(5 Marks x 8 = 40 Marks) CEO of ALCEM Industries, has his eyes on an acquisition target: DELTA, a division of a big Conglomerate. DELTA is a mature business that has underperformed in its industry for the past six years. After an internal campaign to boost performance fell short of senior executives' expectations, Management of the Conglomerate resolved to sell DELTA. Working with division managers from ALCEM industries who know DELTA's operations and with some external valuation consultants, CEO has targeted the following specific opportunities for value creation: DELTA's product line will be rationalized, and some components will be outsourced to improve the company's operating margin by three percentage points. The same changes will reduce inventory and boost payables, producing onetime reductions in net working capital Some of DELTA's nonproductive assets will be sold. Distribution will be streamlined and new sales incentives introduced to raise DELTA's sales growth from 2% to 3% annually to the industry average of 5%. Table 1. Forecasted EBIT and Other Values for DELTA for the next five years based on the projections made above by acquisition team: . N 4 13.5 5.2 0 Forecasted EBIT and Other Data for next five years Year 0 1 3 5 EBIT 22.7 29.8 37.1 40.1 42.1 Depreciation + 21.5 + 11.5 + 12.1 + 12.7 Capital Expenditures 10.7 10.1 10.4 11.5 13.1 Change in net WC -12.3 1.9 4.2 6.1 Change in Other Assets 9 6.9 3.4 0 364 24-4 3006 35.5 3505 Some taxes will be saved, mostly through the interest tax shields associated with borrowing. Seller's representatives have indicated that Conglomerate is reluctant to accept less than book value (currently $307 million) for DELTA, despite its recent lackluster performance. CEO's financial expert team believe that a deal at book value could be financed with about 80% debt, comprising senior bank debt, privately placed subordinated debt, and a revolving credit facility CEO expects to pay down that debt as quickly as possible (lenders will insist on it) and to arrive at a debt to capital ratio no higher than 50% within five years. DELTA does not have publicly traded shares, but a few similar companies do, and they provide benchmarks for estimating the cost of equity. One such company, with a historical debt ratio of 45% to 50%, has an estimated cost of equity of 24%. Another with no debt in capital structure, has an estimated cost of equity of 13.5%. In general, Conglomerates investors expect significantly higher returns of 30% to 35%. Return on long term government bonds (RF) = 5%. Applicable Tax Rate for the target and acquiring firms = 40%. . 4 59 205.1 6.7 270.8 5 65.1 205.5 6.7 2773 Table 2. Forecasted balance sheet for current year and next five years. Pro Forma Balance Sheets Assets Year 01 2 3 Net Working Capital 60 47.7 49.6 53.7 Net Fixed Assets 221 210.3 206.9 205.7 26 Other Assets 17 10.1 6.7 307 Total Assets 275 266.6 266.1 Liabilities and Equity 13 0.2 Revolver @7.5% 4.8 11.7 80 60 40 Bank Loan @ 8.0% 20 150 150 Subordinated Debt @9.5% 150 150 0 0 0 0 Long Term Debentures @9.0% 243 210.2 Total Debt 194.8 181.7 64 64.7 71.8 84.5 Equity 307 274.9 266.6 Total Liabilities and Equity 266.2 20.9 0 150 0 170.9 99.9 270.8 20 0 0 140 160 1172 277.2 Q1. Use table 1 to calculate Free Cash Flows for the Firm (FCFF) for the target company, Q2. Calculate Terminal Value for the target firm assuming terminal growth of 5%. Q3. Value the business as if it were financed entirely with equity. Q4. Using Table 2 and Table 1, calculate the value associated with the financing program (Value of Tax Shield) that acquiring firm is expecting to utilize. This should include terminal value of the tax shield. 