Transcript Real Options

Valuing Business
Methods of valuation
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DCF valuation (e.g. using WACC)
Relative valuation (comparables)
Cost-based valuation
Ideko Corporation
Line of business: designing and manufacturing sports
eyewear
Estimated 2006 Income Statement and Balance Sheet:
Sales = 75,000
EBITDA = 16,250
Net Income = 6,939
Debt = 4,500
You want to acquire this company at a price of $150 mln.
Is it a fair price?
At this price:
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P/E = 21.6
EV = E + D – cash. Assume you estimate that Ideko holds $6.5
mln in cash in excess of its working capital needs (i.e. invested
at a market rate of return)
EV = 150 + 4.5 – 6.5 = $148 mln
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EV/Sales = 2
EV/EBITDA = 9.1
Ideko Financial Ratios Comparison
150 looks like a reasonable price
Valuing Ideko using DCF
So, assume you are buying it for 150 mln.
What’s the NPV of this transaction? (how much
will you gain)
Multiples give a rough idea. After you acquire
the firm you will change it. Hence, you need to
forecast future (after acquisition) FCF and use
DCF techniques
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Business plan
Financial model (to forecast FCF and terminal value)
Estimating cost of capital
Valuation using DCF
Estimated 2005 Income Statement and Balance
Sheet Data for Ideko Corporation (Spreadsheet)
The Business Plan
Expected market growth: 5% per year
Cut administrative expenses and increase
expenditures on product development, sales and
marketing  expected raise in the firm’s market
share from 10% to 15% over 5 years
Once cumulative sales growth reaches 50%
expansion needed
Inflation 
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Selling price will rise at 2% per year
Raw materials price will rise at 1% per year
Labor costs will rise at 4% per year (inflation +
additional overtime)
Ideko Sales and Operating Cost Assumptions
Capital expenditure assumptions
Capital structure changes: levering up
Planned debt and interest payments (after
2010 all is repaid)
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Indeko is underleveraged (book value of debt =
4,500 while total assets = 86,822)
Hence, plan to increase debt: 100 mln now (put in
our pocket) and some more in 2008 and 2009,
interest rate = 6.8%
Sources and uses of funds
You buy the company for 150 mln, get an excess
cash of 6.5 mln and repay the debt of 4.5 mln.
Hence, essentially you spend 148… + 5 mln in
fees = 153 mln
But you raise 100 mln in debt – this allows you
to pay essentially only 53 mln for the company
Building the financial model
Forecasting earnings
Working capital forecast (for details
see BD, ch. 19)
Forecasting free cash flow
Estimating the cost of capital
Estimating beta
We have to unlever betas first:
Let our unlevered beta = 1.20 (based on
comparables)
Let market risk premium = 5%
Hence, rU = rf + βU(E[Rmkt] – rf) = 4% + 1.20*5% =
10%
Valuing the investment
First, we need to estimate continuation value in
year 2010.
Multiples approach (but DCF can also be used):
Now we can value Ideko. Let’s use APV
VLt = VUt + Tt
So, we obtain Equity Value = 113 mln
We have spent only 53 mln
Hence, NPV = 113 mln – 53 mln = $60 mln – good deal!
Our estimate of EV based on comparables, $148mln, was
an underestimation (now we obtain $213 mln)
Why? Because previously we did not take into account the
changes that we are going to implement in the firm