Description
Business valuation is a processed set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of a business.
Using Corporate Valuation as a Teaching Technique to Emphasize Value Based Management
Ralph Sandler, Spring Hill College Andrew Sharp, Spring Hill College This paper describes a finance class project that would require students to estimate the intrinsic value of a specific publicly traded corporation. Ruby Tuesday, a mid-cap, casual restaurant has been selected. The paper will provide pro forma balance and income statements for Ruby Tuesday. Students, working individually or within a group, would then be required to calculate free cash flow from the pro formas as provided. Using a simplified methodology outlined in the paper, they would calculate the cost of capital and then estimate the equity value along with the price per share. An important goal of the project will be for students to recognize how this corporate valuation model can be used to aid decision-making that will maximize shareholders wealth. INTRODUCTION While valuation is a well-established finance methodology with its intellectual origin in capital budgeting, many companies now use the corporate valuation model to make decisions about alternative strategies. In their book, Valuation – Measuring and Managing the Value of Companies(2000), Copeland, Koller and Marrin provide a practical guide to valuation but also emphasize the linkage between strategy and finance. Creating value for shareholders by focusing on a firm’s free cash flow is a unifying educational theme in Brigham and Ehrhardt’s Financial Management – Theory and Practice(2002), a standard textbook for MBA’s and advanced undergraduate students. According to Brigham and Ehrhardt, the corporate valuation model can be used to pull together topics such as financial forecasting, time value of money, cost of capital and at the same time demonstrate to students how the model can be used to guide managerial decisions (Chapter 12, pp. 461-88). To many finance students, the discipline appears to be somewhat daunting and its abstract concepts and mathematics can easily overwhelm. The challenge to the instructor is to present the material in a way that convinces students that the concepts are useful and interesting. Well-designed student projects offer an important means of bridging the gap between classroom and the more practical financial work place. Stohs [1999] has designed an extensive valuation project that represents 40 percent of a student’s grade in their second class in corporate finance. Student groups select their own publicly traded firm, construct the pro forma balance sheet and income statements, calculate betas and derive a cost of capital. Using their free cash flow estimates, they then estimate the intrinsic value of the firm. Stohs concludes his paper with a discussion of the benefits and drawbacks of the project. Clearly, one limitation is the time required for both instructor and student. We propose a more narrowly defined student valuation project: 1. Based on information in the firm’s annual report and the Value Line Investment Survey we provide pro forma balance and income statements
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for Ruby Tuesday. We used a standard percentage of sales method that was adjusted, where necessary, by the Value Line financial forecast. 2. The project requires students to calculate the cost of capital for Ruby Tuesday by using a simplified methodology outlined in a paper by Weaver [2003] that relies on the Value Line data. 3. Students are required to calculate free cash flow from pro formas provided to them and then calculate the value of operations. They would subtract the value of debt to obtain the equity value along with the price per share. Market Value Added (MVA) will also be calculated. 4. An important goal of the project will be for students to recognize the link between corporate valuation and value-based management. At the end of the project students should be required to reflect on a number of managerial issues. According to Brigham and Ehrhardt, “rapid growth in sales may require growth in operating capital which reduces free cash flow [p. 461]. Is this a problem which management at Ruby Tuesday may have to address in the future? What about the company’s current dividend policy? Should free cash flow be used to increase dividends? Generally, has management acted to maximize shareholders wealth? There are some advantages to this more narrowly defined assignment that we think should account for about 10 percent of either a second course in corporate finance or an MBA finance class. There is more time for instructors to cover other topics and assign additional projects, and since students in a class will all be assigned the same firm—the grading will be easier. Nevertheless, there is flexibility in the project. We think instructors may either assign the project to groups or individual students. Instructors may expand the project by requiring the class to do their own financial forecast instead of providing it to them. In calculating cost of capital, instructors may wish to require students to derive their own Beta value from current online stock market data [see Brigham and Ehrhardt, pp. 225-29] rather than use the Value Line Beta measure. In addition, since Ruby Tuesday does pay a dividend, students could be required to compare their estimate of the firm’s equity value (using a corporate valuation model) to the value of equity using a dividend growth model. The firm selected for this project, Ruby Tuesday, must operate within a highly competitive industry as the following statement from the firm’s annual report [2003] suggests: “Our business is subject to intense competition with respect to prices, services, locations and the types and quality of food. We are in competition with other food service operations, with locally owned restaurants, and other national and regional chains that offer the same or similar types of services and products as we do. Some of our competitors may be better established in the markets where our restaurants are or may be located. Changes in consumer tastes, national, regional or local economic conditions, demographic trends, traffic patterns, and the types, numbers and locations of competing restaurants often affect the restaurant business. There is active competition for management personnel and for attractive commercial real estate sites suitable for restaurants. In addition, factors such as inflation, increased food, labor and benefits costs,
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and the difficulty in attracting qualified management and hourly employees may adversely affect the restaurant industry in general and our restaurant in particular [p.5].” We believe that by requiring students to study a real company that is attempting to make real decisions about its financial performance in a difficult environment will bring a sense of intellectual excitement to the study of corporate finance. FINANCIAL FORECAST We used the percent of sales method (ratios are provided in Table 1) described by Brigham and Ehrhardt (chapter 4) to forecast income statements (see Table 2) and balance sheets (see Table 3) over the period 2004-2007. Although the scale of the project is narrowly defined, instructors may require students to do their own financial forecast instead of providing it to them. If so, please keep in mind that the forecasting process is a lengthy one requiring significant effort. In accordance with Brigham and Ehrhardt, the manual approach was employed to incorporate feedback into the financial statements. Generally, four passes were used to adjust balance sheets and three passes to adjust income statements. Although most textbooks emphasize Additional Funds Needed (AFN), we found Ruby Tuesday to have excess funds that had to be allocated. This would certainly be a complicating factor to students. In addition, given the subjective nature of the forecasting process, instructors should consider giving students as much specific guidance as possible. The complete methodology that we used is provided in Appendix A.
