you are required to perform valuation for HES Company as given below.

Show detail work and discuss any assumptions you make.

Consider HES Company’s financial statements given below. Assume the Company’s beta is estimated to be 1.5, risk free
rate 2%, and market risk premium 10%. Furthermore, assume the company has a long-term growth rate for 2% after the
fifth year and net income and comprehensive income will be identical.

What is the company's value using the following methods:

a) Residual Income
b) Free Cash Flow
c) If Owners decide to issue 1,000,000 common shares, how much would be the value for each share?
d) Analyze and explain which one of the above valuation methods provides a better and more realistic valuation.

Income Statement
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $1,976,000 $2,074,800 $2,178,540 $2,287,467 $2,401,840
Cost of Sales 1,213,659 1,274,342 1,338,059 1,404,962 1,475,210
Gross Profit $762,341 $800,458 $840,481 $882,505 $926,630

Accounting 6,000 6,300 6,615 6,946 7,293

Advertising &
15,000 12,360 12,731 13,113 13,506
Promotion
Bank Charges 41,496 43,571 45,749 48,037 50,439
Compensation &
246,643 254,042 261,663 269,513 277,598
Benefits
Consulting Fees 2,400 0 0 0 0
Insurance 1,000 1,050 1,103 1,158 1,216
Lease - Facilities 336,000 336,000 336,000 336,000 336,000
Legal & Professional 500 500 500 500 500
Licenses & Fees 500 510 520 531 541
Maintenance 600 612 624 637 649
Miscellaneous 1,800 1,836 1,873 1,910 1,948
Office supplies 2,700 2,754 2,809 2,865 2,923
Security 720 742 764 787 810
Telephone 1,800 1,836 1,873 1,910 1,948
Utilities 4,200 4,410 4,631 4,862 5,105
Website 1,800 1,800 1,800 1,800 1,800
Total Operating Exp. 663,159 668,323 679,255 690,569 702,276
EBIDTA $99,182 $132,135 $161,226 $191,936 $224,354
Depreciation 4,916 4,916 4,916 4,916 4,916
Operating Profit $94,266 $127,219 $156,310 $187,020 $219,438
Interest Expense 43,199 40,274 37,059 33,524 29,639
Earnings Before
51,067 86,945 119,251 153,496 189,799
Taxes
Income Taxes 17,873 30,431 41,738 53,724 66,429
Net Income $33,194 $56,514 $77,513 $99,772 $123,370

Balance sheets
 Begin Year 1 Year 2 Year 3 Year 4 Year 5

Cash $33,150 $110,697 $210,697 $243,259 $293,834 $363,370

Inventory 425,000 425,000 424,781 446,020 468,321 491,737
Prepaid Leases 28,000 28,000 28,000 28,000 28,000 28,000
Total Current
$486,150 $563,697 $663,478 $717,279 $790,155 $883,107
Assets

Fixed Assets 33,850 33,850 33,850 33,850 33,850 33,850

Less: Depreciation 0 4,916 9,832 14,747 19,664 24,579
Net Fixed Assets 33,850 28,934 24,018 19,103 14,186 9,271
Total Assets $520,000 $592,631 $687,496 $736,382 $804,341 $892,378

Accounts Payable 0 68,908 139,654 146,637 153,968 161,667

Long Term Debt 468,000 438,529 406,133 370,522 331,377 288,346
Total Liabilities 468,000 507,437 545,787 517,159 485,345 450,013
Owner's Equity
Paid-in Capital 52,000 52,000 52,000 52,000 52,000 52,000
Retained Earnings 0 33,194 89,709 167,223 266,996 390,365
Total Liabilities &
$520,000 $592,631 $687,496 $736,382 $804,341 $892,378
Equity

Cash Flow Statements

Year 1 Year 2 Year 3 Year 4 Year 5

Operating Profit $94,266 $127,219 $156,310 $187,020 $219,438

Add: Depreciation 4,916 4,916 4,916 4,916 4,916
99,182 132,135 161,226 191,936 224,354
Working Capital
-68,908 -70,966 14,256 14,968 15,719
Investment
Cash From
168,090 203,101 146,970 176,968 208,635
Operations
Interest Expense 43,199 40,274 37,059 33,524 29,639
Income Taxes 17,873 30,431 41,738 53,724 66,429
Net Cash Before Debt
107,018 132,396 68,173 89,720 112,567
Pmt
Debt Payment 29,471 32,396 35,611 39,145 43,031
Change in Cash $77,547 $100,000 $32,562 $50,575 $69,536

