As a new financial analyst at Pacific Coast Investment Company (PCIC), a private brokerage firm, you are asked to demonstrate the skills you learned in your finance major and proved that you are going to be a fantastic equity analyst in the future. Your first assignment is to value the SyKey Corporation, which is a privately held designer and manufacturer of specialty sports goods, such shoes, eyewear, and apparel.

In mid-2005, its owner and founder, June Wong, has decided to sell the business to Pacific Coast , after having relinquished management control about four years ago.

SyKey has total assets of $87 million and annual sales of $75 million. The firm is also quite profitable, with earnings this year of almost $7 million, for a net profit margin of 9.3%. SyKey currently has debt outstanding of $4.5 million, but it also has a substantial cash balance. You believe a deal could be reached to purchase SyKeys equity at the end of this fiscal year for an acquisition price of $150, which almost double SyKeys current book value of equity.

Is this price reasonable? Below is the financial information for 2005.

Table 1-Estimated 2005 Income Statement and Balance Sheet Data for SyKey Corporation

Income Statement ( $ 000)	2005	Balance Sheet ($ 000)	2005
Sale	$75,000	Cash and Equivalents	$12,664
Cost of Goods Sold	($34,000)	Accounts Receivable	$18,493
Gross Profit	$41,000	Inventories		$6,165
Sales and marketing	($11,250)	Current Assets		$37,322
Administrative	($13,500)	Property, Plant, and Equip	$49,500
EBITDA	$16,250	Total Assets	$86,822
Depreciation	($5,500)	Accounts payable	$4,654
EBIT	$10,750	Long-term Debt		$4,500
Interest Expense (net)	($75)	Total Liabilities		$9,154
EBT	$10,675	Stockholders' equity	$77,668
tax (35%)	($3,736)	Total Debt and Equity	$86,822
Net Income	$6,939

Valuation Using Comparables

In your finance classes you learned that there are two ways to value the companies; (1) Relative (Multiples) Values or (2) Discounted Cash Flow Method. To obtain the first estimate you decided to value SyKey by using comparable firms. Below is the financial information for sporting goods industry in 2005.

Table 2- Comparable Companies Financial Information

		Stock	Market	Enterprise		Price/	Enterprise	Enterprise
Table 2-Ticker	Name	Price	Capitalization	Value	P/E	Book	Value/	Value/
			($ million)	($ million)		Value	Sales	EBITDA
KCP	Kenneth Cole	26.75	562	465	16.21	2.22	0.9	8.36
NKE	Nike, Inc.	84.2	21,830	20,518	16.64	3.59	1.43	8.75
PMMAY	Puma, Inc.	312.05	5,088	4,593	14.99	5.02	2.19	9.02
RBK	Reebok Int'l	58.72	3,514	3,451	14.91	2.41	0.9	8.58
WWW	Wolverine World Wide	22.1	1,257	1,253	17.42	2.71	1.2	9.53
BWS	Brown Shoe Co.	43.36	800	1,019	22.62	1.91	0.47	9.09
SKX	Skechers	17.09	683	614	17.63	2.02	0.62	6.88
SRR	Stride Rite Corp.	13.7	497	524	20.72	1.87	0.89	9.28
DECK	Deckers Outdoor Corp.	30.05	373	367	13.32	2.29	1.48	7.44
WEYS	Weyco Group	19.9	230	226	11.97	1.75	1.06	6.66
RCKY	Rocky Shoes & Boots	19.96	106	232	8.66	1.12	0.92	7.55
DFZ	R.G. Corp.	6.83	68	92	9.2	8.11	0.87	10.75
BOOT	LaCrosse Footwear	10.4	62	75	12.09	1.28	0.76	8.3

Given information in Table-2, what range of acquisition prices for SyKey is implied by relative values.

While comparables provide a useful starting point, whether this acquisition is a successful investment for Pacific Coast depends on SyKeys post acquisition performance. Thus it is necessary to look in details at SyKeys operations, invetments, and capital structure, and to access its potential for improvements and future growth.

