|Type of paper:||Case study|
Mr. Willie Ray,
On behalf of Aliziya Punjwani Consulting (APC), we would like to thank you for the opportunity to evaluate the proposed acquisition of Artforever.com by Neuquen Inc. It is our understanding Neuquen Inc. is considering the acquisition of Artforever.com, a private company, which specializes in restoring damaged artwork and vintage photographs for high net worth individuals. APC will analyze the benefits of the proposed Artforever.com acquisition. APC will analyze the data provided by Neuquen Inc in an accurate, independent and fairly manner. APC will then provide Neuquen Inc. with the right discount rate including the relevant cash flows, as well as the terminal value at year five that will be used in the determination of the maximum price Neuquen Inc. should pay to Artforever.com's equity shareholders. The analysis by APC stipulates the eight steps that are necessary for the calculation of the maximum equity price. The attached Exhibit One shows calculations for the first four steps. Exhibit two shows calculations for the fifth step while the calculations for the sixth to the eighth step are shown in exhibit three. The key data points used in all calculations are summarized by APC which is evident on the attached Summary of Key Data Points. The purpose of providing the main data points is to enhance convenience. Select a cell and press CTRL + '(grave accent) to view the exact formula when stipulating any APC calculation. APC will further outline the various conditions that Neuquen Inc. might consider to enable them to make a higher offer than the recommended maximum price. APC will provide Neuquen Inc. with clear explanations of all the computations and reasoning that will be made. Finally, APC will not provide Neuquen Inc. with any information or analysis of non-quantitative factors such as the implementation of the chosen capital budgeting strategy by Neuquen Inc.
The first task that Neuquen Inc requires APC to do is to calculate the right discount rate that is appropriate to help find the value of Artforever.com. The discount rate is also referred to as the weighted average cost of capital. A four-step process is required to be able to calculate the discount rate. The first step that APC will carry out is to compute the asset beta of ArtToday.net. ArtToday.net is a publicly traded company which can be compared to Artforever.com. As there is very little information regarding Artforever.com, the ArtToday will be used as the proxy company. APC believes that it is crucial to define key terms to help reduce or even eliminate the possibility of any misunderstanding arising.
The measure of the sensitivity of a security's return to a systematic risk is referred to as beta. Asset beta which is also known as the unlevered beta is derived from the Modigliani and Miller theory of the capital structure of a firm. According to this theory, capital structure is irrelevant for valuation since the valuation is not derived from the debt-equity mix but instead it is gotten from the assets of a firm. The asset beta assists in evaluating the risk of a business.
According to the APC calculation, the ArtToday.net's asset beta is 1.03 considering it has an equity beta of 1.5 and a corporate tax rate of 40% and debt to equity ratio of 0.75. The second step that APC will engage itself in is computing the equity beta of Artforever.com. The Equity beta will be the asset beta which will be adjusted for leverage. The equity beta is essential since it pays into consideration the business as well as the financial risk of the company. The capital structure of Artforever.com's differs from that of ArtToday.net's. Artforever.com has a target debt to value ratio of 15% which can be converted to a 17.65% debt to equity ratio. APC computes Artforever.com's equity beta as 1.14 using ArtToday.net's of 1.03 asset beta and Artforever.com's corporate tax rate of 40% considering it has as a 17.65% debt to equity ratio. The financial risk is compensated by Equity beta and tends to be more than the asset beta. The third step that APC will carry out is computing the return on equity of Artforever.com's. This will be carried out using the capital asset pricing model (CAPM).According to this model, the expected return on a security is related to its beta linearly. The expected return on a security is calculated as the risk-free rate plus the beta of security multiplied by the difference between the expected return on the market and the risk-free rate. The difference between the risk-free rate and the expected return on the market is also referred to as the market risk premium. The return of an asset with no default risk being posed is known as the risk-free rate. The market data analysis by APC yielded the risk-free rate which is equivalent to the current yield to maturity on thirty (30) year treasury bonds, 2.50%, a conservative measure. Market data analysis by APC also determined the expected return on the market equal to our estimate of the S&P 500's expected average return over the next thirty (30) years, 8.00%. It is important to note that the CAPM equation does not call for the actual return on the market for a given period but instead calls for the expected return on the market. APC computed Artforever.com's required return on equity as 8.79% using Artforever.com's 1.14 equity beta as well as the 2.50% risk-free rate and the expected market return as 8.00%. Calculating for the WACC is the fourth step. The value of a firm can be calculated using one of three ways from two major categories. One of the ways that can be used is the relative valuation which involves valuing of a company using either precedent transaction techniques or public company comparatives. The other way that can be used is the intrinsic valuation, or valuing a company on a stand-alone basis. The discounted cash flow method is used in this type of valuation. In this case, the discounted cash flow method will be used by APC to value Artforever.com through the use of WACC.
