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Cash
$50,000
$40,000
Accounts receivable
200,000
260,000
Inventories
450,000
500,000
Total current assets
700,000
800,000
Fixed assets, net
400,000
500,000
Total assets
$1,100,000
$1,300,000
Accounts payable
$130,000
$170,000
Accruals
50,000
70,000
Bank loan
90,000
90,000
Total current liabilities
270,000
330,000
Long-term debt
300,000
400,000
Common stock ($10 par)
300,000
300,000
Capital surplus
50,000
50,000
Retained earnings
180,000
220,000
Total liabilities and equity
$1,100,000
$1,300,000
Income Statements
2015
2016
Net sales
$1,400,000
$1,600,000
Cost of goods sold
780,000
900,000
Gross profit
620,000
700,000
Marketing
130,000
150,000
General and administrative
150,000
150,000
Depreciation
40,000
53,000
EBIT
300,000
347,000
Interest
45,000
57,000
Earnings before taxes
255,000
290,000
Income taxes (40%)
102,000
116,000
Net income
$153,000
$174,000
A. Estimate the free cash flows available to the equity investors for 2017.
The following spreadsheet assumes that most accounts are a constant percent
of sales (starting in 2017). We have balanced the balance sheets by raising the
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GAMMA SYSTEMS MANUFACTURING CORPORATION
CHAPTER 15 PROBLEMS 5-7:
Balance Sheets
2015 2016 2017 2018
Check Year
Cash 50,000 40,000 42,400 44,944
Accounts Receivables 200,000 260,000 275,600 292,136
Inventories 450,000 500,000 530,000 561,800
Total Current Assets 700,000 800,000 848,000 898,880
Fixed Assets, Net 400,000 500,000 530,000 561,800
Total Assets
1,100,000 1,300,000 1,378,000 1,460,680
Accounts Payable 130,000 170,000 180,200 191,012
Accruals
50,000 70,000 74,200 78,652
Bank Loan 90,000 90,000 95,400 101,124
Total Current Liabilities 270,000 330,000 349,800 370,788
Long–Term Debt 300,000 400,000 424,000 449,440
Common Stock ($10 par) 300,000 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000 50,000
2015 2016 2017 2018
Net Sales 1,400,000 1,600,000 1,696,000 1,797,760
Cost of Goods Sold 780,000 900,000 954,000 1,011,240
Depreciation
Earnings Before Taxes 255,000 290,000 307,400 325,844
Income Taxes (40%) 102,000 116,000 122,960 130,338
Net Income 153,000 174,000 184,440 195,506
Dividends 134,000 150,240 159,254
Retained Earnings 40,000 34,200 36,252
g = 6.00%
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A)
Statement of Cash Flows Approach to FCF/VCF
2017
Operating:
Net Income 184,440
+Depreciation 56,180
–Inc. in Accts. Receivable
–15,600
–Inc. in Inventories –30,000
+Inc. in Accts. Payable 10,200
+Inc. in Accruals 4,200
CF from Operations 209,420
Investing:
–Inc. in Fixed Assets –86,180
Financing:
+Increase in Bank Loans 5,400
+Increase in Long–Term Debt 24,000
Change in Cash Balance Before Dividends 152,640
Dividends –150,240
Change in Balance Sheet Cash Account 2,400
+Depr 56,180
–Capex –86,180
–Change NWC –28,200
C. By applying the terminal value equation at the end of 2016, what are we
assuming about the future?
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that the required return will remain constant at 18%.
6. [Valuation Sensitivities to Changes in Growth Rates and Discount Rates] Assume
that some of the information relating to the Gamma Systems Manufacturing
Corporation has changed. Using the financial statement data in Problem 5, answer
the following questions.
A. How would your valuation estimate change if the sales growth rate had been 6
percent but the discount rate had been 20 percent?
B. How would your valuation estimate change if the sales growth rate had been 5
percent and the discount rate 18 percent?
