F&C International
Outline Answers
The following are the outline answers/solutions to the questions set in the case
study:
1. Over the period 1987-1991 F&C's revenues have increased at a compound annual rate
of about 50% (inclusive of the effect of the acquisition of Felton assets in May 1990).
Beyond 1991, F&C management expected revenue growth to stabilize but was
confident that such growth would exceed 20 percent per year. In addition, with
improvements in operating margins, management was confident that earnings growth
would exceed forecasted sales growth rates. Exhibit 5 of the case provides Value Line
forecasts of sales and net earnings growth rates for the period 1988-90 to 1995-97 for
F&C's peers. The average future annual growth rates forecasted for sales and net
earnings are, respectively, 9.13 percent and 16.13 percent. Additionally , Predicasts
forecasts (given in case, page 118) for sales growth rates over the period 1990-2000 of
the market segments served by F&C's products are as follows: beverages 6%,
cosmetics and toiletries 8.7%, and food products, 6.1 %. If F&C's revenue growth is
to significantly exceed peer and industry growth, F&C must be expected to
significantly increase its market share relative to its peers.
2. There are two different valuation approaches in the context of valuing shares in an
initial public offering (IPO). These are the DCF approach and the comparable firms approach.
The following information was also provided:
The target long-term debt to equity ratio is approximately 25%
The corporate tax rate is 35% and the t-bill rate is 4%
The average market premium is 8.2%
The pre-tax cost of debt for F&C is 8%
The net cash flow of F&C will grow at 6% per year beyond 1997
F&C’s post-IPO book value of equity is expected to be $26 million
Cash Flow Forecasts for F & C International:
1
Cash Flow Forecasts
1992
1993
1994
1995
1996
1997& beyond
EBIT (1-t)
Incremental Working Capital, ∆ I
Net Capital Expenditures, ∆ I
Net Cash Flow
5.0
3.6
1.4
0.0
7.0
4.2
2.0
0.8
9.1
4.4
2.6
2.1
11.0
3.8
3.1
4.1
12.6
3.5
3.5
5.6
NA
NA
NA
5.9
Once we have the forecasted earnings, the next issue in the valuation process is that of
obtaining an estimate of the weighted average cost of capital (WACC). In theory,
using a WACC based on existing (market value based weights) assumes that both
operating and financial risk do not change; in most IPOs (including F&C) at least
some part of the net proceeds are used to repay existing debt so as to change the
existing capital structure. Hence, determining the WACC is problematic at best; in
addition, a market value for the firm may be difficult to determine since the new
WACC itself requires market value based weights. We undertake a DCF valuation
based on book value weights. Post-IPO, F&C's long-term debt (including capital lease
obligations) is estimated at $6.0 million from its level of $17 million pre-IPO (see
exhibits 1 and 2). For F&C the target long-term debt to equity ratio is given as
approximately 25%. First we need to calculate the levered beta of F&C. Exhibit 6
gives the levered betas of peer companies. Using their average is not a good idea since
the peer firms have D/E ratios quite different from that of F&C. So first we calculate
the unlevered betas of peer firms using the following Hamada equation.
β Levered = β Unlevered [1 + (1 − t ) D / E ]
As an example we take McCormick & Company.
D/E = (Long term debt) / (Share price x No. of shares)
= 207,144,000 / 41.25 x 40,100,000 = 0.125 = 12.5%
Plugging this value in the Hamada equation and putting t = 35%, the unlevered beta
for McCormick is 0.83. Similarly calculate the unlevered beta for the other three
companies (remember D/E for International flavour is zero). The average unlevered
beta for the peer group is 0.99 which we assume is equivalent to 1.