The WACC approach starts by understanding that projects of levered firms are financed simultaneously with both the equity and debt. The weighted average of the cost of debt and the cost of equity is considered to be the cost of capital. The cost of equity of Artforever.com's is 8.79% as previously calculated. The Artforever.com's borrowing rate of 6.2% is considered to be the cost of debt that it has. It is essential to note that tax deductible at the corporate level is regarded as interest. While using the WACC approach, a further computation is required to assist in determining the after-tax cost of debt which according to the calculation by APC is equivalent to 3.72%.
The weights in the WACC formula show the proportion of the total market value that is represented by equity and debt, respectively, by percentage. Artforever.com's target debt to value ratio, or weight of debt, is 15%. Exhibit one shows APC calculations of the total market value of Artforever.com's equity as $8,358,333 using its 17.65% debt to equity ratio and market value long-term debt. The debt and equity weights, on a dollar basis, total $9,833,333. The total derived divided by the total market value of equity to arrive at an 85% weight of equity. As per APC's calculation results, the WACC of Artforever.com's is 8.03%. WACC is the appropriate discount rate since it represents the expected return that Artforever.com should earn on the assets it has to be in a position of maintaining value as well as reflecting the risk and the capital structure of the Artforever.com's existing assets. The WACC is also the best approach to use since Artforever.com is not a pure play for Neuquen.
Neuquen Inc. has secondly engaged APC to assist in the determination of the appropriate cash flows and terminal value at year five for valuing Artforever.com. The fifth step that will be carried out involves the understanding of the different types of cash flows that are crucial to understanding Artforever.com financial position. The earnings before interest and taxes minus taxes plus depreciation measures the cash generated from operations which does not include investments in capital expenditures or net working capital requirement is referred to as the operating cash flow. APC managed to gather Artforever.com forecast data and percentage allocations for costs of goods sold and SG&A expenses which is represented on the attached summary of fundamental data points. The reason in which the calculations for operating cash flow do not include the use of interest payments is that it is assumed that the valuation is performed at the end of 2016 and also that Artforever.com has no debt. Total cash flow of the firm, which is also referred to as distributable cash flow or free cash flow compromises of investment adjustments in the net-working capital as well as capital expenditures. The adjustments are commonly known as investing cash flow. The cash that Artforever.com can distribute to stockholders and creditors because it is not required for capital expenditures or net working capital is referred to as free cash flow. The fifth step includes the calculation of the terminal value at year five as well. The use of the word terminal value does not mean that Artforever.com will cease to be in existence but rather simplifies the free cash flow process. Terminal cash flow is calculated by assuming a constant perpetual growth rate for free cash flows beyond the 2017 - 2021 horizon. Artforever.com's perpetual growth rate is forecasted to be at 2.00% per year by APC for free cash flows beyond the year 2021. APC calculates $16,362,210 as the year five terminal cash flow as per the previously calculated WACC and $967,500 year five free cash flow.
Neuquen Inc. has thirdly engaged APC to assist in determining the maximum price Neuquen Inc.is required to pay to the equity shareholders of Artforever.com's. The sixth step that APC is supposed to carry out is computing the net present value (NPV) of the free cash flows. This will be calculated through the use of the WACC or the appropriate discount rate. NPV refers to the present value of future free cash flows which are discounted at the proper rate minus the current amount of the initial cost of the investment. Artforever.com's NPV formula is modified since there is no initial investment. The Artforever.com's NPV as calculated by APC is $12,942,131 for the years 2017 - 2021. It is crucial to note that the cash flow for year five is the sum of the free cash flow in that given year plus the terminal value of the same year. The NPV of all future free cash flow which is also referred to as the cash flow from assets is the value of the firm. The seventh step that will be carried out is computing the value of Artforever.com which according to APC the value is the same as the NPV, $12,942,131. The final step is determining the maximum price Neuquen Inc. should pay to Artforever.com's equity shareholders. To find the value of equity, the value of debt, $1,475,000 is subtracted from the enterprise value of Artforever.com to get at an equity value of $11,467,131.
The fourth engagement that Neuquen Inc. has involved APC in is to provide the various conditions in which Neuquen Inc. can consider making a higher offer than the recommended maximum equity price to Artforever.com. Neuquen Inc. has the chance to pay Artforever.com's equity shareholders $11,467,131. This value was gotten from the current value of Artforever.com's free cash flows. The sixth step defined NPV as the present value of future free cash flows discounted at the appropriate rate minus the present value of the initial cost of the investment. The incremental value (NPV) of acquiring Artforever.com is the same as the present value minus the cost, or...
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