FIN 6806 Tech Geek Interested in Establishing a Valuation Estimate Analysis

Description

1. Tech Geek is interested in establishing a valuation estimate and how this estimate was arrived at for their firm. Tech Geek is a constant growth perpetuity with for last year equal to $250M. The growth rate in their has been constant at 4% annually for several years now and is expected to remain so into the future. Tech Geek is financed with 50% debt and 50% equity. Their outstanding debt, originally issued in $1,000 increments, is trading at $800 with 10 years remaining, on average. The debt was originally issued at a coupon rate of 10% annually. Tech Geek equity is also publicly traded. Currently, the standard deviation of the returns on the market portfolio is 12% ( . The covariance between the returns on Tech Geek equity and the returns of the market portfolio is 2.16% (. Finally, the current and
Tech Geek has hired us to explain the valuation process for their firm and provide a current estimate of the overall value of Tech Geek.
2. Tech Geek likes to use IRR (Internal Rate of Return) as their main methodology for answering capital budgeting questions. Explain to Tech Geek why NPV (Net Present Value) is the superior capital budgeting methodology taking care to note the specific problems of nonconventional cash flows and mutually exclusive projects and the use of IRR.
3. Tech Geek has heard this all before about capital budgeting and has shifted to using Modified IRR for its capital budgeting decision making in response. Provide examples and explain to Tech Geek why Modified IRR has its on set of problems when it comes to capital budgeting.

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2019
Assets
Current Assets
Cash
$34,000
Accounts Receivables
$36,200
Inventory
$66,432
Total Current Assets $136,632
Fixed Assets
Net PP&E
Total Assets
OCF
Capex
Change NWC
CFFA
CAPM
Rf
MRP
Beta
E(R)
$84,338
$220,970
$77,274
$53,337
($8,462)
$32,399
2.50%
7.50%
1.9
16.75%
ITech Geek
2018 & 2019 Balance Sheet
2020
2019
Liabilities
Current Liabilities
$43,461
Accounts Payable $44,000
$54,950
Notes Payable
$20,000
Total Current Liabilities
$79,159
$64,000
Long-term Liabilities $106,000
$177,570
Total Liabilities
$170,000
Stockholder’s Equity
Common Stock
$125,159
$23,970
Retained Earnings
$27,000
Total Stockholder’s Equity $50,970
$302,729
Total Liabilities + Equity $220,970
CF creditors
CF stockholders
CFFA
$6,000
$26,399
$32,399
2020
$80,000
$33,400
$113,400
$110,000
$223,400
$24,950
$54,379
$79,329
$302,729
ITech Geek
2019 Income Statement
Revenue
$180,030
Cost of Goods Sold
$84,503
Depreciation
$12,516
Earnings before Interest & Tax
$83,011
Interest Paid
$10,000
Taxable Income
$73,011
Taxes (τ = 25%)
$18,253
Net Income
$54,758
Dividends
Addition to RE
$27,379.13
$27,379.13
COGS Margin
D/E
Current ratio
46.9%
0.74
1.57
Question 1:
Tech Geek is interested in establishing a valuation estimate and how it was arrived at for their
firm. Tech Geek is constant growth perpetuity with 0 for last year equal to $250M. The
growth rate in their has been constant at 4% annually for several years now and is
expected to remain so into the future. Tech Geek is financed with 50% debt and 50% equity.
Their outstanding debt, originally issued in $1,000 increments, is trading at $800 with 10 years
remaining, on average. The debt was originally issued at a coupon rate of 10% annually. Tech
Geek equity is also publicly traded. Currently, the standard deviation of the returns on the
market portfolio is 12% ( = .12). The covariance between the returns on Tech Geek equity
and the market portfolio returns is 2.16% ( , ℎ = .0216). Finally, the current = 2%
and ( ) = 5%.
Tech Geek Financial Statements Analysis.
A review of the income statement reveals that the cogs equal 47% of the total revenuesTech Geek Incorporation. This information suggests that Tech Geek right on track with nearly
half of its stocks being the reason for profitability and revenue generation.
