available to all the suppliers of the capital,interest expenses are to be added back. The long-term creditors of the company areinterested in the cash flows that are available for servicing their debt. Since interest hasa tax-shield associated with it, tax adjustments are done prior to its inclusion.

Gross Investment in Fixed Assets

A company, in order to grow continuously, invests in new assets and retires some of theexisting assets. These investments are integral to the successful running of thebusiness. While valuing firms, estimation of expenditure on fixed assets pose asignificant challenge because generally companies do not have a smooth capitalinvestment stream. Specifically, Indian companies often follow random capitalinvestment policies. Hence, it becomes an arduous task to estimate precise capitalinvestments over a period of time.

Changes in Net Working Capital

A firm needs to invest some part of its cash in its working capital in order to ensuresmooth functioning of its day-to-day functions. Working capital usually implies thedifference between the current assets and current liabilities. Current assets compriseinventories, debtors and cash balances. While arriving at the figure for current assets,

we generally exclude cash and cash equivalents as valuationis a forward-looking exercise and change in working capitalreflects the funds accrued but cash has already beengenerated. Cash investments by firms generally earn thema return, unlike other current assets. Some analysts feelthat firms generally maintain cash that is in excess of theirworking capital requirements. So instead of excluding entirecash balances, only that cash which is in excess of theirworking capital requirements should be excluded. There areconflicting views and in practice, analysts often segregatecash flows into required and excess. We have excluded cashaltogether from our calculations of working capital. Comingto current liabilities, these include creditors and accruedexpenses. We only consider non-interest bearing liabilities.Current portion of long-term debt and all interest bearingliabilities are excluded as we are concerned with operating

items, and interest expense is added back to net income while calculating FCFF. Whiledoing valuation, consistency between the different parameters has to be maintained.

After arriving at FCFF from net income, we forecast these FCFF over a period andthen we proceed to find the present value of FCFF using the appropriate discount rate.The mathematical formula is as follows:

Firm value = ( )∑∞

= +1 1t tWACC

tFCFF

WACC stands for weighted average cost of capital. It represents opportunity cost ofcapital to the investors investing in the firm. Weighted average of all the sources ofcapital is taken. The formula for WACC is as follows:

There are

conflicting views

and in practice,analysts often

segregate cash

flows into requiredand excess


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WACC = kd(1- t) x D/V + ke x E/V + kp x P/V

Where:

kd = Pre-tax cost of debt E = Market value of equity

ke= Cost of equity P = Market value of preference capital

kp= Cost of preference capital t = Marginal tax rate

D = Market value of debt V = Market value of the firm

We use market value weights as market value represents the true value of claims byvarious providers of capital.

Debt

Where debt is not traded in the secondary market, traded debt securities of a similarnature in terms of tenure and credit quality are searched. Using their yield to maturityas discount rate, present value is calculated. This presentvalue is used as market value of debt. While estimating costof debt, the coupon interest should never be taken as it isstatic and does not portray a true picture of the currentconditions. Another approach pertains to the use of risk freerate. We dealt with risk-free rate in our previous article.Default risk of the entity is found by assessing its rating andif no ratings are available, then analysts estimate effectiveproxies for these ratings by using their own methods. Afterthat, the rating spread is added to the risk-free rate. Aftercalculating the cost of debt, we calculate the market value ofdebt using the cost to discount the cash flows associated withthe debt.

Coming back to the cost of debt, as it is tax-deductible, itis multiplied by the tax adjustment factor, i.e., (1-t) where tis marginal tax rate, to arrive at post tax cost of debt.

Equity

Equity is traded in the market so that the number of outstanding shares is multiplied bythe current market price to obtain the market value. Cost of equity is already dealt within detail in our previous article. (“Valuation of Equity: Dividend Discount Model” inPortfolio Organizer, May 2005).

Preferred Securities

Preferred stocks pay dividends perpetually to the preferred shareholders. Their costcan be found by dividing the dividends by their market price.

Expected Growth Rate

Another very important issue pertaining to the FCFF model is its expected growth rate.The assumption underlying the firms’ value undergoes key changes depending uponthe growth of the firms. When firms are relatively new, their reinvestment needs aresubstantial. Capital spending is much more than depreciation. However, when firmsapproach the maturity stage, their reinvestment needs are curtailed and the differencebetween capital expenditure and depreciation becomes smaller. Many analysts assumethat during stable growth period capital spending offsets depreciation.

