Marsha McDonnell and Frank Lutge are analysts for the private equity firm Thorngate Ventures. Their primary responsibility is to value the equity of private firms in developed global economies. Thorngate's clients consist of wealthy individuals and institutional investors. The firm invests in and subsequently actively manages its portfolio of private firms. During a discussion with junior analysts at the firm, McDonnell compares the characteristics of private firms with that of public firms and makes the following statements: Statement 1: Private firms typically have higher risk premiums and required returns than public firms because private firms are usually smaller and thus thought to be riskier. Furthermore, the lack of access to liquid public equity markets can limit a private firm's growth. Statement 2: Because of their higher risk, private firms may not be able to attract as many qualified applicants for top positions as public firms. Due to the higher risk, the managers they do attract tend to have a shorter-term view of the firm and their tenure at the firm, compared to public Firm managers. As a result, the private firm may neglect profitable long-term projects. Due to its considerable success, Thorngate has recently attracted a substantial inflow of capital from investors. To deploy that capital, McDonnell and Lutge are considering the purchase of Albion Biotechnology. Albion is using advances in biotechnology for application in the pharmaceutical field. The analysts are primarily interested in Albion because the firm's research team is developing a drug that Thomgate's current pharmaceutical firm is also working on. McDonnell estimates that combining research teams would result in advances that no pharmaceutical competitor could match for at least two years. The firm is currently owned by its founders, who are familiar to Lutge through previous social contacts. Lutge hopes to avoid a competitive bidding process for the firm, because its founders have not advertised the firm's sale publicly. McDonnell is also examining the prospects of Balanced Metals, a metal fabrication firm. Thorngate currently does not have any manufacturing firms in its portfolio, and Balanced would provide needed exposure. The growth in sales at Balanced has been impressive recently, but it is expected to slow considerably in the years ahead due to increased competition from overseas firms. The firm's most valuable assets are its equipment and factory, located in a prime industrial area. Balanced was previously considered for possible purchase by a competitor in the metal fabrication industry. Although (he sale was not consummated, McDonnell has learned that the firm estimated that costs could be reduced at Balanced by eliminating redundant overhead expenses. McDonnell has obtained the following financial figures from (he Balanced Metals CFO as well as the previously estimated synergistic savings from cost reductions. Capital expenditures will equal depreciation plus approximately 4% of the firm's incremental revenues. Current revenues $22,000,000 Revenue growth 7% Gross profit margin 25% Depreciation expense as a percent of sales 1% Working capital as a percent of sales 15% SG&A expenses $5,400,000 Synergistic cost savings $1,200,000 Tax rate 30% Lutge is valuing a noncontrolling equity interest in Jensen Gear, a small outdoors equipment retailer. Jensen has experienced healthy growth in earnings over the past three years. However, given its size and private status, Lutge does not expect that Jensen can be easily sold. To obtain the appropriate price multiple for the Jensen valuation, he has prepared a database of price multiples from the sale of entire public and private companies over the past ten years, organized by industry classification. Using historical data, Lutge estimates a control premium of 18.7% and discount for lack of marketability of 24%. To obtain the cost of capital for Jensen, Lutge uses a cost of capital database that includes public company betas, cost of equity, weighted average cost of capital, and other financial statistics by industry. Given Jensen's small size, Lutge obtains a size premium using the smallest size decile of the database. McDonnell examines Lutge's cost of capital calculations and makes the following statements. Statement 1: I am concerned about the use of this database. The estimation of the size premium may result in an undervaluation of the Jensen equity interest. Statement 2: The use of betas and the CAPM from the database may be inappropriate, [f so, Lutge should consider using the build-up method where an industry risk premium is used instead of beta. Which of the following best describes the standard of value that McDonnell and Lutge will apply to Albion Biotechnology?