Cash Reconciliation
Beginning Cash $33,150 $110,697 $210,697 $243,259 $293,834
Change in Cash 77,547 100,000 32,562 50,575 69,536
Ending Cash $110,697 $210,697 $243,259 $293,834 $363,370
d to be 1.5, risk free
ate for 2% after the

e?
c valuation.
(a) SOLUTION

0 1 2 3
Total assets $486,150 $563,697 $663,478 $717,279
Equity ratio $0.10 $0.14 $0.21 $0.30
Debt ratio(liabilities/assets) $0.90 $0.86 $0.79 $0.70
Cost of debt 0 0.09 0.09 0.09
cost of capital ( rCAPM) 14% 14.0% 14.0% 14.0%
Tax rate 0 35.0% 35.0% 35.0%

EBIT 0 $94,266 $127,219 $156,310

Less: Interest expense 0 $43,199 $40,274 $37,059
EBT 0 $51,067 $86,945 $119,251
Less: Income tax expense 0 $17,873 $30,431 $41,738
Net income 0 $33,194 $56,514 $77,513

Equity capital 52,000 85,194 141,709 219,223

Equity charge (cost of equity) 11927.16 19839.26 30691.22

Net income 0 $33,194 $56,514 $77,513

Less: Equity charge $11,927 $19,839 $30,691
Residual income(RI) $21,267 $36,675 $46,822

Present value of RI @ WACC 0 19379.97557 30299.2462 34727.44986

Book value, V at period t=0 342,365
Add:PV of continuing residual
income $82,695

TOTAL VALUE OF
COMMON STOCK 581,238

VALUE OF THE COMPANY

USING THE RESIDUAL
INCOME MODEL $ 581, 695

WACC
WACC= cost of equity*weight of equity + cost of debt*weight of debt
Year 1 Year 2 Year 3
Equity 52000 85194 141709
Debt 438529 406133 370522
Total debt and equity 490529 491327 512231
weight of equity 11% 17% 28%
weight of debt 89% 83% 72%
cost of equity 14% 14% 14%
cost of debt 9% 9% 9%
WACC 10% 10% 10%
 ASSUMPTIONS

4 5 cost of capital r =rf+Ba(rm-rf)

$790,155 $883,107 =2%+1.5(10-2)
$0.40 $0.50 r= 14%
$0.60 $0.50
0.09 0.09 Equity charge = total equity x cost of capital
14.0% 14.0%
35.0% 35.0% Tax rate = tax expense / EBT

$187,020 $219,438 Value of the company = book value + pv of RI

$33,524 $29,639 RI- residual income
$153,496 $189,799 RI=Net income-equity charge
$53,724 $66,429 Persistence factor for continuing residual income=2%
$99,772 $123,370 2%

318,996 442,365
44659.44 61931.1

$99,772 $123,370
$44,659 $61,931
$55,113 $61,439

36278.82636 35491.871

Year 4 Year 5
219223 318996
331377 288346
550600 607342
40% 53%
60% 47%
14% 14%
9% 9%
11% 12%
 Income Statement
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $1,976,000 $2,074,800 $2,178,540 $2,287,467 $2,401,840
Cost of Sales 1,213,659 1,274,342 1,338,059 1,404,962 1,475,210
Gross Profit $762,341 $800,458 $840,481 $882,505 $926,630

Accounting 6,000 6,300 6,615 6,946 7,293

Advertising & Promotion 15,000 12,360 12,731 13,113 13,506
Bank charges 41,496 43,571 45,749 48,037 50,439
Compensation & Benefits 246,643 254,042 261,663 269,513 277,598
Consulting Fees 2,400 0 0 0 0
Insurance 1,000 1,050 1,103 1,158 1,216
Lease - Facilities 336,000 336,000 336,000 336,000 336,000
Legal & Professional 500 500 500 500 500
Licenses & Fees 500 510 520 531 541
Maintenance 600 612 624 637 649
Miscellaneous 1,800 1,836 1,873 1,910 1,948
Office supplies 2,700 2,754 2,809 2,865 2,923
Security 720 742 764 787 810
Telephone 1,800 1,836 1,873 1,910 1,948

Utilities 4,200 4,410 4,631 4,862 5,105

Website 1,800 1,800 1,800 1,800 1,800

Total Operating Exp. 663,159 668,323 679,255 690,569 702,276

EBIDTA $99,182 $132,135 $161,226 $191,936 $224,354

Depreciation 4,916 4,916 4,916 4,916 4,916

Operating Profit $94,266 $127,219 $156,310 $187,020 $219,438

Interest Expense 43,199 40,274 37,059 33,524 29,639
Earnings Before Taxes 51,067 86,945 119,251 153,496 189,799
Income Taxes 17,873 30,431 41,738 53,724 66,429
Net Income $33,194 $56,514 $77,513 $99,772 $123,370

Balance sheets

Begin Year 1 Year 2 Year 3 Year 4

 Begin Year 1 Year 2 Year 3 Year 4

Cash $33,150 $110,697 $210,697 $243,259 $293,834

Inventory 425,000 425,000 424,781 446,020 468,321
Prepaid Leases 28,000 28,000 28,000 28,000 28,000
Total Current Assets $486,150 $563,697 $663,478 $717,279 $790,155

