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Valuation Report By: Nick Bernhardt, Justin Unger, and Daniel Stone November 20, 2014 1

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Performed a complete valuation of a company with a group of three people; analyzed and forecasted financial statements and free cash flows; used information about insider and institutional trading to predict firm’s performance; found firm’s cost of capital; used DuPont model to find return on equity; used Altman’s Z-Score to analyze degree of financial distress; conducted a multiples analysis on companies in the industry; performed extensive calculations and created graphs in Excel

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Cap Investment Term Paper.docx

Valuation Report

By: Nick Bernhardt, Justin Unger, and Daniel Stone

November 20, 2014

Table of ContentsUnit 1: The Company, Industry, and CompetitorsI. Business Description.8II. Company History.8III. Moving Forward..9IV. Products and Competition.13V. Institutional Holdings, Insider Trading, and The Future18Unit 2: Historical Financial AnalysisI. Stock Price.27II. Financial Ratios..32III. DuPont and Altman Z-Score.36Unit 3: Cost of Capital, Capital Structure Analysis, and DistributionsI. Debt and Presentation of Financial Ratios..41II. External/Internal Equity45III. Presentation of Cost of Capital49IV. Distributions to Shareholders and Plowback Rate.51Unit 4: Financial Statement ForecastsI. Assumptions/Parameters of Financial Forecast..55II. Presentation of Pro Forma Financial Statements56III. New DuPont and Altman Z-Score Calculations.66Unit 5: Cash Flow ValuationI. Cash Flow Valuation72II. Comparison to Market Value..81III. Drivers of Value..82Unit 6: Multiples AnalysisI. Overview of Competitors/Comparable Companies..86II. The Industry, Market and Sector89III. Competitor Breakdown.91IV. Conclusion.96

Unit 7: Summary and ConclusionsI. Conclusions98AppendixI. Relevant Charts/Graphs/Financial Statements101BibliographyI. Works Cited114

Unit 1: The Company, Industry, and Competitors

Executive Summary Company, Industry and Competitors

Major ProductsXeroxs major products are mainly copiers/printers, and multifunction devices that combine scanning, copying, printing, and faxing into one machine. They are produced in the United States, as well as in Fiji. It is also starting to transition to service products, which help companies in a variety of ways, including document management that companies can now outsource to Xerox. Major cost components are directly tied to the outsourcing, maintenance, and rentals of their service. Company HistoryXerox Corporation is an Americanmultinationaldocument management corporation that produces and sells a range of color and black-and-white printers, multifunction systems, photocopiers, digital production printing presses, and related consulting services and supplies. Xerox first became well-known with the development of xerographic office photocopying in 1959. Xerox is adapting to the recent technological shift by moving away from photocopying and expanding into the services sector such as business processing and information technology outsourcing. New ProductsXerox simplified services in government healthcare with Enterprise, its next generation Medicaid Management Information System. Xerox also introduced smart parking solutions in Malaysia and Texas, as well as its real-time analytics-based technology Merge that addresses parking challenges in heavy traffic cities. Finally, Xerox launched its next generation managed print services. Analyst Earnings and Sales EstimatesThe annual revenue projected for Xerox in 2014 is $21.12 Billion, which is based on an estimated 6.9% growth rate in the fourth quarter. Its 2014 EPS projection is $1.11, which is based on an estimated fourth quarter EPS of $0.31. Buy/Sell/Hold RecommendationsAs of June 26th, 2014 Argus recommended that the stock should be downgraded from the status of buy to hold. For September 2014, twelve analysts made recommendations whether to buy, sell, or hold the stock. Six recommended hold, three buy and three strong buy. The indication is that the stock is doing well but not extraordinary and the best tactic would be to hold the stock for now. Positive or Negative Earnings SurprisesFrom December of 2013 to March of 2014 Xerox experienced a negative 12.5% earnings surprise. This was followed with a positive 3.80% earnings surprise from March to June. Xeroxs projected earnings growth in 2015 is 0.50%, which is less than the estimated growth of 1.80% in 2014.Projections for Next 5 to 10 Years

Drivers Behind ProjectionsThe key drivers behind the value associated with Xerox as listed above are as follows: expansion into European markets for business process outsourcing and information technology outsourcing is a major driver behind growth. ROE is driven by excess income from the acquisition of Zeno and Impika, and P/E is a factor of increased earnings as a result of the move into the services sector and a lower share price ($12.21) then in recent years. Expert OpinionsAs of September 12th, 2014, the consensus forecast amongst twenty-one polled investment analysts covering Xerox Corporation advised that the company is posed outperform the market. This consensus forecast was consistent since the status of investment analysts improved on July 28th, 2014. The previous consensus forecast advised investors to hold their position in Xerox Corp.Our OpinionThe conclusive view is that Xerox is set to outperform the market in 2015 and grow at approximately a 7% rate for the five to ten years. This makes Xerox a viable investment option and valuable company that is able provide investors with healthy returns in the foreseeable future. This conclusion is based off several analyst opinions and data collected from Bloomberg, Morningstar, Thompson One, Mergent Online and several other financial analysis sources. CompetitorsMany of the primary competitors to Xerox do not focus solely on document technology and service. Canon specializes in the manufacture of imaging and optical products while HP is a multifunctional information technology corporation. The biggest competitor to Xerox with the most market share is Canon, followed closely by HP (18.2% and 17.6%, respectively). Xerox holds the third largest market share compared to these corporations at 8.7%. Other competitors with smaller market shares include Ricoh, Brother, and Accenture. CompetitionXerox is on the upper end of the price spectrum compared to its competitors, which comes as a result of the superior quality and functionality of its products and services. In 2013 and 2014, Xerox won over a dozen awards from the Buyers Lab Inc., who specializes in ranking and comparing products in the document technology industry. Acquisitions/DivestituresIn April 2013, Xerox acquired Zeno Office Solutions, Inc. (Zeno) for approximately $59 million in cash, and Impika for $53 million in cash. Zenos purpose is to aid Xerox in its business process outsourcing campaign nationwide while Impika serves to help Xerox adapt to the smartphone revolution by making their products compatible with mobile devices such as phones and tablets. In 2013, Xerox decided to exit the paper distribution business and effectively sold its North American paper business and its European paper business. The collaborative sale resulted in $36 million of net proceeds. ExpansionDuring 2013, Xerox maintained its pace of expansion into the European market at 12% of its gross revenue. It also continued to build on investments in the Asian market to help its service department grow internationally.

Table of ContentsSection 1I. Business Description..8II. Company History..8Section 2I. Moving Forward9a. Acquisitions9b. Divestitures9c. Expansion.10II. New Products11III. Law Suits..11IV. Other Events.12Section 3I. Products and Competition..13a. Office Equipment Products.13b. Xerox Services15c. Competitor Breakdown/Description.16d. Market Share.17Section 4I. Corporate Control.18a. Key Executives..18b. Compensation..19II. Members of the Board..19Section 5I. Institutional Holdings.20II. Insider Trading20III. The Future.21

Section 1Business DescriptionWhen people think of Xerox, they think of copiers and printers. After all, Xerox built its image on these products. However, the office equipment industry is not the sole focus of Xerox. For the last 100 years, Xerox dedicated itself to the innovation of products; more specifically, products that will help create a better world. With the ever-increasing demand for easy-to-use technology that simplifies the way things get done, Xerox is stepping up to the plate to meet these demands. For instance, few people realize that Xerox invented Ethernet, which led to the creation of the Internet. No one would guess that Xerox handles toll road and municipal parking transactions on an everyday basis. Chester Carlson, the founder of Xerox, had a vision to simplify the workplace. To this day, Carlsons vision drives the way Xerox is run. Now that technology is changing faster than ever before, there are plenty of opportunities for growth in the future.

Company HistoryCarlsons vision to streamline the business world began when he created the first xerographic image on October 22, 1938. Xerox, which was originally named the Haloid Company, went public just two years before this. The creation of the first laser image opened up a whole new industry: document management. For the next 75 years, Xerox took Carlsons drive for innovation and continued to make one-of-a-kind products. This drive for innovation continues today, and Xerox is focused more than ever on creating new ways in which work can be done.

The Xerox 914, which is the name of the first photocopier created by Xerox, debuted in 1960. It made copying documents quick and easy, and revolutionized the way in which office work gets done. Companies would have to start coming up with ways in which to make these photocopying machines more efficient; however, Xeroxs focus mainly revolves around innovation, keeping the company one step ahead of the curve at all times.

This tradition of innovation and research is the core of the Xerox Corporation. The invention of the first Ethernet cord, mentioned earlier, paved the way for not just the computer, but also for Graphical User Interfaces (built in 1975) and the laser printer (built in 1977).

Section 2Moving Forward Traditionally known as an office supplies company, Xerox is trying to transition to more of a services-based business. This is due to the rise of cell phones, tablets, and other wireless devices that are able to connect to cloud-based storage systems. Since more and more companies are starting to go paperless, the need to copy, print, scan, and fax documents is dropping significantly. In order to maintain consistent growth in sales every year, Xerox must find a way to differentiate from the market. By entering into the services industry, the company is opening itself up to more opportunity for revenue. Thus, if the decline in need for document management keeps going at its current rate, Xerox will be in a good position to focus on service revenue. In order to enter the service industry, Xerox recently acquired many service companies that will help it transition more smoothly. It also exited the paper distribution business. More on these subjects is presented in the section below.

