Finance and Accounting
 Consider the Lucky Inc. Financial Statement below. Assumptions for your analysis:
 Note that Lucky’s capital expenditures are on land. Land is a nondepreciable 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 assetstotal 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 
 In the following matrix, report the Free Cash Flow calculation for Lucky:
FCF= EBIT(1Tax Rate) + Depreciation & Amortization – Change in Net Working Capital – Capital Expenditure
Year 0  Year 1  Year 2  
EBIT(1Tax Rate) 
297.0*(10.4)
178.2 
445.5(10.4)
267.3 
623.7(10.4)
374.22 
+ Depreciation & Amortization  0

0  0 
– Change in Net Working Capital

274.4249.5=24.9
24.9 
411.5274.4=137.1
137.1 
576.241.5=164.7
164.7 
– Capital Expenditure 
16001550=50
50 
17001600=100
100 
17501700=50
50 
FCF 
103.3  30.2  159.52 
 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: 30.2/1.14^{2}=$23.24
In year 2: 159.52/1.14^{3} =$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 =$1,861.07/1.14^{3}= $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
 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  
 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___.
 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_.
 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.
 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 yearend 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 yearend cash flows in years 2016, 2017 and 2018.
In year 2016: 16935/1.131= $14,973.47
In year 2017: 20525/1.131^{2}=$16,045.67
In year 2018: 24335/1.131^{3} =$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?
=278,114.29/1.131^{3}= $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 relever 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 riskfree 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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