Exam 10: Analysis and Valuation

Family owned businesses account for about 89% of all businesses in the U.S.

Why are family owned firms often attractive to private equity investors?

Private businesses may need to be valued to settle shareholder disputes, court cases, divorce, or the payment of gift or estate taxes.

Because of the need to satisfy both the demands of stockholders and regulatory agencies, public companies need to balance the desire to minimize taxes with the goal of achieving quarterly earnings levels consistent with investor expectations. Failure to do so frequently results in an immediate loss in the firm's market value.

All family owned businesses are small.

Cantel Medical Acquires Crosstex International On August 3, 2005, Cantel Medical Corporation (Cantel), as part of its strategic plan to expand its infection prevention and control business, announced that it had completed the acquisition of Crosstex International Incorporated (Crosstex). Cantel is a leading provider of infection prevention and control products. Crosstex is a privately owned manufacturer and reseller of single-use infection control products used primarily in the dental market. As a consequence of the transaction, Crosstex became a wholly owned subsidiary of Cantel, a publicly traded firm. For the fiscal year ended April 30, 2005, Crosstex reported revenues of approximately $47.4 million and pretax income of $6.3 million. The purchase price, which is subject to adjustment for the net asset value at July 31, 2005, was $74.2 million, comprising $67.4 million in cash and 384,821 shares of Cantel stock (valued at $6.8 million). Furthermore, Crosstex shareholders could earn another $12 million payable over three years based on future operating income. Each of the three principal executives of Crosstex entered into a three-year employment agreement. James P. Reilly, president and CEO of Cantel, stated, "We continue to pursue our strategy of acquiring branded niche leaders and expanding in the burgeoning area of infection prevention and control. Crosstex has a reputation for quality branded products and seasoned management." Richard Allen Orofino, Crosstex's president, noted, "We have built Crosstex over the past 50 years as a family business and we continue growing with our proven formula for success. However, with so many opportunities in our sights, we believe Cantel is the perfect partner to aid us in accelerating our growth plans." -What factors might cause Crosstex's net asset value to change between signing and closing of the agreement of purchase and sale?

A pure control premium is the value the acquirer believes can be created by replacing the target firm's incompetent management, by changing the strategic direction of the target, by gaining a foothold in a market not currently served, or by achieving unrelated diversification.

Deb Ltd. Seeks an Exit Strategy In late 2004, Barclay's Private Equity acquired slightly more than one half the equity in Deb Ltd. (Deb), valued at about $250 million. The private equity arm of Britain's Barclay's bank outbid other suitors in an auction to acquire a controlling interest in the firm. PriceWaterhouseCooper had been hired by the Williamson family, the primary stockholder in the firm, to find a buyer. The sale solved a dilemma for Nick Williamson, the firm's CEO and son of the founder, who had invented the firm's flagship product, Swarfega. The company had been founded some 60 years earlier based on a single product, a car cleaning agent. Since then, the Swarfega brand name had grown into a widely known brand associated with a broad array of cleaning products. In 1990, the elder Williamson wanted to retire and his son Nick, along with business partner Roy Tillead, bought the business from his father. Since then, the business has continued to grow, and product development has accelerated. The company developed special Swarfega-dispensing cartridges that have applications in hospitals, clinics, and other medical faculties. After 13 years of sustained growth, Williamson realized that some difficult decisions had to be made. He knew he did not have a natural successor to take over the company. He no longer believed the firm could be managed successfully by the same management team. It was now time to think seriously about succession planning. So in early 2004, he began to seek a buyer for the business. He preferably wanted somebody who could bring in new talents, ideas, and up-to-date management techniques to continue the firm's growth. The terms of the agreement called for Williamson to work with a new senior management team until Barclays decided to take the firm public. This was expected some time during the five-to-seven year period following the sale. At that point, Williamson would sell the remainder of his family's stock in the business (Goodman, 2005). -What do you believe might be some of the unique challenges in valuing a family-owned business? Be specific.

What are the common ways of estimating the capitalization rate?

It is easier to obtain the fair market value of private companies than for public companies because of the absence of volatile stock markets.

