Chapter 13

SECURITY STRUCTURES AND DETERMINING ENTERPRISE VALUES

FOCUS

In this chapter, we discuss important concepts in structuring securities a venture uses to

raise funds. We introduce the notion of primitive securities (like bonds and common
stocks) and consider other more complex securities (like warrants and convertible
preferred) that derive their value from the primitive securities. We introduce the
enterprise valuation method, a straightforward technique for valuing a venture using
complex financial securities.

LEARNING OBJECTIVES

1. Describe the types of securities often involved in venture financing

2. Discuss the structural considerations involved in designing venture securities
3. Draw simple diagrams describing the payoffs to calls, puts, and warrants
4. Value a venture as a complete enterprise and relate that value to the value of the
securities involved in supporting the enterprise

CHAPTER OUTLINE

13.1 COMMON STOCK OR COMMON EQUITY

13.2 PREFERRED STOCK OP PREFERRED EQUITY
A. Selected Characteristics
B. Convertible Preferreds
C. Conversion Value Protection
D. Conversion Protection Clauses
13.3 CONVERTIBLE DEBT
13.4 WARRANTS AND OPTIONS
13.5 OTHER CONCERNS ABOUT SECURITY DESIGN
13.6 VALUING VENTURES WITH COMPLEX CAPITAL STRUCTURES: THE
ENTERPRISE METHOD
SUMMARY

LEARNING SUPPLEMENT 13A:

Alternative Enterprise Valuation Method
LEARNING SUPPLEMENT 13B:
Application of Black-Scholes Option-Pricing Formula

DISCUSSION QUESTIONS AND ANSWERS

1. What is common stock or common equity? What is the purpose of preemptive rights?

184
 Chapter 13: Security Structures and Determining Enterprise Values 185

Common stock: the least senior claim on a venture’s assets (residual ownership)

Pre-emptive rights: the right for existing owners to buy sufficient shares to preserve
their ownership share

2. What is preferred stock? What is participating preferred stock, and what is meant by
paid in kind (PIK) preferred stock?

Preferred stock: equity claim senior to common stock and providing preference on
dividends and liquidation proceeds

Participating preferred stock: preferred stock with rights to participate in any

dividends paid to common stockholders; or, stock with an investment repayment
provision that must be met before distribution of returns to common stockholders

Paid in kind (PIK) preferred stock: preferred stock that has the option of paying
preferred dividends by issuing more preferred stock

3. What are the basic design features for financial securities used in venture investing?

Typically, venture investing securities need to address the type of financial claim
(equity, debt, convertible) and the voting rights assigned. It is common for the
security to have debt-like seniority in promised payments and be convertible in to an
equity claim in successful ventures. There is almost always some claim of equity-like
ownership.

4. Why is the conversion feature in convertible preferred important for venture

investors?

The conversion features allows the venture investor to participate in the venture’s
success as reflected in equity appreciation. This is where the majority of return on
investment in a successful venture will come.

5. What is meant by a (a) full ratchet clause, and (b) down (reset) round?

A full ratchet clause provides that existing investors will receive enough post-
conversion shares to protect their pre-issue conversion value.

Down (reset) round: venture round priced below most recent previous price

6. Which is more favorable to the founders, the Market Price Formula (MPF) or the
Conversion Price Formula (CPF)?

It depends. However in many cases, the MPF is typically more favorable because it
only adjusts for issues below a certain market price. The CPF adjusts for any issue
below the existing conversion price. When the market price is below the conversion
 186 Chapter 13: Security Structures and Determining Enterprise Values

price, the MPF makes no adjustment as long as the shares are issued at or above the
“market price.” For an example of where the CPF is softer than the MPF (market
price is significantly above conversion price and the offering is priced below both, see
problem 4 below).

7. How does convertible debt differ from convertible preferred stock?

Convertible preferred stock: preferred stock with option to exchange into common
stock

Convertible-debt holders have bankruptcy rights that can kick in when coupon
payments are missed. Convertible-debt holders also have a security interest in the
venture’s assets that is senior to preferred shareholders’ interests.

8. Why are options to buy additional shares of stock used in venture financing?
What are warrants?

Options to buy additional shares at specified prices are common “sweeteners” or

“equitykickers” use to increase the attractiveness of a securities offering. Options are
also a common component of venture employee incentive compensation.

Warrants: call options issued by a company granting the holder the right to buy
common stock at a specific price for a specific period of time

9. How do (a) American-style options, (b) European-style options, and (c)

Bermudan-style options differ?

American-Style Option: an option that can be exercised at any time until expiration
European-Style Option: an option that can be exercised only at the expiration date
Bermudan-Style Option: an option that can be exercised only at a specific set of dates

10. How are put and call options similar? How are they different?

Put and call options are similar in that they provide the holder the right to buy (call)
or sell (put) at a specified price. They are different because a call option holder has
the right to buy and gains if the price goes up and a put option holder has the right to
sell and gains if the stock price goes down.

11. What are the “factors” that influence the values of American-style options?

The factors are:

 Underlying Asset
 Exercise (or Strike) Price
 Time to Maturity
 Volatility
 Interest Rate
 Chapter 13: Security Structures and Determining Enterprise Values 187

 Payouts, if any

12. Why is price protection an issue when convertibles or warrants are used?

If an investor has a fixed conversion or exercise price, then new issues at prices below
that fixed price can effectively make the conversion or option less valuable. Price
protection clauses allow for some compensating adjustment in conversion or exercise
prices to allow the investor to retain more of the value when the venture is facing a
down round.

13. Why is it important that convertible securities also be callable (redeemable)?

It is important for convertible securities to also be callable because they can “hang”
otherwise. That is, there may be little incentive to convert them if they can always be
subsequently converted. The unconverted value will be at least as high as the
conversion value. Leaving the security unconverted softens any downside from a
decline in venture value because the security retains its superior claims. Forcing
conversion with a redemption or call feature makes the investor give up this downside
protection in order to continue to participate in venture upside.

