Page 66 - Financial Statement Analysis

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Chapter One | Overview of Financial Statement Analysis 43

At this same time (end of year 2004), we wish to compute the intrinsic value of the remain-
ing 49% of Labrador’s shares using the alternative valuation models (assume a cost of capital
of 10%).
Solution: Since Pitbull will acquire Labrador at the end of 2009 for $25 per share, the terminal
value is set—this spares us the task of estimating continuing (or terminal) value. Using the
dividend discount model, we determine intrinsic value at the end of year 2004 as:
$1 $1 $1 $1 $1 $25
Intrinsic value 19.31
(1.1) 1 (1.1) 2 (1.1) 3 (1.1) 4 (1.1) 5 (1.1) 5
Next, to apply the free cash flow to equity model, we compute the following amounts for
Labrador:

(in $ per share) 2005 2006 2007 2008 2009
Operating cash flows* . . . . . . . . . . . . . . . . . $1.25 $1.50 $1.50 $2.00 $2.25
Capital expenditures* . . . . . . . . . . . . . . . . . . — — (1.00) (1.00) —
Debt increase (decrease) . . . . . . . . . . . . . . . (0.25) (0.50) 0.50 — (1.25)
Free cash flow to equity . . . . . . . . . . . . . . . . $1.00 $1.00 $1.00 $1.00 $1.00

*Amounts taken from analyst’s projections.
The excess cash flows not needed for the payment of dividends are used to reduce long-term
debt. The free cash flows to equity, then, are the cash flows available to pay the dividend
requirement of $1. Then, using the free cash flows to equity model, we determine the value of the
firm as:
$1 $1 $1 $1 $1 $25
FCFE value 19.31
(1.1) 1 (1.1) 2 (1.1) 3 (1.1) 4 (1.1) 5 (1.1) 5
The free cash flows to equity model values the cash flows generated by the firm, whether or not
paid out as dividends.
Finally, to apply the residual income model, we compute the following amounts for Labrador:

(in $ per share) 2005 2006 2007 2008 2009
Net income* . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.20 $1.30 $1.40 $1.50 $ 1.65
Capital charge (10% of beg. book value*) . . . . . (0.50) (0.52) (0.55) (0.59) (0.64)
Residual income . . . . . . . . . . . . . . . . . . . . . . . . . $0.70 $0.78 $0.85 $0.91 $ 1.01
Gain on sale of equity to Pitbull (terminal value) $17.95 †

*Amounts taken from analyst’s projections.
† $25 $7.05.
Using the residual income model, we compute intrinsic value at the end of year 2004 as:

$0.70 $0.78 $0.85 $0.91 $1.01 $17.95
Intrinsic value $5.00 $19.31
(1.1) 1 (1.1) 2 (1.1) 3 (1.1) 4 (1.1) 5 (1.1) 5
All three models yield the same intrinsic value.