Waltham, Inc., a publicly traded firm, is considering the acquisition of a priva
ID: 2613430 • Letter: W
Question
Waltham, Inc., a publicly traded firm, is considering the acquisition of a private company, Artforever.com, which specializes in restoring damaged artwork and vintage photographs for high net worth individuals. Waltham’s CEO and chairman of the board, Willie Ray, described the motivation for the acquisition as follows: “We are running out of profitable investment opportunities in our core vintage shoe restoration business, and our shareholders expect us to continue to grow. Therefore, we must look to acquisitions to expand into growing markets.”
Waltham, Inc.’s common stock is currently trading at $50 per share, and the firm has 100,000 shares outstanding. The book value of the common stock is $20 per share. However, as mentioned by Mr. Ray, sales had been slowing recently and the board was concerned that soon the share price would also begin to flag as investors figured out that the firm was running out of positive NPV investments. The firm has $2,000,000 market value of bonds trading at a yield to maturity of 6.2%.
You have been hired as a consultant to Waltham to evaluate the proposed acquisition of Artforever.com. There is considerable dissension among senior management and the board about whether the acquisition should be undertaken. Your job is to perform a thorough analysis of the merits of the proposed acquisition and make a recommendation to senior management.
After several meetings with Waltham management and a review of Artforever’s financial performance and industry structure, you gathered the data shown in Table 1 below.
Forecast Data for Artforever.com (in $’000)
2017
2018
2019
2020
2021
Sales Revenue
1,000.0
1,250.0
1,875.0
2,100.0
3,750.0
Investment in CapEx and NWC
25.0
55.0
170.0
80.0
80.0
Depreciation
15.0
30.0
50.0
72.0
80.0
Interest payments
94.4
101.4
108.6
115.9
122.4
Artforever.com currently has $1,475,000 (market value) in long-term debt, with a coupon rate of 7%. Its cost of goods sold (COGS) is expected to be 42% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 15 percent of revenues. The depreciation numbers listed above are already included in COGS percentage estimates. The firm’s corporate tax rate is 40% and its current cost of borrowing is 6.2%.
Your research indicates that Artforever has a target debt to value ratio of 15%, based on its assessment of the probability and costs of financial distress. You note that this is different from the capital structure of Waltham and wonder how this would factor into your analysis.
Although Artforever.com is a rapidly growing company, your analysis of industry structure suggests that competition in the art restoration market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows beyond 2021 will be a more modest 2.0% per year.
Your analysis of market data yielded the information in Table 2 below.
Market Data
Current yield to maturity on 30 year treasury bonds
2.50%
Current yield to maturity on 3 month treasury bills
2.0%
Most recent 1-year return on the S&P 500
5.3%
Estimate of expected average return on the S&P 500 over the next 30 years
8.0%
Your analysis of Artforever.com’s industry reveals that most of the firms in the industry, like Artforever, are private firms. However, you find a close competitor, ArtToday.net, that is in the same line of business and is publicly traded. ArtToday has a long-term target debt to equity ratio of 0.75, and has been historically quite close to that target. Your analysis of ArtToday’s historical returns against the market returns yields an equity beta of 1.5. ArtToday currently has 50,000 common shares outstanding trading at $12 per share.
1) What discount rate is appropriate for finding the value of Artforever.com?
Explain your reasoning and computations; show detailed computations.
2) What are the relevant cash flows for valuing Artforever.com? Assume that your valuation is performed at the end of 2016, and that the values shown in Table 1 are end-of-year forecasts.
Explain your reasoning and computations; show detailed computations.
3) Based on your answers to questions (1) and (2) above, what is the maximum price that Waltham should pay to equity shareholders for Artforever.com?
Explain your reasoning and computations; show detailed computations.
4)Under what conditions might you consider recommending that management make a higher offer than your recommended price in (3) above?
