METHODOLOGY AND ASSUMPTIONS

a) Values are showed in USDthousand.

B) Acquisition will have effect from 2002. Hence, the second semester of 2001 will be
projected, and considered as year0. The correspondent cashflows will not be used as part of
the projected value of the company.
C) When management projections are not used, the expected Financial Statements of 2001
were obtained projecting historical performance, considering growth rate and ratios showed
on the first semester June 30, 2001, as shown on Exhibit4.
D) Inflation effects have been ignored.
E) Non-recurring expenses and extraordinary items have been not considered because of their
small significance on the overall financial performance.
F) The corporate tax rate is 39.3%. This is the effective tax rate paid by the company regarding
historic data (Exhibit4) and also the effective corporate tax rate in the US for the 2001. 1
g) Interest rate is the weighted average of the Debt Cost provided by Goldman Sachs, 9.3% as
shown on Appendix1. This projection considers the debt tranches as a whole and do not
differentiate the payments or use given to each one of the credit facilities. On reality, the
weighted average will change depending on the amount of Revolver used and tranches paid
on each year with the available cashflow 2, changing the Cost of Debt and the interest
payments. However, due to lack of information on amortization schedules of the credit
facilities and additional covenants, we assume it as a fixed Cost of Debt.
h) In unlevering the equity beta (Appendix2), the following formula was used:

BL
B u=

[ 1+ ( 1−T C ) × ( DE )]
i) The discount rate applicable to the equity cashflows was obtained using CAPM formula: RE =
RF + BE (RM-RF). (Appendix3)
j) In estimating risk-free rate, the yield on 10-year US-Treasury bond of 5.2% was used.
k) The market premium is 7%.
l) To calculate the value of the equity of the acquired firm at the end of the planned holding
period, the following formula was used:
Equity ValueYear N =Enterprise ValueYear N −Outstanding Debt Year N + CashYear N

m) The investment should be done applying cash-sweep, expecting to exit the investment in 5
years. At the end of the period we have assumed that all the cash has been used to pay the
outstanding debt.
n) Enterprise Value on Year 0 has been calculated using a Comparable Multiple.(Appendix4)
The Enterprise Value of the comparable companies has been obtained adding the Market
Capitalization and Interest-Bearing Debt. The Value of the company would also include cash
and equivalents; however, it has been assumed that there is no available cash to be
considered due lack of information. Terminal value and Exit Value has been calculated using

1
OECD Tax Database
2
This assumption is challenged in answer to Q5.

1
 an Exit Multiple. The Exit Multiple has been calculated using the highest multiple of the
Comparable Companies analysis and a sensitive analysis has been run to test it.
o) Assets are depreciated in 10 years.
p) Due to the expected increase on efficiency, Working Capital is fixed on a ratio of 17% of total
sales. One percentage less than the ratio assumed for 2001, 18% that is the same on 2000.
q) Financial transaction costs are included on the debt cost.

I. HOW DOES BERKSHIRE PARTNERS CREATE VALUE?

As a private equity firm Berkshire acts as a source of capital for firms over multiple economic
cycles, triggering growth and capital expansion to achieve the full potential of the business.
Its investors and the firms where it invests are benefited by the knowledge acquired through
its investment experience that includes 70 acquisitions in different industries with focus on
toughen grow and effective equity-incented management teams. 3

This is a strong combination for value creation because it allows the company to focus on
value on long-term and not on investments that might produce growth on the short term
but compromise value creation on the long run. 4

The investment includes some control over the firm that enhance management decisions.
Through this influence, Berkshire provides assistance on strategic planning and follows it
along its execution. Berkshire management support usually included: a) helping to prioritize
key objectives, b) reviewing organizational design, c) strengthen the bench training key
managers and d) leading the integration process in the event of a subsequent acquisition. 5

One important step into this value creation process is due diligence before the bid. The
accounting, financial and legal due diligence done by Berkshire is also used as a foundation
to operate during the life of the investment. It provides Berkshire with enough information
to take founded decisions and lead managers in solving key issues or benefit from existing
capabilities.

