Recall William's assumptions:

?With the right financing and the right acquisitions, under ideal circumstances, ITE could achieve $6 million in sales in five years, and $14 million in 10 years, with a target 20% growth rate,?William said. He realized this was an ambitious goal, given that the industry was only growing at 2.4%. He estimated that plant, property and equipment would average 15-20% of sales to support this level of growth. William said that while some of the income statement and balance sheet accounts varied in recent years, he thought it was a fair approximation to use averages of the accounts as a percent of sales over the past three years. Overall, he thought that the past statements were reflective of the future. Growth would be much more modest after 10 years, with sales growing at the rate of inflation and low maintenance capital expenditure equaling low depreciation expenses.

William had found statistics about small companies that were in the same line of business as ITE. These are compiled in ITE Case Exhibits (available in the course space).

See Exhibit 1 for comparable transaction information and Exhibit 2 for selected ITE financial information. Exhibit 3 contains information about ITE competitors and Exhibit 4 has financial markets information. Now William had to find a way to set an asking price for ITE so he could decide whether to put the firm on the market, get himself out from under the frustrating burden of partnership, or buy out John?s share of the firm.

Use the ITE Case Exhibits excel file above to calculate the following. Add tabs to the spreadsheet for each of the following tasks.

Value ITE using discounted cash flow.

Calculate WACC. Find cost of equity using beta information in Exhibit 3 and market data in Exhibit 4.

Create forecasted free cash flows for ITE using information in Exhibit 2

Find the value of ITE using free cash flow discounted by WACC, and using a growing perpetuity to calculate terminal value.

Value ITE using comparable transactions in Exhibit 1.

