In the summer of 2010, Smidgeon Industries was evaluating whether or not to pruc
ID: 2669641 • Letter: I
Question
In the summer of 2010, Smidgeon Industries was evaluating whether or not to pruchase one of its suppliers. The supplier, Carswell manufacturing, provides Smidgeon with the raw steel Smidgeon uses to fabricate utility trailers. one of the first things that Smidgeon's management did was to forecast the cash flows of Carswell for the next f ive years:year Cash Flows
1 $1,200,000
2 1,260,000
3 1,323,000
4 1,389,150
5 1,458,608
Next, Smidgeon management team looked at a group of similar firms and estimated Carswell's cost of capital to be 15%. Finally, they estimated that Carswell would be worth six times its year 5 cash flows in five years.
a. What is your estimate of the enterprise value of Carswell?
b. What is the value of the equity of Carswell if the acquisition goes through and borrows $2.4 million and finances the remainder using equity?
Explanation / Answer
Gordon Growth Model for finding EV
We have Disc rate as 15% =Kd
PV of CFs = CF0+Cf1/(1+Kd)^1+Cf2/(1+Kd)^2 +Cf3/(1+Kd)^3 +Cf4/(1+Kd)^4 +Cf5/(1+Kd)^5
ie PV of CFs = 0+$1,200,000/(1+15%)^1+$1,260,000/(1+15%)^2+$1,323,000/(1+15%)^3+ $1,389,150/(1+15%)^4 + $1,458,608/(1+15%)^5
ie PV of CFs = $4,385,550
There are several ways to estimate a terminal value of cash flows, but one well-worn method is to value the company as a perpetuity using the Gordon Growth Model. The model uses this formula:
Terminal Value = Final Projected Year Cash Flow X (1+Long-Term Cash Flow Growth Rate)/(Discount Rate – Long-Term Cash Flow Growth Rate)
ie TV = (6*1458608)*(1+0%)/(15%-0%) = $58,344,320
PV of TV = $58,344,320/(1+15%)^5 = $29,007,439
Sp Total Enterprise Value EV = PV of CFs + PV of TV = $4,385,550+$29,007,439
ie EV = $33,392,989 ........... What is your estimate of the enterprise value of Carswell?
Fair Value of Equity = Enterprise Value – Debt = $33,392,989 - $2,400,000
ie FV of Equity = $30,992,989 or Approx $31M................What is the value of the equity of Carswell if the acquisition goes through and borrows $2.4 million and finances the remainder using equity?
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