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19. Use the two-stage FCFE model to compute the value of Nestle (Illustration 14.4) (20 points) All of the inputs will be the same as in the illustration except: Current net income is Sfr 6,200 million, the firm will raise 40% of its reinvestment needs from debt, and in stable growth we assume a growth rate of 2% and ROE is 14%. 19a) Compute the present value of the first stage. 19b) Compute the present value of the terminal value. 19c) Compute the value of Nestle per share. ILLUSTRATION 14.4: Two-Stage FCFE Model: Nestl in 2001 Nestl has operations all over the world, with 97% of its revenues coming from markets outside Switzerland, where it is headquartered. The firm, like many large European corporations, has a weak corporate governance system, and stockholders have little power over managers. RATIONALE FOR USING THE MODEL Why two-stage? Nestle has a long and impressive history of growth, and while we believe that its growth will be moderate, we assume that it will be able to maintain high growth for 10 years, Why FCFE? Given its weak corporate governance structure and a history of accumulating cash, the dividends paid by Nestl bear little resemblance to what the firm could have paid out. 343 BACKGROUND INFORMATION Curi e -SA 5.763 milice Emin - 14.13 Current capital pending 5.05 C e pende harest Cum depreciatio-S3.330 million Deprecature -S8571 Current revenues - Str 81.422 million Revenue share-St-2,095.64 Noncash working capital 5.1 million Working capital shareS 149.74 Change in working capital - Sfr 368 million Change in working capital share - St 9:47 Nel debe 2 million ESTIMATES We will begin by estimating the cost of equity for Ned during the high growth period in Swiss France. We will me the 10 year Swiss government Str bond rate of 4% as the risk-free rate. To estimate the risk premium, we used the breakdown of Nestle's revenues by region Revenues Region fin Billions Shr) Weight Risk Premium North America 20.21 24.82% 4.00% South America 4.97 6.10% 12.00% Switzerland 1.27 1.56% 400% Germany France United Kingdom 21.25 26.10% 4.00% Italy/Spain 7.39 9.08% 5.50% Asia 6.70 8.23% 9.00% Rest of Western Europe 15.01 18.44% 400% Eastern Europe 4.62 5.67% 8.00% Total 81.42 100.00% 5.26% The risk premiums for each region represent an average of the risk pre s of the countries in the region. Using a bottom-up bota of 0.85 for Nestl, we estimated a cost of equity of Cost of equity - 4% +0.85(5.26%) -8.47% We will assume that this cost of equity will remain unchanged in perpetuity. To estimate the expected growth rate in free cash flows to quity, we first computed the free cash flows to equity in the current year FCFE-Net income -(Cap ex - Depreciation) - Change in working capital + Net debt issues -5,763 - (5,058 -3,330) - 368 +272 - Str 3,939 million The equity reinvestment rate can be estimated from this value: Equity reinvestment rate - 1 - FCFE/Net income - 1 - 3.999,763 - 31,65% The return on equity in 2000 was estimated using the net income from 2000 and the book value of equity from the end of the previous year Return on equity - 5,763/25,078 - 22.98% The expected growth rate in FCFE is a product of the equity investment rate and the retum nequity Expected growth in FCFE - Equity reinvestment rate x Return on equity - 3165 x 2298 - 7.27% We will that capital expenditures and working capital willow at the same rate as camins for the high growth period and that the firm will raise 33.92% of its civestment needs from deb (which is its current book value debt-to-capitale In stable growth, we assume a growth rate of %. We also assume that the cost of equity remains unchanged but that the return on quity drops to 13%. The equity reinvestment rate in stable powth can be estimated as follows Equity reinvestment in stable growth - ROE-4 15% -26.67% VALUATION The first component of value is the present