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GAMMA SYSTEMS MANUFACTURING CORPORATION
Problem 6
A) 1,073,142.86$
B) Balance Sheets
2015 2016 2017 2018
Check Year
Cash 50,000 40,000 42,000 44,100
Accounts Receivables 200,000 260,000 273,000 286,650
Inventories 450,000 500,000 525,000 551,250
Total Current Assets 700,000 800,000 840,000 882,000
Fixed Assets, Net 400,000 500,000 525,000 551,250
Total Assets
1,100,000 1,300,000 1,365,000 1,433,250
Accounts Payable 130,000 170,000 178,500 187,425
Accruals 50,000 70,000 73,500 77,175
Bank Loan 90,000 90,000 94,500 99,225
Total Current Liabilities 270,000 330,000 346,500 363,825
Total Liab. & Equity 1,100,000 1,300,000 1,365,000 1,433,250
2015 2016 2017 2018
Depreciation 40,000 53,000 55,650 58,433
EBIT 300,000 347,000 364,350 382,568
Interest
45,000 57,000 59,850 62,843
Earnings Before Taxes 255,000 290,000 304,500 319,725
Income Taxes (40%) 102,000 116,000 121,800 127,890
Net Income 153,000 174,000 182,700 191,835
Dividends 134,000 154,200 161,910
Retained Earnings 40,000 28,500 29,925
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C. How would your valuation estimate change if the perpetuity growth rate had
been 7 percent and the discount rate 20 percent?
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GAMMA SYSTEMS MANUFACTURING CORPORATION
C) Balance Sheets
2015 2016 2017 2018
Check Year
Cash 50,000 40,000 42,800 45,796
Accounts Receivables 200,000 260,000 278,200 297,674
Inventories 450,000 500,000 535,000 572,450
Total Current Assets 700,000 800,000 856,000 915,920
Fixed Assets, Net 400,000 500,000 535,000 572,450
Total Assets
1,100,000 1,300,000 1,391,000 1,488,370
0
Accounts Payable 130,000 170,000 181,900 194,633
Accruals 50,000 70,000 74,900 80,143
Bank Loan 90,000 90,000 96,300 103,041
Total Current Liabilities 270,000 330,000 353,100 377,817
Long–Term Debt 300,000 400,000 428,000 457,960
Common Stock ($10 par) 300,000 300,000 300,000 300,000
Capital Surplus 50,000 50,000 50,000 50,000
Interest
45,000 57,000 60,990 65,259
Earnings Before Taxes 255,000 290,000 310,300 332,021
Income Taxes (40%) 102,000 116,000 124,120 132,808
Net Income 153,000 174,000 186,180 199,213
Dividends 134,000 146,280 156,520
Retained Earnings 40,000 39,900 42,693
g = 7.00%
Value 1,125,231
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GAMMA SYSTEMS MANUFACTURING CORPORATION
Problem 7
Balance Sheets 2015 2016 2017 2018 2019 2020
Check Year
Cash 50,000 40,000 46,000 50,600 53,636 56,854
Accounts Receivables 200,000 260,000 299,000 328,900 348,634 369,552
Inventories 450,000 500,000 575,000 632,500 670,450 710,677
Total Current Assets 700,000 800,000 920,000 1,012,000 1,072,720 1,137,083
Fixed Assets, Net 400,000 500,000 575,000 632,500 670,450 710,677
Total Assets
1,100,000 1,300,000 1,495,000 1,644,500 1,743,170 1,847,760
00
Accounts Payable 130,000 170,000 195,500 215,050 227,953 241,630
Accruals 50,000 70,000 80,500 88,550 93,863 99,495
Bank Loan 90,000 90,000 103,500 113,850 120,681 127,922
Total Current Liabilities 270,000 330,000 379,500 417,450 442,497 469,047
Long–Term Debt 300,000 400,000 460,000 506,000 536,360 568,542
Common Stock ($10 par) 300,000 300,000 300,000 300,000 300,000 300,000
Marketing
Depreciation 40,000 53,000 60,950 67,045 71,068 75,332
EBIT
300,000 347,000 399,050 438,955 465,292 493,210
Interest
45,000 57,000 65,550 72,105 76,431 81,017
Earnings Before Taxes 255,000 290,000 333,500 366,850 388,861 412,193
Income Taxes (40%) 102,000 116,000 133,400 146,740 155,544 164,877
Net Income 153,000 174,000 200,100 220,110 233,317 247,316
Dividends 134,000 114,600 154,560 190,054 201,457
Retained Earnings 40,000 85,500 65,550 43,263 45,859
Dividend growth g = 34.87% 22.96% 6.00%
2018 Terminal Value 1,583,780
VCF 114,600 1,738,340
2016 NPV 1,345,567
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MINI CASE: MINIDISCS CORPORATION
Brian Motley founded the MiniDiscs Corporation at the end of 2011. After nearly
one year of development, the venture produced an optical storage disk about the size
of a silver dollar that could store more than 500 megabytes of data along with a
mechanism allowing the device to be integrated into a variety of portable consumer
electronic devices including e-books, music discs, and video games.
