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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