Question: Strategically, do you think Mr. Saito and his partners should sell the firm at that time? Why

Saito SolarDiscounted Cash Flow Valuation

On a late November morning in 2012, a boutique investment bank in Japan approached Mr. Takuya Saito, founder and CEO of Saito Solar, about his interest in selling the rm. Even though selling the rm had crossed his mind occasionally in the past, Mr. Saito had never seriously thought about who would be a potential buyer and how much the rm could realistically be sold for. He was excited about the interest shown by the investment bank, yet skeptical about how large the offer might be, in light of the declining sales in recent years. Nevertheless, he invited his two silent partners, Mr. Kenta Suzuki and Mr. Shinji Yoshida, to gather in his of ce to discuss this unsolicited proposal.

Saito Solar and the Solar Energy Industry

Saito Solar is a privately owned photovoltaic (PV) solar panel manufacturer founded by Mr. Takuya Saito in 2002. Mr. Saito worked as an electrical engineer for Monsanto Electronic Materials Company (MEMC), a silicon-wafer company, right after nishing graduate school in the U.S. In 2000, after several years of dismal nancial results, MEMC was acquired by Texas Paci c Group, a private equity rm, for a symbolic dollar plus $150 million of credit lines. It was then that Mr. Saito decided to return to his homeland, Japan.

Mr. Saito had always been intrigued by, and was a big believer in, alternative energy while he was in the U.S. He was particularly interested in solar energy and had spent many of his leisure hours studying the various processes of solar energy production. He understood how solar cells, electrical devices that are used to generate electricity from sunlight through photovoltaic effect, were connected electrically, usually in a series as a module. Multiple solar cells were then integrated into groups, all arranged on one plane, forming a solar panel. His research also showed that most of the solar panels in the world were made of either mono-crystalline or polycrystalline (also called multi-crystalline) silicon solar cells, with those made of thin- lm solar cells accounting for only a small fraction of the overall solar market.

Mr. Saito believed Japanese residential and commercial properties would use a lot more solar energy if solar panels were durable and cost effective. After months of extensive industry research, he determined that solar panels made of polycrystalline silicon cells would have the most potential in Japan. Polycrystalline silicon costs less to produce compared to mono-crystalline because in this process, raw silicon is melted and poured into a square mold, which is then cooled and cut into perfectly square wafers, resulting in less waste. While the ef ciency level is slightly lower than mono-crystalline silicon, polycrystalline silicon-based solar panels are more cost effec- tive and would be very appealing in Japan, especially to residential customers. The thin- lm solar panels, while cheap to manufacture, are the least ef cient in producing electricity.1 They take up four times as much space as the mono-crystalline silicon-based panels to produce the same amount of electricity, making it very impractical for Japanese residential customers.

Mr. Saito spent the next few months soliciting capital to start his company. As a newcomer to the solar in- dustry, he encountered many roadblocks, especially from banks and nance companies. Even though he had saved some money during the 20 years he worked at MEMC, it was not enough to start a solar panel manufacturing

rm, even at a small scale. Finally, through family ties, he was able to convince a couple of his fathers wealthy, long-time friends, Mr. Suzuki and Mr. Yoshida, to contribute the remaining needed capital to start Saito Solar.

Saito Solar was a niche player serving residential and small commercial customers, with superior customer service as its hallmark. Mr. Saito recruited many of his customers by rst educating them on the importance of alternative energy for Japan, and how they could play a role in helping the environment by adopting solar energy for their homes or businesses. Coupled with the exponential growth of the Japanese solar industry during that time, Saito Solars revenue grew more than eight-fold from 2002-2008. It was able to prosper along with other industry leaders in Japan such as Sharp, Kyocera, Mitsubishi, and others.

