1. [DCF Valuation and Ownership Concepts] The venture investors and founders of ACE Products, a closely held corporation, are contemplating merging the successful venture into a much larger diversified firm that operates in the same industry. ACE estimates its free cash flows that will be available to the enterprise next year at $5,200,000. Since the venture is now in its maturity stage, ACE’s free cash flows are expected to continue to grow at a 6 percent annual compound growth rate in the future. A weighted average cost of capital (WACC) for the venture is estimated at 15 percent. Interest-bearing debt owed by ACE is $17.5 million. In addition, the venture has surplus cash of $4 million. ACE currently has five million shares outstanding, with three million held by venture investors and two million held by founders. The venture investors have an average investment of $2.50 per share while the founders’ average investment is $.50 per share.
A. Based on the above information, estimate the enterprise value of ACE Products. What would be the value of the venture’s equity?
According to Chapter 9 of the text: the current value of a growing perpetuity is the next period’s cash flow (VCFT) divided by the spread between the assumed constant discount (r∞) and growth (g) rates:
Enterprise operating value would equal:
Enterprise next year at $5,200,000/ (WACC for the venture is estimated at 15 percent - expected to continue to grow at a 6 percent) 5,200,000 / (.15 - .06) = 57,777,777.78 or $57,777,778
Total entreprise value = $57,777,778 enterprise operating value + $4,000,0000 surplus cash = $61,777,778
Equity Value = $61,777,778 Total enterprise value - $17,500,000 interest bearing debt owed = $44,277,778
B. How much of the value of ACE would belong to the venture investors versus the founders? How much would the venture be worth on a per-share basis?
ACE currently has five million shares outstanding, with three million held by venture investors and two million held by founders. The venture investors have an average investment of $2.50 per share while the founders’ average investment is $.50 per share.
Owner’s percentage = 3M shares held by venture investor / 5M shares outstanding 3,000,000 / 5,000,000 = 0.60 or 60%
Founder’s percentage = 2M shares held by founders / 5M shares outstanding 2,000,000 / 5,000,000 = 0.40 or 40% Venture worth per-share basis: Venture investors: $44,277,778 equity value x .60 = $26,566,667 venture investors value $26,566,667 / 3,000,000 shares held = $8.856 or $8.86 per share Founders: $44,277,778 equity value x .40 = $17,711,111 founders value $17,711,111 / 2,000,000 shares held = $8.856 or $8.86 per share Both the venture investors and founders per share cost = $8.856 or $8.86 which can also be checked by taking the total shares and divide into the equity value: $44,277,778 / 5,000,000 shares held = $8.856 or $8.86 per share
C. What would be the percentage appreciation on the stock bought by the venture investors versus the investment appreciation for the founders?
The venture investors have an average investment of $2.50 per share while the founders’ average investment is $.50 per share.
Venture investor’s percentage appreciation:
[(price per share cost $8.856 minus average Venture investment cost per share $2.50) divided by average investment cost per share] x 100
= [($8.856 - $2.50) / $2.50] x 100
= 6.356 / 2.50) x 100
= 2.5424 x 100
= 254.24 % Venture Investors percentage appreciation
Founder’s percentage appreciation:
[(price per share cost $8.856 minus average Founder investment cost per share $.50) divided by average investment cost per share] x 100
= [($8.856 - $.50) / $.50] x 100
= 8.356 /.50) x 100
= 16,712 x 100
= 1,671.20 % Venture Investors percentage appreciation
D. If the founders have held their investments for five years, calculate the compound annual or internal rate of return on their investments. The venture investors made a first-round investment of 1.5 million shares at $2 per share four years ago. What was the compound annual rate of return on the first-round investment? Venture investors made a second-round investment of 1.5 million shares at $3 per share two years ago. Calculate their compound rate of return on this investment.
IRR: Compound rate of return that equates the present value of the cash inflows received with the initial investments
ACE currently has five million shares outstanding, with three million held by venture investors and two million held by founders. The venture investors have an average investment of $2.50 per share while the founders’ average investment is $.50 per share.