2017
2018
2019
2020
2021
Sales Revenue
1,000.0
1,250.0
1,875.0
2,100.0
3,750.0
Investment in CapEx and NWC
25.0
55.0
170.0
80.0
80.0
Depreciation
15.0
30.0
50.0
72.0
80.0
Interest payments
94.4
101.4
108.6
115.9
122.4
Explanation / Answer
Waltham Inc
Current Market Price = 50
Outstanding shares = 100000
Book Value = 20
Market Value of Bond = 2,000,000
YTM = 6.2%
Artforever.com
Long term debt = 1,475,000
Coupon Rate = 7%
Cost of Goods Sold = 42%
Selling, General & Administrative Expenses = 15%
Corporate Tax rate = 40%
Perpetual growth rate of 2% pa beyond 2021
Current YTM on 30 year treasury bonds – 2.50
Current yield on 3 month Treasury Bills – 2
1-year return on S&P index – 5.3
Expected average return on S&P for next 30 years – 8.0
ArtToday.Net
Long Term Target to Debt Ratio – 0.75
Beta = 1.50
Outstanding shares = 50000
Price = $12
Answer (1)
Current cost of borrowing = 6.2%
Debt Equity Ratio = 0.75 (of ArtToday.Net)
0.75 = 1,475,000 / Equity
Equity = 1,475,000 / 0.75 = 1,966,667
Total Capital = Equity + Long Term Debt
= 1,966,667 + 1,475,000 = 3,441,667
Risk Free rate of return = 2%
Expected average return on S&P = 8.0%
Beta = 1.50 (equivalent stock ArtToday.net)
Cost of Equity = Risk free rate + (market return – risk free rate) * Beta
= 2 + (8-2) * 1.50 = 11%
Weight of Owners Equity in Total Capital = 1,966,667/ 3,441,667 = 0.5714 or 57.14%
Weight of Debt in Total Capital = 1- 57.14% = 0.4286 or 42.86%
Weighted Average cost of capital = Weight of Equity * cost of equity + weight of debt * cost of debt (1-Tax rate)
WACC r = 0.5714 * 0.11 + 0.4286 * 0.062 * (1-0.40)
r = 0.062854 + 0.01594 = 0.078797 or r = 7.88%
Answer (2)
Calculation of Cash Flows
2017
2018
2019
2020
2021
Sales Revenue
1,000,000
1,250,000
1,875,000
2,100,000
3,750,000
Cost of Goods Sold (42% of sales)
420,000
525,000
787,500
882,000
1,575,000
Selling, General & Admn Exp (15%)
150,000
187,500
281,250
315,000
562,500
Interest Payments
94,400
101,400
108,600
115,900
122,400
EBT
415,000
507,500
756,250
831,000
1,532,500
Tax (40%)
166,000
203,000
302,500
332,400
613,000
PAT
249,000
304,500
453,750
498,600
919,500
Depreciation
15,000
30,000
50,000
72,000
80,000
Free Cash Flows
264,000
334,500
503,750
570,600
999,500
The is expected growth of free cash flows after 2021 is at 2%
Free Cash flows in 2022 = 999500 * 1.02 = 1,019,490
Present Value of perpetual flow Cash Flows in 2022 P = Cash Flows in 2022 / WACC
P = 1,019,490 / 0.0788 = 1,287,944.16
Answer (3)
Present Value of Free Cash Flows = (264000/1+0.00788) + (334,500/(1+0.0788)^2) + (503750/(1+0.0788)^3) + (570,600 / (1+0.0788)^4)+ (999500/(1+0.0788)^5) + PV of Perpetual Flow / (1+0.0991)^5
PV = (264000/1.0788) + 334500/ 1.0788^ 2 +503750/1.0788^3 + 570600/1.0788^4 + 999500/1.0788^5 + 1,287,944.16/1.0788^5
PV = 244716.35 + 287,420.51 +401,234.56 + 421,293.56 + 684,073.64 + 881,489.40
PV = $ 2,920,228.02
Maximum Value payable is $ 2,920,228.02
Answer (d)
If the market conditions change in such way that the free cash flows are expected increase at a higher rate than 2% after 2021 or if the cost of borrowing comes down from existing rate a higher rate can be offered to the owners of the target firm
2017
2018
2019
2020
2021
Sales Revenue
1,000,000
1,250,000
1,875,000
2,100,000
3,750,000
Cost of Goods Sold (42% of sales)
420,000
525,000
787,500
882,000
1,575,000
Selling, General & Admn Exp (15%)
150,000
187,500
281,250
315,000
562,500
Interest Payments
94,400
101,400
108,600
115,900
122,400
EBT
415,000
507,500
756,250
831,000
1,532,500
Tax (40%)
166,000
203,000
302,500
332,400
613,000
PAT
249,000
304,500
453,750
498,600
919,500
Depreciation
15,000
30,000
50,000
72,000
80,000
Free Cash Flows
264,000
334,500
503,750
570,600
999,500
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