Fixed Assets 33,850 33,850 33,850 33,850 33,850

Less: Depreciation 0 4,916 9,832 14,747 19,664
Net Fixed Assets 33,850 28,934 24,018 19,103 14,186
Total Assets $520,000 $592,631 $687,496 $736,382 $804,341

Accounts Payable 0 68,908 139,654 146,637 153,968

Long Term Debt 468,000 438,529 406,133 370,522 331,377
Total Liabilities 468,000 507,437 545,787 517,159 485,345
Owner's Equity
Paid-in Capital 52,000 52,000 52,000 52,000 52,000
Retained Earnings 0 33,194 89,709 167,223 266,996
Total Liabilities & Equity $520,000 $592,631 $687,496 $736,382 $804,341

Cash Flow Statements

Year 1 Year 2 Year 3 Year 4 Year 5

Operating Profit $94,266 $127,219 $156,310 $187,020 $219,438

Add: Depreciation 4,916 4,916 4,916 4,916 4,916
99,182 132,135 161,226 191,936 224,354
Working Capital Investment -68,908 -70,966 14,256 14,968 15,719
Cash From Operations 168,090 203,101 146,970 176,968 208,635
Interest Expense 43,199 40,274 37,059 33,524 29,639
Income Taxes 17,873 30,431 41,738 53,724 66,429
Net Cash Before Debt Pmt 107,018 132,396 68,173 89,720 112,567
Debt Payment 29,471 32,396 35,611 39,145 43,031
Change in Cash $77,547 $100,000 $32,562 $50,575 $69,536

Cash Reconciliation
Beginning Cash $33,150 $110,697 $210,697 $243,259 $293,834
Change in Cash 77,547 100,000 32,562 50,575 69,536
Ending Cash $110,697 $210,697 $243,259 $293,834 $363,370
Year 5
Year 5

$363,370
491,737
28,000
$883,107

33,850
24,579
9,271
$892,378

161,667
288,346
450,013

52,000
390,365
$892,378
(b) SOLUTION
Year 1
Total revenue $1,976,000
less:Cost of Goods Sold 1,213,659
Gross profit $762,341

less:Selling, general and administrative expenses 663,159

Earnings before interest, taxes, depr. & amort. (EBITDA) $99,182

less:Depreciation 4,916

Earnings before Interest and taxes (EBIT) $94,266

Federal and State Income Taxes 17,873

Net Operating Profit After-Tax (NOPAT) $33,194

Add :depreciation 4,916

less:Capital Expenditures 0
less: New Net Working Capital -68,908

Free Cash Flow $97,186

Termina value

Present Value of Free Cash Flows @ WACC 88563.3364338504

Total Present Value of Company Operations 555612.6

Plus Current Assets $883

Total Market Value $1,43

WACC
WACC= cost of equity*weight of equity + cost of debt*weight of debt
Year 1

Equity 52,000
Debt 438,529

Total debt and equity 490,529

weight of equity 11%

weight of debt 89%

cost of equity 14%
cost of debt ###
WACC 10%
Year 2 Year 3 Year 4 Year 5
$2,074,800 $2,178,540 $2,287,467 $2,401,840
1,274,342 1,338,059 1,404,962 1,475,210
$800,458 $840,481 $882,505 $926,630

668,323 679,255 690,569 702,276

$132,135 $161,226 $191,936 $224,354

4,916 4,916 4,916 4,916

$127,219 $156,310 $187,020 $219,438

30,431 41,738 53,724 66,429

$56,514 $77,513 $99,772 $123,370

4,916 4,916 4,916 4,916

0 0 0 0
-70,966 14,256 14,968 15,719

$122,564 $58,341 $79,888 $102,735

154924.39467643

111402.5972665 52809.9220634 71958.51790087 230878.27774878

555612.651413381

$883,107

$1,438,720

Year 2 Year 3 Year 4 Year 5

85,194 141,709 219,223 318,996

406,133 370,522 331,377 288,346

491,327 512,231 550,600 607,342

17% 28% 40% 53%

83% 72% 60% 47%

14% 14% 14% 14%
### ### ### ###
10% 10% 11% 12%
 Income Statement
Year 1 Year 2 Year 3 Year 4 Year 5
Revenues $1,976,000 $2,074,800 $2,178,540 $2,287,467 $2,401,840
Cost of
1,213,659 1,274,342 1,338,059 1,404,962 1,475,210
Sales
Gross
$762,341 $800,458 $840,481 $882,505 $926,630
Profit