Acquisitions/Divestitures/ExpansionBelow is a list of recent Acquisitions and Divestitures:

1. Zeno Office Solutions2. Learnsomething, Inc.3. Customer Value Group Ltd. (CVG)4. CPAS Systems, Inc.5. Invoco Holding GmbH6. Impika

Zeno Office SolutionsIn April of 2013, Global Imaging Systems (a Xerox company) purchased Florida-based Zeno Office Solutions for approximately $59 million in cash. Zeno is one of the Southeasts largest and fastest growing providers of print and IT solutions to small- and medium-sized businesses. This will help Xerox capture more of the Southeast market, which should help increase its profits in that region. Acquiring Zeno is an interesting decision by Xerox. Not only does the company gain Zenos market share, customers, and business partners, it also gains a larger workforce and expertise in the technology consulting industrya new venture for Xerox.

Learnsomething, Inc.Xerox acquired Learnsomething in June, 2013. Learnsomething is the leading provider of custom e-learning solutions and consumer education for the food, drug, and healthcare industries. With this acquisition, Xerox broadens its reach into these industries. It will be important for Xerox to focus on these industries in the upcoming years because of the new systems set in place by the government, particularly the healthcare industry. This industry is in a state of rapid change and development, and Xeroxs sales hinges on this growth.

Customer Value Group, Ltd. (CVG)Xerox acquired CVG in July, 2013. CVG is a London-based company that provides a cloud-based receivables management software. The primary product is Value+, which manages customer credit and collections. With the purchase of CVG, Xerox expanded itself further into the finance and accounting service industry.

CPAS Systems, Inc.In August of 2013, Xerox acquired CPAS Systems, Inc. CPAS is a Toronto-based company that specializes in pension management software. The company is able to streamline administration and record keeping for defined benefits, retirement plans, and health insurance premiums. According to the website, CPAS has been trusted as the solution of choice for over 150 organizations throughout Canada, the USA, the Caribbean, Europe, China, and Africa, administering more than 2000 plans, and more than 2,000,000 members worldwide, for over 26 years. The access to this part of the software industry gives Xerox a more specialized approach, which helps the company differentiate even more. The knowledge and expertise Xerox gains with this acquisition is invaluable.

Invoco Holding GmbHXerox continues its pace of expansion into the European and Asian markets, recently acquiring Invoco Holding GmbH, a German-based customer care company. According to Xerox, Invoco will provide Xeroxs global customer base with immediate access to industry-leading German languagecustomer care serviceswhile enabling Invocos existing customers to take advantage of Xeroxs broadbusiness process outsourcing(BPO) capabilities.

ImpikaXerox also acquired Impika, who is a world leader in the design, production and marketing ofadvanced industrial inkjet printing solutions. As is the case with Zeno, the acquisition of Impika should help Xerox capture more of the market. This acquisition reflects 100% ownership. Similar to the acquisition of Zeno, purchasing Impika will benefit Xerox in the fact that it increases market share in the office equipment industry. At Impikas core is the value of innovation, just like Xerox. Impika owns an international portfolio of customers that Xerox can now access. The combination of both Xerox and Impika should yield a great return to shareholders in the future solely based off of market share.

ExpansionsThe acquisitions by Xerox give access to the European and Canadian markets. More specifically, Impika will allow Xerox to expand in France, Invoco will allow Xerox to expand into Germany, CPAS in Canada, and CVG in England. Xerox is a mature company, so it is able to expand into foreign markets quite easily by this point. Since there are so many companies involved with office technology and information technology services, no one company has a dominant hold on any foreign market. However, in the Far East, where companies like Ricoh, Canon, and Brother are based, Xerox sees less of the market share.

ContractionsIn 2013, Xerox decided to exit the paper distribution industry by selling North American and European paper businesses. The collaborative sale resulted in $36 million of net proceeds. This reflects the shrinking demand for paper-based documents. More and more companies are starting to move to a paperless strategy, which means less people will be relying on printing and copying and more on scanning and online document creations.

New ProductsRecently, Xerox released new products into the market. One of these new products is Merge. Merge is a parking management system that adjusts prices on parking meters by supply and demand of parking spaces. This way, when the demand for parking spaces is up, prices will be increased to make more money. In times of low demand, the price will be lower. Merge also manages a citys meters, sensors, enforcement, and collections from parking. Another new product from Xerox is called Ignite Educator Support System. This is a web-based tool for teachers to give tests. It takes statistics on the test to show the teacher how to teach the class better. By doing this, it creates an optimized learning program for each student, based on their strengths and weaknesses on the exams.

LawsuitsClass ActionIn Nevada, about 150 people took action against Xerox and the state regarding the Affordable Care Act. These people went online, paid their premiums, but learned later they were not insured. In November 2013, a tumor was found in the brain of Linda Rolain. After paying her first months premium, Lindas oncologist informed her that she was not insured. Surgery was delayed until she was insured. The tumor was small when they caught it, but, at the time of surgery, the tumor spread up the whole left side of her head. Surgery was May 14, 2014 and she died June 30.

Xerox v. Shareholders who bought stock from October 22, 1998 to October 7, 1999Allegedly, Xerox attempted to deceive its share purchasers about how the company was performing. Xerox is accused of giving false information and/or failing to disclose information on the economic capabilities, growth, and intrinsic value of the companys operations, thus allowing several corporate insiders with information not available to the public to sell their shares and inflate the price of the shares available to the market.

EventsOn October 1, 2014, Xerox released its 2014 Global Citizenship Report. In this report, it notes that Xerox was added to the Dow Jones Sustainability North America Index (DJSI North America). A segment from its website gives information as to what the Index is about: The Dow Jones Sustainability Indices serve as benchmarks for investors who integrate sustainability considerations into its portfolios, and provide an effective engagement platform for companies who want to adopt sustainable best practices. Being on this index is good for Xerox because customers can see the company works hard to be sustainable, making them more inclined to do business with Xerox. Xerox also scored a 95 (A-) by the CDP (Carbon Disclosure Project). In 2012, Xerox was named as a market leader in five industries. In 2013, that grew to seven industries.

On November 17, 2014, Xerox plans to lay off 121 people from a manufacturing plant in Webster, NY. Many of the laid-off workers may be hired by JLL, a company that will be contracted by Xerox after the layoff. This is part of the transition to a service-based business, so fewer products will have to be manufactured in the future.

Section 3Products and CompetitionXerox offers many products and services to its customers. The main product line for most of the companys history includes copiers, printers, scanners, and fax machines. Xerox also sold paper, toner, and other supplies critical to helping these machines run on a day-to-day basis. However, as was mentioned before, Xerox is now beginning to enter the service industry to help make its customers everyday office operations run smoothly. A more detailed description of Xeroxs main products can be found below.

Main ProductsThe invention of printers and other office machines led to a great technological advance in the industry that. What was once done on multiple machines can now be done with the touch of a button on new multifunction devices. A multifunction device is a machine that can perform many office functions that used to only be available on one exclusive machine.

Best SellersFor example, lets take a look at a common product that was introduced into the market in 2013: the Xerox WorkCentre 7800 series.

Exhibit 1.1

At the bottom of the previous page is a picture of a standard WorkCentre 7800 machine (WC 7800). This machine is capable of printing from anywhere, including mobile phones and tablets, as well as from computers or laptops. It can also copy documents and receive faxes. The biggest accomplishments are the scanning capabilities. Traditional scanners were only able to scan a single document and send a PDF image to a computer file or email that could be opened by the user. Now, the new machines can take a document, scan it, and convert it to multiple formats for editing. It can also send the image to cloud-based systems that Xerox provides for its customers. This machine is one of many Xeroxs multifunction devices, and even though each different unit has different qualities, most of them now have these capabilities to offer its customers.

One of Xeroxs main focuses is to be as environmentally friendly as possible. Toner is one of the messiest parts of a multifunction device, and is often disposed of in ways that are not so friendly to the environment. To battle such concerns, Xerox invented a cartridge device that can go into most of its products that makes disposing of toner easy and clean. Another one of its product lines is also revolutionary in the industry, and no other competitor came up with something similar as of now. This product line is called the ColorQube series. What differentiates the ColorQube from the rest of the market is the type of toner used for the machine. Toner comes in liquid form and is administered into most machines via a canister or cartridge. Xerox created a new way to put toner into its machines by creating the first ever, solid ink. A picture of a liquid ink cartridge and solid ink can be viewed below to gain a better understanding of the differences between the two types of toner.

Exhibit 1.2Liquid CartridgeSolid Ink

As can be seen from the photos above, the solid ink does not come in a cartridge: instead, it is a crayon-looking block of ink that Xerox engineers developed so that instead of having to dispose of a cartridge, the solid ink can be put straight into the machine and once it is melted down it is gone, and no waste is created from the toner. This helped Xerox win numerous awards. As with the WC 7800 Series, the ColorQube machines are one of the top selling products for Xerox, especially when it comes to environmentally friendly customers.