While estimatingcost of debt, the

coupon interest

should never betaken as it is static

and does not

portray a truepicture of the

current conditions



This issue was also dealt in detail in our previous article. Expected growth of thefirm depends upon their competitive advantage. There are some fundamentaldeterminants of growth in EPS like ROE and retention ratio. However, analysts’perception of the likely growth of the firm plays an important part in assigning growthfor the firm.

Terminal Value

The calculation of terminal value under this model more or less remains the same asDDM. The dividends are replaced by FCF. At the beginning of the stable period, theterminal value is calculated assuming that FCF would grow at a stable rate forever.

Terminal value = FCF/ k-g

Where FCF can be FCFE or FCFF depending upon the cash flows we are using forvaluation.

k = Discount rate

g = Growth rate in the stable period

While calculating terminal value, the assumptions regarding key parameters likecapital spending, depreciation, cost of equity and cost of debt change. In the maturedstage, due to lack of reinvestment opportunities, the capital spending becomes less. Thecost of equity, if we use CAPM to calculate it, also changes, as beta in stable phase isdifferent from beta in high growth period. After calculating the present value of FCFF,we deduct market value of debt outstanding to arrive at the value of operating assets ofthe firm.

Free Cash Flow to Equity (FCFE)

Free cash flows to equity are the cash flows that are available to equity holders aftersatisfying claims of all other providers of capital. Equity shareholders bear the ultimaterisk of running the business and they are the last ones to be paid in the event ofliquidation of the firm. Hence, FCFF are reduced after tax financing charges. Sincecompanies continually resort to debt financing and pay a part of their debt, netborrowings are added to FCFF in order to estimate the cash flows available to theequity shareholders.

The relationship between FCFF and FCFE can be represented as follows:

FCFE = FCFF – interest (1-t) + Net borrowings

Where net borrowings = Borrowings in new debt – repayment of old debt. The FCFEcan be calculated from the net income as follows:

Net income (as reported)

Plus Net non-cash charges

Less Gross investment in fixed assets

Less Investment in working capital

Plus Net borrowings

Since FCFE are cash flows to equity holders, these are discounted using cost ofequity as discount rate.


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Theoretically, FCFE should be equal to the dividends as these are the actual cashflows that are available to the equity shareholders. In practice, firms do pay less thanthis amount due to varied reasons. One of the reasons which could be cited is thecompany’s preference to adopt stable payout policy over a period of time.

These are standard definitions of FCFE and FCFF from net income as reported bythe firms. However, in practice, analysts use varied methods to derive these cash flows.Many analysts, instead of using the bottom up approach, i.e., net income approach, startwith EBITDA. However, in all these approaches, the basic tenet remains the same.

Value of Non-operating Assets

While calculating FCFE and FCFF, we exclude excess cash and other non-operatingassets from calculation. About their treatment, the analysts are divided. A section feelsthat these are non-operating and hence should be excluded from calculations. However,we feel that sometimes companies have enormous amounts tied up in cash and theyalso invest heavily in marketable securities. Hence, it would be inappropriate to excludethese from calculations. This also ensures consistency since net income includes otherincome. If we include these in our calculations, then another problem arises regardingdiscounting them. WACC cannot be used, as it does not reflect the true cost of holdingthese assets. Many analysts commit the mistake of lumping these with operating assetsand then they try to find out the value. However, we advocate taking them separately.Excess cash can be taken at book value since market vale of cash is equal to its bookvalue. Marketable securities can be valued using their current market value. However,this is a conservative approach, as many firms tend to invest heavily in undervaluedsecurity. Still, this approach seems better than applying discretionary premium to theirvalue, which is subject to manipulation. The value of equity then becomes:

Value = Value of operating assets + Excess Cash + MV of non-operating assets

Suitability of the Model

FCF models score where DDM fails. These models are basically used to valuecompanies which either are non-dividend paying or pay significantly lesser dividendsthen they can afford to pay. Also, cash flows of the firms should exhibit significantrelationship with the earnings of the company. These models can also be used fromcontrol perspective. If investors want to value a firm to eventually take it over thanDDM cannot be used as dividends are board decisions and can be influenced by theinvestor once he gains control over the firm.

