OBJECTIVE
The goal of this analysis is to determine a financial valuation of the fair market value of 100% of The Duke’s Sporting Goods Store (“Duke’s”), by using two of the three approaches to valuation (income and market approaches, but not the cost approach). The valuation date is December 31 of the current year.
The following Excel file containing two spreadsheets: Duke’s Discounted Cash Flow Analysis and Market Approach.
Data have been entered in these spreadsheets that will allow you to calculate valuations for Duke’s under the income and market approaches.
FACTS
- The company’s assets are cash ($100,000), inventory (worth $400,000 based on cost), and accounts receivable ($25,000).Inventory can be sold back to manufacturers for 50% of its cost.Accounts receivable can be sold to a collections agency for 40% of its current level.
- The company’s liabilities are accounts payable of $75,000 and accrued expenses of $75,000.
- The Discounted Cash Flow Analysis spreadsheet shows the most recent three years’ incomestatements in simplified form.
- Assume the company pays a corporate tax rate of 40%.
- For the current year, depreciation and amortization is $25,000. The company is using straight-linedepreciation. Thus, D&A is expected to be $25,000 going forward.
- The physical depreciation and/or amortization of fixed assets is allowed to be booked as an expense,thus lowering the taxable income. Yet, it is not an actual decrease in dollars so it is not a decrease in cash flow. That is why it is added back in to Net Income on the way to calculating Net Cash Flow. Net Cash Flow is actual physical dollars coming out of the business during the time period.
- There is no interest expense.
- For the current year, capital expenditures (CAPEX) is $50,000. CAPEX refers to the currentexpenditure of money by the company to purchase equipment and other assets that will help the company earn more money in the future. It directly affects net cash flow because it is spent in the current year instead of being passed through to the owners (as NCF).
ASSUMPTIONS
- Assume the discount rate is 16% (based on comparables collected from Ibbotson’s database and other adjustments for risk).
- Assume that the perpetual growth rate of net cash flow is 3.5% for the terminal year and beyond (the terminal year is the fourth year out from the current year, and it represents every year thereafter, adjusted for the perpetual growth rate).
- Assume CAPEX is constant over the relevant time periods because the company is consistently and constantly investing in its future.
- Assume D&A will continue to be $25,000 per year, given that the equipment and capital expenditures are being used to obtain fixed assets that are depreciable.
INCOME APPROACH
1. Forecast. Use the Discounted Cash Flow Analysis spreadsheet provided by your instructor and forecast revenues and expenses for Current Year + 1 (CY+1), CY+2, CY+3, and Terminal Year. For this case study, use only the previous years’ revenues and expenses as a guide. (Normally, you would also use other information about the economy, the industry, the company, and so forth). Come up with your own reasonable forecast.
Net income. Calculate the net income for CY+1, CY+2, CY+3, and terminal year.
Net cash flow. Calculate the net cash flow for CY+1, CY+2, CY+3, and terminal year.
- Calculate NCF from net income.
- Start with net income and add back depreciation and amortization to find gross cash flow.
- Subtract CAPEX from gross cash flow.
- Subtract any increase (or add any decrease) in net working capital. To calculate changes in NWC, subtract current liabilitiesfrom current assets (not including inventory, since, even though inventory is technically a current asset, a manager would notwant to rely on inventory to pay workers). Make a reasonable assumption for changes in NWC for future years.
- The result is net cash flow.
Net present value. Calculate the NPV of Duke’s.
- Determine the discount period for each year (CY and going forward).
- Determine the discount factor for each year, including the terminal year.
- Enter the discount rate and perpetual growth rate in the spreadsheet.
- Calculate the terminal value.
- Calculate the present value of the NCF for each year, including the terminal year.
- Add up each year’s present value to find the net present value of the entire business, based on cash flow.
MARKET APPROACH
After an exhaustive search, three businesses that appear to be comparable to Duke’s are found. The Market Approach spreadsheet gives basic financial information about the businesses and recent transactions involving them and provides space for the calculations. The comparable businesses are the following:
- Charlie’s Sporting Goods. Charlie’s is located in a neighboring town and has a similar clientele to Duke’s. It has been in operation for seven years and over the past three years has generated steady revenues and net income. The current majority owner, Bill, purchased Charlie’s from the founder two years ago for $1.5 million. He sold a small piece of it recently for $60,000.