value of the expected FCPE during the high-growth period, free ble assuming camnings, net capital expenditures and working capital grow 7.27% and 33.92% of rivestimentos come from debt in Sir Chungen We Working Equity Earnings Ex p ia Reinvestment R estment FOFE Pa Share Share Share Share Sure 0771 10.89 58 50 38.72 120 30 11000 170.69 51.18 1158 5256 41.54 12915 10075 183.10 5490 12.53 456 108 55 19642 58.90 1 3.44 7234 47 80 148 62 10735 5 210.71 63.18 14 42 77 50 5128 150 43 106 17 5 226.00 57.77 15.47 8325 55 01 17102 10500 7 242 47 72.70 15.60 89.30 5001 18.45 103 260.11 77.99 17.80 95.80 6330 105 81 102.60 9 279 0983.67 10.10 1 0276 5791 211.12 101 56 10 299 32 89.75 20.49 110.24 72.85 225.48 10044 Sum of present value of FCFE 10634 12 Note that the change in werking capital each year is computed based on the existing working capital of Sr 149.74 per share, and that the present value is computed using the cost of equity of 8.47% To estimate the terminal value, we first estimate the free cash flows to equity in year 11: Expected earnings per share in year 11 - EPS, 11 +g) - 299.32(1.04) - 311.30 Equity investment in year 11 -EPS, Stable equity reinvestment rate 311.30 x 2667-83.02 Expected FCFE in year 11 - EPS-Equity reinvestment - 311.30 - 83.02 - 228.28 Terminal value of equity per shore-FCFE/Cost of equity.-) -228.280847-04) - 5,105.88 The value per share can be estimated as the sum of the present value of FCFE during the high growth phase and the present value of the terminal value of equity Value per share - PV of dividend during high growth phase + Terminal prica (1 ) - 1,056.34 +5,105.88/1,0847-3320.65 Str 3.390 Str per share in May 2001 at the time of this valuation, making the stock slightly The stock was trading under valued FCFE2st.xls: This spreadsheet allows you to value a firm with a temporary period of high growth in FCFE, followed by stable growth REINVESTMENT ASSUMPTIONS, TERMINAL VALUE, AND EQUITY VALUE We have repeatedly cmphasized the importance of linking growth assumptions to smisaoutrem e n and especially so in stable growth. A very common assumption in many discounted cash flow valuations is that capital spendiures offset depreciation in stable growth When combined with the assumption of working capital changes ILLUSTRATION 14.4: Two-Stage FCFE Model: Nestl in 2001 Nestl has operations all over the world, with 97% of its revenues coming from markets outside Switzerland, where it is headquartered. The firm, like many large European corporations, has a weak corporate governance system, and stockholders have little power over managers. RATIONALE FOR USING THE MODEL Why two-stage? Nestl has a long and impressive history of growth, and while we believe that its growth will be moderate, we assume that it will be able to maintain high growth for 10 years. Why FCFE? Given its weak corporate governance structure and a history of accumulating cash, the dividends paid by Nestl bear little resemblance to what the firm could have paid out. BACKGROUND INFORMATION Current net income - Sfr 5,763 million Earnings per share - Sfr 148 33 Current capital spending - Sfr 5,058 million Capital expenditures share - Sfr 130.18 Current depreciation - Sfr 3330 million Depreciation share=S 85.71 Current revenues = Sfr 81,422 million Revenue share=Sir 2,095.54 Noncash working capital - Sfr 5,818 million Working capital share=S& 149.74 Change in working capital = Sfr 368 million Change in working capital share=Sfr 9.47 Net debt issues - Sfr 272 million ESTIMATES We will begin by estimating the cost of equity for Nestle during the high growth period in Swiss francs. We will use the 10-year Swiss goverment Sfr bond rate of 4% as the risk-free rate. To estimate the risk premium, we used the breakdown of Nestle's revenues by region: Revenues Region in Billions Sf) Weight Risk Premium North America 20.21 24.82% 4.00% South America 4.97 6.10% 12.00% Switzerland 