CALCULATING FREE CASH FLOW Free cash flow (FCF) is defined as the after tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain ongoing operations [Brigham and Ehrhardt, p. 46]. FCF represents the cash actually available for distribution to investors. Thus by increasing FCF, managers are enhancing the value of their firm. Assuming they have been exposed to these concepts, students may use the forecasts provided in Tables 2 and 3 to calculate FCF. Calculations, which are summarized in Table 4 for the year 2004-2007, are described in detail for 2004 as follows. Line 1 in Table 4 shows the required net operating working capital, or operating current assets minus operating current liabilities for 2003: 1 Required net operating = (Cash + Accounts receivable + Inventories) (1) working capital - (Accounts payable + Accurals) = ($8,662 + $ 10,509 + $12,200) - ($22,949 + $57,605) = - $49.183 Million
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Line 2 shows required net plant and equipment, Line 3, which is the sum of Lines 1 and 2, shows required net operating capital. For 2003, net operating capital is - $49,183 + $660,897 = $611.714 Million Line 4 shows the required new net investment in operating capital from the previous year. For 2004, the required net investment in operating assets is $705,344 $611,714 = $93.630 Million Line 5 shows NOPAT, or net operating profit after taxes [ EBIT x (1- tax rate)]. Given a 2004 EBIT of $151,859 (Table 2) and a tax rate from Value Line of 36 percent, NOPAT for 2004 is projected to be $97.190 million Although Ruby Tuesday’s net operating profit is projected to be $97,190 in 2004, the firm must invest $93,630 in new assets to support its growth in sales. Therefore FCF, as shown on Line 7, is $97,190 - $93,630 = $3.560 million. COST OF CAPITAL The weighted average cost of capital (WACC) is the discount rate used to calculate the present value of the free cash flow stream in Table 4. In what is a critical component of any corporate valuation, students will be required to calculate Ruby Tuesday’s WAAC using a simplified methodology outlined in a paper by Weaver [2003]. According to Weaver his approach “seeks to demystify (for students) the calculation of WAAC by applying data readily available from Value Line [p. 55]. “An article,” Best Practices in Estimating Cost of Capital” [Bruner et al, 1998], that identifies estimating techniques used in practice, is also relied upon. (Results of the survey are referred to in this paper as the COC Survey). Cost of Debt Using the Weaver methodology, the cost of debt is stated on an after tax basis as follows: Kd = I x (1 - T) (2) Where: Kd = cost of debt (after tax) I = Interest rate (before tax) T = marginal tax rate We used the current cost of existing debt (according to the COC survey, 37% of corporations and 40% of financial advisors use this approach which represents the average cost of debt).2 From the Value Line data of December 2003 (Appendix B), reference A indicates Ruby Tuesday’s Long-term annual interest expense and long-term debt balance are $12.0 million and $206.9 million respectively. Therefore the long-term historical interest rate is 5.80% (12.0/ 206.9). I = Int / B (3) Where: I = Interest rate (before tax) Int = Interest Expense B = Long-term Debt Balance
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Reference B on the Value Line data sheet shows the income tax rate for the 2003 column is 34.8%. Consequently, the historical after tax cost of debt is 3.78% for Ruby Tuesday. Kd = 5.80% (1 – .348) (4) = 3.78% Cost of Equity The Capital Asset Pricing Model (CAPM) was used to calculate the cost of equity (81% of the corporations in the COC survey use CAPM). The CAPM approach to the cost of equity is: Ks = Rf + B (K m – Rf) (5) Where: Rf = Risk-free rate of return B = Beta (K m – Rf) = Market’s return in excess of the risk–free rate (market risk premium) We used a 10-year treasury bond rate (December 2003) of 4.3% as the risk free rate and the market risk premium calculated by Weaver [p. 64] of 5.7%.3 ( According to the COC survey 37% of the corporatio ns in the study use a market risk premium of 5% and 6%). Value Line provides a Beta value of .8 for Ruby Tuesday as reference C. The Ruby Tuesday cost of equity is 8.86% Ks = 4.3 +. 8( 5.7%) = 8.86% (6) Weighting the Capital Components The final step in estimating the cost of capital is to weigh each component and calculate the weighted average cost of capital.4 The WACC can be expressed as: WACC = WdKd + WsKs Where: Kd, Ks = cost of debt, cost of stock Wd, Ws = weight in debt, weight in common stock Market weights (rather than book weights) are the preferred approach recommended in textbooks and the COC survey [Weaver p. 66]. 1. The market value of equity is the number of shares outstanding 64.40 million as identified in Value Line for 2003 (reference D) times the price (reference E) $29.35. Therefore 64.40 million x $29.35 = $1,890.14 million. 2. The market value of debt can be assumed equal to book value (Weaver, p. 66). This is further supported by Ehrhardt (1994, p. 75). The book value of debt in 2003 is $207.064 million as identified in the balance sheet (Table 3).
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3. Ruby Tuesday’s current capital structure weights ($millions) are as follows: Amount % Stock 1,890 90% Bonds 207 10% 100% 4. Weighted Average Cost of Capital is therefore WACC = 8.86% (.90) + 3.78% (.10) = 8.35% (7)
VALUE OF OPERATIONS Consistent with the approach followed by Brigham and Ehrhardt [2002, p. 467] and Hirt and Block [2003, p. 175], we used a variant of the constant growth dividend model to calculate the value of operations. Different growth rates for FCF are divided into several periods, with each period having a present value. Figure 1 shows the process of finding the value of operations. Estimated FCF in each of the nonconstant years 2004 through 2006 are discounted back to 2003 using a 8.35% WACC. The terminal value, the amount that Ruby Tuesday could expect to receive if it sold its operating assets in December 2007, was calculated as follows based on the FCF for 2007 and a perpetual growth rate after that of 7.46%. 5 Vop (2007) = FCF2007(1+g) = FCF 2008 WACC-g WACC-g = $16.78 million (1.0746) = $18.03179 million .0835 - .0746 .0835 - .0746 = $2,026.044 million The terminal value is then added to FCF in 2007 ($2026.044 million + $16.78 million = $2,042.824 million) and discounted back at the 8.35% discount rate. The sum of all present value amounts, which represents the value of operations today (December 2003) is approximately $1,502.797 million. Table 5 summarizes the calculations used to find Ruby Tuesday’s intrinsic stock value. There are 64.40 million shares outstanding and their total value is $1,295.733 million (after the value of debt is subtracted). The value of a single share is therefore 1,295.733/64.40 = $20.12. Given the current (December 2003) market price (reference E on the Value Line Sheet) of $29.35 one would have to conclude that Ruby Tuesday is somewhat overvalued. (8)
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DISCUSSION QUESTIONS At the beginning of the project, students should be encouraged to gather their own information about Ruby Tuesday and some of their competitors. 6 At a minimum they should check out http://finance.yahoo.com on the internet which provides a wealth of information. Historical prices, a company profile, key statistics, SEC filings and financial information are just some examples of the data that is easily accessible. Given this information and after deriving free cash flow, estimating the firm’s cost of capital and then calculating the value of operations, students should be required to reflect on the overall financial assessment of the firm and its future. Here are some suggested questions. While most are open ended, we have provided some possible answers (shown in italics after each question).
