Arcadian Microarray Technologies, Inc: The Power of Terminal Value

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Akua Acheampong
Jody Grewal
Kieng Iv
Rhea Rasquinha
 Background
and Current Issues
 Terminal Value
 Estimators of Terminal Value
 Forecast Horizon
 Quantitative Analysis
 Recommendations
 Arcadian:
• Gene diagnostics industry
 Investment
Opportunity:
• Original Offer: 60% equity interest in Arcadian
for $40M
 Value
of the Investment:
• Determined through estimating terminal value
 It
is the lump sum of cash flows at the end of a
stream of cash flows, which represent:
• The proceeds from exiting an investment;
• The present value of all cash flows beyond the
forecast horizon
 Terminal
values are important because:
• They are present in the valuation of almost every
asset
• They measure the “continuing value” derived from
the going concern of the business.
Importance of Terminal Value
Terminal
Value
Liquidation
Assumption
Liquidation
value
Going Concern
Assumption
Market
Multiples
Constant
growth
Approach
Advantages
Disadvantages
When to use approach
Book value
Simple
•Ignores some assets and liabilities
•Historical cost: backward looking
•Subject to accounting manipulation
Appropriate when the
minimum value of a
company needs to be
determined.
Replacement
Value
Current
•Subjective estimates
•Value may be difficult to come by
Appropriate when a
company is deciding
whether to buy another
company or build a new
one from scratch.
Liquidation
Value
Conservative
•Ignores going concern value
•Uncertainty about value of assets in the
market
Appropriate when assets
are marketable
Multiples
•Simple
•Widely used
•“Earnings” subject to accounting
manipulation
•“Snapshot” estimate: may ignore cyclical,
secular changes
•Provides relative value, not absolute value
The approach is used as a
business valuation
benchmark
Constant
Growth
Method
•Reflects the
time value of
money
•Errors in growth rate and/or discount rate
can provide improper value
•Easy to abuse or misuse
•Requires estimate on when firm will grow at
stable rate
Appropriate when cash
flows are strong and
relatively consistent
Going Concern Timeline
Forecast Horizon
Cash Flows beyond the
Forecast Horizon
Terminal Value
As far into the
future as CFs can
be forecasted
•
PV of future cash
flows beyond the
forecast horizon
KEY: When Stable Growth Begins…
• Set the forecast horizon
• Stop Forecasting Cash Flows
• Estimate a Terminal Value
Importance: All future cash flows,
not only the ones that you can
forecast, determine value
Projected Cash Flows by Investment
$350
$300
$250
Movie
Studio
Bottling
Plant
Toll Road
$Millions
$200
$150
$100
$50
$0
($50)
1
3
5
7
($100)
9 11 13 15 17 19 21 23 25 27 29
Year
($150)
Stable growth of 2%
begins in year 3:
-Operational capacity
reached
-Estimate TV at yr 3
Stable growth of 2%
begins in year 12:
-Plant reaches capacity
-Estimate TV at yr 12
Stable growth of 2%
begins in year 27:
-Production capacity
reached
-Estimate TV at yr 27
Arcadian Growth Rate vs. Cash Flows
Very unstable
growth
500
200
Growth Rate
Cash Flow
Forecast
300
150
Resembles
Bottling Plant
100
200
50
100
0
-50
0
1
2
3
4
5
6
7
8
9
10
11
12
-100
-100
Year
Cash Flows ($M USD)
Growth Rate
400

Limitations:
• Forecasts for 10 and 11 years, but neither attains stable growth
• Ideally, we should continue forecasting until stable growth begins
 Difficult due to the company being in its early stages

