Valuation Exercise Upon graduating from college, John Winters entered the financial management training program of a large industrial concern. The pro- gram consisted of one-year assignments in three different departments. In addition, trainees attended class two evenings per week. Below is a problem assigned in one of John's classes. You were hired on January 1, 1984, by Firm Y. Firm Y was going to make an offer for Firm X that week, and your first task was to deter- mine the maximum price that should be paid for each common share of Firm X. You were given the following information. 1. Firm X is in a different industry than Firm Y. Fimm X Balance Sheet at 12/31/83 (000 omitted).. Long-term debt Cash Accounts receivable Inventory Net fixed assets $ 100 250 509 1,650 $2,500 Net worth $ 2,000 $2,500 Depreciation Total After the transaction, Firm Y would own all the assets and assume responsibility for the long-term debt: 3. Net sales for Firm X for the year ended December 31, 1983, were $2 million. (4) Firm Y's investigation revealed that there were no excess assets and that all current asset levels would change in direct proportion to sales. For example, if sales increased by 5 percent, cash, accounts receivable, and inventory would each increase by 5 percent. (5) Because of the nature of Firm X's business, current liabilities were zero and would remain at that level in the future. 6. Firm X's beta at December 31, 1983, was 1.8 and this figure assumed that the debt to capital ratio at December 31, 1983, would be maintained in the future. The interest rate on Firm X's long-term debt was 12 percent. An annual interest payment of $60,000 was made on December 31, 1983. 7. Firm Y's management believed that, because of Firm X's busi- ness, it should have no debt in its capital structure. Thus, immediately 318 VALUATION EXERCISE 319 after the transaction, the $500,000 would be retired. (The reader may assume that there would be no prepayment penalty and may ignore the interest that would be due for the first few days of 1984. In other words, the total cash outlay required to retire the debt would be $500,000.) 10:8. Firm X had 1 million shares of common stock outstanding, at December 31, 1983, and the price per share on that date was $2.00. The market value of its debt at December 31, 1983, was $500,000.; 9. The following estimates of sales and EBIT (earnings before interest and taxes) for Firm X were provided. Annual Sales Annual EBIT Year 1 Years 2 and 3 Years 4 and 5 Years 6-10 $2.2 million 2,5 million 2.7 million 2.8 million $400,000 440,000 460,000 480,000 In arriving at the EBIT estimates depreciation expense of $100,000 per year was deducted for years 1-37and depreciation expense of $140,000% per year was deducted for years 4-10. 10 Expenditures on fixed assets/ would be necessary to replacer worn-out equipment and to provide the new capacity needed for growth, No expenditures would be required for year 1. Expenditures in years? 2-4 would be $200,000 per year. For years 5-9, fixed asset: expenditures would be $50,000 per year, and there would be no fixed: asset expenditures in year 10 11. The terminal value of Firm X at the end of the ten years would be $2.3 million. The reader may ignore the potential tax impact of the sale of Birm Xin ten years. T ere 2012 The income tax rate for Firm X and Firm Ywas 50 percent and that rate was expected for each ofthe next ten years: 13. Firm Y's cost of equity was 181 percent, and its weighted average cost of capital was 12 percent." Required. Compute the maximum price that Firm Y should pay for each of Firm X's shares. You may assume the risk-free rate is 8 percent and the required return for the market is 13 percent
