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The two-stage FCFE model is suitable for valuing firms that:
A) have very high but declining growth rate in the initial stage.
B) have moderate growth in the initial phase that declines gradually to a stable rate.
C) are in an industry with significant barriers to entry.
William Bolton is an avid disc golf player and the owner of Deep in the Game Discs (DITGD), a
business involved in wholesale distribution of discs and other disc golf equipment. DITGD
supplies smaller outlets within the U.S. market and exports overseas. Will has built his
business organically over a 20-year period, starting as a hobby but developing into a mid-
sized business.
Will has recently lost some UK export customers to a smaller UK located competitor called
Fishy Discs Ltd. Will recently met Neil Prebble, the owner of Fishy Discs at a trade fair and
was considering a friendly acquisition in order to expand his business into the UK market.
Will has employed an accountancy firm with a corporate finance division, to give him some
indication of a price to offer for Fishy Discs.
Exhibit 1: Fishy Discs—Selected Financial Information
Income Statement Period Ended 31st December 20x9
£
£
Sales revenue
200,000
Expenses:
Cost of goods sold
80,000
Salaries
10,000
Depreciation
14,000
Interest
1,000
105,000
95,000
Gain from sale of PP&E
20,000
Pre-tax income
115,000
Provision for taxes
40,000
Net income
75,000
Balance Sheet Year Ended 20x9
20x8
20x9
£
£
Current Assets
Cash
18,000
66,000
Accounts receivable
18,000
20,000
Inventory
14,000
10,000
Non-Current Assets
Gross PP&E
282,000
312,000
Accumulated depreciation (80,000) (84,000)
Total Assets
252,000
324,000
Current Liabilities
Accounts payable
10,000
18,000
Salaries payable
16,000
9,000
Interest payable
6,000
7,000
Taxes payable
8,000
10,000
Dividends payable
2,000
12,000
Non-Current Liabilities
Long term debt
20,000
30,000
Deferred tax
30,000
40,000
Stockholders' Equity
Contributed capital
100,000
80,000
Retained earnings
60,000
118,000
Liabilities and Equity
252,000
324,000
On review of the PP&E footnote disclosure, it is discovered that equipment with a carrying
value of £10,000 had been disposed of during 20x9.
All long-term debt is issued with a coupon such that the debt will trade at par value on
issuance.
The effective tax rate relating to Fishy Discs is 40%.
Deferred tax liabilities are not expected to reverse for the foreseeable future.
The corporate finance firm employed by Will has decided to value Fishy Discs based on
sustainable free cash flow, after removing one off items from the cash flow statement. In
addition, they have considered how long Fishy Discs will be able to maintain its cash flow
growth rates. Fishy Discs currently is the only domestically located UK supplier of disc golf
equipment. Their results are included in Exhibit 2.
Exhibit 2: Fishy Discs Ltd. Valuation Data
Free cash flow to the firm
£75,000
(base period estimate)
High growth rate
12%
Sustainable growth rate
4%
Duration of high growth
4 years
Declining growth duration
6 years
Cost of equity
10%
WACC
8%
The corporate finance team believes the market value of Fishy Discs debt is close to book
value in the 20x9 accounts. The team believes that the decline in growth from 12% down to
4% will be linear.
Tony Cermak is a young modeler in the corporate finance team and he has raised a couple
of comments regarding the valuation figures prepared for Fishy Discs.
Concern 1: Fishy Discs reduced its inventory between 20x8 and 20x9. This lead to a boost
of £4,000 in cash flows in 20x9. Given inventory, levels cannot decline below
zero and we are forecasting Fishy Discs to grow, any boost to cash flow from
inventory reduction is likely to be transitory and should be removed from
sustainable cash flow.
Concern 2: Fishy Discs current high growth rates are linked to an exclusivity agreement
that Prebble has with a U.S. disc producer. This agreement gives Fishy Discs
sole supplier status for the global number one selling brand in the UK for a
four-year period. At the end of this period, the U.S. supplier has indicated that
other firms will be allowed to import and retail these products in the UK
market. Given this, I believe our growth rate assumptions detailed in Exhibit 2
are unrealistic.
Tony has been given the firms free cash flow valuation model guide to study before he
attempts to value Fishy Discs. In particular, he is interested in the following formulas that
have been given:
Exhibit 3: Cash Flow Valuation Guide Extract
FCFF from EBIT:
FCFF = EBIT(1 – T) + depreciation – FCINV – WCINV
FCFF from EBITDA:
FCFF = EBITDA(1 – T) + depreciation – FCINV – WCINV