Prof. Thomas J. Chemmanur s1

Prof. Thomas J. Chemmanur

MF807: Corporate Finance

Practice Problem Set – VII

1. You are a venture capitalist considering a $2 million investment in Floating Line Electronics Apparatus, Inc. (FLEA) which is expected to require no additional capital through year 4. FLEA is expected to earn $1.5 million after taxes in year 4. You expect to get your investment plus return at that time by selling your stock. In your opinion, FLEA should at that time be comparable to companies priced at 13 price–earnings multiple. FLEA has $1 million debt outstanding and plans to pay no dividends in year 1 through 4. There are already 500,000 shares outstanding which are owned by the entrepreneur and other investors. You require a 40% rate of return from this type of investment.

(a) What equity participation (percent ownership) would you demand?

(b) How many new shares need to be issued?

(d) What is the implicit “after-the-money” (i.e. after-your-money) valuation of the enterprise equity? (same as “post-money valuation”)

2. You have invested $1 million for 25% equity stake in a new venture. Current sales are $8.1 million and earnings before depreciation, interest and taxes (EBDIT) are 10% of sales. You expect to recover your investment plus return in four years via the sale of the company at an expected exit EBDIT multiple of 8x. No further equity issues are contemplated but the company will have $6 million of debt at exit time. Fees and expenses will amount to 4% of the sale price of market capital. What growth rate of sales is needed in order to provide you with a 40% return? What return will you attain if sales grow at half the required rate and the exit EBDIT multiple is only 6x

3. You are considering whether to invest $10 million in the 5-year subordinated notes of an HLT (a Highly Leveraged Transaction). The annual coupon of these notes is 8% and its principal is due at the end of the fifth year. In order to obtain an acceptable return you demand an equity participation (kicker). Such a participation will be puttable (sold back) to the company on the fifth year or thereafter as follows: You will receive for your equity an amount equal to your percent ownership applied to the difference between 6 times EBITDA on the put year and $4 million. That is, you will receive your percent ownership x (6xEBITDA - $4 million). (EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization). The company current EBITDA is $5 million and is expected to grow at 10% per year during the following five years.

(a) What equity participation (percent ownership) will you demand if you require a 25% expected return from the joint proceeds of the subordinated note and the put exercise?

(b) Under what conditions will your return exceed (be less than) 25%?

4. Power Track is a privately owned manufacturer of aerobic and body building machines. Conrad Owens, its owner, has retained you to value a purchase offer for the equity of Power Track he has just received from R-II, Inc. The offer has three components has follows: (i) A cash payment of $3 million due at the acquisition date, (ii) an 8% annual coupon four-year subordinated note issued by R-II, for $5 million with principal payable in four equal annual installments, and (iii) a contingent payment to take effect at the end of the fourth year equal to three times EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). R-II will assume Power Track’s liabilities of $6.2 million. Under the terms proposed by R-II, Power Track will become a wholly owned subsidiary of R-II and Mr. Owens will stay as its manager with a four- year contract and competitive compensation. At the end of the fourth year, Owens will receive the contingent payment and will retire. The management contract is not to be included in your valuation of R-II’s offer.

You have available the following additional information:

- R-II’s outstanding subordinated notes are priced to yield 12%.

- Mr. Owens is confident that, under his management, Power Track’s EBITDA can grow at 20% per year during the following four years from its current level of $4 million.

- Investors in small companies with characteristics similar to Power Track demand a return of about 18% on their equity.

You are not expected to analyze the tax consequences of Mr. Owens’ sale.

Please, answer the following questions:

(a) What is the value of R-II’s offer for Mr. Owens’ equity?

(b) How much is R-II paying for the market capital (debt plus equity) of Power Track?

(c) What is the initial EBITDA multiple offered by R-II for the market capital of Power Track? What is the significance of this multiple?

5. As the investment banker of TUV-TUV Systems, you are working on TUV-TUV’s purchase of Balkan Audio from his sole owner Mr. Yenidge Sobranie. After several meetings with Mr. Sobranie you have put together the following preliminary purchase package: Mr. Sobranie would receive from TUV-TUV the following:

(1) A cash payment of $8 million at closing.

(2) A ten-year $400,000 annuity.

(3) A lump-sum payment at the end of the third year equal to a multiple of the third year EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization). This multiple is still subject to negotiation.

(4) Balkan Audio would become a subsidiary of TUV-TUV with Mr. Sobranie staying as its president with a competitive salary for three years, at the end of which he would retire.

In addition, you have the following information:

(a) TUV-TUV would assume Balkan’s debt of $15 million.

(b) TUV-TUV has expressed willingness to pay for Balkan’s equity (items (1) to (3) of the purchase package) nine times current EBITDA of $4 million minus assumed debt.

(d) The cost of equity of companies similar to Balkan is about 18%.

(e) Balkan’s EBITDA is expected to increase at 20% per year during the following three years.

At this point you are giving the final touches to the earn-out agreement (item (3) of the purchase package). How high a multiple of third-year EBITDA would be acceptable to TUV-TUV?