Which of the following are often true about the challenges of valuing private firms?

Managers and owners in public companies are likely to have the same emotional attachment to their businesses as those in private firms.

Leveraged employee stock ownership plans are frequently used by owners of private businesses to

Based on its growth prospects, a private investor values a local bakery at $750,000. She believes that cost savings having a present value of $50,000 can be achieved by changing staffing levels and store hours. Based on recent empirical studies, she believes the appropriate liquidity discount is 20 percent. A recent transaction in the same city required the buyer to pay a 5 percent premium to the asking price to gain a controlling interest in a similar business. What is the most she should be willing to pay for a 50.1 percent stake in the bakery?

Shell corporations may have significant value to acquiring firms.

Cantel Medical Acquires Crosstex International On August 3, 2005, Cantel Medical Corporation (Cantel), as part of its strategic plan to expand its infection prevention and control business, announced that it had completed the acquisition of Crosstex International Incorporated (Crosstex). Cantel is a leading provider of infection prevention and control products. Crosstex is a privately owned manufacturer and reseller of single-use infection control products used primarily in the dental market. As a consequence of the transaction, Crosstex became a wholly owned subsidiary of Cantel, a publicly traded firm. For the fiscal year ended April 30, 2005, Crosstex reported revenues of approximately $47.4 million and pretax income of $6.3 million. The purchase price, which is subject to adjustment for the net asset value at July 31, 2005, was $74.2 million, comprising $67.4 million in cash and 384,821 shares of Cantel stock (valued at $6.8 million). Furthermore, Crosstex shareholders could earn another $12 million payable over three years based on future operating income. Each of the three principal executives of Crosstex entered into a three-year employment agreement. James P. Reilly, president and CEO of Cantel, stated, "We continue to pursue our strategy of acquiring branded niche leaders and expanding in the burgeoning area of infection prevention and control. Crosstex has a reputation for quality branded products and seasoned management." Richard Allen Orofino, Crosstex's president, noted, "We have built Crosstex over the past 50 years as a family business and we continue growing with our proven formula for success. However, with so many opportunities in our sights, we believe Cantel is the perfect partner to aid us in accelerating our growth plans." -Speculate why Cantel may have chosen to operate Crosstex as a wholly-owned subsidiary following closing. Be specific

Studies of restricted stock sales since 1990 indicate a median liquidity discount of about 20 percent with several showing a decline to 13 percent after 1997 following the holding period change under Rule 144 from two years to one.

Because of data limitations, valuation of private firms often requires more subjective adjustments than for public firms.

