# Solution financial 9

The SoftTec Products Company is a successful, small, rapidly growing, closely held corporation. The equity owners are considering selling the firm to an outside buyer and want to estimate the value of the firm. Following is last year’s income statement (2010) and projected income statements for the next four years (2011–2014). Sales are expected to grow at an annual 7 percent rate beginning in 2015 and continuing thereafter.

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Selected balance sheet accounts at the end of 2010 were as follows. Net fixed assets were $50,000. The sum of the required cash, accounts receivable, and inventories accounts was $50,000. Accounts payable and accruals totaled $25,000. Each of these balance sheet accounts was expected to grow with sales over time. No changes in interest-bearing debt were projected, and there were no plans to issue additional shares of common stock.

There are currently 10,000 shares of common stock outstanding. Data have been gathered for a comparable publicly traded firm in the same industry that Soft-Tec operates in. The cost of common equity for this other firm, Wakefield Products, was estimated to be 25 percent. SoftTec has survived for a period of years. Management is not currently contemplating a major financial structure change and believes a single discount rate is appropriate for discounting all cash flows. A. Project SoftTec’s income statement for 2015.

B. Determine the annual increases in required net working capital and capital expenditures (CAPEX) for SoftTec for the years 2011 to 2015. C. Project annual operating free cash flows for the years 2011 to 2015. D. Estimate SoftTec’s terminal value cash flow at the end of 2014. E. Estimate SoftTec’s equity value in dollars and per share at the end of 2010. F. SoftTec’s management was wondering what the firm’s equity value (dollar amount and on a per-share basis) would be if the cost of equity capital were only 20 percent. Recalculate the firm’s value using this lower discount rate. G. Now assume that the $35,000 in long-term debt (and therefore interest expense at 10 percent) is expected to grow with sales. Recalculate the equity using the original 25 percent discount rate.

SOLUTION:

(a)See the spreadsheet base case results below. Net sales grow to $374.5 thousands in 2015. This amount is 7% greater than the 2014 level. Net income increases to $54.1 thousands in 2015.

(b)Annual increases in required NWC and in CAPEX are shown below in the spreadsheet base case output.

(c)The annual operating free cash flow to equity is calculated as: net income + depreciation – CAPEX – increases in required NWC + increases in interest-bearing debt. Note: No changes in interest-bearing debt were projected and there were no plans to issue additional shares of common stock. Annual operating free cash flows are shown below in the spreadsheet base case output.

(d)The terminal cash flow is estimated to be $232.4 thousands (rounded). This is estimated by dividing $41.8 thousands (rounded) by .18 (.25 – .07). See the spreadsheet base case output below.

(e)The terminal cash flow is estimated to be $232.4 thousands (rounded). This is estimated by dividing $41.8 thousands (rounded) by .18 (.25 – .07). See the spreadsheet base case output below.

(f)By changing the discount rate from 25% to 20%, to calculate the terminal value cash flows and the present value of the total free cash flows, results in a 2010 present value of $187.4 thousands and a value per share of $18.74. See the last section (Part F) of spreadsheet base case output shown below for these calculations.

(g)See the spreadsheet revised case results (Part G) shown below. One difference between this solution and the base case results solution is the increasing interest expense on the income statement causes the net income to decline. However, this decline in net income is more than offset by the free cash flows contributed by the issuing of more long-term debt. The result is a higher terminal value cash flow as well as higher operating free cash flows. Discounting these cash flows at 25% produces an equity value of $153.4 thousands and a value per share of $15.34.