Mergers, Acquisitions, and Other Restructuring Valuation Homework Problems Due: Tuesday, March 1, 11 AM

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1 Name: Mergers, Acquisitions, and Other Restructuring Valuation Homework Problems Due: Tuesday, March 1, 11 AM FOR UNDERGRADUATE STUDENTS ONLY: The following assignment is worth 5 points and is due at the start of class on Tuesday, March 1 st. No assignments will be accepted after that time. If you have any questions, please see Dr. Yost. You will turn in your answers, with any supporting calculations/spreadsheets (printed out). This is not a group project. This assignment should be completed individually. All work must be your own. You are not to share spreadsheets or work with other students. 1. Sober Brews Corporation is a holding company composed of the following subsidiaries: Sober Brews Beer Corporation produces, markets, and sells various beer products. Beers produced appeal to a wide range of consumer taste and price preferences. Sober Brews Foods Corporation produces, markets, and sells meat products for household consumption. SBC Brews Packaging Corporation produces, markets, and sells packaging products, including bottles, aluminum cans, and cardboard boxes. SBC Properties, Inc. develops and sells commercial and residential properties. SBC International, Inc. act as the holding company for all of Sober Brews` international operations, which are concentrated in Eastern Europe and China. You have performed a DCF analysis on each of the subsidiaries, with the following results: Equity Value ($MM) Sober Brews Beer Corporation Sober Brews Foods Corporation Sober Brews Packaging Corporation SBC Properties, Inc SBC International, Inc Total 1, Sober Brews currently trades on the New York Stock Exchange at $32.80 a share, and has 36.2 million shares outstanding. Debt on Sober Brews` balance sheet totals $396 million. Would you recommend taking any action with regard to Sober Brews? If so, what course of action would you take?

2 The recommended action should be to buy shares of Sober Brews. At $32.80 apiece, Sober s market capitalization comes out to only $1,187.70, 25 percent lower than the estimated equity value of $1,586. This is a violation of value additivity (i.e., VSum of parts > VMarket). Securities analysts and corporate raiders are known to conduct this kind of analysis. 2. Red Hill Vinegar Company is going out of business due to fierce competition in the condiments industry. Jack Mueller, an independent appraiser, has been hired to estimate the liquidation value of Red Hill`s assets. How much will be left to the owner of Red Hill after liquidation? Book Value ($000) Percent Recoverable Cash $ Receivables Inventory PPE Other Assets $2, Debt $1, Equity $4, Nothing will be left to the owner of Red Hill because the liquidation value of assets is less than debt outstanding. The resulting equity value is negative $ Book Value ($000) Percent Liquidation Recoverable Value Cash $ Receivables Inventory PPE Other assets $ 2, ,369.2 Debt 1, ,763.3 Equity $ 4,114.7 $ (394.1)

3 3. Pellagia Inc. is a nationwide retail chain specializing in women`s apparel. The company`s most popular lines are Aura and Home. Aura offers executive wear for women in the middle to high end markets, and Home features casual but stylish clothes, also targeted at women in the middle to high end markets. The company has 135 million shares outstanding, 30 percent of which are publicly trade with a current market price of $5.63 per share. The company is expected to net $38 million in the next 12 months. Forecast sales and EBITDA are $633 million and $57 million, respectively. Debt outstanding is $120 million. a. What is the current enterprise market value of Pellagia? b. Suppose you are asked to value Pellagia Inc. given the following information. What is your estimate of equity value? Of enterprise value? Earnings Enterprise Value to Sales Abrecrombie & Fitch Ann Taylor Stores Corp Bebe Stores Inc Gap Inc. N/A 0.76 Limited Brands Inc Talbots Inc The current enterprise market value of Pellagia is $ million: Shares outstanding Price per share $ 5.63 Equity market value $ Debt market value Market value $ Based on simple averages of the comparable firms multiples (17.44 P/E and 1.09 P/S), the equity value using price earnings is $662.7 million, and the enterprise value using price sales is $690.4 million. Earnings Sales Abercrombie & Fitch AnnTaylor Stores Corp Bebe Stores Inc Gap Inc. NA 0.76 Limited Brands Inc Talbots Inc Average Pellagia earnings & sales Market values

4 4. Tel Talk Inc. is a company that provides domestic and international long distance, regional and local communications services, cable (broadband) television, and Internet communications service. For the past two years, it has paid an annual dividend of $2.31 per share; however the compound rate of growth in dividends per share over the past 10 years has been 6.2 percent. The beta of Tel Talk stock measured over the past three years is Its debt, which makes up 32 percent of total capital, currently yields 7.28 percent, while long term Treasury bonds are yielding 5.63 percent. The market risk premium (geometric) is at 5.9 percent. Tel Talk shares are currently trading at $46.25 per share. Calculate Tel Talk`s cost of equity using both the CAPM and dividend growth model. Using the CAPM = Rf + Beta x Market risk premium = 5.63% x 5.9% = 12.12% Using the dividend growth model = ($2.31 / $46.25) + 6.2% = 5.0% + 6.2% = 11.2% The two methods yield estimated costs of equity that differ by 92 basis points. This is a common problem in valuation. If both estimators are credible, one should triangulate toward an estimate from them. To triangulate means to critically evaluate the assumptions behind each method, and to weigh each method according to its relevance to the company under consideration. For instance, the dividend growth model assumes a constant growth rate in dividends and ignores risk. One must ask whether such assumptions are reflective of the reality of the company being valued. 5. The following is a five year discounted cash flow (DCF) forecast for Middlestates Electric, Inc., an electric utility company: ($MM) Year 1 Year 2 Year 3 Year 4 Year 5 Operating income 2,039 2,325 2,169 2,430 2,615 Taxes Depreciation and amortization ,527 1,584 Change in working capital (169) (205) Captal expenditures/asset sales (1,754) (3,432) 1,180 2,720 2,133 Free Cash Flow 703 (213) Cash flows over the next five years are expected to fluctuate significantly due to key acquisitions and restructuring measures planned by Middlestaes. After the fifth year, however, cash flow is expected to stabilize. Economists expect the long term inflation rate to stabilize at 1.5 percent, and Middlestates expects real growth in sales to be 1.5 percent or less. Management has determined that the cost of capital is 9.28 percent. Estimate Middlestates` enterprise value.

5 Middlestates free cash flows given in the problem need to be discounted at the cost of capital. In addition, terminal value has to be estimated. Terminal value comes out to $15,213, calculated as follows: = [CF5 x (1 + g)] / (r g) = [924 x (1.03)] / ( ) = 15,213 The growth rate is calculated using the Fisher formula: gnominal = (1 + greal) x (1 + ginflation) 1 = (1.015) x (1.015) or 3% $ MM Year 1 Year 2 Year 3 Year 4 Year 5 Operating income 2,039 2,325 2,169 2,430 2,615 Taxes Depreciation and amortization 1,299 1,413 1,470 1,527 1,584 Change in working capital (169) 294 (223) 163 (205) Capital expenditures/asset sales (1,754) (3,432) 1,180 (2,720) (2,133) Free cash flow 703 (213) 3, Free cash flow 703 (213) 3, Terminal value 15,213 Total cash flows 703 (213) 3, ,137 PV 14,117 Inflation 1.5% Real growth 1.5% Terminal value growth rate 3.0% WACC 9.28% The enterprise value, calculated by discounting the yearly free cash flows (given in the problem) and the terminal value ($15,213) at the cost of capital, comes out to $14,117. A valuable insight is that the terminal value makes up most of the enterprise value.