Teton Valley Case

1
Teton Valley Case

• Solution Process

2
Free Cash Flow

• For each future year you want to calculate
• FCF EBIT(1 Tc) (no debt tax shields)
• Depr Amort. (adjust for non-cash
• expenses)
• - Capital Expenditures (a cash flow not
• 
  part of EBIT)
• - Changes in NWC (almost, to adjust
  for incr. or decr. in ST assets and
  liab.)

3
Free Cash Flow

• We start with earnings before interest and taxes.
  Why?
• Before interest because financing costs should
  not be taken out.
• Before taxes to make it easier to ignore the debt
  tax shields that are likely to be included if you
  use actual taxes.

4
Ignore Financing Costs?

• Consider a very simple example
• You are considering a risk free investment in a
  world with no taxes.
• It costs 1,000 now to undertake and will provide
  a payout in one year of 1,100 (FCF).
• The risk free rate is 8. What is its NPV?
• Ans -1,000 1,100/1.08 18.52
• Now consider that you will borrow the 1,000
  start up cash.

5
Ignore Financing Costs?

• Suppose we consider financing costs and subtract
  the interest payments on the loan from FCF.
• 8 interest on 1,000 for a year is 80.
• After interest FCF is
• 1,100 - 80 1,020
• The NPV of this is
• -1,000 1,020/1.08 -55.56
• Clearly wrong! Why would the value of the
  investment itself have changed due to the
  financing?

6
Ignore Financing Costs?

• Is something that looks like this correct?
• Flow to equity approach.
• This separates the cash flows that go to the debt
  holders and the equity holders, then values the
  equity piece at the cost of equity capital.
• This assumes that the debt is priced fairly, i.e.
  that the money raised up front by selling the
  debt just equals the PV of the cash flows that go
  to the debt holders (NPV 0).
• 1,000 from debt (now), 1,080 to debt (later).
• 0 from equity (now), 20 to equity (later)
• The cash flow is risk free so NPV -0
  20/1.08 18.52 same value as before.

7
Why is it almost -?NWC?

• Two reasons
• 1st one of the NWC accounts is the current
  portion of long term debt. We leave out changes
  in long term debt from cash flow since this is a
  financing cash flow. Why put it in 19 years
  later?
• 2nd a level of the cash account is necessary
  only up to a balance required for liquidity.
  Increases in the cash account above this minimum
  could be paid out as dividends or used to pay
  down principal without reducing the effectiveness
  of the firm going forward. Thus increases in
  cash above the minimum are not to be subtracted
  to find FCF so should not be counted in the
  change to NWC.

8
Teton Valley Corporation

• Sales growth at 10 for 5 years then 4 in
  perpetuity.
• CGS at 65 of sales.
• SGA at 500,000 4.5 of sales.
• Net Fixed assets grow at 5 per year for next 5
  years.
• Depreciation is 20 of beginning of year net
  fixed assets.
• NWC is 80,000, grows with sales.
• FCFs grow at 4 in perpetuity after 2011.

9
Forecasting Earnings
10
From Earnings To Free Cash Flow
FCF EBIT(1-Tc) Depr. - ?NWC Cap Ex. So
2007 2008 2009 2010 2011 FCF
791,175 912,418 1,046,141 1,193,610
1,356,219
11
WACC Method

• First find the value of the 5 years of FCFs that
  we forecasted by discounting at the WACC.
• Find the present value of the terminal value of
  the FCFs, again using the WACC.
• The sum of the two is the total firm value before
  any discount.
• Subtract the current value of the existing debt
  from total firm value to find your estimate of
  the current value of the equity.
• As suggested in the case apply the 20 liquidity
  discount to the equity value.

12
APV Method

• Use the cost of capital of the assets (cost of
  equity capital of an unlevered firm) to value the
  forecasted FCFs and the terminal value of the
  FCFs, this is unlevered firm value.
• Add the total value of the tax shields (using the
  cost of debt capital as the appropriate discount
  rate) to find firm value.
• Subtract debt value from firm value to find
  equity value before the discount.
• In this example, apply the 20 discount to
  equity value to find estimated equity value.

13
The Unlevered Cost of Capital

• Equity beta at current leverage is 1.4.
• We can estimate the debt beta as 0.134.
• The asset beta can be estimated with
• The cost of capital of the assets follows from

14
Debt Tax Shields

• To estimate their value I made the heroic
  assumption that the firm will have 350,000 in
  debt from now till the end of time.
• Then the value of the annual tax shield is just
  the interest payment times the tax rate
• Assuming this is perpetual, the total value of
  the debt tax shields is

15
Terminal Value Teton Valley

• FCF in 2011 is estimated at 1,356,219.
• The case suggests a constant growth of 4 in
  perpetuity is expected from this point onward.
• Thus we can calculate the terminal value as of
  2011 as (in the WACC version)
• Dont forget to use the present value of this
  figure.