Question

California Coast General Stores

In December 2018, Steve Baily, the owner of California Coast General Stores announced the highest sales, $50, and profitability of $10 to its employees.

Founded in 1980, California Coast General Stores (CCGS), a regional west coast chain, owns several gas stations, mini-marts, and Auto rentals.

Explaining the original long-term success of the company, a financial analyst commented that the success of the company is due to its sustained growth rate, efficiency and cost savings. As a result, the company is cash rich and is looking to expand its operation.

One of the options that the company considered is to acquire a complementary company. John Marks, the company’s CFO and treasurer was asked to find the suitable acquisition. John identified Prestige Auto Shops, a chain which operates in several adjacent States. Prestige is a privately held company managed by three Johnson’s brothers. They own 10 million shares of the company and they have priced the stock price of the company internally at $20 per share.

Table-1 indicates John’s estimates of Prestige’s earnings potential if it came under CCGS’s management (in millions of dollars). The interest expense is based on Prestige’s existing debt, which is $20 million at a rate of 8 percent. It is expected new debt at rate of 8% to be issued over time to help finance investment in operating capital.

Security analysts based on comparable companies estimate the Prestige’s beta to be 1.28. The acquisition would not change Prestige capital structure, which is 25 percent debt-to value. John realizes that Prestige business plan requires investment in operating capital (net working capital and capital expenditures). The growth rate for operating capital is listed in table (1).

John estimates the risk-free rate to be 3 percent and the market risk premium to be 6 percent. He also estimates that free cash flows after 2023 will grow at a constant rate of 5 percent. Following are projections for sales and other items.

Table -1		Year	2018	2019	2020	2021	2022	2023
Sales growth rate				50%	30%	20%	10%	5%
Net sales			$40
Cost of goods sold	60%		$24
Selling/administrative expense	10%		$4
EBIT			$12
Taxes on EBIT	30%		($3.60)
NOPAT			$8.40
Initial investment in operating capital (NWC +Capex)			$100
Growth in Operating Capital				6%	5%	4%	3%	3%
Interest expense			$1.60

In theory, there are several valuation models. These models are Discounted Cash Flow based on WACC, Cash Flow to Equity (CFE), and AdjustedPresent Value (APV)which could be used to estimate the value of a firm.

Questions:

1.    What is the best model to value Prestige Company?

2.    Given the valuation model in part (1), what is the appropriate discount rate?

Answer 1

1. The models mentioned in the question are used in the following scenarios:

a. WACC - Generally used in capital budgeting where we are trying to compare the inflows with the outflows and trying to find if the NPV is positive (viable project) or negative (not viable project). The WACC gives the intrinsic value of the inflows - outflows which in turn can be compared to the price prevailing or put in this case.

b. Adjusted Present Value: Used if the transaction is financed using equity in its entirety. The difference is that it uses the cost of equity as the discount rate rather than WACC.

c. Cash flow to Equity: Again similar to the adjusted present value concept. But this is usually used in the valuation of banking industries.

Hence Discounted Cash flow based on WACC seems to be the most appropriate choice.

2. Cost of Debt = 8% * (1-0.30)

= 5.6%

Cost of Equity = R_f + (R_m-R_f)* Beta

Here Rf = Risk Free Rate

Rm = Market Premium

Thus, Cost of Equity = 3%+ (6%-3%)*1.28

= 6.84%

Hence, WACC = 5.6% * 1/4 + 6.84% * 3/4

= 6.53%