Financial Reporting Financial Statement Analysis and Valuation a strategic perspective

By: James M. Wahlen, Stephen P. Baginski, Mark Bradshaw(Author)

Edition: 9th edition

Stakeholders
A person, group or organization that has interest or concern in an organization. Stakeholders can affect or be affected by the organization's actions, objectives and policies. Some examples of key stakeholders are creditors, directors, employees,...
Balance Sheet
Balance sheet is a statement of the financial position of a business that list all the assets, liabilities, and owner’s equity and shareholder’s equity at a particular point of time. A balance sheet is also called as a “statement of financial...
Cost Of Capital
Cost of capital refers to the opportunity cost of making a specific investment . Cost of capital (COC) is the rate of return that a firm must earn on its project investments to maintain its market value and attract funds. COC is the required rate of...
Discount Rate
Depending upon the context, the discount rate has two different definitions and usages. First, the discount rate refers to the interest rate charged to the commercial banks and other financial institutions for the loans they take from the Federal...
Expected Return
The expected return is the profit or loss an investor anticipates on an investment that has known or anticipated rates of return (RoR). It is calculated by multiplying potential outcomes by the chances of them occurring and then totaling these...
Free Cash Flow
Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the...

Question:

In Integrative Case 10.1, we projected financial statements for Walmart Stores, Inc. (Walmart), for Years +1 through +5. In this portion of the Walmart Integrative Case, we use the projected financial statements from Integrative Case 10.1 and apply the techniques learned in this chapter to compute Walmart's required rate of return on equity and share value based on the free-cash flows valuation models. We also compare our value estimate to Walmart's share price at the time of the case development to provide an investment recommendation.

The data in Exhibits 12.17 to 12.19 include the actual amounts for fiscal 2015 and the projected amounts for Year +1 to Year +5 for the income statements, balance sheets, and statements of cash flows for Walmart (in millions). These forecast amounts assume Walmart will use implied dividends as the financial flexible account to balance the balance sheet. The market equity beta for Walmart at the end of 2015 was 1.00. Assume that the risk free interest rate was 3.0% and the market risk premium was 6.0%. Walmart had 3,162 million shares outstanding at the end of fiscal 2015, and a share price of $67.50.

REQUIRED:

Part I

Computing Walmart's Share Value Using Free Cash Flows to Common Equity Shareholders

In Integrative Case 10.1, we projected financial statements for Walmart In Integrative Case 10.1, we projected financial statements for Walmart

  • c. Project the continuing free cash flow for common equity shareholders in Year +6. Assume that the steady-state, long-run growth rate will be 3% in Year +6 and beyond. Project that the Year +5 income statement and balance sheet amounts will grow by 3% in Year +6; then derive the projected statement of cash flows for Year +6. Derive the projected free cash flow for common equity shareholders in Year +6 from the projected statement of cash flows for Year +6.
  • d. Using the required rate of return on common equity from Requirement a as the discount rate, compute the sum of the present value of free cash flows for common equity shareholders for Walmart for Years +1 through +5.
  • e. Using the required rate of return on common equity from Requirement a as a discount rate and the long-run growth rate from Requirement c, compute the continuing value of Walmart as of the start of Year +6 based on Walmart's continuing free cash flows for common equity shareholders in Year +6 and beyond. After computing continuing value as of the start of Year +6, discount it to present value at the start of Year +1.
  • f. Compute the value of a share of Walmart common stock.

      (1) Compute the total sum of the present value of all future free cash flows for equity shareholders.

      (2) Adjust the total sum of the present value using the midyear discounting adjustment factor.

      (3) Compute the per-share value estimate.

Part II

Computing Walmart's Share Value Using Free Cash Flows to All Debt and Equity Stakeholders

  • g. Compute the weighted-average cost of capital for Walmart as of the start of Year +1. At the end of fiscal 2015, Walmart had $50,034 million in outstanding interest bearing debt on the balance sheet and no preferred stock. Assume that the balance sheet value of Walmart's debt is approximately equal to the market value of the debt. Assume that at the start of Year +1, Walmart will incur interest expense of 5.0% on debt capital and that Walmart's average tax rate will be 32.0%. In addition, at the end of fiscal 2015, Walmart had non controlling interests of $3,065 million, with an expected return of 12.6%. (For our forecasts, we assume non controlling interests receive dividends equal to the required rate of return each year.)