Production of Physical ProductsAll of Xeroxs products, with the exception of Fuji Xerox products, are produced in the United States. Xerox is the only company in the industry that produces its products within the United States, which domestic customers sometimes prefer to other companies in the industry.

Xerox ServicesAccording to Xeroxs 2013 Annual Report, [Xeroxs] target is to increase business services to approximately two-thirds of total revenue by 2017. As of right now, the companys service revenue in 2013 was about half of its total revenue ($11,859 M, or 55%), so Xerox is looking to increase its business services over the coming years. Since service is a broad topic, specific information into what Xerox does is explained below.

Business Process Outsourcing (BPO)BPO accounts for 59% of Xeroxs total service revenue. This includes streamlining and speeding up all processes of business. Merge and Ignite are a part of this section of service. Anything that will help streamline a business process falls under this category.

Healthcare ServicesRecently, Xerox expanded its business into the healthcare industry. Xerox provides a service that makes it easy to connect people to insurers for the Affordable Care Act. In other words, Xerox is a healthcare provider. Xerox also automates simple healthcare function and allows caretakers to monitor multiple patients at one time.

Commercial ServicesUnder this service, Xerox helps companies with its human resources department. Xerox does this by controlling benefits, retirement plans, and pensions. Xerox also helps financial departments by providing accounting and finance management services. Customer care is another commercial service Xerox provides. Several routes, including phone, text, chat, social networks, and email, are used to help its customers get the help they need, when they need it.

Government and TransportationAs was mentioned with Merge, Xerox helps with transportation services by automating toll collection and providing cities with price optimizing service. Xerox also provides the government with services, such as electronic payments, unclaimed properties, tax structures, and child support processing.

Document OutsourcingXerox contracts document services, which include printing, copying, and scanning for other companies. This is useful in places like college campuses that have print shops. Xerox can hire someone out to use big machines for big projects so that other employees can focus on other things. This accounts for 21% of total services.

CompetitorsSince Xerox offers such a wide array of products and services to its customers, it is classified in several industries with many different competitors. The competitors that will be focused on throughout the rest of the units are explained in detail in Exhibit 1.3 below. A brief description is provided for each competitor. One of the greatest differentiators for Xerox from the rest of the market is the fact that Xerox only specializes in office equipment and services. Most other companies provide products that are unrelated to the business world. This gives Xerox a competitive advantage and helps it stand out from its competitors.

Exhibit 1.3Canon Inc. (CAJ)Canon is a Japanese-based company that specializes in optical imaging products, as well as computer printer products. Canon is like Xerox in the fact that it can also be classified under many different industries. However, Canon remains one of Xeroxs biggest competitors every year.

Ricoh Company, Ltd. (RICOY)

Ricoh, which is also a Japanese-based company, specializes in multifunction office products as well as document management services for its customers. Ricoh is almost identical to Xerox in what it provides for its customers, except Ricoh also offers non-office equipment such as digital cameras.

Brother Industries Ltd. (BRTHY)

Brother is one of the more well-known desktop printers in the industry. Like Xerox, Brother focuses on printers and printer supplies; however, Brother also provides non-office equipment such as machine tools and home sewing and embroidery.

Accenture (ACN)

Unlike the rest of the competitors, Accenture is not focused on selling office equipment products. Instead, Accenture provides management consulting, technology and outsourcing services. Accenture is one of the world leaders in what it does, and with Xeroxs entrance into the consulting and outsourced service industry, it must now be considered when comparing Xerox to other firms.

Market ShareBelow is a graph of the market share by revenue of the top five companies in the industry.

Xerox claims 18.3% of the market. Canon leads the market for printers and other office equipment, while Accenture and Ricoh have higher shares of the market than Xerox. While Xerox does not have the highest market share in either industry, the company is still considered the dominant in the office equipment industry. This is due to the trust its customers gained throughout the life of the company. The name Xerox is commonly used to describe printing machines, even if the machine being described is not a Xerox. Because of the brand loyalty created by Xerox it now controls the industry.

In the services industry, Xerox is new. Since the company is new, Xerox does not have control of the market yet. However, Xerox plans to expand this part of the business, and is expected to increase the revenue created from services over the coming years. Therefore, an increase in market share is likely to happen due to how well the company is already known.

Section 4Corporate ControlUrsula BurnsUrsula Burns is the current CEO and Chairman of the Board for Xerox. She joined the company in 1980 as an engineer. She was given the job of CEO in 2009, and named chairman of the board in 2010. She attended New York University and got her Bachelors Degree in Mechanical Engineering. She then went on to Columbia University for her Masters Degree in the same subject. Before Xerox, she was an Independent Director at American Express and Exxon Mobile.

Kathryn MikellsKatheryn Mikells is the CFO and Executive Vice President of Xerox. She was named CFO in 2013. Mikells got her BS in Finance at the University of Illinois at Urbana-Champaign, and got her MBA at the University of Chicago. Before Xerox, she was the CFO and Senior Vice President at ADT Corporation.

James Firestone James Firestone is the Executive Vice President of Xerox and the President of Corporate Operations. His previous job was at IBM. His current position was given to him in 2008, and he was hired in 1998 as the President of Xerox Channels Group. He got his BS in International Economics at Georgetown University, and got his MBA in Public Management at Yale University.

Jeffrey JacobsonJeff Jacobson is another Executive Vice President for Xerox and is also the President of Xerox Technology. This position was given to him in July of 2014. His previous job was with a company named Presstek, Inc., where he was Chairman of the Board, President, and CEO. He attended State University of Buffalo, New York, went to Cornell University for his Masters, and attained his Juris Doctor Degree at Pace University School of Law.

Robert Zapfel Robert Zapfel is Executive Vice President, and President of Xerox Services. Zapfel was appointed to his current job in April of 2014. His prior job was with IBM. He attended Northwestern University for his undergraduate, and got his Masters at Northwestern University Graduate School of Management. He earned his Juris Doctor at Chicago-Kent College of Law.

2013 Compensation TableUrsula BurnsKathryn MikellsJames Firestone

Salary$1,100,000$466,667$714,000

Bonus$1,320,000$580,000$428,400

Other Compensation$67,019$1,501,852$63,613

Total$2,487,019$2,548,519$1,206,013

As can be seen from the table above, Ursula Burns is not the top earner at Xerox. The CFO, Mikells, makes $61,500 more than the CEO. Both Jacobson and Zapfel assumed their position in 2014, and no news was released regarding their compensation. In the other compensation section of the table, Mikells includes restricted stock awards in the amount of $1,200,008. This makes up most of her total compensation. In reality Burns really does make more money, not including these restricted stock options.

Members of the Board of DirectorsA full view of the members of the board for Xerox is shown below.

116

115

Ursula BurnsChairman of the BoardCharles PrinceRetired Chairman and CEO Citigroup, Inc.Richard J. HarringtonChairman and General Partner The Cue Ball GroupRetired President and CEO The Thomson Corp.Ann N. ReeseExecutive Director Center for Adoption PolicyWilliam Curt HunterDean Emeritus Tippie College of Business, University of IowaSara Martinez TuckerPresident and CEO National Math and Science InitiativeFormer Under-Secretary of Education in the U.S. Department of EducationRobert J. KeeganOperating Partner Friedman, Fleischer & LoweRetired Chairman of the Board, CEO andPresident The Goodyear Tire & RubberCompanyMary Agnes WilderotterChairman and CEO Frontier Communications Corporation

As is the case with any major corporation, each member has his/her own specific duties that are vital the companies operation and success. Xerox has a history of selecting competent and experienced members to be on its board, which is a key component of Xeroxs sustained success through decades of economic and industry change.

Section 5Institutional HoldingsBelow is a glance at the institutional holdings for Xerox and its competitors.

Xerox 82.75% Canon 1.29% Ricoh .06% Brother - .01% Accenture 81.97%

From this information, it is clear that most institutions prefer to hold Xerox and Accenture in one or more of their portfolios on a day-to-day basis. This is because Xerox and Accenture tend to be less risky than the other companies. One thing to mention is that institutions may like to hold Xerox and Accenture because of the rise in the service industry. As new technology is becoming more available, service providers of any sort will have success in managing this technology for people that either cannot do it themselves, or do not have the time to do it. Another note on the holdings percentages is that Canon, Ricoh, and Brother are all foreign companies. Therefore, all these companies are subject to foreign-risk, which could be why the percentages are so low compared to Xerox and Accenture.

Insider TradingThe information regarding insider decisions over the last six months is as follows:

Net Shares Purchased (Sold)Xerox: (574,071) shares= (.09%)Accenture: (277,999) shares= (13.3%)Institution Prior Qtr to Latest QtrNet Shares Purchased (Sold)Xerox: (100,983,000 ) shares= (11.61%)Accenture: (83,660) shares= (.02%)

This information shows that Xerox actually sold 574,071 shares to the public over the last six months, or an equivalent 0.09% of its overall shares in the market. Canon, Ricoh, nor Brother did anything with the number of shares outstanding in the market. Accenture also sold shares to the public, specifically 277,999 shares (13.30% of the companys overall shares). From the prior quarter to the latest quarter, financial institutions sold 100,983,000 shares of Xerox, and 83,660 shares of Accenture. This shows that these institutions prefer to hold on to Accenture. Despite the large number of Xerox shares sold, it is only 11.61% of the overall shares in the market. This means that for the most part, institutions like to hold on to Xeroxs stock and Accentures. As time moves forward and Xerox transitions to more of a service based company, the financial institutions market will likely start to hold on to shares in Xerox in accordance with other service companies like Accenture.