Shell Game: Going Public through Reverse Mergers _____________________________________________________________________________________ Key Points Reverse mergers represent an alternative to an initial public offering (IPO) for a private company wanting to “go public.” The challenge with reverse mergers often is gaining access to accurate financial statements and quantifying current or potential liabilities. Performing adequate due diligence may be difficult, but it is the key to reducing risk. ______________________________________________________________________________ The highly liquid U.S. equity markets have proven to be an attractive way of gaining access to capital for both privately owned domestic and foreign firms. Common ways of doing so have involved IPOs and reverse mergers. While both methods allow the private firm’s shares to be publicly traded, only the IPO necessarily results in raising capital, which affects the length of time and complexity of the process of “going-public.” To undertake a reverse merger, a firm finds a shell corporation with relatively few shareholders who are interested in selling their stock. The shell corporation’s shareholders often are interested in either selling their shares for cash, owning even a relatively small portion of a financially viable company to recover their initial investments, or transferring the shell’s liabilities to new investors. Alternatively, the private firm may merge with an existing special-purpose acquisition company (SPAC) already registered for public stock trading. SPACs are shell, or “blank-check,” companies that have no operations but go public with the intention of merging with or acquiring a company with the proceeds of the SPAC’s IPO. In a merger, it is common for the surviving firm to be viewed as the acquirer, since its shareholders usually end up with a majority ownership stake in the merged firms; the other party to the merger is viewed as the target firm because its former shareholders often hold only a minority interest in the combined companies. In a reverse merger, the opposite happens. Even though the publicly traded shell company survives the merger, with the private firm becoming its wholly owned subsidiary, the former shareholders of the private firm end up with a majority ownership stake in the combined firms. While conventional IPOs can take months to complete, reverse mergers can take only a few weeks. Moreover, as the reverse merger is solely a mechanism to convert a private company into a public entity, the process is less dependent on financial market conditions because the company often is not proposing to raise capital. The speed with which a firm can “go public” as compared to an IPO often is attractive to foreign firms desirous of entering U.S. capital markets quickly. In recent years, private equity investors have found the comparative ease of the reverse merger process convenient, because it has enabled them to take public their investments in both domestic and foreign firms. In recent years the story of the rapid growth of Chinese firms has held considerable allure for investors, prompting a flurry of reverse mergers involving Chinese-based firms. With speed comes additional risk. Shell company shareholders may simply be looking for investors to take over their liabilities, such as pending litigation, safety hazards, environmental problems, and unpaid tax liabilities. To prevent the public shell’s shareholders from dumping their shares immediately following the merger, investors are required to hold their shares for a specific period of time. The recent entry of Chinese firms into the U.S. public equity markets illustrates the potential for fraud. Of the 159 Chinese-based firms that have been listed since 2006 via a reverse merger, 36 have been suspended or have halted trading in the United States after auditors found significant accounting issues. Eleven more firms have been delisted from major U.S. stock exchanges. Huiheng Medical (Huiheng) is one such firm that came under SEC scrutiny, having first listed its shares on the over-the-counter (OTC) market in early 2008. The firm claimed it was China’s leading provider of gamma-ray technology, a cancer-fighting technology, and boasted of having a strong order backlog and access to Western management expertise through a joint venture. What follows is a discussion of how the firm went public and the participants in that process. The firms involved in the reverse merger process included Mill Basin Technologies (Mill), a Nevada incorporated and publicly listed shell corporation, and Allied Moral Holdings (Allied), a privately owned Virgin Islands company with subsidiaries, including Huiheng Medical, primarily in China. Mill was the successor firm to Pinewood Imports (Pinewood), a Nevada-based corporation, formed in November 2002 to import pine molding. Ceasing operations in September 2006 to become a shell corporation, Pinewood changed its name to Mill Basin Technologies. The firm began to search for a merger partner and registered shares for public trading in 2006 in anticipation of raising funds. The reverse merger process employed by Allied, the privately owned operating company and owner of Huiheng, to merge with Mill, the public shell corporation, early in 2008 to become a publicly listed firm is described in the following steps. Allied is the target firm, and Mill is the acquiring firm. Step 1. Negotiate terms and conditions: Premerger, Mill and Allied had 10,150,000 and 13,000,000 common shares outstanding, respectively. Mill also had 266,666 preferred shares outstanding. Mill and Allied agreed to a merger in which each Allied shareholder would receive one share of Mill stock for each Allied share they held. With Mill as the surviving entity, former Allied shareholders would own 96.65% of Mill’s shares, and Mill’s former shareholders would own