14. Is the sale of an out-of-the-money warrant a future sale of equity at a favorable price?

It is not a guaranteed sale at all. It is a contingent “sale” when the venture’s value per
share exceeds the warrant exercise price. However, at that time the company will be
selling the share at less than its value. It is still true that this future contingent sale
may be at more favorable prices than a current sale of the same security.

15. What is the enterprise (entity) method of valuation and how does it differ from the
equity methods of Chapters 9 and 10?

The enterprise method attempts to value the entire firm, value to debt holders and
equity holders, while the equity method attempts to just determine the value to equity
holders.

16. Describe how the enterprise valuation cash flow is determined. That is, identify the
components included in determining the enterprise valuation cash flow.

Enterprise Valuation Cash Flow =

 EBIT x (1 – Enterprise Tax Rate)
 +Depreciation and Amortization Expense
 - Change in Net Working Capital (w/o Surplus Cash)
 - Capital Expenditures

17. What is meant by (a) NOPAT, and (b) EBIAT? How do they compare with each other?

NOPAT is net operating profit after taxes

 188 Chapter 13: Security Structures and Determining Enterprise Values

EBIAT is earnings before interest after taxes

NOPAT and EBIAT will have the same values and are also the same as after-tax
EBIT

18. Why is the weighted average cost of capital (WACC) used as the discount rate in the
enterprise method?

The WACC is used in the enterprise method because the enterprise method values
flows to all security holders. The average return that must be achieved to keep this
group of investors happy requires weighting the individual securities’ required return
in proportion to their (market) weight in funding the venture. The resulting overall
average required return is called the Weighted Average Cost of Capital (WACC).

19. How do debt investors get paid in the enterprise method?

The enterprise method values all possible payments to investors and then subtracts the
market value of debt to arrive at the market value of equity. Consequently, debt
holders are paid with a “slice” of the pie allocated directly to them.

20. From the Headlines – Azul: Discuss what you would need if you wanted to conduct
an enterprise valuation of Azul airlines. Do you see any complex financing
arrangements that could present challenges? Discuss the advantages and
disadvantages of being a serial entrepreneur in the airline industry and in general.

Answers will vary: An enterprise valuation of Azul airlines would typically involve
projections of the income statement, balance sheet and statement of cash flows over
an explicit period with a conjecture for the growth and capital structure it will sustain
after that explicit period. Additionally, one would need estimates of the required
returns for equity, debt and airplane lease providers. With an estimated WACC
calculated using the projected structure and rates, the enterprise valuation can be
completed.

INTERNET ACTIVITIES

1. Web surfing exercise: Search the web for a direct offering of a convertible preferred
security. Possible search words include “direct public offering” or “small corporate
offering registration” (SCOR). Analyze the conversion and dilution clauses offered
in the security.

Web-researched results will vary due to constant updating of the related web sites.

2. Get a current price for a traded call option on a publicly traded security having
publicly traded options (e.g., http://www.cboe.com). Compare the option price to the
value of exercise (stock price – exercise price) and comment on the difference.
 Chapter 13: Security Structures and Determining Enterprise Values 189

Web-researched results will vary due to constant updating of the related web sites.

EXERCISES/PROBLEMS AND ANSWERS

1. [Preferred Stock Characteristics] A share of a venture’s preferred stock is convertible

into 1.5 shares of its common stock. The dividend on the preferred stock is $.50 per
share.

A.If the firm’s common stock is currently trading at $9.75, what is the conversion
value of a share of the preferred stock?

$9.75(1.5) = $14.625
The convertible preferred stock’s value should be directly related to the common
stock price

B. What would be the dividend yield on the preferred stock based on its conversion
value?

$.50/$14.625 = 3.42%

C.What explanation would you give if the venture’s preferred stock currently trades
at $15? What would be the dividend yield?

$15 - $14.625 = $.375

The convertible preferred stock is trading at a premium relative to the current
common stock price. This may reflect a higher dividend yield on the preferred
stock and/or there may be a current price anomaly.

$.50/$15 = 3.33%

D. If the venture doubles the number of shares of its common stock that is
outstanding (and cutting its stock price in half) but increases the conversion
terms on its preferred stock to 2.5 shares of common stock, what would be the
conversion value of a share of preferred stock after the new common stock issue?
What would be the dividend yield on the preferred stock based on this new
conversion value?

$9.75/2 = $4.875 new common stock price

Or, 1.0/2.0 = .50; $9.75(.50) = $4.875
$4.875(2.5) = $12.1875
The preferred stock’s value would decline

$.50/$12.1875 = 4.10%
190 Chapter 13: Security Structures and Determining Enterprise Values

E.If the venture increased its common stock offering by 50 percent (instead of 100
percent), what common stock conversion ratio would be needed on a share of
preferred stock to keep its conversion value the same as it was before the new
common stock issue?

$9.75/1.5 = $6.50
Or, 1.0/1.5 = $.667; $9.75(.667) = $6.50
$14.625/$6.50 = 2.25
That is, one share of preferred stock would have to be convertible into 2.25 shares
of common stock.

2. [convertible Preferred Stock Concepts] The CCC (triple C) Venture has issued
convertible preferred stock to its venture investors. Each share of preferred stock is
convertible into .80 shares of common stock and pays an annual cash dividend of
$.25.

A. If each share of preferred stock has a market value of $4.00, what is the minimum
price that a share of the CCC Venture’s common stock should be selling for
(ignore the dividend yield on the preferred stock)?

