Forecasting and Valuation: Elite Luggage Company

Part-1 Financial Needs of the Company

Upon graduating from college with degree in finance, Robert Blake entered the financial management training program of a large consulting firm. The program consisted of a one-year assignment in two different departments.

Financial Planning and Forecasting Department

In the Financial Planning and Forecasting department, Robert was asked to forecast the future cash flows and financial needs of Elite Luggage Company for 2013 and 2014. Specifically, he was asked to determine the financial needs of the Company for its 2013 and 2014. Initially, he was not sure how to proceed with his analysis, but remembered in his finance classes that he needed to set the pro forma financial statements for the analysis.

To set up the pro forma statements and forecast the company's expected financial needs, Robert decided to seek advice of the company's marketing research department. He was told the most likely sales level for 2013 would be similar to the growth rate of 25% achieved in 2012; however, it could gradually decline to steady sate growth rate of 5% over the next five years. The assessment of the growth rate was based on the company's market share and analysis of the demand for its products.

Financial Planning and Forecasting Procedures

The analytical tool used in forecasting financial needs of a company is based on pro forma financial statements. The preparation of pro forma financial statements involves the following steps:

Project sales revenue for the desired periods.

Project operating expenses (cost of goods sold, selling and administrative, income taxes).

Project assets, liabilities, and shareholders' equity (except non-spontaneous liabilities and retained earnings) needed to support the level of the operations projected in steps 1 and 2.

Determine the cost of financing and the capital structure.

The preparation of pro forma financial statements requires numerous assumptions about the growth rate in sales, cost behavior of various expenses, level of investment in working capital, fixed assets, and mix of financing. The analyst should study the sensitivity of these statements to the assumptions made and to the impact of different assumptions.

Assumptions for Estimation

To develop the projected financial statements, Robert made the following assumptions:

In arriving at the annual EBIT, he assumed the annual dollar amount of the depreciation expense should be based on the needs of the company for future gross fixed assets and is 5% of the total gross fixed assets.

There was no excess capacity or assets. Expenditures on fixed assets would be necessary to replace worn-out equipment and to provide the needed capacity for growth. All fixed and current assets and some of the current liabilities would change in direct proportion to sales.

In order to calculate the cost of capital of the Company, he contacted Elite management and was told that the Company intends to maintain its debt and the current capital structure.

Capital structure is the summation of market value debt and the market value of equity. The debt ratio (D/V) is calculated by market value of debt (D) divided by the sum of the book value of debt plus the market value of equity (D + S).

The cost of capital is based on weighted average cost of capital (WACC) when the company has debt in its capital structure, otherwise it is based on cost of equity.

Part-2 Mergers and Acquisitions Department

In the Mergers and Acquisitions department, Robert was asked to help Best International Corporation (BIC) with the offering price of Elite Company. Robert decided to estimate the enterprise value and equity of Elite Company As a financial analyst, Robert was not sure why BIC was interested in the Elite Company, since the two companies, were not being in the same industry and did not have a synergistic relationship. However, he thought he should do his job and come up with a price offer.

Companies' Background

Best International Corporation an expanding conglomerate, is a manufacturing company whose product lines consist of lighting fixtures. Videodiscs, Electronic timing devices, travel agencies. and self-storage space. Presently the company consists of four divisions, acquired throughout the years. The company's policy has been to acquire businesses that show significant growth and profit potential. If a business fails to attain projected growth or sales, it is usually sold.

Elite Company is a publicly held company which manufactures and wholesales several different lines of luggage in two basic types: soft-sided and molded. Each luggage line consists of several different pieces, all of which come in different sizes. At least one line is a complete set of luggage designed to be used by both men and women, but some lines and styles are designed specifically for men or women. Some lines also have matching attach cases. The Company also manufactures luggage for large retail companies according to each company's specifications. This luggage is marketed under the retail company's own private label.

