Kulpa Fishing Supplies: A Company That Is Seeking To increase Its Value

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Question

Case: You have been hired as a consultant to Kulpa Fishing Supplies (KFS), a company that is seeking to increase its value. The company’s CEO and founder, Mia Kulpa, has asked you to estimate the value of two privately held companies the KFS is considering acquiring. But first, the senior management of KFS would like for you to explain how to value companies that don’t pay any dividends. You have structured your presentation around the following items.

a. List the two types of assets that companies own.

b. What are assets-in-place? How can their value be estimated?

c. What are non-operating assets? How can their value be estimated?

d. What is the total value of a corporation? Who has claims on this value?

e. The first acquisition target is a privately held company in a mature industry owned by two brothers, each with 5 million shares of stock. The company currently has free cash flow of $20 million. Its WACC is 11%, and the FCF is expected to grow at a constant rate of 5%. The company owns marketable securities of $100 million. It is financed with $200 million of debt, $50 million of preferred stock, and $210 million of book equity.
(1) What is its value of operations?
(2) What is its total corporate value?
(3) What is its intrinsic value of equity?
(4) What is its intrinsic stock price per share?
(5) What is its intrinsic MVA (MVA = total corporate value – total book value of capital supplied by investors)?

f. The second acquisition target is a privately held company in a growing industry. The target has recently borrowed $40 million to finance its expansion; it has no other debt or preferred stock. It pays no dividends and currently has no marketable securities. KSF expects the company to produce free cash flows of -$5 million in 1 year, $10 million in 2 years, and $20 million in 3 years. After 3 years, free cash flow will grow at a rate of 6%. The target’s WACC is 10% and it currently has 10 million shares of stock outstanding
(1) What is the company’s horizon value (i.e., its value of operations at Year 3)?
(2) What is its intrinsic value of equity on a price-per-share basis?

g. KFS is also interested in applying value-based management to its own divisions. Explain what value-based management is.

h. What are the four value drivers? How does each of them affect value?

i. What is expected return on invested capital (EROIC)? Why is the spread between EROIC and WACC so important?

j. KFS has two divisions. Both have current sales of $1,000, current expected growth of 5%, and a WACC of 10%. Division A has high profitability (OP = 6%) but high capital requirements (CR = 78%). Division B has low profitability (OP = 4%) but low capital requirements (CR = 27%). Given the current growth rate of 5%, determine the intrinsic MVA of each division. What is the intrinsic MVA of each division if growth is instead 6%?

k. What is the EROIC of each division for 5% growth and for 6% growth? How is this related to intrinsic MVA?

l. List six potential managerial behaviors that can harm a firm’s value.

m. The managers at KFS have heard that corporate governance can affect shareholder value. What is corporate governance? List five corporate governance provisions that are internal to a firm and are under its control.

n. What characteristics of the board of directors usually lead to effective corporate governance?

o. List three provisions in the corporate charter that affect takeovers.

p. Briefly describe the use of stock options in a compensation plan. What are some potential problems with stock options as a form of compensation?

q. What is block ownership? How does it affect corporate governance?

r. Briefly explain how regulatory agencies and legal systems affect corporate governance.

Solution Preview

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a. List the two types of assets that companies own.
Operating assets and non-operating assets.

b. What are assets-in-place? How can their value be estimated?
Assets-in-place are a form of operating asset (the other form being “growth options”). Assets in place include tangible assets (buildings, equipment, inventory, etc.) as well as intangible assets (e.g., patents and general knowledge). Operating assets provide a stream of (free) cash flows that can be discounted by the weighted average cost of capital (WACC) in order to obtain a market value (in contrast to their book value).

c. What are non-operating assets? How can their value be estimated?
Non-operating assets include marketable securities and non-controlling interests in the stocks of other companies. The value of non-operating assets is generally very close to the value listed on the balance sheet....

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