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Interco Case Solution

Solution Id Length Case Author Case Publisher
797 1280 Words (13 Pages) Susan L. Roth Harvard Business School : 291033
This solution includes: A Word File A Word File and An Excel File An Excel File

The relevant stock price table lists out the calculated prices given a range of exit multiples and discount rates or WACC. Three cash flow exit multiples are used in the table (14x, 15x and 16x). At the same time, the discount rate which in essence is the implied WACC of Interco ranges from 10% to 14%. As a result of these assumptions, twelve different prices are obtained. The starting point of the calculations incorporates the formulation of free cash flows for the next ten years. Free cash flow can be computed by inputting the following formula:

Free Cash Flow = EBIT(1-t) + Depreciation - ∆Net Working Capital - Capital Expenditures

Following questions are answered in this case study solution

  1. I would like you to re-­‐construct the stock price table obtained by the investment bankers in the lower right corner of exhibit 12 under various assumptions on discount rate and terminal multiple.

  2. Now suppose cash flows occur continuously during the year. We can model this by assuming that cash flows occur not at the end of the year but in the middle of the year. How will your share price estimates change under the alternate assumption?

  3. Continuing value can also be obtained from assuming that FCF will grow at a constant rate from 1999 onwards. Assume that the firm’s cash flows will grow at a rate g. For the given discount rates in exhibit 12, what growth rates (1999 onwards) are implied by the various terminal multiples?

  4. Assume that the beta of existing equity is 1.2. From exhibit 14, notice that the 10-­‐year risk free rate is 9.01% and the yield on 10-­‐yr AAA corporate debt is 9.5%. Use 5% as the market premium [E(Rm) – Rf]. Use stock price before the offer to obtain market value of equity, 318.5 million as the market value of debt and 41% as the tax rate to calculate the WACC for the existing firm. Now use Miles-­‐Ezzel formula used in class to back out the unlevered cost of capital for Interco. Remember all your inputs should be changeable.

  5. Examine the appropriateness of the assumptions underlying 12. The second panel in the provided spreadsheet might be useful here. It is a comparison of the assumptions in Exhibit 12 with historical operating results. These results are described in Exhibits 6-­‐8.


Case Analysis for Interco

The EBIT is calculated by applying the following accounting equation:

EBIT = Sales * operating margin + Other Income + Corporate Expense

In the current case, the sales are projected to grow at a consistent annual rate of 7.2% for the span of next ten years. One of the most critical assumptions or information alters the nature of FCF calculations to a large extent. The capital investment or the capital expenditure is projected or assumed to be equal to the depreciation. A close look at the formula reveals that the prescribed nature of the relationship cancels out the two terms (+ depreciation and - capital expenditure). Hence, the FCF formula essentially reduces to the following format.

Free Cash Flow = EBIT(1-t) - ∆Net Working Capital

The terminal cash flow is calculated by equaling it to the relevant cash flow exit multiple.

The following tables detail the calculations for the stock prices that incorporate the 14x, 15x and 16x exit multiples. Note that the stock prices are recomputed for every discount rate. The calculated stock price is shown in the yellow background. In total, the calculations behind the twelve listed stock prices are summarized in the preceding tables.

The following table represents the stock price values gathered from the adjoining tables. Note that the stock prices are reflected till two decimal points. In the original table, the stock prices were quoted in with the two decimals as zeroes. Hence, the differences may arise due to the rounding off of numbers.

Now suppose cash flows occur continuously during the year. We can model this by assuming that cash flows occur not at the end of the year but in the middle of the year. How will your share price estimates change under the alternate assumption?

Practically, the cash flow does not simply pop out at the end of the fiscal year. The year-end value represents the cash flows that are attained throughout the year. Hence, using the year-end discounting is not a suitable task. Ideally, the cash flows should be discounted by the mid-year connotation because this step smooth out the time differences rooted from the monthly cash flows. Hence, for year 1, the discounting factor of 0.5 should be applied as it rightfully represents the mid-year discounting. Similarly, for year 2, the relevant value of 1.5 should be applied and so forth. However, the instance of exit multiple does not follow the same rule. The exit multiple occurs at the end of the 10th year. Therefore; it should be discounted separately from the 10th-year cash flow. The terminal value should be discounted with a factor of 10 while the 10th-year cash flow should incorporate 9.5 as the relevant factor. In this scenario, the present value of the individual cash flow increases as now the discounted factories closer to the starting point of the timeline. Hence, as a result of an increase in the present value of cash flows, the stock price increases. The following four tables show the calculations of stock price under the assumption of mid-year discounting. Note that the proposition of increase in the stock price is confirmed by the calculations.

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