The FutureBelow is an article from Morningstar.com titled Xerox's best growth opportunities are in back-office services, but business shift will take time. The author explains his thoughts on Xeroxs stock.

Xerox's best growth opportunities are in back-office services, but business shift will take time.By Peter Wahlstrom

Investment Thesis10/27/2014Xerox has decoupled its fate from the declining copier/printer industry by diversifying into outsourcing services, which offer stickier, longer-term contracts. The firm has become a leading service provider for back-office business processes and health-care solutions, and we believe service sales could grow as the tangle of business regulation and health-care laws worsens.

Xerox was once so prevalent in copiers/printers that "Xeroxing" became synonymous with "photocopying." Today, C/P sales constitute approximately 40% of sales. Xerox's legacy C/P operations continue to generate attractive returns through the selling of high-margin printing supplies to a large install base of enterprise customers. However, we believe there are few opportunities to grow in the printing market; enterprises are using computers, tablets, and smartphones to display rather than print media, while increasingly outsourcing their printing needs.

Instead, we believe Xerox's future lies in its business services segment, which the firm expects to constitute two thirds of sales by 2017. BSS outsources back-office functions and typically delivers contracts for businesses and governments that are sticky and long term and cater to cross-selling opportunities. For example, customers may use Xerox's managed print services--a logical extension of Xerox's C/P business--which gives Xerox a foot in the door with customers to sell other back-office services like human resource functions, cloud services, and network outsourcing. While Xerox has large contracts with governments, which are facing budgetary headwinds, we expect its sticky service contracts can sustain a healthy normalized renewal rate within the firm's target range of 85%-90%.

Xerox has opportunities to expand even further. The firm generates more than 70% of sales in the United States and has room to grow in Europe and emerging markets. Additionally, Xerox's operations touch a large number of adjacent verticals, and we expect the firm will grow organically and through acquisitions to take advantage of expanding markets.

Economic Moat10/27/2014We believe Xerox has a narrow economic moat. The firm is likely to remain a leader in printing technology thanks to its focus on innovation, geographic footprint and manufacturing scale. More, although Xerox competes with other printer manufacturers like Canon and HP when selling the initial printer, Xerox wins a captive audience for high-margin ink and supplies for the following five years once it installs the hardware. Additionally, Xerox's scale positions the firm to capitalize on emerging trends such as managed print services, which require global reach to be competitive.

Xerox also has a moat in its services businesses, which make up about 52% of sales. The business process outsourcing, document outsourcing and IT outsourcing engagements are long term in nature, and it is expensive and time-consuming for the customer to migrate to another vendor. There are many startup costs associated with each engagement. More, Xerox often integrates multiple services that are difficult and risky for competitors to replace a la carte without creating disruption for the customer. As a result, the incumbent vendors are generally favored at renewal, because any competitors hoping to displace an established vendor will face a cost disadvantage.

Valuation01/27/2014Our fair value estimate is $12 per share, implying a December 2014 price/earnings of 12 times, enterprise value/EBITDA multiple of approximately 8 times, and free cash flow yield of more than 10%. We anticipate Xerox's sales to tick up less than 2% in 2014 as acquisitions and services gains to moderately offset the firm's exposure to a deteriorating printer market, keeping operating margins in the 6%-7% range. Going forward, we believe Xerox will focus capital around expanding its outsourcing services. We anticipate back-office outsourcing opportunities are likely to grow as government regulations increase and an aging American population increases the burden on the health-care industry. Additionally, Xerox has limited services exposure in Europe, and we believe there are lucrative opportunities for the company to expand its presence abroad once the eurozone recovers. We model revenue growth remaining in the low single digits and relatively flat operating margins (between 6% and 7%) over the next five years. We anticipate increased competition will erode hardware gross margins while growing demands on the health-care industry will lead to more favorable contracts, expanding services margins.

Risk10/27/2014New technologies such as tablets could accelerate the adoption of paperless workflow, which would present a headwind to all printing technologies. By entering the services market, Xerox is differentiating itself from the equipment-only manufacturers, but competing with the established large professional services firms. Xerox's customer financing business could lead to unexpected losses. Xerox has substantial debt that must be rolled forward during the next few years. Additionally, green initiatives by customers could reduce Xerox's recurring revenue streams from consumables.

Management01/27/2014Overall, we view Xerox's stewardship of shareholder capital as standard. In 2009, Ursula Burns took the reins from veteran Anne Mulcahy. Burns, a company veteran, was promoted to president in 2007 and we expect she will continue to focus on driving costs out of the system and generating recurring revenue streams. Burns received a salary of $1.1 million in 2012 and a total compensation package of $13.1 million. CEO target compensation is broken down into 10% base salary, 16% short-term incentives, and 74% long-term incentives, which are based on a three-year average of adjusted earnings per share, operating cash flow, and revenue growth. Xerox's board is 91% independent, with directors and insiders holding less than 1% of shares outstanding.

In recent years, Xerox has used its capital to build out the services business. This was a smart strategy, given the growing challenges in the printer and copier markets. The ACS acquisition was a transformative deal that wasn't cheap, but it jump-started Xerox's services presence in several key verticals. Fortunately for shareholders, Xerox is not acting out of desperation and chasing every services deal. Instead, the company is focused on opportunistic growth opportunities while returning substantial amounts of its free cash flow to shareholders.

Unit 2: Historical Financial Analysis

Executive SummaryStock PerformanceFor the last five years, Xeroxs monthly change in stock price fluctuates, and the same goes for the four competitors we chose in the same industry. The most notable trend is that during 2011, everyone except Accenture saw a negative price change, which was due to an unexpected downturn in the industry during that year. It lasted until the end of 2012 and then the price changes went positive again.

The performance of Xeroxs stock price growth from 2009-2013 is as follows:Geometric Mean Annualized=8.07% Arithmetic Mean=13.13%High: $14.05Standard Deviation=0.3939 Coefficient of Variation=4.90Low: $4.17

DuPont Analysis for Past Five Years At 8.26%, Xerox possesses an ROE that is seven percent lower than the industry. While the average Asset Turnover of the industry is 134.58%, Xerox claims an extremely low Asset Turnover of 73.86%a difference of 60.72%. This difference also causes Xeroxs ROA to be three percent lower than the industry. Since Xerox is transitioning to more of a services-based business, this might be alarming, but Asset Turnover is up from 67% in 2009 and for the past three years, Asset Turnover remained steadily around 75% in 2011, 76.54% in 2012, and 74.77% in 2013. Profit Margin and Equity Multiplier for Xerox each differ from the industry by less than one percent.

Z-Score Analysis for Past Five Years Xerox, 1.52, is predicted to go bankrupt in less than a year while the industry, 1.93, is in possible financial distress. Normally this would be a cause for concern, but for each of the past five years, Xeroxs Z-score was under 1.81. Xerox boasts an EBIT/Total Assets ratio that is 2.34% higher than the industry; however, the Net Working Capital/Total Assets, Retained Earnings/Total Assets, and Sales/Total Assets ratios are lower than the industry by 9.83%, 11.18%, and 19.82% respectively. The Market Value of Equity/Book Value of Liabilities ratio is also lower than the industry by 1.24%.

Table of ContentsSection 1I. Stock Price Performance..27a. Past performance vs. S&P50027b. Absolute Performance28c. Comparison to Competitors29Section 2I. Historical Financial Ratios32a. Breakdown of Ratios/Analysis33Section 3I. DuPont and Altman Z-score36

Section 1

OverviewWith Xeroxs decision to focus on the information technology services industry, the stock price over the last five years saw its ups and downs. From a low of $4.17 per share to a high of $14.05, it is important to know what caused these dramatic changes in price. Below is a graph showing the historical monthly stock price growth over the last 5 years.

Note: It is important to note that the graphs in this unit are not comparing the price of the stocks. Rather, they compare the monthly growth of each index or company.

Exhibit 2.1

As can be observed, the stock price rose gradually over the last five years. Two trends stand out over this time period. The first is that during the economic downturn of 2009, Xeroxs stock price actually increased over the course of the year. The second is that at the end of 2010, the stock price saw a substantial decline in value until the end of 2012. This can be attributed to many factors, which will be discussed later in the section.

Absolute PerformanceTo get a better understanding of the performance of Xeroxs stock price over the last five years, it is important to take a look at more specific measurements, particularly the arithmetic and geometric mean, the standard deviation, and the coefficient of variation of the stock price. The next page shows a table summarizing the performance of Xeroxs stock price growth over the last 5 years (monthly).