Berkshire acknowledges that can magnify returns using high debt levels, when financing is
available and firms are strong enough. High leverage act as an incentive for management to
maximize efficiency on operations avoiding using FCF for investment projects that enhance
growth at expense of value.6

The specific experience of Berkshire team members assigned to each project can also
enhance value creation because provides a permanent support for management decisions.
In Carter’s specific case, the broad experience on similar operating process that the assigned

3
Baker,"Berkshire Partners: Bidding for Carter's." p.4
4
Koller,(2005). Valuation P. 10
5
Baker p.4
6
Idem. P.490

2
 team had7 will assist Carter’s management to effectively follow the strategy. This support
can be also valued on the process of IPO of the company.

II. DOES CARTER’S FIT WITH THE BERKSHIRE INVESTMENT PHILOSOPHY? WHY IS INVESTCORP SELLING?

Berkshire invests in various industries including manufacturing and retailing, being Carter’s
within their scope of investment.

Carter’s had developed a strong brand name during its 136-year history and management
strategy has reinforce it with a high quality product concentered on satisfying customers
creating customer loyalty, what matched Berkshire investment philosophy. These strengths
made it easier to leverage the company, giving Berkshire the opportunity to increase their
returns.

Carter’s historic performance showed the talented management that Carter’s had, their
achievements and their potential. It showed Berkshire that they were committed with value
creation, both important factors for Berkshire.

Carter’s had learnt from past mistakes and developed a strong basic classic product line that
made the business resistant to economic recessions. This allowed the company to create
efficiencies on production and working capital requirements, since 2/3 of the apparel was
carried forward from season to season with the same fabric and construction, being
unaffected by fashion trends.

Berkshire tended to bet when there was a high winning opportunity. The fact that the group
of financial buyers was small, the consideration given to Berkshire even if the initial bet
wasn’t the highest and the opportunity to meet with the management twice, showed that
the opportunities in the bid were very high. Berkshire was also rated by the high intangible
factors, meaning the experience on the sector both of the company and the team, which
Carter’s was aware, could benefit from. The fact that Carter’s CEO and management team
were former managers of VF Corporation were Rowan was group vice-president, showing
that the relationship with Carter’s management team promised to run smoothly and in the
same line cannot be omitted.

As investor, after a period of growth on the company invested, Investcorp needed to sell the
company and cash its money out to have liquidity for future projects and mainly to show
results to its investors. This enhanced the ability to raise further funds. However, the IPO
would have taken one year or two and Investcorp was not willing to wait that time for
liquidity. Berkshire would consider the fact that Investcorp was a motivated seller willing to
cash the investment quickly in a profitable way.

The long-term strategy as a private equity firm to realize value for its investors mattered too
for Berkshire. It had to be considered that the research done to Carter’s revealed that the
company was ready to be taken public giving the opportunity to cash part of the investment
sooner. Even if their philosophy was not to cash their investment through IPOs, Berkshire

7
Bloom and Jones have experience on retailing and manufacturing companies and Rowan has been involved in
the textile and apparel industries for 38 years, holding senior executive positions for almost 30 years. Idem
Exhibit2

3
 could use the IPO option either as an exit option or as a source for future needs for capital to
help the company to grow if initiated it in the middle of its ownership. This is why the IPO
has not been analyzed in this valuation.

III. HOW MUCH FIRM FREE CASH FLOW WILL CARTER’S GENERATE IN THE NEXT FIVE YEARS (2002-2006) BASED
ON MANAGEMENT ESTIMATES?

The total FFCF generated by Carter’s in the 2002-2006 period based on management
estimates is USD 265,450.75.(Appendix5)

 Value has not been discounted.

