Finance and accounting Assignment

Part I. Problems. Provide enough information that we can understand how you calculated your answers.

 

 

  1. Consider the Lucky Inc. Financial Statement below. Assumptions for your analysis:
    • Note that Lucky’s capital expenditures are on land. Land is a non-depreciable asset.
    • All cash balances are required for the business; no excess cash.

 

Lucky Inc. Financial Statement — Actual and Forecasts
Income Statement and Balance Sheet Forecasts
(for the years ended December 31)
Actual Forecast
Income Statement Year -1 Year 0 Year 1 Year 2
Revenue 1000.0 1100.0 1650.0 2310.0
Cost of Goods Sold -610.0 -671.0 -1006.5 -1409.1
Gross margin 390.0 429.0 643.5 900.9
Selling, general & administrative -120.0 -132.0 -198.0 -277.2
Operating income 270.0 297.0 445.5 623.7
Interest expense -77.0 -81.1 -85.8 -84.7
Income before taxes 193.0 215.9 359.7 539.0
Income tax expense -77.2 -86.3 -143.9 -215.6
Net income 115.8 129.5 215.8 323.4
Balance Sheet
Cash balance 50.0 55.0 82.5 115.5
Accounts receivable 166.7 183.3 275.0 385.0
Inventory 118.6 130.5 195.7 274.0
Total current assets 335.3 368.8 553.2 774.5
Land 1550.0 1600.0 1700.0 1750.0
Total assets 1885.3 1968.8 2253.2 2524.5
Accounts payable 50.8 55.9 83.9 117.4
Other current operating liabilities 35.0 38.5 57.8 80.9
Total current liabilities 85.8 94.4 141.7 198.3
Debt 1200.0 1159.2 1225.4 1210.3
Total liabilities 1285.8 1253.6 1367.1 1408.6
Common stock 383.6 383.6 425.0 439.0
Retained earnings 215.8 331.6 461.1 676.9
Total shareholders’ equity 599.4 715.2 886.1 1115.9
Total liabilities and equity 1885.2 1968.8 2253.2 2524.5
Exhibit may contain rounding errors.

Solutions

Working capital = current assets-total current liabilities

 

Total current assets 335.3 368.8 553.2 774.5
Total current liabilities 85.8 94.4 141.7 198.3
WC       249.5         274.4         411.5        576.2

 

 

  1. In the following matrix, report the Free Cash Flow calculation for Lucky:

FCF= EBIT(1-Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure

 

 

  Year 0 Year 1 Year 2
 

EBIT(1-Tax Rate)

297.0*(1-0.4)

178.2

445.5(1-0.4)

267.3

623.7(1-0.4)

374.22

+ Depreciation & Amortization 0

 

0 0
– Change in Net Working Capital

 

274.4-249.5=24.9

-24.9

411.5-274.4=137.1

-137.1

576.2-41.5=164.7

-164.7

 

– Capital Expenditure

1600-1550=50

-50

1700-1600=100

-100

1750-1700=50

-50

 

FCF

103.3 30.2 159.52

 

 

  1. What is the value of the firm if we assume that the FCF in year 2 grows at a 5% rate into perpetuity and the discount rate is 14%?(Show the formula you use for this calculation.)

 

The value of the firm= PV of FCF0+PV of FCF1+PV of FCF2+PV of Terminal value

In year 0: 103.3/1.14= $90.61

In year 1: 30.2/1.142=$23.24

In year 2: 159.52/1.143 =$107.67

Terminal value = FCF for year 2 (1 + perpetual growth rate) / (discount rate – perpetual growth rate)

Terminal value= 159.52 (1.05) / (0.14 – 0.05) = $1,861.07

The present value of the terminal value =$1,861.07/1.143= $1256.17

The value of the firm is the sum of all the present values

The value of the firm = $90.61+$23.24+$107.67+$1256.17= $1,477.69

  1. What multiple of Year 2 EBITDA would give you a similar terminal value calculation to that calculated in b.

Terminal value= 159.52 (1.05) / (0.14 – 0.05) = $1,861.07

TV= EBITDA × EV/EBITDA ratio

EBITDA= TV/ EV/EBITDA ratio

EBITDA= $1,861.07/4.5

EBITDA =413.57

 

 

Your private equity company, Whitestone, is considering the acquisition of Newco. In the following pages, you will consider some of the available information for Newco to determine an appropriate valuation to be used in your purchase decision.

