Argo Airlines, a privately held firm, is looking to buy additional gates at its home airport for $635,000 Argo has $200,000 in the bank but that money may not be spent as it is used to pay salaries, suppliers, and equipment Argo asked its bank for a loan but the bank refused to say that Argo's interest-bearing debt to equity was too high at 3.1 The bank said that Argo needed to lower that ratio below 2.3 in order to get the loan Separately, SkyBlue Airlines has approached Argo to see if Argo will buy it.

Argos CFO hired you to help with the following task:

1. The price discussed by the two CEOs is 22x SkyBlue's 2019 net earnings You must calculate this price and compare it with the free cash flow value of SkyBlue, which you must also calculate The CFO wants to know if Argo is overpaying or underpaying for SkyBlue.

IMPORTANT: SHOW FORMULAS USED TO CALCULATE

Information from previous questions below:

1 SkyBlue Acquisition 2 - Earnings Multiple 3 - 2018 actual net earnings 4 Price 5 Value based on free cash flows: Price Paid 6 2019 2020 2021 TV Notes From Pro Formas - EBIT projection EBIT minus tax From Pro Formas (exclude Bank note plug!) From Pro Formas Calculation - 7 EBIT 8 EBIAT 9 - Change in Working Capital 10 Change in PP&E 11 Free Cash Flow 12 13 PV of Free Cash Flows 14 - Existing Debt 15 = Present Value of SkyBlue 16 17 (Underpay)/Overpay for SkyBlue Calculation Bank Loan + CPLT + LTD Calculated value If negative, Argo Airlines paid less than SkyBlue is worth 1 SkyBlue Acquisition 2 - Earnings Multiple 3 - 2018 actual net earnings 4 Price 5 Value based on free cash flows: Price Paid 6 2019 2020 2021 TV Notes From Pro Formas - EBIT projection EBIT minus tax From Pro Formas (exclude Bank note plug!) From Pro Formas Calculation - 7 EBIT 8 EBIAT 9 - Change in Working Capital 10 Change in PP&E 11 Free Cash Flow 12 13 PV of Free Cash Flows 14 - Existing Debt 15 = Present Value of SkyBlue 16 17 (Underpay)/Overpay for SkyBlue Calculation Bank Loan + CPLT + LTD Calculated value If negative, Argo Airlines paid less than SkyBlue is worth A B 1 2 3 4 5 6 Component 1 Net Income (M$) 2 Earnings per share 3 # of shares (M) 4 Price per share 5 Market Value - Equity (M) 6 Market Value - Debt (M) 7 Market Value - Total (M) 8 - % Debt 9 -% Equity 10 Beta (levered) 11 Beta (unlevered) 12 Average Beta (unlevered) Caledonian 22.00 0.80 27.50 11.00 303 230 533 43% 57% 1.20 0.68 D E Laker Source 20.00 Given 1.23 Given 16.26 Net Income / Earnings per share 11.00 Given 179 # of shares x Price per share 44 Given 223 Market Value - Debt + Equity 20% Market Value - Debt/Market Value - Total 80% 1-% Debt 0.80 Given 0.64 Beta (levered) x % Equity 0.64 Average 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Values for combined Argo/SkyBlue airline: % Debt 33.0% % Equity 67.0% Beta (relevered) 0.96 Risk free rate 3.0% Market risk premium 5.5% Expected equity return 8.3% Expected cost of debt 5.0% Tax rate 21.0% WACC 6.864% Given 1 -% Debt Average Beta (unlevered) / % Equity Assumption Historical figure CAPM calculation Given Statutory rate Weighed average of costs of equity and debt 21 22 23 24 B D E F G H I J K L M N 0 Q R S 1 2 Here the initial; cost is 635,000 3 4 working capital investment is = 200,000.00 5 6 assuming that the working capital is recovered in the last year 7 8 9 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 7 10 