Accounting 6,000 6,300 6,615 6,946 7,293

Advertisin
g& 15,000 12,360 12,731 13,113 13,506
Promotion
Bank
41,496 43,571 45,749 48,037 50,439
Charges
Compensat
ion & 246,643 254,042 261,663 269,513 277,598
Benefits
Consulting
2,400 0 0 0 0
Fees
Insurance 1,000 1,050 1,103 1,158 1,216
Lease -
336,000 336,000 336,000 336,000 336,000
Facilities
Legal &
Professiona 500 500 500 500 500
l
Licenses &
500 510 520 531 541
Fees
Maintenan
600 612 624 637 649
ce
Miscellane
1,800 1,836 1,873 1,910 1,948
ous
Office
2,700 2,754 2,809 2,865 2,923
supplies
Security 720 742 764 787 810
Telephone 1,800 1,836 1,873 1,910 1,948
Utilities 4,200 4,410 4,631 4,862 5,105
Website 1,800 1,800 1,800 1,800 1,800
Total
Operating 663,159 668,323 679,255 690,569 702,276
Exp.
EBIDTA $99,182 $132,135 $161,226 $191,936 $224,354
Depreciatio
4,916 4,916 4,916 4,916 4,916
n
Operating
$94,266 $127,219 $156,310 $187,020 $219,438
Profit
Interest
43,199 40,274 37,059 33,524 29,639
Expense
Earnings
Before 51,067 86,945 119,251 153,496 189,799
Taxes
Income
17,873 30,431 41,738 53,724 66,429
Taxes
Net
$33,194 $56,514 $77,513 $99,772 $123,370
Income

Balance sheets

Begin Year 1 Year 2 Year 3 Year 4 Year 5

Cash $33,150 $110,697 $210,697 $243,259 $293,834 $363,370

Inventory 425,000 425,000 424,781 446,020 468,321 491,737
Prepaid
28,000 28,000 28,000 28,000 28,000 28,000
Leases
Total
Current $486,150 $563,697 $663,478 $717,279 $790,155 $883,107
Assets

Fixed
33,850 33,850 33,850 33,850 33,850 33,850
Assets
Less: Depr
0 4,916 9,832 14,747 19,664 24,579
eciation
Net Fixed
33,850 28,934 24,018 19,103 14,186 9,271
Assets
Total
$520,000 $592,631 $687,496 $736,382 $804,341 $892,378
Assets

Accounts
0 68,908 139,654 146,637 153,968 161,667
Payable
Long Term
468,000 438,529 406,133 370,522 331,377 288,346
Debt
Total
468,000 507,437 545,787 517,159 485,345 450,013
Liabilities
Owner's
Equity
Paid-in
52,000 52,000 52,000 52,000 52,000 52,000
Capital
Retained
0 33,194 89,709 167,223 266,996 390,365
Earnings
Total
Liabilities $520,000 $592,631 $687,496 $736,382 $804,341 $892,378
& Equity

Cash Flow Statements

Year 1 Year 2 Year 3 Year 4 Year 5

Operating
$94,266 $127,219 $156,310 $187,020 $219,438
Profit
Add: Depr
4,916 4,916 4,916 4,916 4,916
eciation
99,182 132,135 161,226 191,936 224,354

Working
Capital -68,908 -70,966 14,256 14,968 15,719
Investment

Cash From
168,090 203,101 146,970 176,968 208,635
Operations

Interest
43,199 40,274 37,059 33,524 29,639
Expense
Income
17,873 30,431 41,738 53,724 66,429
Taxes
Net Cash
Before 107,018 132,396 68,173 89,720 112,567
Debt Pmt
Debt
29,471 32,396 35,611 39,145 43,031
Payment
Change in
$77,547 $100,000 $32,562 $50,575 $69,536
Cash

Cash
Reconciliat
ion
Beginning
$33,150 $110,697 $210,697 $243,259 $293,834
Cash
Change in
77,547 100,000 32,562 50,575 69,536
Cash
Ending
$110,697 $210,697 $243,259 $293,834 $363,370
Cash
c) If Owners decide to issue 1,000,000 common shares, how much would be the value for each share?

(i) Residual Income approach

value of a share = total market value/ no. of shares
=$ 287,669/1,000,000
0.287669
value of a share = $ 0.29

(ii) Discounted cashflows

value of a share = total market value/ no. of shares
= $ 1,438,720/1,000,000
1.423141
value of a share = $1.42

d) Solution.
(i) The residual income approach values the firm at $ 581, 695 while the free cash flows method value the firm at $
The residual income approach shows the economic profit after deducting the cost of equity, which is the actual val
While the free cashflows use a terminal value of cashflows in the model, the resudual income approach use the act
which is more realistic considering that cashflows are highly uncertain in future periods since it is not possible to as
value for each share?

h flows method value the firm at $ 1,438,720

st of equity, which is the actual value created by the firm to the shareholders.
udual income approach use the actual book value of the common stock at the time of of valuation
periods since it is not possible to assess with certainty the ability of the firm to earn the cashflows.