Exhibit 2.2Monthly Stock Price Growth Rate StatisticsArithmetic MeanGeometric MeanStandard DeviationCoefficient of Variation

0.01660.01170.10198.7144

Arithmetic MeanThe average stock price over the last five years is $8.66. Since each company has stock prices that vary due to differentiating factors, it is better to look at the average growth rate over this time period. In this case, Xeroxs average monthly growth rate since January of 2009 is 1.66%.

Geometric MeanSince each months growth in stock price is dependent on the previous months growth, the geometric mean gives a more accurate look at the average monthly growth rate in stock price. Therefore, the geometric average monthly growth rate of 1.17% will be used for the rest of the unit. At first glance, the positive average indicates that the company is in good financial condition. Later in the section, competitor information will be compared to Xeroxs information to gain a better understanding of how Xerox is doing compared to the industry.

Standard DeviationOne of the basic measures of risk in a companys stock is based off of the standard deviation of return. The lower the standard the deviation, the less risky as stock is. Xeroxs standard deviation is 0.1019. As is the case with the geometric mean, this number will be compared to competitors later in the unit, which will give a better look at how risky Xeroxs stock is to the rest of the industry.

Coefficient of VariationThe coefficient of variation (CV), in simple terms, is a way of measuring the risk-return tradeoff of investing in a stock. The lower the ratio of standard deviation to return, the better the risk-return tradeoff. As is the case with the rest of these measurements, the CV will be compared with competitors later in the unit.

Xerox Stock vs. Competitors

Xerox vs. Canon

As can be seen above, Xerox and Canon were fairly equal in growth over the last five years. In fact, until 2013, the two companies nearly mimicked each other in stock growth. However, Xerox recently started to pull ahead, while Canon flattened out to what appears to be a temporary steady state of growth.

Xerox vs. Brother

Much like the graph of Xerox vs. Canon, the growth of stock of each company is roughly the same over the last five years. Brother outgrew Xeroxs stock during this time, but the valleys and peaks match. One thing to note is that Xerox and Brother trade in different markets since they are based in different countries.Xerox vs. Ricoh

Xerox and Ricoh have fairly similar growth rates; however, Xerox consistently outperformed Ricoh over the last five years. Like Canon, Ricoh reached a somewhat steady growth rate over the last two years. Ricoh also trades in a different market than Xerox.

Xerox vs. Accenture

Over the last five years, Accentures growth rate outperformed Xerox. The two companies were fairly even for a while, but after 2011 Accenture started to pull away. One important distinction in this graph is that Accenture is a service company. Since Xerox is trying to make service a major part of its business, it is important for the company to try and keep up with other service companies.

Growth of $10,000The last figure for this section is the growth of $10,000 over the last five years. This figure can be seen below.

From this figure, we can see that Xerox and the S&P500 followed each other fairly closely until 2011. From then, there is a significant gap between Xerox and the Information Technology Services and S&P500 growth. However, the three companies all grow at a similar rate starting in 2012. Therefore, Xerox is performing at the same rate as the industry and the index.

Section 2Figure 2 provides an overview of the key financial ratios for Xerox over the last 10 years.

The chart above represents all relevant current financial ratios for Xerox Corp. The five major categories represent the overall performance of Xerox and illustrate its performance in separate areas. Xerox has relative low liquidity ratios that can be seen in the chart above. These are gauged against both the industry and the sector. The industry average of quick, current, and net current asset turnover is 1.4x, 1.8x, and 11.31x, respectively. Xerox improved its capital structure significantly in recent years, moving away from debt financing and focusing more heavily on internal equity financing instead. Xerox sustained a sufficient ROE over the last 10 years relative to the industry.

Profitability ratios

Xeroxs ROA for 2013 was slightly below the industry average of 4.13. Over the last three years, this measurement declines. This is most likely due to the switch between focusing on product revenue to focusing on service revenue.

The ROE for 2013 was above the industry average of 7.47. However, like the ROA, ROE also declined over the last three years. Even though it is declining, it can still be looked at as positive since it is above the industry average.

Like the ROA, the ROI was slightly below average for 2013. Also like the two above measurements, ROI declined over the last three years. Since it is under the average and declining, investors might look at this as a warning sign not to buy Xerox stock. However, since Xerox is a leader in the industry, more measurements should be considered before making a final decision.

Liquidity Ratios

All three liquidity ratios rose over the last three years. This is partly due to the sale of multiple business divisions for cash. Since Xerox is starting to move to the service industry, these ratios will likely see some radical changes in the near future. For now, since Xerox is still in transition mode, these ratios will stay fairly consistent.

Debt Management

In 2013, the LT Debt to Equity ratio of 0.55 shows that Xerox preferred to finance its business with more equity than debt. This was the case for most of the last ten years. Since Xerox is a mature company, the company does not necessarily need to borrow long term unless they plan to expand or build on its long-term assets.

Asset Management

For the asset management ratios, Xerox stayed around the average in most of these categories. The total asset turnover seems very low at first, but this is the industry standard, so there is nothing out of the ordinary for the total asset turnover. Everything else is close to the industry, reflecting Xeroxs maturity compared to its competitors.

Per Share

The per-share ratios are close to the industry averages, just like most of Xeroxs ratios. Nothing is out of the ordinary in this category of measurements. Overall PerformanceOverall, Xerox experienced negative growth over the last three years. This is mainly due to its many acquisitions and sale of divisions, in particularly the sale of its paper distribution business. Another big factor in the companys negative growth is the acquisition of Applied Computers. This caused a rise in Xeroxs cost, which hurt many of the companys ratios over the last three years. However, with the expansion into the service industry, Xerox was able to outperform its competitors, specifically its service competitors. With brand loyalty and the many other competitive advantages Xerox established over the life of the business, these ratios will always be close to the industry average and should not experience negative growth any time soon due to the increased revenues from successful expansion.

Section 3DuPont Analysis for Past Five Years

As can be seen in the above information, the ROE for Xerox lies right in the middle of its four competitors. The four subcategories are analyzed below.

Profit MarginThe profit margin for Xerox of 4.55% is close to the average of the five companies. The highest profit margin belongs to Accenture. This is most likely due to the nature of Accentures business. Since it is a service company, most of its revenue comes from services and not physical products. The second highest profit margin, which belongs to Canon, can be explained by the fact that Canon has a diverse product base. The company sells not just printers and office supplies, but also cameras, camera supplies, along with many other random products. Since Canon is in so many different industries, the company has a higher chance of earning more revenue. Ricoh and Brother have the lowest percentages in this category, most likely due to the decline in paper-based business transactions.

Asset TurnoverXerox has the lowest asset turnover of all the comparable companies. This is most likely due to the fact that Xerox acquired many companies in recent years, boosting the total assets on the balance sheets. Going forward, this number should merge towards the industry average since the acquired companies will start contributing to the total sales for Xerox. The highest ratios belong to Ricoh and Accenture.

Equity MultiplierOf its four competitors, Xerox has the second highest Equity Multiplier. This is most likely due to the large number of total assets for Xerox and the high amount of its stockholders equity. Accenture still has the highest number of all the companies, showing the strength of Accenture. As Xerox starts to switch more and more to the service industry, the equity multiplier should move towards Accentures ratio of 3.33.

Return on AssetsXeroxs ROA is the second lowest among the comparable companies. This is most likely due to the fact that Xerox focuses only on document technology and its recently acquired services. Traditionally, the other companies sell more than just office products, so therefore have a higher chance of earning more income in a given year.

Z-Score Analysis for Past Five Years

Xerox, 1.52, is predicted to go bankrupt in less than a year while the industry, 1.93, is in possible financial distress. Normally this would be a cause for concern, but for each of the past five years, Xeroxs Z-score was below 1.81. Xerox boasts an EBIT/Total Assets ratio that is 2.34% higher than the industry; however, the Net Working Capital/Total Assets, Retained Earnings/Total Assets, and Sales/Total Assets ratios are lower than the industry by 9.83%, 11.18%, and 19.82% respectively. The Market Value of Equity/Book Value of Liabilities ratio is also lower than the industry by 1.24%.

Unit 3: Cost of Capital, Capital Structure Analysis and Distributions

Executive Summary Cost of Capital

Capital StructureXerox historically financed its operations heavily with debt and used internal equity to cover the remainder of its required financing. This affected its cost of capital and led to a business structure founded on the basis of high leverage and reoccurring dividends. As Xerox moves towards outsourcing business and technology services, it also moves towards a capital structure consisting of more equity financing and less reliance on debt. This is optimal for investors seeking to contribute capital towards Xerox and helped Xerox establish itself as a company with high internal value that isnt reliant upon external debt financing.

Internal Cost of Equity (CAPM)Given a firm wide beta of 1.34, a risk free rate of 2.29% and a market risk premium of 5.58%, the cost of equity for Xerox Corporation is 9.77%. After the beta was unlevered and re-levered to 1.16 based on the target capital structure weights, the forecasted cost of equity is 8.76%.

Cost of Capital (WACC)The cost of capital for Xerox under its current capital structure is 7.35%. This is based on its current cost of equity and the weights of short and long term debt, the weight on preferred stock, and the cost of using each piece to finance operations. Using the new cost of equity calculated by accounting for the re-levered beta according to the target capital structure, the forecasted cost of capital for Xerox is 6.61%.