  • h. Beginning with projected net cash flows from operations, derive the projected free cash flows for all debt and equity Stakeholders for Walmart for Years +1 through +5 based on the projected financial statements.

  • i. Project the continuing free cash flows for all debt and equity Stakeholders in Year +6. Use the projected financial statements for Year +6 from Requirement c to derive the projected free cash flow for all debt and equity Stakeholders in Year +6.

  • j. Using the weighted-average cost of capital from Requirement g as a discount rate, compute the sum of the present value of free cash flows for all debt and equity Stakeholders for Walmart for Years +1 through +5.

  • k. Using the weighted-average cost of capital from Requirement g as a discount rate and the long-run growth rate from Requirement c, compute the continuing value of Walmart as of the start of Year +6 based on Walmart's continuing free cash flows for all debt and equity Stakeholders in Year +6 and beyond. After computing continuing value as of the start of Year +6, discount it to present value as of the start of Year +1.

  • l. Compute the value of a share of Walmart common stock.

      (1) Compute the total value of Walmart's net operating assets using the total sum of the present value of free cash flows for all debt and equity Stakeholders (from Requirements j and k).

      (2) Subtract the value of outstanding debt to obtain the value of equity.

      (3) Adjust the present value of equity using the midyear discounting adjustment factor.

      (4) Compute the per-share value estimate of Walmart's common equity shares.

Do not be alarmed if your share value estimate from Requirement f is slightly different from your share value estimate from Requirement l. The weighted-average cost of capital computation in Requirement g used the weight of equity based on the market price of Walmart's stock at the end of fiscal 2015. The share value estimates from Requirements f and l likely differ from the market price, so the weights used to compute the weighted-average cost of capital are not internally consistent with the estimated share values.

Part III

Sensitivity Analysis and Recommendation

    m. Using the free cash flows to common equity shareholders, recompute the value of Walmart shares under two alternative scenarios.

      Scenario 1: Assume that Walmart's long-run growth will be 2%, not 3% as before, and assume that Walmart's required rate of return on equity is one percentage point higher than the rate you computed using the CAPM in Requirement a.

      Scenario 2: Assume that Walmart's long-run growth will be 4%, not 3% as before, and assume that Walmart's required rate of return on equity is one percentage point lower than the rate you computed using the CAPM in Requirement a. To quantify the sensitivity of your share value estimate for Walmart to these variations in growth and discount rates, compare (in percentage terms) your value estimates under these two scenarios with your value estimate from Requirement f.

    n. Using these data at the end of fiscal 2015, what reasonable range of share values would you have expected for Walmart common stock? At that time, what was the market price for Walmart shares relative to this range? What would you have recommended?


Answer:


The market equity beta for Walmart at the end of 2015 is 1.00. Assume that the risk-free interest rate is 3.0% and the market risk premium is 6.0%. Walmart has 3,162 million shares outstanding at the end of 2015, and the share price was $67.50.

Part I-Computing Walmart's Share Value Using Free Cash Flows to Common Equity Shareholders

a.

Following the CAPM, Walmart faces a required rate of return on equity capital of
9.0% at the end of Year 4. This rate is computed as follows:

E[RWMT]  = E[RF] + βWMT × E[RM - RF]

=    3.0% + (1.0 × 6.0%)
=    9.0%

b.