1.27 1.56% 400% Germany/France/United Kingdom 21.25 26.10% 4.00% Italy/Spain 7.39 9.08% 5.50% Asia 6.70 8.23% 9.00% Rest of Western Europe 15.01 18.44% 4.00% Eastern Europe 4.62 5.67% 8.00% Total 81.42 100.00% 5 26% The risk premiums for each region represent an average of the risk premiums of the countries in the region. Using a bottom-up beta of 0.85 for Nestl, we estimated a cost of equity of: Cost of equity - 4% +0.85(5.26%) -8.47% We will assume that this cost of equity will remain unchanged in perpetuity. To estimate the expected growth rate in free cash flows to equity, we first computed the free cash flows to equity in the current year: FCFE - Net income -(Cap ex - Depreciation) - Change in working capital + Net debt issues = 5,763 - (5,058 -3,330) - 368 +272=Sfr 3,939 million The equity reinvestment rate can be estimated from this value: Equity reinvestment rate - 1 - FCFE/Net income-1-3,9395,763 - 31.65% The return on equity in 2000 was estimated using the net income from 2000 and the book value of equity from the end of the previous year Return on equity - 5,763/25,078 - 22.98% The expected growth rate in FCFE is a product of the equity reinvestment rate and the return on equity: Expected growth in FCFE - Equity reinvestment rate x Return on equity = 3165 x 2298 - 7.27% We will assume that net capital expenditures and working capital will grow at the same rate as earnings for the high growth period and that the firm will raise 33.92% of its reinvestment needs from deb (which is its current book value debt-to-capital ratio) In stable growth, we assume a growth rate of 4%. We also assume that the cost of equity remains unchanged but that the return on equity drops to 15%. The equity reinvestment rate in stable growth can be estimated as follows: Equity reinvestment in stable growth - GROE - 4%/15% -26.67% VALUATION The first component of value is the present value of the expected FCFE during the high-growth period, (see table) assuming earnings, net capital expenditures, and working capital grow at 7.27% and 33.92% of reinvestment needs come from debt (in Sfr): Change in Net Working Equity Earnings Cap Ex Capital Reinvestment Reinvestment FCFE per per per per per per Present Year Share Share Share Share Share Share Value 159.12 47.71 10.89 58.60 38.72 120 39 110.99 170.69 51.18 11.68 62.86 41.54 129.15 109.76 183.10 54.90 12.53 67.44 44.56 138.54 108.55 196.42 58.90 13.44 72.34 47.80 148.62 107.35 210.71 63.18 14.42 77.60 51.28 159.43 106.17 226.03 67.77 15.47 83.25 55.01 171.02 105.00 242.47 72.70 16.60 89.30 59.01 183.46 103.84 260.11 7 7.99 17.80 95.80 63.30 196.81 102.69 279.03 83.67 19.10 102.76 67.91 211.12 101.56 299.32 89.75 20.49 110.24 72.85 226.48 100.44 Sum of present value of FCFE 1,056.34 Note that the change in working capital each year is computed based on the existing working capital of Sfr 149.74 per share, and that the present value is computed using the cost of equity of 8.47%. To estimate the terminal value, we first estimate the free cash flows to equity in year 11: Expected earnings per share in year 11 = EPS, (1 + 9) = 299.32(1.04) 311.30 Equity reinvestment in year 11 - EPS, Stable equity reinvestment rate-311.30 x 2667-83.02 Expected FCFE in year 11 = EPS, - Equity reinvestment,, - 311.30 - 83.02 = 228.28 Terminal value of equity per share - FCFE,//(Cost of equity 1-9) - 228.28/(.0847-04) - 5,105.88 The value per share can be estimated as the sum of the present value of FCFE during the high growth phase and the present value of the terminal value of equity Value per share= PV of dividend during high growth phase + Terminal price/(1+k)" = 1,056.34 +5,105.88/1.084710 = 3,320.65 Str The stock was trading at 3.390 Sfr per share in May 2001 at the time of this valuation, making the stock slightly under valued. FCFE2st.xls: This spreadsheet allows you to value a firm with a temporary period of high growth in FCFE, followed by stable growth. 