the rest. Step 2. Recapitalize the acquiring firm: Prior to the share exchange, shareholders in Mill, the shell corporation, recapitalized the firm by contributing 9,700,000 of the shares they owned prior to the merger to Treasury stock, effectively reducing the number of Mill common shares outstanding to 450,000 (10,150,000 – 9,700,000). The objective of the recapitalization was to limit the total number of common shares outstanding postmerger in order to support the price of the new firm’s shares. Such recapitalizations often are undertaken to reduce the number of shares outstanding following closing in order to support the combined firms’ share price once it begins to trade on a public exchange. The firm’s earnings per share are increased for a given level of earnings by reducing the number of common shares outstanding. Step 3. Close the deal: The terms of the merger called for Mill (the acquirer) to purchase 100% of the outstanding Allied (the target) common and preferred shares, which required Mill to issue 13,000,000 new common shares and 266,666 new preferred shares. All premerger Allied shares were cancelled. Mill Basin Technologies was renamed Huiheng Medical, reflecting potential investor interest at that time in both Chinese firms and in the healthcare Without the reduction in Mill’s premerger shares outstanding, total shares outstanding postmerger would have been 23,150,000 [10,150,000 (Mill shares premerger) + 13,000,000 (Allied shares premerger)] rather than the 13,450,000 after the recapitalization. industry. See Exhibit 10.4 for an illustration of the premerger recapitalization of Mill, the postmerger equity structure of the combined firms, and the resulting ownership distribution. While Huiheng traded as high as $13 in late 2008, it plummeted to $1.60 in early 2012, reflecting the failure of the firm to achieve any significant revenue and income in the cancer market, an inability to get an auditing firm to approve their financial statements, and the absence of any significant order backlog. Having reported net income as high as $9 million in 2007, just prior to completing the reverse merger, the firm was losing money and burning through its remaining cash. The firm was left looking at alternative applications for its technology, such as preserving food with radiation. Huiheng’s SEC filings state that the firm designs, develops, and markets radiation therapy systems used to treat cancer and acknowledge that the firm had experienced delays selling its technology in China and had no international sales in 2009 or 2010. The filings also show the reverse merger was directed by Richard Propper, a venture capitalist and CEO of Chardan Capital, a San Diego merchant bank with expertise in helping Chinese firms enter the U.S. equity markets. Chardan Capital invested $10 million in Huiheng in exchange for more than 52,000 shares of the firm’s preferred stock. Chardan and Roth Capital Partners, a California investment bank, were co-underwriters for a planned 2008 Huiheng stock offering that was later withdrawn. Chardan had been fined $40,000 for three violations of short-selling rules from 2005 to 2009. Roth is a defendant in alleged securities’ fraud lawsuits involving other Chinese reverse merger firms. Exhibit 10.4 Mill Basin Technologies (Mill) Pre-Merger Equity Structure: Common 10,150,000 Series A Preferred 266,666 Recapitalized Equity Structure Common 450,000a Series A Preferred 266,666 New Mill Shares Issued to Acquire 100% of Allied shares Common 13,000,000 Series A Preferred 266,666 Post-Merger Equity Structure: Common 13,450,000b Series A Preferred 266,666 Post-Merger Ownership Distribution of Common Shares: Former Allied Shareholders: 96.65% c Former Mill Shareholders: 3.35% aMill shareholders contributed 9,700,000 shares of their pre-merger holdings to treasury stock cutting the number of Mill shares outstanding to 450,000 in order to reduce the total number of shares outstanding postmerger, which would equal Mill’s premerger shares outstanding plus the newly issued shares. This also could have been achieved by the Mill shareholders agreeing to a reverse stock split. The 10,150,000 pre-merger Mill shares outstanding could be reduced to 450,000 through a reverse split in which Mill shareholders receive 1 new Mill share for each 22.555 outstanding prior to the merger. bPost-Merger Mill Basin Technologies’ capital structure equals the 450,000 premerger Mill common shares resulting from the recapitalization plus the 13,000,000 newly issued common shares plus 266,666 Series A preferred shares. c(13,000,000/13,450,000) Huiheng ran into legal problems soon after its reverse merger. Harborview Master Fund, Diverse Trading Ltd., and Monarch Capital Fund, institutional investors having a controlling interest in Huiheng, approved the reverse merger and invested $1.25 million in exchange for stock. However, they sued Huiheng and Chardan Capital in 2009 as Huiheng’s promise of orders failed to materialize. The lawsuit charged that Huiheng bribed Chinese hospital officials to win purchasing deals. The firm’s initial investors forced the firm to buy back their shares as a result of a legal settlement of their lawsuit in which they argued that the firm had committed fraud when it “went public.” The lawsuit alleged that the firm’s public statements about the efficacy of its technology and order backlog were highly inflated. Huiheng and its codefendants settled out of court in 2010 with no admission of liability by buying back some of its stock. In 2011, the firm had difficulty in collecting receivables and generating cash. That same year, Huiheng’s operations in China were struggling and were on the verge of ceasing production. -What are the auditing challenges associated with reverse mergers? How can investors protect themselves from the liabilities that may be contained in corporate shells?