You plan to cut administrative costs immediately and redirect resources to new product development , sales, and marketing. By doing so, you believe SyKey can increase its market share from 10% in 2005 to 12.5% in 2010. Table 3 provides information about sales, operating cost assumptions for next five years. Given the information in Table 3, calculate the projected annual production volume:

Table 3- Sales data	growth rate	2005	2006	2007	2008	2009	2010
1. Market Size (units)	5%	10000
2. Market share	0.50%	10%
3. Ave. sales price ($/unit)	2%	$75
Cost of Goods Data
4. Raw Materials	1.00%	16.00
5. Direct Labor Costs	4.00%	18.00
Operating Expense and Tax Data
6. Sales and Marketing		15%	16.50%	18.00%	19.50%	20.00%	20.00%
7. Administrative		18%	15.00%	15.00%	14.00%	13.00%	13.00%
8. Tax Rate		35%	35.00%	35.00%	35.00%	35.00%	35.00%

Based on volume projection (market share x market size) you notice that production volume will exceed SyKey current level by more than 30% by 2010, necessitating an expansion.

The cost of this expansion will be $20 million.

Table 4 shows SyKey capital expendtires and depreciation over the next five years.

Table 4- Year	2005	2006	2007	2008	2009	2010
Fixed Assets and Capital Investment ($000)
Opening book value	$50,000	$49,500	$49,050	$48,645	$48,281	$47,952
New Investment	$5,000	$5,000	$5,000	$5,000	$5,000	$20,000
Depreciation	($5,500)	($5,450)	($5,405)	($5,365)	($5,328)	($6,795)
Closing book value	$49,500	$49,050	$48,645	$48,281	$47,952	$61,157

With little debt, excess cash, and substantial earnings, SyKey appres to be signicantly underleveraged. You plan greatly increase the firms debt, and have obtained bank commitment for loans of $100 million should an agreement be reached. The term loan will have an interest rate of 6.8%, and SyKey will pay interest only during next five years.

The firm will seek additional funding in 2010 associated with the expansion of its manufacturing plant, as shown in Table 5.

Table 5- Year	2005	2006	2007	2008	2009	2010
Debt and Interest Table
Outstanding Debt	100,000	100,000	100000	100,000	100,000
Interest on term Loan

Using above information, project net income through 2010.

Table 6- Year	2005	2006	2007	2008	2009	2010
Sales
Cost of Goods Sold
Raw Materials
Direct Labor Costs
Gross Profit
Sales and Marketing
Administrative
EBITDA
Depreciation
EBIT
Interest Expense
Pretax Income
Income Tax
Net Income

Under the assumptions that SyKeys market share will increase by 0.5% per year, calculate SyKeys working capital requirements though 2010.

Working Capital Days		2004	2005
Assets		Based on:	Days	Days
Accounts Receivable	Sales Revenue	90	60
Raw Materials	Raw Materials Costs	45	30
Finished Goods	Raw Materials + Labor Costs	45	45
Minimum Cash Balance	Sales Revenue	30	30
Liabilities
Wages Payable	Direct Labor + Admin Costs	15	15
Other Accounts Payable	Raw Materials + Sales and Marketing	45	45

Given information above what are the SyKeys free cash flow of the firm and to equity for 2006-2010.

Free cash flow ($000)	2006	2007	2008	2009	2010
Net Income
Plus: After-Tax Interest Expense
Unlevered Net Income
Plus: Depreciation
Less: Increases in NWC
Less: Capital Expenditures
Free Cash Flow of Firm
Plus: Net Borrowing
Less: After-Tax Interest Expense
Free Cash Flow to Equity

Calculate SyKeys unlevered cost of capital when SyKeys unlevered beta is 1.2, risk free rate and market risk premium are 4% and 5% respectively. What is the value of the firm and value of equity?

.

Assume that the future debt-to-value ratio is held constant at 40%; the debt cost of capital is 6.8%; and future expected long-term growth rate is 5%, using the information produced in the income statement, use EBITDA as a multiple to estimate the continuation value (terminal value) in 2010, assuming the current value remains unchanged. What is the value of the firm?