2
Assuming the unlevered beta of F&C is 1 (average of the peer firms), its levered
beta can be calculated as 1.16 (using the Hamada equation). With T-bill rate given
as 4% and market risk premium given as 8.2%, the return on equity can be
calculated using the CAPM
Re = 4% + 1.16(8.2%) = 13.5%
We know D/E = 0.25
Since V= D+E
V/E = D/E +E/E
Therefore V/E = 5/4 or E/V = 4/5
Hence D/V = 20% and E/V= 80%
The pre-tax cost of debt is already given as 8%, therefore
WACC of F&C = 0.135(0.80) + 0.08(0.65)(0.20) = 11.84%
Now we calculate the terminal value of F&C using the following equation
Vn =
=
last projected NCF × (1 + expected NCF growth rate)
WACC - NCF growth rate
$5.9m(1.06)
0.1184 − 0.06
= £107.09m at the end of 1997
Discounting the Net cash flows given in the table above and adding the discounted
terminal value of F&C, the total firm value as of the year end 1991 is estimated as
$62.68m. So post-IPO, the value of outstanding equity = 57.08m (62.68m less the
book value of long term debt which is 5.6m). The total number of shares
outstanding after the offering is given as 6.73m (page 4 of the IPO prospectus), so
The value per share = 57.08 / 6.73 = $8.48
3
In the comparable firms approach the F&C equity is valued based on comparisons
with peer companies applying an average peer MB equity multiple or an average
peer PE multiple to F&C’s post IPO book equity or net earnings.
Using M/B multiples
Exhibit 6 provides us with information which allows us to calculate M/B equity
ratios of the peer group companies. For example, for International Flavour the
M/B = No. of shares x share price / Book value of equity
= 38,200,000 x 88.875 / 990,000,000
= 3.43
We do similar calculations for the remaining 3 peers. The average M/B equity for
the peers = 3.12 with the range from 2.60 (Universal foods) to 3.99 (Crompton &
Knowles).
Using P/E multiples
Exhibit 6 provides us with information which allows us to calculate P/E ratios of the
peer group companies. For example, for International Flavour the
P/E = 88.875 / (170,000,000/38,200,000) = 19.97
We do similar calculations for the remaining 3 peers. The average P/E ratio for the
peers = 20.53 with the range from 16.78 (Universal foods) to 24.15 (Crompton &
Knowles).
Peer companies
M/B multiple
P/E multiple
Average
3.12
20.53
Range
2.6 to 3.99
16.78 to 24.15
Since F&C’s post-IPO book value of equity is given as $26 million, its range of
equity value will be from 2.6x26m = 67.6m to 3.99x26m = 103.74m. Since there are
4
6.73m shares outstanding after the IPO, the range of price per share for F&C is from
67.6 / 6.73 =$ 10.04 to 103.74 / 6.73 = $15.41
M/B multiple
Range of total equity values
$67.6 million to $103.74million
Range of price per share
$10.04 to $15.41
The EBIT (1-t) for 1992 is given as $5million. Since t (corporate tax rate) is 35%
EBIT = $5m/(1-0.35) = $7.7million
The outstanding long-term post-IPO debt = $5.6m. Since the interest rate on this
debt is 8% and the corporate tax rate is 35%. The net earnings of F&C will be
($7.7m – ($5.6m*0.08))*(1-0.35) = $4.71million
Using this information we have the following values for F&C
Using the lowest P/E of the peer (16.78), the total equity value of F&C = 16.78 x
$4.71m = $79.03million. If we divide this by the total number of outstanding shares
post-IPO, the price per share = $79.03/6.73 = $11.74
P/E multiple
Range of total equity values
$79.03 million to $113.75million
Range of price per share
$11.74 to $16.90
IMPORTANT: How will the above calculations change if we used the
forecasted P/E for the peers as given in exhibit 3?
The real offer price was $13.50 which is quite close to the one obtained from the
comparable firms approach. The price obtained using the DCF approach is much
lower as compared to the actual offer price
3. This question brings out the pros and cons of going public. Managers’ usually bring
firms to IPO after a good run on the ‘growth’ pattern (there is some evidence of
5
window dressing though). The management’s decision to go public finds support from
the information provided in answer 1. The prospectus of any IPO contains detailed
information about the motives of the issues and how the funds raised would be used.
In F&C’s case the funds were to be used for a number of reasons (exhibit 1).
6