Valuing a Privately Held Company Background BigCo is interested in acquiring PrivCo, whose owner desires to retire. The firm is 100% owned by the current owner. PrivCo has revenues of $10 million and an EBIT of $2 million in the preceding year. The market value of the firm’s debt is $5 million; the book value of equity is $4 million. For publicly traded firms in the same industry, the average debt-to-equity ratio is .4 (based on the market value of debt and equity), and the marginal tax rate is 40%. Typically, the ratio of the market value of equity to book value for these firms is 2. The average  of publicly traded firms that are in the same business is 2.00. Capital expenditures and depreciation amounted to $0.3 million and $0.2 million in the prior year. Both items are expected to grow at the same rate as revenues for the next 5 years. Capital expenditures and depreciation are expected to be equal beyond 5 years (i.e., capital spending will be internally funded). As a result of excellent working capital management practices, the change in working capital is expected to be essentially zero throughout the forecast period and beyond. The revenues of this firm are expected to grow 15% annually for the next 5 years and 5% per year thereafter. Net income is expected to increase 15% a year for the next 5 years and 5% thereafter. The 10-year U.S. Treasury bond rate is 6%. The pretax cost of debt for a nonrated firm is 10%. No adjustment is made in the calculation of the cost of equity for a marketability discount. Estimate the shareholder value of the firm. Note: To estimate the WACC for a leveraged private firm, it is necessary to calculate the firm’s leveraged . This requires an estimate of the firm’s unleveraged  which can be obtained by estimating the unleveraged  for similar firms in the same industry. In addition, the value of debt and equity in calculating the cost of capital should be expressed as market rather than book values. Calculating COE and WACC: 1. Unlevered Beta for publicly traded firms in the same industry = 2.00 / (1 + .6 x .4) = 1.61, where 2.00 is the levered beta, .6 is (1-tax rate), and .4 is the average debt ratio for firms in this industry. 2. Debt/Equity ratio for the private firm = 5 / (2 x 4) = .625 where 5, 4, and 2 are the private firm’s debt, book value of equity, and the ratio of market value to book value for similar firms. 3. Levered beta for the private firm = 1.61 x (1 + .6 x .625) = 2.21 4. Cost of equity for the private firm = 6 + 2.21 x 5.5 = 18.16 5. After-tax cost of debt = .10 x (1 - .4) = 6.0 6. WACC for the private firm = 18.16 x 2x4 + 6.00 x 5__ 2x4+5 2x4+5 = 18.16 x. 615 + 6.00 x. 385 = 13.48 Valuing the business using the FCFF model: Year 1 2 3 4 5 6 EBIT (EBIT grows at 15% for the first $2.30 $2.65 $3.04 $3.50 $4.02 $4.22 five years and 5% thereafter.) EBIT (1-Tax Rate) $1.38 $1.59 $1.82 $2.10 $2.41 $2.53 Less (Cap. Expenditures-Depreciation) grows $.115 $.132 $.152 $.175 $.201 $0.00 at same 15% annual rate as revenue for 5 years and are offsetting thereafter) Equals Free Cash Flow to the Firm $1.26 $1.46 $1.67 $1.93 $2.21 $2.53 Terminal value = $2.53 / (.1348 - .05) = $29.83 Present Value of FCFF = $1.26 + $1.46 + $1.67 + $1.93 + $2.21 + $29.83 1.1348 1.13482 1.13483 1.13484 1.13485 1.13485 = $1.11 + $1.13 + $1.14 + $1.16 + $1.17 + $15.85 = $21.56 Value of Equity = $21.56 (MV of the firm) - $5 (MV of debt) = $16.56 Pacific Wardrobe Acquires Surferdude Apparel by a Skillful Structuring of the Acquisition Plan Pacific Wardrobe (Pacific) is a privately owned California corporation that has annual sales of $20 million and pretax profits of $2 million. Its target market is the surfwear/sportswear segment of the apparel industry. The surfwear/sportswear market consists of two segments: cutting-edge and casual brands. The first segment includes high-margin apparel sold at higher-end retail establishments. The second segment consists of brands that sell for lower prices at retail stores such as Sears, Target, and J.C. Penney. Pacific operates primarily as a U.S. importer/distributor of mainly casual sportswear for young men and boys between 10–21 years of age. Pacific’s strategic business objectives are to triple sales and pretax profits during the next 5 years. Pacific intends to achieve these objectives by moving away from the casual sportswear market segment and more into the high-growth, high-profit cutting-edge surfer segment. Because of the rapid rate at which trends change in the apparel industry, Pacific’s management believes that it can take advantage of current trends only through a well-conceived acquisition