Active Gear Inc. (AGI) is contemplating an acquisition of Mercury Athletic Footwear (MAF). To assess the situation properly, a discounted cash flow analysis is being carried out.

by afortmuller (student)

University Degree Business and Administrative studies

In the case discussed, Active Gear Inc. (AGI) is contemplating an acquisition of Mercury Athletic Footwear (MAF). To assess the situation properly, a discounted cash flow analysis is being carried out. This analysis allows for the evaluation of cash in-and-outflows to assess Mercury´s current financial performance by discounting them back to present value, and adding a “Terminal Value”. In order to discount these cash flows with the appropriate discount rate, the weighted average cost of capital (WACC) will primarily be calculated.

The WACC-rate is the average cost of financing the company, taking into account both equity and debt. Therefore, it can be viewed as the hurdle rate for any investment. The following equation was used:

rWACC=WE*KE+WD*KD=79%*11.84%+21%*6%=10.17%

The weight of debt and equity was found analysing MAF´s balance sheet (2006) yielding in 79% cost of equity (KE), and 21% cost of debt (KD). Liedtke´s assumption of KD of 6% was adopted. This implies that the only other necessary calculation is for KE, where the Capital Asset Pricing Model was used:

Er=rf+βrm-rf= 4.82%+1.126.31%=11.84%

The US treasury obligating with a maturity of 10 years, yielding 4.82% is suitable for the risk free rate (rf). The risk premium was found by calculating the geometric mean of the annual S&P 500 returns (for the past 10 years), and subtracting the rf form this. Moreover, a tax rate of 38% was used throughout this analysis, as this would depict a true and fair view of the company, as it is today, not after the takeover. 38% was calculated by dividing the annual tax charges by earnings before interest and tax (EBIT), yielding 37.99% every year. The beta (β) was found through the implied beta approach. The unlevered industry average was found then re-levered according to MAF´s capital structure, yielding 1.12.

Falling back on the assumptions of Exhibit 6 and 7, MAF´s Free Cash Flow (FCF) for the next 5 years is as follows:

The FCF were found by firstly subtracting the tax charges from EBIT (giving the Net Operating Profit After Tax- or NOPAT). The capital expenses and changes in working capital (CWC) were then subtracted, after adding the depreciation and amortization. Working capital are the excess current assets compared to current liabilities, therefore, the changes are the differences between two reporting periods. The next step is to discount these free cash flows back to present value ...

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Falling back on the assumptions of Exhibit 6 and 7, MAF´s Free Cash Flow (FCF) for the next 5 years is as follows:

This terminal value is comparable to a perpetuity symbolizing all the anticipated future cash flows, as it is impractical to forecast cash flows for an infinite number of years:

TV=FCFN+1(rWACC-gFCF)=30,836.44(10.17%-3%)=$ 430,075.87

The estimated present value is therefore 430,075.87(1+10.17%)4=$ 291,938.71. Consequently, the sum of the PV of the cash flows and the PV of the terminal value is the present value of the firm, $ 399,400.66. Subtracting the (minimum) current enterprise value of $ 157,287 (= the average P/E multiple of Templeton Athletic and Kinsley Coulter Products x Mercury´s net income) gives a Net Present Value of $ 242,112.8 for the investment. Implying that the investment should be taken on.

The anticipated synergies should also be taken into account, although they have not been quantified in this analysis. The acquisition would reduce inventory by 14.7% due to the lowered DSI value of 42.5, simultaneously also decreasing costs of holding inventory. Moreover, in this analysis, the women´s casual line was not discontinued resulting in a consolidated revenue growth averaging at 6.825%. This was found through carrying out a scenario analysis, optimistically (3% revenue growth, expenses increased in relation to the other segments) and pessimistically (no revenue growth, expenses grew at inflation rate). Comparing this value to the prospects of discontinuing the line (5.35%) implies that the line should not be discontinued. Moreover, there will be savings related to factories in China (2006: average $1,100 annual pay for Chinese factory worker, 60 hour week). More savings can be realized through decreasing their autonomy (compared to pre-acquisition levels under WCF), like laying off all employees in the book-keeping department (as AGI will prepare mutual statements post-takeover). As AGI´s size increases they can also benefit from the consolidation among Chinese contracts and will have more bargaining power. Furthermore, synergies can also arise through the reduced EBIT margin of 9%.

Possible disadvantages to the acquisition include a higher rWACC for AGI, seeing that their combined D/E ratio is 113.7% (assuming a 50% debt, 50% equity financing for Mercury) resulting in a rWACC of 7.88% (assuming the same KE). However, AGI´s debt financing pre-acquisition of 90% could result in problems in the future and is not reflected in its KD. Taking this post-acquisition rWACC, gives a NPV of the investment of $ 541,436.3; and with AGI´s pre-merger WACC (4.5%), the NPV is $ 5,133,683.9.

A Monte Carlo simulation was carried out to provide more information to the decision maker as to what Mercury generates as value. The inputs include revenues, operational expenses and the equity risk premium. It was assumed that the revenues remain within +/- 20% of the estimate, with a uniform distribution. For the operational expenses, a direct average of 87.6% of revenues was assumed between the years 2007-2011, with a standard deviation of 3%. The risk premium assumed a value of 6.31%, with a standard deviation of 1%. Therefore, with 95% confidence, Monte Carlo estimates a value between $ 92,583,490.2 and $ 395,303,930.5, averaging as $ 243,943.71.

Only companies with a revenues under 1 billion were taken into account, Marina Wilderness was also disclosed seeing that they had negative D/E.