In 2008, the global nancial crisis hit. Energy prices fell signi cantly, bringing down the demand for alter- native energy, including solar power. At the same time, many Chinese solar companies, such as Suntech, Yingli Solar, and Trina Solar, ooded the market with solar panels that were 30-40% cheaper than those made in Japan.2 Even though the quality of Japanese solar panels was considered superior, the cost difference was too big in this rapidly commoditized industry for Japanese companies to compete in the world market. Many industry leaders in Japan, such as Sharp and Kyocera, suffered loss of market share. Saito Solar had a hard time competing as well, with its revenue steadily declining and net pro t margins declining also, to about 4.2% in 2012 (see Exhibit 2).

From 2009-2012, crude oil prices started to creep back up, reaching over US$100 per barrel in parts of 2011 and in the spring of 2012. World demand for solar energy rose rapidly again, boosted also by the feed-in tariffs implemented by many nations around the world.3 In Japan, a deadly earthquake hit in 2011, causing explosions and problems at some of the nuclear power plants that were compounded by the ensuing tsunami.

Exhibit 2. Saito Solars Revenue and Net Pro t Margin

At the time of the earthquake, Japan had 54 nuclear reactors and 17 power plants that produced about 30% of Japans electricity.4 In addition to the threat from radiation, many areas of Japan were without power. Nearly sixteen thousand people died and the Japanese economy suffered severely, causing damage totaling about US$300 billion. The earthquake and tsunami gave Japan a sense of urgency to look for alternative energy. On June 18, 2012, the Japanese government approved a new feed-in tariff of 42/kWh (about US$0.53/kWh) for solar energy that would take effect on July 1, 2012. This tariff was almost twice as large of that in Germany, the country with the largest solar energy capacity in the world, and three times of that in China. With this new tariff, Japan was predicted to generate at least US$9.6 billion of new investments in solar installations, according to Bloomberg New Energy Finance forecast.5 These investments were expected to generate up to 3.2 GW of additional capacity, about the output of three nuclear plants, and would rank Japan as one of the largest in the world in solar capacity.

Valuation of Saito Solar

It was early afternoon when the two silent partners, Mr. Suzuki and Mr. Yoshida, arrived at Mr. Saitos of ce. They were both very excited about the solicitation and wanted to know how much the offer was. Mr. Saito explained that the investment bank revealed nothing unless owners of the rm agreed to open up a conversation about the sale. That was the main reason he wanted to meet with his two partners. Besides guring out if the partners were receptive to the sale of the company, Mr. Saito also wanted to know if they had some idea as to how much they would sell the company for.

Mr. Yoshidas Valuation

Mr. Yoshida was especially interested in the sale of the rm because he needed the cash to invest in his sons new venture. He was a retired mechanical engineer who made some of his earlier fortune through a few lucrative real estate deals during the Japanese real estate boom in the late 1980s. He had since invested in a few businesses, all as a minority, silent partner, including Saito Solar. He thought that Saito Solar should be worth about 5 billion. His calculation was simple and straightforward. He argued that the rm was generating about 250 million of net cash ows per year, and he believed these cash ows were likely to continue for the next 20 years. He came out with 5 billion by simply multiplying 250 million by 20.

Mr. Suzukis Valuation

Mr. Suzuki did not agree with the way Mr. Yoshida estimated the rm value. After inheriting a sizable estate from his father 15 years ago, Mr. Suzuki had been working with a nancial advisor and had gained some nancial knowledge. He argued that cash ows in the future are not worth as much as cash ows today, so they have to be discounted. If future cash ows were to stay constant for the next 20 years as Mr. Yoshida suggested, the rm would be worth much less than 5 billion after those cash ows are discounted. However, he did not think cash ows of the rm would stay constant. He was con dent that the new feed-in tariff passed recently would increase the demand for solar panels, and that would increase the rms net cash ows. He believed net cash ows should increase by 3-5% per year over the next 20 years. He just needed to make that calculation after he determined what to use as a discount rate.

