Zhang Supply Corp (ZSC) is a successful distributor of computer supplies in the United States. Founded in 1992 by Jiang (Jay) Zhang, the current CEO, the company grew rapidly in the 1990s and early 2000s, and it completed an initial public offering in 2006. By 2012, the original equity investors in ZSC -- two Chinese and four American private equity firms -- had sold their shares. Jay Zhang was the largest individual stockholder, with 4% of the outstanding shares in December 2020.

In September 2020, activist hedge fund Lambeth Fund Holdings (Lambeth) started to purchase ZSC stock on the NYSE exchange at an average price of $38.75 per share, in the belief that financial markets under-valued ZSC stock.

By December 2020, Lambeth had accumulated a 9% ownership position in ZSC. Lambeth contacted Jay Zhang. Lambeth asked him to consider one of two ideas that might increase the market price of ZSC:

1. ZSC would borrow $600 million of new debt. The company would use the new cash to repurchase ZSC common shares in the stock market via a tender offer at a fixed price. Lambeth suggested a $ 47 price, which is higher than the current market price. Bank of China (NY Branch) and J.P. Morgan would each loan $300 million at 5% interest.
2. As an alternative to #1, ZSC would spin-off its fast-growing customer application software business. ZSC developed this software to service its existing distribution clients in the late 1990s. However, the versatility of the software appealed to companies in other industries, and ZSC began to operate software as a small separate business (Software). After the spin-off, stockholders will have two stock certificates ZSC and Software.

Mr. Zhang is now thinking about these two ideas. If ZSC does nothing, Lambeth threatens to begin a proxy fight. Lambeth will recruit other hedge funds (and other stock market investors) to buy ZSC stock. Lambeth will ask these funds to vote for a new ZSC management team at the next Board meeting. If the proxy fight succeeds, Mr. Zhang will lose his job, but he will still own his ZSC stock. Of course, many proxy fights in the U.S. fail (less than 50% are completed).

Mr. Zhang hired Rhodes & Co., a New York investment bank, to assist him in the evaluation of ideas (1) and (2). Having graduated from JHU Carey, you are a second-year associate of Rhodes. Your boss has requested that you complete a financial analysis of the two ideas. After finishing the analysis, you need to summarize the plus and minus of each idea, from a financial point of view, for the ZSC shareholders. Assume any stock repurchase or spin-off occurs on December 31, 2020 for your forecasts.

Remember, there is no perfect answer. A reasonable answer includes proper calculation, analysis, and judgment.

Beginning Analysis

The time is 11PM at your New York office and you are alone, without the ability to ask questions of your boss or ZSC. You must make reasonable assumptions and judgments. Some matters for you to address are the following:

1)Repurchase Idea

1. What is likely effect on the ZSC stock price, after the interest tax shield and the stock repurchase?
2. What is the repurchases effect on ZSCs cost of equity and ZSCs level of risk?
3. What is the effect on ZSC earnings per share EPS (year 2020) from the repurchase, as if the repurchase occurred on January 1, 2020? (i.e., you must pretend the repurchase occurred on January 1, 2020 for this pro forma calculation).
4. After the repurchase, do you think EPS will grow at a faster, or slower, rate in the future, compared to ZSCs past history? Note that revenue growth will not change because of the repurchase.
5. Given your answer in D, in your opinion, will the stock market decide to change the current P/E ratio (13.8x) of ZSC from a repurchase? Consider the P/E ratios and growth rates of the similar companies set forth in Exhibit 7.
6. If you value the company after the repurchase, based on your opinion of the proper P/E ratio and the 2020 pro forma EPS, what is the new stock price?

2)Spinoff Idea Software (No Repurchase)

1. What is the likely market price per share (50 million shares) for the software business? Use DCF and Comparable Companies techniques as set forth in Value Method X and Y.
2. Value Method X: Discounted Free Cash Flow - 5 years forecast, (Dec. 31, 2020 to Dec. 31, 2025)
   1. What is the approximate equity-cost-of-capital (discount rate) for Software to use in the DCF valuation?
   2. What are your free-cash-flow forecasts for Software? Briefly explain your forecast assumptions.
   3. What is the proper terminal value (or sales price for Software) on 12/31/2025 for the DCF valuation? (You should look at the comparable firms attributes. And then, you make any judgments for whether Software is better or worse than the comparable firms, and estimate the EV/EBITDA ratio for Softwares terminal value in 2025.)
   4. For the equity-cost-of-capital of Software, consider the Hamada equation and the two comparable company stocks. Seek Week 6 slides and Week 7 PowerPoint slides from class.
3. Value Method Y: Comparable Companies Use the EV/EBITDA ratio at Dec. 31, 2020.
   1. Consider the two comparable software stocks.
   2. Should the Software business have the same or different EV/EBITDA value ratio from the two comparables?
   3. Estimate the proper EV/EBITDA ratio for Software, determine Softwares EV and equity market value, and then figure Softwares stock price after a spinoff on December 31, 2020.