Suppose that you want to calculate the value of a company. Your team of analysts has provided you with realized and forecasted company financials. How can we calculate the enterprise value and the equity value of this company using the WACC method? In this video, we will show the steps to get to the solution of this problem. Before we will go to the analysis, let's first have a look at the company and its financials. We have actual realized financials from 2017, and forecasts for the years 2018 up to 2023, for both the balance sheet and profit and loss account. The firm has a target debt-to-equity ratio of 0.4, an unlevered beta of 0.5, and a BBB bond rating. Furthermore, the firm employs a tax rate of 25%, a market risk premium of 5.5%, and a small firm premium of 2.5%. Finally, the risk-free rate equals 2.5%. And the credit spread is equal to 1.5%. Now, how can we determine the value of this company based on its free cash flows? The first step is to calculate the appropriate discount factor. The second step is to calculate and discount the free cash flows of the company for the planning period. And to calculate and discount the terminal value. In the final step, we can determine the enterprise and equity value of this company. Okay, so let's start with calculating the discount factor. From the webcast on discounted cash flow calculations, we already know what the formula for the weighted average cost of capital, or WACC, is. In this example, we do not know, however, the cost of equity, nor the cost of debt, nor the financing ratios. However, we can already fill in the corporate tax rate, which is 25%. Then we can calculate the equity ratio of the firm, which is 1 divided by 1 plus the target debt to equity ratio. So 1 divided by 1 plus 0.4, which gives us 71%. The debt ratio is then relatively easy. Namely, 1 minus the equity ratio, which gives us a debt ratio of 29%. Now let's calculate the cost of debt. The cost of debt is calculated as the risk-free rate plus the credit spread. In this example, the cost of debt is therefore equal to 2.5% plus 1.5%, which is 4%. Next, we can calculate the cost of equity using the known formula. The cost of equity is calculated by multiplying the relevered beta with the market risk premium and adding the risk-free rate, plus firm specific risk premiums. In this case, the firm specific risk premium is a small firm risk premium. We first calculate the relevered beta. The relevered beta is calculated as the unlevered beta times 1 plus 1 minus the corporate tax rate, times the debt-to-equity ratio. Filling in this formula gives us a relevered beta of 0.65. If we use this to fill in the formula for the cost of equity, we obtain a value of 8.6%. Finally, we can fill in the formula for the WACC and this results in a WACC of 6.98%. Let's move on to step two: the calculation of the free cash flows. We can only calculate the free cash flows during the planning period. For the period thereafter, we will make use of the key value driver formula. First, we will calculate the free cash flows from the provided financials. Therefore, we go through the following calculations. We start with the earnings before interest and taxes, or EBIT. From EBIT, we subtract the operating taxes to get the net operating profit after taxes, or NOPAT. Then we subtract the change in the net working capital, add the change in operating provisions, add depreciation, and finally subtract the capital expenditures of the tangible fixed assets, or capex, to get to the free cash flows. To do these calculations, it is convenient to set up an outline such as the following. The first calculation is easy. Since we can simply subtract the tax rate times the EBIT from EBIT to get the NOPAT. For 2018, we obtain a NOPAT of 83. And doing this for all of the other years, gives us the following values. To go from NOPAT to free cash flows, we will need to determine the separate components first. We start with the net working capital, which is defined as the operating short-term assets minus the operating short-term liabilities excluding operating provisions. In this example, the operating short-term assets consist of inventories, accounts receivable, and other operating short-term assets excluding cash in this case, since it's not a part of the company's daily operations. The other short-term liabilities consist of the accounts payable and other operating short-term liabilities. We can calculate the net working capital for each separate year. For example, for 2017, the calculation is as follows: 180 + 144 + 84 - 187- 36 = 185. Doing the same for 2018 gives us a value of 193, and we can use this to calculate the difference in net working capital. Which is 193 - 185 = 8. Doing this for all of the other years gives us the net working capitals and the change in net working capitals as outlined over here. Next is the change in the operation provisions, which is simply the difference in the operating provisions between two years. Thus, five for each year, since each year the provision increases with five. We can fill this in, in the outline again. Then for depreciation, we can simply take the values from the profit and loss account. Thus for 2018, this is 31. And for the other years, these are the following. Next, to calculate the capital expenditures, we take the change in the tangible fixed assets, which we can calculate from the balance sheet, and add this to the depreciation. For 2018, this is equal to 315 minus 300 plus 31, which gives a value of 46. Doing this for all of the other years gives us the following values. Now that we have all the items, we can calculate the free cash flows. These values represent the free cash flows of each year of the planning period. After discounting them with the appropriate discount factor, we get the present value of the free cash flows of the planning period. Next, we calculate the free cash flow value for the continuation period. In this particular case, we use the key value driver formula for determining the terminal value. Provided is that the growth rate after the explicit forecast period is 1.5%, and that the long-run return on capital base, or ROCB, is equal to 8%. The value driver formula looks as follows. The NOPAT in this formula is the NOPAT of the last year of the explicit forecast period times the growth rate and equals 101. Therefore, the terminal value is equal to 1,501. This is the terminal value at the end of the explicit forecast period. So we again need to discount this value. We use the same discount factor as in the last year of the explicit forecast period, which is 2023 in this case. Now we can move on to the final step, which is calculating the enterprise and equity value. The enterprise value is the present value of the free cash flows of the planing period plus the terminal value, which gives an enterprise value of 1,359. Then to get to the equity value, we subtract from the enterprise value the net debt, which is the debt minus cash. And this results in an equity value of 1,359 minus the difference between 250 and 55, and this gives a value of 1,164. Thank you for watching this video. If you have any questions or comments, please let us know.