- Mary’s Sporting Goods. Mary’s is located a few towns away and has existed for over a decade. It specializes in women’s and girls’ sporting goods and draws from a larger market area than Duke’s. Mary’s offers free training on its equipment, which adds to its expenses, but Sally (the current owner) feels that this policy grows its customer base and leads to more sales. Sally, who is quite risk averse (like Mary), purchased the business outright in the current year.
- Jamie’s Sporting Goods. Jamie’s is a three-store chain located on the north and south sides of the nearest large city. It has been operating for over two decades. It recently added its third store and financed this expansion with a loan from a local bank. It is paying substantial interest on that loan. While it produces a high net income, it is also more leveraged than Mary’s or Charlie’s. Jamie, the current majority owner, sold 8% of the business for $500,000 in the current year.Ratio calculations. Calculate the relevant ratios for the comparables.Valuation of subject company based on comparables. Use the market approach to determine a financial value for Duke’s.Adjustments. Adjust the financial value of Duke’s for a controlling interest premium and marketability discount, if needed.
LIQUIDATION VALUE
What is the liquidation value (as opposed to the fair market value) of Duke’s? Look at the present value of all assets that could be liquidated and account for all debts (at their present value). Determine the sum of those values. In other words, if the company were to be liquidated, how much cash would be left over?
The Duke’s Sporting Goods Store
Valuation Analysis as of December 31 of the Current Year
Discounted Cash Flow Analysis
$’s In Thousands
FYE
CY-3
Revenue
Cost of Goods Sold
Gross Profit
SG&A
R&D
EBITDA
Depreciation & Amortization
EBIT
Interest Expense
EBT
Effective Tax Rate
Income Tax Expense
Net Income
$1,000
500
500
300
25
175
25
150
0
150
40.0%
60
$90
FYE
CY-2
$1,200
600
600
350
30
220
25
195
0
195
40.0%
78
$117
FYE
CY-1
$1,400
700
700
400
35
265
25
240
0
240
40.0%
96
$144
Net Cash Flow
Discount Period in Years
(a) Discount Factor
(b) Discount Rate
(c) Perpetual Growth Rate
(d) Terminal Value
(e) Present Value – Cash Flow/Terminal Value
Net Present Value
Notes:
(a) Reflects end-of-year discounting convention.
(b) Based upon the Weighted Average Cost of Capital as reported in Ibbotson’s Cost of Capital Yearbook (data through June
(c) Based upon estimated long term cash flow growth rate of the economy in general (as assumed in the Case Study).
(d) Terminal Value = (Terminal Year Cash Flow / (Discount Rate – Perpetual Growth Rate))
(e) Present value to end of current year.
Sources: Fiscal Year Ending (FYE) CY from audited financial statements and business forecasts.
Fiscal Year Ending
Current Year
FYE
CY+1
Projected (a)
FYE
CY+2
FYE
CY+3
Terminal
Year
$1,500
750
750
425
40
285
25
260
0
260
40.0%
104
$156
Forecast the
Income for CY+1, CY+2, CY+
(Move this text box out of t
Calculate the Net Cash Flow from Net Income.
Follow the steps on the Case Study and in the
Valuation chapter. (Move this text box out of the
way).
Calculate Net Present Value. Follow the steps on
the Case Study and in the Valuation chapter. (Move
this text box out of the way).
of Capital Yearbook (data through June 2006) for SIC 3949 adjusted for other risks.
l (as assumed in the Case Study).
Forecast the Income Statement here to get to Net
Income for CY+1, CY+2, CY+3, and Terminal Year.
(Move this text box out of the way).
The Duke’s Sporting Goods Store
Valuation Analysis as of December 31 of the Current Year
Market Approach
$’s In Thousands
Total Revenues (CY)
Total Expenses (CY)
Net Income
Current Assets (minus inventory)
Current Liabilities
Inventory
Comparable Businesses
Charlie’s
Mary’s
Jamie’s
Sporting
Sporting
Sporting
Goods
Goods
Goods
$1,000
900
100
$2,000
1,850
150
$5,000
4,200
800
100
100
300
250
150
550
500
2,000
1,500
5%
$60
CY
100%
$1,500
CY-2
100%
$3,000
CY
NA
NA
NA
8%
$500
CY
NA
NA
NA
Current Ratio
Quick Ratio
Net Profit Margin
P/R Ratio
P/E Ratio
Previous Transaction
% of business transacted
Transaction Price
Date of Transaction
(2)
% of business transacted
Transaction Price
Date of Transaction
(1)
Duke’s
Sporting
Goods
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