On the other hand, leverage ratios like the debt-to-equity ratio implore that the firm is
cautiously handling most of its debts, good for its stability.
Debt to Equity ratio = Current Debts + Long Term Debts / Shareholders Equity.
= 125,221/322,569
= 0.388
On the part of liquidity, the Current Ratio can be determined using the formula:
Current Ratio = Current Assets/ Current Liabilities
= 177,570/113,400
= 1.565
This is a fair current ratio value suggesting the business is paying its debtors and investors
within the required time. The business can meet its debt obligations.
In the case of the stock or asset turnover, we review Tech Geeks Turnover ratio using the
formula below:
Net Turnover Ratio = Total Revenues/ Total Assets
Total Revenues = 180,030
Total Assets = 302,569
= 180,030/302,569
= 0.595
The ratio resulting from the calculation above represents the turnover ratio for Tech Geek’s
stocks. This suggests that Tech Geek makes revenue and replaces half the entire stock it
possesses in a trading period. This tells us the company has a stable supply of clients and
customers who purchase its services and products.
The following attachments show Forecasted Income Statements and Balance sheets for Tech
Geek Incorporation.
I: Balance Sheet as of 2019 and 2020.
The current ratio for Tech Geek advises that the business has a relatively viable
possibility of settling its debtors. Out of a possible one hundred percent of repaying its debts, the
firm has a probability of 56% to repaying its debts. The current ratio is composed of two
significant variables from the Balance sheet.
1.
Current Assets are made up of Cash balances, accounts receivables, and
Inventories.
2.
Current Liabilities comprise accounts payable and notes payables.
Linking the two variables gives us the current ratio for Tech Geek that we can use to evaluate the
company’s debt settlement capabilities. The assessment of the current ratio contains the most
recent balance sheet values for the company. The balance sheet below was important in
calculating the current ratio for Tech Geek.
Assets
Current Assets
Cash
Accounts Receivables
Inventory
Total Current Assets
Fixed Assets
Net PP&E
Total Assets
OCF
Capex
Change NWC
CFFA
ITech Geek
2019 & 2020 Balance Sheet
2019
2020
Liabilities
Current Liabilities
$34,000
$43,461
Accounts Payable
$36,200
$54,950
Notes Payable
Total Current
$66,432
$79,159
Liabilities
$136,632 $177,570
Long-term Liabilities
Total Liabilities
$84,338
$220,970
$77,274
$53,337
($8,462)
$32,399
$125,159
$302,729
2019
2020
$44,000
$20,000
$80,000
$33,400
$64,000
$113,400
$106,000
$170,000
$110,000
$223,400
$23,970
$27,000
$24,950
$54,379
$50,970
$79,329
Total Liabilities + Equity
$220,970
$302,729
CF creditors
CF stockholders
CFFA
$6,000
$26,399
$32,399
Stockholder’s Equity
Common Stock
Retained Earnings
Total Stockholder’s
Equity
ITech Geek
2019 Income Statement
Revenue
$180,030
Cost of Goods Sold
Depreciation
Earnings before Interest &
Tax
Interest Paid
$84,503
$12,516
$83,011
$10,000
Taxable Income
$73,011
Taxes (τ = 25%)
$18,253
Net Income
$54,758
Dividends
Addition to RE
$27,379.13
$27,379.13
ITech Geek
Income Statement
Year Ending 2020
Net Sales
COG’s
Depreciation
EBIT
Interest paid
Taxable income
$
$
$
$
$
$
180,030
84,503
200
95,327
10,000
85,327
Taxes
Net income
Additional Retained
earnings
Dividends paid
$
$
21,332
63,996
$
$
31,998
31,998
II: Income Statement Analysis
Its revenues have positively impacted the general analysis of Tech Geek for the year
2020. Using Net Sales as base values for the analysis, we see that the companies rate of asset
depreciation is approximately 0.005 percent of the revenues. Forty-seven percent of the revenues
are what the firm uses as cash for the cogs. This implies that there is huge demand in the market
for the organization’s goods and services, or the firm has a colossal market share containing loyal
customers.
