Question

1. The most recent year-end financial data for company “A” is as follows:

Revenues=$112 million; Depreciation=$7 million

Operating income (EBIT) =$28 million

Earnings after taxes=$12 million Total assets=$172 million

Interest bearing debt=$54 million Common equity=$40 million

Shares outstanding=5.6 million Current price of the stock=$16.25

The company “B” is considering acquiring A. The investment bankers believe that the acquisition is a good one even if B were to pay a premium of 40%. Presently A’s cash flow is as follows:

EBIT (operating profit) after taxes $17

Depreciation … 7

Total … $24

Less: capital expenditures 8

Incremental working capital 3

Free cash flow … $13

The company believes that with synergy it can grow the operating income by 20% per year for the next 3 years and then 12% per year for the next 3 years. At the same time, it plans to hold capital expenditures and working capital additions to a combined increase of only $2 million per year. At the end of 6 years, B is advised by investment bankers the cash flow will probably grow at 5% per year. The cost of capital computed by the IBs is 15%.

Certain comparable data of some recent M & A is as follows:

Equity value to book value 2.9x

Enterprise value to sales 1.4x

Equity value to earnings 15.3x

Enterprise value to EBITDA 7.8x

As B’ CFO, would you go ahead with the acquisition?

Answer 1

1) Calculation of Implied Market Capitalisation of Equity;

Offering Share Price = $ 16.25 + ($ 16.25 * 40%) = $ 22.75 per share

Total Shares Outstanding = 5.6 million

Implied Market Capitalisation = $ 22.75 * 5.6 =$127.4 million

2) Calculation of Enterprise Value

Enterprise value = Value of Equity + Value of Debt

     Equity Value = $127.4 Million

     Debt Value = $ 54 Million

     Enterprise Value = $181.4 Million

3) Calculation of EBITDA

= Operating Income + Depreciation ($28 + $ 7) = $ 35 Million

Now calculate the specified ratios for company A to compare the financial position with comparable data;

Ratio	Company A		Comparables
Equity Value to Book Value	Equity Value = $127.40 Book Value = $40	= 127.4 / 40 = 3.18	2.9
Enterprise Value to Sales	Enterprise value = $181.40 Sales = $112	= 181.40 / 112 = 1.62	1.4
Equity Value to Earnings	Equity Value = $127.40 Earnings = $12	= 127.40 / 12 = 10.62	15.3
Enterprise Value to EBITDA	Enterprise Value = $181.40 EBITDA = $35	= 181.40 / 35 = 5.18	7.8

4) Calculation of PV of A’s expected free cash flows:

	0	1	2	3	4	5	6
EBITDA	24	28.8	34.56	41.47	46.45	52.02	58.26
Less: Capital Exp. & Incremental W. C.	11	13	15	17	19	21	23
Free Cash Flows	13	15.8	19.56	24.47	27.45	31.02	35.26

As the cash flow woo grow at constant rate of 5%, therefore terminal value of free cash flows for 6^th year would be;

   = FCF 6 * (1 + g) / ( k – g)     (here; g is growth rate and k is cost of capital)

   = 35.26 * ( 1 + 0.05)/ ( 0.15 – 0.05) = 370.23

Year	FCF	Discount Factor @ 15%	Present Value
1	15.8	0.86957	13.74
2	19.56	0.75614	14.79
3	24.47	0.65752	16.09
4	27.45	0.57175	15.69
5	31.02	0.49718	15.42
6	370.23	0.43233	160.06
			235.79

Conclusion: As the Discounted Cash Flow value of the enterprise ($235.79 million) is more than the value of enterprise ($181.4 million), therefore the acquisition of 'A' offers good value to company B. Further, the P/E ratio (Equity value to earnings 10.6) and Enterprise Value to EBIT (5.2) is far better than the comparable companies' data. Ignoring the equity value-to-book and the enterprise value-to-sales ratios, that are slightly higher than the comparable companies' data, it would be valuable decision to acquire the company B at a share price $ 22.75.