$4.00/.80 = $5.00

B.If a share of the CCC Venture’s common stock is actually trading at $3.00 per
share, what are the implied conversion terms? Given the above actual
conversion terms, explain how the common stock could be trading at $3.00 per
share while the preferred stock is trading at $4.00 per share.

$4.00/$3.00 = 1.3333 implied conversion terms

That is, one share of preferred stock should be convertible into 1.3333 shares of
common stock

Actual conversion value: $3.00(.80) = $2.40 implied value of preferred stock

Even considering the expected $.25 dividend on the preferred stock results in a
value of $2.65 ($2.40 + $.25). Thus, there is an unexplainable current price
anomaly between the preferred stock’s value in terms of its worth in common
stock and its current trading price. Possibly very little trading of one or both of
these securities occurs. Arbitrageurs will soon cause these price differentials to
converge by purchasing the common stock and selling the preferred stock short.

3. [Conversion Price and Market Price Formulas] Calculate the conversion price
formula (CPF) and market price formula (MPF) prices for an offering involving an
existing conversion price of $1, a hypothesized market price of $2, and a new offering
price of $.95 for 1,000 shares with 2,000 shares outstanding prior to the new issue.
Relate the new conversion price to the implied new conversion ratio.

CPF = [(Shares before issue)(Old Conversion Price) + (New Issue Price)(New

 Chapter 13: Security Structures and Determining Enterprise Values 191

Shares)]/(Total shares after issue)

= [(2000)($1.00) + ($0.95)(1000)]/3000 = $2,950/3,000 = $0.9833

MPF = (Old Conversion Price) x [(Shares before issue) + ((New issue price)(New
shares)/(Share value w/o new))/(Total shares after issue)]

= ($1.00)[(2000) + (($0.95)(1000)/($2.00))/3000] = $1.00[$2,475/3,000]

= $0.825

4. [Conversion Price and Market Price Formulas] Show how your answers for Problem
3 would change if the new offering price was $.80 for 1,500 shares. Assume other
things remain the same.

CPF = [(2000)($1.00) + ($0.80)(1500)]/(3500) = $3,200/3,500 = $0.9143

MPF = ($1.00) x [(2000) + (($0.80)(1500)/($2.00))/(3500)] = $1.00[$2,600/3,500]

= $0.7429

5. [Stock Option Concepts] Draw the payoff diagram for the following options:

A. Call option to buy a venture’s stock at $3

B. Put option to sell a venture’s stock back to the venture at $15

192 Chapter 13: Security Structures and Determining Enterprise Values

6. [Stock Option Concepts] Draw the payoff for a portfolio of a share of venture
equity and a short call option to buy that share at $5.

7. [Stock Unit Concepts] Sometimes the combination of a share and a warrant is called
a “stock unit.” What does the payoff diagram look like for such an investment?

8. [Enterprise Valuation Cash Flows] Find the enterprise valuation cash flow expected
for the current year given the following information:

Capital expenditures (CAPEX) = $150,000

Depreciation and amortization expenses = $40,000
Earnings before interest and taxes = $400,000
Effective income tax rate = 30%

Last Year Current Year

Required cash $50,000 $75,000
Surplus cash 20,000 40,000
Accounts receivable 200,000 250,000
Inventories 300,000 360,000
Accounts payable 100,000 120,000
Accrued liabilities 40,000 50,000
Bank loan (short-term) 90,000 110,000

Solution:
 Chapter 13: Security Structures and Determining Enterprise Values 193

Enterprise Valuation Cash Flow =

a. $400,000(1 - .30) = $280,000
b. + $40,000
c. – [($75,000 + $250,000 + $360,000 - $120,000 - $50,000) – ($50,000 +
$200,000 + $300,000 - $100,000 - $40,000)] = - ($515,000 - $410,000)
= - $105,000
d. - $150,000

Enterprise Valuation Cash Flow = $280,000 + $40,000 - $105,000 - $150,000

= $65,000

9.[Enterprise Valuation Cash Flows] Rework Problem 8 assuming that the earnings
before interest and taxes are only $320,000 while CAPEX is $110,000. Assume the
other information remains the same.

Enterprise Valuation Cash Flow =

a. $320,000(1 - .30) = $224,000
b. + $40,000
c. – [($75,000 + $250,000 + $360,000 - $120,000 - $50,000) – ($50,000 +
$200,000 + $300,000 - $100,000 - $40,000)] = - ($515,000 - $410,000)
= - $105,000
d. - $110,000

Enterprise Valuation Cash Flow = $224,000 + $40,000 - $105,000 - $110,000

= $49,000

10. [WACC Calculations] Calculate the after-tax WACC for a firm with a 25% tax rate,
a 10% cost of debt, a 30% cost of equity and a target debt-to-value of .30. Explain
how investing to provide the WACC returns keeps the debt and equity investors
happy. (Review Chapter 7)

WACC = (10%)*(.3)*(1 - .25) + (30%)*(1 - .3) = 23.25%

If the venture earns 23.25% on its capital base, it can pay the debtholders’ cost (after
tax) and the required equity returns will be achieved.

11. [WACC Concepts] Why is the (1-tax rate) in the WACC? How does the government
pay the tax rebate on interest – through a flow or in the rate? (Review Chapter 7)

The “(1-tax rate)” is included in the WACC to provide for the tax savings the firm
receives due to the tax deductibility of interest. In this case, the required rate is being
adjusted down for the tax rebate. We say that this rebate is paid through the discount
“rate.” If we had included a line in the financial statements (and valuation cash
flows) for the tax rebate on interest, then we would have said that we were taking the
tax rebate as a “flow.”
 194 Chapter 13: Security Structures and Determining Enterprise Values

12. [WACC Concepts] Given a WACC of 15%, a target debt-to-value of .5, a tax rate of
28% and a cost of debt of 10%, what is the implied cost of equity?