 Depreciation is not connected with CAPEX it just shows the difference between EBIT
and EBITDA management projections.
 The change in Working Capital is based on assumption n).

IV. HOW REALISTIC ARE THE MANAGEMENT FORECASTS IN LIGHT OF CARTER’S HISTORICAL PERFORMANCE?

Carter’s has created value by partially implementing mechanics for offshore sourcing and
triggering growth by developing alternative distribution channels on department stores and
outlets. This has represented a CAGR of 10,32% on total sales on the 1996-2000 periods,
1997 being the higher year with a 14.05% growth and 1999 the lowest with just 1.57%. Next
to this performance management projections appear overly optimistic, with a CAGR of 15%
for the 2001-2005 period and 13% for the 2001-2006 period, including a bump from a 1996-
2000 CAGR of 7.89% for Wholesale Sales to 19.3% 2001-2005. Additionally, comparing 1996-
2000 and 2001-2006, EBITDA and EBIT margins over total sales are assumed to improve very
highly from an average of 10.34% to 15.75% the first, and from an average of 6.69% to
12.55% the later.(Appendix6)

However, the strategic plan had not been completed and the management was right to
believe that there was more efficiency and growth to be achieved. Carter’s had recently
launched a new brand that could back the management assumptions on growth rate on
wholesale sales, if the deal with the emerging retailer Target were materialized.
Nonetheless, these expectations highly depend on the success of Target. Growth
opportunities were well targeted by the management whose strategy already included
“Capitalize on leading market position” and “Diversify distribution channels” even continue
to extend Carter’s to playwear market.

Strategy was also focused on increasing operating efficiencies. Management has found a low
cost structure additionally, two of its domestic sewing plants were taken abroad achieving
cost improvements. However, Carter’s still had 6 local sewing plants and a main textile mill.
If the management could achieve its target date of 2003 for 100% outsourcing, there could
be even more significant cost improvements than the historic.

It is important to highlight that after the meetings, Berkshire not only acknowledge the
experience of the management but also showed confidence on their growth plan. The
growth strategy was discussed twice with the management and the team highly considered
its work and supporting the reliability of their forecasts.

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 It has to be acknowledged that historical looking approaches may not reflect the prevailing
market conditions or the improvements that the company could be able to achieve based on
past performance. Carter’s historical performance has to be analyzed not only numerically
but understanding what are the opportunities, strengths and capabilities built through time
on the company. As we can see, if management follows their sustained growth strategy
there is a great opportunity that the forecasts are achieved.

V. WHAT SHOULD THE BERKSHIRE TEAM BID FOR CARTER’S?

To present and adequate bid for Carter’s, the value of the company has been projected in
different scenarios for an assumed planned period of 5years assuming the use of the
complete credit facility offered by GS (the assumptions have been tested by a sensitivity
analysis):

i. Three hybrid APV analyses have been done. One with the management
projections(Appendix7), one with our own projections(Appendix8) and a last under
stress assumptions(Appendix9).
ii. Three FFCF models have been projected to find the Equity IRR. One with
management projections(Appendix10), one with our own projections(Appendix11)
and a last with historical projections(Appendix12).

For our own projections a conservative but realistic approach has been taken:.

 A growth rate of 13% for is expected. It reflects the expected growth due to
potential introduction into new sales channels including outlets, introduction of new
product lines, and optimization of the supply chain. The rate also considers the
growth rate of comparable companies.
 CoGS is fixed on a ratio of 60% of total sales. Represents 3.3% less than the historical
average and reflects the improvements on operational process.
 CG&A are fixed on a ratio of 28%, 2% less than the historical average reflecting
efficiencies on management.
 With the acquisition capital efficiency is expected, thus, even if there is a significate
increase on sales, CapEx is fixed on 21,500 (slightly higher than on 2001).

