Northrop Grumman Corporation Module 6 – Cost of Capital and Valuation Alex Aponte - Section 2 – Acct 70311
Brief Overview of Northrop • Northrop Grumman Corporation is a leading global security company providing innovative systems, products and solutions in a number of key segments.
Overview of Northrop Grumman • Founded: 1939 under the name “Northrop Aircraft Incorporated” • In 1994, acquired “Grumman Aeronautical to form Northrop Grumman. • Headquarters: Falls Church, VA • Major Customer: U.S. Government (90% of sales)
Four Segments of Northrop • Aerospace Systems – 36.5% of sales – design, development, integration and production of manned aircraft, unmanned systems, spacecraft, etc. • Electronic Systems – 25.5% of sales – designs, develops and manufactures solutions a variety of defense electronics and systems for controlling a military environment.
Segments (continued) 3. Information Systems – 26.9% of sales – focuses on cyber-security; C4ISR; intelligence processing; ad air ad missile defense. 4. Technical Services– 11.1% of sales - provides training solutions, logistics services, and advanced technology in missile defense, nuclear security, and simulations.
Sales Growth • Adjusted to 4.0% from –3.93% in module 5 • Justification – recession, democratic President • Northrop cannot be expected to decline like this long-term • Adjusted approximately to match inflation
Risk-free rate • Used the most recent risk-free rate (February 7 2014) for 30-year Treasury Note • For regression analysis, used % change in risk-free rates on a monthly basis from 2009 to 2013 • Rf = 3.67%
Return on Market (rMkt) • Used 8.67% • Reasoning: Ballpark return after risk-free rate of 5%. • 8.67% - 3.67% = 5.00%
Alpha (α) • α = 0.0056 • Alpha is the y-intercept calculated when running a regression
Beta (β) • β = 1.023 • Beta is “Raw Beta” off of Bloomberg • Very closely follows the market (beta of 1)
After-tax Cost of Debt Capital (RD) • RD = (interest expense/L-T debt)*(1-.37) = ($257/$5,928)*(.63) = 2.73% • “.37” represents a rough estimate on federal and state taxes • Cost of debt is largely contingent upon the risk that lenders believe exist within the company • Chosen instead of alternative using RNFL because this is believed to be more relevant and approximate
Cost of Debt – Moody’s • Baa2 credit rating (Lower-Medium Grade) • Briefly rated at Baa1 in 2008
Cost of Equity Capital - WACC (REq) • Cost based on the level of risk investors perceive are inherent with Northrop, and the return investors demand as a result. • Req = rf + β(rMkt – rf) • Req= 3.67% + 1.023(8.67% – 3.67%) = 8.79%
Enterprise Value (Vent) • Vent = total value of the enterprise • Vent = NOC Stock$ @ Feb 7 2014 X Common Shares Outstanding = $114.97 X 218M shares = $25,013B
Debt and Equity Portion of Enterprise Value (VD and Veq) • VD = debt portion of the enterprise value • VEq = equity portion of the enterprise value • VD = Net Financial Liabilities (NFL) for year-end 2013 = $4,225B • Veq = Vent – VD = $25,013B - $4,225 = $20,788 • Veq and VDwill be used next to compute cost of capital
Cost of Capital (rEnt) • This includes the risks associated with developing defense equipment, and the return that is required due to that risk • Rent = [(2.73%)*($4,225/$25,013)] + [(8.79%)*($20,788/$25,013)] = 7.76% • Investors requiring less (compared to 10.0% Rent) return on investment (debt & equity).
Why New DCF Makes More Sense.. • Cost of capital: this makes more sense because it takes into consideration the required rate of return separately of both debt and equity holders. • Sales growth: Accounts for inflation and fact that company likely will pick up steam in future. Could change if there is a change in political U.S. climate.
Thoughts • Estimated Intrinsic Value: $56,860. • Cost of Capital still not very reliable because of “ballpark” 37% tax rate. • Not reliable also because we are using an estimated value of the firm to calculate WACC (a form of circular calculation). • Much more accurate than 10.0% cost of capital (considers capital structure, public’s perceived risk in debt and equity specific to firm and Aerospace/Defense Industry).