In addition to Brian Motley’s role as the venture’s CEO, Susan Sharpe, with 6 years
of prior financial management experience at two high technology ventures, was hired
as the CFO. The Vice-President of Marketing was Steven Davis and the Vice-
President of Operations was Sanjay Chavarti. Before being hired by MiniDiscs,
Davis had 12 years of marketing experience in the technology area. Chavarti worked
in high tech operations for eight years before pursuing the opportunity with
MiniDiscs.
Leading electronic manufacturers were anxious to incorporate the minidisk in
their products. Brian Motley obtained $7 million financing at the end of 2012 from
venture investors in exchange for 43 percent of the stock in the venture. After this
round of venture financing, Brian retained 50 percent ownership in MiniDiscs and the
other three members of the management team (Sharpe, Davis, and Chavarti) owned 7
percent of the venture.
Over a four-year period (2013-2016), MiniDiscs moved quickly through its
startup and survival stages and is now in the midst of its rapid growth stage. Brian
Motley has recently decided to harvest his investment by selling the firm. However,
the other three members of the management team want to continue on and proposed a
leveraged buyout to Brian Motley. An external valuation firm estimated that $45
million represented a fair price for all of the equity in the MiniDiscs Corporation.
An abbreviated balance sheet in thousands of dollars for yearend 2016 follows:
Current Assets $15,000 Payables & Accruals $5,000
Fixed Assets, Net 15,000 Long-Term Debt 10,000
Common Equity 15,000
Total $ 30,000 Total $30,000
It is the beginning of 2017, and the management team has $5 million of their own
capital, including their share of the sales price, available to purchase all of the
venture’s existing equity capital. The intent is to retire all of the old stock and issue 2
million shares of common stock in the “new” venture to the management team. LBO
financiers will put up $20 million in 8 percent, 5-year subordinated debt funds plus
1.9 million warrants that can be converted into 1.9 million shares of common stock.
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A bank will also offer a $10 million, 14 percent interest rate, 4-year fully amortized
loan. To make the deal work, Brian Motley was asked to provide seller financing in
the form of a below market 10 percent, 5-year, seller’s note. The amount of the note
was to be for the difference between the $45 million selling price and the amount of
funds raised from management, the LBO financiers, and the bank.
In exchange for the seller financing by Brian Motley, the existing venture
capitalists agreed to reduce their ownership rights from 43 percent to 40 percent. The
management team also lowered their claim on the existing venture from 7 percent to 5
percent. Thus, as the result of agreeing to provide seller financing, Brian’s
percentage ownership of the $45 million selling price was 55 percent. Brian
estimated that the interest rate being paid on similar risk subordinated seller loans was
currently at 16 percent.
A. What will be the dollar amount of seller financing that Brian Motley will need to
provide to complete the financing of the $45 million selling price?
B. How much cash will be available to distribute to the existing owners of the
MiniDiscs Corporation? What will be the dollar breakdown for Brian Motley, the
management team, and the venture capitalists?
Original Percent Exit Percent
Equity Owners Ownership Ownership
If Brian Motley provides $10 million seller financing, at the time of exit
ownership percentages would result in the following dollar breakdown:
C. What compound rate of return did Motley earn on his $1 million end of 2011
investment?
The $1million original investment bought only 50% of the 2016 equity value. The
additional $10 million below-market loan (negative NPV loan) was the
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consideration for the additional 5% to bring Motley’s total ownership to 55%.
For the original $1 million, 50% of the final $45 million is $22.5 million. If we
turn $1 million into $22.5 million in 5 years, the formula for the rate of return is
(22.5/1)1/5 – 1 = 86.4%. Verifying, 1*(1+.864)5= 22.5.
While the annual compound rate of return on his original $1 million investment
D. What compound rate of return did the venture capitalists earn on their $7 million
investment at the end of 2012?
E. After five years of operating as a private venture owing to the LBO, assume that
the common equity in the MiniDiscs Corporation could be sold for $60 million at
the end of 2021. What compound rate of return would the management team earn
on its $5 million investment?
The VCs were given warrants to purchase 1.9 million shares of stock. Thus, at
F. Assume that when MiniDiscs is sold at the end of 2021 for $60 million that the
LBO financiers will have their debt retired and will sell their share of interest in
the venture. What compound rate of return would the LBO financiers receive?
As the exercise price of the warrants is not specified, we will provide two possible
scenarios:
