Question A: Assume you are advising Dr. Martinez in valuing Calaveras. Based on her projections (and including the additional capital expenditures discussed in the case) prepare a discounted cash flow valuation of Calaveras Vineyards.
Answer A: Discounted Cash Flow
In the discounted cash flow model, the future free cash flows that a firm is going to generate over a specific period of time are taken into consideration while valuing that firm. However, the free cash flow values are derived from the values of balance sheet and income statement projected over a certain period of time. The model requires making certain assumptions which arised below:
• The values of balance sheet and income statement are projected over a term of 5 years starting from the end of the year 1993 to 1998. The certainty with which these values can be predicted decreases when larger forecasting period is considered. 5-year period is a reasonable time horizon in which the values can be forecasted with certainty.
• The free cash flow values are discounted at a rate of 5.85 % which is equal to the 30-year Treasury bond rate. It considered as a risk-free rate because the chances of default on this instrument are very less. The U.S government issues these bonds through Federal Reserve Bank and the interest on it is considered as a benchmark for discounting values.
• The market risk premium is an excess return on the market portfolio over the risk-free rate. It is assumed that the future returns of Calaveras will be benchmarked against the portfolio return comprising of all the common stock companies. It simply means that the owners of the company will want a return more than all the companies listed on a stock exchange bunched together in a single portfolio with respect to their proportional market capitalization. The market risk premium using this assumption comes at 5.5 %.
• The value of Beta is taken as 1.35. It is equal to the levered beta value of Finn & Sawyer Wine Company which functions in the same market segment which Calaveras is targeting i.e. premium wine. The value of beta gives an idea about the volatility of a stock price of a listed company in comparison to the market. It is assumed that the market value of Calaveras will fluctuate in the same proportion as Finn & Sawyer. It is consistent relying on the fact that demand and supply of the products of both the companies will change in equal magnitude.
• The values of the risk-free rate, market risk premium and beta are used to calculate the cost of equity which is the minimum return expected from the company. The cost of equity is calculated using the Capital Asset Pricing Model which is 13.28 %. This value is used to discount the cash flow obtained at the end of 5th year to calculate the terminal value of Calaveras i.e. the value till infinity. The rate of 2 % is also assumed for growth of the 5th year free cash flow into perpetuity.
• The value of the cost of equity is also used to discount the interest tax shield value of $ 51000 at the end of the 5th year into perpetuity. The interest expenses decrease in the future as the firm retires its debt. It also decreases the tax shield value and hence the growth rate is negative.
The assumptions form an important part of the DCF model since all the values are forward-looking and involve a certain period of time over which they are to be projected. The free cash flow values are calculated by adding non-cash charges such as depreciation and amortization expenses to the earnings after interest and taxes. The increase in working capital over the previous year is subtracted from this value. Finally, capital expenditures incurred is subtracted to arrive at free cash flows. The total of the present value of FCFs is $ 5313000. The terminal value of Calaveras is $ 34 million which is added to the NPV of free cash flows to arrive at enterprise value. The adjusted enterprise value is calculated by considering the present value of interest tax shield which forms a part of cash flow earnings though it is levered. The adjusted enterprise value is now at $ 40 million approximately. It is the fair consideration that can be paid to buy the operations of the company.
• The values of balance sheet and income statement are projected over a term of 5 years starting from the end of the year 1993 to 1998. The certainty with which these values can be predicted decreases when larger forecasting period is considered. 5-year period is a reasonable time horizon in which the values can be forecasted with certainty.
• The free cash flow values are discounted at a rate of 5.85 % which is equal to the 30-year Treasury bond rate. It considered as a risk-free rate because the chances of default on this instrument are very less. The U.S government issues these bonds through Federal Reserve Bank and the interest on it is considered as a benchmark for discounting values.
• The market risk premium is an excess return on the market portfolio over the risk-free rate. It is assumed that the future returns of Calaveras will be benchmarked against the portfolio return comprising of all the common stock companies. It simply means that the owners of the company will want a return more than all the companies listed on a stock exchange bunched together in a single portfolio with respect to their proportional market capitalization. The market risk premium using this assumption comes at 5.5 %.
• The value of Beta is taken as 1.35. It is equal to the levered beta value of Finn & Sawyer Wine Company which functions in the same market segment which Calaveras is targeting i.e. premium wine. The value of beta gives an idea about the volatility of a stock price of a listed company in comparison to the market. It is assumed that the market value of Calaveras will fluctuate in the same proportion as Finn & Sawyer. It is consistent relying on the fact that demand and supply of the products of both the companies will change in equal magnitude.
• The values of the risk-free rate, market risk premium and beta are used to calculate the cost of equity which is the minimum return expected from the company. The cost of equity is calculated using the Capital Asset Pricing Model which is 13.28 %. This value is used to discount the cash flow obtained at the end of 5th year to calculate the terminal value of Calaveras i.e. the value till infinity. The rate of 2 % is also assumed for growth of the 5th year free cash flow into perpetuity.
• The value of the cost of equity is also used to discount the interest tax shield value of $ 51000 at the end of the 5th year into perpetuity. The interest expenses decrease in the future as the firm retires its debt. It also decreases the tax shield value and hence the growth rate is negative.
