a. The second acquisition target is a privately held company in a growing industry. The target has recently borrowed $40 million to finance its expansion; it has no other debt or preferred stock. It pays no dividends and currently has no marketable securities. KSF expects the company to produce free cash flows of -$5 million in 1 year, $10 million in 2 years, and $20 million in 3 years. After 3 years, free cash flow will grow at a rate of 6%. The target's WACC is 10% and it currently has 10 million shares of stock outstanding.
(1) What is the company's horizon value (i.e., its value of operations at Year 3)? What is its current value of operations (i.e., at Time 0)?
(2) What is its intrinsic value of equity on a price-per-share basis?
b. KFS is also interested in applying value-based management to its own divisions. Explain what value-based management is.
c. What are the four value drivers? How does each of them affect value?
d. What is expected return on invested capital (EROIC)? Why is the spread between EROIC and WACC so important?
e. KFS has two divisions. Both have current sales of $1,000, current expected growth of 5%, and a WACC of 10%. Division A has high profitability (OP = 6%) but high capital requirements (CR = 78%). Division B has low profitability (OP = 4%) but low capital requirements (CR = 27%). Given the current growth rate of 5%, determine the intrinsic MVA of each division. What is the intrinsic MVA of each division if growth is instead 6%?
f. What is the EROIC of each division for 5% growth and for 6% growth? How is this related to intrinsic MVA?