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HBS Toolkit

LICENSE AGREEMENT

HBS Toolkit License Agreement Harvard Business School Publishing (the Publisher) grants you, the individual user, limited license to use this product. By accepting and using this product, you agree to the terms of service described below. Terms You accept that this product is intended for your use, and you will not duplicate in any form or manner, electronic or otherwise, copies of this product nor distribute this product to anyone else. You recognize that the product and its content are the sole property of the Publisher, and that we have copyrighted the product. You agree that the Publisher is not responsible for any interruption of service or malfunction that is a consequence of the Internet, a service provider, personal computer, browser or other software or hardware components. You accept that there is no guarantee that this product is totally error free. You further understand and accept that the Publisher intends to provide reliable information but does not guarantee the accuracy or completeness of any information, and is not responsible for any results obtained from the use of such information. This license is effective until terminated, when the license or subscription period ends without renewal, or when you destroy this product and any related documentation. The Publisher may terminate your license without notice if you fail to comply with the conditions set forth in this agreement, and may pursue any other legal recourse.

Copyright 1999 President and Fellows of Harvard College

Basic Terminal Value

INTRODUCTION

Contents Introduction Assumptions Analysis

This sheet Data entry sheet for cash flow and general assumptions Output report

Overview Estimating Terminal Value is often a key component in valuing a business opportunity. The further out in time our estimates go the less reliable they become. Thus, while we can estimate cash flows one, two or three years out with some hope of accuracy, at some point it becomes necessary to estimate the present value of all the future cash flows if we are to arrive at a total value for the opportunity. Broadly speaking, there are four methods of estimating terminal value. Perpetuity. Having estimated a given number of specific cash flows, we assume a growth rate (sometimes zero) at which we believe the business can grow indefinitely. We then use the formula Value = Cash Flow / (Discount Rate Growth Rate) to arrive at a perpetuity value. This method is most appropriate if we expect to continue in the business indefinitely, but the resulting valuation is often sensitive to small changes in our base assumptions. Price/Earnings. This method assigns a multiple to the earnings (or to some cash flow measure, such as EBIT) of the final estimated year. It is most appropriate when similar quoted companies exist and/or when we expect to exit our investment through an IPO or trade sale, rather than retaining it in the business. Price/Book Value. Similar to P/E, a multiple is placed on ending book value.

Liquidation. An estimate is made as to how much the assets of the business can be sold for. The Terminal Value tool looks primarily at the Perpetuity method, although the basic model could be used to support any of the others. A series of inputs enable the user to construct a simple set of pro-forma financial statements and to calculate free cash flows. The cash flows are then discounted to present value at a discount rate supplied by the user and the value of the perpetuity is established based on a long-term growth forecast. Finally, the tool illustrates the significance of terminal value by stating what percentage of total present value is represented by terminal value, and allows the user to experiment with the impact small assumption changes have on overall value estimates. To start using the tool, remove the sample data from the tool using the Show/Hide Sample Data option under the HBS Menu

Note About Using Internet Explorer The default setting in Internet Explorer is to open these tools in the Explorer application instead of Excel. We recommend against this and provide directions in the Help section of the HBS Toolkit web site to change this default behavior.

HBS Menu Show/Hide Sample Data: Show Calculator: Show/Hide Celltips: Print Sheet with Celltips: Set Zoom: Visit Web Links: About HBS Toolkit:

Displays or removes sample entries Launches Windows calculator Toggles in/out red Celltips in documented cells Prints Celltip documentation on current sheet Provides quick access to 80%, 100%, and 125% zoom levels Links to HBS Toolkit website, Toolkit Glossary, and Toolkit Feedback, as well as HBS and HBS Publishing web sites Launches the about box for the HBS Toolkit

Jon B. DeFriese MBA `00 and Chad Ellis, MBA `98 developed this software under the supervision of Professor Steven Wheelwright as the basis for class discussion rather than to illustrate either the effective or ineffective handling of an administrative situation.
Copyright 1999 President and Fellows of Harvard College

Basic Terminal Value

ASSUMPTIONS

Base Year 1999 Initial Sales End Year PP&E End Year NWC End Year Other Assets Annual Growth Rate Growth Beyond Year 4 Cost of Goods/Sales SG&A/Sales Tax Rates NWC/Sales Ratio PP&E/Sales Ratio Dep/PP&E Ratio Other Assets/Sales Ratio Discount Rate 50.00 25.00 20.00 0.00

Year 1 2000

Year 2 2001

Year 3 2002

Year 4 2003

10.0% 5.0% 0.62 0.20 0.40 0.40 0.50 0.10 0.00 10.0% 0.62 0.20 0.40 0.40 0.50 0.10 0.00

10.0% 0.62 0.20 0.40 0.40 0.50 0.10 0.00

10.0% 0.62 0.20 0.40 0.40 0.50 0.10 0.00

10.0% 0.62 0.20 0.40 0.40 0.50 0.10 0.00

Output Values Sales End Year PP&E End Year NWC End Year Other Assets

50.00 25.00 20.00 0.00

55.00 27.50 22.00 0.00

60.50 30.25 24.20 0.00

66.55 33.28 26.62 0.00

73.21 36.60 29.28 0.00

Copyright 1999 President and Fellows of Harvard College

Basic Terminal Value

ANALYSIS

Base Year 1999 Sales Cost of Sales SG&A Depreciation Other Pretax Profit Income Taxes Profit After Tax Depreciation Cash Flow from Operations Less:Change in NWC Plant and Equipment Less:Capital Expenditures Less:Change in Other Assets Cash Flow to Capital NPV of Forecast Cash Flows Terminal Value of Perpetuity in Year 4 Present Value of Perpetuity Total Value of Cash Flows Percentage of Value from Terminal Value 50.00 31.00 10.00 2.50 0.00 6.50 2.60 3.90

Year 1 2000 55.00 34.10 11.00 2.75 0.00 7.15 2.86 4.29 2.75 7.04 2.00 5.50 3.30 0.00 1.74 6.58

Year 2 2001 60.50 37.51 12.10 3.03 0.00 7.87 3.15 4.72 3.03 7.74 2.20 6.05 3.63 0.00 1.91

Year 3 2002 66.55 41.26 13.31 3.33 0.00 8.65 3.46 5.19 3.33 8.52 2.42 6.66 3.99 0.00 2.11

Year 4 2003 73.21 45.39 14.64 3.66 0.00 9.52 3.81 5.71 3.66 9.37 2.66 7.32 4.03 0.00 2.68

7.69

56.32 38.47 45.05 85.4%


Copyright 1999 President and Fellows of Harvard College

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