In the APV approach the value, the present values obtained are:

  Enterprise Value Equity Value

Management Hybrid Model 1,126,500.41 766,500.41

Own Hybrid Model APV 764,643.43 404,643.43
Stress Case Hybrid APV
Model 253,659.46 56,798.708

As we can see, the PV of the investment could be really high, the stress case scenario
assumes a growth rate of 4% (same as the GDPs), that is very unlikely as explained in Q3 and
4. Berkshire can be sure that the investment will have a high return.

On the other hand, the results of a LBO FFCF with cash sweep are the following:

8
Leverage ratio of 78% has been maintained since the value of the company is lower than the offered credit
facility.

5
   Purchase Price Exit Price
  2001 2006 Equity
IRR
  Firm Value Equity Value Firm Value Equity Value
Management FFCF 556,328.98 196,328.98 1,527,120.00 1,352,116.79 47.10%
FFCF Projections 460,620.84 100,620.84 1,413,184.21 1,169,811.47 63.34%
Historic Projections 506,034.23 146,034.23 1,226,810.89 928,954.39 44.78%
           

Mean 147,661.35 Mean 1,150,294.22

Median 146,034.23 Median 1,169,811.47
High 196,328.98 High 1,352,116.79
Low 100,620.84 Low 928,954.39

Since the minimum bid must be placed over USD130,000.00 we recommend choosing the
best bid value between the median, USD146,034.23 and the minimum. This value derives
from the Firm Value assuming that EBITDA 2001 will reflect the same growth rate than in its
first semester and the mean multiple on comparable companies is used. The value is very
sensitive to the multiple as shown on Appendix12. However, we recommend to use this
value, since it is more cautious to take the value of EBITDA following the same trend that on
the first semester than follow management projections.

To determine an adequate bid offer we must consider the leverage, the equity portion that
will be assigned to management and the transaction costs of the acquisition:

Berkshire
######### Equity Debt Management Berkshire
Eq.
# Value Value E Portion 5% Equity Value
Portion
71.14% 146,034.23 360,000.00 25,301.71 23.86% 120,732.52
Leverage

69.14% 156,154.92 349,879.32 25,301.71 25.86% 130,853.20

68.14% 161,215.26 344,818.97 25,301.71 26.86% 135,913.55
67.14% 166,275.60 339,758.63 25,301.71 27.86% 140,973.89
66.14% 171,335.94 334,698.29 25,301.71 28.86% 146,034.23

The value of the Bid should be USD 135,913.55.

 A 68.14% leverage is reasonable with the historic leverage supported by the

company.(Appendix6)
 The 26.86% Equity portion is slightly over the 25% that Berkshire thought was the
minimum to show the sellers its commitment to the investment.
 A 5% Management Equity Portion will follow Berkshire investment philosophy.
 With the value offered to Investcorp, they could be able to cash out the investment
with an IRR of 41.35%.(Appendix13)
 This bid uses the complete amount of credit facilities proposed by GS, even if the
Revolver is projected to be USD 175,000.00 at close. In case GS does not approve the
leverage proposition, there could be the opportunity to present it to Bank of
America and CSFB Senior, whose offer are still pending. Berkshire could have obtain
credit facilities of USD 273,242.43 to USD 341,553.0375 (4x–5x Carter’sEBTIDA). If
not, the following scenario will apply:

Equity Debt Management E Berkshire Berkshire

Leverage
Value Value Portion 10% E Portion Equity Value

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 62.64% 189,034.23 317,000.00 50,603.42 27.36% 138,430.81

If we assume transaction costs to be 1%. The total Equity invested, and the Equity IRR will
be:

Berkshire Equity Transaction IRR with IRR No

Exit Scenario
Value Costs Costs Costs
138,430.81 5,060.34
Low Exit 45.29% 46.34%
Median Exit 56.62% 57.75%
High Exit 52.15% 53.24%

135,913.55 5,060.34
Low Exit 45.80% 46.87%
Median Exit 57.17% 58.33%
High Exit 52.68% 53.81%