25. Calculate value of target firm using APV method by adding value of business as if it were financed entirely with equity, and value of tax shield. Q6. Calculate traditional weighted average cost of capital (WACC) based on the present capital structure of the firm (Refer Year 0 Liabilities and Equity in Table 2). Q7. Calculate value of the target firm using traditional WACC computed in question 6 above. Q8. Compare and Contrast the firm value obtained using APV method (Question 5) and traditional WACC method (Question 7). (5 Marks x 8 = 40 Marks) CEO of ALCEM Industries, has his eyes on an acquisition target: DELTA, a division of a big Conglomerate. DELTA is a mature business that has underperformed in its industry for the past six years. After an internal campaign to boost performance fell short of senior executives' expectations, Management of the Conglomerate resolved to sell DELTA. Working with division managers from ALCEM industries who know DELTA's operations and with some external valuation consultants, CEO has targeted the following specific opportunities for value creation: DELTA's product line will be rationalized, and some components will be outsourced to improve the company's operating margin by three percentage points. The same changes will reduce inventory and boost payables, producing onetime reductions in net working capital Some of DELTA's nonproductive assets will be sold. Distribution will be streamlined and new sales incentives introduced to raise DELTA's sales growth from 2% to 3% annually to the industry average of 5%. Table 1. Forecasted EBIT and Other Values for DELTA for the next five years based on the projections made above by acquisition team: . N 4 13.5 5.2 0 Forecasted EBIT and Other Data for next five years Year 0 1 3 5 EBIT 22.7 29.8 37.1 40.1 42.1 Depreciation + 21.5 + 11.5 + 12.1 + 12.7 Capital Expenditures 10.7 10.1 10.4 11.5 13.1 Change in net WC -12.3 1.9 4.2 6.1 Change in Other Assets 9 6.9 3.4 0 364 24-4 3006 35.5 3505 Some taxes will be saved, mostly through the interest tax shields associated with borrowing. Seller's representatives have indicated that Conglomerate is reluctant to accept less than book value (currently $307 million) for DELTA, despite its recent lackluster performance. CEO's financial expert team believe that a deal at book value could be financed with about 80% debt, comprising senior bank debt, privately placed subordinated debt, and a revolving credit facility CEO expects to pay down that debt as quickly as possible (lenders will insist on it) and to arrive at a debt to capital ratio no higher than 50% within five years. DELTA does not have publicly traded shares, but a few similar companies do, and they provide benchmarks for estimating the cost of equity. One such company, with a historical debt ratio of 45% to 50%, has an estimated cost of equity of 24%. Another with no debt in capital structure, has an estimated cost of equity of 13.5%. In general, Conglomerates investors expect significantly higher returns of 30% to 35%. Return on long term government bonds (RF) = 5%. Applicable Tax Rate for the target and acquiring firms = 40%. . 4 59 205.1 6.7 270.8 5 65.1 205.5 6.7 2773 Table 2. Forecasted balance sheet for current year and next five years. Pro Forma Balance Sheets Assets Year 01 2 3 Net Working Capital 60 47.7 49.6 53.7 Net Fixed Assets 221 210.3 206.9 205.7 26 Other Assets 17 10.1 6.7 307 Total Assets 275 266.6 266.1 Liabilities and Equity 13 0.2 Revolver @7.5% 4.8 11.7 80 60 40 Bank Loan @ 8.0% 20 150 150 Subordinated Debt @9.5% 150 150 0 0 0 0 Long Term Debentures @9.0% 243 210.2 Total Debt 194.8 181.7 64 64.7 71.8 84.5 Equity 307 274.9 266.6 Total Liabilities and Equity 266.2 20.9 0 150 0 170.9 99.9 270.8 20 0 0 140 160 1172 277.2 Q1. Use table 1 to calculate Free Cash Flows for the Firm (FCFF) for the target company, Q2. Calculate Terminal Value for the target firm assuming terminal growth of 5%. Q3. Value the business as if it were financed entirely with equity. Q4. Using Table 2 and Table 1, calculate the value associated with the financing program (Value of Tax Shield) that acquiring firm is expecting to utilize. This should include terminal value of the tax shield. 25. Calculate value of target firm using APV method by adding value of business as if it were financed entirely with equity, and value of tax shield. Q6. Calculate traditional weighted average cost of capital (WACC) based on the present capital structure of the firm (Refer Year 0 Liabilities and Equity in Table 2). Q7. Calculate value of the target firm using traditional WACC computed in question 6 above. Q8. Compare and Contrast the firm value obtained using APV method (Question 5) and traditional WACC method (Question 7)