 

 

The next page of the exam has information about the financial statements for Newco and some data for comparable companies.

 

 

 

 

 

 

 

 

 

           
2015 Income Statement and Balance Sheet Data for Newco Corporation  
           
Income Statement ($ 000) Year 2015     Balance Sheet ($ 000) Year 2015
Sales 150000     Assets  
Cost of goods sold       Cash and equivalents 25328
   Raw materials -32000     Accounts receivable 36986
   Direct labor costs -36000     Inventories 12330
Gross profit 82000     Total current assets 74644
           
Sales and marketing -22500     Property, plant and equipment 99000
Administrative -27000     Goodwill 0
EBITDA 32500     Total assets 173644
           
Depreciation -11000     Liabilities and Stockholder’s Equity  
EBIT 21500     Accounts payable 9308
        Debt 9000
Interest expense (net) -150     Total liabilities 18308
Pretax income 21350     Stockholder’s equity 155336
Income tax (tax rate 35%) -7472.5     Total Liabilities and equity 173644
Net income 13877.5        
           
           
           
Ratio Oldco Middleco Ancientco    
P/E 19.2 15.1 27.3    
P / Sales 1.7 1.3 2.6    
P / EBITDA 11.6 9.1 14.7    
     

 

  1. a. What range for the market value of equity for Newco is implied by the range of P/E multiples for the comparable firms of Oldco, Middleco and Ancientco.

P/E = equity value/net income

Therefore, equity value= P/E*net income

market value of equity for Newco as implied by the range of P/E multiples for the comparable firms of Oldco, Middleco and Ancientco

Oldco     =19.2*13877500 = $266,448,000

Middleco  =15.1*13877500 = $209,550,250

Ancientco = 27.3*13877500 = $378,855,750

The low price implied by the comparable P/E ratios is _$209,550,250_____.

The high price implied by the comparable P/E ratios is __$378,855,750___.

 

  1. Using the average Price /Sales ratio of the comparable firms, estimate Newco’s value of equity.

(1.7+1.3+2.6)/3 = 1.866666

The average P/Sales ratio is _1.87_.

The estimated equity value     = average P/Sales ratio*total revenues

=1.87*150,000,000= $280,500,000

The estimated equity value for Newco based on that average ratio is __$280,500,000_.

 

  1. How would your analysis differ if you were computing equity value based on EV / EBITDA?

When computing equity value based on EV / EBITDA, the analysis will be based on the market value of common stock, market value of preferred equity, market value of debt, minority interest and cash and cash equivalent. This implies that it will be based on the company’s total value which is an alternative of equity market capitalization. In addition, the analysis will not be based on ratio and hence will be quite accurate.

 

  1. Briefly summarize the strengths and weaknesses of valuation with ratio analysis.

The strengths of valuation with ratio analysis is that it permits the comparison of companies with different sizes, it helps in trend analysis, it helps in simplifying the financial statements and it highlights vital information in simple form quickly.

The weaknesses of valuation with ratio analysis is that it is affected by assumptions and estimates, it will not be very accurate as it uses past information and nor current and future information, and it might be misleading because it compares companies from different industries which are faced with different environmental conditions.

 

 

2e.  It is January 1 2016. Whitestone believes that it can improve the performance of Newco. It has estimated that under its management, the year-end free cash flows will be as follows:

In year 2016, FCF = 16935

In year 2017, FCF = 20525

In year 2018, FCF = 24335

From then on, Whitestone estimates that FCF will grow at a perpetual rate of 4%.

Whitestone believes that the cost of capital for projects of similar risk is 13.1% and will finance the project with all equity. The tax rate is 35%.

Use discounted cash flow methodology to determine the value of Newco as of January 1 2016:

What is the present value of the year-end cash flows in years 2016, 2017 and 2018.