Given the values obtained by both method, explain the differences in valuation models.

Valuation and Financial Modeling: A Case Study of SyKey Acqisitions As a new financial analyst at Pacific Coast Investment Company (PCIC), a private brokerage firm, you are asked to demonstrate the skills you learned in your finance major and proved that you are going to be a fantastic equity analyst in the future. Your first assignment is to value the SyKey Corporation, which is a privately held designer and manufacturer of specialty sports goods, such shoes, eyewear, and apparel. In mid-2005, its owner and founder, June Wong, has decided to sell the business to Pacific Coast , after having relinquished management control about four years ago. SyKey has total assets of $87 million and annual sales of $75 million. The firm is also quite profitable, with earnings this year of almost $7 million, for a net profit margin of 9.3%. SyKey currently has debt outstanding of $4.5 million, but it also has a substantial cash balance. You believe a deal could be reached to purchase SyKey's equity at the end of this fiscal year for an acquisition price of $150, which almost double SyKey's current book value of equity. Is this price reasonable? Below is the financial information for 2005. Table 1-Estimated 2005 Income Statement and Balance Sheet Data for SyKey Corporation Income Statement ( $ 000) Sale Cost of Goods Sold Gross Profit Sales and marketing Administrative EBITDA Depreciation EBIT Interest Expense (net) EBT tax (35%) Net Income 2005 $75,000 ($34,000) $41,000 ($11,250) ($13,500) $16,250 ($5,500) $10,750 ($75) $10,675 ($3,736) $6,939 Balance Sheet ($ 000) Cash and Equivalents Accounts Receivable Inventories Current Assets Property, Plant, and Equip Total Assets Accounts payable Long-term Debt Total Liabilities Stockholders' equity Total Debt and Equity 2005 $12,664 $18,493 $6,165 $37,322 $49,500 $86,822 $4,654 $4,500 $9,154 $77,668 $86,822 Valuation Using Comparables In your finance classes you learned that there are two ways to value the companies; (1) Relative (Multiples) Values or (2) Discounted Cash Flow Method. To obtain the first estimate you decided to value SyKey by using comparable firms. Below is the financial information for sporting goods industry in 2005. Table 2- Comparable Companies Financial Information Table 2Ticker KCP NKE PMMAY RBK WWW BWS SKX SRR DECK WEYS RCKY DFZ BOOT Stock Market Enterprise Price/ Enterprise Enterprise Name Price Capitalization Value P/E Book Value/ Value/ Kenneth Cole Nike, Inc. Puma, Inc. Reebok Int'l Wolverine World Wide Brown Shoe Co. Skechers Stride Rite Corp. Decker's Outdoor Corp. Weyco Group Rocky Shoes & Boots R.G. Corp. LaCrosse Footwear 26.75 84.2 312.05 58.72 ($ million) 562 21,830 5,088 3,514 ($ million) 465 20,518 4,593 3,451 16.21 16.64 14.99 14.91 Value 2.22 3.59 5.02 2.41 Sales 0.9 1.43 2.19 0.9 EBITDA 8.36 8.75 9.02 8.58 22.1 1,257 1,253 17.42 2.71 1.2 9.53 43.36 17.09 13.7 800 683 497 1,019 614 524 22.62 17.63 20.72 1.91 2.02 1.87 0.47 0.62 0.89 9.09 6.88 9.28 30.05 373 367 13.32 2.29 1.48 7.44 19.9 19.96 6.83 10.4 230 106 68 62 226 232 92 75 11.97 8.66 9.2 12.09 1.75 1.12 8.11 1.28 1.06 0.92 0.87 0.76 6.66 7.55 10.75 8.3 Given information in Table-2, what range of acquisition prices for SyKey is implied by relative values. While comparables provide a useful starting point, whether this acquisition is a successful investment for Pacific Coast depends on SyKey's post acquisition performance. Thus it is necessary to look in details at SyKey's operations, invetments, and capital structure, and to access its potential for improvements and future growth. You plan to cut administrative costs immediately and redirect resources to new product development , sales, and marketing. By doing