Question 1: Given the information you have gathered and your own calculations, how do you assess the financial strength of the firm? Ruby Tuesday emerged from the 2001 recession in a much stronger financial position. In 2003, profit margin (9.65%), return on assets (10.99%), return on common equity (21.35%) and the market/book ratio (4.56) all suggest a solid financial performance(Calculations are from Tables 2 and 3). This is reflected in the firm’s stock price, which has almost doubled between January 2001 and December 2003. As our own financial forecast suggests, these results should continue through 2005 although sales growth should moderate thereafter. According to Value Line “Price-appreciation potential to 2006-2008 is less exciting, though still decent.” As our own estimate of stock value suggests, Ruby Tuesday may currently (December 2003) be over valued. Question 2: Generally, has management acted to maximize shareholder’s value? (Calculate market value added MVA). MVA represents the difference between the cash that owners of the firm could get if they sold the business (value of operations) less operating capital. The higher its MVA, the better the job management is doing for the firm’s shareholders. Thus for 2003, MVA is $1,505.797 million – $611.714 million = $891.08 million. Management has added an impressive $891.08 million in stockholders value since the company’s inception in 1996. Question 3: The growth in sales revenue will generally have a positive effect on Company value. However, the effect can be negative if sales require excessive growth in operating capital. Is this a problem which management at Ruby Tuesday may have to address in the future? Examine the spread between Expected Return on Invested Capital (EROIC) and the Weight Average Cost of Capital (WACC). Growth can either increase or decrease value, depending on EROIC, which is defined as expected NOPAT divided by current capital: EROIC t = NOPAT t+1 / Capital t (9)
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If EROIC t > WACC, then an increase in growth increases value If EROIC t < WACC, then an increase in growth decreases value According to Brigham and Ehrhardt, “if EROIC is greater than WACC then the return on capital is greater than the return investors expect, and management is adding value (p.475).” Apparently, this is the situation with Ruby Tuesday where the spread between EROTC and WACC will be positive between 2003 and 2006 (see Table 6). Question 4: Ruby Tuesday’s current corporate policy is to reinvest the cash generated from operating expenditures and pay a very small dividend. Do you think the firm is likely to change its dividend policy in the near future? Although the current dividend yield on Ruby Tuesday’s stock is a dismal 0.2% (2003), we think the firm will continue to follow its policy of retaining and reinvesting most of its earnings. As the above discussion suggests, management’s current growth policy is adding value. Nevertheless, the casual restaurant industry is highly competitive and Ruby Tuesday is unlikely to achieve the same growth rates in revenue over the longer term. We think the firm is likely to begin passing on some of its free cash flow to investors in the form of higher dividends. SUMMARY The paper describes a finance class project that would require students to estimate the intrinsic value of a publicly traded corporation, Ruby Tuesday. The project can serve as a useful supplement to a second undergraduate corporate finance course or an MBA finance class. The corporate valuation model is an ideal tool to be used to pull together topics such as financial forecasting, time value of money, and the cost of capital. At the same time, the project demonstrates how the model can be used to guide managerial decisions. Within the context of the model, we suggest that students be required to reflect on the financial condition of the firm and its future. While we have included several questions and some possible answers, instructors are encouraged to supplement the project by adding some of their own questions. There is additional flexibility to define student assignments narrowly, as we have done in the paper, or expand the project to include several additional tasks that we have described earlier.
ENDNOTES
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Please note the working capital deficiency in all years except 2007. According to the 2003 Annual Report [p.18], this is common in the restaurant industry. Ruby Tuesday carries current liabilities in excess of current assets because cash generated from operating activities is reinvested in capital expenditures (long-term assets) and receivables and inventory levels are generally not significant. 2 While a market based measure is more theoretically sound, Value Line does not provide the information necessary to make market calculations and it would be difficult for students to find the data from alternative sources. In our view, the differences between book and market value for debt will not have a material impact on our estimate of WACC for Ruby Tuesday. 3 According to Weaver [p. 64], the market risk premium of 5.7 % approximates the long-term (from 1926) compounded annual growth rate for the market’s excess return vis-à-vis a long-term U.S. Treasury bond.
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4 5
Ruby Tuesday did not issue preferred stock. We assumed that Ruby Tuesday’s FCF would grow at a constant rate of 7.46% beyond 2007. While this may appear to be a heroic assumption, the restaurant industry is closely tied to the performance of the American economy (see discussion in Value Line concerning the restaurant industry). For the past 40 years (1963-2003) nominal GDP has grown at an annual compound growth rate of 7.46%. At the FEA Conference 2004, Bennie Nunnally suggested that we use the expected growth in population as a proxy for growth in Ruby Tuesday’s FCF. We investigated the possibility, but found these growth rates to be too low to produce realistic valuation results. 6 We understand that T.G. Friday’s, Applebee’s and Chili’s are the firm’s major competitors.
Appendix A Methodology for the Financial Forecast
The 2004-2007 financial forecast of Ruby Tuesday’s income statements and balance sheets utilized the percent of sales method described by Brigham and Ehrhardt (Chapter 4). Additionally, information from the Value Line (December 2003) forecast on Ruby Tuesday influenced the financial forecast prepared in this paper. 2004 Based on Value Line, sales were projected to grow by 10 percent in 2004 with an income tax rate of 36 percent. Cash dividend payments of 5 cents per share on the common stock were assumed for 2004 in accordance with the Value Line forecast. Excess funds resulting were invested in short-term money market instruments since Ruby Tuesday’s (2003 Annual Report, p. 31) cash management program provides for the investment of excess cash balances in such instruments. The current treasury yield curve was used to calculate future interest earned at 1 percent. 2005 For 2005, sales were projected to grow at 10 percent with a tax rate of 36 percent and cash dividend payments at 5 cents as reflected by Value Line. Excess funds again were assumed to be invested in short-term money market instruments with a 1.5 percent rate based on the current treasury yield curve. 2006 For 2006, the growth in sales was assumed to slow to 7.5 percent based on the average historical growth rate for the non-recession years within the period 1997-2003. A tax rate of 36 percent and dividend rate of 6 cents were projected as assumed in Value Line. Larger excess funds, as compared to 2004-2005, were allocated roughly 50/50 between short-term investments and plant assets as Ruby Tuesday’s (2003 Annual Report, pp. 3, 13, 18) policy is to reinvest cash generated from operating activities in capital expenditures— property and equipment. Based on the current treasury yield 9
curve, an interest rate of 2 percent was used for the short-term investments, while a depreciation rate of 7 percent was assumed from historical data. Then, additional funds needed were acquired by issuing new long-term debt at a rate of 5.78 percent, the calculated before tax cost of debt. 2007 The 2007 forecast methodology is the same as that for 2006, except that a 2.5 percent rate on the short-term investments was assumed per the current treasury yield curve. In addition, the dividend payment was raised to 7 cents per share as projected by Value Line. Thus it mirrors the 2006 assumption and mechanics in all other aspects. Feedback In accordance with Brigham and Ehrhardt (Chapter 4), the manual approach was employed to incorporate feedback into the financial statements. Generally, four passes were used to adjust balance sheets and three passes to adjust income statements. Although textbooks, such as the Brigham and Ehrhardt book, emphasize Additional Funds Needed (AFN), this project found Ruby Tuesday to have excess funds that had to be allocated. As mentioned earlier, these funds were invested entirely in short-term money market instruments for 2004 and 2005. Given the larger amount of excess funds available in 2006 and 2007, the allocation as noted earlier was in an appropriate ratio of 50/50 among short-term money market instruments and fixed assets. Financial feedback adjustments were necessary to account for excess funds, taxes and retained earnings throughout the 2004-2007 forecast period. Given the decision to invest the excess funds for 2006 and 2007, about 50 percent is plant and equipment, some additional bond funding was required resulting in adjustments to depreciation accounts in the third and fourth passes.
