urned out to be -32%. As a result of the effective return being so low, I knew that the bid price would have to be lowered. In the graph below, I also illustrate a bid in the amount of $20 million that results in an effective return of 36%. Start Up Phase Growth Phase Terminal
DCF Method 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
WACC 0.20
Period PV (51.88) (226) 1,430
Total PV 78.61
60% Equity 47.16
NPV 27.16 Effective Return ($20) $27 36% → Vs. → ($40) $27 -32%

When calculating the effective return using the book value method I began with $3.5 (given) in 2004 and calculated each year forward. By 2014 the equity book value grew to $671.5. I took 60% of the present value of $671.5 and calculated the effective return using an initial investment of $40 million. Under these assumptions, I found that the effective return was 63%. This return immediately struck me as being high. Please refer to Exhibit 1 for these calculations. Similar results were found when calculating the effective return using the market value method. Using terminal earnings of $203 and a comparable P/E ratio of 15, I found Arcadian’s equity value to be $3039. I then took 60% of the present value of that amount and calculated the effective return using an initial investment of $40 million. Under these assumptions, the effective return was found to be 514%. This return was even more astronomical then that of the book value method. Due to the fact that the market value method is using a comparative P/E ratio when Arcadian currently has negative net incomes, I do not find the market value method to be a substantial indicator of the firm’s value.
Recommendation
The growth rate applied to the steady state phase must be revised in Arcadian’s forecast. Additionally, being how Arcadian and Sierra have polar opposite forecasts, one being very conservative and the other being very optimistic. I recommend a moderate forecast to be created, which will represent financials between that of both company’s forecasts. Below I have created a Consolidated Income Statement, which represents a moderate scenario. Start Up Phase Growth Phase Terminal Steady State (∞) 04 05 06 07 08 09 10 11 12 13 14 15
Total sales 2 9 31 77 158 282 436 563 676 722 779 809.64
Net income (12) (22) (17) (7) 2 18 28 37 61 94 157 163.722
Free cash flow (31) (34) (31) (35) (21) 2 30 53 64 81 164 171.002
Terminal Value 1069
FCF + Terminal Value (31) (34) (31) (35) (21) 2 30 53 64 81 1233
Next, I applied the DCF method to this new forecast and found the maximum bid that would be acceptable with respect to the WACC at 20%. 04 05 06 07 08 09 10 11 12 13 14
WACC 0.20
Period PV (84.14) 80 1,028
Total PV 127.86
60% Equity 76.72
NPV 41.82 Effective Return ($35) $42 20%