19. Use the two-stage FCFE model to compute the value of Nestle (Illustration 14.4) (20 points) All of the inputs will be the same as in the illustration except: Current net income is Sfr 6,200 million, the firm will raise 40% of its reinvestment needs from debt, and in stable growth we assume a growth rate of 2% and ROE is 14%. 19a) Compute the present value of the first stage. 19b) Compute the present value of the terminal value. 19c) Compute the value of Nestle per share. ILLUSTRATION 14.4: Two-Stage FCFE Model: Nestl in 2001 Nestl has operations all over the world, with 97% of its revenues coming from markets outside Switzerland, where it is headquartered. The firm, like many large European corporations, has a weak corporate governance system, and stockholders have little power over managers. RATIONALE FOR USING THE MODEL Why two-stage? Nestle has a long and impressive history of growth, and while we believe that its growth will be moderate, we assume that it will be able to maintain high growth for 10 years, Why FCFE? Given its weak corporate governance structure and a history of accumulating cash, the dividends paid by Nestl bear little resemblance to what the firm could have paid out. 343 BACKGROUND INFORMATION Curi e -SA 5.763 milice Emin - 14.13 Current capital pending 5.05 C e pende harest Cum depreciatio-S3.330 million Deprecature -S8571 Current revenues - Str 81.422 million Revenue share-St-2,095.64 Noncash working capital 5.1 million Working capital shareS 149.74 Change in working capital - Sfr 368 million Change in working capital share - St 9:47 Nel debe 2 million ESTIMATES We will begin by estimating the cost of equity for Ned during the high growth period in Swiss France. We will me the 10 year Swiss government Str bond rate of 4% as the risk-free rate. To estimate the risk premium, we used the breakdown of Nestle's revenues by region Revenues Region fin Billions Shr) Weight Risk Premium North America 20.21 24.82% 4.00% South America 4.97 6.10% 12.00% Switzerland 1.27 1.56% 400% Germany France United Kingdom 21.25 26.10% 4.00% Italy/Spain 7.39 9.08% 5.50% Asia 6.70 8.23% 9.00% Rest of Western Europe 15.01 18.44% 400% Eastern Europe 4.62 5.67% 8.00% Total 81.42 100.00% 5.26% The risk premiums for each region represent an average of the risk pre s of the countries in the region. Using a bottom-up bota of 0.85 for Nestl, we estimated a cost of equity of Cost of equity - 4% +0.85(5.26%) -8.47% We will assume that this cost of equity will remain unchanged in perpetuity. To estimate the expected growth rate in free cash flows to quity, we first computed the free cash flows to equity in the current year FCFE-Net income -(Cap ex - Depreciation) - Change in working capital + Net debt issues -5,763 - (5,058 -3,330) - 368 +272 - Str 3,939 million The equity reinvestment rate can be estimated from this value: Equity reinvestment rate - 1 - FCFE/Net income - 1 - 3.999,763 - 31,65% The return on equity in 2000 was estimated using the net income from 2000 and the book value of equity from the end of the previous year Return on equity - 5,763/25,078 - 22.98% The expected growth rate in FCFE is a product of the equity investment rate and the retum nequity Expected growth in FCFE - Equity reinvestment rate x Return on equity - 3165 x 2298 - 7.27% We will that capital expenditures and working capital willow at the same rate as camins for the high growth period and that the firm will raise 33.92% of its civestment needs from deb (which is its current book value debt-to-capitale In stable growth, we assume a growth rate of %. We also assume that the cost of equity remains unchanged but that the return on quity drops to 13%. The equity reinvestment rate in stable powth can be estimated as follows Equity reinvestment in stable growth - ROE-4 15% -26.67% VALUATION The first component of value is the present value of the expected