Question 1

LAFCO Industries believes that its two primary product lines, automotive and commercial aircraft valves, are rapidly becoming
obsolete. Its free cash flow is rapidly diminishing as it loses market share to new firms entering its industry. LAFCO has $200
million in debt outstanding. Senior management expects the automotive and commercial aircraft valve product lines to
generate $25 million and $15 million, respectively, in earnings before interest, taxes, depreciation, and amortization next year. Senior management also believes that they will not be able to upgrade these product lines due to declining cash flow and excessive current leverage. A competitor to its automotive valve business last year sold for 10 times EBITDA. Moreover, a company that is similar to its commercial aircraft valve product line sold last month for 12 times EBITDA. Estimate LAFCO's breakup value before taxes.

Accepted Answer

$230 million
PV (automotive valves) = 25 x 10 = 250
PV (aircraft valves) = 15 x 12 = 180
Less outstanding debt = 200
Break-up value = 230

Question 2

Acquirer Company's management believes that there is a 60 percent chance that Target Company's free cash flow to the firm will grow at 20 percent per year during the next five years from this year's level of $5 million. Sustainable growth beyond the fifth year is estimated at 4 percent per year. However, they also believe that there is a 40 percent chance that cash flow will grow at half that annual rate during the next five years and then at a 4 percent rate thereafter. The discount rate is estimated to be 15 percent during the high growth period and 12 percent during the sustainable growth period for each scenario. What is the expected value of Target Company?

Accepted Answer

$94.93 million PV₂₀ = 5(1.20) + 5(1.2)² + 5(1.2)³ + 5(1.2)⁴ + 5(1.2)⁵ + 5(1.2)⁵(1.04)/(.12-.04) (1.15) (1.15)² (1.15)³ (1.15)⁴ (1.15)⁵ (1.15)⁵ = 5.22 + 5.44 + 5.68 + 5.93 + 6.19 + 80.41 = 108.87 PV₁₀ = 5(1.10) + 5(1.1)² + 5(1.1)³ + 5 (1.1)⁴ + 5(1.1)⁵ + 5(1.1)⁵(1.04)/(.12-.04) (1.15) (1.15)² (1.15)³ (1.15)⁴ (1.15)⁵ (1.15)⁵ = 4.78 + 4.57 + 4.38 + 4.19 + 4.01 + 52.1 = 74.03 EV = .6 x 108.87 + .4 x 74.03 = 94.93

Question 3

An investor group has the opportunity to purchase a firm whose primary asset is ownership of the exclusive rights to develop a parcel of undeveloped land sometime during the next 5 years. Without considering the value of the option to develop the property, the investor group believes the net present value of the firm is $(10) million. However, to convert the property to commercial use (i.e., exercise the option), the investors will have to invest $60 million immediately in infrastructure improvements. The primary uncertainty associated with the property is how rapidly the surrounding area will grow. Based on their experience with similar properties, the investors estimated that the variance of the projected cash flows is 5% of the NPV, which is $55 million, of developing the property. Assume the risk-free rate of return is 4 percent. What is the value of the call option the investor group would obtain by buying the firm? Is it sufficient to justify the acquisition of the firm?

Accepted Answer

The value of the option is $13.47 million. The investor group should buy the firm since the value of the option more than offsets the $(10) million NPV of the firm if the call option were not exercised. Value of the underlying asset (Expected value of the property) (S) = $55 million Exercise price (Upfront investment to commercialize the property) (E) = $60 million: Variance in underlying asset's value (Measure of cash flow risk) ($\sigma$²): .05 Time to expiration (t): 5 Risk free interest rate (R): 4 Where C = Theoretical call option value = SN(d₁) - Ee^-RtN(d₂) = $55 x N(.6844) - $60 x 2.7183^.04x5x N(.4920) = $37.64 - $24.17 = $13.47 million. d₁ = ln(S/E) + [R + (1/2)$\sigma$²} t = ln($55/$60) + [.04 + (1/2).05]5 = -.0870 + .3250 $\sigma$$\surd$t $\surd$.05 $\surd$5 ..2236 x 2.2361 = .2380 = .4760 .50 d₂ = d₁ - $\sigma$$\surd$t = .4760 - .5 = -.0240 S = Stock price or underlying asset price E = Exercise price R = Risk free interest rate corresponding to the life of the option $\sigma$² = Variance of the stock's or underlying asset's returns t = Time to expiration of the option N(d1) and N(d2) = Cumulative normal probability values of d¹ and d² e = 2.7183