Mr. Saitos Valuation

Mr. Saito was glad that Mr. Suzuki understood the discounted cash ow concept and its importance in valuation. He agreed that the rm would get some much-needed sales boosts in the coming years due to the new feed-in tariff that started in July. As the majority owner who oversaw the day-to-day operation of Saito Solar, he had witnessed an increase in sales orders since the new tariff was passed. Unlike Mr. Suzuki, he didnt think the sales growth would be steady over the 20-year period. He believed sales growth would be quite substantial in the rst few years when consumers and businesses responded to the change in the new tariff, but it would taper off. He also didnt believe that the rm would stop producing cash ows after 20 years. He argued that the company would be in good hands, and hence should exist for the inde nite future. He explained that most companies discounted cash ow valuations were based on rms producing perpetual cash ows, as there was no reason for a rms cash ows to disappear after a certain period.

In fact, Mr. Saito came to the meeting well prepared. Before the meeting, he asked his nance manager, Ms. Yamada, to prepare the 5-year cash ow projections shown in Exhibit 3, with the details presented in Ap- pendix 3. The projection had an aggressive sales growth in the near future, with growth slowing in later years. Ms. Yamada, who had since joined the meeting, also suggested that cash ows beyond the 5-year period should be growing at a constant rate of 1-3%. After some clari cations and discussions, the partners were convinced that the projections in Exhibit 3 were reasonable.

Exhibit 3. Saito Solars Actual and Projected Sales an

Next, Ms. Yamada needed to determine the discount rate, which is the cost of capital for the rm. Since Saito Solar had no debt, the discount rate would be what the owners expected to earn in this business. When the three partners started the business in 2002, they determined that to properly account for the risks inherent in this business, they expected to earn a minimum of 10% return on their equity capital. Ms. Yamada veri ed and con rmed that the partners had not changed their expectations over the years. With this last piece of in- formation and some sensitivity analyses, Ms. Yamada was able to project a range of rm values for the partners.

Appendix 1. Saito Solar, Pro t and Loss Statement

(millions of Yen, year ending June 30)

Question: Strategically, do you think Mr. Saito and his partners should sell the firm at that time? Why

