Wok Yow Imports, Inc., is a rapidly growing, closely held corporation that imports and sells oriental style furniture and accessories at several retail outlets. The equity owners are considering selling the venture and want to estimate the enterprise or entity value and then determine the value of the venture’s equity. Following is last year’s income statement (2013) and projected income statements for the next four years (2014-2017). Sales are expected to grow at an annual 6 percent rate beginning in 2018 and thereafter.
| Actual Projected ———————————————— |
| [$ Thousands] 2013 2014 2015 2016 2017 |
| Net Sales $150.0 $200.0 $250.0 $300.0 $350.0 |
| Cost of Goods Sold -75.0 -100.0 -125.0 -150.0 -175.0 |
| Gross Profit 75.0 100.0 125.0 150.0 175.0 |
| SG&A Expenses -30.0 -40.0 -50.0 -60.0 -70.0 |
| Depreciation -7.5 -10.0 -12.5 -15.0 -17.5 |
| EBIT 37.5 50.0 62.5 75.0 87.5 |
| Interest -3.5 -3.5 -3.5 -3.5 -3.5 |
| EBT 34.0 46.5 59.0 71.5 84.0 |
| Taxes (40% rate) -13.6 -18.6 -23.6 -28.6 -33.6 |
| Net Income 20.4 27.9 35.4 42.9 50.4 |
Selected balance sheet accounts at the end of 2013 are as follows: Required cash, accounts receivable, and inventories accounts totaled $50,000, net fixed assets were $50,000, and accounts payable and accruals totaled $25,000. Each of these balance sheet accounts was expected to grow with sales over time. Long-term debt was $30,000 and there were 10,000 shares of common stock outstanding at the end of 2013.
Data have been gathered for a “comparable” publicly traded firm, Fine Furniture Products, in Wok Yow’s industry. Fine Furniture’s risk index is judged to be 2.00 compared to a risk index of 1.00 for firms of average riskiness. Management believes that a 2.00 adjustment factor should be multiplied times the expected market risk premium for average firms to reflect Wok Yow’s (and Fine Furniture’s) relatively greater riskiness. Wok Yow’s long-term debt to long-term capital (long-term debt plus equity) ratio was 40 percent at the end of 2013. The interest rate on long-term U.S. government bonds is 7 percent, Wok Yow could issue new long-term debt at a 12 percent rate, and the average expected market risk premium (common stocks over government bonds) is 7.5 percent for average firms.
- Project Wok Yow’s net operating profit after-tax (NOPAT) statements for 2014-2018.
The NOPAT results are shown below in the spreadsheet solution. NOPAT amounts were: 30.0 (2014), 37.5 (2015), 45.0 (2016), 52.5 (2017), and 55.7 (2018).
- Determine the annual increases in required net working capital and capital expenditures (CAPEX) for Wok Yow for the years 2014 through 2018.
Results are shown below in the spreadsheet solution. The increases in RNWC were: 8.3 (2014), 8.3 (2015), 8.3 (2016), 8.3 (2017), and 3.5 (2018). The increases in CAPEX were: 26.7 (2014), 29.2 (2015), 31.7 (2016), 34.2 (2017), and 25.5 (2018).
- Project annual operating free cash flows to the entity for the years 2014 through 2018.
Results are shown below in the spreadsheet solution. Operating free cash flows were: 5.0 (2014), 12.4 (2015), 20.0 (2016) and 27.5 (2017). An operating free cash flow of 45.2 was estimated for 2018.
- Management initially thought that an 18 percent discount rate was reasonable.
Estimating an appropriate required rate of return on an equity investment is critical to the valuation effort. For very early stage ventures, various VC “rules-of thumb” might be used ranging from development stage discount rates of 50% down to 20% discount rates for relatively mature, but small ventures. The alternative is to estimate an appropriate discount rate using the security market line approach described in Chapter 7. A venture that employs some interest-bearing debt will have a weighted average cost of capital WACC that is less than the cost of equity capital. Management has made a rough estimate of the firm’s WACC or enterprise (entity) discount rate to be 18%.
- Use the information from Part D above to estimate Wok Yow’s terminal value cash flow at the end of 2017.
The terminal value cash flow is estimated to be 376.3 and is calculated by dividing the estimated operating free cash flow for 2017 of 45.2 by .12 which is the difference between the discount rate (r = .18) and the perpetuity growth rate (g = .06). See the spreadsheet solution presented below. In greater detail, the calculation is: 45.152/(.18 – .06) = 376.267.
- Estimate the firm’s enterprise or entity value at the end of 2013.
The enterprise or entity value at the end of 2013 is estimated to be 233.6 (thousands of dollars). See the spreadsheet solution presented below.
- Adjust the enterprise value to determine Wok Yow’s equity value in dollars and on a per share basis at the end of 2013.
The enterprise value of $233.6, minus the long-term debt value of $20, results in an equity value of $203.6. On a per share basis, the value is $20.36. See the spreadsheet solution presented below.
- Now, estimate Wok Yow’s after-tax cost of long-term debt. Use the risk free rate, the expected market risk premium, and the risk index for the Fine Furniture Company to estimate Wok Yow’s cost of equity capital. Determine Wok Yow’s weighted average cost of capital (WACC).
Cost of common equity capital = 7% + (7.5%)2.00 = 7% + 15% = 22%
After-tax cost of debt = 12%(1 – .40) = 7.2%
WACC = 7.2%(.40) + 22%(.60) = 2.88% + 13.20% = 16.08% or 16.1% rounded.
See the second spreadsheet solution presented below for answers to Parts H and I.
- Re-estimate Wok Yow’s enterprise value using the WACC calculated in Part H. Then, adjust the enterprise value to determine Wok Yow’s equity value in dollars and on a per share basis at the end of 2013.
Revised terminal value = $447.1 [i.e., actually $45.152/(.161 – .06)]
Revised enterprise value = $270.1
Revised equity value = $240.1 (i.e., $270.1 – $30.0)
Revised per share value = $24.01
See the second spreadsheet solution presented below for answers to Parts H and I.
