Operating cash flows and competitive analysis

Do the following SVA Exercise:


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The following information is given:


* Baseline (last year) sales: $200 million


* Sales growth rates: Base year = 15% with a fade rate of 1% a year for years 1-10: (increasing sales due to sustained competitive advantage and a differentiated product)[source: Strategic Plan]. Fade rate is the rate of decline per year from a base year.


* Sales growth rate in year 10 and forward: 5% (in year 11, the competition has caught up and the market has reached maturity) [source: Strategic Plan]


* Profit margin: Base year = 20%, with a fade rate of 1% a year for years 1-10: (during the period of competitive advantage, the firm can charge higher prices, but its profit margin slowly declines as competition increases) [source: Strategic Plan]


* Profit margin in year 10 and going forward: 10% [source: Strategic Plan]


* Fixed capital investment rate: 20% (for every dollar of new sales, we need an additional investment in fixed plant & equipment of $.20) [source: historical relationship]


* Working capital investment rate: 5% (for every dollar of new sales we need an additional investment in inventories & receivables of $.05) [source: historical relationship]


* Cash tax rate: 40% [source: historical relationship]


* Cost of capital: 11% [source: current yield on firm’s debt & the cost of equity estimated using the Capital Asset Pricing Model, weighted average based on the target capital structure]


* Marketable securities: $15 million


* Market value of firm’s debt: $50 million


* The firm has 5 million shares of common stock outstanding selling at:


**scenario 1 = $40/share and


**scenario 2 = $60/share.


As indicated, the values assigned to drivers link directly to the strategic plan and the associated strategic analysis. In arriving at these estimates strategic alternatives have been evaluated for their value creation potential, with the set of strategies selected that create the most shareholder wealth.


1. What is the PV of operating cash flows over the competitive advantage period?


2. What is the residual value of the firm after the period of competitive advantage?


3. What is the value of the firm’s equity?


4. Compare the market value of equity ($40/share) with the estimate provided by SVA for scenario 1. What recommendations would you make to top management based on your analysis? Now compare the market value of equity ($60/share) with your SVA estimate. What would you recommend now?

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