Exhibit 2. Saito Solar's Revenue and Net Profit Margin 6,900.00 5.2% 6,800.00 5.0% 5.0% 6,700.00 4.8% 6,600.00 4.8% 6,500.00 4.6% Revenue (millions of Yen) 6,400.00 Net profit Margin 6,833.20 6,300.00 4.3% 4.4% 4.2% 6,623 6,200.00 4.2% 6,100.00 6,345 6,234 4.0% 6,000.00 5,900.00 3.8% 2009 2010 2011 2012 Revenue Net Profit Margin Exhibit 3. Saito Solar's Actual and Projected Sales and Free Cash Flows 14,000 607 X700 628 12,000 539 600 465 10,000 500 396 8,000 400 Sales (millions) Free Cash Flows (millions) 6,000 250 11,829 12,421 300 10,754 9,351 4,000 7,793 200 6,234 2,000 100 0 0 2012 2013 2014 2015 2016 2017 Projected Sales Free Cash Flows Appendix 1. Saito Solar, Profit and Loss Statement (millions of Yen, year ending June 30) Income Item Sales COGS Gross margin Gross margin (%) 2009 6,833.2 4,323.7 2,509.5 36.7% 2010 6,755.7 4,298.1 2,457.6 36.4% 2011 6,345.1 4,112.0 2,233.1 35.2% 2012 6,234.1 4,041.2 2,192.2 35.2% Marketing & selling G&A expenses 1210.8 586.2 712.5 10.4% 1,199.6 570.7 687.3 10.2% 1,083.1 560.6 589.4 9.3% 1,030.2 569.0 593.0 9.5% EBITDA EBITDA margin (%) Depreciation EBT margin (%) 150.4 562.1 8.2% 167.2 520.1 7.7% 140.3 449.1 7.1% 156.4 436.6 7.0% Taxes Net Income Return on sales (%) 222.0 340.1 5.0% 205.4 314.7 4.7% 177.4 271.7 4.3% 172.5 264.1 4.2% Dividends Retained earnings 150.0 190.1 150.0 164.7 150.0 121.7 150.0 114.1 Appendix 2. Saito Solar, Balance Sheets (millions of Yen, as of June 30) Assets Cash Accounts Receivable Inventory Prepaid Expenses Current Assets 2009 120.3 1,828.0 1,127.7 97.6 3,173.6 2010 83.3 1,895.7 1,100.8 90.1 3,169.9 2011 40.6 2,045.0 1,010.2 89.2 3,185.0 2012 140.7 2,121.3 1,065.0 95.8 3,422.8 Net Fixed Assets 2,210.1 2,250.2 2,246.6 2,090.2 Total Assets 5,383.7 5,420.1 5,431.6 5,513.0 Liabilities & Net Worth Accounts Payable Accrued Expenses Current Liabilities 2009 1,270.6 143.0 1,413.6 2010 1,098.2 187.1 1,285.3 2011 1,001.1 174.0 1,175.1 2012 999.2 143.2 1,142.4 Equity 3,970.1 4,134.8 4,256.5 4,370.6 Liabilities & Net Worth 5,383.7 5,420.1 5,431.6 5,513.0 Appendix 3. Saito Solar, Projected Profit & Loss and Cash Flows (millions of Yen, year ending June 30) Actual Projected Income Item 2012 2013 2014 2015 Sales 6,234.1 7,792.6 9,351.2 10,753.8 COGS 4,041.2 4,994.8 5,993.8 6,892.8 Gross margin 2,192.2 2,797.8 3,357.4 3,861.0 Gross margin (%) 35.2% 35.9% 35.9% 35.9% 2016 11,829.2 7,582.1 4,247.1 35.9% 2017 12,420.7 7,961.2 4,459.5 35.9% Marketing & selling G&A expenses EBITDA EBITDA margin (%) 1,030.2 569.0 593.0 9.5% 1,202.0 660.2 935.6 12.0% 1,344.2 960.0 1,053.2 11.3% 1,504.4 1,134.2 1,222.4 11.4% 1,722.9 1,180.2 1,344.0 11.4% 1,875.0 1,200.0 1,384.5 11.1% Depreciation EBT margin (%) 156.4 436.6 7.0% 174.4 761.2 9.8% 190.0 863.2 9.2% 200.0 1,022.4 9.5% 220.5 1,123.5 9.5% 250.0 1,134.5 9.1% Taxes Net Income (NI) Return on sales (%) 172.5 264.1 4.2% 289.3 472.0 6.1% 328.0 535.2 5.7% 388.5 633.9 5.9% 426.2 696.6 5.9% 431.1 703.4 5.7% 420.5 646.4 725.2 833.9 917.1 953.4 