Name: ______

Final Exam – Spring 2003 MBAC 6060 Corporate Finance

Complete the following valuation exercise using the valuation methodology of your choice. Be prepared to defend your chosen approach. The necessary information is contained in the description. You may do calculations on an excel spreadsheet; however, please transfer the resulting information onto the pages provided.

Case Problem:

Flight Stuff is a family owned company based in Tucson, Arizona that manufactures aviation instrumentation. Its 2,000,000 shares of stock are distributed across the extended family of its founder, Wild Bill Case. Wild Bill’s son Justin took over control of Flight Stuff after Bill’s failure to return from a trip to St. Barts. Unfortunately, a large block of company stock is owned by Justin’s uncle, Ernie. Ernie, currently a director of Flight Stuff, has disrupted the last 3 meetings of the company’s Board of Directors by showing up dressed only in a grass skirt (not a pretty sight) and insisting that everyone sing “Last Mango in Paris.” You have been hired to establish a fair price at which a team led by Justin and his brother Henry Edward David (known as Hed) can buy out Uncle Ernie’s shares.

The firm’s current book-value balance sheet is simplified as follows:

Flight Stuff Balance Sheet December 31, 2002

Assets Liabilities and Owner’s Equity Cash $ 50,000 Accounts Payable $300,000 Accounts Receivable $200,000 Bank Loan $150,000 Inventory $300,000 Current Portion of Long Term Debt $0 Total Current Assets $550,000 Total Current Liabilities $450,000 Gross Fixed Assets $1,950,000 Long Term Debt $750,000 Accum Depr. $500,000 Owner’s Equity $800,000 Net Fixed Assets $1,450,000 Total Assets $2,000,000 Total Liabilities + Equity $2,000,000

1 The firm’s most recent income statement for 2002 is (in simplified form) as follows:

Flight Stuff Income Statement Year Ending December 31, 2002

Sales $9,500,000 Cost of Goods Sold 6,840,000 Gross Margin $2,660,000 Operating Expenses 825,000 Depreciation 75,000 EBIT $1,760,000 Interest 58,500 EBT $ 1,701,500 Tax (0.25) 425,375 EAT $ 1,276,125

Comparable Firm Data: (Three publicly traded firms have been identified.)

Firm: Equity Beta Market value debt to value ratio

1. 0.975 0.10

2. 1.189 0.30

3. 1.725 0.55 (You may assume the comparable firm’s debt is risk free.)

All firms face a 25% corporate tax rate.

Management Forecasts:

Flight Stuff’s management forecasts its sales growth to be 8% for the next three years. After which they expect sales to grow at the overall rate of growth in GDP, or about 2% per year into perpetuity.

Flight Stuff’s cost of goods sold runs a reliable 72% of sales. Operating expenses have a fixed component of $350,000, plus a variable component of 5% of sales.

Net fixed assets are expected to grow at 3% per year for the next three years from the 2002 level.

For each of the next three years depreciation expense is expected to be $75,000.

2 Net working capital, current assets less current liabilities, is expected to grow at the same rate as sales for the next three years.

After 2005, free cash flows can be assumed to grow at 2% in perpetuity, relative to the 2005 level.

The firm has a target debt to value ratio of 6% and can borrow (for both the long term debt and the bank debt) at 1.5% above the risk free rate.

Capital Market Conditions:

The current risk free rate is 5% and the market risk premium is estimated at 7.5%.

Questions:

(1) What is the discount rate you will use to value Flight stuff? Be sure to illustrate the steps involved in its calculation.

(2) What are the free cash flows for the years 2003 – 2006?

(3) What is the total market value of Flight Stuff?

(4) What is its total equity value?

(5) What is its value per share of equity?

(6) What does the firm need to do to achieve its target capital structure?

(7) Explain your choice of valuation method relative to others discussed in class.

3 4 5 6