DUE: Tuesday, September 29 at Midnight

The easiest way to solve the case is to use a spreadsheet to calculate free cash flows. After you set the spreadsheet up for question 1, it should be easy to modify the spreadsheet to answer questions 2, 3 and 4. Answers to Quiz 3 should help you set up the problem.

Please show all your work. In particular, paste the spreadsheets you used for each question into the Word document as exhibits. Please follow the template when formatting your answers.

There is a lot of detail in the case and exhibits. Do not worry about all of the detailswe will focus on quantitatively valuing the firm and will mostly ignore the qualitative component.

In brief, the case is asking you to value Mercury Athletic from the perspective of another, rival footwear company Active Gear, Inc. How much is Active Gear, Inc willing to pay in order to acquire Mercury's operations?

1. [60 points] Put yourself in John Liedtke's shoes at the very beginning of 2007. How much should John Liedtke be willing to pay today for Mercury Athletic? By purchasing Mercury today, Active Gear will have claim to all Mercury's future free cash flows. Assume that Mercury's free cash flows are all generated at the end of each year, starting at the end of 2007 (that is, one year from today's purchase). Show your work by calculating each of the below pieces:

a. What will be Mercury's EBIT for years 2007 to 2011? (Hint: exhibit 6).

b. Assume that Mercury will face a tax rate of 40%. What will be its NOPLAT from 2007 to 2011?

c. What will be Mercury's depreciation for years 2007 to 2011? (Hint: exhibit 6)

d. What will be Mercury's capital expenditure for years 2007 to 2011? (Hint: exhibit 6)

e. What is Mercury's net working capital in 2006? Assume that all the cash on Mercury's balance sheet is used in its operations. (Hint: exhibit 4)

f. What will be Mercury's net working capital for years 2007 to 2011? (Hint: exhibit 7)

g. Find the increase in Mercury's net working capital for years 2007 to 2011.

h. What will be Mercury's free cash flows for years 2007 to 2011?

i. Liedtke's projections stop in 2011, but Mercury athletic will continue to earn cash flows after 2011. Suppose Mercury reaches a steady state in 2011 so that free cash flows grow at a constant rate after 2011 in perpetuity. If this growth rate is 3%, what will be Mercury's free cash flow in 2012?

j. What is the value, in 2011-dollars, of all Mercury's free cash flows from 2012 into perpetuity? Assume Mercury has a discount rate of 15%.

k. Again assuming a discount rate of 15%, how much should Liedtke be willing to pay for Mercury's operations? That is, what is Mercury's enterprise value?

2. [20 points] Footwear companies have high tax rates partially due to significant import taxes and tariffs. Liedtke is optimistic that the U.S. will negotiate a trade deal with China and will lower import taxes on footwear in the near future. In particular, Liedtke expects Mercury's tax rate to drop to 30% starting in 2009 (but stay at 40% for 2007 and 2008). Repeat question 1 to account for the expected change in tax rates, assuming nothing else changes (eg no change in sales, CAPX, NWC, etc). How much is Liedtke willing to pay for Mercury's operations?

3. [20 points] Active Gear is much better at managing inventory than Mercury. In Table 1, we see that Active Gear's days sales in inventory is 2/3rds of Mercury Athletic. Liedtke thinks he may be able to apply the same inventory management to Mercury. Suppose that, starting in 2008, Mercury is able to cut its inventory to be 2/3rds of what Liedtke initially projected in exhibit 7. For example, Mercury's inventory in 2008 would be 2/3*85,465=$56,977. Assume that nothing else changes except Mercury's inventory levels from 2008 and beyond (eg no change in EBIT, CAPX, etc). Repeat question 1 to account for this reduced inventory. How much is Liedtke willing to pay for Mercury's operations?

4. [Bonus 16 points- all or nothing] As is typical with acquisitions, Liedtke plans to expand the profitable parts of Mercury and cut its less profitable parts. In particular, Liedtke plans to wind down Mercury's line of women's casual shoes in 2007. Find the effect of this discontinuation on Mercury's free cash flows, following these steps:

a. EBIT from the women's casual segment is provided in exhibit 6. Assuming a tax rate of 40%, what is the segment's NOPLAT for 2007?

b. Unlike EBIT, past balance sheet items are not broken out by segment but are rather consolidated in exhibit 4. We can weight these balance sheet items by the relative size of the women's shoes segment. Based on 2007 revenues in exhibit 6, what fraction of Mercury's sales are coming from the women's casual segment?

c. Use the weight of the women's casual segment you calculated in 4b to estimate the amount of depreciation (from exhibit 6) that should be applied to the women's casual segment in 2007.

d. Again using the weight from (b), how much Property, Plant & Equipment (PP&E) can be attributed to the women's casual division in 2006? (using exhibit 4)

e. Given your answer to (c) and (d), what is the book value at the end of 2007 for women's casual's PP&E? Assume that Liedktke does not buy or sell any PP&E for the women's casual segment during the year.

f. Liedtke is going to sell all of the PP&E in the women's casual segment. He sells it at the very end of 2007, but can only sell it for $200. What is the after-tax cash flow from this asset sale?

g. Liedtke is also going to sell all of the net working capital in the women's casual segment at the end of 2007. Based on your weight in (b) and Mercury's net working capital in exhibit 4, what is the change in net working capital for women's casual in 2007?

h. Now that we have the NOPLAT in (a), the depreciation in (c), CAPX in (f) and change in net working capital in (g), what is the free cash flow in 2007 from the discontinuation of