so, you believe SyKey can increase its market share from 10% in 2005 to 12.5% in 2010. Table 3 provides information about sales, operating cost assumptions for next five years. Given the information in Table 3, calculate the projected annual production volume: Table 3- Sales data 1. Market Size (units) 2. Market share 3. Ave. sales price ($/unit) Cost of Goods Data 4. Raw Materials 5. Direct Labor Costs Operating Expense and Tax Data 6. Sales and Marketing 7. Administrative 8. Tax Rate growth rate 5% 0.50% 2% 1.00% 4.00% 2005 2006 2007 2008 2009 2010 16.50% 15.00% 35.00% 18.00% 15.00% 35.00% 19.50% 14.00% 35.00% 20.00% 13.00% 35.00% 20.00% 13.00% 35.00% 10000 10% $75 16.00 18.00 15% 18% 35% Based on volume projection (market share x market size) you notice that production volume will exceed SyKey' current level by more than 30% by 2010, necessitating an expansion. The cost of this expansion will be $20 million. Table 4 shows SyKey' capital expendtires and depreciation over the next five years. Table 4- Year Fixed Assets and Capital Investment ($000) 2005 2006 2007 2008 2009 2010 Opening book value $50,000 $49,500 $49,050 $48,645 $48,281 $47,952 New Investment $5,000 $5,000 $5,000 $5,000 $5,000 $20,000 Depreciation ($5,500) ($5,450) ($5,405) ($5,365) ($5,328) ($6,795) Closing book value $49,500 $49,050 $48,645 $48,281 $47,952 $61,157 With little debt, excess cash, and substantial earnings, SyKey appres to be signicantly underleveraged. You plan greatly increase the firm's debt, and have obtained bank commitment for loans of $100 million should an agreement be reached. The term loan will have an interest rate of 6.8%, and SyKey will pay interest only during next five years. The firm will seek additional funding in 2010 associated with the expansion of its manufacturing plant, as shown in Table 5. Table 5- Year Debt and Interest Table Outstanding Debt Interest on term Loan 2005 2006 2007 2008 2009 2010 100,000 100,000 100000 100,000 100,000 Using above information, project net income through 2010. Table 6- Year Sales Cost of Goods Sold Raw Materials Direct Labor Costs Gross Profit Sales and Marketing Administrative EBITDA Depreciation EBIT Interest Expense Pretax Income Income Tax Net Income 2005 2006 2007 2008 2009 2010 Under the assumptions that SyKey's market share will increase by 0.5% per year, calculate SyKey's working capital requirements though 2010. Working Capital Days Assets Accounts Receivable Raw Materials Finished Goods Minimum Cash Balance Liabilities Wages Payable Other Accounts Payable Based on: Sales Revenue Raw Materials Costs Raw Materials + Labor Costs Sales Revenue Direct Labor + Admin Costs Raw Materials + Sales and Marketing 2004 Days 90 45 45 30 2005 Days 60 30 45 30 15 45 15 45 Given information above what are the SyKey's free cash flow of the firm and to equity for 2006-2010. Free cash flow ($000) Net Income Plus: After-Tax Interest Expense Unlevered Net Income Plus: Depreciation Less: Increases in NWC Less: Capital Expenditures Free Cash Flow of Firm Plus: Net Borrowing Less: After-Tax Interest Expense Free Cash Flow to Equity 2006 2007 2008 2009 2010 Calculate SyKey's unlevered cost of capital when SyKey's unlevered beta is 1.2, risk free rate and market risk premium are 4% and 5% respectively. What is the value of the firm and value of equity? . Assume that the future debt-to-value ratio is held constant at 40%; the debt cost of capital is 6.8%; and future expected long-term growth rate is 5%, using the information produced in the income statement, use EBITDA as a multiple to estimate the continuation value (terminal value) in 2010, assuming the current value remains unchanged. What is the value of the firm? Given the values obtained by both method, explain the differences in valuation models