Case

Stay-Fit Company Limited

Stay-Fit Company Ltd ( hereinafter called SFC) is a listed company belonging to mid and low
cap category engaged in manufacturing, distributing and selling high end gym equipments. The
company’s paid up share capital consists of 5 crore shares of Rs.10 each (face value) currently
trading at Rs.25 per share. Presently SFC is a zero debt company with a free reserve of Rs.50
crore. The cost of equity is 16% based on CAPM model. The promoter and couple of large
shareholders are not happy with the company’s current valuation of Rs.25 per share. In other
words they think that - despite regular profit, reserve debt capacity and future growth potential
the shares of the company are grossly undervalued. The management should go for expansion /
acquisition that might have a value enhancing effect. According to them BV (book value) per
share is Rs.20 whereas price is Rs.25 only with such strong financials and growth prospects –
something not acceptable at all.

The company (SFC) can issue secured non-convertible debenture (NCD) of Rs 20 crore to
finance partly or fully, some new project/ acquisition. To create higher value SFC is in talks to
acquire an unlisted company called Youth Energy Company Limited (YEC) having an all India
distribution net work for selling track suit, sneaker and sports shoe. The investment banker (IB)
convinces the management of SFC that the company can go for debt financing (NCD route)
partly, without incurring default risk to acquire and own 100% shares of YEC. The advantages
are two fold –1) cost of debt is lower than cost of equity, and 2) there will be tax benefit on
account of interest payment on debt. In computing tax benefit 30% corporate tax rate is to be
considered. The IB is certain that as SFC has substantial free reserve and good future prospect of
growth it will be able to get AAA rating from credit rating agency for NCD issue. In such event
the interest cost would be 9 % maximum. MM approach adjusted for tax would be the best to
estimate cost of capital for valuation purpose. But the IB opines that complication of MM
approach is not needed at this stage. Simple weighted average cost of capital (WACC) is suffice
to measure approximate risk adjusted opportunity cost of capital. Further, though cost of equity
of YEC will not be different from that of SFC as per the IB, the management of SFC feels that
cost of equity should be 2% more than that of SFC because of ‘illiquidity’ of YEC stock (being
unlisted), as such, the said 2% should be considered as illiquidity premium over and above the
existing cost of equity of SFC. IB further points out that the cost of capital does not depend
upon past investment but on current value and future expectation of the market. Based upon the
input of the IB, the management of SFC contemplates to utilize debt (through use of NCD) of
Rs. 20 crore to finance the deal , the remaining amount will come from current free reserve (of
SFC), substantial portion of which is held in cash and readily en-cashable security.
Any forecasting starts with sales forecast. In the recent year just concluded (year 0) total sales of
YEC was 40 crore. In the past, sales of YEC has increased @ 7% YOY basis but because of the
fact gym equipment can be displayed and sold using distribution network of YEC, YEC products
sale will increase too. The management feels that YOY increase in sales will be 10% for next 3
years after which sales growth will be at 6% for the 4 th and the 5th year . 6th year and beyond it is
difficult to make any guess of sales with reasonable accuracy. But the management estimates that
the FCFF & FCFE will grow steadily at an average of 4% from 6 th year till infinity. In the past,
cost of sales ( other than depreciation) was 74%. In future there will be increase in cost but due
to cost rationalization there will be ultimately net 1% impact on cost. Thus, cost of sales (other
than depreciation) would be 75% of the sales. It is presumed that the ending net fixed asset and
working capital would be 80% and 15% of the sales respectively. Net fixed and working capital
grow in proportion to sales. It is further assumed - depreciation is in proportion to opening net
fixed asset and stands at 10%.

The equity share capital of YEC is Rs.10 crore consisting of 1 crore share of face value of Rs10
each and free reserve of Rs.10 crore. The company has no long term interest bearing debt.

Based on the above information, calculate -

1) FCFF 1st to 5th year and for the 6th year.

2) Value of YEC based on FCFF valuation model
3) FCFE considering that Rs.20 crore of debt financing will be kept as a part of strategic
financial policy to keep control over YEC for now.
4) Value of YEC based on FCFE model.
5) Value per share of YEC under both models.
6) Despite profit why the value of equity shares of YEC appears to be low when we
mechanically compute the value per share under FCFF model ?
7) If the shareholders of YEC are willing to accept the share price based on FCFF
valuation, then after the formal announcement of the acquisition, if the general
consensus of the market participants (investors and equity analysts) is that the valuation
is ‘fair’ what would be the estimated value per share of SFC ?

The YEC management, being anxious of addressing the heritance issue , is willing to sell the
company but they are not satisfied with the FCFF and FCFE valuation figures. According to
them the figures do not reflect the true worth of the company. They hire a consultant who advises
that apart from DCF technique ( FCFF and FCFE are basically DCF technique of valuation),
there are two other methods of valuation – namely – a) Break up value method, and ) Relative
valuation model ( also called market multiples model). As ‘going concern’ concept - relative
valuation model is more appropriate. The consultant locates a company- namely, Go-fit
Corporation, engaged in medical equipment, health products and distribution of sports shoes of a
foreign brand. This is a consistent dividend paying mid cap company the shares of which are
traded regularly in stock exchange. Though not identical but this is the best the consultant can
find as a comparable company for relative valuation. Go-Fit’s shares are traded at – 3X BV , 8 X
EBIDTA, 12X EBIT and 18 X EPS. Total debt of Go-fit is Rs.200 crore and has outstanding 25
crore equity shares of Rs 10 each ( face value). The consultant further points out that as the
YEC’s shares are not listed, considering the illiquidity coupled with small size - it will be
reasonable to allow a discount of 25% in each case after using multiples for pragmatic valuation
exercise.

8) Find array of values of YEC by using market multiples as valuation tools.

[The case has been developed independently by Professor Santanu K Ganguli for class
room discussion purpose only. It is a copy righted document. – (c) Santanu K Ganguli.
Making copy or transmission or use of the case in any form without author’s written
permission is strictly prohibited]