Exhibit 12.D presents the excerpts from FSAP for the valuation of Walmart based on projected free cash flows to common equity. The first rows of the table present the computations for Walmart's projected free cash flows for common equity shareholders for Years +1 through +5. The right-most column contains the projected free cash flows for common equity shareholders in Year +6 based on the projected Year +6 financial statements, assuming 3.0% long-run growth. The remaining rows of the table include discounting the free cash flows for Years +1 through +5 to present value, computing continuing value, and computing share value. The share value estimate is $86.88, which is identical to the estimate using the dividends model


Projected free cash flows for common equity shareholders in Years +1 to +5 are as follows:

 

Net Cash Flows from Operations


+(–) Decr. (Incr.) in Cash Required for Operations


Net Cash Flow from Investing


Net Cash Flows from Debt Financing Net Cash Flows for Non controlling Interests


Free Cash Flows for Common Equity

 



Year +1


Year +2


Year +3


Year +4


Year +5


$ 24,405.8

$ 26,032.3

$ 26,837.2

$ 27,635.8

$ 28,439.8



0.0


0.0


0.0


0.0


0.0



(10,456.5)


(10,465.7)


(10,475.0)


(10,484.5)


(10,494.2)



1,501.0


1,546.1


1,592.4


1,640.2


1,689.4



(386.2)


(386.2)


(386.2)


(386.2)


(386.2)


$ 15,064.1

$ 16,726.5

$ 17,568.5

$ 18,405.3

$ 19,248.9

 

c.   

Projected free cash flows for common equity shareholders in Year +6 are as follows:




Year +6

Net Cash Flows from Operations

$20,961.3

+(–) Decrease (Increase) in Cash Required for Operations

(261.2)

Net Cash Flow from Investing

(7,897.7)

Net Cash Flows from Debt Financing

1,740.1

Net Cash Flows for Non controlling Interests

(305.8)

Free Cash Flows for Common Equity


$14,236.8


d.

The data in Exhibit 12.D show that the sum of the present value of free cash flows for common equity for Walmart for Years +1 through +5, discounted at 9.0%, is $67,013.9 million.


e.

The data in Exhibit 12.D show that the present value at the start of Year +1 of the continuing free cash flows for common equity in Years +6 and beyond amounts to $154,215.2 million [= $14,236.8/(0.090 – 0.03) × 0.650]. (Allow for rounding. The actual present value factor used in Excel is 0.649931.)


f.

The data in Exhibit 12.D show the following computations:


(1)

The sum of the present value of free cash flows for common equity is $221,229.2 million = ($67,013.9 million + $154,215.2 million).


(2)

After adjusting the sum of the present value using the midyear discounting adjustment factor of 1.0450 = (1 + .090/2), the total present value of free cash flows for common equity is $231,184.5 million.


(3)

The per-share value estimate for Wal-Mart, after dividing the total present value by the 3,162 million shares outstanding, equals $73.11.

Exhibit 12.D

Free-Cash-Flows-Based Valuation of Walmart Stores

(amounts in millions except per share amounts)



Part II—Computing Walmart’s Share Value Using Free Cash Flows to All Debt and Equity Stakeholders


g.

Walmart’s capital structure at the end of 2015 consists of the following amounts and proportions:



The equation presented in Chapter 12 for computing weighted average cost of capital is as follows:


RA = [wD × RD × (1 – tax rate)] + [wP × RP] + [wE × RE] + [wNCI × RNCI]


Using this equation, Walmart’s weighted average cost of capital at the end of 2015 is computed as follows:


RA = [0.178 × 0.050 × (1 – 0.320)] + [0.811 × 0.090] + [0.011 × 0.1259]
     = 0.604 + 7.297 + 0.147
     = 8.047%



Exhibit 12.E presents the excerpts from FSAP for the valuation of Walmart based on projected free cash flows to all debt and equity stakeholders. The first rows of the table present the computations for Walmart’s projected free cash flows for all debt and equity stakeholders for Years +1 through +5. The right-most column contains the projected free cash flows for all debt and equity stakeholders in Year +6 based on the projected Year +6 financial statements, assuming 3.0% long-run growth. The remaining rows of the table include discounting the free cash flows for Years +1 through +5 to present value discounted using the weighted-average cost of capital from Part g, computing continuing value, and computing share value. The share value estimate is $72.58, which differs slightly from the value estimate of $73.11 in Part f above.


