As an investment manager from Sierra Capital Partners, Rodney Chu is interested in purchasing a 60% equity interest of Arcadian Microarray Technologies, Inc., a biotechnology firm. The bid is currently at $40 million. The Arcadian’s managers have optimistic projections for their firms’ performance over the next 11 years. However, based on Sierra’s calculations, come up a much more conservative view. With the request of Mr. Chu, a fair bid price could be calculated along with any appropriate counterproposals. Appropriate steady state growth rates and terminal values would be included and explained.
I. Objective
The main objective of this paper is to exercise the terminal value of a firm. The other objectives are to acknowledge:
1. Concept of terminal value
2. Various terminal value estimators along with its advantages and disadvantages
3. The use of tax on terminal value
4. Assumption on liquidation
5. Forecast horizon for estimating terminal value
6. Constant-growth valuation model and its derivation
7. Fisher’s formula for estimating growth rate to infinity
8. Triangulation of a terminal value estimate.
II. Analysis
We could see in the case that the lessor was trying to understand the lessee’s point of view. Thereby, the lessee’s financing problem is the lessor’s investment problem. This perspective would be explained thoroughly below.
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2.1. Presentation and explanation of data in Exhibit 3
Based on Chu’s view, terminal value mostly affects stock price. The sample of Exhibit 3 is shown below.
The calculation would be:
2.2. Consideration and approaches described in Exhibit 4
Exhibit 4 provides an opportunity to discuss the applicability of a wide range of terminal value estimators. The point of this discussion should be to show that, in selective circumstances, each approach could give a fair estimate of market value. For instance, Book values might be realistic in mark-to-market accounting situations, where the firm has just started up, or where the firm consists substantially of working capital. On the other hand, Liquidation estimates would be more realistic in cases where the firm will indeed liquidate. Replacement values might indicate market values where the firm experiences high inflation. In any comparison to this, DCF and multiples give very direct estimates of market values. DCF will dominate where the firm has no earnings to capitalize or when assets consist mostly of intangibles that are not currently reflected in earnings.
2.3. Assessment on forecast horizons for the three projects in Exhibit 5
On the figure above, we can see that the terminal value is used as the horizon in forecasting the three projects. We also have to consider the condition of when we should set the terminal value. The key to set the horizon is when the stable growth of forecasted cash flows begin. When the stable growth begins, stop forecasting the cash flow and estimate the terminal value.
The calculation of the growth is as follows:
Tol road
Bottling plant
Movie studio
2.4. Interpretation of Exhibit 6
Price to Earning Ratio
Price to Book Ratio
2.5. Driver of “g”
constant growth Rate
Options:
1 Real growth rate in the economy = 3%
2 Real growth rate in the Pharmaceutical Industry = 5%
3 USA Population growth = 1%
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Nominal Rates
1 nominal growth rate in the economy ~ 5%
2 Nominal growth rate in the Pharmaceutical Industry ~ 7%
3 USA Population growth = 1%
Best Rate: Nominal growth rate in the economy ~ 5%
2.6. Estimation of terminal values by using multiples and preparation of present value by using them
Estimating Terminal Value using:
P/E Ratio
P/BV Ratio
Constant Growth Rate
a PRICE TO EARNINGS RATIO
Arcadian’s View
P/E Ratio
15
20
Net Income 2014
$203 million
$203 million
Terminal Value
15 x $203 million = $3,045 million
$4,060 million
PV of Terminal Value
$3,045 million/(1+0.2)^10 = $492 million
$656 million
PV of 2005-2014 Cash Flow
$(151 million)
$(151 million)
Total PV
$492 million – $151 million= $341 million
$505 million
Sierra’s View
P/E Ratio
15
20
Net Income 2015
$162 million
$162 million
Terminal Value
15 x $162 million = $2,430 million
$3,240 million
PV of Terminal Value
$2,430 million/(1+0.2)^11 = $327 million
$436 million
PV of 2005-2015 Cash Flow
$(118 million)
$(118 million)
Total PV
$327 million – $118 million= $209 million
$318 million
b PRICE TO BOOK VALUE RATIO
c CONSTANT GROWTH RATE
2.7. Triangulation of value ranges and recommendation of a deal structure P/E Ratio
A P/E = 15
From Arcadian’s point of view:
From the previous calculation, we know that PV = $341 million With 60% ownership, $341 million × 60% = $205 million
From Sierra’s point of view:
From the previous calculation, we know that PV = $209 million With 60% ownership, $209 million × 60% = $125 million
So between both of the point of views, the differences are:
$205 million – $125 million = $80 million
B P/E = 20
From Arcadian’s point of view:
From the previous calculation, we know that PV = $505 million With 60% ownership, $505 million × 60% = $303 million
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From Sierra’s point of view:
From the previous calculation, we know that PV = $318 million With 60% ownership, $ 318 million × 60% = $191 million
So between both of the point of views, the differences are:
$303 million – $191 million = $ 112 million
Constant Growth Valuation
From Arcadian’s point of view:
From the previous calculation, we know that PV = $52 million With 60% ownership, $52 million × 60% = $31 million
From Sierra’s point of view:
From the previous calculation, we know that PV = $36 million With 60% ownership, $36 million × 60% = $22 million
So between both of the point of views, the differences are:
$31 million – $22 million = $9 million
Price to Book Ratio
From Arcadian’s point of view:
From the previous calculation, we know that PV = $773 million With 60% ownership, $773 million × 60% = $464 million
From Sierra’s point of view:
From the previous calculation, we know that PV = $110 million With 60% ownership, $110 million × 60% = $66 million
So between both of the point of views, the differences are:
$464 million – $66 million = $398 million
III. Conclusion and Recommendation
3.1 Conclusion
Rodney Chu should use the constant growth rate valuation to valuate the Arcadian because its value range ($9 million) is close to the Arcadian’s management approach. Also the economic growth rate of 5% should be used because the economic condition has the biggest influence over the industry. Furthermore, by using exit value of $31 million, it could influence Sierra to buy the equity of Arcadian for $22 million which is the present value of Arcadian in Sierra’s point of view.
3.2 Recommendation
There are some recommendations that we would like to give for Arcadian, such as: 1. In valuating Arcadian, it should use constant growth rate valuation. The close value range is $9 million. 2. Arcadian could use economic 5% nominal growth rate as Arcadian is one of the players in the industry. 3. Arcadian could use exit value $31 million as the present value of the firm is $31 million at 5% nominal growth rate. 4. Arcadian could influence Sierra to buy $22 million Arcadian’s equity.
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