Question #51

The two-stage FCFE model is suitable for valuing firms in industries with significant barriers to entry. Where these are present it is possible for the firm to maintain a high growth rate during an initial phase of low competition, and that the rate will drop sharply to a normalized rate when competition ultimately appears. (Module 21.5, LOS 21.j) William Bolton is an avid disc golf player and the owner of Deep in the Game Discs (DITGD), a business involved in wholesale distribution of discs and other disc golf equipment. DITGD supplies smaller outlets within the U.S. market and exports overseas. Will has built his business organically over a 20-year period, starting as a hobby but developing into a mid-sized business. Will has recently lost some UK export customers to a smaller UK located competitor called Fishy Discs Ltd. Will recently met Neil Prebble, the owner of Fishy Discs at a trade fair and was considering a friendly acquisition in order to expand his business into the UK market. Will has employed an accountancy firm with a corporate finance division, to give him some indication of a price to offer for Fishy Discs. Exhibit 1: Fishy Discs—Selected Financial Information Income Statement Period Ended 31st December 20x9 £ £ Sales revenue 200,000 Expenses: Cost of goods sold 80,000 Salaries 10,000 Depreciation 14,000 Interest 1,000 105,000 95,000 Gain from sale of PP&E 20,000 Pre-tax income 115,000 Provision for taxes 40,000 Net income 75,000 Balance Sheet Year Ended 20x9 20x8 20x9 £ £ Current Assets Cash 18,000 66,000 Accounts receivable 18,000 20,000 Inventory 14,000 10,000 Non-Current Assets Gross PP&E 282,000 312,000 Accumulated depreciation (80,000) (84,000) Total Assets 252,000 324,000 Current Liabilities Accounts payable 10,000 18,000 Salaries payable 16,000 9,000 Interest payable 6,000 7,000 Taxes payable 8,000 10,000 Dividends payable 2,000 12,000 Non-Current Liabilities Long term debt 20,000 30,000 Deferred tax 30,000 40,000 Stockholders' Equity Contributed capital 100,000 80,000 Retained earnings 60,000 118,000 Liabilities and Equity 252,000 324,000 On review of the PP&E footnote disclosure, it is discovered that equipment with a carrying value of £10,000 had been disposed of during 20x9. All long-term debt is issued with a coupon such that the debt will trade at par value on issuance. The effective tax rate relating to Fishy Discs is 40%. Deferred tax liabilities are not expected to reverse for the foreseeable future. The corporate finance firm employed by Will has decided to value Fishy Discs based on sustainable free cash flow, after removing one off items from the cash flow statement. In addition, they have considered how long Fishy Discs will be able to maintain its cash flow growth rates. Fishy Discs currently is the only domestically located UK supplier of disc golf equipment. Their results are included in Exhibit 2. Exhibit 2: Fishy Discs Ltd. Valuation Data Free cash flow to the firm £75,000 (base period estimate) High growth rate 12% Sustainable growth rate 4% Duration of high growth 4 years Declining growth duration 6 years Cost of equity 10% WACC 8% The corporate finance team believes the market value of Fishy Discs debt is close to book value in the 20x9 accounts. The team believes that the decline in growth from 12% down to 4% will be linear. Tony Cermak is a young modeler in the corporate finance team and he has raised a couple of comments regarding the valuation figures prepared for Fishy Discs. Concern 1: Fishy Discs reduced its inventory between 20x8 and 20x9. This lead to a boost of £4,000 in cash flows in 20x9. Given inventory, levels cannot decline below zero and we are forecasting Fishy Discs to grow, any boost to cash flow from inventory reduction is likely to be transitory and should be removed from sustainable cash flow. Concern 2: Fishy Discs current high growth rates are linked to an exclusivity agreement that Prebble has with a U.S. disc producer. This agreement gives Fishy Discs sole supplier status for the global number one selling brand in the UK for a four-year period. At the end of this period, the U.S. supplier has indicated that other firms will be allowed to import and retail these products in the UK market. Given this, I believe our growth rate assumptions detailed in Exhibit 2 are unrealistic. Tony has been given the firms free cash flow valuation model guide to study before he attempts to value Fishy Discs. In particular, he is interested in the following formulas that have been given: Exhibit 3: Cash Flow Valuation Guide Extract FCFF from EBIT: FCFF = EBIT(1 – T) + depreciation – FCINV – WCINV FCFF from EBITDA: FCFF = EBITDA(1 – T) + depreciation – FCINV – WCINV