Table of ContentsSection 1I. Debt...41a. Long-Term and Short-Term.41b. Costs and Weights of Long-Term/Short-Term Debt..42c. Key Debt Ratios42Section 2I. External and Internal Equity..45a. External.45i. Cost and Weight of Equity.46b. Internal..47i. Un-levering/Re-levering Beta.47Section 3I. Analysis and Future Assumptions..49Section 4I. Distributions to Shareholders..51II. Plowback Rate.51

Section 1DebtFigure 3.1 provides a snapshot of the current market values of debt for Xerox.

Figure 3.1

The current percent of the firm that is financed with long-term debt is 27.67%. For short-term debt, this number is 4.48%. The total percent of debt used to finance the firm is therefore 32.15%. Historically, these numbers have been about the same, so there will be no significant change in the target values of 28% and 4.48% going forward. Since Xerox is such a strong company, it can afford to be financed with more debt, especially considering its bond rating of Baa2 from moodys.com. A snapshot of this analysis can be seen below in figure 3.2.

Figure 3.2Estimate % of Firm that will be Financed by Long-Term Debt

Current percent of firm financed with long-term debt27.67%

Target percent financed with long-term debt=28%

Estimate % of Firm that will be Financed by Short-Term Debt

Current percent of firm financed with short-term debt 4.48%

Target percent financed with short-term debt =4.48%

Xerox has a cost of long-term debt before tax estimated at 3.29%. This value comes from the current yield on the companys bonds, adjusted for a spread of 1.00%. The tax of 38% gives us an after-tax cost of long-term debt of 2.04%.

As for the short-term debt, the prime rate used to estimate the after-tax cost is 6.00%. There is no adjustment to the prime rate because there is little risk to Xerox defaulting on its payments in the short terms. Therefore, with the same tax rate used for the long-term debt, the after-tax cost of short-term debt comes out to be 3.72%.

After multiplying the after-tax costs of debt by the respected target percentages, then adding those two values together, the portion of debt used to finance the business going forward should be 0.74%. Compared to what it was historically, this is average for Xerox. Since the company does not plan to continue acquiring companies every year or change its capital structure, there is no reason to make any dramatic assumptions when computing the target weights and costs of debt.

Figure 3.3 gives a summary of the above information described for the portion of debt used to finance the business.

Figure 3.3

Above is an illustration of the main components used to calculate the cost of debt for Xerox to be used in the cost of capital calculation. Based on the condensed financial statements, the weight on long-term debt is currently at 27.67% while the weight on short-term debt is 4.48%. Costs on the debt are 2.04% and 3.72% respectively, after accounting for taxes at the corporate wide rate of 38%.

The relevant debt ratios used in the analysis are provided and explained in figure 3.4 below:

Figure 3.4

Long-term debt to equity was reduced as the company moves towards the industry average of 0.53. This provides a good indication of Xeroxs recent ability to become less highly levered and move away from high costs of long-term debt used to finance fixed assets that are no longer relevant to the companys core business.

Figure 3.5Long-Term Debt to Equity

Xerox decreased its long-term debt to equity to 0.56, down from a historical average of 0.90. Since 2009, long-term debt decreased dramatically as the firm funded more of its financing with equity. This comes as a result of the retirement of various bonds and lack of renewed interest in funding the firm with debt. Funding a firm with 56% long-term equity is still high for the technology industry, which presents cause for concern to potential investors who fear investing in a highly levered company. This is mitigated by the fact that Xerox is consistently decreasing its long-term debt financing and focusing more on equity financing, particularly from an internal standpoint.

Figure 3.6Total Debt to Equity

Xerox decreased its total debt to equity to 0.65, down from a historical average of 1.08. This is correlated with its reduced use of long-term debt as well as recent reliance on equity over short or long term debt. The dramatic reduction in debt financing is a good sign the Xerox is focusing on being less levered as it move away from manufacturing to specialize in numerous service categories. Again, an overall debt financing of 65% is high for the technology industry and presents cause for concern for potential investors. The current average debt financing for the technology industry is 52%. This is mitigated by the fact that Xerox is consistently decreasing its debt balances and focusing more on equity financing.

Figure 3.7Quick Ratio

Xerox currently has a current quick ratio of 1.32 and a historical average of 1.47. The average industry quick ratio is 1.62 and the historical average over the last 10 years has been 1.66. The lower quick ratio exhibited by Xerox indicates that the firm has a slight liquidity issue. This ratio measures liquidity based on current assets less inventory as a function of current liabilities. So, Xerox has trouble maintaining current assets like cash and accounts receivable relative to current liabilities such as accounts payable or accruals.

Figure 3.8Current Ratio

Xerox has a current ratio of 1.50 and a historical average of 1.68. Since this is not much higher than its quick ratio, Xeroxs inventory is not as big of a factor, as is typical for technology firms and specifically those focusing on information technology services. Its current ratio is well below the industry average of 1.85 indicating that Xerox faces liquidity issues. This is an area of concern for potential investors as a lack of liquidity can be a main cause for insolvency. This is diminished by the strong historical presence of Xerox and increased revenue and equity balances in recent years.

Section 2External EquityFigure 3.9 provides a snapshot of the market value of equity and the market value of preferred stock.

Figure 3.9

Since 32.38% of the firm is to be financed with debt, the other 67.52% will be financed with external equity. Some of this comes from preferred shares that Xerox has out in the market, which the company sold in 2010.

The cost of the preferred stock for Xerox is calculated by using the current yield on the preferred shares that the company sold in 2010, which is 5.00%. The current coupon rate for these shares is 6.88%. Therefore, the cost of the preferred stock is just the average of the coupon and the yield on these shares, which is 5.94%. A summary of this information can be found in figure 3.10 below.

Figure 3.10

The cost of the external equity for Xerox using CAPM is 9.77%. This is obtained by using a beta of 1.34, a risk-free rate of 2.29%, and a market risk premium of 5.58%. Since the stock market has been high recently, the market risk premium was chosen to be slightly below the default value of 6%. A snapshot of this information can be found in figure 3.11.

Figure 3.11

With the cost of equity for preferred shares and external equity, and the target percentages, the calculated portion of equity used to finance Xerox is 6.65%. The inputs used to calculate this value are shown in figure 3.12 below.

Figure 3.12

Internal Equity

Equity Ratios Cost of Internal Equity Firm Wide Beta = 1.34 Risk Free Rate (Rf) = .0229 Market Risk Premium (Rm) = .0787 Cost of Equity (Rs) = .0229 + 1.34 (.0787-.0229) Rs =.0977

- Rs = 9.77%

In 2013, internal equity as a result of retained earnings was $8,839,000. This represents 71.86% of the firms current total equity. This gives an indication that the firm is heavily financed through its own earnings and relies much less on sources of funding that are external to the companys primary operations.

Re-levering BetaBa = Be/(1+(1-T)*D/E)

*Be = 1.34 *D/E = 0.65

Ba = 1.34/(1+(1-.38)*0.65)

Ba = .9551 for 2013

Then:

Be = Ba[1+(1-T)D/E]

Be = .9551[1+(1-.38).3388)

Be = 1.16

The original equity beta of 1.34 was unlevered to .9551 based on a tax rate of 38% and 2013 debt to equity ratio of 0.65. This asset beta was the re-levered to a new equity beta given the new capital structure based on the predetermined target weights. Given a target debt to equity of 33.88% and a tax rate of 38%, the new equity beta was 1.16.

Ke (new) = Rf + Be(new)(Rm-Rf)

Ke (new) = .0229 + 1.16(.0787-.0229)

Cost of Equity (new) = 8.76%Given the new equity beta and targeted capital structure, the new cost of equity for Xerox is 8.76%. This is one percent less than the previous cost of equity, which was based on the existing equity beta and capital structure given the values taken from the 2013 condensed balance sheet.

Section 3Capital StructureXerox utilized a historical capital structure resulting in a debt to equity ratio of 1.08. Recently, this was reduced to 0.55, which is much more reasonable for the technology industry. The industry average for the technology industry over the last 10 years was a debt to equity ratio of 0.52. Over the last 15 years, Xerox used to be highly levered and relied heavily on debt financing. With its shift away from manufacturing, Xerox relies less on debt and more on equity. This allows them to be less levered and present a more reliable capital structure to both inside and outside investors.

Key Changes Xerox experienced a dramatic increase in equity in 2010; increased $4,920,000 from 2009. This is caused by additional paid in capital of $4,578,000 due to the retirement of long-term debt, as well as the acquisition of Affiliated Computer Services. It also saw a decrease in equity in 2008; decreased $2,350 from 2007. This is due to a decrease in additional paid in capital of $2,403 attributable the repurchase of nearly 14,000 shares of common stock.