WACC = (cost of debt)*(Debt/Value)*(1 – Tax rate) + (cost of equity)*(Equity/Value)

So, Cost of Equity = ((WACC) – ((cost of debt)*(Debt/Value)*(1 – Tax rate)))/
(Equity/Value)

Cost of Equity = ((15%) – ((10%)*(.5)*(1 - .28)))/(.5) = 22.8%

13.[Enterprise and Equity Value Concepts] Assume a venture has a perpetuity enterprise
value cash flow of $800,000. Cash flows are expected to continue to grow at 8
percent annually and the venture’s WACC is 15 percent.

A. Calculate the venture’s enterprise value.

$800,000/(.15 - .08) = $11,428,571.43

B.If the venture has $2,000,000 in interest-bearing debt obligations, what would be
the venture’s equity value?

$11,428,571.43 - $2,000,000 = $9,428,571.43

C.Show how your answers to Parts A and B would change if the perpetuity cash flow
growth rate was only 6 percent and the WACC was 16 percent.

$800,000/(.16 - .06) = $8,000,000 enterprise value

$8,000,000 - $2,000,000 = $6,000,000 equity value

14.[Enterprise and Equity Value Concepts] A venture has a $500,000 bank loan
outstanding, a long-term debt obligation of $900,000, accounts payable of $200,000,
and accounts receivable of $350,000.

A.If the venture’s equity value is $2,450,000, what would be the associated enterprise
value?

Enterprise value = $2,450,000 + $500,000 + $900,000 = $3,850,000

B. Assume the venture’s enterprise value has been estimated to be

$5,300,000 (ignore any information from Part A). What would be the venture’s
equity value?

Equity value = $5,300,000 - $500,000 - $900,000 = $3,900,000

C.Now assume that the venture has surplus cash of $700,000. Show how your
answers (it at all) would change for Parts A and B.
 Chapter 13: Security Structures and Determining Enterprise Values 195

In each case, the surplus cash would add $700,000 to the value:
Revised Part A: Enterprise value = $3,850,000 + $700,000 = $4,550,000
Revised Part B: Equity value = $3,900,000 + $700,000 = $4,600,000

15. [Enterprise Value Concepts] Why is the market value of currently issued debt
subtracted from the enterprise value (in a debt-and-equity-only firm) to arrive at the
value of equity? Why are future debt issues ignored by the process?

The enterprise value is the value of all of the securities (debt and equity). To get
what’s left for the market value of equity, we have to subtract the market value of
debt. This type of formulation assumes all future debt offerings are NPV=0. (Debt is
fairly priced and the tax implications of future debt payments are already incorporated
in the discount rate).

16. [Enterprise Valuation Method] The Datametrix Corporation has been in operation
for one full year (2010). Financial statements are shown below. Sales are expected
to grow at a 30 percent annual rate for each of the next three years (2011, 2012, and
2013) before settling down to a long-run growth rate of 7 percent annually. The cost
of goods sold is expected to vary with sales. Operating expenses are expected to
grow at 75% of the sales growth rate (i.e., be semi-fixed) for the next three years
before again growing at the same rate as sales beginning in 2014. Interest expense is
expected to grow with sales. Depreciation can be forecasted either as a percentage
of sales or as a percentage of net fixed assets (since net fixed assets are expected to
grow at the same rate as sales growth). Individual asset accounts are expected to
grow at the same rate as sales. Accounts payable and accrued liabilities are also
expected to grow with sales.
Because Datametrix is in its start-up life cycle stage, management and venture
investors believe that 35 percent is an appropriate weighted average cost of capital
(WACC) discount rate until the firm reaches its long run or perpetuity growth rate.
At that time it will have survived, recapitalized its capital structure, and will become
a more typical firm in the industry with an estimated WACC of 18 percent. Calculate
Datametrix’s enterprise value as of the end of 2010. Also indicate what the equity
would be worth.
[Note: In the first printing of the Fourth Edition, the income statement and balance
sheet were not properly separated or presented. However, all necessary data for
working the Datametrix problem are included.]
_________________________________
Datametrix Corporation
Income Statement for December 31, 2010
(Thousands of Dollars)
__________________________________
Sales $20,000
Cost of goods sold -10,000
Gross profit 10,000
Operating expenses -7,500
Depreciation -400
196 Chapter 13: Security Structures and Determining Enterprise Values

EBIT 2,100
Interest -100
EBT 2,000
Taxes (40%) -800
Net income $1,200

______________________________________________________________________________
Datametrix Corporation
Balance Sheet as of December 31, 2010
(Thousands of Dollars)
______________________________________________________________________________
Cash $ 1,000 Accounts payable $ 1,500
Accounts receivable 2,000 Accrued liabilities 1,000
Inventories 2,000 Total current liabilities 2,500
Total current assets 5,000 Long-term debt 1,000
Gross fixed assets 5,400 Common stock 5,300
Accumulated depreciation 400 Retained earnings 1,200
Net fixed assets 5,000 Total equity 6,500

Total assets $10,000 Total liabilities & equity $10,000

Solutions:

See spreadsheet solutions presented below.

