612 Making Key Strategic Decisions
ACME is estimated based on the net cash f lows in 2005 and then increasing
them by the estimated sustainable (long-term) earnings growth rate. For the
projection’s final year, items such as interest expense and depreciation need to
be stated at their stabilized ongoing amounts since the hypothetical new buyer
at December 31, 2005, is expecting to receive a stabilized annual net cash f low
using this residual value methodology. The result of this portion of the DCF
analysis is the estimated net cash f lows someone would expect ACME to earn
in 2006. The presumption is that the company will be sold at the end of 2005,
its earnings have stabilized, and a new owner can expect to receive the 2006
cash f lows.
A multiple is applied to ACME’s estimated 2006 net cash f low in order to
determine the residual value at the end of 2005. The multiple is based on the
inverse of the company’s weighted average cost of capital less the estimated
sustainable long-term earnings growth rate. This is called a capitalization rate
(or capitalization factor) and is illustrated:
Capitalization rate Discount rate Sustainable long-term earnings
growth ratePrice-earnings (P/E) multiple
Capitalization rate=−=^1EXHIBIT 18.6 ACME Manufacturing Inc.: Projected invested capital net
cash f lows 2001–2005.
($million)
2001 2002 2003 2004 2005
Projected after-tax income $4.35 $4.88 $5.44 $6.05 $6.65
Projected interest expense 1.04 1.10 1.14 1.21 1.28
Tax shield of interest expense (0.42) (0.44) (0.45) (0.48) (0.51)
Common stock dividend adjustment (0.30) (0.26) — — —
Projected depreciation/amortization 0.88 1.01 1.14 1.29 1.43
After-tax gross cash f low to invested capital 5.55 6.28 7.26 8.06 8.86
±Increase/decrease in working capital
(excluding interest-bearing ST debt) (0.54) (0.63) (0.65) (0.72) (0.73)
±Increase/decreasein investments (2.80) (2.94) (3.09) (3.24) (3.40)
±Increase/decreasein other assets (0.13) (0.15) (0.16) (0.18) (0.20)
±Increase/decreasein other liabilities —————
Cash available for financing 2.08 2.57 3.37 3.92 4.53
−Preferred stock dividends —————
Net cash f low 2.08 2.57 3.37 3.92 4.53
+Beginning cash balance 0.04 0.20 0.20 0.20 0.20
Preliminary cash available 2.12 2.77 3.57 4.12 4.73
−Minimum required cash balance (0.20) (0.20) (0.20) (0.20) (0.20)
Available for dividend to invested capital,
net free cash f low $1.92 $2.57 $3.37 $3.92 $4.53