- 20 Marks
FM – L2 – Q119 – Business valuations
Question
LargeCorp is considering a takeover bid for SmallCorp, another company in the same industry. SmallCorp is expected to have earnings next year of GH₵86,000. If LargeCorp acquires SmallCorp, the expected results from SmallCorp will be as follows:
| Year after the acquisition | |||
|---|---|---|---|
| Year 1 | Year 2 | Year 3 | |
| Sales | GH₵200,000 | GH₵280,000 | GH₵320,000 |
| Cash costs/expenses | 120,000 | 160,000 | 180,000 |
| Capital allowances | 20,000 | 30,000 | 40,000 |
| Interest charges | 10,000 | 10,000 | 10,000 |
| Cash flows to replace assets and finance growth | 25,000 | 30,000 | 35,000 |
From Year 4 onwards, it is expected that the annual cash flows from SmallCorp will increase by 4% each year in perpetuity. Tax is payable at the rate of 30%, and the tax is paid in the same year as the profits to which the tax relates. If LargeCorp acquires SmallCorp, it estimates that its gearing after the acquisition will be 35% (measured as the value of its debt capital as a proportion of its total equity plus debt). Its cost of debt is 7.4% before tax. LargeCorp has an equity beta of 1.60. The risk-free rate of return is 6% and the return on the market portfolio is 11%.
Required:
(a) Suggest what the offer price for SmallCorp should be if LargeCorp chooses to value SmallCorp on a forward P/E multiple of 8.0 times.
(b) Calculate a cost of capital for LargeCorp.
(c) Suggest what the offer price for SmallCorp might be using a DCF-based valuation.
Answer
(A) The earnings of SmallCorp next year are expected to be GH₵86,000. A forward P/E multiple of 8.0 could be applied to this estimate, and the valuation of the equity shares in SmallCorp would be:
GH₵86,000 × 8.0 = GH₵688,000.
(B) The cost of equity of LargeCorp is expected to be:
6% + 1.60(11 − 6)% = 14%.
The WACC of LargeCorp is expected to be:
[35% × 7.4(1 − 0.30)] + (65% × 14) = 10.913%.
(C).
Since SmallCorp is in the same industry as LargeCorp, it is probably appropriate to use the WACC of LargeCorp to obtain a DCF-based valuation of SmallCorp. The WACC of 10.913% will be rounded to 11%.
The cash flows from the acquisition of SmallCorp must be calculated.
| Year 1 | Year 2 | Year 3 | |
|---|---|---|---|
| GH₵ | GH₵ | GH₵ | |
| Sales | 200,000 | 280,000 | 320,000 |
| Cash costs | (120,000) | (160,000) | (180,000) |
| 80,000 | 120,000 | 140,000 | |
| Capital allowances | (20,000) | (30,000) | (40,000) |
| Interest | (10,000) | (10,000) | (10,000) |
| Taxable profit | 50,000 | 80,000 | 90,000 |
| Tax at 30% | (15,000) | (24,000) | (27,000) |
| Profit after tax | 35,000 | 56,000 | 63,000 |
| Profit after tax | 35,000 | 56,000 | 63,000 |
| Add back capital allowances | 20,000 | 30,000 | 40,000 |
| 55,000 | 86,000 | 103,000 | |
| Asset replacement | (25,000) | (30,000) | (35,000) |
| Cash flow | 30,000 | 56,000 | 68,000 |
Cash flows will increase by 4% each year from Year 4 onwards.
The dividend growth valuation model can be used to calculate the Year 3 value of these cash flows, using a growth rate of 4% and a cost of capital of 11%:
Year 3 value of cash flows from Year 4 = $\frac{\text{GH₵68,000} \times (1.04)}{(0.11 − 0.04)}$ = GH₵1,010,286
The expected cash flows can now be converted into a present value.
| Year | Cash flow | Discount factor at 11% | PV |
|---|---|---|---|
| GH₵ | |||
| 1 | 30,000 | 0.901 | 27,030 |
| 2 | 56,000 | 0.812 | 45,472 |
| 3 | 68,000 | 0.731 | 49,708 |
| 4 onwards | 1,010,286 | 0.731 | 738,519 |
| Total value | 860,729 |
- Tags: Acquisition, Business valuations, Cash Flows, DCF, Perpetuity, WACC
- Level: Level 2
- Topic: Business valuations
- Uploader: Samuel Duah