The assumptions form an important part of the DCF model since all the values are forward-looking and involve a certain period of time over which they are to be projected. The free cash flow values are calculated by adding non-cash charges such as depreciation and amortization expenses to the earnings after interest and taxes. The increase in working capital over the previous year is subtracted from this value. Finally, capital expenditures incurred is subtracted to arrive at free cash flows. The total of the present value of FCFs is $ 5313000. The terminal value of Calaveras is $ 34 million which is added to the NPV of free cash flows to arrive at enterprise value. The adjusted enterprise value is calculated by considering the present value of interest tax shield which forms a part of cash flow earnings though it is levered. The adjusted enterprise value is now at $ 40 million approximately. It is the fair consideration that can be paid to buy the operations of the company.
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Question B: Would you advise Dr. Martinez to purchase Calaveras’ at the proposed price? Why or why not?
Answer B: Purchase Advice to Dr. Martinez
The company’s present value of the future worth is $ 40 million and the purchase consideration given to Dr. Martinez to buy all the assets of Calaveras is $ 4.122 million. The enterprise is available at a 90 % discount and it should be bought by Dr. Martinez. It is because the purchase consideration given is only for the assets of the company, it does not take future earning into a picture which the assets will generate over time. Though the funding of the purchase is from both equity and debt, the future cash flows are enough to easily retire the debt as shown in the calculations. The enterprise value without interest tax shield is $ 39.3 million which entirely belongs to the owners.
The company’s present value of the future worth is $ 40 million and the purchase consideration given to Dr. Martinez to buy all the assets of Calaveras is $ 4.122 million. The enterprise is available at a 90 % discount and it should be bought by Dr. Martinez. It is because the purchase consideration given is only for the assets of the company, it does not take future earning into a picture which the assets will generate over time. Though the funding of the purchase is from both equity and debt, the future cash flows are enough to easily retire the debt as shown in the calculations. The enterprise value without interest tax shield is $ 39.3 million which entirely belongs to the owners.
Question C: Does Dr. Martinez have any particular competitive advantage in running Calaveras relative to others, including the current owners?
Answer C: Competitive advantage to Dr. Martinez
Dr. Martinez has been successful in improving brand image of the company by managing quality of the products. She introduced operational changes such as converting redwood to oak cooperage, installing sprinkler system, and upgrading the winery with a bladder press. It resulted into increase in average wholesale price from $ 29.52 in 1989 to $ 44.26 in 1993. This is besides the fact that Dr. Martinez was successful in entering premium wine market segment by the introduction of Estate wines. Calaveras sold 6133 cases of the Estate wine in 1993 up from 4436 in 1991.
Dr. Martinez has a focused work experience in the winery industry from 1980 coupled with training in distillery. She has done numerous trips to Europe for gaining experience in champagne and white wine technology which can be an added advantage if Calaveras managers wish to enter this segment.
Question D: If Dr. Martinez buys the company, how would her incentives change? Does that impact your answer to C above?
Answer D: Incentives to Dr. Martinez after Acquisition
As shown in the answer to question A, the acquisition of Calaveras is a bargain purchase both for equity as well as levered purchase considering debt. The increase in the number of inventories and accounts receivable shows that the business has scalability enough to retire long-term debts and increase the concentration of equity into the business. Dr. Martinez will be the direct owner of an unlevered business 5 years down the line. Anne Clemens assumed that the maximum capacity of the winery could be 110,000 cases per year and could not go beyond that without taking into consideration the bigger picture of the increase in real price beyond inflation. Ernst and Anderson in their proposal also supported the upside trend in the earnings of Calaveras due to a strong track record of Dr. Martinez which Clemens had ignored. Dr. Martinez can efficiently run the winery and avoid diluting her equity by scaling its operations to produce more cases and simultaneously retire the leverage from the business.
As shown in the answer to question A, the acquisition of Calaveras is a bargain purchase both for equity as well as levered purchase considering debt. The increase in the number of inventories and accounts receivable shows that the business has scalability enough to retire long-term debts and increase the concentration of equity into the business. Dr. Martinez will be the direct owner of an unlevered business 5 years down the line. Anne Clemens assumed that the maximum capacity of the winery could be 110,000 cases per year and could not go beyond that without taking into consideration the bigger picture of the increase in real price beyond inflation. Ernst and Anderson in their proposal also supported the upside trend in the earnings of Calaveras due to a strong track record of Dr. Martinez which Clemens had ignored. Dr. Martinez can efficiently run the winery and avoid diluting her equity by scaling its operations to produce more cases and simultaneously retire the leverage from the business.
References
Aswath Damodaran (1996). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. New Jersey: John Wiley & Sons. ISBN-10: 111801152X
Thomas Copeland, Tim Koller, Jack Murrin (2000). Valuation: Measuring and Managing the Value of Companies. New Jersey: John Wiley & Sons.
Richard S. Ruback (1995). Introduction to Cash Flow Valuation Methods. Harvard Business School Background Note 295-155.
Thomas Copeland, Tim Koller, Jack Murrin (2000). Valuation: Measuring and Managing the Value of Companies. New Jersey: John Wiley & Sons.
Richard S. Ruback (1995). Introduction to Cash Flow Valuation Methods. Harvard Business School Background Note 295-155.
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