Cummings Enterprises, Inc. (CEI), is a U .S . conglomerate that operates in a variety of markets. One of CEI's divisions manufactures small fiberglass products, such as bird baths and outdoor storage lockers. CEI is currently considering the expansion of its fiberglass product line to include booms and buckets for aerial lift trucks (often called cherry pickers) which are used for applications such as high voltage power line maintenance. The addition of this new product line is expected to increase CEI's sales by $750,000 per year. Cal Holbrook, CEI's manager of fiberglass operations, is deciding whether to purchase a robotic system to produce cherry picker booms and buckets. The price of the robotic system will be $700,000, plus an additional $ 100,000 for shipping, site preparation and installation. The new equipment will require a $50,000 increase in inventory and a $20,000 increase in accounts payable. The company uses MACRS to calculate depreciation for tax purposes and the straight-line method for financial reporting. The project has an expected life of four years, at which time the robot is expected to be sold for $75,000. The project will be funded with the debt/equity mix reflected by the company's current capital structure. CEI's pretax cost of new debt is 7%. Assume a WACC of' 8%. Some of the relevant end-of-year cash flows for the robotic project are presented in Exhibit 1.
Holbrook calculates the NPV of the robotic project and presents his findings to his supervisor, Geoffrey Mans. After reviewing the report, Mans makes the following recommendations: 1 'You forgot to include the $ 100,000 we have spent so far on consultants and project engineers and who knows what else to evaluate the project's feasibility. Rerun the numbers including that amount and get the revised calculations to me this afternoon.' 2. 'Rerun the analysis assuming straight-line depreciation for tax purposes. The NPV will be higher, and we'll be more likely to get the project funded.' Cummings has two other projects under consideration that would affect the production of storage lockers. Project 1 relates to changing the production process, and Project 2 relates to expanding the distribution facility. Holbrook estimates the NPV of the expected cash flows for Project 1 at negative $7 million. An additional investment of $3 million would allow management to more rapidly adjust to the demand for a certain type of locker. The value of this flexibility is estimated at $9 million. He estimates that the NPV of the expected cash flows for Project 2 at $3 million. An expansion option would require an additional investment of $2 million. At this time, Cummings does not have any capital rationing restrictions. Holbrook emails the lead analyst for the budgeting group and indicates that he cannot make a decision on Project 2 without knowing the value the expansion option will provide. Holbrook calls a capital budgeting meeting with CEI's production manager and quality control manager. Holbrook opens the meeting by stating: 'I think we should accept this project based solely on the fact that it provides great operating margins. Nevertheless, I think we should conduct net present value (NPV) analysis to confirm my opinion.' Holbrook then receives the following comments: Comment 1: It is important that interest is included in the discounted cash flows used with NPV analysis because interest is a real and very significant expense. Comment 2: If applied correctly, the NPV of this project will be higher if we discount economic profits instead of net after-tax operating cash flows in our analysis. I suggest we calculate economic profit as net operating profit after tax minus the dollar cost of capital. The economic income for year 3 for the robotics project from Exhibit 1 is closest to:
Yummy Doughnuts (YD) sells a variety of doughnuts and other related items through both company-owned locations and franchise locations. YD has experienced significant growth over the past five years. However, barriers to entry are low and competition is increasing.
Linda Haas, CFA, follows YD for Gibraltar Capital. Gibraltar Capital prides itself on its thorough fundamental analysis of investment opportunities. The company uses a bottom-up approach to the investment process. Haas's security selection process utilizes residual income models to determine a stock's intrinsic value. Haas obtains YD's 2008 financial statements shown in Exhibit 1. In addition, Haas provides supporting information about YD's financials and other related material found in Exhibit 2.
Haas makes the following statements during her YD presentation to the investment committee. Statement 1: Based on ROE mean reversion, YD's continuing residual income is assumed to decline to zero over time. Statement 2: The residual income model states that if YD's ROE equals its equity cost of capital, then YD's intrinsic value will equal its book value per share. Haas notes that the multi-stage residual equity income model captures more detail in calculating YD's intrinsic value. An assumption of the model is that ROE fades to the cost of equity over time, which is known as a persistence factor (varying from 0 to 1). Identify which characteristic indicates a higher persistence of abnormal earnings.