FCPE during the high-growth period, free ble assuming camnings, net capital expenditures and working capital grow 7.27% and 33.92% of rivestimentos come from debt in Sir Chungen We Working Equity Earnings Ex p ia Reinvestment R estment FOFE Pa Share Share Share Share Sure 0771 10.89 58 50 38.72 120 30 11000 170.69 51.18 1158 5256 41.54 12915 10075 183.10 5490 12.53 456 108 55 19642 58.90 1 3.44 7234 47 80 148 62 10735 5 210.71 63.18 14 42 77 50 5128 150 43 106 17 5 226.00 57.77 15.47 8325 55 01 17102 10500 7 242 47 72.70 15.60 89.30 5001 18.45 103 260.11 77.99 17.80 95.80 6330 105 81 102.60 9 279 0983.67 10.10 1 0276 5791 211.12 101 56 10 299 32 89.75 20.49 110.24 72.85 225.48 10044 Sum of present value of FCFE 10634 12 Note that the change in werking capital each year is computed based on the existing working capital of Sr 149.74 per share, and that the present value is computed using the cost of equity of 8.47% To estimate the terminal value, we first estimate the free cash flows to equity in year 11: Expected earnings per share in year 11 - EPS, 11 +g) - 299.32(1.04) - 311.30 Equity investment in year 11 -EPS, Stable equity reinvestment rate 311.30 x 2667-83.02 Expected FCFE in year 11 - EPS-Equity reinvestment - 311.30 - 83.02 - 228.28 Terminal value of equity per shore-FCFE/Cost of equity.-) -228.280847-04) - 5,105.88 The value per share can be estimated as the sum of the present value of FCFE during the high growth phase and the present value of the terminal value of equity Value per share - PV of dividend during high growth phase + Terminal prica (1 ) - 1,056.34 +5,105.88/1,0847-3320.65 Str 3.390 Str per share in May 2001 at the time of this valuation, making the stock slightly The stock was trading under valued FCFE2st.xls: This spreadsheet allows you to value a firm with a temporary period of high growth in FCFE, followed by stable growth REINVESTMENT ASSUMPTIONS, TERMINAL VALUE, AND EQUITY VALUE We have repeatedly cmphasized the importance of linking growth assumptions to smisaoutrem e n and especially so in stable growth. A very common assumption in many discounted cash flow valuations is that capital spendiures offset depreciation in stable growth When combined with the assumption of working capital changes ILLUSTRATION 14.4: Two-Stage FCFE Model: Nestl in 2001 Nestl has operations all over the world, with 97% of its revenues coming from markets outside Switzerland, where it is headquartered. The firm, like many large European corporations, has a weak corporate governance system, and stockholders have little power over managers. RATIONALE FOR USING THE MODEL Why two-stage? Nestl has a long and impressive history of growth, and while we believe that its growth will be moderate, we assume that it will be able to maintain high growth for 10 years. Why FCFE? Given its weak corporate governance structure and a history of accumulating cash, the dividends paid by Nestl bear little resemblance to what the firm could have paid out. BACKGROUND INFORMATION Current net income - Sfr 5,763 million Earnings per share - Sfr 148 33 Current capital spending - Sfr 5,058 million Capital expenditures share - Sfr 130.18 Current depreciation - Sfr 3330 million Depreciation share=S 85.71 Current revenues = Sfr 81,422 million Revenue share=Sir 2,095.54 Noncash working capital - Sfr 5,818 million Working capital share=S& 149.74 Change in working capital = Sfr 368 million Change in working capital share=Sfr 9.47 Net debt issues - Sfr 272 million ESTIMATES We will begin by estimating the cost of equity for Nestle during the high growth period in Swiss francs. We will use the 10-year Swiss goverment Sfr bond rate of 4% as the risk-free rate. To estimate the risk premium, we used the breakdown of Nestle's revenues by region: Revenues Region in Billions Sf) Weight Risk Premium North America 20.21 24.82% 4.00% South America 4.97 6.10% 12.00% Switzerland 1.27 1.56% 