CorporateFinanceSixthEditionChapter19ValuationandFinancialModeling:ACaseStudyCopyright?2024,2021,2018PearsonEducation,Inc.AllRightsReservedChapterOutline19.1 ValuationUsingComparables19.2 TheBusinessPlan19.3 BuildingtheFinancialModel19.4 EstimatingtheCostofCapital19.5 ValuingtheInvestment19.6 SensitivityAnalysisLearningObjectives(1of3)Describetheuseofcomparablesasapreliminarywaytoestimatefirmvalue.Identifytheprimaryfactorstoconsiderwhenestimatingthefirm’sfuturecashflows.Describetheuseofafinancialmodelinprojectingfuturecashflowsfromaninvestment.LearningObjectives(2of3)UsetheCAPMtoestimatetheequitycostofcapitalforaproposedproject,usingbetasofcomparablefirms.Useavaluationmultipletoestimatethecontinuationvalueforafirmoraproject.Usethediscountedcashflowmethodtoestimateacontinuationvalueforafirmoraproject.UsethevaluationmethodsdescribedinChapter18tocalculatefirmvalue.LearningObjectives(3of3)DiscusstheuseofIRRandcashmultiplesasalternativevaluationmetrics,anddiscussthedrawbacksofthosemethods.CalculateIRRandcashmultiplesforagivenfirmorproject.Describetheuseofsensitivityanalysisinevaluatingtheuncertaintyofthevalueofthedeal.19.1ValuationUsingComparables(1of2)ConsiderIdekoCorporation,aprivatelyheldfirm.TheownerhasdecidedtosellthebusinessYourjob,asapartnerinKKPInvestments,istoevaluatepurchasingthecompany,implementingoperationalandfinancialimprovements,andsellingthebusinessattheendoffiveyearsTable19.1Estimated2005IncomeStatementandBalanceSheetDataforIdekoCorporationTable19.2IdekoFinancialRatiosComparison,Mid-2005RatioIdeko(Proposed)Oakley,Inc.LuxotticaGroupNike,Inc.SportingGoodsIndustryPoverE.21.6x.24.8x.28.0x.18.2x.20.3x.EVoversales.2.0x.2.0x.2.7x.1.5x.1.4x.EVoverEBITDA.9.1x.11.6x.14.4x.9.3x.11.4x.EBITDAoversales.21.7%17.0%18.5%15.9%12.1%19.1ValuationUsingComparables(2of2)Apriceof$150millionforIdeko’sequityhasbeensuggestedThedatainthepreviousslideprovidessomereassurancethattheacquisitionpriceof$150millionisreasonableastheratiosareaboutthesameorbetterthantheindustryaveragesHowever,toassesswhetherthisinvestmentisattractive,theoperationalaspectsofthefirmandoftheultimatecashflowsthedealisexpectedtogenerateneedtobeanalyzedTextbookExample19.1(1of2)ValuationbyComparablesProblemWhatrangeofacquisitionpricesforIdekoisimpliedbytherangeofmultiplesforandinTable19.2?TextbookExample19.1(2of2)SolutionForeachmultiple,wecanfindthehighestandlowestvaluesacrossallthreefirmsandtheindustryportfolio.ApplyingeachmultipletothedataforIdekoinTable19.1yieldsthefollowingresults:Forexample,Nikehasthelowestmultipleof18.2.MultiplyingthisbyIdeko’searningsof$6.94milliongivesavalueofThehighestmultipleofenterprisevaluetosalesis2.7(Luxottica);atthismultiple,Ideko’senterprisevalueisAddingIdeko’sexcesscashandsubtractingitsdebtimpliesapurchasepriceofThetableabovedemonstratesthatwhilecomparablesprovideausefulbenchmark,theycannotberelieduponforapreciseestimateofvalue.AlternativeExample19.1(1of2)ProblemBuyMore,Inc.