Running head: Forecasting and valuation for a Company 1

Student Name

Topic: Cost of Capital Estimation and Company Valuation.

Case study:

Tutor

Date
Running head: Forecasting and valuation for a Company 2

Introduction

NVIDIA Corporation is an American based technology company. It basically designs graphics

processing units, gaming among other developed mobile computing systems. Established in the

1990s with a startup capital of $40,000 the company has recent financial reported growth across

all segments. On this report, both theoretical and practical cost of capital estimation and

company valuation are discussed. Exhibits, Appendix for this report and their sources are also

presented for ease understanding.

Overview:

 Introduction to theory of cost of capital

 Models used to estimate cost of capital

 Data used in models for cost of capital estimation and its application to valuation.

The term Cost of capital can be explained from two perspectives. To the Investors, it is the rate

of return required by the market to attract funds for investment. Primarily on the company capital

structure, it includes the following three components; Long-term debt, preferred equity and

common equity. Key characteristics of cost of capital are;

 It is associated to the market.

 Investment driven

 Metrics are based on nominal terms

 Based on market value and not book value

Running head: Forecasting and valuation for a Company 3

Case1. Sales growth forecast and terminal growth rate after terminal year.

Sale forecasting means projection of sales performance at a terminal period. This is affected

by both external and internal factors within the industry and the company. Methods of

performing a sale forecasting Qualitative and Quantitative. Quantitative forecasting applies

historical data and make assumption on pattern to forecast the future. Sales forecast is useful

to the investors in making decision regarding investment. We first gather data of sale values

for previous years. For this case, we shall use a Time series model moving average method.

This take average of the sales over set number of years. The formula below is applied;

Sales growth Forecast;

Forecasting sales involves the following steps for an Enterprise;

1. Getting the Historical data and the current year sales

2. The Income Statement starts with Current year sales always
3. Forecasting the sales growth with be given by
Sales= Previous year’s sales * (1+ growth)

The terminal growth rate is a steady rate at which a company expected free cash flow are

assumed to grow at. The terminal growth rate formula is given as follows,

𝐹𝐶𝐹 ∗ [1 + 𝑔]
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 =
𝑊𝐴𝐶𝐶 − 𝑔

Where, 𝐹𝐶𝐹 = 𝐹𝑟𝑒𝑒 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤, 𝑔 = 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑, 𝑊𝐴𝐶𝐶 =

𝑊𝑒𝑖𝑔ℎ𝑡𝑒𝑑 𝑎𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙.

Weighted average cost of capital is the blended cost of capital across all sources such as

preferred shares, common shares, and debts. It is calculated as follows

Running head: Forecasting and valuation for a Company 4

𝐸 𝐷
𝑊𝐴𝐶𝐶 = (𝑉 ∗ 𝑅𝑒) + (( 𝑉 ∗ 𝑅𝑑) ∗ (1 − 𝑇)) , 𝑤ℎ𝑒𝑟𝑒 𝐸 = 𝑚𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝, 𝐷 =

𝐸
𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑓𝑖𝑟𝑚(𝑑𝑒𝑏𝑡), 𝑉 = 𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 (𝑒𝑞𝑢𝑖𝑡𝑦 𝑝𝑙𝑢𝑠 𝑑𝑒𝑏𝑡), 𝑉 =

𝐷
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡ℎ𝑎𝑡 𝑖𝑠 𝑒𝑞𝑢𝑖𝑡𝑦, 𝑉 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑡ℎ𝑎𝑡 𝑖𝑠 𝑑𝑒𝑏𝑡, 𝑅𝑒 =

𝑐𝑜𝑠𝑡 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦 (𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑟𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛, 𝑅𝑑 = 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡 , 𝑇 = 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒.

Valuation

 Start with enterprise cash flows derived earlier.

 Compute the growth rate in enterprise cash flows.
 Input: Enterprise cost of capital (aka wacc) is assumed constant for all years.
 Make sure that the enterprise cash flows reach terminal growth before computing terminal
value. Terminal value is computed at the end of Year 5 because the enterprise cash flows
reach terminal growth only after that year. The formula is C5*(1+g)/(wacc-g) or C6/(wacc –
g).
 Enterprise value = PV of enterprise cash flows until Year 5 + PV of terminal value
 Historical data: Initial ending net financial liabilities.
 Subtract net financial liabilities.
 Equity value = Enterprise value – Net financial liabilities

Inferring cost of equity

If one used firm’s cost of equity to derive wacc, then this step is indeed redundant. However, in

many instances, we assume that the firm’s wacc is the same as its competitors, or we use a

subjective estimate of wacc. In these cases, it is useful to know the cost of equity implied by

wacc and leverage.

