Assumptions for Free Cash Flow

The following assumptions are made at the end of 2019 of XYZ protective tool store.

Sales to increase 15 percent in 2020 and 10 percent in 2021; after then, sales growth is expected to slow down to 4% a year, into the indefinite future.

Gross profit margin will improve permanently to 50% by next year.

Selling and administrative costs are expected to rise by 10% in each of the next two years, after which they will remain at the ratio-to-sales reached in 2021.

The company's effective tax rate is expected to be 35 percent.

XYZ Stores currently has $6 million of net working capital (which includes the cash needed to run the business).

In future, it is expected that net working capital to be about 20% of sales.

Net fixed assets at year end 2019 are $18 million. Management expects to invest $6 million during 2020 and another $3 million in 2021 in plant and equipment to enable the firm to meet sales projections (these expenditures cover both the amounts need to replace depreciated assets and provide additional capacity). These investments will increase annual depreciation to $2.04m in 2020 and to $2.22m in 2021. After 2021, net fixed asset turnover will stabilize at 1.5, and depreciation will be 10% of beginning-of-year net fixed assets.

QUESTIONS

a. Value XYZs equity assuming a discount rate of 11% and a total debt at the end of 2019 of

$7.2 million. Compare and contrast XYZs projected growth value under the above assumptions and the value obtained under the assumption that after 2022, XYZs market is competitive (that is, PVGO=0).

b. For each of the two valuations obtained in part a. above, find XYZs market value debt ratio at the end of 2019, as well as its (trailing) AMV/EBITDA and P/E multiples.

c. Identified industry peers for XYZ Stores, indicate that it should trade at a trailing AMV/EBITDA of 9 and P/E of 14. What would these multiples imply about the value of XYZs equity today?

d. If we were to use todays peer multiples to obtain a remainder value for the end of 2022. How would the estimate differ from the remainder value estimates obtained in part a.? What economic factors do you think could explain the difference?

e. State a range of value for XYZs equity today and give reasons the conclusion reached.

XYZ Stores

Income Statement for 2019 (thousands)

Net Sales $27,000

Cost of goods sold $14,850

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Gross margin $12,150

Operating expenses:

Sales and administrative $7,350

Depreciation $1,500

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Operating income $3,300

Interest $600

$2,700

Income taxes $675

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Net income $2,025