High Plains Tubular Company is a leading manufacturer and distributor of quality steel products used in energy, industrial, and automotive applications worldwide. The U .S . steel industry has been challenged by competition from foreign producers located primarily in Asia. All of the U .S . producers are experiencing declining margins as labor costs continue to increase. In addition, the U .S . steel mills arc technologically inferior to the foreign competitors. Also, the U .S . producers have significant environmental issues that remain unresolved. High Plains is not immune from the problems of the industry and is currently in technical default under its bond covenants. The default is a result of the failure to meet certain coverage and turnover ratios. Earlier this year, High Plains and its bondholders entered into an agreement that will allow High Plains time to become compliant with the covenants. If High Plains is not in compliance by year end, the bondholders can immediately accelerate the maturity date of the bonds. In this case. High Plains would have no choice but to file bankruptcy. High Plains follows U .S . GAAP. For the year ended 2008, High Plains received an unqualified opinion from its independent auditor. However, the auditor's opinion included an explanatory paragraph about High Plains' inability to continue as a going concern in the event its bonds remain in technical default. At the end of 2008, High Plains' Chief Executive Officer (CEO) and Chief Financial Officer (CFO) filed the necessary certifications required by the Securities and Exchange Commission (SEC).
To get a better understanding of High Plains' financial situation, it is helpful to review High Plains' cash flow statement found in Exhibit 1 and selected financial footnotes found in Exhibit 2.
Exhibit 2: Selected Financial Footnotes 1. During 2008, High Plains' sales increased 27% over 2007. Its sales growth continues to significantly exceed the industry average. Sales are recognized when a firm order is received from the customer, the sales price is fixed and determinable, and collectability is reasonably assured. 2. The cost of inventories is determined using the last-in, first-out (LIFO) method. Had the first-in, first-out method been used, inventories would have been $152 million and $143 million higher as of December 31,2008 and 2007, respectively. 3. Effective January 1, 2008, High Plains changed its depreciation method from the double-declining balance method to the straight-line method in order to be more comparable with the accounting practices of other firms within its industry. The change was not retroactively applied and only affects assets that were acquired on or after January 1,2008. 4. High Plains made the following discretionary expenditures for maintenance and repair of plant and equipment and for advertising and marketing:
5. During the fiscal year ended December 31, 2008, High Plains sold $50 million of its accounts receivable, with recourse, to an unrelated entity. All of the receivables were still outstanding at year end. 6. High Plains conducts some of its operations in facilities leased under noncancelable capital leases. Certain leases include renewal options with provisions for increased lease payments during the renewal term. 7. High Plains' average net operating assets at the end of 2008 and 2007 was $977.89 million and $642.83 million, respectively. Does High Plains' accounting treatment of its capital leases and receivable sale lower its earnings quality?
In 2001, Continental Supply Company was formed to provide drilling equipment and supplies to contractors and oilfield production companies located throughout the United States. At the end of 2005, Continental Supply created a wholly owned foreign subsidiary, International Oilfield Incorporated, to begin servicing customers located in the North Sea. International Oilfield maintains its financial statements in a currency known as the local currency unit (LCU). Continental Supply follows U .S . GAAP and its presentation currency is the U .S . dollar. For the years 2005 through 2008, the weighted-average and year-end exchange rates, stated in terms of local currency per U .S . dollar, were as follows:
International Oilfield accounts for its inventory using the lower-of-cost-or-rnarlcet valuation method in conjunction with the first-in, first-out, cost flow assumption. All of the inventory on hand at the beginning of the year was sold during 2008. Inventory remaining at the end of 2008 was acquired evenly throughout the year. At the beginning of 2006, International Oilfield purchased equipment totaling LCU975 million when the exchange rate was LCU 1.00 to SI. During 2007, equipment with an original cost of LCU 108 million was totally destroyed in a fire. At the end of 2007, International Oilfield received a LCU 92 million insurance settlement for the loss. On June 30, 2008, International Oilfield purchased equipment totaling LCU 225 million when the exchange rate was LCU 1.25 to $1.
For the years 2007 and 2008, Continental Supply reported International Oilfield revenues in its consolidated income statement of S375 million and $450 million, respectively. There were no inter-company transactions. Following are International Oilfield's balance sheets at the end of 2007 and 2008:
At the end of 2008, International Oilfield's retained earnings account was equal to $525 million and, to date, no dividends have been paid. All of International Oilfield's capital stock was issued at the end of 2005. Assuming International Oilfield is a significantly integrated sales division and virtually all operating, investing, and financing decisions are made by Continental Supply, foreign currency gains and losses that arise from the consolidation of International Oilfield should be reported in: