Mojo Inc, a US company engaged in the automotive industry, proposes to acquire Ottotek Corporation, an unlisted spare parts manufacturer. For this purpose the treasury team of Mojo Inc has been asked to estimate the enterprise value of Ottotek Corporation using the entity valuation method, based on its expected performance as a separate entity. However, the company’s Chairman is not entirely comfortable with discounted cash flow techniques and has asked that, in addition to a free cash flow valuation of the enterprise, the Treasury team should also estimate the equity value using the earnings valuation technique, and compare their results with the discounted cash flow estimate. For valuing Ottotek Corporation, the treasury team has been asked to use relevant data relating to five companies that are quoted on NYSE/NASDAQ, are engaged in the same line of activity as Ottotek, and have debt equity ratios that are not hugely different from Ottotek’s own gearing level. The five companies that have been identified for this purpose are BorgWarner Inc (BWA), Dana Inc (DAN), Lear Corporation (LEA), LKQ Corporation (LKQ), and Meritor Inc (MTOR).

It is now 30 September 2021. Key data from Ottotek Corporation’s income statements for the last three years are summarised below:

USD(millions)

Year ended 30th September	2019	2020	2021
Sales Revenue	28.43	27.24	32.55
Operating profit (after depreciation)	9.96	9.51	11.07
Net interest costs	2.70	2.75	2.90
Profit before Tax	7.26	6.76	8.17
Taxation	2.31	2.02	2.20
After Tax profit	4.95	4.74	5.97
Dividends	0.31	0.36	0.43
Retained earnings	4.64	4.38	5.54

In addition to the above, the following further information has been gathered by the treasury team for the purpose of estimating the free cash flows and appropriate weighted average cost of capital for Ottotek Corporation:

In each of the next three years Ottotek Corporation’s sales revenue is expected to increase at a rate equal to the compound annual growth rate experienced over the period shown above.

➢ The latest operating profit ratio will remain unchanged for the next three years.

➢ The annual capital investment required to maintain current operational levels is equivalent to the annual depreciation (accounting depreciation can be assumed to be equal to tax depreciation).

➢ However, additional working capital would need to be brought in at the start of every year for each of the next three years. The additional amount would be roughly 20% of the increase in sales revenue.

➢ After the next three years, the estimated free cash flowis expected to grow in perpetuity at about 2.5% per year in real terms - inflation rate is forecast at about 1.2% per year.

➢ Ottotek Corporation pays interest at an average rate of 8.34% on its borrowings, which are expected to remain at their current level of USD36 million.

➢ 91-day US Treasury Bills with a nominal value of $1000 are currently trading at a market price of $995.10; the yield on US Treasury Bills is calculated with a day count of 360 (instead of 365) for a year.

➢ The market risk premium is currently estimated at 5.4% per annum. ➢ The corporation tax rate in USA is 28%.

Ottotek Corporation and Mojo Inc have similar levels of gearing, and it is intended that current levels of gearing would continue unchanged after the takeover.

Mojo Inc’s latest balance sheet discloses the following information:

Summarised information from last Balance Sheet of Mojo Inc:

	USD millions
Current Assets	25.20
Non-current Assets	240.20
Total assets	265.40
Liabilities	147.30
Equity - Ordinary share Capital (par value 25 cents) -Retained Earnings/ Reserves	30.00 88.10
Total liabilities & equity	265.40

The liabilities of $147.30 million include debt in the form of 6.5% bonds maturing in 2026, with par value of $1000 per bond and a total par value of $134.00 million. Mojo Inc’s securities are currently trading at the following prices:

Bonds: $947

Ordinary shares: $2.25.

Required:

A. Perform an enterprise valuation of Ottotek Corporation using an appropriate discounted cash flow technique, and also perform an earnings valuation as requested by Mojo Inc’s Chairman; compare the equity value of Ottotek corporation on the basis of the two different techniques.

Answer rating: 100% (QA)

A Discounted cash flow valuation The free cash flow for Ottotek Corporation ... View the full answer