Exhibit 2 - ITE Financial Statement Information Income Statement Information Total Revenue Cost of Goods Sold Direct Costs Gross Profit Indirect Costs Operating Income Other Expenses Other Income Net Income 2011 1,358,013 322,862 226,525 808,626 591,723 216,903 54,606 10,750 173,047 2012 2,185,370 379,726 439,816 1,365,828 840,130 525,698 62,220 3,792 467,270 2013 2,789,920 591,497 685,430 1,512,993 1,313,781 199,212 137,779 736 62,169 Balance Sheet Information 2011 2012 2013 Assets Current Assets Computers/Furniture/Vehicles Depreciation Comp/Furn/Vehicles Leashold Equipment Goodwill on Acquisitions Other Assets Total Assets 392,443 91,502 (38,811) 70,000 3,668 518,802 681,510 137,613 (59,020) 2,575 1,610,614 1,711 2,375,003 387,963 151,604 (87,420) 14,690 1,560,953 1,205 2,028,995 Liabilities Current Liabilities Bank Loans Partner Loans Non-owner Notes Total Liabilities Equity Total Liabilities and Equity 73,589 20,604 94,193 424,610 518,802 215,465 542,349 14,651 183,729 956,195 1,418,809 2,375,003 83,786 517,705 114,569 684,140 1,400,201 628,794 2,028,995 2014 2015 2016 2017 2018 2019 2020 Exhibit 1 - Recent Transactions in the Information Technology Services Industry Source: Pratt's Stats Sales MVIC to Net IncomMVIC to Sales MVIC to Gross Prof MVIC to EBIT Under $1,0 $1,000,000 $5,000,001 $20,000,00 $50,000,00 Over $100, All Compan 0.16 0.11 -0.36 -0.06 0.02 0.073 0.008 0.71 1.35 2.31 0.64 1.12 0.64 1.24 * MVIC = Market Value of Invested Capital 1.02 1.92 4.99 1.78 6.78 2.19 2.41 12.47 5.48 18.91 7.4 22.46 6.42 18.37 MVIC to Book Value of Invested Capital 15.65 6.23 4.06 1.07 11.84 3.4 7.84 Financial Market Information Risk free rate Equity risk premium Small company risk premium Cost of high yield debt 3.85% 6.00% 10.00% 12.00% L.T. US Treasury Bond Yield (20 year) 3.00% L.T. historical expected equity risk premium: Large company stock total returns minus L. T. government bond income returns 6.50% L.T. supply side expected equity risk premium: Historical equity risk premium minus price to equity ratio calculated using 3-year average returns 7.50% Source: Ibbotson and Associate, Stocks, Bonds, Bills and Inflation 2009 Yearbook Exhibit 5 - Competitors Data Kratos Defense and Security Solutions 2007 in millions Revenues EBIT Net Income Price (December) Number of Shares Depreciation Book Value Equity Long Term Debt Current Assets Accounts Receivable Current Liabilties Net Fixed Assets Dividend Beta Hackett Group in millions Revenues EBIT Net Income Price (December) Number of shares Depreciation Book Value Equity Long Term Debt Current Assets Accounts Receivable Current Liabilties Net Fixed Assets Dividend Beta RCM Technologies in millions Revenues EBIT Net Income Price (December) Number of Shares Depreciation Book Value Equity Long Term Debt Current Assets Accounts Receivable Current Liabilties Net Fixed Assets Dividend Beta Sword Group in millions Revenues EBIT Net Income Price (December) Number of shares Depreciation Book Value Equity Long Term Debt Current Assets Accounts Receivable Current Liabilties Net Fixed Assets Dividend (per share) Beta 193.6 -26.9 -40.8 23.5 7.42 4.3 167.2 74 106.9 80.6 83.5 6.9 0 2008 297.3 -106.3 -111.1 14 10.53 7.3 146.9 76.9 116.2 101.2 81.2 7.2 0 2009 334.5 -37.3 -41.5 10.55 15.78 8.3 124.9 51.6 98.8 79.6 61.7 4.3 0 1.18 2007 177.01 9.27 9 4.84 43.63 2.09 98.82 0 58.41 29.74 33.02 5.71 0 2008 192.1 18.34 17.88 2.92 39.49 2.05 93.92 0 62.29 25.48 37.99 5.77 0 2009 142.7 -7.02 -6.81 2.78 38.14 1.86 98.25 0 46.34 28.65 34.91 7.14 0 0.8 2007 214.21 11.05 6.77 5.88 12.06 1.45 92.05 0 61.21 47.36 17.67 4.23 0 2008 209.28 -44.36 -39.81 1.11 12.77 2.06 55.35 0 66.18 55.77 23.49 5.59 0 2009 189.39 11.11 6.92 2.51 12.96 1.62 63.3 0 60.68 46.35 14.01 4.77 0 0.5 2007 263.54 42.16 27.84 50.93 9.29 2.86 218.07 0 164.61 0 116.51 9.23 0 2008 289.98 44.23 30.08 13.88 9.29 3.43 175.13 0 165.81 0 111.32 8.95 0.75 2009 258.84 42.54 31.58 35.13 9.29 2.81 212.26 0 197.6 0 116.14 7.98 0.86 0.68 *All values from Hoovers, unless otherwise noted Beta from Thomson One Banker and Factiva Depreciation from Google Finance Week 10 1 Class Outline M&A in Wine Country results ITE Valuation activity questions Do contract revenues increase the value of the firm or does the lack of contract revenues decrease the value of the firm? How would you value contract vs. non-contract revenues if you were buying ITE? Does debt add or subtract value for the shareholders? Why or why not? ITE Valuation excel 2 ITE WACC Need Weights of debt and equity (D/V and E/V) MV vs. BV weights Cost of debt Very risky debt - small business Cost of equity Capital asset pricing model Tax rate - assume 3 Finding a Discount Rate - Cost of Equity Finding beta using comparable company information Levering and unlevering beta Why - have beta reflect both asset risk and financing risk D L U (1 ( *(1 T ))) E 4 Comparable Company Data Assess comparable company data Available: brief descriptions of companies and limited financial data Choose which companies you will use as comps Lever and unlever betas and average Re-lever according to ITE's capital structure Current or target? 5 Capital Asset Pricing Model Beta from comparable companies Risk-free rate Market risk premium R R f ( Rm R f ) Size premiums - which? 6 Cash Flow from Operations Forecast revenues - most likely 10 year forecast Use William's forecast of future sales: $6 million in 5 years, $14 million in 10 years, 20% growth rate Costs as a historical percent of sales What about taxes? Add back depreciation 7 Free Cash Flows Start with cash flow from operations PP&E estimated as 15-20% of sales (remember to use the change in PP&88E) Working capital forecast as a percent of sales (historical average) - again use the change in NWC Subtract change in capital expenditures and working capital 8 Terminal Value Forecast one more year of free cash flows Determine terminal growth rate Year 10 Present value = FCF in year 11/(WACC - terminal growth rate) Add terminal value to Year 10 cash flows 9 Find Enterprise and Equity Values Enterprise Value: Find the present value of the free cash flows Add cash Find Equity Value Subtract debt No shares given; can't find a per share price 10 Sensitivity Analysis What are you (or William) most uncertain about in the analysis See list from class where we discussed sensitivities Once the base case spreadsheet is done, copying into a new sheet is an easy way to create a sensitivity analysis Examples (but not necessarily limited to: Revenues Discount rate Terminal value growth rate Capital structure weights 11 Multiples Valuation Use Pratt's Stats MVIC (market value of invested capital) to net income, revenues, gross profit, earnings before income and taxes and book value Some multiples may be better than others Use appropriate size category Throw out outliers (remember MFL problem where this was done) 12 Final Valuation Best valuations are a combination of discounted cash flow and comparable company analysis Range of likely values - not a single number down to the penny Deliverable: Excel - base case, sensitivities, multiples Assumptions page with explanations of what was used (and why if relevant) 13