FInance help

You are a financial analyst at GodivaSisters, a major investment banking firm. Your supervisor has just handed you a difficult assignment. You must review the work of an intern, who after given the pro forma income statement and pro forma balance sheet was asked to prepare a valuation. This intern is known to make at least 10 mistakes on each valuation attempted. Your boss wants you to identify those specific errors, suggest how they should have been done but do NOT calculate the correction, nor challenge the assumptions underlying the pro forma statements.

 

Jakarta Partners is interested in buying South African Pharmaceuticals (SAP), a private firm. They have asked GodivaSisters to conduct a valuation of South African Pharmaceuticals. South African Pharmaceuticals has enjoyed medium but not  consistent growth.

 

GodivaSisters believes a tax rate of 25% would be appropriate. It is the firm's policy to use a 6 times EBITDA multiple in calculating terminal value for FCF. The terminal value of tax savings is calculated using a 6 times multiple method. A 10% liquidity discount is applied to acquisitions of private firms. Long term growth after the initial five year period is assumed to mirror economic growth at 5%. Currently, South African Pharmaceuticals pays a 7% interest rate on its debt. South African Pharmaceuticals does not pay a dividend. Econometric studies suggest the current risk free rate is 2%, while the market risk premium is 6%. Because this will be financed using debt, GodivaSisters management has indicated to the intern to assume a 300% debt-to-equity ratio, although the actual ratio will vary.

 

Scoring: Correctly identifying error ½ credit, proper correction ½ credit (remember you do not calculate the correction), misidentifying error – ½ credit. Note that rounding is NOT an error. Each correctly identified error including the correction (no calculation) is worth 4.5 points up to a total of 45 points.

 

Exhibit 1: Pro Forma Income Statement

	Yr 1	Yr 2	Yr 3	Yr 4	Yr 5
Gross Sales	44.3	47.9	52.8	56.4	60.8
Cost of Sales	14.3	15.5	20.1	21.4	23.1
Gross Profit	30.0	32.4	32.7	35.0	37.7
SGA (Incl.R&D)	14.4	14.8	15.6	16.3	17.1
Depr	3.5	3.5	4.0	4.3	4.7
Operating Income	12.1	14.1	13.1	14.4	15.9
Interest expense	2.4	2.4	2.4	2.4	2.4
Taxes	2.4	2.9	2.7	3.0	3.4
Net Income	7.3	8.8	8.8	9.0	10.1

 

Exhibit 2: Pro Forma Balance Sheet (Millions)

	0	1	2	3	4	5
Cash	10.0	20.8	33.1	45.1	58.4	73.2
NWC	25.1	21.6	13.6	5.6	-2.4	-10.4
PPE	30.0	35.0	39.5	43.5	47.2	50.5
Debt	58.0	58.0	58.0	58.0	58.0	58.0
Equity	12.1	19.4	28.2	36.2	45.2	55.3

 

Exhibit 3: Information from Comparable Companies & Beta Calculations

	Sales (millions)	Tax Rate	D/E	Levered Beta	Unlevered Beta Calculated
Galaxy Drugs	300	0.300	.40	1.7	2.2
Smith-Jones	150	0.250	.30	1.4	1.7
Boleche	200	0.350	.45	1.3	1.7
Nu-Boda	400	0.300	.20	0.9	1.0
Average		0.300			1.65

Exhibit 4: Cost of Equity Calculation

2% +1.65 * 6% = 11.9%

Exhibit 5: Debt

                Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Beg Debt   58    58    58    58    58 Payments    End Debt   58    58    58    58    58

Exhibit 6: Subsidiary Schedules

		1	2	3	4	5
Depreciation Calculation
EBITDA		16	18	17	18	21
-EBIT		12	14	13	14	16
Depreciation		4	4	4	4	5
Cap Ex Calculation
Beg Net PPE		30	35	40	44	47
End Net PPE		35	40	44	47	51
Depreciation		4	4	4	4	5
CapEx		5	5	4	4	3
FCF/DCF Calculation
EBIT		12.1	14.1	13.1	14.4	15.9
-Depr		3.5	3.5	4.0	4.3	4.7
-Tax		3.6	4.2	3.9	4.3	4.8
+CapEx		5.0	4.5	4.0	3.7	3.3
+Chg NWC		-3.5	-8.0	-8.0	-8.0	-8.0
FCF		6.5	2.9	1.2	1.5	1.7
Terminal Value
DIscount Factor		.894	.775	.656	.537	.418
DCF	10.3	5.8	2.2	.8	.8	.7
Tax Shield Cash Flow Calculation
Interest Expense		2.4	2.4	2.4	2.4	2.4
Interest Tax Shield		.6	.6	.6	.6	.6
TV
Present Value Factor		.953	.873	.816	.763	.713
PV (Tax Shield)	2.5
Enterprise Value	12.8
Cash	10.0
Equity Value	22.8