Question

9-12 Mini-Case

APV Valuation

Flowmaster Forge Inc. is a designer and manufacturer of industrial air-handling equipment that

is a wholly owned subsidiary of Howden Industrial Inc. Howden is interested in selling

Flowmaster to an investment group formed by company CFO Gary Burton.

Burton prepared a set of financial projections for Flowmaster under the new ownership. For the

first year of operations, firm revenues were estimated to be $160 million, variable and fixed

operating expenses (excluding depreciation expense) were projected to be $80 million, and

depreciation expense was estimated to be $15 million. Revenues and expenses were projected

to grow at a rate of 4% per year in perpetuity.

Flowmaster currently has $125 million in debt outstanding that carries an interest rate of 6%.

The debt trades at par (i.e., at a price equal to its face value). The investment group intends to

keep the debt outstanding after the acquisition is completed, and the level of debt is expected

to grow by the same 4% rate as firm revenues.

Projected income statements for the first three years of operation of Flowmaster following the

acquisition are as follows:

Burton anticipates that efficiency gains can be implemented that will allow Flowmaster to

reduce its needs for net working capital. Currently, Flowmaster has net working capital equal to

30% of anticipated revenues for year 1. He estimates that, for year 1, the firm’s net working

capital can be reduced to 25% of year 2 revenues, then 20% of revenues for all subsequent

years. Estimated net working capital for years 1 through 3 is as follows:

To sustain the firm’s expected revenue growth, Burton estimates that annual capital

expenditures that equal the firm’s annual depreciation expense will be required.

Burton has been thinking for some time about whether to use Howden’s corporate cost of

capital of 9% to value Flowmaster and has come to the conclusion that an independent

estimate should be made. To make the estimate, he collected the following information on the

betas and leverage ratios for three publicly traded firms with manufacturing operations that are

very similar to Flowmaster’s:

1. Calculate the unlevered cash flows (i.e., the firm FCFs for Flowmaster for years 1 to 3).

2. Calculate the unlevered cost of equity capital for Flowmaster. The risk-free rate of

interest is 4.5% and the market risk premium is estimated to be 6%.

3. Calculate the value of Flowmaster’s unlevered business.

4. What is the value of Flowmaster’s interest tax savings, based on the assumption that the

$125 million in debt remains outstanding (i.e., the investment group assumes the debt

obligation) and that the firm’s debt and consequently its interest expenses grow at the

same rate as revenues?

5. What is your estimate of the enterprise value of Flowmaster based on your analysis in

Problem 9-13(a) to (d)? How much is the equity of the firm worth today, assuming the

$125 million in debt remains outstanding?

*

The leverage ratio is the ratio of the market value of debt to the sum of the market values of

debt and equity. Debt ratios are assumed to be constraint.

†

Revenues are the entire firm’s revenues for the most recent fiscal year.

Note 1—Property, plant, and equipment grow at the same rate as revenues so that

depreciation expenses grow at 4% per year.

GIVEN
Growth rate in revenues and expenses	4.00%
Debt (year 0)	$125	million
Interest rate	6.00%
Tax rate	34.00%
Net working capital / Revenues	30.00%
SOLUTIONS GIVEN
	Pro Forma Income Statements
	Year
($ millions)		1	2	3	4	5	6
Revenues		$160.00	$166.40	$173.06	??	??	??
Expenses		(80.00)	(83.20)	(86.53)	??	??
Depreciation		(15.00)	(15.60)	(16.22)	??	??
Earnings before interest and taxes		$65.00	$67.60	$70.30	??	??
Interest expense		(7.50)	(7.80)	(8.11)	??	??
Earnings before taxes		$57.50	$59.80	$62.19	??	??
Taxes		(19.55)	(20.33)	(21.15)	??	??
Net Income		$37.95	$39.47	$41.05	??	??
	Balance Sheet
	Pro forma
	Year
($ millions)	Current	1	2	3	4	5
Net Working Capital (t-1) / Revenues (t)	30%	25%	20%	20%	??	??
Net Working Capital	$48.00	$41.60	$34.61	$36.00	??	??
Debt	$125.00	$130.00	$135.20	$140.61	??	??
START SOLVING
a. Calculate the unlevered equity cash flows for years 1-3.
	Year
Firm free cash flows (unlevered equity)	Current	1	2	3	4
EBIT	$65.00	$67.60	$70.30	$73.12	??
Less:  Tax on EBIT
NOPAT
Plus:  Depreciation	15.00	15.60	16.22	16.87	??
Less:  CAPEX	(15.00)	(15.60)	(16.22)	(16.87)	??
Less:  Increase in NWC
FCF
	Year
Equity free cash flows	Current	1	2	3	4
Net Income	$37.95	$39.47	$41.05	$42.69	??
Plus:  Depreciation	15.00	15.60	16.22	16.87	??
Less:  CAPEX	(15.00)	(15.60)	(16.22)	(16.87)	??
Less:  Increase in NWC
Less:  Paid up principal	-	-	-	-	-
Plus:  New debt issued
Equity FCF
	Year
Check	Current	1	2	3	4
Equity free cash flow
Plus:  Interest (1 – T)
Plus:  Principal payments**	-	-	-	-	-
Less:  New debt issues
Equals: Project free cash flow (PFCF)
b. Unlevered cost of equity capital
	tax rate
Cost of Capital Information
Company	Leveraged Equity Beta	Debt Beta	Debt/Equity Ratio	Revenues** ($ millions)	% weight by revenue	Unlevered beta
Gopher Forge	1.61	0.52	0.46	$400
Alpha	1.53	0.49	0.44	380
Global Diversified	0.73	0.03	0.15	9,400
				$10,180
Flowmaster Forge
Unlevered beta	debt beta	equity	debt	D/E
	0	100	125	1.25
4.50%	rf
6.00%	MRP
	ku	Unlevered cost of capital
c. Value of Flowmaster's unlevered business
PV of FCF in planning period (Year 1-3)
Terminal Value at Year 3
PV of Year 3 value
Unlevered firm value
d. Value of interest tax shields
PV of tax shields on interest payments		Using MM formula
Value of tax shields		Discounted at unlevered cost of equity since debt and interest expense grows and therefore
		varies with firm revenues.
e. Enterprise Value
Enterprise Value
Equals:  unlevered firm value + tax shields
debt value today
Hence equity value

Answer 1