Market Value of Firm (Enterprise Value) = $13,128,000
Less: Long-Term Debt = $1,000,000
Market Value of Equity = $12,128,000

Assuming 1,000,000 shares outstanding would result in a per share value = $12.13
 Chapter 13: Security Structures and Determining Enterprise Values 197

DATAMETRIX, INC. [Enterprise Valuation Method]

Ch 13, Prob 16 Actual Projected ------------------------------------------>I
Percent Sales Increase------> 30.0% 30.0% 30.0% 7.0%
% of 2010 [Thousands of Dollars]
Income Statements Sales 2010 2011 2012 2013 2014
Sales 100.0% 20000 26000 33800 43940 47016
Cost of goods sold -50.0% -10000 -13000 -16900 -21970 -23508
Gross profit 50.0% 10000 13000 16900 21970 23508
Operating expenses -7500 -9188 -11255 -13787 -14752
Depreciation -2.0% -400 -520 -676 -879 -940
EBIT 2100 3293 4969 7304 7816
Interest -0.5% -100 -130 -169 -220 -235
EBT 2000 3163 4800 7085 7580
Taxes (40%) -800 -1265 -1920 -2834 -3032
Net income 1200 1898 2880 4251 4548
Balance Sheets
Cash 5.0% 1000 1300 1690 2197 2351
Surplus cash 0 -53 293 1248 4797
Accounts receivable 10.0% 2000 2600 3380 4394 4702
Inventories 10.0% 2000 2600 3380 4394 4702
Total current assets 5000 6448 8743 12233 16550
Gross fixed assets 5400 7420 10046 13460 15169
Accumulated depreciation -400 -920 -1596 -2475 -3415
Net fixed assets 25.0% 5000 6500 8450 10985 11754
Total assets 50.0% 10000 12948 17193 23218 28304
Accounts payable 7.5% 1500 1950 2535 3296 3526
Accrued liabilities 5.0% 1000 1300 1690 2197 2351
Total current liabilities 2500 3250 4225 5493 5877
Long-term debt 1000 1300 1690 2197 2351
Common stock 5300 5300 5300 5300 5300
Retained earnings 1200 3098 5978 10228 14777
Total equity 6500 8398 11278 15528 20077
Total liabilities & equity 10000 12948 17193 23218 28304
198 Chapter 13: Security Structures and Determining Enterprise Values

Work Sheet for Estimating Free Cash Flows to the Enterprise:

2010 2011 2012 2013 2014
Income Statement Flows:
NOPAT 1976 2982 4383 4689
Depreciation 520 676 879 940

Required Net Working Capital:

Required Cash 1000 1300 1690 2197 2351
Accounts Receivable 2000 2600 3380 4394 4702
Inventories 2000 2600 3380 4394 4702
Accounts payable -1500 -1950 -2535 -3296 -3526
Accrued liabilities -1000 -1300 -1690 -2197 -2351
Required NWC 2500 3250 4225 5493 5877
Increase in Required NWC 750 975 1268 384

Capital Expenditures (CAPEX):

Net fixed assets 5000 6500 8450 10985 11754
Increase in net fixed assets 1500 1950 2535 769
Depreciation 520 676 879 940
Increase in gross fixed assets 2020 2626 3414 1709

Free Cash Flows to Enterprise:

2010 2011 2012 2013 2014
NOPAT 1976 2982 4383 4689
Plus: Depreciation 520 676 879 940
Less: Increase in Required NWC -750 -975 -1268 -384
Less: CAPEX (Inc in GFA) -2020 -2626 -3414 -1709
Annual Free Cash Flows -275 57 580 3536
Horizon Cash Flow Value (18% disc rate) 32144
Total Free Cash Flows to Enterprise -275 57 32724
PV of Operations (35% disc rate) $13,128
Plus: Existing Surplus Cash $0
Market Value of Firm $13,128
Less: Long-term Debt $1,000
Market Value of Equity $12,128
Per Share Value (1 million shares) $12.13
 Chapter 13: Security Structures and Determining Enterprise Values 199

MINI CASE: WOK YOW IMPORTS, INC.

Wok Yow Imports, Inc., is a rapidly growing, closely held corporation that imports and
sells oriental style furniture and accessories at several retail outlets. The equity owners
are considering selling the venture and want to estimate the enterprise or entity value and
then determine the value of the venture’s equity. Following is last year’s income
statement (2010) and projected income statements for the next four years (2011-2014).
Sales are expected to grow at an annual 6 percent rate beginning in 2015 and thereafter.

[Note: In the first printing of the Fourth Edition, the “actual” and “projected”
headings were not properly aligned. Only income statement data for 2010 are
actual. Projected income statement data are provided for 2011 through 2014 as
shown below.]

Actual Projected ------------------------------------------------

[$ Thousands] 2010 2011 2012 2013
2014
Net Sales $150.0 $200.0 $250.0 $300.0 $350.0
Cost of Goods Sold -75.0 -100.0 -125.0 -150.0 -175.0
Gross Profit 75.0 100.0 125.0 150.0 175.0
SG&A Expenses -30.0 -40.0 -50.0 -60.0 -70.0
Depreciation -7.5 -10.0 -12.5 -15.0 -17.5
EBIT 37.5 50.0 62.5 75.0 87.5
Interest -3.5 -3.5 -3.5 -3.5
-3.5
EBT 34.0 46.5 59.0 71.5 84.0
Taxes (40% rate) -13.6 -18.6 -23.6 -28.6 -33.6
Net Income 20.4 27.9 35.4 42.9 50.4
200 Chapter 13: Security Structures and Determining Enterprise Values

Selected balance sheet accounts at the end of 2010 are as follows: Required cash,
accounts receivable, and inventories accounts totaled $50,000, net fixed assets were
$50,000, and accounts payable and accruals totaled $25,000. Each of these balance sheet
accounts was expected to grow with sales over time. Long-term debt was $30,000 and
there were 10,000 shares of common stock outstanding at the end of 2010.
Data have been gathered for a “comparable” publicly traded firm, Fine Furniture
Products, in Wok Yow’s industry. Fine Furniture’s risk index is judged to be 2.00
compared to a risk index of 1.00 for firms of average riskiness. Management believes
that a 2.00 adjustment factor should be multiplied times the expected market risk
premium for average firms to reflect Wok Yow’s (and Fine Furniture’s) relatively greater
riskiness. Wok Yow’s long-term debt to long-term capital (long-term debt plus equity)
ratio was 40 percent at the end of 2010. The interest rate on long-term U.S. government
bonds is 7 percent, Wok Yow could issue new long-term debt at a 12 percent rate, and the
average expected market risk premium (common stocks over government bonds) is 7.5
percent for average firms.