In year 2016: 16935/1.131= $14,973.47

In year 2017: 20525/1.1312=$16,045.67

In year 2018: 24335/1.1313 =$16,820.68

 

What is the terminal value?

Terminal value = FCF for final year (1 + perpetual growth rate) / (discount rate – perpetual growth rate)

Terminal value= 24335 (1.04) / (0.131 – 0.04) = $278,114.29

 

What is the present value of the terminal value?

=278,114.29/1.1313= $192,236.34

What is the overall value of the company using DCF analysis?

The overall value of the company using DCF analysis = the sum of all present values

=14,973.47+16,045.67+16,820.68+192,236.34

= $240,076.16

How does this valuation compare to your valuation based on ratio analysis? What might be your next step or steps if you are not … totally … confident in your valuation?

DCF analysis often produces the closest value to the intrinsic stock value because unlike other alternatives, it is not a relative valuation measure and does not use multiples. This implies that the equity value of the company is close to $240,076.16. Unlike P/E ratio, DCF relies on free cash flows which are trustworthy measures cutting through much of “guesstimates” and arbitrariness involved in the reported earnings. In case I am not totally confident in the valuation, my next step is to run the DCF analysis for different scenarios so as to gauge the valuation’s sensitivity to different operating assumptions. Also, I will ensure that there is a high degree of confidence regarding future cash flows by using as accurate predictions as possible.
3. Corbusier Design Incorporated is a privately held company that has decided to determine an appropriate weighted average cost of capital. While the firm can easily determine that its required return on debt is equal to the 12% it is currently paying, identifying a cost of equity is more difficult. You may assume that the debt beta is zero.

Fortunately, there are three firms in the same industry (office furniture design and manufacture) that had gone public in the last few years. The information shown below was determined based on these company’s stock prices.

 

Company Beta Debt to Total Value Debt to Equity
Greene Furnishings 1.30 0.60 1.5
Sullivan Design/Build 1.28 0.48 .923
Wright Manufacturing 1.20 0.45 .818

 

Like the firms listed above, Corbusier is in a 30% tax bracket. Unlike those firms, however, the principal shareholders believe a low debt level, about 25% of total assets, is more appropriate for a firm of Corbusier’s size.

Find the unleveraged beta for each comparison firm.

Unlevered Beta = Levered Beta / [1 + ((1 – Tax Rate) x (Debt/Equity))]

Greene Furnishings:   1.30/ [1 + ((1 – 0.3) x (1.500))] = 0.6341

Sullivan Design/Build: 1.28/ [1 + ((1 – 0.3) x (0.923))] = 0.7776

Wright Manufacturing: 1.20/ [1 + ((1 – 0.3) x (0.818))] = 0.7631

What is your estimate of the correct equity beta to use in evaluating Corbusier’s cost of capital? Indicate any key assumptions.

First, we find the average of the beta and D/E ratio of the most comparable companies assuming that the specifics of the data and size range of the comparable companies do not vary much.

Average beta = (1.3+1.28+1.2)/3= 1.26

Average D/E ratio = (1.5+0.923+0.818) = 1.08

Then, we get the unlevered beta using the average beta and average D/E.

Unlevered Beta     = Levered Beta / [1 + ((1 – Tax Rate) x (Debt/Equity))]

=1.26/ [1 + ((1 – 0.3) x (1.08))] = 0.7175

To estimate the beta of the company, we re-lever the equity using the Corbusier’s target D/e ratio which is 0.25/0.75= 0.33

Levered Beta= unlevered beta*[1 + ((1 – Tax Rate) x (Debt/Equity))]

=0.7175*[1 + ((1 – 0.3) x (0.33))] = 0.5829

The estimate of the correct equity beta is 0.5829.

 

What is your estimate of the weighted average cost of capital for Corbusier assuming the risk-free rate of return is 8% and the market risk premium is 9%.

WACC= RF+ β (RM – RF)

WACC= 8%+0.5829(9%) = 13.2461%

The estimate of the weighted average cost of capital for Corbusier is 13.25%

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