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solution

As described in Sidebar 4.C (p. 96), the Silna family had a contract to receive 1/7th of the television revenue of four NBA teams (Denver Nuggets, San Antonio Spurs, Brooklyn Nets, and Indiana Pacers) in perpetuity. The NBA’s television deal running from the 2008–2009 season through the 2015–2016 season paid the family $18.9 million annually. Use the above information and the following parameters to calculate the NPV of the contract.

·       The valuation date is January 1, 2009.

·       Assume that the Silnas received their first payment on January 1, 2009, and that the payments will continue annually thereafter.

·       Assume that the Silnas are taxed at 35% for their income on this deal.

·       Assume that their payments from this NBA deal will grow at 2% per year in perpetuity after the final year of this contract. (Although the Silnas’ deal has ended in reality, for purposes of this exercise we will assume that the deal will continue forever.)

·       Assume a discount rate of 8%.

·       Create a table that shows the results you found and gives a brief description of your steps, assumptions, and so forth.

·       What would the value be if the discount rate were 10% and the NCF growth rate were 4%?

Valuation Case Study: The Duke’s Sporting Goods Store

OBJECTIVE

The goal of this analysis is to determine a financial valuation of the fair market value of 100% of The Duke’s Sporting Goods Store (“Duke’s”), by using two of the three approaches to valuation (income and market approaches, but not the cost approach). The valuation date is December 31 of the current year. Your instructor will provide you with an Excel file containing two spreadsheets: Duke’s Discounted Cash Flow Analysis and Market Approach. Data have been entered in these spreadsheets that will allow you to calculate valuations for Duke’s under the income and market approaches.

FACTS

1. The company’s assets are cash ($100,000), inventory (worth $400,000 based on cost), and accounts receivable ($25,000).

a. Inventory can be sold back to manufacturers for 50% of its cost.

b. Accounts receivable can be sold to a collections agency for 40% of its current level.

2. The company’s liabilities are accounts payable of $75,000 and accrued expenses of $75,000.

3. The Discounted Cash Flow Analysis spreadsheet shows the most recent three years’ income statements in simplified form.

4. Assume the company pays a corporate tax rate of 40%.

5. For the current year, depreciation and amortization is $25,000. The company is using straight-line depreciation. Thus, D&A is expected to be $25,000 going forward.

6. The physical depreciation and/or amortization of fixed assets is allowed to be booked as an expense, thus lowering the taxable income. Yet, it is not an actual decrease in dollars so it is not a decrease in cash flow. That is why it is added back in to Net Income on the way to calculating Net Cash Flow. Net Cash Flow is actual physical dollars coming out of the business during the time period.

7. There is no interest expense.

8. For the current year, capital expenditures (CAPEX) is $50,000. CAPEX refers to the current expenditure of money by the company to purchase equipment and other assets that will help the company earn more money in the future. It directly affects net cash flow because it is spent in the current year instead of being passed through to the owners (as NCF).

ASSUMPTIONS

1. Assume the discount rate is 16% (based on comparables collected from Ibbotson’s database and other adjustments for risk).

2. Assume that the perpetual growth rate of net cash flow is 3.5% for the terminal year and beyond (the terminal year is the fourth year out from the current year, and it represents every year thereafter, adjusted for the perpetual growth rate).

3. Assume CAPEX is constant over the relevant time periods because the company is consistently and constantly investing in its future.

4. Assume D&A will continue to be $25,000 per year, given that the equipment and capital expenditures are being used to obtain fixed assets that are depreciable.

INCOME APPROACH (worth 45 points)

1. Forecast. Use the Discounted Cash Flow Analysis spreadsheet provided by your instructor and forecast revenues and expenses for Current Year + 1 (CY+1), CY+2, CY+3, and Terminal Year. For this case study, use only the previous years’ revenues and expenses as a guide. (Normally, you would also use other information about the economy, the industry, the company, and so forth). Come up with your own reasonable forecast.

2. Net income. Calculate the net income for CY+1, CY+2, CY+3, and terminal year.

3. Net cash flow. Calculate the net cash flow for CY+1, CY+2, CY+3, and terminal year.

a. As described on p. 277–279 and illustrated in Exhibit 10.9, calculate NCF from net income.

b. Start with net income and add back depreciation and amortization to find gross cash flow.

c. Subtract CAPEX from gross cash flow.

d. Subtract any increase (or add any decrease) in net working capital. To calculate changes in NWC, subtract current liabilities from current assets (not including inventory, since, even though inventory is technically a current asset, a manager would not want to rely on inventory to pay workers). Make a reasonable assumption for changes in NWC for future years.

e. The result is net cash flow.

4. Net present value.

a. Calculate the NPV of Duke’s. Determine the discount period for each year (CY and going forward).

b. Determine the discount factor for each year, including the terminal year.

c. Enter the discount rate and perpetual growth rate in the spreadsheet.

d. Calculate the terminal value.

e. Calculate the present value of the NCF for each year, including the terminal year.

f. Add up each year’s present value to find the net present value of the entire business, based on cash flow.

MARKET APPROACH

After an exhaustive search, three businesses that appear to be comparable to Duke’s are found. The Market Approach spreadsheet gives basic financial information about the businesses and recent transactions involving them and provides space for the calculations. The comparable businesses are the following:

1. Charlie’s Sporting Goods. Charlie’s is located in a neighboring town and has a similar clientele to Duke’s. It has been in operation for seven years and over the past three years has generated steady revenues and net income. The current majority owner, Bill, purchased Charlie’s from the founder two years ago for $1.5 million. He sold a small piece of it recently for $60,000. Mary’s Sporting Goods.

2. Mary’s is located a few towns away and has existed for over a decade. It specializes in women’s and girls’ sporting goods and draws from a larger market area than Duke’s. Mary’s offers free training on its equipment, which adds to its expenses, but Sally (the current owner) feels that this policy grows its customer base and leads to more sales. Sally, who is quite risk averse (like Mary), purchased the business outright in the current year.

3. Jamie’s Sporting Goods. Jamie’s is a three-store chain located on the north and south sides of the nearest large city. It has been operating for over two decades. It recently added its third store and financed this expansion with a loan from a local bank. It is paying substantial interest on that loan. While it produces a high net income, it is also more leveraged than Mary’s or Charlie’s. Jamie, the current majority owner, sold 8% of the business for $500,000 in the current year.

a. Ratio calculations. Calculate the relevant ratios for the comparables.

b. Valuation of subject company based on comparables. Use the market approach to determine a financial value for Duke’s.

c. Adjustments. Adjust the financial value of Duke’s for a controlling interest premium and marketability discount, if needed.

LIQUIDATION VALUE

What is the liquidation value (as opposed to the fair market value) of Duke’s? Look at the present value of all assets that could be liquidated and account for all debts (at their present value). Determine the sum of those values. In other words, if the company were to be liquidated, how much cash would be left over?

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