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REFERENCES Brigham, Eugene F., Michael C. Ehrhardt, Financial Management: Theory and Practice, Tenth Edition, Dryden Press, 2002. Bruner, Robert F., Kenneth M. Eades, Robert S. Harris and Robert C. Higgins, “Best Practices in Estimated Cost of Capital,” Financial Practice and Education, Spring/Summer 1998. Copeland, Tom, Tim Killer and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, Third Edition, McKinsey & Company, Inc., 2000. Ehrhardt, Michael C., The Search for Value: Measuring the Company’s Cost of Capital, Harvard Business School Press, 1994. Hirt, Geoffrey A., Stanley B. Block, Fundamentals of Investment Management , McGraw-Hill, 2003. Ruby Tuesday Annual Report, 2003. Stohs, Mark, “Teaching Corporate Finance by Valuing a Corporation,” Journal of Financial Education (Fall 1999), 66-74. Value Line Investment Survey, December 12, 2003. Weaver, Samuel C., “Using Value Line to Estimate the Cost of Capital and Industry Capital Structure,” Journal of Financial Education (Fall 2003), 55-71.
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Figure 1 Process for Finding the Value of Operations For Ruby Tuesday (Thousands of Dollars)
2003
2004
2005
2006
2007
2008
3,560 $ 3,286 7,920 9,362 1,482,229 $1,502,797
9,298
24,628
16,780
18,031.79
V(2007)= 2,026,044 = 18,031.79 .0835- .0746 2,042,824 Vop (2003)
Table 1 Ratios Used to Forecast Ruby Tuesday Income And Balance Sheets
Cost to Sales Depreciation to Net Plant and Equipment Cash and Short Term Investment to Sales Accounts Receivable to Sales Inventory to Sales Net Plant and Equipment to Sales Account Receivable to Sales Accruals to Sales Actual 2003 79.90 % 7.00 1.00 1.15 1.33 72.10 2.50 6.30
Table 2 Ruby Tuesday: Income Statements (Thousands of Dollars)
Actual 2003 Sales $ 917,115 Cost (except Depreciation) $ 733,147 Depreciation 45,956 Total Operating Cost $ 779,103 EBIT $ 138,012 Less Interest 2,302 Earnings before Taxes $ 135,710 Taxes 47,226 Net Income $ 88,484 Dividends $ 2,876 Additions to Retain Earnings $ 85,608 2004 $ 1,008,827 $ 806,053 50,915 $ 856,968 $ 151,859 1,967 $ 149,892 53,972 $ 95,920 $ 3,300 $ 92,620 Forecast 2005 $ 1,109,710 $ 886,658 56,007 $ 942,665 $ 167,045 1,137 $ 165,908 59,727 $ 106,181 $ 3,300 $ 102,881 2006 $ 1,192,938 $ 953,157 63,568 $ 1,016,725 $ 176,213 253 $ 175,960 63,345 $ 112,615 $ 3,960 $ 108,655 2007 $ 1,282,408 $ 1,024,644 69,623 $ 1,094,267 $ 188,141 1,397 $ 189,538 68,233 $ 121,305 $ 4,620 $ 116,685
Table 3 Ruby Tuesday Balance Sheets (Thousands of dollars)
Actual 2003 Cash and ShortTerm Investments Accounts Receivable Inventory Other1 Total Currents Assets Net Plant and Equipment Other2 Total Assets Accounts Payable Accurals Total Currents Liability Long Term Bonds Other3 Total Debt Common Stock Other4 Retained Earnings Total Common Equity Total Liabilities and Equity
1 2
2004 $ 43,554 10,088 13,115 19,092 $ 85,849 727,364 93,707 $ 906,920 $ 25,221 63,556 $ 88,777 207,064 102,971 $ 398,762 11,100 (8,082) 505,140 $ 508,158 $ 906,920 $
Forecast 2005 2006 66,986 11,097 14,426 19,092 $ 111,601 808,101 93,707 $ 1,005,409 $ 27,743 69,912 $ 97,655 207,064 102,921 $ 407,640 11,100 (8,082) 594,751 $ 597,769 $ 1,005,409 $ 60,536 11,929 15,508 19,092 $ 107,065 908,108 93,707 $ 1,108,880 $ 29,823 75,155 $ 104,978 208,592 102,921 $ 416,491 11,100 (8,082) 689,371 $ 692,389 $ 1,108,880 $
2007 83,474 12,824 16,671 19,092 $ 132,061 994,616 93,707 $ 1,220,384 $ 32,060 80,792 $ 112,852 211,022 102,921 $ 426,795 11,100 (8,082) 790,571 $ 793,589 $ 1,220,384
$
8,662 10,509 12,200 19,092 $ 50,463 660,897 93,707 $ 805,067 $ 22,949 57,605 $ 80,554 207,064 102,921 $ 390,539 11,100 (8,082) 411,510 $ 414,528 $ 805,067
Income tax receivable, deferred income taxes, prepaid rent, assets held for sale Goodwill, net notes receivable, other assets 3 Deferred income taxes, deferred escalating minimum rent, other deferred liabilities 4 Deferred compensation liability payable in company stock, company stock held by deferred compensation plan, accumulated other comprehensive losses.
Table 4 Ruby Tuesday's Expected Free Cash Flow (Thousands of Dollars)
Actual 2003
2004
2005
2006
2007
Calculation of Free Cash Flow
1. Required Net Operating Working Capital 2. Required Net Plant and Equipment 3. Required Net Operating Capital 4. Required Net New Investment in Operating Capital From Previous Year 5. NOPAT [Net Operating Profit After Taxes =EBIT x (1 - tax rate)] 6. Less: Required Investment in Operating Capital 7. Free Cash Flow ($49,183) ($22,020) ($5,146) ($17,005) $117 660,897 727,364 808,101 908,108 994,616 $611,714 $705,344 $802,955 $891,103 $994,733 93,630 97,611 88,148 103,630
$97,190 $106,909 $112,776 $120,410 93,630 97,611 88,148 103,630 $3,560 $9,298 $24,628 $16,780
Table 5 Finding the Value of Ruby Tuesday's Stock (Thousands of Dollars)
1. Total Market Value of Firm (present value of free cash flows) 2. Less: Value of debt 3. Value of common equity 4. Divide by number of Shares 5. Value per Share
$ 1,502,797 207,064 $ 1,295,733 64,400 $20.12
Table 6 Calculating the Spread between EROIC And WACC for Ruby Tuesday (Dollar amounts are in Thousands)
Actual Forecast 2003 2004 2005 2006 NA 10% 10% 7.5% NA $ 97,190 $ 106,909 $ 112,776 $ $611,714 $ 705,344 $ 802,955 $ 891,103 $ 15.90% 15.2% 14.1% 13.5% 8.35% 8.35% 8.35% 8.35% 7.55% 6.85% 5.75% 5.15%
Sales Growth NOPAT Operating Capital ROIC WACC Spread between ROIC and WACC
2007 7.5% 120,410 994,733
doc_263597505.pdf
Business valuation is a processed set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of a business.
