Kimberly-Clark Corporation (KMB)

Solution to Continuing Case, Chapter 4 THE CASH FLOW STATEMENT Calculating cash flow from operations and free cash flow from the cash flow statement The calculations follow equations 4.10 and 4.11 and Box 4.5:
2004 Reported cash flow from operations Interest payments Interest income (1) Net interest payments Tax (35.6%) Net Interest payments after tax Cash flow from operations Reported cash used in investing activities Investment in marketable securities Sales of investments Net increase in time deposits Cash investment in operations Free cash flow (1) From income statement 2,726.2 175.3 (17.9) 157.4 56.0 101.4 2,827.6 495.4 11.5 (38.0) 22.9 10.8 (29.4) (3.6) 149.0 499.0 2,328.6 178.1 (18.0) 160.1 57.0 103.1 2,655.3 1,260.1 9.0 (44.9) 36.9 2003 2,552.2 183.3 (15.7) 167.6 59.7 107.9 2,449.4 1,287.3 2002 2,341.5

130.4 1,129.7 1,525.6

1.0 1,286.3 1,163.1

The 10-K does not report a number for interest income received in cash, so we use the accrual number from the income statement as an approximation. Cash flow and accruals Accruals are the difference between Net Income and Cash Flow from Operations, reported in the cash flow statement (in millions of dollars): 2004 Net income Cash from operations Accruals 1,770 2,726 ( 956) 2003 1,644 2,552 ( 908) 2002 1,627 2,341 ( 714)

(Strictly, these are accruals for continuing operations, as KMB reports cash flow from discontinued operations separately.) Free cash flow for 2004 is calculated as follows, using equation 4.13: Earnings Net interest paid, after tax (above) Investments (above) Accruals Free cash flow Accruals and balance sheet items Accrual Depreciation and amortization Deferred income tax Net losses on asset disposals Equity earnings Minority owners share of income Change in operating working capital Balance Sheet Item Property, plant and equipment (PPE) Patents in Other assets Deferred tax assets and liabilities PPE Investments in equity companies Minority interest in balance sheet Various current asset and current liabilities $1,770 + 101 - 499 + 956 $2,328

(as above)

Postretirement benefits Other Investment and balance sheet items Investment Capital spending Acquisitions reported Investment in and proceeds from marketable securities Net increase in time deposits Proceeds from dispositions of property

Employee benefit and other obligations ?

Balance Sheet Item PPE All assets and liabilities acquired, throughout the balance sheet These are other assets Cash equivalents or other assets PPE

Discounted cash flow valuation Apply the discounted cash flow (DCF) model to the forecasted cash flows. There is a question of the appropriate growth rate for the continuing value. The valuation below uses 3% for the growth rate and the 8.5% CAPM required return.
2001 FCF Discount factor PV of FCF Total PV of FCF FCF Growth rate Continuing value (CV) PV of CV Value of the firm Book Value of Net debt Value of Equity Value of Equity per share 2002 1,163 1.085 1,072 2003 1,526 1.177 1,296 2004 2,329 1.277 1,823

4,191 3.0% 43,608 34,141 38,332 (3,798) 34,534 66.28

The continuing value is calculated as CV2004 = 2,328.6 1.03 = $43,608 1.085 1.03

The present value of the CV = $43,608/1.277 = $34,149 We are, of course, uncertain about the growth rate to apply in the continuing value. Can KMB maintain this growth rate? You might also ask whether the required return is the right one. The required return is given by the CAPM as follows: Cost of capital = 4.5% + (0.80 5.0%) = 8.5% You might ask why this is different from the 8.9% calculated in the Case solution for Chapter 3. Well, well come to this later (Chapter 13), but for now recognize that the cost of capital for the enterprise is different from that for the equity (and the equity beta of 0.88 in Chapter 3 is different from that for the enterprise, 0.80). You may be familiar with this from finance courses: The cost of capital used here is the Weighted Average Cost of Capital (WACC). A simple valuation at the end of 2004 With a growth rate of 3%, a simple DCF valuation runs as follows: Equity value = FCF2005 - Net debt g FCF2004 g - Net debt g 2,328.6 1.03 - Net debt 1.085 1.03 (you calculated the net debt in the Case

= $43,608 - $3,662 for Chapter 2)

= $39,946 or $82.72 per share on 482.9 million shares outstanding

This is well above the $64.81 that KMB was trading at in early 2005, so we have to conclude that we have the wrong required return, or the market sees a growth rate of less than 3%. Are free cash flows a good base to apply growth to? Well, in KMBs case it might work. This is a firm with positive free cash flows, growing steadily. But note that the growth in free cash flows for 2002-2004 is well in excess of a number that we could use for the long run