Valuation 1: Valuation of a potential acquisition target

You work for Delvco Inc, a firm that is primarily focused on providing safer and more efficient
methods of drug delivery in hospital settings. The company has an extensive portfolio of durable
drug delivery products, systems and related consumables and has established themselves as one of
the key players in the industry. Up to this point, all of the company’s growth has come from
products developed internally but they are now considering making an acquisition of Newco, a
young company that has a product that will fit well with the company’s existing products. They
have received a set of projections for the next five years from Newco’s management team. Newco
has experienced remarkable growth over the past three years, since the product was launched, but
they expect that they will reach peak market share by the end of the projection period. The
industry is currently growing at an annual rate of 3% per year.

Your boss has asked you to put together an estimate of the value of Newco in order for Delvco to
make an offer to start discussions with Newco’s board of directors. Delvco is a private company
and has not calculated their cost of capital, therefore, your boss suggests that you perform your
valuation using a cost of capital of 12%.

Exercise 1: Create a valuation matrix based on three costs of capital (with 12% as the middle of the
cost of capital range) and three growth rates. Value the firm on a “standalone” basis (without any
synergies from the Delvco acquisition). – What if analysis

Exercise 2: Estimate your firm’s cost of equity using CAPM and industry betas found at
http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/Betas.html. Use the 10 year
Treasury rate for the risk free rate (2.4%) and a market risk premium (5.3%). Revalue the
company using this cost of capital. – Genome Solution

Exercise 3: Your boss feels that Newco’s projections are overly optimistic in terms of sales growth
in years two and three of the projections. (The $50 million sales projected for next year is well
supported, so he is comfortable with it). He asks you to calculate a value for the company using
more modest assumptions for years 2 – 5. Offsetting this somewhat will be expected synergies that
can be realized once the companies are merged. Your boss thinks that Delvco will be able to
purchase the raw materials used in Newco’s product more efficiently. He also expects that sales
and market expenses will be considerably lower once Newco is being sold by Delvco’s sales force.
Estimate the value of Newco using cost of materials as 35% of sales and sales and marketing
expenses at 7% of sales. Assume that sales growth is 75% in year 2 and 35% in year 3. – Scenario
analysis

Exercise 4: You want to use all of the valuation tools you learned while you were at KGI so you
decide to also value the company based on a multiple of earnings. Using the PEs from two
comparable companies (Company A PE 12x and Company B PE 16x) value the company based on
Year 1 projected earnings. -- Genome
Projections for Newco:

($ 000s) 1 2 3 4 5
Sales Revenues 50,000 100,000 150,000 175,000 195,000
Cost of Materials 25,000 50,000 75,000 87,500 98,500
Depreciation Expense 1,250 1,250 1,250 1,550 1,550
Other Direct Costs 7,000 15,000 22,000 25,000 30,000
Sales and Marketing
7,500 9,000 12,500 22,750 25,000
Expenses
Other Overhead Expense 5,000 5,500 6,500 7,500 8,500
Working Capital Investment* 12,000 24,000 36,000 40,000 42,000
Capital Expenditures 500 500 2,000 250 250
* Assume that at the time of the acquisition, Newco has a working capital investment of $10 million.

For all three sets of projections, use a corporate tax rate of 24%.