See the equation for cost of equity (re) specified earlier. re generally varies across time if

leverage based on market values changes. Even if NFL/book value of equity is kept
Running head: Forecasting and valuation for a Company 5

constant, as is the case in this model, the ratio of NFL to market value of equity changes

over time. Thus, re varies across time. Therefore, you cannot discount distributions to

shareholders at the current re to derive the current equity value.

Bond Information of NVidia Corporation

NVidia Corporation issued an International bond valued at USD 1,000M. the bond is expected to

mature in the year 2021 with a coupon rate of 2.2%. The bond was sold at a price of 99.802%.

The Bookrunner were Goldman sachs, Morgan Stanley and Wells Fargo. A bond issue is meant

to help raise finance by the issuer. For a bond, it is redeemable after a period of time. To estimate

the yield the firm may have to provide the investors while making a new issue.

To get the current market value of NVidia corporation Bond issue (US67066GAD60).

The market value of a bond is like the present value of all future cash flows. Therefore the face

value is needed, the coupon rate, maturity period and market interest rate.

A bond is therefore a form of debt that an investor expects periodical interest payments that are

based on a stated coupon rate and return the original principal at maturity. Face value is

$1,000M, Maturity 5 years, Coupon rate 2.2% , assumed 9%.

The following formula applied

1−(1+𝑟)−𝑡 𝑓 1+(1+9%)−9 $1000

PV( bond) =𝑐 ∗ 𝑓 ∗ + (1+𝑟)^𝑡 = 2.2% ∗ $1000𝑀 ∗ +
𝑟 9% (1+9%)^9
Running head: Forecasting and valuation for a Company 6

To find the yield on a company’s recently issued long term bonds, given it has bonds outstanding

or it can be can be found by rating the bond also. This can also be done by assessing the yield on

other bonds with a similar rating and in the same industry.

The yield rd is the coupon rate that the company will have to set on a new bond.

Other Metrics involved in cost of capital;

Cost of preffered stock. This is the rate of investment return by holders of a company’s preferred

stock. Calculation involves diving the annual dividend payment on the preferred stock by the

preferred stock’s current market price.

Par value $100, Dividend yield = 10%, issue price = $116.95, Flotation cost = 5%

𝐷𝑝𝑠 .1($100)
𝑟𝑝𝑠 = = $116.95(1−0.05) =9.0%
𝑃𝑝𝑠 (1−𝑓)

Methods of determining the Cost of equity

The existing common stock also called retained earning can be calculated using below methods.

This can be done using three known methods;

 Capital Asset pricing method. This model describes the relationship between the expected

return and the risk of a security. The CAPM shows that the return on a security is equal to

risk-free return together with a risk premium.

CAPM formula and calculation,

Running head: Forecasting and valuation for a Company 7

𝑅a = 𝑅𝑟𝑓 + [𝐵a ∗ (𝑅m − 𝑅𝑟𝑓)]

Where Ra is the expected return on a security, Rrf is the free rate, Ba is the Beta of the

security and Rm is the expected return on the market.

Risk premium is given by subtracting (𝑅m − 𝑅𝑟𝑓)

 Discounted cash flow method. When investors expect returns in form of dividends that

can be done quarterly or half yearly. The discounted cash flow model for measuring the

cost of retained earnings is given by

𝐷1
𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 = + 𝑔, 𝑤ℎ𝑒𝑟𝑒 𝐷1 𝑖𝑠 𝑡ℎ𝑒 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑎𝑖𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑓𝑖𝑟𝑠𝑡 𝑞𝑢𝑎𝑟𝑡𝑒𝑟.
𝑃𝑜

𝑃𝑜 𝑖𝑠 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑠𝑡𝑜𝑐𝑘

G is the growth rate of the stock

 Own-bond- yield plus Judgmental risk premium

This is given by 𝑅s = 𝑅d+ Judgemental risk Premium

For this case using data available for the company NVidia corporation it is easy to

determine the Cost of equity using both methods.

Cash Flows Statement NVidia Corporation

Cash flow statement equation is given by;

𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠 + 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 + 𝐶𝑎𝑠ℎ 𝑓𝑟𝑜𝑚 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑛𝑔.

