Sensitivity analysis of the discounted cash flow valuation

Forecasting the budget period from 2008/09 – 2018/19 and estimating the capital required rate of return has been made by using the financial analysis and the outcome of the strategic analysis. Therefore there are a lot of value drivers that have either a direct or an indirect effect in the valuation of IC Companys.

Furthermore we have to recall what has already been mentioned earlier that IC Companys is considered as a cyclical company. This means we have to face other challenges as well. In the following sections we will start out with the complications that are related to valuating a cyclical company and thereafter we will discuss other value drivers.

There is different ways of valuating a cyclical company. The method we have used is by calculating the market value of IC Companys from a best case scenario and a worst case scenario and weigh them in regards to probability. In appendix 1.10 and 1.10.1 we have the best- and worst case budget. In giving these scenarios probabilities we had two major considerations. Due to this, it is decided to valuate IC Companys by giving the best case scenario a probability of 35% and the worst case scenario a probability of 65%. The first thought regarding the valuation has been how much a buyer would be willing to pay for IC Companys and how much a seller would expect to gain from a possible sale. The second thought is our expectations to the future growth.

We do not believe that is fair to valuate IC Companys by using the value drivers in a time where the development for the company is going in a negative direction. At the same it would also be misleading to estimate a market value of IC Companys by just making use of values that has been generated from an upwards going development. When to valuate the company one must take both the good and bad time into consideration.

Our estimation of IC Companys is that each share is more valuable than 133 DKK. Therefore this is not the price, which should be used. 233 DKK is a more appropriate price that would be acceptable for

both the seller and buyer. Even though there will always be conflicts of interest between the buyer and seller.

Another reason why we have estimated the best case to 35% and worst case to 65% is our expectations to the future growth. We believe that IC Companys will manage to turn their performance in a positive direction. But our estimation is that it would be with a more moderate development in the future. The growth rate has been based on the information we got from the strategic analysis concerning the

planned future implementations and the ability of the company to change this development. Further, the macro/micro economic factors are expected to improve, which will influence the growth rate of IC Companys in a positive direction.

In spite of some of the values have been conservatively estimated, there is some factors in the valuation that have been estimated on subjective and critical valuations. These factors will affect the valuation with separately weight and therefore should the valuation be complemented with a sensitivity analysis to identify how sensitive the valuation is towards these factors.

For instance we have estimated the risk-free rate under the assumption that we make an investment that has a long term and that the investment is risk-free. We have made use of a 10 yearly treasury bond with an effective rate of 3.87%. A growth in the interest level will result in a higher required rate of capital and “all other things equal” will result in a lower market value of IC Companys.

In the below mentioned matrix we have WACC at the horizontal axis and the growth rate in the vertical axis for the worst and best case scenarios. These are the factors that we think has a great impact in valuing the market value of IC Companys.

Figure 5.4

WACC Revenue growth rates

0%/3% 0,5%/3,5% 1%/4% 1,5%/4,5% 2%/5%

7,1% 257 274 297 328 374

7,6% 232 245 261 283 313

8,1% 211 221 233 249 269

8,6% 194 201 210 222 237

9,1% 180 185 192 200 211

The figure above clearly shows how sensitive the market value of IC Companys is towards changes in its main parameters. This shows that the stock price is more sensitive towards a change in the WACC compared to a change in the growth rate. If the calculated WACC of 8,1% is decreased with half a percentage point it will result in an increased stock price of 28 point to 261. Whereas if only the growth rate will be changed from 1%/4% to 1,5%/4,5% the price will only increase by 16 point to 249 DKK.

Furthermore this clearly indicates when the WACC is at a high level the change in the revenue has less effect on the market value of IC Companys. With a WACC of 8,1% and a growth rate of respectively of 1%/4% we have calculated the stock price to be 232,9 DKK. We believe that one should invest in IC Companys because the firm is undervalued.

The estimated value of 232,9 DKK partly prerequisites, that IC Company will be able to keep a growth rate of approximately 2% after the budget period. In the making of the budget and terminal period we have included the expected synergy effects and cost reductions in our deliberations, which hopefully will result in improved earning and profit margin. These factors are mainly based on the strategic analysis. Further, IC Companys is expected to continuously focusing on development and efficiency of the company. Their quarterly report also states a positive announcement and expectation to the future.

All this supports our estimate of 232,9 DKK. Though, there is always some form of uncertainty in relation to this scenario.

Finally it has to be said that the above mentioned valuation has been made basically by discounting the residual income where the terminal period consists of about 60% of the residual income.

We have valuated the growth and the ability to adjust to the cost as the most essential elements of IC Companys. As mentioned, the valuated share price is set to 233 DKK. Further, we don’t believe that IC Companys would have a growth below 2% in the future.

Areas to be focused on for the management:

- The management must perform and make sure of growth in the revenue.

- The cost must be adjusted

- More detailed strategic and economic budgets must be made.

To control the credibility of the residual income model valuation we have calculated the value of IC Companys by using the discounted cash flow model, which is stated in appendix 1.10 and 1.10.1. The free cash flow model is one of the most detailed models used for valuation. Budgeting the operating profit prerequisites a thorough knowledge of IC Companys. By using the estimated forthcoming cash flows we will be able to avoid those implications that occur only by using the annual statement such as problems concerning recognition- and measuring-criteria.