MGMT 332 Corporate Finance I Module 5: Stock Valuation Problem Set 5 – Valuing an airline for acquisition Argo Airlines, a privately held firm, is looking to buy additional gates at its home airport for $635,000 Argo has $200,000 in the bank but that money may not be spent as it is used to pay salaries, suppliers, and equipment Argo asked its bank for a loan but the bank refused saying that Argo's interest-bearing debt to equity was too high at 3.1 The bank said that Argo needed to lower that ratio below 2.3 in order to get the loan Separately, SkyBlue Airlines has approached Argo to see if Argo will buy it. Argo’s CFO hired you to help with the following tasks: 1. Calculate Argo's cost of capital based on two airlines trading in the capital marketsEastern and Western Since Argo does not trade, it has no beta, so you need to use Eastern and Western as proxies. Hint - the textbook has the formula in two separate chapters. 2. Aside from the purchase price, the gates will require a working capital infusion at purchase of $200,000 Argo estimates the gates will generate cash flows of $355,000/ year for the next 7 years After that, the gates will revert back to the airport operator You must calculate the NPV and IRR of the gates. 3. You were given SkyBlue's 2019 income statement (IS) and balance sheet (BS), along with forecasts of the revenue growth and tax rates You must forecast the IS and BS for the next 3 years. 4. The price discussed by the two CEOs is 22x SkyBlue's 2019 net earnings You must calculate this price and compare it with the free cash flow value of SkyBlue, which you must also calculate The CFO wants to know if Argois overpaying or underpaying for SkyBlue. 5. Argo's forecast balance sheet has been included in the Excel file, so you need do nothing to it However, the CFO has asked you to consolidate the two balance sheets - the Argo one given to you and the SkyBlue one that you calculated. Once these two are consolidated, you are asked to calculate three debt ratios, as listed in the file. 6. Finally, the CFO wants to know if the consolidated balance sheet's Debt/Equity ratio is below 2.5 if so, it will allow Argo to buy the gates. Is Argo's ratio low enough that it can borrow to buy the gates? November 2020 | MGMT 332 | College of Business | worldwide.erau.edu All rights are reservedThe material contained herein is the copyright property of Embry-Riddle Aeronautical University, Daytona Beach, Florida, 32114No part of this material may be reproduced, stored in a retrieval system or transmitted in any form, electronic, mechanical, photocopying, recording or otherwise without the prior written consent of the University. 1 2 3 4 5 6 7 8 9 10 11 12 Component Net Income (M$) Earnings per share # of shares (M) Price per share Market Value - Equity (M) Market Value - Debt (M) Market Value - Total (M) - % Debt - % Equity Beta (levered) Beta (unlevered) Average Beta (unlevered) Caledonian 22.00 0.80 27.50 11.00 303 230 533 43% 57% 1.20 0.68 Values for combined Argo/SkyBlue airline: % Debt 33.0% % Equity 67.0% Beta (relevered) 0.96 Risk free rate 3.0% Market risk premium 5.5% Expected equity return 8.3% Expected cost of debt 5.0% Tax rate 21.0% WACC Laker 20.00 1.23 16.26 11.00 179 44 223 20% 80% 0.80 0.64 0.64 Source Given Given Net Income / Earnings per share Given # of shares x Price per share Given Market Value - Debt + Equity Market Value - Debt / Market Value - Total 1 - % Debt Given Beta (levered) x % Equity Average Given 1 - % Debt Average Beta (unlevered) / % Equity Assumption Historical figure CAPM calculation Given Statutory rate Weighed average of costs of equity and debt Start Year 1 Investment Working Capital Operating Cash Flow Total Cash Flow NPV IRR Note: Show all numbers in thousand dollars. Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Income Statement Key Assumptions: Average growth rate: Tax Rate Net Sales - Cost of Goods Sold (COGS) = Gross Profit - S,G & A Expenses Actual 2018 21% 4,432 2,773 1,659 1,300 Projected 2019 2020 2% 21% 4% 21% 2021 Notes 4% 21% Use current statutory rate of 21% Increase using the average growth rate Use same percent of Net Sales as in 2018 = EBIT - Interest 359 85 Calculation Use same percent of Net Sales as in 2018 Calculation (Use for Free Cash Flow valuation!) Hold level = EBT - Taxes 274 58 Calculation Use implicit rate of 2018 216 Calculation = Net Income Balance Sheet Cash Notes and Acc. Rec. Inventory Prepaid 230 1,126 965 75 Increase at average growth rate Current Assets Other Total Assets 2,396 1,000 3,396 Leave flat Bank Loan Payables CPLTD Other Current Liabilities LTD Equity Total Liabilities & Equity Working Capital 830 55 50 75 1,010 550 1,836 3,396 Plug to make balance sheet balance Increase at average growth rate Leave flat Leave flat LTD of previous year minus CPLTD of current year Equity of previous year plus net income of current year Exclude Bank Loan SkyBlue Acquisition - Earnings Multiple - 2018 actual net earnings Price Value based on free cash flows: Price Paid 2019 EBIT EBIAT - Change in Working Capital - Change in PP&E 2020 2021 TV Notes From Pro Formas - EBIT projection EBIT minus tax From Pro Formas (exclude Bank note plug!) From Pro Formas Free Cash Flow Calculation PV of Free Cash Flows - Existing Debt Calculation Bank Loan + CPLT + LTD = Present Value of SkyBlue (Underpay)/Overpay for SkyBlue Calculated value If negative, Argo Airlines paid less than SkyBlue is worth Balance Sheet Cash Notes and Acc. Rec. Inventory Prepaid Actual 2018 240 7,013 5,588 192 Current Assets Other Total Assets 13,033 3,325 16,358 15,460 3,830 19,290 18,385 4,393 22,778 22,090 5,105 27,195 6,070 3,057 433 1,477 7,586 3,705 450 1,712 9,321 4,417 450 1,994 11,404 5,320 450 2,350 Current Liabilities LTD 11,037 2,458 13,453 2,008 16,182 1,558 19,524 1,108 Equity Total Liabilities & Equity 2,863 16,358 3,829 19,290 5,038 22,778 6,563 27,195 Ratios: Bank Loan to Receivables Liabilities / Equity Debt / Equity 0.9 4.7 3.1 0.9 4.0 2.6 0.9 3.5 2.2 0.9 3.1 2.0 Bank Loan Payables CPLTD Other 2019 250 8,385 6,630 195 Projected 2020 250 9,998 7,905 232 2021 Notes 250 12,040 9,520 280 Balance Sheet Cash Notes and Acc. Rec. Inventory Prepaid Current Assets Other Total Assets Bank Loan Payables CPLTD Other Current Liabilities LTD Equity Total Liabilities & Equity Ratios: Bank Loan to Receivables Liabilities / Equity Debt / Equity Actual 2018 Projected 2019 2020 2021 No content - Intentionally left blank
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