Valuation Case Study: The Dukes Sporting Goods Store

OBJECTIVE

The goal of this analysis is to determine a financial valuation of the fair market value of 100% of The Dukes Sporting Goods Store (Dukes), by using two of the three approaches to valuation (income and market approaches, but not the cost approach). The valuation date is December 31 of the current year.

The following Excel file containing two spreadsheets: Dukes Discounted Cash Flow Analysis and Market Approach.

Here:Brown2e_Ch10_Duke's Sporting Goods data.xlsx Download Brown2e_Ch10_Duke's Sporting Goods data.xlsx

Data have been entered in these spreadsheets that will allow you to calculate valuations for Dukes under the income and market approaches.

FACTS

The companys assets are cash ($100,000), inventory (worth $400,000 based on cost), and accounts receivable ($25,000).

Inventory can be sold back to manufacturers for 50% of its cost.

Accounts receivable can be sold to a collections agency for 40% of its current level.

The companys liabilities are accounts payable of $75,000 and accrued expenses of $75,000.

The Discounted Cash Flow Analysis spreadsheet shows the most recent three years income

statements in simplified form.

Assume the company pays a corporate tax rate of 40%.

For the current year, depreciation and amortization is $25,000. The company is using straight-line

depreciation. Thus, D&A is expected to be $25,000 going forward.

The physical depreciation and/or amortization of fixed assets is allowed to be booked as an expense,

thus lowering the taxable income. Yet, it is not an actual decrease in dollars so it is not a decrease in cash flow. That is why it is added back in to Net Income on the way to calculating Net Cash Flow. Net Cash Flow is actual physical dollars coming out of the business during the time period.

There is no interest expense.

For the current year, capital expenditures (CAPEX) is $50,000. CAPEX refers to the current

expenditure of money by the company to purchase equipment and other assets that will help the company earn more money in the future. It directly affects net cash flow because it is spent in the current year instead of being passed through to the owners (as NCF).

ASSUMPTIONS

Assume the discount rate is 16% (based on comparables collected from Ibbotsons database and other adjustments for risk).

Assume that the perpetual growth rate of net cash flow is 3.5% for the terminal year and beyond (the terminal year is the fourth year out from the current year, and it represents every year thereafter, adjusted for the perpetual growth rate).

Assume CAPEX is constant over the relevant time periods because the company is consistently and constantly investing in its future.

Assume D&A will continue to be $25,000 per year, given that the equipment and capital expenditures are being used to obtain fixed assets that are depreciable.

INCOME APPROACH

1. Forecast. Use the Discounted Cash Flow Analysis spreadsheet provided by your instructor and forecast revenues and expenses for Current Year + 1 (CY+1), CY+2, CY+3, and Terminal Year. For this case study, use only the previous years revenues and expenses as a guide. (Normally, you would also use other information about the economy, the industry, the company, and so forth). Come up with your own reasonable forecast.

Net income. Calculate the net income for CY+1, CY+2, CY+3, and terminal year.

Net cash flow. Calculate the net cash flow for CY+1, CY+2, CY+3, and terminal year.

Calculate NCF from net income.

Start with net income and add back depreciation and amortization to find gross cash flow.

Subtract CAPEX from gross cash flow.

Subtract any increase (or add any decrease) in net working capital. To calculate changes in NWC, subtract current liabilities

from current assets (not including inventory, since, even though inventory is technically a current asset, a manager would not

want to rely on inventory to pay workers). Make a reasonable assumption for changes in NWC for future years.

The result is net cash flow.

Net present value. Calculate the NPV of Dukes.

Determine the discount period for each year (CY and going forward).

Determine the discount factor for each year, including the terminal year.

Enter the discount rate and perpetual growth rate in the spreadsheet.

Calculate the terminal value.

Calculate the present value of the NCF for each year, including the terminal year.

Add up each years present value to find the net present value of the entire business, based on cash flow.

MARKET APPROACH

After an exhaustive search, three businesses that appear to be comparable to Dukes are found. The Market Approach spreadsheet gives basic financial information about the businesses and recent transactions involving them and provides space for the calculations. The comparable businesses are the following:

Charlies Sporting Goods. Charlies is located in a neighboring town and has a similar clientele to Dukes. It has been in operation for seven years and over the past three years has generated steady revenues and net income. The current majority owner, Bill, purchased Charlies from the founder two years ago for $1.5 million. He sold a small piece of it recently for $60,000.