Taking the Cogs as a percentage of Net Sales = (COG’s/Net Sales) x 100
= (84,503/180030) x 100
= 0.4693 x 100
=46.93%
ITech Geek
Capital Spending
Year Ending 2020
Ending fixed assets $
124,999
Beginning fixed
assets
$
84,338
Depreciation
$
200
Captial Spending
$
40,861
ITech Geek
Cash Flows From Assets
Year Ending 2020
Operating cash
flows
$
73,796
Capex
$
40,861
NWC
CFFA
$
$
-8,462
41,397
At the end of the trading period of the fiscal year 2020, the firm’s fixed assets make up
69% of the total revenues of Tech Geek Incorporation. The Cash Flow Capex value confirms the
argument that Tech Geek derives most of its monies from the internal sales as the cogs.
Beginning of the fiscal period, fixed assets were at a rate of 46.8% of the company’s revenues.
This shows a distinguished increase in the fixed assets for the firm. Therefore an expanding
business model, which is mainly a result from operating profits.
The calculations above are as shown below:
Percentage of Assets Starting of Fiscal Year 2020= (Beginning Fixed Assets/Net Sales) x 100
= (84,338/180,030) x 100
= 0.4684 x 100
= 46.84%
Percentage of Assets Ending Fiscal Year 2020 = (Ending Fixed Assets/ Net Sales) x 100
= (124,999/180,030) x 100
= 0.6943 x 100
= 69.43%
ITech Geek
Cash Flows
Year Ending 2020
Earnings Before Interest and Taxes
(EBIT)
$
95,327
Depreciation
$
200
Taxes
Operating cash flows
Ending new working capital
Starting NWC
Change in NWC
$
$
$
$
$
21,332
73,796
64,170
72,632
-8,462
III: Changes in Net Working Capital.
The changes in net WC come to attention. The change in working capital is a negative
number, i.e.,(8,462) which proposes the firm is heavily building its new investments in current
assets at the cost of reducing a large portion of its current liabilities. In addition, Tech Geek may
have a credit policy that tightens its further potentials of borrowing. Tech Geek favours paying
its current debts off before taking on other credit facilities in the future. This decreases the
accounts receivables amount and provides cash for the firm to make other open investments in
current assets.
IV: CAPM Evaluation.
In this study our goal to assess the returns that are anticipated from the business’s operations.
Also, we examine the rate of risks that are attached to the securities before an investment move is
made. Then we describe the relationship between the returns from the investment opportunity
and attached risks to portfolio securities. The model compares the expected return to the risk-free
rate of return with an additional premium value based on the beta value for the portfolio.
In order to calculate the expected security returns using CAPM we have to make some
assumptions. First, we assume ITech Geek is operating in the United States and the ten-year
treasury yield at 2.5% applies.
The table below shows expected returns by CAPM model.
Expected Return of a Tech Geek using CAPM formula
U.S. 10-year treasury Yield
Annual excess return for stocks
Beta/Sensitivity
2.50%
7.50%
1.9
Expected Return
16.75%
CAPM = U.S Treasury Yield/ Risk-Free Rate + (Sensitivity/Beta x Excess stock return/ Risk
premium)
= 2.5% + (1.90 x 7.50%)
= 17%
Question 2:
Tech Geek likes to use IRR (IRR) as their primary methodology for answering capital budgeting
questions. Explain to Tech Geek why NPV (NPV) is the superior capital budgeting methodology
taking care to note the specific problems of non-conventional cash flows and mutually exclusive
projects and the use of IRR.
Solution.
Tech Geek’s decision to ensure that its value is assessed using capital budgeting is an
essential idea for the company’s managers. Besides, this idea is vital for the economy due to its
involvement in massive projects with a considerable base of required capital for initiation.
Companies can use the methodology of NPV (NPV) and IRR (IRR) as the primary methods of
evaluating the company value with the investment opportunity available. In addition to this, there
can be the use of a Payback Period and an assessment of Profitability Indices and the Accounting
Rate of Return when evaluating the projects, they look forward to investing into.