strategy. Pacific’s Operations and Competitive Environment Pacific imports all of its apparel from factories in Hong Kong, Taiwan, Nepal, and Indonesia. Its customers consist of major chains and specialty stores. Most customers are lower-end retail stores. Customers include J.C. Penney, Sears, Stein Mart, Kids “R” Us, and Target. No one customer accounts for more than 20% of Pacific’s total revenue. The customers in the lower-end market are extremely cost sensitive. Customers consist of those in the 10–21 years of age range who want to wear cutting-edge surf and sport styles but who are not willing or able to pay high prices. Pacific offers an alternative to the expensive cutting-edge styles. Pacific has found a niche in the young men’s and teenage boy’s sportswear market. The firm offers similar styles as the top brand names in the surf and sport industry, such as Mossimo, Red Sand, Stussy, Quick Silver, and Gotcha, but at a lower price point. Pacific indirectly competes with these top brand names by attempting to appeal to the same customer base. There are few companies that compete with Pacific at their level—low-cost production of ‘‘almost’’ cutting-edge styles. Pacific’s Strengths and Weaknesses Pacific’s core strengths lie in their strong vendor support in terms of quantity, quality, service, delivery, and price/cost. Pacific’s production is also scaleable and has the potential to produce at high volumes to meet peak demand periods. Additionally, Pacific also has strong financial support from local banks and a strong management team, with an excellent track record in successfully acquiring and integrating small acquisitions. Pacific also has a good reputation for high-quality products and customer service and on-time delivery. Finally, Pacific has a low cost of goods sold when compared with the competition. Pacific’s major weakness is that it does not possess any cutting-edge/trendy labels. Furthermore, their management team lacks the ability to develop trendy brands. Acquisition Plan Pacific’s management objectives are to grow sales, improve profit margins, and increase its brand life cycle by acquiring a cutting-edge surfwear retailer with a trendy brand image. Pacific intends to improve its operating margins by increasing its sales of trendy clothes under the newly acquired brand name, while obtaining these clothes from its own low-cost production sources. Pacific would prefer to use its stock to complete an acquisition, because it is currently short of cash and wishes to use its borrowing capacity to fund future working capital requirements. Pacific’s target debt-to-equity ratio is 3 to 1. The firm desires a friendly takeover of an existing surfwear company to facilitate integration and avoid a potential ‘‘bidding war.’’ The target will be evaluated on the basis of profitability, target markets, distribution channels, geographic markets, existing inventory, market brand recognition, price range, and overall ‘‘fit’’ with Pacific. Pacific will locate this surfwear company by analyzing the surfwear industry; reviewing industry literature; and making discrete inquiries relative to the availability of various firms to board members, law firms, and accounting firms. Pacific would prefer an asset purchase because of the potentially favorable impact on cash flow and because it is concerned about unknown liabilities that might be assumed if it acquired the stock. Pacific’s screening criteria for identifying potential acquisition candidates include the following: 1. Industry: Garment industry targeting young men, teens, and boys 2. Product: Cutting-edge, trendy surfwear product line 3. Size: Revenue ranging from $5 million to $10 million 4. Profit: Minimum of break-even on operating earnings for fiscal year 1999 5. Management: Company with management expertise in brand and image building 6. Leverage: Maximum debt-to-equity ratio of 3 to 1 After a review of 14 companies, Pacific’s management determined that SurferDude best satisfied their criteria. SurferDude is a widely recognized brand in the surfer sports apparel line; it is marginally profitable, with sales of $7 million and a debt-to-equity ratio of 3 to 1. SurferDude’s current lackluster profitability reflects a significant advertising campaign undertaken during the last several years. Based on financial information provided by SurferDude, industry averages, and comparable companies, the estimated purchase price ranges from $1.5 million to $15 million. The maximum price reflects the full impact of anticipated synergy. The price range was estimated using several valuation methods. Valuation On a standalone