Marys Sporting Goods. Marys is located a few towns away and has existed for over a decade. It specializes in womens and girls sporting goods and draws from a larger market area than Dukes. Marys offers free training on its equipment, which adds to its expenses, but Sally (the current owner) feels that this policy grows its customer base and leads to more sales. Sally, who is quite risk averse (like Mary), purchased the business outright in the current year.

Jamies Sporting Goods. Jamies is a three-store chain located on the north and south sides of the nearest large city. It has been operating for over two decades. It recently added its third store and financed this expansion with a loan from a local bank. It is paying substantial interest on that loan. While it produces a high net income, it is also more leveraged than Marys or Charlies. Jamie, the current majority owner, sold 8% of the business for $500,000 in the current year.

Ratio calculations. Calculate the relevant ratios for the comparables.

Valuation of subject company based on comparables. Use the market approach to determine a financial value for Dukes.

Adjustments. Adjust the financial value of Dukes for a controlling interest premium and marketability discount, if needed.

LIQUIDATION VALUE

What is the liquidation value (as opposed to the fair market value) of Dukes? Look at the present value of all assets that could be liquidated and account for all debts (at their present value). Determine the sum of those values. In other words, if the company were to be liquidated, how much cash would be left over?

DATA NEEDED:

The Duke's Sporting Goods Store Valuation Analysis as of December 31 of the Current Year Discounted Cash Flow Analysis $'s In Thousands Projected (a) FYE FYE FYE Fiscal Year Ending FYE FYE FYE Terminal CY-3 CY-2 CY-1 Current Year CY+1 CY+2 CY+3 Year Revenue $1,000 $1,200 $1,400 $1,500 Cost of Goods Sold 500 600 700 750 Gross Profit 500 600 700 750 SG&A 300 350 400 425 R&D 25 30 35 40 EBITDA 175 220 265 285 Depreciation & Amortization 25 25 25 25 EBIT 150 195 240 260 Interest Expense 0 0 0 0 EBT 150 195 240 260 Effective Tax Rate 40.0% 40.0% 40.0% 40.0% Income Tax Expense 60 78 96 104 Net Income $90 $117 $144 $156 Net Cash Flow Discount Period in Years (a) Discount Factor (b) Discount Rate (c) Perpetual Growth Rate (d) Terminal Value (e) Present Value - Cash Flow/Terminal Value Net Present Value Notes: (a) Reflects end-of-year discounting convention. (b) Based upon the Weighted Average Cost of Capital as reported in Ibbotson's Cost of Capital Yearbook (data through June 2006) for SIC 3949 adjusted for other risks. (c) Based upon estimated long term cash flow growth rate of the economy in general (as assumed in the Case Study). (d) Terminal Value = (Terminal Year Cash Flow / (Discount Rate - Perpetual Growth Rate)) (e) Present value to end of current year. Sources: Fiscal Year Ending (FYE) CY from audited financial statements and business forecasts. Forecast the Income Statement here to get to Net Income for CY+1, CY+2, CY+3, and Terminal Year. (Move this text box out of the way). Calculate the Net Cash Flow from Net Income. Follow the steps on the Case Study and in the Valuation chapter. (Move this text box out of the way). Calculate Net Present Value. Follow the steps on the Case Study and in the Valuation chapter. (Move this text box out of the way).

The Duke's Sporting Goods Store Valuation Analysis as of December 31 of the Current Year Market Approach $'s In Thousands Comparable Businesses Charlie's Sporting Goods Mary's Sporting Goods Jamie's Sporting Goods Duke's Sporting Goods Total Revenues (CY) $1,000 $2,000 $5,000 Total Expenses (CY) 900 1,850 4,200 Net Income 100 150 800 Current Assets (minus inventory) 100 250 500 Current Liabilities 100 150 2,000 Inventory 300 550 1,500 Current Ratio Quick Ratio Net Profit Margin P/R Ratio P/E Ratio Previous Transaction (1) % of business transacted 5% 100% 8% Transaction Price $60 $3,000 $500 Date of Transaction CY CY CY (2) % of business transacted 100% NA NA Transaction Price $1,500 NA NA Date of Transaction CY-2 NA NA