About the case:
Rodney Chu, the managing director of Sierra Capital Partners is interested in purchasing 60% equity interest in Arcadian Microarray Technologies, a biotechnology firm founded in the year 2003. At present, Sierra Capital Partners have offered $40 million to Arcadian for selling their equity interest. This amount will be used for expansion of the firm. While Arcadian management have forecasted an optimistic projection for their firm’s performance over the period of 11 years, however, Sierra’s projections reveal a conservative outlook. Therefore, Mr. Chu is interested in ascertaining the terminal value and discounting the cash flows and the terminal value to the present. He also sought an assessment of forecast assumptions. In that regard, he requested help from Paige Simon, a new associate with Sierra Capital.
Objective
This paper is commissioned to ascertain the terminal value of the firm using multiple valuation methodologies and then selecting the one that has the least difference in valuation in comparison to that of Arcadian. Below we have highlighted some of the methods that will be used to ascertain the terminal value of the firm:
PE Ratio Valuation
PB Ratio Valuation
Liquidation Value
Constant-growth valuation model
However, to make things easier for the reader, we will describe the answers on the basis of tasks, i.e from Task 1-Task 8 ,as required in the case material
Weighted Average Cost of Capital(WACC)
Be it any valuation method, the Terminal value is highly sensitive to the weighted average cost of capital. For this paper, we have followed the figures provided in exhibit 6, where we found that the WACC rate of the company is 20%.
Following the details in the case study, we found that Chu believes that the stock price is not explained by the present value of future dividends. On the other hand, Simon believes that investors are largely concerned with the dividend payments.
However, in order to prove his point, Chu provides a sample of companies in Exhibit 3 indicating that on an average 93% of the market price is not attributable to dividends.
Exhibit 4 provides an opportunity for Simon to learn extensively about the applicability of available methods of terminal value estimators.Below we have highlighted the situations under which each approach will be relevant for the valuation purpose:
a) Liquidation Approach:
This approach is useful and appropriate only when the firm is considering to wind up and sell its assets in the near term. However, since in this case, there is no such scenario of near time liquidation, it will not be useful here.
b) Multiple Approach:
As part of this approach, the value of the firm is estimated by using multiplying the benchmark valuation multiple with the company’s financial multiple.
c) Replacement Value:
This method is used when the firm is considering to rebuilt the company from scratch or buy an existing company.
d) Book Value Approach:
As part of this method, book value of the available assets is used to access the minimum value of the company
e) Discounted Cash Flow Approach:
One of the most widely used valuation methods, DCF approach is used when cash flows of the company are strong. The method is dominating when the firm has negative earnings or when the majority of the asset base consists of intangibles
While accessing the forecast horizon of the three projects, it is important that the terminal value is calculated when the stable growth begins for each of the project.
Below we have calculated the forecast horizon for the three projects on the basis of above assumption:
a) Movie Studio: In year 27
255/270= 1/(1+growth rate)^3
= 1.924%
b) Bottling Plant: In year 13
200/280= 1/(1+growth rate)^17
= 1.960%
c) Toll Road: In year 3
169/288= 1/(1+growth rate)^27
= 1.993%
Exhibit 6 gives us the opportunity to understand the impact of growth rates on the capital expenditure, working capital and most importantly, the terminal value. As we may note from the given exhibit, under both of the given scenarios, be it Arcadian’s view and Sierra’s view, higher is the growth rate, higher is the terminal value and capital expenditure.
a) Real Growth Rates:
Real growth rate in the economy = 3%
Real growth rate in the Pharmaceutical Industry = 5%
USA Population growth = 1%
b) Nominal Rates:
Nominal growth rate in the economy= 5%(Assuming inflation of 2%)
Nominal growth rate in the Pharmaceutical Industry ~ 7%
USA Population growth = 1%
Rate to consider: Nominal growth rate in the economy= 5%(Assuming inflation of 2%)
In this section, we will ascertain the terminal value of the company using three methods, i.e. PE based valuation, P-BV based valuation and constant growth valuation
a) PE ratio based valuation:
Following the given information in the case details, we found that the expected PE of Arcadian is expected to be 15 to 20 times. Additionally, both Arcadian and Sierra’s management projections related to net income and terminal value are different. Therefore, considering these factors, we have ascertained the terminal value hereunder:
b) Price- Book Value Multiple
While the Price to Book Value multiple for Arcadian is expected to be 8.5, however, both Arcadian and Sierra’s management have different projections on book value of equity and terminal value. Therefore, based on given projections, we have ascertained the terminal value hereunder:
c) Constant Growth Model
Following the projections under 5% growth rate(nominal economic growth rate) and applying 60% equity ownership, the proportionate terminal value is calculated hereunder:
a)PE based valuation:
-PE= 15 times
Arcadian’s view: $204.6 million
Sierra’s view: $125.4 million
Difference: $79 million
-PE= 20 times
Arcadian’s view: $303 million
Sierra’s view: $198 million
Difference: $112.2 million
b) Price- Book Value Multiple
Arcadian view: 462.6 million
Sierra’s view: $66 million
Difference: $396.6 million
c) Constant Growth Model
Arcadian view: $31 million
Sierra’s view: $21 million
Difference: $9 million
Conclusion
Based on the above analysis, Chu should use the constant growth rate to value Arcadian as this model provides valuation close to Arcadian’s management. Moreover, reliance on the economic growth rate of 5% is also a legitimate assumption here and gives a strong support to the mode and the projected terminal value.