Operating Cash Flows (NI + Depreciation) Change in NWC (170.4) (200.0) (210.0) (245.0) (260.0) (275.0) Change in CAPEX 0 (50.0) (50.0) (50.0) (50.0) (50.0) Free Cash Flow 250.1 396.4 465.2 538.9 607.1 628.4 Valuation of Saito Solar based on Mr. Suzuki's Projection (millions of Yen, year ending June 30) WACC 10% Growth Rate 5% Time Year FCF PV of FCF 0 2012 250.3 250.3 1 2013 262.9 239.0 2 2014 276.0 228.1 3 2015 289.8 217.7 4 2016 304.3 207.8 5 2017 319.5 198.4 6 2018 335.5 189.4 7 2019 352.3 180.8 8 2020 369.9 172.5 9 2021 388.4 164.7 2022 407.8 157.2 10 11 2023 428.2 150.1 12 2024 449.6 143.3 13 2025 472.1 136.7 14 2026 495.7 130.5 15 2027 520.4 124.6 16 2028 546.5 118.9 17 2029 573.8 113.5 18 2030 602.5 108.4 19 2031 632.6 103.4 20 2032 664.2 98.7 Total Value 3,183.8 Valuation of Saito Solar based on Growing Perpetuity Projection (millions of Yen, year ending June 30) Free Cash Flow (FCF) 250.3 WACC 10% Growth Rate 5% Total Corporate Value 5,257.2 Valuation of Saito Solar based on Projected Profit & Loss and Cash Flows in Exhibit 1 (millions of Yen, year ending June 30) Year 2012 2013 2014 2015 2016 2017 Free Cash Flow (FCF) 250.1 396.4 465.2 538.9 607.1 628.4 Terminal Value 7,052.0 WACC 10% 1,954.6 1% PV of FCF Terminal Value Growth Rate PV of Terminal Value Total Corporate Value 4,378.8 6,333.3 Valuation of Saito Solar (millions of Yen) Terminal Value Growth Rate 6,333.3 1% 2% 3% 9% 7,166.1 7,961.1 9,021.0 10% 6,333.3 6,929.4 7,695.9 11% 5,668.1 6,128.0 6,703.0 Exhibit 2. Saito Solar's Revenue and Net Profit Margin 6,900.00 5.2% 6,800.00 5.0% 5.0% 6,700.00 4.8% 6,600.00 4.8% 6,500.00 4.6% Revenue (millions of Yen) 6,400.00 Net profit Margin 6,833.20 6,300.00 4.3% 4.4% 4.2% 6,623 6,200.00 4.2% 6,100.00 6,345 6,234 4.0% 6,000.00 5,900.00 3.8% 2009 2010 2011 2012 Revenue Net Profit Margin Exhibit 3. Saito Solar's Actual and Projected Sales and Free Cash Flows 14,000 607 X700 628 12,000 539 600 465 10,000 500 396 8,000 400 Sales (millions) Free Cash Flows (millions) 6,000 250 11,829 12,421 300 10,754 9,351 4,000 7,793 200 6,234 2,000 100 0 0 2012 2013 2014 2015 2016 2017 Projected Sales Free Cash Flows Appendix 1. Saito Solar, Profit and Loss Statement (millions of Yen, year ending June 30) Income Item Sales COGS Gross margin Gross margin (%) 2009 6,833.2 4,323.7 2,509.5 36.7% 2010 6,755.7 4,298.1 2,457.6 36.4% 2011 6,345.1 4,112.0 2,233.1 35.2% 2012 6,234.1 4,041.2 2,192.2 35.2% Marketing & selling G&A expenses 1210.8 586.2 712.5 10.4% 1,199.6 570.7 687.3 10.2% 1,083.1 560.6 589.4 9.3% 1,030.2 569.0 593.0 9.5% EBITDA EBITDA margin (%) Depreciation EBT margin (%) 150.4 562.1 8.2% 167.2 520.1 7.7% 140.3 449.1 7.1% 156.4 436.6 7.0% Taxes Net Income Return on sales (%) 222.0 340.1 5.0% 205.4 314.7 4.7% 177.4 271.7 4.3% 172.5 264.1 4.2% Dividends Retained earnings 150.0 190.1 150.0 164.7 150.0 121.7 150.0 114.1 Appendix 2. Saito Solar, Balance Sheets (millions of Yen, as of June 30) Assets Cash Accounts Receivable Inventory Prepaid