Question #4

If capital expenditures estimates are significantly higher than depreciation for the stable growth period, then the three-stage FCFE model might result in an extremely low value. One possible solution for the problem is to grow the capital expenditures more slowly than deprecation in the transition period to narrow the difference. Another is to assume that capital expenditures and depreciation will offset when growth normalizes. (Module 21.1, LOS 21.a) Burcar-Eckhardt, a firm specializing in value investments, has been approached by the management of Overhaul Trucking, Inc., to explore the possibility of taking the firm private via a management buyout. Overhaul's stock has stumbled recently, in large part due to a sudden increase in oil prices. Management considers this an opportune time to take the company private. Burcar would be a minority investor in a group of friendly buyers. Jaimie Carson, CFA, is a private equity portfolio manager with Burcar. He has been asked by Thelma Eckhardt, CFA, one of the firm's founding partners, to take a look at Overhaul and come up with a strategy for valuing the firm. After analyzing Overhaul's financial statements as of the most recent fiscal year-end (presented below), he determines that a valuation using Free Cash Flow to Equity (FCFE) is most appropriate. He also notes that there were no sales of PPE. Overhaul Trucking, Inc. Income Statement April 30, 2005 (Millions of dollars) 2005 2006E Sales 300.0 320.0 Gross Profit 200.0 190.0 SG&A 50.0 50.0 Depreciation 70.0 80.0 EBIT 80.0 60.0 Interest Expense 30.0 34.0 Taxes (at 35 percent) 17.5 9.1 Net Income 32.5 16.9 Overhaul Trucking, Inc. Balance Sheet April 30, 2005 (Millions of dollars) 2005 2006E Cash 10.0 15.0 Accounts Receivable 50.0 55.0 Gross Property, Plant & Equip. 400.0 480.0 Accumulated Depreciation (160.0) (240.0) Total Assets 300.0 310.0 Accounts Payable 50.0 70.0 Long-Term Debt 140.0 113.1 Common Stock 80.0 80.0 Retained Earnings 30.0 46.9 Total Liabilities & Equity 300.0 310.0 Eckhardt agrees with Carson's choice of valuation method, but her concern is Overhaul's debt ratio. Considerably higher than the industry average, Eckhardt worries that the firm's heavy leverage poses a risk to equity investors. Overhaul Trucking uses a weighted average cost of capital of 12% for capital budgeting, and Eckhardt wonders if that's realistic.