VALUING OF A FIRM

Determining a value of a company is a difficult task, because there are various definitions of "value" depending on the needs and usage of different users. Ideally, the value of a firm should be the current market value of the company if the stock is publicly traded, that is, the market value of the equity is equal to the price per share times the shares outstanding if the firm does not have any debt.

Value of Equity = Price X Shares outstanding

V = P X N

Financial economists generally argue that the stock market is relatively efficient. In an efficient market, it would be difficult for any equity investors to consistently outperform the market by identifying undervalued stocks. Many empirical studies have suggested that the stock market is indeed fairly efficient and it is very difficult to "beat the market."

If the stock market is efficient, one should be able to determine the value of a firm simply by multiplying the public price per share by the outstanding shares. However, if the acquisition is expected to increase the value for the stockholders due to synergy (either one or both firms), then this increase in value is unlikely to be reflected in the public price of either company.

VALUATION MODELS

In theory, there are several valuation models. These models are Discounted Cash Flow, Cash-Flow-to Equity (CFE), Adjusted Present Value (APV), and relative values such as, Enterprise Value/EBITDA, Market/Book Value, and P/E ratio, which could be used to estimate the value of a firm.

Exhibit 1- Elite Company Balance Sheet	(000 omitted)
	12/31/2011	12/31/2012
Cash	$3,000	$4,000
Account Receivable	$5,000	$6,000
Inventory	$7,000	$8,000
Current Assets	$15,000	$18,000
Gross Fixed Assets	$35,000	$40,000
Less: Accumulated Depreciation	($6,000)	($8,000)
Net Fixed Assets	$29,000	$32,000
Total Assets	$44,000	$50,000
Accounts Payable	$4,200	$5,000
Notes Payable (interest rate of 5%)	$5,000	$5,000
Current Liabilities	$9,200	$10,000
Long-term Debt (coupon rate of 7.5%)	$9,000	$10,000
Common Stock (10 M shares at par value of $1.00)	$10,000	$10,000
Paid-in-capital	$10,000	$10,000
Retained Earnings	$5,800	$10,000
Total Debt & Equity	$44,000	$50,000
Exhibit 2- Elite Company Income Statement	12/31/2011	12/31/2012
Sales	$80,000,000	$100,000,000
Cost of Sales	($69,600,000)	($87,000,000)
EBITA	$10,400,000	$13,000,000
Depreciation	($1,750,000)	($2,000,000)
EBIT	$8,650,000	$11,000,000
Interest Expense	($900,000)	-1,000,000
Taxable Income	$7,750,000	$10,000,000
Taxes (40%)	$3,100,000	$4,000,000
Net Income	$4,650,000	$6,000,000
Outstanding Shares	10,000,000	10,000,000
EPS	$0.47	$0.60
Dividend Per Share	$0.14	$0.18

EXHIBIT 3-Financial Data (Millions)
Company	Elite	BIC
Debt (Market Value)	$10	$50
Equity	$30	$125
Beta	1.5	1.25
Per Share Data:
Earnings per share	$0.60	$3.25
Dividend per share	$0.18	$0.65
Stock price (12/31/2012)	$4.00	$36.50

EXHIBIT 4- Total Annual Return, 1926-2012
	Geometric Mean	Arithmetic Mean
Small company stocks	12.20%	16.70%
Large company stocks	10.10%	12.10%
Treasury Bonds	5.70%	6.10%
Treasury Bills	3.50%	3.50%
Inflation	2.90%	3%

EXHIBIT 5 Equity Risk Premium
	Arithmetic Average			Geometric Average
	MRP T. bills	MRP T. bonds		MRP T. bills	MRP T. bonds
1928-2013-Large Cap	8.60%	6.00%		6.60%	4.40%
1928-2013-Small Cap	13.20%	10.60%		13.20%	6.50%
	Treasury Bills	Treasury Bonds		Corporate Rate
Yields in 2012	1%	2.80%		6%

Part 1

1. What is the forecasted future cash flows and financial needs of Elite Luggage Company for 2013 an 2014?

2. What is the WACC?

3. What does this tell you about the company?

Part 2

1. What should the offering price be for Elite Company?