Using Corporate Valuation as a Teaching Technique to Emphasize Value Based Management
Ralph Sandler, Spring Hill College Andrew Sharp, Spring Hill College This paper describes a finance class project that would require students to estimate the intrinsic value of a specific publicly traded corporation. Ruby Tuesday, a mid-cap, casual restaurant has been selected. The paper will provide pro forma balance and income statements for Ruby Tuesday. Students, working individually or within a group, would then be required to calculate free cash flow from the pro formas as provided. Using a simplified methodology outlined in the paper, they would calculate the cost of capital and then estimate the equity value along with the price per share. An important goal of the project will be for students to recognize how this corporate valuation model can be used to aid decision-making that will maximize shareholders wealth. INTRODUCTION While valuation is a well-established finance methodology with its intellectual origin in capital budgeting, many companies now use the corporate valuation model to make decisions about alternative strategies. In their book, Valuation – Measuring and Managing the Value of Companies(2000), Copeland, Koller and Marrin provide a practical guide to valuation but also emphasize the linkage between strategy and finance. Creating value for shareholders by focusing on a firm’s free cash flow is a unifying educational theme in Brigham and Ehrhardt’s Financial Management – Theory and Practice(2002), a standard textbook for MBA’s and advanced undergraduate students. According to Brigham and Ehrhardt, the corporate valuation model can be used to pull together topics such as financial forecasting, time value of money, cost of capital and at the same time demonstrate to students how the model can be used to guide managerial decisions (Chapter 12, pp. 461-88). To many finance students, the discipline appears to be somewhat daunting and its abstract concepts and mathematics can easily overwhelm. The challenge to the instructor is to present the material in a way that convinces students that the concepts are useful and interesting. Well-designed student projects offer an important means of bridging the gap between classroom and the more practical financial work place. Stohs [1999] has designed an extensive valuation project that represents 40 percent of a student’s grade in their second class in corporate finance. Student groups select their own publicly traded firm, construct the pro forma balance sheet and income statements, calculate betas and derive a cost of capital. Using their free cash flow estimates, they then estimate the intrinsic value of the firm. Stohs concludes his paper with a discussion of the benefits and drawbacks of the project. Clearly, one limitation is the time required for both instructor and student. We propose a more narrowly defined student valuation project: 1. Based on information in the firm’s annual report and the Value Line Investment Survey we provide pro forma balance and income statements
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for Ruby Tuesday. We used a standard percentage of sales method that was adjusted, where necessary, by the Value Line financial forecast. 2. The project requires students to calculate the cost of capital for Ruby Tuesday by using a simplified methodology outlined in a paper by Weaver [2003] that relies on the Value Line data. 3. Students are required to calculate free cash flow from pro formas provided to them and then calculate the value of operations. They would subtract the value of debt to obtain the equity value along with the price per share. Market Value Added (MVA) will also be calculated. 4. An important goal of the project will be for students to recognize the link between corporate valuation and value-based management. At the end of the project students should be required to reflect on a number of managerial issues. According to Brigham and Ehrhardt, “rapid growth in sales may require growth in operating capital which reduces free cash flow [p. 461]. Is this a problem which management at Ruby Tuesday may have to address in the future? What about the company’s current dividend policy? Should free cash flow be used to increase dividends? Generally, has management acted to maximize shareholders wealth? There are some advantages to this more narrowly defined assignment that we think should account for about 10 percent of either a second course in corporate finance or an MBA finance class. There is more time for instructors to cover other topics and assign additional projects, and since students in a class will all be assigned the same firm—the grading will be easier. Nevertheless, there is flexibility in the project. We think instructors may either assign the project to groups or individual students. Instructors may expand the project by requiring the class to do their own financial forecast instead of providing it to them. In calculating cost of capital, instructors may wish to require students to derive their own Beta value from current online stock market data [see Brigham and Ehrhardt, pp. 225-29] rather than use the Value Line Beta measure. In addition, since Ruby Tuesday does pay a dividend, students could be required to compare their estimate of the firm’s equity value (using a corporate valuation model) to the value of equity using a dividend growth model. The firm selected for this project, Ruby Tuesday, must operate within a highly competitive industry as the following statement from the firm’s annual report [2003] suggests: “Our business is subject to intense competition with respect to prices, services, locations and the types and quality of food. We are in competition with other food service operations, with locally owned restaurants, and other national and regional chains that offer the same or similar types of services and products as we do. Some of our competitors may be better established in the markets where our restaurants are or may be located. Changes in consumer tastes, national, regional or local economic conditions, demographic trends, traffic patterns, and the types, numbers and locations of competing restaurants often affect the restaurant business. There is active competition for management personnel and for attractive commercial real estate sites suitable for restaurants. In addition, factors such as inflation, increased food, labor and benefits costs,
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and the difficulty in attracting qualified management and hourly employees may adversely affect the restaurant industry in general and our restaurant in particular [p.5].” We believe that by requiring students to study a real company that is attempting to make real decisions about its financial performance in a difficult environment will bring a sense of intellectual excitement to the study of corporate finance. FINANCIAL FORECAST We used the percent of sales method (ratios are provided in Table 1) described by Brigham and Ehrhardt (chapter 4) to forecast income statements (see Table 2) and balance sheets (see Table 3) over the period 2004-2007. Although the scale of the project is narrowly defined, instructors may require students to do their own financial forecast instead of providing it to them. If so, please keep in mind that the forecasting process is a lengthy one requiring significant effort. In accordance with Brigham and Ehrhardt, the manual approach was employed to incorporate feedback into the financial statements. Generally, four passes were used to adjust balance sheets and three passes to adjust income statements. Although most textbooks emphasize Additional Funds Needed (AFN), we found Ruby Tuesday to have excess funds that had to be allocated. This would certainly be a complicating factor to students. In addition, given the subjective nature of the forecasting process, instructors should consider giving students as much specific guidance as possible. The complete methodology that we used is provided in Appendix A.
