Slide 1The StoryFinancial StatementsCommon Financial RatiosValuation Using ComparablesThe Business PlanSales and Cost AssumptionsCapital Expenditures: A Needed ExpansionWorking Capital ManagementWorking Capital ManagementCapital Structure Changes: Levering UpCapital Structure Changes: Levering UpCapital Structure Changes: Levering UpBuilding the Financial ModelBuilding the Financial ModelPro Forma Income StatementWorking Capital RequirementsWorking Capital RequirementsWorking Capital RequirementsWorking Capital AssumptionsWorking Capital ForecastFree Cash Flow ForecastBeta Estimates For Comparable FirmsIdeko’s Unlevered Cost of CapitalUnlevered BetasIdeko’s Unlevered Cost of CapitalValuing the FirmTerminal MultiplesThe Discounted Cash Flow Approach to Terminal ValueThe Discounted Cash Flow Approach to Terminal ValueThe Discounted Cash Flow Approach to Terminal ValueTerminal Value – Direct ApproachTerminal ValueThe Discounted Cash Flow Approach to Terminal ValueAPV Valuation of Ideko EquityAPV Estimate of ValueCase Study: IdekoValuing an AcquisitionThe Story•Consider Ideko Corporation, a privately held firm. The owner has decided to sell the business.•Your job, as a partner in KKP Investments, is to evaluate purchasing the company, implementing operational and financial improvements, and a plan to sell the business at the end of five years.Financial StatementsCommon Financial RatiosA value of $150 million has been proposed for the equityof the firm. This implies the following ratios.Valuation Using Comparables•A price of $150 million for Ideko’s equity ($148 million in enterprise value) has been suggested. ▫The data in the previous slide provides some reassurance that this acquisition price is reasonable as the ratios are about the level of or lower than the industry averages. ▫To assess whether this investment is attractive, the operational aspects of the firm and the ultimate cash flows the deal is expected to generate must be analyzed; the ratios are merely vague shortcuts.•Operational Improvements▫By cutting administrative costs immediately and redirecting resources to new product development, sales, and marketing, you believe Ideko can increase its market share from 10% to 15% over the next five years. ▫The increased sales demand can be met in the short run using the existing production lines. Once the growth in volume exceeds 50%, however, Ideko will need to undertake a major expansion to increase its manufacturing capacity. Furthermore:Ideko’s average selling price is forecast to increase 2% each year. Raw materials prices are forecast to increase at a 1% rate.Labor costs are forecast to increase at a 4% rate.The Business PlanSales and Cost AssumptionsCapital Expenditures: A Needed Expansion•In 2008, a major expansion will be necessary, leading to a large increase in capital expenditures in 2008 and 2009. •Appropriate tax depreciation is also shown.Working Capital Management•Ideko’s Accounts Receivable Days is:▫While the industry average is 60 days▫You believe Ideko can tighten its credit policy to the industry average without sacrificing sales.Accounts Receivable ($)Accounts Receivable Days 365 days/yrSales Revenue ($ / yr)18,493 365 days 90 days75,000= �= � =Working Capital Management•Ideko’s inventory figure on its balance sheet includes $2 million of raw materials inventory. Given raw material expenditures of $16 million for the year, Ideko currently holds 45.6 days worth of raw material inventory. ▫(2 ∕ 16) × 365 = 45.6•You believe that, with tighter controls of the production process, 30 days worth of raw materials inventory will be adequate.Capital Structure Changes: Levering Up•You believe Ideko is significantly underleveraged so you plan to increase the firm’s debt. The debt will have an interest rate of 6.8% and Ideko will only pay interest during the next five years.•The firm will also seek additional debt financing in 2008 and 2009 associated with the expansion.▫The expected cost of the incremental debt is the same as the current cost.Capital Structure Changes: Levering Up•The forecasted interest expense each year is computed as:•Therefore:Interest in Year Interest Rate Ending Balance in Year ( 1)t t= � -Capital Structure Changes: Levering Up•In addition to the $150 million purchase price for Ideko’s equity, $4.5 million will be used to repay Ideko’s existing debt. •With $5 million in transaction fees, the acquisition will require $159.5 million in total funds. •KKP’s sources of funds include the new loan of $100 million as well as Ideko’s own excess cash ($6.5 million, which KKP will have access to). Thus KKP’s required equity contribution to the transaction is $53 million.Building the Financial Model•Forecasting Earnings▫To build the pro forma income statement, begin with Ideko’s sales. Each year, sales can be calculated as:▫The raw materials cost (similarly for direct labor cost) can be calculated from sales as:Sales Market Size Market Share Average Sales Price= � �Raw Materials Market Size Market Share Raw Materials per Unit= � �Building the Financial Model•Forecasting Earnings▫Sales and marketing expenses (similarly for administrative expenses) can be computed directly as a percentage of sales.▫The corporate income tax is computed as:Sales and Marketing Sales (Sales and Marketing % of Sales)= �Income Tax Pretax Income Tax Rate= �Pro Forma Income StatementWorking Capital Requirements•The working capital forecast should include the plans to tighten Ideko’s credit policy and so speed up customer payments as well as plans to reduce Ideko’s inventory of raw materials.▫Accounts Receivable in 2006 is calculated as:Annual SalesAccounts Receivable Days Required 365 days/yr$88.358 million/yr 60 days $14.525 million365 days/yr= �= � =Working Capital Requirements•In order to capture the improvements in inventory management we want to reflect the change from 45.6 days of expenditures on raw materials in raw materials inventory to 30 days.▫Raw Materials Inventory in 2006 is calculated as:Raw Materials ExpenseRaw Materials Inventory Days Required 365 days/yr$18.665 million/yr 30 days $1.534 million365 days/yr= �= � =Working Capital Requirements•The minimum cash balance is the minimum level of cash needed to keep the business running.▫Firms typically earn little