FCF Valuation: A Practical Illustration

After analyzing various companies, we zeroed in on Motor Industries Company Limited(MICO). The Company is into the auto-ancillary sector and a subsidiary of Robert BoschAG (Germany). The company is a key market player in the auto-ancillary sector. Itholds virtual monopoly in some of the key components like manufacturing of sparkplugs and fuel injection system. For the year 2004, it has shown a strong earningsgrowth of around 60%. A fresh injection of capital by the parent company is all set toprovide MICO a platform to launch itself aggressively into the growing internationalmarket. We believe that MICO is an ideal candidate for the FCF valuation due tofollowing factors:

The company has been following a policy of low dividend payout as evident fromTable 1. The dividends payout ratio has been hovering around 9%. The dividend payingcapacity of the firm is quite high as can be gauged from the proportion of cash in total



current assets. The debtequity ratio of the firm isquite stable at 0.1 for past fewyears. These make MICO anideal company for valuationunder FCFF model.

Industry Overview: Despite facing some jitters in the past, the auto-ancillary sectoris back in focus due to easing of the steel commodity cycle. The $7 bn domestic industryis on the threshold of a new revolution in the near future. The industry can be dividedinto two segments—Original Equipment Manufacture (OEM) and after market sales.Demand from OEMs has been growing at a rapid rate, as most of the OEMs prefer tooutsource their requirements due to margin pressures and subsequent efforts to costcutting in order to remain viable in the highly competitive auto industry. OEMs accountfor nearly 75% of the sales of the sector. With the domestic auto industry growing at ahealthy pace, the domestic demand for auto-parts is likely to be healthy in the nearfuture.

The auto-ancillary sector can be segmented into organized and unorganizedsegments. It is highly fragmented. The unorganized sector contributes nearly 78% tothe total market and consists of around 400 players. Many fake products from thissegment flow to the market causing the companies considerable trouble. A report by ATKearney has slated the future growth of auto component industry to be at a CAGR of15% till year 2012.

The global auto industry is worth $1000 bn. It is facing enormous cost pressure dueto the industry being highly competitive. The margins are under pressure. This hasmade international players look towards low-cost manufacturing countries like Indiafor outsourcing. The Indian industry is realizing the potential of exports as India as anoutsourcing hub is better placed than most of its Asian neighbors due to it beingsuperior in engineering designs and availability of quality manpower at a bargain price.It also scores over other non-outsourcing hubs like Mexico, Europe and Brazil due tolow cost of manufacturing of auto-parts. With outsourcing expected to gain momentumthis fiscal, the industry is going to take off in a big way. This is particularly helped by thefact that India is among one of the lowest cost manufacturer of aluminum (a key rawmaterial for auto manufacturing) and steel. The margins of companies are also expectedto improve due to recent news about easing of steel prices.

Valuation of MICO: We divided the growth of the company into three distinct phases,i.e., high growth period followed by transition period followed by stable growth period,starting from the year 2005. MICO is commissioning the production of the Common RailDiesel Injection (CRDi) system in India in 2005. The product will enter the market in2006. Considering the huge potential in India with respect to this product, the sales ofMICO are expected to show a significant increase in 2006. Exports of the company arealso expected to increase in line with the parent company’s plan to increase outsourcingfrom India.

High Growth Period: Auto-ancillary sales are expected to rise in the near-term due tospurt in auto sales and global outsourcing. Nearly all segments of the auto industryhave been showing an upward trend. Although there was a brief lull last year, that didnot stop FIIs from investing in the sector heavily. Domestic sales of the auto-ancillarysector are heavily dependent on the sales of the auto sector. MICO enjoys a virtualmonopoly in two of its flagship products, namely spark plugs and fuel injection system.It controls nearly 65% in the former category while in the latter, it controls nearly 80%

Table 1: MICO Relevant Ratios2001 2002 2003 2004

Debt/equity ratio 0.1 0.1 0.1 0.l (E)Dividends payout ratio 10% 9% 6% 8%Cash/Total assets ratio 20.47% 42.94% 48.29% 43.19% (E)


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of the industry sales. These contribute nearly 38% and 2.87% to the total revenues ofthe company. Another significant item is nozzles, which contributes 22% to the totalrevenues of the company. In the spark plug and nozzle segment, the company mightface some problems, as pressure is two-pronged. First, the threat is from the oversupplyof cheap products from the unorganized sector. The second threat is related to theavailability of cheap substitutes from China and Thailand.