CALCULATING FREE CASH FLOW Free cash flow (FCF) is defined as the after tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain ongoing operations [Brigham and Ehrhardt, p. 46]. FCF represents the cash actually available for distribution to investors. Thus by increasing FCF, managers are enhancing the value of their firm. Assuming they have been exposed to these concepts, students may use the forecasts provided in Tables 2 and 3 to calculate FCF. Calculations, which are summarized in Table 4 for the year 2004-2007, are described in detail for 2004 as follows. Line 1 in Table 4 shows the required net operating working capital, or operating current assets minus operating current liabilities for 2003: 1 Required net operating = (Cash + Accounts receivable + Inventories) (1) working capital - (Accounts payable + Accurals) = ($8,662 + $ 10,509 + $12,200) - ($22,949 + $57,605) = - $49.183 Million
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Line 2 shows required net plant and equipment, Line 3, which is the sum of Lines 1 and 2, shows required net operating capital. For 2003, net operating capital is - $49,183 + $660,897 = $611.714 Million Line 4 shows the required new net investment in operating capital from the previous year. For 2004, the required net investment in operating assets is $705,344 $611,714 = $93.630 Million Line 5 shows NOPAT, or net operating profit after taxes [ EBIT x (1- tax rate)]. Given a 2004 EBIT of $151,859 (Table 2) and a tax rate from Value Line of 36 percent, NOPAT for 2004 is projected to be $97.190 million Although Ruby Tuesday’s net operating profit is projected to be $97,190 in 2004, the firm must invest $93,630 in new assets to support its growth in sales. Therefore FCF, as shown on Line 7, is $97,190 - $93,630 = $3.560 million. COST OF CAPITAL The weighted average cost of capital (WACC) is the discount rate used to calculate the present value of the free cash flow stream in Table 4. In what is a critical component of any corporate valuation, students will be required to calculate Ruby Tuesday’s WAAC using a simplified methodology outlined in a paper by Weaver [2003]. According to Weaver his approach “seeks to demystify (for students) the calculation of WAAC by applying data readily available from Value Line [p. 55]. “An article,” Best Practices in Estimating Cost of Capital” [Bruner et al, 1998], that identifies estimating techniques used in practice, is also relied upon. (Results of the survey are referred to in this paper as the COC Survey). Cost of Debt Using the Weaver methodology, the cost of debt is stated on an after tax basis as follows: Kd = I x (1 - T) (2) Where: Kd = cost of debt (after tax) I = Interest rate (before tax) T = marginal tax rate We used the current cost of existing debt (according to the COC survey, 37% of corporations and 40% of financial advisors use this approach which represents the average cost of debt).2 From the Value Line data of December 2003 (Appendix B), reference A indicates Ruby Tuesday’s Long-term annual interest expense and long-term debt balance are $12.0 million and $206.9 million respectively. Therefore the long-term historical interest rate is 5.80% (12.0/ 206.9). I = Int / B (3) Where: I = Interest rate (before tax) Int = Interest Expense B = Long-term Debt Balance
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Reference B on the Value Line data sheet shows the income tax rate for the 2003 column is 34.8%. Consequently, the historical after tax cost of debt is 3.78% for Ruby Tuesday. Kd = 5.80% (1 – .348) (4) = 3.78% Cost of Equity The Capital Asset Pricing Model (CAPM) was used to calculate the cost of equity (81% of the corporations in the COC survey use CAPM). The CAPM approach to the cost of equity is: Ks = Rf + B (K m – Rf) (5) Where: Rf = Risk-free rate of return B = Beta (K m – Rf) = Market’s return in excess of the risk–free rate (market risk premium) We used a 10-year treasury bond rate (December 2003) of 4.3% as the risk free rate and the market risk premium calculated by Weaver [p. 64] of 5.7%.3 ( According to the COC survey 37% of the corporatio ns in the study use a market risk premium of 5% and 6%). Value Line provides a Beta value of .8 for Ruby Tuesday as reference C. The Ruby Tuesday cost of equity is 8.86% Ks = 4.3 +. 8( 5.7%) = 8.86% (6) Weighting the Capital Components The final step in estimating the cost of capital is to weigh each component and calculate the weighted average cost of capital.4 The WACC can be expressed as: WACC = WdKd + WsKs Where: Kd, Ks = cost of debt, cost of stock Wd, Ws = weight in debt, weight in common stock Market weights (rather than book weights) are the preferred approach recommended in textbooks and the COC survey [Weaver p. 66]. 1. The market value of equity is the number of shares outstanding 64.40 million as identified in Value Line for 2003 (reference D) times the price (reference E) $29.35. Therefore 64.40 million x $29.35 = $1,890.14 million. 2. The market value of debt can be assumed equal to book value (Weaver, p. 66). This is further supported by Ehrhardt (1994, p. 75). The book value of debt in 2003 is $207.064 million as identified in the balance sheet (Table 3).
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3. Ruby Tuesday’s current capital structure weights ($millions) are as follows: Amount % Stock 1,890 90% Bonds 207 10% 100% 4. Weighted Average Cost of Capital is therefore WACC = 8.86% (.90) + 3.78% (.10) = 8.35% (7)
VALUE OF OPERATIONS Consistent with the approach followed by Brigham and Ehrhardt [2002, p. 467] and Hirt and Block [2003, p. 175], we used a variant of the constant growth dividend model to calculate the value of operations. Different growth rates for FCF are divided into several periods, with each period having a present value. Figure 1 shows the process of finding the value of operations. Estimated FCF in each of the nonconstant years 2004 through 2006 are discounted back to 2003 using a 8.35% WACC. The terminal value, the amount that Ruby Tuesday could expect to receive if it sold its operating assets in December 2007, was calculated as follows based on the FCF for 2007 and a perpetual growth rate after that of 7.46%. 5 Vop (2007) = FCF2007(1+g) = FCF 2008 WACC-g WACC-g = $16.78 million (1.0746) = $18.03179 million .0835 - .0746 .0835 - .0746 = $2,026.044 million The terminal value is then added to FCF in 2007 ($2026.044 million + $16.78 million = $2,042.824 million) and discounted back at the 8.35% discount rate. The sum of all present value amounts, which represents the value of operations today (December 2003) is approximately $1,502.797 million. Table 5 summarizes the calculations used to find Ruby Tuesday’s intrinsic stock value. There are 64.40 million shares outstanding and their total value is $1,295.733 million (after the value of debt is subtracted). The value of a single share is therefore 1,295.733/64.40 = $20.12. Given the current (December 2003) market price (reference E on the Value Line Sheet) of $29.35 one would have to conclude that Ruby Tuesday is somewhat overvalued. (8)
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DISCUSSION QUESTIONS At the beginning of the project, students should be encouraged to gather their own information about Ruby Tuesday and some of their competitors. 6 At a minimum they should check out http://finance.yahoo.com on the internet which provides a wealth of information. Historical prices, a company profile, key statistics, SEC filings and financial information are just some examples of the data that is easily accessible. Given this information and after deriving free cash flow, estimating the firm’s cost of capital and then calculating the value of operations, students should be required to reflect on the overall financial assessment of the firm and its future. Here are some suggested questions. While most are open ended, we have provided some possible answers (shown in italics after each question).