400% Germany/France/United Kingdom 21.25 26.10% 4.00% Italy/Spain 7.39 9.08% 5.50% Asia 6.70 8.23% 9.00% Rest of Western Europe 15.01 18.44% 4.00% Eastern Europe 4.62 5.67% 8.00% Total 81.42 100.00% 5 26% The risk premiums for each region represent an average of the risk premiums of the countries in the region. Using a bottom-up beta of 0.85 for Nestl, we estimated a cost of equity of: Cost of equity - 4% +0.85(5.26%) -8.47% We will assume that this cost of equity will remain unchanged in perpetuity. To estimate the expected growth rate in free cash flows to equity, we first computed the free cash flows to equity in the current year: FCFE - Net income -(Cap ex - Depreciation) - Change in working capital + Net debt issues = 5,763 - (5,058 -3,330) - 368 +272=Sfr 3,939 million The equity reinvestment rate can be estimated from this value: Equity reinvestment rate - 1 - FCFE/Net income-1-3,9395,763 - 31.65% The return on equity in 2000 was estimated using the net income from 2000 and the book value of equity from the end of the previous year Return on equity - 5,763/25,078 - 22.98% The expected growth rate in FCFE is a product of the equity reinvestment rate and the return on equity: Expected growth in FCFE - Equity reinvestment rate x Return on equity = 3165 x 2298 - 7.27% We will assume that net capital expenditures and working capital will grow at the same rate as earnings for the high growth period and that the firm will raise 33.92% of its reinvestment needs from deb (which is its current book value debt-to-capital ratio) In stable growth, we assume a growth rate of 4%. We also assume that the cost of equity remains unchanged but that the return on equity drops to 15%. The equity reinvestment rate in stable growth can be estimated as follows: Equity reinvestment in stable growth - GROE - 4%/15% -26.67% VALUATION The first component of value is the present value of the expected FCFE during the high-growth period, (see table) assuming earnings, net capital expenditures, and working capital grow at 7.27% and 33.92% of reinvestment needs come from debt (in Sfr): Change in Net Working Equity Earnings Cap Ex Capital Reinvestment Reinvestment FCFE per per per per per per Present Year Share Share Share Share Share Share Value 159.12 47.71 10.89 58.60 38.72 120 39 110.99 170.69 51.18 11.68 62.86 41.54 129.15 109.76 183.10 54.90 12.53 67.44 44.56 138.54 108.55 196.42 58.90 13.44 72.34 47.80 148.62 107.35 210.71 63.18 14.42 77.60 51.28 159.43 106.17 226.03 67.77 15.47 83.25 55.01 171.02 105.00 242.47 72.70 16.60 89.30 59.01 183.46 103.84 260.11 7 7.99 17.80 95.80 63.30 196.81 102.69 279.03 83.67 19.10 102.76 67.91 211.12 101.56 299.32 89.75 20.49 110.24 72.85 226.48 100.44 Sum of present value of FCFE 1,056.34 Note that the change in working capital each year is computed based on the existing working capital of Sfr 149.74 per share, and that the present value is computed using the cost of equity of 8.47%. To estimate the terminal value, we first estimate the free cash flows to equity in year 11: Expected earnings per share in year 11 = EPS, (1 + 9) = 299.32(1.04) 311.30 Equity reinvestment in year 11 - EPS, Stable equity reinvestment rate-311.30 x 2667-83.02 Expected FCFE in year 11 = EPS, - Equity reinvestment,, - 311.30 - 83.02 = 228.28 Terminal value of equity per share - FCFE,//(Cost of equity 1-9) - 228.28/(.0847-04) - 5,105.88 The value per share can be estimated as the sum of the present value of FCFE during the high growth phase and the present value of the terminal value of equity Value per share= PV of dividend during high growth phase + Terminal price/(1+k)" = 1,056.34 +5,105.88/1.084710 = 3,320.65 Str The stock was trading at 3.390 Sfr per share in May 2001 at the time of this valuation, making the stock slightly under valued. FCFE2st.xls: This spreadsheet allows you to value a firm with a temporary period of high growth in FCFE, followed by stable growth