In the process where Tech Geek initiates an appraisal of investment projects, preference
is derived towards the IRR, Payback Period (PB), and NPV as primary methods used in defining
the current capital investment projects’ viability. Among the three advised methodologies, NPV
is seen as the most adhered and used methodology in evaluating projects. NPV (NPV) is
commonly used because it takes care of the changing value of real money with relation to time, it
adjusts for risks associated with the investment opportunities.
As is with the company policy, there should be a model to highlight the risks associated
with the projects and outline the necessary changes in the value of money to inflation rates and
other fiscal impacts on the value of money. Tech Geek managers should be in the liking of the
IRR model from the fact that the model helps them consider the actual return of each project. It
is a good model that helps a company- Tech Geek rank projects based on the projects’ risks. On
the other hand, the payback period model is used to make it easy to calculate and evaluate the
results into an understandable figure.
Both models and measurements of (IRR) and (NPV) are majorly used to evaluate capital
budgets for firms. By calculation, NPV refers to the difference that is arrived at when there is
deduction of present inflows of cash value from the outflows for a specified period of time.
Contrastingly, the IRR (IRR) estimates profitability from a list of potential investment
opportunities to make for the firm. When an investment opportunity presents itself for a firm, it
is for the firm to make an informed decision and analysis of the investment opportunity before
deciding whether it will undertake the opportunity or not. The decision is ability of a corporate to
generate economic and financial profitability from the investment opportunity.
Before discussing the various merits that come with using the NPV model to evaluate an
investment’s profitability compared with the IRR model, we can look at the differences or
similarities between the two. First, both IRR and NPV are discounted cash flow methods
employed in the evaluation of investments and other capital budgets. For NPV, when the
resulting difference in cash inflows and cash outflows is above zero, the investment is viable and
worthy of initiating. IRR estimates the profits for projects in question using percentage values
rather than realistic dollar values as used in NPV.
Conflicts between NPV and IRR.
When analysing joint projects, we use both NPV model and the IRR. Resulting values
will have a similar indicator of whether the firm will agree or rule against the investment project.
In the process of comparing the projects, both models will result in conflicting values. There may
be a model like the NPV that will show a project with higher returns and low risks while the
other shows a lower value of the IRR values. Differences most of the time occur due to the
difference in cash inflow patterns into the company and corresponding cash outflows from the
firm for the mutually related projects.
The table below represents the idea discussed above. The point being driven is the idea of
using both models of IRR and NPV for joint projects. In this example, an assumption is made of
the discount rate where it is assumed to be ten percent.
YEAR
PROJECT X
PROJECT Y
0
(5000)
(5000)
1
2,000
0
2
2,000
0
3
2,000
0
4
2,000
0
5
2,000
15,000
NPV
2,581
4,314
IRR
30%
25%
The table above shows that Project X has a higher IRR (30%) than Project Y (25%). On
the other hand, the NPV of Project Y is higher than that of Project X. In the case where the two
projects are not mutual; the conflicting results wouldn’t matter because Tech Geek (The firm)
would have to take into account both projects. Furthermore, for mutually exclusive projects like
our case, the firm needs to make a long-lasting and informed decision on which of the two
conflicting projects the company would invest in the above situation. Where projects are
mutually dependent in an exclusive manner, the project resulting from the highest NPV should
be taken into account. This is due to the inherent assumption attached to reinvestment decisions
and opportunities. In the example above, our informed assumption is that the cash flows will be
available for reinvestment at the same rate equal to the discount rate of 10%. In the NPV
calculation, the informed discount rate at ten percent is compared to the IRR assumption rate at
an approximate value of 29% and 25%. The high reinvestment rate of the IRR seems unrealistic
compared to the rate of the NPV. This makes the NPV results reliable compared to the IRR
values. In our example, project Y should be taken into account.
An example of a mutually exclusive project is that the acceptance of one project means
that the other project is denied. The two models of NPV and IRR result in totally contradicting
results. A project manager for Tech Geek who is fond of IRR and prefers the model may be led
to accept a project proposal that the NPV model asks them to reject.