Question 1: Given the information you have gathered and your own calculations, how do you assess the financial strength of the firm? Ruby Tuesday emerged from the 2001 recession in a much stronger financial position. In 2003, profit margin (9.65%), return on assets (10.99%), return on common equity (21.35%) and the market/book ratio (4.56) all suggest a solid financial performance(Calculations are from Tables 2 and 3). This is reflected in the firm’s stock price, which has almost doubled between January 2001 and December 2003. As our own financial forecast suggests, these results should continue through 2005 although sales growth should moderate thereafter. According to Value Line “Price-appreciation potential to 2006-2008 is less exciting, though still decent.” As our own estimate of stock value suggests, Ruby Tuesday may currently (December 2003) be over valued. Question 2: Generally, has management acted to maximize shareholder’s value? (Calculate market value added MVA). MVA represents the difference between the cash that owners of the firm could get if they sold the business (value of operations) less operating capital. The higher its MVA, the better the job management is doing for the firm’s shareholders. Thus for 2003, MVA is $1,505.797 million – $611.714 million = $891.08 million. Management has added an impressive $891.08 million in stockholders value since the company’s inception in 1996. Question 3: The growth in sales revenue will generally have a positive effect on Company value. However, the effect can be negative if sales require excessive growth in operating capital. Is this a problem which management at Ruby Tuesday may have to address in the future? Examine the spread between Expected Return on Invested Capital (EROIC) and the Weight Average Cost of Capital (WACC). Growth can either increase or decrease value, depending on EROIC, which is defined as expected NOPAT divided by current capital: EROIC t = NOPAT t+1 / Capital t (9)
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If EROIC t > WACC, then an increase in growth increases value If EROIC t < WACC, then an increase in growth decreases value According to Brigham and Ehrhardt, “if EROIC is greater than WACC then the return on capital is greater than the return investors expect, and management is adding value (p.475).” Apparently, this is the situation with Ruby Tuesday where the spread between EROTC and WACC will be positive between 2003 and 2006 (see Table 6). Question 4: Ruby Tuesday’s current corporate policy is to reinvest the cash generated from operating expenditures and pay a very small dividend. Do you think the firm is likely to change its dividend policy in the near future? Although the current dividend yield on Ruby Tuesday’s stock is a dismal 0.2% (2003), we think the firm will continue to follow its policy of retaining and reinvesting most of its earnings. As the above discussion suggests, management’s current growth policy is adding value. Nevertheless, the casual restaurant industry is highly competitive and Ruby Tuesday is unlikely to achieve the same growth rates in revenue over the longer term. We think the firm is likely to begin passing on some of its free cash flow to investors in the form of higher dividends. SUMMARY The paper describes a finance class project that would require students to estimate the intrinsic value of a publicly traded corporation, Ruby Tuesday. The project can serve as a useful supplement to a second undergraduate corporate finance course or an MBA finance class. The corporate valuation model is an ideal tool to be used to pull together topics such as financial forecasting, time value of money, and the cost of capital. At the same time, the project demonstrates how the model can be used to guide managerial decisions. Within the context of the model, we suggest that students be required to reflect on the financial condition of the firm and its future. While we have included several questions and some possible answers, instructors are encouraged to supplement the project by adding some of their own questions. There is additional flexibility to define student assignments narrowly, as we have done in the paper, or expand the project to include several additional tasks that we have described earlier.
ENDNOTES
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Please note the working capital deficiency in all years except 2007. According to the 2003 Annual Report [p.18], this is common in the restaurant industry. Ruby Tuesday carries current liabilities in excess of current assets because cash generated from operating activities is reinvested in capital expenditures (long-term assets) and receivables and inventory levels are generally not significant. 2 While a market based measure is more theoretically sound, Value Line does not provide the information necessary to make market calculations and it would be difficult for students to find the data from alternative sources. In our view, the differences between book and market value for debt will not have a material impact on our estimate of WACC for Ruby Tuesday. 3 According to Weaver [p. 64], the market risk premium of 5.7 % approximates the long-term (from 1926) compounded annual growth rate for the market’s excess return vis-à-vis a long-term U.S. Treasury bond.
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4 5
Ruby Tuesday did not issue preferred stock. We assumed that Ruby Tuesday’s FCF would grow at a constant rate of 7.46% beyond 2007. While this may appear to be a heroic assumption, the restaurant industry is closely tied to the performance of the American economy (see discussion in Value Line concerning the restaurant industry). For the past 40 years (1963-2003) nominal GDP has grown at an annual compound growth rate of 7.46%. At the FEA Conference 2004, Bennie Nunnally suggested that we use the expected growth in population as a proxy for growth in Ruby Tuesday’s FCF. We investigated the possibility, but found these growth rates to be too low to produce realistic valuation results. 6 We understand that T.G. Friday’s, Applebee’s and Chili’s are the firm’s major competitors.
Appendix A Methodology for the Financial Forecast
The 2004-2007 financial forecast of Ruby Tuesday’s income statements and balance sheets utilized the percent of sales method described by Brigham and Ehrhardt (Chapter 4). Additionally, information from the Value Line (December 2003) forecast on Ruby Tuesday influenced the financial forecast prepared in this paper. 2004 Based on Value Line, sales were projected to grow by 10 percent in 2004 with an income tax rate of 36 percent. Cash dividend payments of 5 cents per share on the common stock were assumed for 2004 in accordance with the Value Line forecast. Excess funds resulting were invested in short-term money market instruments since Ruby Tuesday’s (2003 Annual Report, p. 31) cash management program provides for the investment of excess cash balances in such instruments. The current treasury yield curve was used to calculate future interest earned at 1 percent. 2005 For 2005, sales were projected to grow at 10 percent with a tax rate of 36 percent and cash dividend payments at 5 cents as reflected by Value Line. Excess funds again were assumed to be invested in short-term money market instruments with a 1.5 percent rate based on the current treasury yield curve. 2006 For 2006, the growth in sales was assumed to slow to 7.5 percent based on the average historical growth rate for the non-recession years within the period 1997-2003. A tax rate of 36 percent and dividend rate of 6 cents were projected as assumed in Value Line. Larger excess funds, as compared to 2004-2005, were allocated roughly 50/50 between short-term investments and plant assets as Ruby Tuesday’s (2003 Annual Report, pp. 3, 13, 18) policy is to reinvest cash generated from operating activities in capital expenditures— property and equipment. Based on the current treasury yield 9
curve, an interest rate of 2 percent was used for the short-term investments, while a depreciation rate of 7 percent was assumed from historical data. Then, additional funds needed were acquired by issuing new long-term debt at a rate of 5.78 percent, the calculated before tax cost of debt. 2007 The 2007 forecast methodology is the same as that for 2006, except that a 2.5 percent rate on the short-term investments was assumed per the current treasury yield curve. In addition, the dividend payment was raised to 7 cents per share as projected by Value Line. Thus it mirrors the 2006 assumption and mechanics in all other aspects. Feedback In accordance with Brigham and Ehrhardt (Chapter 4), the manual approach was employed to incorporate feedback into the financial statements. Generally, four passes were used to adjust balance sheets and three passes to adjust income statements. Although textbooks, such as the Brigham and Ehrhardt book, emphasize Additional Funds Needed (AFN), this project found Ruby Tuesday to have excess funds that had to be allocated. As mentioned earlier, these funds were invested entirely in short-term money market instruments for 2004 and 2005. Given the larger amount of excess funds available in 2006 and 2007, the allocation as noted earlier was in an appropriate ratio of 50/50 among short-term money market instruments and fixed assets. Financial feedback adjustments were necessary to account for excess funds, taxes and retained earnings throughout the 2004-2007 forecast period. Given the decision to invest the excess funds for 2006 and 2007, about 50 percent is plant and equipment, some additional bond funding was required resulting in adjustments to depreciation accounts in the third and fourth passes.