A. Project Wok Yow’s net operating profit after-tax (NOPAT) statements for 2011-
2015.

The NOPAT results are shown below in the spreadsheet solution. NOPAT
amounts were: 30.0 (2011), 37.5 (2012), 45.0 (2013), 52.5 (2014), and 55.7
(2015).

B. Determine the annual increases in required net working capital and capital
expenditures (CAPEX) for Wok Yow for the years 2011 through 2015.

Results are shown below in the spreadsheet solution. The increases in RNWC
were: 8.3 (2011), 8.3 (2012), 8.3 (2013), 8.3 (2014), and 3.5 (2015). The
increases in CAPEX were: 26.7 (2011), 29.2 (2012), 31.7 (2013), 34.2 (2014),
and 25.5 (2015).

C. Project annual operating free cash flows to the entity for the years 2011 through
2015.

Results are shown below in the spreadsheet solution. Operating free cash flows
were: 5.0 (2011), 12.4 (2012), 20.0 (2013) and 27.5 (2014). An operating free
cash flow of 45.2 was estimated for 2015.

D. Management initially thought that an 18 percent discount rate was reasonable.

Estimating an appropriate required rate of return on an equity investment is

critical to the valuation effort. For very early stage ventures, various VC “rules-of
thumb” might be used ranging from development stage discount rates of 50%
down to 20% discount rates for relatively mature, but small ventures. The
alternative is to estimate an appropriate discount rate using the security market
line approach described in Chapter 7. A venture that employs some interest-
 Chapter 13: Security Structures and Determining Enterprise Values 201

bearing debt will have a weighted average cost of capital WACC that is less than
the cost of equity capital. Management has made a rough estimate of the firm’s
WACC or enterprise (entity) discount rate to be 18%.

E. Use the information from Part D above to estimate Wok Yow’s terminal value
cash flow at the end of 2014.

The terminal value cash flow is estimated to be 376.3 and is calculated by

dividing the estimated operating free cash flow for 2012 of 45.2 by .12 which is
the difference between the discount rate (r = .18) and the perpetuity growth rate (g
= .06). See the spreadsheet solution presented below. In greater detail, the
calculation is: 45.152/(.18 - .06) = 376.267.

F. Estimate the firm’s enterprise or entity value at the end of 2010.

The enterprise or entity value at the end of 2010 is estimated to be 233.6

(thousands of dollars). See the spreadsheet solution presented below.

G. Adjust the enterprise value to determine Wok Yow’s equity value in dollars and
on a per share basis at the end of 2010.

The enterprise value of $233.6, minus the long-term debt value of $20, results in
an equity value of $203.6. On a per share basis, the value is $20.36. See the
spreadsheet solution presented below.

H. Now, estimate Wok Yow’s after-tax cost of long-term debt. Use the risk free rate,
the expected market risk premium, and the risk index for the Fine Furniture
Company to estimate Wok Yow’s cost of equity capital. Determine Wok Yow’s
weighted average cost of capital (WACC).

Cost of common equity capital = 7% + (7.5%)2.00 = 7% + 15% = 22%

After-tax cost of debt = 12%(1 - .40) = 7.2%
WACC = 7.2%(.40) + 22%(.60) = 2.88% + 13.20% = 16.08% or 16.1% rounded
See the second spreadsheet solution presented below for answers to Parts H and I.

I. Re-estimate Wok Yow’s enterprise value using the WACC calculated in Part H.
Then, adjust the enterprise value to determine Wok Yow’s equity value in dollars
and on a per share basis at the end of 2010.

Revised terminal value = $447.1 [i.e., actually $45.152/(.161 - .06)]

Revised enterprise value = $270.1
Revised equity value = $240.1 (i.e., $270.1 - $30.0)
Revised per share value = $24.01
See the second spreadsheet solution presented below for answers to Parts H and I.
202 Chapter 13: Security Structures and Determining Enterprise Values
 Chapter 13: Security Structures and Determining Enterprise Values 203

WOK YOW IMPORTS, INC.

Enterprise (Entity) Valuation Solution [Parts A through G]:
Chapter 13 Mini Case Percent Change in Net Sales
% of 33.3% 25.0% 20.0% 16.7% 6.0%
[Thousands of Dollars] 2010 Actual Pro forma --------------------------------------------
NOPAT Statements Sales 2010 2011 2012 2013 2014 2015
Net Sales 100.0% 150.0 200.0 250.0 300.0 350.0 371.0
Cost of Goods Sold -50.0% -75.0 -100.0 -125.0 -150.0 -175.0 -185.5
Gross Profit 50.0% 75.0 100.0 125.0 150.0 175.0 185.5
SG&A Expenses -20.0% -30.0 -40.0 -50.0 -60.0 -70.0 -74.2
Depreciation -5.0% -7.5 -10.0 -12.5 -15.0 -17.5 -18.6
EBIT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8
Interest 0.0% 0.0 0.0 0.0 0.0 0.0 0.0
EBT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8
Taxes (40% rate) -10.0% -15.0 -20.0 -25.0 -30.0 -35.0 -37.1
NOPAT 15.0% 22.5 30.0 37.5 45.0 52.5 55.7

Required Net Working Capital:

