Enterprise valuation: in the summer of 2010, smidgeon industries were evaluating

Question

Enterprise valuation: in the summer of 2010, smidgeon industries were evaluating whether or not to purchase one of its suppliers. The supplier, carswell manufacturing, provides smidgeon with the raw steel smidgeon uses to fabricate utility trailers. One of the first things that smidgeon’s management did was to forecast the cash flows of carswell for the next five years:
year Cash flows
1 $1,200,000
2 $1,260,000
3 $1,323,000
4 $1,389,150
5 $1,458,608

Next, smidgeon’s management team looked at a group of similar firms and estimated Carswell’s cost of capital to be 15%. Finally, they estimated that carswell would be worth approximately six times its year 5 cash flow in five years.
a. What is your estimate of the enterprise value of carswell?
b. What is the value of the the equity of carswell if the acquisition goes through and smidgeon borrows $2.4 million and finances the remainder using equity?

Explanation / Answer

Gordon Growth Model for finding EV We have Disc rate as 15% =Kd PV of CFs = CF0+Cf1/(1+Kd)^1+Cf2/(1+Kd)^2 +Cf3/(1+Kd)^3 +Cf4/(1+Kd)^4 +Cf5/(1+Kd)^5 ie PV of CFs = 0+$1,200,000/(1+15%)^1+$1,260,000/(1+15%)^2+$1,323,000/(1+15%)^3+ $1,389,150/(1+15%)^4 + $1,458,608/(1+15%)^5 ie PV of CFs = $4,385,550 There are several ways to estimate a terminal value of cash flows, but one well-worn method is to value the company as a perpetuity using the Gordon Growth Model. The model uses this formula: Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)/(Discount Rate – Long-Term Cash Flow Growth Rate) ie TV = (6*1458608)*(1+0%)/(15%-0%) = $58,344,320 PV of TV = $58,344,320/(1+15%)^5 = $29,007,439 Sp Total Enterprise Value EV = PV of CFs + PV of TV = $4,385,550+$29,007,439 ie EV = $33,392,989 ...........................Ans (a) Fair Value of Equity = Enterprise Value – Debt = $33,392,989 - $2,400,000 ie FV of Equity = $30,992,989 or Approx $31M................Ans (b)

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