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REFERENCES Brigham, Eugene F., Michael C. Ehrhardt, Financial Management: Theory and Practice, Tenth Edition, Dryden Press, 2002. Bruner, Robert F., Kenneth M. Eades, Robert S. Harris and Robert C. Higgins, “Best Practices in Estimated Cost of Capital,” Financial Practice and Education, Spring/Summer 1998. Copeland, Tom, Tim Killer and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, Third Edition, McKinsey & Company, Inc., 2000. Ehrhardt, Michael C., The Search for Value: Measuring the Company’s Cost of Capital, Harvard Business School Press, 1994. Hirt, Geoffrey A., Stanley B. Block, Fundamentals of Investment Management , McGraw-Hill, 2003. Ruby Tuesday Annual Report, 2003. Stohs, Mark, “Teaching Corporate Finance by Valuing a Corporation,” Journal of Financial Education (Fall 1999), 66-74. Value Line Investment Survey, December 12, 2003. Weaver, Samuel C., “Using Value Line to Estimate the Cost of Capital and Industry Capital Structure,” Journal of Financial Education (Fall 2003), 55-71.
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Figure 1 Process for Finding the Value of Operations For Ruby Tuesday (Thousands of Dollars)
2003
2004
2005
2006
2007
2008
3,560 $ 3,286 7,920 9,362 1,482,229 $1,502,797
9,298
24,628
16,780
18,031.79
V(2007)= 2,026,044 = 18,031.79 .0835- .0746 2,042,824 Vop (2003)
Table 1 Ratios Used to Forecast Ruby Tuesday Income And Balance Sheets
Cost to Sales Depreciation to Net Plant and Equipment Cash and Short Term Investment to Sales Accounts Receivable to Sales Inventory to Sales Net Plant and Equipment to Sales Account Receivable to Sales Accruals to Sales Actual 2003 79.90 % 7.00 1.00 1.15 1.33 72.10 2.50 6.30
Table 2 Ruby Tuesday: Income Statements (Thousands of Dollars)
Actual 2003 Sales $ 917,115 Cost (except Depreciation) $ 733,147 Depreciation 45,956 Total Operating Cost $ 779,103 EBIT $ 138,012 Less Interest 2,302 Earnings before Taxes $ 135,710 Taxes 47,226 Net Income $ 88,484 Dividends $ 2,876 Additions to Retain Earnings $ 85,608 2004 $ 1,008,827 $ 806,053 50,915 $ 856,968 $ 151,859 1,967 $ 149,892 53,972 $ 95,920 $ 3,300 $ 92,620 Forecast 2005 $ 1,109,710 $ 886,658 56,007 $ 942,665 $ 167,045 1,137 $ 165,908 59,727 $ 106,181 $ 3,300 $ 102,881 2006 $ 1,192,938 $ 953,157 63,568 $ 1,016,725 $ 176,213 253 $ 175,960 63,345 $ 112,615 $ 3,960 $ 108,655 2007 $ 1,282,408 $ 1,024,644 69,623 $ 1,094,267 $ 188,141 1,397 $ 189,538 68,233 $ 121,305 $ 4,620 $ 116,685
Table 3 Ruby Tuesday Balance Sheets (Thousands of dollars)
Actual 2003 Cash and ShortTerm Investments Accounts Receivable Inventory Other1 Total Currents Assets Net Plant and Equipment Other2 Total Assets Accounts Payable Accurals Total Currents Liability Long Term Bonds Other3 Total Debt Common Stock Other4 Retained Earnings Total Common Equity Total Liabilities and Equity
1 2
2004 $ 43,554 10,088 13,115 19,092 $ 85,849 727,364 93,707 $ 906,920 $ 25,221 63,556 $ 88,777 207,064 102,971 $ 398,762 11,100 (8,082) 505,140 $ 508,158 $ 906,920 $
Forecast 2005 2006 66,986 11,097 14,426 19,092 $ 111,601 808,101 93,707 $ 1,005,409 $ 27,743 69,912 $ 97,655 207,064 102,921 $ 407,640 11,100 (8,082) 594,751 $ 597,769 $ 1,005,409 $ 60,536 11,929 15,508 19,092 $ 107,065 908,108 93,707 $ 1,108,880 $ 29,823 75,155 $ 104,978 208,592 102,921 $ 416,491 11,100 (8,082) 689,371 $ 692,389 $ 1,108,880 $
2007 83,474 12,824 16,671 19,092 $ 132,061 994,616 93,707 $ 1,220,384 $ 32,060 80,792 $ 112,852 211,022 102,921 $ 426,795 11,100 (8,082) 790,571 $ 793,589 $ 1,220,384
$
8,662 10,509 12,200 19,092 $ 50,463 660,897 93,707 $ 805,067 $ 22,949 57,605 $ 80,554 207,064 102,921 $ 390,539 11,100 (8,082) 411,510 $ 414,528 $ 805,067
Income tax receivable, deferred income taxes, prepaid rent, assets held for sale Goodwill, net notes receivable, other assets 3 Deferred income taxes, deferred escalating minimum rent, other deferred liabilities 4 Deferred compensation liability payable in company stock, company stock held by deferred compensation plan, accumulated other comprehensive losses.
Table 4 Ruby Tuesday's Expected Free Cash Flow (Thousands of Dollars)
Actual 2003
2004
2005
2006
2007
Calculation of Free Cash Flow
1. Required Net Operating Working Capital 2. Required Net Plant and Equipment 3. Required Net Operating Capital 4. Required Net New Investment in Operating Capital From Previous Year 5. NOPAT [Net Operating Profit After Taxes =EBIT x (1 - tax rate)] 6. Less: Required Investment in Operating Capital 7. Free Cash Flow ($49,183) ($22,020) ($5,146) ($17,005) $117 660,897 727,364 808,101 908,108 994,616 $611,714 $705,344 $802,955 $891,103 $994,733 93,630 97,611 88,148 103,630
$97,190 $106,909 $112,776 $120,410 93,630 97,611 88,148 103,630 $3,560 $9,298 $24,628 $16,780
Table 5 Finding the Value of Ruby Tuesday's Stock (Thousands of Dollars)
1. Total Market Value of Firm (present value of free cash flows) 2. Less: Value of debt 3. Value of common equity 4. Divide by number of Shares 5. Value per Share
$ 1,502,797 207,064 $ 1,295,733 64,400 $20.12
Table 6 Calculating the Spread between EROIC And WACC for Ruby Tuesday (Dollar amounts are in Thousands)
Actual Forecast 2003 2004 2005 2006 NA 10% 10% 7.5% NA $ 97,190 $ 106,909 $ 112,776 $ $611,714 $ 705,344 $ 802,955 $ 891,103 $ 15.90% 15.2% 14.1% 13.5% 8.35% 8.35% 8.35% 8.35% 7.55% 6.85% 5.75% 5.15%
Sales Growth NOPAT Operating Capital ROIC WACC Spread between ROIC and WACC
2007 7.5% 120,410 994,733
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