Weekly Challenge 9

You are valuing a private company for sale and have made the following estimates of cashflows and expected growth rates:

q Run by the existing management (which is not entirely efficient), your annual cash flows would be $ 10 million next year and grow 4% a year thereafter. If the management were replaced, you expect cashflows next year to be $ 12 million a year, still growing at 4% a year.

q The market unlevered beta for the firm is 0.8, based upon comparable firms that are publicly traded. However, the average correlation of these firms with the market is 0.40. The firm has no debt; you have estimated an optimal debt ratio of 20% at which point the pre-tax cost of debt would be 6%. (Both private firms and public corporations get taxed at a 40% tax rate)

q The riskfree rate is 5% and the market risk premium is 4%.

1. Estimate the value of the firm if you are selling 40% of the firm to another private individual (who will not be diversified).

2. Estimate the value of the firm if you are selling 51% of the firm to the same private individual. How would your answer be different if you were selling to a publicly traded company?

3. Estimate the value per share of the firm in an initial public offering under the following scenarios:

a. The firm will be issuing 10 million shares with equal voting rights and offering 80% of these shares to the public. The probability of control changing in the firm is 70%.

b. The firm will be issuing 8 million shares with no voting rights to the public and incumbent managers will be retaining the remaining 2 million shares with voting rights. The probability of control changing in the firm is 0%.

c. The firm will be issuing 5 million non-voting shares and 3 million voting shares to the public and management will be retaining 2 million voting shares. The probability of control changing in the firm is 25%.