We expect the sales of MICO to increase by 20% in the year 2005. The Companyrecorded an impressive growth of 60% in earnings for 2004. This was due to freshdemand for their fuel injector system. The Operating Profit Margin (OPM) of thecompany is already 27% and we do not foresee any significant increase in the OPM.MICO is introducing the CRDi system in India from 2006; this product can help thecompany reach new high of sales in the coming year. The pricing power of the productis not known. However, considering the immense potentialof the product, we believe sales of the company will show atleast 70% rise in 2006. Many analysts are of the opinion thatsales will double in 2006, but many foreign carmakers haveambitious plans to enter the country with cars that arealready equipped with the CRDi system. Hence, we aretaking a very conservative view. Considering the plans ofsome players to make an aggressive entry into the segment,the sales from this segment will eventually slow down. Thesales are expected to increase by 40% for the year 2007 and30% for the year 2008.

We prepared a proforma income statement for this highgrowth period from 2005 to 2008. We forecast the individualcomponents of income statement taking the most recentpercentage to sales as MICO achieved significant costefficiency during 2004.

Cost of Capital: The cost of equity is calculated using CAPM. The beta value of MICOwas calculated by regressing the returns of the stock of the company with the S&P 500index. It was around 0.44. The risk free rate is taken at 6.5% while the market riskpremium is taken at 7.5%. (Please refer to “Valuation of Equity: Dividend DiscountModel” in Portfolio Organizer, May 2005). The cost of equity has been calculated asfollows:

6.5% + 0.44(7.5) = 9.8%.

We assumed a target debt equity ratio of 10% considering the historical ratio. Thevalue of debt was found by adjusting the value of equity at the year-end for the netprofits after the dividends. We assumed the dividend payout ratio of 8% againconsidering the historical record of the company. An effective interest rate of 5.13% wasused to calculate the cost of capital. The cost of capital was to 9.22%. After forecastingthese amounts, the projected FCFF statement of MICO was prepared. (See Table 2).

Transition Period: The high growth period will last for 4 years. After the high growthperiod, the transition period will begin at the end of which the earnings of the company willsettle to a stable growth rate. We assume this period to last for 5 years. Entry of newplayers in the fray coupled with the expected slowdown in the auto sector can playspoilsport. Instead of focusing on individual components for this period, we focused on thelikely growth in FCFF that the company is expected to have. As explained in the previousarticle, the stable growth rate of the firms is more or less equal to the long-term growthrate of the economy in which it operates. Growth of the auto-ancillary sector is linked

We expect thesales of MICO to

increase by 20% in

the year 2005. TheCompany recorded

an impressive

growth of 60% inearnings for 2004



closely to the growth of the GDP of the country. We have used the sustainable growth ratemethod to calculate the stable growth rate of the company. The long-term ROE of thecompany is approximately 20%. We have assumed that MICO will pay 50% of its earningsas dividends in the stable period. Therefore, the stable growth rate is taken at 10%. This islower than the long-term growth forecast for the economy at 12%.

The growth in FCFF for the year 2008 was 32.16%. This will decline linearly to 10%at the end of 2013. As we have assumed that the beta of the company will be 1 in thestable phase, we have linearly increased this beta from 0.44 in the year 2008 to 1 in theyear 2013. Hence, cost of capital also changes during the transition phase.

Terminal Value: By making use of expected FCFF during 2013, we calculated theterminal value at the end of 2013 as follows:

Rs. in millions

Year 2005 2006 2007 2008

Sales 27,934.80 47,489.20 66,484.80 86,430.30Other Income 927.28 967.59 1,009.00 1,052.19Total Income 28,862.10 48,456.80 67,493.80 87,482.50Expenditure