Cost of Capital - Historical WACC = WsRs + Wltd(1-T)Rltd + Wstd(1-T)rstd + WpsRps

Ws/Rs = weight/rate on common equity

Ws = 1- (Wltd + Wstd + Wps) Ws = 1 (.2727 + .0448 + .014) Ws = 66.85% Rs = 9.77% Wltd/Rltd = weight/rate on long-term debt Wltd = 27.67% Rltd = 3.29%

Wstd/Rstd = weight/rate on short-term debt Wstd = 4.48% Rstd = 6.00%

Wps/Rps = weight/rate on preferred stock Wps = 1.40% Rps = 5.94%

WACC = (.6685)(.0977) + (.2767)(1-.38)(.0329) + (.0448)(1-.38)(.06) + (.014)(.0594)

WACC = .065312 + .0056441 + .0016666 + .0008316 => WACC = 7.30%Cost of Capital - Forecasted

WACC = WsRs + Wltd(1-T)Rltd + Wstd(1-T)rstd + WpsRps

Ws/Rs = weight/rate on common equity

Ws = 1- (Wltd + Wstd + Wps)

Ws = 1 (.28 + .0448 + .014) Ws = 66.12% Rs = 8.76% Wltd/Rltd = weight/rate on long-term debt Wltd = 28% Rltd = 3.29%

Wstd/Rstd = weight/rate on short-term debt Wstd = 4.48% Rstd = 6.00%

Wps/Rps = weight/rate on preferred stock Wps = 1.40% Rps = 5.94%

WACC = (.6612)(.0876) + (.28)(1-.38)(.0329) + (.0448)(1-.38)(.06) + (.014)(.0594)

WACC = .057921 + .0057114 + .0016666 + .0008316

WACC = 6.61%

The forecasted weighted average cost of capital is shown above. The targeted rate is 0.74% lower than the current rate according to the forecasted projections. The new cost of capital is based on projected target capital structures according to averages of the industry and specific competitors. While the reduced WACC does raise some cause of concern for equity shareholders, the slight reduction indicates that Xerox will be able to sustain its operations as the ROIC is more likely to continue to be higher than the cost of capital or WACC.

Section 4Figure 3.13

Xerox released common dividends at a consistent rate for the last 3 years. From 2007 to 2009, it released no common dividends as it was restructuring and aiming to shift to a mix of less debt and more equity. Preferred dividends were released in correlation with common stock and in excess when possible.

The plowback rate ranged from 0.753 up to one indicating that Xerox returns a decent amount of its earnings to the firm each year for growth or to support operations.

Over the last 10 years, Xerox experienced significant stock repurchases and issuances. In 2004, Xerox issued 1,046,947 shares of stock. At the time, Xerox was attempting to increase its equity balance and gradually moving away from significant debt financing. In recent years, Xerox bought back (or repurchased) stock and, as a result, reduced its total number of shares outstanding and increased the price of its stock.

Unit 4: Financial Statement Forecasts

Executive Summary: Financial Statement Forecasts

DuPont vs. Z-Score AnalysisA decreasing ROE in the last year is a reflection of the decreased sales over the last three years. This is a potential flag for investors as ROE is one of the more significant indicators of firm value. Similarly, ROA decreased over the last year, which is primarily due to the decrease in net income as sales decreased. Sales are projected to increase over the next 5 years, which will result in a higher return on assets and equity. As these ratios move closer to the industry, Xerox will be more aligned with major competitors focusing on business and information technology outsourcing. A Z-Score of 2.20 puts Xerox in the category of a firm that is under financial distress and may experience bankruptcy in the future. Due to the size and historical presence of Xerox, bankruptcy is unlikely and this Z-Score projection shouldnt be taken as major consideration by potential investors. Sales Growth RateAfter 2010, Xerox experienced a decreasing sales growth rate, which only recently experienced positive growth. This trend is expected to continue as Xerox moves more towards services.

Financial ProjectionsProjections for the next 20 years of operations are calculated for analysis based on historical financial statements. Our estimates indicate rising sales growth after 2015 (because of high upfront costs associated with a changing capital structure) until 2017, when it flattens out at 7.1%. By this time, Xerox should be fully adapted to its shift into services. This same trend is true for all the other respective metrics when valuing Xerox, such as current and total assets and liabilities. The projections support the conclusion that the best tactic now is to hold Xerox and wait as its share price appreciates in value. A weak buy recommendation is also supported by the projections, as this strategy would still give investors the opportunity to earn positive returns as increased sales levels generate higher earnings potential that results in higher returns for shareholders.

Table of ContentsSection 1I. Parameters/Assumptions of Forecast...55Section 2I. Presentation of Pro Forma Statements.56II. Discussion/Analysis of Forecasted Statements57III. Comparison to Historical Statements.63IV. Presentation of Financial Ratios.64a. Comparison to Historical Financial Ratios.64Section 3I. DuPont Analysis and Altman Z-Score.66a. Comparison to Historical DuPont and Altman Z-Score..66

Section 1There are many assumptions and parameters in regards to the forecast of the value of Xerox in the future. These assumptions are discussed in the following paragraphs.

AssumptionsThe growth rate for Xerox is assumed to decrease for the first three years. The starting rate of negative 2.39% is projected using the 10Q Earnings Report for 2014. In the past, Xerox usually sees increased revenue in the final quarter of the year. This is most likely due to increased promotions that the company uses to boost sales numbers in order to meet the goals that Xerox set for itself. The long-term growth rate is calculated using the ROE of the most current year (2013) and multiplying it by the plowback ratio of 0.743.

One other very important assumption for Xerox is that the company announced in the most recent financial filing that by 2017, service revenue is supposed to be two-thirds of its overall sales. In the financial statements provided in this report, the assumption is that there will be a mix between the financial statements of Accenture (a business based entirely on outsourcing services) and traditional Xerox (a company based on office equipment). More specifically, the mix of sales growth will be reflected as 67% related to Accentures statements, and 33% traditional Xeroxs statements (pre-2010, before switching to the service industry).

We believe this is Xeroxs most desirable mix of revenues, which from here on will be referred to as the optimal mix. Xerox does not want to completely exit the office equipment industry. Therefore, it is not rationale to project future growth purely based off of Accentures statements.

One last sales growth note is that all starting rates are found using three 10Q reports from the current year and forecasting the fourth quarter based on past trends.

Other assumptionsFor the time before the long term, most of the years are either three or ten. Three is chosen because there are three years until 2017, which is when Xerox would like 2/3 of its revenue as service revenue. We assume that by this date, Xerox will accomplish that goal, and will continue to maintain past growth rates for the long term since it is a mature company.

The ten years until the long term (for inputs that use ten years) is chosen because we believe the effects on these accounts are delayed past the three-year transition to the optimal mix. A round ten year input was chosen based on past changes of this nature in Xerox and its competitors.

Section 2Figure 4.1

Figure 4.2

Note: Figures 4.1 and 4.2 provide a snapshot of the forecasted income statement and balance sheet for Xerox. For a complete view of these pro forma statements, refer to the appendix. Discussion/Analysis of Forecasted Statements

Figure 4.3Sales Growth Rate

The sales long-term rate is found by multiplying the ROE times the plowback rate. This is higher than the average or past trend rate because of the expanded services division. The fade rate assumes that most of the costs of expanding the services division are upfront. The reason sales is expected to decrease over the next year is because of its expansion to services. After the acquisitions of many companies, it could be hard for Xerox to make this transition. Plus, with the recent decline in office equipment demand, the sales of products like copiers and printers could continue to decline. However, after this year of decreased sales growth, it is expected to start increasing again based off of the optimal mix.

Figure 4.4COGS/Sales

The COGS to sales ratio is based off of the optimal mix. There are assumed high upfront costs due to recent acquisitions, therefore the fade rate actually increases, and then levels out over time. During HPs acquisition of Opsware, a computer services provider, HPs Cost of Goods Sold behaved similarly.

Figure 4.5SGA/Sales

The SGA to sales ratio is also based off of the optimal mix. The fade rate follows the trend of past increases, namely, Xeroxs acquisition of Global Imaging Systems. The SGA/Sales ratio is expected to level out when the COGS and sales does (in 2017).

Figure 4.6Depreciation/Net PPE

Since Xerox spent the last few years acquiring many different service companies in order to make the transition to service smooth, it is expected that few assets will need to be purchased (besides the normal trend). Therefore, there will be an increase in depreciation to net PPE since the depreciation will continue to increase, and net PPE will stay the same. The fade rate follows the current trend from past statements, and Xerox depreciates assets on a straight-line basis.

Figure 4.7Cash/Sales

The cash to sales, historically, was around 7%. We believe that this will continue to happen in the future. It just so happens that the Cash/Sales ratio for the optimal mix is also around 7%.

Figure 4.8Inventory/Sales

The long-term rate for inventory to sales of 1.974% is based on the optimal mix. Xerox will need far less inventory once it becomes a predominantly service-based business. The trend follows the trend of 2007-2010, when Xerox purchased Global Imaging Services and began its shift to the service industry.

Figure 4.9Accounts Receivable/Sales

The accounts receivable to sales in the long-term decreases based on the increased technology. With Xeroxs new found expertise in this exact subject, it should be able to decrease its accounts receivable account. We chose this fade rate because it reflects past decreases in this ratio. Our chosen fade rate also follows the industrys fade rate of decreases in this ratio.