Initial investment working capital 0 Year 1 (635,000.00) (200,000.00) 11 12 13 operating cash flow 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 555,000.00 (working capital recovery is added) 14 15 Total (835,000.00) 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 555,000.00 16 17 Here we first calculate the IRR by using the excel IRR formula 18 IRR 19 20 21 IRR(D15:K15) 39.25% 22 the discount rate is not given, so we are assuming that the discount rate is 15% 23 24 NPV @ 15% NPV(15%, E15:K15) + D15 25 26 717,136.41 27 28 29 30 E B Actual 2018 359 85 D Projected 2019 2020 2021 Notes Calculation (Use for Free Cash Flow valuation!) Hold level Calculation Use implicit rate of 2018 Calculation 274 58 216 1 2 Income Statement 10 EBIT 11 - Interest 12 = EBT 13 - Taxes 14 = Net Income 15 Balance Sheet 16 Cash 17 Notes and Acc. Rec. 18 Inventory 19 Prepaid 20 Current Assets 21 Other 22 Total Assets 230 1,126 965 75 Increase at average growth rate 2,396 1,000 3,396 Leave flat 23 830 55 50 75 Plug to make balance sheet balance Increase at average growth rate Leave flat Leave flat 24 Bank Loan 25 Payables 26 CPLTD 27 Other 28 Current Liabilities 29 LTD 30 Equity 31 Total Liabilities & Equity 32 33 Working Capital 1,010 550 1,836 3,396 LTD of previous year minus CPLTD of current year Equity of previous year plus net income of current year Exclude Bank Loan E F 1 2 Balance Sheet 3 Cash 4 Notes and Acc. Rec. 5 Inventory 6 Prepaid 7 Current Assets 8 Other 9 Total Assets B Actual 2018 240 7,013 5,588 192 13,033 3,325 16,358 2019 250 8,385 6,630 195 15,460 3,830 19,290 D Projected 2020 250 9,998 7,905 232 18,385 4,393 22,778 2021 Notes 250 12,040 9,520 280 22,090 5,105 27,195 10 6.070 3.057 433 1,477 11.037 2,458 7,586 3,705 450 1,712 13,453 2,008 9,321 4,417 450 1.994 16,182 1,558 11,404 5,320 450 2,350 19,524 1,108 11 Bank Loan 12 Payables 13 CPLTD 14 Other 15 Current Liabilities 16 LTD 17 18 Equity 19 Total Liabilities & Equity 20 21 Ratios: 22 Bank Loan to Receivables 23 Liabilities / Equity 24 Debt / Equity 2.863 16,358 3,829 19,290 5,038 22,778 6,563 27,195 0.9 0.9 4.7 3.1 0.9 4.0 2.6 3.5 2.2 0.9 3.1 2.0 1 SkyBlue Acquisition 2 - Earnings Multiple 3 - 2018 actual net earnings 4 Price 5 Value based on free cash flows: Price Paid 6 2019 2020 2021 TV Notes From Pro Formas - EBIT projection EBIT minus tax From Pro Formas (exclude Bank note plug!) From Pro Formas Calculation - 7 EBIT 8 EBIAT 9 - Change in Working Capital 10 Change in PP&E 11 Free Cash Flow 12 13 PV of Free Cash Flows 14 - Existing Debt 15 = Present Value of SkyBlue 16 17 (Underpay)/Overpay for SkyBlue Calculation Bank Loan + CPLT + LTD Calculated value If negative, Argo Airlines paid less than SkyBlue is worth 1 SkyBlue Acquisition 2 - Earnings Multiple 3 - 2018 actual net earnings 4 Price 5 Value based on free cash flows: Price Paid 6 2019 2020 2021 TV Notes From Pro Formas - EBIT projection EBIT minus tax From Pro Formas (exclude Bank note plug!) From Pro Formas Calculation - 7 EBIT 8 EBIAT 9 - Change in Working Capital 10 Change in PP&E 11 Free Cash Flow 12 13 PV of Free Cash Flows 14 - Existing Debt 15 = Present Value of SkyBlue 16 17 (Underpay)/Overpay for SkyBlue Calculation Bank Loan + CPLT + LTD Calculated value If negative, Argo Airlines paid less than SkyBlue is worth A B 1 2 3 4 5 6 Component 1 Net Income (M$) 2 Earnings per share 3 # of shares (M) 4 Price per share 5 Market Value - Equity (M) 6 Market Value - Debt (M) 7 Market Value - Total (M) 8 - % Debt 9 -% Equity 10 Beta (levered) 11 Beta (unlevered) 12 Average Beta (unlevered) Caledonian 22.00 0.80 27.50 11.00 303 230 533 43% 57% 1.20 0.68 D E Laker Source 20.00 Given 1.23 Given 16.26 Net Income / Earnings per share 11.00 Given 179 # of shares x Price per share 44 Given 223 Market Value - Debt + Equity 20% Market Value - Debt/Market Value - Total 80% 1-% Debt 0.80 Given 0.64 Beta (levered) x % Equity 0.64 Average 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Values for combined Argo/SkyBlue airline: % Debt 33.0% % Equity 67.0% Beta (relevered) 0.96 Risk free rate 3.0% Market risk premium 5.5% Expected equity return 8.3% Expected cost of debt 5.0% Tax rate 21.0% WACC 6.864% Given 1 -% Debt Average Beta (unlevered) / % Equity Assumption Historical figure CAPM calculation Given Statutory rate Weighed average of costs of equity and debt 21 22 23 24 B D E F G H I J K L M N 0 Q R S 1 2 Here the initial; cost is 635,000 3 4 working capital investment is = 200,000.00 5 6 assuming that the working capital is recovered in the last year 7 8 9 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 7 10 Initial investment working capital 0 Year 1 (635,000.00) (200,000.00) 11 12 13 operating cash flow 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 555,000.00 (working capital recovery is added) 14 15 Total (835,000.00) 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 355,000.00 555,000.00 16 17 Here we first calculate the IRR by using the excel IRR formula 18 IRR 19 20 21 IRR(D15:K15) 39.25% 22 the discount rate is not given, so we are assuming that the discount rate is 15% 23 24 NPV @ 15% NPV(15%, E15:K15) + D15 25 26 717,136.41 27 28 29 30 E B Actual 2018 359 85 D Projected 2019 2020 2021 Notes Calculation (Use for Free Cash Flow valuation!) Hold level Calculation Use implicit rate of 2018 Calculation 274 58 216 1 2 Income Statement 10 EBIT 11 - Interest 12 = EBT 13 - Taxes 14 = Net Income 15 Balance Sheet 16 Cash 17 Notes and Acc. Rec. 18 Inventory 19 Prepaid 20 Current Assets 21 Other 22 Total Assets 230 1,126 965 75 Increase at average growth rate 2,396 1,000 3,396 Leave flat 23 830 55 50 75 Plug to make balance sheet balance Increase at average growth rate Leave flat Leave flat 24 Bank Loan 25 Payables 26 CPLTD 27 Other 28 Current Liabilities 29 LTD 30 Equity 31 Total Liabilities & Equity 32 33 Working Capital 1,010 550 1,836 3,396 LTD of previous year minus CPLTD of current year Equity of previous year plus net income of current year Exclude Bank Loan E F 1 2 Balance Sheet 3 Cash 4 Notes and Acc. Rec. 5 Inventory 6 Prepaid 7 Current Assets 8 Other 9 Total Assets B Actual 2018 240 7,013 5,588 192 13,033 3,325 16,358 2019 250 8,385 6,630 195 15,460 3,830 19,290 D Projected 2020 250 9,998 7,905 232 18,385 4,393 22,778 2021 Notes 250 12,040 9,520 280 22,090 5,105 27,195 10 6.070 3.057 433 1,477 11.037 2,458 7,586 3,705 450 1,712 13,453 2,008 9,321 4,417 450 1.994 16,182 1,558 11,404 5,320 450 2,350 19,524 1,108 11 Bank Loan 12 Payables 13 CPLTD 14 Other 15 Current Liabilities 16 LTD 17 18 Equity 19 Total Liabilities & Equity 20 21 Ratios: 22 Bank Loan to Receivables 23 Liabilities / Equity 24 Debt / Equity 2.863 16,358 3,829 19,290 5,038 22,778 6,563 27,195 0.9 0.9 4.7 3.1 0.9 4.0 2.6 3.5 2.2 0.9 3.1 2.0