In computing weighted-average cost of capital in Part g, we determined the weight of equity using the market price of Walmart’s stock at the time. Our share value estimates from Parts f and l differ from the market price, so the weights we used to compute the weighted -average cost of capital are not internally consistent with the share values we have estimated. In addition, we hold the weighted-average cost of capital constant over time, even though our forecasts project that the debt-equity weights will change.



h.

Projected amounts of free cash flows for all debt and equity stakeholders in Years +1 through +5 are as follows: 


i.

Projected free cash flows for all debt and equity stakeholders in Year +6 are as follows:


Net Cash Flow from Operations

Year +6


$20,961.3


Add Back: Interest Expense after Tax

2,001.7


Subtract: Interest Income after Tax

0.0


+(–) Decr. (Incr.) in Cash Required for Operations

(261.2)


Free Cash Flow from Operations

$22,701.8


Net Cash Flow from Investing

(7,897.7)


Add Back: Cash Flows into Financial Assets

0.0


Free Cash Flow—All Debt and Equity


$14,804.2







j.

The data in Exhibit 12.E show that the sum of the present value of free cash flows for all debt and equity stakeholders for Walmart for Years +1 through +5, discounted at a weighted-average cost of capital of 8.047%, is $71,265.2 million. You could query students about whether the free-cash-flows model correctly measures the value being added by Walmart’s operations during this period. The answer, of course, is no because the model places emphasis on the cash outflows for growth in assets and does not yet include all of the cash flows that Walmart will realize from this growth, which will occur in future years.


k.

The data in Exhibit 12.E show that the present value at the start of Year +1 of the continuing free cash flows for all debt and equity stakeholders in Years +6 and beyond amounts to $199,171.7 million = [($14,804.2 million/(0.08047 – 0.03)) × 0.679]. (Allow for rounding.)


l.

The data in Exhibit 12.E show the following computations:


(1)

The sum of the present value of free cash flows for all debt and equity stakeholders is $270,436.9 million = ($71,265.2 million + $199,171.7 million).


(2)

Subtracting the value of debt and noncontrolling interests provides the present value of common equity, which is $220,633.9 million = ($270,436.9 million – $46,738.0 million – $3,065.0 million).


(3)

After adjusting the sum of the present value using the midyear discounting adjustment factor of 1.0402 = (1 + 0.08047/2), the total present value of free cash flows for all debt and equity stakeholders is $229,511.7 million.


(4)

The per-share value estimate for Walmart, after dividing the total present value by the 3,162 million shares outstanding, equals $72.58.


Exhibit 12.E

Free-Cash-Flows-Based Valuation of Walmart Stores

(amounts in millions except per share amounts)



Part III—Sensitivity Analysis and Recommendation


m.

The data in Exhibit 12.F show the results of various sensitivity analysis scenarios, varying discount rates and growth rates.


Scenario 1:

If we assume that Walmart’s long-run growth will be 2%, not 3% as above, and that Walmart’s required rate of return on equity is one percentage point higher than the rate computed using the CAPM in Part a (that is, 10.0%), the resulting share value estimate falls to $59.75 per share. That amount is 18% lower than our base case estimate of $73.11, and 11% lower than the current market price of $67.50.


Scenario 2:

If we assume that Walmart’s long-run growth will be 4%, not 3% as above, and that Walmart’s required rate of return on equity is one percentage point lower than the rate computed using the CAPM in Part a (that is, 8.0%), the resulting share value estimate increases to $99.30 per share. That amount is 36% greater than our base case estimate of $73.11 and 47% greater than the current share price of $67.50.


n.

At the start of Year +1, Walmart’s share price was $67.50. Our baseline share value estimate is $73.11, implying that Walmart shares are under priced by roughly 8%. Sensitivity analysis reveals that slight variations in the long-term growth rate and discount rate can cause the share value estimate to vary between $59 per share (11% below the current price) up to $99 per share (47% above the current price). If our forecast and valuation assumptions are reasonable, the current share price falls in the bottom half of this value estimate range. We would have concluded that Walmart shares are slightly under priced at roughly $67.50; therefore, we would have recommended a buy.

Exhibit 12.F
Free-Cash-Flows-Based Valuation of Walmart Stores—Sensitivity Analyses