(BMR)hasanEnterpriseValueof$18.7billion.BMR’sEnterpriseValuetoSalesratioisversus1.65forpeers,whiletheirEnterpriseValuetoEBITDAratiois6.5versus15.7forpeers.HowwouldBMR’sEnterpriseValuechangeiftheratioswereequaltotheaveragefortheirpeers?AlternativeExample19.1(2of2)SolutionUsingtheEnterpriseValuetoSalesratio,BMR’sEnterpriseValuewouldbeUsingtheEnterpriseValuetoEBITDAratio,BMR’sEnterpriseValuewouldbeIsBuyMoreunderpricedoraretheirpeersoverpriced?19.2TheBusinessPlan(1of3)OperationalImprovementsBycuttingadministrativecostsimmediatelyandredirectingresourcestonewproductdevelopment,sales,andmarketing,youbelieveIdekocanincreaseitsmarketsharefrom10%to15%overthenextfiveyears19.2TheBusinessPlan(2of3)OperationalImprovementsTheincreasedsalesdemandcanbemetintheshortrunusingtheexistingproductionlinesOncethegrowthinvolumeexceeds50%,however,Idekowillneedtoundertakeamajorexpansiontoincreaseitsmanufacturingcapacity19.2TheBusinessPlan(3of3)OperationalImprovementsIdeko’saveragesellingpriceisforecasttoincrease2%eachyearRawmaterialsareforecasttoincreaseata1%rateLaborcostsareforecasttoincreaseata4%rateTable19.3IdekoSalesandOperatingCostAssumptionsTextbookExample19.2(1of2)ProductionCapacityRequirementsProblemBasedonthedatainTable19.3,whatproductioncapacitywillIdekorequireeachyear?Whenwillanexpansionbenecessary?TextbookExample19.2(2of2)SolutionProductionvolumeeachyearcanbeestimatedbymultiplyingthetotalmarketsizeandIdeko’smarketshareinTable19.3:Basedonthisforecast,productionvolumewillexceeditscurrentlevelby50%by2008,necessitatinganexpansionthen.AlternativeExample19.2(1of2)ProblemWilkersonInc.believesthatitcanincreaseitsshareofthewidgetmarketby2%peryear.Blank20232024202520262027MarketSize(000units)25,00026,50028,09029,77531,562MarketShare7%9%11%13%15%IfWilkersoncurrentlyhasthecapacitytomanufacture3.5millionwidgetsayear,whenwillanexpansionbecomenecessary?AlternativeExample19.2(2of2)SolutionProductionvolumeeachyearisestimatedasMarketBlank20232024202520262027MarketSize(000units)25,00026,50028,09029,77531,562MarketShare7%9%11%13%15%ProductionVolume(000units)1,7502,3853,0903,8714,734Basedonthisforecast,anexpansioninproductioncapacitywillbeneededin2026.CapitalExpenditures:ANeededExpansionIn2008,amajorexpansionwillbenecessaryforIdeko,leadingtoalargeincreaseincapitalexpendituresin2008and2009Table19.4IdekoCapitalExpenditureAssumptionsWorkingCapitalManagement(1of2)Ideko’sAccountsReceivableDaysisWhiletheindustryaverageis60daysYoubelievethatIdekocantightenitscreditpolicytoachievetheindustryaveragewithoutsacrificingsalesWorkingCapitalManagement(2of2)Ideko’sinventoryfigureonitsbalancesheetincludes$2millionofrawmaterialsGivenrawmaterialexpendituresof$16millionfortheyear,Idekocurrentlyholds45.6daysworthofrawmaterialinventoryYoubelievethat,withtightercontrolsoftheproductionprocess,30daysworthofinventorywillbeadequateCapitalStructureChanges:LeveringUp(1of3)YoubelieveIdekoissignificantlyunderleveragedsoyouplantoincreasethefirm’sdebtThedebtwillhaveaninterestrateof6.8%,andIdekowillonlypayinterestduringthenextfiveyearsThefirmwillseekadditionalfinancingin2008and2009associatedwiththeexpansionCapitalStructureChanges:LeveringUp(2of3)Theforecastedinterestexpenseeachyeariscomputedasfollows:Table19.5Ideko’sPlannedDebtandInterestPaymentsCapitalStructureChanges:LeveringUp(3of3)Inadditiontothe$150millionpurchasepriceforIdeko’sequity,$4.5millionwillbeusedtorepayIdeko’sexistingdebtWith$5millionintransactionfees,theacquisitionwillrequire$159.5millionintotalfundsKKP’ssourcesoffundsincludethenewloanof$100millionaswellasIdeko’sownexcesscash(whichKKPwillhaveaccessto)ThusKKP’srequiredequitycontributiontothetransactionis$53millionTable19.6SourcesandUsesofFundsfortheIdekoAcquisition19.3BuildingtheFinancialModel(1of3)ForecastingEarningsProFormaDescribesastatementthatisnotbasedonactualdatabutratherdepictsafirm’sfinancialsunderagivensetofhypotheticalassumptions19.3BuildingtheFinancialModel(2of3)ForecastingEarningsTobuildtheproformaincomestatement,beginwithIdeko’ssales.Eachyear,salescanbecalculatedasfollows:Therawmaterialscostcanbecalculatedfromsalesasfollows:19.3BuildingtheFinancialModel(3of3)ForecastingEarningsSales,marketing,andadministrativecostscanbecomputeddirectlyasapercentageofsalesThecorporateincometaxiscomputedasfollows:Table19.7ProFormaIncomeStatementforIdeko,2005–2010TextbookExample19.3(1of2)ForecastingIncomeProblemBywhatpercentageisIdeko’sEBITDAexpectedtogrowoverthefive-yearperiod?ByhowmuchwoulditgrowifIdeko’smarketshareremainedat10%?TextbookExample19.3(2of2)SolutionEBITDAwillincreasefrom$16.25milliontomillion,oroverthefiveyears.Witha10%marketshareratherthana15%marketshare,saleswillbeonlyoftheforecastinTable19.7.BecauseIdeko’soperatingexpensesareproportionaltoitsunitsales,itsexpensesandEBITDAwillalsobe66.7%ofthecurrentestimates.Thus,EBITDAwillgrowtowhichisanincreaseofonlyAlternativeExample19.3(1of2)ProblemBasedonthedatainAlternativeExample19.2,howmuchwillWilkerson’ssalesincreasebetween2023and2027,assumingitsellseachunitatin2023andexpectstobeabletoincreasethepriceby3%eachyear?AlternativeExample19.3(2of2)SolutionBasedontheforecastinAlternativeExample19.2,Wilkersonsold1,750,000unitsin2023forecasts4,734,000unitssoldin2027.Thepricein2023isWithapriceincreaseof3%peryear,thepricein2027isexpectedtobeThus,salesin2023areandsalesin2027areforecastedtobeSalesareexpectedtoincreasebyWorkingCapitalRequirements(1of2)TheworkingcapitalforecastshouldincludetheplanstotightenIdeko’screditpolicy,speedupcustomerpayments,andreduceIdeko’sinventoryofrawmaterialsAccountsReceivablein2006iscalculatedasfollows:WorkingCapitalRequirements(2of2)TheminimumcashbalanceistheminimumlevelofcashneededtokeepthebusinessrunningFirmstypicallyearnlittleornointerestonthesebalancesAsaconsequence,theopportunitycostofholdingcashisaccountedforbyincludingtheminimalcashbalanceaspartofthefirm’sworkingcapitalTable19.8Ideko’sWorkingCapitalRequirementsTable19.9Ideko’sNetWorkingCapitalForecastForecastingFreeCashFlowUsingthedatafromtheprevioustables,Ideko’sfreecashflowsoverthenextfiveyearscanbeforecastedTheafter-taxinterestexpenseiscalculatedasfollows:NetBorrowingiscalculatedasfollows:Table19.10Ideko’sFreeCashFlowForecastTextbookExample19.4(1of2)LeverageandFreeCashFlowProblemSupposeIdekodoesnotaddleveragein2008and2009,butinsteadkeepsitsdebtfixedat$100millionuntil2010.Howwouldthischangeinitsleveragepolicyaffectitsexpectedfreecashflow?Howwoulditaffectthefreecashflowtoequity?TextbookExample19.4(2of2)SolutionBecausefreecashflowisbasedonunleverednetincome,itwillnotbeaffectedbyIdeko’sleveragepolicy.Freecashflowtoequitywillbeaffected,however.Netborrowingwillbezeroeachyear,andthefirm’safter-taxinterestexpensewillremainatthe2006levelof$4.42million:Inthiscase,Idekowillhaveanegativefreecashflowtoequityin2008and2009.Thatis,withoutadditionalborrowing,KKPwillhavetoinvestadditionalcapitalinthefirmtofundtheexpansion.AlternativeExample19.4(1of3)ProblemWilkerson’sinitialforecastofitsfreecashflowforthenextthreeyearsdoesnotcurrentlyincludeanyadditionalleverage.BlankBlank202320242025BlankFreeCashFlow($000)BlankBlankBlank1FreeCashFlowofFirm$5,834$6,038$6,2802Plus:NetBorrowing$0$0$03Less:After-TaxInterestExpense($427)($427)($427)4FreeCashFlowtoEquity$6,261$6,465$6,707AlternativeExample19.4(2of3)ProblemThefirmisconsideringadding$1millionofadditionaldebtin2023,$1.5millionin2024,and$2millionin2025.Thefirmexpectsthedebttohaveapre-taxcostof7%,andthefirm’smarginaltaxrateis39%.Howwouldthischangeaffectthefreecashflowtoequity?AlternativeExample19.4(3of3)SolutionFreecashflowtoequitywillincreaseeachyear.Theafter-taxinterestexpensewillincreasefor2024and2025,whichslightlyoffsetstheincreaseindebt.BlankBlank202320242025BlankFreeCashFlow($000)BlankBlankBlank1FreeCashFlowofFirm$5,834$6,038$6,2802Plus:NetBorrowing$1,000$1,500$2,0003Less:After-TaxInterestExpense($427)($470)($491)4FreeCashFlowtoEquity$7,261$8,008$8,771TheBalanceSheetandStatementofCashFlows(Optional)(1of3)TheinformationcalculatedsofarcanbeusedtoprojectIdeko’sbalancesheetandstatementofcashflowsOnthebalancesheetCurrentassetsandliabilitiescomefromthenetworkingcapitalspreadsheetInventoryfiguresincludesbothrawmaterialsandfinishedgoodsProperty,plant,andequipmentfigurescomefromthecapitalexpenditurespreadsheetTheBalanceSheetandStatementofCashFlows(Optional)(2of3)StatementofCashFlowsStartswithnetincomeCashfromoperatingactivitiesincludesdepreciationaswellaschangestoworkingcapitalitems(otherthancash)CashfrominvestingactivitiesincludesthecapitalexpendituresCashfromfinancingactivitiesincludeschangesinoutstandingdebtanddividendsorstockissuanceTheBalanceSheetandStatementofCashFlows(Optional)(3of3)DebtfigurescomefromtheplanneddebtandinterestpaymentsspreadsheetNewGoodwilliscalculated:Table19.11ProFormaStatementofCashFlowsforIdeko,2005–2010Table19.12ProFormaBalanceSheetforIdeko,2005–201019.4EstimatingtheCostofCapitalCAPM-BasedEstimationBecauseIdekoisnotpubliclytraded,comparablefirmsmustbeusedtoestimatedthefirm’sbeta.Thebetaforcomparablefirmsiscalculatedasfollows:Table19.13EquityBetaswithConfidenceIntervalsforComparableFirmsUnleveringBetaGivenanestimateofeachfirm’sequitybeta,the“unlevered”betamustbecalculated,basedonthefirm’scapitalstructureTable19.14CapitalStructureandUnleveredBetaEstimatesforComparableFirmsFirmStartfractionEoverEplusDendfraction.StartfractionDoverEplusDendfraction.BetasubscriptE.BetasubscriptD.BetasubscriptU.Oakley1.00.0.00.1.50.Blank1.50.Luxottica0.830.170.7500.62Nike1.05.Negative0.05.0.60.00.63Ideko’sUnleveredCostofCapital(1of2)ThedatafromthecomparablefirmsprovidesguidanceforestimatingIdeko’sunleveredcostofcapitalIdeko’sproductsarenotashighendasOakley’seyewear,soIdeko’ssalesareunlikelytovaryasmuchwiththebusinesscycleasOakley’ssalesdoIdekodoesnothaveaprescriptioneyeweardivision,asLuxotticadoesIdeko’sproductsarefashionitemsratherthanexerciseitemsIdeko’sUnleveredCostofCapital(2of2)Giventheaboveanalysis,Ideko’scostofcapitalislikelytobeclosertoOakley’sthantoNike’sorLuxottica’sYoudecidetouseasyourpreliminaryestimateforIdeko’sunleveredbetaYourestimateofIdeko’sunleveredcostofcapitalisTextbookExample19.5(1of2)EstimatingtheUnleveredCostofCapitalProblemUsingthemonthlyequitybetaestimatesforeachfirminTable19.13,whatrangeofunleveredcostofcapitalestimatesispossible?TextbookExample19.5(2of2)SolutionOakleyhasthehighestequitybetaof1.99whichisalsoitsunleveredbeta(ithasnodebt).Withthisbeta,theunleveredcostofcapitalwouldbeAttheotherextreme,givenitscapitalstructure,Luxottica’sequitybetaof0.56impliesanunleveredbetaofWiththisbeta,theunleveredcostofcapitalwouldbeAswithanyanalysisbasedoncomparables,experienceandjudgmentarenecessarytocomeupwithareasonableestimateoftheunleveredcostofcapital.Inthiscase,ourchoicewouldbeguidedbyindustrynorms,anassessmentofwhichcomparableisclosestintermsofmarketrisk,andpossiblyknowledgeofhowcyclicalIdeko’srevenueshavebeenhistorically.AlternativeExample19.5(1of2)ProblemUSMetalReserveshasanequitybetaof1.25.Thefirmisfinancedwith70%equityand30%debt.Iftheexpectedreturnonthemarketis8%andtherisk-freerateis2%,whatisUSMetalReserve’sunleveredcostofequity?Assumethebetaofthefirm’sdebtis0.AlternativeExample19.5(2of2)SolutionUsingEquation19.12,thefirm’sunleveredbetaisTheunleveredcostofequitycanbecalculatedasfollows:19.5ValuingtheInvestment(1of4)TheMultiplesApproachtoContinuationValuePractitionersgenerallyestimateafirm’scontinuationvalue(alsocalledtheterminalvalue)attheendoftheforecasthorizonusingavaluationmultiple,withtheEBITDAmultiplebeingthemultiplemostoftenusedinpracticeTable19.15ContinuationValueEstimateforIdeko19.5ValuingtheInvestment(2of4)TheMultiplesApproachtoContinuationValueThecontinuationvalueis1.8timesIdeko’s2010sales,andtheequityvalueis16.3timesIdeko’s2010earningsTheseratiosarelowerthanthepeerratiosestimatedearlier19.5ValuingtheInvestment(3of4)TheMultiplesApproachtoContinuationValueUnleveredRatioTheenterprisevalueofafirmdividedbyitsunleverednetincomeinaparticularyearIdeko’sunleveredratiois18.4timesunleverednetincome19.5ValuingtheInvestment(4of4)TheMultiplesApproachtoContinuationValueOnedifficultywithrelyingoncomparableswhenforecastingacontinuationvalueisthatfuturemultiplesofthefirmarebeingcomparedwithcurrentmultiplesofitscompetitorsTheDiscountedCashFlowApproachtoContinuationValue(1of5)TheenterprisevalueinyearT,usingtheWACCvaluationmethod,iscalculatedasfollows:FreecashflowinyearT+1iscomputedasfollows:TheDiscountedCashFlowApproachtoContinuationValue(2of5)Iffirm’ssalesareexpectedtogrowatanominalrategandthefirm’soperatingexpensesremainafixedpercentageofsales,thenitsunleverednetincomewillalsogrowatrategSimilarly,thefirm’sreceivables,payables,andotherelementsofnetworkingcapitalwillgrowatrategTheDiscountedCashFlowApproachtoContinuationValue(3of5)IfcapitalexpendituresaredefinedasThenfreecashflows,giveng,canbeestimatedasTextbookExample19.6(1of3)ADCFEstimateoftheContinuationValueProblemEstimateIdeko’scontinuationvaluein2010assumingafutureexpectedgrowthrateof5%,afuturedebt-to-valueratioof40%,andadebtcostofcapitalof6.8%.TextbookExample19.6(2of3)SolutionIn2010,Ideko’sunleverednetincomeisforecastedtobe$15.849million(Table19.10),withworkingcapitalof$40.425million(Table19.9).Ithasfixedassetsof$69.392million(Table19.4).FromEquation19.17,wecanestimateIdeko’sfreecashflowin2011:Thisestimaterepresentsnearlyan8%increaseoverIdeko’s2010freecashflowof$10.328million.Itexceedsthe5%growthrateofsalesduetothedeclineintherequiredadditionstoIdeko’snetworkingcapitalasitsgrowthrateslows.TextbookExample19.6(3of3)Withadebt-to-valueratioof40%,Ideko’sWACCcanbecalculatedfromEquation18.11orEquation12.13:GiventheestimateofIdeko’sfreecashflowandWACC,wecanestimateIdeko’scontinuationvaluein2010:ThiscontinuationvaluerepresentsaterminalEBITDAmultipleofAlternativeExample19.6(1of3)ProblemAssumeWilkerson’sunleverednetincomeisforecastedtobe$12millionin2027.Networkingcapitalisforecastedtobe$70millionin2027.Fixedassetsareforecastedtobe$85millionin2027.Expectedgrowthis4%.AlternativeExample19.6(2of3)ProblemAssumeTheunleveredcostofequityis11%.Debt-to-valueratioisforecastedtobe50%in2027.Debtcostofcapitalisforecastedtobe7%in2027.Thetaxrateisestimatedtobe39%in2027.EstimateWilkerson’scontinuationvaluein2027.AlternativeExample19.6(3of3)SolutionTheDiscountedCashFlowApproachtoContinuationValue(4of5)BoththemultiplesapproachandthediscountedcashflowapproachareusefulinderivingarealisticcontinuationvalueestimateItisrecommendedtocombinebothapproachesTable19.16DiscountedCashFlowEstimateofContinuationValue,WithImpliedEBITDAMultiple*Netinvestmentequalsthedifferencebetweencapitalexpendituresanddepreciation,sosubtractingthisamountisequivalenttoaddingbackdepreciationandsubtractingcapitalexpenditures(seeEquation9.20).TheDiscountedCashFlowApproachtoContinuationValue(5of5)TheprojectedEBITDAmultipleof9.1canbejustifiedaccordingthediscountedcashflowmethodwithanominallong-termgrowthrateofabout5.3%Givenaninflationrateof2%,thisnominalraterepresentsarealgrowthrateofabout3.3%Ifthisimpliedgrowthrateismuchhigherthantheexpectationsoflong-rungrowthfortheindustryasawhole,youshouldbemoreskepticaloftheestimatebeingusedAPVValuationofIdekoEquity(1of3)TheestimateofIdeko’scontinuationvaluecanbecombinedwiththeforecastsforfreecashflowthrough2010toestimateIdeko’svaluetodayusingtheAPVvaluationmodelAPVValuationofIdekoEquity(2of3)ThefirststepistocomputeIdeko’sunleveredvalueNext,theinteresttaxshieldneedstobecomputed.APVValuationofIdekoEquity(3of3)UsingtheAPVvaluationmodel,theestimateforIdeko’sinitialenterprisevalueis$213million,withanequityvalueof$113million(asshownonthefollowingslide)GiventhatKKP’sinitialcosttoacquireIdeko’sequityis$53million,thedeallooksattractivewithanNPVof$60million