Conflicts between the two discounted cash flow methods happen due to the differences in
the capital amounts present for the proposed investment projects. The differences in timing and
how cash flows will be awarded to the investment opportunities are why there would be
conflicting information or results from the two capital budgeting models. When the project faces
difficulty in making decisions, there is a fast decision that should be made between jointly
contending projects. Therefore, this is where the NPV methods save the project manager when it
comes to their decision-making process. The project to choose will have to be based on its
considerable net positive value. This will cut on the costs and the affordability of capital.
The functioning of the above models is based on the firm’s obligation of maximizing
stockholder’s equity. The best method to making sure stockholders are fascinated by the
enormous returns on their investments is by making sure that a choice is made on projects that
promise the highest NPV. This project will positively add to the share prices of a company and
help elevate the stockholders’ wealth.
Both models of NPV and IRR are functional capital budgeting tools. They, however, do
not resonate with their results as they can tell different results for two joint projects. This mostly
happens when joint projects have favourable choices. The Tech Geek project manager should
consider employing the NPV because it is the best model for mutually exclusive investment
opportunities.
Question 3:
Tech Geek has heard this before about capital budgeting and has shifted to using Modified IRR
for its capital budgeting decision-making in response. Provide examples and explain to Tech
Geek why Modified IRR has its own set of problems regarding capital budgeting.
While comparing the IRR (IRR) and NPV (NPV) gives the nod for the use of NPV. IRR
has numerous demerits, as it only measures the relative value created in a project or investment
opportunity. The IRR is difficult to evaluate, has predetermined assumptions that are unrealistic,
and is based on reinvestment making. Concerning NPV, the IRR delivers a zero return when
discounted on a sample investment portfolio.
Similar to the IRR, the Modified IRR (MIRR) makes the same assumptions in calculating
the value to be made from an investment opportunity. With MIRR, there is a single terminal
payment made. The model is applied for projects that have comparable levels of investment to
the NPV.
Example 1
An investment opportunity for Tech Geek worth $12,000 with cash returns at $4,400,
$6,500, and $1,300, respectively for three consecutive years. Assuming the cost of capital for
Tech Geek is 10%.
The table below shows the DCF, IRR, and NPV for the investment opportunity. From a
NPV perspective, the project is seemingly viable. The IRR also shows the same information
about its results from the value greater than Tech Geeks assumed cost of capital.
YEAR
0
1
2
3
Investment
Cash Flow
(12,000)
4,400
6,500
1,300
DCF
(12,000)
3063.6
4905.9
2205.4
NPV
IRR
850.0
15%
We can employ various methods in calculating the modified IRR.
By hand (traditionally)
Having the project’s cash flows in return phases with the first year being at the forward.
We compound single cash flows concerning Tech Geek’s cost of capital.
YEAR
0
1
2
3
Investment Cash
Flow ($)
(12,000)
4,400
6,500
1,300
Compounded
cash flow for
year 1 at 10%
4840
Compounded
cash flow for
year 2 at 10%
6600
Cash flow $
(modified)
(12,000)
11,440
Using the extended cash flow in year three, we calculate the discount rate required for a
discounted cash flow model equal to the firm’s outlay.
Therefore;
=
ℎ
(1 + )
We can make a rearrangement of the formula to find the solution for the project as follows:

ℎ
)−1
= √(

3
11440
Therefore; = √(12000) − 1 = 18 %
As noted in the example above, both models of IRR, NPV, and Modified IRR face a
problem that requires different capital investments. This is even major when the funds are
limited, and the projects are related to each other in a mutual order. The modified IRR cannot
provide a solution to mutually agreeing on projects on its own due to the complicated nature of
capital requirements and cash flow conflicts. The three models need to be adjusted using the
incremental analysis method. The problem can be made exemplary when an investment fund
needs past the initially agreed and forecasted period. The NPV is evaluated by hand, as done in
the example above. Using the discounted cash flow method, there is significant reduction in all
cash flows. However, the real cost of capital/ discount rate, is derived from an assumption
initially made out of the model’s discount rates. There is also a reserve that requires the financial
outlay to be separated from the main compounding of the formula used to calculate the modified
IRR. This is to secure the free cash flows but spare the initial cash flow back to the present value.
However, if the proposition happens, then the results from the free cash flow from the project
will be made up of both the investments and returns. The investment phase and the returns phase
returns will have been combined into one single entity.
Example 2
For complex capital-intensive projects. The modified IRR (MIRR) will have to employ
IRR techniques for reliable results initially. Not all of the firm’s projects have a good return
when initiated, as discussed within the conflicts between IRR and NPV. The problem sets in
when the firm’s project stretches beyond the realistic and forecasted phase of years. To ensure
that the problem is non-existent, we are required to divide the project’s forecasted cash flows into
two phases. One is a returns phase that defines the returns expected from the project and an
investment phase that outlines the investments and cash inflows into the firm.
For our project, we will assume that the investment project has an investment period
phase of a year which equals 12 months. The initial payment as an investment principal is $700,
and another value paid twelve months later at $300. The total investment made is thus equal to
$1,000. With the launch of the project and kicking it into operation, the initial return is expected
to kick off when the second-year ends. Moreover, the project needs to have a return or payback
of $400, $600, and finally $300 in the corresponding years that is 3 and 4. Like previously, there
is an assumption that the capital cost is rated at ten percent, just like the project’s discount rate.
Investing Phase
Return Phase
YEAR
0
1
2
3
4
Cash Flow of the Project
(700)
(300)
400
600
300
Modified Cash Flow
(700)
(273)
484
660
300
Investment Phase Present Value
(972)
Return Phase- Future Value
Return Phase Present Value
1,444
986
331
451
205
The resulting IRR is 10.6%.
An evaluation of the investment phase returns in the years 0 to 4 for the projects cash flow is
shown in the above table. When this is modified, the cash flow is shown in the column below the
real values for the project’s cash flows. Using the Modified IRR model. The cash flow (modified)
is evaluated using a reduced method of cash flow. The investment phase of the project is
discounted at the assumed rate of 10%. This results in a Present Value (PV) of $973 as capital
investments. When the return phase is compounded rather than capitalized, the terminal cash
flow gets us $1444. Therefore, the modified IRR is conversely evaluated as follows:

ℎ
)−1
= √(

4
1444
)−1
= √(
973
MIRR= 10.4%
Conclusively, using MIRR is relatively quick in making calculations of IRR. There is,
however, a confusing ideology on the reinvestment rates that are applicable for projects. There is
an assumption for IRR and NPV models with reference to investment opportunity generating
cash flows which are ploughed back to the project to strengthen it. One major disadvantage of
the modified IRR for a project is that it implicates the project’s capability to generate cash flows
in liaison with the forecasted value of the NPV. This is most of the time overstated. The only
merit for the modified IRR is that it is conventionally easier to calculate and evaluate. However,
this is a little gain compared to the loss in the financial significance attached to project valuation.
Therefore, financial outlay should be excluded from calculating the modified IRR using
cash flows discounted at a value equal to the marginal cost of involved capital since the marginal
capital cost defines the sundry cost of obligations being financed to the capital providers for the
project. The NPV (NPV) is usually non-inclusive of the idea because all of its cash flows are
initially discounted before they’re included in the calculation. On the other hand, the IRR (IRR)
fails to attend to outlays because the impromptu timing of cash flows dictates it. The modified
IRR (IRR), on the other hand, makes a discounted value of the negative cash flows and reverses
them back to the present (backdating). This is done using the MIRR model even when the cash
flow statements’ values are both negative and cynical. Therefore, there is a need for the
company- Tech Geek to make an underlying difference between the two models and how they
will have to handle outlays and the corresponding values of the operating cash flows.
Modified IRR (MIRR) is only a good measure of the “best looking” project, depending
on its vast returns. Still, it gives little attention to the risks associated with the projects on the
business itself. Executives who need to understand a specific project’s dynamics will move away
from such a model and embrace the NPV (NPV) instead.

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