wk 4 - Estimating Growth and Terminal Value_2011s2

# For example if we expect motorolas roc to rise to

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each period. For example, if we expect Motorola’s ROC to rise to 17.22% over the next 5 years, and new investment will start making 17.22% immediately, then g 1 = g 2 = … g 5 = b *ROC 5 +[ 5 (ROC 5 /ROC 0 ) – 1] =0.5299*0.1722+ [ 5 (0.1722/0.1218) – 1] = 16.30% g 6 , g 7 , … = 0.5299 *0.1722 = 9.12% the growth in return on new investment is gradual and equal to 5 (ROC 5 ROC 0 ) – 1 or 7.17% per year, then g 1 = b *ROC 0 *(1.0717) 1 +[ 5 (ROC 5 – ROC 0 ) – 1] = 0.5299*0.1218(1.0717) 1 + [ 5 (0.1722/0.1218) – 1] = 14.08% g 2 = 0.5299*0.1218(1.0717) 2 + [ 5 (0.1722/0.1218) – 1] = 14.58%, The above is equally applicable to firms expecting a downturn.

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FINS3641 SAV Week 4: Estimating Growth and Terminal Value 13 iii) Estimating Growth when Operating Income is Negative When a firm is losing money with –ve OI (typically young and high growth), the fundamental growth rate, g t , doesn’t make sense given the negative reinvestment rate: ܾ ൌ ஼௔௣௜௧௔௟ ௥௘௜௡௩௘௦௧௘ௗ ೟షభ ா஻ூ் ೟షభ ሺଵି௧௔௫ ௥௔௧௘ሻ negative ROC: EBIT t (1 - tax rate)/( Debt BV,t-1 + Equity BV, t-1 ) Solution: use a three step process to estimate growth: Estimate growth rates in revenues over time may use past revenue growth for guidance of future growth revenue growth rate tends to decrease with the level of revenue Decrease the growth rate as the firm becomes larger Keep track of dollar revenues to make sure that the growth is reasonable, given the size of the market in which the firm operates and its share of the market Estimate expected operating margins each year Set a target margin towards which the firm will eventually achieve Yearly estimates should be consistent with the estimated revenue growth rates, the firm’s age, the business in which the firm operates, … Estimate the capital that needs to be invested to generate revenue growth and expected margins Estimate a sales to capital ratio that you will use to generate reinvestment needs each year.
FINS3641 SAV Week 4: Estimating Growth and Terminal Value 14 iv) An Example of Estimating Growth for Firms with –ve Operating Income Commerce One: Revenues and Revenue Growth Year Growth Rate Revenues AT Operating Margin AT Operating Income R t = R t-1 *(1+g t ) AT OI t = R t *OM t Current \$537 -79.62% -\$428 1 50.00% \$806 -48.17% -\$388 2 100.00% \$1,611 -27.21% -\$438 3 80.00% \$2,900 -13.23% -\$384 4 60.00% \$4,640 -3.91% -\$182 5 40.00% \$6,496 2.30% \$149 6 35.00% \$8,770 6.44% \$565 7 30.00% \$11,401 9.20% \$1,049 8 20.00% \$13,681 11.04% \$1,510 9 10.00% \$15,049 12.27% \$1,846 10 5.00% \$15,802 13.08% (ind. Avg) \$2,068 the growth and margin estimates are justified by the life cycle argument Note the inverse relation between rev. growth rate and operating margin

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FINS3641 SAV Week 4: Estimating Growth and Terminal Value 15 Commerce One: Reinvestment Needs & ROC One last step: Check if the revenue growth and operating margin estimates are reasonable, we need to infer the reinvestment needs to support projected revenue growth, which in turn is needed to arrive at the yearly estimates of ROC for comparison to the industry average.
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