Table19.17APVEstimateofIdeko’sInitialEquityValueARealityCheck(1of2)Atthispoint,itiswisetostepbackandassesswhetherthevaluationresultsmakesenseDoesaninitialenterprisevalueof$213millionforIdekoseemreasonablecomparedtothevaluesofotherfirmsintheindustry?Computetheinitialvaluationmultiplesthatwouldbeimpliedbyourestimatedenterprisevalueof$213millionandcomparethemtoIdeko’sclosestcompetitorsTable19.18IdekoFinancialRatiosComparison,Mid-2005,BasedonDiscountedCashFlowEstimateVersusProposedPurchasePriceRatioIdeko(EstimatedValue)Ideko(PurchasePrice)Oakley,Inc.LuxotticaGroupNike,Inc.SportingGoodsPoverE.31.0x.21.6x.24.8x.28.0x.18.2x.20.3x.EVoversales.2.8x.2.0x.2.0x.2.7x.1.5x.1.4x.EVoverEBITDA.13.1x.9.1x.11.6x.14.4x.9.3x.11.4x.ARealityCheck(2of2)ThemultiplesarenowatthetopendorsomewhatabovetherangeofthevaluesoftheotherfirmsusedforcomparisonAlthoughthesemultiplesarenotunreasonablegiventheoperationalimprovementsthatKKPplanstoimplement,theyindicatethattheforecastmaybesomewhatoptimisticanddependcriticallyonKKP’sabilitytoachievetheoperationalimprovementsitplansIRRandCashMultiples(1of2)PractitionersoftenuseIRRandthecashmultipleasalternativevaluationmetricsTocomputetheIRR,KKP’scashflowsoverthelifeofthetransactionmustbecomputed.AssumingKKPwillsellitsequityshareinIdekoattheendoffiveyears,theIRRforthetransactionis33.3%,asshownonthefollowingslideTable19.19IRRandCashMultipleforKKP’sInvestmentinIdekoIRRandCashMultiples(2of2)CashMultipleTheratioofthetotalcashreceivedtothetotalcashinvestedThecashmultipleiscomputedasfollows:KKPexpectstoreceiveareturnthatis3.7timesitsinvestmentinIdekoThecashmultiplehasanobviousweaknessItdoesnotdependontheamountoftimeittakestoreceivethecash,nordoesitaccountfortheriskoftheinvestmentItisthereforeusefulonlyforcomparingdealswithsimilartimehorizonsandrisk19.6SensitivityAnalysis(1of3)ItisimportanttoassesstheuncertaintyoftheforecastsandtodeterminetheirpotentialimpactonthevalueofthedealSensitivityanalysiscanshowthesensitivityoftheestimatesofthevalueofKKP’sinvestmenttochangesintheassumptionsregardingtheexitEBITDAmultiplethatKKPobtainswhenIdekoissold,aswellasIdeko’sunleveredcostofcapitalTable19.20SensitivityAnalysisforKKP’sInvestmentinIdeko19.6SensitivityAnalysis(2of3)ThetableinthepreviousslideshowsthateachincreaseintheEBITDAmillionininitialvalueKKPwillbreakevenonits$53millioninvestmentinIdekowithanexitmultipleofslightlymorethanThetablealsoshows,however,thatanexitmultipleofisconsistentwithafuturegrowthrateforIdekooflessthan2%,whichisevenlessthantheexpectedrateofinflationandprobablyunrealisticallylow19.6SensitivityAnalysis(3of3)ThetablealsoindicatesthatahigherunleveredcostofcapitalreducesthevalueofKKP’sinvestmentHowever,evenwitharateashighas14%,theequityvalueexceedsKKP’sinitialinvestmentChapterQuizHowarecomparablesusedinth