The following information relates to questions 7–12: Alan Chin, the chief execut
ID: 2620661 • Letter: T
Question
The following information relates to questions 7–12:
Alan Chin, the chief executive officer of Thunder Corporation, has asked his chief financial officer, Constance Ebinosa, to prepare a valuation of Thunder for the purpose of selling the company to a private investment partnership. Thunder is a profitable $200 million annual salesUS domiciled manufacturer of generic household products. Customers consist of several grocery store chains in the United States. Competitors include large companies such as Procter & Gamble, Clorox, and Unilever. Thunder has been in business for 15 years and is privately owned by the original shareholders, none of whom are employed by the company. The company’s senior management has been in charge of the company’s operations for most of the past 15 years and expects to remain in that capacity after any sale.
The partnership has expectations about Thunder similar to the current shareholders and management of Thunder. These investors expect to hold Thunder for an intermediate period of time and then bring the company public when market conditions are more favorable than currently.
Chin is concerned about what definition of value should be used when analyzing Thunder. He notes that the stock market has been very volatile recently. He also wonders whether fair market value can be realistically estimated when the most similar recent private market transactions may not have been at arm’s length.
Chin asks Ebinosa whether there will be differences in the process of valuing a private company like Thunder compared with a public company. Ebinosa replies that differences do exist and mentions several factors an analyst must consider.
Ebinosa also explains that several approaches are available for valuing private companies. She mentions that one possibility is to use an asset-based approach because Thunder has a relatively large and efficient factory and warehouse for its products. A real estate appraiser can readily determine the value of these facilities. A second method would be the market approachand using an average of the price-to-earnings multiples for Procter & Gamble and Clorox. A third possibility is a discounted free cash flow approach. The latter would focus on a continuation of Thunder’s trend of slow profitable growth during the past ten years.
The private investment partnership has mentioned that they are likely to use an income approach as one of their methods. Ebinosa decides to validate the estimates they make. She assumes for the next 12 months that Thunder’s revenues increase by the long-term annual growth rate of 3 percent. She also makes the following assumptions to calculate the free cash flow to the firm for the next 12 months:
· Gross profit margin is 45 percent.
· Depreciation is 2 percent of revenues.
· Selling, general, and administrative expenses are 24 percent of revenues.
· Capital expenditures equal 125 percent of depreciation to support the current level of revenues.
· Additional capital expenditures of 15 percent of incremental revenues are needed to fund future growth.
· Working capital investment equals 8 percent of incremental revenues.
· Marginal tax rate on EBIT is 35 percent.
Chin knows that if an income approach is used, then the choice of discount rate may have a large influence on the estimated value. He makes two statements regarding discount rate estimates:
· If the CAPM method is used to estimate the discount rate with a beta estimate based on public companies with operations and revenues similar to Thunder, then a small stock premium should be added to the estimate.
· The weighted average cost of capital of the private investment partnership should be used to value Thunder.
Ebinosa decides to calculate a value of Thunder’s equity using the capitalized cash flow method (CCM) and decides to use the build-up method to estimate Thunder’s required return on equity. She makes the following assumptions:
· Growth of FCFE is at a constant annual rate of 3 percent.
· Free cash flow to equity for the year ahead is $2.5 million.
· Risk-free rate is 4.5 percent.
· Equity risk premium is 5.0 percent.
· Size premium is 2.0 percent.
Question: Given Chin’s concerns, the most appropriate definition of value for Thunder is:
Select one:
a. intrinsic value.
b. investment value.
c. fair market value.
The least likely factor that would be a source of differences in valuing Thunder compared with valuing a publicly traded company is:
Select one:
a. access to public debt markets.
b. agency problems.
c. the size of the company.
The least likely factor that would be a source of differences in valuing Thunder compared with valuing a publicly traded company is:
Select one:
a. access to public debt markets.
b. agency problems.
c. the size of the company.
The free cash flow to the firm is closest to:
Select one:
a. $23,031,000.
b. $25,441,000.
c. $36,091,000.
Regarding the two statements about discount rate estimates, Chin is:
Select one:
a. correct with respect to adding the small stock premium and correct with respect to the weighted average cost of capital.
b. correct with respect to adding the small stock premium and incorrect with respect to the weighted average cost of capital.
c. incorrect with respect to adding the small stock premium and incorrect with respect to the weighted average cost of capital.
The indicated value of Thunder’s equity using the build-up method and the capitalized cash flow method (CCM) based on free cash flow to equity is closest to:
Select one:
a. $29.41 million.
b. $38.46 million.
c. $125.00 million.
Explanation / Answer
Ans;- Fair market value.
Discounted cash flow approach s’d used here valuation of the firm.
2. The least likely factor that would be a source of differences in valuing Thunder compared with valuing a publicly traded company is:
Ans;- agency problems.
3. The least likely factor that would be a source of differences in valuing Thunder compared with valuing a publicly traded company is:
Ans;- agency problems.
4. The free cash flow to the firm is closest to:
Ans;- $25,441,000
Growth of FCFE is at a constant annual rate of 3 percent.
Beta = 1 (Given)
Present Value of Free Cash Flows = FCFE/ (Re – g)
FCFE = 2.5 million
Re= Rf + Rm* Beta
= 4.5% + 7*1 = 11.5%
Present Value of Free Cash Flows = 2,500,000/ (11.5% - 3%)
= 29,411,764
= 29, 411,000 (Approx)
Therefore free cash flow for the firm is close to $25,441,000.
5. Regarding the two statements about discount rate estimates, Chin is:
Ans;- correct with respect to adding the small stock premium and incorrect with respect to the weighted average cost of capital.
6. The indicated value of Thunder’s equity using the build-up method and the capitalized cash flow method (CCM) based on free cash flow to equity is closest to:
Ans;- $29.41 million
Present Value of Free Cash Flows = 2,500,000/ (11.5% - 3%)
= 29,411,764
value of Thunder’s equity using the build-up method and the capitalized cash flow method (CCM) based on free cash flow to equity is closest to $29.41 million.
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