basis, sales for both Pacific and SurferDude are projected to increase at a compound annual average rate of 20% during the next 5 years. SurferDude’s sales growth assumes that its advertising expenditures in 1998 and 1999 have created a significant brand image, thus increasing future sales and gross profit margins. Pacific’s sales growth rate reflects the recent licensing of several new apparel product lines. Consolidated sales of the combined companies are expected to grow at an annual growth rate of 25% as a result of the sales and distribution synergies created between the two companies. The discount factor was derived using different methods, such as the buildup method or the CAPM. Because this was a private company, the buildup method was utilized and then supported by the CAPM. At 12%, the specific business risk premium is assumed to be somewhat higher than the 9% historical average difference between the return on small stocks and the risk-free return as a result of the capricious nature of the highly style-conscious surfware industry. The marketability discount is assumed to be a relatively modest, 20% because Pacific is acquiring a controlling interest in SurferDude. After growing at a compound annual average growth rate of 25% during the next 5 years, the sustainable long-term growth rate in SurferDude’s standalone revenue is assumed to be 8%. The buildup calculation included the following factors: Risk-Free Rate: 6.00% Market Risk Premium to Invest in Stocks: 5.50% Specific Business Risk Premium: 12.00% Marketability Risk Premium: 20.00% Discount Rate 43.50% Less: Long-Term Growth Rate 8.00% Capitalization Rate 35.50% The CAPM method supported the buildup method. One comparable company, Apparel Tech, had a ß estimated by Yahoo.Marketguide.com to be 4.74, which results in a ke of 32.07 for this comparable company. The weighted average cost of capital using a target debt-to-equity ratio of 3 to 1 for the combined companies is estimated to be 26%. The standalone values of SurferDude and Pacific assume that fixed expenses will decrease as a percentage of sales as a result of economies of scale. Pacific will outsource production through its parent’s overseas facilities, thus significantly reducing the cost of goods sold. SurferDude’s administrative expenses are expected to decrease from 25% of sales to 18% because only senior managers and the design staff will be retained. The sustainable growth rate for the terminal period for both the standalone and the consolidated models is a relatively modest 6%. Pacific believes this growth rate is reasonable considering the growth potential throughout the world. Although Pacific and SurferDude’s current market concentration resides largely in the United States, it is forecasted that the combined companies will develop a global presence, with a particular emphasis in developing markets. The value of the combined companies including synergies equals $15 million. Developing an Initial Offer Price Using price-to-cash flow multiples to develop an initial offer price, the target was valued on a standalone basis and a multiple of 4.51 for a comparable publicly held company called Stage II Apparel Corp. The standalone valuation, excluding synergies, of SurferDude ranges from $621,000 to $2,263,000. Negotiating Strategy Pacific expects to initially offer $2.25 million and close at $3.0 million. Pacific’s management believes that SurferDude can be purchased at a modest price when compared with anticipated synergy, because an all-stock transaction would give SurferDude’s management ownership of between 25% and 30% of the combined companies. Integration A transition team consisting of two Pacific and two SurferDude managers will be given full responsibility for consolidating the businesses following closing. A senior Pacific manager will direct the integration team. Once an agreement of purchase and sale has been signed, the team’s initial responsibilities will be to first contact and inform employees and customers of SurferDude that operations will continue as normal until the close of the transaction. As an inducement to remain through closing, Pacific intends to offer severance packages for those SurferDude employees who will be terminated following the consolidation of the two businesses. Source: Adapted from Contino, Maria, Domenic Costa, Larui Deyhimy, and Jenny Hu, Loyola, Marymount University, MBAF 624, Los Angeles, CA, Fall 1999. -What were the key assumptions implicit in Pacific Wardrobe's acquisitions plan, with respect to the market, valuation, and integration? Comment on the realism of these assumptions.