Change in stock +1,396.74 +2,374.46 +3,324.24 +4,322.00Raw material 11,173.90 18,995.70 26,594.00 34,572.10Staff cost 4,190.22 7,123.37 9,972.72 12,964.50Other expenditure 5,586.96 9,497.83 13,297.00 17,286.10Total Expenditure 19,554.40 33,242.40 46,539.40 60,500.70PBDIT 9,307.72 15,214.40 20,954.40 26,981.80Interest1 64.32 87.38 128.08 190.91PBDT 9,243.40 15,127.00 20,826.30 26,790.90Depreciation2 1,729.30 1,856.95 1,984.60 2,109.78PBT 7,514.10 13,270.00 18,841.70 24,681.10TAX @35%3 2,629.94 4,644.51 6,594.60 8,638.38PAT 4,884.17 8,625.51 12,247.10 16,042.70Plus: Depreciation 1,729.30 1,856.95 1,984.60 2,109.78Minus: Changes in working capital4 150.053 631.60 613.57 644.23Plus: Interest (1-t) 41.808 56.797 83.252 124.092Minus changes in Fixed assets5 5,500.00 1,500.00 1,500.00 1,500.00FCFF 1,005.22 8,407.66 12,201.40 16,132.30PV @9.2% 920.36 7,048.08 9,364.59 11,336.70

1. Interest: For the past few years, the company has been following a policy of keeping a stable D/E ratio of 10%. We continuewith this ratio to arrive at the debt amount for the company. A lot of debt of the company is in the form of short-term credit, likesales-tax deferrals. Hence, the cost of debt for the company is arrived at 5.13%.2. Depreciation: In absence of specific information about the depreciation policy of the company, we took past average ofdepreciation figures as a percentage to gross fixed assets. It was around 8.23%.3. Tax rate: The marginal tax rate of 35% is taken into account.4. Changes in non-cash working capital: We took the average percentage of working capital to sales to arrive at this figure.Working capital investments are highly correlated with the sales in general. Then we deduct the previous yearsí figure from thecurrent year figure to arrive at the changes.5. Investments in fixed assets: According to company sources, the parent company has huge plans for MICO. The parent companyis going to invest Rs. 1000 cr over a period of 4 years in the company. Rs. 550 cr will be invested in the year 2005 to start thecommissioning process of CRDi systems while rest, Rs. 450 cr, will be invested in three installments, in the years 2006, 2007 and2008.

Table 2: Performa Statement during High Growth Period


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Terminal value = FCFF2012 (1+ growth rate stable period) / (WACC stable phase – g stable phase)

In the stable phase, the cost of capital changes significantly. We adopted the customof using beta 1 in the stable phase as in the stable phase the returns of the firms matchwith that on market and risk characteristics of the firms change significantly. We alsoconsider the penchant of the parent company to keep its subsidiary debt-free in thestable phase. Hence, we assumed that in the stable phase, MICO would go debt-free.The cost of capital using the beta 1 and keeping other factors constant come to 14.0%.

The total value of FCFF of the company stood at Rs. 414,065.04 mn.

To arrive at the value of equity, MV of debt, i.e., Rs. 1,253.90 (calculated on our ownsince the final figures have not been available) is deducted. To this figure, we added thevalue of cash (we excluded cash from working capital calculations) and value of non-operating assets to arrive at the total value of the firm.

The total value of the firm’s equity = 414,065.04 – 1,253.90 + 4,891.14 + 2,915 = Rs.420,617 mn

This figure, when divided by the total number of shares outstanding, i.e., 32.05million gives us a figure of Rs. 13,123.78 per share.

Ever since the world discovered the concept of FCF, it has been gaining ground. Thereal importance of FCF lies in its applications. Non-dividend firms can also be valuedusing FCF. However, there are significant practical problems also. FCF valuation, likeother valuation models, depends on significant assumptions regarding growth rate, costof capital, reinvestment opportunities and capital structure. The capital structure canchange and so can the cost of capital for the company. The depreciation policy was notclear from the annual reports so we made our own assumptions, which we found werejustified. We assumed the growth rate to decline linearly during the stable phase, whichmay not be the case.

Year 2009 2010 2011 2012 2013

Growth (%) 27.73 23.00 19.00 14.00 10.00FCFF (Rs. mn) 20,605.80 25,345.10 30,160.70 34,383.20 37,821.05Discounting factor (%) 10.07 10.81 11.63 12.37 14.00Present value (PV) (Rs. mn) 12,753.95 13,690.53 13,962.87 13,525.18 11,630.27Present value of Free CashFlows during high growth

period (Rs. mn) 28,669.73Present value of Free Cash

Flows during Transitionperiod (Rs. mn) 65,562.80

PV of Terminal value (Rs. mn) 319,832.51Total 414,065.04

P

Reference # 6M-2005-06-10-01

Cashflows During Transition Period

valuation

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