When should TV be estimated?
At end of 2013?
 Cash flow growth is volatile after 2013
At end of the Forecasted Cash Flow period?
 Cash Flow growth has declined and will further decline until 5% is
reached
It is reasonable to assume that growth will fall to 5% by
2016 given the pattern of decline since 2013
Use the End of the Forecasting Period to Estimate TV
Best Options:
1. Price/Earnings Ratio
2. Price/Book Value Ratio
3. Constant Growth Rate
Assumptions:
1. WACC – 20%
2. At end of forecast horizon Arcadian is a
mature company
Arcadian
P/E
2014 Net Income
Terminal Value
PV Terminal Value
PV 05-14 CF
PV
60% Ownership
Sierra
15
203
3,045
492
(151)
341
204
20
$ 203
$ 4,060
$ 656
$ (151)
$ 505
$ 303
Terminal Value Explanation
PE
15
Arcadian
144%
20
130%
$
$
$
$
$
$
P/E
2015 Net Income
Terminal Value
PV Terminal Value
PV 05-15 CF
PV
60% Ownership
PE
Sierra
$
$
$
$
$
$
15
162
2,430
327
(118)
209
125
15
157%
$
$
$
$
$
$
20
162
3,240
436
(118)
318
191
20
137%
Arcadian
Price to Book Ratio
BV of Equity
Terminal Value
PV Terminal Value
PV 05-14 CF
PV
60% Ownership
8.5
$672
$5,708
$922
($151)
$771
$462
Terminal Value Explanation
Arcadian
120%
Sierra
Price to Book Ratio
BV of Equity
Terminal Value
PV Terminal Value
PV 05-15 CF
PV
60% Ownership
Sierra
8.5
$199
$1,691
$228
($118)
$109
$66
208%
Options:
1. Real growth rate in the economy = 3%
2. Real growth rate in the Pharmaceutical Industry = 5%
3. USA Population growth = 1%
FisherEquation
g

No min al
 (1  g

Re al
) x(1  g
Inflation=2%

Inflation
) 1
Nominal Rates
1. Nominal growth rate in the economy ~ 5%
2. Nominal growth rate in the Pharmaceutical Industry ~ 7%
3. USA Population growth = 1%
Best Rate: Nominal growth rate in the economy ~ 5%
Arcadian's View
Annual growth rate to infinity
Weighted average cost of capital
Adjusted free cash flow 2015
Terminal value 2014
PV of terminal value 2014
PV free cash flows 2005-2014
Total Present Value
60% Ownership
Terminal Value Explanation
2%
20%
202
1,142
185
($151)
$33
$20
554%
3%
20%
194
1,173
189
($151)
$38
$23
High
495%
4%
20%
185
1,200
194
($151)
$43
$26
Range
455%
5%
20%
180
1,257
203
($151)
$52
$31
392%
6%
20%
174
1,314
212
($151)
$61
$37
347%
7%
20%
165
1,355
219
($151)
$68
$41
324%
Sierra Capital's View
Annual growth rate to infinity
Weighted average cost of capital
Adjusted free cash flow 2016
Terminal value 2015
PV of terminal value 2015
PV free cash flows 2005-2015
Total Present Value
60% Ownership
Terminal Value Explanation
2%
20%
185
1,049
141
($118)
$23
$14
619%
3%
4%
20%
20%
177
168
1,073
1,093
144
147
($118)
($118)
$26
$29
Low
$16 Range
$17
555%
513%
5%
20%
163
1,142
154
($118)
$35
$21
436%
6%
20%
157
1,189
160
($118)
$42
$25
384%
7%
20%
148
1,219
164
($118)
$46
$27
359%
Arcadian Sierra
Difference
Applicable
Price/Earnings Ratio
Low End: 15
204
125
79
No
High End: 20
303
191
112
No
Price/Book Ratio
462
66
396
No
Constant Growth
Rate
31
21
10
Yes
Constant Growth Rate
Arcadian Sierra
Difference
122
30
92

Option on Future Opportunities

Further financing needed
• 40M barely covers 2005 projected cash deficit
• Debt financing
 High debt financing costs: low current earnings -> low interest coverage,
low operating income margin -> high cost of debt
 Impact on WAcc

IPO/Early Exit
• Distribute shares to clients tax-free
• Compare with
 Affymetrix (P/E 50.09, P/B 8.56,P/FCF 97.5, P/SALES 7.49)
 Illumina (PB 8.46, P/SALES 8.82)

Current Average Investment weighting: $31.25M
Counteroffer: $21M
Abandonment Point: $31M
Management Bonus
 If management hits forecast in years
2013-2014, 5% incentive $2M present
value
2013
2014
Arcadian's Forecast
Sierra'sForecast
Difference
5%
PV
$134
$28
$106
$5
$2
$231
$98
$132
$7
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