Req Cash+Receivables+Inventories 33.3% 50.0 66.7 83.3 100.0 116.7 123.7
Minus: Payables+Accruals -16.7% -25.0 -33.3 -41.7 -50.0 -58.3 -61.8
Req Net Working Capital (RNWC) 25.0 33.3 41.7 50.0 58.3 61.8
Increase in RNWC 8.3 8.3 8.3 8.3 3.5
Fixed Assets Schedule:
Net Fixed Assets (NFA) 33.3% 50.0 66.6 83.3 100.0 116.7 123.7
Increase in NFA 16.7 16.7 16.7 16.7 7.0
Plus: Depreciation 10.0 12.5 15.0 17.5 18.6
CAPEX 26.7 29.2 31.7 34.2 25.5

Free Cash Flows to Entity:

NOPAT 30.0 37.5 45.0 52.5 55.7
Plus: Depreciation 10.0 12.5 15.0 17.5 18.6
Minus: CAPEX -26.7 -29.2 -31.7 -34.2 -25.5
Minus: Increase in NWC -8.3 -8.3 -8.3 -8.3 -3.5
Operating Free Cash Flows 5.0 12.4 20.0 27.5 45.2

Terminal Value CF (r =.18, g =.06) 376.3

Total Free Cash Flows (TFCF) 5.0 12.4 20.0 403.8
PV of TFCF (18% Discount Rate) $233.6
Less: LTD Value $30.0
Equity Value $203.6
Value Per Share (10,000 shares) $20.36
204 Chapter 13: Security Structures and Determining Enterprise Values

WOK YOW IMPORTS, INC.

Enterprise (Entity) Valuation Solution [Parts H and I]:
Percent Change in Net Sales
% of 33.3% 25.0% 20.0% 16.7% 6.0%
[Thousands of Dollars] 2010 Actual Pro forma --------------------------------------------
NOPAT Statements Sales 2010 2011 2012 2013 2014 2015
Net Sales 100.0% 150.0 200.0 250.0 300.0 350.0 371.0
Cost of Goods Sold -50.0% -75.0 -100.0 -125.0 -150.0 -175.0 -185.5
Gross Profit 50.0% 75.0 100.0 125.0 150.0 175.0 185.5
SG&A Expenses -20.0% -30.0 -40.0 -50.0 -60.0 -70.0 -74.2
Depreciation -5.0% -7.5 -10.0 -12.5 -15.0 -17.5 -18.6
EBIT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8
Interest 0.0% 0.0 0.0 0.0 0.0 0.0 0.0
EBT 25.0% 37.5 50.0 62.5 75.0 87.5 92.8
Taxes (40% rate) -10.0% -15.0 -20.0 -25.0 -30.0 -35.0 -37.1
NOPAT 15.0% 22.5 30.0 37.5 45.0 52.5 55.7

Required Net Working Capital:

Req Cash+Receivables+Inventories 33.3% 50.0 66.7 83.3 100.0 116.7 123.7
Minus: Payables+Accruals -16.7% -25.0 -33.3 -41.7 -50.0 -58.3 -61.8
Req Net Working Capital (RNWC) 25.0 33.3 41.7 50.0 58.3 61.8
Increase in RNWC 8.3 8.3 8.3 8.3 3.5
Fixed Assets Schedule:
Net Fixed Assets (NFA) 33.3% 50.0 66.6 83.3 100.0 116.7 123.7
Increase in NFA 16.7 16.7 16.7 16.7 7.0
Plus: Depreciation 10.0 12.5 15.0 17.5 18.6
CAPEX 26.7 29.2 31.7 34.2 25.5

Free Cash Flows to Entity:

NOPAT 30.0 37.5 45.0 52.5 55.7
Plus: Depreciation 10.0 12.5 15.0 17.5 18.6
Minus: CAPEX -26.7 -29.2 -31.7 -34.2 -25.5
Minus: Increase in NWC -8.3 -8.3 -8.3 -8.3 -3.5
Operating Free Cash Flows 5.0 12.4 20.0 27.5 45.2

Terminal Value CF (r = .161, g = .06) 447.1

Total Free Cash Flows (TFCF) 5.0 12.4 20.0 474.6
PV of TFCF (16.1% Discount Rate) $270.1
Less: LTD Value $30.0
Equity Value $240.1
Value Per Share (10,000 shares) $24.01

Cost of Capital Worksheet:

"Comparable Firm" Risk Index 2.00
Cost of Equity Capital 0.220
A-T Cost of LTD Capital 0.072
WACC 0.161
 Chapter 13: Security Structures and Determining Enterprise Values 205

MINI CASE 2: RxDELIVERY SYSTEMS, INC. (Revisited)

RxDelivery Systems is an R&D venture specializing in the development and testing of

new drug delivery technologies. The market for alternative drug delivery systems grew
rapidly during the 1990s. Driving factors behind this growth include efforts to reduce
drug side effects through site-specific delivery, the need to maintain the activity of new
biopharmaceutical compounds, and the extension of drug patent life. Improved drug
delivery methods are expected to reduce the number of surgical interventions and the
length of hospital stays, and improve patient compliance in taking prescribed drugs.
The world market for biopharmaceuticals (including peptide, protein, RNA, and
DNA drugs) was more than $50 billion in 2007. Sales of polymer-based drug delivery
systems are forecasted to exceed $2.0 billion in 2014. Pulmonary delivery systems
currently account for one-third of the drug delivery market and sales are projected to
exceed $25 billion by 2014.
RxDelivery Systems believes it can compete effectively in both the polymer-
based and pulmonary drug delivery areas. The venture’s delivery technology is expected
to utilize hydrophobic ion pairing and supercritical carbon dioxide precipitation to
incorporate water soluble drug molecules into biodegradable controlled-release
microspheres. The resulting microspheres will take the form of dry powders and will
contain drug molecules small enough to allow for intravenous, intranasal, or pulmonary
delivery. It is anticipated that this technology will be incorporated into products for
controlled release applications including treatment of cancer, infectious diseases, and
gene therapy.
RxDelivery Systems, through an agreement with its pharmaceutical parent, a
major drug company, will initially operate as an independent corporation but will be
merged into the parent at the end of its second year. At that time, RxDelivery Systems’
entrepreneurial team will be paid a lump sum of $2,500,000 as the terminal value for the
venture. Following are limited financial statement projections for the next two years for
the RxDelivery Systems Corporation:

