Karnak Systems, Inc. (KS)

Karnack Systems, Inc. (KI), an new Augmented Reality (AR)/Artificial Intelligence (A/I) design developer, which has been broached by a non-competing firm Resolute AI, Inc. (RAI) to formally merge operations; the idea being to expand operations to take advantage of scale economies and jointly pursue new markets not to mention advancing the technical capabilities of the combined firm to better compete against the perceived onslaught of new competition. RAI has offered $67.25/share in cash; as such, the company has decided to hire you and your firm, Iconic Consulting, Inc. to analyze, develop a strategy, and finalize a Fairness Opinion representing true value of the firm and ultimately to present a recommendation as to whether or not to accept RAI's offer in a merger of equals or come up with an alternative recommendation.

KI's management is driven to secure an objective valuation for the firm so it has decided to employ your services as lead counsel due to your pervasive experience in Corporate Control, M&A, and leveraged transactions.KI's Board of Directors is largely comprised of high-tech industry professionals that together as a whole are very competent in their industry, but lack the necessary technical skills surrounding such issues as equity valuation, leverage financing, and the overall ability to merge and combine firms. As lead consultant, you are to develop and create a compelling Excel spreadsheet that prominently highlights the step-by-step valution process which will be used to inform the Board of Directors and give recommendations along the lines described above.

Despite your extensive experience you are Iconic Consulting, Inc.'s most recent hire and you want to make your mark with the company and build favor with and develop a positive impression on management.At this stage you compile a list (in order) of items REQUIRED to be calculated and perform an appropriate valuation-the list reads:

1. Operating Cash Flow - First Ten Years & Terminal Phase
2. Free Cash Flow - First Ten Years & Terminal Phase
3. Asset Beta - KI's firm level Beta- derived from Industry Beta
4. Discount Rate - appropriate discount rate for discounted cash flow valuation
5. Asset value - Present Value First Ten Years & Present Value Terminal Phase
6. Equity value - Representation of Intrinsic Value (Market Capitalization)
7. Stock price - Intrinsic Value Per Share Basis
8. Recommendations - Acceptance or Rejection of offer/ Counter Proposal If Any

Iconic Consulting INC.

Market Research:Re: Karnak Systems, Inc.

Projected Unit Sales Growth (as a percentage of the previous year's performance)

FY1

496,632 Units

FY2

6.54%

FY3

6.54%

FY4

6.54%

FY5

6.54%

FY6

3.21%

FY7

3.21%

FY8

3.21%

FY9

3.21%

FY10

3.21%

Terminal

2.76%

Sales:

After in depth market research in all present and anticipated target market's for KI, Sales (in units) are expected to come in at 547,236 in the first year and grow 6.54% for years 2 through 5; 3.21% for years 6 through 10; then 2.76% in the terminal phase.Due to desire to dominate product markets and grow quickly, KI has decided to produce a single product: Karnak Systems, Inc. i14F Programmable Chip. Price per unit of the chip is $273 in the current year and is expected to rise 4.93% years 2 through 5; 4.04% for years 6 through 10; then 2.36% in the terminal phase.

Costs Structure (Variable & Fixed):

Variable cost in the first year are estimated to come in at $123/unit which is expected to grow 2.18% for years 2 through 5; 3.19% for years 6 through 10; then 1.26% in the terminal phase.

Fixed costs start off in year one at $3,882,275 and follows the same time path as variable costs.Growth in fixed costs are anticipated to be 2.99% for years 2 through 5; 2.92% for years 6 through 10; then 2.05% in the terminal phase.

As a result of strong product demand and overtures from the federal government as to possible future contract work, KI is contemplating operating structure changes in an effort to increase operating leverage and by extension higher profitability. Due to the preliminary stages of such planning, no effect on pro forma statement analysis is included herein.

Capital Expenditures & Depreciation:

Necessary capital expenditures at year 0 for KI will be $11,264,695. Also, KI expects capital expenditures of $918,879 in FY1 and $626,725 in FY2 as necessary investments to support the infrastructure of its flagship product-the Karnak Systems, Inc. e13 Processor Chip.

According to IRS tax regulations, capital expenditures for the i14F Programmable Chip project are required to be depreciated beginning in the year following investment according to the 5-year MACRS schedule. In the terminal phase of growth, investment strategy is anticipated to change to that of a maintenance orientation in support of future A/I opportunities presently to the company.As such, the average depreciation charge per year of $627,465 following a straight-line depreciation method is anticipated with an on-going 3-year time horizon strategy.

Working Capital:

Working capital is projected to start at $0 in year 0 but require an investment approximating 9.178% of sales each year through the end of year 5.Starting in year 6 the anticipated necessary investment in working capital falls to 2.89% which is expected to last through year 10. Starting with the terminal phase, a further decline in the necessary working capital investment rate to 1.79% is expected.

Miscellaneous:

KI's applicable tax rate is the current marginal corporate income tax rate set forth in the IRS tax code. You are to investigate what this rate is.

Starting in the terminal phase, Free Cash Flow is expected to grow by the 3.985% indefinitely.

Historically KI's debt/equity ratio has gravitated to an approximate level of 0.52

The P/E is a paltry 1.2056 which is one reason leveraged capital budgeting projects are being considered.By the time the company takes on debt in year 6 the P/E ratio is projected to still be a remarkably low 7.65

Total debt is $95,438,900 with maturity in FY8; but in year 6, it is projected that KI will have to issue $225,000,000 of additional mortgage debt with a maturity of seven years to expand i14F'sProject capacity. KI's overall business risk structure requires the company to currently pay a 3.14% premium to the risk-free rate on their debt issuance.The company is conservatively estimating a downgrade in its credit rating and hence a rise in its risk premium to 4.48% in year six to reflect the debt issuance stated above.

The risk-free rate: 10-year Treasury note yield on the date of your valuation is 2.51%

Historical expected market return of approximately 10.95% is appropriate to be used herein.

The median industry equity beta for the semiconductor industry to be used as a proxy for KI's equity beta is deemed to be 1.95; after debt issuance the beta is projected to be 2.15.

Currently, there are 18,216,883 shares outstanding with an expected level of in the money employee stock options for an additional 1,027,400 exercisable three weeks before the merger is expected to be complete. The current P/E ratio is 1.2056 and is expected to rise to a level of 7.65 after the projected new issuance of debt.

The project is due by the start of class on the date shown in the syllabus representing a functional deadline for notice to be given to RAI so the company can prepare for its own deadline demanded by the SEC for document submission.