Figure 4.10Other Short-term Operating Assets/Sales

Other short-term assets to sales are not expected to increase in the future. The level is based on the historical level, and we have no reason to believe that Xerox will change its view on the use of short-term investments.

Figure 4.11Net PPE/Sales

Net PPE to sales is expected to drop because of the switch to being a service-based business. Therefore, Xerox will not need as many plants or factories to produce the physical products (copiers, printers, multifunction devices, etc.) The purchases for these kinds of long term assets will decline, and straight-line depreciation is used in the projections.

Figure 4.12Other Long-term Operating Assets/Sales

Other long-term operating assets to sales is not expected to change. With its switch to the service industry, Xerox will acquire more assets; however, we believe that most, if not all of these assets will be included in PPE.

Figure 4.13Accounts Payable/Sales

We expect Accounts Payable/Sales to drop over the next three years. With Xeroxs switch to services and its switch to equity financing, this drop will most likely be steep and quick. The fade rate used is comparable to HPs when HP acquired Opsware.Figure 4.14Accruals/Sales

Because of the accruals to sales ratios volatility, it is very difficult to project. We opted to use Xeroxs historical rate as the long-term rate. Coincidentally, this also matches up with the accruals to sales ratio in the optimal mix.

Projected vs. Past statement analysisDue to high upfront costs, Xeroxs net income will fall in the first projected year and then gradually rise. This is the trend for almost every key metric in the financial statements, including current assets, total assets, current liabilities, and total liabilities. The only measure that does not initially fall in the first projected year is the total equity, which actually rises $299 million dollars ($12,300 to $12,599). This is most likely due to the fact that the projected stock price does not fall in the first projected year, and as long as Xerox does not buy back or sell a significant number of shares, the total equity should stay around the same area, give or take the addition to retained earnings.

We believe that the projected financial statements for Xerox accurately reflect expected values in the future based on the previous discussion. When looking at Xeroxs past trends, the sales growth gradually rises from 2004, with the occasional decline in growth (like in 2009). However, given the nature of the market during that time, this is an outlier in the data. That is why sales are expected to increase after the three year expected decline.

Since most other projections are based on the ratio to sales, we believe these projected values are also accurate. There are, however, certain items on the statements that are hard to predict. For instance, the historical amount of cash in the balance sheet jumps from year to year. Even though this number fluctuates, the historical average is used to predict growth. Therefore, while the projected cash values could differ significantly in a given year, the overall increase in cash is reflected by this historical number and should give investors an accurate representation of the cash in the balance sheet.

Another interesting item in the balance sheet is the projected inventory. As can be seen in the condensed statements, inventory hovers around $1000 from year to year. However, since Xerox aims to be a service-based company, the inventory is projected to decrease substantially until 2019, where it then starts to rise. This is because service-based companies do not need to hold on to much inventory due to the fact that physical products are not sold. Xerox will be different and still sell office equipment products, but due to the decline in office equipment demand, inventory will not need to remain as large.

Projected vs. past financial ratiosProjectedPastProfitability Ratios

ROA % (Net)2.25%

ROE % (Net)2.38%

Liquidity Ratios

Quick Ratio1.24

Current Ratio1.45

Net Current Assets % TA8.79%

Debt Management

LT Debt to Equity0.37

Total Debt to Equity1.06

Interest Coverage4.00

Asset Management

Total Asset Turnover0.81

Receivables Turnover6.76

Inventory Turnover19.42

Accounts Payable Turnover13.11

Accrued Expenses Turnover7.64

Property Plant & Equip Turnover10.63

Cash & Equivalents Turnover25.00

Per Share

Cash Flow per Share $ 2.11

Book Value per Share $ 9.89

Profitability Ratios12/31/2013

ROA % (Net)3.93

ROE % (Net)9.45

Liquidity Ratios12/31/2013

Quick Ratio1.12

Current Ratio1.5

Net Current Assets % TA9.73

Debt Management12/31/2013

LT Debt to Equity0.55

Total Debt to Equity0.63

Interest Coverage4.16

Asset Management12/31/2013

Total Asset Turnover0.73

Receivables Turnover4.52

Inventory Turnover14.56

Accounts Payable Turnover12.11

Accrued Expenses Turnover18.38

Property Plant & Equip Turnover14.19

Cash & Equivalents Turnover14.24

Per Share12/31/2013

Cash Flow per Share1.94

Book Value per Share10.64

Above are the projected financial ratios after the first projected year compared to the past financial ratios from 2013 described earlier in unit 2.

Profitability ratiosThe ROA and ROE in the first projected year are expected to decrease, as was the trend in the past. Once Xerox can achieve the goal of having 2/3 of revenue as service, this ratio should eventually start increasing.

Liquidity ratiosThe quick ratio for Xerox increases in the first projected year, however the current ratio and net current assets as a percent of total assets both decrease. The quick ratio increases due to the decrease in inventory over the first projected year, while current assets and current liabilities both increase. Therefore, the current ratio and net current assets both decrease.

Debt ManagementThe total debt to equity measure increases over the projected year, while long-term debt to equity and interest coverage both decrease during this period. This shows that while total debt increases more than equity, most of this is due to the intake of short-term debt since the long-term debt to equity actually decreases.

Asset ManagementAll but the last three ratios under this category increase over the projected year. The total asset turnover, receivables turnover, inventory turnover, and accounts payable turnover all increase over the first projected year. This is because the growth rate in sales surpasses the growth rate in total assets, accounts receivable, inventory, and accounts payable. Even though these ratios all increase, they are still relatively low. This is because Xerox is a large capitalization stock, so the turnover ratios are expected to be lower compared to a stock that is a small capitalization stock. The three ratios that decrease are accrued expenses turnover, property plant and equipment turnover, and cash and equivalents turnover.

Per ShareThe cash flow per share value increases over the first projected year, however, the book value per share decreases. This is partly due to the fact that Xeroxs cash flow is increasing because there are no recent acquisitions that require the use of cash. Also, the book value per share decreases because sales growth is expected to slow down over the first three years, while cost of goods sold growth does not slow down.

Section 3

Figure 4.15 Figure 4.16

Profit MarginAbove is the DuPont Analysis from 2013 compared to the projected DuPont for 2014. The profit margin decreases by 1.75%. This is largely due to the fact that sales growth decreases while other related expenses growth increases. Therefore, the numerator is decreasing while the denominator is increasing. Once sales growth picks back up after the third projected year, this measurement should increase.

Asset TurnoverThe asset turnover ratio increases by 6.56% over the first projected year. This is also due to the difference in growth rates for total assets and sales. However, in this case, sales are growing faster than total assets, which is why the ratio increases over this first year. Since Xerox does not plan to keep acquiring different companies, the number of relative assets should level out and remain steady.

Equity MultiplierThe equity multiplier decreases by 0.40 from 2013 to 2014. This shows that the equity grows slightly more than assets over the first projected year. Overall, this is a relatively small change in value.

Return on AssetsThe ROA decreases 1.11% from 2013 to 2014. This is due to the rise of total assets compared to the rise in net income during this time period. The decrease in this number raises a flag to investors, and moves further away from the industry and market average. However, this is mostly due to the decrease in sales growth for the first three years, so it would be expected that this measurement starts to increase when sales growth rate starts increasing again.

Return on EquityROE decreases 3.61% over the specified time period. Since the ROE is found by multiplying the total asset turnover, profit margin, and equity multiplier, this makes sense due to two of the three values in the ROE calculation decreasing. As with the ROA, as sales growth starts to increase again, this measurement should also see an increase in value.

Altman Z-Score Analysis For First Projected Year

Figure 4.17

Figure 4.18

The figures on the previous page show the projected Z-score for the first year compared to the historical Z-score value. This measurement increases 0.68. Most of this is due to the increase in market value of equity to book value of total liabilities (0.18 to 1.07). However, this value is weighted the least when calculating Z-score. Working capital to total assets stays roughly the same, as does the EBIT to total asset value. The retained earnings to total assets increase by 0.10 and sales to total assets increases 0.07. This reflects the faster growth in sales as compared to total assets.

Overall, the increase in each Z-score component causes the increased Z-score. This increase puts Xerox in the financial distress stage with possible bankruptcy in the future. However, as was mentioned in unit two, the average Z-score for Xeroxs relatable competitors was just 1.91. Therefore, Xerox now surpasses this average in our projections, even though the company was never really in danger of bankruptcy anyway. As Xerox becomes more of a service company, this value should gravitate towards a number comparable to the service industry average.

Unit 5: Free Cash Flow and Cash Flow Valuation

Executive Summary Cash Flow Valuation

Cash Flow MethodologyThe graphic above shows the three respective valuation methods that will be used to determine share price. While each has its merit, the primary method to be used for accurate valuation will be the adjusted present value method.

Market Share vs. Book ValueMany firms have a market value that is above the book value, especially in terms of share price. Because the stated market value of a share doesnt typically represent what a share in the firm is actually worth, it is necessary to perform cash flow analysis to determine to actual value of investing in stock. The entity value will produce a share price that reflects its book value, while the free cash flow to equity and adjusted