Reading: Normalized Projections for Continuing Value

As we have seen above, the second crucial element of continuing value is the first free cash flow of the continuing value period. We want to examine the characteristics of the free cash flow in the steady state. We call that cash flow the normalized free cash flow. The steady state is a situation in which margins are constant and investment for replacement is a constant fraction of net sales. If so, we can write the normalized FCF as:

To compute the normalized FCF, we therefore proceed as follows:

• The basis of the normalized cash flow is a steady-state (or sustainable) level of net sales (revenue);

• The second variable of relevance is m, the long-run EBIT margin. Multiplying that margin times revenue yields the long-run, steady state EBIT;

• We then net out taxes by multiplying EBIT times (1 - τ), where τ is the long-run estimate of the corporate tax rate. That gives us a measure of the sustainable NOPLAT;

• Furthermore, we multiply NOPLAT times the factor (1 - p). p is the plowback ratio, we have used in the previous section to estimate the steady-state growth rate. It is the fraction of the available NOPLAT that is reinvested in new projects. These reinvestments into new projects consist of capital expenditures (such as property, plant, and equipment) as well as additions to the firm's net operating assets (such as inventory, accounts receivable, etc.).

A careful look at the equation reveals that it is quite similar to the standard cash flow statement that we have compiled in tabular form before. The only differences are that:

• We do not add-back depreciation to NOPLAT

• We subtract new investments (NOPLAT × p) instead of the firm's full investments. The reason for this is simple. As we have argued above, the minimum investments a firm has to make in the steady state correspond to the depreciation charges. Therefore, the depreciation charges and the replacement investments cancel each other out in the normalized cash flow statement.

• We do not distinguish between capital expenditures and additions to net working capital.

Let's take a closer look at some of the information in the table. We make the following assumptions:

• The projected net revenues are "normal,” in the sense that they represent net revenues which can be sustainably achieved in the long-run.

• The projected EBIT margin is 24.7%. For the steady state, we assume that margins will be somewhat lower and therefore assume a sustainable EBIT margin (m) of 22%.

• The projected cash flow statement lists new investments of 3'730 for year 2 and depreciation charges of 3'230. Therefore, expected new investments equal 500 [= Net investments - Depreciation and amortization]. At the same time, the operating assets are projected to increase by 238 and the operating liabilities are projected to increase by 158. Hence, the net operating assets will increase by 80. Given a NOPLAT of 4'100, this correponds to a plowback ratio (p) of 14.15% [= 580/4'100]. For the steady state, we assume that the firm will be able to reinvest 15% of NOPLAT in new projects. Hence, we set normalized p equal to 15%.

To finalize or projections, we need two additional assumptions:

• ROIC: We assume that the firm will be able to find new projects with a ROIC of 1% above the WACC. Given a WACC 7.38%, the expected ROIC is 8.38%.

• Inflation: Finally, we assume that the long-term expected rate of inflation is 1%.

With this information, we are finally ready to compute the normalized FCF for the last year of the explicit forecast period as well as the expected growth rate in the steady state. Our assumptions imply a long-term growth rate of 2.1%:

Moreover, the implied normalized FCF is 3'110:

With this information, we are finally ready to estimate the firm's continuing value. This is the topic of the following section.