First year revenues $12,500

Second year revenues $16,000
Expenses (including depreciation) $125,000 per year
Initial time-zero (net) fixed assets $50,000
Depreciation 10% of beginning-of-year net fixed assets
Accounts Payable (Yr. 1 and 2) $750
Inventories (Yr. 1 and 2) $0
Corporate marginal tax rate 30%
Accounts Receivable (Yr. 1 and 2) $0
Accrued Expenses (Yr. 1 and 2) $300
Required Cash $3000
Debt (all years) $0

A. Construct the venture’s balance sheet at startup. Then construct financial statements
for Years 1 and 2. [Put initial fixed asset investments in Year 0 and initial working
capital investments in Year 1. Assume the initial $50,000 is equity financed.]
206 Chapter 13: Security Structures and Determining Enterprise Values

See spreadsheet below.

B. Construct the enterprise valuation cash flows including the $2,500,000 terminal
payment. Treat existing liabilities at the terminal time as though the pharmaceutical
firm assumes them. (The $2,500,000 is “free and clear.”) Strip all non-required cash
out of net working capital (effectively declaring a pseudo dividend).

See spreadsheet below.

C. What is the value of the enterprise at time 0?

The venture has no debt and therefore WACC is the same as the discount rate for
equity. [Note: an equity discount rate of 30% was used in determining the equity
value for RxDelivery Systems in the Mini Case at the end of Chapter 9. This
discount rate should have been provided again in the “revisited” RxDelivery
Systems Mini Case.]

See spreadsheet below.

D. What is the value of the equity at time 0?

See spreadsheet below.

E. Why does this value differ from the value for the equity method in the RxDelivery
Systems mini case at the end of Chapter 9?

Note: a 30% discount rate, the same as given in the Chapter 9 mini case, should have
been stated in this mini case. The venture has no debt and therefore WACC is the
same as the discount rate for equity. There is no debt to subtract from the enterprise
value. Thus, the equity and enterprise values would be the same.

If one uses the delayed dividend approximation (DDA) method (discussed in Chapter
10, Learning Supplement 10B) the answer would be different than the answer
produced by the equity valuation method. See the spreadsheet below for more
information.
 Chapter 13: Security Structures and Determining Enterprise Values 207

From the solutions in Chapter 9 and the DDA (Ch. 10) approach:
Income Statements Year 1 Year 2 Valuation (PDM) (Surplus Cash is Zero for Valuation Purposes)
Revenue 12,500 16,000 Year 0 Year 1 Year 2
Expenses Including Depreciation -125,000 -125,000 NI 0 -112,500 -109,000
EBIT -112,500 -109,000 +Dep 0 5,000 4,500
-Interest 0 0 -Capex -50,000 0 0
EBT -112,500 -109,000 -dNWC 0 -1,950 0
- Cash Taxes 0 0 +Principal Proc. 0 0 0
Net Income -112,500 -109,000 Equity VCF -50,000 -109,450 -104,500
Terminal Flow 2,500,000
Depreciation 5,000 4,500 Total Flow -50,000 -109,450 2,395,500

NPV 1,283,263
Balance Sheets Startup Year 1 Year 2
Assets Valuation (DDA) (Surplus Cash Situation Affects Terminal Flow)
Required Cash 0 3,000 3,000 Year 0 Year 1 Year 2
Surplus Cash 0 -109,450 -213,950 NI 0 -112,500 -109,000
Gross Fixed Assets 50,000 50,000 50,000 +Dep 0 5,000 4,500
Accumulated Depreciation 0 -5,000 -9,500 -Capex -50,000 0 0
Net Fixed Assets 50,000 45,000 40,500 -dNWC 0 107,500 104,500
Total Assets 50,000 -61,450 -170,450 +Principal Proc. 0 0 0
Liabilities and Equity Equity VCF -50,000 0 0
Accounts Payable 750 750 Terminal Flow 2,286,050
Accrued Expenses 300 300 Total Flow -50,000 0 2,286,050
Debt 0 0 0
Equity 50,000 -62,500 -171,500 NPV 1,302,692
Total L+E 50,000 -61,450 -170,450
Sum
Accounting Cash Flows Year 0 Year 1 Year 2 Difference in EqCF 0 109,450 -109,450 0
NI 0 -112,500 -109,000 NPV of Difference 19,429
+Depr 0 5,000 4,500 DDA Value Increase 19,429 (=1,302,263-1,283,263)
-dAR 0 0 0 due to timing differences on surplus cash
-dInv 0 0 0
+dAP 0 750 0
+dAccrd 0 300 0
-Capex -50,000 0 0
+Principal 0 0 0
-Dividend 50,000 0 0
Acct CF 0 -106,450 -104,500
Beg Cash 0 0 -106,450
End Cash 0 -106,450 -210,950

The enterprise valuation approach is:

Enterprise Value Method (Cash Taxes)

EBIT 0 -11,250 -10,900

-tc*EBIT 0 0 0
EBIAT 0 -11,250 -10,900
+Depr 0 500 450
-Capex -5,000 0 0
-dNWC -195 0
Enterprise VCF -5,000 -10,945 -10,450
Terminal Flow 250,000
Total Enterprise Flow -5,000 -10,945 239,550

NPV @ 30% 128,326

-Market Value ' Debt' 0
Market Value Equity 128,326

The deferred tax asset (accrued taxes) approach would give the same enterprise
valuation cash flows after adding a tax credit and taking out the investment in a
deferred tax asset.