Question 4

Under what circumstances might it be more appropriate to use relative valuation methods rather than the DCF approach? Be specific.

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Question 5

Does the application of the comparable companies' valuation method require the addition of an acquisition premium? Why? / Why not?

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Question 6

Titanic Corporation has reached agreement with its creditors to liquidate voluntarily its assets and to use the proceeds to pay off as much of its liabilities as possible. The firm anticipates that it will be able to sell off its assets in an orderly fashion, realizing as much as 70% of the book value of its receivables, 40% of its inventory, and 25% of its net fixed assets (excluding land). However, the firm believes that the land on which it is located can be sold for 120% of book value. The firm has legal and professional expenses associated with the liquidation process of $2,900,000. The firm has only common stock outstanding. Estimate the amount of cash that would remain for the firm's common shareholders once all assets have been liquidated.
 $\begin{array} { | l | l | l | } 
\hline \text { Balance Sheet Item } & \text { Bank Value of Atsets } & \text { Liquidetion Value } \
\hline \text { Cash } & \$ 10 & \
\hline \text { Accaunts Receivable } & \$ 20 & \
\hline \text { Invertary } & \$ 15 & \
\hline \begin{array} { l } 
\text { Net Fixed Assets } \
\text { Excluding Land }
\end{array} &  { \$ 8 } & \
\hline \text { Land } & \$ 6 & \
\hline \text { Total Assets } &   { \$ 5 9 } & \
\hline \text { Tatal Linbilities } & \$ 35 & \
\hline \text { Shareholders Equity } & \$ 24 & \
\hline
\end{array}$

Accepted Answer

The answer of Titanic Corporation has reached agreement with its...

Question 7

Siebel Incorporated, a non-publicly traded company, has 2009 after-tax earnings of $20 million, which are expected to grow at 5
percent annually into the foreseeable future. The firm is debt-free, capital spending equals the firm's rate of depreciation; and the annual change in working capital is expected to be minimal. The firm's beta is estimated to be 2.0, the 10-year Treasury bond is 5 percent, and the historical risk premium of stocks over the risk-free rate is 5.5 percent. Publicly-traded Rand Technology, a direct competitor of Siebel's, was sold recently at a purchase price of 11 times its 2009 after-tax earnings, which included a 20 percent premium over its current market price. Aware of the premium paid for the purchase of Rand, Siebel's equity owners would like to determine what it might be worth if they were to attempt to sell the firm in the near future. They chose to value the firm using the discounted cash flow and comparable recent transactions methods. They believe that either method provides an equally valid. Estimate of the firm's value.
a What is the value of Siebel using the DCF method?
b What is the value using the comparable recent transactions method?
c What would be the value of the firm if we combine the results of both methods?

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Question 8

What are the key assumptions implicit in the comparable companies' valuation method? The recent transactions method? Be specific.

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Question 9

What are real options and how are they applied in valuing acquisitions?

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Question 10

How is the liquidation value of the firm calculated? Why is the assumption of orderly liquidation important?