Expenses Current Assets 2009 120.3 1,828.0 1,127.7 97.6 3,173.6 2010 83.3 1,895.7 1,100.8 90.1 3,169.9 2011 40.6 2,045.0 1,010.2 89.2 3,185.0 2012 140.7 2,121.3 1,065.0 95.8 3,422.8 Net Fixed Assets 2,210.1 2,250.2 2,246.6 2,090.2 Total Assets 5,383.7 5,420.1 5,431.6 5,513.0 Liabilities & Net Worth Accounts Payable Accrued Expenses Current Liabilities 2009 1,270.6 143.0 1,413.6 2010 1,098.2 187.1 1,285.3 2011 1,001.1 174.0 1,175.1 2012 999.2 143.2 1,142.4 Equity 3,970.1 4,134.8 4,256.5 4,370.6 Liabilities & Net Worth 5,383.7 5,420.1 5,431.6 5,513.0 Appendix 3. Saito Solar, Projected Profit & Loss and Cash Flows (millions of Yen, year ending June 30) Actual Projected Income Item 2012 2013 2014 2015 Sales 6,234.1 7,792.6 9,351.2 10,753.8 COGS 4,041.2 4,994.8 5,993.8 6,892.8 Gross margin 2,192.2 2,797.8 3,357.4 3,861.0 Gross margin (%) 35.2% 35.9% 35.9% 35.9% 2016 11,829.2 7,582.1 4,247.1 35.9% 2017 12,420.7 7,961.2 4,459.5 35.9% Marketing & selling G&A expenses EBITDA EBITDA margin (%) 1,030.2 569.0 593.0 9.5% 1,202.0 660.2 935.6 12.0% 1,344.2 960.0 1,053.2 11.3% 1,504.4 1,134.2 1,222.4 11.4% 1,722.9 1,180.2 1,344.0 11.4% 1,875.0 1,200.0 1,384.5 11.1% Depreciation EBT margin (%) 156.4 436.6 7.0% 174.4 761.2 9.8% 190.0 863.2 9.2% 200.0 1,022.4 9.5% 220.5 1,123.5 9.5% 250.0 1,134.5 9.1% Taxes Net Income (NI) Return on sales (%) 172.5 264.1 4.2% 289.3 472.0 6.1% 328.0 535.2 5.7% 388.5 633.9 5.9% 426.2 696.6 5.9% 431.1 703.4 5.7% 420.5 646.4 725.2 833.9 917.1 953.4 Operating Cash Flows (NI + Depreciation) Change in NWC (170.4) (200.0) (210.0) (245.0) (260.0) (275.0) Change in CAPEX 0 (50.0) (50.0) (50.0) (50.0) (50.0) Free Cash Flow 250.1 396.4 465.2 538.9 607.1 628.4 Valuation of Saito Solar based on Mr. Suzuki's Projection (millions of Yen, year ending June 30) WACC 10% Growth Rate 5% Time Year FCF PV of FCF 0 2012 250.3 250.3 1 2013 262.9 239.0 2 2014 276.0 228.1 3 2015 289.8 217.7 4 2016 304.3 207.8 5 2017 319.5 198.4 6 2018 335.5 189.4 7 2019 352.3 180.8 8 2020 369.9 172.5 9 2021 388.4 164.7 2022 407.8 157.2 10 11 2023 428.2 150.1 12 2024 449.6 143.3 13 2025 472.1 136.7 14 2026 495.7 130.5 15 2027 520.4 124.6 16 2028 546.5 118.9 17 2029 573.8 113.5 18 2030 602.5 108.4 19 2031 632.6 103.4 20 2032 664.2 98.7 Total Value 3,183.8 Valuation of Saito Solar based on Growing Perpetuity Projection (millions of Yen, year ending June 30) Free Cash Flow (FCF) 250.3 WACC 10% Growth Rate 5% Total Corporate Value 5,257.2 Valuation of Saito Solar based on Projected Profit & Loss and Cash Flows in Exhibit 1 (millions of Yen, year ending June 30) Year 2012 2013 2014 2015 2016 2017 Free Cash Flow (FCF) 250.1 396.4 465.2 538.9 607.1 628.4 Terminal Value 7,052.0 WACC 10% 1,954.6 1% PV of FCF Terminal Value Growth Rate PV of Terminal Value Total Corporate Value 4,378.8 6,333.3 Valuation of Saito Solar (millions of Yen) Terminal Value Growth Rate 6,333.3 1% 2% 3% 9% 7,166.1 7,961.1 9,021.0 10% 6,333.3 6,929.4 7,695.9 11% 5,668.1 6,128.0 6,703.0