Running head: Forecasting and valuation for a Company 8

𝑁𝑂𝐴 = 𝑂𝐴 – 𝑂𝐿

𝑁𝐹𝑂 = 𝐹𝑂 – 𝐹𝐴

Operating Income is got by subtracting Operating revenues from Operating expenses

NFE is obtained by subtracting financing income from financing expense

𝑇ℎ𝑒 𝑁𝑒𝑡 𝑝𝑎𝑦𝑜𝑢𝑡 𝑡𝑜 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 (𝑑)

= 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 + 𝑠ℎ𝑎𝑟𝑒 𝑟𝑒𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 – 𝑠ℎ𝑎𝑟𝑒 𝑖𝑠𝑠𝑢𝑒𝑠

𝑇ℎ𝑒 𝑁𝑒𝑡 𝑝𝑎𝑦𝑜𝑢𝑡 𝑡𝑜 𝑑𝑒𝑏𝑡 ℎ𝑜𝑙𝑑𝑒𝑟𝑠 𝑎𝑛𝑑 𝑑𝑒𝑏𝑡 𝑖𝑠𝑠𝑢𝑒𝑟𝑠 (𝑓0

= 𝑛𝑒𝑡 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒 𝑜𝑓 𝑡ℎ𝑒 𝐹𝐴 – 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡 𝑖𝑠𝑠𝑢𝑒𝑠

+ 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑 𝑜𝑛 𝑑𝑒𝑏𝑡 – 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑜𝑛 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

1. Method 1.

For this to be possible, reformulated income statements and balance sheets for a firm

must be done. With reformulated statements, any of Method 1 or Method 2 of calculating

free cash flow can be done.

NVidia corporation: Calculation of Free Cash Flow for 2016 (in Millions)

Method 𝑪 – 𝑰 = 𝑶𝑰 − 𝑫𝑵𝑶𝑨

1:

Operating income 2016 $ 16,072

Net operating assets 2016

Running head: Forecasting and valuation for a Company 9

Net operating assets 2015 $61,439

$63,382 -$1943

Free cash flow 2016 $18,015

Note:

𝑁𝑒𝑡 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐴𝑠𝑠𝑒𝑡 = (𝑇𝑜𝑡𝑎𝑙 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠 – 𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦)

We have the Cash flow statement for year 2010 given. To calculate the Free cash flow for year

2016 we take Cash from operating activities subtract the capital expenditure.

Total Operating activities $16,072M

-Capital Expenditure $ 3,067M

-Dividend to shareholders $5,458M

Free Cash Flow $7,547M

The numbers differ. Method 1 above value is different from the value obtained under ordinary

method.

2. Method 2. Calculate for free cash flow.

For this the calculation will involve the sum of NFE for year 2016, the change in NFA

and the dividend.

Running head: Forecasting and valuation for a Company 10

We take the NFA for year 2015 and 2014. The dividend is on the Statement of income.

NVidia Corporation: Calculation of Free Cash Flow for 2016 (in Millions)

Method 2: C – I = NFE - DNFO + d

Net financial expenses 2016 $

Net financial obligations $

2016
$ ()

Net financial obligations

2014

Net dividend 2016

$()

Free cash flow 2016

The two methods should give the same result provided income is a comprehensive

income. Free cash flow appears to be different under the two methods. The difference is

occasioned by the fact that we cannot reconstruct a deferred compensation asset, an

operating asset. The Free cash flow calculation is dependent on income and asset aspects

which is not the issue for operations.

Running head: Forecasting and valuation for a Company 11

Method 2 offers the accurate calculation.

 Calculate the net payout to shareholders from the cash flow statement. (Make remarks)

To achieve this. We get the free cash flow value. The Free Cash Flow value is then

multiplied by the dividend payout ratio.

 What is the relevance of the supplemental disclosure at the bottom of the cash flow

statement?

This exists so that adjustments made to the cash flow statement are known. There are

three categories of this. Cash paid for interest and income taxes. The Reconciliation

Schedule and Non-cash investing and Financing activities.

The return on common equity

𝑅𝑂𝐶𝐸 = 𝑅𝑁𝑂𝐴 + [𝐹𝐿𝐸𝑉 + (𝑅𝑁𝑂𝐴 – 𝑁𝐵𝐶)]

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑁𝑂𝐴 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝑂𝐴

−𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑁𝐹𝐴
𝐹𝐿𝐸𝑉 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐶𝑆𝐸
Running head: Forecasting and valuation for a Company 12