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Question 11

BigCo's Chief Financial Officer is trying to determine a fair value for PrivCo, a non-publicly traded firm that BigCo's is
considering acquiring. Several of PrivCo's competitors, Ion International, and Zenon are publicly traded. Ion and Zenon have
price-to-earnings ratios of 20 and 15, respectively. Moreover, Ion and Zenon's shares are trading at a multiple of earnings
before interest, taxes, depreciation, and amortization (EBITDA) of 10 and 8, respectively. BigCo estimates that next year
PrivCo will achieve net income and EBITDA of $4 million and $8 million, respectively. To gain a controlling interest in the
firm, BigCo expects to have to pay at least a 30% premium to the firm's market value. What should BigCo expect to pay for
PrivCo?
a. Based on price-to-earnings ratios?
b. Based on EBITDA?

Accepted Answer

The answer of BigCo's Chief Financial Officer is trying to...

Question 12

Best's Foods is seeking to acquire the Heinz Baking Company, whose shareholders equity and goodwill are $41 million and $7 million, respectively. A comparable bakery was recently acquired for $400 million, 30 percent more than its tangible book value (TBV). What was the tangible book value of the recently acquired bakery? How much should Best's Foods expect to have to pay for the Heinz Baking Company? Show your work.

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Question 13

Conventional DCF analysis does not incorporate the effects of real options into the valuation of an asset. How might an analyst
incorporate the potential impact of real options into conventional DCF valuation methods?

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Question 14

Which is generally considered more accurate: the comparable companies' or recent comparable transactions method?

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Question 15

Give examples of pre- and post-closing real options.

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Question 16

PEG ratios allow for the adjustment of relative valuation methods for the expected growth of the firm. How might this be helpful in selecting potential acquisition targets? Be specific?

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Question 17

Acquirer Incorporated's management believes that the most reliable way to value a potential target firm is by averaging multiple valuation methods, since all methods have their shortcomings. Consequently, Acquirer's Chief Financial Officer estimates that the value of Target Inc. could range, before an acquisition premium is added, from a high of $650 million using discounted cash flow analysis to a low of $500 million using the comparable companies' relative valuation method. A valuation based on a recent comparable transaction is $672 million. The CFO anticipates that Target Inc.'s management and shareholders would be willing to sell for a 20 percent acquisition premium, based on the premium paid for the recent comparable transaction. The CEO asks the CFO to provide a single estimate of the value of Target Inc. based on the three estimates. In calculating a weighted average of the three estimates, she gives a value of .5 to the recent transactions method, 3 to the DCF estimate, and .2 to the comparable companies' estimate. What it weighted average estimate she gives to the CEO? Show your work.

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Question 18

Explain the primary differences between the income (discounted cash flow), relative (market-based), and asset-oriented valuation methods?

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Question 19

Photon Inc. is considering acquiring one of its competitors. Photon's management wants to buy a firm it believes is most undervalued. The firm's three major competitors, AJAX, BABO, and COMET, have current market values of $375 million, $310 million, and $265 million, respectively. AJAX's FCFE is expected to grow at 10 percent annually, while BABO's and COMET's FCFE are projected to grow by 12 and 14 percent per year, respectively. AJAX, BABO, and COMET's current year FCFE are $24, $22, and $17 million, respectively. The industry average price-to-FCFE ratio and growth rate are 10 and 8%, respectively. Estimate the market value of each of the three potential acquisition targets based on the information provided? Which firm is the most undervalued? Which firm is most overvalued?

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Question 20

Delhi Automotive Inc. is the leading supplier of specialty fasteners for passenger cars in the U.S. market, with an estimated 25
percent share of this $5 billion market. Delhi's rapid growth in recent years has been fueled by high levels of reinvestment in the firm. While this has resulted in the firm having "state of the art" plants, it has also resulted in the firm showing limited profitability and positive cash flow. Delhi is privately owned and has announced that it is going to undertake an initial public offering in the near future. Investors know that economies of scale are important in this high fixed cost industry and understand that market share is an important determinant of future profitability. Thornton Auto Inc., a publicly traded firm and the leader in this market, has an estimated market share of 38 percent and an $800 million market value. How should investors value the Delhi IPO? Show your work.

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Quiz 8: Relative, Asset-Oriented, and Real Option