$1$

PAMPA RV$,$ INC.

Evaluation of an Investment Opportunity

Pampa RV$,$ Inc., a publicly traded firm, is considering the acquisition of Chico Clothing

Company $($CCC$)$ for a price of $$12$ per share. CCC is a private company that specializes in

manufacturing clothing, shoes and accessories for beauty pageant contestants. The RV

business is slow, and Pampa$$s CFO believes that the acquisition of CCC will help to improve

overall profitability and provide much needed cash flow. Pampa$$s has $500,000$ shares of

common stock outstanding, currently trading at $$9\mathrm{.}75$ per share. The book value of

the common stock is $$5$ per share. Pampa also has bonds with a market value of $$3,500,000$

and a yield to maturity of $3\mathrm{.}4\%.$ Based on current market valuations, Pampa is currently

achieving its target debt to equity ratio. Pampa$$s equity beta is $0\mathrm{.}80.$

CCC is a private firm that was founded ten years ago by four sisters, who have a combined $100$

years of experience in the beauty pageant business as competitors, judges, and coaches.

CCC$$s cost of goods sold $($COGS$)$ is expected to be $38\%$ of sales revenues, and selling,

general and administrative $($SG&A$)$ expenses are expected to be $12\%$ of revenues. These

estimates are in line with the firm$$s historical performance, which is expected to continue for the

foreseeable future. The firm is $100\%$ equity financed and has $100,000$ shares of common stock

outstanding. Its equity beta is estimated to be $1\mathrm{.}353.$

CCC has experienced rapid growth over the last ten years. However, your analysis of industry

structure suggests that competition in the beauty pageant clothing and accessories market is

likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free

cash flows after five years will be a modest $1\mathrm{.}5\%$ per year.

Your team has been hired as consultants to Pampa RV to evaluate the proposed

acquisition of CCC$.$ Tables $1$ and $2$ below contain additional data that you have collected

during your research. The corporate tax rate is $40\%$ for all firms.

Table $1$

Forecast Data for Chico Clothing Company

Year $1$ Year $2$ Year $3$ Year $4$ Year $5$

Sales Revenue $300,000335,000375,000410,000575,000$

Investment in CapEx and NWC $18,00025,00040,00050,00065,000$

Depreciation$115,00030,00040,00052,00060,000$

$1$The depreciation numbers listed above are not included in COGS percentage estimates.

Table $2$

Market Data

Current yield to maturity on $30$ year treasury bonds $2\mathrm{.}50\%$

Estimate of expected average return on the S&P $500$ over the next $30$ years $7\mathrm{.}50\%$

$2$

Guidelines for Written Case Report

Prepare a report intended for the board of directors of Pampa RV that contains a valuation of CCC

and a recommendation of the potential value creation if CCC is acquired. Your report should contain

answers to the following questions.

$1)$ What is the value of Chico Clothing Company? Assume that your valuation is performed today at

Year $0,$ and that the revenues shown in Table $1$ are end$-$of$-$year year forecasts.

$2)$ Suppose Pampa RV offers to pay $$12$ for each of CCC$$s outstanding shares. If the market fully

impounds this information, what will be the new price per share of Pampa$$s commonstock?

$3)$ What is the most that Pampa should pay for CCC$?$ Why?

$4)$ Estimate the beta of the combined entity $($Pampa $+$ CCC$)$ after the merger. Based on your answer,

will the merged firm$$s cost of capital to be higher or lower than Pampa$$s current cost of capital?

Explain your answer. Hint: Firm beta is a value$-$weighted average of individual betas.

Here you have a list of suggested steps:

$1-$ Put together the Income Statement for the next $5$ years.

$2-$ Calculate the Operating Cash Flow for the next $5$ years.

$3-$ Calculate the Cash Flow from Assets or Free Cash Flow for the next $5$ years.

$4-$ Calculate the cost of equity for CCC$.$

$5-$ Calculate CCC$$s WACC, in this case is going to be equal to the cost of equity since CCC does not

have any debt.

$6-$ Calculate CCC$$s Terminal Value in Year $5.$

$7-$ Find the tentative value of CC discounting all the Free Cash Flow for the next $5$ years and the

Terminal Value in year $5.$

$8-$ Calculate CCC$$s price per share.

$9-$ Calculate Pampa$$s post$-$merger price per share.$*$

$10-$ Calculate Pampa$$s post$-$merger beta.$**$

$*$The key concept is that, barring other market frictions, firm value will increase by the NPV of the

project. If a firm pays $$100$ cash for something that is worth $$120,$ they exchange $$100$ in assets $($cash$)$

for $$120$ in assets $($value of new project$),$ so market value increases by $$20.$ Of course, this assumes no

information problems, i$.$e$.,$ investors and managers see the same valuation and probability $=1$ that the

deal will be completed.

$**$ If the equity of the newly acquired firm is worth $$120$ and the old firm is worth say $$250,$ then the

equity value of the combined firm will be $$120+$ $$250,$ and it is straightforward to compute the equity

weights for estimating the beta of the combined firm.