Founders Valuation for 5 years:
Present Value: Founder’s cost per share $0.50 x 2,000,000 shares = .50 x 2,000,000 = $1,000,000
Pre calculated Future Value = $17,711,111
Compound Annual Growth Rate (CAGR):
FV $17,711,111 / PV 1,000,000 = 17.711111 1 / year 5 = 0.20 17.711111^.20 = 1.776843
CAGR = 1.776843 – 1 = .776843 or 77.68% Compound rate of return
Venture investors first round investment: 1.5 million shares at $2 per share; 3M initially held
= 1,500,000 x $2.00 = $3,000,000
= 1,500,000 first round shares / 3,000,000 shares
= 0.50 percentage of shares x $26,566,667 venture investors value = $13,283,333.50 or $13,283,334
=Compound Annual Growth Rate (CAGR):
FV $13,283,334/ PV 3,000,000 = 4.427778 1 / year 4 = 0.25 4.427778^.25 = 1.450595846
CAGR = 1.450595946 – 1 = .450595946 or 45.06% Compound rate of return
Venture investors first round investment:
Second-round investment of 1.5 million shares at $3 per share; 3M initially held
= 1,500,000 x $3.00 = $4,500,000
= 1,500,000 first round shares / 3,000,000 shares
= 0.50 percentage of shares x $26,566,667 venture investors value = $13,283,333.50 or $13,283,334
=Compound Annual Growth Rate (CAGR):
FV $13,283,334/ PV 4,500,000 = 2.951852 1 / year 2 = 0.50 2.951852^.50 = 1.718095457
CAGR = 1.718095457 – 1 = .718095457 or 71.81% Compound rate of return
3. [Relative Value Concepts Using Multiples] The WestTek privately held venture is considering the sale of the venture to an outside buyer. WestTek has net sales = $21.2 million, EBITDA = $11.1 million, net income = $2.9 million, and interest-bearing debt = $12 million. Three publicly-traded comparable firms or competitors in the industry have the following net sales, EBITDA, net income, equity value or market capitalization (stock price times number of shares of common stock outstanding), and interest-bearing debt information:
No surplus cash is being held by WestTek or by any of the three comparable firms.
a. Calculate the enterprise value to net sales ratios for each of the three competitors (EastTek, SouthTek, and NorthTek), as well as the average ratio for the competitors.
Enterprise Value / Net Sales Net Sales Ratio
EastTek $ 60,000,000 / $25,000,000 = 2.40
SouthTek $ 80,000,000 / $37,500,000 = 2.13
NorthTek $200,000,000 / $80,000,000 = 2.50
Average ratio = = 7.03 / 3 = 2.3433333 or 2.34
b. Calculate the enterprise value to EBITDA ratios for each of the three competitors, as well as the average ratio for the competitors.
c. Calculate the equity value or market “cap” to net income ratios for each of the three competitors, as well as the average ratio for the competitors.
Enterprise Value / NI NI Ratio
EastTek $ 60,000,000 / $ 2,500,000 = 24.00
SouthTek $ 80,000,000 / $ 3,000,000 = 26.67
NorthTek $200,000,000 / $10,000,000 =20.00
Average ratio = = 70.67 / 3 =23.55666667 or 23.56
d. Estimate the enterprise and equity values for WestTek using the individual net sales multiples from EastTek, SouthTek, and NorthTek, as well as for the average of the three comparable firms. Show the valuation ranges from high to low.
Valuation range from high to low: $53,000,000 $50,880,000 $45,156,000 e. Estimate the enterprise and equity values for WestTek using the individual EBITDA multiples from each comparable firm, as well as the average multiple for the three competitors. Show the valuation ranges from high to low.
Valuation range from high to low: $59,163,000 $53,280,000 $44,400,000 f. Estimate the equity values for WestTek using the individual net income multiples from each comparable firm, as well as the average multiple for the three firms.
Valuation range from high to low: $77,343,000 $69,000,000 $58,000,000
g. Establish a range of equity value estimates for WestTek based on the highest and lowest overall values generated from the multiples analyses in Parts D, E, and F.
(From Net Sales) Valuation range from high to low: $53,000,000 $50,880,000 $45,156,000
(From EBITDA) Valuation range from high to low: $59,163,000 $53,280,000 $44,400,000
(From Net Income) Valuation range from high to low: $77,343,000 $69,000,000 $58,000,000
Equity Value Estimates from highest to lowest overall values:
Highest $77,343,000 Lowest $44,400,000
Range of market value estimates based on WestTek averages from Highest to Lowest:
h. From the perspective of the selling venture investors and founders, would you recommend that they negotiate for the final selling price based on the use of top-line valuation multiples (i.e., using net sales) or bottom-line valuation multiples (i.e., using net income)?
I would recommend using net income (bottom-line valuation multiples) for the final selling price as WestTek compared to competitors in the industry exceeds their percentage of net income to sales and therefore could produce a greater value for both the venture investors and the founders.
