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**Background and I ssues
**

Eskimo pie sells ice-cream and related food products

--earns revenues primarily through licensing, not a big manufacturer

--key assets are brand name recognition

--fragmented industry is consolidating, recent entry by large food cos.

Why was Reynold’s selling Eskimo?

Why did Eskimo management prefer the IPO to the Nestle offer?

What criteria should Reynold’s use in deciding between selling Eskimo to another

firm versus taking Eskimo public in an IPO?

Valuing Eskimo Pie

To value Eskimo we need the following:

(1) An estimate of r

WACC

(2) An estimate of expected cash flows in 1991

(3) An estimate of the growth rate of future cash flows

Step 1: Estimating WACC

(A) Estimate

unlevered

: Use equity betas of stock in table 8, unlever them using the

formula from chapter 12:

equity

= [1 + (1-T

C

)Debt/Equity]

unlevered

equity

unlevered

Ben & Jerry’s 1.2 1.18

Dreyer’s 1.4 1.33

Empire of Carolina .3 0.14

Steve’s Ice Cream 2.5 2.37

Hershey Foods 1.0 0.96

Tootsie Roll 1.0 1.00

Average

unlevered

= 1.162, use this as our estimate.

Estimating WACC (continued)

(B) Estimate

equity

at the target D/E ratio

What would Eskimo’s target capital structure be after IPO?

equity

=

unlevered

= 1.162

(C) Identify r

f

Use 10 year bond yield from exhibit 9: 7.42%

(D) Identify the market risk premium r

M

-r

f

Use 7.43% given in the problem.

(E) Use the CAPM to estimate r

equity

r

equity

= 7.42 + (1.162) x (7.43) = 16.05%

Under the unlevered target capital structure, r

WACC

= r

equity

= 16.05%

Step 2. Expected cash flows

Let’s estimate year-end 1991 after-tax cash flows since the Exhibit 6 forecasts

seem too low.

Net income $4,000,000

Plus current interest expense less taxes (.6 x 67,000) 40,200

Plus: depreciation $1,352,000

Less: interest income from $13 mil. Cash -$355,680

[$13 mil. paid out in the transaction

Lost interest: $13mil. x (1-.4) x 4.56%]

Less: capital expenditures -$1,000,000

change in working capital 0

Total Expected Cash Flow at end of 1991 $4,036,520

Working capital changes

Working capital excluding cash has decreased over the period 1987 to 1991, even

though sales have increased.

Eskimo Pie is a marketing and licensing firm, not a manufacturer.

Would be reasonable to exclude working capital changes from cash flow

estimation.

1987 1988 1989 1990

Working capital 9,342 11,107 10,830 11,735

Cash 5,550 8,109 10,723 13,191

Working capital less cash 3,792 2,998 107 -1,456

Step 2. Expected cash flows

Let’s estimate year-end 1991 after-tax cash flows since the Exhibit 6 forecasts

seem too low.

Net income $4,000,000

Plus current interest expense less taxes (.6 x 67,000) 40,200

Plus: depreciation $1,352,000

Less: interest income from $13 mil. Cash -$355,680

[$13 mil. paid out in the transaction

Lost interest: $13mil. x (1-.4) x 4.56%]

Less: capital expenditures -$1,000,000

change in working capital 0

Total Expected Cash Flow at end of 1991 $4,036,520

Step 3. Estimating a growth rate in future cash flows

Eskimo Pie grows substantially in 1991, which made IPO a potential alternative.

One approach: Estimate average annual growth in sales

1988 (36,695-30,769)/(30,769) = 19.25%

1989 (46,709-36,695)/(36,695) = 27.29%

1990 (47,198-46,709)/(46,709) = 1.05%

1991 (61,000-47,198)/(47,198) = 29.24%

Average sales growth 19.21%

Question: Is this a reasonable estimate of expected cash flow growth?

Has past 4-year period been special – will growth slow down?

Other approaches to estimate growth

1. Past growth in net income

2. Past growth in operating income

3. Past growth in cash flows

Problem: These numbers are more variable, particularly for years with income or

cash flows close to zero.

Bringing in more information

What are analysts saying about future industry prospects?

What does Goldman-Sachs’ project? (forward looking estimates)

Expected 1992 growth in sales 4.54%

Expected 1993 growth in sales 1.24%

Average 2.89%

Expected 1992 growth in net income 10.44%

Expected 1993 growth in net income 6.23%

Average 8.34%

Net income more closely tracks changes in cash flow

Since growth is slowing down, lets use 6.23% for a constant growth rate.

4. Putting it all together

V = [Expected 1991 cash flow x (1+growth rate)] / [r – growth rate]

V = [($4,036,520) x (1 + .0623)] / [.1605 - .0623]

V (or E) = 43,665,939

Should Reynold’s sell to Nestle or do the IPO?

Nestle offer - $61 million cash

IPO proceeds – Cash from stock sale $43,665,939

Special dividend payment of $15,000,000

Total $58,665,939

Looks like Nestle offer is slightly better.

Some Issues:

Results very sensitive to assumptions about growth rates - If more optimistic

since Goldman Sachs’ projection does not reflect the recent development.

– Use 8.34% (the average growth rate) Total proceeds would be $71,720,697.

Other methods of valuing stocks? How about other firms in the same industry?

Comparable public firm multiples

There would be some multiples that could be used to check our estimates.

The value of Eskimo Pie would range from about $84 to $98 million (excluding

the excess cash) – our estimate seems to be undervalued.

Additional issues: Need to convince that IPO is feasible.

Equity-to-net income Total value-to-sales

Average of other firms 22.8 1.6

Estimate for Eskimo Pie 3.7 61

Implied value 84.4 97.6

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